The Outbound Regime
There are two essential, yet often conflicting, elements of U.S. taxation. They are: (1) the worldwide taxation of United States citizens and residents and (2) the status of corporations as separate taxable entities. The informing questions in the taxation of foreign income reflect one or the other, which arise as the problems of double taxation and deferral.
The Foreign Tax Credit
Since direct foreign investments and business operations of United States persons often attract foreign income taxes, not to mention U.S. tax, double taxation is likely to rear its ugly head in cases involving foreign income. In response to the possibility of source-based taxation imposed by other countries, the U.S. tax system allows a foreign tax credit. From a simple idea – a dollar-for-dollar reduction of U.S. tax for income taxes paid to foreign countries – the foreign tax credit has evolved into an elaborate structure.
Foreign Corporations & Deferral
The U.S. tax system recognizes the separate identify of corporations, even when they are owned and controlled by a single person or a small group. In domestic U.S. taxation, the separate identity of corporations is the occasion for two levels of taxation of its earnings: one imposed on the income of an entity and the other on dividend distributions received by shareholders.
However, in international transactions, the separate treatment of corporations may allow the earnings of foreign corporations owned by U.S. persons to escape current U.S. taxation. Because a foreign corporation is a separate foreign person, it is not subject to U.S. taxation on its income derived from foreign sources. The earnings of foreign corporations are only subject to U.S. taxation when distributed to U.S. persons as dividends.
This is known as "deferral" for the simple reason that U.S. taxation is deferred until foreign earnings are paid to U.S. shareholders as dividends. Because the distribution of a dividend is optional, deferral can theoretically go on indefinitely. And because the basis of stock is restated to fair market value at the death of a shareholder, deferral can become forgiveness.
Nearly unlimited in the early days, the possibility of deferral has become heavily restricted. For corporations owned or controlled by U.S. persons – known as controlled foreign corporations – deferral today remains only for a distinct class of active business operations. For foreign corporations not controlled by U.S. persons, the possibilities of deferral are endless. Yet even here, the income of passive foreign investment companies are subject to current taxation in the hands of U.S. shareholders, however small their holdings.
This system may seem simple enough. However, the devil is in the details. Particularly in the taxation of foreign income, the proliferation of rules can be overwhelming. The reason for this complexity is the attempt to formalize distinctions between legitimate business operations outside the United States that enjoy a full credit for foreign taxes, the deferral of U.S. taxation, or both; and tax haven operations.
Both the foreign tax credit and deferral are chock full of rules that attempt to distinguish between legitimate overseas operations, where the U.S. Treasury allows the foreign tax environment to prevail, and tax haven operations, where the U.S. Treasury steps in aggressively. The mechanics of these distinctions, real or imaginary, have put many a taxpayer, not to mention a tax preparer, on the brink of insanity.
The Inbound Regime
The United States taxes foreign persons under two different tax regimes. The first is imposed on passive investments. And the second is imposed on active business operations. U.S.-source passive investment income, otherwise known as "fixed or determinable income not effectively connected with a U.S. trade or business," is taxed at a flat rate. Generally, that rate is thirty percent and there is no allowance for deductions.
Business profits from the United States, otherwise known as income "effectively connected with a U.S. trade or business," are taxed at the regular graduated rates, with an allowance for deductions and credits.
While it might appear that the U.S. taxation of passive investment is the most severe (because it is taxed at a flat rate), looks can be deceiving. In fact, just the opposite is true. And that is not because the highest marginal rates imposed on the net business incomes of foreign individuals and corporations are higher than the thirty percent rate imposed on their passive investment income. While this is true, these rates are only slightly higher. Indeed, they are thirty-five percent in both cases. But this relatively small difference in rates is easily offset by the allowance of deductions and credits in the taxation of business income.
On closer scrutiny, there are gaps in the flat rate tax imposed on investment income – gaps that are large enough to make it essentially benign. For example, gains from the sale of U.S. investment assets (other than interests in real property) by foreign persons, including capital gains from stocks, securities, and other financial assets, are not taxed at all. More importantly, interest from U.S. bank deposits and from U.S. "portfolio" debt is exempt from U.S. taxation in the hands of foreign persons.
On the other hand, the tax on branch profits of foreign corporations in the United States adds a potential extra 30% tax on their business profits. This tax, dating from the 1986 Act, extends two-level taxation of corporate profits to a larger class of foreign business operations in the United States.
With this additional information in hand, it becomes readily apparent that the taxation of active U.S. business operations is more severe than the taxation of passive investment. However, it is rarely incapacitating. And that is thanks, in part, to the combined effect of interest deductions that remove earnings from the reach of U.S. taxation and the protections of various income tax treaties.