As a general rule, the United States taxes U.S. citizens, resident aliens, and domestic corporations on their worldwide income. This may also include their foreign activities. As a result, some U.S. taxpayers attempt to place foreign income beyond the reach of the U.S. tax jurisdiction. This could be especially beneficial if the foreign-source income would be subject to little or no tax in the foreign jurisdiction. Since U.S. taxpayers are taxed on worldwide income, merely shifting U.S.-source income overseas in an attempt to make it foreign-source income will not place this income beyond the reach of the U.S. tax system. However, if income is shifted to a foreign corporation related to the U.S. taxpayer, there may be a chance to defer U.S. taxation.
In some cases, a U.S. taxpayer can shift income outside the U.S. tax jurisdiction by structuring transactions with related foreign parties in a non-arm’s-length manner. In other cases, a U.S. taxpayer structures it so that a foreign corporation rather than the U.S. taxpayer earns income. If such income earned by a foreign corporation is not related to U.S. activities, generally, it will not be taxable in the U.S. The exception to this rule is a foreign corporation is controlled by U.S. taxpayers, in which case, even though it earns income outside the U.S., it may be subject to U.S. taxation.
Factors to consider when structuring foreign business
There are a number of business entity structures a U.S. taxpayer can choose to conduct foreign business activities. Some of them are a foreign corporation, foreign partnership, branch of a domestic entity, or an entity eligible to make a “check-the-box” election. Under Reg. §301.7701-3, a foreign eligible entity may elect to be treated as a disregarded or non-existent entity if it has one owner. Hence, such entity will be regarded as an entity not separate from its single owner for income tax purposes.
When a U.S. taxpayer starts a new business, there is always the risk of losses in the early years. If the taxpayer makes a “check-the-box” election for which the entity of choice is eligible, that entity will be treated as non-existent; hence, the losses incurred will flow directly to the U.S. taxpayer. The same result will be if the taxpayer chooses a foreign partnership or the branch of a domestic entity, where the losses will be allowed for U.S. tax deductions. If the taxpayer chooses a foreign corporation, however, his losses will not pass through on the shareholders’ U.S. tax returns without a “check-the-box” election.
If a U.S. taxpayer conducts business activities overseas through a branch, foreign partnership, or non-existent entity, there is only one level of U.S. tax on the foreign income earned. Within certain limitations, a U.S. taxpayer may conduct business activities abroad through a foreign corporation and incur no U.S. tax until the earnings of such foreign corporation are distributed to the shareholder. The foreign corporation itself is treated for tax purposes as a separate foreign taxpayer not subject to U.S. taxation on its foreign income. The foreign corporation does not pay U.S. taxes on its worldwide income, only the income derived from U.S. sources. Thus, if its income is effectively connected with the conduct of a trade or business within the U.S., then such income will be subject to U.S. taxation.
To illustrate this, let’s say a U.S. corporation owns a foreign corporation. To the extent that the foreign corporation operates in a low-tax jurisdiction, the corporation will be able to defer U.S. taxation on the foreign income earned until the earnings are distributed to the U.S. parent corporation. In 1962, however, Congress enacted subpart F of the Code, the purpose of which was to discourage U.S. taxpayers from taking advantage of such tax deferral by accumulating certain types of income in foreign base companies located in low-tax jurisdictions. Thus, if a U.S. taxpayer considers conducting business through a foreign corporation, he or she should plan to avoid structuring it as a foreign personal holding company, controlled foreign corporation, foreign investment company, or passive foreign investment company.
Thus, because the deferral of U.S. taxes ends when the foreign corporation starts distributing dividends to its shareholders, a U.S. taxpayer who expects the foreign corporation to distribute its earnings every year needs to understand that there will be no benefit of deferral.
Distribution and Liquidation
Foreign corporations in some countries may be subject to withholding tax on distributions, and the U.S. will also impose tax upon distributions. Consequently, when a foreign corporation pays taxes itself, the taxes to its shareholders will be the second level imposed on the foreign corporation’s earnings. If a taxpayer makes distributions through a foreign partnership, such partnership will distribute cash to its partners without paying U.S. taxes. A foreign branch of a domestic entity may be subject to tax on withdrawals of earnings.
Ira Rubenstein, CPA, is principal-in-charge of the New York region for MBAF CPAs, LLC.