Proposed new IRS rules determine the source of income from personal services performed partly within the United States, applicable for tax years beginning on or after the date on which the regs are finalized. Under existing regs, the portion of the compensation treated as US-source income must be determined on the basis that, in the particular circumstances, "most correctly reflects" the proper source. Proposed regs issued in 2000 retained this facts-and-circumstances approach in some cases and were withdrawn by Treasury owing to a host of negative comments from tax practitioners.

The new proposals provide two new general bases--time and geography--for determining the proper source of compensation received by an individual employee. Non-fringe-benefit compensation for labour or personal services performed partly within the United States must be sourced on a time basis: the amount so sourced bears the same relation to the total compensation as the number of days the employee performed such services within the United States bears to the total number of days he or she performed such services. A unit of time less than a full day may be used; the proposal's preamble indicates that this may be a more appropriate unit, for instance, to source compensation paid to an airline flight crew member.

Under the second general basis of apportionment, fringe benefit compensation received by an employee for labour or personal services performed partly within the United States must be sourced on a geographical basis, which is linked to the employee's principal place of work as defined in Code section 217. The relevant fringe benefits are housing, education, local transportation, tax reimbursement, hazardous or hardship duty pay, and moving expense reimbursements; Treasury and the IRS plan to update this list periodically. The fringe benefit must be reasonable and substantiated by adequate contemporaneous records or other sufficient evidence, and must meet the IRS's definition of a permissible fringe benefit.

An alternative basis for apportionment, based on the facts and circumstances, may be used if the employee can establish to the IRS's satisfaction that it more properly determines the compensation's source. For example, an alternative method may more properly determine the source of an employee's compensation that is tied to the performance of specific actions rather than earned rateably over time.

The facts-and-circumstances basis is retained as the general rule for determining the source of compensation for labour and personal services performed partly within the United States received by non-individuals and non-employees (independent contractors). Treasury believes that a facts-and-circumstances test in this situation is more appropriate. For example, if a corporation is paid under a contract for services performed by numerous employees at various pay levels in different geographic locations, the income's source may be correctly reflected by payroll costs under the contract or on some other non-time basis.

The new proposals do not affect the existing de minimis rule that exempts otherwise US-source income from US tax. Code section 861(a)(3) treats compensation for services performed in the United States as foreign-source income if (1) the services are performed by a non-resident individual present in the United States for 90 days or less during the taxable year; (2) the aggregate compensation does not exceed $3,000; and (3) the worker performs the services as an employee of or under a contract with either (a) a non-resident individual, foreign partnership, or foreign corporation not engaged in a US trade or business, or (b) a US citizen, resident individual, partnership, or corporation if such services are performed for an office or place of business maintained by such a party outside the United States. The Canada-US treaty gives employees and independent contractors further relief from US tax. Article XV provides that income received by a Canadian resident for the performance of dependent personal services (as an employee) in the United States is exempt from US tax if (1) the amount does not exceed US$10,000 for the year, or (2) the individual is present in the United States for no more than 183 days during the calendar year, and the income is not borne by a US employer or by the employer's US permanent establishment or fixed base. Article XIV also provides that income received by a Canadian resident for performance in the United States of independent personal services (as a consultant or independent contractor) is US-tax-exempt if there is no fixed base regularly available to him or her in the United States for the purpose of performing the services.