Income Sourcing Rules – Foreign-Source and U.S.-Source Income
In the international tax context, the source of a taxpayer’s income can have significant implications. The source of income may determine whether a taxpayer qualifies for a foreign tax credit with respect to the income. Or, because a foreign person is generally subject to U.S. tax only on U.S.-sourced income, the source of a taxpayer’s income may determine whether the income is even subject to tax in the first place.
It is relatively straightforward to determine the source of many types of income. Depending on the category of income, its source may turn on familiar factors such as the status or nationality of the payor or recipient, or the location of the activities or assets that generate the income.
Certain items of income, however, are subject to special rules, such as the sale of inventory, intangible property, or depreciable property, as well as property sold through a foreign office or fixed place of business. And, of course, tax treaties often change the applicable sourcing rules. We provide an overview of the Internal Revenue Code’s income sourcing rules below.
The United States is a signatory to more than 60 income tax treaties. Tax treaties often change the otherwise applicable income sourcing rules.
Our Freeman Law interactive tax treaty map provides a link to tax treaty materials for each U.S. treaty partner:
U.S.-source income generally includes, among other things, the following:
- Compensation for services performed within the United States.
- Interest income from a payer located within the United States.
- Dividends from a corporation incorporated within the United States.
- Gain realized by a U.S. tax resident on the sale or exchange of personal property is generally U.S.-source income.
The rules above are general rules. This article provides a more detailed look at the various categories of income below.
Foreign-source income generally includes, among other things, the following:
- Compensation for services performed outside the United States.
- Interest income from a payer located outside the United States.
- Dividends from a corporation incorporated outside the United States.
- Subpart F income inclusions and section 951A category income.
- Gain on the sale of non-depreciable personal property sold while maintaining a tax home outside the United States, if the taxpayer paid a tax of at least 10% of the gain to a foreign country.
The rules above are general rules. This article provides a more detailed look at the various categories of income below.
Compensation for Services
Compensation for labor or personal services is sourced to the place of performance. Therefore, compensation for labor or personal services performed in the United States generally is U.S.-source income, although there is an exception for amounts that meet certain de minimis criteria. Under the de minimis exception, income from services performed in the United States is excepted from U.S.-source status if (i) the labor or services are performed by a nonresident alien individual temporarily present in the United States for less than 90 days during the taxable year; (ii) the compensation does not exceed $3,000 in the aggregate; and (iii) the compensation is for labor or services performed as an employee of, or under a contract with:
- a nonresident alien, foreign partnership, or foreign corporation, not engaged in trade or business within the United States, or
- an individual who is a citizen or resident of the United States, a domestic partnership, or a domestic corporation, if such labor or services are performed for an office or place of business maintained in a foreign country or in a possession of the United States by such individual, partnership, or corporation.
Generally, interest income is determined by the residence of the payor. Interest is from U.S. sources if paid by the United States, any agency or instrumentality of the United States, or a State. Interest is also from U.S. sources if paid by a U.S. resident individual, a domestic corporation, or a partnership engaged in a trade or business in the United States. Interest paid by the U.S. branch of a foreign corporation is also treated as U.S.-source income.
However, interest on deposit with a foreign branch of a domestic corporation or domestic partnership engaged in commercial banking is foreign-source income. Interest paid by a U.S. trade or business (a U.S. branch) of a foreign corporation is deemed paid by a domestic corporation and, therefore, is U.S.-source income.
Dividend income is generally sourced according to the payor’s place of incorporation. Thus, dividends paid by a domestic corporation are generally U.S.-source income. Likewise, dividends paid by a foreign corporation are generally foreign-source income. A special rule provides that dividends from a foreign corporation engaged in a trade or business in the United States may be treated as partly U.S.-source and partly foreign-source. A dividend from a foreign corporation may be U.S.-source income, if at least 50 percent of the corporation’s gross income for the preceding three years was effectively connected income (ECI). A dividend may also be U.S.-source income if that dividend was from a foreign corporation that distributed it from earnings and profits (E&P) that the corporation inherited from a domestic corporation, but only to the extent the dividend qualifies for a dividends-received deduction.
Proposed regulations provide special rules for allocating or apportioning gross income from the sale of natural resources. Existing regulations provide a general “export terminal” rule that allocates sales income at the export terminal, sourcing gross receipts equal to the fair market value of the natural resources at the export terminal to the location of the farm, mine, well, deposit, or uncut timber, and gross receipts in excess of that amount either to the place of sale or according to the rules in § 1.863-3, depending on the circumstances.
Current regulations provide a special rule for taxpayers performing additional production activities before shipping the product from the export terminal. The gross receipts are allocated between sources within and without the United States based on the fair market value of the product immediately before the additional production activities. Gross receipts equal to the fair market value of the natural resources immediately before the additional production activities are sourced to the location of the farm, mine, well, deposit or uncut timber, and the gross receipts in excess of that fair market value are sourced based on § 1.863-3.
Due to statutory amendment, however, it is generally no longer appropriate under section 863(b)(2) to allocate or apportion any gross income from sales of inventory, including natural resources, to sales activity. As such, the proposed regulations modify the regulations to remove the export terminal rule so that, where there is no additional production activity with respect to the natural resource, all gross income from sales of natural resources inventory is based on the location of the farm, mine, oil or gas well, other natural deposit, or uncut timber from which the natural resource is derived. In other words, where there are no additional production activities, the location of the farm, mine, oil or gas well, other natural deposits, or uncut timber is considered the place of production generally.
