Question 8

Tax Fraud – Frequently Asked Questions (page 8)

Does it matter whether the income was earned from a foreign corporation (i.e., if his business was incorporated abroad)?

If the client’s business is incorporated abroad and he consulted with his clients who, at the time, were in Europe, he may have a defense (even though he performed some of the consulting work from within the United States). By using a foreign corporation, a taxpayer can postpone the realization of income because taxation can be avoided until he or she repatriates the income. The income will not be taxable to the U.S. citizen simply because he has a foreign company that receives income, but rather, he would not be responsible for paying taxes until he receives it and repatriates it. Therefore, if he does business through a foreign corporation, delay of the taxation of income in the United States is possible.

A large exception that often swallows the rule that the income of foreign corporations is not taxed prior to repatriation of the income is Subpart F of the Internal Revenue Code. It taxes the profits and earnings of a controlled foreign corporation (CFC) to US shareholders holding at least 10% of the CFC’s stock.  If more than 50% of its stock is owned by US persons, a foreign corporation is a CFC. It’s not an absolute rule of taxation insofar as foreign taxes paid by the CFC will be deemed paid by the US persons, entitling them to a foreign tax credit against their US tax. There are further rules that preclude US persons from shifting US income to foreign corporations through transfer pricing.  Section 482 is a provision that is intended to accomplish this as, “the secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades or businesses if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades or businesses.”

Section 482 gives the Secretary of the Treasury or his delegate (i.e., the Commissioner or Internal Revenue Service, an agency within the Treasury Department) great discretion to determine what prices two commonly owned or controlled businesses should charge each other. Without this authority, any United States corporation could charge an affiliated foreign corporation, that happens to be located in a low tax jurisdiction, whatever it wanted. It would effectively transfer a profit that the U.S. company would otherwise earn to its affiliate in the low tax foreign jurisdiction — thus enabling the U.S. company to restructure its income and avoid paying tax (as opposed to “evading” it). It is intended to give the Commissioner wide discretion to re-allocate pricing between commonly controlled entities so that it fairly reflects the profit earned in an objectively reasonable manner and avoidance is prevented.