In addition to the sourcing of income rules discussed above, there exists a special set of sourcing rules for particular types of income relating to the following:
(A) Sales of U.S. Real Estate,
(B) Transportation Income,
(C) Ocean and Space Activity,
(D) Communication Income,
(E) Income earned through passthrough entities, and
(F) U.S. Expatriates.
These special rules override the normal sourcing rules once a taxpayer’s activities fall within one of the above-mentioned categories. While a full discussion, of these special rules exist elsewhere in this topical library, we will briefly mention them below.
We have also provided a list of types of other income, which are commonly received by foreigners, that are sufficiently unique as to require additional discussion in ¶765 regarding the sourcing for these types of income.
705: Sales of U.S. Real Estate
(A) In General
The location of the real property is used to determine the source of income from the sale of real property. Gains, profits, and income from the disposition of the United States Real Property are U.S. source income. Code Sec. 861(a)(5). Gains, profits and income from the sale or exchange of real property located outside the United States are foreign source income. Code Sec. 862(a)(5). Where there is a question as to whether the property is real estate or personal property, the local law of the jurisdiction where the property is located will determine its character for U.S. sourcing purposes.
(B) U.S. Real Estate
United States Real Property includes:
(1) An interest in real estate located in the United States or the Virgin Islands and
(2) Any interest (other than an interest solely as a creditor) in any U.S. corporation which is or was a U.S. Real Property Holding Corporation (USRPHC) at any time during a 5 year period ending on the date of disposition of such interest. Code Sec. 897(c)(1)(A). A USRPHC is a U.S. domestic corporation where the fair market value of its U.S. Real Property equals or exceeds 50 percent of the fair market value of all its assets. Code Sec. 897(c)(2).
Example 1: NRA owns 100% of USCO. USCO manufactures boats in the United States and is strategically located on the Miami River. As a result of an increased population in Miami and a decrease in boat sales, the U.S. Real Estate which USCO owns represents 60 % of the total value of USCO. Therefore a sale of USCO’s stock, to a person interested in buying the U.S. Boat Manufacturing Business, will be deemed to be a sale of a USRPHC.
(C) Domestic Companies excepted from classification as USRPHC include:
(1) An interest in a domestic corporation which is publicly traded. Code Sec. 897(c)(3).
(2) A domestically controlled REIT. Code Sec. 897(h)(2). and
(3) A USRPHC which has had a cleansing transaction through the complete U.S. taxation of gains which it recognized from the sale of its U.S. Real Estate Holdings. Code Sec. 897(c)(1)(B).
(D) Taxation on sale of U.S. Real Property
(1) In General
This special tax regime, causes gains from sale of U.S. Real Property to be taxed differently than other forms of U.S. source passive investments. Gains from sale of U.S. Real Property are treated as effectively connected to a U.S. trade or business and are therefore subject to graduated rates of tax on a net income basis. Code Sec. 897(a). For NRAs this results in eliminating their exemption from U.S. tax on their U.S. source capital gains. See “Non Residents: U.S. Real Property Investments” of this topical library for a complete discussion of sales of U.S. real property.
Under Code Sec. 897(a)(1) any gain or loss of an NRA from the disposition of a real property interest within the United States will be treated as effectively connected with a U.S. trade or business. For purposes of this rule, the definition of a U.S. real property interest (USRPI) includes three categories. See Reg. § 1.897-1(b)(2). The categories are:
(i) land and unsevered natural products of the land;
(ii) improvements; and
(iii) personal property associated with the use of real property.
The first category includes land and any unsevered natural deposits, growing crops and timber, wells and mines. See Reg. § 1.897-1(b)(2). Once the natural resources are extracted or severed from the land they cease to be real property.
The second component is defined as a building or any other inherently permanent structure and the structural components thereof. See Reg. § l.897-l(b)(3)(i).
The third category includes movable walls, elevators, equipment which is used to extract natural resources from the land, i.e. farming and mining equipment and other personal property “associated with the use of real property.” See Regs. §§ 1.897-l (b)(4)(i)(A), (B) and (C).
The foregoing definition does not apply to the sale of real property located without the United States. Gain from the sale of real property located without the United States is treated as foreign source income. Code Sec. 862(a)(5).
(2) Interest Solely as a Creditor.
The special tax regime which taxes foreigner’s investment in U.S. Real Estate, either directly or indirectly through U.S. corporations and partnerships as effectively connected income, does not apply to an interest in U.S. Real Estate solely as a creditor. Code Sec. 897(c). Therefore, if an investment in U.S. Real Estate can be structured as debt, this special tax regime can be avoided. Furthermore if the debt can be structured to qualify as portfolio indebtedness, the qualified interest income received from such indebtedness is exempt from U.S. tax. See ¶ 835 below.
