International Taxation in America: 2011 Edition

By Brian Dooley

International Taxation in America presents the most complete and indispensible guide to international taxation available in todays market. Author Brian Dooley, CPA, is a seasoned tax researcher and specialist in international tax and is among the very few experts who have experienced hundreds of international tax audits without a loss.

Covering international taxation for businesses, the taxation of shareholders of foreign corporations, foreign tax credits, cross-border estate planning, and much more, Dooley offers meticulous research and clear explanations of hundreds of international tax-related issues. Whether the subject is tax haven corporations and trusts, reducing taxes through tax treaties, learning how Americans are taxed abroad, or estate planning for multi-national families, Dooley explains the subject in thorough and clear language.

International Taxation in America provides valuable lessons for your enrichment, including useful links to help guide you online. Youll receive the level of information and expertise required to avoid mistakes and IRS scrutiny.

• Language: English
• Publisher: AuthorHouse
• Release date: Feb 1, 2011
• ISBN: 9781456736385

Brian Dooley

Brian Dooley, CPA. MBT is a CPA and an international tax specialist. He earned his bachelor of science in accounting and a graduate degree in taxation from the University of Southern California. A former university instructor in international taxation, he is the author of many publications regarding foreign tax matters and served for many years as chairman of the California Society of CPAs International Tax Committee of Orange County. Mr. Dooley has also served as an expert witness for the United States House Ways and Means Committee, the Department of Treasury, and the IRS.

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Contents

Preface: How to Use This Book

Chapter One: Foreign Trusts in America

Chapter Two: Fundamentals of International Taxation for Businesses

Chapter Three: Taxation of US Shareholders of Foreign Corporations

Chapter Four: Foreign Tax Credit

Chapter Five: Taxation of Foreign Persons Doing Business in America

Chapter Six: Cross-Border Estate Planning

Chapter Seven: Advanced Topics

Preface: How to Use This Book

I wrote this book to be the first author of a third wave tax book.[1] Major publishing houses’ international tax books continue to teach tax law used by second wave (industrial age) businesses and ignore "third wave" businesses (services, information, knowledge, and Web-based entertainment). They also publish only in second wave form (i.e., paper).[2] While tax law changes almost daily, the major publishing houses’ updates take months. I update each chapter via hyperlinks to articles on my website. Those articles link to court cases and IRS documents. Updates to this book are continuous and timely. Buyers of this book can obtain their free Adobe version by e-mailing me a copy of your purchase receipt to [e-mail].

Individuals trying to learn more about tax law will want to read the complete book in the order written. To learn international tax, you will need to learn a variety of laws simultaneously. I designed Chapter Two to give you the broad foundation of international tax law. This foundation helps to understand the more detailed chapters. For example, the sourcing rules for income are similar to the foreign tax credit. Knowing this as you read will help you to visualize the equation of income, foreign tax credit, and Subpart F income. International tax planning maximizes the equation for each client.

If you are preparing a tax return or undertaking tax research, use the search function and hyperlinks (available in e-book) to quickly find your answer. Use this book for tax planning, tax research, and education on the preparation of a tax return.

Tax planning is no longer just about finding deductions. Tax planning is using current law and future law to reduce taxes by shifting income to the correct type of entity. Tax planning places a portion of a business’ income in a favorable tax entity.

Chapter One introduces the Nat King Cole story, which exemplifies the success of a creative man whose tax planning drove the IRS crazy but impressed the tax court. Chapter One updates the Nat King Cole tax planning concepts for the twenty-first century.

Chapter One also explores the first tax court case where a machine provided a service, much like a human. The Xerox copier first revolutionized the office and then the tax law.

Important quotations from the court’s opinion, written by the judge, are found in the hyperlinks available in the Adobe version.

Visionaries need to know the concepts and not the details. Chapter Two provides those concepts. The chapter includes a little of everything, providing the foundation and making it easier for the reader to understand the remainder of the book.

Chapter Two is the most important chapter in the book. Attorneys and CPAs wanting to learn international tax law must read Chapter Two before the five chapters that follow it. One needs to know the fundamentals and the correlative issues in order to comprehend the complexities of the law discussed later.

