501: Overview.
Income from the sale of personal property is sourced based on the residence of the Seller. Code Sec. 865(a). Income from the sale, exchange or other disposition of personal property by a U.S. resident is U.S. source. Conversely, income from the sale by a nonresident is foreign source. Code Sec. 865(a). There are specific exceptions to this general rule that apply to the sale of inventory, depreciable personal property, intangibles and stock of affiliates. As a result, generally only portfolio stocks, bonds, or other financial instruments would fall within the general rule.
505: In General
Sourcing for the sale of personal property is based on the residence of the seller. Where the seller is a resident of the United States, a gain from the sale of personal property will be U.S. source and where the residence of the seller is other than the U.S., the gain from the sale of personal property will be foreign source. Code Sec. 865(a). A United States resident includes the following:
(1) Any individual who is a United States Citizen,
(2) A U.S. Resident Alien with a tax home in the United States,
(3) A Nonresident Alien with a tax home in the United States, and
(4) Any U.S. corporation, U.S. trust or U.S. estate. Code Sec. 865(g)(1)(A).
A nonresident means any person other than a United States resident. Code Sec. 865(g)(1)(B).
In the case of a partnership, the seller’s residence shall be determined at the partner level. Code Sec. 865(i)(5). However, where the partnership is engaged in a U.S. trade or business, each partner shall be treated as having effectively connected income. Code Sec. 875(1).
Example 1: USP is a partnership organized in the United States and has two partners, Mr. USA and Mr. NRA. USP is not engaged in a U.S. trade or business and sells rare antique coins in Europe. The source of the income from the sale of these coins shall be U.S. source for partner Mr. USA and foreign source for partner Mr. NRA.
To determine whether an individual is a resident for sourcing the income from the sale of a personal property, a determination of the individual’s tax home needs to be made. An individual’s tax home is generally his principle place of business or if the individual has no regular place of business because of the nature of his business, then its his regular place of abode in a real and substantial sense. Reg. § 1.911-2(b).
Example 2: Mrs. NRA came to America to study in college. While here, she discovered that Americans enjoy candies prepared from recipes originating in her home country. She established a successful business in the United States and it is her principle business. While Ms. NRA does not live in the U.S. more than 183 days each year, the sale of personal property by Ms. NRA will be U.S. source since she is deemed a resident for sourcing of personal property sales, regardless of whether they are effectively connected with a U.S. trade or business.
Example 3: Mrs. NRA is a sales woman who travels extensively through the world to sell machinery. Her house and abode are in Europe. Mrs. NRA sells a painting in the United States and she does not spend more than 183 days a year in the United States. The gain from the sale of this painting would be foreign source as Mrs. NRA is deemed to be a nonresident for purposes of sourcing the income from sales of personal property. While Mrs. NRA does not have a regular place of business she does have a regular place of abode and therefore her tax home is in Europe. For further discussion of tax home, see Stand. Fed. Tax Rep. (CCH) ¶ ____.
Example 4: USCO sells stock in Euro Corp. The income from the sale of this personal property will be U.S. source as USCO is a U.S. resident.
515: Exception for Inventory Property.
(A) In General
Income from the sale of inventory property is generally sourced, based on the title passage test. Code Sec. 865(b). If title passes inside the U.S., the income from the sale is U.S. source. Code Sec. 861(a)(6). If title passes outside the U.S., income from the sale is foreign source. Code Sec. 862(a)(6). The term "inventory property" means stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer primarily for sale to customers in the ordinary course of his trade or business. Code Sec. 1221(a)(1).
(B) Title Passage Rule
A sale of property is consummated at the time and the place where the rights, title and interest of the seller in the property are transferred to the buyer. Commercial Law should be consulted to determine where title passes. Generally commercial law provides that a shipment F.O.B. point of sale results in title passage in the country where the personal property is shipped. Alternatively, F.O.B. destination results in title passage when the goods are delivered at their destination. Title passes at the point where the benefits and burdens of ownership transfer from the seller to the buyer. For this reason, where the seller is required to deliver the products to the destination, risk of loss does not pass until the products are delivered at the destination. Likewise, where the risk of loss transfers to the buyer at the seller’s loading dock, title is deemed to transfer to the buyer at the seller’s loading dock.
