What Is Section 861 of the U.S. Tax Code?

Section 861 of the Internal Revenue Code establishes the rules for determining whether income is from sources within or outside the U.S. This geographical sourcing is a primary step in how the U.S. taxes cross-border activities. The regulations under this section provide a framework for classifying various types of income, including wages, interest, and proceeds from property sales. The characterization of income as U.S. or foreign source directly impacts the tax calculations for individuals, corporations, and estates, affecting both U.S. entities with foreign operations and foreign entities with U.S. activities.

The Function of Income Sourcing Rules

The purpose of income sourcing rules is to define the U.S. taxing jurisdiction over income from cross-border situations. These rules are central to two areas of international taxation: the taxation of foreign persons and the U.S. foreign tax credit for domestic taxpayers. Determining where income is sourced dictates which country has the primary right to tax that income, a concept that helps prevent double taxation.

For foreign persons, including nonresident alien individuals and foreign corporations, the sourcing rules are important. The United States taxes these parties on income sourced within the U.S. or effectively connected with a U.S. trade or business. For instance, if a foreign corporation sells products to customers in the U.S., the sourcing rules determine if that income is U.S. source and subject to tax.

This jurisdictional boundary is illustrated by the tax imposed under Internal Revenue Code Section 871. Certain types of U.S. source income paid to nonresident aliens, such as interest and dividends not connected to a U.S. business, are subject to a flat 30% withholding tax unless a tax treaty specifies a lower rate. The sourcing rules provide the required link between the income and the U.S. to impose this tax.

For U.S. citizens, resident aliens, and domestic corporations, the sourcing rules are important for the foreign tax credit. U.S. taxpayers are taxed on their worldwide income, and to mitigate double taxation, the U.S. allows a credit for income taxes paid to foreign governments. This credit is subject to a limitation.

The foreign tax credit limitation prevents taxpayers from using foreign tax credits to reduce their U.S. tax liability on U.S. source income. This limitation is calculated separately for different categories, or “baskets,” of foreign income. Key baskets include:

• General income
• Passive income
• Foreign branch income
• Global Intangible Low-Taxed Income (GILTI)

The sourcing rules are used to classify income into the correct basket and calculate the foreign source taxable income within each. This calculation directly determines the maximum foreign tax credit a taxpayer can claim.

Sourcing Rules for Gross Income

The regulations under Section 861 provide specific guidance for determining the geographic source of different types of gross income. These rules are not based on the currency of payment or the location of the bank account receiving the funds. Instead, each category of income has its own test to identify its economic origin.

Interest

The rule for sourcing interest income is based on the residence of the debtor, which is the person or entity paying the interest. Interest paid by a U.S. citizen, a resident alien, a domestic corporation, or the U.S. government is U.S. source income. Conversely, interest paid by a foreign corporation or a nonresident alien is treated as foreign source income.

There are exceptions to this rule. For example, if a U.S. corporation earns more than 80% of its active business income from foreign sources over a three-year period, the interest it pays may be treated as foreign source. Another exception applies to interest on deposits paid by foreign branches of U.S. commercial banks, which is also considered foreign source income.

Dividends

The sourcing rule for dividends is determined by the nationality of the paying corporation. Dividends paid by a U.S. corporation are treated as U.S. source income. Dividends paid by a foreign corporation are considered foreign source income.

An exception applies if the foreign corporation has significant business activities in the United States. If 25% or more of the foreign corporation’s total gross income over a three-year period is “effectively connected” with a U.S. trade or business, a portion of the dividend is treated as U.S. source. The U.S. source portion is based on the ratio of the corporation’s effectively connected income to its total worldwide income.

Personal Services

The source of income from personal services is the geographic location where the services are physically performed. If an individual performs work while in the United States, the compensation for that work is U.S. source income, regardless of where the contract was signed or payment is made. For example, if a Canadian citizen works for a Canadian company but spends two months in a U.S. office, the salary for the work done in the U.S. is U.S. source income.

An exception exists for “commercial travelers.” Compensation for services in the U.S. is treated as foreign source if three conditions are met:

• The individual is a nonresident alien temporarily in the U.S. for 90 days or less during the tax year.
• The total compensation for U.S. services does not exceed $3,000.
• The services are performed for a foreign person or a foreign office of a U.S. entity.

The $3,000 threshold has not been adjusted for inflation, which limits its practical use.

Rents and Royalties

The sourcing of rental and royalty income depends on where the underlying property is located or used. For rental income from tangible property like real estate or equipment, the source is the property’s physical location. Rental income from a property in the United States is U.S. source.

For royalty income from intangible property, such as patents and copyrights, the source is where the property is used. If a company pays a royalty to use a patent in the United States, the income is U.S. source. When intangible property is used in multiple countries, the royalty income must be allocated based on the extent of use in each location.

Sale of Real Property

The source of income from the sale of real property is its physical location. If a taxpayer sells land or a building located in the United States, any gain is U.S. source income. This rule, part of the Foreign Investment in Real Property Tax Act (FIRPTA) under Section 897, applies regardless of the seller’s tax residence or where the transaction closes. The property’s location is the sole determining factor.

Sale of Personal Property

Sourcing gains from the sale of personal property, which is any property that is not real estate, depends on the seller’s residence according to Section 865. If a U.S. resident sells personal property, the gain is U.S. source, while a sale by a nonresident results in foreign source gain.

There are several exceptions to this rule. For inventory, the source of the gain is the place of sale, where title and risk of loss pass to the buyer. For depreciable personal property, gain up to the amount of prior depreciation deductions is sourced based on where the depreciation was claimed. Any remaining gain is sourced under the rules for inventory or other personal property.

Allocation and Apportionment of Deductions

After determining the source of gross income, expenses must be assigned to that income to calculate taxable income from U.S. and foreign sources. This process is governed by Treasury Regulation 1.861-8 and uses a two-step method of allocation and apportionment. This is necessary for foreign taxpayers to determine their taxable income connected with a U.S. business and for U.S. taxpayers to calculate their foreign tax credit limitation.

The first step, allocation, identifies deductions factually related to a specific class of gross income, such as sales income. A deduction is allocated to a class of income if it is incurred from an activity or property that generates that income. For example, the cost of goods sold (COGS) is allocated entirely to sales income, and depreciation on a machine is allocated to the income from selling the product it makes.

The second step, apportionment, divides deductions between U.S. and foreign source income when they are allocated to a class of income containing both. The method of apportionment depends on the deduction’s nature, with the goal of reflecting the relationship between the deduction and the income. Deductions that cannot be tied to a single class of gross income, like general administrative overhead, are treated as related to all gross income and must be apportioned.

Common apportionment bases include gross income, assets, or time spent. Research and experimentation (R&E) expenditures are apportioned based on gross sales or income, while interest expense is apportioned based on the value of the assets that generate income. For example, if a company’s U.S. assets are 60% of its total asset value, then 60% of its interest expense is apportioned to U.S. source income. This process prevents taxpayers from shifting deductions to high-tax jurisdictions to minimize their overall tax burden.