Foreign Income Series

Provisions Applicable to U.S. and Foreign Persons

Portfolio 905-1st: Source of Income Rules

Source of Income Rules

by Peter H. Blessing, Esq.
Shearman & Sterling
New York, New York
Special Consultant to Tax Management
PORTFOLIO DESCRIPTION
Tax Management Portfolio 905 T.M., Source of Income Rules, analyzes the rules applicable
in determining whether income is treated as from sources within the United States or from
foreign sources. In the case of persons who are not citizens or residents of the United States or
domestic corporations, and thus are not subject to U.S. taxation on their worldwide income, the
source of income rules generally are pivotal in determining whether the tax jurisdiction of the
United States extends to the income. In addition, in the case of all persons who are subject to
U.S. tax, the source of income rules are critical to determining to what extent a credit is available
for income taxes or taxes in lieu of income taxes paid to a foreign government. The source of
income rules are applied in conjunction with the rules governing the allocation and
apportionment of expenses between domestic and foreign sources in order to determine foreign
source taxable income for purposes of the foreign tax credit limitation prescribed for each
separate limitation category under §904.
The source of income rules are contained largely in §§861-863 and §865. In addition, certain
other rules are contained under other provisions of the Code or Regulations under such
provisions or have been prescribed by the IRS or courts by analogy to statutory rules. Since
different rules apply for different types of income, the proper classification of income is a
prerequisite to determining the source of income.
This Portfolio may be cited as Blessing, 905 T.M., Source of Income Rules.
Peter H. Blessing, Princeton University (A.B. 1973); Columbia University (J.D. 1977); New
York University (LL.M. 1981); member, New York Bar, and Section of Taxation of American
and New York State Bar Associations; contributor: The Tax Lawyer; Tax Management
International Journal.

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 DETAILED ANALYSIS
I. Introduction
The U.S. tax system, like that of most other nations, contains rules designed to identify items
of income (or expense) derived from U.S. or foreign sources. These rules are contained primarily
in Sections 861-863 and 865.1 In addition, a number of U.S. tax treaties contain certain source of
income rules, which in a few instances deviate from and are not overridden by the Code.2 It
should be noted that the source of income rules merely provide a basis for taxation. The
operating tax rules are contained elsewhere in the Code.
1
All section references herein are to the Internal Revenue Code, as amended, and the
regulations promulgated thereunder, unless otherwise indicated.
2
See fn. 667 and accompanying text below.

A. Purpose of the Source of Income Rules

There are three primary bases for a nation to assert income tax jurisdiction: (i) citizenship of
or residence within a nation, (ii) a permanent establishment or other fixed place of business
within a nation, and (iii) the source of income within the nation. The Code utilizes these criteria
in determining federal income tax liability. On the first basis of jurisdiction, the U.S. taxes the
worldwide income of its citizens and residents under Sections 1 and 11 and, on the third basis of
jurisdiction, permits foreign tax credit and other relief. On the second and third bases of
jurisdiction, the U.S. taxes income of foreign persons.
1. U.S. Persons
The taxation of U.S. citizens and residents, domestic corporations, and domestic trusts and
estates on income earned from both U.S. and foreign sources often results in double taxation. To
alleviate this double taxation, Section 901 allows, subject to limitations, a credit for foreign taxes
paid or deemed paid by U.S. taxpayers.3 Under Section 904, the credit is limited to that portion of
the U.S. tax liability of worldwide income that is attributable to the taxpayer's foreign source
income.
3
See generally 901 T.M., The Foreign Tax Credit --Overview and Creditability Issues.

In the case of a 10% or greater domestic corporate shareholder of a foreign corporation, the
source rules are relevant both in determining whether the foreign corporation itself is subject to
U.S. tax on the income (see below) and in determining the foreign tax credit relief available to
the shareholder under Sections 901, 902, and 960. Also, in the case of "controlled foreign
corporations," the source rules may be relevant under, in particular, Sections 952(b) and 954(f) in
determining such shareholder's subpart F income.4
4
See generally 926 T.M., Subpart F--General.

Citizens of the United States or resident aliens who perform personal services abroad are
entitled to exclude, subject to certain requirements and an annual limitation, foreign source
income derived from personal services under Section 911.5
5
See generally 918 T.M., U.S. Income Taxation of Citizens and Residents Abroad.

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 2. Foreign Persons
Nonresident aliens, foreign corporations, and certain trusts and estates are subject to U.S.
income tax on income that is derived from U.S. sources and on certain foreign source income
that is considered effectively connected with a U.S. trade or business,6 but are exempt from tax
on other foreign source income.7
6
See Sections 864, 871(b), 882(a).
7
See Sections 872(a) and 882(b), defining "gross income."

The source rules are the first step in determining whether the gross amount of "fixed or
determinable annual or periodical income" paid to foreign persons is subject to U.S. tax under
Sections 871(a)(1) and 881(a). These rules also are of interest to the payor of the income since, if
the income is taxable, the payor generally is required to withhold and deposit the tax associated
therewith under Sections 1441- 42.8
8
See, e.g., Rev. Rul. 80-362, 1980-2 C.B. 208 (foreign corporation payor was withholding
agent). See generally 915 T.M., U.S. Withholding and Reporting Requirements for Payments of
U.S. Source Income to Foreign Persons.

The source rules also are the first step in calculating a foreign person's income that is
considered "effectively connected" with the conduct of a trade or business within the United
States under Section 864, Section 897, and other provisions, and taxed on a net-income basis at
regular individual and corporate rates under Sections 871(b) and 882. Tax on such income may
be required to be withheld by the payor under Section 1445 or Section 1446.9
9
See generally 910 T.M., Partners and Partnerships -- International Tax Aspects.

In addition, the source rules are the first step in determining whether, e.g., a foreign taxpayer
deriving transportation income is liable for the Section 887 tax on certain U.S.-source gross
transportation income, or whether a nonresident alien individual resident in the United States for
at least 183 days during the taxable year but not considered a U.S. resident (an unusual
circumstance, to be sure) is liable for the 30% tax under Section 871(a)(2) on certain U.S. source
capital gains.
3. U.S. Possessions
For purposes of sourcing income within or without U.S. possessions, the regular source rules
apply, with certain adjustments.10 Congress reinforced this by the enactment of §937(b), which
provides that in general and for taxable years ending after October 22, 2004, rules similar to
those for determining income from sources within the United States and income effectively
connected with the conduct of a trade or business within the United States are to apply for
purposes of Title 26 in determining income from sources within the U.S. possessions and income
effectively connected with the conduct of a trade or business within a U.S. possession. See the
American Jobs Creation Act of 2004, P.L. 108-357, §908.
10
See Regs. Section 1.863-6 and discussion in VII, B, 2, c, below.

The source rules are central to whether a domestic corporation that conducts an active
business in Puerto Rico may be eligible for the Section 936 credit and the amount of that credit. 11
11
See generally 933 T.M., The Possessions Corporation Credit Under Section 936.

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 Bona fide individual residents of Guam, American Samoa, or the Northern Mariana Islands
may exclude from gross income under Section 931 income derived from sources within such
possessions or effectively connected with a trade or business conducted within such possessions.
Section 933 permits a bona fide individual resident of Puerto Rico to exclude Puerto Rican
source income (excluding compensation paid by the United States or an agency thereof) from
gross income for U.S. tax purposes.
Special rules dealing with income from sources within the U.S. Virgin Islands or effectively
connected with a trade or business conducted within the Virgin Islands, contained in Sections
932 and 934, depend on the source rules.
The source rules are relevant in certain cases in determining whether bona fide residents of a
possession are considered "United States persons" for purposes of testing the controlled foreign
corporation status of a possessions corporation under Section 957(c).
For each of the reasons set forth above, segregation of gross income derived by U.S. citizens
and residents with international economic activity, or by foreign persons with U.S. economic
activity, into U.S. source and foreign source portions is of critical importance in determining the
U.S. tax liability of such taxpayers. This segregation function is performed primarily by the
source of income rules.12
12
Special source of income rules are also contained in other sections of the Code e.g., Sections
306(f), 338(h)(16), 535(d), 864(e)(7), 877(d), 897(a)(1), 901(j)(4), 904(f)(1), 904(h), (j), 936(h)
(1), and 952(d).

B. Overview of the Source of Income Rules

For many years, the source of income rules remained relatively unchanged. The Tax Reform
Act of 1984 (TRA 84),13 however, provided a number of significant modifications to the source
rules. The Tax Reform Act of 1986 (TRA 86)14 resulted in perhaps the most significant set of
modifications to the source rules that has occurred since their inception.
13
P.L. 98-369 (hereafter referred to as TRA 84).
14
P.L. 99-514 (hereafter referred to as TRA 86).

The source of income rules are largely codified by income category. It may help to
conceptualize them, however, to note that they may be grouped under three general approaches:
(i) The source of income rules contained in Sections 861(a)(1) through (a)(8), 862(a)(1)
through (a)(8), 863(c)(1) and (e)(1)(B), 865, and 884(f)(1), which endeavor to assign
income statutorily to a U.S. or non-U.S. source based on what has been perceived to be the
predominant situs (or at least a predominant situs that is administratively workable) of the
economic activity generating the income and the source of legal protections facilitating such
generation. These rules are applicable to interest, dividends, compensation, rents, royalties,
sale of real and certain personal property, insurance underwriting income, certain
transportation income, certain international communications income, and social security
benefits. These rules are discussed at II-IX and, where appropriate, at XI and XIV, below.
(ii) The "split-source" rules of Sections 863(b), 863(c)(2), and 863(e)(1)(A), which assign
certain income a U.S. source in part and a foreign source in part. The split-source rules are
applicable to certain manufacturing, transportation, and international communications

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 income and to property purchased in a U.S. possession and sold in the United States. These
rules are discussed, where appropriate, at VII, IX, and XI, below.
(iii) Miscellaneous statutory and other source of income rules. These include, e.g., those
applicable to ocean or space activity, certain foreign currency transactions, and notional
principal contracts which look to the residence of the recipient. These and other rules, which
source income by analogy to other source rules or on some other basis, are discussed at X
and XII-XIV, below.
Examples of the predominant-situs approach are the following:
(i) The source of interest income generally is an individual debtor's place of residence and a
corporate debtor's place of incorporation under Sections 861(a)(1) and 862(a)(1).
(ii) The source of dividend income generally is the place of the paying corporation's
incorporation under Sections 861(a)(2)(A) and 862(a)(2).
(iii) The source of income from personal services generally is the place where services are
performed under Sections 861(a)(3) and 862(a)(3).
(iv) Rentals and royalties from the use of real or personal property are sourced either to the
geographic location of the property or the place of permitted use of the property under
Sections 861(a)(4) and 862(a)(4).
(v) Income from a disposition of a U.S. real property interest (broadly defined to include
interests in certain entities holding U.S. real property) is determined according to the situs of
the property under Sections 861(a)(5) and 862(a)(5).
(vi) Various rules governing income from the sale of property:
(A) Income from the sale of inventory (other than inventory sourced under the split-
source rule discussed below) is sourced to the place of sale under the "title passage" rule
under Sections 861(a)(6) and 862(a)(6). However, in the case of a sale by a nonresident, if
the sale is attributable to a fixed place of business in the United States, the income is sourced
in the United States (notwithstanding title passage abroad) unless the inventory is sold for
use, disposition, or consumption outside the United States and a foreign office participates
materially in the sale under Section 865(e)(2).
(B) Income from the sale of depreciable personal property that does not exceed the
depreciation adjustments for such property is sourced between U.S. and foreign sources in
the ratio that the depreciation was deductible for U.S. tax purposes (subject to an exception
for a sale by a nonresident if the sale is attributable to a U.S. fixed place of business) under
Section 865(c)(1). Income from such a sale in excess of such depreciation adjustments is
sourced in the same manner as income from the sale of inventory under Section 865(c)(2).
(C) Income from the sale of intangible property, to the extent gain does not exceed the
amortization adjustments, if any, is sourced similarly to gain from the sale of depreciable
tangible property. Any additional gain, to the extent payments from the sale are contingent on
the productivity, use, or disposition of the property, is sourced where the property is used
(subject to an exception for a sale by a nonresident if the sale is attributable to a U.S. fixed

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 place of business) under Sections 865(d)(1)(B), 861(a)(4), and 862(a)(4); to the extent not so
contingent, such additional gain is sourced as set forth in subparagraph (F) below.
(D) Income from the sale of goodwill (other than to the extent so contingent or, if
legislation permitting its amortization is enacted, representing a recovery of amortization
adjustments) is sourced based on where it was generated (subject to the same exception)
under Section 865(d)(3).
(E) Income realized by a U.S. resident from the sale of an affiliated foreign corporation
deriving more than 50% of its gross income for a three-year period from an active business in
a foreign country is foreign source if the sale occurs in such country under Section 865(f).
(F) While, in general, income from the sale of other property is sourced under Section
865(a) by the residence of the seller, if the sale is attributable to a fixed place of business in
the United States (in the case of a nonresident seller) or abroad (in the case of a domestic
seller), the income is sourced to the location of such place of business under Sections 865(e)
(2) and 864(c)(4)(B)(iii).
(vii) Underwriting income from issuing or reinsuring any insurance or annuity contract in
connection with property in, liability arising out of an activity in, or in connection with the
lives or health of residents of the United States is considered to be from U.S. sources under
Section 861(a)(7).
(viii) U.S. social security benefits are considered to be from U.S. sources under Section
861(a)(8).
(ix) Income from transportation beginning and ending within the United States is considered
to be from U.S. sources.
The split-source rules of Section 863 generally apportion four types of gross income from
international economic activity as income from sources within or without the United States
according to statutory or regulatory formulas:
(i) income from the sale of personal property (inventory) produced within and sold without
the United States (or produced without and sold within the United States);
(ii) income derived from the purchase of personal property in a U.S. possession and its sale in
the United States;
(iii) income from transportation that either begins or ends without the United States; and
(iv) international communications income derived by a U.S. person. Additionally, although
income from the performance of personal services is sourced either to U.S. or foreign sources
under Section 861(a)(3) or Section 862(a)(3), respectively, if personal services are performed
partly within and partly without the United States, income from such services is apportioned
under Regs. Section 1.861-4(b)(1)(i) to U.S. and foreign sources.
Miscellaneous statutory and regulatory provisions provide other source rules. For example,
Section 863(d) sources income from ocean and space activities by the residence of the person
earning the income. Section 988(a)(3)(A) and Regs. Section 1.863-7 apply a similar residence-
of-recipient source rule to income from certain foreign currency transactions and notional

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principal contracts, respectively. International communications income derived by a foreign
person is considered to be from foreign sources under Section 863(e) unless attributable to a U.S.
fixed place of business. Furthermore, where the Code and the regulations are silent, the courts
have provided rules by applying concepts analogous to those underlying the Code rules.
Finally, some bilateral treaties concluded by the United States specifically provide rules for
determining the source of various items of gross income. While treaty rules generally follow the
pattern of the Code rules or (as in the case of shares of corporations treated as U.S. real property
interests) are overridden by the Code rules, several treaties modify these rules (particularly with
respect to the source rules governing gain from the sale of personal property).15 Consequently, the
rules contained in an applicable tax treaty should be considered in determining applicable source
rule.
15
See, e.g., VII, A, 2, e, below, and the treaties listed in fn. 667. See also PLR 9523006 (special
source rule for interest under New Zealand treaty overrides general Section 861(a) rule).

C. Definition of United States

For purposes of applying the source of income rules generally, the term "United States"
includes the 50 states and the District of Columbia.16 The territorial waters of the United States
(and each of the respective states bordering on the sea) extend a marine league (three marine,
nautical, or geographical miles, or about 3.45 land, statute, or English miles) from its shoreline as
measured from the mean low-water line or from the seaward limit of a bay or headland.17 The
U.S. possessions (the Virgin Islands, Puerto Rico, American Samoa, Wake, Guam, and Midway
Islands) generally are not included in the term "United States"18 (except for purposes of Section
911).19
16
Section 7701(a)(9).
17
See,U.S. v. Louisiana, 363 U.S. 1 (1960). Accord, e.g., Regs. Section 49.4262(b)-1(a); State v.
Ruvido, 15 A.2d 293 (S. Jud. Ct. Me. 1940); Rev. Rul. 77-197, 1977-1 C.B. 344 (Section 4261);
Rev. Rul. 56-346, 1956-2 C.B. 330; PLR 8507004; PLR 8025144 (Section 48); PLR
6208025380A (Section 911); GCM 39552 (September 3, 1986) (Section 3121); GCM 38644 (Feb.
27, 1981) (Section 4261). The states and the federal government exercise exclusive jurisdiction
over all activities and resources within this geographic definition of the United States' territory,
including seaward boundaries generally extending three marine miles from the low-water coastline
(but, in the case of Texas and Florida, extending nine marine miles from the low-water coastlines)
under the Submerged Lands Act, (43 USC Section 1301, et seq., delegating formerly federal
jurisdiction to the states. See U.S. v. Louisiana, 363 U.S. 1 (1960).
18
See, e.g., Sections 7701(a)(9), 865(i)(3), 1441(e).
19
Regs. Section 1.911-2(g).

Beyond the geographic territory over which the United States exercises exclusive sovereign
jurisdiction, the United States has asserted tax and other authority over the exploration or
exploitation of the outer continental shelf (extending up to 200 miles beyond the territorial sea). 20
In 1969, Section 638 was added to the Code defining the "United States" to include areas of the
continental shelf with respect to the exploration and development of mines, oil, and gas wells
and other natural deposits. Section 638(1) defines the continental shelf as the "seabed and subsoil
of those submarine areas which are adjacent to the territorial waters of the United States, and
over which the United States has exclusive rights, in accordance with international law, with
respect to the exploration and exploitation of natural resources."
20
This economic definition of the United States was first expressed in the Outer Continental

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 Shelf Lands Act of 1954, which extended federal legal and political jurisdiction to the subsoil and
seabed of the outer continental shelf and all artificial islands and fixtures thereon (other than a ship
or vessel) (43 USC Section 1331, et seq.). In 1961, the United States ratified the 1958 United
Nations Geneva Convention on the Continental Shelf, which recognizes the right of contiguous
countries to exercise sovereign jurisdiction over the seabed and subsoil of the adjacent continental
shelf to a depth of 200 meters, and beyond that limit to whatever depth permitted the exploitation
of natural resources (15 USC 471). See generally, J. Bischel (ed.), Income Tax Treaties, Ch. 6
(P.L.I. 1978).

This definition also applies to foreign countries and U.S. possessions. Thus, Section 638(2)
provides that the terms foreign countries and U.S. possessions include their adjacent continental
shelf areas. However, in the case of a foreign country, Section 638(2) applies only if the foreign
country exercises taxing jurisdiction over the exploration or exploitation of natural resources of
the continental shelf.
Section 638 generally applies to all of chapter 1 of the Code (Sections 1-1399, dealing with
income taxes), with specific reference made to Sections 861(a)(3) and 862(a)(3), dealing with the
source rules for services. Although the statutory definition expressly applies only to chapter 1 of
the Code, Regs. Section 1.638-1(a) extends it to chapter 2 (self-employment income tax, Section
1401 et seq.), chapter 3 (30% withholding tax imposed on income remitted to nonresidents,
Section 1441 et seq.), and chapter 24 (income tax wage withholding, Section 3401 et seq.). For
the Section 638 definition to apply, however, the activity must involve natural resource
exploration or exploitation of the seabed and subsoil adjacent to the relevant jurisdiction. The
regulations interpret the statutory words "with respect to the exploration and exploitation of
natural resources" to include all persons, property, or activities which are engaged in or "related
to" the exploration for or exploitation of mines, oil, and gas wells and other natural deposits,
whether or not physically upon, connected, or attached to the seabed or subsoil.21 On the other
hand, the regulations limit the term "natural resources" to nonliving resources for which
depletion is allowed under Section 611(a).22 Since fish and other living organisms are not
considered a natural resource for purposes of Section 638, fishing is not included under Section
638.23 It appears that the harvesting of coral, crustacea, mollusks, and sponges (as well as all
nondepletable nonliving substances) are similarly excluded from coverage.24
21
Regs. Section 1.638-1(c)(2), and (3). Rev. Rul. 80-64, 1980-1 C.B. 158 (income received by a
bareboat charterer from nonstationary exploratory drilling in the U.S. outer continental shelf) PLR
7950039 (income from a drill ship).
22
Regs. Section 1.638-1(d).
23
Id.
24
This is the case notwithstanding the nontax jurisdiction exercised over these resources under
the Fishery Conservation and Management Act of 1976. 16 USC Section 1801 et seq. Under the
Act, the United States asserts exclusive fishery management authority over all fish (except highly
migratory fish) within a zone extending 200 nautical miles from its territorial coastline, over the
migratory range of all U.S. fresh water spawning fish, and over all immobile organisms attached to
the submarine surface of the U.S. outer continental shelf, including coral, crab, lobster, abalone,
conch, surf clam, quahog, and sponges.

Also excluded from coverage by Section 638 is income from the operation of aircraft or ships
for the transportation of passengers or cargo,25 from tugboat or towing operations,26 bareboat
charter hire (generally),27 and other activities or income from property that do not relate to the
exploration for or exploitation of the submarine seabed or subsoil. Such income nevertheless
could be sourced to the United States in whole or in part under either the transportation income

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rules of Section 863(c) or the ocean activity rules of Section 863(d), as discussed below at IX
and X, respectively.
25
Rev. Rul. 72-495, 1972-2 C.B. 414. Such income may be exempt under Section 883(a).
Compare Rev. Rul. 74-170, 1974-1 C.B. 175 with Rev. Rul. 80-64, 1980-1 C.B. 158 (the Section
883(a) exemption of shipping income applies only to the transportation of passengers and cargo
and not to the operation of a drill ship). See also Art. 4A of U.S.-Norway tax treaty, as amended by
Sept. 19, 1980 Protocol.
26
Cf. Plaisance v. U.S., 433 F. Supp. 936 (E.D. La.1977).
27
But see PLR 8507004 (covered if servicing offshore drilling platforms on the continental
shelf).

Many28 but not all29 U.S. income tax treaties signed since 1970 define the respective
jurisdictions to include their respective continental shelves. The treaty definitions differ in certain
aspects from Section 638, primarily in the omission of the Code requirement that a foreign
country exercise taxing jurisdiction as a condition to the continental shelf definition applying
with respect to economic activities.30 Otherwise, the treaty definitions have generally been
interpreted similarly to Section 638. Thus, the Treasury Department explanation of the
continental shelf provision in Article 2 of the Norwegian treaty states that the definition
"follows" Section 638, and that under this extension of territorial jurisdiction the "income earned
by a ship and its crew engaged in taking seismographic soundings on the United States
continental shelf will be treated for tax purposes the same as the income from a comparable
activity on the land of one of the United States."31 Similarly, in explaining the treaty with the
former Soviet Union, the Joint Committee on Taxation stated that, since the Code's continental
shelf provision applies only to mines, oil and gas wells, and other natural deposits, the treaty
provision will be similarly limited in "practical operation."32
28
See, e.g., treaties with Australia (Art. 3(1)(j)(ii)(B). and (k)(vi)) (1982); Barbados (Art. 3(1)
(a)) (1984); Belgium (Art. 3(1)(a)(ii), (b)(ii)) (1970); Canada (Art. III(1)(a), (b)(ii)) (1980); China
(Art. 3(1)) (1984); Cyprus (Art. 2(1)) (1984); Denmark (Art. 3(1)(f), (g)) (1994); Egypt (Art. 2(1))
(1980); France (Art. 3(1)(b), (c)) (1994); Iceland (Art. 2(1)(a), (b)) (1975); India (Art. 3(1)(a), (b))
(1989); Indonesia (Art. 3(1)(a), (b)) (1988); Italy (Art. 3(1)(f), (g)) (1984); Jamaica (Art. 3(1)(f),
(g)) (1980); Japan (Art. 3(1)(a), (b)) (2003); Morocco (Art. 2(1)(a), (b)) (1977); New Zealand
(Art. 3(1)(g), (h)) (1982); Norway (Art. 2(1)(a), (b)) (1971); Poland (Art. 3(1)(a), (b)) (1974);
Romania (Art. 2(1)(a), (b)) (1973); South Korea (Art. 2(1)(a), (b)) (1976); Spain (Art. 3(1)(a), (b))
(1990); Trinidad and Tobago (Art. 2(1)(a), (b)) (1970); Tunisia (Art. 3(1)(e), (f)) (1985); U.S.S.R.
(Art. 11(1), (2)) (1973); U.K. (Art. 3(1)(h), (i)) (2001).
29
No reference to the continental shelf is made in the treaties with Finland (1989), Germany
(1989), Japan (1971), the Philippines (1976) or Sri Lanka (1985). In addition, no reference is made
in either the 1977 or the 1981 U.S. model treaty. But see Art. 3(1)(f) of the U.S. Model Treaty of
1996 (including seas, sea bed, and submarine subsoil over which the United States exercises
sovereign rights).
30
Under the Chinese treaty, however, recognition of the Chinese continental shelf is
conditioned upon Chinese tax laws in fact being in force with respect thereto.
31
CCH Tax Treaties Para.7042. A September 19, 1980, Protocol to the treaty added Article 4A,
pursuant to which the following tax consequences apply to various activities (not including
shipping, aircraft, and tug transportation) carried on by a resident of one treaty country in
connection with the exploration for or exploration of natural deposits of the seabed and subsoil
situated in the other treaty country:
(i) Such activities exceeding 30 days in any 12-month period shall constitute a permanent establishment or fixed
base in the other country.
(ii) Wages received by nonresident employees in connection with such activities are taxable to the extent the
wages are attributable to 60 or more days of employment within the taxable year in the other country.

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 32
1976-2 C.B. 471.

The IRS has ruled privately that Section 638 applies in construing the term "United States"
for treaty purposes even in the case of treaties entered into before the enactment of Section 638. 33
Presumably, no such result could be reached with respect to treaties signed after 1969 that fail to
make reference to the continental shelf, at least to the extent such failure was intended by the
contracting nations.
33
See TAM 8424007 (construing the term "United States" by reference to the Submerged Lands
Act of 1953, and the Continental Shelf Lands Act of 1953, as amended).

II. Interest Income

The source of income rules for interest payments are contained generally in Sections 861(a)
(1), 862(a)(1), and 884(f)(1). In the discussion below, the general operative rule and various
exceptions are set out, followed by an analysis of the scope of the term "interest," the
determination of the obligor's residence, special issues concerning the identity of the obligor, and
the effect that distribution of interest income through an entity has on its source.
In many cases, interest from a U.S. source paid to a foreign person is exempt from U.S. tax
under the "portfolio interest" exemption.34 In addition, interest paid on deposits with certain
financial institutions may be exempt from tax provided the deposit is not effectively connected
with a trade or business of the payee in the United States.35 If interest is considered effectively
connected with a trade or business of the payee, it is taxable to the payee on a net income basis,
and (assuming the payee timely provides IRS Form 4224 to the payor) withholding will not be
required. If a statutory exception does not apply, the interest is subject to tax at a 30% rate
(unless reduced or eliminated by treaty) under Code Sections 871(a) and 881. This amount is
required to be withheld under Sections 1441 and 1442.
34
See §§871(h) and 881(c). "Portfolio interest" means any interest (including OID) which is
paid on a registered obligation for which the beneficial owner has provided the U.S. payor with a
statement, signed under penalties of perjury, identifying the beneficial owner and certifying that
the owner is not a U.S. person (normally by submitting a Form W-8) or which is paid on bearer
debt described under Section 163(f)(2)(B). See Sections 871(h)(2), (6); Temp Regs. Section
35a.9999-5(b) (rules relating to registered obligations). Portfolio interest does not include interest
received (i) by a person owning, directly or indirectly, at least 10% of the voting stock of the
corporate debtor or of the capital or profits interests in a debtor partnership; (ii) by a bank on an
extension of credit (other than to the United States) pursuant to a loan agreement entered into in
the ordinary course of business, (iii) by a CFC from certain related persons, or (iv) on obligations
issued before July 19, 1984. See §§871(h)(3) and 881(c)(3).
35
See Sections 871(i), 881(d).

A. General Rule -- Residence of Obligor

As a general rule, the place of residence of the obligor may be considered to determine the
source of interest income (treating, for purposes of the general rule, a corporation as resident
where it is incorporated). Section 861(a)(1) provides that, subject to limited exceptions, interest
on obligations of the following is considered to be from U.S. sources: (A) the United States or
the District of Columbia, (B) "domestic corporations," and (C) "noncorporate residents." Section
862(a)(1) on its face deems all other interest to be from foreign sources. A major exception,
however, is the source of interest incurred by a U.S. branch of a foreign corporation under
Section 884(f) (see II, B, 2, below).

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 10

 The regulations define the Section861(a)(1) categories of persons deemed to pay U.S. source
interest as follows:
(i) The "United States or the District of Columbia" includes the United States or any agency
or instrumentality thereof (other than a possession or any agency or instrumentality thereof),
a state or any political subdivision thereof, or the District of Columbia.36
(ii) A domestic corporation is a corporation organized in or under the laws of one of the 50
states or the District of Columbia.37 (In addition, under Section 884(f)(1), a foreign
corporation engaged in a trade or business in the United States is in effect treated as a
resident for purposes of characterizing interest paid by such U.S. trade or business, as well as
certain "excess interest," as from U.S. sources.)38
(iii) The term "noncorporate residents" includes, first, a resident individual.39 Interest paid by
a U.S. citizen who is not a U.S. resident at the time the interest is paid is thus treated as
foreign source interest under Section 862(a)(1). Also, residents of U.S. possessions are
deemed to be residents of foreign countries, so interest paid by a resident of a possession is
not from U.S. sources.40
(iv) Based on the pre-TRA 86 regulations,41 the term "noncorporate residents" apparently
includes a domestic or foreign partnership which at any time during its taxable year is
engaged in a trade or business in the United States. Thus, interest paid by a partnership
(whether domestic or foreign) likely will be considered U.S. source if the partnership is
engaged in a trade or business in the United States at any time during the taxable year. For
taxable years beginning after 2003, if the partnership is foreign and predominantly engaged
in the active conduct of a trade or business outside the United States, the interest is U.S.
source only when either paid by a trade or business engaged in by the partnership in the
United States or allocable to income which is effectively connected (or is treated as
effectively connected) with the conduct of a trade or business in the United States. See
§861(a)(1)(C), enacted by §410 of P.L. 108-357, the American Jobs Creation Act of 2004.
These rules concerning the residence status of the obligor are discussed in greater detail at II, D,
below.
36
Regs. Section 1.861-2(a)(1).
37
Section 7701(a)(4).
38
See II, B, 2 and fn. 122 below. The Section 861 regulations also refer to a foreign corporation
that at any time during its taxable year is engaged in trade or business in the United States. Regs.
Section 1.861-2(a)(2). This reference predates TRA 86, which changed the statutory term
"residents, corporate or otherwise" to "noncorporate residents or domestic corporations";
consequently, the reference to foreign corporations engaged in trade or business in the United
States is no longer relevant under Section 861(a)(1).
39
See Regs. Section 1.861-2(a)(2).
40
See, e.g., PLR 9151038(interest and OID paid by an entity organized under Puerto Rican law
to electing Section 936 corporations qualified as income from Puerto Rican sources, provided that
certain requirements are met, including that the entity is a single-purpose entity under Regs.
Section 1.936-10(c)(3)(iii).
41
Regs. Section 1.861-2(a)(2). But cf. Section 988(a)(3)(B)(partnership residence for foreign
currency purposes).

In determining the source of interest, the place where the interest is paid,42 the place where
the debt is incurred, the source of funds with which the debt is paid, and the place where the

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 11

security, if any, is physically located are not relevant.43
42
See Regs. Section 1.861-2(a)(3); A.C. Monk & Co., Inc. v. Comr., 10 T.C. 77, 82-83 (1948).
43
A.C. Monk & Co., 10 T.C. at 82-83.

Example: A domestic corporation has two branches, a U.S. branch that consistently generates
40% of its gross income and a Hong Kong branch that consistently generates 60% of its gross
income. Interest paid by the Hong Kong branch to a Hong Kong sales agent from a bank
account with funds earned in Hong Kong is considered to be from U.S. sources.44
44
Id.

In the case of individuals, residency is tested at the time the interest is paid.45 In the case of
interest taking the form of original issue discount46 accruing on an instrument while the
instrument is held by a foreign person, the determination of source is made at the time an amount
corresponding thereto is paid or, if the instrument is sold or exchanged, at the time of the sale or
exchange (which is the time the foreign creditor would take the amount into income), as if such
payment or such sale or exchange involved the payment of interest.47 In the case of a partnership,
as noted above, the partnership's status as engaged in a trade or business in the United States is
relevant on each day of the year.48
45
Regs. Section 1.861-2(a)(2).
46
As discussed in II, C, below, original issue discount is considered interest for purposes of
Section 861(a)(1).
47
Section 871(g)(3). The Treasury Department may provide otherwise by regulation. Id.
48
Regs. Section 1.861-2(a)(2).

B. Exceptions to the General Rule

As noted above, the general rule is that the source of interest income in the hands of the
obligee is attributed to the residence (or place of incorporation) of the obligor. There are certain
statutory and nonstatutory exceptions to, and variations on, this general rule.
1. U.S. Debtor with 80% Active Foreign Business Income
Interest paid by a resident alien or domestic corporation deriving substantially all of his or its
gross income from an active foreign business may be treated as from foreign sources under the
rules described below.
a. General
Under Sections861(a)(1)(A) and 862(a)(1), interest paid by a U.S. resident alien or a
domestic corporation is recharacterized as foreign source income to the recipient in whole or in
proportionate part if the resident alien or domestic corporate obligor meets the 80% foreign
business requirements of Section 861(c)(1). In general, the Section 861(c)(1) requirements are
satisfied if it is shown to the satisfaction of the Secretary of Treasury that at least 80% of the
gross income from all sources of the resident alien or domestic corporation for the relevant
"testing period" is "active foreign business income." For this purpose:
(i) "Active foreign business income" is gross income which is derived from sources outside
the United States and "is attributable to the active conduct of a trade or business in a foreign
country or possession of the United States" by the resident alien or domestic corporation.49

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 12

 For purposes of determining whether income is "active," the law developed under Section
355 may be helpful, at least until regulations are issued under Section 861(c).
(ii) The "testing period" is the three-year period ending with the close of the taxable year of
the resident alien or domestic corporation immediately preceding the payment. 50 If the
resident alien or domestic corporation has no gross income for such three-year period, the
testing period is the taxable year in which the payment is made.
49
Section 861(c)(1)(B). Under a transitional rule that applied to any payment made by a
domestic corporation in a taxable year starting before 1988, the active-business requirement did
not apply to the domestic corporation's gross income for taxable years beginning before 1987.
TRA 86, Section 1214(d)(3)(A).
50
Section 861(c)(1)(C). Under a transitional rule, the testing period did not include any taxable
year beginning before 1987. TRA 86, Section 1214(d)(3)(B).

For purposes of the 80% active foreign business requirement, the source and character of
income derived by a lower-tier corporation (domestic or foreign) and paid to an upper-tier
corporation (as, e.g., dividends, interest, rents, or royalties) passes through to the upper-tier
corporation, provided the upper-tier corporation owns, directly or indirectly, at least 50% of both
the voting power and value of the stock of the lower-tier corporation (disregarding preferred
stock described in Section 1504(a)(4)).51 Thus, where a qualifying lower-tier corporation makes,
e.g., a dividend distribution or interest payment to an upper-tier corporation, the active foreign
business character of the lower-tier corporation's income flows through to the upper-tier
corporation for purposes of determining the source of a dividend distribution made by the upper-
tier corporation.
51
Section 861(c)(1)(B); Staff of the Joint Committee on Taxation, General Explanation of the
Tax Reform Act of 1986 (May 4, 1987) (hereinafter TRA 86 Blue Book) (reproduced in the
Worksheets, below).

When the domestic corporation paying the dividends is the surviving corporation in a
reorganization with another domestic corporation, it must take into account the total gross
income of the target corporation, as well as its own, for the purpose of applying the 80% test of
Section 861(c).52
52
See Rev. Rul. 76-300, 1976-2 C.B. 217.

If a domestic corporation joins other domestic corporations in filing a consolidated return, the
80% test is applied on the basis of the joining corporation's own gross income only, which
includes, for this purpose, income otherwise deferred or eliminated in the consolidated return. 53
53
See Rev. Rul. 72-230, 1972-1 C.B. 209.

If the 80% test is met, then, other than in the case of a related person (discussed below), all of
the interest paid by the taxpayer will be treated as from foreign sources. If the 80% test is missed,
even by only $1, none of the interest paid by the taxpayer is foreign source. Thus, the test
generally is an "all or nothing" test.
The President's Budget FY 2000 Proposal, which was not enacted, contained a provision that
would have eliminated the ability to manipulate the 80/20 rules by applying the 80/20 test on a
group-wide basis. A group would be defined to include the U.S. corporation making the payment,
in addition to any subsidiary of which the U.S. corporation owned, either directly or indirectly, at

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 13

least 50% of the stock of the subsidiary.
The Proposal appeared to be responsive to certain transactions designed to permit large
payments to be treated as foreign source payments under the 80/20 test and thereby avoid the
U.S. 30% withholding tax. Such a transaction is described in FSA 199926011. Under the facts of
that FSA, a large foreign corporation sequentially incorporates a top-tier U.S. holding company
each year. Although the U.S. affiliated group had a significant amount of earnings and profits, the
subsidiaries only distributed a small dividend to the U.S. holding company. Then, in the
subsequent year, a large dividend was distributed to the U.S. holding company, which, in turn,
distributed that amount to the foreign parent. Because the "testing period" under §861(c)(1)(C) is
defined as the three-year period ending with the close of the taxable year preceding the year in
which the payment is made, by limiting the amount of the U.S. source dividends paid to the
holding company in the testing period, the 80/20 test could be met even though the amount paid
in the year following the testing period was not active foreign business income as defined under
§861(c)(1)(B).
The FSA applies §269 and asserts that the §1442 withholding tax is due on the actual
dividend distributions made to the foreign parent. The FSA found that the principal purpose of
the transactions described in the FSA was the evasion or avoidance of federal income tax. The
FSA determined that the "allowance" requirement of §269 was met because the term refers to
anything in the Code that has the effect of diminishing tax liability and includes an exemption or
an exclusion.
Note: The active foreign business exception to the general rule of residency contained in
§861(a)(1)(A) does not refer to U.S. citizens or to partnerships (nor did its statutory or
regulatory predecessors). Consequently, it appears that interest paid by a U.S. citizen or a
partnership (domestic or foreign), as opposed to interest paid by a resident alien or domestic
corporation, is entirely U.S. source income, even if all or nearly all of its gross income were
active foreign business income. This distinction seems highly questionable from a policy
standpoint. Section 410 of P.L. 108-357, the 2004 American Jobs Creation Act, addressed this
by providing that for taxable years beginning after 2003 the interest on obligations of a
foreign partnership predominantly engaged in the active conduct of a trade or business
outside the United States is U.S. source only if paid by a U.S. trade or business conducted by
the partnership or allocable to income treated as effectively connected with the conduct of a
trade or business within the United States. The implication remains that interest is always
U.S. source if it arises from obligations of a foreign partnership that is predominantly
engaged in business within the United States or from obligations of a domestic partnership.
b. Look-Through Limitation for Interest Paid to Related Person
Section 861(c) limits the foreign source characterization of interest under the 80% active
foreign business rule where related persons receive interest that is foreign source on a "look-
through" basis. In particular, in the case of interest received by a related person from a resident
alien or domestic corporation meeting the 80% foreign business requirement test, §861(a)(1)
applies only to that percentage of such interest that is equal to the percentage which the gross
income of the obligor for the three-year testing period from sources outside the United States is
of the total gross income of the obligor for such period. The purpose of this look-through
limitation is to prevent a related-party creditor of a domestic corporation earning foreign source

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 14

income from shifting, within the 20% limitation, assets generating U.S. source income into the
corporation.
For purposes of the look-through limitation, the term "related person" generally means a
person who owns, is owned by, or is commonly owned with (applying the §958 attribution rules),
the person making the payment, to the extent of
(i) in the case of a corporation, at least 10% of the combined voting power of all classes of
voting stock or at least 10% of the total value of the stock of the corporation, and
(ii) in the case of a partnership, trust, or estate, at least 10% of the total value of the beneficial
interests of the entity.54
54
See §§861(c)(2)(B), 954(d)(3) ("related person" has the same meaning as such term is given
in §954(d)(3), except that (A) such subsection is applied by substituting the "individual or
corporation making the payment" for "controlled foreign corporation" each place that such term
appears, and (B) such section is applied by substituting "10% or more" for "more than 50%" each
place such percentage appears).

Historical Note: Before TRA 86, interest paid by a resident alien or a domestic corporation
was foreign source income to the recipient if less than 20% of the gross income of such
individual or corporation was derived from U.S. sources for the three-year period preceding the
taxable year of the individual or corporation in which the interest was paid (or such shorter
period as was applicable).55 There was neither an active foreign business requirement nor a look-
through rule.
55
§ 861(a)(1)(B) (as in effect before amendment by TRA 86).

Historical Note: Before certain statutory and regulatory changes in the early 1980's, a
domestic corporation could set up a wholly owned finance subsidiary in certain U.S. possessions
(e.g., Guam) and obtain financing free of U.S. withholding tax based on the interaction of the
U.S. tax system and the "mirror" tax systems of such possessions. For example, the U.S.
company would pay interest on indebtedness to the Guam subsidiary, which was exempt from
U.S. tax since §881(b), as in effect at that time, provided simply that a foreign corporation does
not include a Guam corporation. The Guam subsidiary would in turn pay interest on indebtedness
to a foreign corporate lender; the Guam subsidiary would derive almost all of its income in the
form of U.S. source interest income, making the interest payments made by the Guam subsidiary
to the foreign lender exempt from Guam withholding tax as foreign source income under the
"80-20" test. On December 28, 1982, the IRS issued former Regs. §4a.861-1, which changed this
result by converting the U.S. source interest income into Guam source interest income, thus,
preventing the Guam corporation from meeting the "80-20" test.56
56
For purposes of the "80-20" test, former Regs. §4a.861-1 treated interest income derived
from Guam, the Northern Mariana Islands, or the U.S. Virgin Islands as U.S. source income if
such income was not subject to tax by the source jurisdiction. Under the mirror image of former
Regs. §4a.861-1, interest income derived from the United States by a Guam, a Northern Mariana
Islands, or a U.S. Virgin Islands resident became Guam, Northern Mariana Islands, or U.S. Virgin
Island source income, respectively, if such income was not subject to a withholding tax by the
United States. See Rev. Rul. 83-9, 1983-1 C.B. 126; Rev. Rul. 83-10, 1983-1 C.B. 127.

The government of Guam disputed the IRS' authority to issue former Regs. §4a.861-1.
Accordingly, on November 22, 1983, it filed a petition with the District Court of Guam for

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 15

declaratory and injunctive relief. Congress, however, provided a legislative remedy to the
problem, by amending §881(b) and §1442(c).57 In view of these amendments, the IRS withdrew
former Regs. §4a.861-1.58
57
TRA 84, §130. Under §881(b), for purposes of the withholding tax imposed on U.S. source
passive income and the branch profits tax under §884, a corporation created or organized in Guam,
American Samoa, the Northern Mariana Islands, or the Virgin Islands is treated as a domestic
corporation (and therefore no withholding tax is imposed) only if the following three conditions
are met:
(i) at all times during the taxable year less than 25% in value of the stock of the corporation is owned (directly
or indirectly) by foreign persons;
(ii) at least 65% of the gross income of such corporation is effectively connected with the conduct of a trade or
business in such a possession or in the United States for the three-year period ending with the close of the
corporation's taxable year; and
(iii) no substantial part of the income of such corporation is used (directly or indirectly) to satisfy obligations to
persons who are not bona fide residents of such a possession or the United States. A parallel rule is provided in
§1442(c).
58
See T.D. 8108.

2. Foreign Corporate Debtor Engaged in U.S. Trade or Business

Interest income received from a foreign borrower may be treated as U.S. source income as a
result of the application of the branch profits tax sourcing rule. Interest paid or payable by a
foreign corporation that is engaged in a U.S. trade or business at any time during its taxable year
in which the interest is paid or is payable, or that has income deemed effectively connected with
a U.S. trade or business during such year, may be treated under §884(f)(1) as U.S. source income
in whole or in part.59 If a foreign corporation was engaged in a U.S. trade or business but ceased
to be so engaged (or to have income deemed to be effectively connected) prior to the
commencement of a taxable year, interest paid by it during such year will be treated as foreign
source income.59.1
59
In addition, as discussed in II, B, 2, c, below, if such allocable interest as determined under
Regs. §1.882-5 applicable to such U.S. trade or business exceeds the branch interest as determined
under Regs. §1.884-4(b), an additional tax of 30% is imposed on such excess interest.
59.1
This result may also be inferred from §884(f)(1)(A) which treats only interest paid by the
U.S. trade or business and an amount corresponding to certain interest deductions claimed by such
a trade or business, as from U.S. sources. Treatment of the interest paid as foreign source is also
subject to the proviso that in the year that the foreign corporation ceased to be engaged in its U.S.
trade or business, it has effectively terminated its U.S. for purposes of the branch profits tax
regime. For a discussion of the requirements to terminate a U.S. branch, see 909 T.M., Branch
Profits Tax.

Historical Note: Before the enactment of §884 as part of TRA 86, §86l(a)(1)(C), as in effect
prior to TRA 86, provided that, if a foreign corporation was engaged in a U.S. trade or business
and a substantial portion (i.e., 50% or more) of its worldwide gross income for the prior three-
year (or shorter applicable) period was effectively connected with its U.S. trade or business, then
a corresponding portion of the interest payments made by the corporation was deemed to be from
U.S. sources. An analogous but somewhat different exception applied where the obligor was a
foreign corporation's U.S. branch engaged in the commercial banking business.59.2
59.2
Former §861(a)(1)(F), as in effect before TRA 86.

Accordingly, a basic understanding of the branch profits tax regime is important in assessing

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 16

the impact of these rules on the sourcing of interest expense incurred by a foreign corporation
doing business in the United States and is discussed in the following section.59.3
59.3
A foreign corporation engaged in a trade or business in the United States is also subject to
regular corporate tax on its income effectively connected with such trade or business. See §882(a)
(1). In addition, a branch profits tax of 30% is also imposed on the dividend equivalent amount,
that is the foreign corporation's adjusted-effectively connected earnings and profits from such
trade or business. See §884(a).

a. Branch Interest (Interest Paid by Domestic Branch)

Interest considered "paid" by a "trade or business60 in the United States" of a foreign
corporation (referred to as "branch interest") is treated as if paid by a domestic corporation under
§884(f)(1)(A) (without regard to the 80% active foreign business income exception of §861(c)
(1)),61 and hence is treated as from U.S. sources. As in the case of other U.S. source fixed or
determinable annual or periodical income, absent statutory or treaty exceptions, U.S. tax would
be imposed on a gross income basis at a 30% rate under §§871(a)(1) and 881(a), and withholding
would be required under §§1441 and 1442. Regulations under §884(f), however, state that the
normal statutory exemptions from U.S. tax may apply: in particular, the portfolio interest
exemption (§§871(h) and 881(c)) and the exemption for certain bank and other deposits
(§§871(i) and 881(d)).62 Alternatively, the interest may be effectively connected with a U.S. trade
or business of the obligee, in which case it would be taxable on a net, rather than gross, income
basis and, provided that IRS Form W-8ECI 62.1 is timely furnished to the payor, withholding
would not be required. In addition, exemptions or reduced rates of tax may be available under
income tax treaties.63
60
Whether the conduct of a particular activity constitutes a trade or business is a significant
determination for purposes of applying the branch profits tax. There are statutory and regulatory
safe harbor exceptions for trading in stocks and securities, which provides foreign corporations
with more certainty concerning the type and level of securities investment activities that will
constitute a U.S. trade or business. See §864(b)(2)(A)(i) (broker-dealer trading); §864(b)(2)(A)(ii)
(trading for own account); Regs. §1.864-2(c). Similar exceptions apply for commodities trading.
See §864(b)(2)(B); Regs. §1.864-2(d). For more discussion of the trade or business issue as well
as the branch profits tax regime, see 909 T.M., Branch Profits Tax.
61
Regs. §1.884-4(a)(1). See generally 909 T.M., Branch Profits Tax.
62
Regs. §1.884-4(a)(1).
62.1
Form 4224 was replaced by Form W-8ECI although for 2001, the IRS permitted certain
payors to continue to use the old form, see Section V.A., Notice 2001-4, 2001-2 I.R.B. 267.
63
Regs. §§1.884-4(a)(1), (b)(8). In the case of U.S. source interest paid to a corporation that is
a resident of a foreign country with which the United States has an income tax treaty, treaty
exemptions or reductions are available under such treaty only if the corporation is a "qualified
resident" of such country. See §884(f)(3)(B). Similarly, if U.S. source interest is paid by a foreign
corporation that is a resident of a foreign country with which the United States has an income tax
treaty that on its face exempts interest paid by such a corporation from U.S. withholding tax, the
treaty may be relied upon only if the corporation is a "qualified resident" of such foreign country.
See §884(f)(3)(A). In order to be considered a qualified resident, the corporation must satisfy one
of the following treaty-shopping tests set forth in Regs. §1.884-5: (1) demonstrate in the manner
set forth in the regulations that it is at least 50% owned (directly or indirectly) by individuals who
are either residents of its country of residence or citizens or residents of the United States, and that
less than 50% of its income is used (directly or indirectly) to meet obligations to persons who are
not residents (or, in the case of corporations, "qualified" residents) of its country of residence or
citizens or residents (or, in the case of corporations, "qualified" residents) of the United States; (2)
be primarily and regularly traded on an established securities market in its country of residence or
in the United States; (3) be engaged in the active conduct of a trade or business in its country of

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 17

 residence; or (4) obtain a ruling that it will be treated as a qualified resident.

A foreign corporation is treated as engaged in a trade or business in the United States for this
purpose if it (A) is engaged in trade or business in the United States or derives gross income
during the taxable year that is effectively connected (or deemed effectively connected) with the
conduct of a trade or business in the United States, or (B) owns, at any time during the taxable
year, an asset taken into account under Regs. §1.882-5(a)(1)(ii) or 1.882-5(b)(1) (referring to
assets that generate or may generate effectively connected income) for purposes of allocating
interest expense and the interest apportioned by reference to the value of such asset provides in
any taxable year a tax benefit for U.S. tax purposes.64
64
Regs. §1.884-4(a)(1).

(1) Branch Interest -- Definition

Branch interest is interest paid by a foreign corporation (except a foreign corporation that
maintains a federal branch, federal agency, state branch, or state agency (as defined in §1(b) of
the International Banking Act of 1978 (i.e., a foreign bank)) with respect to a liability: 65
(i) that is a U.S. booked liability within the meaning of Regs. §1.882- 5(d)(2) (other than a
U.S. booked liability of a partner within the meaning of Regs. §1.882-5(d)(2)(vii)); or
(ii) described in Regs. §1.884-1(e)(2) relating to insurance liabilities on U.S. business and
liabilities giving rise to interest expense that is directly allocated to income from a U.S. asset;
65.1
or
(iii) In the case of a foreign corporation other than a bank,65.2 a liability specifically identified
(as described below) as a liability of a U.S. trade or business of the foreign corporation on or
before the earlier of the date on which the first payment of interest is made with respect to the
liability or the due date (including extensions) of the foreign corporation's income tax return
for the taxable year, provided that (A) the amount of such interest does not exceed 85% of
the amount of interest of the foreign corporation that would be excess interest before taking
into account interest treated as branch interest by reason of this provision; (B) the
requirements relating to notification of recipient of interest are satisfied; and (C) the liability
is not a liability incurred in the ordinary course of a foreign business or secured by foreign
assets.
65
Regs. §1.884-4(b)(1).
65.1
Note in this regard, Rev. Rul. 2003-17, 2003-6 I.R.B.__ (2/10/03) where the IRS ruled
regulatory statutory reporting on the NAIC convention blank is to be given due consideration, but
is not determinative of whether assets are effectively connected to the U.S. branch of a foreign
insurer.
65.2
The term bank means a entity where a substantial part of the business consists of receiving
deposits and making loans and discounts, or of exercising fiduciary powers similar to those
permitted to national banks under authority of the Comptroller of the Currency. See §§585(a)(2)
(B) and 581.

(2) Method of Identification of Liabilities

The regulations provide that a liability is identified as a liability of a U.S. trade or business

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 18

only if the liability is shown on the records of the U.S. trade or business, or is identified as a
liability of the U.S. trade or business on other records of the foreign corporation or on a schedule
established for the purpose of identifying the liabilities of the U.S. trade or business. 65.3
65.3
Regs. §1.884-4(b)(3)(i).

Each such liability must be identified with sufficient specificity so that the amount of branch
interest attributable to the liability, and the name and address of the recipient, can be readily
identified from such records or schedule. However, with respect to liabilities that give rise to
portfolio interest (as defined in §§871(h) and 881(c)) or that are payable 183 days or less from
the date of original issue, and form part of a larger debt issue, such liabilities may be identified
by reference to the issue and maturity date, principal amount and interest payable with respect to
the entire debt issue.66
66
Regs. §1.884-4(b)(3)(i).

The regulations also provide that records or schedules that identify liabilities that give rise to
branch interest must be maintained in the United States by the foreign corporation or an agent of
the foreign corporation for the entire period commencing with the due date (including
extensions) of the income tax return for the taxable year to which the records or schedules relate
and ending with the expiration of the period of limitations for assessment of tax for such taxable
year.67
67
Regs. §1.884-4(b)(3)(i).

(3) Notification to Recipient

The regulations provide that interest with respect to a liability connected with a U.S. trade or
business shall not be treated as branch interest unless the foreign corporation paying the interest
either (A) Makes a return, pursuant to §6049, with respect to the interest payment; or (B) sends
a notice to the person who receives such interest in a confirmation of the transaction, a statement
of account, or a separate notice, within two months of the end of the calendar year in which the
interest was paid, stating that the interest paid with respect to the liability is from sources within
the United States.68
68
Regs. §1.884-4(b)(3)(ii).

(4) Increase in Branch Interest Where U.S. Assets Constitute 80% or More of Foreign
Corporation's Assets
The regulations under §884(f) contain a special rule where the U.S. trade or business
constitutes at least 80% of the foreign corporation's business.69 The regulations provide that if a
foreign corporation would have excess interest before application of this rule and the amount of
the foreign corporation's U.S. assets as of the close of the taxable year equals or exceeds 80% of
all money and the aggregate Earnings and Profits bases of all property of the foreign corporation
on such date, then all interest paid and accrued by the foreign corporation during the taxable year
that was not treated as branch interest before application of this rule and that is not paid with
respect liabilities incurred in the ordinary course of a foreign business or secured by non-U.S.

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 19

assets, will be treated as branch interest. This rule is designed to ensure that interest payments by
a foreign corporation that conducts its business primarily in the United States are treated as being
made from a domestic corporation to the actual recipients of the interest rather than to the foreign
corporation as excess interest.
69
See Regs. §1.884-4(b)(5).

The regulations further provide, however, that if application of the preceding rule would
cause the amount of the foreign corporation's branch interest to exceed the amount permitted,
relating to branch interest in excess of a foreign corporation's interest allocated or apportioned to
ECI under Regs. §1.882- 5, the amount of branch interest arising by reason of this rule is reduced
as discussed below.69.1 The following example is provided in the regulations.
69.1
Regs. §1.884-4(b)(6). These rules are intended to implement the provision in §884(f)(1) that
states, to the extent provided in regulations, interest paid by a domestic branch of a foreign
corporation should not apply to interest in excess of the amounts reasonably expected to be
allocable interest.

Example. Foreign corporation A, a calendar year taxpayer, has $90 of interest allocated or
apportioned to ECI under Regs. §1.882- 5 for 1993. A has $40 of branch interest in 1993. A
pays $60 of other interest during 1993, none of which is attributable to a liability incurred in
the ordinary course of a foreign business and liabilities predominantly secured by foreign
assets. As of the close of 1993, A has an amount of U.S. assets that exceeds 80% of the
money and Earnings and Profits bases of all A's property. Before application of this 80% rule,
A would have $50 of excess interest (i.e., the $90 interest allocated or apportioned to its ECI
under Regs. §1.882- 5 less $40 of branch interest). Under the 80% rule, the $60 of additional
interest paid by A is also treated as branch interest. However, to the extent that treating the
$60 of additional interest as branch interest would create an amount of branch interest that
would exceed the amount of branch interest permitted (relating to branch interest that
exceeds a foreign corporation's interest allocated or apportioned to ECI under Regs. §1.882-
5), the amount of the additional branch interest is reduced, which generally allows a foreign
corporation to specify certain liabilities that do not give rise to branch interest or which
generally specifies liabilities that do not give rise to branch interest beginning with the most-
recently incurred liability.70
70
See Regs. §1.884-4(b)(5)(ii), Example.

Accordingly, if the amount of interest that is paid and accrued by a U.S. trade or business
during a taxable year exceeds the sum of the amount of interest apportioned to U.S. effectively
connected income for the year, the amount of branch interest is reduced by such excess.71 The
regulations provide ordering rules for the reduction in branch interest and an alternative election
to specify certain liabilities that do not give rise to interest paid by the U.S. branch. 72 These rules
also apply where the amount of branch interest with respect to liabilities identified under Regs.
§1.884-4(b)(1) exceeds the maximum amount of identified liabilities that may be treated as
branch interest.73
71
Regs. §1.884-4(b)(6)(i).
72
Regs. §1.884-4(b)(6)(ii), (iii).
73
Regs. §1.884-4(b)(6)(i).

Under certain circumstances, a foreign corporation may elect to treat interest that is paid in a

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 20

taxable year prior or subsequent to the year in which the interest accrues as if it were paid in the
year in which it accrues, and to make a corresponding reduction in the amount treated as excess
interest in the year of accrual.74
74
See Regs. §1.884-4(c).

b. Section 884 Election to Reduce Liabilities

Regulations under §884 (Regs. §1.884-1(e)(3)) contain an election whereby a foreign
corporation may opt to reduce the amount of its U.S.-connected liabilities as of a branch profits
tax determination date. This election is designed to deal with the problematic interaction of the
branch profits tax with the apportionment approach to liability allocation, viz., that a taxable
§884 dividend equivalent amount typically results even if earnings are fully reinvested since a
portion of the earnings (e.g., 95% under the existing fixed ratio for banks) is considered
indebtedness rather than an increase in equity. The election also might be made in order to avoid
a branch profits tax that might result from a temporary delay in reinvesting proceeds from the
sale of a major asset, or from a corporation's accumulation of earnings to expand its U.S. trade or
business.
The election under Regs. §1.884-1(e)(3)(i) permits a foreign corporation to reduce the
amount of its U.S.-connected liabilities as determined for branch profits tax purposes by an
amount that does not exceed the excess, if any, of such liabilities over the amount of liabilities
shown on the books of the U.S. trade or business (determined under (current) Regs. §1.882-5) as
of the last day of the taxable year. The election is made annually and is effective only for the year
for which made.
Of principal interest here, the reduction of U.S. connected liabilities has the collateral effect
of reducing interest treated as U.S. source and subject to the branch level interest tax under
§884(f)(1).

c. Excess Interest under §884(f)(1)(B)

The U.S. trade or business of a foreign corporation may be entitled to a deduction for more
interest than it actually paid because the rules governing the allocation of interest expense of the
foreign corporation between U.S. and foreign sources (Regs. §1.882-5) may result in additional
interest being allocated to the U.S. trade or business. Section 884(f)(1)(B) recharacterized the
portion, if any, of (A) interest apportioned under Regs. §1.882-5 to effectively connected income
of the foreign corporation (after taking into account any reduction pursuant to the election under
Regs. §1.884-1(e)(3)) which exceeds (B) the "branch interest" (interest considered "paid" by the
trade or business in the United States) under the §884(f)(1)(A) rules described above.75 Any such
"excess interest" is treated as if it were paid to such foreign corporation by a wholly owned
domestic corporation on the last day of the foreign corporation's taxable year (without regard to
the 80% active foreign business income exception of Section 861(c)(1)).76
75
Regs. §1.884-4(a)(2)(i). See generally 909 T.M., Branch Profits Tax. In addition, to the extent
provided in Regs. §1.884-4(c)(2), if the foreign corporation is a partner in a partnership engaged in
business in the United States, the corporation's distributive share of interest paid or accrued by the

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 21

 partnership that is considered paid by a U.S. trade or business of the partnership generally reduces
the amount of the corporation's excess interest for the year in which such interest is taken into
account by the corporation for purposes of calculating the interest deduction available to it under
Regs. §1.882-5.
76
Regs. §1.884-4(a)(2)(ii).

Accordingly, any excess interest is treated as paid from U.S. sources. Section 884(f)(1)(B)
causes the foreign corporation to be liable directly under §881(a), rather than as a withholding
agent, for the 30% tax on the gross amount of such excess, except to the extent that either, in the
case of a bank, a portion of the excess is treated as interest on deposits (within the meaning of
§871(i)(3)(B)), and thus exempt from tax under §881(d), or the tax is eliminated or the rate
reduced by income tax treaty.77
77
Regs. §1.884-4(a)(2)(iii). In general, the exemptions under §881 are not applicable. Regs.
§1.884-4(a)(2)(ii). If the foreign corporation is a bank, however, a portion of the excess interest
may qualify for the §881(d) exemption for interest on deposits, which portion shall equal product
of the excess interest and the greater of (1) the ratio of the amount of interest-bearing deposits
(within the meaning of §871(i)(3)(A)) of the foreign corporation as of the close of the taxable year
to the amount of all interest-bearing liabilities of the foreign corporation on such date, or (2) 85%.
Regs. §1.884-4(a)(2)(iii).
The IRS has determined that neither the nondiscrimination provision nor any income tax treaty
provision that exempts or reduces the rate of tax on interest paid by a foreign corporation prevents
application of the tax on excess interest. Regs. §1.884-4(c)(3)(ii), T.D. 8432 (9/10/92); Notice 89-
90, 1989-2 C.B. at 397. An exemption or rate reduction applicable to interest paid by a domestic
corporation to the foreign corporation under the interest provision of a treaty with a country of
which the corporation is a resident is available only if such corporation satisfies certain anti-treaty-
shopping requirements. See §884(f)(3); Regs. §1.884-4(c)(3)(i); and fn. 63, above.

The regulations provide the following application of the excess interest rules in the context of
a non-bank corporation:
Example. Foreign corporation A, a calendar year taxpayer that is not a bank, has $120 of
interest allocated or apportioned to ECI under Regs. §1.882-5 for 1997. A's branch interest
for 1997 is as follows: $55 of portfolio interest to B, a nonresident alien; $25 of interest to
foreign corporation C, which owns 15% of the combined voting power of A's stock, with
respect to bonds issued by A; and $20 to D, a domestic corporation.
B and C are not engaged in the conduct of a trade or business in the United States. A, B and
C are residents of countries with which the United States does not have an income tax treaty.
The interest payments made to B and D are not subject to tax under §871(a) or §881 and are
not subject to withholding under §1441 or §1442.
The payment to C, which does not qualify as portfolio interest because C owns at least 10%
of the combined voting power of A's stock, is subject to withholding of $7.50 ($25 × 30%).
In addition, because A's interest allocated or apportioned to ECI under Regs. §1.882-5 ($120)
exceeds its branch interest ($100), A has excess interest of $20, which is subject to a tax of $6
($20 × 30%) under §881. The tax on A's excess interest must be reported on A's income tax
return for 1997. 77.1

77.1
See Regs. §1.884-4(a)(4), Example 1.

As noted above, for banks a portion of the excess interest may be allocated as interest on

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deposits and the following example is provided in the regulations to illustrate this concept.
Example. Foreign corporation A, a calendar year taxpayer, is a bank and is a resident of a
country with which the United States does not have an income tax treaty. A has excess
interest of $100 for 1997. At the close of 1997, A has $10,000 of interest-bearing liabilities
(including liabilities that give rise to branch interest), of which $8,700 are interest-bearing
deposits. For purposes of computing the tax on A's excess interest, $87 of the excess interest
($100 excess interest × ($8,700 interest-bearing deposits/$10,000 interest-bearing liabilities))
is treated as interest on deposits. Thus, $87 of A's excess interest is exempt from tax under
§881(a) and the remaining $13 of excess interest is subject to a tax of $3.90 ($13 × 30%)
under §881(a). 77.2
77.2
See Regs. §1.884-4(a)(4), Example 2.

d. Effective Dates and Transition Rules

(1) Effective dates. The definition of branch interest and excess interest rules as discussed
above were generally effective for taxable years beginning on or after June 6, 1996.77.3
77.3
See Regs. §1.884-4(e)(2).

(2) Waiver of Notification Requirement for Non-Banks Under Notice 89-80. If a foreign
corporation that is not a bank had made an election under Notice 89-80 to apply the rules in Part
2 of Section I of the Notice in lieu of the rules in former Regs. §1.884-4T(b) to determine the
amount of its interest paid and excess interest in taxable years beginning prior to 1990, the
requirement that the foreign corporation satisfy the notification requirements is waived with
respect to interest paid in taxable years ending on or before the date the Notice was issued.77.4
77.4
See Regs. §1.884-4(f)(2).

(3) Waiver of Legending Requirement for Certain Debt Issued Before January 3, 1989. For
purposes of §§871(h), 881(c), and the regulations, branch interest of a foreign corporation that
would be treated as portfolio interest under §§871(h) or 881(c) but for the fact that it fails to meet
the requirements of §163(f)(2)(B)(ii)(II) (relating to the legend requirement), shall nevertheless
be treated as portfolio interest provided the interest arises with respect to a liability incurred by
the foreign corporation before January 3, 1989, and interest with respect to the liability was
treated as branch interest in a taxable year beginning before January 1, 1990.77.5
77.5
See Regs. §1.884-4(f)(3).

3. Deposits with Foreign Banking or Thrift Branches of Domestic Institutions

A third exception to the general interest source rule treats certain amounts paid by foreign
bank branches or foreign thrift branches of a domestic corporation or partnership as from sources
outside the United States.
(i) Under §861(a)(1)(B)(i), interest on "deposits" with a foreign branch of a U.S. corporation
or partnership is treated as from sources outside the United States if such branch is engaged
in the commercial banking business. It is not necessary that the U.S. corporation or
partnership be engaged in the commercial banking business in the United States.78

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 23

 (ii) Under §861(a)(1)(B)(ii), interest paid by a foreign branch of a domestic partnership or
domestic corporation is treated as from sources outside the United States if paid on "deposits
or withdrawable accounts" with savings institutions chartered and supervised as savings and
loan or similar associations under federal or state law (but only to the extent that amounts
paid or credited on such deposits or accounts are deductible under §591, determined without
regard to §§265 and 291, in computing the taxable income of such institutions). These rules
are essentially continuations of the law as it existed before TRA 86.
78
Regs. §1.861-2(b)(5).

Numerous rulings illustrate amounts considered to represent "deposits" for this purpose.79 For
example, the IRS has ruled that amounts deposited with a domestic international banking
corporation were deposits even though they required 24-hour notice for payment.80
79
See Rev. Rul. 81-30, 1981-1 C.B. 388 (Eurodollar Cds); Rev. Rul. 73-505, 1973-2 C.B. 224
(nonnegotiable time deposits payable in U.S. or foreign currency); Rev. Rul. 72-104, 1972-1 C.B.
209 (time Cds, open account time deposits, and multiple maturity time deposits); Rev. Rul. 70-
436, 1970-2 C.B. 148 (negotiable time deposits of foreign branch); Rev. Rul. 54-623, 1954-2 C.B.
14 (deposits with mutual savings bank). But see PLR 8125040 (a government-chartered private
corporation making loans to banks or savings and loan associations was not a "person carrying on
the banking business" within meaning of pre-TRA 86 §861(c)(1)). Compare Rev. Rul. 83-176,
1983-2 C.B. 111 (interest paid on certain debentures issued by the Federal National Mortgage
Association (FNMA) to nonresident aliens did not qualify for the "bank deposit interest"
exemption since FNMA is subject to supervision and examination by HUD, not the Comptroller of
the Currency) with Rev. Rul. 83-175, 1983-2 C.B. 109 (interest paid by a credit union on a
certificate of deposit to a nonresident alien qualified for the "bank deposit interest" exception since
a credit union is an association "similar" to savings and loan associations).
80
Rev. Rul. 75-449, 1975-2 C.B. 285.

