Tax loopholes in the U.S. tax code for foreign persons

Tax Loophole

Income tax

Foreign Tax Havens

Renunciation of U.S. Citizenship

An alternative to foreign tax credit

The current U.S. Tax Code has been noted by many to contain serious flaws that serve as loopholes for tax evasion and the subsequent loss of tax revenue (Drucker,2008). A majority of the culprits are large corporations and the super rich. In this paper, we discuss the major existing loopholes in the current U.S. Tax Code concerning the taxation of nonbusiness U.S.-source income of foreign persons

Tax loophole

Tax loophole was defined by the North Carolina Efficiency and Loophole-Closing Commission as taxes that unfairly give preference to some commodities or to some taxpaying groups (Holshouser, Scott and Boyles,2001). A tax loophole is a term that generally denotes an exploitation of the existing Tax Codes or law and can effectively lower or completely eliminate the existing tax liabilities of the tax filer. Tax code changes may also be a haven of tax loopholes. This is because immediately after the adoption of the tax code changes, savvy tax code experts as well as tax lawyers may find out the existence of flaws in the new tax law.

The tax loopholes in the current U.S. Tax Code concerning the taxation of nonbusiness U.S.

The tax loopholes that exists in the current U.S. Tax Code concerning the taxation of nonbusiness U.S. occurs when the a source income of foreign persons or company. Some individuals could be American but they exploit the loophole by setting up a company in a foreign country where some U.S. taxes are not applicable. Some individuals may even renounce their U.S. citizenship.

Ault and Bradford (1990) indicated that all U.S. persons are subjected to tax payment on a worldwide basis. This means that they have to pay tax regardless of their geographic income "source." This principle has traditionally been referred to as "residence" or "domiciliary-based jurisdiction because it is based on the existence of personal connection of the given taxpayer to the jurisdiction of taxation. On the contrary, foreign persons are subjected to tax on the income generated from "U.S. sources" only. Individual who are considered to be U.S. persons are the citizens of the United States of America. Corporations are also considered to be U.S. persons if they get incorporated in the U.S.

Whitaker (2012) indicated that taxations on individuals who are considered non-U.S. persons (also known as Non-Resident Aliens" or "NRAs") are subjected to the following conditions:

Income tax

In regard to the income tax, the individuals are subjected to United States income tax only on their income generated from U.S. sources and generally at a withholding rate of 30% (I.R.C. § 871(a)(1)).

The U.S. sources of income that are considered for the purpose of Income Tax as outlined by (I.R.C. § 871(a) are;

Dividends that are sourced from U.S. companies but not the proceeds sourced form the sale of U.S. securities

Rent sourced from U.S. real estate property as well as capital gains on real property sales as well as real property holdings.

Interest gained on debts of United States obligors. There is a however an exception of interest gained from publicly traded bonds that were issued after the 18th of July, 1984 since they constitute "portfolio interest" and are therefore qualified for the portfolio exemption.

Salaries that are paid by both U.S. As well as non-U.S. entities for various services that are performed by recipients who are based in the U.S.

United States royalties.

The other elements that are subjected to tax are Estate tax (only on United States situs assets), gift tax as well as treaties.

The major existing loopholes in the current U.S. Tax Code concerning the taxation of nonbusiness U.S.

No individual should pay more tax that is required by the law. Individuals who rely on tax shelters as well as legal loopholes are unethical. The congress has however made several options that influence how individuals use their money. The two main loopholes that are available in the U.S. For avoiding payment of tax are; the incorporation of a business entity in a foreign jurisdiction as well as renouncing of United States citizenship. These methods have their benefits and dangers.

Renunciation of U.S. Citizenship

In the recent past, a large number of very wealthy U.S. citizens have effectively renounced their citizenship and moved abroad. This is in order to be classified as non-U.S. citizens so as to save them an enormous amount of cash in United States income taxes. This is noted by Kristof (1996) as an extreme reaction to the U.S. government taxation of citizen's income.

The main advantage of renouncing United States citizenship or being a non-U.S. person is that the U.S. government will only tax the income of the person which is U.S. sourced provided that he or she is not a citizen or a resident. The income of the non-U.S. person's alien money on his or her deposit is the domestic banks are never taxed. The individuals who renounce their citizenship as well as that non-U.S. persons are therefore not liable to the payment of 55% estate taxes,55% of gift taxes or 39% on income taxes.

