Taxing foreign subsidiaries

Recently, there have been news reports that foreign subsidiaries of U.S. corporations do not pay U.S. taxes, which has people asking as to what rules have to be met for foreign subsidiary income to be US income tax-free.

The truth is that those articles would be more accurate if they described the earnings of foreign subsidiaries of U.S. corporations as tax deferred instead of as tax free. This does not diminish the value of tax deferral, but merely clarifies what is a frequent misunderstanding.

Generally, a foreign subsidiary of a U.S. corporation (or a
U.S. citizen, partnership, trust, etc.) is not subjected to the current U.S. tax on its foreign source income unless that income is within the range of what the tax law calls "Subpart F income". Included in Subpart F income is nearly every type of passive investment income. Also included is the income of a foreign corporation (owned and controlled by U.S. persons or entities) derived from favorable pricing in transactions with related or affiliated U.S. entities or persons.


With a typical foreign subsidiary of a U.S. corporation, the foreign sub is a resident in the foreign country as well as being licensed to conduct business in that country. If the foreign country imposes any kind of income, employment or value added taxes, the foreign subsidiary is subject to those taxes just the same as a local corporation. The foreign corporation is by and large independent of the U.S. parent company in the sense that the foreign sub has its own employees, an office and the facilities necessary to conduct business in the foreign country.

There are, in some cases, treaties between the U.S. and other countries that provide some tax benefits to a foreign based subsidiary of a U.S. company.

As mentioned in a recent article about self employment taxes for U.S. citizens who are living and working in a foreign country, a foreign corporation may be advantageous with respect to the U.S. self employment tax of an individual living and working outside the U.S.

A foreign corporation or IBC may be necessary in some countries in order to purchase foreign investments. If that should be the case, the U.S. owner of the corporation is usually better off to elect to have the
corporation taxed as a disregarded entity and to have the income of the foreign corporation flow through to the owners personal tax returns. The same applies to a foreign limited liability company.

Many people, though, have very short memories about tax matters. A long time ago, it was legal for U.S. citizens to own foreign corporations and to use those corporations to invest in foreign securities on a tax
deferred basis. But in 1962 the rules were changed and have since been refined continuously. Prior to 1981, the top personal tax rate in the U.S. was 70% while, at the same time, the top rate on capital gains was 28%. The top rate on corporations has been as high as 50.75% and is currently 35%. The top personal income tax rate is now 35% with a top rate on long term capital gains and qualified dividend income of 15%.

Many articles found in international tax literature suggest that U.S. personal tax rates are now lower than in many foreign countries while U.S. taxes on U.S. corporations are significantly higher than in many
foreign countries.

For non-corporate owners of foreign corporations, it is an advantage to elect to have the foreign corporation's income taxed at U.S. personal rates by making an election to be taxed as a foreign partnership (multiple owners) or as a disregarded entity (one owner.)

Where a foreign corporation is owned by a domestic corporation, the tax deferral just described is usually an advantage over having to pay current high corporate taxes on that foreign source income.

If you would like more information regarding asset protection, trusts, family limited partnerships or the subject of this article please call or email our office.

 


 

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