Planning Note: Where projected returns on a U.S. Real Estate investment are relatively the same as a fixed rate of interest on a loan (e.g. 12-17 %), then it may be advisable to make the investment in the form of a loan which bears interest of 12-17%. This loan will not subject the investor to these special U.S. tax rules, since their investment in U.S. Real Estate will be solely as a creditor. The interest on this loan may qualify as portfolio indebtedness interest. Where the investment is projected to return substantially more than a fixed arm’s length rate of interest, considering the risks associated with such loan, a portfolio obligation can also have a contingent interest provision in addition to its fixed rate of interest. The fixed rate of interest will be exempt from U.S. taxation. The contingent interest will not be exempt from U.S. taxation, but it will allow the taxpayer creditor to participate in this excess return and have solely the contingent interest subject to the 30% gross basis withholding tax.
715: Transportation Income.
(A) In General
There are special rules for sourcing transportation income. Income that is attributable to transportation that begins and ends in the United States is 100 percent U.S. source. Code Sec. 863(c)(1). Income from transportation that begins or ends in the U.S. is treated as 50 percent U.S. source and 50 percent foreign source. Code Sec. 863(c)(2).
Example 1: Freight is picked up in Miami, Florida and delivered to New York; 100 % of this transportation income is U.S. source.
Example 2: A cruise begins in Miami, goes to Nassau, Bahamas and returns to Miami. 50% of the income from this cruise is U.S. source and 50% is foreign source.
(B) Transportation Income
Transportation income includes income derived from or in connection with the use (or hiring or leasing for use) of a vessel or aircraft; including income from transporting passengers or property or income from the performance of services directly related to the use of a vessel or aircraft. Income from the actual operations of a vessel is transportation income. Income from time, voyage, and bareboat charters is also included as transportation income.
For the operator of a vessel or aircraft, income from the rental of containers and related equipment in connection with such transportation of cargo on such vessels or aircraft, is included as transportation income. Income from the leasing of containers, by a person other than the operator of the aircraft or vessel, is rental income as opposed to transportation income.
Transportation income also includes income derived from or in connection with the performance of services directly related to the use of a vessel or aircraft, whether the services are performed on board or off board the vessel.
(2) On Board Services
On Board Services are performed while on a vessel or aircraft by the operator or related party, in the course of actual transportation of passengers or property. Examples of such income include renting of staterooms, berths, or living accommodations; furnishing meals and entertainment; operating shops and casinos; providing baggage storage and performance of personal services by individuals.
Example 3: F Co. operates a cruise ship from Miami, Florida. The cruise ship has a bar and restaurant, a casino, and a gift shop. Where the bar and restaurant, the casino or the gift shop are owned by the ship operator or a related party, then the income earned through these services will also be transportation income sourced under these special rules.
Planning Note: Where these on board services are performed by independent third parties, they will not be classified as transportation income. These independent on board services will be subject to the normal sourcing rules, which may source most of the income outside of the U.S. as that’s where the majority of the purchases are made and the majority of services are rendered.
(3) Off Board Services
Transportation income includes off board services incidental to operating the vessel, where such services are performed by the operator. Off board services performed by related or independent parties, are not transportation income. Example of such services are terminal services, stevedoring and other cargo handling services, maintenance and repairs and services performed as travel or booking agent.
(C) Personal Services
The transportation sourcing rules do not apply to income derived from the performance of personal services, unless the income is related to transportation income. Income earned by crewmembers is not transportation income, but is sourced under the normal rules for sourcing services income. Rev. Proc. 91-12, 1991-1 C.B. 473.
(D) Taxation of Transportation Income
In general, U.S. source gross transportation income is subject to a 4 percent gross basis tax unless:
(1) Such income is exempt from tax pursuant to Code Sec. 883 or under a tax treaty, or
(2) Such income is effectively connected with a U.S. trade or business.
Solely for purposes of determining whether such income is effectively connected with a U.S. trade or business, the foreign corporation must also maintain a fixed place of business involved in earning the U.S. source gross transportation income and substantially all such income must be attributable to regularly scheduled transportation. Rev. Proc. 91-12, 1991-1 C.B. 473.
(E) Code and Treaty Exemptions for Shipping and Aviation Income
(1) In General
Shipping and aviation income, which is earned by nonresident aliens or foreign corporations may be, subject to certain requirements, exempt from U.S. taxation. Code Secs. 872 (b) and 883. In addition to the Code Section reciprocal exemptions, there are also treaty exemptions for shipping and aviation income. Code Sec. 894.
(2) Reciprocal Exemption – Code Secs. 872(b) and 883
(a) Income derived from the international operation of ships or aircraft is exempt from U.S. source gross income for nonresident aliens who are residents of a foreign country or foreign corporations organized in a foreign country; if such foreign country grants an equivalent exemption to U.S. citizens and U.S. companies. Code Secs. 872(b) and 883. A foreign country may grant an equivalent exemption to U.S. taxpayers by treaty, exchange of diplomatic notes, by letter issued by the foreign government to the IRS or by internal domestic law. Rev. Proc. 91-12, 1991-1 CB. 473.
(b) The reciprocal exemption provided to foreign corporations is available only where the foreign corporation meets one of the following requirements:
(i) Stock of the foreign corporation claming the reciprocal exemption is owned, more than 50% (determined by value), by individual residents of the same foreign country or another foreign country which grants a reciprocal exemption. Code Sec. 883(c)(1).
