As effectively connected income, this foreign source income is subject to United States tax as if it were sourced in the United States. Generally, such income is effectively connected to a U.S. trade or business if the franchise payments are derived from assets used in the conduct of such trade or business, or the activities of the trade or business were a material factor in the realization of the franchise payments. To be effectively connected income, these franchise payments must also be sourced in the United States, unless the foreign franchisor has an office or other fixed place of business in the U.S. to which the franchise payments are attributable and such payments are derived from the active conduct of the franchisor's U.S. trade or business. Thus, if the franchisee is located in the United States, payments to the foreign franchisor will be U.S. source income. However, the U.S. Treasury Department's model income tax treaty, on which many U.S. tax treaties now in force are based, prevents the United States from taxing U.S.-sourced royalties received by residents of a treaty country.
Many treaties reduce, rather than eliminate, U.S. withholding tax on royalties.
See, e.g., Article 12 of the recently concluded U.S.-Mexico treaty. Deductibility of Franchisee Payments Under United States tax law, if the initial franchise fee that a franchisee pays to become enfranchised is paid in one lump sum at the beginning of the franchise agreement, it is generally amortizable over a ten-year period or over the life of the franchise agreement, whichever is shorter. If the initial fee constitutes a series of payments over the life of the franchise agreement or over a period of ten or more years, the payments are deductible in the taxable years in which they are made. This rule applies regardless of whether the initial fee is in the form of one lump sum payment or a series of payments over the life of the franchise agreement. As noted in the above discussion on the deductibility of franchise payments, payments that are not contingent on the productivity or use of the franchise cannot be deducted as ordinary and necessary business expenses of the franchisee.