Section 865: Source Rules for Personal Property Sales

The geographic source of income is a foundational concept in taxation, classifying income as either U.S. or foreign source. This distinction is consequential, as it impacts the foreign tax credit calculation for American taxpayers, which mitigates double taxation on income earned abroad. For non-U.S. taxpayers, sourcing rules determine their U.S. tax liability, as they are taxed on their U.S. source income.

The Internal Revenue Code provides a framework for this purpose, with Section 865 establishing the guidelines for sourcing gains and losses from personal property sales. These rules are structured around a main principle and several exceptions for different asset categories.

The General Sourcing Rule for Personal Property

The default rule for sourcing income from the sale of personal property is based on the seller’s tax residence. This means the gain is sourced to the country where the seller is a resident for tax purposes, regardless of the buyer’s location, where the contract is signed, or where the property is delivered. This residence-based sourcing provides a clear starting point for many transactions.

Defining tax residence is specific under U.S. tax law. For an individual, a U.S. resident includes U.S. citizens, lawful permanent residents (green card holders), and individuals who meet the substantial presence test. The substantial presence test is based on the number of days a person is physically present in the United States over a three-year period. For entities, a U.S. resident is any corporation, partnership, trust, or estate created or organized under the laws of the United States or any state.

Consider a U.S. citizen living in the United States who sells a valuable painting to a collector in France. The painting is shipped from a U.S. location to Paris, and payment is sent from a French bank. Despite these foreign touchpoints, the entire gain from the sale is treated as U.S. source income because the seller is a U.S. resident. This principle applies to a wide range of personal property, with specific exceptions for assets like inventory and depreciable equipment.

Sourcing Rules for Inventory Property

An exception to the residence-of-the-seller rule applies to gains from selling inventory, with treatment depending on whether the inventory was purchased for resale or produced by the taxpayer.

For purchased and resold inventory, the sourcing rule is based on where the sale occurs. This is determined by the “title passage test,” which identifies the location where the rights, title, and interest in the property transfer from seller to buyer, often specified in sales contracts. For instance, if a U.S. company sells goods to a customer in Canada and the title passes upon delivery to the Canadian warehouse, the income is foreign source.

For inventory produced by the taxpayer, income is sourced to the location of the production activities. If inventory is produced entirely in the United States and sold to a customer abroad, the income is U.S. source, linking the income to the location of the underlying economic activity. If production occurs both inside and outside the U.S., the income is apportioned between U.S. and foreign sources.

To illustrate, if a U.S. company manufactures widgets in Ohio and sells them to a German customer, the income is U.S. source because production occurred there. If the company instead purchased finished widgets and resold them with title passing in Germany, the income would be foreign source.

Sourcing Rules for Depreciable Property

The sourcing rules for depreciable personal property are designed to match the source of gain with the location where the economic benefit of depreciation deductions was previously enjoyed. A recapture provision links a portion of the gain to these prior deductions. Gain from the sale, up to the total amount of depreciation deductions previously claimed, is sourced based on where those deductions were allocated. If depreciation was deducted against U.S. source income, the corresponding gain is treated as U.S. source income.

Any gain that exceeds the recaptured depreciation is sourced in the same manner as inventory property. This means the title passage test applies, and the source of the excess gain is determined by the location where title transfers to the buyer.

For example, a U.S. corporation sells machinery for $150,000. The machine’s adjusted basis is $50,000 after the company claimed $70,000 in U.S. depreciation deductions. The total gain on the sale is $100,000. The first $70,000 of this gain, equal to the depreciation deductions, is recaptured as U.S. source income. The remaining $30,000 of gain is sourced based on where title passes.

Sourcing Rules for Intangibles and Corporate Stock

The sale of intangible assets and corporate stock also follows specific rules. For intangibles like patents, copyrights, and trademarks, the treatment of sales proceeds depends on the payment structure. If payments are contingent on the asset’s productivity or use, the gain is sourced like a royalty payment, determined by where the intangible property is used.

A distinct rule applies to the sale of goodwill, which is an asset representing the reputation and customer relationships of a business. Gain from selling goodwill is sourced to the country where that goodwill was generated. For example, if a U.S. company sells a foreign business operation, the portion of the sales price allocated to the goodwill generated by that foreign operation would be foreign source income.

The sale of corporate stock also follows the residence-of-the-seller rule. An exception exists for a U.S. corporation selling the stock of an active foreign subsidiary, which may allow an election to treat a portion of the gain as foreign source. This election is available if the sale occurs in the foreign country where the affiliate had substantial assets and business operations.

This election requires the foreign affiliate to be engaged in an active trade or business and that more than 50 percent of its gross income for the preceding three-year period was derived from that business. This prevents the election from being used for passive foreign investment companies.