Tax Planning for Americans
Companies formed in the United States (“domestic” companies) and individuals who are either citizens or residents of the US for US income tax purposes are subject to US income tax on their worldwide income. Individual US income taxpayers and domestic companies can, in some instances, start international operations with relatively small amounts of capital and then expand with tax-free or low-taxed accumulations of earnings instead of net-tax dollars earned in the US. Expansion abroad can be more rapidly accomplished with 100-cent tax-free dollars, instead of 65-cent dollars in the case of a domestic company (using the current top marginal US corporate income tax rate of 35%) or potentially less in the case of an individual (based upon the current top marginal rate of 39.6% on ordinary income).
Controlled foreign corporation (CFC)
If a Bahamian company is more than 50% (by vote or value) owned (directly, indirectly or constructively) by US shareholders it is known under US tax laws as a “controlled foreign corporation” (CFC). A US shareholder is a US person who owns directly or indirectly (or constructively) 10% or more of the total combined voting power of a CFC. A US shareholder is subject to US income tax each year on his or her proportionate share of certain kinds of income of the CFC regardless of whether dividends are distributed. Some of the more common types of foreign-source income of a CFC which are currently taxable to its US shareholders (referred to as “Subpart F income”) include.
1.Passive income such as dividends, rents, interest, gains from the sale of property which itself produced passive income, capital gains from the sale of stocks and securities, gains on commodities and foreign currency transactions, royalties, etc.
2.Income of the sale of inventory where the goods are either purchased from, or sold to, a “related person.”
3.Income from services if rendered to a “related person.”
The IRC provides specific rules for determining when someone is a related person as to a CFC. Even so, because of certain exceptions and exclusions to the Subpart F income rules, the US shareholders of a Bahamian CFC may still be able to obtain US income tax deferral with respect to their shares of stock until dividends are distributed to them.
Investment opportunities for US shareholders of a Bahamian CFC
The types of CFCs particularly suitable for operations in The Bahamas are those that generate income which qualifies for an exception to the Subpart F income rules such as the following:
1. Sales of manufactured products.
Income from the sale of products or goods manufactured, produced, grown or extracted in The Bahamas generally is not subject to current US income tax even though purchases and sales may involve related persons. Likewise, income from certain incidental services rendered by a related person which are directly related to a sale by the Bahamian CFC of such products or goods and which are performed in advance of the sale may not be currently taxable in the US.
2. Sales of other inventory.
If a related person is not involved in any way, then income from the sale of inventory by a Bahamian CFC will escape current US income tax. Even if a related person is involved, the profits of a Bahamian CFC from the purchase and sale of personal property (on behalf of a related person) will not be considered Subpart F income of the products or goods sold are for use of, consumption or disposition in the Bahamas. Certain presumptions apply in making this determination which can vary depending upon the type of person purchasing the products or goods from the Bahamian CFC and their relationship to the Bahamian CFC
as well as the type of products or goods sold.
3. Insurance income.
A Bahamian insurance company can be considered a CFC if more than 25% of the voting power or value of its stock is owned by US shareholders if the gross amount of premiums or other consideration in respect of the reinsurance or the issuing of “insurance or annuity contracts” exceeds 75% of the gross amount of all premiums or other consideration in the respect of all risks. The US tax laws regarding offshore insurance companies are quite complex and have changed many times over the years. Because different sets of rules may apply depending upon the nature of the insurance business and the source of its profits, the advice of US tax counsel specializing in this area is recommended in each case.
4. Services income.
This potentially broad category may cover many different types of Bahamian companies that render technical, managerial, engineering, architectural, scientific, skilled, industrial or commercial services to consumers. Many types of companies in The Bahamas fall into this category. A partial list would include engineering, sales promotion, sales engineering, merchandising and consulting firms. Income from services of this nature which are rendered in The Bahamas either for or on behalf of a related person may be exempt from current US taxation.
5. Rents and royalties.
Rent derived by a CFC in the active conduct of a trade or business in The Bahamas from persons not related to the CFC will not be subject to current US taxation under the Subpart F rules. Rent, even when received from a related person to the CFC, also may meet the exception to Subpart F income if it is paid for use of property located in The Bahamas, subject to certain limitations. Similar rules apply in the case of income generated by the CFC which is properly classified as royalty income for US tax purposes.
6. Dividends and interest.
Dividend and interest income received by a Bahamian CFC from a related Corporation which is formed in The Bahamas and which uses a substantial part of its assets in its business in The Bahamas may qualify for US income tax deferral.
Passive foreign investment company (PFIC)
A Bahamian company is a PFIC if 75% or more of its gross income is “passive” in nature (ie subpart F type income), or 50% or more of its assets produce, or are held for the production of passive income. Most offshore mutual funds are classified as PFICs for US tax purposes. Interestingly, even an active business with a significant amount of cash and securities on hand could be a PFIC for US tax purposes.
US taxpayers who own (or are considered to own) shares of stock in a Bahamian company that is classified as a PFIC for US tax purposes are subject to US income tax under the excess distribution rules unless certain elections are made. The “excess distribution” rules impose an interest charge and US income tax on certain distributions from PFICs to their US owners (referred to as excess distributions). All gain recognized on the actual or deemed disposition of PFIC stock (such as a sale, gift, exchange, liquidation, pledge, etc) is also treated as an excess distribution (ie, long-term capital gains tax treatment is lost if it otherwise would have applied and the gain is taxed as ordinary income). A US owner of a PFIC may avoid this result by making one of the following two elections:
1. A US owner of a PFIC may be able to elect to be taxed currently on his pro rata share of the PFIC’s earnings and profits, classified as either ordinary income and capital gains, which will be treated as “previously taxed income” when distributed in a subsequent tax year, known as a “qualified electing fund” or (QEF) election.
2. Alternatively, a US owner of a PFIC may be able to mark-to-market his stock on an annual basis if such stock is “marketable.” PFIC stock is “marketable” for this purpose if it is:
a. stock regularly traded on a registered securities exchange;
b. stock that trades like an openend mutual fund; or
c. stock of a fund (open-end or closed-end) that publishes its net asset value at least annually. The mark-to-market election is less favourable than the QEF election, however, because all inclusions are taxed as ordinary income.
Coordination rules also prevent a foreign corporation from being classified as a PFIC as to any US owner during any period in which such foreign corporation is classified as a CFC of which such US owner is considered a US shareholder.
Employment of US citizens living abroad
US income tax benefits may be available to US citizens employed abroad who establish a “tax home” in a foreign country and who meet certain other tests prescribed by the IRC (either a physical presence or residency test with respect to the foreign country). Although a US citizen generally is subject to US income tax on his worldwide income, a US citizen employed abroad who satisfies the IRC tests described above may exclude from gross income for any taxable year foreignsource earned income for wages or salary for services performed outside the US an amount adjusted annually for inflation (US$102,100 for 2019). For any taxable year that a US citizen is employed abroad, he or she may also exclude from gross income a portion of the housing expenses paid for by an employer, or, if such expenses are not paid for by an employer, deduct such expenses (subject to certain limitations).
Reprinted from the 2019 edition of the Bahamas Handbook -
Source from -The Bahamas Investor 2019