THE U.S. FRAMEWORK FOR TAXING MULTINATIONAL TRANSACTIONS
U. S. SOURCE RULES FOR GROSS INCOME AND DEDUCTIONS
Many of the U.S. tax rules that apply to multinational transactions require taxpayers to determine the jurisdictional (geographic) source (U.S. or foreign) of their gross income.15 The source rules determine whether income and related deductions are from sources within or without the United States. All developed countries have source-of- income rules, although most practitioners consider the U.S. rules to be the most com- plex in the world.
The U.S. source-of-income rules are important to non-U.S. persons because they limit the scope of U.S. taxation to only their U.S. source income. For U.S. persons, the primary purpose of the U.S. source-of-income rules is to calculate foreign source taxable income in the numerator of the foreign tax credit limitation. Except in the case of divi- dends eligible for the 100 percent dividends received deduction, the United States im- poses a tax on the worldwide income of U.S. persons, regardless of its source or the U.S.
person’s residence. The United States cedes primary jurisdiction to foreign governments
LO 24-2
14Because 3D is a “small company,” the Ontario tax rate is 3.5 percent, which, added to the federal tax rate of 15 percent, creates a combined tax rate of 18.5 percent. Large corporations are subject to a combined tax rate of 26.5 percent if operating in Ontario.
15The U.S. federal income tax source rules are found in §861–§865 and the accompanying regulations.
Lily’s store in Windsor is an immediate success and reports taxable income on its Canadian opera- tions of C$50,000 for 2018. 3D paid a combined national and provincial income tax of C$9,250 on its taxable income. Because 3D operates the Windsor store as a branch, it also must report the in- come on its U.S. corporate income tax return along with taxable income from its Detroit operations.14
Assuming a translation rate of C$1:US $0.80, 3D reports the Canadian taxable income on its U.S.
tax return as $40,000 and reports the Canadian income taxes as $7,400. 3D also reported taxable income from its U.S. operations of $160,000. The company’s U.S. income tax on $200,000 of total taxable income is $42,000 before any credit for the income taxes paid to Canada. 3D’s income from its Windsor operations is classified as “foreign branch income” for foreign tax credit purposes.
Using the above facts, what is the foreign tax credit limitation that applies to 3D’s Canadian income taxes for 2018?
Answer: $8,400, computed as $40,000/$200,000 × $42,000.
where:
$40,000 = Foreign source taxable income $200,000 = Total taxable income
$42,000 = Precredit U.S. tax on total taxable income
What is 3D’s net U.S. tax after subtracting the available foreign tax credit?
Answer: $34,600, computed as $42,000 − $7,400. 3D has an “excess foreign tax credit limitation” of
$1,000 (that is, 3D could have incurred an additional $1,000 of foreign taxes and received a full-year credit for them).
What is 3D’s effective tax rate on its total taxable income for 2018?
Answer: 21 percent, computed as ($7,400 + $34,600)/$200,000.
What if: Assume 3D pays Canadian income taxes of C$12,800 ($10,240) for 2018 (a tax rate of 26.5 percent). What is its net U.S. tax after subtracting the available foreign tax credit?
Answer: $33,600, computed as $42,000 − $8,400.
The foreign tax credit limitation limits the foreign tax credit to $8,400. 3D now has an “excess foreign tax credit” of $1,840, which 3D can carry forward 10 years. Given the above scenario, what is 3D’s effective tax rate on its total taxable income for 2018?
Answer: 21.92% percent, computed as ($10,240 + $33,600)/$200,000. The FTC limitation prevents 3D from getting a current year tax credit on income taxes paid in excess of the U.S. rate of 21 percent.
Example 24-3
to tax U.S. persons on income earned outside the United States while retaining the re- sidual right to tax foreign source income to the extent it has not been “fully taxed” by the foreign government. The net result is that the United States taxes foreign source income earned by U.S. persons at a rate that theoretically reflects the difference between the U.S.
tax rate and the foreign tax rate imposed on the income.
U.S. persons must understand the source-of-income rules in other situations. For ex- ample, U.S. citizens and residents employed outside the United States may be eligible to exclude a portion of their foreign source earned income from U.S. taxation under §911.16 In addition, U.S. persons who pay U.S.-source FDAP income to foreign payees (e.g., interest or dividends) usually are required to withhold U.S. taxes on such payments.17 U.S. corpora- tions earning “foreign-derived intangible income” (FDII) receive a 37.5 percent deduction on such income that reduces the effective tax rate on such income to 13.125 percent. U.S.
corporations receive a 100 percent DRD on the “foreign-source portion” of dividends re- ceived from 10 percent-or-more owned foreign corporations. (These later two situations were added by the Tax Cuts and Jobs Acts and will be discussed later in the chapter.)
The source-of-income rules are definitional in nature; they do not impose a tax liability, create income, or allow a deduction. Although the primary focus of the source rules is on where the economic activity that generates income takes place, the U.S. government also uses the source rules to advance a variety of international tax policy objectives.
Source of Income Rules
The Internal Revenue Code defines nine classes of gross income from sources within the United States18 and nine classes of gross income from sources outside the United States.19 A summary of the general rules that apply to common sources of income follows. A de- tailed discussion of all the exceptions to these rules is beyond the scope of this text.
Interest As a general rule, the taxpayer looks to the residence of the party paying the interest (the borrower) to determine the geographic source of interest received. A bor- rower’s residence is established at the time the interest is paid. Factors that determine an individual’s residence include the location of the individual’s family; whether the person buys a home, pays foreign taxes, and engages in social and community affairs; and the length of time spent in a country. Under these general rules, interest income is U.S. source if it is paid by the United States or the District of Columbia, a noncorporate U.S. resident, or a U.S. corporation. Although interest income paid by a U.S. bank to a nonresident (e.g., an international student attending a U.S. university) is U.S.-source income, such interest is exempt from U.S. withholding or other income taxation.20 This exception is designed to attract foreign capital to U.S. banks.
THE KEY FACTS Source Rules
• The source rules determine whether income and de- ductions are treated as U.S.
source or foreign source.
• For a U.S. taxpayer, the source rules primarily de- termine foreign taxable income in the calculation of the foreign tax credit limitation.
• For a non-U.S. taxpayer, the source rules determine what income is subject to U.S. taxation.
3D was dissatisfied with the 1 percent interest rate it received on its checking account at Bank of America in Detroit. Lily’s investment adviser suggested the company invest $50,000 in five-year bonds issued by the Canadian government with an interest rate of 3 percent. During 2018, 3D received C$1,500 in interest from the bonds. Per the U.S.–Canada treaty, the Canadian government did not withhold taxes on the payment. Assume the translation rate is C$1:US$1.
What is the source, U.S. or foreign, of the interest Lily receives on the bonds?
Answer: Foreign source. The source of interest income depends on the residence of the borrower at the time the interest is paid. The Canadian government is considered a resident of Canada for U.S.
source rule purposes.
Example 24-4
16If certain conditions are met, a U.S. individual can exclude up to $104,100 of earned income from U.S.
taxation in 2018 plus additional earnings equal to excess “foreign housing expenses” under §911.
17§1441.
18§861(a).
19§862(a).
20§871(i)(2)(A) and §881(d).
Dividends In general, the source of dividend income is determined by the residence of the corporation paying the dividend. Residence usually is determined by the corporation’s country of incorporation or organization (in some countries, such as the United Kingdom, a corporation’s residence is determined by where its central management is located).
As part of diversifying its investment portfolio, 3D purchased 200 shares of Scotiabank (Bank of Nova Scotia, Canada). In 2018, Scotiabank paid 3D dividends of C$400. Scotiabank withheld C$60 in taxes (15 percent) on the payment.
