Types of Foreign Income that Trigger Filing Requirements
If you are a foreign business or person that does business with the U.S., then you are subject to U.S. income taxes. Some examples would be if your business has an office that generates income located in the U.S. or if a company owns rental property in the U.S. from which it derives income.
Other types of income may also be taxed, such as alimony, dividends, royalties, and certain types of interest. Regardless of the source, know that the IRS is pretty hair-triggered about international taxation discrepancies, so you need to understand the laws.
In other words, regardless of where you are based outside the U.S., if you earn money from sources based in the U.S., you will have to pay income tax to the IRS. Sure, there are exceptions to this rule, but for the purposes of this chapter, I am going to focus on the absolutes.
When it comes to sources of income, there are two main categories that foreign persons must be aware of: effectively connected income (ECI) and fixed, determinable, annual, periodical (FDAP) income.
Since these categories are taxed at different rates, it is crucial to understand how your sources of income should be designated and I am going to explain the tax rules surrounding specific sources of income.
If you earn income from sources inside the U.S., then you need to pay attention to the tax ramifications. If you are uncertain about where you stand, call me and we can discuss your situation in more detail.
Effectively Connected Income (ECI)
Nonresidents who derive income from a trade or business connected to the United States will be taxed on such income. In general, personal services performed in the United States are deemed taxable as well as any gains and losses from the sale of real property interests in the U,S.
Being a member of a partnership that is engaged in trade or business in the U.S. will also qualify as ECI. For more examples of the types of activities that constitute ECI, see the IRS’ page on Effectively Connected Income.
ECI from Foreign Sources
While ECI normally applies to U.S. sources of income, some foreign-source income is also treated as ECI.
If one has an office or a place of business in the U.S. that is generating income, the aforementioned office or place of business is a “material factor” in the production of said income, and the income is “produced in the ordinary course of the trade or business carried on through that office or other fixed place of business,” then the following income sources will be considered ECI [as per the IRS guidelines, in relevant part]:
- “Rents and royalties for the use of, or for the privilege of using, intangible personal property located outside the United States or from any interest in such property.” [...]
- “Dividends, interest, or amounts received for the provision of a guarantee of indebtedness issued after September 27, 2010, from the active conduct of a banking, financing, or similar business in the United States.” [...]
- “Income, gain, or loss from the sale outside the United States, through the U.S. office or other fixed place of business, of: a. Stock in trade, b. Property that would be included in inventory if on hand at the end of the tax year, or c. Property held primarily for sale to customers in the ordinary course of business.” [...]
See 2019 Publication 519, Foreign Income, pg. 20
The rules guidelines presented above have been abridged for clarity and so that you may get a general understanding of which foreign sources of income may trigger a filing requirement under the ECI provisions.
Determining whether your U.S. office or place of business is a “material factor” in the income it derives or if the income is produced in the “ordinary course of business” is complicated without an analysis of your specific circumstances in light of the IRS’ past rulings.
Additionally, the rules regarding the three income sources listed are nuanced. If you believe that these provisions may apply to you, we encourage you to review the provisions in full and to consult with an attorney.
Along with determining whether your activities constitute ECI, it is also necessary to determine whether any of your agents or those of your organization are carrying out activities in the U.S. that would qualify under the ECI provisions. Given that the actions of agents are imputed to their principals, you must be aware if any of your agents’ actions are triggering a filing requirement.
The tax rates for ECI are the same as those applied to United States citizens and residents.
Fixed, determinable, annual or periodic (FDAP) income refers to income earned from U.S. sources by foreign individuals with the exception of gains from the sale of personal or real property and income sources excluded from gross income.
Common sources of FDAP income are alimony, dividends, real property income, scholarship and fellowship funds, and certain types of interest. While ECI is income derived from trade or business, FDAP is all other sources of income.
The categories of income that constitute FDAP are expansive so if you are a foreign person who has derived any type of income in the U.S., you should be sure to review the IRS’ resources regarding FDAP and discuss this with your attorney or other tax advisor.
FDAP is taxed at a flat rate of 30 percent, but the rate may be even lower depending on whether there is a relevant treaty between the U.S. and taxpayer’s jurisdiction. While it is the responsibility of the payer of any FDAP income to withhold taxes and remit them to the IRS, the payee will be responsible for paying the tax on the income if the payer fails to fulfill this responsibility.
However, even if the payee ends up remitting the proper taxes, the payer will be responsible for interest and penalties due to their failure to fulfill their withholding responsibility. Given that FDAP and ECI are taxed at different rates, it is crucial that you properly categorize these income sources if you are a foreign citizen for the purpose of avoiding errors and any potential penalties.
