What Is Considered Foreign Income for U.S. Tax Purposes?

Fundamental Principles of Foreign Income

Understanding what constitutes foreign income is important for individuals and businesses to comply with U.S. tax laws. The U.S. tax system operates on a principle of worldwide taxation for its citizens and resident aliens. This means that if you are a U.S. citizen or a resident alien, your income is generally subject to U.S. tax, regardless of where it is earned or where you live. This broad approach ensures that all income generated globally by U.S. taxpayers is considered for tax purposes.

The primary aspect in determining how income is treated under various tax provisions is its source, whether foreign or domestic. Income derived from sources outside the United States is generally categorized as foreign income. This distinction relies on specific criteria outlined in U.S. tax regulations. Proper classification of income as foreign or domestic is a foundational step for accurately calculating tax liabilities and applying relevant tax rules.

The source of income becomes particularly relevant when considering various tax benefits or limitations, such as the foreign tax credit or the foreign earned income exclusion. Recognizing the importance of this classification is a primary step. It influences how income is reported and which tax provisions may apply to reduce or offset U.S. tax on foreign earnings.

Specific Categories of Foreign Income

Various types of income can be considered foreign income, depending on where the economic activity generating that income takes place:

• Wages and salaries are foreign income when earned for services performed physically outside the United States.
• Business profits from activities conducted entirely or predominantly outside the U.S. also fall under foreign income, including profits from a foreign branch of a U.S. company or an independent business operated in another country.
• Interest income is foreign if received from foreign debtors, such as a foreign bank or corporation.
• Dividend income is typically foreign-sourced when it originates from a foreign corporation.
• Rental income derived from real property situated outside the United States is foreign income.
• Royalties, payments for the use of intangible property, are foreign income when the intellectual property is used outside the U.S.
• Gains from the sale of property can also be foreign-sourced. If real property located outside the United States is sold, any gain realized is foreign income. For personal property, the source typically depends on the seller’s residence, but special rules apply to certain types of property.
• Pension or annuity income can be foreign-sourced if paid from a foreign pension plan or other foreign retirement arrangement.

Determining the Source of Income

The U.S. tax system employs specific rules to determine whether income is foreign or domestic. These rules do not always align with where a payment is received or where the payer is located.

For services, the source of income is the location where the services are physically performed. If a U.S. person performs work in another country, the compensation for that work is foreign-sourced, regardless of where the employer is based or where the payment is sent.

Interest income is generally sourced based on the residence of the payer. If a foreign person or entity pays interest, that interest is typically considered foreign-sourced income. Exceptions exist, such as certain interest paid by foreign branches of U.S. corporations, which may be treated as U.S. source.

Dividends are typically sourced based on the country of incorporation of the paying corporation. Dividends paid by a foreign corporation are generally foreign-sourced income. If a U.S. corporation earns a significant portion of its gross income from foreign sources, a portion of its dividends might be treated as foreign-sourced for certain purposes.

Rents and royalties are sourced where the property is located or where the intangible property is used. Rental income from real estate is foreign-sourced if the property is physically located outside the United States. Royalties for the use of patents, copyrights, or other intellectual property are foreign-sourced if the right to use that property is exercised in a foreign country.

Gains from the sale of real property are sourced where the real property is located. For example, selling a commercial building in London would generate foreign-sourced income. The rules for sourcing gains from the sale of personal property are more varied. Generally, gains from the sale of personal property are sourced based on the seller’s residence. However, specific rules apply to inventory property, where the source depends on where the title passes, or depreciable personal property, where the gain is sourced based on prior depreciation deductions.

Income from US Territories and Possessions

Income earned from U.S. territories and possessions, such as Puerto Rico, the U.S. Virgin Islands, Guam, American Samoa, and the Commonwealth of the Northern Mariana Islands, occupies a distinct position within the U.S. tax framework. Despite being outside the 50 states and the District of Columbia, income from these areas is generally not classified as “foreign income” for most U.S. tax purposes. This distinction impacts the applicability of certain tax provisions, such as the foreign earned income exclusion or foreign tax credits, which are designed for truly foreign-sourced income.

Income from U.S. territories and possessions is often subject to specialized tax rules or agreements designed to integrate them with the U.S. tax system while acknowledging their unique governmental structures. Residents of these territories may have different tax filing obligations compared to residents of the 50 states. Some territories have their own tax systems that mirror the Internal Revenue Code, while others operate under different arrangements.

For a U.S. taxpayer residing in one of the 50 states, income earned from activities or investments within these territories is typically treated under specific U.S. tax code provisions that prevent double taxation or provide other forms of relief. While these locations are geographically distinct, income generated there is not typically treated as foreign-sourced income by the IRS when applying most general foreign income tax rules.