Income Sourcing: Why It Matters for US Expats
Introduction
Understanding the eligibility of income for the foreign tax credit (FTC) is crucial as not all income subject to foreign tax qualifies for the FTC. The FTC applies specifically to income categorized as foreign source income. The determination of whether income is sourced from the U.S. or a foreign country helps establish which country has the primary right to tax that income. When income is classified as foreign source, the foreign country holds the authority to tax it, and the U.S. allows taxpayers to claim a credit for the foreign taxes paid. However, accurately identifying the sourcing of income is vital, as any errors can lead to an incorrect overstatement of the FTC.
Interest Income
Interest income is typically determined based on the residence of the payor. Interest income includes earnings from bank accounts, bonds, and notes. If the interest arises from sources within the 50 states and the District of Columbia, it is considered income from within the U.S.
Example:
John, who is a U.S. citizen, receives interest income from a personal loan given to Alex, who is also a U.S. citizen but resides in a foreign country. Since taxpayer B is a resident of the foreign country, even though they are a U.S. citizen, the income is considered foreign sourced income.
Dividend Income
Dividend income is generally determined by the country where the paying company is incorporated. Dividends from domestic corporations are considered U.S. sourced income, while dividends from foreign corporations are considered foreign sourced income.
Wages and Personal Services Income
When it comes to sourcing wages and personal services income, the general rule is based on where the services are performed, disregarding factors like the recipient's residence, contracting location, or payment details.
If services are performed both within and outside the U.S., the compensation is allocated in a way that accurately reflects the proper source of income, often using a time-based apportionment.
However, when a non-resident alien (NRA) performs services in the U.S., the compensation is considered foreign source income if the following conditions are met:
The NRA is temporarily in the U.S.
The presence in the U.S. during the taxable year doesn't exceed 90 days
The compensation for services doesn't exceed $3,000.
Example: Taxpayer A, a citizen and resident of Germany, was hired by a U.S. company to develop a new product for global sales. During the project, taxpayer A spent 56 days (8 weeks) in the U.S. to address production issues. The entire project lasted twenty weeks, and taxpayer A was compensated $60,000.
Since taxpayer A worked as a non-resident alien in the U.S. for 56 days and received payment exceeding $3,000, the income cannot be categorized solely as foreign sourced. Instead, it needs to be allocated as follows: 8 weeks in the U.S. out of a total of 20 weeks for the project multiplied by the $60,000 payment, resulting in $24,000 sourced to the U.S.
Rent and Royalty Income
Income from renting or using property, whether tangible or intangible, within the U.S. is considered U.S sourced income.
Capital Gains
Income sourcing for property depends on the nature of the property being sold. Real property is sourced based on its physical location, while the sale of personal property is sourced to the tax residence of the seller, known as the seller's tax home.
Pension and Retirement Plans
When it comes to sourcing pension income, there are two components to consider: contributions to the pension plan and the earnings generated from those contributions. The contribution portion is sourced based on where the services were performed that earned the pension. On the other hand, the investment earnings portion is sourced according to the location of the pension trust. U.S. social security benefits are generally considered to be from U.S. sources.
For instance, if a U.S. citizen worked in Puerto Rico for a U.S. company and received a pension from the U.S. pension trust after retirement while staying in Puerto Rico, the distributions from the pension trust would need to be allocated between contributions (considered Puerto Rico source income) and investment earnings (considered U.S. source income).
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