Posted by Tiffany Gaskin

Sourcing of Income

Sourcing of Income

Why is it important to know the taxpayer's source of income? This is important because the Foreign Tax Credit (FTC) can only offset U.S. taxes on foreign income. An American is subject to worldwide income taxes from all sources. However, a foreign person is only subject to U.S. tax on income from sources in the United States, with a few exceptions. Therefore, sourcing of income is required because amounts entered by a taxpayer cannot automatically be included in computing taxable income in the United States.

The purpose of this practical unit is to identify the different types of income a person has and the factors used to determine whether that income is of U.S. or foreign origin, sometimes referred to as "within the United States" (United States) or "without the United States" (Foreign). When the Internal Revenue Code (IRC) refers to sourcing of income earned, it refers to the source of income earned in the United States or a foreign country. The taxpayer must first decide whether the gross income for each category is from the United States or from foreign sources; then, the taxpayer can calculate taxable income in each category of sources outside of the United States.

The concept of sourcing is usually associated with the concept of categorization. Different funding rules apply to different types of income. Once the presence of income from foreign sources has been identified, the type of income (e.g., passive, general, etc.) should be classified to properly apply procurement rules.

 

Summary: Not all income for which a taxpayer pays foreign taxes is eligible for the FTC. Instead, the credit is only available for income considered to be of foreign origin. Rules of origin are designed to determine whether the United States or a foreign country has a closer connection or a "nexus" to income. If the income is from a foreign source, a foreign country has the primary right to tax the income. Therefore, the United States will allow the taxpayer to obtain credit for income taxes paid abroad. Inappropriate income can lead to incorrect overstatement by the FTC.


Treaty Implication: Sourcing rules can be difficult and subject to many exceptions. Many tax treaties to which the United States is a party modify the sourcing rules included in the IRC by express agreement of the contracting states. 

 

KEY FACTORS

The sourcing rules are detailed in IRC 861-863 and 865. The legal rules cover interest, dividends, service charges, rents and royalties, profits from the sale of real estate, and fringe benefits.

  • IRC 861 provides rules on when certain groups of income are earned in the United States.

  • IRC 862 is a parallel section that provides information when you earn the same type of income outside of the United States.

  • IRC 864 provides definitions and special rules.

  • IRC 863(b) provides rules for when certain categories of income are earned in part within and partly without the United States.

  • IRC 863(c), (d), and (e) refer to other specialized sourcing items of income.

  • IRC 865 provides rules and regulations for the sale of personal property.

This determination of foreign source is reported from country to country and is listed on Form 1116, Part 1, line g. Gross income from sources outside of the United States is reported on Form 1116, Part 1, Line 1a. This includes gross income, even if the foreign country is not taxed.

Another way to understand the concept of sourcing is that in Form 1040, a taxpayer reports worldwide income, while in Form 1116, part I line 1a, a taxpayer reports only the part that is foreign income. When completing Form 1116 Part 1, it is recommended that you provide a sourcing schedule for gross income (and expenses/deductions).


CAUTION: For the definition of the United States, see IRC 638 and 7701 (a)(9): The United States generally includes the 50 states and the District of Columbia plus the territorial waters adjacent to its coast. However, there may be differences in the U.S. definition between income from foreign sources for FTC purposes and income from foreign sources to exclude foreign earned income (FEIE) and other purposes. For example, income from foreign sources for FTC purposes can be obtained in international waters. Compare this with the U.S. assets included in the U.S. territorial definition for EFIE IRC 911, as this section demands that the income be earned in a foreign country. 

 

ANALYSIS

The residence of the payer generally determines interest income. This assumes that the real identity of the payer is known. Interest income includes income from bank accounts, bonds, and bills of exchange. Interest from sources in all 50 states and the District of Columbia arise from sources in the United States. However, interest deposited in a domestic company or partnership is foreign source income if the deposits are made at a company's foreign branch or partnership. The foreign branch is engaged in commercial banking activities. Interest paid for a business or commercial activity in the United States (U.S. branch) of a foreign company is considered to be paid by a domestic company and, therefore, in the United States.


Example A: Taxpayer A, a U.S. taxpayer, receives interest income from a personal loan made to Taxpayer B, a U.S. citizen but resident of a foreign country X. Because Taxpayer B is a resident of foreign country X, even if you are a U.S. Citizen, your income comes from foreign sources.


Example B: Taxpayer C, a foreign corporation operating in the United States, receives interest income from Taxpayer D, a U.S. citizen and resident. The income is from the United States because the payer is a resident of the United States.


Example C: Using the same facts as Example B, except that Taxpayer D pays from a Swiss bank account at Taxpayer C's bank in the Cayman Islands. The income comes from the United States because the payer is a resident of the United States.

