Territorial v. Worldwide Tax Systems

The United States taxes the worldwide income of U.S. citizens, regardless of where they
reside or are domiciled.  This world-wide tax system is markedly different from that of the vast majority of other countries who tax income based on what is known as a territorial tax system.  A country that follows the territorial tax system – such as Costa Rica – will only tax the income earned by a taxpayer within that country; regardless of the citizenship or residence of the taxpayer.  Simply put, countries such as Costa Rica do not tax income derived from foreign sources.

Problems arise when U.S. citizens earn income in a foreign country and that income is
categorized by the local territorial tax system as being income earned within their territory and thus taxable.  In other words, the U.S. citizen will be subject to double taxation.  As an example, assume that Mr. A, a U.S. citizen, conducts business and earns $100,00 of income in Costa Rica.  Mr. A is subject to income tax on the $100,000 of income in both the U.S. and Costa Rica.  This double taxation problem is usually ameliorated in one of three ways: the foreign tax credit, the foreign earned income exclusion ($95,100 in 2012), or by way of an income tax treaty.

The foreign tax credit is a system whereby the country that has primary taxing jurisdiction
over a taxpayer allows a foreign tax credit for taxes paid on foreign source income.   Problems sometimes arise in this context when the two national taxing authorities have a difference of opinion regarding the sourcing of income.  This usually occurs because the country (like Argentina) sources income based on where the recipient of the services resides and not on where the services are performed (like the U.S.).  By way of
example, a U.S. software company providing U.S.-based technical support services to an Argentinian company.  In other words, the foreign tax credit does not apply to taxes paid to a foreign country when the IRS deems those taxes to have been paid on U.S. source income.

A future blog post will explore the foreign earned income exclusion in greater detail.

A more robust solution to the problem of double taxation is an income tax treaty.  As of the writing of this blog post, the U.S. has entered into tax treaties with 42 countries.  Article 23 of the U.S. Model Treaty (http://www.irs.gov/pub/irs-trty/model006.pdf) addresses double taxation and provides a clear system whereby foreign taxes paid – regardless of source – are allowed as a credit against the taxpayer’s U.S. tax.

The question then arises, what about countries like Costa Rica that do not have an income tax treaty with the U.S.?  In a future blog post, I will explore Section 61 of the Costa Rican Income Tax Law that imposes a withholding tax only in the event that a credit for such tax is available from the taxpayer’s home country, and the IRS’s response found in
Revenue Ruling 2003-8.

As always, if you have an further questions about this post or any other issues relating to estate planning, asset protection, or tax law (domestic and international), please don’t hesitate to contact me.

Marion A. Keyes, J.D., LL.M. (Tax)

U.S.A.:  +1 (855) 539-3799 (toll free general business line)
Costa Rica:  +506 4000-0235 (general business line)
Hong Kong:  +852 8191-5829 (general business line)
Skype:  marion.a.keyes