The U.S. international income tax rules are among the most complex in the Code. The purpose of this article will be to set forth in a comprehensible manner the essence of those rules. Part I will discuss how a foreign person may become subject to U.S. tax, and the distinction between foreign and domestic “source” income. Part I will also introduce the concept of income “effectively connected” with a “U.S. trade or business.” Part II, appearing in the next issue, will conclude a discussion of the trade or business concept, and will discuss the foreign tax credit, the impact of treaties, and other issues.
The Code taxes persons either on the basis of their presence in the U.S., or on the basis of the geographic source of their income, irrespective of their presence. Imposition of U.S. income tax on most persons is based upon their personal relationship with the U.S. Thus, Boris Yeltsin would not be subject to U.S. income tax on income earned as President of Russia, despite the fact that he has visited the U.S. However, a Russian citizen possessing a green card, though not a U.S. citizen, would nevertheless be a U.S. “person” for U.S income tax purposes, and would be taxed as a U.S. citizen. The tax law goes even further: any alien physically present in the U.S. for more than 183 days in the calendar year will be taxed as a resident, irrespective of the bona fides of his presence in the U.S. under the immigration laws.
Conversely, a U.S. citizen living overseas, even permanently, must pay tax on all earned income — this is considered a price of U.S. citizenship. Code Sec. 61 provides that “gross income means all income from whatever source derived.” Thus, a U.S. attorney working for a French law firm in Paris must report all income, notwithstanding the fact France without doubt imposes tax on the same income.
[If the foreign earned income is taxed by France, the foreign tax credit may operate to avoid the incidence of double taxation. The foreign tax credit is nonrefundable: if France taxes the income at rate higher than the U.S., the Treasury will not refund the difference. The credit will also not operate to reduce U.S. tax liability: if France taxes the income at a rate lower than the U.S., the U.S. will credit the tax imposed by France, but will also impose such additional tax as is necessary to ensure that the taxpayer pays the full U.S. rate. [The foreign tax credit will be discussed further in Part II.]
The second independent basis for imposition of U.S. income tax is the geographical source of income. A Russian attorney from Moscow working briefly for a New York law firm, but not spending the requisite 183 days in the U.S., and not in possession of a green card, would clearly taxed on income paid by the New York firm. However, income which the attorney earned working for a Moscow firm having no affiliation with the U.S. firm would not be subject to U.S. income tax. The Russian attorney is taxed on his income earned in New York not because of his personal relationship with the U.S. — which is fleeting — but rather on account of the geographical source of that income, and the fact that the income is “effectively connected with a U.S. trade or business.” (See discussion, infra.)
Much like nonresident alien individuals, foreign corporations are subject to U.S. tax on the basis of their U.S. source income. Would a foreign corporation with only foreign source income elude U.S. tax if no earnings were repatriated to U.S. shareholders? Possibly. Foreign corporations owned in substantial part by U.S. persons have long been a source of irritation to the IRS, since a corporation’s earnings are not taxable to shareholders unless and until distributed.
Rather than change the general rule with respect to corporation taxation, Congress enacted Code provisions which impose tax on earnings of controlled foreign corporations (CFC) whether or not the earnings are repatriated to the U.S. shareholders. (A CFC is a foreign corporation of which greater than 50% of the value of the voting stock is owned by U.S. individuals or corporations.)
The Code provides detailed rules which determine whether income is geographically foreign or domestic source. These operation of these rules are critical: although a nonresident alien, such as Michael Gorbachev, must pay U.S. tax on U.S. source income, he is not required to pay U.S. tax on foreign source income, since he is not a US “person.” A nonresident alien may therefore prefer that income be sourced as foreign, (particularly if the alien resides in a jurisdiction with low taxes), since no U.S. income tax liability will arise.
Six general categories of source income are enumerated in the Code: interest, dividends, personal services income, rents and royalties, gains from the disposition of real property, and gains from the sale of personal property. Deductions associated with some types income are permissible, provided there exists a “factual relationship” between the income and deductions. No deductions are permitted for investment income, i.e., dividends or interest.
Interest payments made by a U.S. resident or a U.S. corporation are U.S. source income. An exception exists for a company 80% or more of whose income is derived from the active conduct of a foreign trade or business. In that case, the interest income received by a nonresident alien will be foreign source.
All dividends paid by a U.S. corporation are U.S. source income. Dividends paid by foreign corporations are U.S. source if 25% or more of the corporation’s gross income, for the preceding three years, was effectively connected with the conduct of a trade or business in the U.S.