(ii) The foreign corporation is a U.S. Controlled Foreign Corporation as defined in Code Sec. 957(e). Code Sec. 883(c)(2). or
(iii) The corporation is organized in a country, which grants a reciprocal exemption, and stock of the foreign company is primarily and regularly traded on an established securities market in that foreign country or another foreign country that grants a reciprocal exemption to the United States taxpayers. Code Sec. 883(c)(3).
(3) Treaty Exemption
(a) In General
Most U.S. income tax treaties with foreign countries generally contain one or more provisions which exempt nonresident aliens and foreign entities from U.S. taxation of international shipping or aircraft income. Most treaties specifically exempt this income pursuant to a shipping article, which exempts shipping income, as defined pursuant to a particular treaty. Where a particular treaty does not contain a shipping article, such international shipping or aircraft income may still be exempt pursuant to the business profits or royalty article of that particular treaty. Additionally, most modern U.S. tax treaties require the nonresident alien or foreign corporation to be a resident of the particular treaty country in order to claim the benefits of that treaty.
Where a particular nonresident alien or foreign corporation cannot obtain a treaty benefit, they should consider the Code Section exemption, since they may still qualify for exemption as a qualified resident of a foreign country which provides a reciprocal exemption, based upon their country’s domestic law or exchange of notes.
725: Space and Ocean Activities.
(A) In General
Income derived from an activity conducted in space or on or under water, which are not within the jurisdiction of a foreign country, is source based on the residence of the recipient. Code Sec. 863(d). Ocean and space activity income which is earned by a U.S. Citizen, Resident Alien, Domestic Corporation, Domestic Partnership, Domestic Trust, or Domestic Estate will be U.S. source income. Ocean and space activity earned by any other person or entity will be foreign source income.
The term Ocean or Space activity means any activity conducted in space and any activity conducted on or under water, not within the jurisdiction of a foreign country, possession of the United States or the United States. The term Ocean or Space activity excludes any activity that gives rise to transportation income, to international communication income, or any activity with respect to mines, oil and gas wells or other natural deposits. Code Sec. 863(d)(2).
Ocean and Space activity seems to be a residual category for things happening outside a particular countries jurisdiction, which do not qualify as transportation, communication, or mineral exploration income.
Example 1: USCO is engaged in the business of providing consulting and advisory services to the fishing industry regarding catching fish in international waters which are exported to a foreign country. USCO has its employees performing services on board the client’s ships, which are beyond 12 nautical miles from the coast of the United States. The performance of these services are Ocean activities and they are U.S. source, since they are performed by a U.S. corporation. Letter Ruling 9012023 (December 19, 1989).
Example 2: F Co. leases satellites to relay television signals to USCO. This income is communication income and not Ocean and Space activity. It is 100% foreign source, under international communication income sourcing rules (see ¶735 below).
735: International Communication Income.
(A) In General
International Communications income earned by a U.S. person, is 50 percent U.S. source and 50 percent foreign source. International communication income of foreign persons is treated as totally foreign source income. However, if a foreign person maintains a U.S. office, any international communication income attributable to such office, is treated as U.S. source. Code Sec. 865(e)(2).
International Communication Income includes all income derived from the transmission of communications or data from the United States to any foreign country (or possession of the United States), or from any foreign country (or possession of the United States) to the United States.
Where International Communication Income also fits within the description of income from Ocean or Space activity, it is treated as International Communication Income. Code Sec. 863(d)(2)(B)(ii).
However, leasing of a satellite or cable does not appear to be International Communication Income, as it is not income derived from the “transmission of communications” but rather is income from the rental of the property utilized in providing transmission of communications.
745: Special Sourcing Rules for Passthrough Entities.
(A) In General
There are many types of entities which are not recognized as separate and apart from the ultimate beneficial owners and therefore, are not taxed at the entity level. Historically these included partnerships, S corporations, trusts and estates. However, with the proliferation of new types of entities like Limited Liability Companies (L.L.C.) and Limited Liability Partnerships (L.L.P.), these new entities must be added to this category of passthrough entities. Generally, accounting is done at the passthrough entity level and a determination of whether the passthrough entity is engaged in a U.S. trade or business is determinant at the entity level, but the actual sourcing of income as well as the taxation of such income is done at the beneficial owner’s level.
(B) Partnerships and Entities Electing to be Taxed as Partnerships, including L.L.C.s and L.L.P.s.
U.S. tax rules will determine whether an entity is to be treated as a partnership. Local country law will determine the characteristics of a particular entity, which will then be reviewed pursuant to U.S. tax law to determine whether the entity is classified as a partnership. Pursuant to check-the-box regulations certain companies, organizations, and associations are now allowed to elect, for U.S. tax purposes, whether they would like to be treated as a partnership. Reg. § 301.7701-1. Therefore, a partnership is any association not taxable as a corporation or some other type of entity which has elected to be taxed as a partnership for U.S. tax purposes. For U.S. tax purposes, a partnership is a nontaxable entity. Code Sec. 701. However, a partnership is considered a person for U.S. income tax purposes. Code Sec. 7701(a)(30). Therefore income which is source by reference to the residence of the recipient, will be source by reference to the residence of the partnership.
