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Michael Tilton
Michael Tilton

U.S. Taxation of International Operations

The tax position of businesses that earn income outside the United States revealed.

August 4, 2011
by Michael Tilton, CPA

U.S. corporations, as well as citizens and permanent residents, are generally taxed on their export income in the same manner as on their income from the United States. This article focuses on the tax position of businesses that earn income outside the United States.

U.S. businesses report income and deductions from export activities on the same tax returns used to report income from domestic sales. However, there are two significant differences:

  • Income may be considered earned by a U.S. business for purposes of U.S. taxation even though exchange or capital controls imposed by foreign governments restrict the ability of the business to use the proceeds of the export sale and
  • There are special forms and schedules to be completed that reflect specific issues that arise only in international transactions.

Recognition and Source of Income

Recognition of Income

In general, businesses are considered to recognize income and are required to report the income for tax purposes when the business receives the income, accrues the income under generally accepted accounting principles or has the right to obtain the income.

Time of Payment

Generally, income is recognized when received or accrued. Recognition of income may take place earlier than actual receipt, however, when funds are deposited in a bank account in the name of the business or otherwise made freely available to the business. Similarly, recognition of income may take place later than actual receipt if the funds are subject to future contingencies.

A business may recognize income even though payment is made to another company. The determination of whether the recipient is acting solely for the business depends on whether the recipient is a real entity engaged in a real transaction.

U.S. businesses are on the cash method of accounting with respect to amounts owed to a related foreign person except where the related foreign person is a controlled foreign corporation, a passive foreign investment company or a foreign personal holding company, in which case the U.S. business can deduct accrued amounts as of the day on which a corresponding amount of income is recognized by the controlled foreign corporation, the passive foreign investment company or the foreign personal holding company.

Effective October 22, 2004, accrued but unpaid amounts due from a U.S. business to a related controlled foreign corporation or passive foreign investment company cannot be deducted by the U.S. business until a corresponding amount in included in the gross income of a U.S. person(s) who owns stock, directly or through a foreign entity, in the controlled foreign corporation or the passive foreign investment company.

Delivery of Goods

In some situations, a U.S. business will recognize income when goods are delivered to a foreign person. If the purchaser makes advance deposits with the seller or the purchaser pays with an irrevocable letter of credit, delivery of the goods may trigger recognition of income to the U.S. business. However if the U.S. business ships goods on consignment to a foreign dealer, the U.S. business will recognize income after the goods are sold by the dealer.

Source of Income

U.S. businesses are generally taxed on worldwide income. To mitigate double taxation of foreign income, U.S. businesses may deduct foreign taxes or, alternatively, elect to take a credit for taxes paid to foreign countries. Foreign taxes are creditable only against the U.S. income tax on foreign-source income. Therefore businesses exporting goods must determine whether profit earned from the sale of goods is foreign-source or U.S.-source income.

Purchase and Sale of Goods (Other Than Manufactured Inventory)

If export income is earned from the purchase and sale of inventory, other than manufactured inventory, then the location where right, title and interest in the property are transferred to the purchaser will generally determine the source of income. For example, if a U.S. business purchases tiles in Mexico and sells the tiles in the United States, the income will be U.S.-source income. On the other hand, if the tiles are sold in France, the income will be foreign-source income.

If beneficial ownership and risk of loss are transferred to the buyer while the seller retains bare legal title, the sale will be deemed to have occurred at the time and place where beneficial ownership passed to the purchaser. For example, if the tiles are sold to a buyer in France and title to the tiles passes in France, the income will be foreign-source income. However, if the French buyer takes the risk of loss for the tiles at the moment the tiles are placed on a ship in New York and the French purchaser pays for tiles before the tiles arrive in France, the income should be U.S.-source income.

Factors to Be Examined

The principal factors to be examined in determining the source of income include the following:

  • Does the purchaser or seller pay for insurance during shipping?
  • Does the purchaser or seller pay for shipping?
  • Does the seller retain a security interest in the goods pending payment?
  • Does the seller have any additional obligations to perform in addition to transporting the goods?

In situations where the source of income is unclear, the point at which the buyer incurs an unconditional obligation to pay for the merchandise must be determined.

Sale of Manufactured Inventory

Income resulting from sales of inventory manufactured or produced by a U.S. business is divided between the locations of manufacture and sale. If inventory is manufactured or produced and sold in the United States, any income from sale of that inventory is sourced to the United States.

Gross income on a sale of inventory produced by a U.S. business outside of the United States or a sale outside of the United States of inventory produced in the United States is sourced partly within and partly outside the United States.

The term “produced” includes manufactured, produced, created, fabricated, extracted, processed, cured or aged. Only production activities conducted directly by the taxpayer are considered for this purpose.

Relevant regulation describe two methods that may be used for allocating or apportioning income from these transactions (Section 863 sales) — a 50/50 method and an independent factory price (IFP) method. The 50/50 method applies to any Section 863 sale unless the taxpayer elects the IFP or books and records method for those sales. Whatever method a taxpayer utilizes for Section 863 sales must be applied separately to U.S. sales of goods produced outside of the United States and foreign sales of inventory produced in the United States.

This article has been excerpted from U.S. Taxation of International Operations: Key Knowledge. You can purchase the publication on CPA2Biz.com.

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Michael Tilton, CPA, JD, has successfully navigated the corporate international tax laws of China, Mexico, Germany, the UK and more, often serving as his company’s voice in tax authority interactions.