Compensation for personal services income, such as the income earned by the Moscow attorney working in New York, is U.S. source income. An exception exists, and the income will be foreign source, if the nonresident alien is temporarily in the U.S. for 90 days or less, less than $3,000 is earned, and the services are performed for a foreign payor not engaged in a U.S. trade or business.
Compensation for services performed outside the U.S. is foreign source income. Therefore, if the Moscow attorney performed consulting work for the U.S. firm in London, that income would not be subject to U.S. tax.
All rents and royalties from property (tangible and intangible) located in the U.S. are U.S. source income. Conversely, rents and royalties from property located or used outside the U.S. are foreign source income.
Gains from the disposition of a U.S. real property interest are U.S. source. Gains from the sale of property located outside the U.S. are foreign source.
Gains from the sale of personal property (e.g., a piano or a share of stock) are sourced at the residence of the seller. If the Moscow attorney sold the New York attorney a piano which the Russian purchased at a bargain in New York, gains realized from such sale would be not be taxable. However, if the Moscow attorney was in the business of selling pianos, then the result would be different: inventory is sourced where the sale takes place.
After determining whether a nonresident possesses U.S. source income, it must then be determined whether that income is “effectively connected” with a “U.S. trade or business.” Effectively connected income (net of deductions) is generally taxed at regular individual (or corporate) rates. The determination of whether a trade or business exists requires consideration of the alien’s profit motive, as well as the quantitative aspects such as frequency, substantiality, and duration of the activities. Aliens engaging in sales of U.S. real property can no longer avoid U.S. income tax by failing to meet the U.S. trade or business requirement, since gains derived from the sale of a U.S. real property interest are conclusively presumed to constitute income effectively connected with a U.S. trade or business.
Income not effectively connected with a U.S. trade or business may constitute investment income, which is taxed at a flat 30% rate, with no deductions allowed. Income which is neither either effectively connected business income nor investment income — and which is not earned by a “U.S. person” — would escape U.S. tax, regardless of its U.S. source. An example of this would be the speaking fee received by a foreign statesman who makes one isolated speech in the U.S.
As noted, the United States reserves the right to tax all U.S. “persons” on worldwide income. For U.S. taxpayers living and working abroad, however, this can result in double taxation. The foreign tax credit, which is elective, can ease the burden placed upon those taxpayers by eliminating the U.S. tax on foreign source income to the extent that income has already been taxed in the foreign jurisdiction.
If the foreign tax is lower than the U.S. tax, the IRS imposes tax on the amount of the difference. If the foreign tax is higher, the IRS will not issue a refund.
Some important limitations apply to the use of the foreign tax credit:
¶ Only U.S. persons are entitled to claim the foreign tax credit;
¶ Only foreign “income” taxes or taxes imposed “in lieu” of an income tax are creditable.
¶ To ensure that the IRS collects tax on U.S. source income, the Code operates to prevent the credit from reducing U.S. tax liability on U.S. source income. Without this limitation, a U.S. taxpayer operating in a high-tax foreign jurisdiction could generate a foreign tax credit large enough to offset U.S. tax on U.S. source income. (However, credits disallowed because of this limitation may be carried back and carried forward to other tax years.)
¶ To reduce the risk of tax fraud, the taxpayer claiming the credit must comply with stringent requirements in order to show that the foreign tax was actually paid.
Treaties operate to coordinate the tax laws of the U.S. and other countries. Treaties also refine the issues involved in the foreign tax credit so that the object of the credit, i.e., to remove tax barriers on U.S. persons investing abroad, and foreign persons investing in the U.S. Article VI of the Constitution provides that treaties and legislative enactments are of equal force.
Treaties interact closely with the effectively connected income rules discussed in Part I of this article. For example, residents of foreign jurisdictions whose country has a tax treaty with the U.S. may avoid tax on their effectively connected business income unless the taxpayer has a permanent establishment, i.e., an office or factory, in the U.S. Conversely, a U.S. taxpayer with business income in a foreign country which has entered into a tax treaty with the U.S. will not be taxed on that foreign source income unless the taxpayer operates out of a permanent establishment there.
The foreign tax credit operates exclusively with respect to foreign income taxes. However, treaties apply to all foreign taxes. Thus, treaties also operate to remove uncertainty about whether the foreign tax levy falls within the “income tax” definition for purposes of the foreign tax credit. Treaties also free the taxpayer from filing returns and paying taxes to foreign jurisdictions that would ultimately be credited by the U.S. anyway.