US or Foreign Income? The Ultimate D-I-Y Guide.
Is it important to know whether your income is attributable to the USA or another country? In fact, the determination of the source of an item of income is a number one priority when it comes to taxation rights, allocation of deductions, and foreign tax credit provisions. As an ease to taxpayers, we have developed this do-it-yourself guide to explain some of the most relevant source of income rules. For simplicity and transparency, we have also presented 14 real-life examples!
Sections 861-865 of the Internal Revenue Code provide the rules that must be followed to determine the source of income of individuals and corporations. To help you apply the rules correctly, we must first convey the definition of the USA in a purely geographic sense. The USA includes the 50 States, the District of Columbia, the US territorial waters and air space determined under the US law. The US possessions of Puerto Rico, Virgin Islands, American Samoa, Northern Mariana Islands, Guam, and the Minor Outlying Islands are generally excluded from the definition. For the source of income rules, the US possessions are treated as a foreign country, unless an exception applies. Next, we have presented some of the most common rules.
Compensation for personal services performed in the USA is a US source income. Consequently, if you work in the USA, the remuneration you receive will be a US source income regardless of who paid the income to you. On the other hand, the opposite is also true. An individual who provides services to a US-based employer from outside the USA will earn foreign-source income.
The form of employer-employee relationship is not a determinative factor too. Therefore, identical rules apply to self-employed individuals and independent contractors. There are exceptions to the general rules that cover foreign diplomats, employees of International Organizations, crew members, and certain other nonresidents.
Example 1. Mrs. J is a citizen and resident of Austria. She was assigned to the USA by her employer, a company located in Austria. Assuming no exception applies, the salary and all other employment benefits paid to Mrs. J while she was working in the USA are a US source income.
Gains, profits and income derived from the sale or disposition of US real property are US source income. A US real property includes land, structures permanently attached to land, buildings, commercial property, and natural deposits located in the USA and the US Virgin Islands. US real property also includes certain shareholder interest in a US real property holding company.
Example 2. Mr. S is a citizen and resident of Spain. Mr. S sold a house located in Miami. He had purchased the house few years ago for investment. The gain from the sale of the house is a US source income.
Rental and royalty income derived from any property located in the USA is a US source income. The term property located within the USA includes real, tangible, and intangible property. An item of intangible property, such as copyright, patent, trademark, franchise, and the like generates a US source income when the royalty income is contingent on the use of the intangible property within the USA.
Example 3. IreCo is a software developer based in Ireland. IreCo licensed software for use in the USA. The royalty income IreCo derived from US-based licensees is a US source income.
Income from the sale of merchandising inventory is sourced to the place where title passes. Merchandising inventory is an item of property that is purchased for resale to others in the ordinary course of business. A title passes from a seller to a buyer at the time the economic risk of loss or decline in value shifts from the seller to the buyer. In the international transport of goods, the INCOTERMS 2010 could provide a clue when title passes to the buyer in an absence of an explicit agreement between the parties.
Example 4. DeuCo is a car dealer located in Germany. DeuCo purchases cars for resale to other in its dealership business. USCo is a client located in the USA. DeuCo sold a car to USCo under FOB Hamburg terms. In this case, title passes when the car is loaded on board a vessel in Hamburg, Germany. The income from the sale is sourced to Germany.
Example 5. The facts are the same as in the previous example. This time, DeuCo sold the car as DAP New York City. In this scenario, the risk of economic loss shifts to the buyer in New York City. DeuCo realized a US source income.
Income from the sale of manufacturing inventory produced by the taxpayer in the USA and sold in the USA is a US source income. The opposite is also true; a manufacturing inventory produced by the taxpayer outside the USA and sold outside the USA is a foreign source income. Manufacturing inventory is any item of personal property produced by a taxpayer in the ordinary course of business.
Example 6. USCo is a US corporation positioned in the furniture manufacturing sector. USCo operates a manufacturing plant in China. USCo sold furniture produced in China to a client based in Singapore. The income from the sale is a foreign source income.
Income from the sale of manufacturing inventory produced by the taxpayer outside the USA and sold in the USA is partly foreign source and partly US source income. The opposite is also true; a manufacturing inventory produced by the taxpayer in the USA and sold outside the USA is party US and partly foreign source income. Thus, income realized from cross-border sales of manufacturing inventory must be apportioned between manufacturing and sales activities. The allocation ratio is calculated under the independent factory price, the 50/50 or the "books and records" methods.
