Oftentimes, as part of their noncompetition agreement, a taxpayer may receive income for restraining from competing with another party in certain areas. An issue often arises with respect to international noncompetition agreement income sourcing rules – i.e. should the income paid as part of such a noncompetition agreement be considered US-source income or foreign-source income? Let’s explore the answer to this question in this essay.
Noncompetition Agreement Income Sourcing: General Rule
The general rule with respect to income sourcing for noncompetition agreements was settled in the distant year 1943. In that year, the Tax Court held that the source of income from a noncompetition agreement is the location of the forbearance. Korfund Co., Inc. v. Commissioner, 1 T.C. 1180, 1187 (1943). In other words, income received from an agreement not to compete is deemed to be income earned in a place where the agreement prohibits the taxpayer from competing.
The reasoning of the Tax Court is clearly laid out in its opinion. The Court stated that the rights that a party enjoys from the noncompetition agreement “were interests in property in [the] country [of forbearance]. … The situs of the right was in the United States, not elsewhere, and the income that flowed from the privileges was necessarily earned and produced here. … These rights were property of value and the income in question was derived from the use thereof in the [country of forbearance].” Id.
In 1996, in its Field Service Advice, the IRS restated its commitment to the position adopted by the Tax Court in Korfund: “income from covenants not to compete covering areas outside of the United States is foreign source income because the income from a covenant covering areas outside the United States is from the use of a property right outside the United States.” 1996 FSA LEXIS 191, *5 (I.R.S. August 30, 1996).
Noncompetition Agreement Income Sourcing: Apportionment
What if a noncompetition agreement covers both, part of the United States and a foreign country? In this case, the IRS is likely to take a position that an apportionment of some sort is necessary. In other words, only part of the income will be deemed as US-source income, while the rest will be considered foreign-source income.
Contact Sherayzen Law Office for Professional Help With Noncompetition Agreement Income Sourcing
If you are dealing with an international noncompetition agreement, you should contact Sherayzen Law Office for professional help with US international tax compliance. Our firm has helped hundreds of US taxpayers around the world with their US international tax issues. We Can Help You!