Tax Loophole Income Tax Foreign

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.

Foreign Tax Havens

Almost any other country in the world possesses a lower tax rate on certain activities than other countries. Due to the fact that nations routinely employ their tax laws in influencing the use of foreign and domestic capital, income tax rates any particular activity vary considerably worldwide (Augustyn,1985). A country that has a high tax regime for a particular activity may also have a low tax regime for another different activity. Some countries however have a legislation and policy for non-taxation of non-citizens. These countries are referred to by tax professionals as "tax havens" (Langer,1985). For instance people who seek to bank their money in a tax haven may choose to do so in the Cayman Islands.

The Cayman is noted to be appropriate for two main reasons. The first reason is that it is one of the most popular places for enjoying the tax haven conditions (Langer,1985).Citizens of the U.S. mainly prefer the Caymans for two main reasons. These are tax avoidance and tax evasion. Tax evasion is the act of illegally hiding one's income or assets for the sole intention of deceiving the United States Internal Revenue Service (IRS) while tax avoidance is any legal measure that is employed to lower an individual's or corporation's tax liability. The legal way of making use of the Cayman tax haven is to effectively form a company under the Cayman law and then effectively assign the income stream to that particular company or corporation (Doggart,1987). The company however must possess a legitimate business intention and purpose other than tax avoidance.

The non-U.S. businesses or persons can the set up Caymanian companies for the sole purpose of tax deferrals. Cayman is known to impose income tax only on companies that do local business. It is therefore an ideal location for U.S. citizens and non-U.S. citizens to locate their income stream. The U.S. citizens and non-U.S. citizens may incorporate a business which is also referred to as a base company under the Caymanian laws and then assign the income streams to the corporation. The property that is employed for starting the company is the subjected to a single one time 35% excise tax. The subsequent incomes are then effectively attributed to the previously formed base company. This form of tax avoidance effectively defers taxation. Certain individuals may also enjoy the various benefits of the company's money while effectively a voiding taxation via the employment of "secondary sheltering." (OECD,1987).

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.