I.

Basic Structure

1. US Citizen & Resident: Taxed on their WWI and receive Foreign Tax
Credit (FTC) under § 901
2. US Citizen & Non-resident: Taxed on the WWI and receive FTC. They
can exclude up to $80k of their foreign gross income (§ 911 Exception).
Consequence: US-citizen teacher working in France earning
French-sourced compensation income can exclude the first $80k.
3. Foreign Citizen & US Resident: Taxed on their WWI and receive FTC
4. Foreign Citizen (and Corporations) & Non-resident: Income is broken
down into ECI and FDAP
ECI: All income whether US or Foreign Source that is
“effectively connected to a US trade or business” is subject to the
same taxes that a US resident citizen would pay. The same
deductions are available too. What is considered ECI will be
defined later.
FDAP: All non-ECI income that is US-Source and “fixed,
determinable, annual, and periodical” (which basically excludes
most sales of property) is taxed at 30% from the gross income
level. This tax must be withheld by the payor. If the payor does
not withhold then payor is personally liable for the tax.
EX: interest dividends, rents, salaries, wages, premiums,
annuities, compensations, remunerations, emoluments, and
other fixed or determinable annual or periodic gains, profits
and income
 Does not include income from sales.
ECI TRUMPS FDAP!

II. Residency

In general, an individual is a citizen of the US for tax purposes if they are

a citizen for non-tax rules.

A. Establishing US Residency (§ 7701)

A person is a US Resident if just 1 of the 2 following tests are met:

(1) Permanent Resident – Whenever an alien applies for or is granted a
green card (permanent resident status) they are considered a US resident
for tax purposes.
(2) Substantial Presence Test (§ 7701(b)(3))
(i) Strong Form  Present in the US for >= 183 days in a given
calendar year.
(ii) Weak Form  [# days Year 3] + 1/3*[# days Year 2] +
1/6*[# of days Year 1] >= 183 days. Must be present at least 31
days in Year 3.
Rebuttable Presumption – Satisfaction of the Weak form
establishes a rebuttable presumption of US Residency.
Rebutting the Presumption – Both below are required
(1) Foreign Tax Home: Taxpayer’s tax home is a
foreign country. Order of tax home (§ 162(a)(2)):
Permanent Place of Business (PPOB); if no PPOB
then place of abode; if neither, no tax home, AND
(2) Closer connection to Foreign Tax Home: We
do the “totality of the circumstances” test and look
at taxpayer’s family, property, social activities, bank
account, voting location, etc. are located

B. “Presence” Defined

General Rule: “Present” for tax purposes = actual physical presence for
any amount during such day
EXCEPTIONS:
(1) Commuter from Mexico/Canada: If a person regularly
commutes to the US for work from Mexico or Canada
(2) Transit between 2 foreign points: Person traveling from a
foreign location to another foreign location that has a layover in
the US for less than 24 hours
(3) 7701(b)(3)(D): Foreign diplomat, employee of UN, teacher
trainees, international student, athlete in US for charity event
(4) Medical Emergency: Arriving healthy to the US, and getting
 stuck here due to a medical emergency. Can’t be a pre-existing
condition like a bug that was picked up from Brazil.

C. Start Date of Residency

Fill-in Rule: If an individual meets either of the two tests for the current
year (Green Card or Substantial Presence Test), AND was a resident of the
US at any time during the preceding year, the residence for current year
begins on January 1.

EX: Suppose a non-citizen resident leaves in April, Year 1, but

returns on June 1, Year 2 and remains until the end of the year. She
is a resident for Year 2 since she was here for more than 183 days.
• Consequence: For the entire period between April, Year 1
and June, Year 2 she is considered a resident of the US (her
residency is “filled in” for the first half of Year 2, and
through the end of December of Year 1).
No Year 1 Residency Rule: If John is not a resident in Year 1, then these
3 rules apply:
(1) Substantial Presence: If John is considered a resident based
on the SP Test then, he is a resident starting on the 1st day he is
considered “present.”
(2) Green Card: If John does not satisfy the SP Test, then he is a
resident starting on the 1st day he got his green card.
(3) Election: Any person may elect to be considered a US
Resident for tax purposes if they choose. You might want to do
this for business losses or you have US-source FDAP and want to
be taxed at the ordinary rates.
10 day Nominal Presence Exception: Suppose John is a resident
starting April 1 (greater than 183 days), but he was also present in
February for 8 days. If John can show a closer connection to a
foreign tax home during those 8 days, then residency starts in
April.

D. Stop Date of Residency

General Rule: Assuming a person will not be a resident in the following

year (otherwise Fill-in rule applies), then the last day they are present in
the US is the last day of their residency if they can show a closer
connection with a foreign tax home for the remainder of the year.
10 day Nominal Presence Exception: Same rule applies for 10 day
returns to US after last day. Must be able to show closer connection to
foreign tax home.

