AB FinWright LLP has expertise to help you in navigating the complex world of international tax.
Our focus is U.S. Cross-border transactions
U.S. citizens – including individuals and companies
With foreign-sourced income or operations.
Foreign persons and companies with activities in the U.S.
The landscape of international tax and U.S. tax filing requirements is vast and complex. To make matters more difficult, it is always changing. Our professionals work to navigate these complexities and find a solution that can best mitigate your tax liability as well as ensure compliance.
International tax policy in the U.S. is a maze of complex tax rules on its citizens and ensures that tax professionals have to stay on top of those rules so that they can appropriately advise their clients.
Overview of the uniqueness of the U.S. tax system
There are two main types of taxing systems in the world.
In a “worldwide system,” tax is imposed on residents of a country for all income- including at home and overseas. Foreign tax credits may be used to mitigate the effect of double taxation.
Most countries use a “source-based taxation,” or “territorial,” system. In this format, the country in which the income is earned is the jurisdiction to tax you, regardless of where you live. In other words, if the income is earned within the jurisdiction’s territory, they will tax you there. Participation exemptions or dividends-received deductions are a hallmark of the territorial system.
The U.S., uniquely, prior to passage of the Tax Cuts and Jobs act in 2017, had or “worldwide,” tax system. In this method, the U.S. taxed the global earnings of corporations, but deferred the tax until the earnings were repatriated. This encouraged corporations to keep their earnings offshore. Additionally, inversion formats were often adopted in order to avoid US tax. US based companies would merge with a foreign-based company in order to attain residency in the foreign country and therefore reduce or avoid US taxation.
To add to more complexity, there are citizenship-based (CBT) or residence-based (RBT) basis of taxation. In a CBT tax system, citizens are taxed on their worldwide income regardless of their physical presence in another jurisdiction. The United States uniquely imposes this taxation structure. CBT is unfavorable for U.S. expats living abroad because they must continue to file and pay taxes on their worldwide income. Tax may be somewhat alleviated with a foreign tax credit, however, the filing requirement is not.
In a RBT tax system, a resident of a country is subject to tax based on where they live versus where they are a citizen. This alleviates filing requirements for citizens who are residents abroad.
There is proposed legislation introduced in December of 2018, the Tax Fairness for Americans Abroad Act of 2018 (TFAA) which recommends moving U.S. citizens from a citizen-based to a residence-based approach.
The Tax Cuts and Jobs Act (TCJA) impact on U.S. International Tax
Since the Tax Cuts and Jobs Act of 2017, effective January 1, 2018, the US moved towards more of a hybrid territorial system. This “hybrid system” has components of both a worldwide and territorial system.
Some of the changes included in the TCJA are the one-time transition tax on untaxed earnings of some foreign corporations, exemptions on foreign dividends (using 100% Dividends Received Deduction or DRD), and Global Intangible Low-Taxed Income (GILTI), Foreign-Derived Intangible Income (FDII), Base Erosion and Anti-Abuse Tax (BEAT), and disallowance of deductions related to hybrid instruments and transactions.
Individuals in the U.S. are still generally taxed on this citizen-based tax “CBT” with a foreign tax credit for certain taxes paid on that income as well are foreign earned income deductions available. In other words, if you are a U.S. citizen and you earn income overseas, the U.S. will require you to report that income on your U.S. tax return.
A special election will allow a US individual to take advantage of paying income tax at corporate rates, indirect foreign tax credits available to corporations, and claiming the 50% GILTI deduction. The corporate federal tax rate was lowered to 21% with the TCJA and is lower than the top individual tax rates and therefore this election can be beneficial.
Inbound and Outbound Taxation
Think of “inbound taxation” as those transactions which come from outside of and into the U.S.- an inbound transaction- is specifically those of foreign persons (non U.S. persons) with U.S. income or activities.
“Outbound taxation” is the system by which the U.S. taxes its citizens and resident aliens on all of their worldwide income on a system of residence-based taxation and on their non-U.S. income or activities. In simpler terms, a U.S. citizen will be taxed on income outside of the U.S as well as within the U.S.
