Income Tax: The Basics of Income Sourcing
A foundational consideration in the international tax realm is rules regarding income sourcing; for nonresidents, whether income is U.S.-sourced ultimately dictates the extent of American tax exposure. This article explores sourcing considerations under the Internal Revenue Code (and associated regulations) for some of the most common income categories earned by multinationals. It does not address income tax treaty relief available to nonresidents residing in a treaty party jurisdiction. While the same general sourcing rules are applicable to treaty party residents, treaties can substantially modify the rates and scope of American tax.
Under American rules, interest on notes, bonds or other interest-bearing obligations of residents or domestic corporations are sourced to the United States. Interest for sourcing purposes includes original issue discount and amounts treated as interest on certain deferred payments. Irrespective of sourcing, however, expansive exceptions exist to American tax of interest income earned by a nonresident. Portfolio interest received by nonresidents from American sources is not subject to American taxation; interest paid to nonresidents on deposits with banking institutions, savings and loan associations, and specified interest paid by insurance companies are also excluded from tax.
Under statutory U.S. rules, dividends whose beneficial owners are nonresidents are subject to tax by the U.S.; dividend income is sourced to the place of incorporation of the payor. The rule is applicable for payments normally considered dividends under the Code — distributions from corporate entities with either accumulated or current earnings and profits. Income generally treated as dividends under Code provisions — like constructive dividends — is treated as dividends for sourcing purposes.
Income from the performance of services — whether as an employee or on an independent basis — is sourced to the country where services are performed. Where a nonresident receives income for personal services performed both inside and outside the U.S. (i.e., an employee compensated through an annual salary who splits workdays in a given year between the U.S. and Mexico), allocation between countries based on workdays is required; in most cases, apportionment on a time basis is appropriate. Similar sourcing rules apply to multinational, multiyear compensation arrangements — where compensation is taxed to an employee in one taxable year but is attributable to services performed in multiple years.
Income from the use of property — primarily rents and royalties — are covered under Sec. 861(a)(4), with both rents and royalties sourced based upon the property’s place of use. For intangible property, sourcing focuses on where the licensee (1) maintains the legal ability to use an intangible and (2) actually uses the intangible. Where a nonresident generates royalties from foreign markets, the income is foreign-sourced even if conversion of the intangible into its tangible end user format occurs in the United States.
Income from the sale of non-depreciable personal property by a U.S. resident is sourced to the U.S., with special rules applicable for depreciable property (discussed separately below); personal property sold by a nonresident is sourced outside the U.S. Depreciable personal property is sourced under separate rules.
Gain not in excess of depreciation adjustments from the sale of depreciable personal property is allocated by treating the same proportion of the gain as sourced in the U.S. as U.S. depreciation adjustments bear to the total depreciation adjustments; the remaining portion is treated as sourced outside the U.S. Gain in excess of depreciation adjustments is sourced as if the property were inventory.
For inventory property, gains, profits and income derived from the sale of inventory property within the U.S. create U.S.-sourced income. Conversely, gains derived from the purchase of inventory within the U.S. and sold outside the U.S. is foreign-sourced income.
Patrick McCormick, Esq., is a partner at Culhane Meadows and practices exclusively in the area of international taxation.
This article appeared in the Spring 2021 issue of New Jersey CPA magazine. Read the full issue.