U.S. citizens are taxed on worldwide income, meaning they must report and pay taxes on all income earned, regardless of where they live or where the income is generated. This includes wages, business profits, investment income, and capital gains, even if the income has already been taxed in another country. To prevent double taxation, the U.S. offers a foreign tax credit for taxes paid to another country, which the U.S. considers to be “foreign sourced.”
Sourcing Rules for Intangibles
When it comes to capital gains on the sales of securities, the default treatment under U.S. tax law is that the “sourcing” of the gain is not based on the location of the shares that were sold but on the residence of the seller. Therefore, if a U.S. tax citizen sells shares anywhere in the world, the gain will usually be considered “U.S. sourced” and, therefore, not eligible for a foreign tax credit, assuming that the foreign country imposes a tax on the same capital gain. (As a sidebar comment, if a non-U.S. person sells shares of a U.S.-listed company at a gain, that gain is usually not subject to U.S. tax as the U.S. considers that gain to be sold by a foreign person residing outside of the U.S., and therefore, “foreign sourced.”)
Section 865(g) Relief
While this default sourcing rule can lead to inequitable results, in the case of a U.S. citizen living abroad, Section 865(g) of the Internal Revenue Code can provide valuable relief. If applicable, Section 865(g) turns off the default sourcing rule and considers the gain as “foreign sourced,” thus enabling a foreign tax credit to be claimed.
Key Requirements for Section 865(g) Benefits
- Tax Home in a Foreign Country: The taxpayer must meet the requirements of having a tax home outside the U.S., which generally means residing and working abroad for the full taxable year. The concept of tax home is complex and focuses on the location where the taxpayer earns his or her income. The IRS defines it as “the general area of your main place of business, employment, or post of duty, regardless of where you maintain your family home.”
- Local Tax Rate of at least 10%: A foreign country must impose a tax of at least 10% on the sale of intangibles for it to be considered foreign-sourced.
Conclusion
Section 865(g) allows U.S. citizens abroad to reduce double taxation and claim foreign tax credits on capital gain income that is generally treated as U.S. sourced. Consulting a tax professional can help ensure compliance and maximize benefits.
Please contact your WG advisor if you require further information or have any questions.
