House passes the Tax Extenders Act of 2009

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On December 9, 2009, the U.S. House of Representatives approved H.R. 4213, the “Tax Extenders Act of 2009.” The bill would extend for one more year more than forty tax provisions that are set to expire at the end of this year, including the research credit and a number of important tax breaks for individuals. In order to offset more than $30 billion in tax relief, the bill also requires stricter reporting on U.S.-held foreign assets by foreign financial institutions and U.S. citizens.

Three provisions draw particular attention. First, starting with tax year 2013, the foreign financial institutions, foreign trusts, and foreign corporations are required to obtain and provide information from each of their account holders to determine if any account is American-owned. Foreign financial institutions must also comply with verification procedures and to report any U.S. accounts maintained by the institution on an annual basis. Then, any foreign financial institution that complies with the new verification and reporting standards would be subject to a 30 percent tax on income from U.S. financial assets held by the foreign institution. Where the owner of the account is a foreign government, an international organization, a foreign central bank, or any other class identified by the Treasury Department as posing a low risk of tax evasion, the withholding tax would not apply. Notice, the H.R. 4213’s requirements only apply if the aggregate value of the accounts in the foreign institutions exceeds $10,000. Hence, the basic FBAR rule that the owners of foreign financial accounts with the aggregate value of below $10,000 do not need to report the accounts still applies.

Second, H.R. 4213 requires any U.S. taxpayer with a foreign financial asset exceeding $50,000 in value to report the asset with their tax return. The penalty for failure to report a foreign financial asset would be $10,000 and could possibly increase to as much as $50,000.

Third, additional annual reporting requirements (similar to other U.S. holders of foreign assets) are imposed on the shareholders of passive foreign investment companies and U.S. owners of foreign trusts. A U.S. taxpayer failing to report a foreign owned trust would pay the greater of $10,000 or 35 percent of the amount of the trust.

Finally, the Tax Extenders Act of 2009 increases the tax rate on so-called “carried interest” levied on investment partnerships by treating carried interest as normal income and taxing it at the standard income tax rate (currently 35 percent) rather than the capital gains rate (currently 15 percent). This measure would have a particular impact on most private equities and hedge funds (which operate as partnerships with a general partner managing the fund and contributing partners supplying the capital), because the managers of these funds generally receive two forms of compensation from the fund: a small percentage of the fund’s assets like a contributing partner, and a higher percentage of the fund’s annual earnings that only the fund’s manager receives (i.e. carried interest).

While most of the provisions of the H.R. 4213 are expected to pass the Senate, the “carried interest” provision might present a significant problem.

IRS Announces 2010 Standard Mileage Rates

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The Internal Revenue Service today issued the 2010 optional standard mileage rates used to calculate the deductible costs of operating an automobile for business, charitable, medical or moving purposes. Beginning on Jan. 1, 2010, the standard mileage rates for the use of a car will be:

  • 50 cents per mile for business miles driven
  • 16.5 cents per mile driven for medical or moving purposes
  • 14 cents per mile driven in service of charitable organizations

Remember, you may not use the business standard mileage rate for a vehicle after using any depreciation method under the Modified Accelerated Cost Recovery System (MACRS) or after claiming a Section 179 deduction for that vehicle. In addition, you cannot use the business standard mileage rate for any vehicle used for hire or for more than four vehicles used simultaneously.

Also note that you always have the option of calculating the actual costs of using your vehicle rather than using the standard mileage rates.

Significance of Income Source Rules in International Tax Law

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When dealing with the international transactions, the United States tax law usually divides income into two broad categories: foreign source income and the U.S. source income. The determination of whether the income is foreign or U.S. in origin depends on a set of rules – the source-of-income rules – created by Congress, elaborated by the U.S. Treasury regulations, refined in courts, and further modified by the international treaties. While jurisdictional in nature, the income source rules are fundamentally and critically important to the understanding and operation of international transactions, primarily because these rules generate real operational consequences that affect a variety of substantive U.S. tax provisions. For the purposes of this essay, these consequences may be classified according to the grouping of the affected taxpayers.

