Is A New Round Of International Tax Regulation Coming?

Over the last few years, large corporation's tax bills have come into more and more public focus.  Both Google and Apple have been called in front of Congress to explain their low rate and the overall tax plan of both corporations has become public knowledge.  These revelations are occurring at a time when the global tax base is being eroded as companies are shifting more and more of their income and assets to low-tax countries.  As a result, the OECD has issued a report titled, "Action Plan on Base Erosion and Profit Shifting." 

Let's first look at a brief history of the OECD-tax haven conflict to provide historical perspective, starting with this question: why are the tax rates in tax havens so low?  There are two inter-related answers: they have a tiny geography and small population.  The Cayman Islands is a mere 264 square km in size with a population of 53,737.  Looking at these two inter-related factors from a governing perspective, there is little need for a massive infrastructure system or social safety net programs and hence, little to no need to tax.  The exact opposite is true for OECD countries, who have large land masses and large populations.

Compounding this difference between large, populous countries and small less populated island nations is that businesses which require far more paper-work than physical product are easily moved to tax havens.  The first and most obvious example of this is financial services, an industry dominated by ledgers and accounts, not physical products.  The digital age has exacerbated this phenomena as web pages replace physical storefronts, thus enabling transactions to occur in cyberspace which can be located on a computer server rather than a bricks and mortar locale.  We can also place non-physical assets such as intellectual property into corporations located in these offshore jurisdictions and establish an intra-company payment system where a company will pay its offshore subdivision for usage of the company's intellectual property.  As a result of all these developments, more and more actual economic activity can be moved to these low-tax jurisdictions, thereby eroding the tax base of larger countries.

The OECD started to target offshore activity in the late 1990s with the issuance of the report "Harmful Tax Competition: An Emerging Global Issue."  In effect, the report argued the combination of banking secrecy and low taxes was eroding the OECD's tax base, leading the group to begin a lobbying campaign with these jurisdictions to both lift the secrecy veil and raise their taxes.  Little happened on this front until 9/11, which added further strength to the OECDs anti-secrecy arguments.  Now, more and more offshore jurisdiction are signing "mutual assistance" treaties which allow coordination of tax prosecutions with treaty signatories in certain situations.  From a macro perspective, these developments are leading to a slow end to the age of banking secrecy, which will probably disappear for the most part by the end of my lifetime.  

However, the issue of offshore tax arbitrage is still alive and well, hence the talk of a new global crackdown:

Finance ministers from the Group of 20 leading nations plan to launch a new phase of the international crackdown on corporate tax avoidance this week even as UK business leaders are warning their government to resist “radical new solutions” to profit shifting by multinationals.

Britain has taken a lead in pressing for reform of the international tax rules after a wave of public anger over the low tax bills paid by some large multinationals. An action plan on tackling base erosion and profit shifting is due to be presented to the G20 by the Paris-based Organisation for Economic Co-operation and Development on Friday.

We have no idea where this will end -- or if it will get anywhere in the first place.  However, I do think with the heightened spotlight on low multi-national  tax bills and increasing number of cross-border tax arrangements, this might have legs.

     

What Does a Tax Scam Look Like?

Planners have offered questionable ways to "minimize" tax since the implementation of the tax code.  Attesting to this are the first assignment of income cases which tested the validity and strength of the grantor trust rules when first established (see code sections 671-679).  In fact, a thorough reading of anti-avoidance case law shows there were several important periods in tax scams: the 1950s brought attempts to create phantom "interest" deductions, the 1970s and early 1980s brought limited partnership plans and the 1990s saw the creation of an entire industry encompassing the accounting, legal and financial professional industry.  

But while the long history of this industry could lead to the impression there is a vast difference regarding these plans, there is in fact a remarkable amount of similarity to the way they were structured.  What follows are some of the more common elements.

A hyper-technical reading of the tax code: this is probably one of the most common traits of tax shelters across the time periods listed above.  While the ability to comprehend particular sections of the tax code is obviously a prime requirement for a tax attorney, that knowledge has to be placed in the context of the legislative intent of the code in general.  For example, a common tax shelter in the 1990s involved the contingent liability section of the tax code, which would shift the gains of a transaction to a tax neutral participant (a party for whom income was immaterial) while it shifted the losses to a party that was trying to offset capital gains (usually a US taxpayer).  While these transactions complied with the technical aspects of the contingent liability section of the code, they had no substance, meaning there was no meaningful business purpose for the transaction, save sheltering taxable income.

