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Major existing loopholes in the current U.S. Tax Code concerning the taxation of non-business U.S. source income of foreign persons
In the U.S., foreign taxpayers are only taxed on incomes arising from U.S sources. However, a few situations exist where the U.S. government would equally tax specific types of foreign incomes earned by non residents. Nonresident earnings are categorized as either business/ trade income passive (non business income). Our main emphasis is on passive income. All passive incomes are taxed at a flat rate of 30 percent and neither deductions nor exemptions are allowed on the income. Examples of income categories that fall under passive incomes are royalty, dividends, rents, specific capital gains in addition to approximately 85 percent of the U.S. social security benefits. The flat tax rate of 30 percent is collected via a withholding mechanism and the burden of withholding is placed upon the individual paying the income. For instance, all U.S. corporations are by law required to withhold 30 percent tax from all dividends they pay to nonresident tax payers and remit the same to the government on behalf of respective shareholders. In some instances, the 30 percent tax rate can be eliminated or reduced if a tax treaty is signed between the U.S and the tax payers country of residence. In addition, the foreigners are not subject to taxation on any capital gains they make or any other nonrecurring income.
Generally, all incomes that are not directly linked to business or trading activities are not taxed in the United States. However, if the said income is from the U.S. sources and it is included in the FDAP definition then it is taxed. FDAP includes salaries and wages, dividends and rental incomes from the U.S sources. America for long has been a safe haven for foreign investment. The foreign tax code has numerous loopholes that can be exploited to the benefit of the foreign investor. Gains from investments in the United States may be tax free or they can be subjected to a 15 percent tax rate. In addition, the complexity of the tax codes provides a number of avenues through which investors can totally avoid the taxes or defer them to a later date (Gudelis, 2008). The major loopholes in the tax code are evident in the following areas.
The loopholes in the current system are plainly evident. To begin with, the large number of deferrals gives companies excess rate differential, which they cannot afford to resist. As a result, the multinationals are increasingly moving their profits to countries with low or zero level profits.
In the real estate sector, a foreign investor can totality avoid the estate taxes if he/she owns a foreign corporation that owns his/her real estate in the United States. For instance, if a foreign investor was to establish a foreign corporation, this corporation then becomes the full owner (100 percent ownership) of the real estate in the United States (Joint Committee on Taxation, 2009). Consequently, the individual will succeed in avoiding entirely the U.S estate tax and no additional charges will be levied in the event that the foreign investor dies. An additional loophole in the real estate sector that can be used by an alien investor is the Non Grantor Trust. It is a whole process when one gets some property in the U.S. but to be on the safe side, he/she makes use not of the personal names but of the relatives.
Second, the U.S. tax code does not impose withholding taxes on capital gains and interest. Certain treaties can equally be entered into the system to either reduce or totally eliminate the tax on dividends. Furthermore, new techniques have been adopted to transform specific incomes that ordinarily would attract tax, into tax exempted incomes (Joint Committee on Taxation, 2009).
Possible avenues through which a foreign person can minimize their tax exposure to non-business U.S-source income
A number of methods can be adopted to minimize their tax exposure to non-business U.S-source income. The methodology adopted depends on the nature of the transaction the foreigner engages in. The following represent a few avenues:
For foreigners who own rental properties in various parts of America which they have rented out to tenants, they ought to know that their assets attract a withholding tax of 30 percent which is levied on the gross amount paid as rent on any real estate located in the United States. Unlike other forms of withholding tax, for example, taxes on dividends and interests, this type of tax is not reduced or eliminated by any bilateral treaty between the U.S and the foreigners country of residence. To avoid the 30 percent withholding tax, then the individual must file a U.S tax return and choose to pay tax on rental income. The foreigner will then be refunded any amount of the taxes withheld equal to the excess of the withheld amount over and above the tax payable. Foreigners who own the U.S rental properties and as a result incur large expenses in the form of insurance, maintenance, mortgage interest, property taxes, property management among others may elect to file the U.S tax return on income and therefore benefit from the rental income election. Compared to the withholding tax of 30 percent, the amount subjected to tax at the marginal rate will be significantly smaller. If an individual elects the net rental income methodology, then the same method will be applied for all future years and is deemed to be permanent, under very limited circumstances it can be revoked. Immediately the property owner makes the election, he issues the tenant with form 4224 and, henceforth, the 30 percent withholding tax is no longer required.
When it comes to selling a property owned by a foreigner who is located in the United States, there is usually a requirement of withholding tax equal to 10 percent of the gross selling price. This tax can be offset by the U.S income tax paid on the gains from the sale, if it is more than the liability.