For the sales of inventory, tax law generally follows commercial law in sourcing income; in that the income is sourced in the country where risk of loss and therefore title passes.
Example 1: F Co. sells leather furniture to Americans. F Co.’s terms for sale are F.O.B. their Italian warehouse. Therefore, the source of income from selling this Italian leather furniture is all foreign source, regardless of the fact that all of the Italian furniture is used and consumed in the U.S. by U.S. purchasers.
Example 2: Same as Example 1, except the terms of shipping are F.O.B. USCO’s warehouse in Miami, Florida. Now the risk of loss does not shift until the goods are delivered in Miami, Florida. F Co. would now have U.S. source income from the sale of this Italian leather furniture.
Planning Note: With the sale of inventory, the seller can determine whether they would prefer to have U.S. source or foreign source income simply by adjusting the terms of the sale. Where the buyer desires not to assume the risk of loss until it is delivered, the seller can still have the risk of loss shift at its warehouse where the shipping terms are C.I.F. (Cost Insurance and Freight). C.I.F. means that the buyer pays for the cost of the merchandise which is shipped F.O.B. seller’s warehouse and also pays for insuring the product and freight for the product during the time it is in transit from the seller’s warehouse to the buyer’s warehouse. For all practical purposes, both parties obtain exactly what they bargained for and the seller is still provided the opportunity to classify the sale as a foreign sale.
Where the seller transfers the risk of loss but maintains bear legal title, the sale is deemed to occur at the time and place of passage of the beneficial ownership and risk of loss to the seller. If a sale transaction is arranged in a particular manner for the primary purpose of tax avoidance, the substance of the transaction will determine where the sale has occurred. In such cases, all factors of the transaction, such as negotiations, execution of the agreement, the location of the property, and the place of payment will be considered, and the sale is treated as being consummated at the place where the substance of the sale occurred. Reg. § 1.861-7(c).
Example 3: USCO sold to its U.S. customers whiskey which it had purchased from UK Co. The U.S. customers would order whiskey from USCO and USCO would place the order with UK Co. for the delivery of such whiskey in America. UK Co. passed title to USCO when the whiskey was delivered to the ship. USCO immediately assigned title to the goods to its U.S. customers. The income which USCO earned is foreign source, since title passed from USCO to its U.S. customers in the U.K. Liggett Groups, Inc. v. Comm. T.C. Memo 1990-18.
The title passage test also applies to sales of inventory by nonresidents. However, income from the sale of inventory attributable to a U.S. office or a fixed place of business of a nonresident is generally treated as U.S. source even though title passed outside the U.S. Code Sec. 865(e)(2)(A).
Example 4: F Co. has an office in Miami which materially participates in all of the sales to South America. All sales are made F.O.B. F Co.’s shipping dock. The source of the income from the sale of F Co.’s products will be U.S. source.
There is one exception to this special rule, income attributable to a U.S. office can still be treated as foreign source if the inventory sold for use outside the U.S. and an office or other fixed place of business of the taxpayer outside the U.S. materially participates in the sale. Code Sec. 865(e)(2)(B).
(C) Manufactured Here/Sold There.
(1) In General
There are special rules for determining the source of income from the sale of property manufactured in the U.S. and sold outside or manufactured outside the U.S. and sold in the U.S. These rules provide that first there must be an allocation of income between manufacturing profit and selling profit. Once this allocation has been made, there then needs to be a sourcing of each type of income to determine what, if any portion, of each type of profit is attributable to the United States.