E. Expatriation Rules (Renounced Citizenship)

Pre-Amended §877 – Dependent on whether the expatriates purpose for
losing citizenship was to avoid taxes.
Applicability of Amended § 877: Expatriates (which are non-resident
aliens) might have to pay a higher alternative tax (more than what they
ordinarily would under 871) under § 877 if they lost their citizenship
within the past 10 years and,
(1) $124,000 Net Income Tax: The expatriate paid an average
annual net income tax of $124k in the 5 taxable years preceding
the loss of US citizenship (and they were not a minor or dual
citizen), or
(2) $2,000,000 Net Worth: The expatriate was worth more than
$2 million at the time of loss of US citizenship (and they were not
a minor or dual citizen), or
(3) Paper: The expatriate fails to send in a document that certifies
that (1) and (2) don’t apply to him.
Alternative 877(b) Tax: Tax is computed using § 1 (same as what US
citizens pay) on all gross income “derived from US sources.”
NOTE: § 7701(b)(10) – If an alien was treated as a resident of the
US during any period which includes at least 3 consecutive
calendar years, AND then there is a gap of less than 3 years and he
becomes a resident again such persons will be taxed for the gap
period in the manner provided by § 877(b).
• This means that if someone, who is not a citizen, and
expatriates (in terms of residency) for less than 3 years, and
then comes back and becomes a resident, that person is
subject to § 877(b) as well.
Newly Required Additional Filings: Ex-patriots and ex-permanent
residents are still treated as citizens (taxable on their WWI) until they file
2 pieces of paper: one to the Secretary of State (Homeland Security for
permanent residents), the other to IRS. This has to be filed annually
otherwise there is a $10k fine.
30 Day Ex-patriot Rule: An ex-patriot is considered a resident if they
come back to the US for more than 30 days within a calendar year within
10 years of expatriation.
III. Sourcing Rules

A. Interest

General Rule: The source of interest is determined by the residence of

the payor.
EXCEPTION #1--80% Foreign Gross Income: If at least 80% of the
gross income of the US payor during the last 3 years is “active foreign
business income,” then all the interest will be considered Foreign-Sourced.
This exception is limited to only payors who are resident aliens and US
corporations (does not apply to US resident citizens). § 861(c)(1)
Related Party EXCEPTION to Exception #1: Where the payor
and payee own at least 10 % of each other’s stock (unilaterally),
the portion of interest paid that is not related to foreign income is
considered US Source. E.g. 90% of Company A’s gross income is
foreign. Then Interest Payee B must declare 10% of the interest
received from A as US Source.
• §954(d)(3) – What is a “Related Person”?
o A person is a related person with respect to a
controlled foreign corporation if such person is an
individual, corporation, partnership, trust, or estate
which controls, or is controlled by, the controlled
foreign corporation, OR
o Such person is a corporation, partnership, trust or
estate which is controlled by the same person or
persons which control the controlled foreign
corporation OR
o Owning 10% or more of total voting class able to
vote.
EXCEPTION #2—Foreign Branch of US Bank: Interest paid by
foreign branch of a US bank is Foreign Source. § 861(a)(1)(B)
 EX: US-corporation with a branch in Hong Kong, borrows money
from a source in HK. Interest paid by a foreign branch of a US
corporation engaged in banking or savings &loan is considered
foreign-sourced.
EXCEPTION #3—Foreign Branch of Foreign Corp: When a foreign
corporation sets up a branch in US, and that office pays interest, that
interest is US source. § 884(f)(1)(A)

B. Dividends

General Rule: Dividends paid by a US corporation are US source and

those paid by a foreign corporation are foreign source.
EXCEPTION #1--80% Foreign Gross Income: If at least 80% of the
gross income of the domestic corporation during the last 3 years is “active
foreign business income,” then although the interest is considered US
 source, a portion of it equal to the “related party calculation” above will
not be subject to the withholding (unlike interest 80% exception which
resources the income as foreign source and exempts all of it)
EXCEPTION #2--25%+ US-ECI for Foreign Corporation: If 25% or
more of a foreign corporation’s gross income is US ECI than, that portion
of the dividends will be US sourced. (E.g. 40% US-ECI  40% of
dividends US source). If less than 25% of the gross income during the
testing period is ECI, dividends paid by the corporation will be foreign-
sourced.
C. Rents & Royalties

General Rule: Rents and royalties from tangible and intangible property
(patents, IP) is sourced as to the location of the tangible property OR
where the intangible property is being “used.” The citizenship of the
lessor is irrelevant.
Real Property: A non-resident alien collecting rent on real property then
owned in the US are ordinarily subject to 30% withholding right off the
top from all the rents coming in. Non-resident aliens can avoid this by
making an election under § 871(d) to treat the income as US-ECI.
Foreign corps can do this under § 882(d).
Cascading Royalties Problem: Suppose A has exclusive world wide
patent rights on a product. A grants an exclusive license to B, a foreign
corporation, to practice invention in US. B is to pay $100 in royalties. B
then grants an exclusive license to C, another foreign corp at $150.
Ordinarily, B would have to withhold $30 as FDAP, and C would withhold
$45 as FDAP. To prevent such cascading fees, we could have B and C
create US corporations that are in the business of licensing patents. This
gets rid of the FDAP, and taxes them on ECI instead.