Business owners and investors must read Chapter Two to understand the parts of the American international tax law that applies to them. Chapter Two explains every aspect of American international tax law in easy to read language.

Chapter Three is the corner stone of American international tax law. Most countries only have corporate entities and do not recognize partnerships, trusts, or limited liability companies. This chapter teaches the controlled foreign corporation law.

Chapter Four is the focus point for privately owned businesses with foreign activities. This chapter presents the best international business structure to the reader.

Chapter Five looks at foreign persons doing business in America. The key to this situation is to pay tax only once on business income.

Chapter Six provides the greatest guide to cross-border inheritance planning. The United States has a transfer tax law, whereas the rest of the world has an inheritance tax or an estate tax. Here you will learn how to avoid double taxation on the transfer of property to family members.

Chapter Seven provides knowledge on advance international tax topics that cannot be found anywhere else.

Each chapter gets into the details of the law, with hundreds of pages of rulings, regulations, and court cases found exclusively in this publication by the use of hyperlinks (which are underlined and in blue). As the chapters progress, you will note that the tax law becomes more complex. If you are purchased a hard copy of this book, please note that the underlined links will not appear, but you can contact me for your free Adobe copy. Merely send to me your receipt.[3]

The hyperlink features of this book found in the Adobe version double your knowledge. While I have footnoted the book in the printed, Kindle, and Adobe versions, only the Adobe hyperlinks the footnote to the Internet, where you will find the referenced item and my annotations. You can reach the updates to the book by clicking on the hyperlinks in each chapter. The hyperlinks to the updates are at the end of each chapter. This book is updated each year, at which time the prior updates are added to the new edition of this book.

You can also use my private Google search, which contains links to hundreds of pages of international tax resources. You can go to the private Google search by clicking here.

Chapter One: Foreign Trusts in America

We all have heard people say that things are not what they used to be. In American business, this is particularly true. In 1910, electricity was not in the White House. Cars were laughed at, with jokes like, Get a horse! Phones were rare, and there was no air travel. If you were born in 1900, then you were thirty-nine years old when we began using the tax code we still have today—the 1939 tax code.[4] The tax-planning chapter of this book revolves around a major flaw in American tax law caused by the speed of change.

Most of the congressmen who wrote the 1939 tax code were born before 1900. Their view of the world was what you see in many silent movies … and so was their tax law.

As I write this page today, May 6, 2010, the newspaper headlines are blaming a computer for the Dow’s flash crash of a thousand points in one hour: Computers, Not Human Error, Likely Caused Market Meltdown.[5] Sounds like the movie 2001: A Space Odyssey and Hal the computer!

President Kennedy’s tax reform in 1962 saw the biggest change for international taxation, with the enactment of the controlled foreign corporation law and the repeal of the force of attraction concept that changed the sourcing rules in American tax law. However, the concepts from 1939 remain intact.

In this book, you will experience my belief in the writings of Alvin Toffler regarding economic times, which he calls the first wave, the second wave, and now the third wave. In 5000 BC, we saw the start of the first wave. At that time, the tax collectors were biblical villains. Because few individuals had money, they paid taxes in kind, or with commodity money.[6] The second wave, the industrial revolution, saw the birth of income taxes, with the payment of taxes by paper money. In the late 1990s, the third wave economy created wealth in the developed world, while the second wave economy moved to Asia. Recently some businesses have started to accept only digital money (credit cards, debit cards, online banking payments, etc.) and will not accept paper money.

While this book covers all aspects of American international taxation and tax planning, it highlights the tax savings created by Congress with its decision to apply industrial age tax laws for a third wave economy.

With third wave tax planning, you will learn:

1. How to use a foreign trust to save income taxes[7]

2. How Congress created a virtual foreign country for your trust’s tax situs[8]

3. How Congress created a virtual domestic corporation to be used as a tax haven corporation[9]

4. How to pay your virtual computer for foreign machine services[10]

The Best Foreign Trust Court Case

The best court case to guide you with tax planning for service income earned in a foreign country is the Nat King Cole case. Nat King Cole and his wife formed two foreign trusts, which in turn owned two tax haven corporations—PMSA and Associated Arts. PMSA was used for his foreign tours; Associated Arts (AA) was used for his music’s copyright and master recordings (which are similar, in concept, to software). Music was sold as tangible property (there were no MP3s or iTunes); however, music was kept on a medium that would be akin to firmware in today’s world.

