IN THIS ISSUE
DID YOU KNOW?
- TAX TREATIES
- FOREIGN EARNED INCOME EXCLUSION (FEIE)
- CONTROLLED FOREIGN CORPORATIONS (CFCs)
- TRANSFER PRICING
- FOREIGN TAX CREDITS (FTC)
PASSIVE FOREIGN INVESTMENT COMPANIES (PFICs)
Tax Planning
by Audrey Jackson
Did You Know?
International taxation encompasses the rules, principles, and practices governing how countries tax individuals, businesses, and entities on income and other forms of wealth that cross international borders. Given the interconnected nature of today’s global economy, understanding international taxation is crucial for both taxpayers and tax professionals. This comprehensive guide explores key aspects of international taxation, including tax treaties, the Foreign Earned Income Exclusion (FEIE), and Controlled Foreign Corporations (CFCs), along with other pertinent information for the 2025 tax season.
Tax Treaties
Tax treaties, also known as double tax agreements (DTAs), are bilateral agreements between two countries designed to avoid double taxation and prevent tax evasion. They establish clear tax rules for income that may be subject to tax in both jurisdictions. These treaties promote international trade and investment by providing certainty and reducing the tax burden on cross-border income.
Key Provisions of Tax Treaties
- Residence and Source Rules: Tax treaties typically define which country has taxing rights based on the residence of the taxpayer and the source of the income. The country of residence generally has the primary right to tax the global income of its residents, while the source country has the right to tax income earned within its borders.
- Permanent Establishment (PE): A crucial concept in tax treaties is the definition of a PE, which determines whether a foreign business has sufficient presence in a country to be subject to tax there. A PE typically includes fixed places of business, such as offices or factories, and significant economic activities.
- Withholding Taxes: Treaties often reduce or eliminate withholding taxes on dividends, interest, royalties, and other types of income paid to residents of the other contracting state. This reduction encourages cross-border investments.
- Non-Discrimination: Tax treaties include clauses to ensure that nationals or residents of one country are not unfairly discriminated against in the other country.
- Mutual Agreement Procedure (MAP): Tax treaties provide a mechanism for resolving disputes between taxpayers and tax authorities of the contracting states through MAP, ensuring that tax issues are addressed amicably.
The United States has an extensive network of tax treaties with various countries. U.S. taxpayers engaged in international activities must understand the provisions of relevant tax treaties to optimize their tax liabilities. For instance, treaties may offer lower withholding tax rates on dividends or interest payments from foreign investments, reducing the overall tax burden.
Foreign Earned Income Exclusion (FEIE)
The Foreign Earned Income Exclusion (FEIE) is a provision in the U.S. tax code that allows U.S. citizens and resident aliens living abroad to exclude a certain amount of their foreign earned income from U.S. taxation. The FEIE is designed to alleviate the tax burden on Americans working overseas and to encourage U.S. companies to send employees abroad.
Eligibility Criteria
- Tax Home in a Foreign Country: To qualify for the FEIE, the taxpayer’s tax home must be in a foreign country. A tax home is the place where the taxpayer is permanently or indefinitely engaged to work.
- Physical Presence Test: The taxpayer must be physically present in a foreign country or countries for at least 330 full days during a 12-month period.
- Bona Fide Residence Test: Alternatively, the taxpayer can qualify by being a bona fide resident of a foreign country for an uninterrupted period that includes an entire tax year.
Exclusion Amounts
For the 2025 tax season, the maximum amount of foreign earned income that can be excluded under the FEIE is $126,500, adjusted annually for inflation. Taxpayers can also exclude or deduct certain foreign housing amounts, subject to limitations.
Implications and Strategies
Taxpayers should carefully plan their foreign assignments and track their physical presence days to maximize the benefits of the FEIE. Proper documentation and adherence to the eligibility criteria are essential to avoid complications during tax filing.
Controlled Foreign Corporations (CFCs)
A Controlled Foreign Corporation (CFC) is a foreign corporation in which U.S. shareholders (owning at least 10% of the corporation’s voting stock or value) collectively own more than 50% of the total voting power or value. CFC rules are designed to prevent U.S. taxpayers from deferring income recognition and tax liabilities by holding profits in foreign subsidiaries.