Example 1: Payment of interest by a U.S. partnership shall be treated as U.S. source, since interest is sourced based on the residence of the payor.
In the case of a sale of personal property by a Partnership, the income is sourced at the partner level. Code Sec. 865(a)(5).
(C) S Corporations
The U.S. Law provides for corporations organized in the U.S. to elect to be treated as passthrough entities. Code Sec. 1362. Such electing corporations have their items of income taxed to their shareholders similar to the partnership tax rules mentioned above.
The S Corporation election and its provisions practically have no impact on source of income rules for NRAs and foreign corporations, as S Corporations are not allowed to have NRAs or foreign corporations as shareholders. Code Sec. 1361(b)(1)(C).
(D) Trusts & Estates
There are two types of trusts for purposes of income taxation: grantor trusts and ordinary trusts. Grantor trusts are ignored for income tax purposes as trust income is taxed directly to the grantor. Code Sec. 671. The grantor is deemed to have received the income directly from the same source which the trust derived it.
There are two types of ordinary trusts: simple trusts and complex trusts. A simple trust is one whose income must be currently distributed to the beneficiaries. Code Secs. 651-652. A complex trust is allowed or is required to accumulate income. Code Sec. 661. Accumulated income is taxed to the trust while non accumulated income (income which is distributed to the beneficiaries in the same tax year in which it was received by the trust) is taxed to the beneficiaries. Code Sec. 661.
Taxable distributions have the same character in the hands of the beneficiaries as they had in the hands of the trust. Code Sec. 652(b). Character includes geographic source. See Isidrio Martin Montis Trust V. Comr., 75 T.C. 381(1980). Accordingly, if a simple trust distributes income from both foreign and domestic sources, a pro rata share of each beneficiary’s income will be treated as foreign and domestic source. See Reg. § 1.652(b)-2. The pro rata share of trust income that is treated as foreign source in the hands of the beneficiary will be proportional to the overall foreign source income earned by the trust as a whole. Code Sec. 652(b).
Income of a complex trust that is distributed currently is governed by the same rules that govern distributions from a simple trust. Code Sec. 661(b). However, accumulated distributions do not retain their character in the hands of an NRA or foreign corporation beneficiaries. Distributions of accumulated income will retain its character, in the hands of an NRA or foreign corporate beneficiary, where it is taxed under the throwback rules. Code Secs. 665-668.
Estates are taxed under the same rules that apply to complex trusts, except that beneficiaries of estates are not subject to the throwback rules upon the distribution of accumulated income. Therefore distributions of current income from an estate, retains its character in the hands of an NRA or foreign corporate beneficiary and distributions of accumulated income, from an estate, do not.
755: U.S. Expatriates.
(A) Special Sourcing Rules and Tax Regime for Expatriates
(1) In General
Starting in 1996, the U.S. strengthened their tax rules regarding taxpayers leaving the United States for tax avoidance purposes. First, they extended these provisions to include long term U.S. residents whose U.S. residency is terminated. Second, the tax avoidance motive is presumed to exist where the taxpayer meets either “the net income” or “the net worth” tests. The effect of these provisions, is that U.S. citizens and long term permanent residents will need to do extensive tax planning on expatriating from the United States and they may still have a substantial amount of their U.S. source income subject to tax, years after expatriating.
(2) Persons Subject to the Expatriation Tax
For individuals who terminate their U.S. citizenship or long-term permanent residency, a tax-avoidance motive for the termination will be presumed if the individual meets either the net income test or net worth test. Code Sec. 877(a)(2). The presumption applies if:
(a) The individual’s average annual net income tax (as defined by Code Sec. 38(c)(1)) for the five years preceding the expatriation date exceeds $100,000 (“net income test”); or
(b) The individual’s net worth as of the expatriation date equals at least $500,000 (“net worth test”).
The $100,000 and $500,000 amounts are indexed for inflation for calendar years after December 31, 1996. Code Sec. 877(a). For 1999, the annual average net income test amount is $110,000 and the net worth test amount is $552,000. Rev. Proc. 98-61, 1998-52 I.R.B. 18.
(3) Exception for Certain Long Term Permanent Residents
The Treasury will issue regulations permitting certain enumerated categories of former long-term residents to seek a ruling request that they lack the principal purpose of U.S. tax avoidance in expatriating. Prior to the issuance of such regulations, the IRS has exercised its regulatory authority, granted under Code Sec. 877(e) and set out the following specific categories of long-term U.S. residents who may submit a ruling request.
(a) Foreign Citizenship Exception.
On the date of expatriation, the individual is a citizen of the country in which the individual, his or her spouse or either of his or her parents were born and the individual becomes, not later than the close of a reasonable period after expatriation, fully liable to tax in such country by reason of his residence.
(b) Long-Term Former Resident Exception.
The individual was present in the United States no more than 30 days in any year during the 10-year period prior to expatriation.
(c) Age of Majority Exception.
The individual ceases to be taxed as a permanent resident, or commences to be treated as a resident of another country under an income tax treaty and does not waive the benefits of such treaty applicable to residents of the foreign country, before obtaining the age of 18-1/2. Notice 97-19, 1997-1 C.B. 394.