For purposes of allocating profits between manufacturing and selling, the regulations provide three methods:
(a) 50-50 Method;
(b) Independent Factory Price Method; and
(c) Books and Records Method. Reg. § 1.863-3.
(2) 50-50 Method.
The 50-50 Method provides for an even split of gross income between manufacturing profit and sales profit.
Example 5: USCO produces microchips and sells them to an unrelated foreign distributor for $100. USCO’s cost of goods sold is $40 which results in the $60 gross income from the sale of these microchips. USCO elects the 50-50 Method and therefore has $30 of gross income attributable to production activity and $30 of income attributable to sales activity.
(3) Independent Factory Price Method (IFP).
An IFP is established where the taxpayer regularly sells part of its output to wholly independent distributors in such a way as to reasonably reflect an arm’s length price for the income earned from the production activity. The independent factory price would be used to allocate the amount of income attributable to production and anything above the independent factory price would be allocated to the sales activity.
An IFP will only be applied to apportionable sales that are reasonably contemporaneous with the sale fairly establishing the IFP. An IFP cannot be applied to sales in other geographic markets, if the markets are substantially different. Where the taxpayer elects to apply the IFP Method, the IFP Method must be applied to all sales and must be applied for the tax year and each subsequent tax year.
Example 6: USCO manufactures bicycle wheels which they sell to various independent distributors throughout the world. However, USCO sells its bicycle wheels in the U.K. through its own branch office. USCO sells its wheels to wholesalers outside of the U.S. at $6 per wheel. USCO’s U.K. branch is selling these wheels to their retail customers for $10 per wheel. Where $6 is deemed to be an IFP, USCO will have $6 U.S. source manufacturing income and $4 foreign source sales income.
Caution: Where USCO’s $6 price is established in markets which are geographically different (e.g. third world countries) to the U.K., it will not be considered a valid IFP.
For more information on Independent Factory Pricing and the elements to prove or disprove the validity of an IFP, see Stand. Fed. Tax Rep. (CCH) ¶ ____.
Caution: Where the facts in Example 6 involve a foreign manufacturer with a U.S. sales office, the above-mentioned rules would not apply and 100% of the income would be U.S. source income. See ¶555 (B) below.
(4) Books and Records Method.
Where the taxpayer can establish to the satisfaction of the district director that its book of accounts details allocation of receipts and expenditures, which clearly reflects the amount of income from production and sales activities and is unaffected by considerations of tax liability, then they may receive permission to use their books and records for apportioning the income between manufacturing the sales activities. Reg. § 1.863-3(b)(3).
(5) Sourcing Manufacturing and Sales Income.
After income has been allocated between manufacturing and sales income, the manufacturing and sales income needs to be classified as U.S. or foreign source. Reg. § 1.863-3(c).
The formula to source manufacturing income is as follows:
Manufacturing x Production Assets in the U.S. = U.S. Source
Taxable Income Production Assets Manufacturing
Worldwide Income
There is no formula for sourcing sales income. Income which is allocated as sales income, shall be sourced pursuant to title passage rules applicable to sales of inventory, discussed at ¶515(B) above.
Total U.S. source income is the sum of U.S. source manufacturing income plus the U.S. source sales income. The residual amount of income will be foreign source.
Taxable income is determined by first deducting expenses, losses, or other deductions allocable to such income along with a ratable part of any expenses, losses and deductions, which cannot definitely be allocated to some item or class of gross income prior to allocating and apportioning gross income between manufacturing and selling activities. Then taxable manufacturing and sales income is sourced as U.S. or foreign. Code Sec. 863(a) and Reg. § 1.863-3(d).
(D) Source of Possession Manufactured or Purchased Inventory.
(1) Apportionment Rules for U.S. Sales of Possession Purchased Inventory.
Code Sec. 863(b) allows for a "Split-Source" Rule, which provides that certain income is U.S. source income in part and foreign source income in part. The Split-Source Rule applies to inventory property purchased in a U.S. possession and sold in the United States. A taxpayer may elect to have such income apportioned under the Business Activity Method or the Books and Records Method. Reg. § l.863-3(f)(3)(i).
