Basics of Foreign Income Taxation

From a U.S. perspective, personal income taxation is based on (1) citizenship, (2) residency, and (3) income source. U.S. citizens are taxed on U.S. source and foreign source income, regardless of residence. Non-citizen residents (those who possess a green card or who were present in the U.S. 31 days during the current year and 183 days over the last three years) are taxed the same as U.S. citizens. Non-citizen, non-residents are usually taxed only on U.S. source income.

Different applications of these basic principles apply to the U.S. territories. For example, U.S. citizens residing in Puerto Rico are taxed similar to non-citizen, non-residents even though Puerto Rico is a U.S. territory: only U.S. source income is taxed by the U.S. In contrast, U.S. citizens residing in American Samoa are taxed on worldwide income but can exclude American Samoa source income; each territory is different.

Those who are taxed on worldwide income by the U.S. and who also have foreign source income and pay taxes to foreign countries may be able to (1) exclude foreign source income from reported U.S. gross income, (2) deduct foreign taxes paid from U.S. gross income, or (3) receive a credit against U.S. taxes for foreign taxes paid. These rules are intended to prevent the same income from being fully taxed by two different countries.

For those not taxed on worldwide income, properly determining the source of income for tax purposes is critical. In general, the U.S. considers personal service income to be sourced from where the services are performed. Interest income is sourced to the payer of the interest. Dividend income is U.S. source if paid by a U.S. corporation and foreign source if paid by a foreign corporation (but different rules apply where a foreign corporation is generating income "effectively connected" to the U.S.) With some exceptions, rents and royalties are sourced to the location of the property generating the income. Income from the sale of personal property is sourced to the seller's location, with special rules for inventory and intangibles. Gains from the sale of real estate is sourced to the location of the real property.

This is a broad overview of general principles that apply to U.S. worldwide income taxation. Other issues that could arise include tax withholding on U.S. source income of foreign persons, tax treaties between the U.S. and foreign countries, and foreign account reporting requirements, to name a few. It is never a bad idea to engage local counsel when dealing with foreign income and tax reporting.