LB&I Concept UnitKnowledge Base - InternationalLibrary LevelNumberShelfTitleIndividual OutboundBook10Foreign Tax Credit (Individual Outbound)Chapter10.2Calculation of Amount of Allowable FTCSectionSubsectionUnit NameSourcing of IncomePrimary UIL Code9432.02-01Sourcing of IncomeDocument Control Number (DCN)FTC/C/10 02-05Date of Last Update04/12/17Note: This document is not an official pronouncement of law, and cannot be used, cited or relied upon as such. Further, this document may not contain acomprehensive discussion of all pertinent issues or law or the IRS's interpretation of current law.

DRAFTTable of Contents(View this PowerPoint in “Presentation View” to click on the links below)General OverviewRelevant Key FactorsDetailed Explanation of the ConceptExample of the ConceptIndex of Referenced ResourcesTraining and Additional ResourcesGlossary of Terms and AcronymsIndex of Related Practice Units2

DRAFTGeneral OverviewSourcing of IncomeWhy is it important to know the source of a taxpayer’s income? It is important because the foreign tax credit (FTC) can only offsetU.S. taxes on foreign source income. A U.S. person is subject to worldwide taxation on income from all sources. However, a foreignperson is subject to U.S. tax only on their income from sources within the U.S., with minor exceptions. Thus, the sourcing of income isnecessary because amounts reported by a taxpayer are not automatically includible in the calculation of U.S. taxable income.The objective of this Practice Unit is to identify an individual’s various types of income and the factors used to determine whether thatincome is U.S. or foreign sourced, sometimes referred to as “within the U.S.” (U.S.) or “without the U.S.” (foreign). When the InternalRevenue Code (IRC) speaks of sourcing of income, it is referring to the origin of the income as being earned in the U.S. or in a foreigncountry. The taxpayer must first determine whether the gross income in each category is from U.S. sources or foreign sources, thenthe taxpayer can figure the taxable income in each category from sources outside of the U.S.The concept of sourcing is often associated with the concept of categorization. Different sourcing rules apply for different types ofincome. Once you have identified that there is foreign source income, you must then categorize the type of income (i.e., passive,general, etc.) in order to properly apply sourcing rules. Matters related to categorization are addressed in another Practice Unit.Summary: Not all income on which a taxpayer pays foreign tax is eligible for the FTC. Rather, the credit is only available for incomethat is considered foreign source income. The source rules are designed to determine whether the U.S. or a foreign country has acloser connection or "nexus" to the income. If income is foreign source income, a foreign country has the primary right to tax theincome. Therefore, the U.S. will allow the taxpayer to take a credit for foreign income taxes paid. Improper sourcing of income can leadto an erroneous overstatement of the FTC.TTREATY IMPLICATION: Sourcing rules can be complicated and subject to many exceptions. Many income tax treaties to whichthe U.S. is a party vary the sourcing rules contained in the IRC by express agreement of the contracting states. If you encounterthis issue, please refer to the specific country’s treaty and consult with the Treaties Practice Network.Back to Table of Contents3

DRAFTRelevant Key FactorsSourcing of IncomeKey FactorsSourcing rules are contained largely in IRC 861-863 and 865. The statutory rules cover interest, dividends, compensation for services,rents and royalties, gains from sales of property and social security benefits. IRC 861 provides rules as to when specific classes of income are sourced within the U.S. IRC 862 is a parallel section providing when those same classes of income are sourced outside the U.S. IRC 863(b) provides rules as to when specific classes of income are sourced partly within and partly without the U.S. IRC 863(c), (d), and (e) relate to other specialized sourcing items of income. IRC 864 provides definitions and special rules. IRC 865 provides rules for the sale of personal property.This determination of foreign source is reported country by country and is listed in Form 1116, Part 1, line g. Gross income fromsources outside the U.S. is reported on Form 1116, Part 1, line 1a. This includes gross income even if is not taxable by that foreigncountry.Another way to think about the concept of sourcing is that on Form 1040 a taxpayer reports their worldwide income, while on Form1116, Part I, line 1a a taxpayer reports only the portion that is foreign income. In completing Form 1116 Part 1, it is recommended thata sourcing schedule of gross income (and expenses/deductions) be provided.Back to Table of Contents4