Ground up tax planning: Most legitimate tax planning starts with a company approaching their attorney with one of four basic needs: the need to increase income (such as expanding into a new market), the need to lower expenses (combining subsidiaries; lowering taxes alone is not a legitimate reason), the need to raise capital or the need to lower risk.  But all four of these transactions starts at a high level and are motivated by a legitimate business need.  In contrast, most tax shelters are transactions in search of a client -- that is, a tax promoter will develop a transaction (usually involving a hyper-technical reading of the tax code) and then sell it to a client, one who is usually looking to offset income or capital gain.  When a transaction starts at a low level it has a difficult time establishing business purpose.  For a further explanation of this issue, see the Senate's Report on tax shelters.

Multiple, pre-planned steps: most transactions are actually very simple: company X buys company Y; company X forms an accounts receivable sub-division; company X divests itself of a subsidiary; company X issues stock, etc...   In contrast, most tax shelters use multiple, pre-planned steps to arrive at a particular destination.  For example, company X and company Y form an offshore partnership.  After 30 days, they purchase short-term notes.  After 35 days, they sell notes to received a contingent liability note.  After 12 months, company Y leaves the partnership ... you get the idea.  Pre-planned steps are a big warning sign that something is probably amiss.

Offshore: first of all, about 30% of my practice involves international tax planning, so I'm obviously not against the practice.  However, tax shelter promoters typically use an offshore jurisdiction for one reason: secrecy, a trait shared by many offshore jurisdictions (although this practice is changing).  This has obvious benefits if the participants are attempting to lower their tax burden in a questionable manner. 

Business Entities with a short life span: how long should a business enterprise exist?  Ideally in perpetuity -- which is one of the primary advantages of the corporate form.  And while businesses do go bankrupt or are sold, thereby ending their corporate life, most business owners want their business to exists for as long as possible as this indicates the company is a viable, ongoing concern.  In contrast, short duration corporations or partnerships are common in tax shelters, some of which contain entities with a life span of no more than 18 months.  While some could argue that joint ventures are an exception to the rule, most of these short-term combinations still have expected corporate an life expectancy of multiple years.

The above points cover most of the basic problems seen in tax shelters.  If you can think of others, please post them in the comments section.

  

How Reality Severely Limits My Vast Legal Super-Powers

The highly skilled lawyer who saves the protagonist from certain impending legal doom is one of the most iconic images in popular media.  Perry Mason of course stands out as one of the first characters that fit this bill, although others such as the cast of LA Law (a college favorite), The Practice and Law and Order stand out as well.  Real life examples include Clarence Darrow (who was portrayed wonderfully by Spencer Tracey in Inherit the Wind) and Johnny Cochran ("If the glove does not fit, you must acquit!").  These real and fictional individuals have given the public the impression that lawyers are super men who can always overcome disadvantageous odds to secure victory.

Sadly, realty often intrudes into real life expectations.  For while I would love to tell clients that I am one of these supermen of yore, I am in fact greatly hampered by three elements: the facts and circumstances of a particular case, the law as it is (not as we want it to be) and the legal code of ethics.  Let me explain each of these in more detail.

Hypothetically, suppose I'm a defense attorney, called in to defend an accused murderer.   On the other side of the court sits the prosecution who has four witnesses, all of whom are nuns with 20/20 vision and perfect recall memory, none of whom were more than 10 feet from the incident when it occurred.  Three video tapes of the crime also exist (all of which can be substantiated at trial), all with a good angle to witness the event.  While the TV or movie lawyer would be able to overcome these facts, the real attorney would merely be trying to keep his client out of the execution chamber (assuming the state had the death penalty).  Although these facts are deliberately extreme, they illustrate a key point: we are always limited by the facts and circumstances of the case we are given.  On a far more mundane (and far more realistic) note, consider a potential client who wants to form a captive insurance company, but who is also in the middle of a lawsuit.  Under the Uniform Fraudulent Transfer Act, I can't do anything because this transaction could easily be construed as an attempt to "hinder, delay or defraud" a potential creditor.  As these illustrations highlight, the facts and circumstances of a particular fact pattern can severely limit my legal options.

The law as it exists (not how we theoretically want it to be) is another element that can provide a fair amount of constraint for legal representation.  Suppose a client wants to transfer money to an offshore jurisdiction that has very tight secrecy laws with the intent of not paying US income taxes.  The clients states this is his goal.  At this point, I have to advise him that 1.) going offshore to hide money is illegal, 2.) he will have to file an informational return to comply with US law, regardless of what he wants to do, and 3.) as the US has a world wide taxation regime, he'll have to pay taxes on his offshore funds.  The preceding three statements highlight the law as it is, so, as an attorney, I would have to tell the client that his motivation runs afoul of the law.  It also means I probably won't be representing this client.