(a) Business Activity Method.
Under the Business Activity Method, gross income from a taxpayer's business activity is sourced in the possession in the same proportion that the amount of the taxpayer's business activity for the tax year within the possession bears to the amount of taxpayer's business activity for the tax year both within and without the possession. The remaining income is sourced in the United States. Reg. § l.863-3(f)(3)(ii)(B). Business activity for this purpose includes the sum of all costs associated with operating the business, plus cost of goods sold, plus amount received from gross sales. Reg. § 1.863-3(f)(3)(ii)(B).
(b) Books and Records Method.
Alternatively, a taxpayer may elect to allocate gross income using the Books and Records Method as previously discussed in ¶515(C)(4) above.
(2) Apportionment Rules for Possession Production Sales.
Allocation of income among foreign and domestic sources for the sale of products that were manufactured in a U.S. possession and then sold abroad may be done by one of the following three methods: The 50-50 Method, the IFP Method or the Books and Records Method.
(a) 50-50 Method.
Under the 50-50 Method, one half of the taxpayer’s income will be considered income attributable to production activity and the remaining one half of such gross income will be considered income attributable to business sales activity. Reg. § 1.863-3(f)(2). That portion of the taxpayer's income that is attributable to production activity is sourced where the taxpayer's production assets are located. Reg. § 1.863-3(c)(1). That portion of the taxpayer's income that is attributable to business sales activity is sourced in the same manner as the Business Activity Method discussed in ¶515(D)(1)(a) above.
(b) IFP or Books and Records Method.
In lieu of the 50-50 Method, a taxpayer may elect the Independent Factory Price (IFP) Method described in ¶515(C)(3) above, or the Books and Records Method described in ¶515(C)(4) above.
(E) Production and Sale of Natural Resources and Farm Products.
Income from the sale outside of the United States of products derived from the ownership or operation of any farm, mine, oil or gas well, other natural deposits or timber within the United States, or vise versa, must be allocated between sources within and without the United States based on the fair market value of the product at the export terminal. Reg. § 1.863-l(b)(l).
If the products were produced outside of the United States, the export terminal is the final point in the foreign country from which the goods are shipped. Reg. § l.863-l (b)(3)(iii). If there is no such final point, (e.g. the property was produced and extracted from the high seas), the export terminal is the place of production. Where the products are produced in the United States, the export terminal is the final point in the United States from which the goods are shipped to the foreign country. The location of the export terminal is determined without regard to any contractual terms agreed to by the taxpayer and without regard to whether there is an actual sale of the products at the export terminal. Fair market value is based on all of the facts and circumstances surrounding the sale. Reg. § l.863-1(b)(4).
Gross receipts equal to the fair market value of the product at the export terminal will be sourced to the location of the farm, mine, well, deposit, or uncut timber. Gross receipts in excess of the fair market value at the export terminal will be determined as follows:
(a) If the taxpayer engages in additional production activities subsequent to shipment from the export terminal and outside of the country of sale, the source of excess gross receipts must be determined under Reg. § 1.863-3 as discussed in ¶515(C) above.
(b) In all other cases, excess gross receipts will be sourced to the country of sale.
Production activity means any activity that creates, fabricates, manufactures, extracts, processes, cures or ages inventory. Reg. § 1.864-1.
525: Exception for Depreciable Personal Property.
(A) In General
Gain (not in excess of the depreciation adjustments) from the sale of depreciable personal property is allocated between U.S. and foreign sources based on the proportion of depreciation deductions previously allowable in computing U.S. taxable income and foreign source taxable income. Code Sec. 865(c).
Gain in excess of depreciation recapture is sourced under the title passage test. Code Sec. 865(c)(2). If depreciable property is used predominantly inside or outside the United States in any tax year, the depreciation for such year is treated as entirely U.S. or foreign source, as the case may be. However, neither the statute nor the committee reports define the term predominantly for this purpose. Code Sec. 865(c)(3)(b).