Nat beat the IRS on the assignment of income doctrine for his personal performances. Nat also beat the IRS on Section 482 (arm’s-length pricing). When he passed away, the assets in his foreign trust were excluded from his taxable estate.

In this chapter, you will read references to a domestic foreign trust. American tax laws have two types of foreign trusts. A trust with a foreign trustee and is governed by foreign law is a foreign trust. A trust with a domestic trustee, governed by domestic law and which has a flee clause, is a domestic foreign trust. A flee clause requires the trust to move if any person attempts to seize the trust assets. A flee clause is an asset protection trust. Chapter Six discusses cross-border estate planning and explores flee clauses. To read the IRS regulation on the use of the flee clause (which the IRS names auto migration), please click on this link.

Just how long should you expect these loopholes to exist? Looking at the government’s approach to foreign trust provides an insight. The effective date for the current law was 1974. A quarter of a century later, in 2000, the IRS issued new regulations, which created a loophole.

Tax planning involving an absence of law requires searching the past one hundred years of court cases to obtain precedence.

Three Unique Second Wave Court Cases Apply to Today’s Third Wave World

Tax case law for the third wave economy has not occurred. However, there are three second wave–era court cases that have third wave traits. These cases provide the design for third wave tax law.

First, a 1930s tax dispute determined that a Mexican radio station run out of Texas had tax-free foreign source income. From this case, we learn that the source of income from a computer hosted in a foreign country providing business service to American customers is foreign source income.

Second, Nat King Cole’s offshore tax planning for his domestic song royalties and foreign touring income gets an A+ by the tax court. From this case, we learn the ideal foreign business structure.

Lastly, Xerox rocked the IRS when a court ruled that income earned by its copiers was machine service income, which was to be sourced where the service computer was located.[11] From this case, we learn that a machine can provide personal service income. Today many devices provide personal services to us, such as a GPS navigation system and the Rosetta Stone language learning software.

Piedras Negras Broadcasting Co., and/or Cia Radio Difusora De Piedras Negras, S.A. v. Commissioner of Internal Revenue (43 BTA)[12] involves the beginning of the third wave commerce. Until the advent of radio and music on records, entertainment and news were in the form of hard copy or live performances. Radio was the sole entertainment that could not be purchase as tangible property.

The setting is the late 1930s. An American radio station moved to Mexico to serve its American audience. Compania Radio Difusora de Piedras Negras, SA, (the English translation of which is Piedras Negras Broadcasting Company) was organized under the state of Coahuila, Republic of Mexico. Piedras Negras, Mexico, and Eagle Pass, Texas, are separated only by the Rio Grande River.

In 1936 and 1937, the radio station deposited $72,204.14 and $66,985.11 of its advertising income in its bank located in Texas.[13] The IRS assessed the radio station taxes, claiming it was American source business income.

W. E. Branch, president of the radio station in 1936 and 1937, registered The Radio Service Co. in the assumed name records of Maverick County, Texas. Some contracts were entered in its name, which was used in connection with the business of the Piedras Negras Broadcasting Co. because of the difficulties Americans had in saying the name Piedras Negras.

Each day, employees of the radio station met in Eagle Pass, Texas, with the advertisers at the Hotel Eagle. The hotel furnished the radio station with a private meeting room. The radio used the hotel as its address. Besides opening the mail, the meeting room was at the disposal of sales clerks for their wares and samples. Tables and chairs were equipped for that purpose and furnished by the hotel.

