Many United States investors have heard about opportunities to mitigate federal income tax liabilities on earnings received through foreign corporations. Although it may be possible to defer U.S. tax on foreign corporate earnings until the payment of a dividend distribution, such practices require careful planning and consultation with your tax attorney or certified public accountant.
Foreign Corporation Tax Basics
The Internal Revenue Service imposes tax on all income of U.S. residents, no matter where in the world the earnings activity takes place. Income of foreign corporations earned from sources wholly outside the U.S. though, typically falls beyond the jurisdiction of the IRS, subject to a battery of complex exceptions. It may not be until a foreign corporation actually distributes earnings in the form of a dividend to a U.S. citizen that the IRS is authorized to tax such income. Then a foreign withholding tax credit may help alleviate the U.S. tax liability on foreign dividends in certain situations.
Ordinary or Qualified Dividends
Either ordinary income tax rates or reduced capital gains tax rates may apply to dividend distributions paid by foreign corporations to U.S. individuals. Sometimes a Form 1099-DIV issued to the recipient will identify the dividend as either ordinary or qualified, but such notice is not necessarily authoritative. Generally, to qualify for reduced capital gains tax rates, the U.S. shareholder must satisfy a minimum ownership period requirement and the foreign corporation must either meet the criteria established in a comprehensive double tax treaty or be listed on a U.S. stock exchange.
Deemed Foreign Dividends
The IRS may also impose tax on U.S. residents with interests in foreign corporations, even if the taxpayer does not actually receive a dividend distribution. Complex technical rules aim to prevent individuals from deferring U.S. tax on the abusive accumulation of undistributed earnings within certain types of foreign corporations. These rules create fictional scenarios in which the earnings of passive foreign investment companies or controlled foreign corporations, for instance, are deemed to be distributed as dividends and therefore immediately taxable to U.S. shareholders.
Passive Foreign Investment Companies
U.S. investors in passive foreign investment companies may face adverse tax implications, substantial administrative requirements or both. The tax code defines a passive foreign investment company as any foreign corporation with at least 75 percent of its gross income derived from passive activities or at least 50 percent of its assets used to produce passive earnings. Passive income generally includes dividends, interest, royalties, rents, annuities and gains on certain property transactions, although various exceptions may apply.
Controlled Foreign Corporations
U.S. owners of controlled foreign corporations may also realize detrimental tax consequences in connection with certain earnings activity. The tax code identifies a controlled foreign corporation as any foreign corporation in which U.S. shareholders own greater than 50 percent of the total voting power or value of the stock. The term "U.S. shareholder" means a U.S. citizen who holds at least 10 percent of the voting power of the foreign corporation, whether directly, indirectly or constructively.
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