D. Personal Services

General Rule: The source of income for the performance of personal

services is the place of the performance of those services.
Commercial Traveler EXCEPTION: If services are performed in the
US by a nonresident alien, the income from those services is treated as
foreign-sourced if three (3) conditions are met:
(1) Alien is in the US for 90 days or less
(2) The compensation is $3,000 or less
(3) The compensation is paid in connection with employment by a
foreign corporation or entity not engaged US-ECI, OR a foreign
branch of a US person, partnership, or entity.
Airline Crew Rule: Non-resident alien crew of a foreign airline must
treat source income as follows:
• Flights that begin and end in the US (LA to Vegas) as 100%
US Source
• International flights that begin or end in US as 50% US-source.
E. Gains and Losses from Sale of Real Property

General Rule: Gains from the sale of real property is sourced based on
the location of the real property. Sale of US real property holding
corporations where 50% of value of stock is real property is treated same
way, so US source.

F. Gains from the Sale of Personal Property

General Rule: Gain from the sale of personal property is sourced at the
residence of the seller. This applies only to non-depreciable property held
for investment like stocks, bonds, and collectibles.
NOTE: A US citizen or resident alien shall not be treated as a nonresident
with respect to any sale of personal property unless an income tax equal to
at least 10% of the gain derived from such sale is actually paid to a foreign
country.
EXCEPTIONS:
(1) Inventory §865(b): Inventory is sourced where the sale is
made, i.e. where title passes. Passing title in the Bahamas e.g. and
then shipping to US, can solve US sourcing problems.
• US-sourced - §861(a)(6) - Gains, profits, and income
derived from the purchase of inventory property without
the United States and its sale or exchange within the United
States.
• Foreign-sourced - §862(a)(6) - Gains, profits, and income
derived from the purchase of inventory property within the
United States and its sale or exchange without the United
States,
SPECIAL RULE FOR Self-Produced Inventory: For
self-produced inventory IRS allows you to separate the
profits you’ve made attributable to the manufacturing from
the profits attributable to the sale. Use one of the three
methods of allocation:
(a) 50-50 Method: Under this method, if item A is
manufactured in the US and sold abroad, or
manufactured abroad and sold in the US, then 50%
of the profit will be sourced based on where the
product was manufactured, and the other 50%
where it was sold.
NOTE: if you produce the planes outside of
the US and then sell into the US, but have
title pass before it reaches the US, then all of
the $60K will be foreign-sourced.
(b) Independent Factory Price (IFP) Method:
Here, we look to see if the product has also been
 sold to a middle man. If it has then we can say that
the profit made in that sale sets the “manufacturing
profit” and the remainder would be attributable to
sale of the item.
EX: Plane manufactured in US for $60k is
sold to middle man in Cuba for $100k ($40k
profit). Planes are also sold directly to
customers in Cuba for $120k (the IFP).
Therefore, $40k is manufacturing profit (US
source) and $20k sales profit (Foreign
Source).
(c) Books and Records Method: We can look to
see if based on the books and records it is clear
where the profits are really being derived from:
manufacturing or sales. Some companies have
designated separate “profit centers” for production
and sales.
Need IRS permission to use this method.
(2) Depreciable Property §865(c): The amount of profit realized
on the sale of personal property equal to the amount of
depreciation taken on the personal property against US taxes is US
source. The remaining profit is sourced according to the inventory
sourcing rules (where title passes).
EX: Computer A was bought in the US for $1k and sold in
Peru for $1200. The amount of depreciation taken on the
computer during the years was $600, $500 of which was
against US taxes and $100 was Peruvian taxes. Thus, the
basis in the computer is $400, and the gain realized is $800.
$500 of this $800 is US Source. The other $100 is Foreign
Source. The remaining $200 is Foreign source as well
because title passed in Peru. 865(c)
Rule of Convenience (§ 865(c)(3)(B)): This allows the
taxpayer to treat all gains against depreciation for a year as
US source when the property has been used predominantly
in the US in that year. Where the property was used
predominantly abroad, then it is foreign source. Does not
apply to property described in §168(g)(4) (property moving
into and out of the US all the time – ships, international
trucks, communication satellites).
(3) Intangible Personal Property (Patents, Trademarks,
Copyrights) §865(d):
• If the payments ARE contingent on productivity, use
or disposition, gains will be treated as royalties, AND
gain is sourced under the royalty sourcing rule  place
of use.
• If the payments ARE NOT contingent on productivity,
 use or disposition, gains will be treated as a sale, AND
gain is sourced under the basic personal property
sourcing rule  residence of the seller.
• If the intangible property has been amortized, then to
the extent of amortization, apply special rules for
depreciable personal property; we only apply the
intangible rules to the excess of the gain on the property
which goes with contingent on sourcing rules.
• Goodwill EXCEPTION: Fixed payments for good
will are sourced according to where the good will was
created.
(4) Branch Offices §865(e):
(i) US Resident in Foreign Branch: If a US resident
makes a sale on property attributable to that foreign office
that is not sourced under inventory, depreciable property, or
intangible property rules, and a foreign income tax of 10%
or more is paid, then the income is foreign source.
865(e)(1)
EXCEPTION: You do not get the benefit of this
unless an income tax equal to at least 10 percent of
the income from the sale is actually paid to a
foreign country with respect to such income.
(ii) Non-Resident Alien in US Branch: If a non-resident
alien makes a sale of property (including inventory
property) here in the US through an office, then it is US
source.
EXCEPTION: If the use of the property is
destined to be abroad, and a foreign branch office
materially is involved in the sale then foreign
source.
(5) US Resident Sells Foreign Corporation Stock §865(f): If a
US resident sells stock of a foreign corporation that is:
(1) “Affiliated” (more than 80% of the stock is owned by
other members of the group)
(2) The sale occurs in the foreign country, AND
(3) More than 50% of the foreign corp’s gross income
comes business conducted in that foreign country within 3
year testing period
Treat wholly owned subsidiaries as one foreign
corporation
 Gain from the sale is foreign source.
G. Special Rules

Alimony: Under domestic law, alimony is deductible to the payor and

includible gross income for the recipient. It is sourced to the residence of
the payor. Thus, US resident paying alimony to foreign ex-spouse must
 withhold 30% unless treaty applies (since it is US-sourced FDAP).