Historical Note: Before TRA 86, interest paid to a nonresident alien or a foreign corporation
on amounts of the type defined as "deposits" under §871(i)(2) of current law was, under
§§861(a)(1)(A) and 861(c) as then in effect, arbitrarily treated as income from foreign sources,
unless such interest was effectively connected with a U.S. trade or business of the recipient.
Similarly, before TRA 86, interest derived by a foreign central bank of issue from bankers'
acceptances was treated as from foreign sources under §861(a)(1)(E), as then in effect. TRA 86
repealed the arbitrary characterization of such interest income as foreign source and instead
provided that no U.S. withholding tax would be imposed on it. (Conforming amendments were
made under §§1441 and 6049(b)(5) to take into account these changes.) The amendments
generally apply to payments made after 1986.81 There are, however, certain transitional rules as
noted above.82
81
TRA 86, §§1214(c), (d)(1).
82
TRA 86, §1214(d)(2)-(4). See fns. 49-50 above.

4. Special Rule for Certain Deposits with Domestic Institutions and Domestic Branches of
Foreign Institutions
Section 871(i) provides that no tax is imposed under §871 on the following amounts of
interest described in §871(i)(2):
(i) Interest on "deposits" (as defined below), if such interest is not effectively connected with
the conduct of a trade or business within the United States; and

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 24

 (ii) Income derived by a foreign central bank of issue from bankers' acceptances. §881(d),
relating to foreign corporations, provides that no tax shall be imposed under §881 on any
amount described in Section 871(i)(2).
The term "deposits" in Section 871(i)(2) includes the following three items.
(a) Deposits with persons carrying on the banking business. The meaning of "deposits" for
this purpose has been elucidated in numerous rulings.83
(b) Deposits or withdrawable accounts with savings institutions chartered and supervised as
savings and loan or similar associations under federal or state law, but only to the extent that
amounts paid or credited on such deposits or accounts are deductible under Section 591
(determined without regard to Sections 265 and 291). Various rulings illustrate qualifying
deposits of this type.84 On the other hand, amounts paid by such associations with respect to
their nonwithdrawable capital stock or with respect to amounts held in restricted accounts
representing proprietary interest are not included.85
(c) Amounts held by an insurance company under an agreement to pay interest thereon. Such
amounts include policy holder's dividends left with the company to accumulate, prepaid
insurance premiums, proceeds of policies left on deposit with the company, and overcharges
of premiums.86 This interest, however, does not include the so-called "interest element" in the
case of annuity or installment payments under life insurance or endowment contracts, and
interest paid to creditors on notes, bonds, or similar instruments if the debtor-creditor
relationship does not arise by virtue of a contract of insurance with the insurance company. 87
83
See 79 above. With regard to Sections 871(i) and 881(d) generally, see 908 T.M., U.S. Income
Taxation of Foreign Corporations; 907 T.M., U.S. Income Taxation of Nonresident Alien
Individuals; 915 T.M., U.S. Withholding and Reporting Requirements for Payments of U.S. Source
Income to Foreign Persons.
84
See fn. 79 above.
85
See Regs. Section 1.861-2(b)(1)(ii).
86
Regs. Section 1.861-2(b)(1)(iii).
87
Id.; see Rev. Rul. 77-231, 1977-2 C.B. 241 (interest paid by insurance company to
reinsurance company on portion of reinsurance premiums retained as security not covered by
former §861(a)(1)(A) and (c)(3) since interest was paid by insured, and not insuring, party).

In the case of deposits with banking and thrift branches described in paragraphs (a) and (b)
above (both of domestic and foreign institutions), the Section 871(i)/Section 881(d) exemption is
primarily of significance to such branches located within the United States, since interest on
deposits with foreign branches generally is considered to be from foreign sources under Sections
861(a)(1)(B) and 862(a)(1).88
88
See II, B, 3, above.

With respect to the exemption for interest derived by a foreign central bank of issue from
bankers' acceptances, the regulations define a foreign central bank of issue as "a bank which is
by law or government sanction the principal authority, other than the government itself, issuing
instruments intended to circulate as currency."89
89
Regs. Section 1.861-2(b)(4).

Historical Note: The Interest Equalization Tax Extension Act of 1971 added Sections 4912(c)

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 25

and 861(a)(1)(G) to the Code to permit a domestic corporation or partnership to borrow from
abroad free of U.S. withholding tax. Under Section 4912(c), a domestic corporation or
partnership could elect to have certain of its obligations treated as debt obligations of a foreign
obligor. Section 861(a)(1)(G) provided that interest paid on certain debt obligations of U.S.
residents covered by a Section 4912(c) election would not constitute U.S. source income. In
1975, Congress added Section 861(a)(1)(H), with the intent of enabling domestic corporations
that were eligible to make a Section 4912(c) election to eliminate their finance subsidiaries
without being subjected to withholding obligations. Section 861(a)(1)(H) provided that interest
paid by a U.S. resident would be foreign source income if such interest was paid on certain debt
obligations that were part of an issue outstanding on April 1, 1971 and treated under the Interest
Equalization Tax provisions as debt obligations of a foreign obligor. These provisions were
eliminated as deadwood in 1990.90
90
Omnibus Budget Reconciliation Act of 1990, P.L. 101-508, Section 11801(a)(29).

5. Exception for Foreign Tax Credit Purposes Where Obligor Is U.S.-Owned Foreign
Corporation with Significant U.S. Income
This special rule is discussed in III, B, 7, below.
6. Exception for Accumulated Earnings Tax Purposes
This special rule, which can apply for purposes of the accumulated earnings tax of Section
531 if the obligor is a foreign corporation with significant U.S. source or effectively connected
income and the obligee is a U.S.-owned foreign corporation, is discussed in III, B, 8, below.
7. Foreign Partnership Debtor Engaged in Both U.S. and Foreign Business Operations
Section 861(a)(1)(C), added by §410 of P.L. 108-357 (the 2004 American Jobs Creation Act),
provides that for taxable years beginning after 2003 the interest received by a creditor on
obligations of a foreign partnership predominantly engaged in the active conduct of a trade or
business outside the United States is U.S. source income unless the interest is neither paid by a
U.S. trade or business conducted by the partnership nor allocable to partnership income treated
as effectively connected with the conduct of a trade or business within the United States. All
other interest paid or incurred by such a partnership would be treated as foreign source income to
the recipient. As the legislative history indicates, this is designed to provide consistent treatment
of interest payments by foreign debtors engaged in U.S. business regardless whether the debtor is
a foreign corporation or a foreign partnership. These rules are fully discussed at II, B, 2, above.
This places particular significance on whether the partnership is organized under domestic law,
which is not always clear. This rule has no application to a domestic partnership (that is, one
formed under domestic law).
C. Definition of Interest
The source rules described herein apply to "interest" that is includible in gross income.
1. General
Interest has been broadly defined as amounts paid for the use of money voluntarily loaned or
for the involuntary retention of money or property.91 For purposes of Section 861(a)(1), interest
includes (i) original issue discount, as defined in Section 1273(a)(1), and (ii) amounts treated as

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 26

interest under Section 483 and the regulations thereunder.92 Under the original issue discount
rules, interest is imputed with respect to certain debt instruments in an amount equal to any
excess of the stated redemption price at maturity over its "issue price," and such excess ("original
issue discount") generally must be included in income over the term of the instrument 93 (though,
in the case of nonresident aliens and foreign corporations not holding the instrument in
connection with a U.S. trade or business, not prior to payment on or sale or exchange of the
instrument).94 Under Section 483, the excess of the sum of the payments due under certain
contracts over their present value using a prescribed rate ("total unstated interest") must be
included in income over the term of the obligation in accordance with original issue discount
rules.95
91
Dailey, "The Concept of the Source of Income," 15 Tax L. Rev. 415 (1960); see Regs. Section
1.61-7 generally for types of income treated as interest, including the portion of proceeds from the
sale of a bond attributable to accrued unpaid interest.
92
Regs. Section 1.861-2(a)(4), as proposed to be amended; PLR 8802038.
93
See generally 535 T.M., Time Value of Money: OID and Imputed Interest.
94
See Sections 871(a)(1)(C), 881(a)(3), 871(g)(3).
95
See generally 535 T.M., Time Value of Money: OID and Imputed Interest.

Interest also includes interest imputed under Section7872, which generally provides for
interest at not less than the "applicable Federal rate" on loans with "below-market" interest rates
in certain contexts (e.g., loans by an employer to an employee, between a corporation and a
shareholder, between relatives, and for tax avoidance purposes). In the case of a loan payable on
demand or a gift loan, the "foregone interest" is deemed paid by the obligor to the obligee on the
last day of the year.96 In the case of a term loan, the excess of the amount loaned over the present
value of all payments required to be made under the loan is considered transferred to the obligee
at the commencement of the loan (e.g., in the case of a loan by an employer, as compensation),
and the amount equal to such excess is taken into account by the parties as interest over the term
of the loan in accordance with the original issue discount rules.97 If, however, the obligor is a
U.S. person and the obligee is not, interest is not imputed under Section 7872, unless the interest
income would be effectively connected with a U.S. trade or business of the obligee and not
exempt under an income tax treaty or the loan is a compensation-related loan or a corporation-
shareholder loan where the borrower is a shareholder that is not a C corporation (as defined in
Section 1361(a)(2)).98 Interest also is not imputed if both the borrower and lender are foreign
persons, unless the interest income would be effectively connected with a U.S. trade or business
of the obligee and not exempt under a treaty.99
96
Section 7872(a).
97
Section 7872(b).
98
Regs. Section 1.7872-5T(c)(2).
99
Id.

A production payment "carved out" of mineral property is treated as a mortgage loan on the
property under Section 636(a), and a production payment retained on the sale of real property is
treated as a purchase money mortgage on the property under Section 631(b). Accordingly, that
portion of such production payments that is treated as interest under the imputed interest
provisions is includible in gross income as interest.
Income derived by the seller of securities in sale and repurchase transactions ("repos") has
been characterized as interest from a loan collateralized by such securities, although the IRS has

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requested comments on whether such income should instead be sourced under rules governing
securities loans (see XII, C, 3, below).
Interest has been held to include interest on an open account,100 a city condemnation award,101
tax refunds,102 judgments,103 and security deposits.104 For example, interest awarded with respect to
a suit by a nonresident alien for conversion of mutual fund shares for the period from conversion
to judgment (i.e., prejudgment interest) has been held to be interest income from U.S. sources
even though received in compensation for amounts that would not have been subject to U.S. tax.
105
On the other hand, interest generally does not include premiums paid upon the redemption of
bonds.106
100
Eitingon v. Comr., 27 B.T.A. 1341 (1933); Rev. Rul. 65-290, 1965-2 C.B. 241.
101
Astor v. Comr., 10 B.T.A. 1009 (1935).
102
Helvering v. Stockholms Enskilda Bank, 239 U.S. 84 (1934)(interest on federal tax refund);
Accord British-American Tobacco Co. v. Helvering, 293 U.S. 95 (1934); Oceanic Steam
Navigation Co. v. Comr., 31 B.T.A. 781 (1934); Regs. Section 1.861-2(a)(1)includes interest on
tax refunds paid by the United States or any state or local government.
103
Lang v. Comr., 45 B.T.A. 256, 265-66 (1941), nonacq., 1942-1 C.B. 25, rev'd on other
grounds sub nom., Comr. v. Raphael, 133 F.2d 442 (9th Cir. 1943), cert. denied, 320 U.S. 735
(1943); see S. Rep. No. 558, 73d Cong., 2d Sess. 38 (1934).
104
A.C. Monk & Co., Inc. v. Comr., 10 T.C. 77(1948).
105
Iglesias v. U.S., 88-1 USTC Para.9389 (2d Cir. 1988), rev'g658 F. Supp. 856(S.D.N.Y. 1987).
The Second Circuit held Regs. Section 1.861-2(a)(1)to be void to the extent it implied that interest
referred only to amounts owed on indebtedness voluntarily incurred.
106
See Section 1271(a)(1); Rev. Rul. 74-172, 1974-1 C.B. 178. To the extent that the "premium"
corresponds to marked discount, it may be treated as interest for various purposes, though not for
purposes of Sections 871(a), 881, 1441, and 1442. See Section 1276(a)(4), discussed immediately
below. Also, if there was an intention to call a bond with original issue discount before maturity,
the unamortized original discount issue is taxed as "ordinary income" Section 1271(a)(2).

2. Market Discount and Premium

In general terms, subject to a de minimis rule, "market discount" of a debt instrument means
the excess (if any) of its stated redemption price at maturity (or, in the case of a debt instrument
having original issue discount, its "revised issue price" as defined in Section 1278(a)(4)) over the
basis of the debt instrument immediately after its acquisition by the taxpayer. 107
107
Section 1278(a)(2).

Absent promulgation of regulations under Section1276 to the contrary, it appears that market
discount would be treated as interest for source of income purposes, though not for purposes of
the 30% withholding tax on payments to foreign persons. Section 1276(a)(4) provides: "Except
for purposes of sections 871(a), 881, 1441, 1442 and 6049 (and such other provisions as may be
specified in regulations), any amount treated as ordinary income under [Section 1276] shall be
treated as interest for purposes of this title." An argument could be made, however, that
regulations should not treat such income as interest but rather as gain from the sale of personal
property, since market discount usually does not involve the obligor directly, and often primarily
reflects movements in general interest rate levels.108
108
Cf. DeStuers v. Comr., 26 B.T.A. 201 (1932) (market discount realized by nonresident alien
upon redemption of bonds purchased at less than face value sourced as gain from sale of personal
property).

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 It appears that acquisition premium under Section1272(a)(7) reduces the amount of original
issue discount treated as interest generally, including for source purposes. Similarly, under
Section 171(e), amortizable bond premium reduces the amount of taxable interest payments. 109
109
Section 171(e) (added by the 1986 TRA). Nevertheless, in the case of a foreign holder, a
withholding agent often would not be in a position to take Section 1272(a)(7) or Section 171(e)
into account, so a refund claim may have to be filed.

3. Substitute Payments Under Securities Loans

It has become commonplace for securities to be "loaned" by the owner to a borrower. A
"substitute payment" with respect to a loan of a debt security is a payment made by the borrower
to the lender of an amount equivalent to the interest payments that the lender would have
received on the security during the term of the loan. The IRS has proposed regulations under
which substitute payments on debt securities would be treated identically to interest paid on the
securities for Sections 1441 and 1442 withholding, foreign tax credit, and income tax treaty
purposes.110 These regulations are discussed in greater detail in XII, C, below.
110
Prop. Regs. Section 1.861-2(a)(7).

4. Related Party Factoring Income

For certain purposes, including determining the Section904 limitations on a U.S. taxpayer's
foreign tax credit, income derived from factoring certain trade or service receivables from a
related person is recharacterized as interest income. More particularly, if a person acquires
(directly or indirectly) accounts receivable or other debt obligations arising out of inventory sales
or the performance of services by a related person, any income (including interest, discount, and
fees) generally is "treated as if it were interest on a loan to the obligor under the receivable." 111
Special rules apply this principle to indirect acquisitions and to pooled swaps.112 An exception
applies if, among other requirements, the related person from whom the receivable is acquired
and the acquiror are organized under the laws of the same foreign country and the related person
has a substantial portion of its assets used in an active business in such country.113
111
Section 864(d); Regs. Section 1.864-8T(a)(1).
112
Regs. Section 1.861-8T(c)(3).
113
Section 864(d)(7).

D. Determination of Residence of Obligor

The following discussion briefly outlines the rules governing the determination of whether
the following types of obligors are U.S. or foreign residents for purposes of the interest sourcing
rules.
1. Individuals
As discussed above, interest paid by an individual is U.S. source income if, at the time of
payment,114 the individual is a resident of the United States (unless the 80% active foreign
business test of Section 861(a)(1)(A) is met).115 Otherwise, it is not, even if the individual is a
U.S. citizen.
114
Regs. Section 1.861-2(a)(2).
115
See the discussion in II, A, and II, B, 1, above.

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 Section7701(b) defines the circumstances under which a "resident alien" is considered a U.S.
"resident." No equivalent statutory definition exists with respect to when a U.S. citizen is
considered to be a resident. Regulations under Section 7701(b) fill this gap by extending the
scope of the Section 7701(b) statutory rules to citizens, although there is some question whether
this was intended by Congress.116
116
Regs. Section 301.7701(b)-1(a). Section 7701(b), however, does not apply for purposes of
determining foreign residence of U.S. citizens, including, in particular, for Section 911 purposes.
Id. Accord H.R. Rep. No. 432 (Part 2), 98th Cong., 2d Sess., p. 1528 (1984). Cases under Section
911 undertake a "facts and circumstances" analysis along the lines of that set forth in Regs.
Section 1.871-2(b), which governed the determination of residency status of aliens prior to the
enactment of Section 7701(b). See, e.g., Jones v. Comr., 91-1 USTC Para.50,174 (5th Cir. 1991);
Sochurek v. Comr., 300 F.2d 34(7th Cir. 1962); Schonenberger v. Comr., 74 T.C. 1016 (1980). See
generally 918 T.M., Citizens and Resident Aliens Employed Abroad.

Under Section7701(b) and the proposed regulations thereunder, in general, a resident alien is
treated as a resident of the United States for a calendar year if such alien satisfies either of the
following two tests: (1) the alien is a lawful permanent resident of the United States under the
immigration laws at any time during the calendar year (i.e., the "green card" test); or (2) the alien
satisfies the "substantial presence" test. (Also, an alien who makes a valid first-year election
under Section 7701(b)(4) is treated as a resident for such year.)117
117
See generally 907 T.M., U.S. Income Taxation of Nonresident Alien Individuals.

Under the substantial presence test, an alien individual is treated as a resident of the United
States for the calendar year in either of the following two situations:
(i) the alien is physically present in the United States for 183 days or more during the
calendar year; or
(ii) the sum of the days the alien is physically present in the United States during the current
calendar year, plus one-third the number of days the alien was present in the United States
during the preceding calendar year, plus one-sixth the number of days the alien was present
in the United States during the second preceding calendar year equals or exceeds 183 days.
Under this three-year look-back rule, however, an alien will not be considered a resident of
the United States if he was not present in the United States for more than 30 days in the
current calendar year, or he can establish that he has closer connections with and a tax home
in a foreign country.
Example: R, an alien who has never applied for a green card, was present in the United States
for 40 days during 1991, 300 days during 1990, and 258 days during 1989. R is considered a
resident for 1991 (as well as for 1990 and 1989), unless he can establish that he has closer
connections with, and a tax home in, a foreign country. The 1991 result would be different if,
e.g., he had been present in the United States for only 257 days in 1989. For purposes of the
substantial presence test, an alien's presence in the United States in the following capacities is
disregarded: (A) as an A-Visa or G-Visa holder, (B) as a teacher or trainee for a limited
period of time, (C) as a student for a limited period of time, (D) by reason of a medical
condition which arose while the alien was present in the United States, and (E) as a
commuter from Canada or Mexico.
For source of interest income purposes, the trade or business status of an individual has no

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bearing on the question of the individual's residence.118 Thus, interest paid by a nonresident alien
engaged in a U.S. trade or business remains foreign source income.
118
Regs. Section 1.861-2(a)(2).

2. Corporations
A corporation that is incorporated in or under the laws of one of the 50 states or the District
of Columbia is a domestic corporation.119 A domestic corporation may be regarded as the
equivalent of a resident of the United States for interest sourcing purposes. Accordingly, interest
paid by a domestic corporation at any time is U.S. source income (unless the 80% active foreign
business test of Section 861(a)(1)(A) is met or the interest is paid by a foreign banking branch
described in Section 861(a)(1)(B).120
119
Section 7701(a)(4).
120
See II, B, 1, and II, B, 3, above.

A corporation that is not incorporated in one of the 50 states or the District of Columbia,
including a corporation that is incorporated in a possession, is a foreign corporation.121 A foreign
corporation not engaged in a U.S. trade or business may be regarded as the equivalent of a
nonresident for interest sourcing purposes;122 accordingly, interest paid by such a corporation is
foreign source income. Interest paid by a foreign corporation that is engaged in a trade or
business in the United States, however, is subject to the source rules contained in Section 884(f)
(1); in effect, those rules treat the foreign corporation's U.S. branch as a resident of the United
States (see II, B, 2, below).
121
See Sections 7701(a)(4), (a)(5).
122
Strictly from the standpoint of post-TRA 86 Section 861, the foreign corporation could be
the equivalent of a nonresident even if engaged in trade or business in the United States. (Regs.
Section 1.861-2(a)(2), which treats such a foreign corporation as a "resident of the United States,"
does not reflect the TRA 86 changes.) On the other hand, Section 861(a)(1) should not be read in
isolation from Section 884(f)(1). See fn. 38 and accompanying text, above.

3. Partnerships
Consistent with the general rule for sourcing interest, the source of interest payments made
by a partnership to a creditor generally is attributed to the partnership's place of residence.
A partnership (whether domestic or foreign within the meaning of Sections7701(a)(4) and
(5)) apparently is considered is a resident of the United States for source of interest income
purposes if it is engaged in a trade or business in the United States at any time during its taxable
year.123 The nationality or residence of the partners does not bear on the resident or nonresident
status of a partnership;124 in other words, interest paid by a partnership is not sourced on a look-
through basis. The place of the partnership's place of organization is also not relevant.125
123
Regs. Section 1.861-2(a)(2). But cf. Section 988(a)(3)(B) (partnership residence for foreign
currency purposes).
124
Regs. Section 301.7701-5.
125
Id.

Since the residence of a partnership is determined strictly by its trade or business status, it is
possible for a partnership to be a resident both within and without the United States.
Nevertheless, before P.L. 108-357, the American Jobs Creation Act of 2004, §861(a)(1) and

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Regs. §1.861-2(a)(2) appeared to require that interest paid by a partnership be treated as wholly
U.S. source income, no matter whether the partnership was domestic or foreign and no matter
where else the partnership may be a resident. Such an "all or nothing" rule is, at least in the case
of a foreign partnership within the meaning of Section 7701(a)(5), unnecessarily broad and
produces inequitable results. The analogous concept for foreign corporations engaged in a trade
or business in the United States reflects an attempt to allocate only an appropriate portion of the
corporation's worldwide interest expense to the corporation's U.S. trade or business.126 From a
policy standpoint, it would be desirable that this approach be extended to both domestic and
foreign partnerships, inasmuch as the domestic or foreign status of a partnership is not always
clear; alternatively, it could be extended to any partnership formed under an agreement governed
by foreign law.
126
Section 884(f)(1).

Consistent with this, P.L. 108-357 added §861(a)(1)(C), which provides that for taxable years
beginning after 2003 the interest received by a creditor on obligations of a foreign partnership
predominantly engaged in the active conduct of a trade or business outside the United States is
U.S. source income unless the interest is neither paid by a U.S. trade or business conducted by
the partnership nor allocable to partnership income treated as effectively connected with the
conduct of a trade or business within the United States. In this way, the treatment of foreign
partnerships was brought into closer line with the treatment of foreign corporations insofar as the
geographic source of interest is concerned.
Note: The time for testing the residence of a partnership is the year of payment. Accordingly,
a resident partnership may convert the character of interest payments from U.S. source to
foreign source by terminating its U.S. trade or business status before the year of payment.
In the case of interest paid by a partnership to a partner on a loan or for the use of capital, the
source of the income will depend upon whether the income is in fact interest for tax purposes or
is the partner's "distributive share" of income earned by the partnership. If the payment is
deemed to be interest, the source will be determined based on the partnership's residence, as in
the case of interest payments made to nonpartners. Different rules (discussed in II, F, 2 and XIII,
A, 1, below) apply if the interest payment is the payment of a distributive share.
Payments made by a partnership to a partner for the use of funds advanced to the partnership
will be respected as interest if the advance of funds was a bona fide loan not made by the partner
in his capacity as a partner.127 The criteria established by the courts and the IRS concerning
shareholder loans to corporations generally apply in determining whether an advance to a
partnership qualifies as a loan as opposed to a capital contribution.128
127
See Section 707(a). Pratt v. Comr., 550 F.2d 1023 (5th Cir.1977) (partnership was entitled to
a deduction for interest payments due partner on promissory notes).
128
See, e.g., Hambuechen v. Comr., 43 T.C. 90(1964); Hartman v. Comr., 17 T.C.M. 1020
(1958); Rev. Rul. 72-350, 1972-2 C.B. 394; Rev. Rul. 72-135, 1972-1 C.B. 200; TAM 8140017.

Even if payments made by a partnership to a partner for the use of capital are not considered
interest on a loan made by the partner other than in his capacity as a partner, they might be
treated as the equivalent of interest for certain purposes if they qualify as "guaranteed payments"
under Section 707(c). Section 707(c) provides that payments made by a partnership to a partner
for the use of capital are considered guaranteed payments to the extent such payments are

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determined without regard to the income of the partnership. Section 707(c) provides that
guaranteed payments are considered to be paid to one who is not a member of the partnership
only for the purpose of Sections 61(a) and 162(a). For purposes of all other provisions of the
Code, guaranteed payments are generally regarded as a partner's "distributive share."129
Nevertheless, in Miller v. Comr.,130 the Tax Court, overruling an earlier decision,131 held that
guaranteed payments should be treated as made to one who is not a member of the partnership
for §911 purposes (and therefore, implicitly, for source income purposes). The Tax Court's view
in Miller was followed by the Court of Claims in a similar situation, and the court expressly
treated the payments as compensation to a nonpartner for source of income purposes.132 Since
these decisions were based on the perceived purpose of §911, it does not necessarily follow that a
guaranteed payment made for the use of capital should be treated as interest paid to a nonpartner
for the purpose of determining the source of such interest under §§861(a)(1) and 862(a)(1).
Although there does not appear to be authority directly on point, there is precedent in other areas
to support either treating a guaranteed payment as interest or as a distributive share for source of
income purposes.133
129
Regs. Section 1.707-1(c).
130
52 T.C. 752 (1969).
131
In Foster v. Comr., 42 T.C. 974(1964), the Tax Court had held that guaranteed payments
should be treated as "distributive shares" for §911 purposes.
132
Carey v. U.S., 427 F.2d 763 (Ct. Cl. 1970).
133
Compare GCMs 38133 and 36702 (guaranteed payments were interest within the meaning
of §61(a)(4), though not for §163 purposes) with PLR 8728033 and PLR 8639035 (REITs entitled
to treat guaranteed payments as distributive shares).

4. Trusts and Estates

If a trust is an obligor, the source of interest income paid by it will be attributed to the place
where it is resident. The regulations defining residency for this purpose are not particularly
helpful as trusts are not included in the definition.134
134
Regs. §1.861-2(a)(2) generally provides that the term "resident of the United States"
includes (i) an individual who at the time of payment of the interest is a resident of the United
States, (ii) a domestic corporation, (iii) a domestic partnership which at any time during its taxable
year is engaged in trade or business in the United States, or (iv) a foreign corporation or a foreign
partnership, which at any time during its taxable year is engaged in trade or business in the United
States.

Accordingly, case law developed the residency test for trusts and under these decisions it was
reasonably certain that a trust was resident in a jurisdiction when the following three factors
coincided: (i) situs of the trust corpus; (ii) situs of the trust administration; and (iii) residence of
at least one of the trustees. Although a case could be made that the residence of the trust
fiduciary rather than the trust itself should be determinative, the law did not take that direction.
Few cases and rulings have specifically considered the question of trust residence. The leading
case was B.W. Jones Trust v. Comr.,134.1 in which a British citizen and resident created five trusts
under English law in favor of beneficiaries who were citizens and residents of England.
However, the trusts' corpora were located in the United States, the trusts were administered in the
United States, and one of the four trustees was a resident of the United States. Under these
circumstances, both the Board of Tax Appeals and the Fourth Circuit held that the trusts were
residents of the United States.

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 134.1
46 B.T.A. 531 (1942), aff'd, 132 F.2d 914 (4th Cir. 1943).

In Rev. Rul. 60-181,135 a trust was created under the laws of a foreign country by a foreign
settlor in favor of foreign beneficiaries. The trust corpus, which consisted principally of U.S.
securities, was held, controlled, and traded in the United States on a domestic stock exchange by
a resident trustee. The IRS ruled that the trust was a resident of the United States. The IRS relied
on the criteria established in B.W. Jones Trust and Rev. Rul. 60-181 in subsequent rulings finding
that certain trusts were U.S. residents.136
135
1960-1 C.B. 257.
136
See Rev. Rul. 70-242, 1970-1 C.B. 89; PLR 7917037; PLR 7917063.

Legislation enacted in 1996 established a two-part objective test for determining when a trust
would be classified as a U.S. person for tax purposes.136.1 Under this definition, effective for
taxable years beginning after 1996, a domestic trust is any trust that meets the following two
tests: (i) a court within the United States is able to exercise primary supervision over the
administration of the trust, and (ii) one or more United States persons have the authority to
control all substantial decisions of the trust.136.2 This legislation raises the question of whether the
characterization as a U.S. person under §7701(a)(30)(E) also defines U.S. residence for purposes
of §861.
136.1
P.L. 104-188, §1907(a)(1); §7701(a)(30)(E). A foreign trust is defined as any trust that is
not a domestic trust. See §7701(a)(31)(B).
136.2
§7701(a)(30)(E).

Although the §7701 definitions apply for purposes of the §865 sourcing rules,136.3 the
Conference Committee report issued in connection with the enactment of §865(g) in 1986 made
clear that this "U.S. person equals U.S. residence rule" was being adopted with regard to the
sales of personal property but other existing sourcing rules were being retained.136.4
136.3
§865(g)(1)(A)(ii).
136.4
See Conference Report to Tax Reform Act of 1986, pp. II-595-596.

When §7701(a)(30)(E)136.5 was added to the Code in 1996, Congress intended to apply the
"U.S. person equals U.S. residence rule" in the context of outbound grantor trusts and the
imposition of the excise tax then applicable under former §1491, but it is not clear that this rule
was intended to apply for all purposes of the Code, specifically §861.136.6
136.5
For further discussion of the jurisdiction and control tests under §7701(a)(30)(E) and the
issues involved in satisfying these requirements, see 911 T.M., Foreign Estates, Trusts and
Beneficiaries.
136.6
See Conference Committee Report to Small Business Job Protection Act of 1996, pp. 330-
338.

Comment: One view after the enactment of §7701(a)(30)(E) is that this provision now
represents the relevant test for determining residence for purposes of §861. Another view is that
B.W. Jones Trust and Rev. Rul. 60-181 continue to be relevant for purposes of determining the
residence of the trust.
A U.S. resident trust theoretically could pay foreign source income if the 80% active foreign
business test of §861(a)(1)(A) were met. (This assumes that the trust would be respected as a
trust for federal income tax purposes.)137 Although §861(a)(1)(A) does not expressly refer to a

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trust, a trust is taxed like an individual (see §641(b)). Since §861(a)(1)(A) is expressly applicable
to an individual, interest paid by such a trust resident in the United States which meets the active
foreign business income test of §§861(a)(1)(A) and 861(c) should be foreign source income.
137
If the trust were not an inter vivos or testamentary trust created for the purpose of protecting
or conserving property for the beneficiaries, conduct of an active business generally would result
in its characterization as an association taxable as a corporation, or possibly as a partnership, for
federal income tax purposes. See, e.g., Regs. §§301.7701-4(a), (b).

5. Estates
The 1996 legislation discussed above relating to the residence of trusts had no impact on the
definition of a foreign estate.138 Therefore, the pre-1996 residency criteria for trusts drawn from
B.W. Jones Trust and Rev. Rul. 60-181 (both discussed in II, D, 4, above) are applied to
determine the residency of estates.138.1 Thus, the estate of a U.S. citizen or resident (i.e., who is
domiciled in the United States at death) that is subject to domiciliary administration in the United
States is a U.S. resident; by the same token, the estate of a nonresident decedent that is subject to
domiciliary administration abroad and not subject to ancillary administration in the United States
is a nonresident of the United States.139
138
Section 7701(a)(31)(A) defines the term foreign estate as an estate the income of which,
from sources without the United States which is not effectively connected with the conduct of a
trade or business within the United States, is not includible in gross income under subtitle A.
138.1
See Rev. Rul. 81-112, 1981-1 C.B. 598; Rev. Rul. 62-154, 1962-2 C.B. 148.
139
See, e.g., Rev. Rul. 81-112, 1981-1 C.B. 598 (estate of a U.S. citizen who died while a
nonresident was a nonresident estate); Rev. Rul. 62-154, 1962-2 C.B. 148; Rev. Rul. 58-232,
1958-1 C.B. 261; Rev. Rul. 57-245, 1957-1 C.B. 286; PLR 7918118; PLR 7917087.

The residence of the estate of a nonresident decedent which is subject to ancillary

administration in the United States depends upon the extent and duration of the activities of the
ancillary administrator in the United States. As long as the ancillary administrator does not
maintain an office in the United States, does not conduct any U.S. trade or business, does not
engage in significant U.S. investment activities, and confines his U.S. activities to marshalling
and distributing assets to appropriate beneficiaries and paying debts, the estate will not be
considered to be a U.S. resident.140
140
Other factors that may be considered in determining whether the estate is resident in the
United States are the location of the estate assets and/or the nationality/residency of the personal
representative. See 911 T.M., Foreign Estates, Trusts and Beneficiaries.

E. Special Issues Concerning Identity of Obligor

Under certain circumstances, the identity of the true obligor is not entirely clear.
1. Guarantors
Where the obligation of a debtor is guaranteed by another party, the question arises as to
whether the debtor or the guarantor is the true obligor.
The §861 regulations make clear that, if the payments are made by the guarantor in his
capacity as a guarantor of the primary obligation, the obligor on the underlying debt (the primary
obligor), rather than the guarantor, is considered to be the obligor for source of income purposes.
141
This principle is illustrated by Tonopah and Tidewater Railroad Co. v. Comr.,142 involving a

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U.S. subsidiary which issued bonds guaranteed by its British parent company. Upon default by
the subsidiary, the parent company was forced to make interest payments. The Board of Tax
Appeals observed that the guaranty by the foreign parent was not an obligation independent of
the subsidiary's obligation to pay interest. Accordingly, the parent's payments of interest to
foreign creditors were held to be made on the obligation of the U.S. subsidiary and, hence, were
U.S. source income subject to withholding.
141
Regs. §1.861-2(a)(5). Accord Rev. Rul. 70-377, 1970-2 C.B. 175 (foreign guarantor required
to withhold trust on payments under guarantee of domestic corporation's debt).
142
39 B.T.A. 1043 (1939), rev'd on other grounds, 112 F.2d 970 (9th Cir. 1940).

If the guarantee is determined to be, at the time made, a separate obligation independent of
the loan, payments made by the guarantor would be considered to have been made by the
guarantor in its capacity as the true obligor. For example, Rev. Rul. 78-118143 addressed the
source of interest income derived by the taxpayer (a commercial bank) in advancing funds to a
foreign corporation pursuant to an agreement with the Eximbank, which itself had entered into a
loan agreement with the foreign corporation. The Eximbank agreed to pay the taxpayer interest
on its disbursements at the per annum rate of .05% above the taxpayer's minimum commercial
lending rate in effect at that particular time. The IRS observed that:
...although Eximbank's obligation under the letter agreement is expressed, in part, as being
that of a guarantor, where a guarantee is combined with other facts showing that the
guarantee is in reality a separate obligation, it will be treated as such. . . . The loan agreement
between Eximbank and [the foreign corporation] and the letter agreement between the
Eximbank and the taxpayer are separate agreements, neither of which involves all three
parties. Each agreement calls for a separate obligation with a separate interest rate. Neither
interest rate is related to the other. Since the Eximbank's obligation was an independent
obligation, the interest payments received by the taxpayer were received from the Eximbank
and, therefore, were income from U.S. sources.
143
1978-1 C.B. 219.

In situations in which the guarantor is a shareholder of the borrower and the borrower is less
than creditworthy, the courts and the IRS have inquired whether the shareholder-guarantor was
the true obligor. The leading cases in this area are Plantation Patterns, Inc. v. Comr.,144 and
Murphy Logging Co. v. U.S.145 While neither of these cases involved cross-border transactions,
the inquiry could have particularly deleterious ramifications in a cross-border context. For
example, if a foreign lender makes a loan to a foreign corporation that is guaranteed by the
borrower's U.S. shareholder, the loan might be recharacterized as a loan to the shareholder, in
which case the foreign lender could be treated as receiving U.S. source interest income subject to
withholding tax, and the borrower could be liable for a failure to withhold. Similarly, a loan to a
U.S. corporation guaranteed by its foreign parent could be treated as a loan to the foreign parent,
in which case the loan payments by the subsidiary could be treated as dividends to the parent,
subject to U.S. withholding tax.
144
462 F.2d 712 (5th Cir. 1972). Accord Casco Bank & Trust Co. v. U.S., aff'd, 544 F.2d 528
(1st Cir. 1976), cert. denied, 430 U.S. 907 (1977) (shareholder-guarantor denied bad debt
deduction for advances on behalf of financially strapped corporation); Rev. Rul. 79-4, 1979-1 C.B.
150 (payments by financially strapped corporation considered dividends to shareholder-guarantor).
145
378 F.2d 222 (9th Cir. 1967), rev'g 239 F. Supp. 794 (D. Ore.1965).

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 2. Financing Affiliates and Other Financing Intermediaries
An inquiry similar to that in the case of shareholder-guaranteed loans146 is appropriate, and
has been applied, in situations in which the borrower, while creditworthy, was a financing
vehicle.
146
See II, E, 1, above. As discussed immediately above in the preceding section, under the
Plantation Patterns rationale, a U.S. shareholder-guarantor of a foreign subsidiary loan possibly
could be recharacterized as the true obligor resulting in interest payments on the loan being treated
as U.S. source interest subject to withholding.

In 1993, Congress enacted §7701(l) which provides the IRS broad regulatory authority to
issue rules recharacterizing any multiparty financing transaction as a transaction between any
two (or more) of such parties (disregarding the others as mere conduits) where recharacterization
is necessary to prevent tax avoidance. 146.1 Pursuant to this legislation, the IRS adopted the conduit
entity financing regulations.146.2 The purpose of these regulations is to prevent avoidance of the
withholding obligations imposed under §881 on "non-effectively connected" U.S. source income
paid to a foreign corporation by using a financing intermediary to qualify for lower withholding
rates under §881 available under certain U.S. tax treaties.146.3 Under these regulations, the IRS has
the sole authority to determine whether a conduit entity involved in a financing transaction
should be disregarded for purposes of imposing the §881 withholding tax.146.4
146.1
P.L. 103-66, §13238.
146.2
T.D. 8611, 60 Fed. Reg. 40997 (8/11/95).
146.3
Regs. §1.881-3(a)(3)(ii)(B).
146.4
Regs. §1.881-3(a)(3)(i). Regs. §1.881-3(a)(3)(ii)(B) limits the regulations use to the IRS
and provides that taxpayers may not rely on these regulations in order to disregard a conduit entity
to reduce applicable tax withholding.

In order to disregard the financing entity the IRS must determine that the formation and
utilization of the entity were in furtherance of a tax avoidance plan. The approach to determining
the presence of tax avoidance is a fact and circumstances approach, comparable to the economic
substance analysis utilized in the Aikencase and rulings discussed below.
The final regulations emphasize the presence of a nontax business purpose to establish the
lack of a tax avoidance plan by providing that the IRS will take into account whether a financing
transaction is entered into in the ordinary course of integrated or complementary trades or
businesses.146.5 In the context of creating the presumption of no tax avoidance under the
significant financing exception, the regulations provide, in part, that the financing subsidiary
must show that (1) its officers and employees participate actively and materially in arranging the
entity's participation in the transaction; (2) officers and employees located in the intermediate
entity's home country exercise management over and actively conduct the day-to-day operations
of the intermediate entity and actively manage material market risks arising from financing
transactions; and (3) the participation of the intermediate entity in the financing transaction
reasonably can be expected to produce efficiency savings by reducing transaction costs and
overhead and other fixed costs.146.6
146.5
Regs. §1.881-2(b)(2)(iv).
146.6
Regs. §1.881-3(b)(3)(ii)(B). For more discussion and analysis of the presence of tax
avoidance under the conduit regulations, see 908 T.M., U.S. Income Taxation of Foreign
Corporations.

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 The disregarding of the financing entity results in a recharacterization of the financing
transaction as being directly between the remaining parties for purposes of imposing the
withholding tax on U.S. source income, presumably with the remaining foreign party being in a
country with a higher applicable withholding rate under §881.146.7
146.7
Regs. §1.881-3(a)(3)(ii)(A). Note that this regulation further provides that
recharacterization of such financing transaction also applies to withholding obligations on U.S.
source income required under §§871, 884(f)(1)(A), 1441 and 1442.

Disregarding the intermediate foreign entity may result in the remaining foreign entity
receiving U.S. source income rather than foreign source income.
Example: Assume a U.S. person (D) pays interest to a foreign corporation (FC1) which in
turns pays interest to another foreign corporation (FC2). The interest paid by D is clearly
U.S.-source (assuming no statutory exception applies). Moreover, if FC1 is respected, the
interest it pays to FC2 will be foreign-source (again, assuming no special statutory exception
applies). However, if the IRS pursuant to its authority under Regs. §1.881-3 determines that
FC1 was formed for the tax avoidance purpose of qualifying for a lower treaty withholding
rate and is ignored as a conduit, then the interest income realized by FC2 will be U.S.-source.
Thus, ignoring FCI can change the source of income realized by FC2.
With regard to furnishing a financial guarantee in connection with a financing transaction,
the regulations state that this may be a factor for the IRS to consider in determining whether a tax
avoidance motive may be present.146.8 Otherwise, the regulations provide that furnishing a
financial guarantee is not, in and of itself, a financing transaction.146.9
146.8
Regs. §1.881-3(c)(2)(i).
146.9
Regs. §1.881-3(e), Ex. 1.

The earlier "treaty-shopping" decisions and rulings that predate the conduit entity regulations
also resulted in disregarding the financing entity under economic substance principles in order to
prevent the taxpayer's financing subsidiary from qualifying for lower withholding rates under
more favorable tax treaties. One such earlier treaty-shopping case, Aiken Industries, Inc. v.
Comr.,147 involved a Honduras corporation which was "inserted" between the U.S. borrower and
the foreign lender in order to attempt to eliminate a U.S. withholding tax, with all three
corporations being commonly owned. The terms of the Honduras corporation's creditor position
in respect of the one loan exactly matched the terms of its debtor position in respect of the other
loan. The Tax Court held that the interest on the loan was not "received by" the corporation
within the meaning of the income tax treaty between that country and the United States since the
corporation did not obtain dominion and control over the interest (in view of the back-to-back
obligation), and hence the corporation's role in the financing should be disregarded.
147
56 T.C. 925 (1971), acq. on other issue, 1972-2 C.B. 1.

The IRS extended this principle in several rulings. Rev. Rul. 84-152148 treated a Netherlands
Antilles finance subsidiary that borrowed from its Swiss parent and lent the proceeds to its U.S.
sister corporation as a mere conduit even though the finance subsidiary was a party to the
original loan arrangements and earned a small "spread" (1% per annum) of the amount loaned.
Rev. Rul. 84-153149 addressed facts typical of a Netherlands Antilles international financing
subsidiary, with the IRS similarly ruling that the financing arrangements were a conduit;
inasmuch as third-party lenders to the subsidiary were involved, disregard of the subsidiary as an

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obligor was a highly aggressive position on the IRS's part. In Rev. Rul. 87-89,150 the IRS treated a
deposit by a foreign corporation with a foreign bank, combined with a loan from that bank to a
domestic affiliate of the depositor, as in effect a direct borrowing by the domestic affiliate from
the foreign affiliate where the interest rate paid by the domestic corporation was lower than it
would have been without the deposit. The fact that the bank would not be permitted to offset its
obligation to the foreign depositor by its loan against the domestic corporation was not
considered relevant.151 These rulings have since been cited favorably by Congress and the Staff of
the Joint Committee on Taxation.152 The IRS issued a TAM that applied the "conduit entity"
principal even in respect of situations in which the financing vehicle itself did not purport to be
an obligor but had received its funds in large part by way of capital contributions.153
148
1984-2 C.B. 381.
149
1984-2 C.B. 383.
150
1987-2 C.B. 195.
151
Compare Rev. Rul. 76-192, 1976-1 C.B. 205 and GCM 35763 (right to offset was
determinative) with Rev. Rul. 69-501, 1969-2 C.B. 233 and TAM 8637008 (absence of right to
offset was determinative).
152
See, e.g., H.R. Rep. No. 247, 101st Cong., 1st Sess. 1240, 1246 (1989) (referring in the
context of §163(j), to Rev. Rul. 84-152, Rev. Rul. 84-153, and Rev. Rul. 87-89 as "current law");
TRA 86 Blue Book at 1046-47 ("Congress did not extend the treaty-shopping prohibition [of
§884] to dividend and interest payments made by U.S. corporations because the appropriate
extension of the theory embodied in Revenue Rulings 84-152 and 84-153. . . may provide
appropriate federal income tax treatment for these transactions").
153
See TAM 9133004. The facts showed that debt payments received by the financing vehicle
generally were promptly paid out to its parent. This memorandum may have been issued partly for
in terrorem effect, as it is believed in the tax community that the taxpayer involved settled on
highly favorable terms.

Note: Rev. Ruls. 84-152, 84-153, and 87-89 (situations 1 and 2), discussed above, are
obsolete for post-September 10, 1995 payments subject to the conduit financing regulations
under §7701(l) discussed above. See Rev. Rul. 95-56.153.1
153.1
1995-2 C.B. 322.

Historical Note: The IRS originally indicated in certain rulings that a domestic parent's
guaranty of its international finance subsidiary's debt obligations generally would not result in
the parent being considered the true obligor where the subsidiary was not a sham and had a debt-
equity ratio not exceeding 5-to-1.154 In 1974, however, the IRS revoked the earlier rulings and
stated that the mere existence of a 5-to-1 debt-equity ratio would not provide immunity against a
debt-equity challenge.155 In 1984, the IRS issued Rev. Ruls. 84-152 and 84-153, discussed above,
in conjunction with the negotiations heading to the termination of most provisions of the income
tax treaty with the Netherlands Antilles. TRA 84, however, grandfathered existing international
finance subsidiaries which met requirements "based on the principles set forth in Revenue
Rulings 69-501, 69-377, 70-645 and 73-110."156 Rev. Rul. 86-6157 concluded that an international
finance subsidiary debt-equity ratio could be relaxed to 5-to-1 based on the principles of the cited
Revenue Rulings. Rev. Rul. 86-6, however, also stated that the debt-equity ratio for this purpose
included only the face amount of the debt and capital contributed by the corporation's
shareholder, so that equity for this purpose did not include the corporation's retained earnings,
which normally would be reflected in computing a corporation's debt-equity ratio.158
154
Rev. Rul. 69-501, 1969-2 C.B. 233; Rev. Rul. 70-645, 1970-2 C.B. 273; and Rev. Rul. 73-
110, 1973-1 C.B. 454. All three rulings were revoked by Rev. Rul. 74-464, 1974-2 C.B. 46.

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 155
See Rev. Rul. 74-464, 1974-2 C.B. 46.
156
TRA 84, §127(g)(3). A number of IRS rulings blessed international finance subsidiaries
under the grandfather rule. See, e.g., TAM 8637008, PLR 8611077, and TAM 8527010. In
addition, Regs. §1.881-3(f) provides that the conduit entity regulations, discussed above, generally
apply to payments made by financed entities on or after September 11, 1995, but do not apply to
interest payments covered by §127(g)(3) of TRA 1984, and to interest payments with respect to
other debt obligations issued prior to October 15, 1984 (whether or not such debt was issued by a
Netherlands Antilles corporation).
157
1986-1 C.B. 286. Accord, e.g., PLR 8449060; PLR 8530050.
158
Accord PLR 8623051.

3. Joint Obligors
There is little guidance concerning the source of interest income from an obligation under
which a U.S. person and a non-U.S. person are each obligated. Regs. §1.861-2(a)(3) states that
neither the method of payment nor the place of payment is relevant in determining the source of
interest income. Under this rule, and by analogy to the rules governing payments made by a
guarantor (discussed above), one might argue that the source of interest payments made by a
joint obligor would be determined according to the payor's right of recovery against the other
joint obligor under the applicable law.
Example: Suppose A, a nonresident alien, and B, a resident of the United States, execute a
note jointly, but A makes all the payments on the note. If, under the applicable law, A has no
right of recovery against B, the interest payments received by the creditor would be foreign
source income. However, if, under the applicable law, A has a right to recover one-half of the
payments made under the note from B, then, under this analysis, only one-half of the interest
income received by the creditor is foreign source income.159
159
See also Dailey, "The Concept of the Source of Income," 15 Tax L. Rev. 415 (1960).

On the other hand, a stronger case can be made for the proposition that the co-obligor that
actually makes the payments should be considered to be the obligor under the instrument with
respect to those payments. This would be consistent with the treatment of joint and several
liabilities for other income tax purposes. For example, for purposes of the §163 interest
deduction, the obligor that in fact pays the interest is entitled to the interest deduction with
respect to that payment, even if the payment is disproportionate as measured by the number of
co-obligors.160 This rule has merit for source purposes, for which purpose one should look to the
place whence the income economically is derived. That place is where the actual payor on the
obligation resides (notwithstanding a different rule in the situation in which a guarantor or other
payor does not originally have primary liability). There is no reason to assume that each of
several co-obligors is likely to pay identical amounts, and the tax result should not proceed from
an assumption that they will.
160
See, e.g., Arrigoni v. Comr., 73 T.C. 792, 806 (1980); Rev. Rul. 71-268, 1971-1 C.B. 58;
PLR 8633046; PLR 8117091. Similarly, no deemed exchange of a note is caused by reason of
another party assuming joint and several liability with the original obligor. See, e.g., PLR
8117091.

4. Agents and Underwriters

The source of interest payments made by agents or underwriters in their capacities as such
depends upon the place where the actual borrower is resident rather than the place where the

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agent or the underwriter is located. This follows from the general principle of agency and the rule
under Regs. §1.861-2(a)(3) that the place and manner of payment is irrelevant.
Example: A U.S. bank underwrites bonds, notes, and certain other obligations of a foreign
government which, by their terms, are payable at the bank's office in the United States. The
interest payments are foreign source income.161
161
Rev. Rul. 71-516, 1971-2 C.B. 264. Accord Rev. Rul. 66-32, 1966-1 C.B. 174.

Example: A domestic corporation lends money to its foreign affiliates, using a domestic bank
as an intermediary. The bank as "escrow trustee" advances the funds to the affiliates and
collects the debt service on behalf of the domestic corporation. The domestic corporation is
considered to derive foreign source interest income.162
162
Rev. Rul. 72-514, 1972-2 C.B. 440.

F. Source of Interest Income upon Taxation to Obligee's Beneficial Owners

As discussed above, the source of interest income in the hands of an obligee is attributed,
with certain exceptions, to the residence of the obligor.163 However, if the interest income
received by an obligee is distributed or taxed directly to the ultimate beneficial owners of the
income, a second level of inquiry relating to the source of interest income in the hands of the
ultimate beneficial owners becomes relevant. For example, if a partnership receives interest
income, its source in the hands of the partners must be determined.
163
See II, A, and II, B, above.

The rules discussed below are relevant not only for interest income but generally for any
income derived by a corporation, partnership, trust, or estate.
1. Corporations
Since a "C" corporation is a separate taxable entity, it cannot pass interest income through to
its shareholders. Consequently, interest income received by a C corporation is taxable to it as
either U.S. or foreign source income. When, however, the corporation distributes its after-tax
interest income to its shareholders, the interest income loses its character as such. Assuming the
distribution is taxable as a dividend (i.e., is deemed made out of earnings and profits), it is taxed
as dividend income under §§301 and 316. The source of dividend income to the shareholders is
then determined according to the appropriate source of dividend income rules discussed in III,
below. Thus, a foreign corporation which is not engaged in a trade or business in the United
States and which receives U.S. source interest (or dividend) income acts as a "source converter"
for such income, since interest (or dividends) paid by it generally is considered foreign source.
A number of exceptions to this general rule exist, which include the following:
(i) For foreign tax credit purposes, §904(g) (redesignated §904(h) for taxable years beginning
after 2006) provides a look-through rule for certain U.S. source income of a "U.S.-owned
foreign corporation" (i.e., one in which U.S. persons own 50% or more of either the
combined voting power or the total value of the corporation's stock).164
(ii) For purposes of the §531 accumulated earnings tax, §535(d) provides a look-through rule
in the case of interest (and dividend) payments by foreign corporations with significant U.S.

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 source income to a "U.S.-owned foreign corporation."165
(iii) In the case of S corporations, pass-through rules parallel to those described in II, F, 2,
below for partnerships apply.166
(iv) In the case of a regulated investment company (RIC) (as defined in §851(a)), the RIC
may elect, under certain circumstances, to pass through to its shareholders the foreign source
character of income received on stock or securities (as grossed up by foreign taxes paid by
the RIC) and the right to claim the foreign tax credit,167 as well as the character of certain
other amounts.168
(v) In the case of a real estate mortgage investment conduit ("REMIC") as defined in §860D,
which may or may not take the form of a corporation or other entity, holders of "residual
interests" in the REMIC include the REMIC's net income or loss on a look-through basis.169
164
See III, B, 7, below. The addition of a new §904(g) by §402(a) of P.L. 108-357, the
American Jobs Creation Act of 2004, necessitated the redesignation of §904(g) through (k) as
§904(h) through (l).
165
See III, B, 8, below.
166
See §§1366(b), 1373(a). See also XIII, A, 2, below.
167
See §853.
168
See III, B, 9, b, below.
169
See III, B, 9, d, below.

2. Partnerships
A partnership, unlike a C corporation, is not a taxable entity. Under §702(a), items of
partnership gross income are considered as belonging to the partners in accordance with their
respective "distributive shares," as determined in accordance with §704. Consequently, when a
partnership in its capacity as the obligee receives interest income, each partner must report its
distributive share of such income.
The source of partnership income carries over to the partners in their distributive shares of
partnership income.170 For example, a partner's distributive share of the partnership's foreign
source interest income is income from foreign sources to the partner.
170
See §702(b). Accord PLR 8802038 (interest and OID on obligations of international
development bank).

The pass-through treatment of partnerships is discussed more generally in XIII, A, 1, below.

3. Trusts and Estates
a. General
For tax purposes, trusts may be divided into ordinary trusts and grantor trusts. Grantor trusts
are disregarded for federal income tax purposes, and trust income is taxed directly to the grantor.
171
Consequently, where a grantor trust in its capacity as obligee receives interest income, the
grantor will be deemed to have received the interest income directly from the source from which
the trust received it.172 In other words, the source of interest income in the hands of the grantor is
attributed to the place of the obligor's residence even though the true obligee is the trust.
171
See §671.

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 172
Rev. Rul. 59-245, 1959-2 C.B. 172, revoked on other grounds, Rev. Rul. 81-244, 1981-2
C.B. 151.

For federal income tax purposes, ordinary trusts may be "simple" or "complex." Simple trusts
are those whose income is required to be currently distributed in its entirety to beneficiaries. 173
Complex trusts are those in which the trustee has the discretion or is required to accumulate
income (which is taxed to the trust but not to the beneficiaries while it is being accumulated). 174
173
See §§651- 52.
174
See §§661 et seq.

Distributions from simple trusts have the same "character" in the hands of the beneficiary as
in the hands of the trust.175 Since the term "character" has been interpreted to include geographic
source, foreign source interest income received by a simple trust and distributed to its
beneficiaries retains its character as foreign source income in the hands of the beneficiaries. 176
175
§652(b).
176
E.g., Isidro Martin-Montis Trust v. Comr., 75 T.C. 381 (1980), acq., 1981-2 C.B. 2; Bence v.
U.S., 18 F. Supp. 848 (Ct. Cl. 1937); Rev. Rul. 81-244, 1981-2 C.B. 151; cf. Rev. Rul. 70-599,
1970-2 C.B. 172 (domestic source capital gain distributed currently from a trust is not fixed or
determinable annual or periodical income subject to withholding).

These rules also apply to current distributions from a complex trust.177 In the case of
accumulation distributions from a complex trust (i.e., distributions of income made in a taxable
year subsequent to that in which the income was derived by and taxed to the trust),178 the amounts
retain their character in the hands of a nonresident alien or foreign corporate beneficiary 179 when
taxed to the beneficiary (with a credit for the tax paid by the trust) under the "throwback" rules. 180
Therefore, an accumulation distribution made from foreign or domestic source interest income at
the trust level will retain such character in the hands of a nonresident alien or foreign corporate
beneficiary.
177
Section 661(b).
178
See Maximov v. U.S., 373 U.S. 49(1963) (capital gain taxed to trust since not distributed
even though, had gain been distributed currently, U.K. beneficiaries would have been exempt from
tax thereon under the U.S.-U.K. income tax treaty).
179
Sections 662(b), 667(e).
180
See generally Sections 665- 68.

Estates are generally taxed like complex trusts, except that beneficiaries of estates are not
subject to taxation on accumulation distributions.181 The rules relating to complex trusts discussed
above apply equally to estates.
181
See Sections 641, 661, and 667.

The tax rules governing trusts and estates are discussed more generally in XIII, B, below.
b. Interest on Bank and Other Deposits
Despite the general rule that even accumulation distributions from a complex trust or from an
estate retain the source of the income from which they are made, special considerations apply in
the case of distributions of interest from certain bank and other deposits, since the provisions
characterizing that income as foreign source (under the law prior to TRA 86) or exempting it
from taxation (under current law) apply only if the taxpayer is a nonresident alien or a foreign

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corporation. In Isidro Martin-Montis Trust v. Comr.,182 the Tax Court held that, in accordance with
the general conduit theory of trust taxation embodied in Section 652, noneffectively connected
U.S. bank deposit interest earned by a nongrantor trust retained its character as foreign source
income (under Sections 861(a)(1)(A) and 861(c) as then in effect) when distributed to foreign
beneficiaries. The IRS acquiesced in this decision and revoked its prior position to the contrary. 183
182
75 T.C. 381 (1980), acq., 1981-2 C.B. 2.
183
See Rev. Rul. 81-244, 1981-2 C.B. 151, revoking Rev. Rul. 59-245, 1959-2 C.B. 172.

Similar rules apply to estates, which again are taxable essentially in the manner of a complex
trust. Thus, bank deposit interest earned by a U.S. resident estate which is distributed to the
nonresident alien beneficiaries within the taxable year of receipt qualifies as foreign source
income under pre-TRA 86 Sections 861(a)(1)(A) and 861(c), which is consistent with the
rationale of Isidro Martin-Montis and Rev. Rul. 81-244.184
184
Rev. Rul. 86-76, 1986-1 C.B. 284 (situation 1); PLR 8548030(U.S. bank deposit interest
received by a resident estate and distributed to its nonresident alien beneficiaries in the year of
receipt not subject to withholding); accord PLR 8609013(original issue discount income received
by a resident estate on U.S. treasury obligations with a maturity of 183 days or less and distributed
to its nonresident alien beneficiaries in the year of receipt not subject to withholding).

On the other hand, where bank deposit interest earned by an estate resident in the United
States is not distributed (or required to be distributed) by the estate until a subsequent year, it is
taxed to the estate.185 When the accumulated amounts are distributed in subsequent years, the
amounts taxable to the beneficiaries are limited by the estate's distributable net income for the
years of distribution under Section 662(a)(2); since the previously taxed interest income is not
again includible in the estate's distributable net income in the years of distribution, the
nonresident alien beneficiaries are, in effect, not taxable on the receipt of such income. 186
185
Rev. Rul. 86-76, 1986-1 C.B. 284 (situation 2); GCM 39506 (underlying Rev. Rul. 86-76);
PLR 8324015.
186
See Rev. Rul. 86-76, 1986-1 C.B. 284; GCM 39506.

The general character retention rule of Sections652, 662 and 667(e), discussed above, does
not apply to individual retirement accounts ("IRAs") or qualified employees' trusts. Interest
earned by an individual retirement account or a qualified employee's trust on a deposit with a
U.S. bank does not retain its character as U.S. bank deposit interest when paid (even if currently)
to a nonresident alien beneficiary.187 Although qualified employees' trusts and IRA accounts
established in the form of trusts are trusts for local law purposes, they are not governed by
subchapter J of the Code. No provisions in Sections 402 and 408 or otherwise in subchapter D of
the Code provide for the retention of the character of certain items of income earned by and
distributed from a qualified employees' trust or from an IRA.
187
PLR 8721106.

Technically speaking, the authorities discussed in II, F, 2, b, no longer are relevant to the
source of income after the changes made by TRA 86. They continue to be relevant, however, in
determining whether nonresident alien trust beneficiaries are exempt from U.S. tax on the
income under Section 871(i)(2).188
188
See the discussion in II, B, 4, above.

III. Dividend Income

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 The source of income rules for dividend payments are contained generally in Sections 861(a)
(2) and 862(a)(2). In the discussion below, the general operative rule and various exceptions are
set out followed by an analysis of the term "dividend" and of the effect that a distribution of
dividend income through an entity has on its source.
A. General Rule -- Place of Incorporation of Payor
As a general rule, the place of incorporation of the payor corporation governs the source of
dividend income.189 If the payor is incorporated under the laws of one of the 50 states or the
District of Columbia,190 the dividends paid by it generally are treated as U.S. source income. If
the payor is not incorporated under the laws of one of the 50 states or the District of Columbia,
the dividends paid by it generally are treated as foreign source income. For example, under
Section 861(a)(2)(A), dividends paid by a corporation incorporated in a U.S. possession are
generally sourced under the rules applicable to foreign corporations.
189
See Sections 861(a)(2)(A) and (B), 862(a)(2).
190
See Section 7701(a)(4).

Subject to certain exceptions, income earned by a corporation loses its character and source
in the hands of the corporation and does not affect the source of the dividends paid by the
corporation. Thus, under certain circumstances, a corporation acts as a "source converter" for the
income received. This phenomenon has been greatly circumscribed legislatively over the years,
as discussed below.191
191
See discussion in, e.g., III, B, 2; III, B, 7; III, B, 8; and III, D.

B. Exceptions
The general rule that dividends are sourced by reference to the place of incorporation of the
payor is subject to a number of exceptions and variations.
1. Possessions Corporations
Section 861(a)(2)(A) provides that dividends paid by a domestic corporation are not U.S.
source income if a Section 936 election is in effect. Thus, pursuant to the residuary format of
Section 862(a)(2), dividends paid by a corporation with respect to which a Section 936 election
is in effect are foreign source income.
In general, a domestic corporation may make an election under Section 936 if 80% or more
of the corporation's gross income is from sources within Puerto Rico or the U.S. Virgin Islands
for the three-year period (or the period of corporate existence if shorter) ending with the taxable
year for which the Section 936 credit is elected, and 75% or more of the corporation's gross
income is derived from the active conduct of a trade or business within Puerto Rico or the U.S.
Virgin Islands.192 In general, an electing Section 936 corporation is entitled to a credit against its
U.S. tax equal to the portion of such tax which is attributable to the sum of (A) the taxable
income from sources without the United States (and, subject to certain exceptions, not received
in the United States) either from the active conduct of a trade or business within Puerto Rico or
the U.S. Virgin Islands or from the sale or exchange of substantially all of the assets used by the
taxpayer in the active conduct of such trade or business, plus (B) the "qualified possession source
investment income" as defined in Section 936(d)(2).193 Dividends paid by an electing corporation
to another member of the same affiliated group are entitled to a 100% dividends received

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deduction for purposes of the shareholder's regular U.S. income tax liability.194
192
Section 936(a)(2).
193
See Section 936(a)(1), (b).
194
Section 243(a)(3), (b)(1). This dividends received deduction, however, is not available for
alternative minimum tax purposes. This gives rise to an issue whether such dividends should not
be entitled to look-through treatment for purposes of the Section 904 separate limitation
categories, and the argument that their omission from Section 904(d)(5)(C) was simply a mistake.
See Letter to The Honorable Kenneth W. Gideon by Messrs. Mentz, McClure & O'Donnell dated
November 1, 1991, reprinted in Highlights & Documents, December 18, 1991, at 2729.

2. Foreign Corporations with at Least 25% Effectively Connected Income

a. General Rule
In general, under Section 861(a)(2)(B), a portion of dividends paid by a foreign corporation
which is engaged in a U.S. trade or business is treated as domestic source income if 25% or more
of the corporation's worldwide gross income over a certain testing period is effectively connected
with its U.S. trade or business or treated as effectively connected (subject to certain exceptions
described below). If less than 25% of a foreign corporation's worldwide gross income over the
testing period is effectively connected with a U.S. trade or business or is treated as effectively
connected, none of the dividends paid by the foreign corporation is treated as U.S. source
income. The statutory predecessor of this provision was enacted to prevent persons from
avoiding the dividend withholding tax that would be imposed on dividends from domestic
corporations. As noted below, the significance of this source rule has been substantially
diminished by the enactment of the branch profits tax (Section 884) as part of TRA 86.195
195
See generally 908 T.M., U.S. Income Taxation of Foreign Corporations.

Any income of the following types that is effectively connected with a U.S. trade or business,
or treated as effectively connected for certain purposes, is excluded from the numerator of the
fraction (and, in the case of income described in Section 883(a)(1) or (2), from its denominator
as well) for purposes of the 25% test under Section 861(a)(2)(B):196
(i) income not includible in gross income under paragraph (1) or (2) of Section 883(a)
(dealing with certain income from the operation of ships or aircraft);
(ii) income treated as effectively connected with the conduct of a trade or business within the
United States under Sections 921(d) or 926(b) (dealing with certain income from FSCs);
(iii) gain on the disposition of a U.S. real property interest described in Section 897(c)(1)(A)
(ii) (dealing with shares of certain domestic corporations holding interests in U.S. real
property);
(iv) income treated as effectively connected with the conduct of a trade or business within the
United States under Section 953(c)(3)(C) (dealing with related person insurance income of a
controlled foreign corporation); and
(v) income treated as effectively connected with the conduct of a trade or business within the
United States under Section 882(e) (dealing with certain interest received by banks organized
in U.S. possessions). Income that is U.S. source but is not effectively connected with a U.S.
trade or business is also not included in the numerator of the fraction. Items excluded from

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 gross income generally (e.g., tax-exempt interest and, as indicated above, income excludable
under Section 883(a)(1) or (2)) are, of course, not included in the numerator or denominator
of the calculation.197
196
Sections 861(a)(2)(B), 884(d)(2).
197
Regs. Section 1.861-3(b)(3)(ii), (iii).

The testing period generally is the three-year period ending with the close of the corporation's
taxable year immediately preceding the declaration of the dividend (or such part of such period
as the corporation has been in existence). If the foreign corporation has no gross income from
any source for such testing period, the relevant testing period becomes the taxable year in which
the dividend is paid.198
198
Section 861(d).

If the 25% effectively connected income threshold is met, the dividends paid by a foreign
corporation are treated as U.S. source income in an amount which bears the same ratio to such
dividends as the corporation's gross income for the testing period which was effectively
connected income or treated as such (excluding certain types of income as described above)
bears to its gross income from all sources for such period.
Example: If the foreign corporation's relevant effectively connected income is 40% of its
gross income from all sources over the testing period, 40% of the dividends paid by it are
treated as U.S. source income. This would be the case even if the corporation's effectively
connected income in the year the dividend is paid (as opposed to the testing period) is 100%
of its gross income or, alternatively, 0%.
b. Applicability Limited by Branch Profits Tax
Before P.L. 108-357 (discussed immediately below following the Historical Note), §861(a)
(2)(B) was relevant primarily for purposes of imposing a U.S. tax, subject to withholding, on
dividends paid by certain foreign corporations to non-U.S. persons under §§871(a)(1) and 881(a)
(i.e., a "second-level" withholding tax). The enactment of the branch profits tax (Section 884) as
part of TRA 86 vastly diminished the situations in which the second-level dividend withholding
tax would have any significance. The two regimes are mutually exclusive for any given taxable
year, and the branch profits tax, where applicable, preempts the second-level dividend
withholding tax.199 The branch profits tax generally applies with respect to effectively connected
earnings and profits for taxable years beginning after 1986 (post-TRA 86 years) of a foreign
corporation,200 provided that an income tax treaty with the country in which the corporation is
resident does not prohibit its application or, even if it does, the corporation is not a "qualified
resident" of the country within the meaning of Section 884(e)(4).201 Thus, the second-level
withholding tax applies with respect to distributions of effectively connected earnings and profits
from post-TRA 86 tax years only if the taxpayer is a qualified resident of a country with which
the United States has a treaty that prohibits the branch profits tax and the treaty permits a second-
level dividend withholding tax.202
199
See Section 884(e)(3)(A). See also 909 T.M., Branch Profits Tax.
200
TRA 86, Section 1241(e).
201
Section 884(e)(1).
202
The income tax treaties with Korea, the Philippines, and Sweden are examples of this type of
treaty.

