601: Overview
Source of income for services rendered is determined by the place where the services are performed. Code Secs. 861(a)(3) and 862(a)(3). Services performed in the U.S. will be treated as foreign source, if they are performed on a temporary basis for a period not to exceed ninety (90) days during a tax year, by a nonresident alien employee and the compensation does not exceed $3,000. Additionally, many U.S. tax treaties provide that services performed in the U.S. will be treated as foreign source, where the individual does not spend more than one hundred and eighty three (183) days in the United States.
Where services are performed both within and without the U.S., the services can be apportioned based on specifically allocable amounts paid, or if no specific allocable amounts were paid, apportionment can be made on a basis that most correctly reflects the proper sourcing of income under the facts and circumstances of a particular case. A time basis allocation may be appropriate, since it reflects time spent in the U.S. versus time spent elsewhere. Reg. § 1.861-4(b).
Example 1:Ms. NRA works as a computer programmer for JAPCO. During Y1 she worked 260 total days of which 60 days were in the United States. Therefore, 23% of her compensation is U.S. source income from personal services.
The general rule that personal services are sourced where the services are rendered is not affected by whether the employer is foreign, whether the payment was made from a foreign bank account, whether the payment was made in a foreign currency or any other facts such as where the contract was negotiated, the residence of the payor, the residence of recipient, etc. Sourcing income from services is based solely upon where the services are rendered. W.N. Dillin, 56 TC 228, Dec. 30, 768 (Acq.). Thus U.S. source income includes payment, in whatever form made, for services rendered in the United States. Code Sec. 861(a)(3).
605: Special Sourcing Rules For Personal Services.
(A) Crew Members of Foreign Vessels
For tax years beginning after December 31, 1997, compensation for labor or services performed by a nonresident alien in connection with the individuals temporary presence in the United States as a regular member of the crew of a foreign vessel engaged in transportation between the United States and a foreign country or between the United States an a U.S. possession, will be treated as foreign source income that is exempt from U.S. income and withholding tax. Code Sec. 861(a)(3). However, remunerations paid to nonresident alien crew members are not treated as foreign source income for purposes of:
(1) Group Term Life Insurance Rules. Code Sec. 79,
(2) Accident and Health Plan Rules. Code Sec. 105, and
(3) Pension Plan Rules. Code Sec. 401-424.
(B) Continental Shelf
Wages and salaries received for personal services performed with respect to a mine or an oil or gas well located or developed on the continental shelf of the United States constitutes income from sources within the U.S. Code Sec. 638.
(C) Pensions
The source of pension distribution depends upon whether the distribution represents compensation for past services or interest thereon. Contributions for labor and personal services includes employer’s contributions to an annuity or pension plan. Rev. Rul. 56-82, 156-1 C.B. 54. Therefore, these employer contributions will be sourced under the general rule for sourcing compensation for personal service, which is based on where the services were performed. Where the employer’s contributions were made with respect to wages earned abroad, then the contributions constitute compensation for personal services performed outside the U.S. Where the distributions are attributable to contributions with respect to services rendered in the U.S., the distributions constitute U.S. source income. Rev. Rul. 72-149, 1972-1 C.B. 218 and Rev. Rul. 79-389, 1972-C.B. 281.
The portion of the distribution from a U.S. pension plan that represents interest on earnings on the contributions, is U.S. source interest income. Where certain requirements are met, there is an exclusion from gross income which applies to certain nonresident aliens who receive interest on pension income from a plan located in the U.S. Code Sec. 871(f).
(D) Reimbursement of Moving Expenses
A moving expense is sourced based upon where the personal services of the employee being moved are rendered. Where the moving expense is paid for future services by a new employer, the moving expense will be sourced in the place of the new employment. Alternatively, where the moving expense is paid by a former employer to return the employee back to his home, the moving expense will be sourced based on where the past services were rendered.
615: Compensation for Personal Services vs. Other Payments.
(A) In General
Prior to sourcing services income based on where the services are rendered, a determination must first be made as to whether the remuneration received is actually compensation for personal services or some other type of income.
With the sale of any particular product, there are a certain amount of associated services which are being performed in connection with the sale and servicing of such product. This provides an opportunity for taxpayers to separately state and separately source a portion of the income attributable to personal service, which can be carved out from the actual sale of the product.
