U.S. International taxation
All taxpayers should have a basic understanding of the fundamental concepts.
U.S. International Taxation
The U.S. international taxation system can be broken into two primary areas of focus:
U.S. Person: citizen or resident of the United States, a domestic partnership, a domestic corporation, any estate (other than a foreign estate) and any trust (if a U.S. court is able to exercise primary supervision over the administration of the trust, and one or more U.S. persons have the authority to control all substantial decisions of the trust.)
Foreign Person: an individual or entity that is not a U.S. person as described above. This includes nonresident aliens (individuals who are neither U.S. citizens nor residents), foreign corporations, foreign partnerships and foreign trusts and estates.
The Report of Foreign Bank and Financial Accounts (FBAR) requires taxpayers with an interest in, or signature authority over, foreign financial accounts whose aggregate value exceeded $10,000 at any time during the calendar year to the file FinCEN Form 114. FBAR rules can be found at the links below:
The Foreign Account Tax Compliance Act (FATCA) requires taxpayers to report their financial interest in certain specified foreign financial assets by using Form 8938, which is attached to and submitted with an individual taxpayer Form 1040. See the links below.
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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) must be reported on an individual taxpayer’s Form 1040 or an entity’s related tax return.
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.
The United States taxes citizens and resident aliens (foreign citizens who are residents of the United States under either the “green card” or “substantial presence” test) on their worldwide incomes. However, nonresident aliens (individuals who are neither citizens nor residents of the United States) are subject to different U.S. tax rules.
A nonresident alien is taxed only on the income earned or derived within the United States. In general, a nonresident alien’s income is categorized into two separate categories:
- Effectively connected income (ECI), and
- Fixed, determinable, annual or periodical (FDAP) income that is not effectively connected with the conduct of a trade or business, including, but not limited to: interest, dividends, services, rents, royalties, wages, etc.
The main difference in taxation between these two categories of income is the rate at which the income is taxed. Generally, if the income is treated as ECI, the tax rate on the net income will be graduated and will range from 10% to 35%, depending on the amount of taxable income and the entity that generated the taxable income. If the income is treated as FDAP, the tax and withholding rate will generally be a flat 30%, which is on a “gross” basis and does not allow for any deductions or modifications to reduce the income. Foreign persons may be subjected to graduated tax rates on the disposition of certain real property located in the United States.
Since foreign persons are only subject to U.S. tax on their income that is connected to the United States, it is critical to properly determine the source and underlying character of the income in question. Because these situations are highly-specific and unique to each circumstance, tax advisors should be enlisted to assist with the determination process.