Source rules for gross income are organized by categories of income, such as interest, dividends, personal services income, rentals, royalties, and gains from disposition of property.
A transaction involving computer programs or software must be classified as one of the following:
A transfer of a copyright in the computer program.
A transfer of a copyright article.
The provision of services for the development or modification of the computer program.
The provision of services for the development or modification of the computer program.
The provision of know how relating to computer programing techniques.
In general:
Interest income is U.S source if debtor is a U.S resident or a domestic corporation and foreign source if debtor is a foreign resident or a foreign corporation.
Dividends are U.S source income if payer is a domestic corporation and foreign source if payer is a foreign corporation.
Personal services income U.S source income if services are performed in the U.S and foreign source if services are performed abroad.
Rental and royalties are U.S source income if property is used in the U.S and foreign source if property is used abroad.
Gains on sale of real property are U.S source income if property is located in the U.S and foreign source if property is located abroad.
Gains on sale of personal property is U.S source if seller is a U.S resident and foreign source if seller is a foreign resident.
Income from the sale of inventory purchased for resale is U.S source if title passes in U.S and foreign source if title passes abroad.
Income from the sale of inventory manufactured by taxpayer is U.S source if allocated between U.S and foreign source income using the 50-50 method.
Gains on sale of depreciable property is U.S source if title passes in the U.S and foreign source if title passes abroad.
Gain on sale of patents and other intangibles is U.S source if seller is a U.S resident and foreign source if seller is a foreign resident.
Interest Income
U.S source if payer is a domestic corporation or U.S resident and foreign source if the payer is a foreign corporation or a non-resident.
Following taxpayers are considered to be U.S residents:
Individuals who, at the time the interest is paid, are residents of the United States.
Domestic corporations.
Domestic partnerships which at any time during the taxable year were engaged in a U.S trade.
Foreign Corporation or foreign partnerships which at any time during the taxable year were engaged in a U.S trade or business.
Interest received from deposits made with a foreign branch of a domestic corporation or partnership engaged in the commercial banking business is treated as foreign source income.
Interest paid to a 10% or more U.S shareholder by a foreign corporation that is at least 50% owned by U.S persons is U.S source income to the extent the interest payment is attributable to income that the foreign corporation derived from U.S sources.
Interest paid by a U.S branch of a foreign corporation is treated as if it were paid by a domestic corporation, which generally makes the interest U.S source income and potentially subject to U.S withholding tax.
Dividend Income
A portion of the dividends paid by a foreign corporation are U.S source income if during the preceding three taxable years, 25% or more of the foreign corporation’s gross income was effectively connected with the conduct of a U.S trade or business.
Dividends paid by a foreign corporation that is at least 50% owned by U.S persons are U.S source income to the extent the dividend is attributable to income that the foreign corporation derived from U.S sources.
A domestic corporation that claims a dividend received deduction with respect to a portion of a dividend from a foreign corporation must treat that portion of the dividend as U.S source income for purposes of computing the foreign tax credit limitation.
Personal Services Income
Compensation for personal services performed in the United States is U.S source income and compensation for personal services performed abroad is foreign source income.
Personal services income includes salaries, wages, fees and commissions.
Income of nonresident alien that is attributable to U.S services is considered a foreign source income if following requirements are met:
The nonresident alien is present in the United States for 90 days or less during the taxable year.
The nonresident alien receives no more than $3,000.00 for his or her U.S services.
A nonresident alien works as an employee or under contract for either a person who is not engaged in a U.S trade or business or the foreign office of a U.S person.
Rental and Royalty Income
Rentals and royalties are U.S source income if the property is located or used in the United States and foreign source income if the property is located or used abroad.
Income from the disposition of Property
Real Property
A gain on the sale or exchange of a U.S real property interest is U.S source income, where as a gain on the sale or exchange of real property located abroad is foreign source income.
Personal Property
It includes a wide variety of assets, including stocks and securities, machinery and equipment, patents, trademarks and copyrights. A gain on the sale of personal property is U.S source income if the tax payer is a U.S resident and foreign source income if the tax payer is a nonresident.
For the purpose of this source rules the following taxpayers are considered to be U.S residents.
A domestic corporation.
A U.S citizen or resident alien who does not have a tax home in a foreign country.
A nonresident alien who has a tax home in the United States.
A trust or estate whose situs is in the U.S.
Special rule for U.S citizens and resident aliens who have a foreign tax home.
Gain realized by a U.S citizen or resident alien who has a tax home in a foreign country is treated as foreign source income.
Special rule for Sales by U.S residents through a foreign office.
