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International Tax: Source of Income Source of income rules are foundation of US international tax system –Foreign Persons: if not ETB, taxed only on US.

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Presentation on theme: "International Tax: Source of Income Source of income rules are foundation of US international tax system –Foreign Persons: if not ETB, taxed only on US."— Presentation transcript:

1 International Tax: Source of Income Source of income rules are foundation of US international tax system –Foreign Persons: if not ETB, taxed only on US source FDAP; if ETB, taxed only on income that is “effectively connected” with the US TB –US Persons: taxed on worldwide income with tax credit for foreign taxes on foreign source income

2 International Tax: Source of Income Source of income rules: The foundation of US international tax system Foreign Persons: if not ETB, taxed only on US source FDAP; if ETB, taxed on net basis on income that is ECI and on gross basis on FDAP US Persons: taxed on worldwide income with tax credit for foreign taxes on foreign source income Source of Income Rules § 861: US (single) source income, e.g., dividends and interest § 862: Foreign (single) source income, e.g., dividends and interest § 863(b): Mixed source income, e.g., integrated manufacturing and sales § 865: Source of income from personal property sales

3 International Tax: Source of Income Overview of US taxation of Foreign Persons: Foreign persons not ETB: Taxed only on US source FDAP income (§§ 871 and 881) Tax collected by withholding at source (§§ 1441 and 1442) Source basis taxation often reduced or eliminated by treaty Foreign persons ETB: Taxed only on income that is ECI with the US TB (§ 864(b) and (c) ; and 871(b) ) Treaties require higher “permanent establishment” threshold before source country can tax

4 International Tax: Source of Income International Tax Algorithm: Character: Dividend, royalty, wage, etc.? Source: US or foreign? Taxation under the Code: tax (gross or net) or exempt? Withholding: if income taxable, is withholding required or exemption available? Treaty: Is recipient eligible for any treaty benefits?

5 International Tax: Source of Income US Source Interest Interest paid by federal or state government, domestic corporation, or noncorporate resident (§ 861(a)(1)) Exceptions: –Interest paid by RA or DC satisfying 80% foreign business test –Interest paid by foreign branch of US bank or S&L Interest paid by US branch of FC ETB is US source (§ 884(f))

6 International Tax: Source of Income Interest Rate Swaps Swap: part of the family of notional principle contracts (NPCs), which are agreements between two parties to make payments calculated by reference to the change of an index upon a notional amount. In an interest rate swap, one party typically agrees to pay floating (LIBOR) and the other fixed. Assume that A and B enter into an interest rate swap under which A pays annually fixed (10%) and B pays LIBOR on a NPA of $1MM. If LIBOR is 8%, A will pay B $20,000. Swap income is sourced by reference to the residence of the recipient. Regs (b). AB Fixed ($100K) Net $20k Floating 80K

7 International Tax: Source of Income Taxation of US Source Interest Although US source interest is FDAP (§ 871(a)(1), 881(a)(1)), because of portfolio interest exception, most US source interest is exempt from US tax Portfolio Interest (§ 871(h), 881(c)): –Includes most US source interest on registered obligations (or nonregistered obligations provided certain requirements met) –Excludes interest received by 10% shareholder –Excludes certain contingent debt –Excludes interest paid on bank debt Interest on US deposits is exempt (§ 871(i)(2)) If no exemption under Code or treaty, withholding required (§ 1441, 1442)

8 International Tax: Source of Income Treatment of Interest under Treaty Article 12: Source basis taxation prohibited (¶1) Notice definition of interest (¶2) and source of interest (¶4) Special rules applicable to certain contingent interest (¶6)

9 International Tax: Source of Income US Source Dividends Dividends generally sourced by nationality of payor corporation (§ 861(a)(2)(A)) Dividends paid by FC are US source if 25% or more of FC’s income over preceding 3 years is ECI; US source in same proportion that FC’s income that is ECI bears to its entire income (§ 861(a)(2)(B)). Doesn’t apply to FCs subject to BPT (§ 884(e)(3)). If DC satisfies 80% foreign business income requirement, dividends paid by DC exempt from tax for foreign persons to the extent of DC’s FSI (§ 871(i)(2)(B))

10 International Tax: Source of Income Securities Lending Transactions In a typical securities lending transaction, broker borrows security (and agrees to return it) from securities lender and delivers security in settlement of a short sale. Borrower must pay lender any income—interest or dividend—paid with respect to the borrowed security. Substitute interest & dividend sourced in same manner as actual income on security, and if received by foreign person, has the same character as underlying payment. (Reg (a)(7), -3(a)(6); (b)(2); (c)). Buyer Broker Short seller Security Lender Security Substitute payment

11 International Tax: Source of Income Treatment of Dividends under Treaty Article 10: Permits residence and source basis taxation, but source basis taxation limited to 15% (¶¶1 and 2) or 5% if recipient owns at least 10% of payor corporation 0% if recipient is a US corporation owning at least 25% of the VS of payor for prior two years Second-level withholding tax not permitted (¶ 5)

12 International Tax: Source of Income Source of Compensation for Personal Services Sourced by location of performance of services (§ 861(a)(3)) Commercial traveler exception: 90 day/$3,000 rule (§ 861(a)(3)(A)-(C)) For services performed partly inside the US and partly outside of the US, income must be allocated between US and foreign source (§ 863(b)(1)) –If not separately stated, must be allocated “on the basis that most correctly reflects the proper source under the facts and circumstances of the particular case.” (Reg (b)(1)) –Apportionment by time is often acceptable (Id.) See Stemkowski

13 International Tax: Source of Income Source of Compensation for Personal Services Covenant not to compete (Korfund) Advanced compensation (Rev. Rul ) Lump sum payment in connection with endorsement contract (FSA ) Sale Commissions (Rev. Rul ) Advertising income (Piedras Negras)

14 International Tax: Source of Income Taxation of US Source Compensation Although listed as FDAP under section § 871(a), performing servicing constitutes engaging in a US T/B, which causes the income to be ECI (§ 864(b)(1)) If ECI, no withholding is required (Reg (a)(2))

15 International Tax: Source of Income US Source Compensation and Treaties Articles 15, 16, –Article 15: Independent services taxable only on a residence basis unless “fixed base regularly available” in source country –Article 16: Dependent services taxable only by source country if recipient present fewer than 184 days during 12 month period, remuneration paid by non-resident employer, and not borne by PE – Article 18: Artistes & Athletes

16 International Tax: Source of Income US Source Rents and Royalties US source if property located in US or if for the use in the US of patents, CRs, secret processes and formulas, goodwill, TMs, franchises (§ 864(a)(4) Cascading Royalties (Rev. Rul and SDI) FC FC H DC Royalties License

17 International Tax: Source of Income SDI SDI NA SDI Neth SDI US Royalties License SDI Ber SDI LTD Royalties License

18 International Tax: Source of Income Royalties Under the Treaty Article 13: no source basis taxation permitted Definition of royalty: Article 13, ¶ 2. Source of royalty: Article 13, ¶4

19 International Tax: Source of Income Royalties v. Personal Service Income Ingram v. Bowers (creator of intellectual property) Boulez Rev. Rul FSA


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