international tax lawyers

Personal Services Income Sourcing | International Tax Lawyer & Attorney

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This article continues our series of articles on the source of income rules. Today, I will explain the general rule for individual personal services income sourcing. I want to emphasize that, in this essay, I will focus only on individuals and provide only the general rule with two exceptions. Future articles will cover more specific situations and exceptions.

Personal Services Income Sourcing: General Rule

The main governing law concerning individual personal services income sourcing rules is found in the Internal Revenue Code (“IRC”) §861 and §862. §861 defines what income is considered to be US-source income while §862 explains when income is considered to be foreign-source income.

The general rule for the individual personal services income is that the location where the services are rendered determines whether this is US-source income or foreign-source income. If an individual performs his services in the United States, then this is US-source income. §861(a)(3). On the other hand, if this individual renders his services outside of the United States, then, this will be a foreign-source income. §862(a)(3).

In other words, the key consideration in income sourcing with respect to personal services is the location where the services are performed. Generally, the rest of the factors are irrelevant, including the residency of the employee, the place of incorporation of the employer and the place of payment.

As always in US tax law, there are exceptions to this general rule. In this article, I will cover only two statutory exceptions; in the future, I will also discuss other exceptions as well as the rule with respect to situations where the work is partially done in the United States and partially in a foreign country.

Personal Services Income Sourcing: De Minimis Exception

IRC §861(a)(3) provides a statutory exception to the general rule above specifically for nonresident aliens whose income meet the de minimis rule. The de minimis rule states that the US government will not consider the services of a nonresident alien rendered in the United States as US-source income as long as the following four requirements are met:

1. The nonresident alien is an individual;

2. He was only temporarily in the United States for a period or periods of time not exceeding a total of 90 days during the tax year;

3. He received $3,000 or less in compensation for his services in the United States; AND

4. The services were performed for either of two persons:

4a. “A nonresident alien, foreign partnership, or foreign corporation, not engaged in trade or business within the United States”. §861(a)(3)(C)(i); OR

4b. “an individual who is a citizen or resident of the United States, a domestic partnership, or a domestic corporation, if such labor or services are performed for an office or place of business maintained in a foreign country or in a possession of the United States by such individual, partnership, or corporation.” §861(a)(3)(C)(ii).

Personal Services Income Sourcing: Foreign Vessel Crew Exception

The personal services income performed by a nonresident alien individual in the United States will not be deemed as US-source income if the following requirements are satisfied:

1. The individual is temporarily present in the United States as a regular member of a crew of a foreign vessel; and

2. The foreign vessel is engaged in transported between the United States and a foreign country or a possession of the United States. See §861(a)(3).

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2018 Individual Tax Rates | International Tax Lawyer & Attorney

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The Tax Cuts and Jobs Act of 2017 modified the tax brackets that existed in tax year 2017. In this short essay, I will discuss the new 2018 individual tax rates.

2018 Individual Tax Rates: Historical Background

Tax rates seem to change every time there is a new President. For example, when President Bush got elected in 2000, the Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001 creating a new tax bracket and bringing the rest of the tax rates down; the top rate was gradually reduced to 35% from 39.6%.

Then, under the new administration of President Obama, the American Taxpayer Relief Act of 2012 increased the tax rates again with the top rate going back up to 39.6%.

2018 Individual Tax Rates: 2017 Tax Reform

Under President Trump, the Congress passed a major reform of the US tax system through the Tax Cuts and Jobs Act of 2017. The tax rates were among the most important changes with respect to domestic US tax law.

While the tax reform preserves the same seven tax brackets for individual tax payers, it introduces new 2018 individual tax rates for almost each of them. Under the previous law, the tax brackets were 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. Now, the new rates starting tax year 2018 are much lower: 10%, 12%, 22%, 24%, 32%, 35%, and 37%.

It is important to emphasize that these are not permanent changes. The new tax brackets will operate only through tax year 2025; starting January 1, 2026, the tax rates will return to those that existed in 2017.

2018 Individual Tax Rates: Income Thresholds for Tax Brackets Increase

In addition to lower tax rates, the 2017 tax reform also restructured the income thresholds that apply to most tax brackets. Generally, the income thresholds went up.

