Determine why sourcing rules are important before and after the Tax Cuts and Jobs Act (TCJA).
Identify the steps to analyze the source of income.
Identify how various types of income are sourced.
Recognize how the effectively connected income (ECI) rules interact with sourcing rules with respect to dividends paid by foreign corporations.
Recognize how the sourcing rules for use of tangible and intangible property interact with the sale of personal property sourcing rules.
Identify the modified rule of Section 863(b), that now provides that gross income from the sale or exchange of property produced by the taxpayer will be sourced at the place of manufacture.
Summary of source of income rules
U.S. businesses are generally taxed on worldwide income. The geographic source of business gross income, as derived either from within or outside the United States, may determine the extent to which such income is subject to U.S. taxation. The U.S. rules for sourcing income provide an important foundation for the U.S. taxation of international activities. The statutory source rules can be overridden by specific treaty provisions between the United States and a foreign country.
The criteria for determining source of income vary, depending on the nature or type of income. Taxpayers must carefully characterize their income to decide which criteria are applicable (for example, royalty income versus gain from sale of personal property). In addition, taxpayers must determine whether the item is gross income according to U.S. tax laws (Section 61). If the income is excludible from gross income, then the source rules are irrelevant for U.S. tax purposes.
The TCJA promulgated significant changes to U.S. tax law, including the addition of the qualified business income (QBI) deduction under new Section 199A. The QBI deduction allows for a deduction of up to 20% of the qualified business income from partnerships, limited liability companies (LLCs), S corporations, trusts, estates, and sole proprietorships. One significant nuance of the QBI deduction involves a rule related to sourcing. Under TCJA, only taxable items of income, gain, deduction, or loss that are effectively connected with the conduct of a trade or business within the United States are eligible to be considered in the computation of QBI. Therefore, the determination of whether the income, gain, deduction, or loss is U.S. sourced or foreign sourced becomes critically important.
Here are some common rules on sourcing (domestic or foreign source) different types of income. The primary consideration for determining source of income is generally for application of the foreign tax credit (FTC) and (post-TCJA) to determine which new U.S. tax provision and incentive may apply to a taxpayer’s international business activities. For example, income from a foreign branch, a CFC’s global intangible low-taxed income (GILTI), and a U.S. C corp’s foreign-derived intangible income (FDII) would not be eligible for the Section 199A QBI deduction, but GILTI (CFC’s computed or tested income) and FDII (qualified foreign-source income earned by a U.S. C corp) each have their own and beneficial federal income tax incentives and lower effective tax rates.
| Income source | What determines sourcing? |
| Income from personal services | Where services are physically performed |
| Interest income | Tax residence of the borrower/debtor |
| Rental income | Location of the rental property |
| Royalty income | Jurisdiction of the underlying intangibles being used or exploited by the licensee |
| Gain from the sale of real property | Location of the real property |
| Gain from the sale of personal property/Capital Gains | Residence of the seller Under Section 865, foreign persons are generally not subject to further U.S. tax (for example, U.S. source withholding tax) on capital gain income unless connected to U.S. real property. |
| Gain from the sale of intangible property | Jurisdiction of the underlying intangibles |
| Sale of depreciable property | Where the depreciation deduction was sourced |
| Inventory income and gains produced or manufactured by the taxpayer (for tax years after 2017) | Where production activities are performed, pursuant to revised Section 863(b) |
| Inventory income for property not produced by the taxpayer | Location of the sale (that is, location of title transfer) regardless of the place of purchase |
| Definitely related deductions | Consistent with the type of income giving rise to such deductions |
| Deductions not definitely related | May be allocated to a gross income class or various gross income classes — These deductions may be further apportioned between statutory grouping and residual grouping in a manner that best reflects the factual relationship between the deduction and grouping of gross income. |
| Interest expense and R&D expenses | May be allocable to all gross income that the assets of the taxpayer generate, typically on the tax book value of the assets –The use of FMV in the apportionment of interest expense under Section 864 of the Internal Revenue Code (see Section 14502(a) of the TCJA) has been repealed. Research and experimental expenditures are generally allocated to the jurisdiction of the activities. |
Prior to TCJA, taxpayers were typically incentivized to treat as much income as possible as a foreign source to maximize available FTCs as a way to offset residual U.S. income taxation. However, QBI does not generally include foreign-source income. Therefore, for taxpayers who are able to and want to maximize the domestic pass-through deduction, it would make sense to maximize U.S. source ECI within and through the respective pass-through business.
Interest income
The term interest includes any payment for the use of borrowed funds, including unstated interest that is part of a deferred payment on the sale of property and original issue discount. Any payment of interest by the U.S. government, a U.S. territory, or any subdivision of a U.S. territory (not including U.S. possessions) is U.S.-source income. Note that the source of interest does not depend on such factors as where funds are borrowed or spent, the place where principal is paid, or the place where a debt obligation is issued.
In general, the source of interest income is determined by the residence of the debtor.
Sections 861(a)(1) and 862(a)(1) generally source interest income by reference to the debtor’s residence (in the case of a “noncorporate” debtor, such as an individual, partnership, trust, or estate) or the debtor’s place of incorporation (in the case of a corporation). The general rule of Sections 861(a)(1) and 862(a)(1) treats interest income as U.S.-source income if the debtor is a U.S. resident or a domestic corporation, and as foreign-source income if the debtor is neither a U.S. resident nor a domestic corporation.
Generally,
