U.S. international taxation has never been an easy topic. Recently, we got asked about income earned on international waters. So let’s dig in and see what it is in reality! There are two main mechanisms available to US persons to avoid being taxed in the US (in the case of the foreign tax credit, while also paying taxes overseas):
- The Foreign Tax Credit (FTC) and
- The Foreign Earned Income Exclusion (FEIE)
The mechanics of the Foreign Tax Credit require the income to be sourced to a country other than the US (using US tax concepts). Whereas the foreign earned income exclusion requires income to have been earned “from sources within a foreign country or countries which constitute earned income attributable to services performed by such individual”. As such, the income could not be excluded using the FEIE. This makes the case of income earned in international water particularly interesting (or sad based on your perspective).
The tax court ruled that income earned in international water could not be excluded using the foreign earned income exclusion. Further, if you consider foreign tax credit, income needs to be sourced to a foreign country. IRC section 863(d) states that “Source Rules for Space and Certain Ocean Activities: “Space and ocean income derived by a United States person is income from sources within the United States. However, space and ocean income derived by a United States person is income from sources without the United States. To the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed. Or risks assumed in a foreign country or countries.”
What is space and ocean activity?
- Space activity is any activity conducted in space. For purposes of this section, space means any area not within the jurisdiction (as recognized by the United States) of a foreign country, possession of the United States, or the United States, and not in international water.
- Ocean activity Is any activity conducted on or underwater, not within the jurisdiction (as recognized by the United States) of a foreign country, possession of the United States, or the United States (collectively, in international water)
It means that the income earned on international waters by a US person is sourced to the US. As such the foreign tax credit is not available. Thus, only a foreign tax deduction (as an itemized deduction on Schedule A) would be available. Although much less beneficial than either the FTC or the FEIE.
John Richardson just provided a very comprehensive analysis on this topic at https://citizenshipsolutions.ca/2022/01/20/airline-and-cruise-ship-employees-how-income-earned-in-international-waters-may-lead-to-double-taxation-for-only-americans-abroad/ – check it out