Upon delivery of the mail, the employees of the advertiser, along with two employees of the radio station, opened the mail. During the meeting, the radio station and the advertisers divided payments received in the mail. The radio station’s deposited its share of the money (checks) to the radio station’s credit in one of two banks: in Eagle Pass or in a bank in Piedras Negras.[14] The court noted that the place of signing a contract was not determinative in determining the source of this type of income.[15]

The radio station at Piedras Negras was a powerful one, broadcasting on fifty kilowatts in 1936 and 1937, and the advertisers got listener responses over a wide area, from nearly all of the states in the United States. The station also received mail from Canada, Cuba, and New Zealand. The Piedras Negras station had no directional antennae; the waves radiated by the antennae went in all directions with equal force. About 95 percent of the station’s income was from American advertisers, and about 90 percent of the listener responses to the advertisers came from the United States.

The entertainers and announcers who put the programs on the air went to the studio in Piedras Negras, Mexico. The radio station generally employed the entertainers or musicians and furnished the programs that were broadcast. However, sometimes the advertisers would do so. In the latter instances, radio station furnished only the time on the air.

The judge noted that the IRS considered the activities at the meeting room as to constitute doing business in Texas, and thus the source of income was within the United States. The IRS argued that radio station’s income came from the division in Eagle Pass, Texas.

Although the IRS wanted the meeting room to be an office or fixed place of business, the court held otherwise. The judge stated,

Nor should greater effect be given to the use by radio station of a room in the hotel in Eagle Pass, Texas, for the purpose of sorting the mail received by advertisers and dividing the proceeds of remittances received. No rent was paid for the room and no furniture or desk was owned or maintained therein by the radio station. It was a basement sample room donated by the hotel, obviously because of the patronage realized from those in connection with the broadcasting operations. It was not an office in any usual sense. As a place of business it was only incidental - for the sorting of mail and collection of income. Regulations 94, article 231-1(b), says in part:

Whether a foreign corporation has an office or place of business within the United States depends upon the facts in a particular case. The term office or place of business, however, implies a place for the regular transaction of business and does not include a place where casual or incidental transactions might be, or are, effected.[16]

The use of the meeting room for samples was not casual but daily. Yet the court ruled that it was only incidental, allowing the radio station not to have a United States business

Many tax planners believe that negotiating a contract in the United States causes all future profits to be domestic source. This is not the case. The judge stated,

However, the only indication of the use of that company or name for solicitation in the United States is the fact of registration in the assumed name records of Maverick County, Texas. Internal activities of a corporation, such as holding a stockholders’ meeting, do not constitute transacting business. Nor is collection of debts, nor litigation to so collect, doing business [as argued in] Equitable Credit Co. v. Rogers, 299 S.W. 747; Continental Assurance Co. v. Ihler, 26 Pac.(2d) 792.

The contract’s venue of Maverick County, Texas, for litigation was immaterial to the judge.[17] Further, the place of signing a contract was not determinative in determining the source of this type of income.[18]

The judge was specific regarding sourcing:

Income has been defined as the gain derived from capital, from labor, or from both combined, or from the sale or conversion of capital assets [as argued in] Eisner v. Macomber, 252 U.S. 189. In Paul and Mertens’ Law of Federal Income Taxation, vol. 4, p. 350, it is said, in part:

[The source] is not a place, it is an activity or property. As such, it has a situs or location; and if that situs or location is within the United States, then the resulting income is taxable to nonresident aliens and foreign corporations…. Thus, if an income be taxed, the recipient thereof must have a domicile within the jurisdiction, or the property or activities out of which the income issues or is derived must be situated within the jurisdiction so that the source of the income may be said to have a situs in this country. The basic rule is that the consideration for taxation is protection of life and property and that the income rightly to be levied upon to defray the burdens of the United States government is that income which is created by activities and property protected by this government.

The court gives us the first clue as to the sourcing income provided over an intangible pathway such as radio waves or the Internet.

It thus appears that broadcasting through the ether[19] does not in any ordinary sense cause contact or interaction between properties of different owners, such as transaction of business usually entails, and that the foreign broadcasting corporation here cannot be said to be using property in the United States. Shipping goods into a state is not doing business therein [as argued in] Novelty Manufacturing Co. v. Connell, 34 N.Y.S. 717; nor is sale by solicitor, transportation of merchandise into a state, and collecting therefore [as argued in] Bruner v. Kansas Moline Plow Co., 168 Fed. 218; nor distributing a magazine by a foreign corporation [as argued in] System Co. v. Advertisers’ Cyclopedia Co., 121 N.Y.S. 611. If these physical activities do not constitute transaction of business within a state, we think that mere broadcasting through the ether over a state is not such.

