25 INTERNATIONAL TAX PLANNING

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Here are some important highlights affecting international tax

planning decisions.

THE PENTAPUS

The term Pentapus, as well as other expressions, has been coined for

five challenging areas of the Internal Revenue Code that international

tax planners face on behalf of their American clients. Their assignment

for helping U.S. taxpayers with these potential tax liabilities

is to work around them legally when both possible and advantageous

for reducing or deterring taxes.

These are the five stumbling blocks:

1. Controlled foreign corporation

2. Foreign personal holding company

3. Personal holding company

4. Passive foreign investment company

5. Accumulated earnings

These complex IRS codes are only brief ly described here.

CONTROLLED FOREIGN CORPORATION

Subpart F of the Internal Revenue Code was enacted to tax U.S. shareholders

on undistributed profits of foreign corporations regardless of

whether a dividend is paid. This measure prevents majority owners of

foreign corporations from accumulating profits and delaying payment

of taxes until they choose to declare a dividend.

The IRC defines a controlled foreign corporation (CFC), IRC

951–64, as a corporation having more than 50 percent of its outstanding

voting shares owned by a maximum of five U.S. shareholders. A

U.S. stockholder is defined as an American who directly or indirectly

owns 10 percent or more of the voting stock.

It is difficult, but not impossible, for a U.S. majority shareholder

in a foreign corporation to circumvent the CFC tax, but if direct control

can be relinquished, taxes can be deferred indefinitely or until

the corporation is sold or liquidated.

For example, the U.S. shareholder is permitted to own up to and

including 50 percent of the voting stock of the corporation. Although

this is not majority control, it still amounts to considerable interest.

The U.S. shareholder brings in another shareholder, an unrelated foreign

person or corporation, to take possession of the remaining 50

percent of the voting shares. The bylaws of the offshore corporation

call for the shareholders to elect two directors who will sit on the

board and manage the corporation’s affairs. The articles also stipulate

that an additional, nonelected director may be appointed by the

U.S. director, although the U.S. director-shareholder cannot influence

the third director’s decisions or appoint another one. This strategy

amounts to indirect control and ultimately gives the U.S. directorshareholder

the upper hand.

There are two other methods for a U.S. shareholder to own shares

in a foreign corporation. They fall under the Attribution of Ownership

Rules: Chain of Ownership, IRC 958(a); and, the Constructive

Ownership rule IRC 958(b). Explore these avenues with your chosen

international tax planning expert.

FOREIGN PERSONAL HOLDING COMPANY

The foreign personal holding company (FPHC), IRC 551–58, derives

its income from passive sources, such as dividends, interest, royalties,

annuities, profits from stock sales, certain commodity profits, rents,

income from the sale of an estate or trust, certain personal service

contract monies, and a few other sources.

A U.S. shareholder is taxed on a proportionate share of the undistributed

income if a maximum of the five U.S. citizens own 50 percent

or more of the value of the outstanding stock and if at least 60 percent

of the gross income is FPHC income. As with the CFC, the FPHC tax

can be circumvented by not directly controlling the corporation or by

attribution.

PERSONAL HOLDING COMPANY

Another tax is the personal holding company (PHC), IRC 542(a), which

is similar to the foreign personal holding company (FPHC). The PHC

tax is not levied against U.S. shareholders but a tax against the company.

PASSIVE FOREIGN INVESTMENT COMPANY

Regardless of the number of shares held by Americans, if 75 percent of a

foreign corporation’s income is from passive sources or more than half

its assets contribute to the creation of that income, the U.S. citizen owning

shares will pay taxes on the proportionate amount along with interest

when profits are no longer deferred, as defined by IRC 904(d)(2)(A).

The passive foreign investment company (PFIC), IRC 1291–1297, effectively

replaced the foreign investment company provisions.

ACCUMULATED EARNINGS

The accumulated earnings (AE) tax, IRC 532(a) is intended to discourage

accumulated earnings so that funds will be reinvested or distributed

and/or taxed. Both U.S. and foreign corporations are subject

to the AE tax, but it only applies on U.S. income. The IRS computes

the tax rate at 39.8 percent.

Effective 2003, there are exemptions from the AE income tax with

respect to its shareholders, regardless of the number of shareholders,

which include:

_ PHC—a personal holding company, IRC 542

_ FPHC—a foreign personal holding company, IRC 552

_ Subpart F—a tax-exempt corporation, IRC 501

_ PFIC—a passive foreign investment company, IRC 1297

For a more comprehensive review of these Internal Revenue Codes,

how they can affect your offshore activities, and possible strategies for

avoiding them, readers and their tax planners will benefit by reviewing

Tax Havens of the World by Thomas P. Azzara (see Appendix A: “Offshore

Reading”) and Offshore Planning by Mary Simon, LLM, JD (see Part

Four: “Offshore Reference Works” for further information).

REPORTING REQUIREMENTS OF U.S. CITIZENS

Special requirements are imposed on U.S. taxpayers to report certain

international financial transactions including income, profit, transfers,

ownership, and other purposes. Here are some of the more frequently

used IRS forms that you should be aware of:

Form 5471—Information Return with Respect to a Foreign Corporation—

This form is used when acquiring or disposing of an interest

in a foreign corporation, when a controlled foreign

corporation conducts certain transactions, and when declaring

income received from a foreign corporation.

