Outbound International Taxation System
The United States taxes its citizens and residents on their worldwide income. In contrast, some countries will implement a territorial taxation regime, whereby individuals are taxed only according to the source of their income or solely within that country’s borders. Under the U.S. worldwide taxation regime, regardless of where it was earned, every dollar of income (absent an applicable exclusion) will make its way onto an individual taxpayer’s Form 1040 or an entity’s related tax return.
If a U.S. citizen is working in a foreign country, earning compensation for the services provided, the IRS will expect the taxpayer to report that income and pay the applicable tax on Form 1040. However, if the U.S. citizen must also pay in tax in the foreign country on the income earned while overseas, the U.S. will allow the taxpayer to take advantage of a foreign tax credit on his or her individual income tax return to avoid the potential for double taxation. Additionally, if the specific requirements are met, U.S. citizens may be able significantly reduce their taxable income using the foreign earned income exclusion.
It is also important to understand that where U.S. tax law allows for treating a corporation as a separate taxable entity, U.S. income taxes on income earned by the corporation can be deferred until the corporation is repatriated to the United States. Because the potential to postpone payment of U.S. taxes on a corporation’s foreign earnings can lead to the possibility of permanent deferral and under-taxation, several provisions in the U.S. tax system extend to the incomes of foreign corporations with U.S. ownership.
The primary device by which this income is attached for purpose of U.S. taxation is via “controlled foreign corporations.” A controlled foreign corporation is most often used when earnings and income have been routed to low-tax environments for purpose of tax avoidance. It is important to note that deferral is available under U.S. tax law for active business operations conducted in a foreign country. However, the same deferral does not apply for any number of “tax haven” operations, conducted in controlled foreign corporations.