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Our "Offshore Tax Strategies" newsletter gets into more depth about the tax issues that affect Americans who want to do business outside the US. Future issues will be dealing more extensively with the tax implications of global e-commerce than in the past.There has been a lot of discussion about the taxation of e-commerce and most of that talk revolves around the sales tax imposed by various states or countries on products sold to residents of their state or country. For now, there is a moritorium on the imposition of new taxes while the government agencies argue about whether changes are needed in the way sales taxes are assessed for goods or services sold via the Internet. I suspect there will be some minor changes, but the current system of taxing mail order sales will be adapted to deal with Internet sales.
But, it's fairly clear the U.S. government isn't going to make it easy for U.S. persons to avoid paying income taxes by simply renting space on a computer in an offshore island tax haven such as Nevis or Bermuda and then operating that remote computer over the Internet from an office or home in the US. There are actually a number of issues that will make it more than a little bit difficult for the US entrepreneur to easily avoid US taxes on his global e-commerce business.
The first hurdle is that the US person (citizen or permanent resident) is subject to US income taxes on his or her world wide income. This rule is also true for the residents of most high tax countries, but even if a US citizen is residing in a foreign country, he or she is still subject to US tax on their world wide income. If there is a tax imposed in the country where the US person resides, the US allows for a credit against the US tax up to the amount of tax the US would have imposed on that same income. (If the other country has a higher tax rate, you don't get a credit for more than the tax the US would impose on that same income.)
A second hurdle is that even if a US person has a foreign corporation in a tax haven and uses a web server outside the US, the US government is going to look at where the real work is being done. Is the entrepreneur physically in the US or is there a substantial physical business presence in the tax haven country? Anyone who asserts that they do not owe taxes to the US because the income is generated by a web site located on an offshore web server is "buying a court case". I'm convinced the IRS will dispute this issue and will litigate it aggressively. I could not offer a tax client who was operating a web site from the U.S. any confidence that they could win such a court case.
But there are even more hurdles for the US entrepreneur who seeks to avoid US taxes by operating a cyber business in a tax haven using a web server in that country and processing the business through a foreign corporation or IBC. The US controlled foreign corporation rules include some complicated provisions (IRC 951-964) to prevent US persons from diverting profits from a related US company to a foreign corporation. Thus, the foreign enterprise would need to be entirely different from and unrelated to any existing business in the US to avoid that problem.
And to add insult to injury, the US tax code has a provision (IRC 367) that imposes immediate capital gains taxes on the transfer of various kinds of appreciated assets to a foreign corporation in exchange for stock in that corporation. The definition of assets for this purpose include intangible assets -- such as "know how". To avoid this problem, the US entrepreneur would need to capitalize the foreign business with cash or pay a capital gains tax on any appreciated assets that are transferred to the foreign corporation. However, the US may still attempt to impose a current tax on the alleged value of intangible assets by using a complicated formula method to replicate a deemed royalty arrangement. And right now there aren't a lot of people (including myself) who are really clear as to what is included in the catch-all of "know how".
For the entrepreneur who is willing to reside nearly full time (more than 329 days per year) in a foreign tax haven country such as the Bahamas, Bermuda or Nevis, the US tax system permits the US person to exclude up to $76,000 per taxpayer (for the year 2000) of earned income while living outside the US. This exclusion is also available to the self employed. Any excess earnings are subject to U.S. taxes. If your spouse actively works in the business, you could get a double tax exemption ($152,000) for 2000. This exemption is scheduled to increase by $2,000 per year until it reaches $80,000 in 2002.
A more drastic but less uncertain alternative for the US person who wants to do business tax free via a web server in a foreign tax haven is to expatriate and change citizenship. However, this is not a quick solution and requires serious thought and pre-planning.
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