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International Personal Services Sourcing Rules | International Tax Lawyer

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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.

Contact Sherayzen Law Office for Professional Help With International Personal Services Sourcing Rules and Other US International Tax Issues

Sherayzen Law Office can help you with all of your US international tax needs, including the international personal services sourcing rules. Our highly experienced international tax team has successfully helped US taxpayers around the globe to deal with their US international tax issues. We can help You!

Contact Us Today to Schedule Your Confidential Consultation!

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.

Contact Sherayzen Law Office for Professional Help With US International Tax Law, Including Interest Income Sourcing Rules

Sherayzen Law Office is a leading international tax law firm in the United States which has helped hundreds of US taxpayers with their US international tax issues. We can help you!

Contact Us Today To Schedule Your Confidential Consultation!

2018 Tax Filing Season | International Tax Lawyer News

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On January 4, 2018, the IRS announced that the 2018 tax filing season for the tax year 2017 will commence on January 29, 2018. This date was chosen by the IRS to make sure its software incorporates the full impact of the Tax Cuts and Jobs Act of 2017 on the 2017 tax returns.

2018 Tax Filing Season: EITC and ACTC Refunds

Despite the fact that the 2018 tax filing season will begin on January 29, the IRS warned that taxpayers who will claim Earned Income Tax Credit (EITC) and the Additional Child Tax Credit (ACTC) will not receive their refunds until at least February 27, 2018.

2018 Tax Filing Season: Processing of Paper Tax Returns

Also, it is important to note that the processing of paper returns will begin only in mid-February, because the system updates will continue until that time. The IRS, however, will begin accepting both, electronic and paper tax returns, on January 29, 2018.

This is very important for taxpayers who file US international information returns, such as Forms 926, 5471, 8621, 8865, 8938, et cetera. A lot of these returns are voluminous and cannot be e-filed due to tax software limitations; hence, they must be filed on paper.

2018 Tax Filing Season: Deadline on April 17, 2018

The filing deadline to submit 2017 tax returns will be on Tuesday, April 17, 2018. Usually, the deadline would be on April 15, but, in 2018, April 15 falls on a Sunday and April 16 is a legal holiday in the District of Columbia (Emancipation Day). Under the tax law, legal holidays in the District of Columbia affect the filing deadline for federal tax returns; hence, the filing deadline moved by one more day to April 17, 2018.

US taxpayers who have to file international information returns should keep in mind that there are two categories of such returns: information reports which are filed with their 2017 tax returns and the information reports which are filed (or e-filed) separately from the 2017 tax returns. Forms 926, 5471, 8621, 8865, 8938 and other similar information returns must be filed with the original US tax returns.

On he other hand, FBARs (FinCEN Form 114) and Form 3520 should be filed separately from the taxpayers’ tax returns. The deadline for this category of returns, however, is the same as the deadline for the 2017 tax returns – April 17, 2018 (unless an extension is filed).

Contact Sherayzen Law Office for Help with Your US International Tax Compliance During this 2018 Tax Filing Season

If you have foreign income and/or foreign assets, or if you received a foreign gift or inheritance, you should contact Sherayzen Law Office for professional help in determining your US tax compliance obligations and the preparation of the required US international information returns.

Contact Us Today to Schedule Your Confidential Consultation!

Tax Cuts & Jobs Act: 2018 Standard Deduction and Exemptions

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The Tax Cuts and Jobs Act of 2017 made dramatic changes that affected pretty much every US taxpayer. This is the first article of the series of articles on the Act. I will start this series with the discussion of simple US domestic issues (such as 2018 standard deduction and personal exemptions), then gradually turn to more and more complex US domestic and international tax issues, and finish with the examination of the highly complex issues concerning E&P income recognition for US owners of foreign corporations and the new type of Subpart F income.

Today, I will focus on the 2018 standard deduction and exemptions.

Standard Deduction for the Tax Year 2017

Standard deduction is the amount of dollars by which you can reduce your adjusted gross income (“AGI”) in order to lower your taxable income and, hence, your federal income tax. The standard deduction is prescribed by Congress. If you use standard deduction, you cannot itemize your deductions (i.e. try to reduce your AGI by the amount of actual allowed itemized deductions) – you have to choose between these two options.

Standard deduction varies based on your filing status (there is an additional standard deductions of individuals over the age of 65 or who are blind).

For the tax year 2017, the standard deduction are as follows: $6,350 for single taxpayers and married couples filing separately, $12,700 for married couples filing a joint tax return and $9,350 for heads of household.

