What Is Section 863 and Its Income Sourcing Rules?

Section 863 of the Internal Revenue Code establishes specific guidance for determining the geographic source of income. These rules clarify whether income is considered U.S. or foreign-sourced when economic activities cross international borders. This determination is important for taxpayers with global operations, as the source of income directly impacts how it is taxed by the United States.

Sourcing income is a compliance step for U.S. persons and entities calculating their allowable foreign tax credit. The amount of foreign source income calculated under these provisions often sets the ceiling for the credit, which is designed to prevent double taxation. For foreign individuals and corporations, these same rules are used to identify which portion of their income is subject to U.S. taxation.

Income Sourced Under Section 863

Section 863 applies to specific categories of income where the underlying economic activity is not confined to a single country. The regulations provide a method to allocate or apportion the resulting gross income between U.S. and foreign sources.

Income from the Sale of Personal Property (Inventory)

This category covers income from the sale of inventory that a taxpayer produces. It applies when production occurs in one country and the sale occurs in another, such as goods produced in the United States and sold abroad, or vice versa. “Production” is a broad term encompassing manufacturing, fabrication, creation, processing, or curing of property.

Income from Natural Resources

The sourcing rules also address income derived from the exploitation of natural resources, including profits from owning or operating a farm, mine, oil or gas well, or other natural deposits. When a taxpayer extracts a resource in one country and sells it in another, Section 863 provides the framework for splitting the income between the location of the natural resource and the location of the sale.

Transportation Income

Income earned from the use of a vessel or aircraft in international commerce falls under these sourcing rules. This applies to transportation services that begin in the United States and end in a foreign country, or vice versa.

Space and Ocean Activities

This provision addresses income from activities conducted in space or in international waters. The regulations provide a sourcing determination based on the residence of the person earning the income.

International Communications Income

International communications income is defined as income from the transmission of communications between the United States and a foreign country. This includes telephone calls, data transmission, and other communication services.

Sourcing Rules for Sales of Personal Property

The Tax Cuts and Jobs Act of 2017 (TCJA) significantly altered the sourcing rules for taxpayers who produce and sell inventory across borders.

Sourcing Based on Production Activities

Following the TCJA, income from the sale of inventory produced by a taxpayer is now sourced entirely based on the location of the production activities. The prior method, which split income between production and sales activities, was eliminated for these transactions.

This income is sourced based on the location of the taxpayer’s production assets, which are the tangible and intangible assets owned by the taxpayer that are directly used to produce the inventory. The income is apportioned between U.S. and foreign sources using a factor based on the location of these assets. For example, if all production assets are in the U.S., all production income is U.S. source.

The Books and Records Method

In certain circumstances, a taxpayer may be permitted to apportion income based on its own books and records. This method is allowed only if the taxpayer can clearly and accurately segregate the income from U.S. and foreign sources in its financial statements. The IRS must be convinced that the taxpayer’s accounting method fairly represents the income derived from each location. This method is not commonly used and requires a high level of detail and justification.

Sourcing Rules for Other Specific Income Types

Beyond the sale of inventory, Section 863 provides clear sourcing rules for other types of cross-border income.

Transportation Income

For income derived from transportation services that begin or end in the United States, the sourcing rule is a simple split. Fifty percent of such income is treated as U.S. source, and the remaining fifty percent is treated as foreign source. This applies to income from operating ships and aircraft in international traffic.

Space and Ocean Activity Income

The sourcing of income from activities in space or international waters depends on the status of the person earning it. For a U.S. person, which includes U.S. citizens, resident aliens, and domestic corporations, all income from these activities is considered U.S. source. For a foreign person, this income is generally sourced outside the United States.

International Communications Income

The sourcing of international communications income also depends on the taxpayer’s status. For a U.S. person, 50% of the income is sourced in the U.S., and 50% is sourced in the foreign country involved in the communication. For a foreign person, the income is generally foreign source. An exception exists if the foreign person maintains an office or other fixed place of business in the United States to which the income is attributable; in that case, the income can be treated as U.S. source.

Reporting and Tax Form Implications

The allocation of income between U.S. and foreign sources directly affects the calculation of tax liability and the availability of tax credits.

Impact on the Foreign Tax Credit

For U.S. taxpayers, Section 863 sourcing relates to the foreign tax credit, which is calculated on Form 1116 for individuals and Form 1118 for corporations. The purpose of the credit is to mitigate the double taxation of foreign earnings. The amount of foreign source taxable income acts as a limitation on the amount of foreign tax credit that can be claimed. This limitation prevents taxpayers from using foreign tax credits to reduce U.S. tax on their U.S. source income.

Relevance for Foreign Corporations

For foreign corporations, Section 863 sourcing is important for determining the amount of income that is considered “Effectively Connected Income” (ECI). ECI is income that has a sufficient connection to a trade or business conducted within the United States and is taxed at the same graduated rates as a U.S. corporation. This income is reported on Form 1120-F, U.S. Income Tax Return of a Foreign Corporation.

Record-Keeping

To support the income sourcing allocations claimed on a tax return, taxpayers must maintain detailed records. For inventory sales, this includes records of the location and adjusted basis of all production assets. For other income types, records might include transportation logs or contracts for communication services.