Federal Tax

Source of Income Rules (Portfolio 6620)

  • This Bloomberg Tax Portfolio analyzes the rules applicable in determining whether income is treated as from sources within the United States or from foreign sources.

Description

In the case of persons who are not citizens or residents of the United States or domestic corporations, and thus are not subject to U.S. taxation on their worldwide income, the source of income rules generally are pivotal in determining whether the tax jurisdiction of the United States extends to the income. In addition, in the case of all persons who are subject to U.S. tax, the source of income rules are critical to determining to what extent a credit is available for income taxes or taxes in lieu of income taxes paid to a foreign government. The source of income rules are applied in conjunction with the rules governing the allocation and apportionment of expenses between domestic and foreign sources in order to determine foreign-source taxable income for purposes of the foreign tax credit limitation prescribed for each separate limitation category under §904. The source of income rules are contained largely in §861, §862, §863 and §865.

In addition, certain other rules are contained under other provisions of the Code or regulations under such provisions or have been prescribed by the IRS or courts by analogy to statutory rules. Since different rules apply for different types of income, the proper classification of income is a prerequisite to determining the source of income.

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Table of Contents

DETAILED ANALYSIS — 

I. Introduction

    A. Purpose of the Source of Income Rules

        1. U.S. Persons

        2. Foreign Persons

        3. U.S. Possessions

    B. Overview of the Source of Income Rules

    C. Definition of United States

II. Interest Income

    A. General Rule — Residence of Obligor

    B. Exceptions to the General Rule

        1. Foreign Corporate Debtor Engaged in U.S. Trade or Business

            a. Branch Interest (Interest Paid by Domestic Branch) — General Rules

                (1) Regulations Under §884

                (2) Regulations Under §882

            b. “Excess Interest” Under §884(f)(1)(B)

            c. Section 884 Election to Reduce Liabilities

        2. Deposits With Foreign Banking or Thrift Branches of Domestic Institutions

        3. Special Rule for Certain Deposits With Domestic Institutions and Domestic Branches of Foreign Institutions

        4. Exception for Foreign Tax Credit Purposes Where Obligor Is U.S.-Owned Foreign Corporation With Significant U.S. Income

        5. Exception for Accumulated Earnings Tax Purposes

        6. U.S. Debtor With 80% Active Foreign Business Income — Taxable Years Before 2011

            a. General

            b. Look-Through Limitation for Interest Paid to Related Person

    C. Definition of Interest

        1. General

        2. Market Discount and Premium

        3. Substitute Payments Under Securities Loans

        4. Related Party Factoring Income

    D. Determination of Residence of Obligor

        1. Individuals

        2. Corporations

        3. Partnerships

        4. Trusts

        5. Estates

    E. Special Issues Concerning Identity of Obligor

        1. Guarantors

        2. Financing Affiliates and Other Financing Intermediaries

            a. Section 7701(l) and Conduit Financing Arrangements

            b. Treatment of Financing Intermediaries Prior to §7701(l)