Here the judge focused on the flaw of the American tax code by stating,

The commonly accepted definition of the term ‘source’ is ‘that from which anything comes forth, regarded as its cause or origin, the first cause’ [according to] Webster’s New International Dictionary…. Neither broadcasting nor the other facts above examined come within the items which section 119 of the Revenue Act of 1936 enumerates as to be treated as income from sources within the United States, viz., interest, dividends, personal services, rentals, royalties or sale of property, real or personal.

The Nat King Cole Case

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Nat King Cole and his wife formed two foreign trusts in the Bahamas: PMSA & Associated Arts.

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The best foreign business structure is the theme of the Nat King Cole story. While he lived during the second wave, he created his wealth with third wave ideas.

Can 1960s offshore tax planning really be today’s state-of-the-art planning in this third wave economy? You bet. Unlike the 1960s, we now have a virtual tax haven (created by Congress), a foreign country with no name or land mass. The 1996 Tax Act provided that any trust located in the United States can (for tax purposes) elect to be a foreign trust. Of course, the trust is still legally in the United States. When this election is made, the IRS no longer considers the trust to be in America; in effect, the trust resides in an imaginary country.

The Nat King Cole case is a model for best international business structure. This case also provides the blueprint for foreign source service income and licensing income tax planning.

As you read about this famous entertainer, you will see that his international planners got it all. His offshore estate planning was so solid that upon his death, the IRS did not even challenge his trust or his private annuity.

Like Nat King Cole, you want only a portion of your assets owned by your trust. The profits earned by the trust must represent money that you do not need for your current living expenses. Much like your IRA, this is retirement money or money for future growth.

The Structure

His structure included two non-grantor foreign trusts (one for Nat and one for his wife), which owned two foreign corporations. One corporation was used for the musical tours overseas,[20] and the other was used to own and license his copyrights.[21] The two corporations were virtual companies that became major enterprises. They had no office and no employees, but they made a tax-free fortune.

The Nat King Cole tax story took place a half century ago. Nat King Cole was the first American to take advantage of multinational tax planning. As author Alan Toffler explains in Revolutionary Wealth, the production, sale, and distribution of intangible assets (versus manufacturing of tangible assets such as cars) know no national boundaries. [22]

Nat King Cole produced, sold, and distributed the intangible of music and his services as an entertainer. He established a multinational trust as the centerpiece of his structure. With this trust, his tax planning involved:

• Forming and using tax haven corporations

• Turning his copyright income into foreign source income

• Avoiding the Subpart F rules that apply to American-controlled foreign corporations

• Avoiding estate taxes on the assets owned by the multinational trust

• Avoiding the constructive receipt doctrine on his offshore deferred compensation plan

• Avoiding the arm’s-length pricing rules of Section 482 by the use of his offshore-deferred compensation plan

In the old days, the IRS considered his tax planning abusive. The tax court gave Nat King Cole top marks. He used four aggressive tax-planning principles that were new in the 1950s.

1. Deferred compensation

2. Private annuities

3. Foreign trusts

4. Treaty shopping

The Story

In those old days, music was on a master hard media (known as the master recording). In today’s world, we would call this firmware. Music was in a solid state; it really was a vinyl product. Royalties were paid for each song sold and were determined by the number of vinyl records sold. The legal aspect is similar to the sale of a magazine.

During Cole’s time, few US businesses provided services outside America. An entertainer often incorporates himself for tax purposes. In the entertainment industry, this is known as a loan out corporation. In professions such a medicine, architecture, and accounting, this type is known as a personal service corporation. Nat King Cole used a foreign loan out corporation for his foreign tours.

Nat’s foreign tours included him, his orchestra, light technicians, makeup artists, wardrobe consultants, and accountants[23].