Form 5472—Information Return of a 25 percent Foreign-Owned

U.S. Corporation or a Foreign Corporation Engaged in a U.S.

Trade or Business—It is used when an American company has substantial

foreign ownership or a foreign company is doing business

in the United States.

Form 3520—Annual Return to Report Transactions with Foreign

Trusts and Receipt of Certain Foreign Gifts—Use it when establishing

or transferring assets to a foreign trust.

Form 926—Return by U.S. Transferor of Property to a Foreign Corporation—

This is used when transferring property to a foreign

entity.

Form 3520A—It is used to declare income of a foreign trust when a

U.S. taxpayer holds an interest.

Forms 1042 and 1042S—Use this form when payments are made to

a foreign person.

Forms 1020NR (corporation) and 1040NR (individual)—This form is

used for receipt of U.S. income or foreign effectively connectedwith

income by a resident or nonresident alien, respectively.

Form 4789—Currency Transaction Report (CTR)—It is used by financial

institutions to report cash deposits or transactions of

$10,000. or more. (These same financial institutions are also required

to keep records of all transactions of $3,000 or more.)

Form 4790—Report of International Transportation of Currency

or Monetary Instruments—This form is to be filed with the Bureau

of Customs if $10,000 or more in cash or monetary instrument

equivalent is being carried in or out of the United States.

Form 8300—The form that is used to report business transactions

involving $10,000 cash or more.

Form 8362—Currency Transaction Report by Casinos (CTRC)—It

is the same as a CTR but is used by casinos to report transactions

exceeding $10,000.

Form 8621—Return by a Shareholder of a Passive Foreign Investment

Company or Qualified Electing Fund.

Treasury Form TD F 90-22.1—Report of Foreign Bank and Financial

Accounts (FBAR)—A U.S. taxpayer must file this form annually

disclosing any financial interest in or signing power over a foreign

bank or other financial account if the aggregate value of the account

exceeded $10,000. Multiple accounts can now be reported

on the same form.

The FBAR reads, in part:

F. Bank, Financial Account. The term “bank account” means a savings, demand,

checking, deposit, loan, or other account maintained with a financial institution

or other person engaged in the business of banking. It includes

certificates of deposit. The term “securities account” means an account maintained

with a financial institution or other person who buys, sells, holds, or

trades stock or other securities for the benefit of another. The term “other financial

account” means any other account maintained with a financial institution

or other person who accepts deposits, exchanges, or transmits funds, or acts as a

broker or dealer for future transactions in any commodity on (or subject to the

rules of ) a commodity exchange or association.

SUSPICIOUS ACTIVITY REPORTS

This is the ultimate requirement. A Suspicious Activity Report

(SAR) gets filed anytime anyone thinks you are doing something

wrong. Actually, all it takes is for you to look suspicious. The eagle

eye is usually a financial institution. The SAR is required to be filed

with FINCEN, a division of the U.S. Treasury, in the case of “any suspicious

transaction relevant to a possible violation of law or regulabarb_

tion.” So far, they are fairly ineffective, as very few lead to prosecution.

What they do is create a lot of paperwork and more bureaucratic

expense.

STRUCTURING

Under a 1991 amendment to the Bank Secrecy Act of 1970, the Financial

Record Keeping, Currency and Foreign Transactions Reporting

Act, structuring is basically the act of avoiding the system set up to detect

money laundering, and this is illegal. This includes structuring

deposits to avoid the $10,000 currency transaction reporting required

by the government of banks. This form is a red f lag that a suspicious

transaction may have taken place. In an effort to get around this detection,

a method of structuring transactions is executed in hopes of

avoiding attention. This is also known as smurfing.

If you take a lump sum of whatever amount, and break it down

into amounts smaller than $10,000 each, and deposit these in various

accounts rather than depositing the single sum as originally received

in a single account (requiring the receiving bank to file Form 4790),

or if you delay depositing such lesser amounts into one or more accounts,

spreading them over time to avoid the $10,000 threshold at

which the bank must file their report, then you are structuring, and

this in itself is illegal. It can be an individual acting independently or

any number of others assisting in the process. The penalties are stiff,

so it’s worth avoiding.

TAX TREATIES

There are numerous income tax treaties between the United States

and foreign countries, including tax havens. These are also referred

to as double-taxation agreements and provide the U.S. taxpayer living

in the United States with a foreign tax credit, not a deduction, for all

foreign taxes that qualify.

Frequently, these treaties include exchange-of-information

clauses that allow several possibilities for exchanging information between

countries, such as routine or automatic transmittal of information,

requests for specific information, and spontaneous information

requests. More disconcerting than having this type of clause incorporated

into an income tax treaty is the Tax Information Exchange

Agreement (TIEA), which is not a tax treaty at all, but a way for the

IRS to obtain from another country that is party to such an agreement,

confidential information that would otherwise be protected by

the tax haven’s secrecy and confidentiality laws. Chapter 28 provides

more information on TIEAs.

These treaties are important in countries like Switzerland where

there is a 35 percent withholding tax on investment earnings and will

save the taxpayer from paying twice as much tax, once to Switzerland

and again to the IRS. The amount of the withholding tax is deducted

right off the amount you would be owing the IRS that year. You can

also get a refund direct from the Swiss.