2018 Standard Deduction and Exemptions

Under the Tax Cuts and Jobs Act of 2017, the 2018 standard deduction will virtually double in size: $12,000 for single taxpayers and married couples filing separately, $24,000 for married couples filing a joint tax return and $18,000 for heads of household. All of these amounts will be indexed for inflation.

It is important to point out, however, that these increased standard deduction amounts will only last until 2025. Then, the standard deduction should revert to the old pre-2018 law.

Personal Exemptions & Impact of 2018 Standard Deduction

Personal exemption is an additional amount of dollars by which the Congress will allow you to reduce your AGI (already reduced by either standard deduction or itemized deductions). When IRC Section 151 was enacted in 1954, the idea behind a personal exemption was to exempt from taxation a certain minimal amount a person needs to survive at a subsistence level.

Personal exemption can be claimed for you and your qualified dependents; in case of joint tax returns, each spouse is granted a personal exemption. However, a personal exemption for a spouse can be claimed even if the spouses are filing separate tax returns, but certain requirements have to be met.

For the tax year 2017, the personal exemption amount is $4,050. The exemption is subject to a phase-out at a certain level of income.

The Tax Cuts and Jobs Act of 2017 repeals personal exemptions for the tax years 2018-2025. After 2025, the law reverts to the one that existed as of the tax year 2017. In other words, the increase in 2018 standard deduction will be at least partially offset by the elimination of 2018 personal exemption.

In some cases, where taxpayers claim many personal exemptions for their dependants, the elimination of personal exemptions may actually result in the increase in taxation (compared to the 2017 law) despite the increase of 2018 standard deduction. Of course, such an increase in taxation needs to take into account potential increase in child tax credit under the new law. Hence, in order to assess the full tax impact of the tax reform for large families, one needs to consider other factors in addition to just 2018 standard deduction.

New 11 IRS Compliance Campaigns | International Tax Lawyer & Attorney

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On November 3, 2017, the IRS Large Business and International Division (“LB&I”) announced the rollout of additional 11 IRS Compliance Campaigns in addition to the 13 already existing campaigns. Most of these campaigns directly address the IRS concerns with respect to US international tax law compliance. Let’s explore these new 11 IRS Compliance Campaigns.

New 11 IRS Compliance Campaigns: What Does This Mean for Taxpayers?

The issue-based IRS Campaigns is the brand-new strategy of the IRS to maximize the utility of its strained resources. Unlike previous efforts, a Campaign basically focuses on a specific issue that may carry a significant non-compliance risk and, then, applies a variety of solutions (called “treatment streams”) to increase the compliance with respect to this issue. The treatment streams range from development of an externally published practice unit, potential published guidance to issue-based examinations.

From a taxpayer point of view, the new strategy means that, if the IRS announces a new campaign, US taxpayers associated with the risk issue at the heart of a new campaign are at increased audit risk.

New 11 IRS Compliance Campaigns: General Emphasis on International Tax Compliance

Seven out of total eleven campaigns are focused on international tax compliance. This means that the IRS continues to give priority to international tax enforcement. Hence, US taxpayers who own foreign assets or are involved in international business transactions are likely to be affected by the IRS campaigns and should make sure they are in full US tax compliance.

Let’s briefly describe each of the new 11 IRS Compliance Campaigns.

New 11 IRS Compliance Campaigns: 1120-F Chapter 3 and Chapter 4 Withholding

This campaign focuses upon verification of the withholding credits before the claim for refund or credit is allowed. To make a claim for refund or credit to estimated tax with respect to any U.S. source income withheld under chapters 3 or 4, a foreign entity must file a Form 1120-F. Before a claim for credit (refund or credit elect) is paid, the IRS must verify that withholding agents have filed the required returns (Forms 1042, 1042-S, 8804, 8805, 8288 and 8288-A).

In other words, this campaign is designed to verify withholding at source for 1120-Fs claiming refunds.

New 11 IRS Compliance Campaigns: Swiss Bank Program

A non-surprising new addition to campaigns that will focus on tax and FBAR noncompliance of US beneficial owners of Swiss bank and financial accounts. The IRS will draw on the materials supplied to the DOJ by Swiss Banks as part of the Swiss Bank Program.

New 11 IRS Compliance Campaigns: Foreign Earned Income Exclusion

This campaign is likely to affect US taxpayers who reside overseas. The campaign will focus on taxpayers who claimed Foreign Earned Income Exclusion, but did not meet the requirements for claiming them. The IRS will address noncompliance through a variety of treatment streams, including examination.