DRAFTRelevant Key Factors (cont’d)Sourcing of IncomeKey Factors!CAUTION: With respect to the definition of United States, see IRC 638 and 7701(a)(9): Generally, the U.S. includes the 50states and the District of Columbia plus the territorial waters adjoining its coastline. There may be differences, however, indefining United States between what is foreign source income for FTC purposes and foreign earned income for foreign earnedincome exclusion (FEIE) purposes, as well as for other purposes. For example, foreign source income for FTC purposes maybe earned in international waters. Compare this to U.S. possessions which are included in the territorial definition of the U.S. forpurposes of the FEIE IRC 911, as this section requires that the income be earned in a foreign country. Matters related to FEIEare beyond the scope of this Practice Unit.Back to Table of Contents5

DRAFTDetailed Explanation of the ConceptSourcing of IncomeSourcing of Interest IncomeAnalysisGenerally, interest income is determined by the residence of the payor. This presupposes thatthe true identity of the payor is known. Interest income includes earnings from bank accounts,bonds and notes. Interest that arises from sources within the 50 states and the District ofColumbia is income from sources within the U.S. However, interest on deposit with adomestic corporation or partnership is foreign source income if the deposits are with a foreignbranch of the corporation or partnership and the foreign branch is engaged in the commercialbanking business. Interest paid by a U.S. trade or business (U.S. branch) of a foreigncorporation is deemed paid by a domestic corporation and, therefore, from sources within theU.S.Resources IRC 861(a)(1)IRC 862(a)(1)Treas. Reg. 1.861-2Treas. Reg. 1.862-1(a)(1)(i)Example 1: Taxpayer A, a U.S. taxpayer, receives interest income from a personal loan madeto taxpayer B, a U.S. citizen but resident of foreign country X. Since taxpayer B is a residentof foreign country X, although a U.S. citizen, the income is foreign sourced income.Back to Table of Contents6

DRAFTDetailed Explanation of the Concept (cont’d)Sourcing of IncomeAnalysisResourcesSourcing of Interest Income (cont’d)Example 2: Taxpayer C, a foreign corporation doing business in the U.S., receives interestincome from taxpayer D, a U.S. citizen and resident. The income is U.S. sourced becausethe payor is a resident of the U.S.Example 3: Using the same facts as Example 2, except that taxpayer D makes the paymentfrom a Swiss bank account to taxpayer C’s bank in the Cayman Islands. The income is U.S.sourced because the payor is a resident of the U.S.Back to Table of Contents7

DRAFTDetailed Explanation of the Concept (cont’d)Sourcing of IncomeAnalysis Generally, dividend income is determined by the payer’s country of incorporation. Dividends from domestic corporations are U.S. source income. Dividends from foreign corporations areforeign source. However, a dividend from a foreign corporation may be U.S. source income, if at least 50 percent of the corporation’s gross income for the preceding three years waseffectively connected income (ECI). A dividend may also be U.S. source income if thatdividend was from a foreign corporation which distributed it from earnings and profits (E&P)that the corporation inherited from a domestic corporation, but only to extent the dividendqualifies for a dividends-received deduction.Sourcing of Dividend IncomeResourcesIRC 861(a)(2)IRC 862(a)(2)Treas. Reg. 1.861-3Treas. Reg. 1.862-1(a)(1)(ii)Treas. Reg. 1.243-3Example 1: Taxpayer A, a U.S. person, received dividends from an Italian corporation with noU.S. ECI. The dividend is foreign sourced income.Example 2: Taxpayer B, a citizen of Hungary and residing in the U.S., receives dividends fromArgentina with no U.S. ECI and deposits them in her U.S. bank account. The dividend isforeign sourced income.Consultation: ECI is an inbound topic. If you encounter this issue with a nonresidentalien (NRA) or a foreign corporation, please consult with the U.S. Business ActivitiesPractice Network.Back to Table of Contents8

DRAFTDetailed Explanation of the Concept (cont’d)Sourcing of IncomeAnalysisResourcesSourcing of Dividend Income (cont’d)Example 3: Taxpayer C, a citizen of the Netherlands residing in the U.S., receives 800 individends in 2006 from a Netherlands Antilles corporation, which has the following incomethat is ECI.YearTotal Gross IncomeForeign SourceIncomeECI/U.S.Source Income2003 15,000 6,100 8,9002004 25,000 15,500 9,5002005 10,000 3,200 6,800Totals 50,000 24,800 25,200Since the corporation is foreign and more than 25 percent of its gross income is ECI, some orall of the dividend becomes U.S. sourced.Effectively connected income for testing period / All gross income for testing period: 25,200 / 50,000 x 800 403 . This is the U.S. source portion of the 800 dividend.Back to Table of Contents9

