Chapter 1: INTRODUCTION - SOURCE OF INCOME RULES.
The purpose of this section entitled nonresidents: U.S. portfolio investments is to explain the basic principles of the source of income rules and the statutory basis for taxation of foreign taxpayer’s portfolio and passive income.
Determining the source of income, U.S. or foreign, is essential in determining the U.S. tax consequences of International transactions. U.S. Citizens, U.S. Corporations, and U.S. Resident Aliens are subject to tax in the U.S. on their worldwide income. Code Secs. 1 and 11. U.S. taxpayers who are subject to tax on their worldwide income are provided a foreign tax credit to relieve any possible double tax issues.
Nonresident Aliens and foreign corporations are generally taxed on income which they derive from U.S. sources, whether or not it is connected with the active conduct of a U.S. trade or business. Foreign source income is generally not subject to U.S. taxation.
105: Significance of Sourcing Rules.
(A) In General.
Sourcing rules are significant for many different reasons:
(1) They determine the amount of U.S. source income, which is subject to U.S. tax.
(2) They determine the extent of a foreign tax credit, which is available to reduce U.S. income tax on the same items of income which have also been subject to foreign taxes.
(3) Sourcing rules determine how much of a foreign tax credit is available from a U.S. shareholder’s inclusion of subpart F income.
(4) They determine the amount of U.S. source gross transportation income, which is subject to a 4% gross basis tax.
(5) They determine the amount of income allocable to a U.S. possession, which may qualify for possession tax credit and
(6) They determine the allocation of income to a foreign sales corporation.
(B) Taxation of Nonresident Aliens and Foreign Corporations.
Nonresident Aliens and foreign corporations are generally subject to tax only on their U.S. source income. Income is generally U.S. source if it is produced by an activity or an investment in the United States. There are two different methods for taxing nonresident aliens and foreign corporations on their U.S. sourced income:
(1) Income effectively connected with a U.S. trade or business and
(2) Income not effectively connected with a U.S. trade or business.
Income effectively connected with a U.S. trade or business is subject to regular graduated income tax rates after providing for allowable deductions and exemptions. Code Secs. 872 and 882. Other U.S. source income, which is not effectively connected with a trade or business, is generally subject to U.S. withholding tax of a flat 30 percent (or lower treaty) rate with no allowance of deductions. Code Secs. 871 and 881.
(C) Foreign Tax Credit.
The amount of a U.S. tax credit which is allowed for foreign taxes paid relating to the same income is limited to a percentage, the numerator to which foreign source taxable income and the denominator which is worldwide taxable income. Code Sec. 904.
(D) Foreign Earned Income Exclusion.
U.S. Citizens or Resident Aliens are allowed to exclude from U.S. income tax, up to a certain limit, income which they earned from foreign sources. Code Sec. 911.
(E) Taxable Subpart F Income.
U.S. Citizens and Residents which are subject to tax on income of foreign corporations which they control, will be allowed a U.S. foreign tax credit to the extent of that foreign corporation’s income is foreign source.
(F) 4% Gross Basis Tax on Shipping Income.
Foreign taxpayers are subject to a 4% gross basis tax on U.S. source gross transportation income, unless this income is effectively connected with a U.S. trade or business. U.S. gross transportation income will only be effectively connected with a U.S. trade or business, where the foreign taxpayer maintains a fixed place of business within the U.S. and substantially all of the foreign taxpayer’s U.S. gross transportation income is attributable to regularly scheduled transportation.
(G) Possession Income.
The possession tax credit is terminated for tax years beginning after December 31, 1995. However, there is a special phase-out rule which allows existing credit claimants, a portion of credit attributable to their active business income from a U.S. possession. In determining the amount of the credit there must first be a determination of the U.S. possession source income.
(H) Foreign Sales Corporation (FSC).
The United States tax rules allow a certain portion of foreign trade income to be exempt from U.S. taxation. In determining a FSC’s exempt foreign trade income, there must be a sourcing of income and expenses attributable to the FSC.
115: Statutory Overview of U.S. Source Rules.
(A) Statutory Overview.
Stated below is a statutory overview of the U.S. provisions dealing with sourcing of income. Each one of these source of income rules will be described extensively throughout the remainder of this volume.
(B) Income From Sources Within the United States.
(1) Gross income from sources within the United States. Code Sec. 861(a).
(2) Taxable income from sources within the U.S. Code Sec. 861(b).
(C) Income From Sources Without the United States.