        3. Joint Obligors

        4. Agents and Underwriters

    F. Source of Interest Income Upon Taxation to Obligee’s Beneficial Owners

        1. Corporations

        2. Partnerships and S Corporations

        3. Trusts and Estates

            a. General

            b. Interest on Bank and Other Deposits

III. Dividend Income

    A. General Rule — Place of Incorporation of Payor

    B. Exceptions

        1. Possessions Corporations

        2. Foreign Corporations With at Least 25% Effectively Connected Income

            a. General Rule

            b. Applicability Limited by Branch Profits Tax and Withholding Tax Exemption

        3. Foreign Corporations Succeeding to Earnings and Profits of a Domestic Corporation

        4. Domestic International Sales Corporations (DISCs), Former DISCs, and Interest-Charge DISCs (IC-DISCs)

        5. Foreign Sales Corporations (FSCs)

        6. Extraterritorial Income Exclusion (ETI)

        7. Exception for Foreign Tax Credit Purposes for Dividends Eligible for §245 Deduction

        8. Exception for Foreign Tax Credit Purposes Where Payor Is U.S.-Owned Foreign Corporation With Significant U.S. Income

        9. Exception for Accumulated Earnings Tax Purposes

        10. Pass-Through Treatment With Respect to Certain Corporations

            a. S Corporations

            b. Regulated Investment Companies

            c. Real Estate Investment Trusts

            d. Real Estate Mortgage Investment Conduits

        11. Domestic Corporations With 80% Active Foreign Business Income

    C. Definition of Dividend

        1. General

        2. Dividend Equivalent Amounts and Substitute Payments Under Securities Loans

    D. Source of Dividend Income Upon Taxation to Payee’s Beneficial Owners

IV. Service Income

    A. General Rule — Place Where Services Performed

        1. General

            a. General Tax Regime and Exemptions

            b. Definition of United States

        2. Income Under Community Property Laws

    B. Temporary Presence Exception to the General Rule

        1. Code Exception

            a. Commercial Travelers

            b. Regular Members of the Crew of Certain Foreign Vessels

        2. Treaty Exceptions

            a. Employment and Dependent Personal Services

            b. Independent Personal Services

            c. Other Exceptions

    C. Determination of Place of Performance of Services

        1. Apportionment of Service Income Between U.S. and Foreign Sources

            a. General Rules, Including Time-Basis Apportionment

            b. Employee Stock Options, Restricted Stock Grants, and Other Multi-Year Compensation

            c. Seamen and Flight Personnel

            d. Services Performed by Business Entities

        2. Reimbursed Moving Expenses

        3. Continental Shelf Activities

    D. Deferred Compensation and Pensions

        1. Compensation Component

        2. Interest Component

        3. Illustrative Examples

        4. Authorized Method for U.S. Defined Benefit Plan

    E. Definition of Services/Areas of Overlap

        1. “Labor or Personal Services”

        2. Service Income vs. Income From Use or Sale of Property

            a. Intellectual Property

                (1) Artistic Creations of Nonresident Aliens

                (2) Artistic Creations of U.S. Citizens (Section 911 Qualification)

                (3) Know-How

            b. Construction, Engineering, Fabrication, and Installation Activities

            c. Technical Services Ancillary to Transfer of Property

            d. Contract Processing or Manufacturing

            e. Income From Agreement Not to Perform Services

            f. Finder’s Fees

            g. Standby Loan Commitment Fees

            h. Global Trading of Securities

            i. Sponsor Fees and Endorsement Income

            j. Cloud Transactions

        3. Service Income vs. Interest Income

        4. Service Income vs. Transportation Income

        5. Service Income vs. Space or Ocean Activity

        6. Service Income vs. International Communications Income

        7. Service Income vs. Partnership Share

    F. Effect of Agent

V. Income From Use of Property — Rents and Royalties

    A. General Rule — Place Where Property Is Used

    B. Real Property

    C. Personal Property

        1. Place of Use

            a. General

            b. Trademarks

            c. Manufacturing Intangibles

        2. Back-to-Back Licensing Arrangements

        3. Cross Licensing

        4. Apportionment if Property Is Used Within and Without the United States

        5. Special Rules for Use of Ships, Aircraft, Railroad Rolling Stock, and Shipping Containers

    D. Rents and Royalties vs. Other Characterizations

        1. License vs. Sale

        2. License vs. Services

        3. Interaction of Rental Activity Rules With Ocean or Space Activity Rules

VI. Income From the Sale of Real Property

    A. U.S. Real Property Interests

    B. Real Property Located Without the United States

        1. General

        2. Virgin Islands

    C. Definition of Real Property

        1. U.S. Real Property

        2. Foreign Real Property

VII. Income From the Sale of Personal Property

    A. Property Other Than Inventory Property

        1. General Rules

            a. Nondepreciable and Nonamortizable Property

                (1) General Rule — Residence of Seller

                (2) Definition of U.S. Resident and Nonresident

                    (a) General

                    (b) Tax Home

                        (i) Current Law

                        (ii) Prior Law

                    (c) Special Rule for Stock Sales by Residents of Puerto Rico and for Other U.S. Possessions Residents

            b. Depreciable and Amortizable Property

                (1) Gain Not Exceeding Depreciation Adjustments

                (2) Gain Exceeding Depreciation Adjustments

            c. Allocation and Apportionment of Loss

                (1) Section 865 Regulations

                    (a) Regulatory History

                    (b) General Rule

                    (c) Losses on Disposition of Personal Property Other Than Stock

                        (i) General

                        (ii) Allocation of Losses to Foreign Tax Credit Baskets

                        (iii) Allocation of Partnership Losses

                        (iv) Losses on Sales of Depreciable Personal Property

                        (v) Losses on Sales of Contingent Payment Debt Instruments

                        (vi) Losses on Sales of Bonds

                        (vii) Losses on Accrued Interest From Debt Obligations

                        (viii) Anti-Abuse Rules

                            (A) Transactions Involving Built-In Losses

                            (B) Offsetting Positions

                            (C) Matching Rule

                    (d) Losses on Disposition of Stock

                        (i) General

                        (ii) Allocation of Losses to Foreign Tax Credit Baskets

                        (iii) Dividend Recapture

                        (iv) De Minimis Rule

                        (v) Anti-Abuse Rules

                            (A) Transactions Involving Built-In Losses

                            (B) Offsetting Positions

                            (C) Matching Rule

                (2) Rules Applied Before the §865 Regulations

        2. Exceptions to the General Rules

            a. Certain Intangible Property Sold for Contingent Price

                (1) General Rules

                (2) Definitions of Intangible and Property

                (3) Definition of Sale

            b. Goodwill

            c. Certain Sales of Personal Property Through Offices or Other Fixed Places of Business