This resourcing rule for depreciable personal property also applies to depreciable personal property of nonresidents, subject to the office or fixed place of business exception contained in Code Sec. 865(e)(2).
Example 1: F Co. is engaged in business around the world and has a U.S. trade or business. F Co. has many portable computers which its employees use throughout the world and in Y1 through Y3, 37% of the computer’s time is used in the United States. At the end of Y3, F Co. sells its portable computers in Europe for $100,000 and recognizes a gain of $100,000, since it had fully depreciated its original $500,000 cost basis to 0 during the first three years of use. F Co. will have 37% of its gain taxed as U.S. source under the depreciation recapture rules stated above. The remaining $63,000 will be foreign source, since the sale took place outside the United States and title passed outside the United States.
Caution: The depreciation resourcing rules consider depreciation allowed or allowable. This is important since depreciation, which was allowed but was not actually taken as a deduction on the nonresidents U.S. tax return, will still be subject to being resourced in the United States pursuant to the depreciation recapture resourcing rules. Code Sec. 865(c)(3).
Example 2: Same facts as Example 1, except that F Co. never filed a U.S. tax return and never got the benefit of taking $185,000 of U.S. source depreciation deductions ($500,000 cost x 37% use in the United States). F Co. would still be required to resource $37,000 of its gain to the U.S.
535: Exception for Intangible Personal Property.
(A) In General
Generally, intangible personal property is treated like any other personal property and is source based on the residence of the seller. Code Sec. 865(a).
(B) Exception for Contingent Sales of Intangible Property.
To the extent an intangible personal property is sold and the consideration for the sale is contingent on the productivity, use, or other disposition of the intangible, then the income from the sale shall be recharacterized as royalty payments and shall not be sourced pursuant to the general rule based on the residence of the seller. Code Sec. 865(d).
Example 1: See Example 7, Chapter 4 for application of sourcing rule to an intangible which has both a noncontingent and a contingent purchase price.
(C) Resourcing Amortization on Intangibles.
Noncontingent sale of intangibles are source based on the residence of the seller. However where that intangible was also subject to an amortization allowance, then the depreciation recapture rules discussed above will resource a portion of the gain as U.S., up to the amount of amortization allowed or allowable in the United States. Code Sec. 865(d)(4).
(D) Special Rule for Goodwill.
Income from the sale of goodwill is sourced in the country in which the goodwill was generated. Code Sec. 865(d)(3).
Planning Note: Due to the difficulty in determining where goodwill is generated, consideration should be given to obtaining an appraisal that provides both the amount and where the goodwill was generated.
545: Exception for Stock of Affiliates.
Any gain from the sale of stock of an affiliate (an 80% or more owned subsidiary as defined in Code Sec. 1504(a)) by a U.S. resident is treated as foreign source income, if:
(1) the affiliate is a foreign corporation,
(2) the sale occurs in a foreign country in which the affiliate is engaged in the active conduct of a trade or business, and
(3) the sale occurs in a foreign country in which the affiliate derived more than 50% of its gross income for the last three tax years proceeding the year of the sale. Code Sec. 865(f).
This exception only applies to U.S. residents, therefore, it has no relevance for NRAs or foreign corporations.
555: Exception for Sales through an Office or Fixed Place of Business.
(A) Sales by U.S. Residents.
Income from the sale of any personal property that is not sourced under the normal rules, the special inventory rules, the depreciation recapture rules, the contingent intangible sales rules, or the disposition of stock of affiliate rules; which is attributable to a fixed place of business outside the U.S. will be foreign source, if at least a 10% income tax is actually paid to a foreign country on such income. Code Sec. 865(e)(1).
(B) Sales by Nonresidents.