As a first corollary to the preceding point, it's also important to note that I can't fix your behavior after it occurs so that it complies with the law.  Like most people, potential clients regularly "shoot first and ask questions later."  And while I don't expect to be consulted on mundane issues, being aware of a bigger decision before it's made to discuss its legal ramifications helps to prevent bigger problems from developing.  Regrettably, attorneys are usually the last people consulted on decisions.

Finally, there is the legal code of ethics, with the biggest prohibition I face as an attorney:

(a) A lawyer shall not knowingly:

(1) make a false statement of fact or law to a tribunal or fail to correct a false statement of material fact or law previously made to the tribunal by the lawyer;

.....

(3) offer evidence that the lawyer knows to be false. If a lawyer, the lawyer’s client, or a witness called by the lawyer, has offered material evidence and the lawyer comes to know of its falsity, the lawyer shall take reasonable remedial measures, including, if necessary, disclosure to the tribunal. A lawyer may refuse to offer evidence, other than the testimony of a defendant in a criminal matter, that the lawyer reasonably believes is false.

I realize it may sound like a joke that an attorney can't lie, nor can he coach others to lie.  But there it is, plain as day in the model code of conduct.  And it's something that I and other lawyers whom I know take very seriously.  There is also new formal guidance for attorneys regarding representation and its relationship to money laundering -- rules which are very similar to the "know your client" rules.

So, what exactly can I do?  Within the confines of the above stated concepts, a great deal.  First, I can develop and implement a strategy that is compliant with the law as it exists.  Unlike the impression given by such services as Legal Zoom, the law is not merely a series of interlocking forms; each element of a form has legal ramifications and is derived from a substantive area of law that must be understood.  Second, I can keep this plan compliant with the law at it develops.  Remember, the law is always changing, sometimes in substantive ways.   Third, I can keep you out of trouble so long as you consult me on big decisions.     

So, the above three points are really my vast legal super powers as they exist in the real world.  

 

Using the Material Participation Rules to Establish Corporate Substance

As I have previously noted, the concept of corporate "substance" is a poorly developed area of law.  In this post, I wanted to expand the concept for the practitioner with the intent of borrowing from other legal areas in the hopes of providing further guidance.  I want to note upfront that the analysis I am about to offer has to my knowledge not been proposed or offered in any case law or law review article (if a reader knows of this, please post it in the comments); it's merely presented as a way to broaden the concept and provide high level guidance.

Establishing corporate substance is incredibly difficult for the small to medium size business owner for two reasons: (1) they typically work long hours building their business but (2) they have insufficient staff to document their actions in order to establish the requisite paper trail proving corporate substance.  Compare this to a larger company which either has in-house legal or an ongoing relationship with an outside firm that continually monitors and documents the company's legal developments in real time.  The former situation could leave a company vulnerable to a veil piercing claim in the event of lawsuit with the lack of a contemporaneously created record adding fuel to the fire.  But an alternative approach does exist which borrows from tax law, using the concept of material participation.

The material participation rules were added to the tax code in reaction to the tax shelter industry of the 1970s and 1980s, where promoters put together limited partnerships that primarily invested in assets with high interest deductions or depreciation expenses.  A deeper examination of these deals usually revealed a remarkable lack of business substance, and included things such as phantom loans, circular cash flows and massively overstated basis.  These deals were sold to high net worth individuals who were looking for ways to obtain losses to offset income; they wouldn't "materially participate" in these deals, instead acting as the classic "silent partner" exemplified by their legal status as a limited partner. 

As a result, Congress passed section 469 of the tax code, which divided income into passive and active income.  "Usually, passive activity losses can be offset only against passive activity income." William Hoffman, Corporations, Partnerships, Estates and Trusts, page 10-35 (c) 2008, West.  Hence, limited partners would now need to have passive gains against which to offset their passive losses, essentially shutting down this type of tax shelter.

But just as important as passive activity is active activity, which is established by a person "materially participating" in the enterprise.  Under section 469, "[a] taxpayer shall be treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis which is—
 

(A) regular,
(B) continuous, and
(C) substantial. 

