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:
Interest income is not sourced by the residence or place of incorporation of the payor in the following four situations: