The IRS and the courts have interpreted this to mean all income from where-ever derived. They have also concluded that the U.S. income tax applies to citizens and permanent residents even when they are not living in the U.S. 

The U.S. is the only major industrial country that has such an all encompasing income tax system.

Other major countries also tax the world-wide income of their permanent residents, but if their citizens or long term residents change their residence to another country (including a tax haven), they are no longer subject to tax in their former country. It's as if one of the fifty state in the U.S. asserted the right to continue to tax a former resident who had moved to a different state.

If the U.S. only imposed a tax on the income derived within the U.S. our international tax system would be much less complicated. Because we assert the right to tax the income of our citizens who live in other countries, we have to deal with the problem of double taxation, when that income is also subject to tax in the other country. The mechanism for avoiding double taxation is called the foreign tax credit. U.S. taxpayers are allowed to take a credit against their U.S. taxes for income taxes paid to foreign countries on the same income. However, due to politics, there are substantial restrictions on the foreign taxes that can be claimed as a credit and in many cases, substantial foreign taxes are paid in addition to U.S. taxes on the same income.

Once upon a time (before 1962) it was legal for U.S. companies and individuals to own foreign based corporations without being subject to tax on any of the income of the foreign corporation. However, the politicians saw this as a growing loophole that was costing a substantial loss in tax revenues so they invented the concept of the "controlled foreign corporation" or CFC. The U.S. does not have any legal jurisdiction to tax the income of a foreign entity, but the politicians were advised by their lawyers that the U.S. does have the right to tax the U.S. shareholders of foreign corporations.  As large corporations attempted to find ways to circumvent the CFC rules, the Congress responded with more detailed restrictions. 

Prior to 1976, it was legal for U.S. persons to put assets into a foreign trust and to defer taxes on income earned by those assets for an extended period of time. The Congress began to worry that a lot of tax revenues were being lost, so they changed the law to require the grantors (settlors) of a foreign trust with a U.S. beneficiary to pay current income taxes on the income earned by the foreign trust.  However, for almost 20 years after that change, a lot of U.S. taxpayers simply ignored the rules and didn't report the income earned by their foreign trust. They felt safe in doing that because the U.S. government did not have the legal authority to force the foreign trust to submit information to the IRS with which to determine if taxes were due by the U.S. grantor.

Then in 1996, the Congress enacted some very severe penalties for a failure to submit foreign trust information returns to the IRS and imposed the penalties on the U.S. grantor of the foreign trust. The law also made it clear that even if disclosue was a crime in the jurisdiction of the foreign trust, the U.S. grantor would still be subject to harsh penalties if the required information was not forthcoming.

Meanwhile, with a continuing cut in the availability of legal tax sheltered investments, more and more Americans were putting money into foreign bank accounts and various foreign investments. With the development of international credit cards, the offshore banks made it possible for their account holders to gain access to the funds in their offshore accounts through a credit card.  In January, 2003, the IRS announced an initiative to audit the returns of U.S. persons with credit cards drawn on or secured by foreign financial accounts. They offered a partial amnesty program to those taxpayers who would come forward and volunteer to submit information regarding unreported income from their foreign accounts.

In the midst of this continuing crackdown on U.S. persons who were not paying taxes on income from foreign sources, the U.S.A. continued to be a favored tax haven for foreign investors. Foreign persons with no ties to the U.S. can receive interest income from U.S. government debt obligations, U.S. banks, savings and loans and insurance companies free of any U.S. tax. Nor do foreign persons have to pay any tax on capital gains from the sale of U.S. securities. Prior to the 2003 tax law, foreign persons were required to pay a 30% tax on dividends paid to them by U.S. corporations and the tax was enforced via withholding at the source by the U.S. dividend payor. The 2003 reduction in the tax rate on dividend income to 15% is certain to make investments in high dividend paying stocks in the U.S. even more attractive to foreign persons.

Why do we permit foreign persons to enjoy tax benefits from U.S. investments that are not available to U.S. persons?

It's politics.

Our politicians want to attract foreign money to buy U.S. debt obligations and to provide funding for our large corporations. Conversely, our politicians want to discourage U.S. taxpayers from moving money outside the U.S. and also paying less taxes.

Vernon Jacobs
(C) Copyright, 2004, All rights reserved