Generally, a "long-term resident" refers to an individual, other than a U.S. citizen, who is a lawful permanent resident of the United States for at least 8 tax years during the 15 tax years ending with the tax year during which the expatriating event occurred.
(4) Special Expatriate Sourcing and Income Taxation Provisions
For a period of 10 years following the year of loss of U.S. citizenship (or termination of U.S. residency, as the case may be), a NRA caught by the expatriation tax provisions of Code Sec. 877 will be subject to income tax and alternative minimum tax in the same manner and at the same rates applicable to U.S. residents or citizens, except that gross income will be limited to:
income which is effectively connected with the conduct of a U.S. trade or business; and
income derived from U.S. sources which are not effectively connected with the conduct of U.S. trade or business. Code Secs. 877(b)(1) and 872(a).
The expatriate will only be subject to the Code Sec. 877 tax if it results in a higher tax liability than the tax that would have been imposed under the normal income tax rules applied to NRAs under Code Sec. 871. Code Secs. 877(a)(1) and (b).
(a) Special Sourcing Rule.
There are complex sourcing rules to be applied in determining what property is subject to the expatriation tax. Under these rules, gains realized on the sale or exchange of U.S. situs property other than stock or debt, and gains on the sale or exchange of stock of a U.S. issuer and debt obligations of U.S. persons shall be treated as U.S.-source income for purposes of imposing the tax. Code Secs. 877(d)(1)(A) and (B). The legislative history makes clear that the expatriation tax will apply to U.S.-source income and gains of the individual during the 10-year period, without regard to whether the property giving rise to the income was acquired before or after the date the individual became subject to the expatriation tax provisions.
Example 1: Mr. NRA owns stock of GM in Y1. In Y2 through Y12, Mr. NRA is a resident of the United States. In Y13 Mr. NRA becomes a resident in Europe and sells his GM stock. Unless Mr. NRA can prove a nontax avoidance purpose, he will be subject to tax on the capital gain from these shares in the same manner as U.S. citizens and residents.
Income or gain derived from stock in a foreign corporation (FC) will be treated as U.S.-source income if the expatriate owned or was considered to own (taking into account the attribution rules of Code Secs. 958(a) and (b)) at any time during the two-year period ending on the date of loss of U.S. citizenship (or termination of U.S. residency, as the case may be) more than 50 percent of either:
the total combined voting power of all classes of voting stock; or
the total value of the stock of the FC.
However, the income and gain subject to the expatriation tax cannot exceed the earnings and profits attributable to the stock which were earned or accumulated before the loss of citizenship (or termination of residency) and during the periods that the ownership requirements outlined above were met. Code Sec. 877(d)(1)(C).
Example 2: Ms. NRA owns stock of FCo in Y1. In Y2 Ms. NRA became a U.S. resident. Therefore, starting in Y2 FCo was a U.S. controlled foreign corporation. Ms. NRA did not have any U.S. taxation of her interest in FCo as FCo was engaged in an active trade or business and never made any dividend distributions during the years Ms. NRA was a U.S. resident. In Y15 Ms. NRA obtained a new residence in Chile. From Y2 to Y15 FCo had earned $450,000. In Y16 Ms. NRA sells FCo stock for a $600,000 gain. Ms. NRA will have U.S. source income in the amount of $450,000 from her sale of FCo stock, which is taxable to her as though she continued to be a U.S. resident alien.
(b) Contributions to Certain Foreign Corporations.
There are detailed provisions designed to prevent the use of FCs to convert U.S. source income into foreign-source income.
If U.S. source property is transferred to a FC, then during the 10-year post expatriation period, any income or gain with respect to such property received or accrued by the FC is treated as if received or accrued directly by the expatriate, and not by the FC. Code Secs. 877(d)(4)(A) and (B). The rules also apply to property held by the FC which has a tax basis determined in whole or in part by reference to the contributed U.S. source property. Code Sec. 877(d)(4)(A).
Further, if during the 10-year expatriation tax period when the U.S. source property is held by the FC, the stock of the corporation is sold, “a pro rata share of such property” (determined on the basis of the value of the stock) is treated as if sold by the corporation immediately prior to the sale of the FC stock. This results in the taxation to the expatriate of some portion or all of the gain on the deemed sale of the U.S. source assets. Thus, under these rules, if the expatriate sells 60 percent of his stock in the foreign corporation, he will be treated as if he sold 60 percent of the contributed U.S. property.
(c) Limitations on Tax-Free Asset Conversions.
In an effort to minimize the ability of an expatriate to sanitize U.S. source income or gains by converting the assets on a tax-free basis to non U.S. source assets, Code Sec. 877(d)(2)(A) provides that notwithstanding any nonrecognition provision of the Code, where property giving rise to U.S. source income or gain is exchanged in an otherwise tax-free transaction for property generating non U.S. source income or gains, such property will be treated as if sold for its fair market value on the date of the exchange, with the result that any gain will be recognized by the expatriate in that tax year.
