International Taxation Fundamentals (Pt 2)

As part of the ongoing series on international taxation, we are going to delve into various areas, focusing first on the fundamentals, then moving on to US inbound taxpayers and eventually over the course of several months, working on US outbound taxpayers. US inbound taxpayers are defined as anyone who isn’t a non-US tax person (individual or corporate entity) who then has some taxable income sourced to the US which would then be subject to US income taxation.

Basic Overview of the Logic of International Taxation in the US

Countries decide who they can tax for income based on two things: where the taxpayer lives and where their income comes from. In the United States, they mainly use where the taxpayer lives to figure out how much tax they owe if they're a U.S. citizen, resident, or domestic company. For everyone else, they look at where their income comes from to determine their tax obligations to the United States.

Some U.S. policymakers prefer to tax people based on where they live, while others think it should be based on where the money is made. If they follow the residence principle, people are taxed according to the laws of the country they live in, no matter where they earned the money.

The source principle, on the other hand, means people pay taxes based on the laws of the country where they earned the money, regardless of where they live. Either way, the goal is to avoid taxing the same income twice and reduce the need for agreements between countries.

Neutrality is important in international taxes because they want to make sure tax laws don't influence economic decisions too much. They talk about ideas like capital export neutrality and capital import neutrality, which mean that taxes should be fair whether you invest at home or abroad.

The Organization for Economic Cooperation and Development (OECD) is also working on dealing with issues like base erosion and profit shifting and the challenges caused by the digital economy. It shows that international tax rules are always changing and getting more complicated.

Definition of a US Person

The United States has a unique way of taxing its citizens, residents, and domestic companies. Unlike most countries that base taxes on where someone lives or earns income, the U.S. taxes its citizens on all the money they earn worldwide, no matter where they live or where the money comes from.

This rule is not clearly stated in the tax law, but it's understood because foreign income is usually taxed unless there's an explicit exception. In a US Supreme Court case called Cook v. Tait, it was decided that the U.S. has the power to tax its citizens' global income, even if they live in another country.

To avoid double taxation, the U.S. allows a credit for taxes paid to foreign countries under a section called 901. This means that if you pay taxes on your income in a foreign country, you can subtract that amount from what you owe in U.S. taxes. The credit is limited to the amount of U.S. tax that would be applicable to the foreign income.

There's also a provision called 911 that lets U.S. citizens living in foreign countries exclude a certain amount of their income from U.S. taxes. This is helpful for people working in countries with lower tax rates. In 2017, Congress made some changes to the tax laws to make them more focused on where income is earned, but they also made sure that multinational companies couldn't avoid paying significant taxes worldwide.

These changes included rules about deducting dividends from foreign companies, taxes on foreign earnings, and minimum taxes on certain payments to foreign affiliates.

Definition of a Foreign Person

Foreign individuals (aliens who do not reside in the US) and foreign corporations are only taxed by the United States on income they earn within the country. There are two tax systems in place for such income. If a nonresident alien or foreign corporation conducts a business in the United States, they are taxed at regular rates on the income that is directly linked to their US business.

However, if a foreign person earns income from US sources that is not connected to a business in the US, they may be subject to a flat tax rate of 30 percent (or a lower rate if determined by a bilateral treaty).

The key difference between the two tax systems lies in the allowance of deductions. The effectively connected income tax permits deductions for all relevant expenses directly related to the connected income, while the 30 percent tax is a gross income tax without any deductions.

Given the complexity, and changing nature of legislation, consulting an international tax CPA is highly recommended.

In our next article, we’ll carry on with definitions and overall considerations before delving into more specific areas.

-Karen Park, CPA, MBT