Offshore Planning’s Impact on Calculation of U.S. Income Tax LiabilityPosted March 1st, 2012
Why is this Topic Important to Wealth Managers? Discusses how international planning can impact clients’ tax position domestically. Provides discussion on a number of common international tax concepts as they relate to U.S. taxpayers.
In a previous blog, it has been briefly discussed that there may be a number of reasons a client may consider offshore planning, generally. Today we will focus on one major component of offshore considerations, the impact of world-wide income on U.S. taxpayers. It is generally accepted that U.S. taxpayers are expected to pay income taxes on income earned from sources worldwide. This concept is commonly referred to as “outbound” taxation. 
It is the case that many sovereign nations will also have taxes on personal and/or corporate income that an individual or corporation could become subject to, creating in effect “double taxation.” And some foreign nations choose to have very low or no tax rate on certain types of income, or on corporations in general, thus allowing foreign income to potentially escape foreign taxation (and current U.S. taxation in the year that it is earned).
What are some rules that that Congress has attempted to avoid double taxation or subject foreign income to U.S. taxation?
Foreign Tax Credit
Under the foreign tax credit, the “United States allows its taxpayers to reduce their U.S. tax liability by some or all of the foreign income taxes paid on income earned outside the United States.”  The credit, created by Congress, reduces U.S. income by “foreign income taxes paid or accrued.” “The credit is a dollar-for-dollar reduction of U.S. income tax liability.” 
Controlled Foreign Corporations
As a general rule, “the income of a foreign corporation is included on the U.S. shareholder’s U.S. income tax return only when dividend income is received.”  Yet for certain situations when U.S. taxpayers have a shareholding in a foreign corporation, Congress has established special rules that “deem” a dividend to have been paid by the foreign corporation, regardless of whether it is actually paid or not. These special rules are known as “anti-deferral” rules – rules that mitigate the tax advantages of taxpayers deferring U.S. tax until foreign income has been received.
In general the rules that most impact U.S. taxpayers with a shareholding in a foreign company are known as “controlled foreign corporation” rules (aka CFC rules). A CFC exist when “any foreign corporation in which more than 50 percent of the total combined voting power of all classes of stock entitled to vote or the total value of the stock of the corporation is owned by U.S. shareholders on any day during the taxable year of the foreign corporation.” 
Not all income earned by a CFC will be deemed as a dividend to its U.S. taxpayers. Congress does not want to stop U.S. taxpayers from investing or doing business overseas. However, Congress is concerned that it is common that U.S. taxpayers will “shift the income-generating activity to a foreign entity where the income earned will not be subject to U.S. tax until repatriated.”  Congress considers that such business activities or investment activities could have or should have occurred in the United States, or at least should have been taxed in the United States regardless of where they occurred.
Thus, Congress has established complex rules to determine which types of income it will allow to be earned overseas without the U.S. taxpayers incurring current U.S. taxation on a deemed dividend, and correspondingly which types of income for which Congress will disallow deferral. Income that Congress disallows deferral for is known as ‘tainted’ income. It is this “tainted” income that is included in the gross income of its U.S. shareholders without regard to its actual distribution.
Income that is subject to current taxation from a CFC, “can be characterized as income that is easily shifted or has little or no economic connection with the CFC’s country of incorporation”  and may include, “foreign personal holding company income, foreign based company sales [and service] income, …as well as certain insurance income, …and certain other narrowly defined categories of income [including passive income, ‘such as interest dividends rents and royalties’].”  Well, that’s a mouthful of legal terms that we will need to discuss in future blogticles.
 26 U.S.C § 61; See also, Taxation of Business Entities. James E. Smith, William H. Raabe, David M. Maloney. Chapter 13. 2007 Annual Edition, citing 26 U.S.C § 61, “Gross income for a U.S. person includes ‘all income from whatever source derived’. ”Source“ in this context means not only type of income (e.g., wages or interest) but geographic source as well (e.g., the United States or Belgium). Westlaw.
 Corporations, Partnerships, Estates & Trusts. Chapter 9. , 2007 Annual Edition. Westlaw.
 Taxation of Business Entities. Ch 13
 Taxation of Business Entities.
 3 Legal Compliance Checkups § 20:35 (2009). Westlaw.
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