765: Other Income
(A) Underwriting Income
Amounts received as underwriting income for insuring U.S. risks as defined in Code Sec. 953(a), are U.S. source income. Code Sec. 861(a)(7).
Underwriting income is sourced to the location of the insured risk. Code Secs. 861(a)(7) and 862(a)(7). Underwriting income is any premium earned on an insurance contract during the tax year, less expenses and losses. Code Sec. 832(b)(3). Any amounts received as underwriting income (as defined in Code Sec.832(b)(3)) derived from the issuing (or reinsuring) of any insurance or annuity contract is treated as income from sources within the United States if it is:
(1) In connection with property in, liability arising out of an activity in, or in connection with the lives or health of the residents of the United States. Code Sec. 861(a)(7)(A); or
(2) In connection with risks not described in paragraph (1) as a result of any arrangement whereby another corporation receives a substantially equal amount of premiums or other consideration in respect to issuing (or reinsuring) any insurance or annuity contract in connection with property in, liability arising out of an activity in, or in connection with the lives or health of the residents, of the United States. Code Sec. 861 (a)(7)(B).
Underwriting income from any other property or risk not described above may be treated as foreign source.
(B) U.S. Social Security Benefits
Any Social Security benefit as defined in Code Sec. 861(d), is U.S. source income. Code Sec. 86l(a)(8).
(C) Foreign currency gains or losses
Generally sourced based on the residency of the taxpayer or the qualified business unit of the taxpayer. Code Sec. 988(a)(3).
(D) National Principal Contracts
(1) Notional Principal Contract.
A notional principal contract is a financial instrument that provides for payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts. Reg. § l.863-7(a)(1). The term "notional contracts" specifically includes an interest rate cap agreement and an interest rate swaps, basis swaps, interest rate floors, commodity swaps, equity index swaps, and similar agreements. Reg. § 1.446-3(c)(1)(i). The contract must be denominated in terms of the taxpayer's functional currency.
(2) Lump-Sum Payments.
Lump-sum payment received in connection with notional principal contracts must be recognized over the life of the contract to more clearly reflect income. Reg. § 1.446-3(f)(2).
(3) Source of Notional Principal Contract.
The source of notional principal contract income is determined by reference to the residence of the taxpayer. Reg. § l.863-7(b)(1). The source, however, may be determined by reference to the Qualified Business Unit (QBU) of a taxpayer if:
(a) The taxpayer's residence is the U.S.;
(b) The QBU's residence is outside the U.S.;
(c) The QBU is engaged in a trade or business where it is resident; and
(d) The QBU is the only active and material participant in negotiating and acquiring the contract. Reg. § l.863-7(b)(2).
(E) Letter of Credit and Guarantee Fees
Letter of credit fees and guarantee fees are sourced based upon the location of the risk the bank is assuming. Where the letter of credit fees are paid to a U.S. bank to assume the credit risk of a foreign bank and guarantee payment to the holder of letter of credit, the risk is foreign and therefore the fees are foreign source income. Bank of America v. U.S., 680 F. 2d 142 (Ct. Cl. 1982).
The IRS has held that the source of income related to guarantee fees for a guarantee by a U.S. person of debt of a CFC was foreign. The rationale was that the guarantee enabled the CFC to obtain financing outside the U.S. and therefore the fees associated with such guarantee should be sourced based on the location of the obligor, since that was the location of the risk assumed. Private Letter Ruling 7712289960A.
The source of alimony income is the residence of the payor spouse. Manning v. Comr. 38 T.C.M. 646 (1979).
(G) Scholarships, Grants, Gambling, and Lottery Payments
The source of payments made as a scholarship, fellowship, or an award for solving a puzzle is the residence of the payor. Rev. Rul. 89-67, 1989-1 C.B. 233. Similarly income from gambling as well as income from winning a lottery, should be sourced based upon the residence of the payor.
(H) Amounts Includable from Controlled Foreign Corporations and Certain Passive Foreign Investment Companies
Generally, if a foreign corporation is a controlled foreign corporation (CFC) for an uninterrupted period of 30 days or more during any tax year, every U.S. shareholder who owns stock in such CFC on the last day of the tax year in which such corporation is a CFC, must include in his gross income the sum of his pro rata share of the CFC’s subpart F income. The most common reason for a U.S. shareholder to determine the source of such income is for foreign tax credit purposes. For foreign tax credit purposes the amount included in gross income by a domestic corporation as Subpart F income, plus any Code Sec. 78 deemed dividend of taxes paid on such Subpart F income, is deemed to be derived from sources within the foreign country or U.S. possession under the laws of which the CFC is organized See Reg. § 1.960-1(h). If the CFC that generates the subpart F income is held indirectly by another CFC, the second-tier CFC will be disregarded as a conduit entity and the amount included will be treated as if received directly from the first-tier CFC. See Reg. §1.960-1(h).