What is the source, U.S. or foreign, of the dividend 3D receives on the stock?
Answer: Foreign source. The source of dividend income depends on the residence of the payor of the dividend. Scotiabank is headquartered in Toronto, Canada, and is a resident of Canada for U.S.
source rule purposes.
Example 24-5
What if: Assume that for quality-control purposes Lily has decided to do all the baking for her Windsor store in Detroit. Every morning a Windsor employee drives a truck to Detroit and picks up the baked goods for sale in Windsor. One of her Windsor employees, Stan Lee Cupp, made the 2-hour trip on 120 different days during 2018 (240 hours spent in the United States). 3D paid Stan a salary of C$50,000 during 2018. He worked a total of 1,920 hours during 2018. Assume the translation rate is C$1:US$0.80.
How much U.S. source compensation does Stan have in 2018? Base your computation on hours worked.
Example 24-6
Compensation for Services The source of compensation received for “labor or per- sonal services” is determined by the location where the service is performed. The IRS and the courts have held that the term includes activities of employees, independent con- tractors, artists, entertainers, athletes, and even corporations offering “personal services”
(e.g., accounting). The Code provides a limited commercial traveler exception, in which personal service compensation earned by nonresidents within the U.S. is not treated as U.S. source if the individual meets the following criteria:
∙ The individual was present in the United States for not more than 90 days during the current taxable year;21
∙ Compensation for the services does not exceed $3,000; and
∙ The services are performed for a nonresident alien, foreign corporation, or foreign partnership or for the foreign office of a domestic corporation.22
The United States frequently alters the limitations on length of stay and compensa- tion through treaty agreements. In most cases, the 90-day limit is extended to 183 days, and no dollar limit is put on the amount of compensation received.
Compensation for services performed within and outside of the United States must be allocated between U.S. and foreign sources. An individual who receives compensa- tion, other than compensation in the form of fringe benefits, as an employee for labor or personal services performed partly within and partly outside the United States is required to source such compensation on a time basis. An individual who receives compensation as an employee for labor or personal services performed partly within and partly outside the United States in the form of fringe benefits (e.g., additional amounts paid for housing or education) is required to source such compensation on a geographic basis; that is, de- termined by the employee’s principal place of work.
21For purposes of this test, a full day is considered to be any part of a day.
22§861(a)(3)(A)–(C).
Answer: $5,000 (C$50,000 × 240/1,920 × $0.80). Stan sources his salary for U.S. tax purposes based on where he performed the services. Using hours worked, Stan spent 12.5 percent of his time performing services in the United States (240/1,920).
Using only the exception found in the IRC, will Stan be subject to U.S. tax on his U.S.-source wages in 2018?
Answer: Yes. Stan fails the commercial traveler exception. He is in the United States for more than 90 days during 2018.
What if: Assume Stan limits his trips to 90 days during 2018 (180 hours spent in the United States).
Using only the IRC exception, will Stan be subject to U.S. tax on his U.S.-source salary in 2018?
Answer: Yes. Stan still fails the commercial traveler exception. Although he is in the United States for not more than 90 days, his U.S.-source salary is $3,750 (C$50,000 × 180/1,920 × $0.80), which exceeds $3,000.
As we discuss later in the chapter, the U.S.–Canada income tax treaty significantly liberalizes the com- mercial traveler exception, thus allowing Stan to spend more time in the United States without being taxed by the U.S. government on his U.S.-source wages.
TAXES IN THE REAL WORLD Taxing Professional Golfers
One of the issues that the IRS has struggled with is whether to characterize fees paid to foreign professional golf and tennis players pursuant to on-course/on-court endorsement contracts (e.g., contracts that require wearing a company’s logo or using its equipment) as income from royalties or income from personal services, or both. Two recent Tax Court cases with well-known profes- sional golfers illustrate the complexities of this issue.