New 11 IRS Compliance Campaigns: Verification of Form 1042-S Credit Claimed on Form 1040NR

The campaign’s goal is to ensure the amount of withholding credits or refund/credit elect claimed on Forms 1040NR is verified and whether the taxpayer has properly reported the income reflected on Form 1042-S.

New 11 IRS Compliance Campaigns: Agricultural Chemicals Security Credit

The first of the new four domestic campaigns. The Agricultural chemicals security credit is claimed under Internal Revenue Code Section 45O and allows a 30 percent credit to any eligible agricultural business that paid or incurred security costs to safeguard agricultural chemicals. The credit is nonrefundable and is limited to $2 million annually on a controlled group basis with a 20-year carryforward provision. In addition, there is a facility limitation as outlined in Section 45O(b). The goal of this campaign is to ensure taxpayer compliance by verifying that only qualified expenses by eligible taxpayers are considered and that taxpayers are properly defining facilities when computing the credit. The treatment stream for this campaign is issue-based examinations.

New 11 IRS Compliance Campaigns: Deferral of Cancellation of Indebtedness Income

This is an interesting addition and a correct one to the campaigns; I also believe that this area suffers from high rate of noncompliance. This issue stems from the Great Recession of 2008; in 2009 and 2010, a lot of US taxpayers elected to defer their cancellation of indebtedness (“COD”) income incurred as a result of reacquisition of debt instruments at an issue price less than the adjusted issue price of the original instrument. Such taxpayers should have reported their COD income ratably over a period of five years beginning in 2014 through 2018.

Furthermore, whenever a taxpayer defers his COD income, any related original issue discount (OID) deductions on the new debt instrument, resulting from debt-for-debt exchanges that triggered the original COD must also be deferred ratably and in the same manner as the deferred COD income.

The goal of this campaign is to ensure taxpayer compliance by verifying that taxpayers (who properly deferred COD income in 2009 and 2010) actually properly reported it in subsequent years beginning in 2014. The campaign will also look at situations where an accelerating event occurred and required earlier recognition of income under IRC § 108(i). The treatment stream for this campaign is issue-based examinations. The use of soft letters is under consideration.

New 11 IRS Compliance Campaigns: Energy Efficient Commercial Building Property

The goal of this campaign is to ensure taxpayer compliance with the section 179D (Energy Efficient Commercial Building Deduction). Section 179D allows taxpayers who own or lease a commercial building to deduct the cost or portion of the cost of installing energy efficient commercial building property (EECBP). If the equipment is installed in a government-owned building, the deduction is allocated to the person(s) primarily responsible for designing the EECBP. The treatment stream for this campaign is issue-based examinations.

New 11 IRS Compliance Campaigns: Economic Development Incentives Campaign

The goal of this campaign is to ensure taxpayer compliance with respect to a variety of government economic incentives. These incentives include refundable credits (refunds in excess of tax liability), tax credits against other business taxes (for example, payroll tax), nonrefundable credits (refunds limited to tax liability), transfer of property and grants. The common problems targeted by this campaign are situation where taxpayers improperly treat government incentives as non-shareholder capital contributions, exclude them from gross income and claim a tax deduction without offsetting it by the tax credit received. The treatment stream for this campaign is issue-based examinations.

New 11 IRS Compliance Campaigns: Section 956 Avoidance

This campaign focuses on situations where a CFC loans funds to a US Parent (USP), but nevertheless does not include a Section 956 amount in income. The goal of this campaign is to determine to what extent taxpayers are utilizing cash pooling arrangements and other strategies to improperly avoid the tax consequences of Section 956. The treatment stream for this campaign is issue-based examinations.

New 11 IRS Compliance Campaigns: Corporate Direct (Section 901) Foreign Tax Credit

Domestic corporate taxpayers may elect to take a credit for foreign taxes paid or accrued in lieu of a deduction. The goal of the Corporate Direct Foreign Tax Credit (“FTC”) campaign is to improve return/issue selection (through filters) and resource utilization for corporate returns that claim a direct FTC under IRC section 901. This campaign will focus on taxpayers who are in an excess limitation position. The treatment stream for the campaign will be issue-based examinations. The IRS emphasized that this is just the first of several FTC campaigns. The IRS further specified that future FTC campaigns may address indirect credits and IRC 904(a) FTC limitation issues.

New 11 IRS Compliance Campaigns: Individual Foreign Tax Credit (Form 1116)

This campaign addresses taxpayer compliance with the computation of the foreign tax credit (“FTC”) limitation on Form 1116. Due to the complexity of computing the FTC and challenges associated with third-party reporting information, some taxpayers face the risk of claiming an incorrect FTC amount. The IRS will address noncompliance through a variety of treatment streams including examinations.