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 47

 With respect to distributions of earnings from pre-TRA 86 years, Section 861(a)(2)(B) as in
effect before TRA 86 continues to apply.203 Thus, the pre-TRA 86 50% threshold applies for this
purpose. Post-TRA 86 year deficits in earnings and profits do not reduce pre-TRA 86 year
earnings and profits for this purpose (nor do pre-TRA 86 year deficits reduce post-TRA 86 year
earnings and profits).204 It is not clear which three-year base period is to be used for purposes of
post-TRA 86 year distributions from pre-TRA 86 year earnings and profits (and the result for any
given taxpayer obviously could cut either way); however, the jurisdictional basis for the tax
could, depending on the facts, be more tenuous if a "frozen" base period were selected.
203
S. Rep. No. 445, 100th Cong., 2d Sess. 350 (1988), H.R. Rep. No. 795, 100th Cong., 2d
Sess. 284 (1988); TRA 86 Bluebook, n.22 at 1047.
204
Id.

Historical Note: Before TRA 86, as noted, the Section 861(a)(2)(B) threshold percentage was
50% rather than 25%. This source rule, operating in conjunction with Sections 871(a)(1) and
881(a), represented the only mechanism for a second-level U.S. withholding tax on U.S. profits
repatriated by foreign corporations. Imposition of the tax was rationalized by the U.S. contacts
and the legal protections enjoyed by the foreign corporation in the United States. The tax was
relatively easily avoided, especially, in view of the high (50%) threshold that had to be met
before any dividends paid by the foreign corporation were treated as U.S. source. The TRA 86
change was made for taxable years beginning after 1986.205
205
TRA 86, Sections 1241(b)(2), 1241(e).

P.L. 108-357, the American Jobs Creation Act of 2004, further limited the significance of
§861(a)(2)(B) by adding, in §871(i)(2)(D), the dividends that are treated as U.S. source income
under §861(a)(2)(B) to the list of items in §871(i)(2) that are not subject to tax under §871(a)(1)
(A) or (C) or under §§1441 or 1442 by reason of §§871(i)(1), 881(d), 1441(c)(10), and 1442(a).
The amendment applies to payments after December 31, 2004. The Conference Committee
Report on H.R. 4520 (which ultimately became P.L. 108-357) summarized the reason for the
amendment by indicating the decreased significance of §861(a)(2)(B) as a consequence of the
enactment of the branch profits tax and the existence of several U.S. tax treaties that eliminate
the second-level withholding tax even where the branch profits tax is barred from application.
The effective date, when interpreted together with this reasoning, appears to eliminate U.S. tax
on distributions of pre-TRA 86 earnings also. Accordingly, the principal remaining significance
of §861(a)(2)(B) for dividends paid after 2004 appears to be the effect that the source rule may
have on the foreign tax credit limitation.
3. Foreign Corporations Succeeding to Earnings and Profits of a Domestic Corporation
Section 861(a)(2)(C) provides that dividends paid by a foreign corporation are U.S. source
income to the extent such amount is treated, under Section 243(e), as dividends paid by a
domestic corporation which is subject to tax under chapter 1 of the Code. Since Section 243(e)
by its terms is relevant only for purposes of Sections 243(a) and 245, dealing with the dividends
received deduction for corporate shareholders, Section 861(a)(2)(C) is not relevant to
noncorporate taxpayers.
Under Section 243(e), dividends paid by a foreign corporation are treated for certain
purposes as having been paid by a domestic corporation if: (i) the foreign corporation has
succeeded to the earnings and profits accumulated by a domestic corporation during a period

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 48

with respect to which such domestic corporation was subject to tax under chapter 1 of the Code;
and (ii) the foreign corporation pays the dividend out of such earnings and profits.
Example: A domestic corporation accumulated earnings and profits during a period for which
it was subject to tax under chapter 1 of the Code and subsequently reincorporated as, or
merged into, a foreign corporation in a reorganization qualifying under Section 368, or
liquidated into a parent foreign corporation in a liquidation qualifying under Section 332. 206
The foreign corporation would succeed to the earnings and profits of the domestic
corporation under Section 381, which could be augmented by income recognized on the
transfer.207 For purposes of Section 243(e), any dividend paid by such a foreign corporation,
to the extent paid out of such accumulated earnings and profits, is treated as a dividend paid
by a domestic corporation and, thus, U.S. source income under Section 861(a)(2)(C).208
206
Another example is a distribution of a foreign corporation by a domestic corporation in a
transaction described in Section 355. Note that such a transaction would be tax-free only to the
extent the distribution were to a domestic corporation and Section 1248(f) did not apply. See Regs.
§1.367(b)-5(b); Regs. §1.367(e)-2T(b).
207
Section 367(a)(1) would apply to most such transactions, though not all (see Sections 367(a)
(2)(3), (5), and (6) and Prop. Regs. Sections 1.367(a)-3, 1.367(a)-8). Section 367(a)(1), however,
where applicable, mandates the recognition of gain but does not override Section 381. See Regs.
Sections 1.367(a)-1T(b)(1), (b)(4). "Appropriate adjustment to earnings and profits . . . shall be
made according to otherwise applicable rules." See Regs. Section 1.367(a)-1T(b)(4).
Even if such transfer is not taxable under Section 367(a)(1), it may give rise to tax and
augmented earnings and profits under Section 367(b). See Prop. Regs. Section 1.367(b)-1(a) (to
the extent that a transfer is not actually taxable under Section 367(a), it may be taxable under
Section 367(b). Thus, if a domestic corporation transfers stock of a foreign corporation, with
respect to which it met the Section 1248 ownership requirements, to another foreign corporation
for stock in the latter pursuant to an exchange described in Section 351 or certain provisions of
Section 368, and the transferor does not meet the Section 1248 requirements with respect to the
transferee (e.g., if the transferee is not a controlled foreign corporation), the transferor must
include in income as a dividend the "section 1248 amount" (i.e., the amount that would have been
included in income if the stock in question had been sold). See Prop. Regs. Sections 1.367(b)-4,
1.367(b)-2(c). If the transaction were described in Section 368(a)(1)(C), this Section 1248 amount
would augment the U.S. source earnings and profits inherited by the transferee.
208
Cf. Georday Enterprises, Ltd. v. Comr., 126 F.2d 384 (4th Cir. 1942) (for purposes of
applying 50-50 rule of statutory predecessor of Section 861(a)(2)(B) to dividends paid by foreign
corporation out of earnings and profits inherited from domestic corporation in tax-free
reorganization, gross income of domestic corporation for three-year base period held to carry over
to successor foreign corporation).

If a dividend paid by a foreign corporation is treated as U.S. source income under Section
861(a)(2)(C), Section 861(a)(2)(B) is inapplicable to such dividend.
4. Domestic International Sales Corporations (DISCs) and Former DISCs
The tax regime governing DISCs was substantially modified as of 1985 at which time DISC
elections were deemed to terminate.209 Former DISCs and new entities were permitted to elect to
be taxed under a new "interest-charge" DISC regime.210
209
See generally Regs. Section 1.921-1T(a); Prop. Regs. Section 1.991-1(e).
210
Section 995(f); Prop. Regs. Section 1.995(f)-1.

In order to maintain the foreign source character of certain export-related income derived
through a DISC, Section 861(a)(2)(D) provides that dividends paid by a "DISC" or "former

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 49

DISC" (as defined in Section 992(a)) are foreign source income to a specified extent. The portion
of such dividends treated as foreign source is that portion that is attributable to "qualified export
receipts" described in Section 993(a)(1), excluding the following types of qualified export
receipts:
(i) producer's loan interest;211
(ii) gain on property, other than a qualified export asset, to the extent it was acquired tax-free;
212
and
(iii) gain on disposition of certain property, other than inventory or similar property, to the
extent it was acquired tax-free and the gain would have been ordinary income to the
transferor.213
211
Section 995(b)(1)(A).
212
Section 995(b)(1)(B).
213
Section 995(b)(1)(C).

The regulations flesh out the rule set forth in Section 861(a)(2)(D) and may be summarized
as follows:214
(i) Deemed distributions taxable as dividends under Sections 995(b)(1)(A), (b)(1)(B), and (b)
(1)(C) are regarded as entirely U.S. sources.215
(ii) Deemed distributions taxable as dividends under Sections 995(b)(1)(D), (E), and (F) are
entirely foreign source if the DISC had no "nonqualified export taxable income" (as defined
in Regs. Section 1.861-3(a)(5)(ii)(c)) for the taxable year.216
(iii) If the DISC has nonqualified export taxable income in a taxable year, a portion of
deemed distributions taxable as dividends under Sections 995(b)(1)(D), (E), and (F) in such a
year is U.S. source, and the balance is foreign source. The U.S. source portion of the deemed
distribution is that fraction of the nonqualified export taxable income which equals: 217
Sum of Sections 995(b)(1)(D), (E), and (F) Distributions
-----------------------------------------------------------------
DISC Taxable Income - Sections 995(b)(1)(A), (B), and (C) Distributions

(iv) If no portion of the "accumulated DISC income" (as defined in Regs. Section 1.861-3(a)
(5)(ii)(b)) of a DISC or former DISC is attributable to nonqualified export taxable income 218
from any transaction during a year for which it is (or is treated as) a DISC, then the entire
amount of any dividend that reduces (under Regs. Section 1.996-3(b)(3)) accumulated DISC
income is treated as foreign source.219
(v) If any portion of the accumulated DISC income is attributable to nonqualified export
taxable income, a portion of any dividend which reduces accumulated DISC income is U.S.
source and the balance is foreign source. The U.S. source portion of the dividend distribution
is that fraction of the dividend which equals:220
Accumulated DISC Income Attributable to Nonqualified
Export Taxable Income
-----------------------------------------------------------------
Total Accumulated DISC Income

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 50

 214
Amounts described in Sections 995(b)(1)(A)-(G) generally are deemed distributed (subject
to available earnings and profits) on the last day of the DISC's taxable year. The amounts deemed
distributed subsequently can be distributed free of tax. See Sections 996(a)(1)(A), and (a)(3). The
DISC's remaining earnings are not taxed to the DISC's shareholder until (a) the earnings are
actually distributed; (b) the shareholder disposes of the DISC's stock; (c) the corporation ceases to
be a DISC; or (d) the DISC is liquidated. See Sections 996(a), 995(c), 995(b)(2).
215
Regs. Section 1.861-3(a)(5)(i).
216
Regs. Section 1.861-3(a)(5)(iii)(a).
217
Regs. Section 1.861-3(a)(5)(iii)(b).
218
Regs. Section 1.861-3(a)(5)(iv)(a).
219
Regs. Section 1.861-3(a)(5)(iv)(a).
220
Regs. Section 1.861-3(a)(5)(iv)(b).

Section 901 effectively grants domestic corporate shareholders owning 10% or more of DISC
voting stock the Section 902 deemed paid foreign tax credit for foreign taxes paid by the DISC.
Since the DISC itself is a tax-exempt entity, the deemed-paid tax credit is necessary to assure
creditability of foreign taxes allocable to dividends (actual or constructive) paid by the DISC to
its shareholders. For this purpose, Section 901(d) treats a dividend from a DISC or former DISC
as a dividend from a foreign corporation, but only to the extent the dividend is foreign source
under the Section 861(a)(2)(D) rule described above.
Historical Note: Sections 991-96, enacted in 1971,221 sought to promote U.S. export trade by
permitting partial deferral of U.S. tax on qualified export earnings from U.S. products sold or
leased abroad through a domestic corporation qualifying as a DISC. Under the statutory scheme,
the income of a DISC was not subject to federal income tax. Instead, a portion of the DISC's
earnings was taxed currently to its shareholders as constructive dividends in a deemed
distribution. The tax on the remaining earnings (accumulated DISC income) was deferred until
an actual distribution, until a disposal of DISC stock by a shareholder, or until the corporation
ceased to qualify as a DISC, in which event such earnings were includible as a dividend at the
shareholder level.
221
Revenue Act of 1971, P.L. 92-178.

TRA 86 modified the DISC tax deferral provisions so that the deferral is available only for
incremental export income.
Certain nations party to the General Agreement on Tariffs and Trade (GATT) contended that
the failure of the U.S. Treasury to charge interest on the deferred taxes generated by the DISC
deferred income was an unfair trade practice under GATT. In order to retain the use of the DISC
mechanism for small businesses (which, unlike "foreign sales corporations," discussed below,
permits small businesses to continue to operate through domestic corporations), Congress
modified the DISC rules. The taxable year of all noninterest-charge DISCs was automatically
closed at the beginning of 1985, regardless of whether they operated on a fiscal year, and all
DISC elections were deemed to terminate on such date.222 However, former DISCs, or new
corporations wishing to be treated as DISCs, are permitted to operate under a revised DISC
regime; the principal distinction is that, under Section 995(f), a hypothetical tax on deferred
DISC income (income neither deemed distributed nor actually distributed within a year
following the close of the DISC's taxable year) is calculated as if the income were distributed,
and this amount of tax is treated as a borrowing by the DISC's shareholder from the treasury
subject to an interest charge.223 The basis on which DISC income is permitted to be deferred has

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been expanded under the interest-charge DISC provisions. The "base-period incremental rules,"
which substantially reduced the amount of deferrable DISC income, as well as the provisions
causing deemed distributions of one-half of the DISC's income to its shareholders, were
eliminated.224
222
TRA 84, Section 805(b)(1)(A). See fn. 209 above.
223
See fn. 210 above.
224
See TRA 84, Sections 802(b), 68(d, amending Sections 995(b)(1)(E), (F)(i).

5. Foreign Sales Corporations (FSCs)

TRA 84 added Sections 921-927, which generally replaced the system of DISCs with a
simpler, territorial-type system of taxation for U.S. exports, the FSC. In order to avoid charges of
illegal export subsidies under GATT, the FSC provisions exempt income from U.S. taxation only
if certain economic processes giving rise to the income occur outside the United States. To this
end, the FSC provisions institute foreign management and foreign economic process
requirements.225 Special source rules applicable to income derived by an FSC or on sales to an
FSC or using an FSC as a commission agent are discussed in XIV, A, 3, below.
225
See Section 924. See generally 264 T.M., Foreign Sales Corporations.

Section 926(b) provides that any distribution made by an FSC or former FSC out of earnings
and profits attributable to exempt or nonexempt "foreign trade income" (as defined in Section
923(b)) to a shareholder which is a foreign corporation or a nonresident alien is treated as
effectively connected with a U.S. trade or business conducted through a permanent establishment
of such shareholder in the United States and as U.S. source income. For this purpose,
distributions to a foreign partnership, foreign trust, foreign estate, or other foreign entity that
would be treated as a pass-through entity under U.S. law are treated as made directly to the
partners or beneficiaries in proportion to their respective interests in the entity.226 FSC
distributions made out of other earnings and profits are considered to be foreign source under the
general source rule. Regs. Section 1.926(a)-1(b)(1) sets forth the order in which distributions are
deemed made from the various categories of the FSC's earnings and profits.
226
Regs. Section 1.926(a)-1T(a).

Dividends attributable to foreign trade income (within the meaning of Section 923(b)) or
income effectively connected with a U.S. business earned while the issuing corporation was an
FSC and paid to a U.S. corporation are eligible for full or partial exclusion under Section 245(c).
To the extent such dividends are not so excluded, they are considered foreign source under the
general source rule. For purposes of the Section 904 foreign tax credit limitations, the taxable
portion of FSC dividends attributable to foreign trade income or interest or carrying charges
derived from a transaction which results in foreign trade income must be included in a separate
limitation category.227
227
See Section 904(d)(1)(H).

P.L. 106-519, the FSC Repeal and Extraterritorial Income Exclusion Act of 2000, repealed
the FSC provisions, effective generally for transactions after September 30, 2000. The
extraterritorial income exclusion enacted in that legislation was, in turn, repealed by P.L. 108-
357, the American Jobs Creation Act of 2004, for transactions occurring after December 31,
2004, subject to certain transitional relief for transactions occurring in 2005 and 2006.

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 52

 6. Exception for Foreign Tax Credit Purposes for Dividends Eligible for Section 245
Deduction
Two seemingly overlapping provisions provide special source rules for foreign tax credit
purposes where dividends are paid by a foreign corporation entitled to a Section 245 dividends
received deduction. This deduction generally is allowed, at the rate specified in Section 243, for
the "U.S.-source portion" of dividends received from a foreign corporation, other than a foreign
personal holding company or passive foreign investment company, in which the taxpayer owns at
least 10% of the vote and value of the foreign corporation (a qualified 10% owned foreign
corporation).228 The "U.S.-source portion" of a dividend is an amount bearing the same ratio to
the dividend as the "post-1986 undistributed U.S. earnings" (as defined in Section 245(a)(5))
bears to the total "post-1986 undistributed earnings" (as defined in Section 902(c)(1)).
228
Section 245(a)(1).

First, for purposes of Section 904, Section 245(a)(9) provides that the U.S.-source portion of
any dividend received by a corporation from a qualified 10% owned foreign corporation is
treated as from sources in the United States. If, however, treating any portion of a dividend as
from U.S. sources under Section 245(a)(9) violates a treaty obligation of the United States, the
taxpayer may elect the benefit of the treaty source rule (but Sections 902, 904(a)-(c), 907, and
960 must be applied separately with respect to such portion of the dividend).229
229
Section 245(a)(10).

Second, Section 861(a)(2)(B) generally provides that, for purposes of the Section 904 foreign
tax credit limitation, a dividend paid by a foreign corporation is foreign source income only to
the extent it exceeds the amount which is 100/70ths of the amount of the deduction allowable
under Section 245(a) with respect to such dividend (100/80th in the case of dividends from a
"20-percent owned corporation," as defined in Section 243(c)(2)). A technical modification is
made to this rule in the regulations to treat as foreign source a corresponding portion of any
Section 78 dividend.230 (However, dividends paid out of earnings and profits of a foreign
corporation for a taxable year during which all of its stock is owned, directly or indirectly by the
taxpayer and all of its gross income is effectively connected with a U.S. trade or business are
considered wholly U.S. source, since 100% of such dividends are deductible under Section
245(b).) The general rule was added to Section 861(a)(2)(B) at the time of the enactment of
Section 245 to preclude both a foreign tax credit and a dividends received deduction attributable
to the same income.231 The 100/70ths (100/80ths) ratio functions to gross up the amount
deductible under the 70% (80%) dividends received deduction to obtain the total amount of the
dividend eligible for the Section 245 deduction; only the balance of the dividend is treated as
foreign source income for foreign tax credit purposes.
230
See Regs. Section 1.861-3(a)(3)(ii) (though still reflecting the 85% rate for the dividends
received deduction).
231
See Dailey, "The Concept of the Source of Income," 15 Tax L. Rev. 426-432 (1960).

Historical Note: Before 1951, a deduction was not allowed for dividends received from a
foreign corporation regardless of the U.S. source component of such foreign corporation's
earnings and profits. Considering this to be discriminatory, in 1951 Congress added Section 245
to allow a deduction for dividends received from a foreign corporation attributable to earnings
and profits arising in the United States.232 The provision was completely rewritten as part of TRA

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 53

86233 and further amended by the 1988 TAMRA.234
232
Under the Revenue Act of 1918, the source of both dividends and interest was determined by
the residency of the obligor. When this proved inequitable, Section 217(a)(2) of the 1921 Act
added a predominant source rule under which both U.S. and foreign corporate dividends were
presumed to be entirely from U.S. sources if more than 50% of the base period income was from
U.S. sources. The 1924 Act modified Section 217(a)(2) to add the present "80-20" rule for U.S.
corporations. This rule proved unfair to shareholders following the 1934 elimination of the
individual exemption from normal tax and the corporate deductibility of U.S. source dividends.
The 1934 Act sought to alleviate the denial of the exemption by treating foreign dividends as
entirely from foreign sources for purposes of the foreign tax credit (Section 217(a)(2)(B)). Since
this credit was unavailable to foreign persons and corporations, the 1936 Act (Section 119(a)(2)
(B)) added the current "50-50" pro rata predominant source rule applicable to foreign corporations.
Finally, the 1951 Act added Section 245 to end the "discrimination" of subjecting foreign
corporations to double domestic tax; first, on the receipt of taxable income and later on the
payment of dividends, while domestic dividends were permitted a dividends received credit (now
a deduction). See Dailey, "The Concept of the Source of Income," 15 Tax L. Rev. 415, 429 (1960).
233
TRA 86, Section 1226(a).
234
Technical and Miscellaneous Revenue Act of 1988, P.L. 100-647 (hereinafter cited as
"TAMRA"), Section 1012(1)(2).

7. Exception for Foreign Tax Credit Purposes Where Payor Is U.S.-Owned Foreign
Corporation with Significant U.S. Income
Section 904(g), redesignated §904(h) by §402 of P.L. 108-357 for taxable years beginning
after December 31, 2006, treats as U.S. source income, solely for purposes of the computation of
the foreign tax credit limitations, certain kinds of income derived from U.S.-owned foreign
corporations that would otherwise be foreign source income under the regular source rules.235 The
aim of the provision is to prevent U.S. source income from being converted to foreign source
income (which would increase the numerator of the Section 904 limiting fraction) by routing it
through a foreign corporation. Prime targets of the provision were international finance
subsidiaries and offshore captive insurance companies.
235
See generally 901 T.M., The Foreign Tax Credit--Overview and Creditability Issues.

The resourcing rule applies to any foreign corporation as to which U.S. persons (as defined in
Code Section 7701(a)(30)) own 50% or more of (i) the total combined voting power of all
classes of the corporation's stock that are entitled to vote, or (ii) the total value of the
corporation's stock.236
236
Section 904(g)(6).

Under Section 904(g), for purposes of the Section 904 foreign tax credit limitations, the
following five types of income that would otherwise constitute foreign source income are
resourced as U.S. source income:
(i) Subpart F income, etc.
Income includible in the income of a U.S. shareholder of a controlled foreign corporation
under Section 951(a) to the extent that such income is attributable to income of the controlled
foreign corporation derived from U.S. sources.237
(ii) Foreign personal holding company income.

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 Income includible under Section 551 to the extent that such income is attributable to income
of the foreign personal holding company derived from U.S. sources.238 P.L. 108-357, the
American Jobs Creation Act of 2004, struck this item from the list in conjunction with the
repeal of §551 and the foreign personal holding company provisions for taxable years of
foreign corporations beginning after December 31, 2004, and for taxable years of U.S.
shareholders with or within which such taxable years of foreign corporations end.
(iii) Passive foreign investment company currently includible income.
Income includible under Section 1293 to the extent that such income is attributable to income
of the passive foreign investment company derived from U.S. sources.239
(iv) Certain interest.
Certain interest paid or accrued by a U.S.-owned foreign corporation allocable (under
regulations) to its U.S. source income. The interest covered by this rule is interest paid or
accrued to a 10% U.S. shareholder or a person related to such shareholder under the rules of
Section 267(b). Treasury is authorized to promulgate regulations extending the rule to less-
than-10% U.S. shareholders.240 For this purpose, a U.S.-owned foreign corporation includes a
U.S. corporation meeting the 80% active foreign business income test of Section 861(c)(1)
for purposes of Section 861(a)(1)(A).241
(v) Dividend Income.
Dividends paid by a U.S.-owned foreign corporation to the extent of the "U.S. source ratio,"
i.e., the ratio of U.S. source earnings and profits for the taxable year from which the dividend
is paid to total earnings and profits for such taxable year.242 For purposes of Section 904(g), a
dividend includes any amount treated as ordinary income under Section 1246 (as in effect
before its repeal by P.L. 108-357) or as a dividend under Section 1248.243
237
Sections 904(g)(1)(A)(i) and (g)(2).
238
Sections 904(g)(1)(A)(ii) and (g)(2). Since such income is considered a dividend under
Section 551(b), it is not clear why such income is separately set forth in Section 904(g).
239
Sections 904(g)(1)(A)(iii) and (g)(2).
240
Sections 904(g)(1)(B) and (g)(3).
241
See Section 904(g)(9)(A).
242
Sections 904(g)(1)(C) and (g)(4). Accord Prop. Regs. Section 1.1291-5(c)(1) (Section 1291
"excess distribution").
243
Section 904(g)(7). (The reference to Section 1246 is much less significant following the
enactment of Section 865, since the sale of stock by a U.S. person would generally give rise to
U.S. source income, other than when Sections 865(e), (f), or (h) applies.) Section 904(g)(9)(B)
probably should be deleted as deadwood in view of the deletion of former Section 861(a)(2)(A) by
TRA 86.

If less than 10% of the earnings and profits of a U.S.-owned corporation for a taxable year is
attributable to U.S. sources, dividends paid out of the earnings and profits for such year and
interest paid or accrued during such year will not be subject to the special source rules of Section
904(g).244 This de minimis exception does not apply with respect to subpart F income, foreign
personal holding company income or passive foreign investment company income.245
244
See Section 904(g)(5).
245
Id.

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 If characterization of an amount derived from a U.S.-owned foreign corporation is
inconsistent with an obligation of the United State under an income tax treaty with the country of
which the corporation is resident, the taxpayer may elect to have the benefit of the treaty; in such
case, Sections 902, 904(a)-(c), 907, and 960 are applied separately with respect to the amount for
which recharacterization is avoided.246 For this purpose, amounts included in income under
Section 951(a)(1) of the Code's subpart F provisions are treated as a dividend if payment of such
amounts to the U.S. shareholder are considered as arising from foreign sources under the treaty.247
246
Section 904(g)(10)(A).
247
Section 904(g)(10)(B).

Historical Note: Section 904(g) was added to the Code by TRA 84.248
248
TRA 84, Section 121.

TRA 84 added another provision, codified as Section 904(d)(3), to deal with a similar
problem.249 Solely for foreign tax credit purposes, former Section 904(d)(3) recharacterized as
interest what would otherwise be foreign source dividend income. Section 904(d)(3) provided
that, when a U.S.-owned foreign corporation, a regulated investment company, or a foreign
corporation in which the taxpayer was a "U.S. shareholder" under Section 951(b), paid or
accrued dividends or interest, then, subject to a de minimis exception, such payments were
treated as interest in the hands of the U.S. recipient to the extent the paying corporation's
earnings and profits for the relevant taxable year included interest subject to separate foreign tax
credit limitation under Section 904(d)(2) as then in effect.
249
TRA 84, Section 122. Certain technical corrections were made to Section 904(d)(3) by TRA
86, but have no effect for post-TRA 86 periods.

Like Section 904(g), Section 904(d)(3) was aimed at an income conversion available to U.S.
taxpayers with excess foreign tax credits. Whereas Section 904(g) addressed the potential
conversion of certain U.S. source income into foreign source income, Section 904(d)(3)
addressed the potential conversion of foreign source interest income, which generally was
subject to separate limitation under Section 904, into foreign source dividend income, which
generally was not subject to separate limitation before TRA 86. For example, prior to TRA 84, if
a controlled foreign corporation derived both low-taxed interest income treated as subpart F
income and higher taxed intercompany sales income treated as subpart F income, the amount
included under subpart F was not separated out into interest and other components for Section
904 purposes.250 Similarly, before TRA 84, if a U.S. taxpayer with excess foreign tax credits
invested surplus cash outside the United States and earned interest, such foreign source interest
did not enable the taxpayer to absorb the excess credits because of the separate foreign tax credit
limitation on interest income under Section 904(d)(2) as then in effect. However, the taxpayer
could avoid Section 904(d)(2) by converting the character of potential interest income into
dividend income. If the taxpayer routed loans abroad through a foreign subsidiary, the foreign
source interest income earned by the subsidiary was treated as foreign source dividend income
when included in the gross income of the U.S. shareholder as subpart F income or when actually
distributed. The same result could be achieved by investment in a U.S. mutual fund which was an
"80-20" company under former Section 861(a)(2)(A). The "look-through rules" for controlled
foreign corporations contained in current Section 904(d)(3) and the separate limitation category
for "noncontrolled Section 902 corporations" as defined in Section 904(d)(2)(E) made former
Section 904(d)(3) unnecessary.

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 250
See generally Regs. Sections 1.960-1(c)(1)(i), (c)(4), Ex. (1).

8. Exception for Accumulated Earnings Tax Purposes

For purposes of the Section 531 accumulated earnings tax, if 10% or more of the earnings
and profits of a foreign corporation for any taxable year are derived from U.S. sources or are
effectively connected with a U.S. trade or business, any distribution out of such earnings and
profits (and any interest payments) received (directly or indirectly through one or more other
entities) by a "U.S.-owned foreign corporation" is treated as derived by such corporation from
U.S. sources.251 This provision was added by TRA 84252 to address the perceived abuse that
earnings of a foreign corporation, which would cause the corporation to be subject to the
accumulated earnings tax if retained in the corporation, could be distributed to an upper-tier
foreign corporation and thus avoid the accumulated earnings tax on both corporations. This
provision has been made largely unnecessary in light of the enactment of the PFIC (passive
foreign investment company) provisions as part of TRA 86.253
251
Section 535(d). See generally 796 T.M., Accumulated Earnings Tax.
252
TRA 84, Section 125(a).
253
The PFIC provisions, however, would apply only if the income earned by the foreign
corporation is "foreign personal holding company income" within the meaning of §954(c) (subject
to certain exceptions). See §1297(b).

9. Pass-Through Treatment with Respect to Certain Corporations

Certain corporations are permitted or required to pass through the character and source of the
income they receive (or of certain such income).
a. S Corporations
In the case of a qualifying corporation that has elected under Section 1362(a) to be treated as
an "S corporation," each shareholder's pro rata share of items of income of the corporation has
the same source as in the hands of the corporation.254
254
Section 1366(b). Furthermore, for purposes of the foreign tax credit, controlled foreign
corporation, and boycott provisions, an S corporation is treated as a partnership and the
shareholders are treated as partners thereof. Section 1373(a). See generally 731 T.M., S
Corporations: Operations.

b. Regulated Investment Companies

In the case of a "regulated investment company" as defined in Section 851 (RIC), the entity
may pass through the character of certain tax-exempt interest255 and net capital gains256 to its
shareholders.257 Dividends and capital gain dividends paid by a RIC generally are from U.S.
sources.258 However, if more than 50% of the RIC's assets as of the close of the taxable year
consists of stock or securities in foreign corporations, and if it meets the distribution
requirements of Section 852(a) for the year, the RIC may elect under Section 853 to pass through
to its shareholders the foreign source character of income received on such stock or securities (as
grossed up by foreign taxes paid by the RIC) and the right to claim the foreign tax credit.
255
See Section 852(b)(5).
256
Section 852(b)(3).
257
See generally 740 T.M., Taxation of Regulated Investment Companies.

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 258
See Rev. Rul. 69-235, 1969-1 C.B. 190.

c. Real Estate Investment Trusts

For taxable years beginning on or before October 22, 2004, a "real estate investment trust" as
defined in §856 (REIT) may elect to pass through the character of net capital gain.259 In addition,
a mandatory look-through rule applies to any distribution by a REIT to a nonresident alien or
foreign corporation to the extent attributable to gain from the sale or exchange by the REIT of a
"U.S. real property interest" (as defined in Section 897(c)(1)).260 See the discussion in VI, A,
below. Such a distribution is taxable to a foreign shareholder as gain from the disposition of U.S.
real property.261 As a consequence of receiving such gain, the foreign investor was required to file
a U.S. federal income tax return for the year and to apply the branch profits tax absent a tax
treaty provision to the contrary. To reduce these requirements, §418 of P.L. 108-357 amended
§§857(b)(3) and 897(h)(1) to provide that for taxable years beginning after October 22, 2004, if
the distribution is received with respect to a class of stock regularly traded on an established
securities market located in the United States and the foreign investor does not own more than
5% of the class of stock at any time during the taxable year within which the distribution was
received, then instead of pass-through treatment the REIT distribution would be treated as a
REIT dividend that is not capital gain.
259
See Section 857(b)(3). See generally 742 T.M., Real Estate Investment Trusts.
260
See Section 897(h)(1). See the discussion in VI, A, below.
261
Id.

d. Real Estate Mortgage Investment Conduits

In the case of a "real estate mortgage investment conduit" as defined in Section 860D
(REMIC), which may or may not take the form of a corporation or other entity,262 each holder of
a "residual interest" in the REMIC must take into account the holder's "daily portion" of the
taxable income or net loss of the REMIC for each day during the taxable year on which the
holder owned the residual interest.263 On the other hand, "regular interests" in the REMIC are
treated as debt instruments issued by the REMIC, regardless of whether described as debt
instruments.264 Thus, in determining the taxable income of a REMIC that must be included by the
holders of residual interests, amounts paid to holders of regular interests are deducted.
262
See generally 741 T.M., REMICs and Other Mortgage-Backed Securities.
263
Section 860C(a)(1); Regs. Section 1.860C-1(a). Prop. Regs. §1.863-1(e), published as part of
REG-162625-02, 68 Fed. Reg. 43055 (7/21/03), would require that an inducement fee, defined as
an amount paid to induce a person to become the holder of a noneconomic residual interest in a
REMIC, be treated as income from sources within the United States.
264
Section 860C(b)(1)(A); Regs. Section 1.860G-1(b)(6).

10. Special Rule for Taxation of Domestic Corporations with 80% Active Foreign Business
Income
Unlike in the case of interest, the Code does not include a source rule for dividends paid by
certain domestic corporations with a large percent of active foreign business income. However, a
portion of a dividend paid by a domestic corporation to a nonresident alien or foreign corporation
is not subject to the 30% tax under Section 871(a) or Section 881 if at least 80% of its worldwide
gross income is "active foreign business income" for the three-year (or shorter applicable) base
period ending with the taxable year preceding the year of dividend declaration.265 If the 80%

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threshold test is met, that portion of dividends paid by it is foreign source income as bears the
same ratio to the entire dividend as the corporation's gross income from sources outside the
United States bears to its worldwide gross income.266 Thus, unlike the look-through limitation
applicable to sourcing interest, this dividend look-through limitation applies to dividends paid to
unrelated as well as related persons.
265
See Sections 871(i), 861(c). See the discussion of Section 861(c) in II, B, 1, above.
266
See Sections 871(i)(2)(B), 861(c)(2)(A).

When the domestic corporation paying the dividends is the surviving corporation in a
reorganization with another domestic corporation, it must take into account the total gross
income of the target corporation as well as its own for the purpose of applying the 80% test of
Section 861(c).267
267
See Rev. Rul. 76-300, 1976-2 C.B. 217.

If a domestic corporation joins other domestic corporations in filing a consolidated return, the
80% test is applied on the basis of the joining corporation's own gross income only, which
includes, for this purpose, income otherwise deferred or eliminated in the consolidated return. 268
268
See Rev. Rul. 72-230, 1970-1 C.B. 209.

Historical Note: Before TRA 86, if a domestic corporation derived less than 20% of its gross
income from sources within the United States for the three-year period ending with the year
preceding the year in which the dividend was declared (or such shorter period that the
corporation was in existence), then the entire dividend was considered to be foreign source
income to the recipient.269 Congress was concerned that both domestic and foreign persons were
able to manipulate the pre-TRA 86 Act 80-20 test by using the 20% residual feature to their
advantage.270 Further, since the only objective of this rule was to exempt certain dividends paid to
foreign persons (and not to affect the foreign tax credit calculation of domestic taxpayers),
recasting the source rule as an exemption was considered appropriate.271
269
Sections 861(a)(2)(A) (as in effect prior to amendment by TRA 86), 862(a)(2).
270
See TRA 86 Blue Book at 937.
271
Id. at 938.

C. Definition of Dividend
1. General
The source of income regulations state that the term "dividend" has the meaning set forth in
Section 316. Thus, a distribution by a corporation is treated as a dividend to the extent the
corporation has either earnings and profits "accumulated" from periods after February 28, 1913,
or has "current" earnings and profits. Current earnings and profits include earnings and profits
for the entire taxable year in which the dividend is paid, including for the portion of such year
following the payment of the dividend, and are not reduced by any deficit earnings and profits
from prior years.272 Earnings and profits are calculated in accordance with Section 312, and
generally exceed undistributed taxable income.273
272
See generally 764 T.M., Dividends -- Cash and Property; 189 T.M., Earnings and Profits --
Effect of Distributions and Exchanges.
273
See generally 175 T.M., Earnings and Profits -- General Principles and Treatment of
Specific Items; 932 T.M., Foreign Corporation Earnings and Profits.

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 For source of income purposes, dividends include, e.g., constructive dividends, dividend
equivalent redemptions under Section 302(d),274 stock dividends that are taxable under Section
305(b), proceeds of the redemption or sale of certain preferred stock ("section 306 stock")275 to
the extent deemed made out of Section 312 earnings and profits, property distributions with
respect to a shareholder's stock, Section 356(a)(2) "boot" dividends, inclusions of earnings and
profits required under Section 367(b),276 a shareholder's proportionate share of "undistributed
foreign personal holding company income" includible under Section 551(b), capital gain
dividends from a regulated investment company,277 consent dividends under Section 565, and the
portion of gain on the disposition of an interest in a foreign corporation that is taxable to a U.S.
shareholder as a dividend under Section 1248.278 On the other hand, redemptions which qualify
for Section 302(a) "sale" treatment, distributions in complete liquidation taxable as capital gain
under Section 331279 or as ordinary income from a "collapsible" corporation under Section 341,
distributions representing a return of capital under Section 301(c)(2), or gain under Section
301(c)(3) and nontaxable stock distributions under Section 305(a) are not dividends for source of
income purposes.
274
De Nobili Cigar Co. v. Comr., 1 T.C. 673 (1943), acq., 1943 C.B. 6, aff'd, 143 F.2d 436 (2d
Cir. 1944) (pro rata distributions in redemption of stock treated as dividends).
275
See VII, A, 2, f, below.
276
See Regs. Section 1.367(b)-2(e).
277
Rev. Rul. 69-235, 1969-1 C.B. 190. Such dividends, however, are not considered "fixed or
determinable annual or periodical" income subject to the 30% (or lower treaty rate) withholding
tax. Id. Based on Rev. Rul. 69-235, in the case of a REIT holding one or more real properties
located abroad, both ordinary dividends and capital gain dividend attributable to the foreign
properties are treated as U.S. source dividends, even though a look-through rule would apply
under Section 897(h) to any dividend attributable to gain from the disposition of real property
located in the United States. However, for taxable years beginning after October 22, 2004, §418 of
the American Jobs Creation Act (P.L. 108-357) provided an exception to the look-through rule
whereunder the distribution is treated as a REIT dividend if the distribution is received with
respect to a class of stock regularly traded on an established securities market located in the
United States and the foreign investor does not own more than 5% of the class of stock at any time
during the taxable year within which the distribution was received. This legislative change had the
salutary effect for many foreign investors of eliminating the requirement of a U.S. federal income
tax return and application of the branch profits tax (absent a tax treaty provision to the contrary).
278
See VII, A, 2, h, below.
279
In Hay v. Comr., 2 T.C. 460 (1943), aff'd 145 F.2d 1001 (4th Cir.1944), cert. denied, 324
U.S. 863 (1945), the sole shareholder of a California corporation transferred all of his stock in the
corporation to a newly created Bahamian corporation, which liquidated the California corporation.
The Fourth Circuit held that the distribution was income from U.S. sources on the theory that the
predecessor of Section 861(a)(2) encompassed liquidating distributions as well as ordinary
dividends. This holding appears to be incorrect; liquidating distributions have been held not to be
dividends for other purposes of the Code. See, e.g., Associated Telephone & Telegraph Co. v. U.S.,
306 F.2d 824 (2d Cir. 1962) (Second Circuit refused to follow Hay and held that the term
"dividend," as used in Section 902(a), did not include a liquidating distribution); post-2000 Regs.
§1.1441-3(c)(2)(i)(B) and pre-2001 Regs. §1.1441-3(b)(1)(ii) (liquidating distributions under §331
are not subject to withholding).

Section 302(e)(4)(A) of the Jobs and Growth Tax Relief Reconciliation Act of 2003, P.L.
108-27, repealed the §341 collapsible corporation provision effective for taxable years beginning
after December 31, 2002. Also, §413 of the American Jobs Creation Act of 2004, P.L. 108-357,
repealed §551 and the other foreign personal holding company provisions for taxable years of
foreign corporations beginning after December 31, 2004, and for taxable years of U.S.

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shareholders with or within which such taxable years of foreign corporations end.
2. Substitute Payments Under Securities Loans
It has become commonplace for securities to be "loaned" by the owner to a borrower. A
"substitute payment" with respect to a loan of a debt security is a payment made by the borrower
to the lender of an amount equivalent to the dividend payments that the lender would have
received on the security during the term of the loan. The IRS recently proposed regulations under
which substitute payments on debt securities would be treated identically to dividends paid on
the securities for Section 1441 withholding, foreign tax credit, and income tax treaty purposes.280
This regulation is discussed in greater detail in XII, C, below.
280
See Prop. Regs. Section 1.861-2(a)(7).

D. Source of Dividend Income upon Taxation to Payee's Beneficial Owners

When dividends received by an entity are subsequently distributed, they are sourced in the
hands of the ultimate recipient in the same manner as interest income (see II, F, 1, above). Thus,
dividend income received by a C corporation loses its character in the hands of the corporation.
Assuming that the redistribution of such income to the corporation's own shareholders is taxable
as a dividend, its source in the hands of such shareholders is determined by reference to the place
of incorporation of the corporation (subject to the exceptions discussed above), in the same
manner as any other dividends paid by the corporation. Thus, a foreign corporation which is not
engaged in business in the United States and which receives U.S. source dividend (or interest)
income generally acts as a "source converter" for such income, since dividends (and interest)
paid by it generally would be foreign source. Certain exceptions to this general rule exist, as
discussed in II, F, 1, above.
The rules relating to the source of interest income received by a partnership and distributed to
the partners, discussed in II, F, 2, above, apply equally to dividend income. Thus, a partner's
distributive share of the partnership's dividend income is foreign source income to the partner to
the extent it was foreign source income in the hands of the partnership.
The rules relating to the source of interest income taxed to the ultimate beneficial owners of a
trust or an estate, discussed in II, F, 3, above, apply equally to dividend income. Thus, when a
trust or estate distributes dividend income to a beneficiary, the source of such dividend is the
same as it was in the hands of the trust or estate, regardless of whether the income is distributed
by the trust or estate in the year in which it was received. However, if a complex trust or an estate
receives dividends from a domestic corporation that meets the 80% foreign business requirement
of Section 861(c)(1) and the trust or estate distributes such dividends in a taxable year after that
in which they were received, the dividends presumably are not eligible for the Section 871(i)(2)
exclusion for the same reason that interest from deposits would not be.281
281
See II, F, 3, above.

IV. Service Income

This section analyzes the various issues involved in the application of the service income
source rules. It presents the general place-of-performance rule and the "commercial traveler"

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exception thereto. This is followed by a discussion of various rules for allocating compensation
income to the place of performance and apportioning such income if services are performed in
more than one place, the sourcing of deferred compensation, the scope of the term "services" and
the overlap between service and other income, and the effect that activities of an agent may have
on the source of service income.
A. General Rule -- Place Where Services Performed
1. General
Under Sections 861(a)(3) and 862(a)(3), the source of compensation for labor or personal
services is the place of performance of such services. Income from services performed in more
than one country is generally allocated by the regulations to the countries of performance on a
"time spent" basis, as described more fully in IV, C, 1, below. The nationality and the residence
of the person or firm providing services (and of the person or firm for whom services are
rendered) are irrelevant to the source of such income,282 as are the place in which the contract was
made or the place or time of payment.283 But cf. PLR 9628024 (settlement payment attributable to
performance of services in foreign country while taxpayer was not a U.S. resident nevertheless
includible in gross income if received while taxpayer is a U.S. resident, regardless of payment's
source).
282
See Piedras Negras Broadcasting Co. v. Comr., 43 B.T.A. 297 (1941), nonacq., 1941-2 C.B.
22, aff'd, 127 F.2d 260 (5th Cir. 1942) (income from U.S. advertisers solicited by a Mexican radio
station in the United States held to be foreign source income attributable to broadcast services
performed in Mexico); Dillin v. Comr., 56 T.C. 228, 244 (1971) (cash basis, U.S. citizen who
expatriated himself before receipt of compensation, taxed as a nonresident alien); Dowell v. Comr.,
36 T.C.M. 470, 472 (1977); U.S. v. Balanovski, 236 F.2d 298 (2d Cir. 1956); Cini v. Comr., 67 T.C.
844(1977); Roerich v. Comr., 38 B.T.A. 567 (1938), acq. and nonacq. in part, 1938-2 C.B. 27, 56,
aff'd, 115 F.2d 39 (D.C. Cir. 1940), cert. denied, 312 U.S. 700 (1941).
283
Regs. §1.861-4(a)(1). As stated by the court in Dillin v. Comr., 56 T.C. 228, 244 (1971), "
[t]he source of [service] income is determined by the situs of the services rendered, not by the
location of the payor, the residence of the taxpayer, the place of contracting, or the place of
payment."

a. General Tax Regime and Exemptions

Compensation for services performed by a typical foreign employee stationed temporarily in
the United States thus is considered to be from U.S. sources. It also is considered to be
effectively connected with a U.S. trade or business under Section 864 and, unless exempt under
an income tax treaty, subject to regular U.S. income tax under Section 871(b)(1).284 In certain
cases, however, the income may qualify for the annual exclusion under the Code or, more likely
a treaty, or for a special Code rule or tax treaty provision concerning research fellows, teachers,
trainees, artists, athletes, international shipping and aircraft crew, pension income, or U.S.
possessions' residents and income.
284
See, e.g., PLR 8319044. See generally 907 T.M., Nonresident Individuals -- U.S. Income
Taxation. With regard to possible income tax treaty exemptions, see discussion in IV, B, 2, below.

Compensation for services performed by a U.S. citizen or resident in a foreign country may,
in appropriate cases, qualify for the Section 911 exclusion for foreign earned income.285
285
See generally 918 T.M., Citizens and Resident Aliens Employed Abroad.

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 b. Definition of United States
As in the case of the source rules generally, the United States includes the 50 states and the
District of Columbia plus the territorial waters adjoining its coastline.286
286
See fns. 16-17 above.

The U.S. possessions (Virgin Islands, Puerto Rico, American Samoa, Guam, Midway, and
Wake Islands) are not included within either the territorial or continental shelf definitions of the
"United States"; however, the U.S. possessions are included in the territorial definition of the
"United States" for purposes of Section 911`s exclusion of foreign source personal service
income earned by U.S. citizens and resident aliens living abroad.287 While possessions income is
not excludable under Section 911, services performed within such possessions may be eligible
for the income exclusionary rules of Sections 931-36 relating to the taxation of possessions
citizens, residents, or income.288
287
See fns. 18 and 19 above.
288
See generally 933 T.M., The Possessions Corporation Tax Credit Under Section 936.

For purposes of applying the source rules for services with respect to income from services
related to the exploration and exploitation of inanimate natural resources, services performed in
the United States includes services performed in the adjoining continental shelf and, under
certain circumstances, services performed in a foreign country include services performed in that
country's adjoining continental shelf.289
289
See the discussion in I, C, above, and in IV, C, below.

2. Income Under Community Property Laws

The application of the source rules for service income generally is not affected by community
property laws.
In the case of a married couple one or both of whom are nonresident aliens and who, under
community property laws, have community income for the taxable year derived from personal
services, the income generally is treated under Section 879(a)as the income of the spouse who
rendered the personal services. (Special rules apply for income derived through a partnership or
in a trade or business.)290
290
In the case of either income derived from a trade or business or a partner's distributive share
of partnership income, however, the community property income is treated as provided in Section
1402(a)(5), per Section 879(a)(2). See generally 907 T.M., Nonresident Individuals -- U.S. Income
Taxation.

For purposes of applying the Section 911 exclusion in the case of community income, a
similar approach is taken. Under Section 911(b)(2)(C), the aggregate amount which may be
excluded from the gross income of the husband and wife for any taxable year is the amount
which would be excludable if the income were not community income.
In any situation not governed by the special rules of Sections 879 and 911, the nonstatutory
residual rule is that one-half of community income derived from the performance of services is
treated as the income of the spouse providing the service, and it retains its character and source
in the hands of such spouse as under the pre-Section 879 law described below. This residual rule
is relevant for determining the foreign tax credit of a married couple each of whom is a U.S.

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citizen or resident and who file separate returns.
Historical Note: Before the enactment of Section 879 as part of the Tax Reform Act of 1976
(P.L. 94-455), one-half of a spouse's personal service income could be considered attributed to a
nonearner nonresident alien spouse under domestic or foreign community property law; since the
nonearner spouse inherited the source of such income, if the services were performed outside the
United States, such income was exempt from U.S. tax.291 As originally enacted, Section 879 did
not apply in a situation in which both spouses (rather than one) were nonresident aliens from a
community property country. To prevent such taxpayers from splitting their income to obtain the
benefit of a lower effective tax rate (assuming an election under Section 6013(g) had not been
made), Section 879 was amended by TRA 84.292
291
See, e.g., Crawford v. U.S., 84-1 USTC Para.9294 (Ct. Cl. 1984); Rev. Rul. 60-57, 1960-1
C.B. 620; Rev. Rul. 56-269, 1956-1 C.B. 318 (nonresident alien wife's share of community income
earned without the United States could be excluded from income under pre-1976 law).
292
See TRA 84, Section 452. See generally Westerdahl v. Comr., 82 T.C. 83, 95 (1984).

B. Temporary Presence Exception to the General Rule

The Code provides a de minimis exception to the service income source rule for persons
temporarily present in the United States (sometimes referred to as "commercial travelers") and
earning a de minimis amount of income in the United States. Tax treaties provide exemptions
from taxation for commercial travelers under certain circumstances. No other exemption is
available.293
293
For example, foreign newsmen employed in a U.S. news bureau were ruled potentially
subject to tax whether or not the country of their nationality exempts resident U.S. journalists.
Rev. Rul. 70-246, 1970-1 C.B. 156.

1. Code Exception
Under Section 861(a)(3), income from services performed in the United States shall not be
treated as from U.S. sources if:
(i) performed by a nonresident alien individual temporarily present in the United States for
one or more periods not exceeding 90 days during the taxable year;
(ii) such income does not exceed $3,000;294 and
(iii) the services are performed as an employee of or under a contract with (a) a nonresident
alien, foreign partnership, or foreign corporation not engaged in a U.S. trade or business, or
(b) for the foreign (including U.S. possessions) office of a U.S. citizen, resident, domestic
partnership, domestic corporation or the U.S. government.295 While a corporation can perform
personal services through its employees, the Section 861(a)(3) exception applies only to
nonresident alien individuals and not to corporations.
294
The excess of travel advances over expenses is included, but pensions and retirement pay
attributable to United States services is excluded. Regs. Section 1.861-4(a)(4).
295
See Rev. Rul. 57-69, 1957-1 C.B. 239.

Section 864(b)(1) provides an identical exception with regard to the U.S. trade or business
status of a nonresident alien employee or independent contractor who qualifies for the source of
income exception of Section 861(a)(3). Under Section 864(b)(1), the nonresident alien individual

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performing temporary services is not considered to be engaged in a U.S. trade or business by
virtue of the performance of such services. Were it not for this exception, a qualifying
nonresident alien performing services would receive nontaxable foreign source compensation
income under Sections 872 and 861(a)(3), and yet potentially be subject to tax as a resident on
other U.S. source ordinary income, if any, deemed "effectively connected" with the conduct of a
U.S. trade or business under Section 864(c)(3).
In addition, the foreign person for whom the temporary services are performed is not
considered to be engaged in a U.S. trade or business solely by reason of such temporary services.
296
Were it not for this exception, not only might the employee not satisfy the requirements of
Section 861(a)(3)(C)(i), but the foreign person for whom services are performed could be
considered under certain circumstances to be engaged in trade or business in the United States
and subject to U.S. tax on any income effectively connected with such trade or business.297
296
See Regs. Section 1.864-2(b)(2)(ii).
297
But cf. Regs. Section 1.864-3(b), Ex. (2) (services performed in United States by chief
executive officer of both foreign holding company and its domestic subsidiary did not cause
foreign holding company to be engaged in business in the United States, where activities on behalf
of foreign holding company consisted of supervising its investment in the U.S. subsidiary).

The Code's commercial traveler's exception has limited application for obvious reasons. For
example, the exemption is entirely lost if income exceeds $3,000, whether or not received in the
year of services,298 or if the individual is present in the United States for more than 90 days
during the taxable year (although the exemption is not lost by an individual's continual presence
within the United States for, e.g., a 180-day period evenly split between two taxable years). 299 An
individual's commercial traveler status will be unaffected by the status of other individuals, but
the Section 864(b)(1)trade or business exemption of the person for whom the services are
performed will be lost if only one individual performing services within the United States (i) is in
the United States more than 90 days during the taxable year, (ii) is paid more than $3,000 for
such services, or (iii) is not a nonresident alien individual.
298
Regs. Section 1.864-2(b)(3), Ex. 2; Rev. Rul. 69-479, 1969-2 C.B. 149.
299
Dailey, "The Concept of Source of Income," 15 Tax L. Rev. 415, 435 (1960).

For services performed in taxable years beginning after 1997, §1174 of the 1997 Taxpayer
Relief Act amends §861(a)(3) (and makes a conforming amendment to §863(c)(2)(B), with
respect to income that otherwise would be transportation income) to provide that compensation
for labor or services performed in the United States is not U.S. source income if the labor or
services are performed by a nonresident alien individual in connection with the individual's
temporary presence in the United States as a regular member of the crew of a foreign vessel
engaged in transportation between the United States and a foreign country or U.S. possession.
Accordingly, this compensation is not subject to U.S. income or withholding taxes. Further, for
purposes of determining whether an individual is a U.S. resident under the §7701(b)(7)
substantial presence test, the Act provides that any day such a crew member is present in that
capacity is disregarded, provided that he does not engage in any U.S. trade or business on that
day.
Note: This special source rule, unlike the general (commercial traveler) §861(a)(3) source
rule, applies without reference to any cap on the amount of the alien's compensation.

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 2. Treaty Exceptions
A commercial traveler's provision exempting certain income (as opposed to resourcing it)
generally is found in the bilateral tax treaties to which the United States is a party. In a typical
treaty provision, compensation for personal services performed by a resident of one country in
the other country is exempt from tax in the other country if: (i) such services are performed as an
employee or under contract with a natural person resident in the employee's country or a
corporation formed in such country, and such compensation is "borne by" such resident or
corporation,300 and (ii) the employee is present in the other country for no more than 180301 to 183
302
days (90 days in some treaties).303 In addition, under certain treaties, the individual may not
receive more than a stated dollar amount as compensation (e.g., $3,000304 or $10,000305). Treaties
often distinguish between dependent and independent personal services.
300
E.g., Germany (Art. 15), New Zealand (Art. IX), and Luxembourg (Art. XII).
301
E.g., Luxembourg (Art. XII) and Sweden (Art. XI).
302
E.g., Greece (Art. X), New Zealand (Art. IX), Pakistan (Art. XI), Belgium (Art. 7(5), incl.
fixed base), Hungary (Art. 14), Iceland (Art. 18, incl. fixed base, and Art. 19), Japan (Art. 18),
Korea (fixed base, Arts. 18, 19), Netherlands (Art. XVI), Norway (Arts. 13, incl. fixed base, 14),
Poland (Arts. 15, 16), Romania (Arts. 14, 15), Trinidad and Tobago (Art. 17), Union of South
Africa (Protocol, Art. II), Switzerland (Art. 10), and U.K. Treaty (Arts. 14, incl. fixed base, 15).
303
E.g., Italy (Art. XI).
304
E.g., Luxembourg (Art. XII), Korea ($3,000, Arts. 18, 19), and Trinidad and Tobago (must
not exceed $3,000 or must be received by employees of the nonresident, Art. 17).
305
E.g., Greece (Art. X), Switzerland (unless employed or retained by treaty country of
performance, Art. X), and Canada (regardless of time or residency of employer, Art. XV).

Example: A German corporation sells equipment to U.S. purchasers, and its U.S. subsidiary
enters into contracts with the purchasers to install the equipment. Skilled employees of the
German corporation are sent to assist the U.S. subsidiary in meeting its obligations under the
contract. The German corporation charges the U.S. subsidiary for this arrangement based on
the number of hours spent by the employees, which is the same basis as that on which the
purchaser paid the U.S. subsidiary. At least in the view of the IRS, the compensation is not
"borne by" the German corporation in view of the back-to-back nature of the billing
arrangement, and, therefore, its employees are not exempt from U.S. tax.306
306
TAM 8748003.

Students, teachers, and trainees are also subject to specific, usually more limited, exemptions.
307
The "commercial traveler's" provisions generally do not apply, or apply in a more restricted
fashion, to artists (including entertainers) and athletes.308 Many treaties exempt wages received by
a member of the "regular complement" of a ship or aircraft operated by a treaty country resident
in international commerce from tax imposed by the other treaty country.309 Certain treaties also
provide specific rules which source income derived from personal services to the treaty country
of performance.310 These treaty rules parallel rather than depart from the Code source rule.
307
See generally MacDonald, "Annotated Topical Guide to U.S. Income Tax Treaties" (Prentice
Hall Law & Business) (1990).
308
E.g., Belgium (limited to 90 days presence and $3,000, Art. 14), Iceland (limited to 90 days
and $100/day, Art. 18), Norway (limited to 90 days and $10,000 (Art. 13), Romania (limited to 90
days and $3,000, Arts. 14, 15), Sweden (limited to 90 days and $3,000, Art. XI), Trinidad and
Tobago (limited to $100/day, Art. 17), Switzerland (Art. X), and Canada (Art. XVI).
309
E.g., Belgium (Art. 15), Hungary (Art. 14), Iceland (Arts. 6(6), 19), Korea (Art. 19), Norway
(Art. 14), Romania (Art. 15), Trinidad and Tobago (Art. 17), and U.K. (Art. 15).

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 310
E.g., Finland (Art. 6(6)), Iceland (Art. 6(6)), Japan (Art. 6(6)), Korea (Art. 6(6)), and
Trinidad and Tobago (Art. 5(6)).

C. Determination of Place of Performance of Services

In general, income from services performed both within and without the United States must
be apportioned between U.S. and foreign sources. In addition, special rules exist with respect to
whether certain types of service income (e.g., reimbursements of moving expenses and income
from certain continental shelf activities) are allocated to U.S. or foreign sources.
1. Apportionment of Service Income Between U.S. and Foreign Sources
The regulations under Section 861(a)(3) require allocation to U.S. sources if either a specific
amount is paid for services performed within the United States or a payment can reasonably be
segregated into compensation for U.S. services. Apportionment between U.S. and foreign
sources is required wherever an accurate segregation of compensation for services cannot be
made, or the services are performed partly without the United States.311
311
Regs. Section 1.861-4(a). Where services are rendered on a highly sporadic basis, it has been
held that apportionment on a time basis is not appropriate. Dillin v. Comr., 56 T.C. 228, 246, and
n.17 (1971).

a. General Time-Basis Apportionment Rule

The regulations generally provide a "facts and circumstances" rule for the allocation of
compensation when services are performed partly within and partly without the United States,
but more specifically state:312
In many cases the facts and circumstances will be such that an apportionment on the time
basis will be acceptable, that is, the amount to be included in gross income will be that
amount which bears the same relation to the total compensation as the number of days of
performance of the labor or services within the United States bears to the total number of
days of performance of labor or services for which the payments is made.
312
Regs. Section 1.861-4(a).

The courts and the IRS generally apply the easily workable, mechanical time-basis
apportionment rather than a more sophisticated method, at least in the absence of a clear showing
of a more accurate method of apportionment.313 For example, the Tax Court has applied a strict
time-basis apportionment method according to the number of days the taxpayer worked within
and without the United States for his European employer, in the absence of a showing that
bonuses measured by foreign sales were paid for foreign services.314 Under that method, the U.S.
source portion of total compensation is determined by multiplying total compensation by a
fraction, of which the numerator is the total days worked in the United States in earning such
compensation, and the denominator is the total days worked worldwide in earning such
compensation.315 Days on which no affirmative services are required to be performed, including
holidays, vacation days, weekends in many cases, and presumably temporary leaves of absence,
generally are excluded from both the numerator and the denominator.316 Weekends and holidays
are included in the numerator and denominator, however, if the individual is on call every day of
the week.317
313
An example of a different approach is in PLR 8711107 (discussed at text accompanying fn.

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 338, below).
314
Cini v. Comr., 67 T.C. 857(1977). Cf. Levy v. Comr., 1 T.C.M. (CCH) 316, 320, (1942)
(fractional parts of months counted in determining amount of compensation from sources outside
United States; court rejected another method urged by IRS); TAM 8046005 (employee's foreign
service allowance, such as cost of living, was allocated in the same manner as salary rather than
solely to foreign sources because it was paid even while the employee was temporarily in the
United States).
315
See, e.g., Tipton & Kalmbach, Inc. v. U.S., 480 F.2d 1118, 1120-21 (10th Cir. 1973)
(allocation on time basis as provided in Regs. Section 1.861-4(b); Stemkowski v. Comr., 82-2
USTC Para.9589 (2d Cir. 1982), aff'g in part and rev'g and rem'g in part on other grounds 76 T.C.
252, 284 (1981) (allocation between U.S. and Canadian services of hockey player); Mooney v.
Comr., 9 T.C. 713, 720 (198/365 of petitioner's income excludable because of nonresidence for
198 days of taxable year); Rev. Rul. 77-167, 1977-1 C.B. 239 (airline pilot's income determined
by comparing flight hours in United States to total flight hours); TAM 8046005 (taxpayer must
consider total compensation package and must apply time apportionment method to determine
how much of total compensation was earned within United States).
316
See Stemkowski, 76 T.C. at 298-99, aff'd on this issue, 82-2 USTC Para.9589 (2d Cir. 1982)
(days during hockey player's off season excludable notwithstanding general negative covenants
operative during such time).
317
Regs. Section 1.861-4(b)(1)(ii), Ex. 1; cf. Rev. Rul. 56-268, 1956-1 C.B. 317 (payments by
foreign branch of domestic corporation to dependents of nonresident alien employee in period in
which he studied various aspects of particular business field with domestic foundation deemed
compensation for personal services performed in United States).

Note: There does not appear to be any direct authority concerning periods of sickness or
hospitalization. It seems reasonable, however, to include bona fide sick days but to exclude
longer periods of absence.
The IRS has proposed to revise the regulations governing the sourcing of compensation for
services, requiring the use of the time-basis test by certain individuals. On January 21, 2000, the
IRS issued proposed regulations allocating on a time basis compensation for the personal
services of individuals performed partly within and partly without the United States and for
persons other than individuals on the basis that most correctly reflects the proper source of the
income under the particular facts and circumstances. REG-208254-90, 65 Fed. Reg. 3401
(1/21/00). On August 6, 2004, the IRS withdrew these proposed regulations and issued revised
proposed regulations under which a time basis of allocation is stated to be generally the most
appropriate for allocating the compensation for services as an employee within and without the
United States, with a facts-and-circumstances basis of allocation for self-employed individuals
and other taxpayers. The regulations are proposed to be effective for taxable years beginning on
or after the date that final regulations are published in the Federal Register.
The impetus for the proposed rules, according to the preamble in 2000, is the foreign source
treatment of certain fringe benefits by both U.S. and nonresident alien individuals. In the case of
a nonresident alien individual, the treatment of income derived from fringe benefits as foreign
source income would result in no U.S. tax on such foreign source income. That preamble also
states that the rule under the current regulations that allocates compensation from personal
services income on a correct reflection basis permits an individual to claim inconsistent positions
for U.S. and foreign tax purposes with respect to the fringe benefits associated with an overseas
posting and avoid any tax (whether U.S. or foreign) on the fringe benefit compensation. For
example, a U.S. person may exclude an amount from gross income under §911 for foreign
earned income. The same individual could claim for foreign tax purposes that the fringe benefit

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income was U.S. source income. Under a territorial system of taxation, the fringe benefit income
would not be taxable by a foreign jurisdiction with such a system of taxation.
The 2004 proposed regulations continue this concern over the use of sourcing as a tax
avoidance device with respect to compensatory fringe benefits. They identify a number of fringe
benefits for employees (housing, education, local transportation, tax reimbursement, hazardous
or hardship duty pay, and moving expense reimbursement) that are stated to have a specific
geographic source, generally the employee's principal place of work. The regulations also
authorize the use of an alternative basis, if properly documented and established as the most
appropriate source determinant.
The 2004 proposed regulations also contain some particular positions, one of which is that
the regulations are not to change the existing law with regard to artists and athletes and another
of which explores the possibility that in certain circumstances it may be appropriate to use a time
unit shorter than a day (as in the case of the members of an airline flight crew) or longer than a
year (as in the case of certain multiyear compensation arrangements).
Persons Other Than Individuals. Under Prop. Regs. §1.861-4(b)(1), income for
compensation performed partly within and partly without the United States is allocated on the
basis that most correctly reflects the proper source of the income under the particular facts and
circumstances. If an allocation is made on a time basis, the time period is presumed to be the
taxable year of the taxpayer, unless either the taxpayer establishes to the satisfaction of the
Commissioner, or the Commissioner determines, that a distinct, separate and continuous period
of time is required by a change in circumstances. The proposed regulations provide an example
of an allocation on the basis of the relative payroll costs of the employees providing the services
and an example of an allocation on a time basis because the employees providing the services
have the same rate of compensation.
Individuals. Under Prop. Regs. §1.861-4(b)(2), income derived from the compensation for
personal services paid to an individual would also be required to be allocated on the basis that
most correctly reflects the proper source of the income under the facts and circumstances, except
that according to the regulation compensation for the personal services of an individual employee
is generally based upon the ratio of the number of days that services are performed within the
United States to the total number of days for which the compensation is paid. The calendar year
is presumed to be the time period to which the compensation relates, unless the taxpayer can
establish, or the Commissioner determines, that a change in circumstances establishes a distinct,
separate, and continuous period of time. An example of the establishment of two periods of time
is a transfer of an individual from the United States to an overseas posting. Short-term returns to
the United States during the foreign posting would not result in the establishment of a separate
time period, but would be relevant to the apportionment of the compensation during that period.
Historical Note: For taxable years beginning before January 1, 1976, Regs. Section 1.861-
4(b) provided that apportionment must be made on a "time basis." Following several judicial
decisions which, on the basis of the regulations, permitted taxpayers to use the "time basis" rule
as a matter of right in preference to other methods urged by the IRS, Regs. Section 1.861-
4(b)was amended in 1975.
A series of cases involving hockey players illustrate that, where a taxpayer's duties pass
through different phases, some of which may be described as preliminary to or in preparation for

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others, each phase is generally taken into account equally. In Stemkowski v. Comr.,318 for example,
the Second Circuit held that the salary paid to a nonresident alien Canadian professional hockey
player is allocable to the period covered by training camp, the exhibition season, the regular
season, and the playoff games (but not the off-season). The basic contract salary was allocated to
sources within and without the United States on the basis of the ratio of the number of days the
taxpayer spent in the United States during the appropriate period divided by the total number of
days in that period.319 In Hanna v. Comr.,320 the Fourth Circuit followed the Second Circuit's
holding in Stemkowski on an identical fact pattern, as did the Claims Court in Favell, Jr. v. U.S..
321
In Rev. Rul. 87-38,322 the IRS announced that it would follow the holdings of Stemkowski and
Hanna in allocating the salary paid to a professional hockey player (a Canadian citizen and
resident) by a U.S. professional hockey club. Rev. Rul. 76-66, which concluded that salary paid
to a hockey player under the standard hockey league contract was paid for services performed
during the regular season only, was revoked.
318
690 F.2d 40 (2d Cir. 1982), rev'g in part and aff'g in part, 76 T.C. 252 (1981). The Tax Court
held that the base salary covered only the services of the taxpayer during the regular hockey
season.
319
The Tax Court had held that the appropriate fraction was the number of days spent in the
U.S. during the regular season divided by the total number of days in the regular season.
320
763 F.2d 171 (4th Cir. 1985), aff'g, rev'g, and rem'g 76 T.C. 252 (1981).
321
16 Cl. Ct. 700 (1989).
322
1987-1 C.B. 176 (revoking Rev. Rul. 76-66, 1976-1 C.B. 189).

