Source Rules

Source Rules

January 01, 2007

Source Rules for determining where income is earned are important. The more income that a US company can report earning outside the United States, the more foreign taxes the company will be able to claim as a credit to reduce its US income taxes.

The IRS explained in regulations in late December how to determine where income is earned that a company receives from a project on or under the high seas, in outer space or involving cross-border communications. The regulations interpret sections 863(d) and (e) of the US tax code.

It will be hard for US companies to claim that ocean or space projects produce any foreign source income. Income received from such projects by US persons will be treated as earned entirely in the United States.The ocean is defined as the area outside territorial waters of any country,meaning more than 200 miles offshore. The rule makes sense since such income is unlikely to have been taxed by another country.

A US company cannot ordinarily convert ocean or space income into foreign source income by investing through an offshore subsidiary. That’s because a subsidiary that is owned more than 50% by US shareholders will be treated like a US person for this purpose.

There is one possible out.The income will turn into foreign source income to the extent the company can show that the income was tied to tasks performed, resources employed or risks assumed in a foreign country. This rule is a trap for foreign companies involved in projects on the oceans or in outer space that have a US connection. Some of their income may end up being taxed in the United States as US source income based on the same principle.

A television company that has its programs broadcast by satellite into other countries does not earn income from an activity in outer space if it merely pays someone else to transmit the programming; the satellite operator does. However, it does have space income if it leases transponders or capacity on the satellite to make the broadcasts. The IRS said it is still studying how to treat income earned from leasing shipping containers. This will be addressed separately in the future.

US telephone and internet companies that earn income from “international communications” must treat the income as earned 50% in the US and 50% abroad. However, communications are considered to take place entirely in the US if they are between two points in the United States or between a point in the US and the high seas or outer space. Foreign telecom and internet companies with offices in the United States will have US source income — and have to pay tax on it in the United States — to the extent their income is tied to the US office.

The IRS acknowledged that it may be hard in today’s world to figure out where telephone calls or internet use starts and ends. It said it will accept any “consistently applied reasonable method.”


Keith Martin