Notwithstanding any other exceptions, income from the sale of personal property including inventory, depreciable personal property, intangibles, by a nonresident that is attributable to a fixed place of business inside the U.S. is treated as U.S. source income except for: (1) export trade corporations under Code Sec. 971 and (2) income from the sale of inventory for the use outside of the United States if an office or a fixed place of business of the taxpayer outside the U.S. materially participates in the sale. Code Sec. 865(e)(2). This rule takes precedence over all rules including the allocation and apportionment rules for items manufactured abroad and sold here which is discussed at ¶505(C) above.
Example 1: F Co. manufactures sneakers in Asia. F Co. has an office in the United States which sells these sneakers. In Y1, F Co. sells $1,000,000 of sneakers in the United States. F Co. will have $1,000,000 of U.S. source taxable income. The allocation and apportionment rule for allocating income between manufacturing and sales income and then sourcing these two different types of income, does not apply.
(C) Definition of U.S. Resident.
A United States resident includes the following:
(1) Any individual who is a United States Citizen,
(2) A U.S. Resident Alien with a tax home in the United States,
(3) A Nonresident Alien with a tax home in the United States, and
(4) Any U.S. corporation, U.S. trust or U.S. estate. Code Sec. 865(g)(1)(A).
A nonresident means any person other than a United States resident. Code Sec. 865(g)(1)(B).
565: Special Sourcing Rules.
(A) Treatment of losses from the sale of personal property other than inventory property.
Income from the sale of non-inventory personal property is generally sourced to the residence of the seller. Code Sec. 865. The Tax Court has held that the same rule is generally applicable in sourcing losses realized on the sale of such property. See International Multifoods Corporation and Affiliated Companies v. Comr. 108 T.C. 579 (1997). In Multifoods, the IRS argued that Section 865 applied only for the purposes of sourcing "income" and that the rules of Sections 861(b) and 862(b) still apply for sourcing losses. The Tax Court held that the IRS's reliance on Sections 861(b) and 862(b) is misplace because TRA 1986 amended those sections to eliminate their applicability to the sale of non-inventory property. See Id at 585. "Congress intended to change the rules [in TRA 1986] regarding the allocation of losses realized on the sale of non-inventory personal property.” Id at 586. The legislative history of Section 865 indicates that it is intended to apply to sourcing of both income and losses, not just “income.” See Id at 588-89.
The Treasury issued regulations which embrace the Tax Court’s ruling in Multifoods and provide that losses shall be sourced pursuant to Code Sec. 865. Temp. Reg. § 1.865-1T.
(1) General Rules for the Allocation of Loss.
(a) Allocation against Gain.
Loss recognized with respect to personal property other than stock will be allocated to the class of gross income with respect to which gain from the sale of such property would give rise in the hands of the seller. For example, loss from the sale of a bond held by a U.S. resident will be allocated against U.S. source income.
Example 1: U.S. Corp. purchases a $1,000 bond from Foreign Corp. in January of 1997 with a stated principal amount of $1,000 payable at maturity. The bond provides for unconditional interest payments of $100, payable December 31st of each year. Interest on the bond is foreign source interest income. Between 1997 and 2001 U.S. Corp. receives $500 of foreign source interest income with respect to the bond. On January 1st, 2002 U.S. Corps. sells the bond and recognizes a $500 loss. Pursuant to Temp. Reg. § 865-1T(a)(1), the $500 loss is allocated against U.S. source income.
(b) Loss Attributable to Foreign Office.
Loss recognized by a United States resident with respect to property that is attributable to an office or other fixed place of business in a foreign country shall be allocated to reduce foreign source income if the gain on the sale of such property would have been taxable by the foreign country and the highest marginal rate of tax imposed on such gains in the foreign country is at least 10%. However, loss from the sale of property will not be sourced or attributable to a foreign office when the special sourcing rules which are applicable to sourcing of depreciation, sourcing of contingent payments for intangibles or for goodwill apply. Temp Reg. § 1.865-1T(a)(2).