The Non-U.S. persons however operates in an environment with absolutely no U.S. income as well as estate taxes are paid and their work is therefore to be careful with the sources of pitfalls like U.S. residence, U.S. situs assets as well as U.S. source income.The other method that they mainly use is falsification of tax returns, not filling the tax return forms as well as not reporting part or all of their income, also known as Tax evasion

The impact of closing the loopholes that are related to foreign tax credits

The impact of closing the loopholes that are related to foreign tax credits would be enormous. Mooche (2012) indicated that the Obama Administration has vowed to claim expenses of close to $60 billion that were claimed on the foreign investments when U.S. citizens took advantage of the foreign laws in order to defer income. About $43 billion would then be recovered from the blatant abuse of foreign tax credits.

Income accrual in Foreign Retirement Plans

The non-U.S. persons who relocate to the U.S. And subsequently become legitimate U.S. tax residents usually participate in foreign retirement plans. Most people have often questioned if the income that is accrued in the foreign retirement plans on an annual basis must be made part of the United State's tax return. However, the rule for this kind of a situation is clearly stated and indicated in Rev. Proc 2002-23: which states that under the U.S. domestic law, a U.S. citizen or resident (Non U.S. person) who is a beneficiary of a foreign retirement plan would be subjected to the existing U.S. income taxation on all of the income that is accrued in their foreign investment plans even though their income is never currently distributed per se to the beneficiary. This should be the case unless the foreign retirement plan accounts as the employee's trust as described in section 402(b) of the U.S. Internal Revenue Code and the said individual is not one of the highly compensated workers who is subjected to the meaning of the section 402(b)(4)(a) Internal Revenue Code.

Therefore, as long as a given foreign retirement plan accounts as an employee's trusts with the person not being one of the highly compensated workers, then there is never an inclusion that is required by law. On the contrary, if the given foreign retirement plan is never an employee's trust or again if the given individual is one of the highly compensated workers, then the annual increase in the value of one's foreign retirement plan should be included on their individual U.S. tax return.

There are however certain rules that are deemed special and contained in the in U.S. tax treaties which may modify the way pension as well as retirement plans are taxed. It is therefore necessary for the applicable treaty to be reviewed in order to determine if the United States domestic law is effectively overridden by the existing treaty.

The non-U.S. persons may however exploit loopholes in regard to the declaration that the foreign retirement plan accounts is part of their trust when in actual sense it is not part of it and by providing falsified earning records to indicate that they are not highly compensated workers.

Legitimate opportunities for gaining significant tax benefit in offshore account operations

Due to the high level of scrutiny of offshore transactions by the IRS as well as the criminal penalties that are meted to individuals and corporation that are found to effectively evade their appropriate tax responsibilities, U.S. citizens as well as U.S.-non-citizen investors must be extremely careful in regard to how they invest their tax-reduction as well as tax-deferral investments. There are several windows of opportunity that they can exploit in order to gaining significant tax benefit in their offshore account operations. They include;

Tax reduction through credits and treaties

The U.S. And well as non-U.S. persons are noted to be not in a position to rely on the various existing treaties to reduce their appropriate tax burden. This is because the U.S. government has entered into various tax treaties with several foreign nations but has at the same time cancelled some of these treaties with the offshore tax havens. At the moment, it has tax treaties with tax havens such as Bermuda, Barbados as well as Netherlands Antilles. The income tax treaties are specially formulated to help in relieving the U.S. taxpayers from cases of double taxation. This could be as a result of the fact that the individual could be earning income in two countries that are signatories to the treaty. These treaties may help the individuals in the elimination as well as reduction of the tax to be withheld at source.

Avoiding the designation of a CFC status

Tax on the earning of a foreign company (Non-U.S.) may effectively be deferred if the given company manages to avoid the designation as a CFC. The United States investors must ensure that they effectively own fifty percent or less of the value of the foreign operation as well as voting power or by dispersing the ownership of the company among 11 or more United States shareholders. The avoidance of the CFT status as well as the impact of the Subpart F can allow the United States investors to effectively defer the tax on the value of the share of the company's income as well as to transfer the socks of the company without any form of a penalty.

An alternative to foreign tax credit

The alternative to foreign tax credit is not an abolishment of the foreign tax credit system at all since doing so would be disastrous as it would put the U.S. fund investors at a disadvantage in comparison with the direct investors (Viitala,2004). The alternative would be to allow the payment of the foreign tax credit to be done on a case-by-case basis in order to determine the legitimacy of the claims and transactions.