Importance of Income Sourcing

1. Importance of Income Sourcing • U.S. persons earning foreign source income are entitled to a foreign tax credit • Foreign persons earning U.S. source income are subject to U.S. taxation • Sourcing for U.S. tax purposes is independent of sourcing for foreign tax purposes

2. Some Sourcing Possibilities • Source to physical location of property or person earning the income • Source to residence or domicile of payor of income • Source to residence or domicile of recipient of income

3. Source of Interest Income • What is the general rule? • Exceptions to the general rule: • 80-percent rule • Branch interest rule • Note that sourcing of the interest income does not also control sourcing of the interest deduction by the payor

4. Source of Dividend Income • What is the general rule? • Exception to the general rule: • 25-percent rule

5. Source of Income from Services • What is the general rule? • Exception to the general rule: 90-day exception • Sourcing of income of employees performing services also impacts sourcing of income of employer from those services • How to allocate when services performed in multiple countries?

6. Source of Rents & Royalties • What is the general rule for tangible property? • What is the general rule for intangible property?

7. Source of Gains from Sale of Real Property • What is the general rule for real property? • Note that the sourcing rule for real property includes sales of ‘U.S. real property interests’ by domestic corporations • Why is this distinction important, and who does it impact?

8. Sales of Non-inventory Personal Property • What types of assets are included in this category? • What is the general sourcing rule? • How does the definition of a resident for this purpose differ from the definition used in defining a ‘U.S. person’?

9. Sourcing of Inventory Sales • What is the general rule for purchased inventory? • What is the general rule for manufactured inventory? • Exception to the general rule: independent factory price

10. Special Rules and Issues • Sales of personal property by foreign persons using a U.S. place of business are considered U.S. source • Characterization of income is critical to sourcing • Services versus transfers of intellectual property rights • Computer software

11. Examples: How should each be sourced? • Pat, a U.S. citizen, loans money to Ann, a nonresident alien, receiving interest income • What if Ann is a resident alien earning income exclusively from U.S. sources? What if her income is exclusively from foreign sources? What if Ann is a foreign corporation with a U.S. branch operation? • Lil, a nonresident alien, loans money to Ed, a U.S. citizen, receiving interest income • What if Ed is living abroad at the time of the payment?

12. Examples continued • David, a foreign person, invests in the stock of a U.S. corporation and receives dividend income • What if the corporation is a foreign corporation with no U.S. operations? With U.S. operations? • Ray, a U.S. citizen working for a U.S. corporation, travels abroad on business 3 weeks of the year • What if Ray’s employer is a foreign corporation with U.S. operations?

13. Examples continued • Worldco, a U.S. corporation, purchases inventory abroad and imports it • What if Worldco manufactured the inventory abroad for import? • What if Worldco were a foreign corporation shipping both purchased and manufactured inventory into the U.S.?

14. Transfer Pricing • Issue arises when goods and services are transferred between related parties • Ability to manipulate transfer prices allows shifting of income from high-tax jurisdictions to low-tax jurisdictions, and affects determination of income source

15. Transfer Pricing Example Assume a US shirt manufacturer has a foreign sub in country X. Cloth to make shirts is woven in the US, at a cost of $4 per shirt, and shipped to country X where it is cut and sewn at a cost of $5 per shirt. These shirts are sold in Europe for $30 per shirt. The profit on each shirt is $21, a portion of which is US source income and a portion of which is foreign source income, depending on the price at which the cloth is transferred from the US to country X. If the tax rate in country X is lower than the US tax rate, the manufacturer would prefer to recognize profit in country X, and might set a transfer price equal to the cost of the cloth ($4). If the tax rate in country X is higher than the US tax rate, the manufacturer would prefer to recognize profit in the US, and might set a transfer price equal to cost plus net profit ($25).

16. Transfer Pricing Rules • What is the general rule for pricing transfers of goods and services between related parties? • What is a comparable uncontrolled transaction? • Comparability factors include • Economic functions carried on by taxpayers • Form of contracts • Risks incurred by the parties to the contract • Economic conditions • Nature of the property or services

17. Example: Finding Comparable Uncontrolled Transactions Cordovan Inc. is a US computer manufacturer providing products to customers in both the US and Europe. Cordovan has foreign manufacturing subsidiaries in countries X and Y and foreign marketing subsidiaries in 5 additional countries. Manufacturing facilities in country X produce computer components that are shipped to facilities in country Y and the US for assembly. Completed products are shipped to the US and the marketing subsidiaries for sale to customers. Cordovan must identify comparable uncontrolled transactions for pricing the transfer of components from country X to the US and country Y, and for pricing the transfer of completed products from the US and country Y to the marketing subsidiaries.

18. Example: Comparable Uncontrolled Price Method • Suppose Cordovan’s country X sub sells identical parts to unrelated parties for $200. Such sales are comparable uncontrolled transactions. If the terms of sale are the same as the terms of sale to Cordovan and its country Y sub, then $200 would be an appropriate transfer price under the comparable uncontrolled price method.If the parts sold or the terms of the sales to unrelated third parties are not identical, then application of this method is possible only if the differences are minor and such differences have a reasonably ascertainable effect on price. For example, suppose that sales to third parties require the purchaser to pay freight costs, but the country X sub pays freight on sales within the Cordovan group. Assuming freight costs of $5 per part, $205 would be an appropriate transfer price under the comparable uncontrolled price method.

19. Example:Resale Price Method Cordovan’s marketing subs sell its computers for $1,500 and also sell other computer products purchased from unrelated suppliers. The marketing subs earn a 25% average gross profit margin on the other products. If the functions performed by the marketing subs and the risks and contract terms of these other sales are sufficiently comparable to sales of Cordovan’s computers, then the resale price method uses the gross profit margin on the uncontrolled transactions to determine the appropriate transfer price for transferring products to the marketing subsidiaries. Thus, a transfer price of $1,125 ($1,500 - $1,500 * 25%) would apply to transfers from Cordovan and the country Y assembly facilities to the marketing subs.

20. Example: Cost Plus Method Cordovan’s country X sub sells substantially different parts to unrelated parties for $300. These parts cost the sub $180 to produce, earning a gross profit of $120. This gross profit represents a 66.7% market on cost. Because these parts are substantially different than those transferred within the Cordovan group, this price cannot be used to apply the comparable uncontrolled price method. However, the cost plus method would apply the 66.7% markup earned on these uncontrolled sales in determining the transfer price for controlled sales. If cost of goods sold for the controlled sales is $125, the cost plus method would result in a transfer price of $208 [$125 * 1.667].

21. Other Transfer Pricing Issues • Existence of multiple comparable uncontrolled transactions will produce a range of potential transfer prices • Transfer of the rights to use intangible property subject to ‘superroyalty’ provision • What are the advantages and disadvantages of entering into an APA?