By Howard S. Fisher, Esq.1, California, USA and Alexander J. Fisher2, Georgia, USA
Wesley Snipes is an accomplished American action-comedian star of the silver screen, having appeared in more than 50 movies, who earned as much as USD19 million a year during the years in question. Using the tax laws intended for foreigners - Section 861 of the Internal Revenue Code - Mr. Snipes applied for tax refunds totalling USD11 million with regards to taxes he paid in 1996 and 1997. Further, he did not file tax returns for 1999 through 2004 even though he earned USD58 million during those six years. Ultimately, Mr. Snipes was convicted of failing to file tax returns for three of the six years however, he was acquitted of the most serious claims.
The income tax code was enacted in 1913 and was immediately subject to attack by tax protestors asserting a myriad of reasons why the tax law was invalid,3 or did not apply. From the beginning the courts have had no trouble in defeating one protestor’s claim after another - Mr. Snipes is just the latest victim to fall to the lure of erstwhile tax-avoidance theories.
Mr. Snipes’ magic tax talisman that he hoped would shield him from US income tax was Section 861 - Income from Sources within the United States. The concept of ‘source’ as set forth in Section 861 is the cornerstone of how the US taxes ‘foreign persons’, and has no general application as to how US taxpayers are taxed.4 Relying upon a tortured reading of Section 861(at best), Mr. Snipes formulated a belief that he was immune from US tax on income earned in the US.
This article will explore Mr.Snipes’ case, will attempt to describe the so-called Section 861 argument, and will offer some thought for the future of this and other international related tax-avoidance schemes.
Blame the ‘Offshore’ World
In August 2006, the US Senate’s Permanent Subcommittee on Investigations released a report entitled: Tax Have Abuses: The Enablers, The Tools, And Secrecy (the Abuse Report5). Senator Levin, the Subcommittee’s Ranking Minority Member stated that the Abuse Report’s findings were ‘explosive: the report blows the lid off tax haven abuses...’ The Abuse Report concludes that offshore cheating by Americans is rampant - as much as 7% of all US income tax goes unpaid - that’s 7 cents on every tax dollar. The Abuse Report lays a large part of the blame on the ‘armada’ of advisors who ‘help clients skirt US tax ...laws.’
Senator Levin, one of the members of the Committee that prepared the Abuse Report stated that ‘...he grew angry as he learned ...how existing government rules aided tax cheats.’6 The Abuse Report failed to address the complexity of the tax system, or the inability of the IRS to administer the system due to its complexity which are the real root causes of much of the ‘offshore’ tax fraud, and which set the basis for Mr. Snipes’ Section 861 claim, even though Snipes has nothing to do with being ‘offshore.’
How Foreign Persons are Taxed - The Importance of Source of Income
US individuals are taxed on their worldwide income. There is no concern as to where the money is earned, and no concern as to how tenuous that person’s contact is with the US - for example, a child born in the US in 1950 while their Chinese parents were on vacation in California, and who left the US right after birth, not to return for 55 years, is still a US citizen, and is subject to tax on their income earned in China.
In order for the US to have ‘jurisdiction’ to impose tax in the international context on persons who are neither US citizens, nor foreign persons who ‘reside’ in the US, it relies upon the concept of ‘sourcing’ of the income - the US generally only taxes ‘foreign persons’ on their ‘US sourced’ income. This is the reason the ‘source rules’ are the cornerstone of US international tax, and is the first substantive topic usually covered in any course or text book on the subject.
The US ‘sourcing rules’ are contained in Internal Revenue Code Sections 861 (US source), 862 (foreign source), 863 (special source rules), 864 (definitions applicable to sourcing rules), and 865 (source rules for sale of personal property). The sourcing rules of Section 861-865 relate almost exclusively to ‘Subchapter N’ of the tax Code, dealing with taxation for foreign persons, and foreign income of a US person.
If the foreign person, be it an individual or an entity that operates in or has income from or relating to their operations in the United States, there is a potential that the US will impose its tax regime. Essentially, a foreign person is subject to US tax on only two types of US sourced income:
1.A flat 30% withholding tax is imposed on US sourced ‘passive’ income, such as interest, net rents, dividends and royalties.7 The payor of the income, who is usually a person based in the United Sates is required to withhold and remit the 30% of the ‘gross’ amount to the IRS. The foreign person is not entitled to any ‘deductions’ in calculating tax on passive income.
2.If the foreign person is ‘engaged in a trade or business’ in the United States, then the income from that business, which is: (A) US sourced, and (B) ‘effectively connected’ to that US business is subject to tax just like any other ‘American’, at the full graduate rates, and is entitled to most of the same deductions that any other US person is entitled to.8
Certain types of activity or income is not subject to tax under one of the above two disciplines, then no United States tax is imposed on the foreign person’s income. Many of these ‘exceptions’ from tax are based upon public policy. For example, to encourage ‘foreign persons’ to put money in US banks, and to invest in the US stock market - in most circumstances, income earned from these activities is exempt from US tax.