Example 1: USCO manufacturers generators in the United States. A substantial part of USCO’s success is due to the size of its telemarketing operation. Title to USCO’s generators passes in the U.S. resulting in all of USCO’s income being classified as U.S. source. USCO forms a new corporation in the Bahamas to perform its telemarketing operation. An economic analysis is performed to determine the arm’s length fair market value which should be paid to the Bahamian corporation for the telemarketing services performed. This results in the telemarketing portion of the total profit being resourced as foreign source income, since these services are now being rendered by the Bahamian corporation.
Planning Note: Resourcing through personal services is one of the most effective ways of resourcing income, since people are easiest to move and since telemarketing and other personal services can easily be performed outside of the country of origin as a result of new technology (e.g. Internet, computers, etc.).
(B) Commissions
Commissions are analogous to personal services for purposes of sourcing income. Commissions received by a foreign corporation operating and selling exclusively in a foreign country, from a U.S. corporation as compensation for selling U.S. products constitutes foreign source income. Rev. Rul. 60-55, 1960-1 C.B. 270. The fact that a U.S. company is selling the product and that it may have U.S. source income from these inventory sales is irrelevant, since the commission is compensation for services which are separate and apart from the sale of the actual product. The commission income is sourced where the sales services were rendered.
However, commissions received by banks which are compensation for assumption of a credit risk will be treated as interest and all commissions charged for negotiating letters of credit and other commissions, which have no associated credit risks, will be sourced as personal services. Bank of America v. U.S., Ct. Cls. 82-1 U.S.T.C. ¶9415, 680 F.2d 142.
(C) Intangible Personal Property
The definition of rents and royalties is so broad as to include items which may be classified as personal services including: secret processes and formulas, trade secrets, know how, etc. Code Sec. 861(a)(4). Where such personal services can be separately classified as intangible personal property, then the sourcing rules for rents and royalties will apply.
Example 2: Dr. NRA designed a methodology for healing cancer. Dr. NRA sells his methodology to USCO for $25,000. Where Dr. NRA is deemed to be performing personal services, the entire $25,000 will be foreign source income. Where Dr. NRA’s knowledge, skills, etc. are viewed as a separate intangible product, the entire $25,000 will be U.S. source as a royalty payment for the use of an intangible in the U.S.
(D) Support Services with Sale of Products.
Where personal property is sold, which also includes support services, there exists an issue as to allocation of purchase price between the associated services and the sale of personal property. The IRS takes the position that there is no allocation necessary for services, to the extent they are ancillary and subsidiary to the sale of the product. Reg. § 1.482-2(b)(8). However, U.S. courts have allowed separate allocation for services that are severable from the sale of the actual product. See Marcor, Inc. v. Comr., 89 T.C. 181(1987) and PPG Industries, Inc. v. Comr., 55 T.C. 928 (1970).
(E) Special Industry Income.
There are special sourcing rules for income from certain industries, which overrule the general rules for personal services. There are special sourcing rules for the following industries:
(1) Transportation Industry (see Code Sec. 863(c));
(2) Ocean and Space Activities (see Code Sec. 863(d)); and
(3) International Communications (see Code Sec. 863(e)).
(F) Sourcing of Deferred compensation
There are generally two components of income where compensation for services is deferred. The main component is the actual compensation for the services that were performed, and the second is the interest equivalent on such compensation. The compensation component is sourced under the relevant service income source rule and the interest component is sourced under the interest income source rules.
There are two exceptions to this general rule. The first is under § 871 (f) for annuities paid on behalf of an NRA employee under a qualified trust or annuity plan. The second is under §402(a)(4) for civil service pension income received by an NRA.
(G) Construction, Engineering, Fabrication and Installation Activities
It is not clear to what extent that income should be treated as service income or manufacturing income with respect to activities such as construction, engineering, fabrication and installation. It is also unclear how Reg. §1.863-3 (manufacturing apportionment regulation) should be applied in the event that such income is treated as manufacturing income (see ¶515 (C) above).