Key Provisions
- Subpart F Income: U.S. shareholders of a CFC must include their pro-rata share of the CFC’s Subpart F income in their taxable income. Subpart F income includes passive income, such as dividends, interest, royalties, and income from certain sales and services.
- Global Intangible Low-Taxed Income (GILTI): GILTI provisions require U.S. shareholders of CFCs to include in their income a portion of the CFC’s earnings exceeding a 10% return on tangible business assets. GILTI aims to tax income from intangible assets held in low-tax jurisdictions.
- CFC Look-Through Rule: This rule allows certain income received by a CFC from a related CFC to be excluded from Subpart F income if the income would not be Subpart F income if earned directly by the receiving CFC.
Compliance and Reporting
U.S. shareholders of CFCs must file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, to report ownership interests and financial information. Compliance with CFC rules requires careful record-keeping and timely reporting to avoid penalties.
Transfer Pricing
Transfer pricing refers to the rules andmethods for pricing transactions between related entities, such as subsidiaries of a multinational corporation. Transfer pricing aims to ensure that transactions are conducted at arm’s length, meaning the prices are consistent with those that would be charged between unrelated parties.
Arm’s Length Principle
The arm’s length principle requires related entities to set prices for intercompany transactions—such as the sale of goods, provision of services, or use of intellectual property—based on comparable transactions between independent entities. This principle helps prevent profit shifting and ensures that each jurisdiction receives its fair share of tax revenue.
Common Transfer Pricing Methods
- Comparable Uncontrolled Price (CUP) Method: Compares the price charged in a controlled transaction to the price charged in a comparable uncontrolled transaction.
- Resale Price Method: Bases the transfer price on the resale price to an unrelated party, minus an appropriate gross margin.
- Cost Plus Method: Determines the transfer price by adding an appropriate markup to the costs incurred in providing goods or services.
Documentation and Compliance
Taxpayers must maintain comprehensive transfer pricing documentation to support their pricing policies and demonstrate compliance with the arm’s length principle. This documentation is crucial in the event of an audit by tax authorities.
Foreign Tax Credits (FTC)
The Foreign Tax Credit (FTC) is a provision that allows U.S. taxpayers to offset their U.S. tax liability with foreign taxes paid on income earned abroad. The FTC prevents double taxation by ensuring that income is not taxed twice by both the U.S. and the foreign country.
Eligibility and Limitations
- Eligible Taxes: The FTC is available for income, war profits, and excess profits taxes paid or accrued to a foreign country or U.S. possession.
- Limitations: The FTC is limited to the lesser of the actual foreign taxes paid or the U.S. tax liability on the foreign-source income. Excess credits can be carried back one year and carried forward for ten years.
Calculation and Filing
Taxpayers must calculate the FTC using Form 1116, Foreign Tax Credit. Proper documentation and accurate reporting of foreign taxes paid are essential to claim the credit successfully.
A common misconception about the Foreign Earned Income Exclusion (FEIE) is that the excluded income does not need to be reported on a U.S. tax return. In reality, the exclusion applies only if you are a qualifying individual with foreign earned income who meets all of the requirements to claim the exclusion and you file a tax return reporting the income. The maximum amount of foreign earned income that can be excluded is adjusted annually for inflation. For the 2024 tax year, the maximum exclusion is the lesser of the foreign income earned or $126,500 per qualifying person.
Passive Foreign Investment Companies (PFICs)
A Passive Foreign Investment Company (PFIC) is a foreign corporation that meets either of the following tests:
- Income Test: At least 75% of the corporation’s gross income is passive income.
- Asset Test: At least 50% of the corporation’s assets produce or are held to produce passive income.
Taxation and Reporting
U.S. shareholders of PFICs face complex tax rules designed to prevent the deferral of income. There are three primary methods of taxation for PFICs:
- Qualified Electing Fund (QEF) Election: The shareholder includes their share of the PFIC’s income and gains annually.
- Mark-to-Market Election: The shareholder annually marks the value of PFIC shares to market and recognizes any gains as ordinary income.
- Excess Distribution Regime: Distributions from the PFIC and gains from the sale of PFIC shares are subject to punitive tax rates and
Compliance
U.S. shareholders of PFICs must file Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, to report their holdings and any income or gains.