                (1) Sales by U.S. Residents

                (2) Sales by Nonresidents

            d. Stock in Foreign Affiliated Companies Sold by Residents

            e. Treaty Protection on the Sale of Intangible or Foreign Stock

            f. Liquidation of Possessions Corporation

            g. Section 306 Stock

            h. Certain Inclusions Under §91 or §367

            i. Gain Under §1248 and §1291

            j. U.S. Real Property Interests

            k. Certain Foreign Currency Transactions

            l. Special Rules for §338 Elections

                (1) General

                (2) Section 338(h)(16)

            m. Sale of Partnership Interests

                (1) General Rule

                (2) Inbound Investments

                    (a) Section 897(g)

                    (b) Section 864(c)(8)

                    (c) Section 1446(f)

                    (d) Rev. Rul. 91-32 and Grecian Magnesite

                (3) Outbound Investments

            n. Imputed Interest

    B. Inventory Property

        1. Inventory Property Not Subject to Apportionment Rules

            a. General Rule — Place of Sale

                (1) General Principles

                (2) Bare Legal Title Exception

                (3) Tax Avoidance Exception

                (4) Proposed Rules for Sales or Exchanges of Copyrighted Articles Through an Electronic Medium

                (5) General Title Passage Rule Precedents

        2. Exception for Sale by Nonresident Through U.S. Office or Other Fixed Place of Business

            a. Sales of Inventory Property Having U.S. Destinations

                (1) Interaction of §865(e)(2)(A) and §863 and Allocation of Income Between Sales and Production Activities

                (2) Office or Other Fixed Place of Business

                (3) Material Factor Test

            b. Sales of Inventory Property Having Foreign Destination

                (1) Material Participation by a Foreign Office or Other Fixed Place of Business

                (2) Use, Consumption, or Disposition Outside the United States

        3. Inventory Property Subject to Apportionment Rules

            a. Production Apportionment Rules

                (1) Production Apportionment After the TCJA

                (2) Production and Sale Apportionment Before the TCJA Involving Production in the United States and Sale in a Foreign Country (or Vice Versa)

                (3) Sourcing of Income From Inventory Produced in the United States and Sold in a U.S. Possession (or Vice Versa)

                    (a) Taxable Years Beginning After December 31, 2017

                    (b) Taxable Years Beginning On or Before December 31, 2017

            b. Inventory Property Purchased in a U.S. Possession and Sold in the United States

                (1) Taxable Years Beginning After December 31, 2017

                (2) Taxable Years Beginning On or Before December 31, 2017

            c. Inventory Property Produced in a U.S. Possession and Sold in a Foreign Country (or Vice Versa)