The first case involved Retief Goosen, a PGA tour member and winner of the 2001 U.S. Open Championship.* Mr. Goosen was a citizen of South Africa and a resident of the United Kingdom, but he spent most of his time competing in the United States and Europe.
Mr. Goosen entered into several endorse- ment and appearance agreements with spon- sors that allowed the sponsor to use his name and likeness to advertise and promote the spon- sor’s products or in connection with advertising and promoting a specific tournament or event.
The “on-course” endorsement agreements re- quired him to wear or use the sponsor’s prod- ucts during golf tournaments, whereas the
“off-course” endorsement agreements did not have this requirement.
Mr. Goosen reported all his prize money from golf tournaments and appearance fees in the United States as “effectively connected” income taxable in the United States. He characterized his endorsement fees from on-course endorsements as 50 percent royalty income and 50 percent
personal services income. He sourced the per- sonal services income from the on-course en- dorsement fees to the United States based on the number of days he played within the United States over the total number of days he played golf for the year. Mr. Goosen characterized his endorsement fees from the off-course endorse- ment agreements as 100 percent royalty income.
The IRS argued that the sponsors primarily paid Mr. Goosen to perform personal services, which included playing golf and carrying or wearing the sponsors’ products.
The Tax Court awarded a partial victory to both parties. The Court found that Mr. Goosen’s name had a value beyond his golf skills and abili- ties for which his sponsors paid a substantial amount of money for the right to use his name and likeness. The sponsors also valued Goosen’s play at tournaments, as evidenced by the fact that the sponsors conditioned the full endorse- ment fee on his playing in 36 tournaments a year.
The Court thus held that his performance of ser- vices and the use of his name and likeness were equally important and characterized 50 percent of the endorsement fees from the on-course endorsement agreements as royalty income and 50 percent of the fees as personal services income.
The Court held that Mr. Goosen’s earnings from playing golf in the United States was effectively
*Retief Goosen v. Commissioner, 136 T.C. No. 27 (June 9, 2011).
(continued on page 24-10)
Rents and Royalties Rent has its source where the property generating the rent is located. Royalty income has its source where the intangible property or rights generating the royalty are used. Royalties include payments related to intangibles such as patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, and fran- chises. An intangible is “used” in the country that protects the owner against its unautho- rized use.
connected U.S.-source income. The on-course endorsement and appearance fees and his on- course royalty income also were held to be U.S.- source effectively connected income to the extent they were sourced as U.S.-source income because payment depended on whether he played a specified number of tournaments. Both categories of income were taxed at the regular U.S. graduated tax rates.
The Court held that income Mr. Goosen re- ceived from off-course endorsement agreements did not depend on whether he played in golf tour- naments. Thus, the income was not effectively connected with a U.S. trade or business and was thus subject to a 30 percent withholding tax to the extent it was treated as U.S.-source income.
The second case involved Sergio Garcia, a Spanish citizen but a resident of Switzerland.†
The IRS again argued that the “vast majority” of the golfer’s endorsement income should be
treated as personal services income and subject to U.S. taxation at the regular tax rates. Mr. Garcia characterized 85 percent of his endorsement in- come as royalty income, which was not subject to U.S. taxation under the U.S.–Swiss income tax treaty. The Tax Court judge held that 65 percent of the endorsement income should be character- ized as royalty income. It is interesting to note that the Tax Court apportioned a higher percent- age of Mr. Garcia’s income as royalties because he was designated as a “global icon” by the golf company that paid him the endorsement fees. The same company regarded Mr. Goosen as a “brand ambassador” and paid him less than Mr. Garcia because the company valued Mr. Garcia’s “flash, looks and maverick personality” more than Mr. Goosen’s “cool ‘Iceman’ demeanor.”
†Sergio Garcia v. Commissioner, 140 T.C. No 6 (March 14, 2013).
