No matter if you are a US-based investor, a US expatriate, or an "other" US person living abroad, I am going to share three basic international taxation principles to you so you can get working outline how international taxation really works.
A big reason why these international taxation principles exist is because of the judicially-created concept of "Universal Tax Jurisdiction." If you make a dollar anywhere, the IRS thinks it should not just know about it, but maybe they'll want to go ahead and tax you on it. If you make a dollar anywhere in the world, the IRS is completely allowed to assert a claim on ownership on at least part of that dollar because of its international taxation principles.
Principle One: Attempting to defeat the IRS by moving accounts and assets internationally is not nearly as easy as it was even 10 years ago.
Earning income outside the United States does not automatically remove, or exempt, that income from US taxation. Historically, one reason many may have moved assets and money is to avoid US taxation. It used to be very difficult for the IRS to track what kinds of assets and income US taxpayers had around the world. Ex-spouses used to be a great source, and sometimes the only source, of information. However, with the imposition of FATCA there is now an affirmative duty for many foreign banks to inquire about a bank account holder's US tax status. The IRS also imposes significant FBAR penalties on those who fail to report the existence of accounts over $10,000.00.
While there are still some legitimate international tax planning tools available for the individual, for many international tax shelters, the IRS considers them abusive. "Abusive" is the IRS' term for tax shelters that have no legitimate business purpose but to avoid taxes.
Principle Two: The IRS comes first.
If you are a US person earning money abroad or domestically, guess what? You still have to file your taxes and pay any tax due. True, you may be entitled to not have foreign income exclusion and a foreign tax credit for taxes that you paid, but you still have that reporting obligation.
While UK-domiciled individuals who are not residents for three consecutive tax years are not liable for United Kingdom taxation on their worldwide income, US-domiciled individuals, like those on an H1-B Visa or Green card, are immediately liable to the IRS for their worldwide income.
The penalties for making innocent mistakes and not reporting income and the existence of accounts can be quite high and draconian. New choices like the Streamlined OVDP are available and are most beneficial for those who can claim a residency status outside the US in any of the last three years.
Principle Three: International tax shelters used to be easy.
So what does a legitimate tax shelter do? You may already be familiar with a domestic type of tax shelter — the traditional 401(k). A 401(k) allows an employee to contribute pre-tax dollars and all earnings the accounts generate. The account grows tax-free until a disbursement.
Looking for the right path? Just follow the arrows
The technical term used to describe the ability to grow your money tax-free until an actual disbursement is called "deferral." Like a 401(k), deferral is typically the primary objective of any legitimate international tax planning. It used to be relatively simple. Simply move your money offshore to a foreign corporation with a low corporate rate and let it grow, grow, grow. Like a 401(k), you would only have a tax obligation when you actually took money out.
Let's look at an illustration why deferral is so valuable:
| Invested Domestically in 1974: | Invested International with 100% deferral of yearly gains in 1974: |
| $100,000 | $100,000 |
| Assume 5% interest rate | Assume 5% interest rate |
| Assume 20% US tax rate per year | Assume no foreign taxes, only 20% tax rate upon disbursement |
| Grows to $495,259 | Grows to $738,804. If 100% is disbursed @ 20% tax net is approx. $591,043 |
In the above table, we only assume a 20% domestic tax rate, and a 5% per year rate of return. The savings get larger the higher the domestic tax rate and the higher the rate of return. The following table is an example.
| Invested Domestically in 1974 | Invested in Foreign Corporation in 1974 |
| $100,000 | $100,000 |
| Assume 10% rate of return | Assume 10% rate of return |
| Assume domestic 35% tax rate (for effective 6.5% rate of return) | Assume 0% foreign tax rate, 35% domestic tax rate upon disbursement |
| Grows to 1,346,062. | Grows to $5,456,824. If 100% disbursed at tax rate @ 35%, net is approx $3,546,935. |
Above we see the real value of deferral much more clearly. There is nearly a three-time increase over the domestic investment. To put it another way, if you had only $40,000 to invest in 1974 and yet invested in a foreign corporation that grew tax-free, you would have a lot more than the $100,000 someone else invested domestically. That's something, after taking into account the 35% tax on a final and complete distribution.
You're fine giving the IRS a cut when you take a disbursement, but until then, why not have your money grow tax-free? Isn't it the same thing as a traditional 401(k)? Why isn't everyone doing this?
And here comes the bad news. In 1962, a nasty little law was passed. Jargon alert: It is called the "Subpart F Rules". Subpart F Rules set the tax treatment for Controlled Foreign Corporations (CFCs), which gives rise to Form 5471. And this really ruined much of the international tax planning fun. What is Subpart F and why has it ruined the party? Click here to find ream more.