The IRS concluded that income from an “integrated transaction” may be classified in accordance with the predominant character of such a transaction, even if an incidental part of the income might be characterized differently. See Rev. Rul. 86-155, 1985-2 C.B. 89. The classification of the income depends upon the facts and circumstances of each contractual arrangement. See Id. For example, income from the construction of a dam which is “specifically designed and constructed in accordance with geological and environmental considerations particular to that site” is service income rather than the sale of a manufactured good. See Guy F. Atkinson Co. of California V. Comr. 82 T.C. 275 (1984).
(H) Non-Compete Agreement
Income from an agreement not to perform has been treated as both services and personal property in different situations. The Tax Court held that a non-compete agreement is the transfer of a right which is analogous to a property right. See Korfund Co. V. Comr., 1 T.C. 1180 (1943). Accordingly, compensation received for an agreement not to compete in the United States would be U.S. source income.
In a later case, the Tax Court sourced a hockey player’s signing bonus as service income. See Linesman v. Comr., 82 T.C. 514 (1984). The agreement was a preliminary agreement which prevented the player from signing with other clubs. The court held that the bonus, while itself is not compensation for services, should nevertheless be sourced based on the location where the actual services are rendered. See Id.
(I) Finder's Fees
Finders Fees are treated as service income and are sourced under the service income sourcing rules. See Lowrey v. Comr., 24 T.C.M. 1078 (1965).
(J) Standby Loan Commitment Fees
A loan Commitment Fee is in the nature of a standby charge which is equivalent to a property right; the right to use money. Rev. Rule 81-160, 1981-1 CB 312. Therefore, Standby Loan Commitment Fees are treated as income from the disposition of a property right and are sourced accordingly. See PLR 8543004.
(K) Global Trading of Securities.
The trading of securities across international bounds gives rise to the question of how to allocate income among different jurisdictions. This in turn gives rise to the question of whether and how to allocate income among the service and sale components of an international securities transaction. The tax laws do not specify whether and how income from such a transaction should be allocated. Gains from the sale of securities should be sourced under the sale of personal property sourcing rules, and the service component, i.e. brokerage fees and commissions, should be sourced under the service income sourcing rules.
625: Computer Programs and Electronic Commerce
(A) Computer Programs
(1) In General
For all computer transactions entered into on or after December 1, 1998, the Treasury has issued regulations which classify a transaction involving the transfer of a computer program, or the provision of services, or know-how with respect to a computer program, as being treated solely as one of the following:
(a) A transfer of a “copyright” in a computer program;
(b) A transfer of a copy of the computer program (a “copyrighted article”);
(c) The provision of service for development or modification of the computer program; or
(d) The provision of know-how relating to computer programming techniques. Reg. § 1.861-18(a)(2).
In the case of a transfer of a “copyright”, the regulations provide rules for determining whether the transaction should be classified either as a sale or exchange or a license generating royalty income. In the case of a transfer of a “copyrighted article”, the regulation provides rules for determining whether the transaction should be classified either as a sale or exchange or a lease generating rental income. In the case of income from the provision of services or the provision of know-how, this income is sourced pursuant to the rules for sourcing services, except where these services are treated as a transfer or use of a “copyright” or a “copyrighted article” as a result of the intent of the parties and how the risk of loss is allocated between the parties. Therefore, an analysis generally needs to be made as to the relationship of the parties, the duration of such relationship, who has the risk of loss and the benefits and burdens of ownership; in order to correctly categorize amounts received as amounts received for “copyrights” or “copyrighted articles” and amounts received for services and know-how.
Any transaction consisting of more than one of the above mentioned categories, shall be treated as separate transactions and an allocation of income should be allotted to each of the separate transactions. However, any De minimis transactions shall be ignored. Reg. § 1.861-18(b)(2).
(2) “Copyright” of the Program and “Copyrighted Article”
A computer program is a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result. Reg. § 1.861-18(a)(3).
The transfer of a computer program is classified as a “copyright” if the transferee acquires one or more of the following rights:
(a) The right to make copies of the computer program for purposes of distribution to the public by sale or other transfer of ownership, or by rental, lease, or lending;
(b) The right to prepare derivative computer programs based upon the copyrighted computer program;
(c) The right to make a public performance of the computer program, or
(d) The right to publicly display the computer program.
Where a person acquires a copy of a computer program, but it does not acquire one or more of the above mentioned rights to classify it as a copyright, then the transfer will be classified solely as a transfer of a “copyrighted article”. Reg. § 1.861-18(c)(1)(ii).