(1) Gross income from sources without the United States. Code Sec. 862(a).
(2) Taxable income from sources without the U.S. Code Sec. 862(b).
(D) Special Rules for Determining Source of Income for Items Not Covered in Code Secs. 861 and 862.
(1) Items of gross income, expense, losses and deductions other than those specified in Code Secs. 861(a) and 862(a), shall be allocated or apportioned to sources within or without the U.S. Code Sec. 863(a). Allocation of gains, profits, and income from:
(a) Income derived from services, other than certain transportation services, rendered partly within and partly outside the United States. Code Sec. 863(b)(1).
(b) Sale or exchange of inventory property produced within the United States and sold outside of the United States, or produced outside the United States and sold or exchanges within the United States. Code Sec. 863(b)(2) and
(c) Income from the sale in the United States of inventory property purchased in the possession of the United States. Code Sec. 863(b)(3).
(E) Transportation Income.
Special Sourcing Rules for transportation income. Code Sec. 863(c).
(F) Space and Certain Ocean Activities.
Special Sourcing Rules for Space and Certain Ocean Activities. Code Sec. 863(d).
(G) International Communication Income.
Special Sourcing Rules for International Communication Income. Code Sec. 863(e).
(H) Regulatory Sourcing Rules exist for:
(1) Foreign Currency Transactions. Reg. § 1.863-7,
Natural Resources. Reg. § 1.863-1(b) and
(3) Scholarship, Fellowship, Grants, Prizes and Awards. Reg. § 1.863-1(d).
(I) Source Rules for Sales of Personal Property.
(1) Income from personal property is generally sourced in the country of the residence of the seller. Code Sec. 865(a).
(2) Exception to the general rule for inventory property. Code Sec. 865(b).
(3) Exception to the general rule for depreciable personal property. Code Sec. 865(c).
(4) Exception to the general rule for intangible personal property. Code Sec. 865(d).
(5) Special rule for sales by residents and nonresidents through offices or fixed places of business. Code Sec. 865(e).
(6) Exception to general rule for sale of stock of a foreign affiliate. Code Sec. 865(f).
(J) Income Not Covered by Statutory Sourcing Rules.
(1) Items of income where there are no statutory source of income rules, must be sourced according to general principles of law. Stand. Fed. Tax Rep. (CCH) ¶ 27, 122.01.
125: Definition of United States.
The term “United States” when used in a geographical sense includes only the 50 States and the District of Columbia. Code Sec. 7701(a)(9). The United States has historically considered its boundaries as extending out and including its “territorial waters”. Rev. Rul. 75-483, 1975-2 C.B. 286. United States territorial waters are defined by reference to a three-mile limit. U.S. v. California, 332 U.S. 19 (1947). The territorial waters of the United States extend three nautical miles from its shoreline as measured from the mean low-waterline mark and the outer limit of inland waters. U.S. v. Louisiana, 363 U.S. 1 (1960). Three nautical miles translates roughly to 3.45 statutory miles. United States ex rel COX v. Iowa Health System, 29 F. Supp. 2d 1022.
The 1988 Presidential Proclamation 5928, signed by President Ronald Regan, extended the territorial seas of the United States to 12 nautical miles limit, in order to conform to international standards. 43 U.S.C.A. § 1331 (West Supp. 1998). The proclamation itself explicitly limits its impact by refusing to “extend or otherwise alter existing federal or state law or any jurisdiction, rights, legal interests, or obligations there from”. Furthermore, it is not entirely clear whether such an extension was valid without implementing legislation from Congress. In 1996 Congress did however, extend the jurisdiction of the United States to 12 miles in its Antiterrorism and Effective Death Penalty Act of 1996 (“AEDPA”) solely for purposes of federal criminal jurisdiction. 18 U.S.C.A. § 7 (West Supp. 1998).
Despite the above-mentioned presidential proclamation and the extension to 12 miles pursuant to AEDPA, the territorial waters of the United States extend 3 nautical miles from its shoreline for all purposes other than criminal activity. The U.S. Court of Appeal for Second Circuit has concurred with a 3 nautical mile limit for U.S. territorial waters for all purposes, except criminal activity, in its recent decision regarding the operation of a gambling ship outside the 3 nautical mile limit but within 12 nautical miles from the coast of the United States. U.S. v. One Big Six Wheel, 166 F. 3d 4898 (1999). The Treasury’s own regulations provide that United States territorial waters include those waters within 3 nautical miles (3.45 statutory miles) from low tide on the coast line, for purposes of applying $3 transportation tax imposed pursuant to Code Sec. 4471. Reg. § 43.4472-1 (e). This regulation section can only be used as persuasive authority, since it also specifically provides that no inferences intended as to the extent of the territorial limits for other federal tax purposes.
