Navigating a complex U.S. tax system
In the United States, almost any unit of government may charge a tax. In fact, there are nearly 10,000 tax jurisdictions in America. Complying with all these laws and rules can be a monumental challenge.
At the same time, cash-strapped federal, state and local tax collectors are becoming more vigilant in ensuring compliance with this sometimes-confusing array of tax codes.
The taxes include income taxes, gross receipts taxes, payroll-related taxes, taxes on transactions, property taxes (real estate, personal property and intangible property), estate and gift taxes, and excise taxes on certain goods and services. However, the federal government does not charge a sales tax or a property tax.
The United States is one of the few countries that does not make use of value-added taxes. However, most states impose a sales tax on retail sales of goods and certain enumerated services to customers within the state. The sales tax is generally based on purchase price and is typically collected by the seller from the final consumer and remitted to the state. A seller who makes retail sales to customers in a state in which it has nexus must register with that state’s taxing authority and report and pay sales tax due.
Most states also impose a use tax on the storage, use or consumption of goods and certain enumerated services within the state. The use tax is complementary to the sales tax and is only imposed when the state’s sales tax, or an equivalent tax at the same or a higher rate, was not collected by the seller as a sales tax collection agent for the state, which most often occurs when the seller does not have nexus within the state of use. The use tax is typically based on the cost of the taxable good or service, and the purchaser must report and pay use tax due directly to the state.
Framework of the law
The Internal Revenue Code is the basic law for the federal income tax. This federal law undergoes frequent change and amendment. The Treasury Department implements federal tax statutes, and the Internal Revenue Service (IRS), a division of the Treasury Department, is the federal tax collection agency and charged with enforcing the code.
The IRS, under the supervision of the Treasury Department, issues regulations and other guidance, with respect to the application and interpretation of certain provisions of the federal tax law. In some instances, taxpayers with questions about specific transactions may submit a written request to the IRS for an interpretation of the law as it applies to that fact pattern.
Foreign investment in the United States
Foreign investors are generally subject to U.S. income tax under one of two different tax regimes.
The first is a withholding regime that taxes certain types of U.S.-sourced income at the source. A 30% rate of withholding is applicable if the income is not considered effectively connected with a U.S. trade or business. For example, this type of income would include dividends or royalties paid to a foreign investor. The 30% rate can be reduced to the extent that the foreign recipient qualifies for a reduced rate under a double tax treaty with the recipient’s country of residence.
The second regime taxes income that is effectively connected with a U.S. trade or business. This income is subject to taxation at regular graduated corporate tax rates. Furthermore, foreign corporations may be subject to a second level of taxation upon distribution of income from a U.S. corporation or upon a distribution of earnings from a U.S. branch business at a 30% or lower treaty rate.
Foreign corporations doing business in the United States
A foreign corporation can conduct business in the United States without the establishment of a U.S. corporation. This business can be conducted as an unincorporated branch operation or, alternatively, by investing in a U.S. partnership or LLC, which may be particularly useful to accommodate certain investors’ tax-planning needs.
Foreign investors are subject to U.S. income tax, at normal tax rates, on income that is considered effectively connected with a U.S. trade or business. Effectively connected income generally includes one of the following:
- Capital gains and other fixed or determinable annual or periodic (FDAP) income are effectively connected income if they are considered to be earned by a U.S. trade or business.
- All non-FDAP U.S.-source income that is connected with a U.S. trade or business
- Certain other statutorily defined categories (e.g., gain from the disposition of U.S. real property interest)
- Foreign-source income earned by a foreign taxpayer is not generally subject to U.S. income tax unless it is effectively connected with a U.S. trade or business.
The code does not provide a detailed definition of what activities constitute a U.S. trade or business, so taxpayers must analyze each case based upon the facts and circumstances. In contrast, U.S. income tax treaties often provide a more specific definition of what activities constitute a permanent establishment. Generally speaking, taxpayers with no permanent U.S. establishment are not subject to U.S. income tax on effectively connected income.
Taxpayers who claim treaty protection must file a corporate tax return and disclose the activities taking place in the United States and the basis for the treaty position exempting those activities from U.S. tax. However, U.S. income tax treaties do not bind individual U.S. states, so it is possible for a foreign corporation to be exempt from U.S. federal income tax but still have individual state income tax liabilities.
A foreign taxpayer’s investment in a U.S. partnership or an LLC taxed as a partnership may constitute a U.S. trade or business. The foreign investor’s earnings from the operations of those investments could therefore be subject to U.S. tax at the normal corporate or individual tax rates, depending upon the investor’s status. The foreign investor in this case will be required to file U.S. tax returns. In addition, the U.S. partnership could be required to withhold and remit tax to the tax authority based upon the earnings of the foreign partner, regardless of whether or not there is an actual cash distribution to the partner. The foreign taxpayer may claim a credit for amounts withheld toward any U.S. tax liability.
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