Last week, we started a conversation with Ryan Losi, an international tax specialist based in Virginia. Today, we pick up the conversation with some insights into different income tax deferral programs available to Americans living overseas…
IM: Because the US is one of the few countries in the world that taxes its citizens on worldwide income based on citizenship rather than residency, tax deferral is a pretty common theme. Especially for those who live completely outside the system but are still expected to pay into it.
Beyond some of the common structures like the IRA and life insurance annuities, are there really any legal strategies for deferring income abroad?
RL: Without trying to get too complicated, we need to look at some of the fundamentals first.
There are basically two types of tax systems, territorial and credit.
In a territorial system, the government looks at the sources of the income as well as the residency of the person that generated it to determine applicable taxes, if any. Any income sourced outside that territory is generally not subject to taxation.
The United States, on the other hand, operates under a credit system where worldwide income is taxed regardless of source but credits may be allowed to mitigate any instances of double taxation.
But, this only makes the situation much more complex. It's not only expats who complain about this – green card holders who go abroad also have this continuing burden of complexities even though they receive no benefits from the home country.
With that said, are there ways to defer or reduce your tax rate when you're going abroad or when you have activities abroad? For an individual I would say absolutely. One of the most popular programs is the Foreign Earned Income Exclusion.
Every year, the government allows a certain amount of compensation or “independent contractor income” earned overseas (the equivalent of a 1099 or W2) to be exempt from income tax. That amount gets indexed every year, but right now, I believe it's around USD $91,500 (or the equivalent of this local currency). So long as you can pass certain tests confirming your physical presence outside the US, or maintaining a bona fide residence outside the US while having these earnings, you can exclude those overseas earnings from US taxation.
There's the potential to have a little bit more in the form of some housing allowances, which varies by the city that you're in.
Also, if you're an individual and you have business ventures outside the US (or if you're a large corporate organization and you're looking at staying competitive) there is a part of the tax code that's referenced by many tax practitioners like myself as the CFC regime – the Controlled Foreign Corporation regime.
This regime is also called the deferral regime and is one that allows foreign corporations owned by US individuals, US corporations or anyone that meets the definition as a “US person” under US tax law to defer their foreign business earnings from current US taxation, provided that certain rules are met.
In the simplest form of the CFC regime, let's say you wanted to do business in the UK, Germany or France and wanted to form a foreign corporation in each jurisdiction to house the business activity in that country. To the extent that you have that entity operating sufficiently on its own and with foreign earnings in that specific jurisdiction, you can leave those earnings abroad and they currently wouldn't be subject to US taxation.
To the extent that you bring those earnings back, either in the form of a dividend, loaning it back to someone or entity in the US, or having that entity serve as a guarantor for any kind of US debt – at that point in time the deferral ceases to exist. It's treated as if there was a dividend or a deemed dividend to its US shareholders.
IM: So obviously this law really seems designed for corporations operating overseas without any direct connection to the US day to day. It is a structure that an individual can use as well?
RL: Unfortunately, not really unless the individual moves to the country and forms a CFC and contracts through the CFC, which then it can work. The CFC regime is really based on economic substance. You can't just form a foreign corporation and have foreign customers settle your invoices outside. You really actually have to have economic substance in these foreign subsidiaries.
First, you need to have foreign business assets in the CFC that are actually used to carry on business.
Second, you need to have functions performed in that jurisdiction. For example, sales and marketing, R&D, distribution and logistics, treasury related functions etc.
Third, you need to show risk. Is it just a paper company or is it a real business that has taken on the regular risks of business?
For a large multinational it's easy. They ship executives over there, have offices, contract and handle the customers out of that jurisdiction. Instead of having all that done out of the US and having that revenue hitting the US tax return and subject to current taxation, it's done through a subsidiary in that specific country.
Now scale that down for the independent entrepreneur. It's really prohibitive, the cost as well as the complexities, and what would be saved in taxes isn't generally worth it.
Some folks try to game the system by setting up foreign corporations to run everything through, but if ever audited I will tell you for certain that they will collapse – everything will be subject to US taxation as well as substantial penalties.
IM: That's actually very interesting, because there's talk all the time within the internationalization community about just setting up an overseas corporation as a way to defer tax. Registration takes a couple days and then you have an offshore company through which income and expenses are run. So, you're saying that is a bad idea?
RL: That can be true in other countries but not in the US. Here, they will tax you where you are and are actually doing business. It's a substance-over-form doctrine.
That's all for today. We'll conclude the interview next week with talk about some of the most common mistakes Americans make when heading overseas, as well some thoughts on where the increased regulation and enforcement might ultimately take us.