The Tax Court and the IRS have taken different approaches regarding the apportionment of
income received for a sign-on bonus. In a case involving a sign-on bonus,323 the Tax Court
determined that, since a sign-on bonus is primarily designed to induce the player to play for the
employer, the most reasonable allocation of the sign-on bonus was on the basis of the number of
games played within and without the United States during the regular season following the
agreement. In Rev. Rul. 74-108,324 the IRS analogized a sign-on bonus to a covenant not to
compete, and on that basis expressed the view that, in some cases it might be reasonable to
allocate a soccer team "sign-on" fee on the basis of the relative value of the player's services
within and without the United States, or on the basis of the portion of the year during which
soccer is played within and without the United States. The decisions in this area are described
more fully in IV, E, 2, e, below.
323
Linseman v. Comr., 82 T.C. 514 (1984).
324
1974-1 C.B. 248. Rev. Rul. 2004-109, 2004-50 I.R.B. __, revoked Rev. Rul. 74-108 because
it cited another revoked revenue ruling, Rev. Rul. 58-145, 1958-1 C.B. 360, for the principle that a
fee cannot be wages if no services are required to be performed. Based on Rev. Rul. 2004-109, the
IRS believes the proper view is that an inducement fee is wages if paid in connection with the
establishment (or at least potential establishment) of an employer-employee relationship even if no
services are required. Rev. Rul. 2004-109 did not consider the source of the income as did Rev.
Rul. 74-108, although revocation (rather than modification) indicates that the IRS may disagree
with the conclusion in the revenue ruling in that regard as well.

While the foregoing authorities involve Regs. Section 1.861-4(b), a similar result is provided
under the regulations governing the Section 911 foreign earned income exclusion. Pursuant to
Regs. Section 1.911-3(e)(4), a bonus or substantially nonvested property attributable to services
performed in more than one taxable year is treated as earned ratably over the period to which
attributable (unless a Section 83(b) election is made with respect to substantially nonvested
property). In the case of vesting restrictions, the period to which the income is attributable is the

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vesting period.325 This concept is developed further in the discussion immediately below.
325
See Regs. Section 1.911-3(e)(4)(ii), Ex. 3.

b. Employee Stock Options, Restricted Stock Grants, etc.

A nonresident alien executive may be granted a nonstatutory stock option while he is an
employee of a foreign corporation, performing services in that corporation's home country. Such
an option generally is not taxable until it is exercised. Between the time of grant and the time of
exercise, however, the executive may be transferred and become an employee of the U.S. parent
or subsidiary of that corporation, performing services in the United States, but maintaining
foreign residency.326 As discussed above, a nonresident alien is not taxable on compensation paid
for services performed outside the United States but, subject to certain exceptions, is taxable on
compensation paid for services performed in the United States. Consequently, the option spread
will be subject to U.S. tax to the extent that the option is for services performed in the United
States.327
326
If the individual were to be classified as a U.S. resident at the time he exercises the option,
the entire spread (bargain element) would be includible in his income. See Stanford v. Comr., 297
F.2d 298, 304 (9th Cir. 1961) (pension payments earned by taxpayer in Germany while classified
as U.S. resident deemed taxable) aff'g 34 T.C. 1150, 1157 (1960); Dillin v. Comr., 56 T.C. 228, 224
(1971) (payments received by petitioner who had renounced U.S. citizenship at time of receipt of
payments deemed nontaxable despite citizenship when amounts earned), acq., 1975-1 C.B. 1.
327
In the case of qualified stock options and incentive stock option, the determination of the
services for which the option was granted is important in the event of a disqualifying disposition.
In the case of qualified stock options, such determination also was important in determining
liability for the minimum tax. See Sections 56, 57(a)(6), 58(g)(2) (prior to amendment by
TEFRA); Regs. Section 1.58-8(b). In the case of incentive stock options, such determination is
important in the case of a disqualifying disposition and in determining liability under the
alternative minimum tax.

Alternatively, a U.S. executive may be granted a nonstatutory stock option while he is an

employee of a foreign subsidiary, performing services and residing in that corporation's home
country, and, between the time of grant and the time of exercise, be transferred and become an
employee of the U.S. parent or subsidiary of that corporation, performing services and assuming
residency in the United States. To the extent that the option spread is attributable to services
performed by the executive abroad, subject to the dollar limits of Section 911, a part of the
option spread may be excludible from the employee's gross income.
Similar issues arise with respect to awards of stock that are subject to vesting restrictions.
The obvious difficulty in applying the time apportionment formula to stock options or
restricted stock is to determine in which period or periods the services for which the options or
stock were granted were rendered. This issue must be determined before it can be determined in
what manner the income allocated to that period should be apportioned between domestic and
foreign sources.
Regulations under Section 911 suggest that, in the case of substantially unvested property
granted for services, in general, the income on vesting should be attributed ratably over the
vesting period.328 If an election is made under Section 83(b) to recognize compensation income
with respect to the property at the time of grant rather than vesting, however, the taxpayer may
elect either to attribute the income ratably over the entire vesting period or to treat the income as

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attributable entirely to the taxable year in which an election to include it in income is made. 329
328
See Regs. Section 1.911-3(e)(4)(ii), Ex. 3.
329
Regs. Section 1.911-3(e)(4)(iii). Section 83(b) permits a service-provider who has been
granted, subject to a vesting schedule, a property for services, to elect within 30 days of the date of
grant to include in income as compensation for the year of grant the excess, if any, of the fair
market value of the property over the amount, if any, paid for it, and so avoid having to include in
income as compensation any excess value at the time of vesting.

Example: Employee C is granted 1,000 shares of stock on April 1, 1992, to vest in equal
increments on each of the first two anniversaries of the grant date. Employee C is transferred
abroad effective January 1, 1993, for two years. If C did not make a Section 83(b) election
within 30 days of the grant, then, for purposes of Section 911, three-fourths of the income
realized on the vesting of the first 500 shares is considered attributable to services performed
in the United States and allocated to U.S. sources; one-fourth of such income, and all of the
income realized upon the vesting of the second 500 shares, is attributable to foreign services
and allocated to foreign sources. Had C made an election under Section 83(b), all of the
income realized upon the election would have been allocated to U.S. sources.
The approach taken in the Section 911 regulations (in situations not involving a Section 83(b)
election) is generally consistent with the relatively sparse case law in the area. Mooney v. Comr.,
330
which appears to be the closest case on point and in which the IRS acquiesced, involved a
stock bonus plan under which an award was "earned out" ratably over four years and was
payable in four annual installments. The taxpayer, a nonresident citizen of the United States for
the taxable year in question (1939), received awards in 1936, 1937 and 1938 and, pursuant to
those awards, was credited in 1939 with proportionate parts of the fourth installment for 1936,
the third for 1937, and the second for 1938. Considering that the stated purpose for the plan was
to benefit employees who "contributed in a special degree to the success of the corporation by
their inventions, ability, industry and loyalty or exceptional service," the court noted that "there
might have been logic in ascribing the bonus to all of an employee's years of service."331 Neither
the IRS nor the taxpayer suggested that approach, however, and the court noted that the approach
appeared "impracticable."332 Rather, the issue addressed was whether each bonus should be
deemed earned in the year originally awarded, as the IRS urged, or during that year and the
following three years during which the bonus became vested and was paid, as the taxpayer
argued. The court determined that to attribute the bonus to the single year in which it was
awarded would be unreasonable. In view of the ratable earn-out and that the notice of
stockholders' meeting describing the plan referred to the purpose of encouraging "further efforts"
by the employees, the court held that each bonus should be deemed earned during the four-year
period in which it became vested and was paid.333
330
9 T.C. 713 (1947), acq., 1948-1 C.B. 2.
331
Id. at 718.
332
Id.
333
Id. at 719-20

The IRS had earlier ruled privately that when nonstatutory stock options were exercisable in
five annual installments following a year of required service, the compensation element involved
in each installment was deemed attributable to the 12-month period preceding the time when the
installment first became exercisable.334 Although the Mooney case was not cited, the ruling is
consistent with the holding in that case. The IRS left open the possibility, however, that in a

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particular case, the employee could show that the option was attributable to services performed
in a period before such 12-month period. Apparently, the IRS viewed the annual nature of the
installment grants as indicating that they were intended for prior rather than future services. 335
334
See PLR 6701305110A.
335
Accord PLR 6208215200A (granting of options at annual intervals "would suggest that they
were intended as bonuses for prior service but conditioned upon the employee remaining in the
Company's employ").

On the other hand, when restricted stock options were granted under facts generally
suggesting that the options were intended to be for future services, even though the grants were
at annual intervals, the IRS, in a private ruling, reached a different result.336 In that ruling, the IRS
concluded that in any case when it did not clearly appear that the option was granted by the
corporation for prior services rendered, the U.S. source income resulting from a disqualifying
disposition is the portion of the total income from such disposition bearing the same relation to
such total income as the number of days the optionee was employed in the United States between
the date of grant and the date of exercise bore to the total number of days which had elapsed
between the date of grant and the date of exercise. Thus, not only was the option determined to
be for future services (which is consistent with the avowed congressional purpose behind
statutory stock options and their holding period requirements, i.e., stimulating the employee's
post-grant efforts), but the period over which the compensated services were deemed performed
varied with the period for which each particular employee held the option in question. The ruling
stated that the intention of the parties was the "paramount" factor in attributing compensation to
particular services, and recited as helpful indicia the employment contract, the company's overall
compensatory scheme, the terms of the stock option plan and agreements, the frequency of grants
to a particular employee or group of employees, and the resolutions authorizing the grants.337 The
ruling did not indicate, however, whether the perceived intentions of the parties led the IRS to
view the options as intended for future services in general terms (with the IRS itself devising the
apportionment formula) or as intended precisely for those services rendered by each employee
up to the respective exercise dates. That is, while the ruling did make clear that the parties, in
drafting the option plan and agreements and the authorizing resolutions, could control the period
for which the option would be attributable, it did not make clear whether the IRS viewed the
formula sanctioned therein as generally applicable in ambiguous situations.
336
See PLR 6208215200A (corporation granted options to induce employee to remain with
corporation; optionee could not exercise option until one year following grant).
337
Id.

In a much later private ruling addressing the source of income earned by nonresident alien
employees under a stock bonus plan which provided for vesting upon the earlier of retirement or
five years from the date of award, the IRS attributed the income to the vesting period.338 The IRS
ruled that, if an employee performed any services within the United States during the vesting
period, a portion of the income on vesting should be U.S. source, regardless of whether the
employee rendered any services within the United States during the year of vesting.339 Having so
determined the period to which the services should be allocated, the IRS next addressed the
manner of apportionment of income within that period. The fraction of the income from the stock
award treated as from U.S. sources equaled the ratio of the employee's income from services
rendered in the United States during the vesting period to the employee's income from services
rendered worldwide during such period. This approach, while (as noted above) not the general

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rule, generally should provide a more realistic allocation of the income than simply allocating the
income based on the number of days spent within or without the United States.
338
PLR 8711107.
339
The IRS ruled that, in the case of pre-TRA 86 years, if the employee did not perform
services within the United States during the year of vesting, 30% withholding under Sections
871(a)(1)(A) and 1441(a) applied to the U.S. portion of such income; for post-TRA 86 years, the
U.S. portion of such income is treated as effectively connected income under Section 864(c)(6).

Note: In situations involving mobile executives, such as those hypothesized above, the
parties may be able to stipulate in advance the exact period for which a stock option or
restricted stock award is granted and thus identify such period for tax purposes. Of course,
the actual source of the income still depends upon where the executive performs services
during such period.
c. Seaman and Flight Personnel
The following special rules apply to crew members of oceangoing vessels and aircraft.
(i) Compensation received by seamen and flight personnel in connection with transportation
provided between the United States and a foreign country (and in connection with non-
transportation income that is not considered income from a space or ocean activity) is
sourced under Sections 861(a)(3) and 862(a)(3) with certain exceptions, as discussed below.
340

(ii) Compensation received by seamen or flight personnel in connection with transportation

between two points within the United States is considered transportation income and
regarded as from U.S. sources under 863(c)(1).341 (In the case of Section 638 activities, this
includes transportation to and from drilling rigs on the U.S. continental shelf.)342
(iii) Compensation received by seaman or flight personnel in connection with transportation
between the United States and a possession is sourced under the 50-50 source rule of Section
863(c)(2).343
(iv) Compensation received by seamen in connection with nontransportation services on the
high seas is considered income from an ocean activity under Section 863(d), and sourced to
U.S. or foreign sources depending upon whether the taxpayer is a U.S. person.344
340
See TRA 86 Blue Book at 929.
341
Regs. Section 1.861-4(c); Rev. Rul. 70-227, 1970-1 C.B. 155 (coastwise trade does not
include voyages from a U.S. port to a port of U.S. possession); accord PLR 7816072. See the
discussion in IX, below.
342
See IV, C, 3, below.
343
See the discussion in IX, below.
344
See the discussion in X, below. See, e.g., PLR 9610015 (services of foreign nationals
performed for U.S. corporation on U.S. ships more than 12 miles off U.S. coast generated foreign
source income).

Apportionment of income from international flights or voyages between the United States
and foreign countries may be made under the normal "days spent" apportionment rule of Regs.
Section 1.861-4(b). Under certain circumstances, however, another basis may be more
appropriate. Thus, Rev. Rul. 77-167345 concludes that compensation based on actual flight time
that is paid to an airline pilot who is a U.S. citizen and a resident of a foreign country must be

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allocated between U.S. and foreign sources by comparing the hours of both flight and required
preflight services performed in the United States to the total hours of such services.
345
1977-1 C.B. 239.

The taxation of compensation paid to seaman and flight personnel may be affected by income
tax treaties. For example, in Rev. Rul. 79-28,346 the IRS addressed the source of compensation
received by a U.S. citizen residing in Japan who was a member of a flight crew of a Japanese
airline operating aircraft between Alaska and other parts of the world. The ruling concluded that
the compensation, including the portion of compensation attributable to services performed in
the United States, should be treated as income from sources within Japan under Article 6(6) of
the U.S.-Japan treaty for purposes of computing the foreign tax credit under Article 5(1)(a). That
article sources compensation derived by a member of the regular complement of a ship or
aircraft operated in international traffic by a resident of one of the Contracting States to such
Contracting State.347 In general, under the post-1967 tax treaties which have been influenced by
the model treaties developed by the Organization for Economic Cooperation and Development,
wages of the "regular complement" of an aircraft or ship operated by a resident of a treaty
country in international traffic are exempt from tax by the other country.348
346
1979-1 C.B. 457, clarified in Rev. Rul. 79-206, 1979-2 C.B. 279.
347
See 1973-1 C.B. 630, for the text of this treaty. In Rev. Rul. 79-206, 1979-2 C.B. 279, the
IRS, clarifying Rev. Rul. 79-28, ruled that, for purposes of computing the foreign tax credit
limitation of Section 904(a), which was incorporated in Section 911(a)for the taxable year in
question, the personal service income of the taxpayer mentioned in Rev. Rul. 79-28 would also be
considered to have its source in Japan.
348
E.g., U.K. (Art. 15); Trinidad and Tobago (Art. 17), Romania (Art. 15), Poland (Art. 16),
Norway (Art. 14, fishing included), Korea (Art. 19), Japan (Art. 18), Iceland (Art. 19, fishing
included), Hungary (Art. 14), France (Art. 15), Belgium (Art. 15), and Canada (Art. 15).

d. Services of Corporations
A corporation may be considered to earn income from services provided through its
employees or agents.349 Under the general rule of Sections 861(a)(3) and 862(a)(3), the situs of
the services determines the source of the income.350 Thus, commissions paid by a U.S. person to a
foreign corporation for client referral activities conducted abroad were held to be foreign source
income.351
349
See, e.g., Bank of America v. U.S., 680 F.2d 142 (Ct. Cl. 1982) (negotiation commissions in
connection with letters of credit). See the discussion at IV, E, below.
350
Id. (commission paid by Canadian bank to domestic bank was U.S. source since services
were performed in the United States). Accord Rev. Rul. 80-64, 1980-1 C.B. 158 (situation 1)
(amounts paid to a foreign corporation to conduct oil and gas test-drilling on the outer continental
shelf of the United States taxable as U.S. source income from services).
351
See British Timken Ltd. v. Comr., 12 T.C. 880(1949), acq., 1949-2 C.B. 1; Rev. Rul. 60-55,
1960-1 C.B. 270.

Piedras Negras Broadcasting Co. v. Comr.352 involved a Mexican corporation which operated
a radio broadcasting station located on the Mexican side of the Rio Grande, but which
maintained in the U.S. bank accounts, a mailing address, and a hotel room for the collection of
advertising income. Ninety-five percent of the taxpayer's income was received from U.S.
advertisers (secured through an independent contractor in the United States), pursuant to
contracts executed in Mexico. The remaining 5% of its income was received from the rental of

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its Mexican broadcast facilities pursuant to contracts executed in Mexico for the sale of such
"radio time." The court found that the taxpayer's income was exclusively derived from the
operation or rental of its broadcast facilities in Mexico, and thus allocated all of the taxpayer's
income to sources outside the United States according to the place-of performance and place-of-
use source rules applicable to personal services and the rental of property, respectively,353
notwithstanding the U.S. contacts.354
352
127 F.2d 260 (5th Cir. 1942).
353
Sections 861(a)(3), 861(a)(4).
354
Accord PLR 8147001. Note that under post-TRA 86 law, the income derived from the
operation of the broadcast facilities is presumably treated as international communications income
and sourced under Section 865(e). In Le Beau Tours Inter-America, Inc. v. U.S., 415 F. Supp. 48
(S.D.N.Y. 1976), aff'd per curiam, 547 F.2d 9 (2d Cir. 1976), discussed in IV, E, below, the
taxpayer sought to exclude services performed by its parent as either not performed by the
taxpayer itself or as merely "incidental" to the taxpayer's business under the taxpayer's
interpretation of the holding of Piedras Negras. The court rejected this argument and noted that
Piedras Negras, "whatever its validity after Tipton & Kalmbach," 415 F. Supp. 52, at n.2,
(discussed below), was not in conflict with its decision because there the services performed in the
United States were "minor and insignificant," while the U.S. services performed by the taxpayer's
parent were "fairly substantial."

In Tipton & Kalmbach, Inc. v. U.S.,355 the taxpayer, a Denver-based engineering firm, derived
95% of its income from two contracts for the performance of engineering services incident to the
design and construction of canals and ground water and reclamation projects in West Pakistan.
The taxpayer's compensation under these contracts consisted of three categories of payments: (i)
a fixed monthly fee; (ii) reimbursement for specified costs including salaries paid to taxpayer's
employees; and (iii) an overhead allowance in the amount of 50% of reimbursable salaries.
Taxpayer's services under the contracts were performed by expatriate personnel in Pakistan,
Pakistani nationals, employees in the taxpayer's Denver office, and its two principals, Messrs.
Tipton and Kalmbach. Tipton and Kalmbach spent 20% to 40% of their professional time in
Pakistan and the remainder in Denver substantially devoted to work on the Pakistan projects.
355
480 F.2d 1118 (10th Cir. 1973).

The IRS contended that utilization of the "payroll cost" method more accurately reflected the
allocation of the taxpayer's compensation than the taxpayer's figures computed under the "time
basis" apportionment in Regs. Section 1.861-4(b)(1).356 The reported opinion does not include the
exhibits on which the taxpayer's allocation was based, but it is implied that the taxpayer's figures
reflected a greater amount of foreign source income (i) computed according to the number of
days worked in Pakistan not adjusted to reflect differences in skill or importance of the
taxpayer's employees; or (ii) computed without regard to incidental or overhead functions
performed by the Denver-based staff. Characterizing as "debatable" the IRS' contention that the
"payroll cost method" was more accurate, the court found that neither system could "reflect with
complete exactness the amount of taxable income."357 The court approved the "time basis" rule as
a "reasonable, convenient and expeditious method of allocating income between foreign and
domestic sources" not in conflict with the statutory sections, and held that the IRS could not
disregard such a method established by its own regulations.358
356
An analogy for the IRS' "payroll cost" method may be found in the pre-1976 Section 954
regulations (defining foreign base company service income), which specify that apportionment by
time spent should be weighted to reflect differences in the level of skill and functions performed.
Regs. Section 1.954-4(c) (pre-1976).

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 357
480 F.2d at 1121.
358
Id.

2. Reimbursed Moving Expenses

Reimbursed moving expenses are treated as income attributable to personal services, taxable
under Section 82.359 Two rules generally apply to determine the source of these reimbursements.
(i) A moving expense reimbursement paid by a new employer, or by a continuing employer if
the reimbursement is conditioned on the performance of future services, generally is sourced
by reference to the situs of the future services to be performed for that employer in the new
place of employment.360 For example, an employer's reimbursement of an employee's
expenses incurred in moving from the United States to work for a foreign affiliate of the
employer would be considered income from foreign sources. If the employee is later
reimbursed for expenses of moving back to the United States to work for the original
employer, the income from the reimbursement is from U.S. sources.
(ii) Moving expenses reimbursed by a former employer (e.g., where the employee is
returning to retire or to work for a new employer), or even by a continuing employer if the
agreement to reimburse expenses is not contingent on continued employment, are sourced by
reference to the place of services rendered by the employee for the former employer.361 For
example, if, as an inducement for the taxpayer to accept a transfer to a foreign country, the
employer agrees at the time of the taxpayer's transfer to reimburse him for all moving
expenses incurred in returning to the United States, the reimbursed moving expenses are
attributable to his employment in the foreign country and, therefore, are foreign source
income.362
359
A moving expense deduction, however, is allowed under Section 217. In the case of a cross-
border move, the deduction is more generous than for domestic moves. See Section 217(h).
360
See Regs. Section 1.911-3(e)(5)(i); Hughes v. Comr., 65 T.C. 566, 572 (1975); Dowell v.
Comr., 36 T.C.M. 470 (1977); Metz v. Comr., 49 T.C.M. 575 (1985).
361
Markus v. Comr., 486 F.2d 1314(D.C. Cir. 1973); Rev. Rul. 75-84, 1975-1 C.B. 236; Rev.
Rul. 75-85, 1975-1 C.B. 242; Rev. Rul. 76-162, 1976-1 C.B. 197; TAM 8108002(parent subsidiary
as employer).
362
See Dammers v. Comr., 76 T.C. 835 (1981); Redding v. Comr., 43 T.C.M. 719 (1982).

3. Continental Shelf Activities

As discussed in I, C, above, for purposes of applying the source rules for services with
respect to mines, oil and gas wells, and other natural deposits, the term "United States" includes
"the seabed and subsoil of those submarine areas which are adjacent to the territorial waters of
the United States and over which the United States has exclusive rights, in accordance with
international law, with respect to the exploration and exploitation of natural resources." (Such
seabed and subsoil are referred to as the "continental shelf" of the United States.) The terms
"foreign country" and "possession of the United States" are similarly defined to include the
seabed and subsoil of submarine areas adjacent to the territorial waters of such foreign country or
possession with respect to such exploration and exploitation but, in the case of a foreign country,
only if it exercises taxing jurisdiction with respect to such exploration and exploitation. (Such
seabed and subsoil are referred to as the "continental shelf of a possession of the United States"
and "foreign continental shelf," respectively.)

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 Under the examples in the regulations, Section 638 apparently encompasses any activities
which are conducted on a continental shelf in connection with the exploration or exploitation of
depletable resources thereon.
(i) Physician providing medical exams on drilling rig. A U.S. physician gives regular on-site
physical examinations to employees living aboard a drilling rig affixed to a foreign country's
continental shelf. The physician is treated as being in the foreign country to the extent it taxes
the physician (or others with respect to oil or other natural resource exploitation). The
physician's activity is considered "related" to the exploration of oil resources, and, therefore,
the income apportionable thereto is considered to be from foreign sources.363
(ii) Time chartering a ship and crew for oil exploration. A domestic corporation time charters
a ship and equips it with special oil exploration equipment and its own personnel to explore
for oil on the continental shelf of a foreign country. The foreign country exercises taxing
jurisdiction with respect to natural resource exploration or exploitation. Income received by
the time charter lessor is from sources within the foreign country since the time charter lessor
provided both property and crew used in oil exploration within that foreign country. Oil
exploration income received by the time charterer is also from foreign sources.364
(iii) Cook on such time chartered vessel. A citizen of the United States is employed as a cook
and is physically present on the ship described in the second illustration above. The cook's
sole duties consist of cooking meals for personnel aboard the ship. Since the cook's activities
are related to the exploration for oil, the cook is treated as being in the foreign country for the
period he is aboard such ship while it is engaged in activities relating to the exploration for
oil in the foreign continental shelf. Accordingly, his compensation for such period is treated
as derived from sources without the United States.365
(iv) Exploratory oil drilling by contract. A foreign corporation enters into a contract with a
U.S. corporation to engage in exploratory oil drilling activities on a leasehold held by the
U.S. corporation that is located in the continental shelf of the United States. Since the foreign
corporation is engaged in, and has property and activities which are engaged in, the
exploration for oil, the property and activities are treated as being in the United States for the
period the property and activities are engaged in or related to the exploration for oil in the
continental shelf of the United States and are not in a foreign country. Amounts paid to the
corporation pursuant to the contract are treated as derived from sources within the United
States.366
363
Regs. Section 1.638-1(f), Ex. 3.
364
Regs. Section 1.638-1(f), Ex. 5.
365
Regs. Section 1.638-1(f), Ex. 6.
366
Regs. Section 1.638-1(f), Ex. 7. The IRS has ruled that, under Section 638, income received
by a foreign corporation as compensation for conducting test drilling for oil and gas in the outer
continental shelf of the United States is subject to U.S. taxation even though the drilling was
performed by a bareboat-chartered drill ship that did not rest on and was not anchored to the
seabed and that did not penetrate the subsoil except to remove core samples. Rev. Rul. 80-64,
1980-1 C.B. 158.

On the other hand, if the activities are not conducted on the continental shelf, the income is
sourced under the general geographical definitions even if the activity is related to the
continental shelf in the Section 638 sense. For example, suppose a nonresident alien engineer is

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employed in a foreign country to design equipment for use on oil drilling platforms affixed to the
U.S. continental shelf. Although the engineer's activities are "related" to the United States in the
economic sense of Section 638, his activities are not geographically located within the U.S.
continental shelf and hence are not within the United States for purposes of Section 638.367
367
Regs. Section 1.638-1(f), Ex. 4.

D. Deferred Compensation
Distributions under a plan of deferred compensation have two components:
(i) Contributions for services performed; and
(ii) Interest or an interest equivalent on contributions. Generally, the source of the
compensation components is traced to the services for which the contributions were made
and apportioned by the place of performance of such services under the service income
source rules368 "irrespective of the residence of the payer . . . or the place or time of payment."
369
However, the source of the interest component generally is determined under the interest
source rules370 according to the residence of the payor (unless an exception applies).371
368
Rev. Rul. 73-252, 1973-1 C.B. 337 (U.S. supplemental unemployment benefits received by a
Canadian citizen who lived and worked in Canada was foreign source income); PLR 7835003
(source of retirement income for U.S. citizen employed in the Navy within and without the United
States allocated partly to sources within and partly to sources without the United States). Accord
Muhleman v. Hoey, 124 F.2d 414 (2d Cir. 1942) (bonus); Mooney v. Comr., 9 T.C. 713 (1947)
(restricted stock option bonuses).
369
Regs. Section 1.861-4(a).
370
The conduit (character retention) rule of Section 662(b) does not apply to deferred
compensation distributions. See fns. 187 and accompanying text, above and 364 and
accompanying text, below.
371
In the case of U.S. civil service pensions granted to nonresident aliens (Section 402(a)(4))
and periodic distributions by certain qualified pension plans with respect to exclusively foreign
services (Section 871(f)), however, the interest component of the pension is sourced in the same
manner as the compensation is sourced.

1. Compensation Component
The source of the compensation component is determined directly under the service income
source rules of Sections 861(a)(3) and 862(a)(3). Thus, a pension paid to a U.S. citizen for
services rendered both within and without the United States is allocated to both U.S. and foreign
sources.372 Apportionment is accomplished by tracing each contribution to the location of the
services for which such contribution constituted compensation. Similarly, only that portion of
payments received by a U.S. citizen from an employer's qualified noncontributory pension plan
which is attributable to the employer's contributions with respect to wages earned abroad is
income from foreign sources for purposes of computing the Section 904(a) foreign tax credit
limitation.373
372
Rev. Rul. 84-144, 1984-2 C.B. 129; PLR 7835003 (Navy pension).
373
Rev. Rul. 79-389, 1979-2 C.B. 281.

With respect to nonresident aliens, this tracing is accomplished statutorily under Section
72(f).374 Section 72(f)(2)generally permits tax-free recovery of contributions which would not
have been included in the employee's gross income if paid directly to the employee at the time of

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contribution.375 However, employer contributions which would have been excludable from the
employee's income under Section 911 if paid to him at the time of contribution are not permitted
to be recovered tax-free under Section 72(f).376
374
Section 72is part of the general scheme for taxing distributions from qualified and
nonqualified pension trusts, annuities, and other plans of deferred compensation (Sections 402(a)
(exempt trusts), 403(a)(1) (exempt annuities), 402(b) (nonexempt trusts), and 403(c) (nonexempt
annuities). Section 72does not apply to certain lump-sum distributions. See Section 402(a)(2)
(providing long-term capital gain treatment for lump-sum distributions applicable to pre-1974 plan
years).
375
Section 72also permits tax-free recovery of the after-tax contributions made by the taxpayer
(see Section 72(b)(1)) as well as contributions by an employer which were previously included in
the employee's gross income (and hence previously taxed), by virtue of Section 72(f)(1)'s
inclusion of such previously taxed income within the consideration deemed paid for deferred
compensation distributions. Employer contributions to a qualified plan or annuity are excluded
from an employee's income until distributed or made available to him (Regs. Sections 1.402(a)-1
and 1.403(a)-1). Employer contributions to a nonqualified trust or annuity are included within an
employee's income when the beneficiary's rights to such property are transferable or are not
subject to substantial risk of forfeiture. Taxable contributions are recovered tax-free under Section
72(b).
376
See Sections 72(f), 911(b)(1)(B)(i); Rev. Rul. 72-149, 1972-1 C.B. 218.

Contributions of amounts that would have been nontaxable (because foreign source
compensation) if paid directly to a nonresident alien employee at the time of contribution retain
their nontaxable character even though the recipient may at the time of distribution be a U.S.
citizen or resident alien. Similarly, Section 72(f)(2) by its terms does not give credit for
contributions of amounts which, if paid directly to the employee at the time of the contribution,
would have been included in the employee's income. Thus, Section 72(f)(2), in effect, "locks in"
the residency of the employee at the time the contribution is made. On the other hand, income
which would be includible in gross income by reason of Section 72 may nonetheless be excluded
from gross income by other applicable sections, such as Sections 872, 101(a), and 104(a).377 For
example, contributions in respect of foreign services which would have been taxable if currently
distributed (e.g., to a U.S. resident alien employee) may be excluded from income under Section
872 if at the time of distribution the recipient is a nonresident alien.
377
Regs. Section 1.72-2(b)(1)(i). (Section 72(f)(2) itself does not apply to contributions which
would, but for the contribution to the trust, have been included in the employee's income.) Note
that Section 872would not exclude income that was received for U.S. services. See Section 864(c)
(6).

Contributions which would be nontaxable foreign source compensation under Section 72(f)
(2) are also nontaxble when received as part of a lump sum distribution.378
378
See Section 402(e)(4)(D). Sections 402(a)(2) and 403(a)(2), prior to their repeal by TRA 86
(TRA 86, Section 1122(b)(1)) treated part of a qualified plan lump sum payment as capital gain to
domestic recipients but, in the case of nonresident aliens, were overridden by Section 871(a)(1)
(B), which treated amounts described in those sections as fixed or determinable annual or periodic
income subject to the Section 871(a) 30% tax on the gross amount of such gain unless the income
was taxable as income effectively connected with a U.S. trade or business of the recipient. For
post-TRA 86 years, Section 864(c)(6) would treat such income as effectively connected income
even if the recipient were not engaged in a U.S. trade or business in the year the income was
received.

2. Interest Component

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 The deferral of compensation usually results in a return of contributions plus an interest or
growth increment. The source of this "interest" component is determined under the interest
source rules by reference to the payor of the deferred compensation. The payor will generally be
a trust if a pension or profit-sharing plan is involved or an insurance company if an annuity is
purchased.
Recipients of deferred compensation payments from a trust are treated like creditors of the
trust rather than trust beneficiaries; the conduit source rules of Sections 652(b) and 662(b)do not
apply to employee trusts.379 Thus, the interest component of trust distributions is sourced
according to the residence of the trust (or insurance company, with respect to purchased
annuities). The interest component of distributions from a U.S. resident trust is from U.S. sources
whereas the interest component from a foreign resident trust is from foreign sources. See, e.g.,
Clayton v. U.S., 95-2 USTC Para.50,391 (Fed. Cl. 1995) (earnings and accretions of terminating
ESOP distribution to nonresident participants were U.S. source).
379
Rev. Rul. 79-388, 1979-2 C.B. 270. See authorities cited in Harllee, "U.S. Income Taxation
of Aliens on Current and Deferred Compensation," 37th Ann. N.Y. Inst. on Fed. Tax., ch. 21 and
n.107 (1979). See fn. 187 and accompanying text, above.

There are two statutory exceptions to the general rule that the source of the interest
component is determined separately from the source of compensation.
(i) Section 871(f) attributes entirely to foreign sources annuities paid on behalf of a
nonresident alien employee under a qualified trust or annuity plan if (a) all personal services
are rendered outside the United States by a nonresident alien or qualify as temporary services
under Section 864(b)(1) and (b) either 90% of the covered employees are U.S. citizens or
residents at the time of the first annuity payment or the recipient's country of residence grants
a substantially equivalent exclusion to citizens and residents of the United States.380 Since all
of the contributions to such a plan are from foreign sources, Section 871(f) allocates the
source of the interest component to the source of compensation regardless of the residence of
the trust or insurance company payor.
(ii) Pursuant to Section 402(a)(4), a nonresident alien pensioner is entitled to a pro rata
exclusion of civil service pension income received for U.S. Government services performed
both within and without the United States, in the proportion of the pension payment
represented by his base salary for services performed outside the United States to his total
base salary.
380
See PLR 9537028. Section 871(f) applies only to amounts paid as an annuity under Regs.
Section 1.72-2(b)(2)(ii) (i.e., periodic distributions) and thus does not apply to lump sum
payments.

3. Illustrative Examples
The general principles concerning the sourcing of distributions from pensions may be
illustrated by the following examples, drawn from IRS rulings.
(i) A nonresident alien employee of a U.S. corporation performs services within and without
the United States. In such case: (a) the portion of each pension distribution from the
corporation's qualified noncontributory plan attributable to earnings of the pension plan is
income from U.S. sources; (b) the portion of each payment attributable to the employer's

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 contributions with respect to services rendered within the United States is income from U.S.
sources; and (c) the portion of each payment attributable to the employer's contributions with
respect to services rendered outside the United States is income from foreign sources.381
(ii) A U.S. company, which operates both in the United States and in branch form in Canada
has maintained an ESOT (qualified employee stock ownership trust) for the benefit of
employees working in the United States and nonresident alien employees working in its
Canadian branch. After several years the company terminates the ESOT and distributes either
its common shares, or cash in lieu of such shares, to covered employees, including the
nonresident alien employees working in its Canadian branch. The portion of the distributions
attributable to earnings and accretions to employer or employee contributions to the ESOT 382
is U.S.-source income subject to 30% tax under Section 871, whereas the portion of the
distributions attributable to contributions for foreign services is foreign source income
exempt from U.S. tax in the hands of a nonresident alien.383 Furthermore, since earnings
distributed from a qualified U.S. employee benefits trust (unlike from an accumulation trust
taxable under Subchapter J) do not retain their character in the hands of the distributees, the
provisions of Article XXII.2 of the treaty with Canada, dealing with "other income," apply to
the U.S.-source "earnings and accretions" distributed from the ESOT to Canadian employees.
384

(iii) Same facts as in (ii) above except that a distributee from the ESOT rolls the distribution
into an IRA. The portion of distributions from the IRA that is attributable to employer
contributions made to the plan with respect to wages earned abroad is income from foreign
sources, whereas the portion of distributions that is attributable to earnings and accretions to
contributions to the ESOT which were rolled over, and to earnings and accretions of the IRA,
is U.S. source income.385
381
See Rev. Rul. 79-388, 1979-2 C.B. 270; PLR 200426001. See also CCA 200441030 (same
income source analysis applies to Keogh plan distributions to a self-employed U.S. resident
individual who had worked partly within and partly without the United States and made
contributions to the U.S. retirement fund). Rev. Proc. 2004-37, 2004-26 I.R.B. 1099, provides
guidance on how to determine the portions of the benefit payments that are attributable to services
within and without the United States, using the number of years worked at each location.
382
Such "accretions" represent the growth in the fund due to the receipt by the ESOT of
interest, dividends, and capital gains, as well as unrealized appreciation in the stock held by the
ESOT is U.S. source income subject to 30% tax under Section 871, whereas the portion of the
distributions attributable to contributions for foreign services is foreign source income exempt
from U.S. tax in the hands of a nonresident alien.
383
PLR 8633081.
384
Id. But cf. Clayton v. U.S., 95-2 USTC Para.50,391 (Fed. Cl. 1995) (terminating cash ESOP
distribution to nonresident alien plan participants was U.S. source; Canadian treaty protection did
not exempt distributions from tax because treaty applies to pensions and annuities but not stock
bonus plans).
385
See Rev. Rul. 84-144, 1984-2 C.B. 129. Accord PLR 8332054.

E. Definition of Services/Areas of Overlap

1. "Labor or Personal Services"
Although Sections 861(a)(3) and 862(a)(3) refer to income from "labor or personal services,"
the intended coverage is income from services as opposed to income from capital or property.
"Labor" refers to income of wage earners, and "personal services" includes the individualized

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services of professionals, artists, entertainers, and athletes. There is no requirement, however,
that the services be uniquely personal or that they be rendered by individuals.386 A corporation
can render "personal services"; for example, processing services performed by a corporation for
a commission have been held to be "personal services."387
386
Helvering v. Boekman, 107 F.2d 388, 389 (2d Cir. 1939), assumes such a limitation
arguendo, but subsequent decisions indicate that the labor source rules are intended to apply to
corporate services as well.
387
Hawaiian Philippine Co. v. Comr., 100 F.2d 988, 991 (9th Cir. 1939). Accord, e.g., Rev. Rul.
74-331, 1974-2 C.B. 282 (Ex. 3).

Commission income received by a sales agent or commission agent from the sale of products
consigned or produced by another is income from personal services sourced to the place of the
sale activities.388
388
See British Timken Ltd. v. Comr., 12 T.C. 880 (1949), acq., 1949-2 C.B. 1.

Example: A New York art gallery is owned by a nonresident alien through a foreign
corporation. The gallery holds paintings on consignment and conducts its sales activities in
the United States. Upon a sale, the gallery is paid a commission. The commission is treated
as U.S. source income from personal services rendered within the United States.389 A variety
of other activities giving rise to service income are discussed in IV, E, 2 and IV, E, 3, below.
389
If, instead, the artist sold paintings to the gallery, the gallery's income would be determined
under the rules governing the sale of inventory property.

In general, then, the service income source rules determine the source of income from a
variety of activities that may be broadly characterized as services, whether performed by an
individual or by an entity. In contrast, income primarily received as a return on capital or from
the disposition of property is sourced under the interest or dividend source rules described in II
and III, above, or the sale of property source rules described in VI and VII, below, even though
an activity may also have been an income-producing factor.
Activities to be distinguished from services for purposes of Section 861(a)(3)include, as
discussed below, manufacturing, transportation activities, ocean or space activities, and
international communications activities. As discussed below,390 income from the international sale
of manufactured products is sourced under split-source rules which rely on principles underlying
both the service and property rules. Such income is sourced both to the place of the
manufacturing activity and to the place of sale. Similarly, certain international communications
income and transportation income is sourced under a split-source approach.
390
See VII, B, 2, a, below.

2. Service Income Versus Income from Use or Sale of Property

The issue of characterizing income as from services as opposed to from the use or disposition
of a property right has arisen in a variety of contexts.
a. Intellectual Property
If property is created through the performance of personal services, the resulting income may
be characterized as from either services or both services and property. If the income were viewed
solely as compensation for personal services, its source would be attributed to the place at which

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the services are performed, even though compensation is measured by or paid for the sale or use
of a resulting product in a country other than where the services were rendered. If the income
were viewed as resulting in part from the sale of personal property, the income would be
allocated under the Section 863(b) manufacturing source rules.391 If the income were viewed as
resulting in part from the use of personal property (or the sale of property described in Section
865(d)(2) for an amount contingent on productivity or use), the entire income generally would be
allocated under the Sections 861(a)(4) and 862(a)(4) rules governing the use of property.
391
See the discussion in VII, B, 2, a, below.

This property/services dichotomy arose early and repeatedly in the context of payments for
the creation or use of intellectual property, such as patents, copyrights, and works of art.
(1) Artistic Creations of Nonresident Aliens
A series of cases involving nonresident aliens have treated "royalties" as service income
rather than income from the use of personal property if the taxpayer's personal efforts gave rise
to the underlying property and the taxpayer retained no ownership interest in the property. For
example, in Ingram v. Bowers,392 the court held that Enrico Caruso's contract to record master
discs at Victor Talking Machine Company's New York studios resulted in income from the
rendition of personal services in the United States. Since Caruso never obtained an interest in the
record matrices which were distributed worldwide for copying, the court found irrelevant the
contractual requirement that he be paid a portion of the royalties received from the license of
such property. For tax purposes, the source of Caruso's income was the place his voice was
recorded, and not the place where the resulting records were sold.
392
57 F.2d 65 (2d Cir. 1932).

A similar fact pattern was presented in Boulez v. Comr.,393 in which the Tax Court again held
that the payments received by the taxpayer were compensation for personal services rather than
royalty income. Boulez, a musical conductor who resided in Germany, made recordings under a
contract with CBS Records, pursuant to which his compensation was tied directly to the proceeds
received by CBS Records from sales of the recordings. The court found that the parties intended
a personal services contract and that the taxpayer did not have any property right in the
recordings which he could license.
393
83 T.C. 584 (1984), cert. denied, 484 U.S. 896 (1987).

A similar result was reached in Karrer v. U.S.,394 involving a Swiss scientist who contracted
with a Swiss employer to provide basic research in return for a portion of the patent royalties
generated from such research. Although the patents were applied for in the taxpayer's name for
legal reasons, the applications were assigned to a U.S. company. The licensee made royalty
payments to both the scientist and his Swiss employer. The royalties paid by the U.S. company to
the Swiss scientist were held to be nontaxable compensation for services provided by him
outside the United States.
394
152 F. Supp. 66 (Ct. Cl. 1957).

In these cases, the taxpayers contractually agreed to perform services leading to the creation
of an intellectual property right owned by another person. If a nonresident taxpayer
independently creates an intellectual property right and then sells or licenses it, the resulting

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income is sale gain or royalty income, the source of which would be determined by the place of
the property's sale or use, respectively, and if sold, also by the place of its creation.395 Even if the
creator transfers all ownership rights in property prior to creating it, so that the creator is never
the owner of the property, the income might be treated as sale gain or as royalty income if the
creator is under no obligation to perform and creates the property without the control or
assistance of the payor. For example, consideration paid to a nonresident alien individual for the
exclusive right to publish in the United States all books and stories written by the author was
held to be royalty income rather than service income.396 Since the licensee had no control over the
subject matter of the author's product or the schedule of production, the source of the income was
determined by the end product rather than by the creative process.397
395
See fns. 397-401 below.
396
Rev. Rul. 74-555, 1974-2 C.B. 202, modified, Rev. Rul. 76-283, 1976-2 C.B. 222.
397
Cf. Rev. Rul. 84-78, 1984-1 C.B. 173 (payments received by domestic corporation, which
owned rights to broadcast and record a prize fight, for another corporation's right to broadcast the
fight in a particular foreign country was royalty income and not service income since the fight was
not exclusively performed for the foreign corporation's benefit and the foreign corporation did not
obtain the benefit of the domestic corporation's labor).

For example, consider the following alternatives a nonresident alien might have for
distributing a copyrighted work in the U.S. market:
(i) The author might write a short story in England and sell the U.S. copyright to a U.S.
publisher for a fixed amount. If the copyright is inventory property within the meaning of
Section 865(i)(1) and title passes in the United States, a portion of the gain is allocated to
U.S. sources under the manufacturing source rules of Section 863(b)(2)based on the sale
component, and only the remainder is foreign source.398 If the copyrighted work is produced
in England and either is not inventory property or, if it is, is sold (title passing) in England,
all profit is considered to be from foreign sources.399
(ii) Alternatively, the author might write a short story in England but license its distribution in
the United States. Gross royalty income is entirely allocated to U.S. sources under the place
of use of property rule of Section 861(a)(4)400 even though a substantial portion of the royalty
income represents compensation for foreign personal services.401 A similar result would
obtain if the English author were to "sell" his copyright to a U.S. publisher for periodic
payments contingent on the productivity, life, or use of such literary property. Under Sections
865(d)(1)(B) and 871(a)(1)(D), the payments are treated as U.S. source royalty income
subject to withholding tax to the extent the copyright is used in the United States.402
(iii) If the English author contracts with a U.S. publisher to write a short story for which the
publisher receives the U.S. copyright, all income (even if measured by U.S. royalties) is
allocated to England under the service income source rule, as per Ingram and its progeny.403
398
See VII, B, 2, a, below.
399
A taxpayer may sell substantial rights or an undivided interest in a patent or copyright, even
for payments contingent on the productivity, life, or use of the property, patent, or copyright (see
Rev. Rul. 60-226, 1960-1 C.B. 26), although Sections 865(d)(1)(B), 871(a)(1)(D), and 881(a)(4)
treat such contingent payments received by nonresident aliens or foreign corporations as
withholdable "royalty" income or gain if the property is either used in the United States or sold
there.
400
See, e.g., Rohmer v. Comr., 5 T.C. 183(1945), aff'd, 153 F.2d 61 (2d Cir. 1946), cert. denied,
328 U.S. 862 (1946).

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 401
This approach may be distinguished from the split-source approach taken under Section
863(b) with respect to the sale of property produced by a taxpayer.
402
See the discussion in VII, A, 2, a, below. Before the enactment of these provisions, in
Wodehouse v. Comr., 337 U.S. 369 (1949), the Supreme Court held that Congress intended to tax
such periodic payments, without deciding the sale versus license characterization issue.
403
See fn. 392-94 and accompanying text, above.

(2) Artistic Creations of U.S. Citizens (Section 911 Qualification)

For purposes of Section 911`s exclusion of foreign source "earned income" received by U.S.
citizens,404 the courts have declined to recognize a distinction between property and services (and,
expressly or implicitly, with respect to the source of such income under Section 861). In Tobey v.
Comr.,405 a U.S. citizen painter resided and maintained a studio in Switzerland and received the
bulk of his income from the sale of paintings through U.S. galleries. Moreover, all of Tobey's
paintings were painted without any prior commission, contract, order, or other arrangement with
the purchaser; consequently, Tobey owned all rights in a painting until the closing of a sale. The
issue was whether Section 911(b) "earned income" included income from the sale of personally
created "products" or merely income from services.406 The Tax Court held the distinction
irrelevant for Section 911(b) purposes. Since the paintings were found to be the result of Tobey's
personal efforts, the income derived from their sale was held to be Section 911(b) earned income:
407

To avoid discriminatory treatment, we perceive no sound reasons for treating income earned
by the personal efforts, skill, and creativity of a Tobey or a Picasso any differently from the
income earned by a confidence man, a brain surgeon, a movie star or, for that matter, a tax
attorney.
404
U.S. citizens living abroad have been permitted to exclude part of their foreign source
"earned income" since 1926. See Tobey v. Comr., 60 T.C. 227, n.4 (1973). Before 1976, Section
911 provided a $20,000 ($25,000 after three years) earned income exclusion for U.S. citizens who
were bona fide residents of, or present for 510 days out of an 18-month period, in one or more
foreign countries. The Tax Reform Act of 1976 reduced the exclusion to $15,000, but the 1976 Act
amendments were delayed until 1978 by the Tax Reduction and Simplification Act of 1977. The
Foreign Earned Income Act of 1978 replaced the exclusion (except for certain charitable services
and residents of hardship camps) with a new system of deductions for excess foreign living costs.
The Economic Recovery Tax Act of 1981 restored and raised the exemption to $75,000 in 1982
(increasing to $95,000 in 1986) applicable to U.S. citizens and resident aliens residing abroad, and
lowered the qualification for presence abroad to 330 days in any period of 12 consecutive months.
See generally 918 T.M., Citizens and Resident Aliens Employed Abroad. The test for a U.S.
citizen's foreign residence is discussed at fn. 116 above.
405
60 T.C. 227 (1973), acq., 1979-1 C.B. 1.
406
Either because Tobey had substantially more foreign source income than the maximum
permitted under the Section 911 exclusion or because he retained title in Switzerland to the
paintings consigned to U.S. galleries, the court did not have to decide for source of income
purposes whether Tobey received income for his artistic services or for his paintings.
407
60 T.C. at 235. While the Tax Court refused in Tobey to distinguish between personally
created products and services for Section 911(b) "earned income" purposes, it did make such a
distinction for source of income purposes in an earlier case. In Roerich v. Comr., 38 B.T.A.
567(1938), acq. and nonacq. in part, 1938-2 C.B. 27, 56, aff'd, 115 F.2d 39 (D.C. Cir. 1940), cert.
denied, 312 U.S. 700 (1941), a U.S. artist made an extended tour of Central Asia for the purpose
of recording its people and scenery on paintings which were sent back to the taxpayer's New York
gallery. The case involved elements of fraud, and the Tax Court held the payments fully taxable
upon finding that the taxpayer had in fact sold the paintings with title passing in the United States.

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 (A personal services characterization would have resulted in an exclusion of the resulting foreign
source income under the predecessor to Section 911.)

Cook v. U.S.408 applied the rationale of Tobey to determine the source of income in a similar
situation. The case involved a sculptor who was a U.S. citizen residing in Rome. Cook sold both
commissioned (contracted) and noncommissioned works to U.S. purchasers. The court followed
Tobey in holding that the sales income from not only the commissioned works but also the
noncommissioned works should be treated as income from personal services for purposes of
Section 911. In addition, the court rejected on the same basis the IRS' argument that the sale of
noncommissioned sculptures through U.S. galleries should be sourced as the sale in the United
States of a foreign manufactured product under Section 863(b)(2). The Court of Claims
buttressed its holding by observing that a "well-counseled" artist could in any event avoid U.S.
taxation under the IRS' product characterization by simply arranging to have title pass outside the
United States under Section 861(a)(6).409
408
599 F.2d 400 (Ct. Cl. 1979).
409
It should be noted that this services characterization may not be entirely consistent with the
authorities in the area of construction, discussed immediately below.

(3) Know-How
The property-service distinction also must be made with respect to intellectual property in the
context of the transfer of know-how. The rule as enunciated by the IRS is that income from the
transfer of know-how is considered income from the use or sale of property, rather than service
income, if the country in which the transferee uses the know-how provides legal protection
against unauthorized disclosure of the know-how.410
410
Rev. Rul. 64-56, 1964-1 (Part 1) C.B. 133.

b. Construction, Engineering, Fabrication, and Installation Activities

Construction and similar activities can be viewed as giving rise to manufacturing income or
to service income. The issue is very analogous to that described above with respect to intellectual
property. Typically, it is not clear to what extent the income should be considered to arise from
services as opposed to manufacturing and, if from manufacturing, how the manufacturing
apportionment regulations (Regs. Section 1.863-3)411 should be applied.
411
See discussion in VII, B, 2, a, below.

In Rev. Rul. 86-155,412 for example, the IRS addressed the characterization of income as
manufacturing sales income or service income for purposes of Section 954. The taxpayer and its
subsidiary, a controlled foreign corporation, were engaged principally in the engineering,
fabrication, and installation of fixed offshore platforms, pipelines, and other facilities used in
drilling and producing oil and gas around the world. For purposes of Section 954, income (other
than foreign personal holding company income, which always must be segregated) derived from
the performance of an "integrated transaction" is classified in accordance with the "predominant
character" of the transaction, even though an incidental part of the income could be characterized
as a different class of income.413 The ruling concludes that the classification of the controlled
foreign corporation's income "depends upon the facts and circumstances of each contract or
arrangement." The ruling revoked Rev. Rul. 83-118,414 which treated such activities as
manufacturing (the gross income from which is total sales less cost of goods sold under Regs.

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Section 1.61-3(a)).
412
1986-2 C.B. 134.
413
See former Regs. Section 1.954-1T(e)(3).
414
1983-2 C.B. 27.

The Tax Court has held that a domestic corporation that constructed a dam and related
structures in the Dominican Republic could treat the gross receipts as gross income from services
for purposes of qualifying for the Western Hemisphere Trade Corporation deduction.415 The court
held that the taxpayer's function was primarily performing a service rather than manufacturing
since it performed "an onsite construction of a unique item specifically designed and constructed
in accordance with geological and environmental considerations particular to that site and to
serve the particular purposes demanded by the buyer."416 The taxpayer "did not build many dams
at one location and ship one to the site in the Dominican Republic," nor did it construct the dam
from a "standard set of plans."417
415
Guy F. Atkinson Co. of California v. Comr., 82 T.C. 275, 298 (1984), aff'd on other grounds,
87-1 USTC Para.9279 (9th Cir. 1987), cert. denied, 108 S. Ct. 1286 (1988).
416
Id. Cf. Rev. Rul. 74-555, 1974-2 C.B. 202 (payments received by nonresident author were
royalties rather than compensation because the contract did not prescribe content or timing or
writing.
417
Id.

An engineer who does not build anything but simply draws the plans and supervises the work
of construction was not permitted to use the completed contract method of accounting since the
work done was in the nature of a personal service.418
418
See Rev. Rul. 70-67, 1970-1 C.B. 117. Accord, e.g., Rev. Rul. 84-32, 1984-1 C.B. 129
(painting contractor); Rev. Rul. 82-134, 1982-2 C.B. 88 (engineering services and construction
management).

Following this principle, the IRS ruled that a taxpayer in the business of engineering,
procurement, construction management, and actual construction was required to sever the service
portions of the contract (engineering, procurement, and construction management services) from
the actual construction portion, and was only permitted to use a long-term contract method of
accounting with respect to the latter portion.419 The IRS noted that the services were "not incident
to nor . . . interrelated with the actual construction performed."420 To the same effect, the Tax
Court has held that uncomplicated installation services were severable from product sales for
Section 471(inventory accounting) purposes.421 The IRS disagrees with this holding.422
419
See TAM 8308005.
420
Id.
421
Marcor, Inc. v. Comr., 89 T.C. 181 (1987), nonacq., 1990-2 C.B. 1.
422
See A.O.D. CC: 1990-028 (1990).

The potential operation of the source rules in this area can create problems for certain
domestic taxpayers engaged in turnkey projects for the construction of facilities abroad. Such a
project typically would involve on-site construction, and in addition, the sale of equipment from,
e.g., the United States, engineering and other services from the United States, and licensing of
know-how from the United States. In part to minimize local taxation, the taxpayer might create
separate agreements or subcontracts to procure equipment, provide engineering services, and
provide know-how or other intangibles. Certain local tax authorities, however, have been

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aggressive in asserting that the entire package, including engineering and technical services
performed in the United States and profit on equipment sales, are subject to local taxation. The
U.S. taxpayer would have difficulty obtaining effective foreign tax credit relief against its
domestic tax liability for the foreign taxes on such service income (domestic source) and
equipment sale income (essentially 50% domestic source).423 Even if the project could be viewed
as a sale of property424 and even if the services could be interrelated with the facility,425 the result
for the taxpayer might be worse since, the apportionment rules under Regs. Section 1.863-3 still
would require treating as much as 50% of the total income as from U.S. sources.426 If the United
States has an income tax treaty with the contracting jurisdiction, however, competent authority
relief might be available.
423
See the discussion in B, 2, a, (1), (B).
424
Cf. TAM 9233003 (tangible personal property not excludible from inventory as services
even if custom-made). But see Guy F. Atkinson, above.
425
TAM 8308005, while disallowing integrated treatment, left open the possibility that
"interrelated" services could be integrated under certain circumstances. Also, the taxpayer would
have the problem of disavowing the form it chose for the transactions. Cf. Regs. Section 1.482-
2(b)(8).
426
If viewed as property, the facility, built to the customer's order, probably would be
considered property held primarily for sale to customers in the ordinary course of business and,
therefore, inventory property within the meaning of Section 865(i)(1). Note also that depreciable
personal property would be taxed in the same manner under Section 865(c)(2).

c. Technical Services Ancillary to Transferring Property

The property versus services issue also arises with respect to services ancillary to the transfer
or license of patents, know-how, and certain sophisticated tangible personal property. For
example, while know-how may constitute legally recognizable property in terms of a formula or
secret process,427 its transfer to another party usually requires the concomitant provision of
technical assistance and training. An issue raised in these transfers is whether the technical
assistance may be disregarded as merely incidental to the property transfer or must be recognized
as services of the transferor requiring an allocation of income.
427
See Rev. Rul. 64-56, 1964-1 (Part 1) C.B. 133.

In dealings between related parties, the Section 482 regulations do not require separate
compensation for services that are "ancillary and subsidiary" to the transfer of property and to
which the parties do not separately allocate compensation.428 This principle, which originally was
developed in connection with the transfer of intangible rights, was extended in the regulations to
transfers of tangible property.429 The regulations provides certain examples of the meaning of
ancillary, apparently drawn from Rev. Rul. 64-56.
428
Regs. Section 1.482-2(b)(8).
429
See T.D. 6952 (1968). However, the Tax Court has held that uncomplicated installation
services are severable from product sales for Section 471 purposes. See Marcor, Inc. v. Comr., 89
T.C. 181, 191-2 (1987), nonacq., 1990-2 C.B. 1. Accord TAM 8308005(services severable from
construction contract for purposes of long-term contract accounting).

Rev. Rul. 64-56430 states that royalty income need not be apportioned between property and
services where technical assistance is merely ancillary and subsidiary to the transfer of patents or
proprietary know-how.431 Examples of the type of ancillary services which may disregarded are:
(i) start-up assistance; (ii) services pursuant to a guarantee of effective start-up; and (iii)

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promotional demonstration and explanation of the use of property. Rev. Rul. 64-56 concludes
that certain other types of technical assistance, including training the transferee's employees in
general skills and providing technical assistance continuing beyond the start-up phase, are
considered service income requiring an allocation as to both the income and the place of
performance of such services. In PPG Industries, Inc. v. Comr.,432 however, the IRS did not
contest the ancillary (property) character of future technical assistance in connection with the
transfer of patents.433
430
1964-1 (Part 1) C.B. 133, modifying Rev. Rul. 55-17, 1955-1 C.B. 388 (which had provided
for separate allocation to services of even a nominal value).
431
Accord Hooker Chemical and Plastics Corp. v. U.S., 79-1 USTC Para.9163 (Ct. Cl. 1979).
432
55 T.C. 928 (1970).
433
See also 115 T.M., Section 482: The Statute and the Regulations.

d. Contract Processing or Manufacturing

Contractor (commission) processing or manufacturing generally is considered the rendition
of personal services if the processor or manufacturing is paid a fixed amount and bears no risk of
loss.434 A processor which is contractually permitted to retain a portion of the processed goods as
its commission may therefore derive income sourced by the place of processing and not by the
place of title passage. For example, in Comr. v. Hawaiian Pineapple Co.,435 the taxpayer milled
cane from surrounding Philippine farms pursuant to milling contracts that permitted it to retain
(and sell) a portion of the sugar for its own account as a commission for its milling services. The
commission sugar's fair market value at the time and place of milling was compensation for
services rendered in the Philippines. Although this property was sold in the United States, no
gain was recognized because the miller's cost basis was the fair market value of the sugar.
434
See, e.g., Comr. v. Hawaiian Philippine Co., 100 F.2d 988 (9th Cir. 1939), cert. denied, San
Carlos Milling Co. v. Comr., 24 B.T.A. 1132 (1931), aff'd, 63 F.2d 153(9th Cir. 1933); PLR
8749060 (controlled foreign corporation paid independent contractor for manufacturing services).
435
100 F.2d 988 (9th Cir. 1939), cert. denied, 307 U.S. 635 (1939).

Depending upon the facts, however, a contract manufacturer may be considered to earn
manufacturing income.436
436
See, e.g., Sundstrand v. Comr., 96 T.C. 226, 354-55 (1991) (IRS abandoned its argument that
manufacturing by taxpayer's Singapore subsidiary was a service to taxpayer).

e. Income from Agreement Not to Perform Services

Income derived from agreements not to perform services have been sourced under both the
property source rules and, more recently, the service source rule. The Tax Court in Linseman v.
Comr.437 applied the service income source rule to apportion the "sign-on" bonus received by a
nonresident alien hockey player between U.S. and foreign sources. The "sign-on" bonus was paid
to the taxpayer to induce him to sign and become bound to the bonus-paying club by the
provisions of the "uniform player" contract. The agreement did not require the player to actually
play hockey for the club, but was merely a preliminary agreement preventing other clubs from
signing the taxpayer. The Tax Court determined that the most reasonable allocation of the sign-
on bonus was on the basis of the number of games played within and without the United States
during the regular season following the agreement. The court observed that the fact that a sign-on
bonus is not itself compensation for services did not preclude using the places where the

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contemplated services were to be performed as the basis for allocation. The court held that, while
theoretically the promise to enter into an agreement could be construed as intended only as a
covenant not to compete, it doubted that the bonus would have been paid merely to keep the
individual from playing elsewhere.438
437
82 T.C. 514 (1984).
438
82 T.C. at 522, n.13.

In Korfund Co. v. Comr.,439 the court rejected the arguments of both parties that income
received by individuals residing in Germany from an agreement not to compete in the United
States was sourced to the place of "performance." Instead, the court analogized the
noncompetition agreement to a transfer of a fundamental right of the payee to engage in a U.S.
trade or business, which property was used by the payor in the area of agreed-upon
noncompetition. Thus, income from an agreement not to compete in the United States was
allocated to U.S. sources.440
439
1 T.C. 1180 (1943).
440
Korfund had cited as support the "property" approach of the Second Circuit in Sabatini v.
Comr., 98 F.2d 753(2d Cir. 1938). Included within the various exclusive licenses granted U.S.
publishers by a U.K. author was the exclusive "right to publish certain of the author's works
already in the public domain." Payments made to the taxpayer for such right were considered by
the court as made "for foregoing his right to authorize others for a time to publish the works here."
Id. at 755. The court treated the payments as royalties and sourced them to the United States as the
place of the licensee's use of such right.

The Tax Court in Stemkowski441 affirmed its holding in Korfund that negative covenants in
employment contracts and other contractual provisions which do not require affirmative action
by the taxpayer do not constitute the performance of personal services. The court specifically
held that conditioning activities performed by a hockey player during the off-season were not
services but a condition of employment, so that, consistently with Korfund, the time-basis
apportionment rule of Regs. Section 1.861-4(b) should not take into account the offseason time.
441
76 T.C. 252, 298-89, aff'd in part and rev'd on another point, 82-2 USTC at 9589 (2d Cir.
1982).

In Rev. Rul. 74-108,442 issued after Korfund but before Linseman and Stemkowski, the IRS
ruled that a "sign-on" fee paid by a U.S. soccer team to a nonresident alien player (precluding
him from negotiating with other U.S. or foreign teams) was analogous to a covenant not to
compete, and hence, in its view, was neither income from future services nor from the sale of
"property." The IRS treated the fee as Section 871(a) fixed or determinable annual or periodical
income from the forfeiture of a "right to act" and, to the extent from U.S. sources, subject to tax
and to withholding under Section 1441.443 The IRS stated that, "[f]or example, in some cases it
may be reasonable" to allocate the fee on the basis of the relative value of the player's services
within and without the United States, or on the basis of the portion of the year during which
soccer is played within and without the United States.
442
1974-1 C.B. 248, revoked by Rev. Rul. 2004-109, 2004-50 I.R.B. __.
443
Had the IRS found the income to be from the sale of a property right, withholding would not
have been required. See Regs. §1.1441-2(b)(2)(i).

In CCA 200219011, the Chief Counsel's Office analysis demonstrated the importance of the
factual characterization of the sign-on bonus. In a case involving a sign-on bonus paid to a

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nonresident as part of entering into a minor league baseball contract, the Chief Counsel's Office
distinguished the facts in Linseman and Rev. Rul. 74-108, noting that in both of those instances,
the sign-on bonus was paid pursuant to a separate contract, distinct from the player contract. In
CCA 200219011, the sign-on bonus was part of the player contract and it was only paid after the
Commissioner of Major League Baseball approved the entire player contract. Accordingly,
unlike Linseman and Rev. Rul. 74-108, the Chief Counsel's Office advised that the proper
characterization of the sign-on bonus was as an item of advance compensation. Since the minor
league player played all of the games outside of the United States, the Chief Counsel's Office
none of the sign-on bonus would be sourced to the United States.
In Rev. Rul. 2004-109, the IRS ruled that a signing bonus to a baseball player constituted
wages even though the contract provided that the bonus was not contingent on the performance
of future services and, in so doing, revoked Rev. Rul. 74-108. The stated reason for the revenue
ruling's revocation was because it relied upon Rev. Rul. 58-145 (which the IRS also revoked in
Rev. Rul. 2004-109) for the conclusion that a sign on fee paid to a foreign soccer player would
not be compensation for labor or personal services for purposes of §861. Whether the fee is paid
for services may be inconsequential, however. As previously indicated, Rev. Rul. 74-108
preceded two Tax Court cases that expressed support for sourcing the fees where the
contemplated services for the particular payor were likely to be performed. This, in turn, is
generally not very different from an allocation of the fees on the basis of the relative value of the
athlete's services at various locations, as espoused by the revoked revenue ruling.
f. Finder's Fees
A finder's fee, which is a payment made to a party for bringing a deal to the payor out of
which the payor derives income, has been held to be compensation paid for services rendered.444
The IRS followed this rule in a private ruling addressing the source of a fee paid by a corporation
to a foreign corporation to find investors to purchase an oil drilling rig as part of a cross-border
sale-leaseback transaction.445
444
See generally Lowrey v. Comr., 24 T.C.M. 1078 (1965); Sinclair v. Comr., 19 T.C.M. 602
(1960).
445
See PLR 7817125.

g. Standby Loan Commitment Fees

At one time, the IRS took the position that standby loan commitment fees were fees for
services.446 More recently the IRS rejected the service analogy (and an interest analogy) and ruled
the fees to be received for a property right.447
446
See PLR 7808038.
447
See TAM 8543004; GCM 39434. See the discussion below in XIV, B, 1, c.

h. Global Trading of Securities

Commercial banks, investment banks, securities dealers, and certain other financial
intermediaries execute customer orders and take proprietary positions in markets in different
parts of the world on a 24-hour basis. The products traded include equities, debt instruments,
currencies, and derivative products such as forwards, futures, options, and swaps. A typical
trading operation might be made up of trading (usually located in major trading centers),
management, sales, and support. While legal title to inventory usually remains at the primary

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trading market, trading authority with respect to the "book" (the firm's trading positions) passes
to branches or affiliates in other jurisdictions. The latter, however, are not operated as separate
profit centers.448
448
See generally Plambeck, "The Taxation Implications of Global Trading," Tax Notes, Aug. 27,
1990, 1143, 1148.

