Cross-border taxation.

• Author: Leibowicz, Barry

Fifty years ago, Marshall McLuhan coined the phrase "global village" (1) to describe the contraction of the world caused by rapid advances in communication technology.' Ongoing technological advancement has brought with it a corresponding increase in cross-border business transactions. Once the exclusive province of large accounting and law firms, now even the smallest firms must master cross-border tax issues.

The tax laws governing cross-border transactions are both arcane and complex, and they present a host of traps, demanding familiarity with the basic tax rules that apply to both U.S. and foreign persons. The following discussion of inbound and outbound cross-border transactions is in-tended to provide that basic knowledge.

The Basic Framework of Cross-Border Taxation

U.S. citizens are taxable on their worldwide income, with a credit or deduction for taxes paid on foreign income. The United States makes no distinction between earnings from business or investment activities within the United States and those outside its borders. Transactions by U.S. taxpayers in other countries are 'generally referred to as "outbound transactions," while those of foreign taxpayers within the United. States are "inbound transactions." Rules for outbound transactions capture foreign income for U.S. tax purposes and are intended to prevent tax avoidance through the use of foreign entities. The tax rules governing inbound activities impose tax on income from sources within the United States and income that is effectively connected with the conduct of a trade or business within the United States. Some inbound income of a nonresident alien (e.g., capital gain income) (3); is not taxed unless the individual is in the United States for more than 183 days during the tax year.

The Internal Revenue Code provides default rules for taxing cross-border transactions. However, a tax treaty between the United States and the home country of a foreign taxpayer, or a country in which a U.S. taxpayer does business or produces income, takes priority over the default rules. Thus, assessing the tax impact of cross-border activity requires familiarity with any applicable tax treaty as well as with the default rules set forth in the Code.

Outbound Transactions

In the simplest form of outbound transaction, individual U.S. taxpayers invest in or do business in foreign jurisdictions directly, reporting all income and losses on an annual basis just as they would for U.S.-based business or investment, subject only to their obligations to the relevant foreign jurisdiction. Income tax paid to the foreign jurisdiction is taken as either a credit or deduction against the U.S. taxes generated by the foreign income. The credit is limited each year by a taxpayer's total U.S. tax liability multiplied by a ratio of the taxpayer's total foreign source income over the taxpay er's total worldwide income. This limit effectively results in foreign income being taxed at the higher of the U.S. or average tax rate paid on worldwide foreign income. Income earned in low-tax jurisdictions thus permits the U.S. taxpayer to take advantage of excess tax paid in high-tax jurisdictions that would otherwise be lost.

U.S. Taxpayers Investing Through Foreign Entities

U.S. taxpayers often choose to engage in foreign business and investment activity through corporations, partnerships, or limited liability companies for a variety of reasons. For example, the separate-entity status of corporations may permit shareholders to defer taxation on their corporate earnings until they receive a corporate distribution, either in the form of a dividend or redemption.' Historically, a corporation was often the investment vehicle of choice for foreign business and investment activity, since corporations with no U.S.-source income offered multiple tax-avoidance opportunities. In response, Congress enacted various provisions restricting the manipulation of income and expense that might otherwise accrue by using the corporate form for international investment.

Controlled Foreign Corporation

Subpart F of the Code provides the primary mechanism used to prevent avoidance or deferral of U.S. tax through the use of a controlled foreign corporation (CFC). The subpart F rules trigger the immediate inclusion in shareholders' gross income of their pro rata share of certain earnings of a CFC even if not yet distributed, and, as such, are an antideferral regime. The types of undistributed income that a CFC shareholder must include are (1) the CFC's subpart F income for the year; (2) the CFC's previously excluded subpart F income that is withdrawn during the year from certain investments; and (3) the CFC's increase in earnings invested in U.S. property. (5) The income is not taxed again when distributed. (6)

A CFC is any foreign corporation in which U.S. shareholders own more than 50% of the value or voting power on any day during the tax year. (7) Subpart F defines a U.S. shareholder as a U.S. person (8) (citizen, resident alien, or. U.S. partnership, trust, estate, or corporation) that owns 10% or more of the total combined voting power of the foreign corporation. (9) For purposes of determining U.S. shareholder and CFC status, stock ownership may be direct, indirect, or constructive, taking into account attribution of ownership from related persons or entities. (10) However, U.S. shareholders are subject to taxation under subpart F only to the extent of their direct and indirect ownership. (11) In addition, if shareholders do not own CFC stock at the end of the tax year, they have no subpart F inclusion, regardless of whether they were U.S. shareholders during the tax year. (12)

Taxable subpart F income is treated as a deemed dividend distribution up to the CFC's total earnings and profits for the tax year. (13) However, income included under subpart F is taxed at ordinary income tax rates rather than the U.S. rate on dividends. (14) A U.S. domestic corporate shareholder of a CFC is allowed a foreign tax credit for any foreign taxes the CPC paid on income that is attributed or distributed to it as a U.S. shareholder, limited to the taxes that would have been deemed paid if the CFC had made an actual distribution to the domestic corporation. (15) A deemedpaid credit is also available to any individual U.S. shareholder who elects to be taxed at domestic corporate rates on amounts included in gross income. (16) Subpart F income is taxed directly to the U.S. shareholder, regardless of how many tiers of CFCs exist between the U.S. shareholder and the CFC whose income is deemed distributed. (17)

Passive Foreign Investment Company

U.S. shareholders of foreign corporations are also subject to the passive foreign investment company (PFIC) rules, (18) which tax U.S. shareholders that escape CFC taxation because they own less than 10% of a foreign corporation. (19) Unlike the CFC rules, the threshold in determining PFIC ownership is based not on stock ownership or value, but rather on the nature of the income or assets of the particular foreign corporation.

A PFIC is a foreign corporation that meets either an income test (at least 75% of the foreign corporation's gross...