In late 1959, Norman Granz, a prominent jazz music promoter, proposed to Nat King Cole’s agent, Carlos Gastel, that Cole tour through Western Europe in the spring of 1960 under Granz’s auspices. Cole agreed to do the tour.

A lawyer representing Granz informed Cole’s attorney that a Panamanian corporation was the preferred vehicle for promoting such a tour. Because it would not do business in the United States, it would not be subject to United States taxation.

International tax attorney Harry Margolis, Esq., was hired to form the foreign loan out corporation, and a Panamanian corporation, Presentaciones Musicales, SA (PMSA), was incorporated on March 7, 1960. This corporation had no office and no employees.[24]

The original capitalization of PMSA was $10,000, of which $5,100 came from a Panamanian corporation wholly owned by Granz, (Record Manufacturing, SA). The other $4,900 came from Nat King Cole. The stock was issued, 51 percent to Record Manufacturing, SA, 24.5 percent to Maria Cole (Nat King Cole’s wife), and 24.5 percent to Nat King Cole.

On March 15, 1960, Nat King Cole entered into an employment agreement with PMSA. PMSA paid him $8,500 per week for personal appearances outside the United States. The agreement provided for Nat King Cole’s services on a three-week tour of Europe during April of 1960. PMSA had an option to extend the tour for an additional two weeks.

During April 1960, Cole toured Western Europe for PMSA for twenty days. Nat King Cole appeared in England, which was taped jointly by PMSA and ATV, a British corporation that operated a commercial television network and engaged in other entertainment activities.

The tape was owned one-half by PMSA and one-half by ATV. PMSA employed Norman Granz as its representative to handle Cole’s European tour and paid him $2,000 per week for three weeks. Here is an important tax fact: PMSA also supplied and paid for the orchestra, transportation, promotional salaries and expenses, and all other items required for the tour.[25] The tour was not successful, and PMSA had a net operating loss from the tour of $8,388.40.[26]

The total profits to PMSA from activities that Nat King Cole engaged in during 1961 were $17,024.92 and $13,000 for the English tapes (a total of $30.024.92, which was a lot of money in 1961).

In 1962, the only activity by Cole on behalf of PMSA was a trip to Mexico. Cole was paid on this tour at the rate of $8,500 per week for a total of $12,000. PMSA paid $3,000 in Mexican taxes and a small amount of travel and incidental expenses for the trip. PMSA had a small operating loss from this tour in 1962.

In 1963, Nat King Cole went to both England and Australia for PMSA. The tours together took four weeks, and Nat King Cole was paid the same rate per week, receiving a total of $34,747. The gross income from the two tours for PMSA was $98,338. PMSA supplied transportation, housing, and promotion; paid Australian income tax; and otherwise took all of the producer’s risks.

The Foreign Trust

On April 28, 1960, Nat King Cole transferred his 24.5 percent ownership of PMSA to a foreign trust he created for the benefit of his wife, Maria Cole, and his descendants. On the same day, Maria Cole transferred her 24.5 percent ownership of PMSA to another foreign trust created for the benefit of Nat King Cole and her descendants. The trustee of both trusts was the Arawak Trust Co., Ltd., a large Bahamian trust company.

The trusts were discretionary trusts and were irrevocable.[27]

Nat King Cole, in the trust he created for Maria Cole, reserved the right to change the trustee to another corporate trustee. This role is considered as a trust protector, a power that the IRS considers evil, despite the United States Supreme Court holding otherwise (See Bryum v. United States). His wife retained the same right to change the trustee of the trust she settled.

Treaty Tax Haven Company for Copyrights

The two trusts created Associated Arts, a Netherlands Antilles corporation. In 1955, the United States extended a tax treaty to the Netherlands Antilles (which is a tax haven). This treaty provided a great tax avoidance advantage.[28] The key is that the tax treaty entity must actually earn the income, versus just collecting and depositing the income.[29]

On July 26, 1960, PMSA (the corporation wholly owned by the Cole trust) and ATV (the English TV company) incorporated Associated Arts, NV (AA) under the laws of the Netherlands Antilles. AA was formed for the purpose of exploitation of the television tape made by Cole in England in 1960. But as we will see, it will end up with Nat’s music copyrights.

