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.