H. Expenses

General Rule: You should allocate your expenses to the income

producing activity. I.e. expenses incurred for generating income in
Mexico should be expensed against Mexican foreign income. Expenses
that can not be attributable to any one source of income (overhead
expenses) can be divided up on a pro rata apportionment across all gross
income.
Interest Expenses: Interest expenses of “Affiliated” corporations are
divided across all the groups as if they were one big corp based on the
value of their assets. This prevents a US corp from deducting interest
expenses on a loan its taken out but given the principal to its foreign sub.
See 864(e)
III. ECI Income

A. Basic Framework

Overlying Considerations:
(1) If a non-resident alien's or foreign corporation's income is considered
US-Source ECI then the taxpayer will be taxed at the same rates on that
income as other US citizens. They will also be allowed to take deductions
against that income. Thus they are effectively taxed on their net-income.
(2) If a non-resident alien's or foreign corporation's income is considered
non-ECI, then they will be taxed at a 30% flat rate on their Gross income.

Three Questions for Determining US ECI:

(1) Is the non-resident alien engaged in a trade or business?
(2) Is it a US trade or business?
(3) Assuming US trade or business, what income is “effectively
connected” to that trade or business?

(1) “Engaged in a Trade or Business” Defined

(i) “Continuous, Regular, and Considerable Activities”: Courts
have held that isolated transactions aren’t generally trades or
business. Instead the business activities must be continuous,
regular, and considerable for it to constitute a trade or business
(ii) Agents: The activities of an agent will be charged to the
principal taxpayer. If the “agent” hired is merely an independent
person performing services for the taxpayer then person is not an
agent.
(iii) Partnerships and LLCs: The activities of a partnership in
the US will be charged to all the partners and limited partners of
the partnership. Thus, a non-resident alien who is a member of a
partnership, which is at any time during the taxable year engaged
in a US trade or business, the alien is also held to have been
engaged in a US trade or business.
(iv) Investments: Investments are not considered a trade or
business. More clarification is needed as to what this entails.
(2) “US Trade or Business” Defined
Rule: This one is easy because you just use common sense. If the
transactions are regularly occurring inside the US, such as sales to
US residents, then it’s a US trade or business.
(3) Income “Effectively Connected” Defined:
US Source Income
(1) FDAP and Gains From Capital Asset – TWO
TESTS: ECI if either test is satisfied):
(i) Assets Test – Income is ECI if it is derived from
assets used or held for use in the conduct of the
trade or business.
 (ii) Activities Test – Income is ECI income if the
activities of the trade or business were a material
factor in producing that income.
(2) All other Income -- All other income that is derived
from US sources is ECI income. If there is this catch all
provision, why do we even use the assets and activities
test? What about casual investments in US stock ?
o HYPO: Canadian mail order company that is
bringing in $1 million in sales from the US.
 It is not going to be taxed by the US since
the company is not engaged in a US trade or
business.
 It is not FDAP since it is from sales.
o HYPO: Now assume it opens a little candle shop in
Vermont that produces $10K of business a year.
 The whole $1 million is now ECI because
we have a US trade or business. It is all
taxable under §11 rates.
 NOTE: The income does not have to be
related at all to the trade or business at all.
 Q: How do we restructure this?
• Create a wholly-owned subsidiary to
run the candle shop. The parent is
now not engaged in a US trade or
business.  Not ECI.
Foreign Source Income
All income generated by the non-resident alien or foreign
corporation engaged in a US trade or business that is from
foreign sources is not ECI unless that foreign entity has US
offices and that office brings in income related to the
following is ECI: 864(c)(4)
(1) Intangible Property Royalties: If the entity licenses
out and collects royalties on intellectual property from
foreign sources
(2) Banks and Securities Holding Companies: Interest or
dividends received by a banking business from foreign
sources, or dividends received from sources by a company
that makes money holding stock
(3) Income from the Sale of Inventory: Sale of inventory
to foreign sources for use in foreign country unless a
foreign branch office materially participated in the sale.
• HYPOS
o (1) Foreign Corporation has an office in LA;
through that office it makes movies and licenses the
rights to those movies in the US and outside the US.
 Focus on the royalties received for the
foreign rights  They are foreign-sourced.
Nevertheless under §864(c)(4)(i), this is
income attributable to a fixed place or
business in the US, and it is for an intangible
property.
•  All these foreign-sourced income
is taxable in the US as ECI.
o (2) Assume Barclay’s British Bank has a branch in
NY that makes loans to customers in Bermuda, and
they pay interest back.
 Foreign-sourced since it is residence of the
payor.
 Q: Is it ECI?  Yes. It is interest derived in
a banking business, and it is subject to tax at
§11 rates.
B. Real Property Interests