The above fact pattern gives rise to many issues, the one of relevance here being the need
under current tax law to allocate income among jurisdictions on an arm's-length basis. This, in
turn, gives rise to the question of whether income should be allocated based on a sales paradigm,
whereby a trader employed by a branch is considered to purchase inventory for the branch's own
account from the unit holding the inventory, or a services paradigm, whereby the branch is
considered to earn a commission or management fee.449 Gains on sales would be sourced as
described in VII, B, 1, a, (1), (A); XII, A; and XII, B, above. Service income would be sourced as
described in IV, A, above.
449
Id.

i. Sponsor Fees and Endorsement Income

The National Office advised in FSA 1999-1149 (6/3/92) that income derived from "tie-in"
rights associated with entertainment events in the United States would be treated as personal
services income under the Artistes and Athletes Article of the U.S.-U.K. Income Tax Treaty. The
"tie-in" rights consisted of a right to be identified as a sponsor of the entertainment events on
billboards, in advertisements, in commemorative programs, in press releases, on tickets, and in
commercials for broadcasts of the entertainment events. The taxpayer, a U.K. resident, asserted
that the income from the "tie-in" rights should be characterized as royalty income. Under the
Artistes and Athletes Article of the U.S.-U.K. Income Tax Treaty, the United States may tax a
U.K. resident on U.S. source services income over $15,000, which requirement was apparently
satisfied. On the other hand, the Treaty exempts from U.S. tax royalty income derived by a U.K.
resident.
The National Office admitted that no clear legal distinction exists between activities that
generate royalty income and those that generate personal services income. The FSA cited
favorably an OECD paper on the scope of treaty provisions pertaining to artistes and athletes that
supports the view that "tie-in" rights are payments for services. The FSA further analogized the
rights to broadcasting rights. Whether a taxpayer had broadcasting rights or "tie-in" rights, the
companies were seeking to generate goodwill and were, in effect, paying for the services of the
entertainers.
Ultimately, the National Office concluded in FSA 1999-1149 that the rights were more like
services than royalties. The companies were buying access to an event. Although the value of
that access may have been dependent upon intangible property, the right acquired was a right to
participate in a business operation, not a right to use intangible property. The companies were
buying advertising space, not licensing intangible property.
In later and more general advice, CCA 199938031, the Chief Counsel's Office opined that
U.S. source endorsement income that is "closely and proximately related" to a performance of an
artist or athlete (and not attributable to a U.S. fixed base or permanent establishment) is taxable
by the United States under the Artistes and Sportsmen Article of most U.S. treaties signed since

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1989 (specifically including France, Germany, Italy, Luxembourg, the Netherlands, and Sweden,
but not Mexico, which more broadly allows source-based taxation of any remuneration received
for product endorsements). For endorsement income that is not closely and proximately related
to a performance by the artist or athlete, the income will either be classified as independent
services income or royalty income, as appropriate. Endorsement activities may include the
wearing or use of a product of a sponsor, making commercials, permitting the use of one's name
by a sponsor, permitting the use of a photograph and signature, and appearances at charitable or
promotional events organized by the sponsor. The analysis contained in the advice is based in
large part of the OECD Commentary to Article 17 (Artistes and Sportsmen) to the OECD Model
Income Tax Treaty and the Technical Explanation to Article 17 of the U.S. Model Income Tax
Treaty.
The Chief Counsel's Office also advised that a single endorsement contract may generate
more than one type of income. Allocation of income in that case may be based upon comparable
third party contracts or other relevant valuation evidence.
In FSA 199947028, a nonresident alien professional athlete entered into an endorsement
contract with a U.S. manufacturer of athletic clothing. The athlete agreed to wear and use the
manufacturer's products on an exclusive basis while participating in public sporting events, and
to make a specified number of appearance on the manufacturer's behalf. The manufacturer also
gained the right to use the athlete's name and likeness in the promotion of its products. In return,
the athlete received a lump sum "signing bonus," as well as a fixed annual renumeration for the
life of the contract. There was no income tax treaty between the United States and the athlete's
country of residence.
The Chief Counsel concluded that the lump sum payment could be analogized to the signing
bonus paid in Linseman v. Comr., 82 T.C. 514 (1984), and would be characterized and sourced in
accordance with the rights exercised and services performed in the first year of the contract. The
annual payments, Chief Counsel concluded, were a combination of royalties and personal service
income, and each component would have to be sourced under the applicable rules of §§861 and
862.
3. Service Income Versus Interest Income
Certain income may involve an overlap between the services and interest source rules.
In Bank of America v. U.S.,450 for example, at issue was the source of confirmation,
negotiation, and acceptance commissions received by a U.S. bank from foreign banks in export
letter of credit transactions. The IRS maintained that the confirmation, negotiation, and
acceptance transactions amounted in substance to a rendition of personal services, and that the
commissions should be sourced according to the service income source rule. The taxpayer, on the
other hand, argued that the commission income it derived was something similar to interest on a
loan and should be sourced in accordance with the interest source rules. The court ruled that,
although the confirmation and acceptance transactions involved elements of personal services,
their predominant feature was the substitution of the taxpayer's credit for that of the foreign
banks, and accordingly that confirmation and acceptance commissions were sourced by analogy
to interest under §§861(a)(1) and 862(a)(1). With respect to the negotiation transactions, the
court found that the commissions were charged for personal services and that there was no
assumption of credit risk, so that the negotiation commissions were sourced by analogy to

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personal services under §§861(a)(3) and 862(a)(3).
450
82-1 USTC ¶9415 (Ct. Cl. 1982).

The IRS has, however, characterized guarantee fees as income for services for purposes of
the §163(d) investment interest limitation and §482.451 One explanation for the service income
approach in the §482context is that the IRS may have felt constrained by the limited scope of the
§482 regulations dealing with loans and advances, and had little alternative but to treat guarantee
fees as service income.452 In one ruling, the IRS sourced guarantee fees to the situs of the obligor
of the underlying debt, largely on the theory that the services were performed where the risk was
located.453 By 1980, when the Bank of America case was being litigated, the IRS declined to take
a position on the source of guarantee fees pending the outcome of that case.454
451
See TAM 8508003 (technical advice memorandum treating guarantee fee as compensation
rather than investment income under §163(d)(3)(B)); GCM 38499 (Sept. 19, 1980), dealing with
confirmation and acceptance commissions, PLR 7822005 (§482); PLR 7712289 (§482). But cf.
Centel Communications Co. v. Comr., 92 T.C. 612(1989), aff'd, 920 F.2d 1335 (7th Cir. 1990)
(guarantee fees were not services for purposes of §83).
452
See PLR 7712289960A.
453
Id. Cf. §861(a)(7).
454
GCM 38499.

These authorities are discussed in somewhat greater detail in XIV, B, 1, below.

4. Service Income Versus Transportation Income
Compensation received by seamen or flight personnel in connection with transportation
between two points within the United States is considered transportation income and regarded as
from U.S. sources under §863(c)(1).455
455
In the case of §638 activities, this would include transportation to and from drilling rigs on
the U.S. continental shelf.

The transportation income rules are discussed in IX, below.

5. Service Income Versus Space or Ocean Activity
Compensation received by seamen in connection with nontransportation services on the high
seas is considered income from an ocean activity under §863(d), and sourced to U.S. or foreign
sources depending upon whether the taxpayer is a U.S. person. (If the income also is described in
the definition of income from international communications, however, it is sourced under the
§863(e) rules.)
The space or ocean activity rules are discussed in X, below.
6. Service Income Versus International Communications Income
If services performed by a taxpayer consist of the transmission of communications or data
from the United States to a foreign country (or U.S. possession), or vice versa, income from the
services is considered income from international communications and sourced under §863(e). It
seems unlikely, however, that services that are merely related to the transmission of international
communications or data would be sourced under the §863(e) rules.456
456
Unlike §863(c), §863(e)does not expressly include "related" service.

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 The international communications rules are discussed in XI, below.
7. Service Income Versus Partnership Share
In general, a partner's distributive share of income from a partnership, including a partnership
primarily engaged in rendering services, is sourced on the basis of the partnership's income,
rather than where the partner performs the services.457
457
See §702(b); Foster v. U.S., 329 F.2d 717 (2d Cir. 1964); Balestreri v. Comr., 47 B.T.A. 241
(1942) (wages of a crew member of a deep sea fishing boat to be paid out of owner's sale of fish in
San Diego; source of wages held to be San Diego as the place of sale). Cf. Johnston v. Comr., 24
T.C. 920 (1955) (Chicago office of domestic partnership attributed to Canadian partner who
supplied Canadian cattle to it for sale). See also fn. 1186 and the discussion generally in XIII, A,
below.

Suppose, instead, that the partnership compensates the partner for his services in an amount
that is not dependent upon the income of the partnership. Such payments would be treated as
"guaranteed payments" under §707(c). The courts have held that guaranteed payments for
services abroad may be sourced for §911 purposes (and implicitly for purposes of §§861(a)(3)
and 862(a)(3))458 in the same manner as compensation, by reference to where the services were
performed.459 To the extent such a partner would derive income in excess of amounts excludible
from income under §911, the income should be foreign source for purposes of the §904 foreign
tax credit limitation.
458
Cf. Cook v. U.S., 599 F.2d 400(Ct. Cl. 1979).
459
Miller v. Comr., 52 T.C. 752(1969); Carey v. U.S., 427 F.2d 763(Ct. Cl. 1970).

F. Effect of Agent
The key consideration in determining the extent to which services (and the source of service
income) can be attributed to the taxpayer from the taxpayer's employee or other agent is whether
the taxpayer performs services through the employee or agent, so that the taxpayer is
compensated for such services. This may be distinguished from a situation in which the taxpayer
derives its income from activities substantially distinct from the services rendered by the
employee or agent.460
460
Helvering v. Boekman, 107 F.2d 388 (2d Cir. 1939) (U.S. brokerage discount income
attributed to foreign employer of U.S. clerk who obtained produce orders for export); cf. Balestreri
v. Comr., 47 B.T.A. 241 (1942) (arrangement for a deep sea fishing boat's crew member to receive
compensation as a portion of sale of fish in San Diego was sourced to San Diego as the place of
sale).

If a principal receives compensation for services performed through an employee or other

agent, the place of the employee's or agent's performance of services determines the source of the
employer's or principal's income as discussed in IV, C, 1, d, above.461 As stated by Judge Learned
Hand in Helvering v. Boekman:462
[I]t can hardly be that when an alien employs agents in this country to do things from which
he collects a profit, Congress intended him to escape, though it meant to tax him, if he came
here to do them himself. The income, de facto, certainly comes from local activities which
are carried on for the benefit of the alien; and the natural aim of Congress would be to reach
it. For example, in Le Beau Tours Inter-America, Inc. v. U.S.,463 the U.S. taxpayer acted as a
wholesale travel agent putting together Latin American package tours and selling them

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 through U.S. travel agents. The taxpayer collected the full tour cost and remitted the
proceeds, net of a commission retained by it, to the actual providers of the foreign
accommodations and tour services. Bookkeeping, administrative, and promotional activities
relating to the taxpayer's business were provided by the New York office of its parent for a
contract price. The taxpayer contended that its parent was acting as an independent contractor
and that the taxpayer's commission income was received not for the activities performed by
its parent but for the provision of foreign hotel accommodations and tour services.464
461
See, e.g., Bank of America v. U.S., 680 F.2d 142 (Ct. Cl. 1982).
462
107 F.2d 388 (2d Cir. 1939) citing Helvering v. Stockholms Enskilda Bank, 293 U.S. 84; cf.
Perkins v. Comr., 40 T.C. 330(1963), acq., 1964-1 (Part 1) C.B. 5 (U.S. attorney's services not
attributed to foreign executrix, because executrix' fees were reduced in consideration of the
attorney's services which were separately compensated).
463
415 F. Supp. 48 (S.D.N.Y. 1976), aff'd per curiam, 547 F.2d 9 (2d Cir. 1976).
464
The taxpayer sought to qualify for favorable tax treatment as a Western Hemisphere Trade
Corporation, 95% of the gross income of which was required to be derived from foreign sources in
the Western Hemisphere. See §921 (prior to repeal by P.L. 94-455, §1052(b), effective for taxable
years beginning after Dec. 31, 1979).

The court held that the taxpayer was a service corporation in the business of planning,
arranging, and promoting foreign tours,465 rather than a provider or purchaser of the foreign hotel
accommodations and ground services that it arranged, and that a substantial part of its
commissions were attributable to administrative and promotional services performed in the
United States by the parent corporation.466 The services and accommodations provided by the
foreign agents and hotels were held to be independent contractor services and accommodations
which were separately compensated for and not attributable to the taxpayer.
465
In this sense, the taxpayer was analogized to the independent sales agency provided in
British Timken, 12 T.C. 880, 887 (1949). See text accompanying fn. 472 below.
466
The court, in disqualifying the taxpayer's claimed Western Hemisphere Trade Corporation
status, held that "[the taxpayer] may not avoid having income attributable to services performed in
the United States for the sole benefit of its Latin American operations characterized as United
States source income by contracting for those services with its parent company . . . ." 415 F.2d at
52.

Thus, the place of an agent's performance of services determines the source of its principal's
income if the principal's income is received for such services, such as where the taxpayer has
subcontracted or otherwise delegated services.467 Analogous to this principle is that the character
of service income derived by joint ventures and partnerships is passed through to the partners
under the partnership conduit rules of Section 702.468
467
The agency test for source of income purposes may be compared with the agency test for a
permanent establishment under tax treaties (see Williams, "Permanent Establishments in the
United States," 29 Tax Law. 277 (1976)) or the agency test under §864(c)(5).
468
See XIII, A, 1, below.

On the other hand, the mere fact that both parties derive the income in question from the
same ultimate source in an economic sense is irrelevant provided one party is not being
compensated for services performed by the other. The leading case in which income, while
derived in part with the assistance of an agent's services, was not considered derived through the
agent is British Timken, Ltd. v. Comr.469 Wartime conditions prohibited a British taxpayer from
selling roller bearings to its Asian and African customers. Bearings were supplied and sold

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directly to such customers for delivery F.O.B. Canton, Ohio470 by the taxpayer's U.S. affiliate for
a 20% commission paid to the taxpayer. The Tax Court held that the British taxpayer, though
affiliated with its U.S. principal, acted as an independent sales agent and that its commission
income was from foreign sources, allocable to the activities of its overseas sales force 471 and the
contractual right to sell to such customers. Accordingly, the taxpayer properly allocated all of its
commission income to the place of its sales activities, without regard to the source of the U.S.
principal's profit. Similarly, the U.S. principal allocated all of its profit to the place of sale,
without reference to the source of its agent's (the British affiliates's) sale activities.
469
12 T.C. 880, 887 (1949); Accord Rev. Rul. 60-55, 1960-1 C.B. 270.
470
Thus, the Section 863(b) split-source rules were inapplicable.
471
The British corporation was considered to derive service income through the services
rendered by the agents comprising its sales force, in accordance with the agency principle
discussed above.

In Perkins v. Comr.,472 an Italian resident executrix hired a New Jersey attorney to represent
her in the probate of her husband's U.S. estate. The taxpayer's subsequent receipt of a substantial
executrix' commission was held to be compensation solely for the taxpayer's activities in Italy.
Although the taxpayer retained an attorney to represent her in the United States, the attorney's
activities did not affect the source of her executrix fees.
472
40 T.C. 330 (1963), acq., 1964-1 (Part 1) C.B. 5.

In neither Perkins nor British Timken was the principal compensated for services performed
through its agent. In Perkins, the principal and agent performed different services and were
separately compensated. In British Timken, the principal sold products and the agent performed
services for which they were separately compensated.
While both Perkins and British Timken involved independent agents, British Timken
recognizes that a dependent agent, such as an employee, may have a source of income different
from his employer's:473
Although a manufacturer's profits may be the direct result of the production and sale of its
products, it does not follow that such sales constitute the source of the income of the many
persons associated with the sales such as its salesmen, buyers, agents, and officers whose
earnings are attributable to other considerations such as their sales ability or technical
knowledge. This is true even though the compensation received may be measured by the
amount of sales. It is the situs of the activity or property which constitutes the source of the
compensation paid and not the situs of the sales by which it is measured that is of critical
importance.
473
12 T.C. at 887.

Another example is a U.S. insurance intermediary performing underwriting, investment, and

claims management activities in the United States for a foreign reinsurer. The intermediary
receives U.S. source commissions for its activities performed in the United States. The foreign
principal, on the other hand, determines the source of its underwriting and investment income
according to the place of insured risk rule of Section 861(a)(7)474 and the dividend and interest
income rules of Section 861(a)(1) and (2). Thus, premiums written by the U.S. intermediary in
the United States for the foreign reinsurer covering Canadian risks and invested in Canadian
bonds are exempt from U.S. tax in the hands of the foreign reinsurer,475 even though the

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intermediary's commission income on such premiums is from U.S. sources. The place of
performance of the agent's activities is irrelevant to the source of income derived by the
insurance company because the insurance company's income is received for providing insurance
and investing capital.
474
See VIII, A, below.
475
See generally Sections 4373(1), 864(c)(4)(A), 861(a)(7).

V. Income from Use of Property -- Rents and Royalties

A. General Rule -- Place Where Property Is Used
Income from the use of property includes rents and royalties from the lease or rental of real
property (including transfers of mineral rights with retained rights), rents and royalties from the
lease or rental of tangible personal property, and royalties from the license of intangible personal
property. The general source rule applicable to all such income is the place-of-use (situs) rule of
Sections 861(a)(4) and 862(a)(4) applicable to the lease or rental of real and tangible personal
property, and the place-of-use or right-to-use rule of Sections 86l(a)(4) and 862(a)(4) applicable
to the license of intangible personal property.
These rules are premised on the notion that property that is leased or licensed is a productive
asset in its own right. Accordingly, the source of income from the use of property generally is
determined by its economic situs, without reference to its place of manufacture or creation, the
place where income is paid or received, the residence of the payor, or the place of contract.
This section will first discuss rents from real property, then deal with rents and royalties from
tangible and intangible personal property, including the apportionment required when property is
used or is entitled to be used in more than one place, and finally address how rents and royalties
interface with other types of income.
B. Real Property
The source of income from the use, rental, or lease of real property generally is the place of
its geographic situs under the general rule of Sections 86l(a)(4) and 862(a)(4).
In determining the place of use, the United States, U.S. possessions, and foreign countries
(provided that the relevant foreign country exercises its taxing jurisdiction with respect thereto)
include their respective outer continental shelves as defined in Section 638. As discussed in I, C,
above, this definition applies in determining the source of income from activities (including the
lease or rental of personal property) relating to the exploitation or exploration of oil, gas, and
other depletable mineral resources in the seabed or subsoil of shelf areas extending about 200
miles past U.S. territorial waters.
C. Personal Property
Sections 861(a)(4) and 862(a)(4) apply a place-of-use rule to rent, royalties, or other income
from the lease, license, or other use of tangible and intangible personal property. A gloss on this
rule is that royalties from intangible property are sourced to the place in which the taxpayer is
entitled to use and uses the property.
As discussed in I, C, above, Section 638 applies to income from the lease or rental of

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property relating to the exploration or exploitation of outer continental shelf mineral resources. 476
Rental income from the use of property not so related is sourced according to the territorial
definition of the United States. Thus, Rev. Rul. 75-483,477 which predates the special
transportation income rules of Section 863(c), applied the three-mile territorial limit to a bareboat
charter hire.
476
Regs. Section 1.638-1(c). See the discussion in I, C, above.
477
1975-2 C.B. 286.

As discussed in VII, A, 2, a, below, gains from the sale of certain intangibles for an amount
contingent on their productivity, use, or disposition is sourced in the same manner as royalties. 478
478
See Section 865(d)(1)(B). See discussion in V, C, below.

1. Place of Use
In the case of tangible property, the place of use is evident from the nature of the property.
Special rules apply for certain property, however.479
479
See V, C, 3, below.

For intangible property (i.e., trademarks, patents, etc.), the place-of-use test allocates
royalties according to the place in which the licensee is legally entitled to use, and legally
protected in using, the intangible property, assuming the property is actually used there. If
intangible property provides rights in multiple jurisdictions, only those jurisdictions in which the
property is actually used are taken into account for sourcing purposes.480
480
As discussed in V, C, 2, difficult proof problems may be presented in claiming
apportionment.

For example, in Rev. Rul. 68-443,481 the owner of the right to use a trademark outside the
United States granted an exclusive license to a U.S. manufacturer, which affixed the trademark to
goods sold in the United States for shipment to foreign customers. The ruling concluded that the
place of use of the trademark was the place in which the products to which the trademark was
affixed were used or consumed and in which the use of the trademark was legally permitted (i.e.,
each of the foreign countries in which the products were used or consumed) and not the place in
which the trademark was affixed.482 Similarly, the IRS has ruled that royalties received by a
nonresident alien author from a domestic corporation were foreign source where they related to
property sold exclusively in a foreign country under the protection of such country's copyright
law; the fact that the payor printed the books in the United States was not relevant. 483
481
1968-2 C.B. 304.
482
The IRS noted that, since an unrelated party owned the rights to use the mark in the United
States, the foreign licensor had no legal right to license use of the mark in the United States. Cf.
AMP, Inc. v. U.S., 492 F. Supp. 27 (M.D. Pa. 1979) (the place where an exclusive license of a
foreign patent was considered to be "sold" was foreign since the foreign patent had no legal effect
in the U.S.). If the owner of the trademark is also the owner of the goods to which the mark is
affixed, the place of sale rule, applicable to the sale of the trademarked products, applies rather
than the place-of-use rule (otherwise applicable to the use of the mark), because the buyer of the
trademarked goods has a common-law right to royalty free use of the mark pertaining to the
advertising and sale of the goods. Rev. Rul. 75-254, 1975-1 C.B. 243.
483
Rev. Rul. 72-232, 1972-1 C.B. 276.

In Rev. Rul. 80-362,484 a nonresident alien (resident in a country with which the United States

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did not have a tax treaty) licensed a patent to an unrelated Netherlands corporation, which re-
licensed the patent to a U.S. corporation for use in the United States. Although the royalties on
the second license were exempt from U.S. tax under Article 12 of the U.S.-Netherlands income
tax treaty, the royalties paid by the Netherlands corporation to the nonresident alien were ruled to
be from U.S. sources (and subject to withholding of U.S. tax by the Netherlands corporation).
The IRS reasoned that the Netherlands corporation actually used the patent in the United States
(by re-licensing the patent for use in the United States), and thus the royalties paid to the
nonresident alien were for the actual use by the licensee of the patent in the United States. This
ruling illustrates that the consideration for each license in a chain of back-to-back licenses by
foreign persons (which might be described as a cascading royalty) theoretically could be subject
to U.S. tax (absent treaty protection) as U.S. source income.485
484
1980-2 C.B. 208.
485
See ALI, Federal Income Tax Project: International Aspects of United States Income
Taxation 34, 52, 137-40 (1987), which recommends that, in imposing a gross-basis tax on rents,
royalties, gains with respect to intangibles, and other income the source of which is determined on
a like basis, a taxpayer be allowed a credit for any gross-basis tax already imposed by the United
States on income derived from the same use of the same property.

In Rev. Rul. 84-78,486 a U.S. corporation obtained from the contestants in a prize fight, which
was to take place in the United States, exclusive rights to broadcast the fight live and to record it
for subsequent viewing. The U.S. corporation entered into a contract with a foreign corporation
granting the latter, in return for a lump sum payment, the right to broadcast the fight live via the
closed circuit television in the foreign country. The IRS ruled that, since the copyright license 487
was used in the foreign country, the lump sum payment was foreign source income to the U.S.
corporation.
486
1984-1 C.B. 173.
487
The IRS also ruled that, since the foreign corporation could not exploit the broadcast for the
life of the copyright and since it had no recording rights, the U.S. corporation had licensed the
copyright rather than sold it.

2. Apportionment if Property Is Used Within and Without the United States

Like the service income source rule, the personal property place-of-use rule contemplates the
apportionment of income from property used in more than one country. The apportionment of
rental income from tangible property generally presents few substantial problems owing to the
tangible nature of such property and the relationship of rental income to place of actual use.
Historical Note: Before the enactment of Section 863(c) providing special rules for
transportation income, railroad car rental income had been apportioned on the basis of car days
of use488 and bareboat charter hire on the basis of time within and without the U.S. territorial
waters.489
488
See, e.g., Missouri Pacific Railroad Co. v. U.S., 392 F.2d 592 (Ct. Cl. 1968).
489
Rev. Rul. 75-483, 1975-2 C.B. 286; GCM 36084 (Nov. 14, 1974) (underlying Rev. Rul. 75-
483).

More substantial issues are presented with regard to the allocation and apportionment of
royalties from the use of intangible property, since such property may enjoy rights in several
jurisdictions but might actually be used only in certain or none of those jurisdictions or to
uncertain degrees in the various jurisdictions. The taxpayer's burden of showing factual

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apportionment in the absence of contractual allocation has historically been substantial.
In Alexander Marton Est. v. Comr.,490 the Board of Tax Appeals, and in Molnar v. Comr.,491 the
Tax Court denied apportionment of royalties received from a U.S. licensee for worldwide motion
picture rights that were never used. The court found evidence of the licensee's U.S. and
worldwide income to be too speculative. In Rohmer v. Comr.,492 the Tax Court denied
apportionment of a lump sum for U.S. and Canadian serial rights that was based on the licensee's
circulation figures in the two countries for serial publication of the author's works in both
countries. In affirming both the Molnar493 and Rohmer494 decisions, the Second Circuit hinted that
the results might have been different if the taxpayer had introduced expert testimony.
490
47 B.T.A. 184 (1942).
491
4 T.C.M. 951 (1945), aff'd, 156 F.2d 924 (2d Cir.1946).
492
153 F.2d 61 (2d Cir. 1946), aff'g 5 T.C. 183 (1945), cert. denied, 328 U.S. 862 (1946).
493
156 F.2d 924, 926 (2d Cir. 1946). The Second Circuit subsequently decided a similar case
involving patent royalties. See Sanchez v. Comr., 162 F.2d 58 (2d Cir. 1947) (royalty payments,
measured by the percentage of sales' proceeds from a domestic exclusive licensee to a nonresident
alien were not apportioned and were includable in gross income despite foreign sub-licensees
being granted use of the foreign patents royalty-free).
494
153 F.2d 61, 65 (2d Cir. 1946).

The Tax Court subsequently rejected circulation figures and expert testimony in Wodehouse
v. Comr.495 In that instance, however, the decision was reversed in separate appeals by both the
Second Circuit (which made an apportionment)496 and the Fourth Circuit (on remand from the
Supreme Court for failure to determine the apportionment issue.)497 The Tax Court subsequently
computed its own apportionment in a second Wodehouse498 decision, and also in a second
unrelated opinion in Rohmer v. Comr.,499 based on circulation figures and expert witnesses'
testimony.
495
8 T.C. 637 (1947), acq., 1947-2 C.B. 5, aff'd on other grounds, 166 F.2d 986 (4th Cir. 1948),
rev'd and remanded on this and other grounds, 337 U.S. 369 (1949), rev'd and remanded on this
issue, 178 F.2d 987 (4th Cir. 1949), on remand, 15 T.C. 799 (1950).
496
Wodehouse v. Comr., 177 F.2d 881 (2d Cir. 1949), rev'g 8 T.C. 637 (1947).
497
178 F.2d 987 (4th Cir. 1949).
498
15 T.C. 799 (1950). The IRS confirmed this in TAM 9730005.
499
14 T.C. 1467 (1950).

Two years following its decision in Wodehouse, the Second Circuit held that royalties
received by a foreign corporation from a domestic corporation for distribution rights in the
United States and various other countries were wholly from domestic sources since the taxpayers
"presented no basis for apportionment" of the payment between the United States and the foreign
jurisdictions.500
500
Misbourne Pictures, Ltd. v. Johnson, 189 F.2d 774 (2d Cir.1951). See also FSA 200222011
(taxpayer's sales-based method of sourcing software royalty income to foreign source based on the
location of the customer or the place of the sale was unreasonable and failed to give adequate
recognition to the fact that all of the software development and modification creating the royalty
income was performed by taxpayer's subsidiary in the United States).

These cases make clear that, as a drafting matter, royalties for the use of intangible property
in more than one jurisdiction should be specifically allocated in the license agreement or be
made the subject of separate agreements regarding U.S. and non-U.S. uses. In the absence of
such allocation or separate agreements, or a reasonable relationship between factual

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apportionment and the income expected to be derived from the license, all royalty income
generally will be allocated to U.S. sources.
3. Special Rules for Use of Ships, Aircraft, Railroad Rolling Stock, and Shipping Containers
Income derived by a nonresident alien individual or foreign corporation from the rental of
ships or aircraft, and income derived by a foreign corporation from the temporary rental (not to
exceed 90 days in any taxable year) of railroad rolling stock to a common carrier, may be eligible
for exclusion from gross income under Sections 872(b) and 883(a),501 if the individual is resident
in, or the corporation is formed in, a foreign country which grants an equivalent exemption to
U.S. residents or corporations, respectively.
501
See discussion in IX, C and IX, D, 2, below.

Income derived by a domestic person (or, to the extent the above-referenced exemptions are
unavailable, by a foreign person) from the rental of a vessel or aircraft or of a container used in
connection with a vessel or aircraft, is sourced under the transportation income rules set forth in
IX, A, below.
D. Rents and Royalties Versus Other Characterizations
1. License Versus Sale
The IRS takes the position that a transfer of rights under a copyright or patent is a sale if the
property owner grants to another the exclusive right to exploit the property in a particular
medium or jurisdiction throughout the life of the copyright or patent in return for consideration. 502
On the other hand, if the property owner transfers the right to exploit the property for a period
less than its remaining legally protected life, the transaction is a license and the property owner's
income is sourced under the royalty source rules in Sections 861(a)(4) and 862(a)(4).503
502
Rev. Rul. 60-226, 1960-1 C.B. 26. See VII, A, 2, a, (3), below.
503
Id.

Even if a transaction is treated as a sale rather than a license for tax purposes, when the
transaction involves an intangible, Section 865(d)(1)(B) applies the royalty source rule to
payments that are contingent on the productivity, use, or disposition of the intangible.504
Following years of litigation, Congress substantially restricted sale versus license tax planning
for nonresident aliens and foreign corporations. U.S.-source gains from transfers of patents,
copyrights, trade secrets, goodwill, trademarks, brand names, franchises, and like property
(excluding any imputed interest component) are subject to a 30% withholding tax under Section
871(a)(1) (if not taxed at normal rates as effectively connected income or subject to a reduced
rate of tax by income tax treaty) to the extent such gains are contingent on the productivity, use
or disposition of such property.505 The Section 865(d)(1)(B) source rule ensures that such gains
will be allocated to U.S. sources if the intangible property is used in the United States. 506
504
See VII, A, 2, a, below.
505
Sections 871(a)(1)(D) and 88l(a)(4), applicable for sales after October 4, 1966. For purposes
of these provisions, Regs. Sections 1.871-11(d) and (f) permit recovery of basis first (an "open
transaction" approach), and apportion basis between fixed and contingent payments received
within a given taxable year in accordance with their respective amounts.
506
Section 865(d)(1)(B) replaced Section 871(e)(2), which was repealed. See VII, A, 2, a, below
for a discussion of Section 865(d)(1)(B).

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 Even though Section 865(d)(1)(B) was directed at nonresidents, it is equally applicable to
residents. Consequently, a sale by a U.S. resident (as defined in Section 865(g)(1)(A)) of, e.g., a
foreign trademark for an amount contingent on its use gives rise to foreign source income for
foreign tax credit purposes, whereas a sale for a fixed amount would not. On the other hand, a
sale for a contingent amount might more readily attract a foreign tax.
If the manufacturer of a product sells a trademarked product to independent distributors and
receives no separate consideration for use of the trademark, the IRS has ruled that the gain from
the sale of the product is sourced wholly under the rules that apply to sales of personal property
produced by the seller, and not in part under the source rule for the use of property.507
507
Rev. Rul. 75-254, 1975-1 C.B. 243 (use of trademark treated as incidental to purchase of
product).

2. License Versus Services

As discussed more fully above,508 a series of cases have treated royalties paid to nonresident
aliens in connection with intellectual property as income from personal services when the
taxpayer's personal effects gave rise to the property and the taxpayer retained no ownership
interest in the property. If income is characterized as from the use of property produced by the
taxpayer, the income is sourced under Sections 861(a)(4) and 862(a)(4) in its entirety, with no
apportionment in respect of any production or service component. This may be contrasted with
the apportionment principle under Section 863(b) for property produced in one jurisdiction and
sold in another.
508
See IV, E, 2, a, above.

3. Interaction with Rental and Ocean or Space Activity Rules

To the extent that Section 863(c), dealing with transportation income, applies to a taxpayer's
rental income, the rules in that provision override the rules in Sections 861(a)(4) and 862(a)(4)
discussed above.509
509
See discussion in V, C, 3 and IX, A, below.

To the extent that a taxpayer's rental or royalty income constitutes income from a space or
ocean activity, the special source rules in Section 863(d) should override the rental and royalty
income source rules in Sections 861(a)(4) and 862(a)(4).510
510
See discussion in X, below.

VI. Income from the Sale of Real Property

Nations have historically claimed sovereign jurisdiction to tax income derived from real
property within their borders. Since real property is immovable, the attributes of ownership of
real property are fixed to the jurisdiction of the property's situs. Therefore, the economic source
of income or gain from the sale or other disposition (or use) of real property generally is viewed
as such situs. Accordingly, Sections 861(a)(5) and 862(a)(5) have treated income from the
disposition of real property located in the United States (and other "United States real property
interests") as from U.S. sources and income from the disposition of real property located without
the United States as from foreign sources, without regard to, e.g., the place of contract, receipt of
income, or delivery of deed.511 The right to tax domestic real property income is confirmed in the

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bilateral income tax treaties to which the United States is a signatory.
511
Accord Regs. Section 1.861-6.

A. U.S. Real Property Interests

The property source rule of Section 861(a)(5), as modified by the Foreign Investment in Real
Property Tax Act of 1980 (FIRPTA),512 generally allocates to U.S. sources the gain from the
disposition of a U.S. real property interest (USRPI). As discussed below, gain from the sale of
shares in certain domestic corporations holding U.S. real property and of the sale of certain other
equity interests in entities may be treated as gain from U.S. sources under Section 861(a)(5).
512
P.L. 96-499.

Section 897, which codified the operative taxing provisions of FIRPTA, treats gain or loss
realized by a foreign corporation or nonresident alien from the disposition of USRPIs as
effectively connected with a U.S. trade or business of the foreign person.513
513
See Section 897(a)(1).

An interest is a USRPI if it is either:

(i) an interest in real property (including an interest in a mine, well, or other natural deposit)
located in the United States or the Virgin Islands514 and also including personalty associated
with the use of the real property;515 or
(ii) an interest (other than an interest solely as a creditor) in a domestic corporation which is
or was a U.S. real property holding corporation (USRPHC) at any time during the shorter of
the period during which the taxpayer held the interest or the five-year period ending on the
date of disposition of the interest.516
514
Section 897(c)(1)(A)(i). Even though the Virgin Islands is treated as equivalent to the United
States for purposes of determining income subject to tax under Section 897, income attributable to
the sale of an interest in Virgin Islands property is characterized as foreign source income under
the source rules, as discussed in VI, B, 2.
515
Section 897(c)(6)(B). Under certain circumstances, however, a sale of associated personal
property separate from the real property is not considered a sale of a USRPI. Regs. Section 1.897-
1(b)(4)(ii).
516
Section 897(c)(1)(A)(ii). Under Section 897(i), however, a corporation resident in one of
certain countries with which the United States has entered into an income tax treaty containing an
appropriate nondiscrimination provision may elect to be treated as a domestic corporation for
purposes of Sections 897 and 1445. The corporation must, upon making the election, qualify as a
U.S. real property holding corporation. Regs. Section 1.897-8T.

A USRPHC is any corporation if the fair market value of its USRPIs equals or exceeds 50%
of the fair market value of the sum of:
(i) its USRPIs;
(ii) its interests in real property located outside the United States; plus
(iii) any other of its assets which are used or held for use in a trade or business.517 For
purposes of determining USRPHC status, a look- through rule treats a corporation as owning
its proportionate share of the assets of any corporation in which it owns 50% or more by

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 value of the outstanding shares; such deemed ownership also is taken into account in testing
USRPHC status of higher-tier corporations.518 In addition, solely for purposes of testing
USRPHC status, a USRPI includes an interest, other than an interest solely as a creditor, in a
foreign corporation (as well as a domestic corporation) unless it is established that the foreign
corporation is not a USRPHC during the shorter of the period during which the taxpayer held
the interest or the five-year period ending on the date of disposition of the interest.519
517
Section 897(c)(2).
518
See Section 897(c)(5).
519
Section 897(c)(4)(A).

There are various statutory exceptions to the USRPI definition as set forth above. The term
USRPI does not include:
(i) An interest in a domestic corporation if any class of stock of such corporation is regularly
traded on an established securities market, except, in general, in the case of a person who, at
some time during the shorter of the period the interest was held or the five-year period ending
on the date of disposition of the interest held more than 5% of such regularly traded class of
stock or held any other interest in the corporation having a fair market value greater than the
fair market value of 5% of the regularly traded class with the lowest fair market value. 520
(ii) An interest in a domestically controlled REIT.521 A domestically controlled REIT is one in
which less than 50% of the fair market value of the outstanding stock was directly or
indirectly held by foreign persons during the five-year period ending on the applicable
determination date.
(iii) An interest in a corporation which has disposed of all its USRPIs in transactions in which
the full amount of gain, if any, was recognized.522
(iv) An interest solely as a creditor either in real property or in a domestic corporation. 523 In
addition, an interest solely as a creditor in a partnership, trust, or estate is not a USRPI.524
520
Section 897(c)(3); Regs. Section 1.897-1(c)(2)(iii); Regs. Section 1.897-9T.
521
Section 897(h)(2), Regs. Section 1.897-1(c)(2)(i).
522
Section 897(c)(1)(B); Regs. Section 1.897-1(c)(2)(ii).
523
Section 897(c)(1)(A)(ii); Regs. Section 1.897-1(d)(1).
524
Id.

With respect to the fourth exception, whether an interest is considered debt under any
provisions of the Code is not determinative of whether it constitutes an interest solely as a
creditor.525 A loan to an individual or entity under the terms of which a holder of the indebtedness
has any direct or indirect right to share in the appreciation in value of, or the gross or net
proceeds or profits generated by, an interest in real property of the debtor or of a related person
is, in its entirety, an interest in real property other than solely as a creditor.526 An interest in
production payments described in Section 636 does not generally constitute an interest in real
property other than solely as a creditor, but does if it conveys a right to share in the appreciation
in value of the mineral property.527 A right to installment or other deferred payments from the
disposition of an interest in real property constitutes an interest solely as a creditor if the
transferor elects not to have the installment method of Section 453(a) apply, any gain or loss is
recognized in the year of disposition and all tax due is timely paid.528
525
Id.

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 526
Regs. Section 1.897-1(d)(2)(i). Note, however, that, while a sale of the instrument would be
taxable under Section 897(a), the receipt of principal and interest upon its maturity would not be,
on the theory that principal and interest payments do not constitute gain under Section 1001. Regs.
Section 1.897-1(h) Ex. (2).
527
Id.
528
Regs. Section 1.897-1(d)(2)(ii)(A).

At least to the extent provided in regulations,529 a "look-through" rule applies to interests held
in partnerships, estates, and trusts, whereby an amount received upon the sale of an interest in
such an entity may be treated under Section 897(g) as received from the sale of a USRPI to the
extent attributable to a USRPI held by the entity.530 Under regulations, an interest in a partnership
in which, directly or indirectly, 50% or more of the value of the gross assets consists of USRPIs,
and 90% or more of the value of the gross assets consists of USRPIs plus any cash or cash
equivalents, is treated as a USRPI entirely for Section 1445 withholding purposes but only to the
extent that the gain on the disposition is attributable to USRPIs (and not cash, cash equivalents,
or other property) for Section 897(g) purposes.531 Even if these tests are not met, the IRS takes
the position that Section 897(g) is operable.532
529
The statute begins: "Under regulations prescribed by the Secretary . . ."
530
Section 897(g).
531
Regs. Section 1.897-7T. See also Regs. Section 1.897-1(c)(2)(iv) (publicly traded
partnerships treated like corporations for Section 897 purposes).
532
See Rev. Rul. 91-32, 1991-1 C.B. 107, 110.

In addition, a distribution by a REIT to a nonresident alien or foreign corporation of an

amount attributable to gain from the sale of a USRPI is treated under Section 897(h)(1) as gain
from the sale of a USRPI by such shareholder and, accordingly, is taxed as U.S. source income
effectively connected with a U.S. trade or business. However, this look-through treatment was
limited by §418 of the 2004 American Jobs Creation Act (P.L. 108-357) which provided that the
distribution is instead treated as a REIT dividend that is not capital gain if the distribution is
received with respect to a class of stock that is regularly traded on an established securities
market located in the United States and the foreign investor does not own more than 5% of the
class of stock at any time during the taxable year within which the distribution is received. This
change enabled the described foreign investors to avoid the requirements that attended the pass-
through treatment, such as the requirement of a U.S. federal income tax return and possible
application of the branch profits tax provisions.
Historical Note: Before June 19, 1980, nonresident aliens and foreign corporations could
easily avoid U.S. source characterization or taxation of gain from the sale of U.S. property by a
variety of techniques. The incorporation of U.S. real property holdings provided an assured
method of obtaining application of real property source rules for the use of such property and
application of the title-passage rule of Section 861(a)(6) for the sale of the USRPI (through sale
or other disposition of the shares). Such incorporation in the Netherlands Antilles and British
Virgin Islands became a common device for minimizing the tax on real property rental income
while permitting tax free capital gain upon the eventual sale of the underlying shares. 533 A real
property partnership interest (treated as a capital asset by Section 741) arguably could be sold
outside the United States with similar tax avoidance effect.534 In addition, a partnership or
corporate stock interest in a real property holding organization could be sold tax free within the
United States in a year the shareholder or partner was not engaged in a U.S. trade or business.535

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Following the tax-free transfer of shares in a real property holding corporation, the property
could be readily removed from the corporate entity by liquidation of the holding company
without recognized gain at the corporate or shareholder level. Effective for dispositions on or
after June 19, 1980 (subject to treaty relief in certain situations through December 31, 1984 536 and
to additional transition relief under Article XIII(9) of the Canadian treaty), FIRPTA virtually
eliminated relief from U.S. tax on the sale or other disposition by a foreign person of a USRPI.537
533
Taxation of net rental income under some treaties may be elected on an annual basis, rather
than irrevocably under Section 882(d). Thus, e.g., a Netherlands Antilles corporation holding
leased real property could receive net lease rentals taxed only to the extent, if any, that such rentals
exceeded applicable deductions (instead of at the 30% Section 881(a) rate), by making the Art. X
election under the Netherlands Antilles treaty then in effect. By not making the election for the
year in which the property would be sold, gain on the sale could be tax-exempt as income not
effectively connected with a U.S. trade or business.
534
But cf. Rev. Rul. 91-32, 1991-1 C.B. 107.
535
Although gain from such a sale would be U.S. source under the "title passage" rule, the gain
was tax-exempt since it was not effectively connected income under Section 864(c)(2) nor "fixed
or determinable annual or periodical income" subject to withholding under Sections 1441-42.
536
See FIRPTA, Section 1125(c).
537
The IRS has ruled that a 1987 executive agreement between the United States and Argentina
providing for a reciprocal exemption of income from the international operation of ships and
aircraft pursuant to Sections 872(b) and 883(a) could not modify the taxation of gain from the
disposition of real property under Section 897, even though the real property was used in the
shipping company's business. Rev. Rul. 90-37, 1990-1 C.B. 141. To the extent, however, an
interest in real property is not a USRPI under Section 897 (e.g., real property held through a
foreign corporation or certain participating mortgage loan interests held to maturity), U.S. taxation
may still be avoided.

B. Real Property Located Without the United States

1. General
Under Section 862(a)(5), gain from the sale or exchange of real property located without the
United States is treated as foreign source income. It is interesting to consider that, while Section
861(a)(5) invokes the sweeping definition of USRPIs contained in Section 897(c), Section 862(a)
(5) applies only to "real property" located without the United States. Thus, gain from the sale of
interests in entities not qualifying as U.S. real property are sourced under the Section 865 rules
governing sales of personal property generally. There appears to be little consequence for foreign
persons in this context, since, for example, the sale of an interest in an entity holding foreign real
property generally is sourced without the United States in any event under the Section 865 rules
governing sales of personal property. In the case of a U.S. person, however, the sale of an interest
in such an entity generally would give rise to domestic source income under Section 865 based
on the seller's residence, whereas a sale of the underlying real property would give rise to foreign
source income under Section 862(a)(5).
2. Virgin Islands
As noted above, for purposes of the tax imposed under Section 897, an interest in real
property located in the Virgin Islands is considered equivalent to an interest in real property
located in the United States. For source of income purposes, however, gain from the disposition
of a USRPI is treated as foreign source under Section 862(a)(8) when the real property is located
in the Virgin Islands. The principal reason for this provision is to permit gain from the sale of an

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interest in real property located in the Virgin Islands to be taxed under Section 897 of the
"mirror" tax code of the Virgin Islands.538 If the seller of such an interest is a U.S. person, this
provision also would provide the seller foreign source income, for purposes of the Section 904
foreign tax credit limitation, which would help the seller obtain a credit for the Virgin Islands tax
payable on the sale.539
538
See Staff of Joint Comm. on Tax'n, 97th Cong., 1st Sess., General Explanation of the
Economic Recovery Tax Act of 1981, at 370 (1981).
539
Id.

C. Definition of Real Property

1. U.S. Real Property
The regulations under Section 897 define the term "real property" to include three categories
of property:540
(i) land and unsevered natural products of the land;
(ii) improvements; and
(iii) personal property associated with the use of real property; Local law definitions will not
be controlling for purposes of determining the meaning of the term "real property" as it is
used in Section 897.541
540
Regs. Section 1.897-1(b)(1).
541
Id. Cf. Regs. Section 1.48-1(c) (local law definition not controlling for investment tax credit
purposes); Regs. Section 1.856-3(d) (local law definitions not controlling for REIT purposes).

The first category of real property, land and unsevered natural products of the land, includes
land, growing crops and timber, and mines, wells, and other natural deposits.542 Crops and timber
cease to be real property at the time that they are severed from the land.543 Ores, minerals, and
other natural deposits cease to be real property when they are extracted from the ground. 544
542
Regs. Section 1.897-1(b)(2).
543
Id.
544
Id.

The second category of real property is an improvement on land, which is defined as a

building, any other "inherently permanent structure," or the "structural components" of either.545
(i) A "building" generally means any structure enclosing a space within its walls and
"usually" covered by a roof, including any structure classified as a building for purposes of
Section 48(a)(1)(B) and Regs. Section 1.48-1, dealing with the former investment tax credit
for certain personal property.546
(ii) The term "inherently permanent structure" for this purpose means any property, not
otherwise treated as an improvement, that is affixed to real property and that will ordinarily
remain affixed for an indefinite period of time.547 Property that is not classified as a building
for purposes of Section 48(a)(1)(B) and Regs. Section 1.48-1, may nevertheless constitute an
inherently permanent structure.548 Any property not otherwise treated as an improvement that
constitutes "other tangible property" under the principles of Section 48(a)(1)(B) and Regs.
Sections 1.48-1(c) and (d) is treated as an inherently permanent structure.549 For example, the

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 term includes swimming pools, paved parking areas and other pavements, special
foundations for heavy equipment, wharves and docks, bridges, fences, inherently permanent
advertising displays, inherently permanent outdoor lighting facilities, railroad tracks and
signals, telephone poles, permanently installed telephone and television cables, broadcasting
towers, oil derricks, oil and gas pipelines, oil and gas storage tanks, grain storage bins, and
silos.550 Where precedents developed under the principles of Section 48 fail to provide
adequate guidance with respect to the classification of particular property, the determination
of whether such property constitutes an inherently permanent structure is made by
considering all the facts and circumstances. In particular, the factors specified in Regs.
Section 1.897-1(b)(3)(iii)(C) must be taken into account.
(iii) Structural components of buildings and other inherently permanent structures, as defined
in (former) Regs. Section 1.48-1(e)(2), themselves constitute improvements. Structural
components include walls, partitions, floors, ceilings, windows, doors, wiring, plumbing,
central heating and central air conditioning systems, lighting fixtures, pipes, ducts, elevators,
escalators, sprinkler systems, fire escapes, and other components relating to the operation or
maintenance of a building.
545
Regs. Section 1.897-1(b)(3)(i).
546
Regs. Section 1.897-1(b)(3)(ii).
547
Regs. Section 1.897-1(b)(3)(iii).
548
Id.
549
Regs. Section 1.897-1(b)(3)(iii)(B).
550
Id.

Note: In T.D. 8474, 58 Fed. Reg. 25587 (4/27/93), the IRS removed Regs. Section 1.48-1(e).
The reference remains, however, in Regs. Section 1.897-1(b)(3)(iii)(B) to former Regs.
Section 1.48-1(e).
The third category of "real property" includes movable walls, furnishings, and other personal
property "associated with the use of real property."551 The regulations describe four subcategories
of such property.
(i) Personal property is associated with the use of real property if it is predominantly used to
exploit unsevered natural products in or upon the land.552 Such property includes mining
equipment used to extract ores, minerals, and other natural deposits from the ground.553 It also
includes any property used to cultivate the soil and harvest its products, such as farm
machinery, draft animals, and equipment used in the growing and cutting of timber.554
(ii) Personal property also is associated with the use of real property if it is predominantly
used to construct or otherwise carry out improvements to real property, whether to alter the
natural contours of the land, to clear and prepare raw land for construction, or to carry out the
construction of improvements.555
(iii) Personal property is associated with the use of real property if it is predominantly used in
connection with the operation of a lodging facility.556 Property that is used in connection with
the operation of a lodging facility includes property used in the living quarters of such
facility, such as beds and other furniture, refrigerators, ranges and other equipment, as well as
property used in common areas of such facility, such as lobby furniture and laundry
equipment.557

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 (iv) Personal property is associated with the use of real property if it is predominantly used
by a lessor to provide furnished office or other work space to lessees.558 Property that is so
used includes office furniture and equipment included in the rental of furnished space.559
551
Regs. Section 1.897-1(b)(4)(i).
552
Regs. Section 1.897-1(b)(4)(i)(A).
553
Id.
554
Id.
555
Regs. Section 1.897-1(b)(4)(i)(B).
556
Regs. Section 1.897-1(b)(4)(i)(C).
557
Id.
558
Regs. Section 1.897-1(b)(4)(i)(D).
559
Id.

2. Foreign Real Property

The definition of interest in real property in Section 897 and the regulations thereunder does
not apply for purposes of Section 862(a)(5), dealing with the source of income from the sale of
real property located without the United States. The characterization of property as real or
personal for tax purposes generally is determined under federal law; while reference may be
made to local law, the determination generally is not governed by local law.560 Real property
generally includes land and any buildings or other structural improvements. An interest in real
property generally includes both an interest in fee and a leasehold interest. Real property
generally includes fixtures to real property.
560
See Rev. Rul. 68-226, 1968-1 C.B. 362 (domestic oil and gas leasehold), cited in PLR
8726061 (dealing with Section 862(a)(5)); cf. Regs. Section 1.48-1(c) local law not controlling as
to whether property is personal or real for investment credit purposes; Regs. Section 1.856-3(d)
(same for REIT purposes).

An interest in natural resources underlying land generally is considered real property.561 Once
extracted, however, the natural resources are personal property.562
561
See Rev. Rul. 68-226 1968-1 C.B. 362 (interest of lessee in foreign oil and gas in place);
PLR 8726061 (undivided interest in foreign oil and gas concession; cf., e.g., Texas-Canadian Oil
Corp. v. Comr., 44 B.T.A. 913 (1941) (Canadian corporation reincorporated into a Bahamian
corporation by transferring assets, including Texas oil and gas leases, in exchange for the
Bahamian corporation's stock and an agreement to assume all liabilities; since the leases were real
property under Texas law and the transferor had not sought a prior ruling under the predecessor of
Section 367, the gain realized from the transfer of assets was held to be taxable U.S. source
income.
562
See PLR 8726061.

Real property generally does not include an interest in a corporation, partnership, or other
entity.563
563
But cf. Comr. v. Ferro-Enamel Corp., 134 F.2d 564 (6th Cir.1943). In that case, a domestic
corporation purchased stock in a Canadian corporation to secure a continuing source of raw
materials for the taxpayer's domestic business. The Canadian corporation subsequently went out of
existence and its stock became worthless. The Sixth Circuit held that the loss was derived from a
Canadian activity or use of property, which it analogized to an investment in Canadian real
property.

A mortgage secured by real property is generally not considered real property,564 including for
purposes of Section 861(a)(1). Consistently with this approach, most U.S. tax treaties specifically

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exclude interest on such a mortgage from the "real property" income article and assign it instead
to the interest article.565 On the other hand, if the mortgage loan has sufficient attributes of equity
ownership, it may be treated as real property in whole or in part.566
564
See, e.g., Rev. Rul. 83-51, 1983-1 C.B. 48 (shared appreciation mortgages of noncommercial
borrowers); Rev. Rul. 76-413, 1976-2 C.B. 213 (contingent interest earned by REIT); PLR
7006290500A (contingent interest on sale of land).
565
See, e.g., treaties with Germany (Art. II(2)) and Switzerland (Arts. VII(1) and IX(1)). The
treaty with Austria (Arts. VII, IX(1)) is an exception. See GCM 38849 (May 10, 1982) (interest on
mortgages secured by real property is taxable as real property).
566
See, e.g., Farley Realty Corp. v. Comr., 279 F.2d 701 (2d Cir. 1960) (loan calling for fixed
interest and repayment of principal plus share of appreciation in value of underlying real property
bifurcated into loan and equity interest in real property); PLR 7846033 (unclear whether 65-year
mortgage loan by Section 401 trust to developers giving trust option to buy land for principal
amount, and giving developer a ground lease for rent corresponding in amount to interest was loan
or equity). See generally Feder, "Either a Partner or a Lender Be -- Emerging Tax Issues in Real
Estate Finance," 36 Tax L. Rev. 191 (1983).

Real property generally does not include personal property, no matter how closely associated
with the real property.
VII. Income from the Sale of Personal Property
The rules governing the source of income from the sale of personal property generally may
be divided into two different regimes, the first applicable to property other than inventory
property (discussed in A, below) and the second applicable to inventory property (discussed in B,
below). In addition, special rules under Section 904(f) with respect to deemed dispositions of
branches with overall foreign losses and special rules dealing with the production and sale of
natural resources are discussed in C and D, below, respectively.
A. Property Other than Inventory Property
In general, the source rules for the sale of property other than inventory are set forth in
Section 865. The discussion below first describes certain general rules and then discusses a
number of exceptions.
In the case of a sale of property by a partnership, except as provided in regulations, the rules
discussed below apply at the partner level.567 In making this determination, any office or other
fixed place of business of the partnership is attributed to the partners. The regulations, however,
may provide for a determination of source at the partnership level where it is administratively
impossible to apply the rules at the partner level (e.g., a publicly traded partnership with
hundreds of partners).568
567
Section 865(i)(5) (added by TAMRA, Section 1012(d)(3)(B); changed the TRA 86 rule
which had looked to the partnership's residence).
568
S. Rep. No. 445, 100th Cong., 2d Sess. 236, 237 (1988).

For purposes of Section865, any possession of the United States is treated as a foreign
country.569
569
Section 865(i)(3).

Historical Note: Section865, added by TRA 86 and generally effective for taxable years

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beginning after December 31, 1986,570 significantly altered the rules relating to the source of
income derived from sales of personal property other than inventory property. Under prior law,
income derived from the purchase and resale of tangible and intangible personal property
(regardless of depreciation or amortization adjustments) generally was sourced where title to the
property passed to the purchaser. The source of income from the sale of certain intangible
property was held to be determined by the place of contract acceptance.571
570
In Notice87-65, 1987-2 C.B. 376, the IRS announced the effective dates for the Section 865
source rules. For U.S. persons and controlled foreign corporations, Section 865 applies to
payments received in taxable years beginning after 1986, including installment payments received
under an installment sale contract entered into before the effective date. For foreign persons other
than controlled foreign corporations, Section 865 applies to transactions entered into after March
18, 1986. If an installment sale contract was entered into on or before March 18, 1986, the source
of payments is determined under prior law, no matter when received.
571
See, e.g., Sabatini v. Comr., 32 B.T.A. 705(1935), rev'd on other grounds, 98 F.2d 753(2d
Cir. 1938). But see, AMP, Inc. v. U.S., 492 F. Supp. 27 (M.D. Pa. 1979) (passage of title test was
not applicable to sale of patents since patents were effective only in the foreign country under
whose laws they were issued and the only connection the United States had with the patents and
transactions was that AMP was a domestic corporation and the agreements were formally signed
in the United States).

1. General Rules
After TRA 86, it is not possible to state a single general rule for the sale of personal property,
even disregarding inventory property. Rather, a general rule, looking to the residence of the
seller, may be stated for property that is neither depreciable nor amortizable, and a very different
rule for property that is either depreciable or amortizable.
a. Nondepreciable and Nonamortizable Property
(1) General Rule -- Residence of Seller
As a general rule, Section865(a) provides that gain from the sale of personal property (other
than inventory) is sourced by the residence of the seller. Accordingly, if a "U.S. resident" (as
specifically defined in Section 865(g)) sells such personal property, the income generally is
sourced in the United States, and if a "nonresident" sells such personal property, the income
generally is sourced outside of the United States. There are, however, important exceptions to
this general rule, including for certain sales attributable to an office or other fixed place of
business in the United States (in the case of a foreign seller) or abroad (in the case of a domestic
seller).572
572
These are discussed in VII, A, 2, below.

Under the general rule, gain realized by a U.S. citizen or resident (with a U.S. tax home)
from the sale or exchange of a portfolio interest in stock573 generally is considered to be from
U.S. sources, and such gain realized by a nonresident alien (with a tax home abroad) generally is
considered to be from foreign sources, regardless of whether the corporation is domestic or
foreign or the sale is consummated on a domestic or foreign stock exchange.574
573
It is assumed that the sale is not governed by Section1248.
574
See PLR 9847016 (capital gain income from sale of securities by nonresident alien (within
meaning of §865(g)(1)(B)) is not subject to U.S. tax). Under pre-TRA 86 law, the gain was
sourced generally by reference to the place of sale. See, e.g., Ardbern Co. v. Comr., 41 B.T.A. 910,

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 922 (1940), mod. on another issue, 120 F.2d 424 (4th Cir. 1941) (sale occurred in United States
where share certificates endorsed and delivered to agent for transfer to depository bank in
Montreal for merely clerical delivery); Hazleton Corp. v. Comr., 36 B.T.A. 908, 923 (1937),
nonacq., 1938-1 C.B. 50; Elston Co. v. Comr., 42 B.T.A. 208, 218 (1940); Rev. Rul. 75-263, 1975-
2 C.B. 287 (source of gain or conversion of debentures into stock depended on where debentures
were delivered to exchange agent). Accord PLR 7927045 (stock of domestic corporation sold
abroad). Similarly, gain on a liquidating distribution had been held to be sourced by analogy to
dividend income. See Hay v. Comr., 145 F.2d 1001 (4th Cir. 1944). In a private ruling, the IRS
followed this approach with respect to a foreign corporation and, initially, a domestic corporation,
but (apparently at the taxpayer's request) changed the conclusion to an assumption in the case of
the domestic corporation. See PLR 7851001, as amended. Regulations under former Section 58
indicated that a sale of shares executed on the New York Stock Exchange would be considered to
occur in the United States even if the stock certificates had been delivered to a foreign broker who
executed the exchange. See Regs. Section 1.58-8(d), Ex. (9), T.D. 7564 (September 11, 1978).

(2) Definition of U.S. Resident and Nonresident

(a) General
For these purposes, Section865(g) defines the term United States resident as:575
(i) any individual who either (A) is a U.S. citizen or resident alien (under Section 7701(b)
and either does not have a "tax home" (as defined in Section 911(d)(3)) in a foreign country
(or a U.S. possession), or has such a tax home but is not subject to foreign tax at a rate of at
least 10% on gain from the sale of the property at issue, or (B) is a nonresident alien and has
a tax home in the United States; and
(ii) any corporation, trust, or estate which is a U.S. person (as defined in Section 7701(a)(30),
i.e., a domestic corporation or a trust or estate which is subject to U.S. taxation of its income
regardless of source). In turn, the term "nonresident" means any person other than a U.S.
resident.576
575
Sections 865(g)(1)(A), 865(g)(2).
576
Section 865(g)(1)(B).

In the case of a sale of property by a partnership, except as provided in regulations, Section

865 is applied at the partner level.577 The legislative history suggests that it may be appropriate to
determine source at the partnership level in the case of a publicly traded partnership which has
hundreds of partners.578
577
Section865(i)(5), added by TAMRA, Section 1012(d)(3)(B).
578
See fn. 568.

(b) Tax Home

Section911(d)(3) defines an individual's "tax home" as the individual's home for purposes of
Section 162(a)(2) relating to traveling expenses while away from home), provided, however, that
an individual is not treated as having a tax home in a foreign country during any period in which
his "abode" is in the United States. The regulations elaborate on this definition by providing that,
subject to the same proviso, "an individual's tax home is considered to be located at his regular or
principal (if more than one regular) place of business or, if the individual has no regular or
principal place of business because of the nature of the business, then at his regular place of
abode in a real and substantial sense."579 Maintenance of a dwelling in the United States does not

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necessarily mean that an individual's abode is in the United States.580
579
Regs. Section 1.911-2(b). For a detailed discussion of Section 911, including the definition
of "tax home," see 918 T.M., Citizens and Resident Aliens Employed Abroad.
580
Regs. Section 1.911-2(b). Compare Lemay v. Comr., 53 T.C.M. 862 (1987), aff'd, 88-1 USTC
Para.9182 (5th Cir. 1988) (taxpayer's economic, familial, and personal ties to Louisiana prevented
Tunisia, where taxpayer worked on offshore drilling rigs, from becoming abode) with Jones v.
Comr., 91-1 USTC Para.50,174 (5th Cir. 1991) (JAL airline pilot based in Japan had abode and tax
home in Japan though he lived in hotel there and his wife remained in Anchorage, Alaska).

A individual's tax home is not considered to shift by reason of a temporary, rather than
permanent or indefinite, employment in another country.581 In determining whether an
individual's employment is permanent and thus the individual's tax home has shifted, the IRS
applies the following rules:582
(i) If an individual's business assignment in a second country is for less than one year, the
question of whether the business assignment is temporary and the individual's tax home
remains in the home country is determined from all the facts and circumstances.
(ii) If an individual is expected to or actually does remain employed in the second country for
two years or more, the assignment is deemed indefinite regardless of any other facts or
circumstances, and therefore the individual's tax home has shifted to the foreign country.
(iii) If the individual is expected to and does remain employed in the second country for one
year but less than two years, the taxpayer's home is presumed to have shifted to the second
country, but the presumption may be rebutted.
581
Rev. Rul. 83-82, 1983-1 C.B. 45.
582
Id.

To rebut the presumption of indefiniteness with respect to employment that lasts for one year
or more but less than two years, the individual "must clearly demonstrate by objective factors
that the taxpayer realistically expected" that the employment would last less than two years and
that the taxpayer would return to the claimed tax home after the employment terminates; in
addition, the individual must show that the claimed tax home is the individual's "regular place of
abode in a real and substantial sense."583 Three objective factors generally may be used to
determine whether the claimed abode is the individual's regular place of abode in a real and
substantial sense:584
(i) whether the individual has used the claimed abode for lodging while performing work
nearby and continues to maintain bona fide work contacts (job-seeking, leave of absence,
ongoing business, etc.) in that area during the claimed temporary employment;
(ii) whether the individual's living expenses at the claimed abode are duplicated because
work requires the taxpayer to be away from the abode; and
(iii) whether the individual has a marital or lineal family member or members currently
residing at the claimed abode, or continues to currently use the claimed abode frequently for
purposes of lodging. These factors are based on case law dealing with assignments of
between one year and two years.585 They also are similar to the three factors set forth in Rev.
Rul. 73-529 to determine, for Section 162 away from home purposes, the bona fide nature of
an individual's claimed abode where the individual has no regular or principal place of

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 business.586
583
Id.
584
Id. See, e.g., PLR 8452103 (one year teaching assignment in U.K. under teacher-exchange
program did not change tax home, since, taxpayer maintained work contacts (e.g., benefits and
accrual of seniority) in the United States). See generally 918 T.M., Citizens and Resident Aliens
Employed Abroad. See also fn. 580 above.
585
Rev. Rul. 83-82 1983-2 C.B. 45.
586
Id.

(c) Special Rule for Certain Possessions Residents

As noted above, a U.S. citizen or resident alien will not be treated as a nonresident with
respect to any sale of personal property unless an income tax equal to at least 10% of the gain
derived from such sale is actually paid to a foreign country with respect to such gain.587
Notwithstanding this 10% tax rule, an individual who is a U.S. citizen but has a tax home in
Puerto Rico does not lose his status as a nonresident of the United States because he did not pay
tax to Puerto Rico equal to at least 10% of the gain derived from the sale of stock of a
corporation, provided: (i) the individual is a bona fide resident of Puerto Rico for the entire
taxable year; (ii) the corporation is engaged in the active conduct of a trade or business in Puerto
Rico; and (iii) the corporation derived more than 50% of its gross income, over the three-year
period ending with the close of the corporation's taxable year immediately preceding the year in
which the sale occurred, from the active conduct of a trade or business in Puerto Rico (for
purposes of which income test the taxpayer may elect to treat a corporation and all other
corporations wholly owned, directly or indirectly, by the corporation as one corporation).588
Treasury has authority to waive, by regulations, the 10% requirement for bona fide residents of
Puerto Rico for purposes of determining source of income from a sale of other personal property
and to waive the 10% requirement for bona fide residents of Guam, American Samoa, and the
Northern Mariana Islands.589 For example, low-taxed or untaxed income from sales of personal
property within the possession by such an individual might be exempted, but only to the extent
the possession has "delinked" from the "mirror code" regime.590
587
Section865(g)(2).
588
Section865(g)(3), added by TAMRA, Section 1012(d)(6)(A).
589
Section865(j)(3), added by TAMRA, Section 1012(d)(6)(B).
590
Staff of the Joint Committee on Taxation, Description of the Technical Corrections Act of
1988 (March 31, 1988) 249. The intent of these provisions is to preserve the benefits of Sections
933 and 931, respectively, for bona fide residents of the possessions who are U.S. citizens. Id. It is
intended that regulations not permit the exception to apply to U.S. citizens or residents who may
be only temporarily resident in the possession, and that rules analogous to those in Section 877
apply (to the extent not already applicable under Section 1277(e) of TRA 86). Id.

b. Depreciable and Amortizable Property

(1) Gain Not Exceeding Depreciation Adjustments
Section865(c) provides a separate set of rules for depreciable personal property. In particular,
Section 865(c) provides, generally, that gain (not in excess of depreciation adjustments) from the
sale of "depreciable personal property" is allocated between sources in the United States and
sources outside the United States in the following manner:
(i) by treating the same proportion of such gain as sourced in the United States as (A) the

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 U.S. depreciation adjustments with respect to such property bear to (B) the total depreciation
adjustments, and
(ii) by treating the remaining portion of such gain as sourced outside the United States.591
591
Section 865(c)(1). It is not clear whether, in the case of an installment sale, the IRS would
source gain from installments received in a given taxable year under this Section 865(c)(1) in
priority to gain from a subsequent year's installments, or whether the Section 865(c)(1) portion of
the gain would be assigned ratably to the various installments. See also fn. 613 below.

For these purposes, the term "depreciable personal property" means any personal property if
the adjusted basis of such property includes depreciation adjustments.592 The term "depreciation
adjustments" means adjustments reflected in the adjusted basis of any property on account of
depreciation deductions, regardless of whether allowed with respect to such property or other
property and whether allowed to the taxpayer or to any other person.593 In turn, the term
"depreciation deductions" means any deductions for depreciation or amortization or any other
deduction allowable under any provision which treats an otherwise capital expenditure as a
deductible expense;594 thus, the term includes, e.g., "research or experimental expenditures"
deducted under Section 174(a). Finally, the term "United States depreciation adjustments" means
the portion of the depreciation adjustments to the adjusted basis of the property which are
attributable to the depreciation deductions allowable in computing taxable income from sources
in the United States.595
592
Section 865(c)(4)(A).
593
Section 865(c)(4)(B).
594
Section865(c)(4)(C).
595
Section 865(c)(3)(A).

The above rule, however, is modified with respect to property "used predominantly" inside or
outside the United States. In particular, except in the case of property of a kind described in
Section168(g)(4), if for any taxable year:
(i) such property is used predominantly in the United States, or
(ii) such property is used predominantly outside the United States, then all of the depreciation
deductions allowable for such year are treated as having been allocated to income from
sources in the United States, or, as the case may be, outside the United States.596 Accordingly,
in the case of such property, an amount equal to the total depreciation adjustments for such
property are allocated wholly to the place of predominant use.
596
Section 865(c)(3)(B).

