An Equity-Based, Multilateral Approach for Sourcing Income Among Nations

Abstract

The source of income rules used in the United States and elsewhere in large part establish the contours of income tax jurisdiction that is exercised by countries. Source rules do this by allocating a taxpayer's income for purposes of assigning countries their rights to tax such income. Thus, source rules are of critical importance in the functioning of the income tax rules that apply to cross-border business and investment activities.
The source rules play a vital role in the foreign tax credit system applicable to U.S. persons with foreign investment or business activities. This is because a U.S. taxpayer is subject to an annual foreign tax credit limitation, which is generally equal to the taxpayer's average U.S. tax rate multiplied by the taxpayer's foreign source income as determined under the source rules. The source rules also play a central role in the United States' exercise of taxation over foreign persons with U.S. businesses or investments. For the most part, only U.S. source income is subject to tax under the U.S. tax regimes that apply to foreign persons. Moreover, if the United States were to move to a full or partial territorial system for taxing U.S. persons, the source rules would assume even greater importance given that they would determine whether the United States would impose any tax (as opposed to a residual tax) on the income of U.S. persons from crossborder activities. Other countries likewise use source rules or their equivalent in applying foreign tax credit or territorial systems to their residents and exercising source taxation over nonresidents.