Section 862: Determining Foreign Source Income

The U.S. tax system requires income to be categorized based on its geographic source to calculate tax liability for individuals and businesses with international activities. United States citizens and resident aliens are subject to tax on their worldwide income, regardless of where it is earned. In contrast, nonresident aliens are taxed only on income effectively connected with a U.S. trade or business and certain U.S.-based investment income. This difference requires a clear method for distinguishing between domestic and foreign earnings by applying rules to determine if they originate within or outside the United States.

The Principle of Income Sourcing

Internal Revenue Code Section 862 provides the rules for identifying income from sources outside the United States. Its counterpart, Section 861, defines income from sources within the United States. Together, these sections assign a geographic location to most types of income. This establishes jurisdiction for taxation, ensuring income is correctly attributed as either U.S. or foreign source.

Identifying Foreign Source Income Categories

Section 862 of the Internal Revenue Code outlines the rules for classifying different types of gross income as foreign source. These regulations are based on the economic origin of the income, not where payment is received. Applying the distinct sourcing rule for each category is the first step in properly calculating foreign source taxable income.

Interest

Interest income is sourced to the residence of the payer, or obligor. If a foreign corporation, a nonresident individual, or a foreign government pays interest, that income is foreign source. For example, interest earned on a bond issued by a German corporation is foreign source because the payer is a foreign resident.

An exception exists for interest paid by certain U.S. corporations. This interest can be treated as foreign source if at least 80 percent of the corporation’s gross income over a three-year period was from an active foreign trade or business. This prevents income that is economically foreign from being classified as U.S. source simply because the paying entity is legally domiciled in the United States.

Dividends

The source of a dividend depends on the paying corporation’s country of incorporation. Dividends from a corporation organized outside the United States are treated as foreign source income. For example, a dividend from a Japanese company is sourced to Japan, even if the company has significant U.S. operations.

An exception applies if a foreign corporation’s earnings are highly connected to a U.S. business. If 25 percent or more of the corporation’s gross income over a base period was effectively connected with a U.S. business, a portion of the dividend may be reclassified as U.S. source. This rule prevents companies from using foreign entities to shield U.S.-based earnings from taxation when distributed.

Personal Services

Compensation for personal services is sourced to the location where the work is physically performed. If an individual works in another country, the wages and salaries earned for those services are foreign source income. For example, if a U.S. consultant works on a project in Canada, the income earned during that period is sourced to Canada.

When services are performed both within and outside the United States, the income must be apportioned. This allocation is commonly done on a time basis, allocating total compensation based on the number of workdays in the U.S. versus abroad.

Rents and Royalties

Income from rents and royalties is sourced to the location where the underlying property is used. If a taxpayer owns and rents out a residential property in Spain, the rental income is foreign source because the property is used in Spain.

This principle also applies to intangible property. Royalties for the use of a patent, copyright, or trademark in a foreign country are foreign source income. For instance, royalties from a book licensed for distribution only in the United Kingdom are foreign source, as the location of use dictates the source.

Sale of Real Property

Income from the sale of real property is sourced to the property’s physical location. If a U.S. person sells a condominium located in France, any gain from that sale is foreign source income, regardless of where the sale is negotiated.

Sale of Personal Property

Income from selling personal property, such as stocks and bonds, is sourced to the seller’s tax residence, which for a U.S. resident means the gain is U.S. source. However, Internal Revenue Code Section 865 provides exceptions. If a sale is attributable to a foreign office or fixed place of business, the income may be sourced abroad.

An exception applies to inventory property. Income from selling inventory is sourced based on where the title and risk of loss pass to the buyer. If title passes outside the U.S., the income is foreign source. For inventory produced by the taxpayer, income is sourced based on production location.

Allocating Deductions Against Foreign Income

After identifying gross foreign source income, the next step is to determine the taxable portion by allocating and apportioning deductions. Under Section 862, expenses, losses, and other deductions directly related to earning specific foreign source income must be subtracted from that income. This calculation determines the net profit from that foreign source.

For example, if a taxpayer earns rental income from a property in another country, they must deduct the expenses associated with that property. These would include items such as property management fees, repairs, local property taxes, and depreciation. Only the net amount after these direct expenses are subtracted is considered taxable income from that foreign source.

Deductions not directly allocable to a specific income class must be apportioned ratably between U.S. and foreign source income. For individuals who do not itemize, the standard deduction must be apportioned in this manner.

Application in the Foreign Tax Credit Limitation

The primary reason for calculating net foreign source income is to determine the foreign tax credit (FTC) limitation. The FTC is a non-refundable credit that reduces the double taxation that occurs when income is taxed by both a foreign country and the United States. The amount of credit that can be claimed in a year is limited.

This limitation is calculated on Form 1116, Foreign Tax Credit, using a specific formula: (Foreign Source Taxable Income ÷ Total Taxable Income from All Sources) × U.S. Tax on Total Taxable Income. The numerator of this fraction is the figure derived from identifying foreign gross income and then allocating deductions under Section 862.

This formula establishes a ceiling on the foreign taxes that can be credited against U.S. tax liability. The U.S. will not provide a credit for foreign taxes that exceeds the U.S. tax that would have been due on that same foreign income. This ensures the credit only offsets U.S. tax on foreign earnings.