International Tax FAQ
How does the U.S. tax foreign persons who have activities in the U.S.?
There are two basic ways that foreign persons in the US are taxed
- A 30% withholding is imposed on gross amount of certain U.S. sourced income, usually passive, and referred to as FDAP income, that is not effectively connected with a US trade or business.
- For those foreign persons doing business in the US and who have determined that they have effectively connected income (ECI), graduated rates or corporate tax rates will apply.
What is a U.S. person with regards to filing a U.S. tax return?
The term ”United States person” means:
- A citizen or resident of the United States
- A domestic partnership
- A domestic corporation
- Any estate other than a foreign estate
- Any trust if:
- A court within the United States is able to exercise primary supervision over the administration of the trust, and
- One or more United States persons have the authority to control all substantial decisions of the trust
- Any other person that is not a foreign person.
IRS Page on Classification of Taxpayers for U.S. Tax Purposes Here
Do I need to file a U.S. tax return if I live outside of the U.S.?
A U.S. person is a U.S. citizen or resident alien individual and is taxable on all of their worldwide income- or on the residence-based system.
Additionally, certain corporations, partnerships, estates, and trusts may also be classified as a U.S. person. Partnerships and corporations organized within the United States will fall under this category. Partnerships and single member LLC’s may different rules, with an election under the check the box regime.
Check-the-box rules have allowed eligible entities to elect to be classified as an association taxable as a corporation or a disregarded entity.
Check to see if your foreign entity is eligible under the list of “Per se” entities.
U.S. Regulation CFR 301.7701-3 Here
Do I need to file a U.S. tax return if I’m a resident alien?
Resident aliens are physically present in the U.S. and fulfill the 183 day physical presence test. This test may be applied during a year, or over 3 years on a weighted average.
Green card holders also satisfy the resident alien individual test as they are lawful permanent residents of the U.S..
What is a U.S. sourced income Effectively Connected to a trade or business?
Generally, when a foreign person engages in a trade, business in the United States, all income from sources within the United States connected with the conduct of that trade, or business is considered Effectively Connected Income (ECI). This applies whether or not there is any connection between the income, and the trade or business being carried on in the United States, during the tax year.
Effectively Connected Income (ECI) IRS FAQ Page Here
<h4″>Citizens and resident aliens will generally need to file a U.S. tax return regardless of where they now live. There are, of course, exceptions and ways to navigate this general rule.
The United States Uses a hybrid approach of both residence and source-based taxation. As a citizen or resident alien will need to file a U.S. tax return indicates a sourced-based taxation system. However, they may credit foreign taxes paid or accrued in other countries. The foreign tax credit is one of the indications of source-based taxation. Additionally, the participation exemption or dividends received deduction moves the U.S. towards the source-based or hybrid approach.
If I don’t live in the U.S, but I am still a citizen, will I still need to file a U.S. tax return?
Until you have fully expatriated, then yes, you would still need to file a U.S. tax return.
I have different types of income, how do I determine where those will be taxed- either here in the U.S. or in the foreign country?
In U.S. federal income taxation, these are referred to as the source of income rules. These rules have numerous. exceptions and certain fact patterns may change the outcome altogether. As a very general rule, here are some of the types of income and where they are sourced:
Interest and dividends are generally based on the residence of the payor.
Compensation for services is generally sourced based on where the revenue is generated- in other words, where the services are provided.
Rents or royalties are generally sourced to where the location of the property is or where it is Used. If real property is sold, the gain is generally also sourced to the location of the property.
Personal property has many different rules for determining sourcing and will not be covered here.
With source of income, it is also important to see any applicable treaties, and therefore exceptions and rate exemptions that may apply.
Are there exclusions from income earned outside of the U.S.?
A “qualified individual” may exclude certain foreign earned income (called a “foreign earned income exclusion”) attributed to services adjusted for inflation. Housing costs may also be excluded based on 30% x number of days of the taxable year within the applicable period provided by an employer. Rules apply where housing not reimbursed by an employer may be deducted to arrive at adjusted gross income.
What is a qualified individual for purposes of the foreign earned income exclusion?
