This book is about the U.S.
tax treatment of U.S.
shareholders of a foreign corporation that is controlled by U.S.
persons or entities. It is
intended to dispel the many myths and outright lies that have been
dispensed by
a variety of promoters who are either:
(1)
not aware of the complex tax rules
that apply to the U.S. shareholders of a foreign corporation; or
(2) are not
concerned about the problems they may cause to their U.S. customers.
The U.S.
tax
rules that apply to U.S.
persons (including entities) that own shares of a foreign corporation
are among
the most ambiguous and convoluted sections of the entire tax law. Any
attempt
to provide a technically accurate, comprehensive and authoritative
explanation
of those rules would require a mere repetition of those convoluted and
ambiguous Internal Revenue Code (“IRC”) sections and related Treasury
Regulations (Treas. Regs.). Since there are a sufficient number of
technical books
and guides that attempt to do that, we see no need to produce another
incomprehensible explanation of the U.S.
tax rules that apply to U.S.
owners of foreign corporations.
We
have instead chosen to produce a book that translates the confusing
jargon of
the tax law into a semblance of plain English. Where tax jargon is
unavoidable,
we explain it. In addition, we have produced an extensive plain English
glossary of all the international tax terms, acronyms and phrases used
in this
book.
Our Controlled Foreign
Corporation Tax Guide, 3rd Edition, is
intended
primarily for the benefit of investors and entrepreneurs who are
thinking of
venturing offshore. However, it should also be useful to lawyers,
accountants
and other financial advisors who are not specialists in the somewhat
arcane
subject of international tax law.
Prior
to 1962, it was legal for U.S.
persons to form foreign corporations to hold investment assets and to
not owe
any U.S. tax on the
investment income until the income was repatriated to the U.S.
But in 1962,
the Congress became concerned that using foreign corporations to avoid U.S.
taxes was becoming much too popular. They changed the tax law so that
taxes
would be imposed on certain U.S.
owners of foreign corporations to the extent of any passive investment
income
received by the foreign corporation (and certain other kinds of income
as
described later).
But
for many decades thereafter, enforcement of the law was negligible and
a lot of U.S.
investors just ignored it. Certain members of the U.S. Congress came to
believe
that no U.S.
person would utilize a foreign corporation based in a tax haven country
unless
he or she intended to commit tax evasion. To some extent that was true
because
it was difficult for the IRS to penetrate the veil of secrecy that was
commonplace in most offshore jurisdictions. In many countries (other
than the U.S.)
it would be a crime to reveal information about a bank account,
investment or
business entity to anyone, for any reason.
But
in the mid-1990s, the IRS and some other government agencies discovered
a way
to penetrate the secrecy in foreign banks. And after September 11,
2001, the U.S. Patriot Act gave the U.S.
government a lot more tools to uncover hidden foreign accounts. Since
then, the
IRS has embarked on a witch hunt to
uncover unreported income from foreign accounts. They stumbled on an
opportunity to get the names of about 1,500 U.S. persons who had money
in a
Cayman Islands bank. Then they discovered how foreign debit cards were
being
used to gain access to secret foreign bank accounts and they subpoenaed
the
records of foreign account holders of the major credit card companies.
As part
of the process of auditing those people, they required that the
taxpayer give
them the names and contact information of the lawyers, accountants and
other
facilitators or promoters of foreign entities. As they audited those
people who
were subject to U.S.
jurisdiction, they secured a list of their customers. So, in an
expanding
circle, they are gradually gathering information about more and more of
the U.S.
persons who have unreported foreign accounts and who own foreign
corporations.
Because
of U.S. securities
laws,
many foreign banks require U.S.
persons to open accounts through a foreign corporation or international
business company (IBC) that is treated as a corporation for U.S.
tax purposes. Thus, the IRS
efforts to locate unreported foreign accounts also results in locating
unreported foreign corporations.
Even
though some members of the U.S. Congress and most of the employees of
the IRS
apparently believe that any U.S.
person
with a foreign account and/or foreign corporation is guilty of tax
evasion, it
is perfectly legal (so far) for U.S.
persons to have foreign accounts and to own shares of foreign
corporations. What
is not legal is to fail to pay taxes on the foreign-source income (if
required)
and to file the required reports that are discussed extensively in this
book.
It
has been our observation that the IRS is not as interested in taxpayers
who
have foreign corporations and financial accounts if they are properly
disclosed. This has been confirmed by a number of international tax
lawyers and
accountants with whom we are acquainted. And it makes a lot of sense.
