In a previous column (March 2002, “The Globalization of U.S. Taxation”) we discussed the tax issues confronting the international investor who is a non-U.S. citizen or resident. In this article, we’ll address what happens when a U.S. citizen or resident makes investments or holds assets outside the United States.
Many U.S. citizens or residents have investments and transactions around the globe. Some have moved overseas and intend to live there for an extended period. An understanding of how the U.S. tax system applies to them, and how it interacts with foreign tax systems, will help them to make informed investment, business, and legal decisions. The U.S. has income tax and estate tax treaties with many countries, and these treaties have a significant impact on how the U.S. investor gets taxed.
The United States probably has the most far-reaching tax jurisdiction base over its citizens and residents in the world. For income tax purposes, if you are a U.S. citizen or resident, then you are subject to U.S. taxes on your worldwide income from all sources. This rule applies not just to those who are legal immigrants (a person who is a permanent resident, i.e., with a “green card”), but may apply to non-permanent visitors to the U.S. (such as those with a B, E, H, or L visa), and who meet what is known as the “substantial presence” test.
For U.S. estate and gift tax purposes, if you are a U.S. citizen or resident (for estate tax purposes), then you are subject to U.S. estate and gift tax on your worldwide assets. Determination of “residence” for “estate and gift tax purposes” operates under a different set of rules than those for “income tax purposes.” While for income tax purposes the standards are very precise and codified in U.S. tax law, residency for U.S. gift and estate taxes are based on a “facts and circumstances” test. Therefore, it happens quite frequently that a person can be classified as a U.S. resident for income tax purpose while not being considered a U.S. resident for estate and gift tax purposes. The reverse situation is also possible, although it happens less frequently. One example is the United Nations employee who has been working in the U.S. on a G-4 visa for an extended period. Such an individual is exempt from the “substantial presence” test and is clearly a “non-resident” for income tax purposes. However, for U.S. estate tax purposes, this person can be classified as a U.S. resident and be subject to the U.S. estate tax on worldwide assets.
In this article, the term “U.S. person” shall include both a U.S. citizen and any person who is considered as a “resident for tax purposes” (for the type of tax we are discussing then: income tax or estate tax).
Income Taxes Overseas
How a U.S. person gets taxed on income from investments abroad depends on two initial questions: What is the U.S. person’s residency status in the country where the investment is located? Does the U.S. have an income tax treaty with that country?
If the U.S. person is not a resident in the country where the investment is located, then investment-type income (such as interest, dividends, or royalties) from abroad are typically subject to local withholding taxes.
If an income tax treaty exists between the U.S. and the particular country, then probably the withholding tax rate will get reduced. Possibly, for treaties with certain countries, some categories of income are exempt from tax altogether.
An example is the U.S. person who has a bank deposit at a bank in Canada. Under the Canada-U.S. Tax Treaty, a 15% Canadian withholding tax on the gross interest income is imposed (rather than a higher 25% tax rate against someone from a country that has no tax treaty with Canada). The U.S. person will then report the interest income on her or his U.S. tax return, and claim a “foreign tax credit” for the Canadian tax paid. Therefore, it is possible that the U.S. person will have no additional tax cost due to the overseas investment, since the foreign tax paid is in fact “cancelled” out by the credit claimed on her or his U.S. tax return.
It’s important to note that other countries can have different concepts of what income should be taxed, and how they should be taxed, as compared to the U.S. tax system.
On capital gains income from sale of stocks or other securities, the tax rules in countries around the world differ widely: some tax capital gains of residents no matter where the capital gains come from, others only tax capital gains derived locally, and still others completely exempt capital gains.
If the U.S. person is a resident under the tax laws of the country where the investment is located, then the person will likely need to file local tax returns, and pay taxes on his income “sourced” to the foreign country based on the tax rules for local residents. The person would still have to file a U.S. tax return, and claim whatever foreign taxes were paid on the U.S. return.
Depending on the “sourcing rules” of the foreign country, a U.S. person may find his income subject to local taxation that is similar to or differs drastically from what is taxable for U.S. tax purposes. For instance, Hong Kong has a “territorial basis” of taxation. Any income derived by a Hong Kong resident outside of Hong Kong sources is not subject to taxation. The definition of what is the “source” is extremely significant. Under Hong Kong sourcing rules, interest income from a U.S. bank account, or capital gains from the sale of U.S. stocks, are considered non-Hong Kong sources. Under U.S. tax rules, the interest income or capital gains derived by a U.S. person is always a U.S. source, as the U.S. sourcing rules adopt the concept that the source of income from intangible assets (i.e., interest, dividends, capital gains) follows the recipient’s tax residency.
The attraction of a narrow tax base (such as Hong Kong’s) and lower tax rates in other countries has given the incentive to many U.S. persons to remove themselves from the U.S. tax jurisdiction by ridding themselves of their U.S. citizenship or residency status.
However, these days, U.S. persons with that desire need to deal with the “expatriate tax provisions” enacted in 1996. Under these provisions, individuals who relinquished U.S. citizenship or their “long-term U.S. residency” with a principal purpose of avoiding U.S. taxes are taxed on their U.S. source income at the graduated rates applicable to U.S. citizens for 10 years after “expatriation”. For example, gains on the sale of personal property located in the U.S. and gains on the sale of U.S. stocks are treated as U.S. source income. Although the expatriation tax rules seem harsh, expatriation can still be an attractive tax reduction strategy.
Many people believe that simply placing assets (such as bank accounts or securities) offshore will allow them to escape U.S. taxation. That is simply not true. As mentioned earlier, the U.S. has a very expansive tax base concept, so that as long as the U.S. person owns it directly or indirectly, the chances are that income from those assets is subject to U.S. taxation. The technique of placing assets into an offshore corporation or trust may not necessarily work if one of the anti-deferral mechanisms of the U.S. tax law is triggered. These anti-deferral mechanisms include the following: CFC (Controlled Foreign Corporation), PHC (Personal Holding Company), PFIC (Passive Foreign Investment Company), FIC (Foreign Investment Company), and Section 1248 (the CFC “backstop” to convert capital gains to ordinary income). Generally speaking, if over a certain stock ownership percentage is met (ie. stocks owned by U.S. persons), and if more than a certain portion of the company’s income is “passive” (i.e. interest, dividends, royalties, rents, etc.), then the company’s income (all or a portion) becomes immediately taxable in the U.S. Extremely careful navigation in this complex web of rules is necessary to avoid penalties and to arrive at the investor’s tax objective.
Estate Taxes Overseas
If a U.S. person has investments abroad, these assets may be subject to the estate taxes (sometimes called inheritance tax) in the foreign country if the U.S. person passes away. Assets that are tangible (such as real estate) are invariably taxed under the country’s estate tax system.