General Rule: If a non-resident alien sells a “US real property interest,”

any gains or loss on such sale will be treated as though it were US-ECI
and the person is taxed under § 1 and § 55. FTC does not apply. § 897
For this purpose, stock in a domestic US real property holding
corporation will be treated as a US real property interest itself.
Dealing with Non-Recognition Problems: Congress is worried that
you’ll exchange US real property interest for foreign real property interest
and then sell with no tax.
897 (e) limits scope of non-recognition rules in the code—can only
exchange for property that would be taxable—if you are
exchanging for property that wouldn’t be taxable, then non-
recognition rules no longer apply
EX: You can exchange CA property for OR property, but
you can’t exchange for property in Tokyo
Withholding Requirement: The Buyer of the property must withhold
10% of the Purchase Price unless the Seller furnishes a statement under
penalty of perjury that they are not foreign and provides tax ID number.
§ 1445
US Real Property Interest Defined: US real property includes any
interest in land, mines, leaseholds, and any interest in a US real property
holding corporation. §897(c)
US Real Property Holding Corp Defined: A US Real Property Holding
Corp is any US corporation whose real property assets equal or exceed
50% of the total of all its assets on any day during the previous 5 years
before the sale.
Total Assets Defined: Total assets include all US and foreign
property and any asset held for use in a trade or business. They do
not include investments like stock. Mortgages incurred against
 real property during acquisition are counted against the value the
real property asset (i.e. numerator goes down).
Regs: Make the determination on determination dates (generally
one of 3 dates): last day of taxable year, any day on which US real
property interest is acquired, any day on which a foreign real
property interest is disposed of. 1.897-2c1

Cascaded US Real Property Corporations:

Parent Owns 50% or more: Suppose we have a Parent
Corp and a Sub Corp. The Parent owns 51% of the Sub.
We need to determine whether Parent is a US Real Property
Holding Corp. We “look through” the Sub and apply 51%
of the value and character of each asset (or acquisition
indebtedness) held by the Sub directly to the Parent.
Parent Owns less then 50%: This time we don’t do the
“look through.” We simply determine whether the Sub
itself is a US Real Property Corp. If it is, then the value of
the stock held by the Parent of this Sub will be treated as a
real property interest.

C. Deductions

General Rule: Deductions are only allowed to extent connected to

income that is itself effectively connected to US trade or business, and
return must be timely filed.
Non-Business Deductions: Only three kinds allowed
(1) Personal Casualty Loss: Limited to property in US
(2) Charitable Contributions: Contribution to US charities
(3) Personal Exemption: Only 1 exemption allowed unless
Canada or Mexico alien (then many) 873(b)

D. Income Received After Ceasing Trade or Business

864(c)(6): Income received (deferred payments) for goods or services of a
US trade or business after that business has shutdown is still counted as
ECI income in the year the transaction was made.
864(c)(7): If property is used in connection with a US trade or business
and that property is sold within 10 years of the close of the business or
within 10 years of ceasing to used for the business, any gains derived will
be treated as ECI.
 IV. 30% FDAP

A. General Rule – FDAP stands for “fixed, determinable, annual, or

periodical.” For the purposes of this class we assume that income derived from
sources that do not include sales (sales of stock, inventory, services, etc.) is FDAP.

B. Exceptions
(1) Dividends Exception: A percentage of the dividends paid by a US
corp who derives more than 80% of there gross income from foreign
sources will not be subject to withholding (although still US source)
according to the related party calculation under II. A. 871(i)(2)(B)
(2) Interest—Portfolio Exception: If payee is a non-resident alien, then
he can send in a statement to the payor that says he is not a US person
(citizen or resident of the US). The company then does not have to
withhold. 871(h)(2)
10% Shareholder Exception: The Portfolio Interest Exception
does not apply to individuals who own more than 10% of the
voting right stock of the corporation. 871(h)(3)  therefore still
subject to 30% flat tax
(3) Interest—Bank Deposit Exception: If a non-resident alien deposits
money in a US bank and is not related to US-ECI, then this interest paid is
not subject to FDAP withholding (still US-Source though). 871(i)(2)(A)
(4) Interest—State and Local Bonds: Interest paid on state and local
bonds in not includable in gross income under 103(a), and thus not subject
to withholding.
(5) Patents—Return of Capital: Even though payments for US patent
may be contingent on revenue and therefore subject to FDAP, only that
portion that exceeds the return of capital investment in developing the
patent (considered the gain) will be subject to the withholding.
(4) Mineral Deposits: Income from mineral deposits is FDAP even
though it’s a sale of minerals
(5) Annuities: The portion of an annuity paid that is not considered a
return of the original investment is FDAP and subject to the 30% tax. The
portion that is considered a return of the original investment is not FDAP.
(6) Insurance Premiums: Is not FDAP.

Big Question: What effect does 871(a)(2) have? First, non-resident alien present
for more than 183 days is a resident alien taxed on WWI. Second, (a)(2) refers to
gains and losses of capital assets connected US ECI. Wouldn’t 871(b) trump?

