Sourcing of Income and Deductions in International Business and Investment Transactions
International taxation rules pertain to business transactions where the business being conducted is in a country other than the country of citizenship of the business owners, or, in the case of a corporation, the country of incorporation. Likewise for investment income, where the country source of income differs from the country of citizenship of the investor. Complexities arise because most countries tax their citizens and domestic corporations regardless of where they do business and they also tax business conducted within their borders, even if the business owners are foreigners. International transactions are generally taxed by the countries involved, but since their tax rates, types of taxes, and deductions are treated differently, the net taxes paid on an international transaction will depend on how income and deductions are sourced to the appropriate countries; this article discusses sourcing rules by the United States (US) for inbound transactions conducted by foreigners within the US and outbound transactions, where US citizens conduct business in foreign countries.
Any discussion of international taxation depends on how income and deductions are sourced according to country. IRC §861 lists the US source rules for most types of US taxable income. IRC §862 stipulates that if income is not US sourced, then it is foreign sourced.
Interest income is sourced in the US if it is earned from the US government, District of Columbia, or from non-corporate US residents or domestic corporations. However, if a US corporation earned 80% or more of its active business income in another country over the 3-year period previous to the current tax year, then any interest earned from the corporation is foreign sourced income. Interest earned from a foreign branch of a US commercial bank is also foreign sourced.
Except for companies incorporated in US possessions, dividends from domestic corporations, foreign sales corporations, and domestic international sales corporations are sourced to the US. By contrast, a foreign corporation dividend is foreign sourced income unless 25% or more of the company's gross income for the 3 years preceding the current tax year were the result of trade or business within the US, in which case, the portion of the dividend that is US sourced is equal to the amount earned from the United States business or trade divided by the total amount earned by the foreign corporation.
|US Sourced Income from Foreign Corporation||=||Dividend Amount||×||US-Based Income Over Previous 3 Years|
Total Income over Previous 3 Years
So if a US taxpayer received a $1000 dividend from a foreign corporation that performed 75% of its business within the US, then $750 of the dividend is US sourced.
Example: Allocation and Apportionment of Dividend Income As US- or Foreign-Sourced
You received dividends from the 3 corporations listed below, where each corporation had variable amounts of effectively connected US income for the past 3 years. Since the 1st 2 corporations are domestic, the entire dividend amount is sourced to the US, even though only part of their income is effectively connected to the US. Because GHI is a foreign corporation which had US-based income ≥ 25% in the previous 3 tax years, the amount of the dividend that is sourced to the US is in proportion to the US-based income over its total income. Because JKL earned less than 25% of its income in the US over the past 3 years, the entire dividend amount is foreign sourced.
|US Income |
|ABC Domestic Corporation||$1,500||75%||$1,500||$0||Income from domestic corporations are all sourced to the US.|
|DEF Domestic Corporation||$2,000||20%||$2,000||$0|
|GHI Foreign Corporation||$1,000||28%||$280||$720||US Sourced Income = Dividend Amount × US-Based Income %|
Foreign Sourced Income = Dividend Amount – US Sourced Income
|JKL Foreign Corporation||$500||20%||$0||$500||This foreign corporation does not satisfy the 25% rule, so all of the income is foreign sourced.|
Personal Services Income
The source of personal services income is generally attributed to the country where the services are performed. If the service is performed partly inside the United States, then income must be allocated to accurately reflect the apportionment. The courts have generally held that considering the number of hours worked is a reasonable basis for the allocation.
Sometimes a question will arise as to whether the income came from personal services, especially in the case of corporations. However, the courts have generally held that a corporation can provide a personal service, even if there is no recipient of the service, if there was no capital income-producing factor involved.
There is a commercial traveler exception for foreigners working within the United States that avoids the sourcing of income to the United States for work conducted there if the following requirements are satisfied:
- the services were performed by a nonresident alien during a sojourn in the US not exceeding 90 days for the tax year;
- compensation for the services did not exceed $3000;
- services were performed for:
- a nonresident alien, foreign partnership or corporation not engaged in a US business; or
- a place of business in a foreign country or US possession that is maintained by a US citizen or resident, or a domestic partnership or corporation.
Rents and Royalties
Income earned from the rental of tangible property is sourced in the country of the property's location; intangible property, such as patents, copyrights, and other intellectual property, to the country where it is used.
Sale or Exchange Of Property
The sale or exchange of real property is sourced to the country of the property's location. The source for personal property sales depends on:
- whether the property was made by the seller;
- the residence of the seller;
- type of property sold, such as whether it was inventory or a capital asset.
Income earned from a personal property sale is sourced according to the seller's residence, but the sale or purchase of inventory is sourced to the country where the sale takes place.
If the seller produced the property, then gross income is generally sourced under a 50/50 allocation method between the country of production and the country of sale. In a few cases, an independent factor price method may be used, if it is available, or a separate books and records method.
Income from the sale of non-inventory personal property is sourced to the seller's residence unless depreciation was claimed on the personal property, in which case the depreciation recapture is sourced to the country where the depreciation was taken, and any excess gain is sourced to the country of sale.
The sale of intangibles are treated in a similar fashion to depreciable personal property in that any gains are sourced to the country where prior amortization deductions were taken, but any remaining gain is sourced to the country where the property is used. However, contingent payments are sourced as royalty income.
Income earned by US residents from a fixed place of business outside of the United States is foreign sourced. Likewise, a fixed place of business maintained by a nonresident in the United States is sourced to the US.
The sourcing of losses is governed by more complicated rules, depending on the type of property, such as stock or other personal property.
Transportation and Communication Income
If income is earned from transportation that either begins or ends within the United States, not including intermediate stops, then 50% is sourced to US.
Personal services income is not included under this rule except for transportation between the US and one of its possessions. Income earned from any type of transportation outside of any country's jurisdiction is sourced to the domicile of the primary person who earns income from the activity. Income earned by a US person from an international communication between the United States and another country is 50% sourced to the US, but income earned by foreign persons is foreign sourced unless it is out of a fixed place of business within the United States, thence it is US sourced.
If the software copyright itself is sold, then the income is sourced as royalty income. But if only the right to use the software is sold, which is the usual case, then the income is sourced as a personal property sale.
Allocation and Apportionment Of Deductions
Deductions and losses must generally be allocated and apportioned to the appropriate items of income, which then determines which sources of income are offset by the deductions or losses. Any deduction or loss that cannot be unambiguously allocated to a specific source of income must then be ratably apportioned among all income, between US and foreign sourced income. Deductions or losses must be allocated to one of the gross income classes already discussed; any remainder is then allocated and apportioned ratably.
Since money is fungible, interest expense is generally allocated and apportioned according to the assets earning US and foreign-sourced income, regardless of how loan proceeds were used. Interest expenses must be allocated and apportioned on the basis of assets, either their fair market value or their tax book value. If fair market value is chosen, then the company must continue with that election every year.
Example: Allocation and Apportionment of Interest Expenses As US Sourced or Foreign Sourced
|Tax Book Value of Assets Earning US-Sourced Income||$20,000,000|
|Tax Book Value of Assets Earning Foreign-Sourced Income||$5,000,000|
|Allocation to US Sources||$640,000||= Interest Expense × Tax Book Value Of Assets Earning US-Sourced Income/Total Income|
|Allocation to Foreign Sources||$160,000||= Total Income – Allocation to US Sources|
Note that special rules, not discussed here, apply to the following situations:
- the interest expenses of an affiliate group of corporations
- legal and accounting expenses
- research and development expenses
- certain stewardship expenses.