25 INTERNATIONAL TAX PLANNING
Here are some important highlights affecting international tax
planning decisions.
THE PENTAPUS
The term Pentapus, as well as other expressions, has been coined for
five challenging areas of the Internal Revenue Code that international
tax planners face on behalf of their American clients. Their assignment
for helping U.S. taxpayers with these potential tax liabilities
is to work around them legally when both possible and advantageous
for reducing or deterring taxes.
These are the five stumbling blocks:
1. Controlled foreign corporation
2. Foreign personal holding company
3. Personal holding company
4. Passive foreign investment company
5. Accumulated earnings
These complex IRS codes are only brief ly described here.
CONTROLLED FOREIGN CORPORATION
Subpart F of the Internal Revenue Code was enacted to tax U.S. shareholders
on undistributed profits of foreign corporations regardless of
whether a dividend is paid. This measure prevents majority owners of
foreign corporations from accumulating profits and delaying payment
of taxes until they choose to declare a dividend.
The IRC defines a controlled foreign corporation (CFC), IRC
951–64, as a corporation having more than 50 percent of its outstanding
voting shares owned by a maximum of five U.S. shareholders. A
U.S. stockholder is defined as an American who directly or indirectly
owns 10 percent or more of the voting stock.
It is difficult, but not impossible, for a U.S. majority shareholder
in a foreign corporation to circumvent the CFC tax, but if direct control
can be relinquished, taxes can be deferred indefinitely or until
the corporation is sold or liquidated.
For example, the U.S. shareholder is permitted to own up to and
including 50 percent of the voting stock of the corporation. Although
this is not majority control, it still amounts to considerable interest.
The U.S. shareholder brings in another shareholder, an unrelated foreign
person or corporation, to take possession of the remaining 50
percent of the voting shares. The bylaws of the offshore corporation
call for the shareholders to elect two directors who will sit on the
board and manage the corporation’s affairs. The articles also stipulate
that an additional, nonelected director may be appointed by the
U.S. director, although the U.S. director-shareholder cannot influence
the third director’s decisions or appoint another one. This strategy
amounts to indirect control and ultimately gives the U.S. directorshareholder
the upper hand.
There are two other methods for a U.S. shareholder to own shares
in a foreign corporation. They fall under the Attribution of Ownership
Rules: Chain of Ownership, IRC 958(a); and, the Constructive
Ownership rule IRC 958(b). Explore these avenues with your chosen
international tax planning expert.
FOREIGN PERSONAL HOLDING COMPANY
The foreign personal holding company (FPHC), IRC 551–58, derives
its income from passive sources, such as dividends, interest, royalties,
annuities, profits from stock sales, certain commodity profits, rents,
income from the sale of an estate or trust, certain personal service
contract monies, and a few other sources.
A U.S. shareholder is taxed on a proportionate share of the undistributed
income if a maximum of the five U.S. citizens own 50 percent
or more of the value of the outstanding stock and if at least 60 percent
of the gross income is FPHC income. As with the CFC, the FPHC tax
can be circumvented by not directly controlling the corporation or by
attribution.
PERSONAL HOLDING COMPANY
Another tax is the personal holding company (PHC), IRC 542(a), which
is similar to the foreign personal holding company (FPHC). The PHC
tax is not levied against U.S. shareholders but a tax against the company.
PASSIVE FOREIGN INVESTMENT COMPANY
Regardless of the number of shares held by Americans, if 75 percent of a
foreign corporation’s income is from passive sources or more than half
its assets contribute to the creation of that income, the U.S. citizen owning
shares will pay taxes on the proportionate amount along with interest
when profits are no longer deferred, as defined by IRC 904(d)(2)(A).
The passive foreign investment company (PFIC), IRC 1291–1297, effectively
replaced the foreign investment company provisions.
ACCUMULATED EARNINGS
The accumulated earnings (AE) tax, IRC 532(a) is intended to discourage
accumulated earnings so that funds will be reinvested or distributed
and/or taxed. Both U.S. and foreign corporations are subject
to the AE tax, but it only applies on U.S. income. The IRS computes
the tax rate at 39.8 percent.
Effective 2003, there are exemptions from the AE income tax with
respect to its shareholders, regardless of the number of shareholders,
which include:
_ PHC—a personal holding company, IRC 542
_ FPHC—a foreign personal holding company, IRC 552
_ Subpart F—a tax-exempt corporation, IRC 501
_ PFIC—a passive foreign investment company, IRC 1297
For a more comprehensive review of these Internal Revenue Codes,
how they can affect your offshore activities, and possible strategies for
avoiding them, readers and their tax planners will benefit by reviewing
Tax Havens of the World by Thomas P. Azzara (see Appendix A: “Offshore
Reading”) and Offshore Planning by Mary Simon, LLM, JD (see Part
Four: “Offshore Reference Works” for further information).
REPORTING REQUIREMENTS OF U.S. CITIZENS
Special requirements are imposed on U.S. taxpayers to report certain
international financial transactions including income, profit, transfers,
ownership, and other purposes. Here are some of the more frequently
used IRS forms that you should be aware of:
Form 5471—Information Return with Respect to a Foreign Corporation—
This form is used when acquiring or disposing of an interest
in a foreign corporation, when a controlled foreign
corporation conducts certain transactions, and when declaring
income received from a foreign corporation.