The regulations provide some guidance on the actual definition of these terms.  Here are three basic facts patterns from the accompanying Treasury Regulations that would apply to most individuals:

(1) The individual participates in the activity for more than 500 hours during such year;

(2) The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;

(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;

Arguing material participation is prima facia evidence of corporate substance has one powerful benefit: counsel is not advancing a new, untested concept, but instead relying on a well-established and now well-developed area of law to prove his point.  

The three fact patterns would apply to a broad swath of entrepreneurial activities.  Assuming a 40 hour work week (which grossly understates the hours worked by most business owners), fact pattern 1 would account for 3 1/2 months of work.  Fact pattern two would be appropriate for any individual who is self-employed and has filed entity status (and when combined with fact pattern 1 would be extremely powerful) while fact pattern 3 would apply to most lightly staffed companies.  

More importantly, all three fact patterns should establish a sufficient amount of corporate substance as they indicate a fair amount of activity -- at least enough to give a potential veil piercing claim pause.

Veil Piercing and Corporate Substance

The idea of corporate substance is essential to corporate law.  Professors inform students in corporation class they must endeavor to give their corporate clients "substance" lest courts be given the opening to pierce the corporate veil.   Unfortunately there is a dearth of scholarship defining and developing this concept, despite its obvious importance.  While this post will hardly provide the depth needed for a true analysis, it will provide some insight on the exact nature of this idea.

Depending on your view, a corporation is either a privilege granted by the state (an older, more traditional view) or a nexus of contracts (from a law and economics analysis).  But regardless, it's an artificial construct with no physical existence.  At the same time, a corporation is allowed to perform many of the acts of an individual such as sign contracts, sue and be sued, hold property, transact business and the like. Del. Code Ann. tit. 8 Section 122.  This leads to the question of how exactly do we prove the corporation not only exists, but is in fact a unique entity with a separate existence? Or, to put it more existentially, how to we demonstrate it is "alive" or has "substance?" 

This is usually demonstrated by establishing a paper trail -- meeting minutes, a sales records, contracts and the like.  This leads to point number 1: the paper trail must exist and it must be documented.  Ideally, each fiscal year of a corporation's life can be placed into a folder (most likely electronic in nature) that includes contracts, payments, meeting minutes etc... outlining what exactly has occurred.  The folder should be readily available and easy to access. 

But there is an important corollary to rule number 1: the existence must demonstrate uniqueness, which is defined as, "existing as the only one or as the sole example; single; solitary in type or characteristics."  While this is easily accomplished with a larger publicly traded or private company it can run into trouble with smaller, closely held family businesses.  As an example, take the generic company Acme Corp.; Mr. Smith is the president, and Mrs. Smith is the treasurer.  The company has made two questionable purchases: high-end cars for its executives as a perk and property in a known vacation spot like Colorado in the name of "entertaining potential clients."  Has the company purchased these for legitimate corporate reasons or has the Smith family used the company to make personal purchases disguised as company purchases?

Enter the concept of "alter ego" from veil piercing doctrine.  According to Ballentine's Law Dictionary, an alter ego is literally "the other self."  Instead of the company being a separate and distinct legal entity, it's actually an extension of an individual or another company who are using the limited liability shield not to protect their investment (a primary reason for the shield) but instead for other, non-state sanctioned purposes such as fraud.  When the inter-mingling of personal and business substance is so inter-twined -- or when a company is not "unique" but a mere extension of an individual --  a court can "pierce the corporate veil" stripping the company of its limited liability shield thereby making the individual shareholders personally responsible for the corporation's debt. 

Depending on the jurisdiction, there are either two or three elements to veil piercing.  The three prong test is usually worded thusly: (1) a single individual or small group of individuals is in complete control of the company, (2) they use the corporation to commit some type of tort or breach of contract and (3) the tort or breach is the proximate cause of the plaintiff's harm.  The two prong test is phrased thusly: there is such unity of the interests between the individual and the corporation that the separateness of the corporation is erased and holding the "alter ego" as the only liable party would lead to an injustice.  There is a fair amount of overlap between the two tests.  In addition, veil piercing is not the cause of action but the equitable remedy; the plaintiff must allege an additional cause of action such as fraud or breach of contract.