DRAFTDetailed Explanation of the Concept (cont’d)Sourcing of IncomeAnalysisSourcing of Compensation IncomeThe general rule for sourcing wages and personal services income is controlled by where theservice is performed. The residence of the recipient of the service, the place of contracting,and the time and place of payment are irrelevant.Resources IRC 861(a)(3)IRC 862(a)(3)Treas. Reg. 1.861-4Treas. Reg. 1.862-1(a)(1)(iii) General rule for employees: Source is determined on a time basis except fringe benefits. General rule for non-employee Individuals: Source is determined on the basis that mostcorrectly reflects the proper source of that income under the facts and circumstances of thatparticular case. If services are performed both within and without the U.S., the compensation for theservices is allocated on a basis that most correctly reflects the proper source of incomeunder the facts and circumstances. In many cases, it may be that an apportionment on atime basis may be acceptable. However, compensation for services performed by a NRA in the U.S. is foreign source if allof the following are met: The services are performed by a NRA temporarily in the U.S., Presence in U.S. during the taxable year does not exceed 90 days and Compensation for services does not exceed 3,000.Back to Table of Contents10

DRAFTDetailed Explanation of the Concept (cont’d)Sourcing of IncomeAnalysisResourcesSourcing of Compensation Income (cont’d)Example: Taxpayer A, a citizen and resident of Germany, was engaged by a U.S. firm todevelop a new product for worldwide sales. In developing this product, taxpayer A waspresent in the U.S. for 56 days (8 weeks) to work out actual production problems. The entireproject took twenty weeks for which he was paid 60,000.Taxpayer A performed services as a NRA temporarily in the U.S. for 56 days. He was paid inexcess of 3,000. Therefore, the income cannot be solely foreign sourced and needs to beallocated as follows:8 weeks in U.S. / 20 weeks total project x 60,000 paid 24,000 sourced U.S.NOTE: Completion of Form 1116, Part I line 1(a) should reflect exclusions (Section 911) andadjustments. Adjustments to foreign source gross income are beyond the scope of thisPractice Unit. Form 1116Back to Table of Contents11

DRAFTDetailed Explanation of the Concept (cont’d)Sourcing of IncomeAnalysisSourcing of Compensation Income (cont’d)Resources Treas. Reg. 1.861-4(b)(2)(ii)(G),Example (3)Example: Compensation apportionment of income. A, a U.S. citizen, is employed by Corp N,a domestic corporation. A’s annual salary is 100,000. A performed services entirely withinthe U.S. during the first quarter; A was transferred to country X for the remainder of the year.Fringe benefits attributable to her new principal place of work in country X totaled 30,000( 25,000 paid for housing, 5,000 for local transportation).A was required to work on a 5-day week basis, Monday through Friday. During the last threequarters of the year, A performed services 30 days in the U.S. and 150 days in country X andother foreign countries. A establishes that the first quarter of the calendar year and the lastthree quarters of the calendar year are two separate, distinct and continuous periods of time.During the last 3 quarters, 30/180 is attributable to services performed within the U.S.Annual Salary 100,000 ( 25,000 first quarter, 75,000 last three quarters)First Quarter : 25,000 (domestic)Last 3 Quarters: 75,000 ( 12,500 domestic, 62,500 foreign)Fringe Benefits: 30,000 (foreign)Total attributable to services within U.S. 37,500 ( 25,000 12,500)Total attributable to services outside U.S. 92,500 ( 62,500 30,000)Back to Table of Contents12

DRAFTDetailed Explanation of the Concept (cont’d)Sourcing of IncomeAnalysis Gross income from sources within the U.S. includes rents or royalties from property located in the U.S. or from any interest in such property, including rents or royalties for the use, or the privilege of using, in the U.S., patents, copyrights, secret processes and formulas, goodwill,trademarks, trade brands, franchises and other like property. The income arising from therental of p