If the income is not ‘US sourced’, a foreign person is generally not subject to US tax on the income. The ‘sourcing’ rules have no application to a US citizen’s income from their personal services!9
The Theory behind the 861 Argument
Some tax scheme promoters contend that tax is only applicable to ‘foreign income’ of US taxpayers - hence, for most Americans there is no obligation to pay tax. The argument is predicated upon reading a few select words here or there in the Code of the regulations - in particular the source rules of Section 861, as amplified by Treasury Regulations § 1.861-810 argue that taxes are only imposed on income derived from certain foreign-based activities. They also claim that federal income taxes are excise taxes imposed only on nonresident aliens and foreign corporations for the privilege of receiving income from sources within the United States. The premise for this argument is a misreading of US sourcing rules, which for the most part apply only to the ‘foreign taxpayer’ (and to a very limited extent to Americans, but only as specified in the Code, e.g., the exclusion of a limited amount of foreign sourced earned income by expatriate US taxpayers [§ 911, et seq.], or the claiming of the foreign tax credit [§ 901 et seq.])
The Theory: The 851 argument goes something like this - all Americans must pay income tax in accordance with the rates in Section 1 of the Code. The tax is imposed on taxable income (defined in § 63 - gross income less deductions). Gross income ‘means all income from whatever source derived....’11. So why look to section 861 and the regulations under 861? To confuse!! Nothing in the Code points to section 861 for Americans.
Section 861 defines the ‘source’ of income which is not relevant to most Americans who live in the US (who are taxed on income from ‘whatever source’). It only applies to foreign persons.
The promoters of the 861 scheme rely upon Regulations Section 1.861-8, which is 60+ pages of some of the most complex and opaque regulations in the Internal Revenue Code. To a lay person, Section 1.861-8 is impenetrable - and that is what the promoters of the scheme count on. To practitioners of international tax law - they have worked well with these regulations for decades; Section 1.861-8 provides that it applies: ‘... in determining taxable income of the taxpayer from specific sources and activities under other sections of the Code, referred to in this section as operative sections.’
The key, claim the promoters, is set forth in Section 1.861-8(f), which provides:
‘(f) . . . Operative sections. The operative sections of the Code which require the determination of taxable income of the taxpayer from specific sources or activities and which give rise to statutory groupings to which this section is applicable include the sections described below. ...’
However, subsection (f) clearly states that the sourcing rules are only applicable to the ‘operative sections of the Code which require’ its application. For example, nonresident taxpayers are only taxed on US sourced income, so it is important in the determination of their taxes.12
Most promoters of the 861 argument never explain the interaction of Section 861 (which applies only to specific and narrow situations), and Section 61 that states gross income includes income from ‘whatever source,’ - they rely upon the ignorance and greed of their client to take snippets of the tax law as the Holy Grail. A well known advocate of the 861 argument has a 60+ page tome explaining why so many tax professionals ‘blundered’ and don’t understand the Section.13
The authors are sure that if some of these promoters actually read all of the Internal Revenue Code and the Treasury Regulations, they could find all of the answers not only to the Da Vinci Code, but to the meaning of life itself (interdum stultus bene loquitur).
Snipes was sentenced to 36 months in prison - more on this in Part 2 in the next issue.
END NOTES:
1. Mr. Fisher is a member of the California Bar, and the Honourable Society of Lincoln's Inn (London [student bencher]). Mr. Fisher is a graduate of Southwestern University (J.D.), and the University of Cambridge (LL.B. with honours).
2. Mr. Fisher is a graduate of the University of Michigan (BA –
Econ/Comm 2004), Emory University School of Law (JD - 2007), and is an MBA candidate at Emory 2008.
3. Brushaber v Union Pacific Railroad, 240 U.S. 1, 17-19 (1916), the Supreme Court upheld the validity of the 16th [Income Tax] Amendment to the Constitution.
4. Sourcing rules are applicable to US taxpayers only when specified in the tax code. For example, under Section 911 a US person living abroad can exclude from their taxable income a limited amount of ‘foreign sourced’ earned income IRC § 911(a)(1), it also has application to the foreign tax credit rules under § 901.
5. http://levin.senate.gov/newsroom/supporting/2006/PSI.
taxhavenabuses.080106.pdf
6. N.Y. Times, “Tax Cheats Called Out of Control,” by D. Johnson, August 1, 2006.
7. IRC §§ 871 and 881.
8. IRC § § 872 and 882.
9. Except where the US persons lived and worked outside of the US and qualify for the exclusion under Section 911.
10. These regulations are intended to ‘allocate’ income between US and foreign source. It is an extremely complicated regulation, even for the cognoscenti.
11. Section 61.
12. IRC §§ 871 and 881.
13. Taxable Income (The Evolution of a Deception) by Larken Rose, can be found at http://www.theft-by-deception.com/ TaxableIncome2007.pdf |