(2) Gain Exceeding Depreciation Adjustments

If the sale of depreciable personal property generates gain in excess of the depreciation
adjustments, under §865(c)(2), such gain is sourced as if the property were "inventory property."
In such case, as discussed in VII, B, below, the gain is sourced under the title passage rules of
§§861(a)(6) and 862(a)(6) and the split-source rules of §863(b), as appropriate under the
circumstances.597 Section 865(c)(2), however, does not apply to any gain from the sale of an
"intangible"598 as defined in §865(d)(2);599 hence, such gain cannot be allocated under the title
passage rules.
597
§865(b).

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 598
§865(d)(4)(B).
599
See VII, A, 2, a, (2), below.

c. Allocation and Apportionment of Loss

(1) Pre-1987 Rules
Section 865(j)(1) authorized the Treasury Department to prescribe such regulations as may
be necessary or appropriate to carry out the purposes of §865 including regulations relating to
the treatment of losses from sales of personal property. 600 While this Portfolio generally deals
with the source rules for income, and not with the allocation and apportionment of deductions,
the treatment of losses from the sale of property has a particular relevance with the source rules
for gain from the sale of property, as indicated by the authorization under §865.
600
§865(j)(1). See Int'l Multifoods Corp. v. Comr., 108 T.C. 579 (1997) (loss on sale of foreign
subsidiary stock held U.S. source under §865(j)(1) and Prop. Regs. §1.865-2(a)(1)).

The §861 regulations contain rules for allocating and apportioning losses from the sale of
capital assets and §1231(b) property.601 In general, these older rules allocated loss on disposition
of an asset or property to the class of gross income to which the asset ordinarily gives rise in the
hands of the taxpayer in the "taxable year or years immediately preceding" the disposition.602 For
example, in the case of a sale of property which is leased abroad in early years but is leased
domestically in the years before sale, loss from the sale would be allocable to domestic sources.
603
Loss on the disposition of stock of a foreign corporation conducting its business abroad or on
the sale of a business asset used abroad generally is allocated to foreign sources.604 However, the
application of these rules was not always clear.605 The regulations under §861 were issued before
the enactment of §865 as part of TRA 86 and are now superseded by the regulations under §865
governing the allocation and apportionment of losses discussed below.
601
Regs. §1.861-8(e)(7). Regs. §1.861-8(e)(7)(iii) provides Regs. §§1.865-1 and 1.865-2 are the
governing precedent regarding the allocation of certain loss recognized in taxable years beginning
after December 31, 1986.
602
Regs. §1.861-8(e)(7).
603
See id.
604
See, e.g., Black and Decker Corp. v. Comr., T.C. Memo 1991-557, aff'd, 986 F.2d 60 (4th Cir.
1993) (worthless security loss under §165(g)(3) in respect of stock of foreign subsidiary that did
business entirely in Japan allocated entirely to foreign sources under Regs. §1.861-8(e)(7)(i) on
the basis that the stock would ordinarily give rise to foreign source dividend income, even though
no dividends had been declared). Accord PLR 7946058 (loss on sale-leaseback of oil tanker
sourced by reference to source of sales of crude oil transported by tanker and sales of products
refined from crude oil by taxpayer). But see Int'l Multifoods Corp. v. Comr., 108 T.C. 579 (1997)
(U.S. corporation's loss on foreign subsidiary stock sale properly treated as U.S. source under
§865(j)(1) and Prop. Regs. §1.865-2(a)(1); Regs. §1.861-8(a)(7) found inapplicable in post-1986
Act years).
605
See, e.g., Ferro-Enamel Corp. v. Comr., 46 B.T.A. 1279 (1942), rev'd, 134 F.2d 564 (6th Cir.
1943). The taxpayer, a domestic corporation, acquired stock in one of its suppliers, a foreign
corporation, to assure itself of a source of supply and subsequently sold the stock at a loss. The
case, which preceded the regulations, generated a variety of views for sourcing the loss, including
as to what was the allocable class of gross income. The IRS argued that the loss was foreign
source because the dividends paid would have been foreign source gain if the foreign investments
had been profitable. The Board of Tax Appeals held that the taxpayer had a domestic source loss
because the purpose of the investment was to obtain raw materials for its domestic business. The
Court of Appeals held the loss to be foreign source on the theory that the taxpayer had purchased

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 a foreign operation and thus sustained a loss on it.

Allocating losses from the disposition of shares of stock of a foreign subsidiary to foreign
sources, however, may give rise to a whipsaw problem for U.S. taxpayers, especially following
TRA 86. Under §865, gain from the sale of shares by a U.S. resident (as defined in §865(g)(1))
generally is sourced to the United States. If a similar rule did not apply for losses, anomalies
could arise if, for example, a U.S. resident realized gain on a block of shares and loss on another
block, since the gain and loss could not be offset for purposes of determining the foreign tax
credit limitation under §904. For this reason, the Staff of the Joint Committee of Taxation
previously stated that it anticipated that the regulations, when issued, would provide "that losses
from sales of personal property will be allocated consistently with the source of income that gain
would generate but that variations of this principle may be necessary."606 This general approach
had been taken in Rev. Rul. 91-32,607 dealing with the sale of a interest in a partnership engaged
in business in the United States by a non-U.S. person.
606
TRA 86 Blue Book at 923. Accord, Int'l Multifoods Corp. v. Comr., 108 T.C. 579 (1997)
(finding that Congress intended consistent treatment of losses and gains, rejecting post-1986 Act
applicability of Regs. §1.861-8(e)(7) to losses on sales of noninventory personal property, and
holding that seller-residence rule implied in §865(j)(1) (via similar rule for sourcing gains in
§865(a)) and provided in Prop. Regs. §1.865-2(a)(1) allowed U.S. corporation to treat as U.S.
source its loss on the sale of stock in its Brazilian subsidiary, for purposes of computing the
§904(a) limitation). Cf. TAM 9724004, where the IRS followed the Black and Decker analysis for
foreign tax credit limitation purposes in a pre-1987 taxable year transaction in which a U.S.
consolidated group recognized a capital loss on the sale of the stock of a domestic subsidiary. The
National Office advised that under §904(b), the capital loss first was netted with foreign source
capital gain in the numerator of the foreign tax credit limitation fraction; the remainder of the
capital loss was U.S. source under Regs. §1.861-8(e)(7) because gain from the sale of the
domestic corporation's stock ordinarily would give rise to U.S. source income.
607
1991-1 C.B. 107

Under the authority of what is now §865(j)(1), the IRS issued Notice 89-58, which provided
rules for allocating and apportioning losses incurred by a bank or group of banks included in an
"affiliated group" (as defined in Regs. §1.861-11T(d)(1)) with respect to certain loans made in
the ordinary course of the bank's trade or business.608 Notice 89-58 was declared obsolete as of
January 11, 1999, the effective date of former Regs. §§1.865-1T and 1.865-2T(b)(4)(iii).608.1
Under the rule in this notice, loan losses, whether arising by sale, exchange or charge-off, were
required to be apportioned between domestic source interest income and the separate limitation
categories of foreign source interest income, on the basis of the income in each category minus
qualifying writedowns. It is not clear on what basis the IRS arrived at a result that departs from
the old rule (that would look to the source of income ordinarily generated by the loans) yet is not
symmetrical with how gains from a sale of the loans would be treated.
608
1989-1 C.B. 699. The IRS has extended the coverage of these rules to debt instruments held
by any numbers of a bank holding company's affiliated group that are "financial services entities"
within the meaning of Regs. §1.904-4(e)(3). PLR 9047008.
608.1
T.D. 8805, 64 Fed. Reg. 1505 (1/11/99).

In International Multifoods Corp. v. Comr.,608.2 the Tax Court held that a U.S. corporation's
loss on the sale of its wholly owned foreign subsidiary was U.S. source under §865(j). Lacking
final regulations under §865(j), the Tax Court attempted to do the best it could in applying the
policy underlying §865. The court held that the 1986 Act amendments rendered §§861 and 862,

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and, in particular, Regs. §1.861-8(e)(7) inapplicable to sales of noninventory personal property
in post-1986 years. The Tax Court reasoned that §865(a) determines the source of gain by
reference to the residence of the seller, and §865(j)(1) directs the IRS, with respect to losses, to
promulgate regulations to carry out the purpose of §865. That purpose, the court found, based
on its reading of the legislative history, is generally to source gains and losses on the sale of
noninventory property at the residence of the seller. The court also noted that the proposed
regulations under §865(j)(1) would permit the taxpayer to elect to treat its loss as U.S. source
had the regulations been finalized as proposed.
608.2
108 T.C. 579 (1997).

(2) The Section 865 Regulations

Regulatory History
Under the authority of §865(j), the IRS issued temporary regulations allocating and
apportioning losses from the sale of certain trade receivables in the same manner as interest
expense.609 T.D. 8805609.1 finalized with amendments the stock loss rules under Regs. §1.865-2 and
provided new temporary regulations for losses from personal property other than stock.
Additionally, T.D. 8805 made obsolete Notice 89-58609.2 as of January 11, 1999.
609
Regs. §1.861-9T(b)(3)(i).
609.1
64 Fed. Reg. 1505 (1/11/99). The stock loss rules were originally proposed by REG-
209750-95, 1996-2 C.B. 484. In T.D. 8973, 66 Fed. Reg. 67081 (12/28/01), the IRS published
final Regs. §1.865-1 relating to the allocation of loss on the disposition of personal property other
than stock and Regs. §1.865-2 for losses incurred on the sale of stock, both discussed below.
609.2
1989-1 C.B. 699.

At the same time, the IRS and Treasury withdrew Prop. Regs. §1.865-1, published in 1996,
and substituted the text of the temporary regulations under Regs. §§1.865-1T and 1.865-2T(b)(4)
(iii) as the text of the proposed regulations. The temporary regulation were elective for open
taxable years beginning on or after January 1, 1987. In T.D. 8973, the IRS published in 2001
final Regs. §1.865-1 and -2. The final regulations adopted without significant change the
provisions of the earlier proposed and temporary regulations. The following is a summary of the
key provisions of these loss allocation and apportionment regulations.
Effective Dates
These loss allocation/apportionment rules are applicable to losses recognized on or after
January 11, 1999 except that the sourcing rule for losses incurred by bona fide residents of
Puerto Rico, the matching rule, and the expansion of the dividend recapture period for periods
when risk of loss are diminished are applicable to losses recognized on or after January 8, 2002.
A taxpayer may apply the regulations to losses recognized in any taxable year beginning on or
after January 1, 1987 provided that the taxpayer's tax liability as shown on an original or
amended tax return is consistent with the final regulations for each such year for which the
statute of limitations does not preclude the filing of an amended return on June 30, 2002 and the
taxpayer makes appropriate adjustments to eliminate any double benefit arising from the
application of these rules to years that are not open for assessment.609.3
609.3
See Regs. §1.865-2(e).

The regulations follow the general residence of the seller rule. Commentators had criticized

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the former proposed regulations on this basis. Thus, the general rule under Regs. §1.865-1(a) is
that loss from personal property other than stock will be allocated in the same manner as the
manner in which gain from the sale of such property would have been sourced. 609.4
609.4
The drafters of the regulations believed that Notice 89-58 was inconsistent with this general
rule and, accordingly, obsoleted the Notice. The underlying theory of this regulation is that losses
should follow the source of the interest income produced by debt obligations, but that when loss
has been reallocated to the extent of interest income, the general residence of the seller rule should
apply.

Scope
Regs. §1.865-1 does not apply to foreign currency and financial instruments subject to §988,
inventory property described in §1221(a)(1), and interest equivalents and trade receivables. 609.5
609.5
See Regs. §1.865-1(c)(1)-(3).

Losses on the Disposition of Personal Property Other than Stock

Losses recognized with respect to personal property must be allocated to the class of gross
income and, if necessary, apportioned between the statutory grouping of gross income (or among
the statutory groupings) and the residual grouping of gross income, with respect to which gain
from a sale of such property would give rise in the hands of the seller. For these purposes, losses
includes bad debt deductions and loss on property that is marked-to-market.609.6
609.6
Regs. §1.865-1(a)(1).

Losses recognized by a U.S. resident with respect to property that is attributable to an office
or other fixed place of business in a foreign country must be allocated to reduce foreign source
income if a gain on the sale of the property would have been taxable by the foreign country and
the highest marginal rate of tax imposed on such gains in the foreign country is at least 10%.609.7
609.7
Regs. §1.865-1(a)(2).

Losses on property recognized by a U.S. citizen or resident alien that has a tax home in a
foreign country are allocated to reduce foreign source income if a gain on the sale of such
property would have been taxable by a foreign country and the highest marginal rate of tax
imposed on such gains in the foreign country is at least 10%.609.8
609.8
Regs. §1.865-1(a)(3).

The statute, in providing an explicit rule for gains (only regulatory authority is provided for
losses) states that an income tax equal to at least 10% of the gain actually must be paid to a
foreign country with respect to the income from the sale. Thus, the statute appears to contemplate
an item-by-item approach that looks to the actual tax paid. The regulation, by imposing a
marginal rate test, appears to have chosen an easily administrable rule for losses, even though the
rule is more general than the explicit one statutorily provided for gains.
Allocation of Losses to Foreign Tax Credit Baskets
For purposes of the foreign tax credit, losses recognized with respect to property that is
allocated to foreign source income are allocated to the separate category to which gain on the
sale of the property would have been assigned.609.9 For purposes of Regs. §1.904-4(c)(2)(ii)(A),
any such loss allocated to passive income must be allocated prior to the application of Regs.

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§1.904-4(c)(2)(ii)(B) to the group of passive income to which gain on a sale of the property
would have been assigned had a sale of the property resulted in the recognition of a gain under
the law of the relevant foreign jurisdiction or jurisdictions.
609.9
Regs. §1.865-1(a)(4).

Allocation of Partnership Losses

A partner's distributive share of loss recognized by a partnership with respect to personal
property must be allocated and apportioned as if the partner had recognized the loss. If loss is
attributable to an office or other fixed place of business of the partnership, such office or fixed
place of business must be considered to be an office of the partner.609.10
609.10
Regs. §1.865-1(a)(5).

Losses on the Sale of Depreciable Personal Property

In the case of a loss recognized with respect to depreciable personal property, the gain is the
gain that would be sourced under depreciation recapture sourcing rules.609.11
609.11
Regs. §1.865-1(b)(1).

Section 865(c)(1) provides that gain from the sale of depreciable personal property must be
allocated between U.S. and foreign sources based upon the ratio of U.S. depreciation adjustments
(i.e., adjustments reflected in the adjusted basis of property on account of depreciation
deductions) over total depreciation adjustments. Section 865(c)(3)(B) provides an exception to
this general rule: if for any taxable year the property is used predominantly in the United States
or in a foreign jurisdiction, all of the depreciation deductions will be treated as having been
allocated to the income of either the United States or the foreign jurisdiction, contrary to the
general rule that allocates the deductions on a proportional basis of actual depreciation
adjustments. Although the regulations do not define or quantify "predominant use," other
regulations that employ the phrase define it as more than 50% of the time that the property is in
use.609.12 Under such a definition, the "predominant use" rule becomes the general rule for
property that generates both U.S. and foreign depreciation deductions. However, §865(c)(1)
contains an important limitation: gain is sourced under this special rule only to the extent of
depreciation deductions. Gain in excess of depreciation adjustments is sourced under §865(c)(2)
as though the property were inventory, but loss in excess of depreciation adjustments continues
to be sourced entirely under §865(c)(1) and (c)(3), according to Regs. §1.865-1(b)(1).
609.12
See Regs. §1.48-1(g)(1)(i).

The application of the rules concerning depreciable personal property is illustrated in Regs.
§1.865-1(e), Ex. 1. The example highlights the mismatch between the "predominant use"
exception and the actual reductions of income caused by the depreciation deductions. In this
example, a total of $400 of depreciation deductions are taken: $250 against foreign source
income and $150 against U.S. source income.
Note the variance from §865(c)(1) that measures against depreciation adjustments, although
perhaps it is assumed that in the example the two are the same. (Generally, depreciation
deductions require a corresponding reduction in basis of the property being depreciated;
however, in certain cases, a depreciation deduction may be disallowed, while basis reductions
nonetheless are required, e.g., §167(e)). The example posits a loss of $500 incurred on the sale of

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the depreciable personal property, a machine that produces widgets sold both in the United States
and abroad. The machine is located and used exclusively outside the United States throughout
the taxpayer's holding period.
Therefore, the example concludes, the entire $500 loss is allocated against foreign source
income, citing §865(c)(1)(B) and (c)(3). The "predominant use" rule under §865(c)(3) overrides
the general allocation rule under §865(c)(1) and, therefore, results in §865(c)(1)(B) allocating all
of the loss (including the $100 amount in excess of the depreciation adjustments) to foreign
sources.
Losses on the Sale of Bonds
If a taxpayer recognizes loss with respect to a bond and did not fully amortize bond premium,
the amount of unamortized bond premium must be allocated to the class of gross income and, if
necessary, apportioned between the statutory grouping of gross income and the residual grouping
of gross income, with respect to which interest income from the bond was assigned.609.13 Losses
attributable to accrued but unpaid interest on debt obligations must be similarly allocated or
apportioned.609.14
609.13
Regs. §1.865-1(c)(4).
609.14
Regs. §1.865-1(c)(5).

A loss recognized on a contingent payment debt instrument to which Regs. §1.1275-4(b)

applies (instruments issued for money or publicly traded property) is allocated in the same
manner as the interest income from the instrument would be treated. Thus, in Regs. §1.865-1(e),
Ex. 2, a loss of $770 is allocated based upon the rule provided by Regs. §1.1275-4(b)(8)(ii).
Under this rule, $630 of the loss is treated as ordinary loss, while the remaining $140 of the loss
is treated as a capital loss. Because $150 of the interest income was foreign source general
limitation income and $480 was foreign source passive income, the $630 of ordinary loss is
characterized and allocated in the same manner. The $140 of capital loss is allocated against
foreign source passive income. A more conceptually satisfying result might be to apply the
general residence of the seller rule to the remaining $140 and, thus, allocate the $140 loss to U.S.
income. (The seller in the example is a domestic corporation.) However, applying the residence
of the seller rule may not affect the foreign tax credit position of the taxpayer because the
taxpayer may be able to generate additional foreign source passive income to absorb the loss in
that basket.
Losses on the Sale of Stock
Losses recognized with respect to stock are allocated to the class of gross income and, if
necessary, apportioned between the statutory grouping of gross income and the residual grouping
of gross income with respect to which gain from a sale of such stock would give rise in the hands
of the seller.609.15 Losses recognized by a U.S. resident that are attributable to an office or other
fixed place of business in a foreign country are allocated to reduce foreign source income if a
gain on the sale of the stock would have been taxable by the foreign country and the highest
marginal rate of tax imposed on such gains in the foreign country is at least 10%.609.16
609.15
Regs. §1.865-2(a)(1).
609.16
Regs. §1.865-2(a)(2).

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 Losses recognized by a U.S. citizen or resident alien that has a tax home in a foreign country
are allocated to reduce foreign source income if a gain on the sale of the stock would have been
taxable by a foreign country and the highest marginal rate of tax imposed on such gains in the
foreign country is at least 10%.609.17
609.17
Regs. §1.865-2(a)(3)(i).

Stock losses recognized by a U.S. citizen or resident alien that is a bona fide resident of
Puerto Rico during the entire taxable year are allocated to reduce foreign source income and if
the gain from the sale of such stock would have been exempt from tax under §933, the losses
from the sale of such stock shall also be allocated to such income exempt from tax by virtue of
§933.609.18
609.18
Regs. §1.865-2(a)(3)(ii).

Losses recognized by a nonresident alien individual or a foreign corporation with respect to

stock that constitutes a U.S. real property interest are allocated to reduce U.S. source income. 609.19
609.19
Regs. §1.865-2(a)(4).

For purposes of applying the foreign tax credit limitation, losses recognized with respect to
stock that are allocated to foreign source income are allocated to the separate basket to which
gain on a sale of the stock would have been assigned.609.20 Any such loss allocated to passive
income is allocated to the group of passive income to which gain on a sale of the stock would
have been assigned had a sale of the stock resulted in the recognition of a gain under the law of
the relevant foreign jurisdiction.609.21
609.20
Regs. §1.865-2(a)(5).
609.21
Regs. §1.865-2(a)(5).

Dividend Recapture
The amount of dividend recapture amount is equal to the subpart F accrual included in the
earnings of a controlled foreign corporation that is included in foreign personal holding company
income and the earnings and profits subpart F annual inclusion.609.22 If a taxpayer recognizes a
loss with respect to shares of stock, and the taxpayer included in income a dividend recapture
amount with respect to such shares at any time during the recapture period, then, to the extent of
the dividend recapture amount, the loss must be allocated and apportioned on a proportionate
basis to the class or classes of gross income or the statutory or residual grouping or groupings of
gross income to which the dividend recapture amount was assigned.609.23
609.22
Regs. §1.865-2(d)(2).
609.23
Regs. §1.865-2(b)(1)(i).

This rule does not apply to a loss recognized by a taxpayer on the disposition of stock if the
sum of all dividend recapture amounts included in income by the taxpayer with respect to such
stock during the recapture period is less than 10% of the recognized loss.609.24
609.24
Regs. §1.865-2(b)(1)(ii).

A recapture period is the 24-month period preceding the date on which a taxpayer recognizes
a loss with respect to stock, increased by any period of time in which the taxpayer has
diminished its risk of loss and by any period in which the assets of the corporation are hedged

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against risk of loss with a principal purpose of enabling the taxpayer to hold the stock without
significant risk of loss until the recapture period has expired.609.25 In addition, the dividend
recapture rule does not apply to the extent of a dividend recapture amount that is treated as
income in the separate category for passive income. This exception does not apply to any
dividend recapture amount that is treated as income in the separate category for financial services
income basket.609.26
609.25
Regs. §1.865-2(d)(3).
609.26
Regs. §1.865-2(b)(1)(iii).

Example: P, a domestic corporation, owns all of the stock of N1, which owns all of the stock
of N2, which owns all of the stock of N3. N1, N2, and N3 are controlled foreign
corporations. All of the corporations use the calendar year as their taxable year. On February
5, 1999, N3 distributes a dividend to N2. The dividend is foreign personal holding company
income of N2 that results in an inclusion of $100 in P's income as of December 31, 1999. The
inclusion is general limitation income for purposes of the foreign tax credit. The income
inclusion to P results in a corresponding increase in P's basis in the stock of N1. On March
5, 2001, P sells its shares of N1 and recognizes a $110 loss. The $100 1999 subpart F
inclusion is a dividend recapture amount that was included in P's income within the recapture
period preceding the disposition of the N1 stock. The de minimis exception does not apply
because the $100 dividend recapture amount exceeds 10% of the $110 loss. Therefore, to the
extent of the $100 dividend recapture amount, the loss must be allocated to the separate
limitation category to which the dividend recapture amount was assigned (general limitation
income). The remaining $10 loss is allocated to U.S. source income.
Anti-Abuse Rule Regarding Built-in Losses
If one of the principal purposes of a transaction is to change the allocation of a built-in loss
with respect to stock by transferring the stock to another person, qualified business unit, office or
other fixed place of business, or branch that subsequently recognizes the loss, the loss must be
allocated by the transferee as if it were recognized with respect to the stock by the transferor
immediately prior to the transaction.609.27 If one of the principal purposes of a change of residence
is to change the allocation of a built-in loss with respect to stock, the loss must be allocated as if
the change of residence had not occurred.609.28
609.27
Regs. §1.865-2(b)(4)(i). The anti-abuse rule is also applicable to the sale of personal
property other than stock. See Regs. §1.865-1(c)(6)(i).
609.28
Regs. §1.865-2(b)(4)(i).

If one of the principal purposes of a transaction is to change the allocation of a built-in loss
with respect to stock (or other personal property) by converting the original property into other
property and subsequently recognizing loss with respect to such other property, the loss must be
allocated as if it were recognized with respect to the original property immediately prior to the
transaction.609.29 If a taxpayer recognizes loss with respect to stock and the taxpayer holds (or
held) offsetting positions with respect to such stock with a principal purpose of recognizing
foreign source income and U.S. source loss, the loss will be allocated and apportioned against
such foreign source income. Positions are offsetting if the risk of loss of holding one or more
positions is substantially diminished by holding one or more other positions.609.30
609.29
Regs. §1.865-2(b)(4)(i).

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 609.30
Regs. §1.865-2(b)(4)(ii).

Matching Rule
If a taxpayer engages in a transaction or series of transactions with a principal purpose of
recognizing foreign source income that results in the creation of a corresponding loss with
respect to stock, the loss must be allocated and apportioned against such income to the extent of
the recognized foreign source income.609.31 This rule applies to any portion of a loss that is not
allocated under the dividend recapture rule, including a loss in excess of the dividend recapture
amount and a de minimis loss or passive dividend that is related to a dividend recapture amount.
609.32

609.31
Regs. §1.865-2(b)(4)(iii). As a result of the comment that the matching rule in the
temporary regulations was unrealistic, the IRS noted that Regs. §§1.865-1(c)(6)(iii) and 1.865-2(b)
(4)(iii) are modified to provide that the matching rule will only apply if a taxpayer engages in a
transaction or series of transactions with a principal purpose of recognizing foreign source income
that results in the creation of a corresponding loss. The IRS observed that the matching rule
targets transactions that are designed to produce an artificial or accelerated recognition of income
that directly results in the creation of a corresponding built-in loss. The IRS also noted that the
step-down preferred transactions described in Examples 4 and 5 of former Regs. §1.865-2T(b)(4)
(iv) are tax abuse transactions but these transactions are now expressly addressed by Regs.
§1.7701(l)-3, and therefore the final regulations omit Examples 4 and 5.
609.32
Regs. §1.865-2(b)(4)(iii). The matching rule is also applicable to the sale of personal
property other than stock. See Regs. §1.865-1(c)(6)(iii).

Example: On January 1, 2001, P and Q, domestic corporations, form R, a domestic

partnership. The corporations and partnership use the calendar year as their taxable year. P
contributes $900 to R in exchange for a 90% partnership interest and Q contributes $100 to R
in exchange for a 10% partnership interest. R purchases a dance studio in country X for
$1,000. On January 2, 2001, R enters into contracts to provide dance lessons in Country X
for a 5-year period beginning January 1, 2002. These contracts are prepaid by the dance
studio customers on December 31, 2001, and R recognizes foreign source taxable income of
$500 from the prepayments (R's only income in 2002). P takes into income its $450
distributive share of partnership taxable income. On January 1, 2002, P's basis in its
partnership interest is $1,350. On September 22, 2002, P contributes its R partnership interest
to S, a newly-formed domestic corporation, in exchange for all the stock of S. P's basis in S is
$1,350. On December 1, 2002, P sells S to an unrelated party for $1050 and recognizes a
$300 loss. P recognized foreign source income for tax purposes before the income had
economically accrued, and the accelerated recognition of income increased P's basis in R
without increasing its value by a corresponding amount, which resulted in the creation of a
built-in loss with respect to the S stock. The $300 loss is allocated against foreign source
income if P had a principal purpose of recognizing foreign source income and corresponding
loss.
The final regulations eliminated the exception to the residence of the seller rule for portfolio
and RIC stock and makes the rule applicable to all recognized C corporation stock losses, not
just those resulting from a sale or exchange. The final regulations delete the special reference to
worthless stock deductions. Lastly, the consistency rule under Prop. Regs. §1.865-2(b)(2)
(requiring a taxpayer to allocate loss from the sale of a foreign affiliate to passive basket foreign
source income if the taxpayer had recognized foreign source gain from the sale of a foreign

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affiliate within five years of the loss recognition) was eliminated due to several concerns raised
by commentators.
2. Exceptions to the General Rules
a. Certain Intangible Property Sold for Contingent Price
(1) General Rules
Under §865(d)(1), in the case of any "sale" of an "intangible,"610 the general seller-residence
rule of §865(a) applies only to the extent that the payments in consideration of such sale are not
contingent on the productivity, use, or disposition of the intangible. To the extent that the
payments are so contingent, the source of such payments generally is determined as if such
payments were royalties.611 Thus, such contingent payments will be sourced generally under
§§861(a)(4) and 862(a)(4) based on the location of use of (or right to use) the intangible. It
should be noted, however, that only the portion of such payments that is gain, rather than a
recovery of basis or imputed interest, is sourced (and taxable) as a royalty. Other rules govern the
determination of gain (i.e., how payments should be allocated between gain and a recovery of
basis) and whether a portion of the payments should be deemed to be interest.612
610
See VII, A, 2, a, (2) and (3), below, for a discussion of these terms.
611
§865(d)(1)(B).
612
If a nonresident alien or a foreign corporation sells an intangible described in §871(a)(1)(D)
or §881(a)(4) that is not held in connection with a U.S. trade or business for an amount contingent
on the productivity, life, or use of the property, the seller is permitted to recover tax basis first (an
open transaction approach). See Regs. §1.871-11(d), (f). If fixed and contingent payments are
reportable for a taxable year and exceed in amount the amount of any unrecovered basis, such
basis is apportioned between such fixed and contingent payments in proportion to their respective
amounts. On the other hand, in the case of gain realized by a U.S. person (or by a foreign person if
the gain is effectively connected with a U.S. trade or business) from the sale of an intangible, the
installment sale rules generally would govern, unless the taxpayer elects out of the installment
method pursuant to §453(d). Installment sale treatment generally would entail adverse basis
recovery (see Regs. §15a.453-1(c)) and the deferred tax liability would be increased by an interest
charge if, in general terms, the amounts deferred exceed $5 million (§453A). In the case of a sale
by either a U.S. person or a foreign person, interest may be imputed, subject to certain exceptions,
under §483 and/or §1274. See Regs. §§1.483-4, 1.1275-4, 1.1275-6; T.D. 8674, 61 Fed. Reg.
30133 (6/14/96, finalizing these regulations).

In the case of an amortizable intangible or one the development costs of which have been
deducted by the taxpayer, however, to the extent that gain from the sale of the intangible does not
exceed the depreciation (amortization) adjustments with respect to such property, the gain
(including any portion attributable to contingent payments) is sourced in the same manner as is
the portion of gain from the sale of tangible personal property that does not exceed the
depreciation adjustments (including "research or experimental expenditures" deducted under
§174(a)) with respect to such property.613 As discussed above, under §865(c)(1), a portion of such
gain is sourced to the United States in the same ratio as the U.S. depreciation adjustments with
respect to the property bear to the total depreciation adjustments, and the remainder is sourced
without the United States.614 Gain in excess of the depreciation adjustments is sourced under the
§865(d)(1) rule set forth above (i.e., under the seller-residence rule if not contingent and the
royalty rule if contingent), and not, as in the case of tangible personal property, in the manner of
inventory.615

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 613
§865(d)(4); Staff of the Joint Committee on Taxation, Description of the Technical
Corrections Act of 1988 (Mar. 31, 1988) at 249. If contingent gain is reported on the installment
method, while not clear, it seems likely that the IRS would source gain from installments received
in a given taxable year in priority to gain from a subsequent year's installments.
614
See VII, A, 1, b, above. In a situation in which gain sourced under §865(d)(4) for a taxable
year is attributable to both fixed and contingent payments but is less than the sum of the total
payments for such year, it is not clear what portion of the fixed and contingent portions of the
gain, respectively, should be sourced under this rule. One approach would be to apportion in the
same ratio as the fixed and contingent payments for the year. Cf. Regs. §1.871-11(d) (referred to in
fn. 612 above). Another approach would be to match, as closely as possible, source of gain against
source of deduction.
615
§865(d)(4)(B).

The rules applicable to gain from the sale of an intangible (other than from the sale of
goodwill616 or certain sales of an intangible by a nonresident attributable to a U.S. office or fixed
place of business),617 then, may be summarized as follows:
(i) First, gain (including any portion attributable to contingent payments) to the extent of
depreciation adjustments (including, e.g., §174 deductions), if any, is sourced under the
§865(c)(1) rules.
(ii) The remaining gain, if any, is sourced (A) under the §861(a)(4) royalty rule in the same
proportion that payments contingent on the productivity, use, or disposition of the intangible
bear to total payments in the taxable year, and (B) under the §865(a) seller-residence rule in
the same proportion that noncontingent payments bear to total payments for the taxable year.
616
See VII, A, 2, b, below.
617
See VII, A, 2, c, below.

For purposes of §865(d), intangible means any patent, copyright, secret process or formula,
goodwill, trademark, trade brand, franchise, or other like property.618
618
§865(d)(2). See discussion below in A, 2, a, (2).

The principal objective of the deemed royalty source rule for contingent income from sales of
intangible property is to subject nonresident alien individuals and foreign corporations to either a
regular tax or a 30% withholding tax on gain derived from the productive use or transfer of
intangible property in the United States. Were it not for this rule, foreign persons could escape
U.S. tax on income economically analogous to royalties by transferring the property in the form
of a sale.619 As noted in V, D, 1, above, however, the deemed royalty source rule also applies to a
U.S. seller and can be beneficial from a foreign tax credit standpoint.
619
See the examples in IV, E, 2, a, (1), above. Under a sale characterization, the resulting
income would escape U.S. tax, either as noneffectively connected U.S. source capital gain or as
foreign source income under the seller-residence rule.

As discussed below,620 a taxpayer resident in one of certain countries may be able to rely on
the income tax treaty between the United States and such country to treat gain from the sale of an
intangible as foreign source income.
620
See VII, A, 2, e.

In the case of a transfer of an intangible by a U.S. person to a foreign corporation in certain

incorporation or reorganization transactions (including a contribution to capital), a special rule

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(§367(d)) taxes certain deemed sale proceeds as U.S. source income.621 A similar result may
apply to a capital contribution of an intangible by a U.S. person to a foreign partnership.622
621
See discussion below in VII, A, 2, g.
622
See §§367(d)(3) and 721(c), both effective August 5, 1997, and, prior to that, former
§§1491-92.

Historical Note: As described below,623 a number of cases reached the courts in which the
characterization of a transfer as a sale or a license was at issue. In order to minimize the impact
of this issue for the source rules and withholding tax regime, a special source rule was added by
the Foreign Investors Tax Act of 1966.624 Sections 871(a)(1)(D) and 881(a)(4) classify as periodic
or determinable income, in the case of a nonresident alien or foreign corporation, gain not
effectively connected with the conduct of a trade or business within the United States from the
post-October 4, 1966 sale or exchange of patents, copyrights, secret processes and formulas,
goodwill, trademarks and brands, franchises, and other like property to the extent that payments
are contingent on the productivity, use, or disposition of such property. If more than 50% of the
gain was from contingent payments, Section 871(e)(1), prior to its repeal by TRA 86, deemed the
remainder to be contingent payments.625 Furthermore, Section 871(e)(2), prior to its repeal by
TRA 86, provided that, solely for the purpose of determining whether gain from the sale of
certain intangible property was from domestic sources, the gain was treated as royalties and
sourced according to the place of use. If this special rule did not result in the allocation of gain to
domestic sources, then the normal source rules applied. Section 865(d)(1), as enacted by TRA
86, represents a similar rule but with a significant difference in that it applies to characterize
income as either domestic or foreign source.
623
See VII, A, 2, a, (3).
624
P.L. 89-809.
625
It would seem that repeal of this 50% rule would increase the incidence of litigation on the
sale versus license issue.

(2) Definitions of Intangible and Property

As noted above, for purposes of Section865(d), an intangible is any patent, copyright, secret
process or formula, goodwill, trademark, trade brand, franchise, or other like property.626 Certain
types of intangible property consist of rights to intellectual property arising by operation of local
law (e.g., patents, copyrights, trademarks, tradebrands, franchises, etc. may arise under the laws
of a jurisdiction). The degree of legal protection in the place of use of property may determine
whether such intellectual rights as know-how,627 trademarks,628 and patents629 qualify as "property"
for this purpose.
626
Section 865(d)(2).
627
Rev. Rul. 64-56, 1964-1 C.B. (Part 1) 133 (legal protection of know-how in country of
transferee required); Rev. Proc. 69-19, 1969-2 C.B. 301 (legal protection of know-how in country
of Section 351 transferee required for Section 367 ruling).
628
Rev. Rul. 68-443, 1968-2 C.B. 304 (legal protection of trademarks in country of transferee
assumed).
629
Cf. AMP, Inc. v. U.S., 492 F. Supp. 27 (M.D. Pa. 1979) (lack of legal effect of foreign patent
in United States held relevant factor in determining foreign source of income from sale of patent).

Noncompetition agreements have been held to constitute the transfer of an intangible

property right to do business.630

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 630
See, e.g., International Multifoods Corp. v. Comr., 108 T.C. 25 (1997).

The concept of property is frequently raised in the context of distinguishing intellectual

property from the personal services leading to its creation. The cases and rulings in this area are
discussed above in IV, E, 2, e, in connection with the source of income from personal services.
(3) Definition of Sale
An issue relating to the source of income from certain intangible property is whether the
taxpayer should be considered a seller or a licensee.631 The issue arises since rights under a
patent, a copyright, a trademark, or know-how may be sold in divisible form with respect to the
duration, place and nature of the rights granted, and the payments may be periodic and/or
contingent upon the productivity, use, or disposition of the rights transferred.
631
See V, D, 1, above.

Certain decisions establish the principle that an exclusive license of all of a patent's rights
will not be denied sale status because the licensor retains the rights to terminate the license for
either the licensee's insolvency or failure to meet quantity requirements. For example, in Myers v.
Comr.,632 the Tax Court held that an exclusive license will qualify as a sale if it grants, for the life
of the patent, rights to make, use, or sell the patented product or process within a designated
territory even though payment therefor consists of royalties contingent on the product's sales.
Congress essentially codified the Myers decision for certain patent transfers in Section 1235,
which provides that transfers (other than by a gift, inheritance, or devise) by an inventor (or an
unrelated holder prior to disclosure of the invention) of all substantial rights to a patent or an
undivided interest therein will qualify as a sale resulting in long-term capital gain; such treatment
results under Section1235 whether payments are contingent on patent productivity, use, or
disposition of the property transferred or are coterminous with the life of the patent. In Coplan v.
Comr.,633 the Tax Court viewed the Myers decision as not being preempted by what is now
Section 1235 of the Code. After some initial reluctance, the IRS acquiesced in the Myers and
Coplan decisions in 1958.634
632
6 T.C. 258 (1946).
633
28 T.C. 1189, 1190 (1957).
634
Rev. Rul. 58-353, 1958-2 C.B. 408.

In Rev. Rul.60-226,635 the IRS concluded that " [s]ince the property rights of patents and
copyrights are similar," the IRS should adopt for copyrights the position it had taken in the case
of patents. The ruling concludes that income from:
a grant transferring the exclusive right to exploit [a] copyrighted work in a medium of
publication throughout the life of the copyright shall be treated as proceeds from a sale of
property, regardless of whether the consideration received is measured by a percentage of the
receipt from the sale, performance, exhibition or publication of the copyrighted work, or is
measured by the number of copies sold, performance given, or exhibition made of the
copyrighted work, or whether such receipts are payable over a period generally coterminous
with the grantee's use of the copyrighted work.
635
1960-1 C.B. 26.

In Rev. Rul.84-78,636 the IRS ruled that payments received by a U.S. corporation from a

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 130

foreign corporation for the exclusive or nonexclusive right to broadcast a prize fight live to a
foreign country were not for the sale of property. Since the foreign corporation could not exploit
the broadcast for the life of the copyright and since it had no recording rights, the payments were
considered to have been received in return for the privilege of using a copyright rather than from
its sale.
636
Rev. Rul. 84-78, 1984-1 C.B. 173.

Historical Note: In a 1933 ruling,637 the IRS took the position that a copyright was an
indivisible "bundle of rights" (e.g., serial, volume, translation, dramatization, and motion picture
which, from a tax standpoint, could not be subdivided and sold according to a specified time,
place of use, or publication medium. In Sabatini v. Comr.,638 the Second Circuit held that a
transfer of worldwide motion picture rights for a limited time was a license rather than a sale. In
Rohmer v. Comr.,639 the court stated that the transfer of less than all of the "bundle of rights" in a
copyright, whether for a lump sum or periodic payments, created royalty rather than sales
income. Moreover, the court found Rohmer's transfer of his serial rights for an unlimited time
indistinguishable from Sabatini's transfer of motion picture rights for a limited time. Three years
later, in Wodehouse v. Comr.,640 the U.S. Supreme Court held that certain lump sum payments
received by the taxpayer, in advance and in full, for the American serial and book rights to
certain literary works of which he was the author (and which were ready to be copyrighted) were
royalties and includible in gross income from sources within the United States.
637
I.T. 2735, 1933-2 C.B. 131, 134, declared obsolete, Rev. Rul.70-293, 1970-1 C.B. 282.
638
98 F.2d 753 (2d Cir. 1938).
639
153 F.2d 61 (2d Cir. 1946), cert. denied, 328 U.S. 862 (1946).
640
337 U.S. 369 (1949).

The "sale" issue arises with respect to trademarks and know-how principally in a Section 351
transfer or exclusive license to a subsidiary corporation. To qualify as a sale rather than a license,
the transfer of trademarks or know-how must be in perpetuity or until legal protection is lost, 641
and must be exclusive as to the territory or field in which the license is granted. Moreover, the
IRS has indicated that the transferred trademark or know-how must be legally protected in the
country of transfer in order to qualify as "property,"642 and the transferor must transfer the right to
enjoin others from use or disclosure of the technology in the territory or field of transfer.643
641
Rev. Rul. 71-564, 1971-2 C.B. 179; Rev. Rul. 64-56, 1964-1 (Part 1) C.B. 133 (know-how).
642
Rev. Rul. 64-56, 1964-1 (Part 1) C.B. 133 (know-how); see Rev. Rul. 68-443, 1968-2 C.B.
304 (trademarks); Rev. Proc. 69-19, 1969-2 C.B. 301 (know-how).
643
Cf. Myers v. Comr., 6 T.C. 258, 263 (1946).

With respect to the transfer of trademarks and know-how, as well as patents and copyrights,
the requirements for a complete sale -- perpetual transfer, exclusive use, and the right to
monopolize the transferred right -- are not defeated by the transferor's retention of certain rights.
644
These rights include:
(i) retention of legal title for the purpose of bringing an infringement suit, provided the
transferee or licensee also has such power with respect to the transferred right; and
(ii) right of termination of the license for breach, bankruptcy or insolvency,645 or failure to
meet quantity or quality requirements.646
644
See generally 558 T.M., Tax Planning for the Development and Licensing of Copyrights,

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 Computer Software, Trademarks and Franchises (U.S. Series).
645
Coplan v. Comr., 28 T.C. 1189, 1190 (1957).
646
Myers v. Comr., 6 T.C. 258, 260 (1946).

b. Goodwill
In general, payments in consideration of a sale of goodwill are treated under Section 865(d)
(3) as from sources in the country in which such goodwill was generated. In the event, however,
that payments for the goodwill are contingent on its productivity, use or disposition, then, to such
extent, payments for the goodwill are sourced in the same manner as royalties under Sections
865(d)(1) and (4).647 In the case of a sale of goodwill by a nonresident that is attributable to a U.S
office or other fixed place of business, however, gain from such sale is sourced in the United
States under Section 865(e)(2)(A) to the extent not otherwise so sourced.648
647
Section865(d)(4), of course would be relevant only if legislation permitting amortization of
goodwill is enacted. Cf. International Multifoods Corp. v. Comr., 108 T.C. 25 (1997) (goodwill not
foreign source under Section 865(d)(3) when inseverable from and embedded in the foreign
franchise interest and trademarks sold; all generated U.S. source income under Section 865(d)(1)).
648
See VII, A, 2, c, (2), below.

As discussed below649 in VII, A, 2, e, a resident of one of certain treaty countries (including a

controlled foreign corporation) may be able to treat amounts received for the sale of goodwill as
foreign source income under the treaty.
649
See VII, A, 2, e, below.

c. Certain Sales of Personal Property Through Offices or Other Fixed Places of Business
(1) Sales by U.S. Residents
If a U.S. resident (as defined in Section865(g)(1)(A)) maintains "an office or other fixed
place of business" outside of the United States, income from the sale of certain personal property
"attributable to" such office or other fixed place of business is sourced outside the United States
under Section 865(e)(1)(A). This rule, however, does not apply if the income is sourced under
one of the following:
(i) Section865(b) (applicable to inventory property);
(ii) Section865(c) (applicable to depreciable personal property);
(iii) Section865(d)(1)(B) (applicable to contingent payments for intangibles);650 or
(iv) Section865(f) (applicable to stock of affiliates).
650
TAMRA, Section 1012(d)(2), amended Section 865(e)(1)(A) to provide that the office rule
applies to sales of intangible property for payments that are not contingent on the productivity,
use, or disposition of the property.

Furthermore, Section865(e)(1)(A) does not apply unless an income tax equal to at least 10%
of the income from the sale is actually paid to a foreign country with respect to such income.
This requirement is intended to discourage the establishment of offices in tax havens in order to
change the source of the income from the sale of personal property. Treasury, however, is
authorized to provide that, subject to certain conditions (which may be comparable to those in

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Section 877), this 10% tax requirement will not apply for purposes of Section 931, Section 933
or Section 936 (dealing with income from certain possessions).651
651
Section 865(j)(3), added by TAMRA, Section 1012(d)(6)(B).

For purposes of determining (i) whether a taxpayer has an "office or other fixed place of
business," and (ii) whether a sale is "attributable to" such location, the principles of Section
864(c)(5) apply. These principles are discussed below.652
652
See VII, B, 1, b, (1), below.

The IRS has ruled privately653 that U.S. residents who sold a substantial limited partner
interest in a foreign partnership, the sole activity of which was constructing and leasing an asset
in a foreign country, could treat the gain as foreign source under Section865(e)(1). The gain was
subject to tax in the foreign country at an effective rate of at least 10% (computed in accordance
with former Regs. Section 1.954-1T(d)(2)). The property was not depreciable personal property
described in Section 865(c) and was the only property of the partnership.654 On these facts, the
IRS ruled that, under Section 864(c)(5) principles, the gain was attributable to the partnership's
foreign office and that that office was deemed to be the office of the taxpayer for purposes of
Section865(e)(1). As discussed below, the IRS has issued a public ruling reaching a similar result
under Section 865(e)(2) with respect to the sale of an interest in a domestic partnership by a
foreign person.655
653
PLR 9142032. Cf. PLR 9612017 (foreign office of S corporation attributed to its
shareholders; gain on the sale of their shares ruled foreign source).
654
The importance of this fact is that, by its terms, Section865(e)(1) does not apply to gain
sourced under the Section 865 rules governing the sale of, e.g., inventory property, depreciable
personal property, or goodwill.
655
Rev. Rul. 91-32, 1991-1 C.B. 107. See discussion below in VII, A, 2, c, (2) and VII, A, 2, 1.

Similarly, in PLR 9612017, the IRS ruled that U.S. residents' gain from the sale of stock in an
S corporation engaged in business through a foreign office was foreign source. The IRS reasoned
that under §1373(a) an S corporation is treated as a partnership and its shareholders are treated as
partners for purposes of §§901-907, 951-964, and 999. An S corporation can be treated as a
partnership for purposes of determining the source of gain derived from the sale of its stock
under §865(e)(1), and under §865(i)(5), the source rules of §865 are applied at the partner level.
Therefore, the office maintained in the foreign country by the S corporation was attributed to the
selling shareholders. The IRS concluded that the gain was foreign source provided that an
income tax of at least 10% (as required by §865(e)(1)(B)) is actually paid to the foreign country.
(2) Sales by Nonresidents
In general, if a nonresident of the United States maintains an office or other fixed place of
business in the United States, income attributable to such location from the sale of personal
property is sourced in the United States under Section 865(e)(2)(A), generally regardless of the
type of property sold (e.g., intangibles (including goodwill), stock of affiliates, etc.). However, as
discussed below,656 income from certain inventory sales may nevertheless be sourced abroad.
Also, the Section 865(e)(2)(A) rule does not apply for purposes of sourcing income of export
trade corporations under Section 971.657
656
See VII, B, 1, b, (2).
657
Section 865(e)(2).

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 For purposes of determining (i) whether a taxpayer has an office or other fixed place of
business, and (ii) whether a sale is attributable to such location, the principles of Section 864(c)
(5) apply. These principles are discussed below in VII, B, 1, b, (1).
The IRS has ruled that, in the case of a nonresident alien individual who is a partner in a
partnership that is engaged in business in the United States through a fixed place of business, the
foreign partner himself is considered to have a fixed place of business in the United States, under
the principles of Section 875(1). With little discussion, the IRS also concluded that gain from the
sale of the partnership interest by the foreign partner is considered attributable to such fixed
place of business under Section 864(c)(5)(B), and hence is U.S. source income under Section
865(e)(2) (as well as effectively connected income under Section 864(c)).658 As discussed above,
659
the IRS has issued a private ruling taking the same approach with respect to a sale by a
domestic taxpayer of an interest in a foreign partnership engaged in business abroad (assuming
the sale gain was subject to a local tax at least a 10% effective rate).660
658
See Rev. Rul. 91-32, 1991-1 C.B. 107, discussed in greater detail below in VII, A, 2, (1).
659
See VII, A, 2, c, (1).
660
See PLR 9142032. Cf. PLR 9612017 (foreign office of S corporation attributed to its
shareholders; gain on the sale of their shares ruled foreign source).

d. Stock in Foreign Affiliated Companies Sold by Residents

If a U.S. resident sells stock in an "affiliate" which is a foreign corporation, then, under
Section 865(f), any gain from such sale is sourced outside of the United States provided:
(i) the sale occurs in a foreign country in which the affiliate is engaged in the active conduct
of a trade or business; and
(ii) the affiliate derived more than 50% of its gross income for the three-year period ending
with the close of the affiliate's taxable year immediately preceding the year during which
such sale occurred from the active conduct of a trade or business in such country.661 For these
purposes, the term "affiliate" means a member of the same affiliated group within the
meaning of Section 1504(a), applied without regard to Section 1504(b).662
661
Under pre-TRA 86 law, a domestic corporation's gain on a sale of stock of a West German
corporation was treated as foreign source under the title passage test in Rev. Rul. 55-677, 1955-2
C.B. 289.
662
Section 865(i)(4).

The U.S. resident may elect to treat an affiliate and all other corporations which are wholly
owned (directly or indirectly) by the affiliate as one corporation for purposes of the two
requirements listed above.663 Hence, gain derived from the sale of stock in a foreign parent
company which wholly owns a foreign subsidiary is foreign source income if: (i) either the
foreign parent or the foreign subsidiary is engaged in an active business in the country in which
the sale occurs, and (ii) 50% or more of the combined gross income of the parent and the
subsidiary over the prior three-year period is derived from the active conduct of a trade or
business in the foreign country in which the sale occurs. If, however, the foreign corporation is
not itself engaged in the active conduct of a trade or business and holds, e.g., three subsidiaries
each engaged in the active conduct of a trade or business in a different foreign country but the
gross income from no one of which is sufficient to meet the 50% test, the sale of the foreign
holding company could not qualify under Section 865(f).

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 663
Section 865(f), as amended by TAMRA, Sections 1012(d)(4) and (8).

As discussed below,664 a resident of one of certain foreign countries (including a controlled

foreign corporation) may be able to rely on the tax treaty with such country to treat gain from the
sale of foreign stock as foreign source in any event.
664
See VII, A, 2, e, below.

e. Treaty Protection on the Sale of Intangible or Foreign Stock/Liquidation of Possessions

Corporation
If the gain from the sale of stock in a foreign corporation or from the sale of an "intangible"
(as defined in Section 865(d)(2)) would be treated as U.S. source income under Section 865 but
would be treated as foreign source income under an applicable treaty, the taxpayer may elect to
treat the gain as foreign source income.665 This provision creates an exception to the general rule
that the Section 865 source rules added by TRA 86 prevail over conflicting treaty provisions
under the later-in-time rule.666 Note that, in the case of a treaty enacted after the date of enactment
of Section 865, the treaty provision should govern even without an election under Section865(h).
Treaties for which the Section 865(h) election may be relevant include those with Cyprus, Egypt,
Iceland, Indonesia, Korea, Japan, Morocco, Norway, and Trinidad and Tobago,667 which, in
general, source gain from the sale of intangibles (other than such gain treated as royalties) by
reference to the place of sale.
665
Sections 865(h)(1), (h)(2)(A). See also PLR 199918047, in which the IRS ruled that a U.S.
corporation was entitled to make an election under Section 865(h)to treat the gain recognized by
its U.S. subsidiary (a member of its consolidated return group) as foreign source gain, although
Section 865(a) would treat the gain as U.S. source gain. The "Other Income" article of the
applicable income tax treaty permitted the treaty partner country (apparently Australia) to apply its
internal tax law to determine whether a U.S. resident's items of income not otherwise dealt with in
the treaty are derived from sources within its territory and, accordingly, taxable by the country.
The internal tax law of the particular country taxes the gain recognized on the sale of stock of a
corporation formed under its laws. The PLR also ruled that any treaty partner country tax imposed
on the gain would be allocable to a separate Section 865(h) income category for purposes of the
Section 904 foreign tax credit limitation.
666
See Section 7852(d); S. Rep. No. 445, 100th Cong., 2d Sess. 239 (1988).
667
Cyprus (Art. 6(7)), Egypt (Art. 4(6), Iceland (Art. 6(7)), Indonesia (Art. 7(7)), Korea (Art.
6(7)), Japan (Art. 6(7)), Morocco (Art. 5(7)), Norway (Art. 24(7)), and Trinidad and Tobago (Art.
5(7)).

Second, gain from the liquidation of a corporation organized in a possession of the United
States is foreign source income if the corporation derived more than 50% of its gross income
over the three-year period preceding the year in which the distribution is received from the active
conduct of a trade or business in that possession.668
668
Sections 865(h)(1), (h)(2)(B).

In each case, Sections902, 904(a)- (c), 907 and 960 must be applied separately to such gain.669
669
Section 865(h)(1)(B).

f. Section 306 Stock

Under Section306(a)(1), all or part of the amount realized from the sale of certain preferred
stock (Section306 stock) received in certain transactions deemed to give rise to the potential for

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"bailout" of corporate earnings is taxed as ordinary income. The amount taxable as ordinary
income is limited to the stock's ratable share of the amount that would have been a dividend had
the corporation instead distributed money in an amount equal to the fair market value of the
stock. Under Section 306(f), the amount taxed as ordinary income is treated as having the same
source as it would have had it been distributed as a dividend by the issuer. If, as a result, such
amount is considered to be from sources within the United States, it also is considered under
such provision to be "fixed or determinable annual or periodical" income within the meaning of
Sections 871(a)(1) and 881(a), as may be relevant. Thus, for example, in the case of Section 306
stock issued by a domestic corporation and held by a foreign person, the proceeds of sale of such
stock may be subject to the withholding of tax at a 30% rate (or lower treaty rate) under Sections
1441-1442. The portion of the amount realized from the sale of Section 306 stock that is not
treated as a dividend under these rules is sourced under the rules governing the sale of personal
property.
Under Section306(a)(2), the amount realized upon the redemption of Section 306 stock is
treated as a distribution of property under Section 301 (without regard to whether any of the
Section 302(b) tests for nondividend treatment are met). Consequently, as in the case of any
Section 301 distribution, to the extent of the available earnings and profits of the corporation, the
redemption proceeds are taxable as a dividend and sourced under the dividend source rules.670 To
the extent the redemption proceeds exceed available earnings and profits, they are treated, first,
as a nontaxable return of capital to the extent of the taxpayer's tax basis in the shares. Any
portion of such proceeds exceeding available earnings and profits and tax basis is taxable as gain
from the sale of personal property, and sourced accordingly.
670
Sections301, 316.

Section 302(e)(3) of the Jobs and Growth Tax Relief Reconciliation Act of 2003, P.L. 108-
27, added §306(a)(1)(D), applicable to taxable years beginning after December 31, 2002, which
provides that for purposes of §1(h)(11) and such other provision as the IRS may specify, any
amount treated as ordinary income for purposes of §306 will be treated as a dividend received
from the corporation.
g. Certain Section 367 Inclusions
Section367(a)(3)(C) sets forth a loss "recapture" rule for certain foreign branches of U.S.
taxpayers. This provision requires that any gain realized by a U.S. person on the incorporation of
assets of a foreign branch into a foreign corporation be recognized, to the extent that losses were
incurred by the foreign branch and deducted by it in an amount in excess of the sum of any
taxable income of the branch following such losses and any amount included as U.S. source
income under the Section 904(f)(3) overall foreign loss rule. Any gain recognized under Section
367(a)(3)(C) is treated as from sources outside the United States and as having the same
character as the losses had.
Section367(d) imposes an "exit tax" with respect to the transfer of intangible property by a
U.S. person to a foreign corporation in certain incorporation or reorganization transactions
described in Section 351 or Section 361.671 The U.S. person in such a transaction is treated as
having sold the property for payments which are contingent upon the productivity, use, or
disposition of such property and as receiving amounts which are "commensurate with the income
attributable to the intangible" and "which reasonably reflect the amounts which would have been

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received," either "annually in the form of such payments over the useful life of such property,"
or, "in the case of a disposition following such transfer (whether direct or indirect), at the time of
the disposition."672 Any amount so included in income is treated as ordinary income from sources
within the United States.673 A similar result may apply in the case of a U.S. person's contribution
of an intangible to the capital of a foreign partnership.674
671
Section 367(d)(1). A contribution to capital would be described in Section 351 for this
purpose. See Section 367(c)(2).
672
Section 367(d)(2)(A).
673
Section 367(d)(2)(C). The earnings and profits of the foreign transferee are reduced by the
amount characterized as U.S. source ordinary income. Section 367(d)(2)(B). Also, for any amount
treated as received on or after Aug. 5, 1997, the amount is to be treated in the same manner as a
royalty for purposes of the foreign tax credit limitation baskets of §904(d). §367(d)(2)(C), as
amended by the American Jobs Creation Act of 2004, P.L. 108-357, §406.
674
See Section 1492(2)(B).

The Section367(d) source rule is inconsistent with the source rule generally governing the
license or sale of intangible property for payments contingent on the productivity, use, or
disposition of the property, which refers to the place in which the property is used.675 Congress'
rationale in treating Section367(d) income as from U.S. sources was apparently to source the
income in the same manner as, it assumed, research and development expenditures typically
were deducted at that time.676 This reasoning is extremely questionable, especially since the
assumption upon which it was based is incorrect if significant sales within the relevant product
category are made abroad.677 Furthermore, as noted by Congress itself, the source rule result
could be avoided by licensing or selling the intangible, since the special Section 367(d) source
rule does not apply in the context of Section 482 reallocations.678 (In fact, the "commensurate
with . . . income" standard itself does not apply to sales if Section 482 is inapplicable.) Finally,
the justification for a special source rule has been further called into question by the enactment of
§§865(c) and (d)(4) as part of TRA 86, which, in the case of a sale of an intangible, source an
amount of gain up to (but not in excess of) the amount of research expenditures previously
deducted against U.S. source income to U.S. sources (see VII, A, 1, b and A, 2, a, above).
675
See Sections861(a)(4), 862(a)(4), 865(d)(1)(B).
676
See S. Rep. No. 169 (Vol. 1), 98th Cong., 2d Sess. 361, 368 (1984).
677
See Regs. §1.861-8(e)(3)(ii)(B); St. Jude Medical, Inc. v. Comr., 97 T.C. 457 (1991), aff'd in
part and rev'd in part, 34 F.3d 1394 (8th Cir. 1994) (holding former Regs. §1.861-8(e)(3) invalid
as applied to DISC CTI computations), nonacq., 1995-1 C.B. 1. See also Regs. §1.861-17,
revising and replacing former Regs. §1.861-8(e)(3), and Boeing Co. v. U.S., 258 F.3d 958 (9th Cir.
2001), confirming the validity of former Regs. §1.861-8(e)(3) as applied to the calculation of the
combined taxable income of a DISC and FSC, contrary to the Eighth Circuit's reasoning and
analysis in St. Jude Medical. The Supreme Court affirmed the decision of the Ninth Circuit, 537
U.S. 437 (2003), and held the taxpayer's grouping of R&E expense based on industry accepted
product lines was only entitled to limited deference. The Court found that the IRS determination
that the taxpayer should have grouped and apportioned all of its R&E based on the transportation
standard industrial code pursuant to former Regs. §1.861-8(e)(3) was reasonable.
678
S. Rep. No. 169 (Vol. 1), 98th Cong., 2d Sess. 361, 368 (1984). For this reason, taxpayers
generally seek to structure a transfer of an intangible as a sale or license of the intangible; a sale to
a newly formed corporation, however, would entail the risk of recharacterization as a Section 351
transfer (with boot), subject to Section 367(d).

In addition to these special source rules under §367, final and temporary regulations under
§367(b) require that, upon certain exchanges of shares, certain amounts must be included in

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income by the transferring shareholder. The domestic parent would be generally be required to
include in income as a deemed dividend (with associated foreign tax credits) the "all earnings
and profits amount" with respect to the shares held in the foreign corporation.679 The IRS has
reserved for future consideration whether the parent must recognize exchange gain or loss to the
extent that the foreign corporation's capital account has appreciated or depreciated by currency
fluctuation.680 A limited option to elect to treat the exchange as taxable is provided in the
temporary regulations but only if the exchange occurs before February 24, 2001.681 In the latter
case, the domestic corporation would recognize dividend income (with associated foreign tax
credits) to the extent provided in §1248 (sourced and categorized for §904(d) separate limitation
purposes under the §904(d)(3) look-through rule) and capital gain (sourced to the United States
under §865(a) or abroad under §865(f) and within the §904(d)(2)(A)(i) "passive" basket for
foreign tax credit purposes) to the extent of any excess. To the extent the all earnings and profits
amount exceeds the amount of gain recognized, certain tax attributes of the liquidated
corporation would have to be reduced.682 If an amount required to be included in income under
§367(b) is attributable to earnings and profits of a corporation held through intermediate entities,
the amount included is treated as a dividend paid through such entities.683
679
Regs. §1.367(b)-3(b)(3)(i).
680
Regs. §1.367(b)-3(b)(3)(iii).
681
Regs. §§1.367(b)-3T(b)(4)(i) and (ii). The IRS, in the preamble to the final regulations,
stated that the taxable exchange option was inconsistent with the policies of §367(b) that apply to
inbound transactions and was not required by the statute. Where an exchange election is made,
§332 would be overridden but the §337 nonrecognition treatment of the foreign corporation would
not be affected.
682
See Regs. §1.367(b)-3T(b)(4)(i)(B).
683
Regs. §1.367(b)-2(e)(2).

h. Gain Under Sections 1248 and 1291

Although not technically a source rule, §1248 recharacterizes under certain circumstances all
or part of any gain realized by a U.S. person upon the sale or exchange of stock in a foreign
corporation as dividend income. For §1248 to apply, §1248(a) requires that the U.S. person must
own or have owned, at any time during the five-year period ending on the date of the sale or
exchange, at least 10% of the total combined voting power of all classes of stock entitled to vote
of the corporation and the corporation must have been a controlled foreign corporation ("CFC")
(as defined in §957) at some time during such period when such 10% ownership requirement
was met. The portion of any gain recognized characterized as a dividend is an amount equal to
the portion of the foreign corporation's earnings and profits that are: (i) accumulated in taxable
years beginning after December 31, 1962; (ii) while the corporation was a CFC; and (iii) that are
"attributable" under the §1248 regulations to the stock sold or exchanged by the taxpayer. To
such extent, any gain recognized is sourced under the dividend rules and, hence, generally is
foreign source.684 Only the portion of the gain recognized that exceeds the amount so
characterized as a dividend is sourced under the §865 sale of property rules.685
684
Although §1248 generally only recharacterizes gain that is recognized, §1248(f)(1)
theoretically can result in the recognition and recharacterization of gain that otherwise would have
gone unrecognized under §337 upon the liquidation of a wholly owned foreign corporation into its
domestic parent. This provision, however, is essentially superseded by Regs. §1.367(b)-3(b)(3)(i).
See discussion in VII, A, 2, g, immediately above.
685
See, e.g., Regs. §1.367(b)-3T(b)(4)(i)(D), Example. As this example indicates, the gain
generally would be treated as in the §904(d)(2)(A)(i) (passive) separate limitation category for

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 foreign tax credit purposes.

In general, §1248 does not apply to a U.S. person's disposition of stock in a passive foreign
investment company (PFIC) which is taxable under the tax regime of §1291.686 Under §1291(a)
(2), in general, a portion of the gain is treated as an "excess distribution" defined in §1291(b);
such portion, to the extent provided in §1291(a)(1)(B), is taxable as ordinary income and, in
addition, the taxpayer is liable for the "deferred tax amount" (as defined in §1291(c)). Section
1291(g) sets forth rules governing the allowance of foreign tax credit with respect to excess
distributions. In the case of an excess distribution resulting from the disposition of stock under
§1291(g)(2)(C), the foreign tax credit is available with respect to such gain (and only such gain)
as would have been, but for §1291, includible in gross income as a dividend under §1248; to
such extent, the gain treated as an excess distribution is considered foreign source income for
purposes of the foreign tax credit.687 Apart from this exception, the source of gain treated as an
excess distribution is not affected by such treatment.
686
See §1248(g)(2)(B); Prop. Regs. §1.1291-3(i). As a technical matter, §1248 does not apply to
the disposition of stock in a "§1291 fund," which the regulations define as an "unpedigreed QEF"
or a "nonqualified fund," each as defined in Prop. Regs. §1.1291-1(b)(2) , (iii) and (iv) ,
respectively.
687
See Prop. Regs. §1.1291-5(c) , (d) , and (e) .

i. U.S. Real Property Interests

As discussed in VI, above, an interest in certain corporations, partnerships, trusts, and estates
holding interests in U.S. real property may be treated as "United States real property interests"
under § 897(c). Any gain from the disposition of an interest so treated would be sourced and
taxed under the rules governing real property.
j. Certain Foreign Currency Transactions
As discussed in XII, A, below, foreign currency gain or loss realized in a "§988 transaction"
is sourced under §988(a)(3).
k. Special Rules for Section 338 Elections
Under §338, a corporate taxpayer that has made a qualified stock purchase of another
corporation may elect (and, in certain circumstances, is deemed to elect) to treat the stock
purchase as resulting in a deemed sale by the target of all its assets and a reacquisition of those
assets by a deemed new corporation. Such an election is unattractive in most cases as a result of
the TRA 86 amendments to §§336 and 337. However, a §338 election may be attractive if the
target is a domestic subsidiary in an affiliated group filing a consolidated return since the
purchaser and seller can elect to treat the stock purchase as an asset sale and purchase under
§338(h)(10). If the target holds shares of a foreign corporation meeting the §1248 ownership test,
the deemed sale of such shares gives rise to dividend income, and potential foreign tax credit
relief under §§901-902, to the extent of the lesser of the deemed gain or the §1248 earnings and
profits attributable to such shares.
If the target holds shares of a CFC sufficient to meet the stock ownership requirements of
§338, a §338 election could be made with respect to the CFC.688 Whether or not it is, the selling
group would be treated as having sold the shares of the CFC and would recognize gain or loss on

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such deemed sale (for which purpose, e.g., §§1246, 1248, and 1291-98 may be applicable).689 In
addition, if a §338 election is made for the CFC, the CFC is treated as selling its assets.
Depending on the nature and appreciation in value of the assets, this deemed sale may give rise
to foreign personal holding company income, subpart F income, or income includible under
§1293.690 Even if such income does not arise, the CFC's earnings and profits taken into account
under §1248 will generally increase.691 The subpart F income is includible by the seller and
therefore would result in an increase in stock basis under §961 before determining gain on the
deemed stock sale.692 Consequently, all or part of what would have been gain on the stock sale
may be treated as either subpart F income or §1248 dividend income, with no net change in the
income recognized.
688
Regs. §§1.338-3(b)(4) and - 4(h)(8), Ex. 4.
689
Regs. §1.338-4(h)(3).
690
§1293 deals with inclusions by a PFIC that has made a QEF election.
691
See Regs. §§1.338-9(b) and - 4(h)(8), Ex. 4.
692
See PLR 8938036. This result should not be affected by Regs. § 1.338-3(b)(4), which
provides generally that a deemed sale and purchase of a lower-tier subsidiary's assets is considered
to take place "instantaneously after" the deemed sale and purchase of its parent's assets, since any
basis adjustment would have retroactive effect. Accord Regs. §1.338-4(h)(8), Ex. 4 (deemed sale
earnings and profits affect characterization of stock sale).