Where there are additional production activities with respect to the natural resource either within or without the jurisdiction from which the natural resource is derived, the gross income is allocated or apportioned first to the jurisdiction where the farm, mine, oil or gas well, other natural deposit, or uncut timber is located, in an amount equal to the fair market value of the product before the additional production activities. Any income in excess of that fair market value is then allocated or apportioned between sources within and without the United States under proposed regulation principles based on the location of the assets used in the additional production activities.
Royalty income is sourced to the location or place of use of the property. The nationality or the country of residence of the payor or recipient of the royalties does not affect the sourcing determination. Royalties for the use of property in the U.S. are generally U.S.-source income, and royalties for the use of property outside the U.S. are generally foreign-source income. Royalty income includes amounts paid for the use of or for the privilege of using patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises, and other such property.
The theory underlying this source rule is that the place in which the intangible property is used is the situs of the economic activity giving rise to the income, regardless of the place at which the intangible property was developed.
Royalties received from a controlled foreign corporation (CFC) by its U.S. shareholders are treated as income in a separate foreign tax credit limitation basket (category) to the extent they are derived from income of the CFC in the same basket. This look-through rule characterizes a U.S. shareholder’s income received from a CFC as having the same character as that of the income from the CFC. For example, royalties from a wholly-owned foreign subsidiary that earns only active business profits are general limitation income (and not passive income) for its U.S. parent corporation.
Rental income or compensation for the use of tangible property is sourced to the place where the rental property is located. Thus, rental income from property located in the United States (or from any interest in such property) is from U.S. sources. Rents received from a controlled foreign corporation (CFC) by its U.S. shareholders are treated as income in a separate foreign tax credit limitation basket (category) to the extent they are derived from income of the CFC in the same basket. This look-through rule characterizes a U.S. shareholder’s income received from a CFC as having the same character as that of the income from the CFC.
The Sale of Real Property
U.S.-source income includes gain derived from the sale or other disposition of real property located in the U.S. On the other hand, gains and income from the sale or exchange of real property located outside of the U.S. give rise to foreign-source income.
The Sale or Exchange of Personal Property
In most cases, if personal property is sold by a U.S. resident, the gain or loss from the sale is treated as U.S. source. If personal property is sold by a nonresident, the gain or loss is treated as foreign-source income.
This rule does not, however, apply to:
- the sale of inventory;
- the sale of depreciable property used in a trade or business;
- the sale of intangible property such as a patent, copyright, or trademark; and
- transportation services that begin or end in the United States or a U.S. possession
- property sold through a foreign office or fixed place of business.
Sale of Inventory
The general rule is that income from a sale of personal property is sourced based on the residence of the seller. Inventory, however, is excepted from this rule and income derived from the sale of inventory is generally sourced based on either the place of sale (for purchased inventory) or based on the allocation and apportionment rules (for inventory produced by the taxpayer). The place-of-sale rules typically depend on the title-passage rule.
Inventory that is purchased and later sold is sourced to the location where the inventory is sold.
But where inventory is produced partly in the U.S. and partly outside the U.S., income from the inventory must be allocated. Gains, profits, and income from the sale or exchange of inventory property produced partly within, and partly outside, the United States is sourced on the basis of the location of production with respect to the property.
The Code also provides another exception, applicable to sales of inventory by nonresidents that are attributable to an office or other fixed place of business in the United States.
Generally, income from any sale of inventory attributable to such an office or other fixed place of business is sourced in the United States. There is an exception, however, for a sale of inventory for use, disposition, or consumption outside the United States if a foreign office of the nonresident “materially participated” in the sale. For these purposes, the “principles of section 864(c)(5) shall apply” to determine whether a nonresident has an office or other fixed place of business and whether a sale is attributable to such office or other fixed place of business.
Sale of Intangibles
Intangibles include patents, copyrights, trademarks, and goodwill. The gain from the sale of amortizable or depreciable intangible property, up to the previously allowable amortization or depreciation deductions, is sourced in the same way as the original deductions were sourced. This is the same as the source rule for gain from the sale of depreciable property.
Gain in excess of the amortization or depreciation deduction is sourced in the country where the property is used if the income from the sale is contingent on the productivity, use, or disposition of that property. If the income is not contingent on the productivity, use, or disposition of the property, the income is sourced according to the seller’s tax home. Payments for goodwill are sourced in the country where the goodwill was generated if the payments are not contingent on the productivity, use, or disposition of the property.
The gain from the sale of depreciable personal property, up to the amount of the previously allowable depreciation, is sourced in the same way as the original deductions were sourced. Thus, to the extent the previous deductions for depreciation were allocable to U.S. source income, the gain is U.S. source. To the extent the depreciation deductions were allocable to foreign sources, the gain is foreign source income. Gain in excess of the depreciation deductions is sourced the same as inventory.
If personal property is used predominantly in the United States, the gain from the sale, up to the amount of the allowable depreciation deductions, is entirely U.S.-source income.
If the property is used predominantly outside the United States, the gain, up to the amount of the depreciation deductions, is entirely foreign-source income.
A loss is sourced in the same way as the depreciation deductions were sourced. However, if the property was used predominantly outside the United States, the entire loss reduces foreign-source income.