Unknowingly Creating U.S. Income? Services Related to the Sale of Goods Result in a Trap for the Unwary
Foreign individuals and businesses that sell inventory and other products in the U.S. may unknowingly create U.S. source income by providing services in relation to the sale of goods.
A foreigner is taxed in the U.S. only on income from U.S. sources. Generally, foreigners selling products to U.S. customers are able to avoid creating U.S. source income if the transactions are structured properly.
The sourcing rule for services income under U.S. tax law is relatively straightforward. Any compensation for services performed in the U.S. is U.S. source income subject to taxation by the IRS. Any installation, programming, supervisory, consulting, or other services performed in the U.S. are subject to U.S. tax as U.S. source income. When foreign businesses or individuals selling furniture or other inventory in the ordinary course of business perform services related to the sale while physically present in the U.S., they may unknowingly generate U.S. source income subject to U.S. tax.
For example, if a sale of machinery or manufacturing equipment requires that a foreign business’ representative be present in the U.S. to ensure the machine is installed or programmed correctly, the foreign business is technically performing services in the U.S. Even though those services are directly related to a sale of machinery, the income from which is properly classified as foreign source, the rule still applies to deem a portion of the income from the sale as related to the services performed in the U.S. Because services performed in the U.S. create U.S. source income, the installation or programming services performed in conjunction with the delivery of the foreign source product result in U.S. source income, fully taxable at U.S. rates.
In another example, a furniture company selling custom woodworking or furniture, as part of its contracts with its customers in the U.S., may be required to perform installation or other related services upon delivery of the products. Although the actual sale of furniture or other woodworking can properly be structured to generate foreign source income, the provision of any services, including installation services, in the U.S. will create U.S. source income fully taxable in the U.S. Although hiring third party contractors to perform the actual delivery and installation of the products can help to ensure no income from the sale is U.S. source income, the company may still create U.S. source income if it is required to supervise the installation and does so via representatives, including employees, officers, or business owners, who are physically present in the U.S. when supervising third party contractors.
When U.S. source income is inadvertently generated in one of the above-mentioned ways, the IRS will deem a portion of the sales contract amount to be related to the services provided. That portion of the income will be fully taxable by the IRS. Foreign tax credits will not apply to lower the tax liability in this situation because the income is U.S. source and foreign tax credits only apply to foreign source income. Worst of all, where no treaty applies, both the U.S. and the business’ home country may tax the business on the same income. To ensure that your business avoids unknowingly generating income in this way, as well as a myriad of other ways, Barbosa Legal can assist in analyzing your business operations for unexpected tax consequences.