7 - Taxation of residents: Investment income

Summary

In this part of the book, we consider outbound tax rules, which apply to tax residents who derive income from overseas. The fundamental problem in the outbound tax situation is that U.S. residents are taxed on U.S.-source income as well as foreign-source income, because residents are taxed on all income “from whatever source derived.” One way to get around this is to set up a foreign corporation; setting up a foreign corporation is very easy now that you can simply “check the box” to make it a corporation, and getting foreign classification is easy because any corporation that is not incorporated in the United States is automatically foreign. In addition, the foreign-source income must be shifted from the U.S. resident to the foreign corporation; this is possible only for foreign-source income, because both residents and nonresidents are taxed on U.S.-source income.

The foreign company faces delayed taxation on this income in one of two ways. The first instance of taxation occurs when a dividend is distributed. In this case, the income is foreign-source income because it is a dividend from a foreign corporation, but it is taxable because it is payable to a U.S. resident. The other instance of taxation occurs when shares of the corporation are sold. In this case, the income is capital gains, which is considered U.S.-source income and therefore is also taxable.