401: Overview
The source of rental income from the use of tangible personal property is the country in which that property is located. The source of rental income derived from the use of real property is the country in which the real property is located. The source of royalties for the use or licensing for use of intangible personal property is the country in which the property is used. Code Secs. 861(a)(4) and 862(a)(4).
Gains from the sale or exchange of patents, copyrights, secret processes and formulas, goodwill, trademarks, tradebrands, franchises and other like property, to the extent such gains are from payments which are contingent on the productivity, use or disposition of the intangible interest sold or exchanged, shall be sourced as rental or royalty income. Code Sec. 865(d).
405: Rents
(A) Rents of Real or Tangible Personal Property
Rents can be for the use of real or tangible personal property. The source of income from the rental of real or tangible personal property will be the country in which the property is located. Code Secs. 861(a)(4) and 862 (a)(4). Therefore, any rental of U.S. real estate will be U.S. source income. Any rental of personal property used in the United States will also be U.S. source income. Code Sec. 861(a)(4).
Example 1: NRA obtains rental income from the rent of her condominium in the United States. This rental income is U.S. source.
Example 2: F Co. rents a container which is used in the United States. The rent from this container is U.S. source, since the container is located in the United States.
For tangible personal property which is moveable, an allocation of the rental income will have to be made to reflect the portion of the time during which it is located in the United States as a percentage of the total time it is rented. Only that portion of the rental income, for the time it is located in the United States, will be United States source income.
Example 3: F Co. rents a farm tractor. During Y1, the tractor was rented 200 days. It was rented 50 days to a U.S. farmer and the remaining amount of days to non-U.S. farmers. Therefore, the rental income which F Co. received from the U.S. farmer for the rental of this tractor will be U.S. source rental income subject to U.S. gross basis withholding tax.
Caution: Where F Co. is engaged in a U.S. trade or business, there may be other resourcing rules which apply to subject more of F Co.’s rental income to a U.S. tax. Code Sec. 865(c)(3). The above-mentioned example assumes an isolated rental by F Co. to U.S. farmer on a non-recurring and non-continuous basis.
415: Royalties
(A) Royalties for Use of Intangible Personal Property
Royalties from the use of or from the privilege of using in the United States, patents, copyrights, secret processes and formulas, goodwill, trademarks, tradebrands, franchises, and other like property are U.S. source income. Code Sec. 861(a)(4).
Royalties from the use of a foreign trademark on products that are ultimately used in foreign countries are income from sources without the United States. Code Sec. 862(a)(4). This is true even where the initial sale of the articles takes place in the United States. Rev. Rul. 68-443, 1968-2 C.B. 304.
Example 1: F Co. owns various trademarks in many foreign countries throughout the world. F Co. licensed to USCO the right to use its trademark and manufacture products in the United States for use and consumption in the foreign countries where F Co. has trademarks. The products are sold by the USCO F.O.B. United States. The royalty paid by USCO to F Co. for the use of its trademark in foreign countries is foreign source royalty income regardless of the fact that the products are manufactured in the United States and that the payment is made by a U.S. corporation. Rev. Rul. 86-443, 1968-2 C.B. 304.
Example 2: Mrs. NRA wrote a book to be used in public schools outside of the United States. The books were printed in the United States by USCO and they were sold exclusively in foreign countries. The royalties Mrs. NRA receives are foreign source royalties. Rev. Rul. 72-232, 1972-1 C.B. 276.
Caution: The IRS in both of the above mentioned examples was cleared to emphasize that none of the products were sold within the United States by the licensor, the manufacturer or any related party. Where some products are sold in the United States, there may be a requirement of apportioning the royalty between the portion of products sold under a U.S. trademark and the portion sold pursuant to foreign trademarks.
(B) Use of Intangibles in the U.S.
Receipt of payment for the use of trademarks, trade names, or the like in the United States results in U.S. source royalty income. Code Sec. 861(a)(4). Where the intangible personal property is documented or protected under the laws of the United States through patent, trademark, or otherwise, any income in the form of royalties from the use of these patents, trademarks, or otherwise is U.S. source income.
The source of a royalty payment for use of an intangible in the United States maintains its character through several layers of intervening payors or licensors, since the ultimate person receiving the royalty receives it for the use of the intangible in the United States. There is no recharacterization of a royalty payment through multiple licensors. This concept is sometimes referred to as a “Cascading Royalty”. No matter how many intervening levels of licensors there are between the intangible personal property owner and the ultimate user of the intangible in the United States; each payment received by each licensor will be U.S. source subject to U.S. gross basis withholding tax.