The courts will look at many factors to consider piercing the veil, such as, "(1) majority ownership and pervasive control of the affairs of the corporation; (2) thin capitalization; (3) nonobservance of corporate formalities or absence of corporate records; (4) no payment of dividends; (5) nonfunctioning of officers and directors; (6) insolvency of the corporation at the time of the litigated transaction; (7) siphoning of corporate funds or intermingling of corporate and personal funds by the dominant shareholder(s); (8) use of the corporation for transactions of the dominant shareholder(s); and (9) use of the corporation in promoting fraud."  Pointer (U.S.A.), Inc. v. H & D Foods Corp., 60 F. Supp. 2d 282, 287 (S.D.N.Y. 1999).  There is no magical combination of factors for the court to use in arriving at its decision.  Instead, they weigh various elements in relation to the facts.

And this returns us to the concept of "substance."  A company that exhibits some of the factors listed in the previous paragraph and also engages in questionable behavior does not demonstrate that it has sufficient substance to be recognized at law.  In the alternative, it is not a unique entity with its own demonstrable personality, but instead an abuse of the limited liability granted by law.  As there is insufficient substance, a court can hold individual shareholders personally liable for corporate debts and obligations.  

 

An Inquiry Into the Legitimacy of Offshore Planning: Establishing Business Purpose

I have previously referred to US anti-avoidance law as a "conceptual briar patch."  In learning about this law, the practitioner is first faced with a fundamental question of just how many US doctrines exist.   He could easily come to the conclusion there were five, which are

1. Substance over form
2. Sham Transaction
3. Business Purpose
4. Economic Substance 
5. Step Transaction Doctrine

At the same time, he could reasonably conclude the sham transaction and economic substance doctrine are the same concept (both have an objective and subjective component) with sham transaction terminology used from the late 1950s to the late 1970s/early 1980s and the economic substance doctrine used thereafter. Or he could conclude the sham transaction is used in simpler transactions (such as interest deduction manipulations) whereas economic substance is used in more complex transactions (such as the tax evasion plans promulgated during the 1990s).  And is the business purpose doctrine a separate doctrine or one of the factors of the shame transaction/economic substance doctrine?  A reading of the case law supports both views.  And just to make matters that much more confusing, aren't they all really just branches of the substance over form doctrine?  

The preceding discussion highlights the overall complexity of this area of US tax law.  I will admit to treating the business purpose doctrine as one of the factors of the economic substance doctrine for a number of years, largely based on the BNA Tax Portfolio asserting this argument. However, I have come to the conclusion that business purpose is a separate doctrine for two reasons.   The first is the Frank Lyon Supreme Court Decision Frank Lyon Co. v. United States, 435 U.S. 561 (1978).  Any doctrine outlined in a Supreme Court case should rise of the level of black letter law, largely based of the precedential weight afforded the deciding body.  But just as importantly, this case provides a positive set of factors with which the practitioner must comply.  This is in sharp contrast to the vast majority of anti-avoidance cases which contain only negative suggestions: most cases essentially state don't do this, but offer no affirmative guidance. 

The facts in the case are straightforward.  Worthen bank in Arkansas wanted to build a new headquarters.  However, "[a]s a bank chartered under Arkansas law, Worthen legally could not pay more interest on any debentures it might issue than that then specified by Arkansas law. But the proposed obligations would not be marketable at that rate."  To avoid this problem, the bank structured a sale-leaseback transaction, selling the building and underlying property to the Frank Lyon company (Frank Lyon sat on the bank's board), who in turn leased the building back to the bank.  New York Life also provided financing.  The service determined that for tax purposes Lyon did not own the building, so the deductions claimed as a result of property ownership were not allowed.  While the lower court sided with Lyon, the appellate court ruled for the service.

Sale-leaseback transactions are hardly a revolutionary concept.  In fact, I believe one could argue they are part and parcel of corporate transactional practice -- a reality recognized by the court:

The present case, in contrast, involves three parties, Worthen, Lyon, and the finance agency. The usual simple two-party arrangement was legally unavailable to Worthen. Independent investors were interested in participating in the alternative available to Worthen, and Lyon itself (also independent from Worthen) won the privilege. Despite Frank Lyon's presence on Worthen's board of directors, the transaction, as it ultimately developed, was not a familial one arranged by Worthen, but one compelled by the realities of the restrictions imposed upon the bank. Had Lyon not appeared, another interested investor would have been selected.  The ultimate solution would have been essentially the same. Thus, the presence of the third party, in our view, significantly distinguishes this case from Lazarus and removes the latter as controlling authority (Lyon at 576-576).