In 2018, 3D rented its Windsor store for C$2,500 per month, for a total of C$30,000. Under the U.S.–
Canada income tax treaty, 3D must withhold U.S. taxes at a 30 percent rate on rent payments that flow from the United States to Canada if the rent is U.S.-source income. Will 3D have to withhold taxes on the rent payments it makes in 2018?
Answer: No. The rent is considered foreign source income because the store that is rented is located in Canada.
Example 24-7
Gain or Loss from Sale of Real Property In general, gain or loss from the sale of realty has its source where the property is located.
Gain or Loss from Sale of Purchased Personal Property Under the general rule, gain or loss from the sale of purchased personal (nonrealty) property has its source based on the seller’s residence.23 There are many exceptions to this general rule. In particular, gross income (sales minus cost of goods sold) from the sale of purchased inventory is sourced where title passes. Title is deemed to pass at the time when, and the place where, the seller’s rights, title, and interest in the property are transferred to the buyer.
23Personal property under the source rules includes stock of a corporation. Sales of intangible property such as a patent, copyright, secret process, goodwill, trademark, trade brand, or franchise are subject to different source rules.
Source of Deduction Rules
After determining the source of gross income as being from U.S. or foreign sources, a taxpayer may be required to allocate and apportion allowable deductions to gross in- come from each geographical source to compute taxable income from U.S. and foreign sources. For a U.S. taxpayer, this allocation and apportionment process identifies the foreign source deductions that are subtracted from foreign source gross income in com- puting foreign source taxable income in the numerator of the FTC limitation computa- tion. A non-U.S. taxpayer with gross income that is effectively connected with a U.S. trade or business must identify the U.S. source deductions that are subtracted from U.S. gross income to compute U.S. taxable income.
U.S. and non-U.S. taxpayers can have different motivations in seeking to deduct (or not deduct) expenses from either foreign source or U.S. source gross income.
A U.S. taxpayer seeking to maximize the foreign tax credit limitation will want to allocate as few deductions to foreign source gross income as possible, the goal being to make the ratio of foreign source taxable income to total taxable income as close to 100 percent as possible (or whatever ratio is needed to absorb any excess credits).
Non-U.S. taxpayers operating in a low-tax-rate country (a tax rate less than the U.S.
rate) have a tax incentive to allocate as many deductions to U.S. source income as possible to minimize their U.S. tax liability. Non-U.S. taxpayers operating in a high- tax-rate country (a tax rate greater than the U.S. rate) have a worldwide tax incentive to allocate as many deductions to foreign source income as possible to minimize their worldwide tax liability.
ETHICS
International Contractors, Inc., has been hired by the U.S. government to build roads and bridges in Spartania, a country with which the United States recently signed a treaty. To facili- tate the issuance of visas and licenses to begin construction, an official from the Spartanian government asked for 100 “facilitating pay- ments” (also known as “grease payments”) of
$5,000 each from the company. These pay- ments were customary in Spartania and did not violate Spartanian law. The company intended
to deduct the $500,000 payment in its finan- cial statements. It was not clear if these pay- ments violated the Foreign Corrupt Practices Act. To avoid IRS and possible Department of Justice scrutiny, the company’s tax director sug- gested that the payment be described as “taxes and licenses” on the tax return (line 17 of Form 1120) without further details. What do you think of the tax director’s advice? What tax and other consequences might result from taking this advice?
General Principles of Allocation and Apportionment The IRC provides very broad language in describing how to allocate deductions to U.S. and foreign source gross income. The regulations attempt to match deductions with the gross income such deduc- tions were incurred to produce.24 Matching usually is done based on the “factual relation- ship” of the deduction to gross income. Deductions that can be directly associated with a particular item of income (e.g., machine depreciation with manufacturing gross profit) are referred to as definitely related deductions. Deductions not directly associated with a particular item of gross income (e.g., medical expenses, property taxes, standard deduc- tion) are referred to as not definitely related deductions and are allocated to all gross income.
24Reg. §1.861-8 provides the general rules for allocating and apportioning deductions to U.S. and foreign source gross income.