How To Pay Less Tax As An Entrepreneur Abroad
The U.S. IRS divides the world of how things get taxed into four quadrants. On one axis is the concept of domestic income versus foreign income. On the other axis, we have passive income versus active income. Only the quadrant that lines up both foreign and active income qualifies for legal tax deferral, meaning that money is taxed in the United States at the time that it is distributed rather than the year when it is earned. While most types of passive investments do not fit into this category, many international businesses can, creating an opportunity for international entrepreneurs.
Most countries tax their corporate and individual clients based on “residence,” not citizenship. This means that, if you live somewhere (or, in the case of a company, are domiciled there), you pay local taxes. Frequently, however, the tax applies only to income generated in the jurisdiction. Income generated outside the jurisdiction is not subject to local taxation.
The United States, on the other hand, taxes its citizens and corporations based on citizenship, not residence, meaning that finding ways to legally defer tax is much more difficult for an American than, say, a German (who pays no tax on his income from sources outside Germany).
There are basically three types of tax systems in the world, as follows:
1) Developed-world, high taxes. I would put the United States, Japan, Korea, most European countries, Australia, and New Zealand into this category. While the taxes in these jurisdictions are high, they also have what are called “double-taxation treaties” designed to make sure you don’t pay taxes twice on the same money. So, if, for example, you set up shop in Korea and pay a Korean tax of 30%, that amount could be taken as a credit against your U.S. tax. If your U.S. rate were 35%, you’d pay Korea 30% and then 5% more to the U.S. IRS. You’d be in basically the same position as if you were working solely in the United States.
2) “No-tax” or “low-tax” jurisdictions. These include Belize, Panama, the Caymans, Hong Kong, the Cook Islands, Singapore, and Malta. These are typically the best places for an entrepreneur to focus on when deciding where to base his business. It is possible, even for an American, depending on many variables, to operate from one of these jurisdictions completely tax-free.
3) High-tax countries that can be used like tax havens because of their tax-sourcing rules that make nearly all tax earned outside the jurisdiction non-taxable. Costa Rica is an example. This country taxes only income generated inside the country, and the way they interpret “income generated inside the country” excludes most international types of income. As a result, much of the offshore internet gambling industry has been established in this country, because, even though the servers are based in Costa Rica, the government deems the income as being earned somewhere else.
Say you based an international diving business in Costa Rica. You’d pay taxes when someone walked into your shop and paid you to take them out on a dive. All other income from outside Costa Rica (say charters to Belize or Panama) would not be subject to Costa Rican taxation. You could end up with a very low overall tax rate (even zero if no business were done inside Costa Rica).
It has become and is becoming increasingly difficult to move funds out of (not so much into) the United States. Legislation starting with the Patriot Act, and most recently FATCA (the Foreign Account Tax Compliance Act), now forces banks and individuals into more and more reporting to ensure that tax is paid on income.
My advice on doing international business is first to minimize superfluous transactions by having a good corporate structure and bank account in the region where you are doing business so not every US$100 transaction needs to go through the United States. Next, you need to use a good accountant familiar with the various reports that are required. The forms are not rocket science, but failure to file (even when you don’t owe any tax) can bring about large fines and penalties.
Required reporting for individuals includes the FBAR (Foreign Bank Account Report), Form 8938 (detailing U.S.-owned assets abroad), Form 5471 (corporate information return on foreign activities), and Form 3520 (for assets held in a foreign trust). These forms are not significantly more difficult that domestic tax forms, but, because they are different, it is important that you work with someone familiar with their preparation.
International business can be exciting, fun, and certainly profitable. However, knowing how to structure your business and personal affairs so as to protect your assets while minimizing and deferring taxation can truly make the difference in any project’s overall financial success.
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