Example 7. USCo manufactures equipment in the USA. USCo sells the equipment to clients located in France. If USCo avails of the 50/50 method, 50% of the income will be a US source income and the remaining 50% will be sourced to France.
Gains, profit, and income from the sale of any other personal property are sourced to the "tax home" of the seller. Other personal property is any item of property that does not fall within the definitions of real property or inventory property. The definition of "tax home" is quite complex, but in general terms, it is the area where the taxpayer regularly and continuously works or conducts business. When applied to individuals, the tax home is often, but not always, the metropolitan area where the individual's permanent home is located.
Example 8. Mr. B has been working and residing in Las Vegas for many years. Mr. B auctioned and sold a painting that he had received as a birthday gift. The buyer is located in France. Assuming a gain is realized from the sale, the gain will be a US source income as Mr. B's tax home is in Las Vegas.
Alimony and Child Support paid incident to a divorce or separation are sourced to the residency of the payer. If alimony and child support are paid by a US citizen or resident, they are always a US source income regardless of the residency of the recipient.
Example 9. Jenny is a citizen and resident of the United Kingdom. She received alimony from her ex-husband Frank, who is a US citizen. Jenny's alimony income is a US source income.
Interest income is sourced to the residency of the payer. The general rule states that interest income paid by US banks and US corporations is a US source income. Same applies to interest paid on US Treasury, State and Municipals bills, bonds, and notes. However, interest paid by a foreign corporation could be treated as US source income if certain conditions are met.
Example 10. Mr. P is a citizen and resident of Portugal. Mr. P deposited money in a US bank account. The interest paid on the deposit is a US source income.
Dividends are sourced to the residency of the payer. Under the general rule, dividends paid by US corporations are US source income. Special rules apply to dividends paid by a DISC or former DISC. There are numerous exceptions to the general rule that apply to both US and foreign corporations. Moreover, if the company that declares dividends is publicly traded the location of the stock exchange is irrelevant for the source of income rules.
Example 11. Mrs. R is a citizen and resident of Russia. Mrs. R purchased shares of a US corporation traded on the London Stock Exchange. The dividends paid by the US Corporation are US source income.
The source of scholarships, fellowships, grants, prizes, awards and similar items of income are determined by reference to the residency of the payer. Scholarship and fellowship grants paid to students and researchers are US source income if the payer is a US person. Same applies to other similar grants, prizes and awards. It is important to note that this rule covers only grants, prizes, and awards that are not contingent on the provision of personal services by the grantee.
Example 12. Mrs. B was a citizen and resident of Bulgaria at the time she was admitted to the USA as a full-time student on an F-1 visa. The US University paid her a scholarship as her GPA was 3.9. Mrs. B was not required to provide any personal services to qualify for the grant. The scholarship is a US source income.
Pension and annuity income attributable to the performance of services is sourced to the place where the services were performed. Pension and Annuity include any qualified or nonqualified retirement plan determined under the US law. If the contributions to the plan are borne by services performed entirely within the USA, the income from the plan is US source income. If the services were performed entirely outside the USA, the income is a foreign source income. An apportionment is required if the services were performed partly within and without the USA.
Example 13. Mr. N is a citizen and resident of the Netherlands, who worked in the USA for seven consecutive years. While in the USA, Mr. N contributed to his US employer's 401(k) plan. Any future distribution from the 401(k) will be a US source income.
Social Security Benefits paid by the US Government are US source income. Social Security and equivalent benefits paid by the US Government are always US source income. Moreover, Social Security Benefits paid to a nonresident of the USA are 85% taxable to the recipient.
Example 14. Ms. K was a retired citizen and resident of Kenya when she qualified for US Social Security Benefits. The Social Security Benefits paid to Ms. K are US source income.
To sum up, the source of income rules determine the attribution of an item of income to the USA or a foreign country. The examples in this guide assume there is no tax treaty in effect between the United States and any foreign country. The tax treaties effectively shift taxation rights, and we have not evaluated the potential tax consequences of each particular transaction.