Generally, subject to four exceptions below, the source of interest income is determined by the residence or place of incorporation of the payor (party that is paying the interest expense related to borrowed funds). When a U.S. corporation or individual pays interest, the interest is sourced to the country of incorporation, the US. When interest is paid by individuals, partnerships, trusts, or estates, the interest is sourced to the payor’s residence. Thus, interest income has a U.S. source if the payor is a U.S. resident or is a domestic corporation.
A 30% withholding requirement, or lower treaty rate, is imposed on US taxpayer that pay interest expense to a foreign lender. U.S. Taxpayer’s will incur personal liability for the unpaid withholding so extreme caution is required in this area. Withholding is the methodology whereby the US government taxes a foreign lender for the interest income earned from US sources.
The determination of who is a “resident” is sometimes a difficult one, since the person might be a resident prior to paying the interest but not after, or vice versa. However, Reg. §1.861-2(a)(2) indicates that the term “resident of the United States” includes:
an individual who at the time of payment of the interest is a resident of the United States,
a domestic corporation,
a domestic partnership which at any time during its taxable year is engaged in trade or business in the United States, or
a foreign corporation or a foreign partnership, which at any time during its taxable year is engaged in trade or business in the United States.
Interest income is not sourced by the residence or place of incorporation of the payor in the following four situations:
Interest income has a foreign source if the payor is an individual, resident alien or domestic corporation and at least 80% of the payor’s gross income for the previous three years is from foreign sources, attributable to an active business conducted in a foreign country by the payer (or its subsidiary).
Interest income has a foreign source if the payor is a foreign branch of a domestic corporation or partnership that is engaged in commercial banking, or if the interest is paid on certain amounts on deposit with the branch.
Interest income has a U.S. source if the payor is a foreign partnership that is primarily engaged in an active foreign trade or business, but only to the extent that it is paid or allocated to the partnership’s U.S. trade or business.
Interest income has a U.S. source if the payor is a foreign corporation, which is in turn receives revenue from the foreign corporation’s trade or business in the United States. The same is true of interest paid from a foreign corporation’s “effectively connected income” (ECI).