Big Question: What effect does 871(i)(2)(A) have? Any interest derived from a
deposit in a US bank if not US-ECI is tax free?
V. Model Tax Treaty

A. Determining Residency -- Article 4

General Rule: Entities may only be a “Resident” of one Contracting

State. Entities are generally “Residents” of a Contracting State based on
tax liability due to domicile, residence, citizenship, place of incorporation,
and not simply on whether they have income in that State.
Tie Breaker: When a person is a resident of both States based on the
General Rule (Art. 4 ¶ 1) the following tie breaker decides what State they
are the “Resident” of:
(1) Location of Permanent Home
(2) Location of Personal and Economic Relation are Closer (if
he has permanent homes in both States)
(3) Habitual Abode
(4) National (if no abode or habitual abode in both)
(5) Competent Authorities Decide (if he is national of both or
none)
Savings Clause: Typically permits country to tax its own citizens or
residence as if they treaty did not exist.

Corporations—Anti-Treaty Shopping -- Article 22

Corporations are Residents of a State if incorporated in that State
and:
(I) 50% or + Publicly Traded (voting power and capital)
(II) 50% or + owned by Residents of the State and less
than 50% of their gross income goes to paying off debt to
non-residents that are deductible.

B. “Permanent Establishment” Defined -- Article 5

Article 5, ¶ 1: Permanent establishment means a fixed place of
business through which the business of an enterprise is wholly or
partly carried on.
What it is:
(1) Place of Management
(2) Branch or Office
(3) Factory or Workshop
(4) Mine or Quarry
What it is Not:
(1) Storage Facility
(2) Delivery Facility
(3) Display Facility
(4) Purchasing Facility
(5) Preparatory Facility

C. Business Profits -- Article 7

 US Model Treaty, Article 7: Business profits of an enterprise of a
contracting state shall only be taxable in that state unless it conducts
business in the other contracting state through a permanent establishment
situated herein.
General Rule: Taxpayer is a Resident of Country A. Country B may
only tax Taxpayer for business profits generated in Country B, when the
Taxpayer has a “permanent establishment” setup in Country B through
which this income was derived. And even then Country B may only tax to
the extent of those profits generated in Country B.
Agents: If an agent has a permanent establishment in Country B that has
and habitually concludes contracts on behalf of the principal, the principal
is charged to have a permanent establishment in that State. If independent,
no permanent establishment.
What it Includes: Article 7 “business profits” do not include:
(i) interest,
(ii) dividends,
(iii) income from real property,
(iv) royalties, and
(v) income from the sale from permanent property

D. Dividends -- Article 10

General Rule:
¶ 1: Dividends paid by a resident of a Contracting State to a
resident of the other Contracting State may be taxed in that other
State.
¶ 2: However, such dividends may also be taxed in the Contracting
State of which the payor is a resident and according to the laws of
that State, but if the dividends are beneficially owned by a resident
of the other Contracting State, except as otherwise provided, the
tax so charged shall not exceed:
a) 5% of the gross amount of the dividends if the beneficial
owner is a company that owns directly at least 10% of the
voting stock of the company paying the dividends;
b) 15% of the gross amount of the dividends in all other
cases.
EX: Taxpayer is a Resident of Country B. He receives dividend income
from Company X who is a Resident of Country A. Both Country B and
Country A may tax these dividends. However, Country A may only tax up
to 15% withholding (instead of 30%), and if Taxpayer owns more than
10% of Company X, only 5% maybe withheld. This applies whether or
not this is ECI income.

E. Interest -- Article 11
 General Rule: Interest arising in a Contracting State and beneficially
owned by a resident of the other Contracting State may be taxed only in
that other state.
EX: Taxpayer is a citizen of Country B, and receives interest income from
Company X (citizen of Country A). Only taxable by Country B, not
Country A.

F. Independent Personal Services -- Article 14

General Rule: Independent personal services are services provided by

someone on their own behalf and not because of employment by a boss.
Taxpayer is a Resident of Country A. He provides independent personal
services in Country B. He may only be taxed by Country B (in addition to
whatever taxes are imposed by Country A) to the extent that such services
were rendered in connection with a “fixed base.” He may also take
deductions incurred against this income due to expenses.

G. Dependent Personal Services -- Article 15

General Rule: Taxpayer is a Resident of Country A and performs

personal services on behalf of his employer in Country B. The only way
Country B may also tax the Taxpayer is if:
(1) The Taxpayer is present in Country B for 184 days or more,
(2) His employer is a resident of Country B, or
(3) Employer’s fixed place of business in Country B cuts
Taxpayer’s checks.
Airline and Ship Crew Rule: Employees of ships and airlines engaged
in international traffic are taxable only in Country A.
VI. Foreign Tax Credit

A. Overview

§ 901(a) -- If the taxpayer chooses to have the benefits of this subpart, the tax imposed by
this chapter shall, subject to the limitation of section 904, be credited with the amounts
provided in the applicable paragraph of subsection (b) plus, in the case of a corporation,
the taxes deemed to have been paid under sections 902 and 960. Such choice for any
taxable year may be made or changed at any time before the expiration of the period
prescribed for making a claim for credit or refund of the tax imposed by this chapter for
such taxable year. The credit shall not be allowed against any tax treated as a tax not
imposed by this chapter under section 26 (b).

(1) The foreign tax credit is optional!

(2) You must elect for the tax credit every year, subject to a 3 year statutory limitation.
(3) Credit is not allowed against any tax treated as a tax.