The first set of such taxpayers are U.S. citizens, residents and domestic corporations subject to foreign tax on their income. The income source rules are crucial for these taxpayers because the U.S. foreign tax credit is available only if the foreign taxes are paid on the foreign source income. Hence, foreign taxes paid on the U.S. source income are not available to offset U.S. income tax liability. For example, suppose that a U.S. corporation earns income in the United Kingdom, which under the U.S. tax rules and relevant treaties is considered to be U.S. source income. If the U.K. authorities tax this income, the U.S. corporation will not be able to credit these taxes against the U.S. tax liability. Thus, the unfortunate result in this situation is double-taxation of the same income (note, however, that a deduction may be available to the U.S. corporation).

The other set of affected taxpayers is comprised of the nonresident aliens and foreign corporations. For this group, the impact of income source rules is two-fold. First, with respect to the business income, only U.S. source income may be regarded as effectively connected income and subject to the U.S. taxation. Hence, if the income is not a U.S. source income, then it cannot be considered as effectively connected income, thereby avoiding taxation by the U.S. government, unless the exception under I.R.C. §871(c)(4) applies. Under this exception, where certain types of income (such as dividends, interest, rents, royalties, sale of personal property, et cetera) are attributed to the nonresident alien’s (or foreign corporation’s) U.S. office or other fixed place of business, the income is regarded as effectively connected income and may be subject to the U.S. taxation.

Second, in case of non-business (usually, investment) income, the 30 percent withholding tax may be imposed only on U.S. source income. If, however, the income is considered by the U.S. tax authorities to be foreign source income, then no such tax may be imposed. For example, if a French investor receives interest that is deemed not to be U.S. source income, then the withholding tax will not be imposed.

Thus, based on the analysis above, the enormous importance of the income source rules in structuring international transactions becomes apparent. Obviously, for the purposes of illustrating their significance, I simplified this discussion into a simple domestic versus foreign dichotomy. The reality may quickly become much more complex when one takes into account various variations with respect to U.S. territories, certain types of income and/or transactions, politically-motivated exceptions regarding some foreign countries, and modification of the rules by bilateral tax treaties.

It should be remembered, however, that while they contain many traps and dangers for the unwary, the income source rules may provide excellent opportunities for beneficial and responsible tax planning.

Definition of Foreign Earned Income for the purposes of Foreign Income Exclusion under I.R.C. §911

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Under I.R.C. §911, if certain conditions are met, a qualified individual can exclude as much $91,400 (for tax year 2009) of foreign earned income from taxable gross income. Two questions arise: what is earned income, and when is such income considered to be foreign earned income?

Earned Income

Earned income usually means wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered, but does not include that part of the compensation derived by the taxpayer for personal services rendered by him to a corporation which represents a distribution of earnings or profits rather than a reasonable allowance as compensation for the personal services actually rendered.

The issue of earned income becomes complicated in a situation where a taxpayer engaged in a trade or business in which both personal services and capital are material income producing factors. Capital is a material income-producing factor if the operation of the business requires substantial inventories or substantial investments in plant, machinery, or other equipment. In this case, a reasonable allowance as compensation for the personal services rendered by the taxpayer, not in excess of 30 percent of his share of the net profits of such trade or business, shall be considered as earned income (I.R.C. §911(d)(2)(B)). This rule, however, would not apply where the capital is merely incidental to the production of income (see Rousku v. Commissioner (Tax. Ct.1971)).

In a situation where the services rendered abroad culminate in a product that is either sold or licensed, it is difficult to determine whether the proceeds are earned income. Usually, such issues are resolved on a case-by-case basis.

Foreign Earned Income

Earned income is usually considered as “foreign earned income” if it is attributable to services actually rendered by the taxpayer while oversees. The place at which the taxpayer receives the income is not relevant. For example, an employee working abroad for a U.S. employer does not lose the exclusions by having her compensation paid into a bank account in the United States. Note, however, that services rendered in anticipation of, or after the conclusion of an oversees assignment are not covered by the exclusion. I.R.C. §911(b)(1)(A) and §911(d)(2)