However, many individuals and families in China are either U.S. citizens or permanent residents, even if they do not spend significant time in the U.S. That means their U.S. tax compliance may languish. This is a dangerous tendency, particularly at a time when the U.S. is enforcing its tax laws more firmly than ever.
U.S. Withholding Tax
For non-U.S. taxpayers that have no requirement to file U.S. tax returns, the only way the U.S. can get any tax money is via withholding on payments sent from the U.S. to those persons. U.S. source income paid to foreign individuals amounts to $140 billion each year. The tax withholding rules are complex and difficult to summarize. However, most types of U.S. source income paid to a foreign person are subject to a withholding tax of 30%, although a reduced rate or exemption may apply in the case of some tax treaties.
The U.S. relies on private parties and companies to collect this withholding tax and remit it to the IRS. In fact, if withholding is required and a payer fails to withhold the required tax, the withholding agent (the payer) is liable for it. That is one reason non-U.S. individuals and companies often find that U.S. payers err on the side of withholding tax. The IRS does not criticize over-withholding.
However, not every payment is subject to withholding, and much of the terminology is hard to decipher. In general, the payment must be from sources within the U.S. to be subject to withholding. Moreover, it also must generally be classified as fixed or determinable annual or periodical income. This phrase has been interpreted as covering compensation for personal services, dividends, interest, rents, royalties, and many other types of payments. Gains from selling intangibles such as patents or copyrights are also subject to withholding.
For any individual or company receiving payments from the U.S., planning ahead is best. Payers in the U.S. want to be certain they are complying with U.S. law so they are not liable for the tax themselves. But there is often a way to address the issue provided that there is adequate time.
U.S. Citizens and Residents
In some ways, withholding tax problems are nothing compared to the tax issues facing U.S. citizens and residents. U.S. citizens and green card holders face a far more serious interaction with the IRS. There are more than 7 million U.S. citizens living outside the U.S. and many green card holders too. A green card holder is classified as a permanent U.S. resident for tax purposes regardless of how little time he spends in the U.S. U.S. citizens and green card holders must report their worldwide income to the IRS, and make annual FBAR financial disclosures.
In addition, if U.S. citizens or green card holders own more than 10% of the stock of any foreign company, additional U.S. tax and disclosure obligations arise. The biggest problem occurs for those who have invested more than 50% in a foreign company that holds their business, investments or even their residence. Under U.S. controlled foreign corporation rules, additional U.S. tax and disclosure obligations are triggered.
Moreover, there are deemed ownership rules that can attribute constructive ownership between family members. As a result, the propensity of foreign investors and families to have one or more companies in which they hold businesses or real estate can cause tax headaches.
Some U.S. citizens and green card holders choose to give up their U.S. citizenship or residency in view of what they may see as high U.S. compliance burdens. The number of expatriations from the U.S. is at a record high. But in some cases, the act of expatriating itself can involve compliance and disclosure.
Over the last few years, IRS subpoenas and prosecutions have caused banks to identify U.S. citizens and residents with foreign accounts. In addition, the U.S. has gathered stockpiles of information from whistleblowers, banks under investigation and cooperative witnesses. But the biggest sea change is the Foreign Account Tax Compliance Act (FATCA), the U.S. law that compels banks worldwide to turn over the details of American account holders.
As a result of FATCA, many nations are entering agreements with the U.S., including the UK, Canada, and numerous other nations. Despite delays in negotiations between China and the U.S., the two countries have expressed a desire to work together to implement a FATCA agreement. Hong Kong SAR has already embraced FATCA and an official agreement is expected to be signed in 2014. For all of these reasons, U.S. tax compliance is in the spotlight.
U.S. citizens and green card holders must report their worldwide income on their U.S. taxes, even if they claim foreign tax credits or an exclusion of income earned abroad. There are also disclosure obligations. If you have a foreign account, check es (on Schedule B).
As part of your tax return, you must file Form 8938 if your foreign assets (generally) exceed $50,000 in value. You also must file a Foreign Bank Account Report (FBAR) annually if the aggregate of your foreign accounts exceeds $10,000 at any time during the year. FBARs are separate filings due by June 30 each year. If you fail to report your worldwide income on your tax return or fail to check the foreign account box, it can be considered tax evasion or fraud.
The criminal statute of limitations is six years. The statute of limitations never expires on civil tax fraud, so the IRS can pursue you 10 or 20 years later. Tax bills can include a 20% penalty or a 75% civil fraud penalty.
Failing to file an FBAR carries a civil penalty of $10,000 for each non-willful violation. If willful, the penalty is the greater of $100,000 or 50 percent of the account balancefor each year you failed to file.Filing a false tax return is a felony that can mean up to five years in jail and a fine of up to $250,000. Failing to file FBARs can even be considered criminal, carrying fines up to $500,000 and up to ten years in prison.