There are also special sourcing rules for income of a Passive Foreign Investment Company (PFIC) where the shareholders have made an election to treat the corporation as a qualified electing fund (QEF). Code Secs. 1295(a)(1) and (2). Every U.S. person who owns (or is treated under Code Sec.1298(a) as owning) stock of a QEF shall include in gross income:
(1) As ordinary income, such shareholders pro rata share of the ordinary earnings of such fund for such year, Code Sec.1293(a)(1)(A), and
(2) As long-term capital gains, such shareholder’s pro rata share of the net capital gain of such fund for such year. Code Sec.1293(a)(1)(B).
A foreign tax credit is provided for a 10% or more corporate shareholder by treating, for purposes of Code Sec. 960, amounts included in income by such shareholder under Code Sec. 1293(a) as if they were included as Subpart F income and therefore such amounts are treated as foreign source. Code Sec. 1293(f)(1).
In the case of an actual distribution by a PFIC, where a QEF election has not been made or by a CFC to the extent not includable as Subpart F income, the general rules for sourcing dividends apply which result in such distributions being classified as a foreign source dividends.
(I) Income Earned by an FSC or by related supplier on sales through an FSC
The FSC (Foreign Sales Corporation) provisions provide an incentive to U.S. manufacturers to export by exempting a portion of FSC income from U.S. taxation. “Foreign trade income” is gross income of an FSC attributable to “foreign trading gross receipts.” Code Sec. 923(b). The specific types of earnings and profits which constitute "foreign trading gross receipts" are set forth in Code Sec. 924(b). Exempt foreign trade income (defined in Code Sec. 923) shall be treated as foreign source income that is not effectively connected with a U.S. trade or business. Code Sec. 921(a). Nonexempt foreign trade income under Code Secs. 925(a)(l) and (2) (transfer pricing rules) is treated as U.S. source. All other nonexempt foreign trade income of an FSC is sourced under the normal code rules. See Reg. § 1.921-3T(b)(2)(v).
Section 927(e) sets forth special source rules that limit the amount of foreign source income that may be realized by a related supplier of an FSC. Specifically, the income of a person described in Code Sec. 482 from a transaction that gives rise to "foreign trading gross receipts" of an FSC which is treated as foreign source shall not exceed the amount which would be treated as foreign source income earned by such person if the pricing rule under Code Sec. 994 which corresponds to the rule used under Code Sec. 925 with respect to such transaction applied to such transaction.
(J) Income Sourced by Analogy
There are many types of other income where there is an absence of statutory or regulatory guidance concerning the sourcing of such income. For specific guidance regarding the sourcing of such income, the taxpayer must consult IRS Rulings and Case Law for authority. Most of the time, this other type of unique income will be sourced based on the sourcing of analogous types of income. For example, to source a bank’s confirmation, negotiation and acceptance commissions received from a foreign bank in connection with export letter of creditor transaction, the courts have held that the predominant feature of such credit transaction was the substitution of the accepting bank’s credit risk for that of the foreign bank and therefore should be sourced analogous to interest. However, with respect to negotiating transaction fees associated with the same letter of credit transactions, these commissions are for personal services since there was no assumption of credit risk and should be sourced by analogy to personal services. Bank of America v. U.S., 82-1 USTC ¶9415 (Ct. Cl. 1982). The following are examples of other income where there is an absence of statutory or regulatory guidance concerning the sourcing of such income.
(1) Tax Refunds.
The source rules do not address the source of a tax refund. However, the regulations provide that the deduction for payment of state, local or foreign income taxes should be apportioned between the U.S. and foreign sources. See Reg. § 861-8(e)(6). The tax refund should be allocated to the source of the deduction. This is in line with the basic "recapture" and "tax benefit" principles found in the regulations. See Regs. §§ 1.861-11T(e)(2)(i) and 1.904-5(c)(2)(i).
(2) Damages and Settlement Payments.
The IRS has ruled that damages or settlement payments should be sourced with respect to the underlying obligation that is satisfied by the damages or settlement payments. The interest portion of the settlement should be sourced pursuant to the interest sourcing rules.
For example, damages paid to a NRA for patent infringement within the United States, is deemed to be a U.S. source royalty payment. Rev. Rul. 64-206, 1964-2 C.B. 591. Also, payments made to settle a breach of contract action, where the contractors were to perform foreign services, produce foreign source income. Rev. Rul. 83-177, 1983-2 C.B. 112.
(3) Expropriation and Eminent Domain Recoveries.
Expropriation and Eminent Domain recoveries are generally sourced in the same manner as gain or loss realized from the disposition of the underlying assets would be sourced. See Torrington Co V U.S., 149 F. Supp. 172 (Ct. Cl. 1957). However, the IRS has considered other factors to determine the source of expropriation recoveries. For example, in Rev. Rul 76-154,1976-1 C.B. 191, the IRS sourced expropriation payments by reference to the location of the property and the jurisdiction within which the decree was issued. Currently, the proper rule to source this type of gain or loss, is to source it as though the proceeds were from the sale of the underlying asset, with reference to the residence of the taxpayer. Code Sec. 865.
(4) Property and Casualty Insurance Recoveries.