A “qualified individual” is one who falls under both:
- Tax home is in a foreign country and who is
And either A or B
- ) A citizen of the U.S. and a bona fide resident of a foreign country for an uninterrupted period which includes an entire taxable year. OR
B.) A citizen or resident of the U.S. and who is present in a foreign country during at least 330 full days during any period of 12 months.
What does “earned income” include for purposes of the Foreign Earned Income Exclusion?
“Earned Income” includes wages, salaries or professional fees or compensation for any other personal services provided. It does not include compensation for services provided to a corporation which represents a distribution of earnings and profits rather than a reasonable allowance as compensation for the personal services actually provided.
If you are “engaged in a trade or business” where both personal services and capital are a material income-producing factor, then a reasonable allowance for the personal services, not in excess of 30% of his share of net profits in the trade or business, shall be considered earned income.
What is a “tax home” and “abode” for purposed of the Foreign Earned Income Exclusion? Why is this important?
If it is established that you have an abode in the U.S., you will not qualify for the foreign earned income exclusion. Your abode is generally where you live or have your strongest economic, familial, and personal ties. You will not be treated as having a tax home in a foreign country when your abode is in the U.S., unless you are serving in an active combat zone.
If you have children and a spouse, for example, in the U.S., and you have a U.S. bank account and residence, your work is the only thing tying you to the foreign country, it will be difficult to qualify for a foreign earned income exclusion.
Your tax home in contrast usually applies to your vocation or business and is generally referred to as the location of your regular or principal place of business as defined in IRC Section 162(a)(2).
Additionally, you may have a tax home in a foreign country, but closer ties to your abode in the U.S. You will not qualify for the foreign earned income exclusion if this is the case. You must establish an abode in the foreign country as well where the link is stronger to that foreign country. In other words, your time in the foreign country cannot seem transitory in nature.
What is a Controlled Foreign Corporation (CFC)?
A CFC is a foreign corporation that is more than 50% owned (directly or indirectly) by U.S. persons who each own (directly or indirectly) at least 10% of its vote or value.
What is a Passive Foreign Investment Corporation (PFIC)?
A foreign corporation is a PFIC, if either: (1) at least 75% of its gross income is passive income; or (2) on average, at least 50% of its assets produces passive income or is held to produce passive income.
What is a Participation Exemption (or Dividends Received Deduction (DRD))?
The participation exemption allows a U.S. C Corporation to deduct a foreign dividend from gross income for income from foreign subsidiaries in which the parent owns at least 10%. This deduction is not allowed for individual shareholders or S corporations.
What is the Transition Tax?
U.S. parent pays the transition tax on pre-TCJA foreign earnings at a reduced rate and with partial foreign tax credit. It is a deemed-repatriation tax on accumulated foreign earnings. Taxes were paid prior to the TCJA on dividends repatriated to the U.S., so those are exempt since tax has already been paid on them. Prior to TCJA, the incentive, therefore, was to keep profits retained within companies and not to pay dividends because those dividends would be taxed. In order to transition from that system to the new hybrid territorial system, the transition tax equalizes those dividends not repatriated by subjecting foreign earnings to a tax as follows:
- 5% on cash and cash equivalents
- 8% tax on other liquid assets
What is Global Intangible Low-Taxed Income (GILTI)?
Beginning in 2018, a US shareholder of a CFC must include its global intangible low-taxed income in gross income. All high-return foreign earnings, including both passive and active business profits are subject to GILTI. GILTI income includes the excess of a CFC’s foreign income over a 10% return on tangible assets. This assessment is determined at the individual shareholder level and has a complex formula in order to determine the basis for the tax. There is a 50% deduction available through December 31, 2025. The deduction is then reduced to 37.5% after that date.
Foreign tax credits may be applied up to 80%.
What is Foreign-Derived Intangible Income (FDII)?
FDII is a portion of a domestic corporation’s intangible income that is derived from foreign markets. FDII rules operate together with GILTI rules to provide a deduction from the tax for 37.5% beginning in 2018 based on the excess of a US company’s foreign income over a 10% return on intangible assets.