FTC Applies to:

(1) income taxes
(2) war profits or
(3) excess taxes (surtaxes on income taxes)
FTC Does NOT APPLY to:
(1) §884 – branch profit tax – the second tax we’re imposing on
the branch (1st being the ECI § 11 tax they pay) to help mimic
the double taxation we desire of corporations.
(2) taxes listed in §26(b)

901(b)(1) – Why shouldn’t all foreign taxes be creditable? You remember

from your basic tax course that taxes in general deductible. §164 says we
deduct state, local, foreign income taxes. Under 162 you can deduct any
taxes including sales taxes. So we have these other provisions that allow
us these deductions. So why have both?

There is a difference between deductions and credits. When the US is

giving you a credit, then we are relinquishing tax jurisdiction. We back
off by giving foreign tax credit. So it makes sense that 901(b)(1) allows
credit only toward income taxes paid to foreign countries, and not
other taxes that are not related to income where we are not relinquishing
jurisdiction, but instead giving deductions as a cost of business. This way
foreign-sourced income is not being double-taxed.

HYPO: Earn income in Taiwan of $1000. Taiwanese tax of $150. US tax

rate is 28%.
o If the Taiwanese tax is creditable, then the US tax before credit will be
$1000 x 28% = $280. This will be reduced by a FTC of $150. Now
US tax liability is $130. Total tax liability is $280.
o If the tax is not creditable (and merely deductible), you subtract the tax
from the income, giving a net income of $850. Now you apply the tax
rate of 28%, which comes out to $238. Total tax liability is $388.
Taxes in Lieu (§ 903) – If a tax is not creditable under § 901, it may be a
tax in lieu under § 903. The term "income, war profits, and excess profits
taxes" shall include a tax paid in lieu of a tax on income, war profits, or
excess profits otherwise generally imposed by any foreign country or by
any possession of the United States.
EX: Look at the taxes we impose: (1) tax on non-resident aliens for
ECI; (2) second tax that we impose on gross income so within the
meaning of § 901 our withholding tax is not an income tax, but a
tax in lieu.
If some other country imposes some other tax on gross income, it
may nevertheless be creditable as a tax in lieu even though it does
not meet the requirement of § 901 to constitute an income tax per
se.

§ 902 – Indirect Credits – Taxes Paid By Subsidiary to Foreign

Country: § 902 allows an indirect credit where a subsidiary pays taxes to
a foreign country. This allows the parent corporation to take a credit in the
amount paid by subsidiary on the dividends it receives from the sub (and
which gets taxed as WWI).

§ 904 Limitation on Credit:

Limits the credit to: Pre-credit US Tax × (foreign income/total
income)
Carry-Back and Carry-Over: If taxes exceed credit, the excess is
disallowed, but it can be carried back 2 years and carried
forward 5 years. If it cannot be used up in that 8-year window,
the tax credit expires.
Baskets: Two baskets now (passive income, and general income)
Recapture of overall foreign loss - § 904(f) deals with the
following problem:
HYPO: Suppose you incur a foreign loss in 2007 of $1000.
Suppose in 2008, you make $1000 in foreign income. If
you are not required in effect to carry the loss forward for
foreign tax purposes, what is going to happen? Note here
that over time we have not made any money at all. If you
are going to apply the limitation over time, the §904
limitation amount should be $0. What §904(f) does is
require a carry-over of old losses for purposes of
computing the §904 limitation and treated as US-sourced
income.

§ 901(c) President is authorized, but not required to suspend the FTC, with
respect to any country that does not give the US a credit. Most countries
 do not give a reciprocal tax.
§ 901(e & f) deal with special taxes for mineral, oil, or gas companies.
§ 901(i) deals with taxes used to provide subsidies
EX: If a foreign country imposes an income tax and it succeeds in
the characterization then the companies operating in Nicaragua
will take it as a credit in US income taxes.
§ 905 allows cash method taxpayers to claim the credit in the year in
which the foregoing taxes accrued, even if they do not pay the foreign
taxes until later.
EX: 2007 taxes owed to France will not be paid until 2008. §905
allows you to credit it them in 2007.
§ 906 – Application to non-resident aliens and foreign corporations – one
tax we impose is ECI which is not limited to US-sourced. If it is foreign
sourced and taxed abroad then they get a tax credit too.
§ 908 reduces the FTC for any taxpayer who participates in the Arab
boycott of Israel.

B. Creditable?

Early Days: Pretty much everything was creditable.

Biddle v. Commissioner (1938) – In dictum, SC says income taxes paid as
used in our revenue laws are “we know it when we see it.” Result: Now
the IRS now seeks to regularly reduce the meaning of income and the
courts regularly agree.
Bank of America v. US (1972) – Court said a direct tax is creditable even
though imposed on gross income if it was highly likely or reasonably
imposed to always reach some net gain in the normal circumstances in
which it applies.
Likely to reach net gain in normal circumstances if it satisfies each
of three tests:
• Realization
• Gross receipts
• Net income

