AROUND THE WORLD WITH SEYMOUR MANSFIELD
Legal News with an International Perspective
Death and Taxes Around the World
Seymour J. Mansfield, Attorney at Law
"Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes." - Benjamin Franklin, Letter to Jean-Baptiste Leroy (1789).The quintessential American tax deadline of April 15 may have come and gone for 2008, but with the certainty that Benjamin Franklin recognized, April 2009 will bring with it the deadline to file your taxes for 2008. Today, in Thomas Friedman's Flat Earth, or IBM's Small Planet, an increasing number of individual Americans will have earned income from sources outside the United States, which most of us would think of as "foreign income." There are a few things, however, to keep in mind, when making money around the world.[1]
At the onset, we remind you that what follows is not tax advice. The Tax Code is extremely complex and rules applying to foreign income are among the most difficult. William Gale, the Director of the think tank Economic Studies, testified before Congress that "the concepts of international taxation are sometimes murky and the practice of international taxation can be complex and situation-specific." The applicable tax provisions runs over 200 pages, single spaced, not counting IRS regulations and advisory letters. While we hope to plant the seeds that will allow you to identify the broad issues, you should always consult your professional tax advisor as to your specific circumstances.[2]
General Considerations
There is nonetheless one simple overarching concept to remember: U.S. citizens and residents are taxed on their worldwide income. Whether you derive income from wages abroad, interest, dividends or gains in capital from assets overseas, or any other form of income received from foreign sources, that income is taxable and must be reported to the IRS.
Unfortunately, this apparently straightforward concept can be counterintuitive, if not confounding. If you purchase a share of a closely-held British corporation in Britain, in Pounds Sterling, and receive a dividend paid into a British bank account in your name, in a branch in the UK, also in Pounds Sterling, it may seem illogical to report it to the United States IRS. Yet, the Tax Code makes it clear that, after applicable deductions, income from sources without the U.S. "shall be treated in full as taxable income" to the same extent as domestic income. When the income is received in a foreign currency, as in the above example, it should be reported in dollars using the average exchange rate for the fiscal year.[3]
Special Rules
OK, so why does the Tax Code take up 200 pages of rules about foreign income? Jerrybuilt over many decades, with new and revised provisions piled one on top of another, and written by our U.S. Congress, it is hardly a work of concision, great consistency, intuitive or consistent content. In many circumstances, special rules, exclusions and deductions apply.
Even defining what constitutes foreign income is not always self-evident. Compensation for personal services performed overseas is foreign income - even if paid by an American company. Interest or dividends derived from sources abroad are foreign income. Income such as rents or royalties derived from property located abroad is foreign income. Gains from the sale of property abroad are governed by the place of sale. For instance, inventory purchased in the U.S. and sold overseas will be considered foreign income.[4]
The exceptions or exclusions differ depending on whether the taxpayer physically resided in the U.S. or abroad for the relevant tax year. To take advantage of the more generous exclusions available to U.S. citizens residing abroad, the taxpayer must be a legal resident of the foreign country during the tax year, or have been physically present in that country for 330 full days. The first test effectively protects the ability to leave the country for brief vacation periods, while maintaining a bona fide physical residence there.
Taking advantages of the exclusion or credits available does not (officially) increase the chances of audits. If an audit does occur, the service will allow at least 90 days to present supporting documents, the increased period of time reflecting the probable need for documentation maintained in foreign countries. Failure to comply with a formal document request, however, will operate as a waiver of any right to introduce foreign documents later on.
When Residing in the United States
As a general rule, but subject to various specific exceptions, U.S. citizens with foreign income, but still residing in the U.S., may claim the Foreign Tax Credit. Under that provision, the taxpayer can get a dollar for dollar tax credit in the U.S. for taxes paid to foreign countries. The foreign tax must have accrued and have been paid to the tax authorities of another country before they may be deducted from taxes due to the U.S. Government. The foreign tax can alternatively be claimed as a deduction instead, but the dollar-to-dollar (subject to limits described below) credit is usually more beneficial.
In lieu of the above credit, a U.S. Citizen residing abroad can choose the foreign income exclusion described below, which is usually more beneficial, unless the income is much larger than the exclusion's cap.
There are a wide variety of rules specific to certain incomes or certain countries, which once again highlights the need to consult with your tax advisor for each specific situation. For example, there are distinctive tax provisions applying to income derived from the extraction of minerals, the sale of oil or gas, profits derived from speculation, and to taxes paid to a country subsidizing exports, or to taxes paid to countries with which the U.S. has severed diplomatic relations.
Another wrinkle on the Foreign Tax Credit is that it is limited to the same proportion of total taxes as the foreign income bears to the taxpayer's total income. For example, if the taxpayer derives one third of his income from foreign sources, he or she can only claim a tax credit equal to one third of his or her total taxes, or less. What this amounts to, in practical terms, is that the taxpayer will not benefit from high tax rates abroad in any given year, but excess tax credit can be carried over to succeeding tax years.
When Residing Overseas
U.S. Citizens who work and live overseas may qualify for the Foreign Income Exclusion. As explained above, this is only available if you lived in-country at least 330 days in the tax year.[5] However, when electing to take the Foreign Income Exclusion, the taxpayer may choose any consecutive 12-month period and exclude the applicable amount in each such 12-month fiscal year ("FY") so covered. This maintains the exclusion for citizens assigned for a 12-month (or longer) period overseas that does fall within a calendar year.
