The Foreign & US-Sourced Income (IRS Sourcing Rules)

Non-Resident Alien Source of Income Taxation

Foreign & US-Sourced Income

In general, when a person is considered a US citizen or resident for US tax purposes, they are going to get taxed on their worldwide income. And, unless the closer connection exception applies –or a person is able to make it make a treaty election to be treated as a foreign person for tax purposes, all of their worldwide income is taxable by the United States. Conversely, when a person is a nonresident alien, then the United States only taxes them on their US-sourced income (FDAP and ECI).  In addition, not all income generated from the United States is considered US-sourced — and therefore it is very important to determine the source of income for non-resident aliens since only US tourist income is taxable. Non-resident aliens typically file a form 1040-NR to report their US-sourced income. Let’s go through the basics of sources of income as provided by the Internal Revenue Service.

Common Sourcing Rules

 As provided by the IRS:

Salaries, wages, and other compensation

Where services are performed.

Business income

• • • Personal services Where services performed:

      • • All wages and any other compensation for services performed in the United States are considered to be from sources in the United States. The only exceptions to this rule are discussed in Employees of foreign persons, organizations, or offices, later, and in Crew members, earlier.

        • If you are an employee and receive compensation for labor or personal services performed both inside and outside the United States, special rules apply in determining the source of the compensation. Compensation (other than certain fringe benefits) is sourced on a time basis. Certain fringe benefits (such as housing and education) are sourced on a geographical basis.

        • Or, you may be permitted to use an alternative basis to determine the source of compensation. See Alternative Basis, later

    • Sale of inventory—purchased Where sold

    • Sale of inventory—produced Where produced

Interest

Residence of payer

• • • Generally, U.S. source interest income includes the following items.

      • Interest on bonds, notes, or other interest-bearing obligations of S. residents or domestic corporations.
      • Interest paid by a domestic or foreign partnership or foreign corporation engaged in a U.S. trade or business at any time during the tax year.
      • Original issue discount (OID).
      • Interest from a state, the District of Columbia, or the U.S. Government.

    • The place or manner of payment is immaterial in determining the source of the income.

    • A substitute interest payment made to the transferor of a security in a securities lending transaction or a sale-repurchase transaction is sourced in the same manner as the interest on the transferred security.

Dividends

Whether a U.S. or foreign corporation*

• • • In most cases, dividend income received from domestic corporations is U.S. source income. Dividend income from foreign corporations is usually foreign source income. An exception to the second rule is discussed later.

    • A substitute dividend payment made to the transferor of a security in a securities lending transaction or a sale-repurchase transaction is sourced in the same manner as a distribution on the transferred security.

      • Exception.

        • Part of the dividends received from a foreign corporation is U.S. source income if 25% or more of its total gross income for the 3-year period ending with the close of its tax year preceding the declaration of dividends was effectively connected with a trade or business in the United States. If the corporation was formed less than 3 years before the declaration, use its total gross income from the time it was formed. Determine the part that is U.S. source income by multiplying the dividend by the following fraction.

Rents

• • • Location of property

      • Your U.S. source income includes rent and royalty income received during the tax year from property located in the United States or from any interest in that property. U.S. source income also includes rents or royalties for the use of, or for the privilege of using, in the United States, intangible property such as patents, copyrights, secret processes and formulas, goodwill, trademarks, franchises, and similar property

Other Sourcing Rules

Here are some of the other (less common) sourcing rules:

Royalties: Natural resources

• • • Location of property

Royalties: Patents, copyrights, etc.

• • • Where the property is used.

Sale of real property

• • • Location of property

Sale of personal property

• • • Seller’s tax home (but see Personal Property, later, for exceptions)

Pension distributions attributable to contributions

• • • Where services were performed that earned the pension

Investment earnings on pension contributions

• • • Location of pension trust

Sale of natural resources

• • • Allocation based on fair market value of product at export terminal. For more information, see section 1.863