The tax rate in the Netherlands Antilles was less than 5 percent. The tax treaty between the Netherlands Antilles and the United States eliminated almost all of the US income tax on US source royalty income.[30]

In July 1962, ATV sold its AA stock for approximately $25,000 to another Netherlands Antilles corporation, World Minerals, NV.[31] World Minerals NV was managed by persons associated with the two lawyers who were officers of ABC (the TV company).[32]

When the initial tax planning for the two foreign trusts, PMSA and AA, was completed by Harry Margolis (the tax planning attorney), he did not contemplate that AA could be used to assist in solving the problem of increasing the amount Nat King Cole would realize from his deferred compensation agreement with Capitol Records.

However, Cole told his tax planning team to investigate a possible deferred compensation contract between him and AA with more favorable terms than he was receiving from Capitol.

A risk of using AA was the constructive receipt doctrine. Under this doctrine, you are considered to have received payment if, when the payment was due, you transferred the rights to payment to someone else.[33]

An agreement between Nat King Cole and AA was reached within a month, and Capitol was informed of the agreement. At that time, Capitol’s yearly gross receipts from Cole’s records were averaging between four and five million dollars.

The tax court ruled that Nat King Cole was not taxable on any of the income earned by PMSA or AA.[34] Further, the IRS never raised the issue of taxation under the controlled foreign corporation law because none of the income was Subpart F income. Upon Cole’s death, all of the assets owned by the trusts were excluded from his taxable estate.

Many businesses have intangible assets that can be owned in a trust or a corporation located in a low tax or no tax country or state.[35] Intangible assets include a business computer system with its software and data; it is similar to the master recording for music in the 1960s. Other intangibles include trade name, trademark, and your know-how. In some cases, it may be your marketing.

Xerox v. the United States (More Than Just a Machine)

The concept of photocopying was beyond my understanding at age nineteen. How could a picture be made so quickly?[36] Finding the correct pricing was a challenge for Xerox because this product had never existed. Xerox wanted, as does any good business, to make its fortune while it had the monopoly. Xerox decided on pricing based upon the value of the copies. Unlike a rental, where the lessor looks at the capital expended for the asset (such as an auto lease or an apartment), Xerox looked at the value of an instant copy of document.

Xerox treated the equipment as theirs and paid all of the cost of paper, ink, and maintenance.

The machines in issue were tangible personal property and had useful lives of at least five years. Without more, these machines would seem to constitute Section 38 property entitling Xerox for the investment tax credit. However, Section 48 sets forth certain exclusions from the definition of Section 38 property. This tax court case focused on the exclusions in Section 48(a)(4), which excludes property used by certain tax exempt organizations, and Section 48(a)(5), which excludes property used by governmental units. The tax court case involved the US government using the copying machines.

Xerox claimed that the machines provided a service; the machines were not used by governmental units and tax-exempt organizations In other words, the question was whether Xerox’s copying machines were providing a service to the government (and therefore used by Xerox to provide the service), and thus, the copiers were not used by the government’s employees—an interesting point. When I lease a car, I use the car. When you hire a taxi, you do not use the car; instead, you get the service of being driven somewhere.

The court provided a thorough historical review of machines providing a service. The next few quotations are from the court. When the court references the plaintiff, it refers to Xerox. The text in italics is my emphasis of important items. The issue in the case was a law created to spur the economy during a recession. A tax credit up to 10 percent of the cost of equipment was allowed. If a business paid $1,000 for equipment, a $100 reduction in its taxes was allowed. The tax credit did not apply to equipment leased to a government or a nonprofit organization. Xerox leased equipment to the United States and claimed the tax credit.

Upon audit, Xerox told the IRS that the copies earned service income and not rental income. The court agreed with Xerox.

I found the court’s discussion of ancient equipment, such as switchboards and vending machines, helpful in seeing how a machine can provide a service. You can read it at this link.

The judge in this case provided advice to determine when equipment creates service income versus rental income. I am including portions of the judge’s advice below. The complete explanation is at