The United States source of income rules are of critical importance for U.S. taxation purposes for both foreign and U.S. persons. Foreign persons are generally subject to U.S. tax only on their income from sources within the United States. U.S. persons are subject to worldwide U.S. taxation on income from all sources derived. The source of the income received by U.S. persons is critical to the determination of the extent to which they can claim a foreign tax credit for income taxes paid to foreign governments, and therefore has a major effect on U.S. taxation.
The sourcing rules begin with the very simple general proposition that the source of income is the geographic location from which that income is derived. A multitude of exceptions is then overlaid on top of this general rule depending on the particular type of income involved. The sourcing rules also differ based upon the specific category of income at issue, such as interest, dividends, or income from trade or business. For example, the place where personal services are rendered is the most relevant sourcing factor under United States tax law. Personal services rendered in the United States are sourced to the United States. Services rendered outside of the United States are source to the foreign country where the services were rendered. The main overarching issue to be determined under the sourcing rules is whether there is sufficient connection (or Nexus) between the category of income derived and a specific country’s taxing authority to require the income to be taxed within a specific country. (Note: Income can and often is subjected to tax in more than one country – more on that later) Accordingly, the United States sourcing rules classify income in one of three basic manners:
1. as income from a United States source
2. as income from a non-United States source;
3. or as income from partly within and partly without the United States.
Scattered throughout the Code are a number of provisions dealing with the source rules that determine when income is of a foreign or U.S. source. The basic rules, however, are contained in Internal Revenue Code §§861, 862, 863, and 865. In addition, extensive case law and the voluminous regulations add further provisions to that list. Despite the sundry locale of these rules, most of them can be organized around five groupings:
(1) the payor’s nationality or residence,
(2) the payee’s residence,
(3) the income-producing asset’s location,
(4) the income-producing activities’ location; and
(5) “mixed” source income rules.
The source rules are important for two chief reasons. First, certain individuals and corporations-namely, nonresident aliens and foreign corporations-are taxed only on income having a U.S. source. Second, the source rules a major component of the foreign tax credit calculation (FTC). The FTC is a credit utilized by U.S. citizens, residents, and domestic corporations to offset or mitigate double taxation on domestic corporations and individuals. Where income is taxed both by the U.S. and a foreign government, the foreign tax credit offsets a portion of the US tax for all or a portion of the foreign tax levied on that same income and thus the effects of double taxation are mitigated.