For many, participation in the IRS offshore amnesty program is the best way to solve a failure to comply in the past without facing potential prosecution or civil penalties that can be severe. The IRS amnesty program involves submitting up to 8 amended tax returns and 8 FBARs. It involves paying taxes, interest and a 20% penalty on any unreported income. Finally, the IRS program calls for a penalty equal to 27.5% of the highest balance in your foreign accounts over the 8 years.
For many participants, the most painful part of the IRS program is the 27.5% penalty paid at the very end of the case. For some U.S. citizens living outside the U.S., though, there is a more favorable IRS program referred to as the treamlined program. For those who qualify, it only involves 3 tax returns, 6 FBARs, and no penalties.
For those who do not enter either amnesty program, the choices are narrowing. Some opt for a uiet disclosure. That means amending tax returns and filing FBARs outside the IRS amnesty programs. Although a quiet disclosure is better than doing nothing, the IRS warns that it will treat you harshly if it catches you. For fortunate taxpayers who do not owe any U.S. taxes despite improper reporting (because of foreign tax credits, for example), the IRS has said that amended tax returns are not necessary.
Moreover, in such a case, filing past due FBARs is not considered a quiet disclosure. And while both tax returns and FBARs are important, FBARs are arguably more sensitive than tax returns. Civil and criminal penalties for failing to file FBARs are worse than tax penalties. That is one reason filing FBARs can help ameliorate liability even if minor errors on your tax returns are not corrected. You can avoid FBAR penalties if you had easonable cause, but the grounds for waiving penalties are not clearly enumerated.
Some people do not attempt to correct the past and instead commence filing accurate tax returns and FBARs prospectively. However, the risks can be high. The IRS may ask about the lack of prior FBARs and tax returns disclosing a foreign account. Moreover, simply closing foreign accounts is not an answer to compliance failures in the past. Tying off the problem prospectively can make sense, but ironically, it can exacerbate a lack of past compliance if the actions are viewed as efforts to conceal previous offshore activities.
Company Issues
As discussed, owning as little as 10% of the stock of a foreign company can trigger additional IRS filing obligations. The obligations are most onerous when you and other U.S. persons own more than 50% of the foreign company. Even if you own less than 50% yourself, the U.S. shareholders owning more than 50% means the company is a controlled foreign corporation for U.S. tax purposes.
That entails very unfavorable tax treatment. First, you generally must file a special form (5471) with your annual tax return. Moreover, you are generally taxed on your portion of the company income even if it was never distributed to you. In effect, your pro rata share of the corporate income is attributed and taxable to you because you are a U.S. person.
You might assume that you are safe from the past if you did not know about this rule and have not been filing the required IRS Form 5471. But if you fail to file the Form 5471 with your tax return where required, the IRS statute of limitations never runs on your tax return. The normal 3 year or 6 year periods that cut off the IRS ability to audit you do not apply.
As a result, if the IRS discovers that you owned shares in a controlled foreign corporation and that you failed to file a Form 5471, the IRS can audit you for an unlimited period, even ten or 20 years back!
Expatriation Formalities and Exit Tax
The U.S. tax rules can be onerous. For some, these tax rules can motivate expatriation. Yet even leaving America can have a special tax cost. To exit, you generally must prove 5 years of tax compliance in the U.S. In addition, if you have a net worth that is greater than $2 million or have average annual net income tax for the 5 previous years of $155,000 or more (tax, not income), you face an exit tax.
The theory of the exit tax is practical. It is the last chance the U.S. has of taxing a person who is giving up U.S. citizenship or permanent residency. The exit tax treats you as having sold your property upon your departure. Only gain is taxed, so if you have a basis of $3M in your assets and on expatriation, they are worth $6M, the $3M gain is taxed, but there is an exemption of $668,000.
U.S. citizens are not the only ones to face the exit tax. Long-term residents giving up a Green Card can also be required to pay it. A decision to expatriate should never be taken lightly, and careful thought is needed. Fortunately, advance planning can often reduce or eliminate the exit tax.
Conclusion
How and when you file, respond, or react to the IRS can have important legal and financial consequences, in whatever context you come into contact with U.S. taxes. For that reason, consider U.S. tax exposure before implementing legal or investment structures. Consider U.S. tax issues before filing, reporting or responding to the IRS. Implement your strategy carefully after obtaining tax advice tailored to your facts.
Robert W. Wood practices law with Wood LLP, in San Francisco (www.WoodLLP.com), a tax law firm representing clients throughout the world. He is the author of numerous tax books and contributes regular tax columns to Forbes and Tax Notes Magazines. He has decades of practical experience with the U.S. tax system and its effects on foreign persons and companies. This discussion is not intended as legal advice, and cannot be relied upon for any purpose without the services of a qualified professional.