Form 5472—Information Return of a 25 percent Foreign-Owned
U.S. Corporation or a Foreign Corporation Engaged in a U.S.
Trade or Business—It is used when an American company has substantial
foreign ownership or a foreign company is doing business
in the United States.
Form 3520—Annual Return to Report Transactions with Foreign
Trusts and Receipt of Certain Foreign Gifts—Use it when establishing
or transferring assets to a foreign trust.
Form 926—Return by U.S. Transferor of Property to a Foreign Corporation—
This is used when transferring property to a foreign
entity.
Form 3520A—It is used to declare income of a foreign trust when a
U.S. taxpayer holds an interest.
Forms 1042 and 1042S—Use this form when payments are made to
a foreign person.
Forms 1020NR (corporation) and 1040NR (individual)—This form is
used for receipt of U.S. income or foreign effectively connectedwith
income by a resident or nonresident alien, respectively.
Form 4789—Currency Transaction Report (CTR)—It is used by financial
institutions to report cash deposits or transactions of
$10,000. or more. (These same financial institutions are also required
to keep records of all transactions of $3,000 or more.)
Form 4790—Report of International Transportation of Currency
or Monetary Instruments—This form is to be filed with the Bureau
of Customs if $10,000 or more in cash or monetary instrument
equivalent is being carried in or out of the United States.
Form 8300—The form that is used to report business transactions
involving $10,000 cash or more.
Form 8362—Currency Transaction Report by Casinos (CTRC)—It
is the same as a CTR but is used by casinos to report transactions
exceeding $10,000.
Form 8621—Return by a Shareholder of a Passive Foreign Investment
Company or Qualified Electing Fund.
Treasury Form TD F 90-22.1—Report of Foreign Bank and Financial
Accounts (FBAR)—A U.S. taxpayer must file this form annually
disclosing any financial interest in or signing power over a foreign
bank or other financial account if the aggregate value of the account
exceeded $10,000. Multiple accounts can now be reported
on the same form.
The FBAR reads, in part:
F. Bank, Financial Account. The term “bank account” means a savings, demand,
checking, deposit, loan, or other account maintained with a financial institution
or other person engaged in the business of banking. It includes
certificates of deposit. The term “securities account” means an account maintained
with a financial institution or other person who buys, sells, holds, or
trades stock or other securities for the benefit of another. The term “other financial
account” means any other account maintained with a financial institution
or other person who accepts deposits, exchanges, or transmits funds, or acts as a
broker or dealer for future transactions in any commodity on (or subject to the
rules of ) a commodity exchange or association.
SUSPICIOUS ACTIVITY REPORTS
This is the ultimate requirement. A Suspicious Activity Report
(SAR) gets filed anytime anyone thinks you are doing something
wrong. Actually, all it takes is for you to look suspicious. The eagle
eye is usually a financial institution. The SAR is required to be filed
with FINCEN, a division of the U.S. Treasury, in the case of “any suspicious
transaction relevant to a possible violation of law or regulabarb_
tion.” So far, they are fairly ineffective, as very few lead to prosecution.
What they do is create a lot of paperwork and more bureaucratic
expense.
STRUCTURING
Under a 1991 amendment to the Bank Secrecy Act of 1970, the Financial
Record Keeping, Currency and Foreign Transactions Reporting
Act, structuring is basically the act of avoiding the system set up to detect
money laundering, and this is illegal. This includes structuring
deposits to avoid the $10,000 currency transaction reporting required
by the government of banks. This form is a red f lag that a suspicious
transaction may have taken place. In an effort to get around this detection,
a method of structuring transactions is executed in hopes of
avoiding attention. This is also known as smurfing.
If you take a lump sum of whatever amount, and break it down
into amounts smaller than $10,000 each, and deposit these in various
accounts rather than depositing the single sum as originally received
in a single account (requiring the receiving bank to file Form 4790),
or if you delay depositing such lesser amounts into one or more accounts,
spreading them over time to avoid the $10,000 threshold at
which the bank must file their report, then you are structuring, and
this in itself is illegal. It can be an individual acting independently or
any number of others assisting in the process. The penalties are stiff,
so it’s worth avoiding.
TAX TREATIES
There are numerous income tax treaties between the United States
and foreign countries, including tax havens. These are also referred
to as double-taxation agreements and provide the U.S. taxpayer living
in the United States with a foreign tax credit, not a deduction, for all
foreign taxes that qualify.
Frequently, these treaties include exchange-of-information
clauses that allow several possibilities for exchanging information between
countries, such as routine or automatic transmittal of information,
requests for specific information, and spontaneous information
requests. More disconcerting than having this type of clause incorporated
into an income tax treaty is the Tax Information Exchange
Agreement (TIEA), which is not a tax treaty at all, but a way for the
IRS to obtain from another country that is party to such an agreement,
confidential information that would otherwise be protected by
the tax haven’s secrecy and confidentiality laws. Chapter 28 provides
more information on TIEAs.
These treaties are important in countries like Switzerland where
there is a 35 percent withholding tax on investment earnings and will
save the taxpayer from paying twice as much tax, once to Switzerland
and again to the IRS. The amount of the withholding tax is deducted
right off the amount you would be owing the IRS that year. You can
also get a refund direct from the Swiss.