Source rules for Deductions:
If a foreign person is only a passive investor in the United States, we do not need to source his income. His income is taxed on a gross basis through a flat rate withholding taX.
If a foreign corporation has a branch office in the United States, it will be taxed on its net income effectively connected with United States.
A U.S person’s foreign tax credit limitation is based on the ratio of net taxable income from foreign sources to net income from all sources.
In computing taxable income from sources within (or without) the United States, a taxpayer can deduct expenses and losses directly related to either US or foreign source gross income.
Allocation:
The first step in sourcing a deduction is to allocate it to a related income producing activity or class of gross income.
Potential classes of gross income include compensation for services, gross income from a business, gains derived from dealing in property, interest, rents, royalties and dividends.
The allocation rules emphasize the factual relationship between a deduction and a class of gross income.
Most deductions are definitely related to a specific class of gross income, some deductions are related to all gross income.
Example:
USAco, a domestic corporation, derives $800,000 of gross income from sales of services and $200,000 of gross income from product sales. USAco expenses include $500,000 of salaries paid to service technicians, $130,000 of salaries paid to product sales persons, and $100,000 of rent paid on its headquarters offices. Because the rent expense is related to all of USAco’s gross income, USAco allocates 80% of the rent expense to sales and 20% to product sales.
Step 1:
Allocate deductions to a class of gross income:
Compensation for services
Gross income from business.
Gains from dealing in property.
Interest.
Rents.
Royalties.
Dividends.
Step 2:
Apportion deductions between U.S and foreign sources.
Gross income.
Gross sales.
Units sold.
Cost of goods sold.
Profit contributions.
Expenses incurred.
Assets used.
Salaries paid.
Space utilized.
Time spent.
Apportionment:
We have to apportion deductions between U.S source and foreign source income.
Potential apportionment bases include gross income, gross receipts of sales, units sold, cost of goods sold, profit contributions, expenses incurred, assets used, salaries paid, space utilized and time spent.
Example:
USAco is a domestic corporation that sells its products both in the United States and abroad. During the current year USAco had $10 million of sales and a gross profit of $5 million, and incurred $1 million of selling, general, and administrative (SG&A) expenses. USAco’s $10 million of sales include $6 million of foreign sales and $4 million of domestic sales. On the other hand, because USAco’s domestic sales generally involved higher margin products than its foreign sales, USAco’s gross profit of $5 million was split 50-50 between U.S and foreign sources. So, if USAco uses gross profit as an apportionment base, it would apportion $500,000 of SG&A expenses to foreign-source income (50% x $1 million of SG&A expenses), as opposed to $600,000 if gross sales is used as an apportionment base [($6 million of foreign sales / $10 million of total sales) x $1 million of AG&A expenses].
USAco:
U.S. customers
Sales = $4 million
Gross profit = $2.5 million
SG&A = $1 million
Foreign customers:
Sales = $6 million
Gross profit = $2.5 million
The election of an apportionment base also is impacted by the type of records that the taxpayer maintains.
Example:
The facts in this example are the same as in above example except now assume that USAco’s SG&A expenses of $1 million consist of the president’s salary of $250,000, the sales manager’s salary of $100,000, and other SG&A expenses of $250,000, the sales manager’s salary of $100,000, and other SG&A expenses of $650,000.Also assume that USAco’s president and sales manager maintain time records which indicate that the president devoted 30% of her time to foreign operations and 70% to domestic operations, while the sales manager devoted 40% of her time to foreign operations and 60% to domestic operations. USAco should now apportion the salaries of the president and sales manager on the basis of time spent and apportion the other SG&A expenses on the basis of gross profit. Therefore, USAco apportions to foreign-source income $75,000 of the president’s salary [30% x $250,000], $40,000 of the remaining SG&A expenses [50% x $650,000], for a total of $440,000 of SG&A expenses apportioned to foreign-source income.
USAco:
U.S. Customers:
Sales = $4 million
Gross profit = $2.5 million
SG&A = $1 million
President’s salary (30% of foreign) = $250,000
Manager’s salary (40% foreign) = $100,000
Other SG&A = $650,000
Foreign customers:
Sales = $6 million
Gross profit = $2.5 million
Interest Expense:
Let us assume a U.S. company arranges a second mortgage on its factory in the U.S. and uses the proceeds to buy an office building in a foreign country. Interest incurred on these funds is related to all of tax payer’s activities and property and will be allocated to all of taxpayer’s gross income.
Interest expense is apportioned between U.S. and foreign source income using the relative basis of U.S. and foreign assets as an apportionment base. For example, if 20% of a taxpayer’s assets are foreign in nature, then that taxpayer must apportion 20% of its interest expense to foreign source income.
The asset figures for a taxable year are the averages of the adjusted basis at the begining and the end of the year.
A tax payer may elect to apportion interest expense on the basis of the fair market value of its assets.
Taxpayers may also elect to use the alternative tax book value method, which allows the taxpayer to depreciate its U.S. assets using the same alternative depreciation system (ADS) that applies to foreign assets.
Research and Experimental Expenses:
The rule for research and experimental expenses provide that a taxpayer must generally apportion the entire amount of the deduction for R & E expenditures imposed by a government (I.E legally mandated R & E) to that jurisdiction (U.S or Foreign).
Deduction for non-legally mandated R & E expenditures are apportioned between U.S. and foreign sources using the sales method.
Under the sales method, if more than 50% of R & E activities are performed in a single geographic source (U.S or Foreign), 50% of the deductions for non-legally mandated R & E are exclusively apportioned to that source.
Members of an affiliated group of U.S Corporations must allocate and apportion R & E deductions as if all the members of the affiliated group were a single corporation.
Losses from Disposition of Stock and other personal property:
Losses from the sale or other disposition of stock and other personal property are generally sourced under the same rules that apply to gains from such property that is, based on the residence of seller.
Other Specialized Rules:
Legal and accounting expenses:
Legal and accounting expenses incurred with respect to a specific property or activity are allocate to the gross income produced by that property or activity. On the other hand, the cost of general legal and accounting functions is allocated to all gross income and apportioned on the basis of gross income.
State Income Taxes:
State income taxes are allocated to the gross income on which the taxes were imposed and apportioned on the basis of gross income.
Net operating losses:
A net operating loss deduction allowed under code section 172 is allocated and apportioned in the same manner as the deductions giving rise to the net operating loss deduction.
Stewardship expenses attributable to dividends:
Expenses associated with stewardship activities are allocated to the class of gross income that includes dividends received from the subsidiary.
Standard deductions:
The standard deduction is allocated to all of the individual taxpayer’s gross income and apportioned on the basis of gross income.
Certain personal expenses:
An individual taxpayer’s deductions for real estate taxes on a personal residence, medical expenses, and alimony payments are allocated to all of the taxpayer’s gross income and apportioned on the basis of gross income.
Personal exemption:
Personal exemption deductions are not taken into account for purpose of allocating and apportioning deductions.
Charitable contributions:
Charitable contributions are allocated to all of the taxpayer’s gross income and apportioned on the basis of gross income.
Disclaimer:
This information is for educational purposes only. It does not constitute any legal advice or opinion. Please do not use any of its contents without seeking a professional advice.
References:
Practical Guide to U.S. Taxation of International Transactions written by Robert J. Misey, Jr. And Michael S. Schadewald, 9th Edition, Published by Wolters Kluwer CCH
Mansoor Suhail (Mani)
Accountant
BSBA – EA – ICIA – RA
Tax for Canada and U.S.A
Web: www.theaccountingandtax.com and www.taxservicesguru.com
Blog: http://taxservicesguru.blogspot.ca
416 – 283 – 8774