For purposes of computing foreign tax credit limitations, except as otherwise provided in
regulations, an election under §338 has no effect on the source or character of income from the
transaction, other than to the extent gain is includible in income by the seller as a dividend under
§1248 (determined without regard to a deemed sale under §338 by a foreign corporation).693
Section 338(h)(16) provides, in effect, that, for foreign tax credit purposes, a target CFC's
additional earnings and profits generated by a §338 election are sourced and basketed (under
§904(d)) in the same manner as the seller's capital gain would have been sourced and basketed
absent such election. Thus, while the seller's capital gain may be converted into ordinary income
by the election, that ordinary income will either be U.S. source (if the seller did not meet the
requirements of §865(f)) or foreign source passive income. The primary abuse that §338(h)(16)
is intended to prevent is the increase of general limitation foreign source income for purposes of
the foreign tax credit rules through the deemed sale of foreign assets, when the only actual sale is
of the stock of a domestic or foreign corporation, which ordinarily generates passive foreign or
U.S. source income. Because no foreign taxes are paid on the deemed sale of the foreign assets,
the general limitation deemed sale earnings and profits can be used to absorb excess foreign
taxes in the same basket.
693
§338(h)(16).

The potential for abuse is clear to the extent no subpart F income is generated on the sale,
since absent §338(h)(16), the earnings and profits generated by the deemed sale generally would
increase the general basket foreign source income of the seller. In such a case, regulations apply
the principle of §338(h)(16) to prevent an unintended taxpayer benefit.694 To the extent, however,
that subpart F income is generated by the deemed sale, the seller generally would not generate
general basket foreign source income but, instead, other separate limitation income for foreign
tax credit purposes. Depending upon the relative amounts of gain, pre-transaction §1248 earnings
and profits and subpart F income generated in the transaction absent §338(h)(16), this subpart F
income could displace §1248 earnings and profits unrelated to the transaction that would have
given rise to general basket foreign source income for the seller. Section 338(h)(16) should be

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applied under such facts to source and basket the portion of the subpart F income that displaced
§1248 earnings and profits unrelated to the transaction in the same manner as such earnings and
profits would have been sourced and basketed.695 The IRS has yet to resolve this issue as final
regulations published reserved on the effect of §338(h)(16) and its application where the deemed
sale of assets results in subpart F income under §952.696
694
See Regs. §1.338-4(h)(8), Ex. 4. Accord PLR 8938036. Note that a taxpayer would be in the
position, in the event of a subsequent sale of the assets deemed sold pursuant to a §338 election, of
generating a foreign tax liability without a corresponding amount of foreign source income
because the basis of the assets would have been increased for U.S. tax purposes only.
695
Accord PLR 8938036 (reference to §951 in ruling 6).
696
Regs. §1.338-9(e). For a detailed discussion of the international tax issues and
considerations in making a §338 election, including §338(h)(16), see 788 T.M. Stock Purchases
Treated as Asset Acquisitions-Section 338.

Historical Note: Prior to TAMRA, §338 was often available to absorb excess credits
generated by other items of residual income. In effect, until TAMRA, a §338 election gave the
seller the benefit of an asset sale, which effectively increased the amount that was sourced
abroad, eligible for the indirect credit, and rebasketed by the §904(d)(3) look-through rules,
without incurring the foreign tax cost potentially associated with an asset sale.697 TAMRA698
eliminated this tax planning opportunity by adding §338(h)(16) to the Code, generally effective
for sales of stock after March 31, 1988.
697
If neither a transitional nor regular exclusion election (as provided under the temporary §338
regulations then in effect) had been made, a §338 election with respect to a CFC would have
resulted in a deemed sale of the CFC's assets. Assuming the assets had appreciated, positive E & P
would have been generated in the CFC (resulting in so-called "enhanced" E & P in the CFC) (pre-
1994 Regs. §1.338-5T(g)(3)). The seller, in determining the portion of its gain on the sale of the
CFC taxable as ordinary income under §1248, would have taken into account the total "enhanced"
E & P (including the E & P generated by the deemed asset sale) (pre-1994 Regs. §§1.338-5T(g)
(1), (g)(2)(i)), up to the amount of its gain in the CFC's stock. Note that under the final Regs.
§1.338-8(a)(1), the CFC will generally not be treated as having made a §338 election unless it
makes an express election.
698
TAMRA, §1012(bb)(5).

Historical Note: Regs. §1.338-5T(h) provides a special source rule in the context of a §338
election involving a foreign subsidiary. This regulation was promulgated prior to the enactment
of Section §865 and is inconsistent with Section §865. Consequently, it probably should not be
regarded as binding and should be withdrawn. Regulations proposed under Section 338 on
January 13, 1992, would, when finalized, accomplish this.
The Section338 regulations address the consequences of a Section 338 election with respect
to a corporation for which a Section 936 election has been made. In order to qualify for the credit
under Section 936, at least 75% of such corporation's gross income over a test period must be
from the active conduct of a trade or business conducted in Puerto Rico.699 To the extent that the
assets deemed sold are used in the conduct of an active trade or business in a possession for
purposes of Section 936(a)(1)(A)(i), and assuming all the other conditions of Section 936 are
satisfied, the income from the deemed sale qualifies for the credit granted by Section 936(a). The
source of income from the deemed sale is determined as if the assets had actually been sold and
is not affected for purposes of Section 936 by Section 338(h)(16). Because new T is treated as a
new corporation for purposes of subtitle A of the Code, the three-year testing period in Section

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936(a)(2)(A) begins again for new T on the day following T's acquisition date.700
699
Section 936(a)(2)(B).
700
Thus, if the character or source of old T's gross income disqualified it for the credit under
Section 936, a fresh start is allowed by a Section 338 election. Accord PLR 8903045.

l. Sale of Partnership Interests

(1) General
The source rules do not specifically address gain from the disposition of a partnership
interest,701 with one exception. A "look-through" rule applies under Section 897(g) to interests
held in certain partnerships holding U.S. real property interests (USRPIs) whereby an amount
received upon the sale of an interest in such a partnership may be treated as received from the
sale of a USRPI to the extent attributable to a USRPI held by the partnership. An interest in a
partnership in which, directly or indirectly, 50% or more of the value of the gross assets consists
of USRPIs, and 90% or more of the value of the gross assets consists of USPRIs or cash or cash
equivalents, is treated as a USRPI in its entirety for Section1445 purposes, but only to the extent
that the gain on the disposition is attributable to USRPIs (and not cash, cash equivalents or other
property) for Section 897 purposes.702 Even if these tests are not met, the IRS takes the position
that the look-through principle of Section 897(g) is operable.703
701
U.S. Representative Gradison introduced a bill into Congress in 1991 that, among other
things, would source the sale of certain qualifying partnership interests on a look-through basis.
See H.R. 2948, Foreign Income Tax Bill of 1991 (Section 10), 102d Cong., 1st Sess.
702
Regs. Section 1.897-7T. See also Regs. Section 1.897-1(c)(2)(iv) (publicly traded
partnerships treated like corporations for Section 897 purposes).
703
See Rev. Rul. 91-32, 1991-1 C.B. 107, 110. Note, however, that the statute begins: "Under
regulations prescribed by the Secretary . . ."

With respect to partnership interests not treated, or the portion not treated, as real property by
Section 897(g), it should first be noted that a partnership interest is personal property.704 The
general rule applicable to sales of personal property is that gain is sourced by reference to the
residence of the seller.705 If the seller is a resident and if the sale of the property is attributable to a
foreign office or other fixed place of business and the gain is subject to a foreign income tax
imposed at an effective rate of at least 10%, the gain is treated as foreign source. 706 If the seller is
a nonresident and if the sale is attributable to a U.S. office or other fixed place of business, the
gain is treated as U.S. source.707 An argument, however, can be made that a partnership interest
holding depreciable property is itself depreciable personal property under Section 865(c)(4) since
the adjusted basis of the partnership interest includes depreciation adjustments; in such case, the
special rules of Section 865(c) apply.
704
Uniform Partnership Act, Section 26; Uniform Limited Partnership Act, Section 701.
705
Section 865(a).
706
Section 865(e)(1).
707
Section 865(e)(2).

The foregoing analysis would not be valid if a partnership is not treated as an entity for this
purpose. There is precedent for treating a partnership either as an entity or as an aggregate of
individuals, depending upon the purpose for which the determination is being made. Under
Section741, gain from a sale of a partnership interest generally is taxed as if the partnership were
an entity rather than on a look-through basis (subject to an exception for certain "hot" assets).708

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This approach is followed in defining foreign personal holding company income,709 which is
determinative for subpart F, PFIC, and foreign tax credit purposes. On the other hand, for
example, an aggregate approach is taken, at least for general partner interests, for Section 367
purposes.710 Similarly, Section 875 takes an aggregate approach for purposes of determining
whether a partner is engaged in business in the United States.711
708
Accord, e.g., Petroleum Corp. of Texas, Inc. v. U.S., 939 F.2d 1165(5th Cir. 1991) (recapture
income not triggered by 1983 corporate distribution of partnership interest).
709
Section 954(c)(1)(B)(ii), added by TAMRA, Section 1012(i)(18).
710
See, e.g., Section 367(a)(4) (for applying Section 367(a) rules); S. Rep. No. 169 (Vol. 1),
98th Cong., 2d Sess. 367 (1984) (under regulations, the look-through rule will not apply to "most"
transfers of limited partner interests).
711
Accord, e.g., Unger v. Comr., 936 F.2d 1316(D.C. Cir. 1991)(partnership's U.S. permanent
establishment attributed to Canadian limited partner); Vitale v. Comr., 72 T.C. 386(1979) (same for
limited partner); cf. Rev. Rul. 89-85, 1989-2 C.B. 218 (aggregate approach taken to avoid abuse
under Regs. Section 1.1502-13); PLR 9130039 (partnership treated as aggregate for purposes of
RIC income and asset tests).

In 1991, the IRS ruled, in the case of both interests held by nonresidents in partnerships
engaged in business in the United States, and interests held by U.S. residents in partnerships
engaged in business abroad, that the gain may be sourced by looking to the place of business of
the partnership. These rulings are discussed immediately below.712
712
1991-1 C.B. 107; PLR 9142032.

(2) Inbound Investments

The IRS ruled in Rev. Rul.91-32,713 in the case of a sale after March 18, 1986714 of an interest
in a partnership that is engaged in business in the United States by a foreign person, that gain on
such sale may be treated as effectively connected with a U.S. trade or business on a partial look-
through basis,715 to the extent the foreign person is not already subject to tax under Section
897(g). The ruling considered the gain or loss to be attributable to the U.S. office of the
partnership. Similarly, for purposes of income tax treaties, the ruling treats the gain or loss as
attributable to a U.S. permanent establishment.
713
1991-1 C.B. 107.
714
The ruling notes that this is the effective date of Section 865, upon which the ruling is based.
715
The total amount of gain or loss, however, is determined on an entity basis.

Under the ruling, the portion of the taxpayer's gain or loss on the sale of a partnership interest
that is treated as effectively connected with a U.S. trade or business of the partnership is
determined as follows:716
1. The taxpayer determines the amount of gain or loss realized on the sale of the partnership
interest on an entity basis.
2. The partnership determines the amount of effectively connected gain or loss, on the one
hand, and the amount of other gain or loss, on the other hand, that would result from a
hypothetical sale of all of its assets and that would be allocated to the selling foreign partner.
717

3. The selling partner's gain or loss realized on the sale of the partnership interest (as
determined in step 1) is multiplied by a fraction, the numerator of which is the partner's share

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 of the partnership's effectively connected gain or loss from the hypothetical sale of its assets,
and the denominator of which is the partner's share of the partnership's total gain or loss from
the hypothetical sale of its assets. Thus, net noneffectively connected loss will not offset
effectively connected gain, and net effectively connected loss will not offset net
noneffectively connected gain.718
716
Rev. Rul. 91-32, 1991-1 C.B. 107.
717
Id. For purposes of Section 865, except as provided otherwise in regulations, Section 865 is
applied at the partner level. Section 865(i)(5). The selling partner would be a "nonresident" within
the meaning of Section 865(g)(1)(B). Even so, effectively connected gain or loss might result
from, e.g., depreciation recapture, U.S. real property (under Section 897(g)), and, giving effect to
Section 865(e)(2), inventory and any other property that could be considered attributable to the
U.S. fixed place of business of the partnership.
718
Further, if a foreign partner realizes a loss on the disposition of its partnership interest, and if
its distributive share of ECI gain or loss from the deemed disposition of ECI assets by the
partnership is a net ECI gain, then none of the loss realized by the foreign partner on the
disposition of the partnership interest is treated as ECI loss. If a foreign partner realizes a gain on
the disposition of its partnership interest, and if its distributive share of ECI gain or loss from the
deemed disposition of ECI assets by the partnership would be a net ECI loss, then none of the gain
realized by the foreign partner on the disposition of the partnership interest is treated as ECI gain.
Id.

From a policy standpoint, the aggregate (look-through) result of the ruling makes sense, in
that gain from a disposition of the partnership interest is taxed in the same manner as income
generated by the partnership would be taxed. The straightforward way of reaching this result,
however, which would involve treating the partnership as an aggregate rather than entity, may be
foreclosed by Section 741, which takes an entity approach to the taxation of gain or loss on the
transfer of a partnership interest.719
719
The fact that Section 751 would look through the partnership interest for purposes of
determining whether gain should be taxable as ordinary income or capital gain should not be
relevant for source purposes.

Perhaps recognizing this difficulty, the IRS in Rev. Rul.91-32 took an entity approach to the
sale of the partnership interest, but stated that, under Section 865(e)(2) and the look-through
principle of Section 875, all of the partner's gain or loss is considered effectively connected on
the theory that it would be attributed to the partnership's U.S. office or other fixed place of
business (FPB). In order to limit the gain or loss treated as effectively connected to that amount
which it perceived as intended by Congress, the IRS then applied a quasi-aggregate approach, via
Section 865(e)(2). The problem, however, is that the premise -- that gain from the sale of such a
partnership interest is theoretically fully taxable because "attributable" to a U.S. FPB -- might not
stand up under scrutiny. In determining whether the gain or loss is so attributable for this
purpose, the principles of Section864(c)(5) apply.720 Under Section 864(c)(5)(B), a taxpayer's
gain is not attributable to a FPB unless the FPB both is a "material factor" in the production of
the gain and "regularly carries on activities of the type from which such . . . gain . . . is derived."
To fit within this language, the term "derived" must be construed very broadly to mean derived
indirectly, through the build-up of value. Until Rev. Rul. 91-32, the term had not been construed
so broadly. It remains to be seen whether the courts will accept that reading.
720
Section865(e)(3).

Regardless of the merits of the IRS' position, it should be noted that enforceability will be a

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problem unless statutory provisions requiring withholding of tax by the purchaser are enacted.
(3) Outbound Investments
The IRS has ruled privately that U.S. residents who sold a limited partner interest in a foreign
partnership could treat the gain as foreign source on the facts presented.721 The partnership's sole
activity was constructing and leasing an asset in a foreign country. The taxpayer both held and
sold a major interest in the partnership (about 33% and 28%, respectively). The gain was subject
to tax in the foreign country at an effective rate of at least 10% (computed in accordance with
former Regs. Section 1.954-1T(d)(2)). The property was not depreciable personal property
described in Section 865(c) and was the only asset of the partnership.722 On these facts, the IRS
ruled that, under Section 864(c)(5) principles, the gain was attributable to the partnership's
foreign office and that that office was deemed to be the office of the taxpayer. Accordingly,
assuming that the gain in fact was subject to foreign tax at an effective rate of at least 10%, the
gain would be foreign source under Section 865(e)(1).723
721
PLR 9142032.
722
Presumably, the property was depreciable real property. The importance of this fact is that,
by its terms, Section 865(e)(1) does not apply to gain sourced under the Section 865 rules
governing the sale of, e.g., inventory property, depreciable personal property, or goodwill.
723
The IRS also ruled that the gain would be passive for Section904 purposes. See PLR
9612017 (U.S. residents' sale of stock in S corporation engaged in business through a foreign
office was under Section 1373(a)akin to a sale of a partnership interest).

By relying on Section865(e)(1), rather than adopting a complete look-through approach, the

IRS has created potential distinctions between the results from the sale of partnership interests by
U.S. residents, depending upon the types of assets held, that may not make sense. Under the
approach taken in the private ruling, in the case of a sale by a U.S. resident of an interest in a
partnership engaged in business abroad, foreign sourcing of gain is not possible to the extent the
partnership holds, e.g., inventory, depreciable personal property, or goodwill even if that property
is used in a business abroad. Consequently, under the Section865(e)(1) approach taken in the
ruling, complete look-through treatment would be available only in a narrow range of cases (in
particular, real estate investment partnerships).
In resolving the proper sourcing of the gain of a domestic taxpayer from the sale of a
partnership interest engaged in business abroad, the function of the source rules should be
heavily weighted. The effect of adopting a look-through rule would be generally to treat gain
from the sale of real property located abroad and inventory and depreciable assets used in a
business abroad, and from the sale of goodwill attributable to such business, as foreign source. In
addition, gain from the sale of certain other assets could be treated as foreign source if the sale is
attributable to a foreign office or other fixed place of business and the foreign jurisdiction
subjected such gain to income tax at a rate of at least 10%.724 Under the laws of certain
jurisdictions, gain from the sale of a partnership interest that is attributable to personal property
or real property located in the country is subject to tax.725 Consequently, treatment of the gain as
foreign source would be necessary to avoid the risk of double taxation. Furthermore, it would be
inappropriate to have a different rule for sourcing such income for purposes of taxing foreign
persons as compared with domestic persons. Finally, look-through treatment, by definition,
would conform the tax treatment of a sale of a partnership interest for source purposes to the
treatment of a partner's distributive share of income from the partnership, including its share of

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gain from a disposition of assets by the partnership. Such conformity, which characterizes the
result reached (though not the approach taken) in, e.g., Rev. Rul. 91-32, makes sense both
theoretically and from the standpoint of a fair and understandable tax system.
724
Section 865(e)(1).
725
See, e.g., PLR 9142032.

Look-through treatment may not be appropriate for certain relatively small partnership
interests. The general purpose of a minimum is to restrict look-through treatment to situations
that may not be characterized as mere portfolio investments, as a matter of policy and tax
administrability. An exception for a partnership interest of less than 10% in value of all
outstanding partnership interests (other than in the case of a noncorporate general partner) that is
not held in the ordinary course of the partner's active trade or business would conform with Regs.
Section 1.904-5(h)(2), which addresses the extent to which income from a partnership is eligible
for a "look-through" rule in determining the limitation category of such income for Section 904
purposes.
m. Imputed Interest
While they are not, strictly speaking, source rules, certain provisions can characterize a
portion of the proceeds from a sale of property for deferred payment as interest rather than gain.
In particular, in the case of a debt instrument given in exchange for the sale or exchange of
property, in appropriate circumstances (generally if the debt instrument does not bear a market
rate of interest), interest may be imputed, in the form of original issue discount, under either
Section 1273(b)(3) (if the debt instrument is traded on an established securities market or the
property acquired is stock or securities so traded) or under Section 1274 (if neither the debt
instrument nor the acquired property is so traded). In narrow circumstances in which neither
Section 1273 nor Section 1274 applies, a portion of the gain from a sale of property may be
recharacterized as interest under Section 483. Any gain recharacterized under the above
provisions would be sourced under the Section 861(a)(1) interest sourcing rules, discussed in I,
above.
B. Inventory Property
Section865(b) provides that the rules of Section 865, discussed above, do not apply to
income derived from the sale of inventory property. Rather, such income (including certain gain
from the sale of tangible depreciable personal property)726 is sourced under the rules set forth in
Sections861(a)(6), 862(a)(6), 863(b), and 865(e)(2).727 Thus, income arising from sales of
inventory property is sourced without regard to the residence of the seller.
726
See, e.g., Section 865(c)(2).
727
Sections865(b), 865(e)(2). The fact that 865(b) does not refer to Section 865(e)(2) is due
presumably to oversight.

As discussed more fully below, the general rule applicable to sales of inventory property is
the place-of-sale rule set forth in Sections 861(a)(6) and 862(a)(6), as modified by Section 865(e)
(2).
Income from the sale of inventory property acquired by production, manufacture, extraction,
processing, curing, or aging (rather than by purchase) in the United States and sold in a foreign
country or U.S. possession, or vice versa, is sourced under Section 863(b)(2) partly to the place

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of such production and partly to the place of sale (as determined under Sections 861(a)(6) and
862(a)(6)), pursuant to apportionment formulas specified in Regs. Section 1.863-3 and discussed
below.728
728
See VII, B, 2, a, below.

Similarly, income from the sale of inventory property purchased in a U.S. possession and
sold in the United States is treated as partly from sources within and partly from sources without
the United States pursuant to an apportionment formula set forth in the regulations under
Section863(b)(3) discussed below.729
729
See VII, B, 2, b, below.

For these purposes, the term "inventory property" includes personal property (and not real
property) that is described in Section1221(a)(1), relating to stock in trade and other property
which would properly be included in the inventory of the taxpayer if on hand at the close of the
year, and property held by the taxpayer primarily for sale to customers in the ordinary course of
business.730 In addition, however, gain from the sale of tangible depreciable personal property is
treated as inventory property to the extent, if any, that the gain exceeds the depreciation
adjustments reflected in the basis of the property.731 As used in this portfolio, then, the term
"inventory property" generally should be treated as including any gain taxed as inventory
property under Section 865(c)(2).
730
Section 865(i)(1), cross-referenced in Sections 861(a)(6), 862(a)(6), and 863(b).
731
See Section865(c)(2). Intangible property is excluded from this rule. See Section 865(d)(4)
(B).

For purposes of Section865, the term "sale" includes an exchange or any other disposition.732
732
Section 865(i)(2); Regs. Section 1.864-1.

1. Inventory Property Not Subject to Apportionment Rules

Income from the sale of inventory property that is not subject to apportionment under Section
863(b) is sourced by its place of sale. There is, however, a significant exception for inventory
sales by a "nonresident" (as defined in 865(g)(1)(B))733 attributable to a U.S. office or other fixed
place of business.734 Section 865(b) provides another exception to the place of sale rule for
unprocessed softwood timber cut from an area located in the United States. These rules are
discussed in order below.
733
See A, 1, a, (2), above.
734
No equivalent rule applies to a U.S. resident, so that, as under pre-TRA 86 law, a domestic
corporation that manufactures abroad and sells in the United States through a marketing force here
may cause such sales to occur abroad for purposes of the Section 863(b) manufacturing
apportionment rule. See PLR 7904076.

Notwithstanding the wording of Sections861(a)(6) and 862(a)(6), the place-of-sale rule

generally735 applies regardless of the place of purchase.736 Thus, in addition to income from the
sale of inventory property purchased abroad (other than in a U.S. possession)737 and sold within
the United States, income from the sale of inventory property both purchased and sold within the
United States is U.S. source income under the principle of Section 861(a)(6). Similarly, in
addition to income from the sale of inventory property purchased within the United States and
sold abroad (including in a U.S. possession),738 income from the sale of inventory property both

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purchased and sold within a foreign country or possession is foreign source income under the
principle of Section862(a)(6).739
735
The exception relates to goods purchased in a U.S. possession and sold in the United States,
which are subject to the Section 863(b) apportionment rule.
736
Carding Gill, Ltd. v. Comr., 38 B.T.A. 669, 672 (1938). This is consistent with the concept
under U.S. tax law that income is not derived from the mere purchase of goods. See e.g., Dorn Co.
v. Comr., 12 B.T.A. 1102, 1108-09 (1928).
737
In order to conform with Section 863(b)(3), Section 861(a)(6) expressly excludes purchases
in U.S. possessions.
738
Unlike Section 861(a)(6), Section 862(a)(6) does not exclude United States possessions.
739
See PLR7305070980A.

Furthermore, in situations not covered by the Section863 manufacturing apportionment rules

and natural resources rules,740 the place-of-sale rule applies even if the inventory property was
produced rather than purchased.741 Thus, income from the sale of inventory property that is
produced entirely in the United States and sold in the United States is U.S. source income under
the principle of Section 861(a)(6). Similarly, income from the sale of inventory property that is
produced entirely in a foreign country or U.S. possession and sold in a foreign country or U.S.
possession is foreign source income under the principle of Section 862(a)(6).
740
Regs. Section 1.863-1(b); Regs. Section 1.863-3; PLR 8726061(inventory property
consisting of interests in extracted oil and gas is sourced by Regs. Section 1.863-1(b), not Section
861(a)(6)). See VII, D, 1, below.
741
See Rev. Rul. 75-254, 1975-1 C.B. 243; PLR 7904076; cf. Regs. Section 1.861-7(a).

a. General Rule -- Place of Sale

The source of income from the sale or other disposition of inventory property (including
tangible depreciable personal property to the extent the gain is taxed as inventory property under
Section 865(c)(2)) that is not subject to apportionment generally is determined by the place of
sale of the property under Section 861(a)(6).742 The applicable regulations provide that, in general
"a sale of personal property is consummated at the time when, and the place where, the rights,
title, and interest of the seller in the property are transferred to the buyer."743 The courts have
consistently held that this occurs where title, together with (or incorporating) certain indicia of
beneficial ownership pass to the purchaser.744 Hence, the source rule for income from the sale of
inventory property has come to be referred to as the "title-passage" rule.
742
The IRS has ruled that, where property was sold at the midpoint of the International Bridge
between Laredo, Texas and Mexico, the taxpayer had not established that the goods were sold in
Mexico. Rev. Rul. 75-310, 1975-2 C.B. 297. It appears that a sale of property being transported to
or from the United States could be considered to occur on the high seas, assuming title and risk of
loss passed there. However, Rev. Rul. 70-304, 1970-1 C.B. 163 (discussed at text accompanying
fn. 1269), involving goods pilfered on the high seas, suggests that the IRS may disagree. See also
the text accompanying fn. 1107.
743
Regs. Section 1.861-7(c). Somewhat analogous is Regs. Section 1.446-1(c)(1)(ii), which
provides that a manufacturer "may account for the sale of an item when the item is shipped, when
the item is delivered, when the item is accepted, or when title to that item passes to the purchaser"
(emphasis added). See Hallmark Cards, Inc. v. Comr., 90 T.C. 26 (1988): "Far from being a
ministerial act, the passage of title and risk of loss to the buyer constitutes the very heart of the
transaction and is the sine qua non to petitioner's right to receive payment."
744
See Compania General De Tobacos De Filipinas v. Collector,279 U.S. 306 (1929); U.S. v.
Balanovski, 236 F.2d 298 (2d Cir. 1956), cert. denied, 352 U.S. 968 (1957); Briskey Co. v. Comr.,

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 148

 29 B.T.A. 987 (1934), aff'd, 78 F.2d 816(3d Cir. 1935); East Coast Oil Co., S.A. v. Comr., 31
B.T.A. 558 (1934), aff'd, 85 F.2d, 322 (5th Cir. 1936), cert. denied, 299 U.S. 608 (1936); Piedras
Negras Broadcasting Co. v. Comr., 43 B.T.A. 297(1941), aff'd, 127 F.2d 260 (5th Cir. 1942);
Barber-Greene Americas, Inc. v. Comr., 35 T.C. 365, 384 (1960).

Historical Note: Since the 1920s, the courts have determined the place of sale according to
the title-passage test.745 After initially applying this test, the Treasury Department rejected it from
1930 to 1947 in favor of a "place of contract" concept.746 The courts, however, continued to apply
the title-passage test.747 In 1947, the title-passage rule was finally adopted in principle in Regs.
Section 1.861-7(c),748 with the concept of "where the substance of the sale occurred" retained in
instances of a tax avoidance purpose or a seller's retention of bare legal title. Although certain
administrative proposals in 1984 and 1985 would have sourced inventory under the seller-
residence rule,749 TRA 86 ultimately retained the title-passage rule with respect to inventory out
of concern that elimination of the rule would exacerbate the trade deficit by making goods
exported from the United States less competitive in price.750 Congress, however, directed the
Treasury Department to conduct a study of the source rules relating to sales of inventory
property.751
745
The Board of Tax Appeals applied the title passage test in several cases without reference to
the place of contract. Birkin v. Comr., 5 B.T.A. 402(1926); Yokohama Ki-Ito Kwaisha, Ltd. v.
Comr., 5 B.T.A. 1248 (1927); Tootal Broadhurst Lee Co. v. Comr., 9 B.T.A. 321 (1927); R.L. Dorn
Co. v. Comr., 12 B.T.A. 1102 (1928). The Treasury had similarly ruled in O.D. 1100, 5 C.B. 118
(1926); I.T. 1569, 1923-1 C.B. 126; I.T. 2068, 1924-2 C.B. 164; GCM 2467, 1928-2 C.B. 188. See
generally Galler, "Risk of Loss in Sourcing Profits from Sales of Personal Property," 17 Int'l Tax J.
77, 80-81 (1991); Galler, "An Historical and Policy Analysis of the Title Passage Rule in
International Sales of Personal Property," 52 U.Pitt. L. Rev. 521 (1991).
746
The IRS revoked its earlier rulings in GCM 8594, 1930-2 C.B. 354 which interpreted the
Supreme Court's Compania General opinion to apply a "place of contract" test.
747
See East Coast Oil Co. S.A. v. Comr., 31 B.T.A. 558 (1934), aff'd, 85 F.2d 322(5th Cir.
1936), cert. denied, 299 U.S. 608 (1936);Briskey Co. v. Comr., 29 B.T.A. 987 (1934), aff'd, 78 F.2d
816 (3d Cir.1935); Exolon Co. v. Comr., 45 B.T.A. 844 (1941); Ronrico Corp. v. Comr., 44 B.T.A.
1130 (1941); Elston Co. Ltd. v. Comr., 42 B.T.A. 208 (1940); Hazleton Corp. v. Comr., 36 B.T.A.
908, 923 (1937), nonacq., 1938-1 C.B. 50; Livingston v. Comr., 4 T.C.M. 943 (1945).
748
The IRS acquiesced in Ronrico (1944-1 C.B. 24), and in East Coast Oil and Exolon (1947-2
C.B. 85). In the same year as the latter acquiescences, the IRS revoked GCM 8594 (the "place of
contract" test) in GCM 25131, 1947-2 C.B. 85, which accepted the title passage rule as presently
stated in Regs. Section 1.861-7(c), subject to reservations regarding the retention of bare legal title
and tax avoidance. GCM 25131was declared obsolete in Rev. Rul. 69-45, 1969-1 C.B. 313.
749
Treasury Report on Tax Simplification and Reform -- General Explanation of Treasury
Department Proposals 345-46 (Dec. 3, 1984); The President's Tax Proposals to the Congress for
Fairness, Growth and Simplicity 402-03 (May 29, 1985).
750
S. Rep. No. 313, 99th Cong., 2d Sess. 329 (1986).
751
TRA 86, Section 1211(d).

(1) Title Passage

The tax law provides no statutory rule to identify the place where title to inventory property
passes. State law determines the passage of rights and interests between parties, while federal
law determines the effect of these rights and interests on income taxation.752
752
Kates Holding Co. v. Comr., 79 T.C. 700, 706-07 (1982);Philipp Brothers Inter-Continent
Corp. v. U.S., 66-1 USTC Para.9421 at 86,004 (S.D.N.Y. 1966); see Helvering v. Stuart, 317 U.S.
154 (1942); Lyeth v. Hoey,305 U.S. 188 (1938).

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 (a) General
The courts generally have found that title passes under the law of sales at the place where the
parties intend it to pass, either as expressly stated or as evidenced by their actions (e.g., the last
act required of seller); they have applied a similar standard for tax purposes (always or virtually
always in circumstances, however, in which the statement of intent, if any, was consistent with at
least certain rights or actions of the parties).753 It is important to bear in mind that passage of title
as generally used for purposes of the title-passage rule is not a subjective test, and does not mean
passage of legal title if all other significant indicia of ownership have passed.
(i) Subjective intent is not determinative of where title passes if inconsistent with other facts.
754
The courts generally look to objective evidence, such as written agreements or actions of
the parties.
(ii) Legal title will be disregarded for tax purposes if it is inconsistent with all other
significant indicia of ownership.755 Although both the IRS and taxpayers have from time to
time sought to broaden this exception under "tax avoidance" or "substance of the transaction"
rubric, these efforts have been virtually uniformly unsuccessful to date.756
(iii) Under Regs. Section1.861-7(c), if "bare legal title is retained by the seller, the sale is
deemed to have occurred at the time and place of passage to the buyer of beneficial
ownership and risk of loss."757 This rule, which is similar to Uniform Commercial Code
(UCC) Section 2-401(2), is perhaps best understood as a particular application of the general
rule described in paragraph (ii) above, designed to address shipments of goods as to which
title is retained until the goods are delivered to the buyer or shipping documents are
presented or assigned by the seller against the buyer's letter of credit. Article 9 of the UCC,
cross-referenced by UCC Section 2-401(1), provides that the retention of bare legal title
merely creates a security interest in the seller and that the buyer acquires title to the goods in
accordance with Article 2 of the UCC.758 Thus, the seller's retention of bare legal title to
secure a bona fide extension of credit does not prevent passage of title to the buyer.759 On the
other hand, despite the broad wording of Regs. Section 1.861-7(c), the courts generally do
not construe it as requiring that "beneficial ownership and risk of loss" be the general test for
title passage.
753
See, e.g., A.P. Green Export Co. v. U.S., 284 F.2d 383, 388 (Ct. Cl. 1960); Hazelton Corp. v.
Comr., 36 B.T.A. 908, 923 (1937), nonacq., 1938-1 C.B. 50.
754
See Miami Purchasing Service Corp. v. Comr., 76 T.C. 818, 830 (1981). In Liggett Group,
Inc. v. Comr., 58 T.C.M. 1167 (1990), the court based its determination as to when title passed on
testimony of both the taxpayer and certain of its principal customers that there was an unwritten
agreement ("understanding") concerning title passage; no significant facts were contrary, however.
Id. at 1170, 1172.
755
See, e.g., Regs. Section 1.861-7(c); Ronrico Corp. v. Comr., 44 B.T.A. 1130 (1941) (title
retention by seller disregarded where C.I.F. sales from Puerto Rico to United States and buyer
generally paid for the goods before they arrived); Otis Elevator Co. v. U.S., 356 F.2d 157 (Ct. Cl.
1980)(dicta); U.S. v. Balanovski, 236 F.2d 298, 306 (2d Cir. 1956), cert. denied, 352 U.S.
968(1957) (dicta); Kates Holding Co. v. Comr., 79 T.C. 700, 707 (1982) (dicta); cf. Amtorg
Trading Co. v. Higgins, 150 F.2d 536 (2d Cir.1945) (contract for purchase of Russian matches,
which stated that title passed in Leningrad or Hamburg, was disregarded when title was retained
by the seller after goods were shipped to East Coast warehouses).
756
See discussion in VII, B, 1, a, (2), below.
757
Regs. Section 1.861-7(c). The reference to the seller's retention of bare legal title first
appeared in 1947 in GCM 25131, 1947-2 C.B. 85, prior to adoption of the UCC. A similar rule had

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 been incorporated in the Uniform Sales Act, Section 20(2)(a). Cf. Norfolk & Western Railroad Co.
v. Sims, 191 U.S. 441, 447 (1903) (retention of possession until payment of the price "is a mere
method of collection").
758
To the same effect, the Comment under Section 9-202 states that Article 9 does not apply for
purposes other than determining rights in secured transactions.
759
In appropriate cases, the parties should recite that title is retained solely for Article 9
purposes.

UCC §2-401(1) and §2-401(2) are reproduced in the Worksheets, below.

A contractual recitation of where title passes generally will be determinative of the place of
sale for tax purposes, assuming legal title and at least some significant indicium of beneficial
ownership (e.g., risk of loss) coincide. For example, in A.P. Green Export Co. v. U.S.760 the Court
of Claims held that, since the contract expressly stated that the seller retained "title to [the] goods
and responsibility for their shipment and safe carriage," it was unnecessary to go on to examine
the shipping terms (which, in fact, conveyed a contrary presumption). Similarly, the IRS has
ruled that a written contract providing for title passage abroad and that the responsibility for
shipment and risk of loss would remain with the seller until the goods reached their destination
constituted a "clear expression of intent" that title pass abroad, even though the bill of lading
named the customer as consignee.761 Sample title passage and title retention contract language is
contained in the Worksheets, below.
760
284 F.2d 383, 388 (Ct. Cl. 1960).
761
Rev. Rul. 74-249, 1974-1 C.B. 189.

Where the parties' intent as to title passage and risk of loss or some other significant
commercial factor has not been explicitly expressed in the sale contract or shipping documents,
certain presumptions were developed under the law of sales762 to determine the unexpressed
intent of the parties as to where title passes. These presumptions look to factors such as the place
of performance, the place where risk of loss passes, shipping terms and other usage of trade, and
the place and terms of contract negotiation and acceptance and payment.763 Much of this law was
incorporated in the UCC, adopted in all states but Louisiana, and can be discussed within that
framework.
762
See, e.g., American Food Products Corp. v. Comr., 28 T.C. 14, 18 (1957).
763
See, e.g., East Coast Oil Co. S.A. v. Comr., 31 B.T.A. 558 (1934), aff'd, 85 F.2d 322(5th Cir.
1936), cert. denied, 299 U.S. 608 (1936).

As noted below, Article 2 of the UCC does not encompass all inventory property, but only
"goods."764 For example, the source of income from the sale of securities held by a securities
dealer for sale to its customers generally is determined under the title-passage rule without regard
to the UCC.765 In general, under the title-passage rule, the place of sale of exchange-traded
instruments is the place of the exchange (or any associated clearing system) the rules of which
govern the legal rights under the contract.766 The source is not affected by the fact that a linked
exchange may be involved.767 The place of sale of a nonexchange traded instrument is more
readily subject to manipulation.768 If, however, income of a nonresident (as defined in Section
865(g)) from a sale of securities (or other personal property)769 is attributable to a U.S. office or
other fixed place of business, it may be both sourced and taxed domestically.770
764
UCC Section 2-105(1).
765
Securities traded by a securities dealer for its own account, however, would not be
considered inventory and hence would be sourced under the general rule of residence of the

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 taxpayer (subject to Section 865(e)). Note also that gain attributable to a national principal
contract is sourced under Regs. Section 1.863-7. See XII, B, below.
766
See, e.g., Plambeck, "The Taxation Implications of Global Trading," Tax Notes, Aug. 27,
1990, 1143, 1151; Regs. Section 1.58-8(d), Ex. 9, T.D. 7564 (dealing with former minimum tax)
cf. Zander & Cia v. Comr., 42 B.T.A. 50 (1940) (same result but without applying title passage
rule) (see discussion in XIV, B, 15, below); Samuels & Brown, "Observations on the Taxation of
Global Securities Trading," 45 Tax L. Rev. 527, 554 (1990).
767
Rev. Rul. 87-43, 1987-1 C.B. 252 (income from futures and options executed using a facility
linking the Chicago Mercantile Exchange with the Singapore International Monetary Exchange
Limited).
768
See, e.g., Ardbern Co. v. Comr., 41 B.T.A. 910, 922 (1940), mod. on another issue, 120 F.2d
424 (4th Cir. 1941) (sale occurred in United States where share certificates endorsed and delivered
to agent for transfer to depository bank in Montreal for merely clerical delivery); Rev. Rul. 75-
263, 1975-2 C.B. 287 (source of gain from conversion of debenture dependent upon location of
office of exchange agent).
769
Various statutory provisions have since been enacted that treat futures contracts and other
derivative products as personal property. See Sections 1234, 1234A, and 1256(c). But cf. Rev. Rul.
74-223, 1974-1 C.B. 23 (futures contracts not offset by other positions are not includible in
inventory of commodities dealer); Rev. Rul. 74-227, 1974-1 C.B. 120 (futures contracts may not
be included in inventory of commodities dealer where not integral to cost of commodity, as
opposed to merely simultaneously acquired with commodity).
770
See Sections 865(e)(2), 864(c)(4)(C)(iii). If the direct sale activities are conducted by the
U.S. branch, it does not appear that a foreign branch could be considered to "materially
participate" in the sale under Regs. Section 1.864-6(b)(3)for purposes of the Section 865(e)(2)(B)
exception. See Samuels & Brown, above, 45 Tax L. Rev. at 556-57 n.145.

(b) Uniform Commercial Code

When the title concept was originally adopted to analyze the source of gains from sales of
personal property, the location of title to goods as between seller and buyer could give rise to
various legal consequences, such as risk of loss, a seller's right to the purchase price, a buyer's
right to the goods, and rights of third parties (e.g., creditors or trustees in bankruptcy).771 Business
persons, however, often did not think in terms of title and, therefore, frequently failed to express
their intentions regarding title passage, giving rise to legal presumptions to fill these gaps and
consequent litigation.772
771
Whiteside, "Uniform Commercial Code -- Major Changes in Sales Law," 49 Ky. L.J. 165,
173 (1960). Accord A.P. Green at 387; East Coast Oil Co., S.A. v. Comr., 31 B.T.A. 558, 561
(1934), aff'd, 85 F.2d 322, cert. denied, 299 U.S. 608 (1936).
772
See Whiteside, 49 Ky. L.J. at 172-75.

The UCC, adopted in 1953, recodified the Uniform Sales Act.773 The most prominent
innovation of the recodification of the law of sales in Article 2 was the abandonment of the title
(property) approach in favor of considering the various factual situations in which rights and
obligations arise, and prescribing specific legal consequences for those situations.774 For example,
the UCC includes provisions regarding risk of loss, a seller's right of action for the price, and a
buyer's right to obtain the goods, all without reference to title. The UCC's title rule, UCC Section
2-401, which restates pre-UCC principles,775 applies only to residual factual situations and
generally would appear to be of little commercial significance, per se.776 Absent contrary
agreement, however, the determination of title passage under this rule is based on significant
commercial rights (such as the point at which the seller is considered to have performed). 777
Therefore, title as so determined remains the primary reference for determining the place of sale

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for tax purposes. This is illustrated by the analytical approach taken in certain post-UCC cases. 778
773
As noted above, the UCC has been adopted in all states other than Louisiana. The UCC
provisions that are discussed in this section are reproduced in the Worksheets, below.
774
G. Gilmore & C. Black, Law of Admiralty Section 3-8 (2d ed.).
775
See Galler, 17 Int'l Tax J. at 86.
776
See Kates Holding Co., 79 T.C. at 707.
777
There is virtually no guidance on when title is considered to pass for tax purposes (including
under pre-UCC law) if, e.g., the agreement provided that title passed at one point but risk of loss
and delivery by seller occurred at another.
778
See Miami Purchasing Service Corp. v. Comr., 76 T.C. 818, 826-30 (1981); Liggett Group,
Inc. v. Comr., 58 T.C.M. 1167 (1990). In Kates Holding Co., the court stated that "[t]he concept of
title, as used in article 2 [of the UCC], is no more than `bare legal title' such as is referred to in
Regs. Section 1.861-7(c)." 79 T.C. at 707. The court placed greatest reliance on risk of loss, but
concluded that title and risk of loss passed together.

Article 2 of the UCC is limited to sales of "goods," defined as anything movable when
identified to the contract of sale, but excluding, e.g., growing crops and securities.779 This term,
therefore, while generally broader than the tax term "inventory property" (as defined in Section
865(i)(1)), does not encompass all inventory property (e.g., securities held by a securities dealer).
780

779
UCC Section 2-105(1).
780
See discussion in VII, B, 1, a, (1), (A), above.

UCC Section 2-401 provides that title to goods passes as explicitly agreed by the parties.
Unless otherwise agreed:
(i) Title generally passes at the time and place the seller completes its performance with
reference to the physical delivery of goods,781 which may be at the point of shipment782 or
destination.783 For example, if goods have been purchased in the United States, placed in
transit, fully insured against loss, and the only remaining act of the seller consists of the
presentation of shipping documents against an irrevocable letter of credit, title passes in the
United States.784
(ii) If delivery is made without moving goods, title generally passes, when and where any
documents required to be delivered are delivered and, if no such delivery is required, at the
time and place of contract (provided the goods are identified).785 This accords with certain
pre-UCC case law holding that a sale subject to approval at the home office occurred at the
place of such office.786
(iii) Title to unidentified goods passes not earlier than when the goods are identified787 which,
in the case of a sale of future goods (other than crops or unborn young), is when the goods
are shipped or designated by the seller (and, in the case of existing goods, is when the
contract is made).788
(iv) Title to goods delivered to the buyer with an option to return the goods (e.g., subject to
inspection or on approval) passes upon delivery of the goods to the buyer, but revests in the
seller upon the buyer's return of the goods within the contract term or a reasonable period
after delivery.789
781
UCC Section 2-401(2); U.S. v. Balanovski, 236 F.2d 298, 304-305 (2d Cir. 1956): "By the
overwhelming weight of authority, goods are deemed `sold,' when the seller performs the last act

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 demanded of him to transfer ownership, and title passes to the buyer." Accord Hazleton Corp. v.
Comr., 36 B.T.A. 908, 923 (1937), nonacq., 1938-1 C.B. 50; Ardbern Co. v. Comr., 41 B.T.A. 910,
922 (1940), mod. on another issue, 120 F.2d 424(4th Cir. 1941) (sale occurred in United States
where share certificates endorsed and delivered to agent for transfer to depository bank in
Montreal for merely clerical delivery); East Coast Oil Co., S.A. v. Comr., 31 B.T.A. 558 (1934),
aff'd, 85 F.2d 322 (5th Cir.), cert. denied, 299 U.S. 608 (1936).
782
See UCC Section 2-504; Liggett, T.C. Memo 1990-18.
783
See UCC Section 2-503. Note that, under the UCC, in cases in which delivery is required to
be made to the place of shipment, risk of loss passes when the goods are delivered to the shipper.
UCC Section 2-509 (1)(a). In destination contracts, risk of loss shifts when the goods are tendered
to the buyer while still in the carrier's possession. UCC Section 2-509(1)(b).
784
U.S. v. Balanovski, 236 F.2d 298 (2d Cir. 1956); American Food Products Corp. v. Comr., 28
T.C. 14 (1957).
785
Section 2-401(3).
786
See Compania General de Tobacos de Filipinas v. Collector,279 U.S. 306, 308 (1929)
(Spanish corporation, which maintained its principal office and did most of its business in the
Philippines, sold goods in United States through agents of its Philippine branch; Supreme Court
held that title passed in the Philippines, since sales were "subject to confirmation and absolute
control as to price and other terms and conditions" by taxpayer's Philippine office and
confirmation represented "the final acts . . . making effective the sales").
787
UCC Section 2-401(1).
788
UCC Section 2-501(1), providing that a buyer obtains an insurable interest in goods upon
their identification as goods to which the contract refers. For example, a contract for Indian hides
was held to pass title in India at such time as the hides were, with the buyer's consent, selected
there by the seller and delivered for shipment. Briskey Co. v. Comr., 29 B.T.A. 987 (1934), aff'd,
78 F.2d 816(3d Cir. 1935); cf. Burk Bros. v. Comr., 20 B.T.A. 657 (1930) (skins purchased in India
as raw materials for finishing in the United States resulted in U.S. source income); Exolon Co., 45
B.T.A. 844 (1941) (orders were accepted by a domestic company in the United States, with
payment made in the United States, for goods thereafter manufactured to order at, and shipped
F.O.B. from, the company's Canadian plant to U.S. and foreign customers; title passed in Canada
where the goods were ascertained and sold).
789
See UCC Section 2-401(4) (a justified or unjustified revocation of acceptance by buyer
"revests" title to goods in seller, by operation of law; East Coast Co., S.A. v. Comr., 31 B.T.A
558(1934), aff'd, 85 F.2d 322, 323 (5th Cir. 1936), cert. denied, 299 U.S. 608 (1936) (title passed
in Mexico under F.O.B. and C.I.F. oil shipments from Tampico, Mexico, even though the buyer
had a right to inspection before acceptance at the U.S. destination port); Uniform Sales Act
Section 19, Rule 3.

In cases in which goods are required to be delivered, standard trade usage with respect to
terms of cost and shipping indicates where final performance by the seller occurs (assuming no
contrary statement in the contract). Thus these terms are relevant for purposes of UCC Section 2-
401 (and, in fact, are defined in the UCC). Even if UCC Section 2-401 is not applicable, these
terms give rise to presumptions concerning title passage.790 These terms include the following:
F.O.B. (free on board) place of shipment: The seller bears the expense and risk only of
putting the goods into the hands of the carrier and making a contract for their transportation,
arranging for and delivery documentation, and notifying the buyer in the manner provided in
UCC Section 2-504.791 If the term is F.O.B. vessel, car, or other vehicle, the seller must, in
addition, at its own expense and risk load the goods on board.792 Risk of loss passes when the
goods are delivered to the carrier or placed on board a carrier, as the case may be, for
shipment to the buyer.793
F.O.B. place of destination: The seller bears the expense and risk of transporting the goods to

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 the destination, and must tender delivery of the goods to the buyer at the destination in the
manner provided in UCC Section 2-503.794 Risk of loss passes when the goods reach the
destination and are there duly tendered while still in the possession of the carrier. 795
F.A.S. (free alongside ship): Same as F.O.B. place of shipment, except that risk of loss passes
when the goods are placed alongside the vessel or on a designated dock for loading onto a
vessel.796
C.I.F. (cost, insurance & freight): The quoted price includes the costs of goods, loading,
insurance, and ocean freight to the designated destination.797 Risk of loss generally passes
when the seller puts the goods into the possession of the carrier at the place of shipment.798
C. & F. (cost and freight): Same as C.I.F., except that the seller does not assume
responsibility for insuring the goods.799
790
See Miami Purchasing Service Corp., 76 T.C. at 828; cf. 4 S. Williston, Contracts, Section
612 (3d ed. 1961) (presumption for commercial purposes). See generally Surrey & Warren, "The
Income Tax Project of the American Law Institute: Gross Income, Deductions, Accounting, Gains
and Losses, Cancellation of Indebtedness," 66 Harv. L. Rev. 761 (1953).
791
UCC Section 2-319(1). See generally Amtorg Trading Corp. v. Higgins, 150 F.2d 536 (2d
Cir. 1945); U.S. v. Balanovski, 236 F.2d 298, 305 (2d Cir. 1956); Miami Purchasing Service Corp.
v. Comr., 76 T.C. 818(1981);Topps of Canada, Ltd. v. Comr., 36 T.C. 326, 334 (1961).
792
UCC Section 2-319(1)(c).
793
UCC Section 2-509(1)(a).
794
UCC Section 2-319(1)(b).
795
UCC Section 2-509(1)(b).
796
UCC Section 2-319(2).
797
UCC Section 2-320. See generally Ronrico Corp. v. Comr., 44 B.T.A. 1130, 1134 (1941)
(delivery of Puerto Rican rum C.I.F. U.S. ports resulted in foreign source income); East Coast Oil
Co., S.A. v. Comr., 31 B.T.A. 558 (1934), aff'd, 85 F.2d 322(5th Cir. 1936), cert. denied, 299 U.S.
608 (1936) (Mexican oil delivered C.I.F. U.S. ports from Mexico by common carrier; held title
passed in Mexico under C.I.F. presumption).
798
UCC Section 2-509(1)(a). But see, e.g., A.P. Green Export Co. v. U.S., 284 F.2d 383, 388
(Ct. Cl. 1960) (C.I.F. presumption overcome by contrary contract language).
799
UCC Section 2-320(3). See generally Kates Holding Co. v. Comr., 79 T.C. at 708-9 (1982).

Certain cases have applied these terms in the context of an analysis of title passage under the
UCC. In Miami Purchasing Service Corp. v. Comr.,800 sales invoices of the taxpayer (which
sought to qualify as a Western Hemisphere trade corporation) generally bore an "F.O.B. Miami"
term. The court, which was not presented with any other written evidence of the transactions,
held that the taxpayers were bound by the consequences of such terms, which had commercial
significance. Therefore, it concluded, risk of loss, and title passed in the United States without
regard to whether a contrary intent of the taxpayer could be shown.
800
76 T.C. 818 (1981).

In Kates Holding Co. v. Comr.,801 the taxpayer (which sought to qualify as a Western
Hemisphere trade corporation) shipped steel from Philadelphia to Brazil under invoices that bore
a C. & F. term next to the quoted price (which equaled the cost of steel and freight). The court,
looking to the UCC for the applicable law, held that the income was from domestic sources
since, under the UCC, title and, most importantly, risk of loss passed to the purchaser when the
seller joint venturer delivered the steel to the shipmaster within the United States and received a
bill of lading and receipt for prepaid freight. The taxpayer was unable to adduce evidence that its

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performance under the contract had not been completed within the United States in accordance
with the presumption created by the C. & F. term. The court's opinion suggests the result might
have been different if, e.g., the freight had not been prepaid.
801
79 T.C. 700 (1982).

In Liggett Group, Inc. v. Comr.,802 the Tax Court applied the title rule of UCC Section 2-401
to treat scotch sold on an F.O.B. United Kingdom basis as sold abroad, since final delivery was
made at the place of shipment in the United Kingdom. This case is discussed in further detail in
VII, B, 1, a, (2), below. Sample title passage and title retention contract language is contained in
the Worksheets, below.
802
58 T.C.M. 1167 (1990). See the text below accompanying fns. 843-46.

(c) Convention on the International Sale of Goods

On January 1, 1988, the United Nations Convention on the International Sale of Goods
(CISG) was ratified by the United States and, in matters within its scope, became international
trade law for U.S. persons in dealings with resident of other ratifying parties.803 (The CISG is
reproduced in the Worksheets, below.) Prior to the CISG there was no unified law of
transnational trade to govern situations in which the parties had not set forth certain rights and
responsibilities clearly. In ratifying countries, the CISG fills this void.804
803
See generally J. Honnold, "Uniform Law for International Sales under the 1980 United
Nations Convention" (Kluwer) (1982); 2 Laws of International Trade, ch. 701, "The U.N.
Convention on Contracts for the International Sale of Goods" (Business Laws 1992); Griffin &
Calabrese, "The New Rules for International Contracts," ABA Journal, March 1, 1988, 62;
Honnold, "The Sales Convention in Action -- Uniform International Words: Uniform
Application?", 8 J. L. & Com. 207 (1988); Kastely, "Unification and Community: A Rhetorical
Analysis of the United Nations Sales Convention," 8 Nw. J. Int'l L. & Bus. 623 (1988); Sampson,
"The Title-Passage Rule: Applicable Law under the CISG," 16 Int'l Tax J. 137 (1990); Zwart, "The
New International Law of Sales: A Marriage Between Socialist, Third World, Common and Civil
Law Principles," 13 N.C.J. Int'l L. & Com. Reg. 109 (Winter 1988).
804
Besides the United States, other ratifying (or accepting, acceding, or approving) countries
include, e.g., Argentina, Australia, Austria, Bulgaria, Belarus, Canada, Chile, China,
Czechoslovakia, Denmark, Ecuador, Egypt, Finland, France, Germany, Guinea, Hungary, Iraq,
Italy, Lesotho, Mexico, The Netherlands, Norway, Romania, Spain, Sweden, Switzerland, Syrian
Arab Republic, Uganda, Ukraine, Yugoslavia, and Zambia.

The CISG applies to contracts of sale of property between parties whose places of business
are in different contracting nations.805 While it generally also applies to contracts of sale when
private international law leads to the application of the law of a contracting nation, 806 the United
States, in ratifying the CISG, excluded the operation of this article (apparently because of likely
conflict-of-law issues). Therefore, unless the parties agree otherwise, the CISG will not apply to
contracts between a party whose place of business is in the United States and a party whose place
of business is in a noncontracting nation.807 The CISG governs sales of all "goods," except those
specifically excepted.808
805
CISG, Art. 1(1). If a party has more than one place of business, the relevant place of
business is that which has the closest relationship to the contract. CISG, Art. 10(a).
806
Id.
807
2 Laws of International Trade, above, fn. 803, at 701.009-701.012; Gabor, "Step-child of the
New Lex Mercatoria: Private International Law from the United States Perspective," 8 Nw. J. Int'l
L. & Bus. 538, 539 (1988). See also Note, "Contracts for the International Sale of Goods:

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 Applicability of the United Nations Convention," 69 Iowa L. Rev. 209 (1983).
808
CISG, Art. 2. As indicated by the express exceptions (e.g., stock and securities are excepted),
"goods" for this purpose is a broader term than goods under the UCC. In the case of "mixed
goods-services contracts," the CISG does not apply if "the predominant part" of the obligations of
the seller is to furnish services rather than goods. CISG, Art. 3(2). The commentary to Article 3(2)
suggests that, under applicable national law, the goods portion of a contract might be severable
and governed by the CISG. This could be relevant to, e.g., a contract to construct a power plant.
See 2 Laws of International Trade, above, fn. 803, at 701.013. It is not clear whether the CISG
applies to sales of software. See id.; Gupta, Eimert & Ross, "New Rules for International Sales of
Computer Hardware and Software," 5 Computer Law. 22 (Aug. 1988).

The law of all states of the United States is the CISG where applicable, not the UCC. Treaties
override conflicting state laws, even if the matter would otherwise be a power reserved to the
states. Therefore, if parties subject to the CISG simply specify the law of a given state or country
to govern the agreement, the CISG, rather than the UCC, generally is invoked.
The CISG permits parties to choose not to be bound by its terms. However, departure from
the CISG must be express, not implied. Therefore, choice of the UCC can be made only by
specifically excluding the CISG.809
809
E.g., "This contract is governed by the UCC of the State of ____________, and not by the
CISG." See, e.g., 2 Laws of International Trade, above, fn. 803, at 701.069.

The CISG does not determine the passage of title to property sold. Title is governed under the
CISG by the domestic law selected by the parties. If none has been selected, conflict of law rules
decide the relevant domestic law.
Determination of title transfer is facilitated by use of trade terms (delivery terms), even if the
governing commercial law is unclear. Trade terms in the contract, such as F.O.B. and C.I.F., are
given effect in priority to the CISG's risk-of-loss provisions.810 The CISG does not define trade
terms, however. The CISG's commentary specifically refers to the use of Incoterms.811
810
See CISG, Art. 6, 8(3), and 9; comment to former CISG Act 78 (current Art. 67). The CISG
provides that, when carriage is involved, risk of loss passes on delivery to the first carrier. CISG,
Art. 67. This rule, like Article 509 of the UCC, focuses on possession rather than title. See 2 Laws
of International Trade, above, fn. 803, at 701.062.
811
See note to comment to former CISG Art. 78 (current Art. 67).

"Incoterms" are a standard set of trade terms published since 1936 by the International
Chamber of Commerce. In addition to standard trade terms, such as F.O.B. and C.I.F., they
include, e.g., terms for shipment by truck, railroad, airplane, and terms used in connection with
container shipments.812 These terms presumably are considered standard usage for transnational
sales governed by the CISG and, to the extent they overlap with UCC terms, the CISG
definitions may apply. In sales covered by the CISG, one cannot assume that the UCC meanings
and implied title-passage rules of those terms apply.
812
See Sampson, above, fn. 803, Int'l Tax J. at 144-48; Jan Ramberg, International Chamber of
Commerce, Guide to Incoterms 1990 (1991).

Buyers and sellers are advised to specify what law governs, as well as delivery, risk-of-loss,
and title-passage terms, to avoid unwanted tax consequences. In particular, in order to be assured
of foreign source sales income, U.S. exporters should specifically provide that title and risk of
loss passes at the destination and that the seller bears the responsibility for shipment until

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delivery to the buyer at the destination.813 Sample title passage and title retention contract
language is contained in the Worksheets, below.
813
This would bring the seller within the safe harbor of Rev. Rul. 74-249, 1974-1 C.B. 189. See
FSA 200052002, in which the Chief Counsel's Office advised that sales occurred outside the
United States because customers specifically did not assume risk of loss until the goods reached
the port of entry in the foreign country; therefore, even if the delay in title passage until payment
of the invoice attached to the goods were disregarded as a mere security interest, beneficial
ownership and risk of loss passed outside the United States.

(2) Tax Avoidance Purpose/Substance of the Transaction

As noted previously, state law determines the passage of rights and interests, and federal law
determines the effect of these rights and interests on federal taxation.814 On this basis, the IRS
takes the position that tax law and the UCC differ in certain respects in determining where a sale
takes place: "We believe UCC concepts should not be applied rigorously in determining where a
sale takes place for tax purposes."815
814
See fn. 752 above.
815
A.O.D., Liggett Group, Inc., CC-1991-03 (Feb. 11, 1991).

Regulations have long provided that the title-passage rule does not apply
in any case in which the sales transaction is arranged in a particular manner for the primary
purpose of tax avoidance. In such cases, all factors of the transaction, such as negotiations,
the execution of the agreement, the location of the property, and the place of payment, will be
considered, and the sale will be treated as having been consummated at the place where the
substance of the sale occurred.816 The courts, however, have repeatedly held that the title-
passage rule may be used with deliberate tax avoidance purpose in the absence of a sham
transaction. The cases discussed below suggest that, if there is any commercial purpose (e.g.,
transfer of risk of loss) underlying an express declaration that title pass within or without the
United States, the title-passage rule will govern.
816
Regs. Section 1.861-7(c). In adopting this language, Treasury may have been influenced by
Kaspare Cohn, Inc. v. Comr., 35 B.T.A. 646 (1937) (Canadian corporation formed for the sole
purpose of effecting sale of U.S. subsidiaries outside the United States). (This decision is
discussed in Barber-Greene Americas, Inc. v. Comr., 35 T.C. 365, 389 (1960).) The regulation,
however, goes far beyond that case, which disregarded an obvious sham corporation without
applying the title passage rule.

In U.S. v. Balanovski,817 the court applied the title- passage rule to characterize as from U.S.
sources sales income from partnership activities occurring almost entirely in the United States.
Speaking of the rule's tax avoidance potential in other contexts, the court added:818
Of course this test may present problems, as where passage of title is formally delayed to
avoid taxes. Hence it is not necessary, nor is it desirable, to require rigid adherence in all
circumstances. But the rule does provide for a certainty and ease of application desirable
international trade. Where as here, it appears to accord with economic realities (since these
profits flowed from transactions engineered in major part with the United States), we see no
reason to depart from it.
817
236 F.2d 298 (2d Cir. 1956).
818
Id. at 306-307 (footnotes omitted). Accord Comr. v. Pfaudler Inter-American Corp., 330 F.2d

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 471, 474 (2d Cir. 1964).

The government seized upon this language to subsequently argue in a number of cases that a
corporation which delayed passage of title in order to obtain the Western Hemisphere trade
corporation (WHTC) deduction should be considered to have passed title in the United States, at
least if the corporation had made no economic penetration (offices, agents, etc.) in the foreign
country of intended title passage. Each of these cases involved a domestic exporter which
organized a domestic subsidiary for the sole purpose of purchasing goods manufactured by the
parent, and then reselling the goods to purchasers in the Western Hemisphere. The sales
documents explicitly stated that title to the goods passed from the seller to the buyer outside the
United States. The government argued, first, that tax avoidance purposes in passing title abroad
should prevent reliance on the title-passage rule, and second, that the title-passage rule should be
construed consistently with the "substance of the transaction."
The government was a consistent loser in this endeavor. For example, inBarber-Greene
Americas, Inc. v. Comr.,819 the court viewed the tax-inspired arrangements as within the
contemplation of Congress, since the WHTC was created specifically to provide tax benefits to
domestic corporations engaged in foreign trade. As to the government's "substance-of-the-
transaction" argument, the court concluded that both beneficial ownership and legal title passed
at the foreign port, reasoning that, in retaining ownership, the seller undertook real
responsibilities, risks, and obligations that would not have been assumed had title passed in the
United States.820
The petitioners assumed the risk of delays in transit or loss or damage en route, the
responsibility of engaging freight forwarders and of arranging many other details. They could
and did protect themselves to some extent by insurance against losses in transit, but if the
insurer would not or could not pay, the loss would be that of the petitioners. It is their right to
elect whether to avoid these risks or to undertake these risks and qualify for the tax benefits
offered by Congress. Other commercial motives for delaying title passage "might include
control over goods while in transit, rights and remedies in the event the purchase fails to pay
or becomes insolvent, and protection against losses caused by a trade embargo, seizure, or
nationalization by a foreign government, or strike."821 In addition, retaining title permits the
shipper to insure goods with a U.S. insurance carrier, enabling it to recover directly in U.S.
currency.822
819
35 T.C. 365, 386-87 (1960).
820
Id. at 388.
821
Galler, 17 Int'l Tax J. at 89 (citations omitted).
822
Id.

It might be argued "that risk of loss is limited by readily available insurance, and that the
buyer ultimately bears the cost of insurance, either by purchasing coverage directly, or by paying
a price that reflects the cost of insurance purchased by the seller." However, "the loss event may
be excluded from the policy, the amount of insurance coverage may be inadequate, or the seller
may inadvertently fail to satisfy the terms of the policy."823
823
Id.

In A.P. Green Export Co. v. U.S.,824 the Court of Claims addressed facts similar to those in
Barber-Greene Americas and held a tax avoidance intent immaterial for source of income

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purposes, provided there was also at least some commercial purpose to be served by the intended
passage of title. The court rejected a "substance of the contract" approach, since such an
approach would not provide taxpayers with an adequate degree of certainty. The court was
content that the parties' clear statement that the seller was retaining "[t]itle to the goods and
responsibility for their shipment and safe carriage" until delivery in the foreign country overrode
the contrary implications of the C.I.F. term.
824
284 F.2d 383, 388 (Ct. Cl. 1960).

The IRS, which lost several other cases involving similar facts,825 acquiesced in these cases in
1964.826 Nevertheless, for some time following its initial acquiescence, the IRS attempted to
establish a substance-of-the-transaction principle. A 1971 GCM observes:827
It is still the litigating position of the Service that the substance-of-the-sale test may be
applicable in certain cases where a foreign subsidiary acts as the export arm of a domestic
parent corporation, purchasing products from the parent in the United States and reselling
them to foreign customers with title passing in the foreign country. This office has taken the
position that:
825
Comr. v. Hammond Organ Western Export Corp., 327 F.2d 964 (7th Cir. 1964); Frank v.
International Canadian Corp., 308 F.2d 520 (9th Cir. 1962); Baldwin-Lima-Hamilton Corp. v.
U.S., 69-1 USTC Para.9269 (N.D. Ill. 1967); Pan American Eutectic Welding Co. v. Comr., 36 T.C.
284 (1961); Babson Bros. Export Co., T.C. Memo 1963-144.
826
Rev. Rul. 64-198, 1964-2 C.B. 189. Accord Rev. Rul. 74-249, 1974-1 C.B. 189; TAM
8210018(involving a DISC); GCM 38805(underlying TAM 8210018).
827
GCM 34464(March 25, 1971).

- where there is not significant economic penetration into the foreign market areas by the
export subsidiary,
- the significant acts in making and completing the sales have occurred in the United States
and
- no business purpose can be shown in passing title outside the United States,
the substance-of-the-sale test can be applied . . . . The GCM went on to note that the IRS
found no suitable case for testing this position in litigation.828
828
Although several cases were docketed, after further development of the facts in each of these
cases, it was discovered that there was economic penetration of the foreign country by the foreign
export company and that there was support for the finding that the sales income had its source in a
foreign country under the substance-of-the-sale as well as the title-passage test. Id.

Twenty years following A.P. Green Export, the Court of Claims in Otis Elevator Co. v.
Comr.,829 restated what it viewed as the test enunciated by that case for determining whether the
place of sale would be respected for tax purposes:
(i) title must in fact pass at the location in question; and
(ii) the passing of title must not be a sham and/or must have a commercial purpose (e.g.,
shifting risk of loss) other than tax avoidance. The court found that, in the case before it, the
risk of loss did not shift until title was actually passed, and that, therefore, the requirement of
passage of title was not a sham.830 The court had no problem in further concluding that the

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 desire to shift the risk of loss from one corporation to another and to have a sale occur only if
the goods in fact arrive at the point of delivery served a commercial purpose.831
829
356 F.2d 157 (Ct. Cl. 1980).
830
Accord Comr. v. Pfaudler Inter-American Corp., 330 F.2d 471 (2d Cir. 1964).
831
Curiously, the court expressed confusion concerning whether absence of a "sham"
transaction and presence of a commercial purpose were intended by the A.P. Green Export court to
express separate requirements. It seems reasonably clear, including from the wording of the test in
the earlier case, that one is the "flip side" of the other, so that a commercial purpose and a sham
transaction are mutually inconsistent notions.

