As a general rule, interest paid by individuals, partnerships, and trusts takes its source from their place of residence.  A natural corollary to this rule is that interest paid by individuals, partnerships, and trusts that are “residents” of the United States has U.S. source.

This source rule has consequences that both borrowers and lenders will occasionally find startling.  An example will help illustrate this point.  Hans is a German citizen.  He meets John, a U.S. citizen, at St. Andrew’s Golf Course for the British Open.  John is the owner of Tyco, a U.S. toy-manufacturing corporation.  Hans loans John $ 100,000.  One year later, the two meet up for another rendez-vous at the British Open.  At that time, John repays the loan, complete with interest.

Is the interest paid to Hans U.S.-source income or foreign-source income?  As a preliminary matter, why does that even matter?  If the interest is foreign source, then it is not exposed to U.S. taxation in the hands of Hans.  But if it is U.S.-source, then it is subject to U.S. taxation in the hands of Hans.  Here, the interest is U.S.-source income, notwithstanding the fact that the loan was initiated outside the United States (in Scotland), that the lender was not a citizen or resident of the United States, and that the interest was paid outside the United States (in Scotland).  Why?  Because John is a U.S. citizen, and interest paid by an individual takes its source from his or her place of residence.

While this result might seem counter-intuitive, there is a rationale for it.  It reflects the broad expectation that a borrower is most likely to put borrowed money to work where he resides and pay the interest from funds available at that place.  Let’s assume that John invested the $ 100,000 that he borrowed from Hans to expand Tyco’s toy-manufacturing operations in the United States.  Let’s say that that expansion came in the form of a capital improvement to the assembly line in Tyco’s main plant.

To that extent, the borrowed money was being put to work to enhance the productivity of a U.S. company’s workforce with the goal of increasing profits.  Therefore, the interest was paid from profits generated by a capital improvement that was only made possible through a loan.  Viewing the hypothetical through this lens makes it easier to understand why the sourcing of interest rule is a proxy for matching interest with the activity that generates income from which it is paid.

There is both difficulty and opportunity in the day-to-day operation of this source rule.  A threshold problem is determining the residence of the payer of interest.  All too often, lenders are more pre-occupied with the physical whereabouts of their borrowers (or their assets) than with the more abstract notion of their current tax residence, which may not be readily discernible to a lender whose dealings with the borrower focus narrowly on his or her ability to repay a loan.

Compounding this problem is the fact that the residence of foreign individuals is governed by a set of explicit tests codified in section 7701(b).  These tests are tied to immigration status or length of time spent in the United States.  Both tests may not only be difficult for a lender to ascertain but also may change from year to year.