(3) Sale or Exchange vs. Royalty and Rental Income
(a) In General.
Where a taxpayer owns sufficient rights to categorize its ownership as a “copyright”, then a determination must be made whether the use of this “copyright” should be treated as a sale or exchange or a license which generates royalty income.
(b) Source of Income “Copyright”.
The determination of whether a transfer of copyright is a sale or exchange of property is made on the basis of whether, taking into account all of the facts and circumstances, there has been a transfer of all substantial rights in the copyright. Income derived from the sale or exchange of a “copyright” will be sourced under the sourcing rules for personal property sales pursuant to Code Sec. 865(a),(c),(d),(e) or (h), as appropriate.
A transaction which does not constitute a sale or exchange, because not all substantial rights have been transferred, will be classified as a license generating royalty income. Reg. § 1.861-18(f). Income derived from licensing of a “copyright” will be sourced under the royalty rules of Code Sec. 861(a)(4) or 862(a)(4), as appropriate. Reg. § 1.861-18(f).
(c) Source of Income “Copyrighted Article”.
A transfer of a “copyrighted article” is classified either as a sale or exchange or a lease which generates rental income. A transaction that does not constitute a sale or exchange, because insufficient benefits and burdens of ownership of the “copyrighted article” have not been transferred, will be classified as a lease generating rental income which is sourced pursuant to Code Sec. 861(a)(4) or 862(a)(4), as appropriate. A sale on the other hand will be sourced pursuant to the normal rules for sourcing sales of personal property pursuant to Code Sec. 865(a),(c),(d),(e) or (h), as appropriate. Reg. § 1.861-18(f)(2).
(4) Classifying Transactions by Category
A determination of whether the transaction should be treated as a transfer of the computer program (with or without certain rights), the provision of services, or the provision of know how shall be determined based on all the facts and circumstances, including how risk of loss is allocated and the intent of the parties. Reg. § 1.861-18(d).
An analysis of the examples contained in the regulations seems to indicate that no matter how the acquirer acquires the program, via floppy disk, download from the internet, from a home page, via email, etc.; where the individual receives the program for an unlimited duration, the transaction will be treated as a sale or exchange of either a “computer program” or a “copyrighted article”. The applicable sourcing rules are the same in either case, and the income from the sale shall be sourced pursuant to the sale of personal property rules discussed in Chapter 5 above.
Where the acquirer does not obtain the rights to the program in perpetuity, then it will be treated as a royalty if it’s a “copyright” or a rent where its deemed to be a “copyrighted article”, the sourcing of which are both described in Chapter 4 above.
Example 1: U.S. Corp. owns a copyright in a computer program, Program X. It copies Program X on to disks and sells these disks to Ms. NRA. There is no limitation on the amount of time Ms. NRA can use the disks. There are just various restrictions on making additional copies of the program and a restriction on the number of computers in which the program may be installed. Therefore, none of the rights associated with the copyright are transferred to Ms. NRA. Ms. NRA has acquired solely a “copyrighted article”. She is treated as the owner of the “copyrighted article”, since there is no limitation on her use. The income from the transfer of this “copyrighted article” will be sourced as a sale of personal property.
Example 2: USCO transfers a disk containing Program X to F Co., a company engaged in manufacturing and sale of personal computers in Country Z. USCO gives F Co. the nonexclusive right to copy Program X onto the hard drives of an unlimited number of computers which F Co. manufactures. This transfer to F Co. will be classified as a transfer of a “copyright”, since F Co. did acquire the right to make copies and distribute Program X. The transfer will also be treated as a sale and sourced under the sale of personal property rules since F Co. did acquire substantially all of the rights to Program X.
Example 3: Same facts as Example 2 except terms of the agreement with F Co. is for 2 years, which is less than the remaining life of the copyright in Program X. Here the transaction will still be considered to be a transfer of a “copyright” however, the payments shall be treated as rent as a result of not having all the benefits and burdens of ownership (i.e. limited to two years). Reg. § 1.861-18(h).
