U.S. citizens and residents are taxed on their income from all sources worldwide. Worldwide taxation by the U.S. does not disarm the taxing power of other countries. Americans pursuing income outside of the U.S. are bound to encounter tax collectors asserting their own national claims. The world is awash in possibilities of double taxation. Below is a hypothetical illustrating international double taxation and its main cause: inconsistent sourcing rules in different countries imposing overlapping taxes.

A CONTRACT IN YEMEN

John is a lawyer who practices in NYC. One day, he gets a call from Ali, a client in Yemen. Ali asks John to do some research on a question and to send his findings in the form of a memorandum. John goes ahead and does the work, consisting of some research and some writing, which takes twenty hours of his time.

John’s final product is a memorandum, which he sends to Ali, along with a bill for $ 4,000 reflecting his hourly rate of $ 200. A check for $ 4,000 arrives by return mail and John gives the matter little further thought.

At the end of the year, John receives an official-looking letter from the Treasury of Yemen, adorned with a seal and crests, asking him to pay $ 2,000 in income tax to the Yemeni Treasury with respect to his $4,000 of Yemen-source income. The letter explains that the rate of Yemeni income tax on the Yemen-source income of foreigners from professional services is 50%.

John is taken by surprise. He knows that the fee that he earned for writing the memorandum is subject to U.S. income tax, but it never occurred to him that Yemen might attempt to tax it as well. John asks a friend who specializes in taxation if the demand of the Yemeni Treasury is correct.

John’s friend tells him that in the U.S. tax system, his fee has its source in the United States, not in Yemen. That’s because under the U.S. tax law, income is sourced from the place of the economic activity that gives rise to it. Here, all of the work that culminated in the finished product (i.e., the written memorandum) – from legal research to the writing of the memorandum – was done in the United States.

John writes back to the Yemeni Treasury, explaining that all of the work that produced his $ 4,000 fee was done in the United States and that he doesn’t think that it should be subject to Yemeni tax. The Yemeni Treasury responds that its tax system identifies the source of income with the source of payment rather than the place in which the underlying work was done. Because the $ 4,000 came out of Yemen’s economy and reduced its claims on the world’s resources by $ 4,000, Yemen is the source of payment. To the extent that John was optimistic about persuading the Yemeni Treasury to rethink its position and forego collecting the tax, the last sentence of the letter must have been very sobering: “Our official determination is final.”

Yemen has won the narrow legal argument. As a matter of Yemeni law, John owes the tax. And while the tax is not consistent with U.S. notions of the source of income, it is not per se wrong. At this point, one possible course of action for John is to pay the tax. On the other hand, it may matter very little to John that Yemen has won the argument.

Depending on John’s anticipated future ties to Yemen, he can just say no – simply not pay the Yemeni tax – without further ado. Yemen can’t do anything to John, unless he’s planning on taking his next vacation there. And the United States will not enforce Yemen’s demand. Therefore, John ignores Yemen’s tax claim.

Precisely because John can do so, and likely with impunity, the course of events described above will never occur. Yemen’s view of the source of John’s income in this vignette is entirely realistic, but Yemen’s laid back approach to collecting its tax is not. Yemen knows full well that it has little or no leverage to collect tax from John, and more than likely will not even attempt the vain act of doing so.

Instead, John will receive a check from Ali for $ 2,000. Attached to that check will be an official form indicating that $ 2,000 of Yemeni income tax has been withheld by Ali at the source and paid over to the Yemeni Treasury. John can engage in the same arguments with Yemen as he did before, but such efforts will be futile. This time Yemen does not care who wins the legal argument. It has the money.

What if John decides to sue Ali for the balance of his fee? Will he win? No. Why not? Because under Yemeni law, John has been paid in full. Yemen’s requirement of withholding income tax at the source from payments to foreign persons has reversed the balance of power between John and the Yemeni Treasury. Put simply, John cannot avoid the tax.

Given the inevitability of Yemen withholding its tax at the source, John’s next concern is how the United States will tax his fee in light of this action. Assume that the United States also imposes a fifty percent income tax. The worst case scenario is that the United States Treasury gives no consideration whatsoever to John’s payment of the Yemeni tax – that is, it denies John any deduction or other allowance for this payment.

If so, John is up a creek without a paddle. His U.S. taxable income on account of the fee is $ 4,000. With a U.S. tax rate of 50%, John must pay $ 2,000 in income taxes to the U.S. Treasury. The combined tax payments to Yemen and the United States – $ 2,000 for each – have unilaterally eviscerated John’s income from this venture.

This pathetic result is the text book definition of absolute double taxation – the taxation of the same income by each of two countries without any allowance by either for the tax imposed by the other. If it were common, double taxation would stop international economic activity dead it its tracks.

Can this draconian result be remedied? The answer is a resounding, “yes.” There are at least two possibilities – one that is only slightly better than absolute double taxation and the other which goes much farther in mitigating the harsh effects of double taxation. With respect to the former, a less disastrous possibility is for the United States to at least permit John to deduct the Yemeni tax from his U.S. taxable income. Without delving too deeply into the U.S. tax code, a deduction of the Yemeni tax might be defended as an expense of carrying on the business that generated the income.