Impact to the U.S. economy should the loopholes related to foreign tax credits be eliminated
The U.S economy should eliminate the Discuss the loopholes related to foreign tax credits then the following benefits are highly likely to be experienced in the economy; by adopting a low and simple tax code, the U.S will further promote the free market in the U.S economy. Currently, the complexity of the American tax system is a big threat to its competitiveness. Tax legislation alone is contained in 5100 pages. Growth levels in America are likely to be higher with reduced taxes as it will encourage setting up of more firms, enhance work and create more jobs.
A good tax system will equally encourage compliance as few firms will see the need for avoiding it. The government will in turn raise sufficient internal revenues which can be used to improve infrastructure, health services among other expenditures. A good tax system will equally reduce the income disparity between the rich and the poor. This will in turn reduce social conflicts in the society. The rich ought to more towards the provision of social services.
Equally, with increased globalization, and the progressive removal of barriers to trade an increasing number of companies are looking towards to expand their activities to international locations. Before expansion to foreign markets, firms have to choose between producing their exports locally and producing them abroad. The decision reached is affected by tax factors. America, therefore, stands to benefit if it adopts a favorable foreign tax system that will attract companies to the nation, increase employment and output (Shay, 2005).
Furthermore, an efficient tax system would raise revenues without causing distortions such as discouraging work incentives for individual persons and company investment incentives. Given the fact that such a system will be fair, it will receive popular support from the general citizens and investors will be attracted to undertake investment in the country.
An alternative to the foreign tax credit and an explanation as to why the alternative would be better than the existing regulations
The taxation of foreign incomes has a direct impact on the U.S. tax base. If foreign incomes are taxed at a lower rate compared to U.S. incomes, then citizens will have an incentive to shift their U.S. income to foreign income. By imposing high foreign taxes to be used as credits to balance the low tax on the U.S. foreign income, it will amount to subsidies to those countries imposing high foreign taxes.
Major tax reform initiatives should be undertaken in the area of international tax. This can be done by widening current taxation levels of foreign corporation earnings which are controlled by the U.S., which are subject to foreign tax credit. Alternatively, the government can foreign business incomes that bear a sufficient rate of foreign tax can be exempted from taxation so as to reduce tax induced shifts in economic activity. By enhancing the taxation of the U.S. controlled foreign companies, it is less likely that investments will shift to lower taxed economies. Through expansion of foreign incomes, majority of the complexities arising from deferral will be eliminated. In addition, taxation is very important to the federal government since it helps in enhancing the expansionary policy of the Federal Reserve and the federal government.
An alternative foreign credit policy will be to exempt all active foreign business from taxation. Such an exemption will eliminate the repatriation tax in addition to encouraging the U.S citizens to carry out business activities abroad. If America adopts a consumption tax while at the same time exempting businesses from taxation, then the other countries will have no reason to continue the existing tax treaties with the U.S., they might retaliate by increasing taxation of the U.S owned companies foreign business operations.
Foreigners can equally minimize estate taxes they pay to the U.S. government by holding their properties through a foreign corporation rather than in their own names. This happens because foreign companies are not considered as properties within the U.S. and, therefore, no U.S tax law applies. Ordinarily, if a foreigner uses the same property for his/her own use, then he/she must submit tax to his/her home country, which is equal to the value of the propertys rental usage. To avoid this problem, the foreign individual can initiate single purpose corporation to own the property.
Foreigners can equally benefit from foreign tax credits. Generally, a tax credit refers to a reduction in the U.S tax liability based on a dollar for dollar basis. The maximum possible foreign tax relief an individual can get cannot exceed the tax liability he/she owes the United States times a specific percentage. If an individual gets a foreign tax credit over and above the required limit, then the excess will be forwarded backwards to the passed year or, on the contrary, to the future coming years. Finally, the current tax regime for charging tax on cross border incomes lacks a conceptual framework. There is some level of conflict as to who should tax intangible assets like patents since no specific body has been set aside for performing the tasks.
An efficient tax system would raise revenues without causing distortions such as discouraging work incentives for individual persons and company investment incentives. Given the fact that such a system will be fair, it will receive popular support from the general citizens and investors will be attracted to undertake investment in the country. The overall outcome is improved economic activity in the country.
References
Gudelis, M. (2008). How a Foreign National Can Buy Real Estate in America. Web.
Joint Committee on Taxation. (2009). Tax compliance and enforcement issues with respect to offshore entities and accounts. Web.
Shay, E. (2005). International tax reform: perspectives on reforming U.S. taxation of foreign business income. Web.
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