By noting the taxpayer had a legitimate business reason to structure the transaction in this manner, the court outlined several factors that must be present in all business transactions to demonstrate business purpose:

1. there is a genuine multiple-party transaction 
2. with economic substance that is 
3. compelled or encouraged by business or regulatory realities, 
4. that is imbued with tax-independent considerations, and 
5. that is not shaped solely by tax-avoidance features to which meaningless labels are attached.  (Lyon at 583-584)

Now that we've outlined business purpose factors, the question logically turns to proving a transaction complies with them.  As I've previously noted, one commentator has correctly observed that business transactions fall into three categories: increasing revenue, lowering expenses, raising financing or some combination of the three (Peter C. Canellos, Business Purpose, Economic Substance and Corporate Tax Shelters, 54 SMU L. Rev. 47, 52-53, (2001)).  I would add that lowering a risk profile is also a valid business purpose.  This is one of the fundamental reasons corporations divide themselves into divisions and a primary motivator for incorporation in the first place.  Successfully showing that a transaction falls into one or more of these categories would demonstrate substance.  The process of making this determination requires the lawyer to look at the transaction at the company level, making an exhaustive inquiry one that is similar to those engaged in by courts implementing an economic substance doctrine investigation.  Only after the practitioner develops the facts of the case should he begin developing a transactional strategy that incorporates various elements of law such as business entities, tax, securities and insurance.

An Inquiry Into The Legitimacy Of Offshore Tax Planning; Substance Over Form and World Wide Taxation

When planning and constructing a transaction, merely complying with the technical provisions of the code is insufficient.  For example, the tax code allows a specific deduction for interest (26. U.S.C. 163).   But the debt used in a transaction claiming the deduction must comply with certain factors in order for the transactional instrument to be recognized at law.  All tax code sections contain this added layer of depth with which each element of the transaction must comply.  This is the lesson learned from the myriad tax shelters promoted by large accounting firms in the 1990s that followed the letter of the law to a "T" but had no corporate substance (see this Senate report (from the 108th Congress) on the US tax shelter industry).  

All of the transactions listed in this report (BOSS, son of BOSS, OPIS, BLIPs and many others) began with an extremely technical analysis of a particular code provision -- or even a much smaller sub-section of the code.  A structure was then built around this particular analysis and sold to clients.  The inherent problem with this methodology is it completely ignores the particular client's situation and moreover assumes a uniformity of structure and need between potential clients that does not exist.  The proper way to construct a transaction is the exact opposite: begin with an analysis of a client's overall situation and stated goals then develop a solution which complements that situation.  While it sounds cliche' (and perhaps a bit like a legal inside joke) the individual facts and circumstances of each circumstance really are unique and should be considered in their respective entirely to craft a unique solution to each situation.

When looking at the legislative intent (or substance) of the tax code, one fact stands out very clearly, rising to the stature black letter law: the US' tax code intends to tax US citizens on their world wide income.  This is derived from two sources, the first of which is a plain reading of 26 U.S.C. 61 which states, "gross income means all income from whatever source derived, including (but not limited to) the following items."  The accompanying Treasury Regulations use the exact same phrase: "Gross income means all income from whatever source derived, unless excluded by law."  And finally, Treasury Regulation 1.1-1(b) states, "In general, all citizens of the United States, wherever resident, and all resident alien individuals are liable to the income taxes imposed by the Code whether the income is received from sources within or without the United States."

Regarding foreign earned business income, earnings from various foreign corporations is included in the income of certain US shareholders under the controlled foreign corporation statute (sections 951-965 of the tax code).  These rules were added to the tax code in the early 1960s as a way to prevent the then growing practice of forming a corporation offshore and then transferring family wealth to the newly formed foreign corporation.  The assumption in this section of the code is that certain offshore structures are prima facie evidence of tax evasion.  Offshore partnership income is assumed to flow through to US taxpayers via general partnership law tax principles and the code sections listed in the previous paragraph clearly and indisputably apply to personally earned income.  Certain income from offshore trusts are also included in US taxpayer's income under specific grantor trust rules.  Finally, the US tax code uses a foreign tax credit system, offsetting US taxes with foreign taxes paid.    

The legislative intent could not be clearer: the code defines income in the broadest terms possible, and then specifically excludes various categories of income, all contained in Chapter 1, Subchapter B of the tax code.  The locus of the earning activity is not relevant; it is included unless specifically excluded.  Put more directly, the substance of the tax code when read in its entirely is that all income earned by US citizens is taxable by the US.  Moving offshore for the sole purpose of avoiding US taxation runs counter to legislative intent and the substance of the tax code when read holistically.  And complying with the technical requirements of code -- especially in small section level pieces -- is insufficient legal grounds for a transaction to be recognized at law.