(c) Loss Recognized by United States Citizen or Resident Alien with a Foreign Tax Home.
Loss from the sale of non-inventory personal property owned by a United States citizen or resident alien that has a tax home in a foreign country shall be allocated to reduced foreign source income, if the gain on the sale of such property would have been taxable by the foreign country and the highest marginal rate of tax imposed on such gains in the foreign country is at least 10%.
(d) Allocation for Purposes of Section 904.
For purposes of Code Sec. 904, loss from the sale of non-inventory personal property that is allocated to foreign source income shall be allocated to the separate category to which gain on the sale of such property would have been assigned. For purposes of Reg. § 1.904-4(c)(2)(ii)(A), any such loss allocated to passive income shall be allocated to the group of passive income to which gain on the sale of such property would have been assigned had a sale of the property resulted in the recognition of a gain under the law of the relevant foreign jurisdiction or jurisdictions.
(e) Loss Recognized by a Partnership.
A partner's distributive share of loss recognized by a partnership with respect to the sale of personal property other than inventory property shall be allocated and apportioned in accordance with these rules as if the partner had recognized the loss. If loss is attributable to an office or other fixed place of business of the partnership within the meaning of Code Sec. 865(e)(3), such office or fixed place of business shall be considered to be an office of the partner for purposes of this section.
(2) Exceptions to Loss Sourcing Rules.
The above-mentioned loss sourcing rules may only apply to a portion of the income, where the property being sold is depreciable personal property or a contingent payment debt instrument. The loss sourcing rules will only apply to that portion which is not otherwise sourced pursuant to the special sourcing rules for depreciable property and contingent payment debt instruments. Temp. Reg. § 1.865-1T(b).
The loss sourcing rules will also not apply to sourcing losses from the disposition of foreign currency and certain financial instruments, inventory, trade receivables, bonds with un-amortized bond premiums and debt instruments with accrued interest. Temp Reg. § 1.865-1T(c). There are special rules for sourcing these types of income which take precedence over the general loss sourcing rules.
The regulation also contains an exception to the personal property loss allocation rules for situations in which one of the principle purposes of a transaction was to change the allocation of a built-in loss or achieve offsetting positions with respect to the personal property in an abusive arrangement. See Temp. Reg. § l.865-1T(b)(6)(i). This anti abuse provision applies where the recognition of foreign source income results in the creation of a corresponding loss and provides that such loss shall also be allocated to the income which was artificially generated by the transaction.
(B) Treaty Protection on the Sale of Intangible or Foreign Stock.
Generally the sourcing rules under Code Sec. 865, supercede any conflicting provisions of a treaty that was ratified earlier in time. Code Sec. 7852(d). However, Code Secs. 865(h)(1) and (h)(2) create an exception to this general rule. Under these provisions, a taxpayer may elect to treat gain from the sale of stock of a foreign corporation or from the sale of an intangible (which is defined in Code Sec. 865(d)(2)) as foreign source, notwithstanding the fact that it would be treated as domestic source under Code Sec. 865, if it would be treated as foreign source under an applicable treaty. The provisions of any treaty ratified after the enactment of Code Sec. 865 should govern even without an election under Code Sec. 865(h).
(C) Liquidation of Possessions Corporations.
Gains realized from the liquidation of a possessions corporation is foreign source if the corporation derived more than 50% of its gross income for the preceding three years from the active conduct of a trade or business within that possession. Code Secs. 865(h)(1) and (h)(2)(B). However, Code Secs. 904, 902, 907 and 960 must be applied separately with respect to each gain.
(D) Section 306 Stock.
All or part of the gain realized from the sale of certain preferred stock received in a transaction deemed to give rise to the potential for “bailout” of corporate earnings is taxed as ordinary income. Code Sec. 306(a)(1). Only that portion of the stock that would have been a dividend had the corporation distributed money is taxed as ordinary income. The amount that is treated as ordinary income is sourced as it would have been had it been distributed as a dividend. Code Sec. 306(f). The portion which is considered to be U.S. source dividend income may be subject to the 30% U.S. gross basis withholding tax. The portion that is not treated as a dividend is sourced in accordance with the general rules governing the sale of personal property.
