In a previous article, I explained that US tax law sources personal services to the place where these services are performed. What about a situation where such services are performed partially in the United States and partially outside of the United States (hereinafter, I will call such services “international personal services”)? In this article, I will address this situation and discuss the US international personal services sourcing rules.
I will specifically limit my discussion in this essay to international personal services sourcing rules concerning non-corporate independent contractors. In the future, I will discuss the income source rules for corporations and employees, including the source of income rules concerning fringe benefits and stock options.
International Personal Services Sourcing: Two Main Situations
The rules concerning the sourcing of international person services income depend on how a contracting agreement structures the payment for such services. In this context, there are two most common categories of contracts.
The first category of contracts specifically designates part of the payment to cover the services performed in the United States and part of the payment to compensate for services performed in a foreign country. In this situation, we can easily apply the general rule and source each part of the payment to the place where services are performed. In other words, the payment for US services will be US-source income and the payment for foreign services will be foreign-source income.
Unfortunately, contractors rarely structure their agreements in this way, because they often fail to retain an international tax lawyer to review their contracts for US international tax issues. Business lawyers also often make the same mistake, because they fail to see the need to involve a tax attorney.
Hence, most contracts fall within the second category of contracts, where a contract does not allocate the payment between services performed in the United States and those performed in a foreign country. The general rule is of little help for these contracts; hence, the IRS developed a supplementary legal process for income sourcing in this type of a situation.
International Personal Services Sourcing: the Two-Step Allocation Process
If the contract does not divide the payment between the countries where the services are performed, then the taxpayer will need to engage in a two-step process.
First, the taxpayer should determine if the terms of the contract allow to make an accurate allocation of payment between the United States and a foreign country. Sometimes, a contractor may perform services so specific to a country that the allocation of payment is obvious, even though the contract does not expressly allocate the payment to this country.
Second, if no such accurate allocation is possible, then the taxpayer should allocate the payment “on the basis that most correctly reflects the proper source of income on the facts and circumstances of the particular case.” Treas. Reg. §1.861-4(b)(1). This appears to be a very general rule that opens up possibilities for creative tax planning, but, once we look at the history of this rule, we will quickly realize that one method – the Time Rule (described below) – limits its flexibility.
The current flexible rule is in force only since 1976. Prior to that year, the IRS required the allocation of payment strictly based on the Time Rule. The impetus to changing to a more flexible rule was a 1973 case from the Tenth Circuit, Tipton & Kalmbach, Inc v US, 480 F2d 1118, 32 AFTR2d 73-5334 (10th Cir 1973). In that case, the IRS determined that a re-enlistment bonus was a compensation for services which the taxpayer performed on the day he re-enlisted. The paradoxical result was the fact that the location of the soldier on the day of his re-enlistment determined the sourcing of the entire re-enlistment bonus.
Hence, the IRS infused more flexibility into the Time Rule by adopting the language currently found in Treas. Reg. §1.861-4(b)(1). Nevertheless, given this history, there is no question that the Time Rule remains the most persuasive method of income allocation for non-corporate individual contractors.
It should be emphasized, however, that dominance of the Time Rule should not deter a taxpayer utilizing alternative methodology (for example, the value produced by specific services) if it is more accurate. In other words, the Time Rule is the default methodology which the IRS will use to allocate the payment between the countries, but a taxpayer may use other alternatives as long as he can persuade the IRS that his methodology represents a more accurate allocation of income.
International Personal Services Sourcing: the Time Rule
The time has come to define the Time Rule. According to Treas. Reg. §1.861-4(b)(2)(ii)(E), under the Time Rule, the amount of payment allocated to the United States “is the amount that bears the same relation to the individual’s total compensation as the number of days of performance of the labor or personal services by the individual within the United States bears to his or her total number of days of performance of labor or personal services.” Taxpayers should use fractions in determining the allocations.
Let’s use an example to demonstrate the application of the Time Rule. A US Corporation signs a contract with Mr. Hause, a tax resident of Germany, to provide professional advice concerning incorporation of German heavy machinery into a Chinese factory owned by the corporation. The total price paid is $900,000; the work is performed within 180 days. Out of these 180 days, Mr. Hause spends 60 days in the United States working on the implementation plans and 120 days in China overseeing the implementation process. Based on the Time Rule, Mr. Hause spent 1/3 of his time in the United States and 2/3 in China; hence, $300,000 will be considered US-source income and $600,000 will be sourced to China. Of course, if Mr. Hause can show that the value of his work in China was far more important to the contract than his work in the United states, he can use an alternative methodology (which may still have to survive the IRS scrutiny during an audit).
Based on this example, you can see why the IRS likes the Time Rule – it is a relatively straightforward, objective calculation that can be easily implemented in almost any case.
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