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Taxation & Foreign Corporations

There have been a number of news reports recently that have claimed that foreign subsidiaries of U.S. corporations do not pay U.S. taxes. Seeing these reports has many people asking what rules have to be met for a foreign subsidiary income to be free from foreign taxation by the U.S.

The fact of the matter is that those articles would be accurate if they described the earnings of foreign subsidiaries of U.S. corporations as being tax deferred, vice tax free. However, this does not diminish the value of tax deferral. It simply clarifies what is a frequent misunderstanding of foreign taxation.

In most cases, a foreign subsidiary owned by a U.S. corporation (or a U.S. citizen, partnership, trust, etc.) is not subjected to the U.S. tax on its foreign source income unless that income is within the range of what is called in the tax law "Subpart F income". Included in Subpart F income is almost every kind of passive investment income. Foreign taxation also includes the income of a foreign corporation (owned and controlled by U.S. persons or entities) that is derived from favorable pricing in transactions with affiliated U.S. entities or persons.

With a typical foreign subsidiary of a U.S. corporation, the foreign subsidiary is a resident as well as being licensed to conduct business in that foreign country. Should the foreign impose any kind of income, employment or value added taxes, then the foreign subsidiary is subjected to those taxes just the same as a local corporation. The foreign corporation is usually independent of the U.S. parent company in the sense that the foreign subsidiary has its own employees and an office and other facilities necessary to conduct business in the foreign country. It's still subjected to foreign taxation

In some cases there are treaties between the U.S. and other countries providing some tax benefits to a foreign based subsidiary of a U.S. company.

In a recent article mentioned self-employment taxes for U.S. citizens living and working abroad in a foreign country, a foreign corporation may be advantageous with respect to the U.S. self employment tax of a citizen who lives and works outside the U.S.

In some countries, a foreign corporation or IBC may be necessary in order to purchase foreign investments. Should that be the case for foreign taxation, the U.S. owner of the corporation is usually better off electing to have the corporation taxed as a disregarded entity and have the income of the foreign corporation flow through to the owner's personal tax returns. This would also applies to a foreign limited liability company.

Most people have very short memories in regards to tax matters. Nearly 40 years ago, it was legal for U.S. citizens to own foreign corporations and then use those corporations to invest in foreign securities on a tax deferred basis. After 1962, however, the rules for foreign taxation changed and have been refined continuously ever since. Prior to 1981, the top personal tax rate in the U.S. was 70% while, at the same time, the top rate on capital gains was 28%. The top rate on corporations has been as high as 50.75% and is now currently at 35%. The top personal income tax rate is currently 35% with a top rate on long term capital gains and qualified dividend income of 15%.

Numerous articles that are found in international tax literature have suggested that U.S. personal tax rates are lower than most countries overseas, while U.S. taxes on U.S. corporations are much more higher than in many foreign countries. This is a factor to consider for foreign taxation.

For non-corporate owners of foreign corporations, it is advantagious to elect having the foreign corporation's income taxed at U.S. personal rates simply by making an election to be taxed as a foreign partnership (multiple owners) or as a disregarded entity (one owner.)

In cases in which a foreign corporation is owned by a domestic corporation, the tax deferral described above is usually has an advantage over having to pay current high corporate foreign taxation.