When the
IRS discovers someone who has not reported his income from foreign
investments
and has not filed the required returns, the IRS can impose and collect
substantial amounts of tax and penalties. In many cases, substantial
penalties
may be collected even where no taxes are due because the offshore
venture or
investments were not profitable.
But
the likelihood of getting any more blood
from the turnip with taxpayers who have filed the required reports
and have
paid taxes on their foreign-source income is minimal. It just isn’t as
financially rewarding for the IRS to spend a lot of time auditing those
who
have clearly complied with the law.
We
have no statistical proof, but it appears from the inquiries that we
both
receive that an increasing number of U.S. people are interested
in
business opportunities in other countries. We have had inquires or have
done
work for people who have entered into business ventures in Cayman
Islands, China,
Romania, Russia, Belize, Costa Rica, New Zealand, Bermuda, Ireland and
Isle of
Man. There is a rough correlation between risk and reward and the true
entrepreneur seeks higher risk opportunities in order to earn higher
rewards.
Today, many U.S.
entrepreneurs believe that much greater opportunity is available in
countries
that are in a period of dynamic growth like China
and India.
Others see opportunities in countries that were part of the former Soviet Union. In nearly every instance where U.S. persons are pursuing a business
opportunity
outside the U.S.,
they do so through a corporation.
Meanwhile, U.S.
multi-national corporations continue to encourage their employees to
take jobs
in various foreign markets and to live there for an indefinite period
of time.
These “expats” soon buy a home, open a bank account, buy investments
and
sometimes embark on business ventures. Many or even most of these
expats will
form a corporation to own their foreign investments.
Due
to the deterioration of the U.S.
tort system in the past sixty years, nearly every financially
successful self-employed
professional person and small business owner in the U.S.
is paranoid about losing a
lifetime of savings because of a predatory lawsuit. The U.S.
courts and juries have become
notorious about favoring the plaintiff in any civil dispute. Liability
insurance is not available for many kinds of professionals and business
risks
or is prohibitively costly. The only alternative for many people is to
implement some kind of asset protection arrangement. Although a foreign
trust
and/or foreign limited liability company (LLC) should be the final step
rather
than the first step, a lot of U.S.
business owners and professionals have formed foreign trusts or LLCs to
protect
a part of their net worth. However, to be effective, some assets need
to be
moved offshore into the trust or LLC. Once offshore, the question of
finding
investment opportunities arises and that usually leads to a decision to
have a
foreign corporation in order to have access to foreign securities
markets.
These
are the three primary reasons why U.S. persons venture
offshore. And
with rare exceptions, each situation results in the formation and
ownership of
a foreign corporation by the U.S.
person. With equally rare exceptions, the corporation is owned
(directly or
indirectly) by the U.S.
person or by his foreign trust.
This
book is for those U.S.
persons who have a legitimate reason to venture offshore for a business
or
investment opportunity, for employment or for the protection of some of
their
assets from predatory litigation. Our objective is to explain the rules
that
apply to the U.S.
owners of foreign corporations in the plainest possible terms, and with
a
minimum of confusing IRC citations and tax jargon. This will hopefully
help
those with foreign corporations to understand what the U.S. Government
(via the
IRS) requires so that they can avoid punitive penalties and the time
consuming
and costly process of an audit.
Before
we begin to describe these rules, we need to make it as clear as
possible that
neither of us condone or support or agree with the political
motivations that
have led to these intrusive, ambiguous and costly rules. The U.S.
is the only major country that
imposes taxes on its citizens even when they are not resident in their
host
country and are not deriving income from that country. Foreign
corporations
owned by U.S.
corporations
or individuals are subject to U.S.
tax on their worldwide income, although some foreign business income
can be tax-deferred
until it is repatriated to the U.S.
owners.
These
rules put our multi-national corporations at a substantial competitive
disadvantage in the world market place. Nearly every major industrial
country
in the world (except Japan)
now has a lower corporate tax rate than the U.S. In spite of this, some
politicians like John Kerry want to pour
gasoline on the fire by imposing a U.S.
tax on all of the income of any U.S.
corporation, even if it is active business income earned in a foreign
country.
In
spite of our personal disagreement with the political policies that
have led to
the rules for the tax treatment of U.S. owned foreign corporations, our
focus
is on helping readers to avoid being in violation of the laws and
thereby
subject to very punitive taxes and penalties.
Vernon Jacobs & Richard Duke