(E) Gain from Incorporation of Foreign Branch.
Section 367(a)(3)(C) provides a special recapture rule for foreign branches of U.S. corporations. Under this rule, any gain realized by incorporating a foreign branch is recognized to the extent that losses were previously incurred by the foreign branch and deducted from the U.S. corporations U.S. taxable income. Any gain recognized under this rule is treated as U.S. source.
(F) Gain under Code Secs. 1248, 1291 and 338.
In certain situations, Code Sec. 1248 will re-characterize gain from the disposition of foreign stock as a dividend. Code Sec. 1248 applies if the taxpayer owns, or owned during the preceding five years, 20% or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation and the corporation must have been a "controlled foreign corporation as defined in Code Sec. 957" during such period. The amount of gain that is re-characterized as a dividend, is an amount equal to the corporation’s earnings and profits which are earned and accumulated during tax years after December 3l, 1962, while the corporation was a controlled Foreign Corporation that are attributable to the stock sold or exchanged by the taxpayer. The portion of the gain which is re-characterized a dividend is sourced under the dividend sourcing rules. The remaining gain that is not re-characterized as a dividend is sourced as a sale of personal property.
If a person owns stock in a passive foreign investment company (PFIC), which is taxable under Code Sec. 1291, then Code Sec. 1248 does not apply. A portion of the gain realized by the sale of such stock is treated as an "excess distribution" which is taxable as ordinary income. Code Sec. 1291(a)(2).
Pursuant to Code Sec. 338, certain stock purchases will be treated as asset acquisitions. If the purchasing corporation makes an election under Code Sec. 338 (or is deemed as having made one by sub-section (e)), then, in the case of any qualified stock purchase, the purchase is deemed to be a sale by the target of all of its assets and a reacquisition of those assets by a deemed new corporation. Such an election may be beneficial if the target is a domestic company with a foreign subsidiary. The deemed sale of the foreign subsidiary's share may be re-characterized as dividend income pursuant to Code Sec. 1248, thereby increasing the foreign tax credit allowed under Code Secs. 901-902.
(G) Sale of Partnership Interests.
The source rules are generally silent with respect to the sale of a partnership interest. However, Code Sec. 897(g) sets forth a special rule that applies to partnerships holding U.S. real property interest (USRPI). Under Code Sec. 897(g) any amount received upon the sale of an interest in such a partnership may be treated as received from the sale of a USRPI to the extent attributable to the USRPI held by the partnership. Sales of partnership interests not so treated are treated as sales of personal property.
(H) Imputed Interest.
The source rules are silent with respect to imputed interest. However, in some situations, gains may be re-characterized as interest, in which case the source rule applicable to interest income will apply. For example, certain sections may re-characterize proceeds from the sale of property for deferred payments as interest. Code Secs. 1272 and 1273. Gains that are re-characterized as interest income will be sourced under the relevant sourcing rule for interest income.
(I) Exception for Foreign Tax Credit Purposes on Deemed Disposition of Assets of Overall Foreign Loss Branch.
Code Sec. 904(f)(1) provides a recapture rule which limits the availability of the foreign tax credit in situations where a foreign branch of a U.S. corporation sustained an overall foreign loss in a preceding tax year. This rule recharacterizes previous foreign loss deductions as U.S. source income, in situations where a foreign branch of a U.S. corporation which previously sustained overall foreign losses, has now become profitable.
In the case of a U.S. corporation which incorporates or otherwise disposes of a foreign branch, which has previously sustained an overall foreign loss, Code Sec. 904(f)(3) provides a special recapture rule which will recharacterize previous overall foreign losses of that branch as U.S. source income.