January 16, 2013
January 16, 2013
Reprinted from the 2013 edition of the Bahamas Handbook.
A US individual or company can, in some instances, start international operations with relatively small amounts of capital and then expand with tax-free or low-taxed accumulations of earnings instead of net-tax dollars earned in the US. Thus, expansion abroad can be more rapidly accomplished with 100-cent tax-free dollars, instead of 65-cent dollars (which is net after approx 35% US tax).
The tax advantages, or tax deferrals, are available by reason of the foreign taxation provisions of the Internal Revenue Code (IRC) which set forth conditions under which the US will exempt or defer foreign income from US taxation.
To become eligible for US tax advantages, Bahamian business ventures must be operated by a Bahamian company. If a Bahamian or other foreign company (except a passive foreign investment company) is not engaged in a US trade or business, and at least 50% of the voting power and value is owned by non-US persons (insurance companies are an exception), US tax laws generally do not apply to its foreign income, and only in rare instances will there be any US income tax.
If US persons own 50% or less of the voting power and value of a Bahamian company, and the Bahamian company does not conduct activities in the US which would cause it to be taxable in the US, none of its foreign income will generally be subject to US taxation unless and until dividends are paid to US shareholders, or they sell their shares, or the assets of the company are distributed.
If a Bahamian or other foreign company is more than 50% controlled or more than 50% of its value is owned (directly or indirectly) by US persons who each own at least 10% of the voting power, it is known under US tax laws as a controlled foreign corporation (CFC). US shareholders who own (directly or indirectly) at least 10% of the voting control of a CFC (US 10% shareholders) are taxable each year on their proportionate share of certain kinds of income of the corporation.
The kinds of income currently taxable are, generally:
- Income from the insurance or reinsurance of risks.
- Passive income such as dividends, rents, interest, gains from the sale of property which itself produced passive income, capital gains from the sale of stocks and securities, gains on commodities and foreign currency transactions, royalties, etc.
- Sales income where the goods are either purchased from or sold to a related person.
- Income from services if rendered to a related person.
- Increases in investments in US property.
- Income attributable to international boycotts.
- Income attributable to the bribery of foreign government officials.
- Income that is foreign oil or gas-related.
Even so, there are many exceptions and exclusions to the above. For example, if such income comprises less than 5% of a Bahamian company’s adjusted gross income (and less than $1,000,000), none of the company’s income will be taxable by the US.
In most cases, however, every other kind of foreign income is free of US taxation. In other words, even if the Bahamian company is US-controlled, its US 10% shareholders are not required to include such other foreign earnings in their annual taxable income.
A Bahamian company engaged in a US trade or business will be subject to US corporate taxes on income effectively connected with such trade or business, as well as the “branch profits tax” (a 30% tax imposed on earnings of a US branch of a foreign company that are deemed repatriated to the foreign parent company). Therefore, careful planning is required to minimize the effect of this tax.
Best-suited offshore operations
The types of US CFCs particularly suitable for operations in The Bahamas and having these US tax advantages include, among others, the following:
1. Manufacturing production. Income from the sale of products or goods manufactured or produced in The Bahamas generally is not subject to US taxation even though purchases and sales involve the parent corporation or other related persons.
The same applies to rental income where such products or goods are leased to an unrelated party instead of sold, provided certain “active-business” tests are met. In addition, rental income from the lease of such products or goods to a related party generally is not subject to US taxation provided that the products or goods are used in The Bahamas. Likewise, income from certain incidental services rendered before a sale or in connection with an effort to sell such products or goods is not currently taxable.
2. Sales of products and goods. If the parent corporation or other related person is not involved in the purchase or sale of products or goods, then income from such sales is not subject to current US taxation, no matter where or by whom the products or goods were manufactured, where the sales are made or where such products or goods are used or consumed.
Even if a related person is involved, the sales income is free of current tax if the products or goods are manufactured, produced, grown or extracted in The Bahamas, or if they are for use, consumption or disposition in The Bahamas.
3. Insurance. A Bahamian insurance company is considered a CFC if more than 25% of the voting power or value of its stock is owned by US 10% shareholders. Income earned by a Bahamian insurance or reinsurance company which is a CFC is taxable only to a US 10% shareholder.
