An overview of US income sourcing rules
An important and fundamental question arises in considering when a non-resident business meets the threshold of being taxed in the United States. I have outlined some of the basic rules for non-residents seeking to determine whether income is taxable in the United States.
Non-resident individuals or businesses are taxable by the US on two categories of income:
Effectively Connected Income (ECI)
This is a typically misunderstood area. When a non-resident person or business sells into the US, this is typically US source income. However, it does not mean that this income is necessarily taxable in the US. A non-US taxpayer must pay US tax on income only if that income is effectively connected with a trade or business in the United States. This threshold is usually met when a dependent agent creates a permanent establishment (PE) by exercising authority within the country to conclude contracts on behalf of the business enterprise.
In addition, the impact of US taxation can be reduced (or eliminated) if a tax treaty exists with the non-US taxpayer’s home country. Under each treaty, the United States is permitted to tax business profits only to the extent those profits are attributable to a US PE of the non-US taxpayer. Under treaty, the threshold level of activities that constitute a US PE is generally higher than the threshold level of activities that constitute a US trade or business and typically requires the maintenance of a fixed place of business over a significant period.
What is a dependent agent?
This is a relationship whereby the agent’s actions are clearly an extension of the non-US taxpayer. This category includes employees, independent contractors acting as employees and companies working almost exclusively for the non-US taxpayer.
A taxpayer is generally considered to be engaged in a US trade or business when the non-resident taxpayer:
- Performs personal services in the United States.
- Is a member of a partnership that at any time during the tax year is engaged in a trade or business in the United States.
- Owns and operates a business in the United States selling services, products, or merchandise.
- Realizes gains or losses from the sale or exchange of US real property interests.
- Income from the rental of real property may be treated as ECI if the taxpayer elects to do so.
The Tax Code allows deductions against effectively connected income then taxed at the graduated rates that apply to US citizens and resident aliens. In addition, a second layer of taxation exists. Under the branch profits tax, the United States imposes a tax of 30 percent on a foreign corporation’s earnings and profits or “dividend equivalent amount.” of a US “branch” attributable to its ECI. The purpose of the branch profits tax is to treat US operations of non-resident corporations in much the same manner as US corporations owned by a non-resident taxpayer.
Fixed or determinable annual or periodic (FDAP) income
ECI and FDAP income are subject to two different tax regimes. FDAP income is taxed on a gross basis (gross income without deductions) at 30 percent whereas ECI is taxed on a net basis (gross income less allowable deductions) at graduated rates. The 30 percent tax rate on FDAP income may be reduced (or eliminated) pursuant to an income tax treaty. The 30% tax on FDAP income is collected by withholding at the source. Accordingly, the payer of the FDAP income is required to withhold and remit this tax to the IRS. The person who withholds and pays the tax is often referred to as the withholding agent.
Some of the common FDAP categories are:
- Interest income from a payer located within the United States. Generally, this is determined by the residence of the payor. Interest is also from US sources if paid by a US resident individual, a domestic corporation, or a partnership engaged in a trade or business in the United States. Interest paid by the US branch of a foreign corporation is also treated as US source income.
- Dividends from a corporation incorporated within the United States. This is generally sourced according to the payor’s place of incorporation. Thus, dividends paid by a domestic corporation are generally US source income.
- Royalty income is sourced to the location or place of use of the property. The nationality or the country of residence of the payor or recipient of the royalties does not affect the sourcing determination. Royalties for the use of property in the US are generally US source income, and royalties for the use of property outside the US are generally foreign-source income. Royalty income includes amounts paid for the use of or for the privilege of using patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises, and other such property.
- Rental income or compensation for the use of tangible property is sourced to the place where the rental property is located. Thus, rental income from property located in the United States (or from any interest in such property) is from U.S. sources. This income may be classified as ECI under specific election under certain circumstances.
This is clearly an important area to consider when commencing operations in the US. The facts and circumstances of each business should be considered against the many complex rules and compliance items. The above represents an overview of sourcing rules and should not be used in lieu of consultation with international tax professional.