See the IRS’ page on Fixed, Determinable, Annual, Periodical (FDAP) Income
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Foreign Dividends, Service Income, Property Sales, Rents, and Other Income
Remember the general rule: foreign entities and persons are only liable for U.S. income tax connected to domestic activities or one’s annual income as well as income sourced to the United States. Generally, foreign activities otherwise are not subject to U.S. income taxes.
Also remember examples of FDAP income such as alimony, dividends, real property income, scholarship and fellowship funds, and certain types of interest. We will discuss some of the rules and issues we see in this area.
In order to determine if the income is traceable to the United States for tax liability to be incurred, we have to source the income. Income can be sourced by the Predominant Situs, Residence of the Recipient, or by Split Source method.
Predominant situs has the income classified based on the location of the economic activity that produced the income. Examples of income classified in this manner are interest, dividends, personal services income, rents, royalties, sale of real property, sale of certain personal property, certain transportation income, insurance underwriting income, and social security benefits as under 26 U.S. Code § 861.
If income does not meet the domestic source ties listed in 26 U.S. Code § 861, then it will be considered foreign income under 26 U.S. Code §862. We will focus primarily in the “predominant situs” area.
Residence of the recipient is self-explanatory and applies to income from sale of personal property other than inventory, ocean or space income, and certain foreign currency gains and losses. Split source income is classified based on a statutory scheme as part U.S. source and part foreing source. This applies to transportation and international communications income.
To then properly source and classify the income, we follow a two-step process. First, we determine the gross income category, and then second, apply the category specific source rule.
Income dividend is generally sourced to the residence of the payer, therefore the location of the company paying the dividend will control the source of the income. Therefore, foreign dividends are usually not taxable. There is an exception where a foreign corporation that has more than 25 percent of the gross income from all sources of such foreign corporation for a three-year period is effectively connected to the United States.
However, this will only be in an amount which bears the same ratio to such dividends as the gross income of the corporation for such period. In addition, dividends paid exclusively from the U.S. branch of a foreign corporation will likely count as U.S. dividends.
Foreign Interest Income
Interest income is similar to dividends and is generally sourced to the residence of the payer foreign company. The exceptions that will make foreign interest income taxable in the U.S. will be interest from foreign branches of U.S. banks as well as interest from certain foreign entities under 26 U.S. Code §884.
Personal Service Income
The source of personal service income is based on where the service was rendered. Services performed in both the U.S. and a foreign country are allocated based on the time spent in each location. Commercial travelers and actions considered ‘de minimis” are exempt from U.S. taxes as well.
Rental income is general sourced at the location of the rental property. If the rental property is used (think large, non-real estate rental assets), the income is appropriated between the time or actual use in the U.S. and in the foreign country.
Royalty income is sourced based on where the intangible property (i.e., patents, copyrights, customer lists, corporate secrets, etc.) is used. Computer software program income can be treated as royalty income from the sale or lease of a program. Treasurer Regulation §1-1.861-18 governs this area.
Inventory vs. Non-Inventory Income
Foreign personal property sale proceeds are treated differently based on if they are inventory or not. Non-inventory personal property sale gains are sourced based on the residence of the seller. 26 U.S. Code §865 laws out numerous exceptions to this general rule.
Partnership interests are usually considered connected to the U.S. income.
Income from inventory sales are sourced from the place the inventor is held. Manufactured inventory prior to 2018 was treated as it was sourced half in the U.S. and half in a foreign country. Today and moving forward, the inventory is considered sourced where it is produced.
Transfers of Partnership Interests
Generally, sale of partnership assets by foreign nationals are outside of the U.S. tax nexus. However, when the partnership is a U.S. partnership, the IRS will treat the sale of that American partnership interest as subject to U.S. taxes. The U.S. partnership or buyer will need to file a Form 8288 to report the U.S. tax withholdings they must make for any taxes possibly owed by the foreing person from the sale.
The IRS will overturn every stone possible to collect taxes and they are particularly fixated on international transactions. That means if you are outside the U.S. but generate income over here from various sources, you most likely need to pay Uncle Sam
It is worth the time to review your revenue streams to sort out what types of income they are and their sources. The IRS is particularly fixated on international taxation and their reach extends the boundaries of the United States.
If you have questions about whether you owe income taxes to the U.S. government, then come in and see me. My firm, Brotman Law, has experience in straightening out these types of situations for our clients. International tax law is complicated and we are experts in this area.