The term United States, when used in a geographical sense also includes the seabed and subsoil of those submarine areas which are adjacent to the territorial waters of the United States and over which the United States have exclusive rights in accordance with International Law, with respect to the exploration for, and exploitation of, natural resources. Reg. § 1.638-1. This area is generally knows as the Continental Shelf of the United States and it extends out 200 miles beyond the territorial sea and includes the sea bed and sub soil. 15 U.S.C. § 471 (1961). This extended geographical territory for the continental shelf area, only applies for the exploration and exploitation of the continental shelf area and does not apply to any other activities not associated with such exploration and exploitation. Code Sec. 638.
135: United States Tax System-Nonresident Aliens and Foreign Corporations.
(A) Effectively Connected and Noneffectively Connected Income.
Nonresident Aliens and foreign corporations normally are subject to U.S. tax only on their U.S. source income. To determine the method of taxation and the applicable rate of tax, U.S. source income is separated into two categories:
1. Income effectively connected with a U.S. trade or business and
2. Income not effectively connected with a U.S. trade or business.
The first category of income is subject to a regular graduated income tax rate after allowing for associated deductions and exemptions. The second category is subject to a flat 30 percent (or lower treaty) gross basis tax rate, with no allowance of any deductions.
(B) Income Effectively Connected With a U.S. Trade or Business.
To classify income as effectively connected with a U.S. trade or business requires:
1. That there is actually a U.S. trade or business and
2. That the U.S. source income and certain foreign source income are effectively connected to the U.S. trade or business.
A U.S. trade or business has been defined as a continuous carrying on of a commercial or industrial income producing activity within the United States. The activity must be considerable, continuous and regular as opposed to an isolated or sporadic business activity. Linen Thread Co. v. Comm., 14 T.C. 725 (1950).
Once it has been determined that a regular U.S. trade or business exists, then there must be a determination as to whether the particular item of income (U.S. source income and in certain limited circumstances foreign source income) is effectively connected with the U.S. trade or business. All U.S. source income, other than certain fixed and determinable income and gains, is automatically treated as effectively connected income whether or not it is related to the U.S. trade or business. Code Sec. 864(c)(3). Fixed and determinable income and capital gains from U.S. sources are effectively connected, if they are deemed to be related to the U.S. business activity. Code Sec. 864(c)(2).
(C) Income Not Effectively Connected With a U.S. Trade or Business.
This type of U.S. source income consists of income which is not effectively connected with a U.S. trade or business. This type of income is also classified as fixed and determinable periodic income (FADPI). U.S. source FADPI income is subject to U.S. gross basis withholding tax. Foreign source FADPI income is generally not effectively connected to a U.S. trade or business and therefore is not subject to U.S. gross basis withholding tax.
Withholding tax on U.S. source FADPI income are collected at the source by the person making the payment to the foreign person. Code Secs. 1441, 1442, and 1461. U.S. payors are required to withhold at the statutory rate (currently 30 percent) or the applicable treaty rate, and pay over all withheld taxes to the IRS. The obligation to withhold is imposed upon all persons, acting in whatever capacity, having the control, receipt, custody, disposal or payment of any kind of FADPI income derived from sources within the United States by a nonresident or foreign corporation. The place of payment is irrelevant as it relates to the obligation to withhold.
(D) U.S. Source Capital Gains.
Nonresidents and foreign corporations are generally not taxed on their U.S. source nor foreign source capital gains, if the gains are not connected with a U.S. trade or business. Reg. § 1.871-7(a)(1) and Reg. § 1.1441-2(a)(3). A nonresident will be subject to a 30 percent tax on his capital gains, which are not effectively connected with a U.S. trade or business, where he is physically present in the United States for 183 days or more during any taxable year. Code Sec. 871(a)(2).
(E) For further discussion of the following:
(1) Taxation of nonresident alien individuals (See ¶ 805-825 and ¶ 855 below) and
(2) Withholding obligations for U.S. payors from payments to foreign persons (See ¶ 845 below).
145: Classification of U.S. Source Income.
(A) In General.
The following chapters cover the sourcing of the following types of U.S. source income: