Income Sourcing Rules for US NRIs

Where your income comes from can be just as important as how much you earn when dealing with U.S. taxes. The IRS generally classifies income as U.S.-source or foreign-source using different rules depending on the type of income. Salary, interest, dividends, rent, royalties and capital gains can each follow different sourcing rules.

For nonresident aliens, U.S.-source income is generally subject to U.S. taxation, while foreign-source income is generally outside the U.S. tax system, subject to specific exceptions. U.S. citizens and resident aliens are different because they generally report worldwide income, but income sourcing remains important when calculating the foreign tax credit.

If you are an NRI, U.S. citizen, green card holder, resident alien, or another taxpayer with financial connections to India and the United States, understanding these rules can help you report income correctly and avoid mistakes in your foreign tax credit calculation.

What Are Income Sourcing Rules?

Income sourcing rules for NRIs are guidelines used by the IRS to determine whether your income will be treated as US source or foreign-source. You might have various types of income, such as salary, interest, dividends, capital gains, rental income, or royalties. So, it's important to understand that each income type has its own sourcing rules, which the IRS applies.

However, remember that these rules are applied based on the nature of your income, not your nationality or where you live. To make it easier, let's take the help of an example:

• Your salary is sourced based on where you physically perform your work.
• The interest income depends on who pays it.
• Dividend income depends on where the company is incorporated.

These rules play a crucial role in determining how your income is taxed and also whether you are eligible to claim any tax relief under US tax laws or international tax treaties. Besides this, there are other reasons why income sourcing rules are important; let's see them.

Why Do Income Sourcing Rules Matter?

Your US tax obligations are directly affected by the source of your income. The US will typically tax only US-source income for nonresident aliens, and their foreign-source income will remain outside their US tax obligation. On the other hand, US citizens and green card holders will be taxed on their worldwide income in the US, regardless of where they earn it.

You must be thinking, then, why do the income sourcing rules matter? It's because these rules will affect your foreign tax credit (FTC) calculation. It's important for taxpayers to identify their correct foreign-source income, as it helps them claim credit for taxes paid in another country and reduce the risk of double taxation.

But what if you classify your income incorrectly? In such cases, you may attract IRS compliance issues, unnecessary taxes, or missed tax credits. It will not be a good feeling to face these consequences, so it's better to remember that income sourcing rules are an important part of your cross-border tax planning.

Does U.S.-Source Income Always Mean You Pay U.S. Tax?

Not necessarily. Income being classified as U.S.-source does not by itself determine the final U.S. tax liability. Other rules can affect the result, including tax treaties, statutory exemptions, withholding rules, deductions, effectively connected income rules and the taxpayer's residency status.

Similarly, foreign-source income does not automatically mean that a U.S. citizen or resident alien can exclude it from U.S. taxation. U.S. citizens and resident aliens generally report worldwide income, although provisions such as the foreign tax credit may provide relief from qualifying foreign taxes.

Tax Treaty Rules Can Change the Sourcing Result

Domestic U.S. sourcing rules are not always the final answer in a cross-border case. An income tax treaty can sometimes modify how income is treated for U.S. tax or foreign tax credit purposes. This is particularly important when the same income is taxed by both the United States and India.

For example, a treaty may contain provisions that allow certain income to be treated as arising in the other country for purposes of the foreign tax credit. Therefore, taxpayers should review both the Internal Revenue Code sourcing rules and the applicable India-U.S. treaty provisions before calculating the foreign tax credit.

Now that we understand that both domestic sourcing rules and applicable tax treaty provisions can affect the final result, let's look at how the IRS determines the source of different types of income.

Salary and Employment Income

The IRS follows a very simple rule for salary and wages: salary is sourced based on where you physically perform the work. The location where you actually perform your work physically is what matters, not where you deposit your salary or which currency you get paid in.

For example:

• You work for a US company but remotely while being in India. Since you performed the work in India, your salary is generally classified as foreign-source income.
• You travel to the U.S. for work. In this case, the salary you earn during the days you worked in the U.S. will generally be considered as US-source income.

Now, what if you work in both countries during the year? So, in such a case, you may need to allocate your salary between US-source and foreign-source income. This can be done by considering the number of days you worked in each country.

Interest Income

Interest income follows a distinct sourcing rule. The source of interest is determined based on who pays the interest and not the place where you live or where the money is deposited.

For example:

• If you earn interest from a U.S. bank or a U.S. company, it will generally be classified as U.S.-source income.
• Conversely, if you earn interest from an Indian bank or an Indian financial institution, it is generally considered foreign-source income.

For NRI and U.S. taxpayers who maintain bank accounts in multiple countries, it's important to understand these differences. This is because it affects both taxation and calculation of the foreign tax credit.

Dividend Income

Dividend income is sourced based on where the company that is paying the dividend is incorporated.

For example:

• When you receive a dividend from a US corporation, it is generally treated as US-source income.
• If you receive a dividend from an Indian company, it is generally classified as foreign-source income, even if the shares are held through a US brokerage account.

The company's country of incorporation is what matters, and your broker's location or investment account doesn't determine the source of dividend income. Since dividends may qualify for different tax treatment, withholding rates, and FTC calculations based on whether it is treated as US-source or foreign-source income, it's important to understand this rule.

Rent & Royalty Income

Considering where the property is located, the IRS determines the source of rental income. Likewise, the source of royalty income is determined based on where the intellectual property or asset is used.

For example

• Rent received from a house or apartment located in India is generally treated as foreign-source income.
• Rent earned from a property in the United States is generally considered US-source income.
• Royalties received from a patent, trademark, or copyright used in the US are usually treated as US-source income, even if the owner doesn't live in the US.
• The royalty is considered foreign-source income if the intellectual property is used in India.

You can identify your US tax obligation and whether you qualify for tax credits or treaty benefits by learning where your rental or royalty income is sourced.

These are some common types of income and how they are affected by the income sourcing rule. However, if you have noticed, we haven't covered capital gains. So, capital gains are not at all treated the same and are treated differently by the IRS based on what you sell. Let's understand the income-sourcing rules for selling property.

Selling Property: Real Estate vs Stocks

Capital gains are treated very differently by the IRS. They use different sourcing rules based on whether you are selling real estate or financial assets such as stocks and bonds.

Sale of Real Estate

The income source from selling real estate depends on where the property is situated.

For Example:

• If you sell a property in India, it creates foreign-source income.
• If you sell a property in the US, it creates US-source income.

Sale of Stocks and Securities

The source of gain from selling stocks and other personal property is generally determined by the seller's tax home, rather than simply by the country where the company is incorporated. However, special rules can apply to U.S. citizens and resident aliens who have a foreign tax home, as well as to certain types of property.

For a nonresident alien, gain from the sale of personal property is generally foreign-source unless a specific exception applies. For a U.S. citizen or resident alien, the rules are more complicated and can depend on the taxpayer's tax home, foreign tax home, and whether foreign income tax is imposed on the gain.

Therefore, you should not automatically classify the sale of shares of an Indian company as either U.S.-source or foreign-source solely because the company is Indian or because the seller is a U.S. tax resident.

For Example:

• You are a US tax resident selling shares of an Indian company. In this case, you may still have US-source capital gains, even though the company is incorporated in India. This is a common point that creates confusion among many cross-border taxpayers because this rule is different from dividend sourcing.

To calculate foreign tax credit and determine US tax liability, you must understand this difference. Next, let's understand income sourcing rules on pension and retirement income.

Pension and Retirement Income

Pension sourcing can be more complicated than salary sourcing. The IRS generally separates a pension distribution into a compensation element and an investment-earnings element.

The compensation element is generally sourced based on where the services that earned the pension were performed. The investment-earnings portion may instead be sourced based on the location of the pension trust.

For example, a pension attributable to services performed in the United States may contain a U.S.-source compensation element. However, the complete distribution cannot automatically be classified as U.S.-source without examining the type of pension and the components of the payment.

Tax treaties can also modify how pensions and retirement distributions are taxed, so cross-border taxpayers should review the applicable treaty provisions separately.

Now, to recap everything and understand better, let's next take a look at a quick comparison table of US income sourcing rules on various income types.

Quick Comparison of US Income Sourcing Rules on Various Income Types

The table below lists various types of income and how the IRS determines their income source:

Additionally, here is an example to understand how income sourcing rules apply to an individual.

Common Mistakes Taxpayers Make

Many taxpayers misunderstand income sourcing rules. This might not seem like a problem at first, but it can have several consequences. Mistakes in understanding the rules can lead to incorrect tax filings or missed tax benefits. Some of the common mistakes include:

• Assuming that every income you receive from an Indian company is automatically foreign-source.
• Similarly, assuming that salary from a US employer is always US-source, regardless of where the work was performed.
• Not paying attention to the effect of temporary work assignments in another country.
• Getting confused between the sourcing rules for interest, rent, dividends, and capital gains.
• Due to income being classified under the wrong source, calculating foreign tax credit (FTC) incorrectly.

When you review each type of income separately, you can ensure that you report your taxes accurately and reduce the risk of IRS notices or penalties.

The Bottom Line

If you are someone who earns income in both the United States and another country, it's crucial for you to understand US income sourcing rules. It's very important for you to identify whether your income is treated as US-source or foreign-source, as it affects your tax liability. It also helps you determine whether you qualify for any tax treaty benefits and the amount you can claim as a foreign tax credit.

Since various types of income follow different sourcing rules, don't assume that all of them are treated the same way. If you make any mistake in classifying your income, you may attract higher taxes, missed tax credits, or IRS compliance issues.

Moreover, if your tax situation involves multiple types of income or cross-border investments, you must seek guidance from a qualified tax professional at Savetaxs. At Savetaxs, we have a team of cross-border experts who can help ensure accurate reporting and maximize your tax benefits.