 

Sourcing of Dividend Income

Dividend income is generally determined by the country of establishment of the payer. Dividends from domestic companies are U.S. income. Dividends of foreign companies come from foreign sources. However, a dividend from a foreign corporation can be U.S. income if at least 50% of the corporation's gross income over the past three years was effectively connected income (ECI). A dividend may also be collected in the United States if the dividend is from a foreign company with distributed earnings and profits (E&P) that the company has inherited from a domestic company, but only to the extent that the dividend yields the right to a dividend deduction for dividends received deduction.


Example A: Taxpayer A, a U.S. citizen, received dividends from an Italian company without a U.S. effectively connected income (ECI). The dividend comes from foreign sources.


Example B: Taxpayer B, a Hungarian citizen and resident of the United States, receives Argentine dividends without US ECI and deposits them into his U.S. bank account. The dividend is income from foreign sources.

 

Source of compensation income

The general rule for sourcing wages and income for personal services is governed by the service's place. The residence of the service recipient, the place of termination, and the date and place of payment are irrelevant.

General rule for employees: the source is determined over time, excluding indirect benefits.

General rule for the unemployed: the source is determined that it faithfully reflects the appropriate source of income per the facts and circumstances of the case.

If the services are provided within, and without the United States, compensation for the services is awarded because it most faithfully reflects the appropriate source of income based on the facts and circumstances. In many cases, it may be that an apportionment on a time basis may be acceptable.

However, compensation for services provided by a national regulatory authority of the United States is a foreign source if all of the following conditions are met:

  • The services are provided temporarily by a national regulatory authority in the United States,

  • Presence in the United States during the fiscal year does not exceed 90 days 

  • The service charge does not exceed $3,000.


Example: Taxpayer A, a German citizen and a resident, was hired by a U.S. company to develop a new product for sale worldwide. In developing this product, Taxpayer A was present in the United States for 56 days (8 weeks) to resolve real production issues. The whole project lasted twenty weeks, for which he received $60,000.

Taxpayer A temporarily performed the duties of NRA in the United States for 56 days. He was paid over $3,000. Thus, income cannot be exclusive of foreign origin and must be broken down as follows:

8 weeks in the US/20 weeks project total x $60,000 paid = $24,000 in the US

NOTE: The completed Form 1116, Part I, Line 1 (a), should reflect the exclusions (section 911) and adjustments. Adjustments to gross foreign source income are outside the scope of this practical unit.

 

Sourcing of Rent and Royalty Income

Gross income from sources located in the United States includes rents or royalties from properties located in the United States or any interest in such properties, including rents or royalties for use or privilege of use, in the United States, patents, copyrights, secret processes, and formulas, goodwill, trade brands, trademarks, franchises, and other similar assets. Income from the rental of tangible or intangible assets located in the United States, OR from the use of tangible or intangible assets in the United States, is sourced from within the United States.

 

Rental income or commissions for the use of tangible property arising from the location of the leased property is sourced. Income and royalties received from a controlled foreign corporation (CFC) from its U.S. shareholders are treated as income in a separate limitation basket (category) because it is derived from the income of CFCs in that basket. This transparency rule characterizes the income of a U.S. shareholder received from an SEC as having the same character as the income of the SEC. As an example, the copyright of a foreign wholly-owned subsidiary, which generates only active business profits, is a general income limit (not passive income) for the parent company in the United States.

 

Sourcing of Pensions and Retirement Plans

The Lump-Sum Distribution Category on Form 1116 is used to calculate a separate FTC limit on any income received from a foreign pension plan. If a lump sum is received from a foreign 401(k) source and tax on it is calculated using an average special treatment (elected on Form 4972), a special calculation must be made. For retirement income purposes, there are two components: contributions to the pension plan and income from those investments. The contribution is obtained according to the place where the services that generated the pension were provided. The share of investment income is received depending on the location of the pension fund. U.S. Social Security benefits are believed to come from American sources.

 

Miscellaneous Sourcing Considerations: Flow-through information on Schedule K-1s

The source and character in the hands of a partner or shareholder of an S corporation of any item of income, expense, etc., will be determined as if that item had been obtained directly from the source from which realized by the partnership or S corporation. The flow-through entity usually provides information about the origin of the distributive values. An exception is that the capital gain on the sale of a real estate company is obtained according to IRC 865, depending on the partner's residence (with exceptions). However, partnership income generally retains its character when it is recorded in the individual's 1040 form.


Example: A company derives 60% of its regular income from foreign sources. Thus, 60% of the distribution would come from a foreign source.


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Tiffany Gaskin
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