Regs §§ 1.901-2 & 1.901-2A

Foreign levy is income tax if and only if:
(1) It is a tax, AND
(2) Predominant character of the tax is income tax in US
sense
Q: Is it a tax at all? 1.901-2(a)(2): Is levy compulsory, or is the
levy really something else (penalty, fine, interest, customs duty)?
EX: Saudi Arabia is engaging with ARAMCO in two
capacities: as owner of oil and as a government. Worry that
it will characterize all of levy as tax, but that some might be
for the right to extract oil.
Specific Economic Benefit: Includes property, service of fee, right to
 extract or other ability to use something the country owns; does not
include a right to engage in business generally. So has to be a specific
type of right not available to taxpayers generally.
It is not a tax to the extent the taxpayer receives a specific
economic benefit
If there is tax element and economic benefit element, there are two
parts, and they must be separated. No credit allowable unless
taxpayer establishes amount that is actually tax. Done by § 1.901-
2A.
Soak-Up Tax: Foreign country taxes people who have foreign tax credit
to soak up possibility of extra tax. Do not count as income taxes.
Use Bank of America test

C. Dual Capacity Taxpayer

Dual Capacity Taxpayer: Where you pay a levy and also get a specific
economic benefit. Governed by the rules of § 1.901-2A.
§ 1.901-2A(a) – If the application of a foreign levy is different
either as it appears in the books or how it is administered, then
there is deemed to be a relationship between the difference in
levies and the specific economic benefit.
EXCEPTION For Lower Rate: If dual capacity taxpayers
are taxed at 20% and everyone else at 30%, it does not look
like quid pro quo. Does not look like they are benefiting,
looks like the country is paying them.
Qualifying Levy
Suppose no treaty applies or the tax is not specifically addressed by treaty,
what happens?
First we have to learn some more vocabulary: 2A(c)(1)
Defines the term “qualifying levy” – a levy that otherwise
meets the requirements of 901 and 903, but has not been
disaggregated yet. “Qualifying amount” is the portion of
the qualifying levy that will be treated as a tax.
How is Qualifying Amount Determined?
(1) Facts and Circumstances Method, OR
(c)(2) - Look at the portion that is not
quid pro quo – this will be the qualifying
amount based on all the facts and
circumstances.
It is not always obvious what is not quid pro
quo
(2) Safe Harbor Method
(e) Safe Harbor Formula - Amount paid is
amount equal to:
• (A-B-C) × (D/[1-D])
o A = gross receipts
 o B = expenses
o C = amount of levy
o D = generally applicable tax
rate

ANALYSIS
(1) Look if there is an economic benefit
(2) Then is it a specific economic benefit that not everyone gets.
(3) Dual capacity taxpayers – do they pay a different rate or base?
If they do, we disaggregate
If they do not, the disaggregation rules do not apply.

D. Requirements to be an income tax?

(1) Realization Requirement – §1.901-2B(2)(i) (pg. 466)
RULE: Three ways to meet this requirement:
(1) If a tax is imposed upon or subsequent to the
occurrence of events that would result in the
realization of income under the income tax
provisions of the Tax Code.
(i.e. they don’t tax income any earlier than
the US does)
(2) Upon the occurrence of an event prior to a
realization event, provided that the consequence of
such event is the recapture (in whole or part) of a
tax deduction, tax credit or other tax allowance
previously accorded to the taxpayer
If prior to what is realization event for tax
purposes something has happened and
they take away a benefit they gave earlier
(3) Upon the occurrence of a prerealization event,
but only if the foreign country does not, upon the
occurrence of a later even, impose tax with respect
to the income on which tax is imposed by reason of
such prerealization event AND
(1) The imposition of the tax upon such
prerealization event is based on the
difference in the values of property at the
beginning and end of a period, OR
(2) The prerealization event is the physical
transfer, processing, or export of readily
marketable property.
(2) Gross Receipt Requirement - §1.901-2(b)(3) – pg. 466
In order for it to be an income tax in the US sense, you
have to start with this gross income concept from which
you can make deductions.
RULE: A foreign tax satisfies the gross receipts
 requirement if, judged on the basis of its predominant
character, it is imposed on the basis of –
(A) gross receipts, OR
(B) gross receipts computed under a method that is
likely to produce an amount that is not greater than
FMV.
HYPO: Suppose you have a HQ tax in the
Bahamas. The HQ will charge the
affiliates for its bookkeeping services.
There is no assurance that these rates will
be FMV rates.
The Bahamas might say that for the
purpose of computing gross income,
they will deem the gross receipts of
the HQ company to be 110% of
costs.
If you can show the formula used is
likely to produce an amount not
more than FMV, not a problem. All
you have to show is that on the basis
of predominant character, it does an
okay job of guesstimating receipts.
(3) Net Income Requirement - §1.901-2(b)(4) – pg. 467
RULE: A foreign tax satisfies the net income requirement
if, judged on the basis of its predominant character, the
base of the tax is computed by reducing gross receipts to
permit –
(A) Recovery of such significant costs and
expenses, attributable, under reasonable principles,
to such gross receipts, OR
Idea is that you should be able to recover
your significant costs, including your capital
costs.
(B) Recovery of such significant costs and expenses
computed under a method that is likely to produce
an amount that approximates, or is greater than,
recovery of such significant costs and expenses.
It is okay to use an estimation technique that
underestimates net income by
overestimating deduction; but it is not okay
to use a technique that overestimates net
income by underestimating deductions.
If all three of these are met, you have an income tax, and therefore
you have a creditable tax.