For example, in order to be subject to 39.6% tax in 2017, taxpayers filing a joint tax return must have had income in excess of $470,700. In 2018, in order to be subject to the top bracket’s tax rate of 37%, the same couple will have to have income in excess $600,000. The income of $470,700 would only trigger the 35% tax rate in 2018.

Sherayzen Law Office has long held the view that the increase in the income thresholds for tax brackets is especially important (perhaps, more so than the decrease in tax rates) to alleviate the tax burden of the middle class. However, we do note with alarm that the benefits might have been spread too widely to include the top 1% of the earners while the 10% bracket was kept essentially the same. We believe that this was one of the reasons why the Congress made the increase in income thresholds for tax brackets a temporary one despite the anticipated inflation pressures in the future.

Interest Income Sourcing | International Tax Lawyer & Attorney

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This article is a continuation of a recent series of articles on the US source of income rules. In this article, I would like to introduce the readers to the interest income sourcing rules.

Interest Income Sourcing: Definition of “Interest”

Let’s first understand what is meant by the word “interest”. It is very curious that there is no definition of this term in the Internal Revenue Code nor in the Treasury regulations. Indeed, when applied to real life situations, the tax definition of interest spreads to items which do not at first appear as interest income (the most famous example is the original issue discount); the contrary is also true – sometimes an income that appears to be interest income is not considered to be such by the IRS (for example, commitment fees).

Generally, “interest” is a payment for the use of money. In most cases, there is a relationship of indebtedness that accompanies the requirement to pay interest; however, this is not always the case. In fact, there are numerous rules and rulings that one must know in order to properly determine how the IRS will treat a certain payment.

Interest Income Sourcing: General Rule

Generally, the interest is sourced at the residence of the obligor. IRC § 861(a)(1). Thus, if the obligor resides in the United States, then the interest paid on the obligation will be considered as US-source income. This is the case even if the obligor is a foreign national who resides in the United States. On the other hand, if a US citizen resides in a foreign country, then the interest that he pays to his lender is a foreign-source income.

This rule may lead to a paradoxical situation. For example, if a US citizen resides in Spain and pays interest to a Spaniard, this interest would be considered as Spanish-source income. At the same time, if a Spaniard resides in the United States and pays interest to a US citizen who resides in Spain, then the interest would be considered as US-source income.

Generally, interest paid by domestic corporations and domestic partnerships follows the same interest income sourcing rules. There are, however, some exceptions to this rule. For example, with respect to banks, interest on deposits with a foreign branch of a domestic corporation is not considered to be US-source income. IRC § 861(a)(1)(A)(i).

I wish to emphasize that I am stating here a general rule only. There are various exceptions, especially with respect to the portfolio interest. Most of these exceptions are especially relevant to nonresident aliens who receive interest from the United States.

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Source of Income: Sale of Real Property | International Tax Law Firm

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One of the most common questions that often arises is whether a sale of real property is considered to be a foreign-source or US-source income. In this short essay, I will briefly describe the source of income rule for the sale of real property and discuss its importance.

Sale of Real Property: What is “Source of Income”

The sourcing rules within the United States Internal Revenue Code (“IRC”) determine to which part of the world a particular income item needs to be assigned. In other words, the source of income rules allow a taxpayer to determine whether his income is considered to be “domestic” or “foreign” for US tax purposes.

Sale of Real Property: the Importance of the Source of Income Rules

The importance of the source of income rules is difficult to overstate. For US tax residents, the source of income rules determine the amount of foreign tax credit that can be claimed on their US tax returns. Moreover, the source of income rules may have other important effects, especially for corporate taxpayers.

However, the significance of the source of income rules is felt the most by nonresident aliens. For these foreign persons, the determination of whether income is foreign or domestic may result in a complete escape from US taxation or, on the opposite end, the obligation to submit a US tax return (even if the nonresident alien has no other connection to the United States). Moreover, the sourcing of income has direct implications for the numerous US tax withholding obligations.