Under the Foreign Income Exclusion, you are eligible to exclude foreign wages from U.S. Taxes, up to a cap of $87,600 for 2007. This number is adjusted each year for inflation. If your income is significantly greater than this amount, the Foreign Tax Credit could exceed the amount saved under the Exclusion.
If you are eligible to and elect to exclude the totality of your income, you must still file your taxes in the U.S., declaring the foreign income earned and claiming the exemption. It does not matter how many years you spend overseas or that you are eligible to exclude the totality of your income while stationed abroad. A U.S. tax return must be filed each year, claiming no taxable income or whatever net taxable income you generate.
Additionally, intrepid travelers spending a year or more overseas for the good of the country's economy may deduct their housing costs. This includes not only rent (or fair rental value) but also repairs, basic utilities, insurance and even furniture rental and parking fees. It does not include, however, mortgage for a taxpayer electing to buy property abroad, or extravagant expenses. The Housing Exclusion and Income Exclusion are claimed separately and an eligible taxpayer may elect either, both or neither in any given year.
Corporate Foreign Income Is Worldwide
The U.S. follows a doctrine known as Worldwide Income. So long as the parent company's headquarters are located in the U.S., generally speaking, all of an American corporation's subsidiaries are subject to U.S. taxation.
Nonetheless, the U.S. recognizes the need to avoid double taxation of income earned by foreign subsidiaries, both by in the country in which they are located and by the U.S. Conceptually, two methods are available to avoid this pitfall: foregoing taxation of foreign-earned income, or tax credits for the taxes paid overseas, similar in concept, if not in details, to the one available to individual U.S. taxpayers. The U.S. (as well as Japan, the United Kingdom, Italy and others) chooses the credit method, and subjects foreign income to taxation but permits credits to be claimed for foreign taxes, up to the U.S. statutory rate. Corporations benefit from one additional fiscal advantage over individuals, however. Their foreign profits above the statutory rate are taxed only when those profits are returned to the U.S., not when those profits are earned.
It has been argued that the U.S. tax system provides incentives to headquarter firms outside the country. On the other hand, to somewhat counter this, the U.S. has designated as a foreign business those businesses that derive at least 80% of their income from activities not substantially related to U.S. Commerce. This designation results in treating income by companies nominally headquartered overseas, but doing 21% or more of their business in the U.S., as income within the U.S.
Offshore Tax: Havens or Hell?
Limits of space restrain us from addressing this very hot issue. We will address this in a future e-Watch article. Suffice it to say, offshore residency, corporations and trusts can be either a valid haven or a painful hell depending on proper structure and the particular facts and circumstances. The IRS red-flags and scrutinizes, and when it fails, heavily penalizes civilly and criminally, this type of tax avoidance, so extreme care must be taken. As members of Lawyers Associated Worldwide, www.lawyersworldwide.com, we work with both U.S. Tax specialists and our fellow member specialists in the Caribbean (viz., Cayman Islands, Bermuda, and the Bahamas) and Channel Islands in the English Channel.
Conclusion
Individuals and businesses will be increasingly enmeshed in reconciling and minimizing multiple taxes by countries, states and provinces because of the rapid and inevitable globalization of both the U.S. and worldwide economies.
Seymour J. Mansfield is a founding shareholder of Mansfield Tanick & Cohen, P.A. His practice includes complex and class action litigation (including antitrust and consumer protection cases). Mr. Mansfield is the Firm's representative for Lawyers Associated Worldwide (LAW), an association of over fifty independent law firms located in over 100 major commercial centers throughout the world. Membership in LAW allows member firms to service the legal needs of clients that are expanding their operations and relationships into new domestic and foreign markets because of the increasing globalization of the business world. Mr. Mansfield has served on LAW's Executive Committee (governing board) since 2004. He can be reached at 612-339-4295 or via email at smansfield@mansfieldtanick.com.
[1] Our focus here is individual U.S. citizens. We do not deal with domestic, multinational, or so-called offshore companies, trusts or other entities.
[2] In accordance with IRS Circular 230, any tax advice in this email is not intended to be and cannot be used or relied upon for preparation of a tax return or to avoid tax penalties imposed by the Internal Revenue Code. If you desire a formal opinion on a particular tax matter for the purpose of filing a return or avoiding the imposition of any penalties, you should seek such an opinion from an independent tax advisor or contact us to discuss whether the Treasury and Code requirements can possibly be met based on your particular circumstances, as well as our anticipated time and fees involved.
[3] Exchange rate information can be found, for example, on the dedicated web site www.x-rates.com; The Federal Reserve's official number through 2007 can be found at www.federalreserve.gov/releases/g5a/current.
[4] Compare a hotly contested domestic issue - a foreign U.S. state's power to tax income of companies based out of state. "Supreme Court Restricts the Taxation of Income of Companies Based Out of State," N.Y. Times, 4/16/08, www.nytimes.com/2008/04/16/business/16bizcourt.html?ref=business&pagewanted.
[5] This is in contrast to many countries minimum residency periods for tax purposes. For example, a person who spends 183 days in Canada is considered a resident Canadian under that country's Income Tax Act, so that 183 days abroad may suffice to avoid domestic taxation instead of 330. The United Kingdom does not impose any bona fide presence test (but will impose, starting in 2008, an alternative minimum tax of sorts, by charging a fee when filing a claim foreign residency).