Insurance proceeds are not mentioned in the source rules or the regulations thereunder. In Rev Rul. 70-304, the IRS ruled that the situs of the property determines the source of gain from insurance proceeds received as a result of the loss. See Rev. Rul. 70-304, 1970-1 C.B. 163. After the Tax Reform Act of 1986, insurance proceeds for theft or damaged personal property and the resulting gain or loss there from, should be treated and sourced as gain or loss from the sale of the underlying asset. Here again, any interest portion should be stated separately and sourced under the interest income sourcing rules.
(5) Life Insurance Proceeds and Annuities.
A life insurance contract will provide proceeds to the beneficiary upon the death of the insured. Most life insurance policies also offer a savings element, which creates a significant amount of investment income. Generally all amounts received by the beneficiary of a life insurance policy, if such amounts are paid by reason of death of the insured, are excluded from U.S. gross income. Code Sec. 101(a)(1). However, if the policy does not qualify as life insurance pursuant to Code Sec. 7102(a), then a determination of the source of the various types of income produced by a non-qualifying life insurance policy need to be determined. Code Sec. 7702(9)(1)(A). In PLR 8543046, the IRS analogized the investment income portion of an annuity contract, sold by a life insurance company, to interest income. Factors that should be taken into consideration when determining the source of the investment portion of a life insurance policy are the place of incorporation of the insurance company and whether the policy was written by a foreign or a domestic branch of that company. Code Secs. 86l(a)(1)(A) and (a)(1)(B).
For the risk portion of the life insurance policy, the IRS has held that where a U.S. insurance company pays a Non-Resident Alien beneficiary proceeds pursuant to a life insurance policy on a Non-Resident Alien individual, such proceeds are subject to U.S. gross basis withholding tax. Rev. Rul. 64-51, 1964-1 C.B. 332. However, the ruling does not mention the rationale for sourcing the payment of the life insurance as U.S. source. Perhaps a better sourcing rule would be based upon the residence of the insured, as that would be indicative of the location of the risk being insured against and it would also be consistent with the sourcing of insurance income rules contained in Code Sec. 861(a)(7).
Insurance companies also offer many types of annuities. Where an annuity contains a mortality element, it should be analyzed in the same manner as a life insurance contract. To the extent the annuity does not have a mortality element, the income there from is closely analogous to interest income and should be sourced accordingly.
(6) Non-Compete Payments.
In Korfund Co. v. Comr., 1.T.C. 1180(1943), NRAs entered into a covenant not to compete in the U.S. The contract was made in the U.S. and the promise made was not to compete in the U.S. The court held that income earned on the contract was from sources within the United States because the amount received was paid in consideration of giving up the right to earn income in the U.S. See Id. at 1187.
(7) Unemployment Benefits.
The residence of the payor of unemployment benefits is immaterial to the determination of their source. See Rev Rul. 73-252, 1973-1 C.B. 337. In Rev. Rul 73-252, the IRS ruled that supplemental unemployment benefits paid by a U.S. Employee Benefit Association to a citizen and resident of Canada are foreign source income under Code Sec. 863. Relying on British Timken Ltd., 12 T.C. 880 (1949) and Comr. V. Ferro-Enamel Corp., 134 F.2d 564 (6th Cir 1943), the IRS ruled that “the main factor in determining the source of income of payments received is the location of the property to which the payment related or the situs of the activities that resulted in its being made. See Rev. Rul. 73-252, 1973-1 C.B. 337. Where the source of the employee's wages while he was employed was outside the U.S. and the activities which gave rise to the receipt of the unemployment benefits took place outside the U.S., the unemployment payments are deemed to be income from sources outside the U.S. See Id.
(8) Options Payments.
The purchaser of an option pays a sum of money to the writer of said option for the right to either purchase from ("call" option) or sell to ("put" option) the writer, at any time before a specified future date, a stated number of shares of stock at a specified price. See Rev. Rul. 78-182 1978-1 C.B. 265. An option is usually treated as personal property. Accordingly, income realized by the writer of an option upon its lapse should be sourced as a disposition of personal property. Generally, any gain or loss realized from the sale of an option is considered gain or loss from the sale or exchange of property that has the same character as the property to which the option relates has, or would have, in the hands of the taxpayer. See Id.
The gain or loss on exercising or lapse of an option, should be sourced based on the residence of the seller, unless the sale or lapse of the option is deemed to be inventory property. Code Secs. 865(e) and 865(b).
(9) Cancellation of Indebtedness.
Generally, cancellation of indebtedness is not considered to be fixed and determinable periodic income within the meaning of Code Secs. 871 and 881. Therefore, cancellation of indebtedness realized by an NRA or foreign corporation is not subject to U.S. taxation, provided it is not effectively connected with its U.S. trade or business. However, if the cancellation is connected with a U.S. trade or business, the source rules are still relevant. The source rules do not address sourcing income earned from cancellation of indebtedness. The most logical approach would be to source such income in the same manner as deductions with respect to the underlying debt have been sourced.
(10) Agricultural Export Subsidies.
Agricultural export subsidies have been held to be U.S. source. See G.A. Stafford & Co., Inc. V. Pedrick, 171 F.2d 42 (1948). The decision was based on the fact that the payor was the United States Treasurer, a U.S. resident, and every act which the exporter must do to become entitled to the subsidy is done in the U.S. See Id. at 44.