Sourcing of a Sale of Real Property

The US source of income rule with respect to sales of real property is clear: the gain from a sale of real property is sourced to the place where the property is located. In other words, if a house is located in the United States, then the gains from the sale of the house will be considered US-source income. On the other hand, if a house is located in a foreign country, then it will be considered foreign-source income (actually, sourced to the specific country where the sold property is located).

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Dividend Income Sourcing | International Tax Lawyer & Attorney

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One of the most important issues in US international tax law is the sourcing of income – i.e. the determination of whether the income is foreign or domestic for US tax purposes. In this article, I will introduce readers to US tax rules concerning dividend income sourcing (note, I will not be discussing substitute dividends and so-called “fast-pay” stocks as part of this article).

Dividend Income Sourcing: General Rule

Aside from limited exceptions, the source of dividend income is determined by whether the corporation that pays the dividends is foreign or domestic.

Dividend Income Sourcing: Domestic Corporations

Generally, if a US domestic corporation pays a dividend to its shareholders, the income is sourced in the United States. IRC §861(a)(2)(A).

There are three limited exceptions to this general rule, but only the first exception is really relevant at this point. The first exception is found in the complex rules concerning a Domestic International Sales Corporation (“DISC”). Basically, under IRC §861(a)(2)(D), dividends from a DISC are US-source income unless the dividends are attributable to “qualified export receipts”. In other words, if all of the gross income of a DISC satisfies the definition of qualified export receipts, then the entire gross income will be considered as derived from a foreign source. This is the basic rule and there are important exceptions and considerations that must be considered if one engages in a detailed analysis.

The second exception was a dividend paid by a Section 936 corporation. A Section 936 corporation was a special type of a domestic corporation that did business in the US possessions. At this point, the repeal of IRC §936 makes this section largely irrelevant.

Finally, the third exception existed mostly prior to 1987. At that time, if a taxpayer was able to show that 80% of the gross income of the payor corporation for the relevant period of time consisted of foreign-source income, then the dividend was also foreign-source even if it was paid by a domestic corporation. The relevant period of time for making this determination included the three fiscal years of the corporation preceding the year in which the dividend was declared (obviously, if the corporation existed for less than three years, then the period of time was reduced to the number of years the corporation had been in existence). Interestingly, with the exception of mergers and consolidations, the dividends were foreign-source even if the payor corporation filed a consolidated return with an affiliated group which did not meet what was known as the 80/20 rule.

This third exception became largely irrelevant as of January 1, 1987. However, the 80/20 corporations were exempted from tax withholding even as late as prior to 2010. At that time, the Congress finally repealed the 80/20 company rule, though it still left a grandfather clause for it.

Dividend Income Sourcing: Foreign Corporations

Dividend income sourcing with respect to foreign corporations is more complex. Generally, dividends from foreign corporations are considered to be foreign-source income unless 25% or more of the corporation’s gross income for the three years preceding the taxable year (in which the distribution occurred) was from income that was effectively connected with a trade or business in the United States. This is the so-called “25% exception”.

If the 25% threshold is satisfied, then the dividend is apportioned according to the percentage of the corporation’s income effectively connected to the United States versus foreign-source income. This rule obviously affects the ability of a US person to take full foreign tax credit.

Now, let’s look at the 25% exception from the perspective of a foreign person receiving a dividend from a foreign corporation. Again, if a foreign dividend was paid to a foreign person from a company that did not satisfy the 25% exception, then no part of the dividend was sourced to the United States. If, however, the 25% exception was satisfied, then a foreign person had US-source income according to the apportionment rule described above. In other words, a foreign dividend paid from a foreign company to a foreign individual may result in US-source income even though none of these persons are US tax residents!

Moreover, prior to 2005, such a foreign individual would have to declare this US-source income in the United States and, theoretically, pay tax on it. Obviously, this was unlikely to happen because either the foreign corporation was subject to the branch profits tax which offset the tax on dividends paid by the corporation or a tax treaty prevented the taxation of such dividend. Nevertheless, if neither exception applied, a foreign person could find himself in noncompliance with US tax laws (and there was even some litigation on this subject).

When it passed the American Jobs Creation Act of 2004, the US Congress finally relented and exempted from US taxation all dividends that fell within the 25% exception and were paid to foreign persons on or after January 1, 2005. IRC §871(i)(2)(D).

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