Any gain or loss realized on a Section 988 transaction that is treated as interest income or expense must be sourced or allocated and apportioned between U.S. and foreign-source income and expense. The allocation and apportionment of exchange gain or loss does not affect the source of exchange gain or loss.
U.S. dollar approximate separate transactions method
A QBU must adopt the U.S. dollar approximate separate transactions method (DASTM) if its functional currency would otherwise be a hyperinflationary currency (for example, Venezuela at times), that is, a currency in which cumulative inflation was at least 100% over the 36-month period immediately preceding the tax year. Cumulative inflation is determined with compounding. If inflation in a particular currency over the relevant 36-month period is 29%, 25%, and 30%, the cumulative rate of inflation is 109.6% (129% of 125% of 130%, less 100%), not 84% (sum of 29, 25, and 30). The inflation rate is based on the consumer price index for the country issuing the currency, as given in International Financial Statistics (a publication of the International Monetary Fund).
Assume U.S. corporation D has a branch in country Z for which the functional currency is the country Z u. Country Z has experienced substantial inflation, and extraordinarily high interest rates reflect an expectation of continued inflation. D borrows 1000u from a country Z lender at 45% interest. If corporation D is allowed to calculate branch taxable income under the profit-and-loss method, D would be allowed to deduct annual interest expense of 450u translated at the average exchange rate for the year. Most of the interest is effectively compensation to the country Z lender for erosion of the lender’s principal through inflation. If cumulative inflation in the u is 40% during the year, the value of the principal falls by 40% during the year, and the interest cost in constant u’s is only 50u (450u nominal interest less 400u decrease in value of principal).
A change to DASTM required by the regulations is deemed made with IRS consent. If a QBU is required to use DASTM for any year, DASTM becomes a method of accounting that can be changed only with IRS consent, except that the QBU must return to the profit-and-loss method, using the currency of its economic environment as functional currency, once that currency has not been hyperinflationary for three successive years.
If a dollar election is made by a QBU whose functional currency is a hyperinflationary currency, the dollar will be the functional currency of the QBU. This method of accounting must be used to compute profits and losses. The translated amount of income and earnings and profits is a combination of operating profits plus exchange gains or losses for each taxable period. The computation is accomplished in a four-step procedure listed in the following material:
1 Prepare financial statements from the books regularly maintained by the QBU as recorded in the QBU’s hyperinflationary currency.
2 Adjust these statements to conform with U.S. generally accepted accounting and tax principles.
3 Translate the income statement accounts into U.S. dollars, and compute the profit in U.S. dollars.
4 Compute the foreign exchange gain or loss.
Chapter 3 Determining Source of Income
Learning objectives
Determine why sourcing rules are important before and after the Tax Cuts and Jobs Act (TCJA).
Identify the steps to analyze the source of income.
Identify how various types of income are sourced.
Recognize how the effectively connected income (ECI) rules interact with sourcing rules with respect to dividends paid by foreign corporations.
Recognize how the sourcing rules for use of tangible and intangible property interact with the sale of personal property sourcing rules.
Identify the modified rule of Section 863(b), that now provides that gross income from the sale or exchange of property produced by the taxpayer will be sourced at the place of manufacture.
Summary of source of income rules
U.S. businesses are generally taxed on worldwide income. The geographic source of business gross income, as derived either from within or outside the United States, may determine the extent to which such income is subject to U.S. taxation. The U.S. rules for sourcing income provide an important foundation for the U.S. taxation of international activities. The statutory source rules can be overridden by specific treaty provisions between the United States and a foreign country.
The criteria for determining source of income vary, depending on the nature or type of income. Taxpayers must carefully characterize their income to decide which criteria are applicable (for example, royalty income versus gain from sale of personal property). In addition, taxpayers must determine whether the item is gross income according to U.S. tax laws (Section 61). If the income is excludible from gross income, then the source rules are irrelevant for U.S. tax purposes.
The TCJA promulgated significant changes to U.S. tax law, including the addition of the qualified business income (QBI) deduction under new Section 199A. The QBI deduction allows for a deduction of up to 20% of the qualified business income from partnerships, limited liability companies (LLCs), S corporations, trusts, estates, and sole proprietorships. One significant nuance of the QBI deduction involves a rule related to sourcing. Under TCJA, only taxable items of income, gain, deduction, or loss that are effectively connected with the conduct of a trade or business within the United States are eligible to be considered in the computation of QBI. Therefore, the determination of whether the income, gain, deduction, or loss is U.S. sourced or foreign sourced becomes critically important.
Here are some common rules on sourcing (domestic or foreign source) different types of income. The primary consideration for determining source of income is generally for application of the foreign tax credit (FTC) and (post-TCJA) to determine which new U.S. tax provision and incentive may apply to a taxpayer’s international business activities. For example, income from a foreign branch, a CFC’s global intangible low-taxed income (GILTI), and a U.S. C corp’s foreign-derived intangible income (FDII) would not be eligible for the Section 199A QBI deduction, but GILTI (CFC’s computed or tested income) and FDII (qualified foreign-source income earned by a U.S. C corp) each have their own and beneficial federal income tax incentives and lower effective tax rates.
| Income source | What determines sourcing? |
| Income from personal services | Where services are physically performed |
| Interest income | Tax residence of the borrower/debtor |
| Rental income | Location of the rental property |
| Royalty income | Jurisdiction of the underlying intangibles being used or exploited by the licensee |
| Gain from the sale of real property | Location of the real property |
| Gain from the sale of personal property/Capital Gains | Residence of the seller Under Section 865, foreign persons are generally not subject to further U.S. tax (for example, U.S. source withholding tax) on capital gain income unless connected to U.S. real property. |