Classification of Income
A primary area of concern for both U.S. citizens and resident aliens regarding the classification of income relates to the foreign tax credit. Determining whether the income is classified as foreign or U.S.-sourced will impact the foreign tax credit limitation and the available credit.
A major issue regarding income classification is the lack of clarity and global acceptance regarding how to determine the proper source of a stream of income. One country’s tax regime may not treat a transaction in the same manner as another. The sections below detail various characters of income and items for consideration in determining their sources for U.S. tax purposes.
Interest payments originate from the individual or the underlying business activity of the entity which remits payment. Payments made by nonresident individuals of the United States, by default under IRC Section 861(a) (1), are sourced to the United States. Foreign branches of U.S. banks make foreign-sourced interest payments. Somewhat more-difficult to determine is the source of income from partnerships that remit interest payments.
The rules for determining the proper situs of the source for these entities changed in 2004. Prior to that time, the analysis was relatively simple. If the partnership was, in fact, engaged in a U.S. trade or business, it paid U.S.-sourced interest. Conversely, if the partnership was not engaged in a U.S. trade or business, the source was deemed to be foreign. In 2004, the rules for partnership interest sourcing were modified so that all foreign partnerships made foreign-sourced interest payments if their business operations were predominantly engaged outside of the United States, and the income was not allocable to income which was effectively connected to U.S. operations. In theory, these rules put partnerships and corporations on a semi-equal playing field.
From a corporate standpoint, the basic idea sources interest payments to the place of incorporation, subject to a few exceptions including obligations issued before August 10, 2010. Under this special provision, interest received from a resident alien was considered to be foreign-sourced if 80% of the domestic corporation’s gross income was from foreign trades or businesses. These types of domestic corporations are often referred to as “80/20 corporations” because the remaining 20% of activity was related to U.S. activity.
Dividend payments follow the same general principle as interest payments where the situs of the corporation is controlling, absent an exception. Foreign corporations that issue a dividend receive U.S.-sourcing if 25% or more of the gross income for the corporation in the three preceding years to declaring the dividend is effectively-connected income with the United States. In addition, the amount of the U.S.-sourced dividend is adjusted based upon the ratio of U.S.-sourced income to the corporation’s entire income for the same period.
For example, if a foreign corporation issued a $500 dividend, and 50% of its previous three years’ income was 50% effectively connected to the United States, the original $500 dividend would be sourced one half to the United States.
Compensation for Personal Services
The general rule sources income to the location where the services were performed; however, the problem lies with employees who work from all around the globe, which can lead to confusion surrounding the performance location.
As always, there are certain exceptions to the general rules. A 90-day rule excludes certain compensation from the breadth of the U.S. tax system when the services are actually performed in the United States. This rule considers all compensation earned by a foreign person to be foreign-sourced if: (1) the individual is present for 90 days or fewer in the United States during the current taxable period, (2) the services are for a foreign person not engaged in a trade or business in the United States, and (3) the total compensation does not exceed $3,000. Practically speaking, the 90-day rule is never utilized as the dollar threshold is considerably low.
In determining the performance location and the proper allocation method when services are performed in multiple locations, the Treasury regulations allocate compensation on the basis of time. In contrast, other employee benefits are determined on the basis of geography. Housing, transportation and education benefits are determined based upon the employer’s business location. Moving expense reimbursements are sourced to the employee’s new location.
Rental and Royalties
Sourcing of the use of tangible property is relatively straight-forward as the place of use is controlling. However, also included in this category are rents and royalties from the use of intangible property such as patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises and other like property, which can create difficult scenarios to work through. For starters, intangible property has no physical location. In addition, intangible property can be used in many locations, with multiple licenses, across multiple jurisdictions. The Internal Revenue Code has attempted to simplify the approach. Under IRC Section 861, royalties from the same stream of licenses and sublicenses that are derived from the same intangible property could all be sourced to the United States.
Gains from the Sale of Property
Within this category of transactions, there are several types of property that carry different sets of rules. In its simplest form, the sourcing of the sale of property is tied to the place of sale. Certain transactions and deals are easy to figure out when all of the elements to a contract occur at the same location. However, some transactions can be more complicated. Sales of real property create the easiest situations, while the sale of personal property, intangible property and inventory present considerable challenges.
Sale of Real Property
IRC Section 861(a)(5) sources to the United States, “gains, profits, and income from the disposition of a United States real property interest.” U.S. real property interests include directly-owned real property and ownership of stock of a domestic corporation that owns an interest in U.S. real property. Gains attributable to each of these situations produce U.S.-sourced income.
Sale of Personal Property
In its simplest form, the Internal Revenue Code sources gains from the sale of personal property by a citizen and resident alien to the United States. The sale of personal property by a nonresident alien is sourced outside the United States. For these purposes, the rules for determining resident and nonresident alien status are different than those previously discussed and do not include the substantial presence test for foreign individuals.
Under the sourcing and status rules, IRC Section 865(g) states that a resident is any U.S. citizen or resident alien with no tax home outside of the United States or any nonresident alien with a tax home inside of the United States. Since the rules are different, certain individuals can be treated as resident aliens for some sections of the tax code, but as nonresident aliens for other parts.
Again, there are exceptions to the general rule. Citizens and resident aliens who pay an income tax equal to less than 10% of the gain from the sale of personal property to a foreign country can never be treated as nonresident aliens. Additional exceptions apply to the sale of depreciable property, intangible property and goodwill. For depreciable property, past depreciation is recovered with the same source of income it was used to offset. In determining the U.S.-sourced gain from the recovered depreciation, it bears the same proportion to the total gain as U.S. depreciation to total depreciation.
The rules surrounding the sale of intangible property contain their own caveats and exceptions. The main qualifier in this area is in the terms of the pricing included in the final contract. For fixed sales, residency rules control. The sale of intangible property by U.S. residents generally results in U.S.-sourced gain. The reverse occurs with foreign persons. For contingent sales, royalty rules control, meaning the income is sourced to the place of use of the intangible property.
Additionally, where the sale of intangible property contains returns of capital, the rules differ based upon the taxpayer. For a U.S. resident, the installment sale provisions would apply, and gain would be recognized accordingly. Conversely, payments to foreign persons are allocated first to return of capital. After that is exhausted, then gain may be recognized.
Regarding the sale of inventory, IRC Section 861(a)(6) looks to the place of sale in assigning the source. The problem in international transactions, as in all transactions, is that a number of steps are involved to complete a deal. For starters, some point of inquiry and negotiation needs to take place to arrive at the terms, but the terms of the final contract may be determined at another place. The final goods and title may also be set at a different location. Fortunately, the United States has determined and codified that the source of the sale is at the same time and location as the passage of title unless the rules were manipulated as a tax-avoidance scheme. Title passes at the point of delivery by default.
However, as with any contract, terms can be negotiated to reflect the will of the parties or to depart from standard procedures. Because of the ability to control the terms of a contract, taxpayers are presented with an opportunity to determine the sourcing of the sale of inventory. This is very important for all interested parties. For foreign persons, crafting the title to pass outside of the United States will allow the income associated with the deal to escape U.S. taxation. For U.S. persons, shifting the passage of title to a foreign jurisdiction is also very important. In any scenario, the income will be taxable in the United States. However, for purposes of the foreign tax credit, it is advantageous for U.S. residents to push as much income as possible to the foreign-sourced category to take advantage of the foreign tax credit and its related limitation computation.