With a deduction for the Yemeni tax, John’s U.S. taxable income would be reduced from $ 4,000 to $ 2,000. With a U.S. income tax rate of 50%, John would owe the U.S. Treasury $ 1,000 in taxes (50% of $ 2,000 = $ 1,000). Therefore, his total worldwide tax cost would be $ 3,000 ($ 2,000 Yemeni tax + $ 1,000 U.S. tax = $ 3,000).

Although this too is double taxation, it is double taxation in a milder form. Indeed, it is less extreme than if neither country made any allowance for the tax imposed by the other. While John has paid tax to two governments, one of them, the United States, has made a concession for the tax paid to the other, Yemen. However, the combined rate of tax is 75%, still a considerable tax on international economic activity, especially when compared to domestic economic activity.

Better yet, John might hope to be allowed a foreign tax credit. The foreign tax credit is the heart of the U.S. system of outbound taxation. Just as the U.S. taxes the U.S.-source income of foreign persons, other countries to which Americans are themselves foreigners, such as Yemen in this example, assert source-based tax claims against U.S. persons pursuing foreign income inside their borders. Coupled with the worldwide reach of U.S. taxation, this would result in painful multiple levels of taxation if no concession was made by the U.S. Treasury. Thankfully, such a concession has been made.

The central provision addressed to fix this problem in the U.S. tax system is the foreign tax credit. Broadly speaking, the credit prevents double taxation of the foreign income of U.S. persons by reducing the U.S. tax on that income by the amount of income tax paid to the foreign government.

The foreign tax credit is a unilateral measure adopted by the U.S. tax system. On its surface, the U.S. tax system asks nothing from foreign treasuries in return for the credit. The foreign tax credit is a virtual necessity when it comes to taxing the worldwide income of U.S. citizens and residents. It rests on a simple idea: income taxes paid to the U.S. Treasury are reduced (credited, in tax parlance) by the amount of income taxes paid by the U.S. person to the foreign government.

Returning to the hypothetical, if the U.S. were to allow such a credit, then John’s U.S. income tax would be reduced – dollar-for-dollar – by the amount of tax that he paid to the Yemeni government. Let’s see how this plays out. John’s U.S. taxable income from the venture would still be $ 4,000, resulting in a pre-credit U.S. tax of $ 2,000. However, because John paid $ 2,000 of income tax to the Yemeni Treasury, he would be entitled to a tax credit of $ 2,000. That credit reduces John’s pre-credit U.S. income tax from $ 2,000 to $ 0.

With a U.S. tax credit, the combined effect of Yemeni and U.S. tax is $ 2,000 – the same as the 50% rate imposed by either country on its own income. With a full foreign tax credit, there is no double taxation.

If you expected a U.S. credit for Yemeni income tax in this hypothetical, however, you would be sorely disappointed. To be sure, the U.S. does allow a dollar-for-dollar credit for foreign income taxes with a view toward mitigating international double taxation. As discussed above, the foreign tax credit is a concession of the U.S. Treasury to the taxing power of the country of source. But that credit applies only to foreign taxes imposed on foreign source income.

This raises an important point that is easy to overlook. The willingness of the United States to forego taxation and defer to the taxing power of a foreign country extends only to income considered, within the U.S. tax system, to have its source in that foreign country. This forbearance does not extend to income considered, within the U.S. tax system, to have its source in the United States.

Recall that the Yemeni tax here was imposed on a fee for work that was done in the United States. This fact is critical because under the U.S. tax system, income takes its source from the place of the economic activity that gives rise to it. Put simply, work done in the United States is classified as U.S.-source income, not foreign-source income. Because all of the work that produced the fee was done in the United States, it is classified as U.S.-source income, not Yemen-source income.

What impact does the classification of John’s fee as U.S.-source income have on the willingness of the United States to forego taxing it? Because John’s fee is not foreign-source income, he will be denied a foreign tax credit. Therefore, it will be subject to U.S. income tax.

Does the fact that Yemen took a different view of the source of John’s income and classified it as Yemeni-source income matter? No. Why not? Because that was a matter of Yemeni tax law. In deciding whether to allow the foreign tax credit, it is the United States’ own principles of source, and not another country’s, that takes precedent. Therefore, John will be denied a foreign tax credit.

As a last resort, John might attempt to recharacterize the income from his Yemeni client as some sort of foreign source income, so that he might be entitled to a U.S. credit for the tax paid to Yemen. One way of accomplishing this is to try and recast the transaction as a sale of a written product in Yemen, which the U.S. might acknowledge as generating foreign source gain. The rationale for this is that the memorandum was sent to a client who lived in Yemen.

Much to John’s dismay, this attempt would likely fail. Put simply, it is unlikely that the U.S. Treasury would view this transaction as compensation for the transfer of a physical object. That such a strategy could even be considered in order to achieve a better tax result reveals the special importance of characterizing transactions in the international tax setting.

As indicated in the preface, this vignette illustrates the main cause of international double taxation – inconsistent rules of source in different countries imposing overlapping taxes. Both the U.S. and Yemen have taxed the same item of income – to wit, John’s fee – as their own. Both have the power to tax in this instance and so both can be “right” in the only sense that matters. If all countries had perfectly consistent rules of source and a system of credits, there would be no double taxation. But they don’t, and so there is.

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