(B) Electronic Commerce
(1) In General
Electronic Commerce, the Internet, email, etc. have dramatically changed the way business is being conducted. Through the use of these technologies, it is more difficult to determine where transactions take place and it is more difficult to determine how to characterize transactions. Is the transaction a sale? Is the transaction a sale of services? Did the seller come to your jurisdiction to sell, as in the case of email? Did the buyer go to another jurisdiction to buy, as in the case of accessing a homepage?
Along with these factual issues, there are also many technical issues created by E commerce, including characterizing and sourcing the type of service which is provided by E Commerce. Is there a difference between obtaining service from a human via the internet and obtaining mechanical services via the internet; such as access to programs, access to databases, program trading and the like?
To date, there are no specific regulations designed for the sourcing of income from E Commerce. It appears that the sourcing of income from E Commerce will be dependent upon the type of the transaction generated from E Commerce.
(2) Sale of Personal Property
Where a buyer purchases property by going to seller’s homepage, the rules for sourcing sales of personal property should apply. The fact that the medium for purchasing such product was the Internet, a phone or other vehicle should make no difference.
(3) Purchases of Services
Where a buyer purchases services, be it astrological advice, medical advice, etc., the general rule for sourcing services as the place where services are rendered should apply. However, the use of the computer server in combination with the use of the internet makes it difficult to determine where these services are provided. We contend that the place where the services are rendered is the place where the computer server is located. The computer server maintains the home page which is accessed by buyers around the world. Whether the homepage is used to chat with an online service provider in the form of a human being or whether the homepage contains programs which can be accessed by consumers to obtain the same type of information should not make a difference, since they are both services which are being provided at the location of the server which generates the homepage.
Example 4: Mr. UK established a computer server in the British Virgin Islands which generates a web page entitled Astro Now. Buyers from around the world can access Astro Now for a $30 charge for 15 minutes. During the 15 minutes, buyers can chat with a professional astrologer or access the many computerized astrological programs contained in the homepage. The providing of astrological advice is a service. The service in this case is rendered at the location of computer server which generates the Astro Now homepage, which is located in the British Virgin Islands. Therefore, under the income sourcing rules, the income from providing this astrological service in the form of the homepage is sourced to the British Virgin Islands. The fact that this home page can be accessed anywhere in the world and can be accessed by U.S. Residents should not change this answer. The BVI being a tax haven jurisdiction may or may not tax such services. For U.S. tax purposes, the services will be foreign sourced as they are provided outside the United States.
(4) Email
Where a seller of products or services uses the email to conduct such transactions or to advertise such goods and services, there may be a jurisdictional issue which does not exist in solely having buyers access a web page. Here the seller has nexus with the U.S. through its voluntary actions of sending E mail to U.S. Residents. The issues which arise from this regular and continuous engaging in U.S. commerce are:
(a) Does this activity constitute a U.S. trade or business?
(b) Is there U.S. source income from the sale of inventory where title to the goods passes in the U.S. or from services which are rendered in the U.S. (possibly a second computer server located in the U.S.) which would be effectively connected?
(c) Is there a U.S. office to which foreign source rents or royalties from the foreign use of computer programs can be attributed?
Depending upon how email is used by each taxpayer to transact business with U.S. residents, will determine whether and to what extent the above mentioned issues may cause the taxpayer to become subject to U.S. taxation.
Comment: E Commerce is replacing the traditional forms of doing business which were direct mail of catalogs and door-to-door salesmen as well as show rooms. Our laws never anticipated the ability of U.S. buyers to be marketed, view products, and converse with salesmen via a homepage located in another country. The traditional model to provide such access to a U.S. buyer would have rendered such sales or a portion of such sales to U.S. jurisdiction and therefore U.S. taxation. However, until new laws are written, it appears that services which are provided via homepages on the Internet will be sourced based upon where the server which generates the homepage is located. This provides planning opportunity for companies providing services over the Internet to locate their server in a tax haven jurisdiction and thereby remove themselves from U.S. taxation. This also provides a planning opportunity for companies selling products over the Internet to locate their server in a tax haven jurisdiction and remove themselves from U.S. taxation, where title to such merchandise passes outside the U.S. (i.e. no U.S. source income, possibly no U.S. trade or business and certainly no foreign source income attributable to a U.S. office). The use of email to transact business with U.S. residents should be strictly scrutinized in order to determine whether it may result in U.S. taxation.