Example 3: Mr. NRA has a patent to use a product in the United States which is protected by U.S. patent law. Mr. NRA licenses this patent to X, a Netherlands Antilles corporation. X relicenses the right to use this patent to Y, a U.S. company. The Netherlands Antilles has a treaty with the United States which provides that U.S. source royalties are exempt from U.S. gross basis withholding tax on payments to Netherlands Antilles resident corporations. The payment of the royalty from Y to X is U.S. source royalty income exempt from withholding pursuant to the Netherlands Antilles/U.S. tax treaty. The subsequent payment from X to Mr. NRA is also classified as U.S. source royalty income which is subject to U.S. gross basis withholding tax and X is required to withhold and pay over 30% of its royalty payment to Mr. NRA. This is true regardless that the terms of the license from Mr. NRA to X and from X to Y are different. Rev. Rul. 80-362, 1982-2 C.B. 208.
Caution: Most U.S. tax treaties now have anti-treaty shopping provisions which would prevent an intermediary recipient to claim a treaty reduction or elimination of gross basis tax on royalties which in reality are repaid to a third party who is the actual beneficial owner.
(C) Royalty versus Sale of Personal Property
Where income is received solely in the form of royalties for the use of intangible personal property in the United States, it is clear that the income would be U.S. source income. However, where personal property is sold along with the use of an intangible (e.g. trademark) there is a factual issue of how much of the purchase price is allocated to the sale of the product and how much of the purchase price is attributable to the trade name or trademark.
Example 4: F Co. manufactured pharmaceuticals and sold them outside of the United States. F Co. also owned a trademark and trade name for the products which it sold to its U.S. independent distributors. F Co. sold its personal property FOB loading dock in the foreign country which resulted in the source of its income being non-U.S. source. Code Sec. 865(b); See ¶515 below for sourcing of income from the sale inventory property. The issue is whether there would be an imputed royalty for the use of F Co.’s trademark in the United States. A royalty may be defined as the share of profit reserved by the owner for permitting another to use its intangible property. However, the sale of a trademarked product carries with it the right to use the trademark on the re-sale of such property. In as much as the use of F Co.’s trademark by the independent U.S. distributors is not dependent upon the granting of such right by F Co. (the trademark just appears on the product being sold); there are no imputed royalties for the use of F Co.’s trademark or trade name in the United States. Rev. Rul. 75-254, 1975-1 C.B. 243.
Caution: Where personal property is sold in the United States and where a patent or trade name is also protected in the United States, any specific granting of the use of the name or trademark may create an imputed royalty when the ultimate product is sold in the United States.
Example 5: F Co. enters into an exclusive Distribution Agreement with USCO to distribute its foreign made fashions in the United States and to use its name in the United States. F Co. does not charge a royalty for the use of its name and trademark in the United States. Because F Co. sells FOB its foreign factory, it has no U.S. source income. However, the IRS could perform an economic study showing that a certain portion of the proceeds from the sale of such goods is attributable to brand loyalty and brand recognition and thereby bifurcate the sales price of such products in the United States into two components:
1. the sales price for such product and
2. a payment of a royalty for the use of the trademark.
The source of the sale of the product maybe foreign source but the portion of the sales price attributed to the royalty will be U.S. source subject to the U.S. gross basis tax.
(D) Re-characterizing Royalties
Generally, gain from the sale of personal property is source based on the residence of the seller. Code Sec. 865(a). Therefore the unconditional sale of intangible personal property will also be source based on the residence of the seller regardless of the situs of where the intangible property is used. The sale of a U.S. patent or other intangible property is foreign source where it is sold by a nonresident alien or foreign corporation (assuming that the intangible is not effectively connected with a U.S. trade or business).
Planning Note: Where a nonresident alien or a foreign corporation can economically receive, on a noncontingent basis, the net present value of the future rents and royalties which it expects to receive from its U.S. property, then it would be advisable for an NRA or foreign corporation to sell its interest in such property located in the United States and have no U.S. taxation as compared to receiving rents and royalties subject to 30% gross basis withholding tax. This planning may be negatively impacted where the NRA or foreign corporation is a resident of a country which has a tax treaty with the U.S. which reduces the U.S. withholding tax on rents and royalties.
Planning Note: It may be advisable to have the U.S. intangibles owned by a foreign corporation organized where there is no tax on rents, royalties or gains from the sale of personal property. This would allow the foreign company to sell its intangible interest in the United States on a net fair market value basis and not pay tax in the U.S. nor in the jurisdiction where the foreign company is organized.
Example 6: UK Co. desires to patent its idea in the United States. UK Co. forms BVI Co. which then registers for patent in the United States. From Y1 to Y5 BVI Co. receives 70% of the royalty payments from USCO, the licensee. In Y6, USCO seeing the value in this patent agrees to purchase this patent from F Co. for the discounted fair market value in the next 35 years of forecasted income (U.S. grants patents for 40 years). The monies which F Co. receives from its noncontingent sale of its trademark to USCO is foreign source income which is not subject to U.S. taxation. BVI Co. is not required to pay any additional tax in the British Virgin Islands upon its receipt of the royalties from Y1 to Y5 nor on its net income from the sale of its U.S. patent.
Nonresident aliens and foreign corporations may recharacterize their rent and royalty income to income from the sale of personal property only where the consideration which they receive is unconditional. Where a nonresident seller sells their U.S. intangible for a noncontingent payment, the income from the gain from this sale will be foreign source income which would not be subject to U.S. taxation (unless it was effectively connected with a U.S. trade or business). Code Sec. 865(a)(2). However, where the nonresident seller of the U.S. intangible receives as payment for the sale of this intangible, any remuneration which is contingent on the productivity, use or other disposition of the intangible, then such sale shall be re-characterized and all payments pursuant to such sale will be re-characterized as royalty payments for the use of property in the United States which is U.S. source and is subject to U.S. gross basis withholding tax. Code Secs. 865(d), 871(a)(1)(D) and 881(a)(4).
Example 7: Dr. NRA developed and patented in the U.S. a drug that made people instantly happy. Realizing the potential value of such a patent, USCO offered Dr. NRA $10,000,000 to purchase such U.S. patent. Dr. NRA not wanting to sell his patent for less than its fair market value, agrees to sell his patent for $5,000,000 plus $1 for every 100 units of the pill sold in the U.S. Dr. NRA would have foreign source capital gain income on the $5,000,000 which he receives from the sale of his U.S. intangible. Code Sec. 865(a)(2). However, to the extent he receives the contingent payments in the future, for each 100 pills sold in the U.S., these payments shall be treated as a U.S. source royalty income subject to U.S. gross basis withholding tax. Code Sec. 865(d).
(E) Burden of Proof
The nonresident alien or foreign corporation bears a burden of proof with respect to the source of rental and royalty income. F. Molnar, CA.-2, 46-1USTC ¶ 9303, 156 F 2d 924. Where the nonresident or foreign corporation does not present sufficient evidence relating to the source of rental or royalty income, all such income will be deemed U.S. source. Misbourne Pictures, Ltd. v. Johnson, 189 F. 2d 774 (2nd Cir 1951); aff’g 90 F. Supp. 978 (1950).
425: Apportionment of Rents and Royalties
Where the property is located or is used both within the United States and outside the United States, then an apportionment of the rent or royalty needs to be made so that only that portion where the property is rented in the United States or that portion where the royalty is derived from property used in the United States, will be U.S. source rental or royalty income.
Example 1: Payments made to a nonresident alien author for exclusive worldwide rights for a limited time to produce motion pictures based on his literary works are U.S. source income. The payment is a royalty payment for the use of literary property in the United States. Absent a showing that the royalty is for use of the intangible personal property in another country, the royalty will be deemed to be U.S. source. R. Sabitini, CA-2, 38-2 USTC ¶ 9470, 98 F. 2d 753. Payments will be deemed made for the right to use intangible property in the U.S. where there is no segregation between worldwide and U.S. rights. Marton Est., 47 BTA 184, Dec. 12, 567.
435: Rents and Royalty versus Other Type of Payment
(A) Rents and Royalties as Disguised Payments
Before considering the U.S. rules for sourcing rents or royalties, you must make sure that the rent or royalty is not a disguised payment of some other type of income. A rent with option to buy may actually be reclassified as a sale. Rentals or royalties may actually be disguised payments for personal services. Furthermore, a license to use personal property may actually be a sale of that personal property.
Therefore, the first requirement in sourcing rents and royalties is to analyze the transaction to determine economically whether it is a rent or royalty and to determine whether there has been a shifting of the risk of loss from one party to another in order to determine whether the payment is actually a rental payment or a royalty payment. Where the payment is determined to be a rent or royalty, the above-mentioned rules will determine whether the rent and royalty is U.S. source. Where the analysis results in a recharacterization of the rent and royalty as some other type of payment, then the sourcing rules for that type of payment need to be reviewed.
445: Special Sourcing Rules for Rents and Royalties
(A) Insurance, Transportation, Oceanic Space and International Communication Income
In addition to the general factual reclassification of gains from the sale of intangibles as royalty payments where payments are conditional and recharacterizing disguised rental and royalty payments; there are also special sourcing rules for rents and royalties produced from the following commercial activities:
(1) Insurance Underwriting;
(2) Income from Transportation;
(3) Income from Space or Ocean Activity; and
(4) International Communications Income.