If the sale is attributable to a foreign office and the gain on the sale is subject to foreign tax at a rate of 10% or more, then the gain is treated as foreign source income, despite the taxpayer’s U.S residency.
Sales of Inventory
For purpose of the source of income rule, inventory includes personal property that is held by the tax payer primarily for sale to customers in the ordinary course of business.
Income from the sale of inventory by wholesaler or retailer may be attributable to a number of geographically dispersed economic activities, such as purchasing, marketing and distribution.
Inventory purchased for resale
Gross income from the sale of inventory that the taxpayer purchased for resale is sourced on the basis of where the sale occurs. Therefore, such income is U.S source if the sale occurs within the United States and foreign source if the sales occurs abroad.
Inventory produced by taxpayer
Income from the sale of inventory that the taxpayer produces in the United States and sells abroad is apportioned between U.S and foreign source income using one of three methods: the 50:50 method, the independent factory price method or the taxpayer’s own books and records.
50 / 50 Method
Under this method a U.S manufacturer apportions 50% of the gross income from export sales based on a sale activity and the other 50% based on a production activity factor. The sales activity factor equals the ratio of the gross amount of export sales that are classified as foreign to the gross amount of all export sales.
Special rules for sale by nonresidents through a U.S office
If a nonresident maintains an office or other fixed place of business in the United States, income from any sale of personal property including inventory attributable to that U.S office is treated as U.S source income.
Depreciable personal property
Depreciation deductions reduce a taxpayer’s basis in the depreciable property and thereby increase the gain computed on the disposition of that property. The portion of the gain on the disposition of depreciable personal property that is attributable to prior depreciation deductions is treated as having the same source as the related deductions.
Intangibles
A gain on the disposition of an intangible may be attributable in whole or in part to prior amortization deductions. The portion which is attributable to prior amortization deductions is treated as having the same source as the related deductions determined using the same trace rule applicable to depreciation on tangible property.
Any gain attributable to appreciation in the value of the intangible is sourced using the residence of seller.
If an intangible is sold for a price that is contingent on its productivity, use, or disposition, then the appreciation portion of the gain source as if it were a royalty payment.
Royalties are sourced based on the location of the actual use of, or the right to use, the underlying intangible.
Sale of Stock of foreign affiliates
A domestic corporation treats a gain on the sale of stock as U.S source income.
If following requirements are met, a domestic corporation can treat a gain on the dale of the stock of a foreign affiliate as foreign source income:
The domestic corporation sells stock in an 80% or more owned affiliate that is a foreign corporation.
The sale occurs in a foreign country in which the affiliate is engaged in the active conduct of a trade or business.
The affiliate derived more than 50% of its gross income during the preceding three taxable years from the active conduct of a trade or business in such country.
Other types of Income
Foreign currency gains and losses
Special source of income rules apply to a defined group of transactions referred to as “section 988 transactions” that include following:
Disposition of a nonfunctional currency.
Debt instruments, receivables and payables, currency forward, futures and options.
Insurance underwriting business
Insurance income generally is sourced on the basis of where the insured risk is located.
Premiums from issuing or reissuing any insurance or annuity contract in connection with property located in the United States, a liability arising out of an activity located in the United States or in connection with the lives or health of residents of United States, is treated as U.S source income.
Any other type of underwriting income is treated as foreign source income.
International Communication
The source rule for international communication income varies depending on whether the taxpayer is a U.S person or a foreign person.
In the case of a U.S person, 50% of international communications income is treated as U.S source income and the other 50% is treated as foreign source income.
A foreign person generally treats all international communication income as foreign source income, unless that person maintains an office or other fixed place of business with in the United States, in which case any business attributable to that fixed place of business is treated as U.S source income.
Scholarships and Fellowships
Scholarships and fellowships received by someone who is not required to perform services for the payer are source based on the residence of payer.
U.S Social Security benefits
U.S social security benefits are considered U.S source income regardless the recipient spent employment years working in the United States or abroad.
Space and Ocean activities
Income from space and ocean activities is treated as U.S source income if derived by a U.S person and as foreign source income if derived by a foreign person.
Transportation
Income from transportation that both begins and ends with in the United States is treated as U.S source income. If the transportation begins in the United States and ends abroad or begins abroad and ends in the United States, then 50% of the resulting income is treated as U.S source income and the other 50% is treated as foreign source.
Distributive shares of income from a pass through entity
In the case of partnerships and “S” corporations, the source of income usually is determined at the entity level and that source characterization carries over to the partners or shareholders in their distributive shares of 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 US Taxation of International transactions 9th Edition
Robert J. Misey Jr.
Michael S. Schadewald
Publishers: Wolter Kluwer, CCH Incorporated.