            d. Global Dealing Operations

    C. Exception for Foreign Tax Credit Purposes on Deemed Disposition of Assets of Overall Foreign Loss Branch

    D. Production and Sale of Natural Resources or Farm Products

        1. 2019 Proposed Regulations Reflecting TCJA

        2. General Rules After 1996 Regulations

        3. Pre-1996 Regulations

        3. Continental Shelf

        4. Ocean Activities

VIII. Insurance Underwriting Income

    A. General

    B. Controlled Foreign Corporations

        1. Section 953 Insurance Income

        2. Risk Location Rules

            a. General

            b. Specific Risks

                (1) Property Generally

                (2) Activities

                (3) Life or Health

IX. Income From Transportation

    A. Transportation Income (Shipping and Aviation)

        1. General Rule

            a. Between Two Points Within the United States

            b. Between the United States and a Foreign Country or Possession

        2. Definition of Transportation Income

    B. Four Percent Tax on U.S.-Source Gross Transportation Income

    C. Code and Treaty Exemptions of Shipping and Aviation Income

        1. Code Exemptions

        2. Treaty Exemptions

    D. Land Transportation

        1. General Rule

        2. Special Rule for Use of Railroad Rolling Stock

        3. Canadian Income Tax Treaty

X. Income From Space and Ocean Activity

    A. Definition of Space and Ocean Activity

        1. General

        2. Definition of “Space” and “Ocean”

        3. Particular Space or Ocean Activities

            a. General Definition

            b. Income From Services

    B. Source of Space and Ocean Income

        1. General Rules

            a. U.S. Persons

            b. Controlled Foreign Corporations

            c. Other Foreign Persons

        2. Special Rules for Income From Sales of Property

            a. Place of Sale

            b. Sales of Purchased Property

            c. Sales of Property Produced by Taxpayer

        3. Special Rule for Income From Services

        4. Special Rule for Income From Communications Activity

        5. Allocation of Deductions

        6. Treatment of Partners and Partnerships

    C. Reporting and Documentation Requirements

XI. Income From Communications Activities

    A. Definition of “Communications Activity”

        1. General

        2. Categories of Communications Activity

    B. Source of Communications Income

        1. International Communications Income

            a. U.S. Persons

            b. Controlled Foreign Corporations

            c. Other Foreign Persons

            d. Allocation of Deductions

        2. Other Communications Income

            a. Income From U.S. or Foreign Communications Activities

            b. Income From Geographically Indeterminate Communications Activity

            c. Income From Space/Ocean Communications Activity and Coordination of Communications Rules With Space and Ocean Activity Rules

        3. Treatment of Partners and Partnerships

    C. Reporting and Documentation Requirement

XII. Income From Certain Financial Transactions

    A. Certain Foreign Currency Transactions

    B. Dividend Equivalent Payments

    C. Notional Principal Contracts

    D. Securities Loans — Substitute Payments and Loan Fees

        1. Substitute Payments

            a. Background and Definitions

            b. Source Rules

            c. Character Rules

            d. Withholding and Treaty Issues

        2. Fees and Interest

        3. Withholding on Substitute Payments

            a. Current Law

            b. Prior Law

        4. Pre-Final Regulations Law

    E. Loan Guarantee Fees

XIII. Distributive Share of Income From Certain Pass-Through Entities and S Corporations

    A. Partnerships and S Corporations

        1. Partnerships

        2. S Corporations

    B. Trusts and Estates

        1. Trusts

        2. Estates

    C. Hybrid Entities

    D. Other

XIV. Transactions Involving Computer Programs, Digital Content, and Cloud Computing

    A. General

    B. Classification of Transactions Involving Computer Programs and Other Digital Content

        1. Transfer of Copyright Right in a Computer Program or Other Digital Content

            a. Definition

            b. Right to Make Copies for Distribution to “the Public”

            c. Right to Prepare Derivative Programs

            d. Right to Public Performance and Public Display

            e. Sale vs. License

                (1) “All Substantial Rights” Test

                (2) Source Rules Applicable to Sale vs. License

        2. Transfer of Copyrighted Articles

            a. Definition

            b. Sale vs. Lease

            c. Proposed Sourcing Rule for Digital Content Transferred Through an Electronic Medium

        3. Provision of Know-How

        4. Provision of Services

    C. Interaction With §482

    D. Sourcing Income From Cloud Computing Transactions

        1. Definition of Cloud Computing and Cloud Transactions

        2. Characterization and Sourcing of Cloud Transactions

XV. Other Income and Special Rules

    A. Miscellaneous Statutory and Regulatory Rules

        1. U.S. Social Security Benefits

        2. Amounts Includible From Controlled Foreign Corporations and Certain Passive Foreign Investment Companies

            a. General Rules

            b. Exception Where Foreign Corporation Is U.S.-Owned and Has Significant U.S. Income

        3. Income Earned by an FSC or by Related Supplier on Sales Through an FSC

        4. Extraterritorial Income Exclusions

        5. Section 306 Stock

        6. Certain §367 Inclusions, §1248 Gain, and §1291 Gain

        7. Accumulated Earnings Tax

        8. Section 864(e)(7) — Affiliated Groups

        9. Individuals Who Expatriated Before June 17, 2008

        10. Income From Countries Supporting International Terrorism or With Which the United States Lacks Diplomatic Relations

        11. Section 904(b), (f), (g), (h) and (i) — Foreign Tax Credit

        12. Intangible Property Income of Possessions Corporation

        13. Market Discount

    B. Rules Derived by Analogy

        1. Certain Financing Fees

            a. Letter of Credit Fees

            b. Loan Guarantee Fees for Guarantees Issued Before September 27, 2010

            c. Standby Loan Commitment Fees

            d. Loan Fees for Services

        2. Tax Refunds

        3. Damages and Settlement Payments

        4. Expropriation Recoveries

        5. Property and Casualty Insurance Recoveries

        6. Life Insurance Proceeds and Annuities

        7. Noncompetition Payments

        8. Unemployment Benefits

        9. Alimony

        10. Fellowships, Scholarships, Awards, and Prizes

        11. Wagers and Lotteries

        12. Option Payments

        13. Futures Trading Income

        14. Cancellation of Indebtedness Income

        15. Agricultural Export Subsidies

TABLE OF WORKSHEETS

lubkin-gregory-2015
Gregory Lubkin
Director
PricewaterhouseCoopers LLP
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