In this video, I discuss sourcing of income in international taxation as covered on tax compliance and planning TCP exam.
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The sourcing rules outlined in the Internal Revenue Code (IRC) are essential for determining how different types of income and deductions are categorized as either originating within the United States or from international sources. These rules are particularly important for non-U.S. persons (such as foreign individuals or entities) because they define what income is subject to U.S. taxation. For U.S. persons (which include citizens and resident entities), these rules help identify the portion of their income that qualifies as foreign taxable income, which can impact their tax liabilities and credits for taxes paid to other countries.
The IRC specifies nine categories of income that are considered to be sourced from within the United States. Here's a simplified explanation of three of these categories, along with examples for each:
Interest Income: This includes interest earned from entities or obligations based in the U.S. For example, if a non-U.S. resident invests in a bond issued by a U.S. corporation and receives interest payments, those payments are sourced from the U.S. and may be subject to U.S. taxation.
Dividend Income: The source of dividend income is typically based on the location of the corporation issuing the dividends. So, if a British investor owns shares in a U.S.-based corporation and receives dividends, those dividends are considered U.S.-sourced income.
Personal Services Income: This category covers income earned from labor or personal services performed in the U.S. There's a notable exception for nonresident aliens who are in the U.S. temporarily and meet specific criteria, such as being in the U.S. for no more than 90 days in the tax year, earning less than $3,000 in total for the services performed, and working either for a non-U.S. entity or for a U.S. entity but performing the services for a foreign office of that entity. For example, a freelance graphic designer from Canada who comes to the U.S. to work on a project for a U.S. company but only stays for 60 days and earns $2,500 would not have this income subject to U.S. tax, provided the work is for the U.S. company's Canadian office.
Rents and Royalties: This category includes payments received for the use of real or intellectual property located in the U.S. For instance, if a foreign individual owns a building in the U.S. and receives rental income from tenants, this income is sourced to the U.S. Similarly, royalties paid for the use of patents, copyrights, or other intellectual property rights used in the U.S. fall into this category. For example, if a Japanese company licenses a software patent to a U.S. company and receives royalty payments, these payments are considered U.S.-sourced income.
Disposition of U.S. Real Property Interest: Income from selling or otherwise disposing of real estate located in the U.S. falls under this category. This means that if a non-U.S. citizen sells a property they own in the U.S., the gain from this sale is U.S.-sourced. For example, if a Canadian investor sells a vacation home in Florida, the profit from this sale would be subject to U.S. tax laws.
Sale or Exchange of Inventory Property: This refers to profits made from selling inventory in the U.S. that was purchased outside of the U.S. (excluding U.S. possessions). An example could be a German manufacturer that produces cars in Germany and then sells them in the U.S. The income from these sales would be considered U.S.-sourced.
Underwriting Income: This category covers income earned from underwriting insurance or annuity contracts, including reinsurance. For instance, if a British insurance company underwrites life insurance policies for U.S. residents, the premiums collected would be treated as income sourced in the U.S.
Social Security Benefits: U.S. social security benefits paid to non-U.S. residents can also be considered U.S.-sourced income, although specific treaties and exemptions can apply to reduce or eliminate the tax liability on these benefits for foreign beneficiaries. For example, a retired British individual living in the UK but receiving U.S. social security benefits would generally have this income considered as sourced from the U.S.
Income from "Guarantees" involves payments received for guaranteeing debt obligations and is considered U.S.-sourced in two main scenarios:
Guarantees for U.S. Entities: Fees for guaranteeing debts of U.S. individuals or corporations are U.S.-sourced. For example, a fee charged by a foreign entity to guarantee a U.S. corporation's loan is treated as U.S.-sourced income.
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