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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