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

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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

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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
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Source of Dividend Income
What is the general rule?
 Exception to the general rule:


25-percent rule
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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?

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Source of Rents & Royalties
What is the general rule for tangible
property?
 What is the general rule for intangible
property?

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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?
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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’?

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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
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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

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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?
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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?
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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.?

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Transfer Pricing
Issue arises when goods and services
are transferred between related
parties
 Ability to manipulate transfer prices
allows shifting of income from hightax jurisdictions to low-tax
jurisdictions, and affects
determination of income source

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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).
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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
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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
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the marketing subsidiaries.
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
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comparable uncontrolled price method.
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
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facilities to the marketing subs.
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].
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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?

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