In addition, unless certain exceptions are met, if a Bahamian insurance company is at least 25% US-owned, all US shareholders (even if such shareholders own less than 10%) must include in income their pro rata share of the company’s related person insurance income (premium or investment income on insurance policies where the person insured, directly or indirectly, is a US shareholder or related person). Related person insurance income also includes income from reinsurance if the ceding company or its insured is a US shareholder in the Bahamian insurer.
A Bahamian insurance company that is a CFC can elect to be treated as a US corporation for all US tax purposes. If this election is made, US shareholders will not be taxed on the company’s income until distributed as dividends. The charge for electing is 0.75% of capital and surplus as of Dec 31, 1987, up to a max charge of $1.5 million.
The Bahamas government provides advantages and incentives for insurance companies insuring and reinsuring non-Bahamian risks.
4. Banks and finance companies. Passive income of a Bahamian bank or finance company that is a CFC that is “predominantly engaged in the active conduct of a banking, financing or similar business” (as defined in the IRC) and conducts substantial activity with respect to such business is not subject to current US taxation. Interest earned by a Bahamian bank that is a CFC in connection with export financing for related US persons, with certain exceptions, is not subject to US tax.
5. Service companies. This is a broad category and includes any Bahamian corporation rendering services that are technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial or the like.
Many types of companies in The Bahamas fall into this category. A partial list would include engineering, sales promotion, sales engineering, merchandising, consulting, etc. With reference to such companies, income from such services, rendered outside the US and performed for persons who are not related without substantial assistance of related US persons, is exempt from current US taxation.
Income from services rendered within The Bahamas is also exempt even though such services are rendered for, or on behalf of, a related person. Income from services rendered by a foreign company in The Bahamas before a sale or in connection with an effort to sell products or goods manufactured, produced, grown or extracted by it are also exempt from current US tax even though such income is received from a related person.
6. Leasing and royalties. Rents derived in the active conduct of a trade or business in The Bahamas and received from persons not related are not subject to current US taxation.
Rents are also so exempt even when received from a related person if such rents are for use of property located in The Bahamas.
Royalties, for example–payments in connection with patents, copyrights, inventions, models, designs, secret formulas or processes–are currently exempt from US taxation when derived in the active conduct of a trade or business in The Bahamas and received from persons who are
Royalties are also so exempt, even when received from a related person, if such royalties are for the use of property or property rights within The Bahamas.
7. Certain investment income. Dividend and interest income received from a related foreign corporation generally is exempt from current tax if both payer and payee are incorporated in The Bahamas and the payer has a substantial part of its assets used in the business in The Bahamas.
Passive foreign investment company (PFIC)
A Bahamian company is a PFIC if 75% or more of its gross income is “passive” income (dividends, interest, etc), or 50% or more of its assets are held to produce passive income. Thus, a mutual fund, and even a manufacturing company with large retained earnings invested in securities, could be a PFIC.
US shareholders in a Bahamian PFIC may be subject to additional taxes (plus interest) on certain PFIC distributions or on a sale of PFIC stock. A US shareholder of a PFIC may avoid this result by making one of the following two elections. First, a PFIC shareholder can elect to be taxed currently on his pro rata share of PFIC ordinary income and capital gains, which then can be distributed tax free. If a shareholder makes this election, he also can elect to defer the current tax but must pay interest on the deferred taxes. Second, a US shareholder of a PFIC may elect to mark-to-market his stock on an annual basis if such stock is marketable (eg, regularly traded on a national securities exchange registered with the SEC).
Coordination rules prevent the same income being taxed twice in cases where a PFIC also qualifies as a CFC. An important exception is that PFIC rules generally will not apply to bona fide insurance companies predominantly engaged in the active conduct of an insurance business and certain banks.
Employment of US citizens abroad
Tax benefits are available to US citizens employed abroad who establish a tax home in a foreign country (ie, the foreign country is the taxpayer’s principal place of business) and who meet certain other tests prescribed by the IRC (either a “physical presence” or residency test with respect to the foreign country). Although a US citizen generally is subject to US income tax on his worldwide income, a US citizen employed abroad who satisfies the IRC tests described above may exclude from gross income for any taxable year foreign-source earned income (ie, wages or salary for services performed outside the US) an amount equal to the product of $80,000 and the inflation factor determined under section 1(f) (3) of the IRC; $91,400 for taxable years beginning in 2009.
- Exclude from gross income a portion of the housing expenses paid for by his employer, or
- In the event such expenses are not paid for by his employer, deduct such expenses (subject to certain limitations).