This blog is a primer on the source of interest rules. It is a four-part series.
Let’s begin with some basics. The U.S. taxes U.S. persons on their worldwide income.
Why are the source of interest rules important? Because sourcing can have a significant effect on the computation of a U.S. person’s foreign tax credit limitation. The foreign tax credit limitation equals the portion of the pre-credit U.S. tax that is attributable to foreign-source income.
For those who think analytically, the formula for calculating the foreign tax credit limitation is as follows:
Foreign Tax Credit Limitation = Pre-credit U.S. tax x (Foreign-source taxable income / Worldwide taxable income)
The limitation establishes a ceiling on the amount of foreign taxes that can offset U.S. taxes. It is designed to prevent U.S. persons operating in high-tax foreign countries from offsetting those higher foreign taxes against the U.S. tax on domestic income.
When a U.S. person’s creditable foreign taxes are less than the limitation, the cost of paying foreign income taxes is entirely offset by the U.S. tax savings associated with the credit. Therefore, foreign taxes do not represent an out-of-pocket tax cost for the U.S. person.
In contrast, when a U.S. person’s creditable foreign taxes exceed the limitation, the non-creditable foreign income taxes increase the U.S. person’s total tax burden beyond what it would have been if only the U.S. had taxed the foreign-source income.
Consider the following example. USAco is a domestic corporation. It has taxable income of $ 1,000, all of which is attributable to a foreign branch operation. Assume that the U.S. tax rate is 35%.
Scenario 1: When a U.S. person’s creditable foreign taxes are less than the limitation: If USAco’s foreign branch is subject to foreign taxation at a 30% rate, USAco can claim a credit for the entire $ 300 of foreign taxes paid, as follows:
1. Step 1: What is the Foreign tax credit limitation?
a. Foreign Tax Credit Limitation = Pre-credit U.S. tax x (Foreign-source taxable income / Worldwide taxable income)
b. Pre-credit U.S. tax = .35 x $ 1,000 = $ 350
c. Foreign source taxable income = $ 1,000
d. Worldwide taxable income = $ 1,000
e. Foreign Tax Credit Limitation = $ 350 x ($ 1,000 / $ 1,000) = $ 350
2. U.S. Tax Return
a. Taxable income: $ 1,000
b. Tax rate: 35%
c. Pre-credit tax: $ 350
d. Foreign tax credit: – $ 300 (i.e., .30 x $ 1,000)
e. U.S. tax: $ 50
3. Foreign Tax Return
a. Taxable income: $ 1,000
b. Tax rate: 30%
c. Foreign tax: $ 300
4. The total tax burden on USAco’s foreign profits is $ 350 [$ 50 U.S. tax (+) $ 300 foreign tax].
Scenario 2: When a U.S. person’s creditable foreign taxes exceed the limitation: The foreign tax credit limitation equals the U.S. tax of $ 350 on USAco’s foreign source income. If USAco’s branch is subject to foreign taxation at a 40% rate, the foreign tax credit limitation will prevent USAco from claiming a credit for $ 50 of the $ 400 of foreign taxes paid.
1. U.S. Tax Return
a. Taxable income: $ 1,000
b. Tax rate: 35%
c. Pre-credit tax: $ 350
d. Foreign tax credit: – $ 350
e. U.S. tax: $ 0
2. Foreign tax return
a. Taxable income: $ 1,000
b. Tax rate: 40%
c. Foreign tax: $ 400
3. Foreign taxation now increases the total tax burden on USAco’s foreign profits from $ 350 to $ 400, resulting in $ 50 out-of-pocket tax costs.
Just because an item of income is taxed in a foreign country doesn’t necessarily mean that under the U.S. sourcing rules it is foreign source income. Conversely, an item of income may not be subject to foreign tax but under the U.S. rules, it may nevertheless be treated as foreign source income. An important distinction must be made. The issue is not whether the income is subject to tax in a foreign country. Instead, the issue is whether the income is foreign source or U.S.-source. For purposes of this discussion, we’re going to assume that the income is subject to tax in a foreign country.
The source of interest rules are not only important for U.S. persons doing business abroad but also for foreign persons who operate in the U.S. Why? Because they effectively define the boundaries of U.S. taxation. For example, the U.S. taxes the gross amount of a foreign person’s U.S.-source nonbusiness income at a flat rate of 30%. The U.S. also taxes foreign persons at graduated rates on the net amount of income effectively connected with the conduct of a U.S. trade or business.
The overriding policy behind the sourcing rules is to source income where the economic activity occurs. Determining the source of income is a two-step process. Step one is to determine the applicable statutory category. And step two involves using the applicable source rule to classify the item of income as either U.S. or foreign-source.
Let’s take a closer look at step one. The source rules for gross income are organized by categories of income, such as interest, dividends, personal services income, rentals, royalties, and gains from the disposition of property. Below is a chart that displays the general rules for sourcing gross income:
| Type of income | U.S.-source income if: | Foreign-source income if: |
| Interest income | D/or is a U.S. resident or a domestic corp. | D/or is a foreign resident or a foreign corp. |
| Dividends | Payer is a domestic corp. | Payer is a foreign corp. |
| Personal Services Income | Services are performed in the U.S. | Services are performed abroad |
| Rentals and royalties | Property is used in U.S. | Property is used abroad |
| Gain on sale of real property | Property is located in U.S. | Property is located abroad |
| Gain on sale of inventory purchased for resale | Title passes in U.S. | Title passes abroad |
| Gain on sale of inventory manufactured by TP | Allocated between U.S. and foreign sources using the 50-50 method | Allocated between U.S. and foreign sources using the 50-50 method |
| Gain on sale of securities | Seller is a U.S. resident | Seller is a foreign resident |
| Gain on sale of depreciable property | Title passes in U.S. | Title passes abroad |
| Gain on sale of patents and other intangibles | Seller is a U.S. resident | Seller is a foreign resident |
This determination is sometimes ambiguous! For example, the same item of income may be allocated between U.S. and foreign sources differently, depending on how it is classified. Consider the following two examples.
Example # 1
a. Facts: Assume that the taxpayer is an orchestra conductor. A U.S. record company hired him to conduct various songs at a recording session that took place in the U.S. The taxpayer was compensated based on a percentage of the sales of the recording, which is owned by the record company. Most of the record sales took place outside the U.S.
b. Sourcing rules that apply: Personal services income is sourced based on where the services are performed. Royalty income is sourced based on where the intangible is used.
c. Analysis: The taxpayer’s income is entirely U.S.-source income if it is classified as personal services income because the taxpayer conducted all of the songs in the U.S. However, it is mainly foreign-source income if it is classified as royalty income because most of the records were sold outside the U.S.
Example # 2
a. Facts: John is a prolific writer who writes books on the topic of international taxation. John’s publisher asks him to write a book about transfer pricing. So that he will be able to research and write the book without any distractions, John’s publisher arranges for him to stay in the Netherlands for a couple of months. John will be paid $ 10 for each book sold. Not too tech savvy, John plans on writing the 2,000 page manuscript on a typewriter.
b. Issue: What is the source of John’s income?
c. Analysis: There are three possibilities.
1. First, a royalty. If so, it will be U.S. source income if the book is sold in the U.S.
2. Second, personal services income (i.e., if the book publisher pays John a set amount for writing the book). Because John is performing this service in the Netherlands, a foreign country, it will be foreign-service income.
3. Third, John supplies his publisher with the 2,000 page type-written manuscript. This is tangible personal property. As such, it might fall under the tangible personal property rules which are sourced from the taxpayer’s tax home. Here, that would be the United States, where John lives.
Stay tuned for future blogs that explain the sourcing of other types of income.