Certain taxpayers that faced disallowance of WHTC status as a result of passing title to goods
in the United States have asserted that the substance of the transaction should govern.832 These
taxpayers met no more success than had the IRS.
832
See Kates Holding Co. 79 T.C. 700(1982); Miami Purchasing Service Corp., Perry Group,
Inc. v. U.S., 80-2 USTC Para.9603 (D.N.J. 1980), aff'd without opinion (3d Cir. 1981).

In appropriate circumstances, however, a court may apply substance-of-the-transaction

concepts to override the place of legal passage of title.833 Cases involving bare legal title would
be the clearest example.834 In Philipp Brothers Inter-Continent Corporation v. U.S.,835 the court
held that, for purposes of the Korean excess profits tax, the taxpayer had not shown that at least
95% of its gross income was from foreign sources even though the goods were located abroad at
the time title passed. The court separately analyzed the case under the title-passage test and came
to the same conclusion, finding that the "parties cannot by their intent determine that the place
where title is to pass shall be some place other than that where the act occurs which causes title
to pass."836 The court stated that the "true [title passage] rule is that the place where title passes is
the place where the seller performs the act which causes title to pass."837
833
See e.g., U.S. v. Balanovski, 236 F.2d 298 (2d Cir. 1956)(dicta).
834
See discussion above in B, 1, a, (1), (A).
835
66-1 USTC Para.9421 (S.D.N.Y. 1966).
836
Id. at 86,001.
837
Id. at 85,999.

In AMP, Inc. v. U.S.,838 the court held that the domestic taxpayer's transfer of a foreign patent
to a foreign licensee resulted in foreign source income, despite the acceptance of the contract in
the United States.839 The court's holding was based primarily on the lack of any economic
connection between the transferred intangible property and the place of sale, since rights under a
foreign patent only had meaning in the foreign country. Therefore, this decision probably is not
significant for other kinds of personal property.840
838
492 F. Supp. 27 (M.D. Pa. 1979) (for purposes of foreign tax credit limitation).
839
For years after TRA 86, this income would be sourced under Section 865.
840
See, e.g., Perry Group, Inc. 80-2 USTC at 84,972 (passage of title test applied over
taxpayer's objection that, under AMP, substance of transaction should govern).

An example in regulations under former Section 58,841 which dealt with a former version of
the minimum tax, posits a tax avoidance purpose and absence of any commercial purpose. The
example involves two U.S. residents who negotiate and agree on a contract in the United States
for the sale of stock of a close corporation by one to the other. They travel to a foreign country in
order to close the sale abroad for the purpose of avoiding tax. Predictably, the gain was
attributable to U.S. sources under Regs. Sections 1.58-8(b) and1.861-7(c).842 (Of course, title

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passage is not relevant for stock sales, other than for dealers and as provided in Section 865(f),
for post-TRA 86 years.)
841
Regs. Section 1.58-8(d), Ex. 10, T.D. 7564 (September 11, 1978).
842
Cf. TAM8334003(taxpayer could not avoid having an investment in U.S. property under
Section 956 by reason of its time charter of a drilling vessel on the U.S. continental shelf simply
by moving the vessel off the shelf for a few hours at the end of the year). The pre-TRA 86 case
law under Section 861(a)(6), however, was applied much more leniently than this regulation
would suggest. See, e.g., Hazleton Corp. v. Comr., 36 B.T.A. 908, 923-24 (1937), nonacq., 1938-1
C.B. 50. See authorities in fn. 574 above.

A relatively recent title-passage case indicates that the IRS will continue to assert substance-
of-the-transaction and tax-avoidance arguments. In Liggett Group, Inc. v. Comr.,843 the Tax Court
held that a domestic corporation which acquired title to goods abroad and disposed of them
abroad to a U.S. purchaser transferred "rights, title, and interest" to those goods abroad,
producing foreign source income, even though it held title only momentarily and even though it
had no significant contracts abroad. The taxpayer was the exclusive and sole representative in the
United States of the manufacturer of J & B Scotch whiskey ("J & B"). In the case of most of the
sales before the court (so-called "Direct Import sales"), the taxpayer, upon receipt of a purchase
order from its customer, issued its own written purchase order to the manufacturer, containing
the same information as in the customer's order and directing the manufacturer to send the goods
directly to the taxpayer's customer on a vessel of the carrier designated by the customer.
Immediately after delivering the goods to the shipper, the manufacturer forwarded the documents
to the taxpayer, which endorsed the bill of lading to its customers, prepared additional documents
as necessary, and forwarded all relevant documents to the customer. The customer took delivery
of the goods from the taxpayer F.O.B. British Isles (which term was pursuant to an unwritten
understanding between the customer and the taxpayer). The IRS conceded that these sales were
not arranged by the taxpayer for a tax avoidance purpose, but based its argument that the sales
nevertheless gave rise to U.S.-source income on the fact that the taxpayer had no significant
contacts abroad (an argument reminiscent of its earlier substance-of-the-transaction arguments).
The court held that the sale of good to the taxpayer's U.S. customers took place abroad.844
843
58 T.C.M. 1167 (1990).
844
The court cited in support Epic Metals Corp. v. Comr., T.C. Memo 1984-322, which held that
momentary title to goods was sufficient to require their inclusion in inventory.

The Chief Counsel's Office issued an AOD with respect to Liggett in which it recommended
nonacquiescence in the decision.845 Although the court had not found tax avoidance to be an issue
in Liggett, the IRS apparently now disagrees:846
We believe sales involving United States buyers and sellers, where the economic activities
surrounding the sales take place in the United States, and where the seller holds purported
title to goods outside the United States only momentarily, are most likely arranged for tax
avoidance purposes. For example, "flash title" sales that in substance take place in the United
States bear little or no foreign tax, yet purportedly generate foreign source income, enabling
taxpayers to use excess foreign tax credits to reduce United States taxes. In addition, we
question whether a seller effectively transfers "the rights, title, and interest" in the goods
outside the United States, within the meaning of Treasury regulation 1.861-7(c), where both
parties to the sale and activities surrounding the sale have a United States situs.
845
A.O.D. CC-1991-03 (February 11, 1991).

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 846
Id.

The position articulated by the IRS hearkens back to the litigating position taken in the
WHTC cases. In Liggett, of course, there was substantially less substance to the foreign passage
of title, inasmuch as the taxpayer had ownership risks and responsibilities only momentarily. 847
By the same token, however, by passing title immediately, the taxpayer avoided ownership
responsibilities and risks. Consequently, the title passage had commercial significance and was
properly respected.848 The real question would seem to be whether the government will pursue a
legislative change to the title-passage rule, at least for certain fact situations.
847
UCC Section 2-401(1).
848
See Compania General de Tobacos de Filipinas v. Collector,279 U.S. 306, 308 (1929)
(Spanish corporation).

b. Exception for Sale by Nonresident Through U.S. Office or Other Fixed Place of Business
Under Section865(e)(2), the title-passage rule for inventory property does not apply to
certain sales of such property by a "nonresident" (as defined in Section 865(g)(1)(B)) that are
attributable to a U.S. office or other fixed place of business unless the property is sold for use,
consumption, or disposition abroad and a foreign office of the seller participates materially in the
sale.849 (Note that no parallel rule exists for a resident's sales of inventory property attributable to
a non-U.S. office.) This provision, and Section 864(c)(4)(B)(iii)(treating certain foreign source
income as effectively connected with a U.S. business), cover much the same terrain, with
virtually identical language. Thus, whether or not the income is considered to be from U.S.
sources, the nonresident in most cases would be subject to tax thereon under Section 864(c)(4)
(B)(iii)(in the absence of treaty relief); and, whether or not Section 864(c)(4)(B)(iii)were in the
Code, in most cases the income would be taxable by reason of the Section 865(e)(2) source rule.
Section 865(e)(2), however, standing alone, was not felt to be adequate.850 On the other hand, an
instance in which Section 865(e)(2) is relevant but Section 864(c)(4)(B)(iii)is not is that, in the
case of such income derived by a controlled foreign corporation, the income is not considered
effectively connected with a U.S. business851 and yet, under Section 865(e)(2), is U.S. source,
thus affecting the foreign tax credit position of the corporate U.S. shareholders under Section
960.
849
It is interesting to note that Section865(b), which provides that Section 865 shall not apply to
inventory property, is not quite correct, in that Section 865(e)(2)(A) (which applies
"[n]otwithstanding any other provisions of this part") expressly covers inventory.
850
Section 864(c)(4)(B)(iii), which had been deleted from the Code as part of TRA 86 (Section
1211(b)(2)), was reinstated retroactively in substantially identical form by TAMRA (Section
1012(d)(7)) in order that persons who are U.S. residents under the Section 865(g)(1)(A) source
definition but not residents under the general Section 7701(b) definition not escape U.S. tax on
inventory sales made through a U.S. office. Staff of the Joint Committee on Taxation, Description
of the Technical Correction Act of 1988 (March 31, 1988) 250.
851
See Section864(c)(4)(B)(ii).

A few income tax treaties, such as that with Switzerland, permit the United States to tax only
U.S. source industrial or commercial profits and thus override Section 864(c)(4)(B)(iii). 852 Such
treaty benefits would have been nullified by Section 865(e)(2) but for the fact that Congress, in
TAMRA, provided protection against treaty override.853 Thus, Section 865(e)(2) does not apply in
the case of such treaties.
852
See, e.g., Rev. Rul. 74-63, 1974-1 C.B. 374.

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 853
See TAMRA, Section 1012(aa)(3)(A)(ii) (Section 865(e)(2) inapplicable to extent
inconsistent with treaty obligations in effect on enactment of TRA 86).

From a functional standpoint, this special source rule is best understood by separately
analyzing sales of inventory property by a nonresident for U.S. destinations (imports), and sales
of property for foreign destinations (exports).
(1) Sales Having U.S. Destinations
In general, if a nonresident maintains an "office or other fixed place of business" in the
United States, income "attributable to" such fixed place of business from any sale of inventory
property for use, consumption, or disposition in the United States is sourced in the United States
under Section 865(e)(2)(A), regardless of the place of sale.854 For purposes of determining
whether a taxpayer has an office or other fixed place of business in the United States, and
whether a sale is attributable to such location, the principles of Section 864(c)(5) apply. 855 These
are discussed immediately below.
854
As noted above, however, if such inventory property were manufactured by the taxpayer
abroad, the manufacturing element of the income would be separated by the apportionment rules
(discussed in VII, B, 2, a, below) and sourced separately.
855
Section865(e)(3).

(a) Office or Other Fixed Place of Business

An office or other fixed place of business (FPB) is a "place, site, structure, or similar facility"
through which the taxpayer conducts a trade or business.856 It includes, but is not limited to, a
factory, store, sales outlet, workshop, mine, quarry, or other place of extracting natural resources.
857
A corporation is not considered for this purpose to have a FPB in a particular country simply
because a person controlling such corporation has an office in that country from which general
supervision and control over the policies of the corporation are exercised.858
856
Regs. Section 1.864-7(b)(1).
857
Id.
858
Regs. Section 1.864-7(c).

A FPB of an "independent agent" is never treated as a FPB of the taxpayer, irrespective of

whether such agent has authority to negotiate and conclude contracts on behalf of the taxpayer or
maintains a stock of goods from which to fill orders on behalf of the taxpayer.859 An independent
agent for this purpose is a general commission agent, broker, or other agent of independent status
acting in that capacity in the ordinary course of his business.860 The test for independence is based
on the agent's activities, not its ownership. For example, a wholly owned subsidiary may be an
independent agent under appropriate circumstances.861 All facts and circumstances must be
considered, however, to determine whether an agent that acts exclusively, or almost exclusively,
for the taxpayer is in fact an independent agent.862
859
Section864(c)(5)(A); Regs. Section 1.864-7(d)(2).
860
Regs. Section 1.864-7(d)(3)(i).
861
Regs. Section 1.864-7(d)(3)(ii).
862
Regs. Section 1.864-7(d)(3)(iii).

An FPB of a "dependent" agent is not treated as an FPB of the taxpayer unless the agent (i)
has the authority to negotiate and conclude contracts in the name of the taxpayer and regularly

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exercises that authority or (ii) has a stock of merchandise belonging to the taxpayer from which
the agent regularly fills orders on behalf of the taxpayer.863 For example, a subsidiary that buys
from the parent and sells in its own name is not an FPB of the parent.864
863
Section864(c)(5)(A); Regs. Section 1.864-7(d)(1).
864
Regs. Section 1.864-7(d)(1)(i).

(b) The Material Factor Test

A sale is considered to be "attributable" to an FPB which a nonresident alien or foreign
corporation has in the United States only if the FPB is a "material factor in the realization of the
income, gain or loss, and if the income, gain or loss is realized in the ordinary course of the trade
or business carried on through that [FPB]."865
865
Regs. Section 1.864-6(b)(1).

Activities of an FPB are considered to be a "material factor" in the realization of income,

gain or loss from the sale of personal property only if they provide a significant contribution to,
by being an essential economic element in, the realization of such gain; but it is not necessary
that such activities be a "major factor" in the realization of such gain.866 The regulations provide
that an FPB is a material factor with respect to income, gain or loss from the sale of inventory
items or property held primarily for sale to customers in the ordinary course of business
if the [FPB] actively participates in soliciting the order, negotiating the contract of sale, or
performing other significant services necessary for the consummation of the sale which are
not the subject of a separate agreement between the seller and the buyer. The [FPB] in the
United States shall be considered a material factor in the realization of income, gain, or loss
from a sale made as a result of a sales order received in such [FPB] except where the sales
order is received unsolicited and that [FPB] is not held out to potential customers as the place
to which such sales orders should be sent. The income, gain, or loss must be realized in the
ordinary course of the trade or business carried on through the [FPB] in the United States. . . .
[An FPB] in the United States shall not be considered to be a material factor in the realization
of income, gain, or loss for purposes of this subdivision merely because of one or more of the
following activities: (a) the sale is made subject to the final approval of such [FPB], (b) the
property sold is held in, and distributed from, such [FPB], (c) samples of the property sold
are displayed (but not otherwise promoted or sold) in such [FPB], or (d) such [FPB] performs
merely clerical functions incident to the sale. Activities carried on by employees of a [FPB]
constitute activities of that office or other fixed place of business.867
866
Id.
867
Regs. §1.864-6(b)(2)(iii).

Under Regs. §1.864-6(c)(2) and (c)(3) Ex. (1), if the property sold by the nonresident
through the U.S. FPB was produced by the nonresident without the United States, the amount of
income from the sale that is considered attributable to the U.S. FPB (and hence the amount
considered U.S. source) will not exceed the amount that would be considered U.S. source under
the manufacturing apportionment rules of §863(b) if the property had been sold in the United
States. This rule makes sense since a taxpayer should not have more U.S. source income under
the §865(e)(2) "deeming" rule than it would have had by actually selling the property within the
United States.

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 (2) Sales Having Foreign Destination
Even if the sale of inventory property by a nonresident is attributable to a U.S. FPB,
however, the normal place-of-sale rules apply (i.e., §865(e)(2)(A) will be overridden) if (i) the
property is sold for "use, consumption or disposition" outside the United States and a FPB of the
seller in a foreign country868 "materially participated" in the sale.869 These terms are discussed
immediately below. Thus, the rules relevant to the sale of such property by a nonresident for use,
consumption, or disposition outside the United States but attributable to a U.S. FPB may be
summarized as follows:
(i) Foreign source, if title passes abroad and a foreign office materially participates in the
sale; and
(ii) U.S. source if a foreign office does not materially participate in the sale (or, even if it
does, if title passes in the United States).
868
TAMRA (§1012(d)(5)) substituted "in a foreign country" for "outside the United States" to
exclude a FPB in a U.S. possession.
869
§865(e)(2)(B). As noted above, however, if such inventory property was manufactured by
the taxpayer in the United States, the source of income is governed by the apportionment rules
discussed below in VII, B, 2, a.

Furthermore, for purposes of §971, relating to certain controlled foreign corporations which
are "export trade corporations," income from the sale of property may be considered to be
foreign source under the title-passage rule even if the sale is attributable to a U.S. FPB of the
taxpayer.870
870
§865(e)(2)(A).

(a) Material Participation by a Foreign Office or Other Fixed Place of Business

Presumably, the determination of whether there is material participation by a foreign FPB
with respect to the sale of inventory property will be determined under the same principles as
those employed for purposes of determining the effectively connected foreign source income of a
nonresident alien individual or foreign corporation under §864(c)(4)(B)(iii).871 In such case, a
foreign office or fixed place of business is considered to have materially participated in a sale if
it actively participates in soliciting the order that results in the sale, negotiates the contract of
sale, or performs other significant and necessary services for the consummation of the sale that
are not subject to a separate agreement between the buyer and nonresident seller. 872 However, the
foreign office or fixed place of business is not considered to have materially participated in a sale
merely by virtue of conducting one or more of the following activities: giving final approval to
the sale; holding and distributing the property subject to the sale; displaying samples of the
property sold (but not otherwise promoting or selling such property); providing for title-passage
to occur at such office or fixed place of business; or performing clerical functions incident to the
sale.873
871
As noted above at fn. 850, §864(c)(4)(B)(iii) was deleted as part of TRA 86 (§1211(b)(2)),
but was reinstated retroactively in substantially identical form in TAMRA (§1012(d)(7)).
872
Regs. §1.864-6(b)(3)(i).
873
Id.

(b) Use, Consumption, or Disposition Outside the United States

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 Presumably, whether inventory property is sold for use, consumption, or disposition outside
the United States will also be determined for this purpose under the same principles employed
for determining the effectively connected foreign source income of a nonresident alien individual
or foreign corporation under §864(c)(4)(B)(iii). In such case, and absent actual or constructive
knowledge to the contrary, inventory property will generally be assumed to be sold for use,
consumption, or disposition in the country of its destination (disregarding temporary
interruptions in shipment).874
874
Regs. §1.864-6(b)(3)(ii).

There are exceptions to this general presumption for sales to related persons, sales to retail
establishments, and sales of fungible goods.875 A taxpayer who sells personal property to a related
person is presumed to have sold the property for use, consumption, or disposition in the United
States unless the taxpayer establishes the use made of the property by the related person. 876 A
taxpayer who sells personal property to any person whose principal business consists of selling
from inventory to retail customers at retail outlets outside the United States may assume at the
time of the sale to that person that the property will be used, consumed, or disposed of outside
the United States.877 A taxpayer who sells to a purchaser personal property which because of its
fungible nature cannot reasonably be specifically traced to other purchasers and to the countries
of ultimate use, consumption, or disposition must, unless the taxpayer establishes another proper
disposition, treat that property as being sold, for ultimate use, consumption, or disposition in
those countries, and to those other purchasers. Such treatment must be in the same proportions in
which property from the fungible mass of the first purchaser is sold in the ordinary course of
business by such first purchaser, but only if the taxpayer knew, or should have known from the
facts and circumstances surrounding the transaction, the manner in which the first purchaser
would dispose of property from the fungible mass.878 No apportionment is required to be made,
however, on the basis of sporadic sales by the first purchaser.879
875
Id.
876
Id.
877
Id.
878
Id.
879
Id.

Historical Note: As originally enacted as part of TRA 86, the special rule for sales
attributable to a U.S. FPB of a nonresident did not apply with respect to income from the sale of
personal property by a controlled foreign corporation that was required to be included in the
gross income of its U.S. shareholders under the subpart F provisions.880 This provision was
deleted retroactively by TAMRA.881
880
Former §865(e)(2)(ii).
881
TAMRA, §1012(d)(5).

Section 865(b) provides a strict U.S.-source rule for income from sales after August 10, 1993
of unprocessed softwood timber cut in the United States.
2. Inventory Property Subject to Apportionment Rules
Apportionment of income from the disposition of "inventory property" (as defined in §865(i)
(1))882 between U.S. and foreign sources is required under Regs. §1.863-3 in three different
situations:

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 (i) Where inventory property is manufactured or processed (in whole or in part) by the
taxpayer within the United States and sold or exchanged by it outside the United States (or
vice versa), income is apportioned between the countries or places of manufacture and sale.
(ii) Where inventory property is manufactured or processed (in whole or in part) by the
taxpayer within a U.S. possession and sold or exchanged by it within the United States (or
vice versa), income is apportioned between the possession and the United States.
(iii) Where inventory property is purchased by the taxpayer within a U.S. possession and sold
or exchanged by it within the United States (but not vice versa and except for determining the
benefits to the seller under §936), income is apportioned between the possession and the
United States.
882
Section 865 and not §863(b) generally would apply to gain from the sale of personal
property other than inventory property. See S. Rep. No. 313, 99th Cong., 2d Sess. 328-33 (1986);
H.R. Rep. No. 841 (Conf.), 99th Cong., 2d Sess. II-596 (1986); Staff of Joint Committee on
Taxation, General Explanation of the Tax Reform Act of 1986, 916-19 (1987). An exception,
however, is that, in the case of a sale of "depreciable personal property" (as defined in §865(c)(4)
(A)) that is tangible property, any gain in excess of the depreciation adjustments on such gain is
sourced in the same manner as inventory. §865(c)(2). To the extent property is produced by the
taxpayer but held in a manner that would permit depreciation adjustments, gain on its sale should
not be sourced under the §863(d) apportionment rules.

In addition, as discussed below,883 the apportionment principles may be applicable where

income must be apportioned between a U.S. possession and a foreign country. Also, as discussed
below,884 the apportionment principles may also be applicable to income from the extraction and
sale of natural resources in certain cases. An exception in §865(b) to the apportionment
principles of §863(b) provides that income from the sale outside the United States of
unprocessed timber which is softwood and which is cut from an area located in the United States
is U.S. source income in its entirety.
883
See VII, B, 2, c.
884
See VII, D.

a. Manufacturing (Processing) Apportionment Rules

The manufacturing or processing apportionment (split-source) rules determine the source of
income from inventory property885 which is produced in whole or in part in one country or
possession by the taxpayer and sold in another by such taxpayer, if the United States is either the
place of sale or production.886 The place of sale for this purpose generally is determined by title-
passage in the case of U.S. residents (as defined in §865(g)(1)(A));887 in the case of nonresidents
(as defined in §865(g)(1)(B)), the place of sale generally is determined by title-passage, subject
to the special rule for sales attributable to a U.S. office or other fixed place of business.888
885
In TRA 86, the term "inventory property" was substituted for the term "personal property."
TRA 86, §1211(b)(1)(A). Although the regulations still refer to personal property, the discussion
below assumes the reference is to inventory property.
886
Section 213(c) of the Revenue Act of 1918 originally provided that nonresident aliens are
taxed on "all amounts received (although paid under a contract for the sale of goods or otherwise)
representing profits on the manufacture and disposition of goods within the United States." The
Board of Tax Appeals rejected taxpayers' arguments that this was not intended to tax goods
manufactured abroad and sold within the United States. See Billwiller v. Comr., 11 B.T.A. 841, 845
(1928), aff'd, 32 F.2d 286 (2d Cir.1929); Birkin v. Comr., 5 B.T.A. 402 (1926). The present

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 manufacturing source rules recognize the validity of the argument by allocating such income
between the countries of manufacture and sale.
887
§§861(a)(6), 865(b).
888
See §§861(a)(6), 865(b), and 865(e)(2).

In that, for purposes of these rules, the term "United States" refers to the 50 states and the
District of Columbia, the rules do not apply to the sale of personal property manufactured in a
foreign country and sold in a U.S. possession, or vice versa. Similar rules govern such
transactions, however, as discussed below.889
889
See VII, B, 2, c.

Historical Note: Before TRA 86, these rules potentially applied to noninventory property,
e.g., the creation of intellectual property in one country and its sale in another.890 TRA 86
substituted "inventory property" for "personal property" in §863(b)(2).891
890
See Lokken, "The Source of Income From International Uses and Dispositions of Intellectual
Property," 36 Tax L. Rev. 233, 286, 292 (1981).
891
TRA 86, §1211(b)(1)(A), generally effective for taxable years beginning after 1986, but, in
the case of foreign persons (other than controlled foreign corporations), for transactions entered
into after March 18, 1986. TRA 86, §1211(c).

In T.D. 8687,891.1 the IRS adopted as final the proposed regulations issued on December 11,
1995 dealing with the source of income from inventory property produced or manufactured in
the United States and sold abroad (and vice versa). The final regulations make several major
changes to the prior regulations. The significant changes include the following:
(1) In Regs. §1.863-3(b)(1), (2) and (3), the regulations adopt the 50/50 method as the
general rule with the independent factory price (IFP) method and the books and records
method as elective methods.
(2) A taxpayer may not establish an IFP by methods other than sales to independent
distributors.
(3) The three methods for apportioning income between production activity and sales activity
apply to sales outside the United States as opposed to sales within a foreign country (e.g.,
sales on high seas and in space are included).
(4) For purposes of determining income from production activities, the regulations restrict
the production assets to those that are used by the taxpayer directly to produce relevant
inventory property (e.g., assets of contract manufacturers are not included).
891.1
61 Fed. Reg. 60540 (11/29/96).

The final regulations retain the three methods provided in the prior regulations for
apportioning income between production activities and sales activities. Regs. §1.863-3(a)(1)
provides that a taxpayer must divide gross income from §863 sales between production activities
and sales activities using one of the methods described in Regs. §1.863-3(b). Regs. §1.863-3(b)
(1)(i) provides that, as a general rule, income from §863 sales will be apportioned between
production activity and sales activity under the 50/50 method. Under that method 50% of the
taxpayer's gross income is considered attributable to production activity and the other 50% of the
taxpayer's gross income is considered attributable to sales activity. In lieu of the 50/50 method,

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however, a taxpayer may elect to determine the portions of gross income attributable to
production and sales activities under the IFP method, or, with the consent of the district director,
under the books and records method.
Comment: Adoption of the 50/50 method as a general rule is very favorable because it
enables taxpayers to maximize foreign source income and thus FTCs.
A taxpayer may elect to apportion gross income between production activity and sales
activity under the IFP method provided an IFP is fairly established. In order fairly to establish an
IFP, a taxpayer must demonstrate that it regularly sells part of its output to wholly independent
distributors or other selling concerns and that, with respect to the sale establishing the IFP, its
sale activity is not significant in relation to all other activities.891.2 Under the IFP method, that
portion of the gross sales price that is equal to the IFP is attributed to the production activity. The
excess of the gross sales price over the IFP is attributed to the sales activity.891.3 The amount of a
taxpayer's gross income from production activity equals the amount of gross receipts attributable
to production activity less the cost of goods sold properly attributable to production activity.
Similarly, the amount of gross income from sales activity equals gross receipts attributable to
sales activity less the cost of goods sold properly attributable to sales activity.891.4
891.2
Regs. §1.863-3(b)(2)(i).
891.3
Regs. §1.863-3(b)(2)(ii).
891.4
Regs. §1.863-3(b)(2)(iii).

A taxpayer may, in lieu of the 50/50 and IFP methods, elect to use the books and records
method to apportion gross income between production activity and sales activity, provided it has
obtained advance permission from the district director. In order to obtain the district director's
permission, the taxpayer must establish that it will, in good faith and uninfluenced by any tax
liability considerations, regularly make a detailed allocation of receipts and expenditures in its
books and records which clearly reflects the amount of income from production and sales
activities.891.5
891.5
Regs. §1.863-3(b)(3).

Income attributable to production activity is sourced where the production assets are located.
Production activity itself is defined as an activity that creates, fabricates, manufactures, extracts,
processes, cures, or ages inventory.891.6
891.6
Regs. §1.863-3(c)(1)(i).

If the taxpayer's production assets are located only within the United States or only outside
the United States, all of the income attributable to production activity is sourced to the place
where the production assets are located.891.7 Otherwise, income attributable to production assets is
allocated partly to U.S. and partly to foreign sources. Income allocable to foreign sources is
determined by multiplying income allocable to production activity by a fraction, the numerator
of which is the average adjusted basis of production assets located outside the United States and
the denominator of which is the average adjusted basis of all production assets. The remaining
income attributable to production activity is sourced to the United States.891.8 The average
adjusted basis of an asset is computed by averaging the adjusted basis (determined under §1011)
of the asset at the beginning and at the end of the taxable year. But if, due to material changes
during the taxable year, the average does not fairly represent the average for the taxable year, that
average adjusted basis may be computed on a more appropriate basis.891.9

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 891.7
Id.
891.8
Regs. §1.863-3(c)(1)(ii)(A).
891.9
Regs. §1.863-3(c)(1)(ii)(B).

With the exception of production activity conducted by consolidated groups and partnerships,
production assets include only tangible and intangible assets owned directly by the taxpayer that
are directly used by it to produce inventory property. Thus, for example, production assets do not
include accounts receivable, marketing intangibles, transportation assets, warehouses, the
inventory property itself, raw materials, work-in-progress, cash, and investment assets. If the
taxpayer engages a contract manufacturer to produce inventory property on its behalf, production
assets do not include production assets of the contract manufacturer.891.10 The regulations also
provide rules for determining the location of production assets. Tangible assets are considered
located where such assets are physically located. An intangible asset is considered located where
the tangible asset to which it relates is physically located.891.11
891.10
Regs. §1.863-3(c)(1)(i)(B).
891.11
Regs. §1.863-3(c)(1)(i)(C).

To prevent manipulation of the formula, the regulations also provide an anti-abuse rule
authorizing the district director to make adjustments if a taxpayer has entered into one or more
transactions with a principal purpose of reducing its U.S. tax liability by manipulating the
apportionment formula.891.12
891.12
Regs. §1.863-3(c)(1)(iii).

The final regulations retain the prior regulations' title passage rule for purposes of sourcing
income attributable to sales activity. As opposed to the prior regulations, the regulations do not,
however, require that title pass within a foreign country in order for foreign source income to
arise. The regulations merely require that title to inventory property pass outside the United
States in order to allocate the income attributable to sales activity to foreign sources. The
regulations again provide an anti-abuse rule here to prevent the manipulation of the title passage
rule. Under this rule, the title would be presumed to pass in the United States if inventory
property is wholly produced in the United States and is sold for use, consumption, or disposition
in the United States.891.13
891.13
Regs. §1.863-3(c)(2).

If a taxpayer does not elect the IFP method or the books and records method, it must use the
50/50 method. A taxpayer may elect the IFP method by using this method on a timely filed
original tax return (including extensions). A taxpayer may elect the books and records method by
similarly using it on a timely filed original tax return (including extensions) provided the
taxpayer has received permission from the IRS to use this method. Once a taxpayer has elected
the IFP method, it must use this method in subsequent years unless the Commissioner grants
permission to change the method. Similarly, once a taxpayer has elected books and records
method, it must use this method in subsequent years unless the IRS grants permission to change
the method.891.14
891.14
Regs. §1.863-3(e)(1). Elections to use the IFP method or the books and records method
pursuant to Regs. §1.863-3(b)(1) and (e)(1) should be sent to: Philadelphia Submission
Processing Center, P.O. Box 245, Bensalem, PA 19020. See Notice 2003-19, 2003-14 I.R.B. 703.

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 Irrespective of which method (i.e., the 50/50 method, the IFP method, or the books and
records method) is used, the taxpayer is required by the regulations to attach a statement to its
return explaining the method used, the circumstances justifying the use of the method, the extent
to which sales are aggregated, and the amount of income allocated.891.15
891.15
Regs. §1.863-3(e)(2).

As a general rule, a taxpayer's production or sales activity does not include production and
sales activity of a partnership of which the taxpayer is a partner either directly or through one or
more partnerships.891.16 There are two exceptions to this rule:
(1) For purposes of determining the source of a partner's distributive share of partnership
income or determining the source of a partner's income from the sale of inventory property
distributed in kind to the partner by the partnership, the partner's production or sales activity
will include production and sales activities of the partnership.891.17
(2) If a partner contributes to the partnership inventory property in a §721transaction and
the property is related to the production activity of the partner, the production activities of the
partnership will include the production activity of the partner.891.18
891.16
Regs. §1.863-3(g)(1).
891.17
Regs. §1.863-3(g)(2)(i).
891.18
Id.

The final regulations promulgated by T.D. 8687 are effective for taxable years beginning
after December 30, 1996. However, taxpayers have an option to elect to apply these regulations
to taxable years beginning after July 11, 1995, and on or before December 30, 1996.891.19
891.19
Regs. §1.863-3(h).

(1) Manufacturing in the United States and Sale in a Foreign Country (or Vice Versa)
The manufacturing or processing apportionment rules provide three methods to apportion the
income from the production of inventory property in whole or in part in the United States by a
taxpayer and its sale in a foreign country by such taxpayer (or vice versa) between U.S. and
foreign sources.892 The rules apply to property which is "produced," i.e., "created, fabricated,
manufactured, extracted, processed, cured, or aged."893 The following methods have long been
available, but before T.D. 8687 some thought these to be generally available only in the priority
listed: (i) the independent factory or production price (IFP); (ii) the 50-50 property/sales formula;
and (iii) the taxpayer's own books.894
892
Regs. §1.863-3(b).
893
Regs. §1.863-3(a)(2). The manufacturing or other production can take the form of "contract
manufacturing" performed on behalf of the taxpayer by a related or unrelated party. But cf.
Ashland Oil, Inc. v. Comr., 95 T.C. 348 (1990); Rev. Rul. 97-48, 1997-2 C.B. 89. See FSA
200152006 (contract manufacturing performed by Mexican subsidiaries assembling components
not attributable back to U.S. parent for purposes of sourcing parent's income under §863(b)
because of the control retained by U.S. parent: legal title to manufactured property, intellectual
property rights with regard to manufacturing process, product design and research, and
manufacturing equipment used by Mexican subsidiaries owned by U.S. parent); See also FSA
200141010 (contract manufacturing performed by Mexican subsidiaries cannot be attributed back
to U.S. parent for purposes of sourcing parent's income under §863(b) because of U.S. control of
manufacturing process).

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 894
Regs. §1.863-3(b)(2).

In connection with the debate concerning TRA 86, it became clear that there was substantial
uncertainty concerning whether the IFP method set forth in former Regs. §1.863-3(b)(2) Ex. 1 (as
in effect prior to T.D. 8687) was elective with taxpayers, in which case the 50-50 method set
forth in former Regs. §1.863-3(b)(2) Ex. 2 (also as in effect prior to T.D. 8687) was available
even if an IFP could be shown.895 The Export-Source Coalition of 17 multinational corporations
was formed to maintain the availability of the 50-50 method, and succeeded in securing
favorable statements in the legislative history to TRA 86.896 The legislative history expressed
Congress's concern over the adverse trade effects of any change in the source rules governing
exports and indicated that under present law, the 50-50 method "generally" is available. 897
895
For example, in a letter dated September 21, 1988 to Leonard Terr, then International Tax
Counsel of the IRS, on behalf of the National Association of Manufacturers, Peggy Duxbury
stated that, under the "commonly-understood interpretation of the export source rules," which "has
been universally accepted for decades by taxpayers," export sales "generally" give rise to 50%
U.S. source and 50% foreign source income. Reprinted in Highlights & Documents 209 (10/6/88).
896
Matthews, "Treasury Meeting with CEOs Presages Export-Source Rule Guidance," Tax
Notes 983, 984 (9/5/89).
897
See H.R. Rep. No. 841 (Conf. Rep.), 99th Cong., 2d Sess. II-595-96 (1986), reprinted in
1986-3 (Vol. 4) C.B. 1, 595; H.R. Rep. No. 426, 99th Cong., 1st Sess. 359 (1985), reprinted in
1986-3 (Vol. 2) C.B. 1, 359.

On the other hand, the legislative history also indicates that, if an IFP is available, the IFP
method is mandatory rather than elective.898
898
See H.R. Rep. No. 841 (Conf. Rep.), 99th Cong., 2d Sess. II-595, reprinted in 1986-3 (Vol.
4) C.B. 1, 595; S. Rep. No. 313, 99th Cong., 2d Sess. 329, reprinted in 1986-3 (Vol. 3) C.B. 1,
329; H.R. Rep. No. 426, 99th Cong., 1st Sess. 359, reprinted in 1986-3 (Vol. 2) C.B. 1, 359. See
also Intel Corp. v. Comr., 100 T.C. 616 (1993), aff'd, 76 F.3d 976 (9th Cir. 1995), where the court
reiterated that when all the factual prerequisites of former Regs. §1.863-3(b)(2) Ex. 1 (as in effect
prior to T.D. 8687) are present, the IFP is mandatory.

Based on certain wording in former Regs. §1.863-3(b)(2) Ex. 1 (referred to hereinafter as

simply "Ex 1") and on the legislative history, the IRS concluded in Rev. Rul. 88-73899 that, if an
IFB is available, it must be used, to the exclusion of the 50-50 method. The conclusion of Rev.
Rul. 88-73 has been confirmed by the Tax Court in Phillips Petroleum Co. v. Comr.900
Contemporaneously with the issuance of Rev. Rul. 88-73, the IRS issued temporary regulations
which sought to make clear that the 50-50 method was available only if an IFP did not exist.901 In
Intel Corp. v. Comr.,901.1 the court however disagreed and held that, in order for the IFP method to
apply, not only an IFP must exist, but also, sales must be made through a selling or distributing
branch or department located in a country other than the country in which manufacturing takes
place. Consequently, a taxpayer may use the 50-50 method even if an IFP exists, provided the
sale is not made through a selling or distributing branch.
899
1988-2 C.B. 173.
900
97 T.C. 30 (1991), aff'd, 70 F.3d 1282 (10th Cir. 1995). But see Intel Corp. v. Comr., 100 T.C.
616 (1993), aff'd, 76 F.3d 976 (9th Cir. 1995), in which the Tax Court held that for Ex. 1 to apply
an IFP must exist and the sales must be made through a selling or distributing branch located in a
country other than the country in which manufacturing takes place. See also Phillips Petroleum
Co. v. Comr., 101 T.C. 78(1993), aff'd, 70 F.3d 1282 (10th Cir. 1995), where the Tax Court found
Ex. 1 to be inapplicable because an IFP did not exist.
901
See T.D. 8228, 1988-2 C.B. 136 (9/9/88).

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 901.1
100 T.C. 616 (1993), aff'd, 76 F.3d 976 (9th Cir. 1995).

In Intel, the taxpayer was engaged in the manufacture and sale of semiconductor and
computer systems. It sold various products that it manufactured in the United States to unrelated
foreign parties with title passing outside the United States. The taxpayer did not maintain any
selling or distributing branch located outside the United States during the years at issue. It used
the 50-50 method of former Regs. §1.863-3(b)(2) Ex. 2 (referred to hereinafter as simply "Ex. 2")
to source its income generated from the sales abroad. The IRS, however, contended that the
taxpayer's income from export sales to unrelated foreign parties must be sourced under Ex. 1
because the only condition necessary to make that example applicable is that an IFP exists. The
court rejected this argument and held that the plain language of Ex. 1 requires that both
conditions exist for its apportionment method to apply. The court noted that the introductory
language of Ex. 2 sanctions the use of Ex. 2 where the requirements of Ex. 1 are not met. The
taxpayer, accordingly, was permitted to use Ex. 2 in apportioning its income from the export
sales to unrelated foreign parties between U.S. and foreign sources.
Note: In the second round of litigation, the Tax Court, in Phillips Petroleum Co. v. Comr.,901.2
held that the taxpayer was entitled to use the 50-50 method of Ex. 2 because no IFP was
established through sales to independent distributors or other selling concerns.
901.2
101 T.C. 78 (1993), aff'd, 70 F.3d 1282 (10th Cir. 1995).

Shortly before issuance of the ruling and the temporary regulations, Treasury officials
announced that the impact of Rev. Rul. 88-73 would be relatively narrow since the IRS would
publish guidelines (hopefully with bright-line tests) construing the term IFP so that most
taxpayers would not have one.902 Nevertheless, Rev. Rul. 88-73 was widely condemned by U.S.
multinational corporations, which maintained its invalidity.903 The promised guidance was issued
in the form of Notice 89-10904 (discussed below), though without bright-line tests.
902
See Matthews, above, at 983.
903
Numerous letters are reprinted in Highlights & Documents, Oct. 6, 1988, at pages 189-210.
904
1989-1 C.B. 631.

(a) Independent Factory or Production Price

With Notice 89-10,905 the IRS provided guidance concerning instances where an IFP existed
under former Ex. 1. That example provided as follows:
Where the manufacturer or producer regularly sells part of his output to wholly independent
distributors or other selling concerns in such a way as to establish fairly an independent
factory or production price -- or shows to the satisfaction of the district director (or, if
applicable, the Director of International Operations) that such an independent factory or
production price has been otherwise established -- unaffected by considerations of tax
liability, and the selling or distributing branch or department of the business is located in a
different country from that in which the factory is located or the production carried on, the
taxable income attributable to sources within the United States shall be computed by an
accounting which treats the products as sold by the factory or productive department of the
business to the distributing or selling department at the independent factory price so
established. In all such cases the basis of the accounting shall be fully explained in a
statement attached to the return for the taxable year.

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 174

 905
Id.

Notice 89-10 described the application of former Ex. 1 by enunciating the following six
principles.906
(i) An IFP may be derived only from sales of the manufacturer or producer,907 unless the
taxpayer chooses to show to the IRS's satisfaction that an IFP has been otherwise established.
908
Thus, for example, sales of taxpayers that are not affiliated with the taxpayer making the
sale under consideration may not be used to establish an IFP unless the taxpayer chooses to
use them.
(ii) An IFP may be established only on the basis of sales "regularly" made to independent
businesses of "part" of the "output" of the manufacturer or producer. An IFP may not be
established by sales that are sporadic and occasional, or by sales that represent an
insubstantial part of the total output of the relevant product of the manufacturer or producer.
(iii) Sales used to establish an IFP must be to "distributors or other seller concerns." If the
purchaser of the relevant product customarily retains it for its own use, and does not in turn
sell the relevant product or a product into which the relevant product is integrated or
transformed, such purchaser is not a distributor or other selling concern within the meaning
of former Ex. 2.
(iv) Sales to distributors or other seller concerns will not be considered in establishing an IFP
unless such concerns are wholly independent from the manufacturer or producer. For this
purpose, the selling concern is not treated as wholly independent of the manufacturer or
producer if the former controls, or is controlled by, the latter within the meaning of §482.
(v) For sales to "fairly establish" an IFP, they must reasonably reflect the income earned from
manufacturing or production.
906
Unless otherwise indicated, the statements in paragraphs (i) through (vi) derive from Notice
89-10.
907
For purposes of Notice 89-10, the term "manufacturer or producer" includes manufacturing
or producing operations conducted by members of the same affiliated group.
908
An example of how an IFP can be otherwise established may be where a price is uniformly
charged independent distributors by competing manufacturers.

Sales will not establish an IFP if income-generating activity of the taxpayer other than
manufacturing or production activity with respect to sales of the relevant product is significant in
relation to manufacturing or production. For this purpose, if expenses of the manufacturer or
producer attributable to909 nonproduction, income-generating activity910 with respect to sales of
the relevant product are significant in relation to the gross receipts from such sales, such activity
ordinarily will be considered significant. Expenses that are not attributable to nonproduction,
income-generating activities include transportation costs, duties, excise taxes, insurance
premiums, and similar expenses.911
909
For purposes of determining expenses attributable to sales of the relevant product, the
principles of Regs. §1.861-8 apply. Notice 89-10. Such expenses may be allocated directly to sales
income from the relevant product or to a class of sales income including sales income from the
relevant product under the principles of that section. To the extent such expenses cannot be
allocated to sales of the relevant product, such expenses shall be apportioned on the basis of gross
receipts from such sales of the relevant product and of other products. Id.

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 175

 910
Nonproduction, income-generating activities include marketing and selling activities (at any
stage of distribution), and similar activities. Id.
911
In the case of sales made with an FSC acting as commission agent, the commission shall be
treated as an expense relating to nonproduction, income-generating activity. Id.

Sales made to independent distributors or other selling concerns in the country of

manufacture or production that meet the other requirements noted above will generally
reasonably reflect the income earned from manufacturing or production. This will not be the case
only if it can be demonstrated that (i) market conditions in the country of manufacture or
production permit the taxpayer to earn a substantially higher profit margin from the sale of the
relevant product than in the country of the sale to which Ex. 1 is being applied, and (ii) the
taxpayer directly engages in substantial activity in connection with such sale in the country of
sale that constitutes non-production, income-generating activity.
If a taxpayer produces goods in one country and exports them to two other countries, sales in
one destination country will not establish an IFP with respect to sales in the other destination
country if the two markets are materially different with respect to sales of the relevant product.
Such a difference might arise, for example, because of the taxpayer's policy of selling to
unrelated parties at the same level of distribution at a significantly lower price in a particular
market to establish or maintain market share. The determination of whether the two markets are
materially different shall take into account the prices at which the relevant product is sold in the
two markets to unrelated parties at the same level of distribution (whether or not by the
manufacturer or producer), after adjustments for transportation costs, insurance premiums, excise
taxes, duties and similar expenses, and after translation into U.S. dollars (if necessary) at the spot
rate for the relevant foreign currency in effect as of the date of the relevant sale.
Sales used to establish an IFP must be reasonably contemporaneous with the sales to which
Example 1 is being applied. Generally, a reasonably contemporaneous sale is one that occurs in
the taxable year of the sale to which Ex. 1 applies or in the prior taxable year. However,
significant price instability during the period between the time of the sale being used to establish
an IFP and the time of the sale to which Ex. 1 is potentially applicable may indicate that the prior
sale does not fairly establish an IFP.

(vi) An IFP may be established only on the basis of sales of products that are substantially
similar in physical characteristics, function, and price of sale to unrelated parties at the same
level of distribution.
In Phillips Petroleum Co. v. Comr.,911.1 the Tax Court disagreed with the IRS's interpretation of
the term "distributor or other selling concern" in Notice 89-10. The court held that a distributor is
an entity that sells the product it buys. The term does not imply that a distributor transforms or
integrates the product it acquires from the manufacturer; nor does it imply that a distributor is a
user of the product. The court further observed that the IRS's interpretation of the term
"distributor" in Notice 89-10 is so broad that it encompasses nearly all sales made by a producer.
The focus under the IRS's analysis is on the level of marketing activities and not on whether the
sales were made to a distributor. This, in the court's opinion, is a plain misreading of Ex. 1.
911.1
101 T.C. 78 (1993), aff'd, 70 F.3d 1282 (10th Cir. 1995).

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 176

 In Phillips Petroleum, the taxpayer extracted natural gas in Alaska, liquefied it, and
transported the liquefied natural gas (LNG) to Japan by tanker. The LNG was sold in Japan to
Tokyo Electric and Tokyo Gas pursuant to long term contracts. Tokyo Electric used the LNG for
the generation of electric power. Tokyo Gas regasified the LNG it purchased from the taxpayer,
reformed the natural gas, and/or blended it with other gases before selling it to its customers. The
court held that neither Tokyo Electric nor Tokyo Gas were distributors of the LNG sold to them
by the taxpayer because they did not sell to their customers the same product they purchased
from the taxpayer. Accordingly, sales to Tokyo Electric and Tokyo Gas could not be used to
establish an IFP. Since the record did not disclose any other wholly independent distributor
which was a purchaser of the taxpayer's LNG so as to establish an IFP, the court concluded that
Ex. 1 was inapplicable.
While Notice 89-10 did not go as far as some taxpayers had hoped, it achieved in at least
some measure the objective of making the 50-50 test "generally" available. Ultimately, the IRS
was not able to incorporate the "bright-line" tests sought by taxpayers because the varying
factual circumstances of different taxpayers made such an approach unworkable. Because a
number of terms used in Notice 89-10 are necessarily subjective, disputes are likely to arise. In
short, Notice 89-10 did not lay to rest the issue of the electivity of the IFP method under Ex. 1.912
912
See Oosterhuis & Cutrone, "The Export Source Rule: An Age-Old Rule with a Dubious New
Interpretation," Tax Notes 1643 (6/26/89).

For the availability of the IFP price method versus the 50-50 method in the case of sales by
FSC, see XIV, A, 3, below, discussing Notice 89-11 and Notice 89-87.
(b) 50-50 Property/Sales Formula
If an IFP cannot be established (or, as discussed above, apparently even if it can), an equally
weighted property and sales formula may be used to compute U.S. source taxable income from
such manufacturing and sales activities.913
913
See Regs. §§1.863-3(b)(1) and 1.863-3AT(b)(2) Ex. (2). See Intel Corp. v. Comr., 100 T.C.
616 (1993), aff'd, 76 F.3d 976 (9th Cir. 1995) (lack of wholly independent distributors or other
selling concerns). See also Phillips Petroleum Co. v. Comr., 101 T.C. 78 (1993), aff'd, 70 F.3d
1282 (10th Cir. 1995), where the Tax Court held that an IFP did not exist and thus the taxpayer
was entitled to use the 50-50 method under former Ex. 2.

Computation of taxable income attributable to U.S. sources under this formula requires the
following steps:914
(i) Determine the amount of gross income from the sale of inventory property manufactured
(in whole or in part) by the taxpayer in the United States and sold by it in the foreign country
(or manufactured in the foreign country and sold in the United States).
(ii) Apportion such gross income between the United States and the foreign country based
equally on the ratios of the location of the taxpayer's "production assets" (which include only
those assets directly owned and used to produce the inventory and do not include such assets
as accounts receivables, marketing intangibles, transportation assets, warehouses, the
inventory itself, or raw materials and work in process)915 and sales (the location of which are
determined under Regs. §1.861-7, generally the point of transfer of rights, title and interest,
except this is presumed to be the United States if the property is wholly produced in the

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 177

 United States and sold for use, consumption, or disposition in the United States)916 as follows:

Gross Income × 1/2 × U.S. Production Assets

__________________________________
Production Assets in United States
and in foreign country

Plus
Gross Income × 1/2 × Sales in United States
__________________________________
Sales in United States
and in foreign country

For purposes of this formula, production assets are generally taken into account at the
average adjusted bases at the beginning and end of each year, with a further adjustment by
any reasonable method to reflect the portion of the production assets that produce the
inventory in question.917 In Phillips Petroleum Co. v. Comr.,918the Tax Court held that, for
purposes of applying the similar property apportionment fraction under the prior regulations,
the term "property" does not include leased property or property located in international
waters.
(iii) Apportion the deductions from gross income that are allocable and apportionable to the
gross income determined in (i) between the U.S. and foreign portions of such income on a
pro rata basis, without regard to whether the deduction relates primarily or exclusively to the
production of property or the sale of property.919 The taxable income attributable to sources
within the foreign country may be derived by substituting the property and sales attributable
to the foreign country in the numerator of these fractions.
914
Regs. §1.863-3AT(b)(2) Ex. (2) (ii).
915
Regs. §1.863-3(c)(1). Instead of production assets, the term "property" applied for this
purpose for periods beginning before December 30, 1995 (the effective date of T.D. 8687). The
term "property" included only the property held or used to produce income derived from the sales
in question, but was nevertheless broader in scope. Under former Regs. §1.863-3(b)(2) Ex. (2)(iv),
for example, bills and accounts receivable were specifically allocated to the United States when
the debtor resides there, unless the taxpayer had no office, branch, or agent in the United States, or
a satisfactory reason for a different allocation was shown. In Phillips Petroleum Co. v. Comr., 101
T.C. 78 (1993), aff'd, 70 F.3d 1282 (10th Cir. 1995), the Tax Court held that the Tax Court held
that the receivables were located in Japan because the debtors were residents of Japan and the
taxpayer had at least an agent in Japan.
916
Regs. §1.863-3(c)(2). Prior to the effective date of T.D. 8687, the regulations used the term
"gross sales" for this purpose, but noted that it referred only to the sales of inventory property
produced (in whole or in part) by the taxpayer in the United States and sold in a foreign country, or
vice versa. Former Regs. §1.863-3(b)(2) Ex. (2) (iii).
917
Regs. §1.863-3(d). For years prior to the effective date of T.D. 8687, property was taken into
account at actual value, which in the case of property valued or appraised for inventory, depletion,
depreciation, or other tax purposes is considered to be the highest amount at which so valued or
appraised and, in the case of other property, is considered to be its book value absent affirmative
evidence showing that value to be more or less than its actual value; average values may be used
in the absence of a distortion. Former Regs. §1.863-3(b)(2) Ex. (2)(iv).
918
101 T.C. 78 (1993), aff'd, 70 F.3d 1282 (10th Cir. 1995).
919
Regs. §§1.863-3(d) and 1.863-3AT(b)(2) Ex. (2)(ii).

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 178

 (c) Allocation According to Taxpayer's Books
Allocation according to the taxpayer's books of account will be "considered" by the IRS and,
at its continuing discretion, may be used by a taxpayer who receives in advance the permission
of the IRS district director having audit responsibility and who, in good faith and unaffected by
considerations of tax liability, regularly employs in his books of account a detailed allocation of
receipts and expenditures which reflects clearly (or, under the regulations prior to T.D. 8687,
"more clearly" than the other available methods) the taxable income from U.S. sources. 920 The
taxpayer must regularly employ in the books of account a detailed allocation of receipts and
expenditures in order to use this method of allocation.
920
Regs. §§1.863-3(b)(3) and 1.863-3A(b)(2) Ex. (3). Accord Billwiller v. Comr., 11 B.T.A. 841
(1928), aff'd, 31 F.2d 286 (2d Cir. 1929) (IRS relied on taxpayer's books of account to show "true"
manufacturing costs).

As illustrated by the example below, the result of the 50-50 property/sales formula as applied
to an enterprise which manufactures products in the United States is to source at least 50% of the
income attributable to foreign sales abroad (more if the products are manufactured in part
abroad).
Example: A domestic manufacturer manufactures goods entirely in the United States and
exports them abroad. The percent of gross income sourced abroad would be 50%: (1/2)(0%)
+(1/2)(100%). If the U.S. property fraction instead were 70%, reflecting partial manufacture
of goods abroad, the percent of gross income sourced abroad would be 65%: (1/2)(30%)
+(1/2)(100%).
(2) Manufacturing in United States and Sale in a Possession (or Vice Versa)
The manufacturing apportionment rules for inventory property manufactured in the United
States and sold in a possession (or vice versa) set forth three methods similar to those described
immediately above with respect to apportioning manufacturing income in transactions involving
foreign countries.921 If an IFP is available in this context, it may be used or, under the prior
regulations, generally must be used.922If an IFP is not used, a 50/50 method like that discussed
above based on the location of production assets and business sales or, if applicable, a books and
records method may be applied. Since the promulgation of Regs. §1.863-3(f) by T.D. 8786,923
these rules have become very similar to those discussed above in the preceding section, aside
from the fact that the formula only looks to assets and sales in the United States and a U.S.
possession.
921
Regs. §§1.863-3(f)(1) and 1.863-3A(c).
922
Regs. §§1.863-3(f)(2)(i)(B) and 1.863-3A(c)(3).
923
63 Fed. Reg. 55020 (10/14/98), adopting without significant change proposed regulations
published at 62 Fed. Reg. 52953 (10/10/97).

For taxable years subject to the regulations prior to T.D. 8786 (years beginning before
November 13, 1998), the rules differed from that discussed in the preceding section. The
preamble to T.D. 8786 criticized the prior regulations for allocating "excessive" income to sales
because they allowed all property, not just production assets, to be taken into account and for
including cost of goods sold in the business fraction as well as the property fraction. The
following other variances of the prior regulations from the above are also noteworthy:

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 179

 (i) First, the possessions manufacturing two-factor formula included in its second factor
certain direct expenses as well as gross sales (together, referred to as the taxpayer's
"business"), while the foreign country manufacturing source formula includes just gross
sales.924
(ii) Second, in the possessions manufacturing formula the "total" property and business
factors included only property and business in the United States and in a U.S. possession, and
not worldwide property or business.925
(iii) Third, expenses were allocated and apportioned against gross income before applying the
two-factor formula.926
924
Regs. §1.863-3A(c)(3) Ex. (2).
925
Id.
926
Id.

Accordingly, if an IFP did not exist, the prior regulations (unlike the current regulations that
apply deductions last) determined taxable income from covered transactions that was treated as
from U.S. sources by the following steps under the two-factor apportionment formula:927
(i) Determine the amount of gross income from the sale of inventory property manufactured
(in whole or in part) by the taxpayer in the United States and sold by it in a possession or
manufactured in a possession and sold in the United States.
(ii) Determine the taxable income by subtracting from such gross income the deductions that
are allocable and apportionable to it in accordance with the regulations governing the
allocation and apportionment of expenses under §861.
(iii) Apportion such taxable income between the United States and the possession based on
equally weighted property928 and "business" ratios as follows:929
Gross Income × 1/2 × Property in United States
__________________________________
Property in United States
and in possession

Plus

Gross Income × 1/2 × Business in United States

__________________________________
Business in United States
and in possession

927
Id.
928
The term "property" for this purpose included only the property held or used to produce
income derived from the sales in question. Regs. §1.863-3A(c)(3) Ex. (2)(iii).
929
The term "business" for this purpose was comprised only of factors attributable to the sales
of inventory property produced (in whole or in part) by the taxpayer in the United States and sold
in a foreign country, or vice versa. Id.

For this purpose, "business" was defined as amounts paid for employee compensation and
purchases of goods, materials, and supplies consumed in the regular course of such business,
plus the amount of gross sales, such expenses, purchases, and gross sales being limited, however,

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 180

to those attributable to the production (in whole or part) of personal property within the United
States and its sale within a possession or the production (in whole or in part) of personal property
within a possession and its sale within the United States.930
930
Regs. §1.863-3A(c)(3) Ex. (2) (iii).

As a possible alternative to the IFP and two-factor formula methods, the former regulations
provided that a taxpayer's application to allocate based on its books of account will be
"considered" by the IRS, on the same conditions as described above.931
931
See VII, B, 2, a, (1), (C), above.

b. U.S. Sales of Possession-Purchased Inventory

Under §863(b)(3), an apportionment approach applies to the sale in the United States of
inventory property purchased in a U.S. possession.932 The regulations promulgated by T.D. 8786,
although using a different order of steps as noted in the immediately preceding section, continue
to provide a single-factor formula for allocating taxable income according to the "business sales"
of the taxpayer.933
932
Regs. §1.863-3A(c)(4).
933
Regs. §§1.863-3(f) and 1.863-3A(c)(4) Ex. (1).

Generally, the taxable income that is treated as U.S. source is determined by the following
steps:934
(i) Determine the amount of gross income derived from the purchase of inventory property in
a possession of the United States and its sale in the United States.
(ii) Apportion such taxable income between sources within the United States and sources
within the possession based on the ratio of the amount of the taxpayer's business sales for the
taxable year within the United States to the amount of the taxpayer's business sales for the
taxable year both within the United States and within the possession using the formula below.
(iii) Compute the taxable income from such sales by deducting from the gross income
expenses, losses, or other deductions properly allocated or apportioned thereto in accordance
with the regulations under §861 governing the allocation and apportionment of deductions.
Taxable Inc. × U.S. Business Sales
__________________________________
Business Sales in United States
and in possession

934
Id.

For this purpose, the "business sales" of the taxpayer is measured by the amounts paid out
during the taxable year for employee compensation and for the purchase of goods and supplies
sold or consumed in the regular course of business, plus the amount received from gross sales.
Such expenses, purchases, and gross sales are limited to those attributable to the purchase of
inventory property within a possession and its sale within the United States.935
935
Regs. §§1.863-3(f)(3), (4) and 1.863-3A(c)(4) Ex. (1)(iii).

As a possible alternative to this single-factor business formula, the regulations provide that a

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 181

taxpayer's application to use its books of account will be "considered" by the IRS, under the
same conditions provided by the manufacturing source rules.936
936
Regs. §1.863-3A(b)(2) Ex. (3). See VII, B, 2, a, (1), (C), above.

Historical Note: Section 863(b)(3) represents a 1926 concession to the complaints of U.S.
buyers of Puerto Rican tobacco which was being taxed both in Puerto Rico on the crop grown
there and again in the United States under the title-passage rule.937
937
Dailey, "The Concept of the Source of Income," 15 Tax L. Rev. 415, 444 (1960). The
exception, as enacted in 1926, ran both ways; i.e., a sale in a possession of property purchased in
the United States was subject to the same allocation rules. The outbound allocation formula was
repealed in 1938 to allow domestic taxpayers to realize all income in U.S. possessions (principally
the Philippines) for purposes of the §931 exclusion. H.R. Rep. No. 1860, 75th Cong., 3d Sess. 44
(1938).

In T.D. 8786,937.1 the IRS promulgated final regulations under §863(b)(2) and (3) without
significant change from the proposed regulations published about a year earlier.937.2 The final
regulations became effective for taxable years beginning after November 12, 1998.
937.1
63 Fed. Reg. 55020 (10/14/98).
937.2
The proposed regulations were published at 62 Fed. Reg. 52953 (10/14/97).

These regulations modified existing rules in a number of significant ways. First, the order of
the various steps to determine the source of taxable income from either the production and sale
of property or the purchase and sale of property is changed. Under the regulations, the allocation
rule first is applied to allocate the gross income to the activities of the taxpayer. The source of the
income is determined next, followed by a determination of the source of the taxable income.
Under prior regulations, the taxable income from the sales is determined first, followed by an
apportionment of that taxable income between the United States and the possession.
Second, the production income formula under the 50/50 method (applicable to produced and
sold property) has been changed to limit the inclusion of assets only to those assets that are
production assets. The prior regulations permitted the value of all property of the taxpayer
located in the United States and the possession to be included in the fraction. The preamble to the
revised regulations states that the prior formula included sales assets, as well as production
assets, thus resulting in "excessive" income being allocated to sales activities. Thus, the revised
regulations have adopted the definition of Regs. §1.863-3(c)(1)(i)(B), which limits production
assets to taxpayer-owned intangible and tangible assets that the taxpayer uses directly to produce
the inventory that produces the gross receipts to be apportioned.
Third, the term "business of the taxpayer" used by the prior regulations has been modified for
both the 50/50 method applicable to property produced and sold and for the allocation method
applicable to property purchased and sold. For property produced and sold, the term is renamed
the "business sales activity;" for property purchased and sold, the term is renamed the business
activity method. The preamble to the regulations states that costs of goods sold are not included
in the business sales activity fraction because such costs have been included in the production
assets fraction. Cost of goods sold are included, however, for purposes of the purchased and sold
property business activity method, but only to the extent that the costs are attributable to
property, that is manufactured, produced, grown, or extracted in the possession.
Finally, the denominator of both of the business sales activity fraction for produced and sold

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 182

property and of the business activity method for purchased and sold property includes expenses
incurred both within and without the possession, thus including expenses incurred in a foreign
country. The prior regulations only included expenses related to activities within the possession
or within the United States. Thus, to the extent that a taxpayer has activity outside the United
States and the possession, the revised regulations reduce the possession source income of the
taxpayer.
c. Manufacturing (Processing) in Possession and Sale in Foreign Country (or Vice Versa)
Section 937(b), as added by the American Jobs Creation Act of 2004 (P.L. 108-357, §908),
provides that for purposes of Title 26 and for taxable years ending after October 22, 2004, rules
similar to those for determining income from sources within the United States and income
effectively connected with the conduct of a trade or business within the United States are to
apply in determining income from sources within the U.S. possessions and income effectively
connected with the conduct of a trade or business within a U.S. possession. This rule is subject to
the following two exceptions: (1) as provided in regulations and (2) any income treated as from
U.S. sources or as effectively connected with the conduct of a U.S. trade or business is not to be
treated as from possession sources or as effectively connected with the conduct of a trade or
business within a possession. Although regulations will be required to know what income comes
within the two exceptions and what deviations from U.S. source and effectively connected rules
will be considered "similar" to such rules, the rules described below as expressed before the
enactment of §937(b) would seem appropriate guidelines until the IRS provides further
information.
It may be important to distinguish the particular source of income from manufacturing or
processing in a U.S. possession and sales in a foreign country (or vice versa). For example, in
order to obtain a §936 possessions corporation tax credit, a U.S. corporation must establish that
80% of its income is from possessions sources over a three-year period.938 For this and similar
purposes, the regulations under §863 state that the principles applied in the regulations under
§§861-862, as well as §863, apply, substituting the particular U.S. possession (or foreign
country) for the words "United States" and reading "domestic" as referring to the substituted
possession (or foreign country) to determine the source of income from sources within a U.S.
possession (or foreign country).939 For purposes of this provision, however, certain deductions
peculiar to U.S. taxes, such as the dividends received deduction and the §931 deduction for
exempt possessions source income received by individuals, do not apply.940 This provision does
not apply to property either manufactured (in whole or in part) or sold in the United States, since
such income must be allocated pursuant to the rules under Regs. §1.863-3, discussed above.941
Second, the provision does not apply to the extent it would create foreign or possessions source
income greater than that obtainable without application of the provision.942
938
§936(a)(2)(A).
939
Regs. §1.863-6.
940
Id.
941
See id. See also the discussion in VII, B, 2, a.
942
Id.

In addition, it should be noted that, for the limited purpose of determining whether bona fide
residents of a possession are considered U.S. persons for purposes of testing the controlled
foreign corporation status of a possessions corporation under §957(c), Regs. §1.955-6(d)

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 183

provides a special rule for determining whether income from the sale of tangible personal
property produced within a possession or sold for use, consumption, or disposition within a
possession is from possession sources.943 Section 957(c) was amended by TRA 86944 to provide
different rules for Puerto Rico as opposed to Guam, American Samoa, and the Northern Mariana
Islands.
943
See Regs. §§1.957-3(b), 1.955-6(d); Rev. Rul. 79-352, 1979-2 C.B. 284.
944
TRA 86, §1224(a).

Under §865(b), income derived from a sale outside the United States of unprocessed timber
which is softwood and which is cut from an area located in the United States is U.S. source
income in its entirety, for sales, exchanges, or other dispositions made after August 10, 1993.
d. Global Dealing Operations
Proposed regulations under §863(b) sourcing income from a global dealing operation were
published on March 6, 1998 as part of a group of regulations addressing the allocation, mark-to-
market treatment, source, determination of income attributable to a U.S. permanent
establishment, and effectively connected status of global dealing operation income. 944.1 In general,
Prop. Regs. §1.482-8 sets forth the rules that apply to global dealing operations to determine the
arm's length allocation of income among the participants. The §863(b) proposed regulations
adopt the existing §482 regulations concerning the best method rule, comparability analysis, and
best method range, in addition to providing new specified methods that, in lieu of the specified
methods found in Prop. Regs. §§1.482-3 through -6, must be applied. For a complete discussion
of Prop. Regs. §1.482-8, see 887 T.M., Transfer Pricing: The Code and the Regulations.
944.1
REG-208299-90, 63 Fed. Reg. 11177 (3/6/98).

Prop. Regs. §1.863-3(h) provides the following rules:

• In general, the source of income from a global dealing operation is determined by reference
to the residence of the participant to whom the income is allocated under Prop. Regs. §1.482-
8.
• The rules of Prop. Regs. §1.863-3(h) are limited to global dealing income that is earned by
or allocated to a participant under Prop. Regs. §1.482-8 in a global dealing operation. Types
of income for which specific source rules are provided under §861, §862, or §865 are
sourced under those sections and not under Prop. Regs. §1.863-3(h).
• Each qualified business unit ("QBU") of a participant is treated as earning income allocated
to it under Prop. Regs. §1.482-8 (subject to the special rule discussed below) as if each QBU
were a separate entity. The allocation under Prop. Regs. §1.863-3(h) must satisfy an arm's
length standard. The source of the income of the participant is determined by reference to the
various residences of each QBU, thereby providing for "split" sourcing of income of the
participant from the global dealing operation. This rule is in contrast to the Regs. §1.863-
7(a)"all or nothing" rule for notional principal contracts that are not part of a global dealing
operating under which the source of the income from the contract is sourced in one
jurisdiction, even though more than one person may have contributed to the earning of the
income. The "split" sourcing of income rule may provide a better foreign tax credit result
than the "all or nothing" rule in situations where portions of the income (that would

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 otherwise be treated as U.S. source income) are treated as foreign source income.
• A special rule, acknowledging the economic effects of a single legal entity to supplement
Prop. Regs. §1.482-8, essentially extends the fungibility of money principle embodied in the
Regs. §1.861-9T(a) rule. That regulation provides that money is fungible and that, therefore,
interest expense is attributable to all activities and property. Accordingly, Prop. Regs. §1.863-
3(h) determines the source of compensation from bearing the risk of capital by serving as a
counterparty (without performing any other global dealing functions) not by reference to the
residence of the capital provider, but by the place where the persons carrying out the global
dealing functions use the capital.
• Proposed rules to be added to the §§864 and 894 regulations limit the amount of income
from global dealing operations that can be treated as effectively connected income or as
attributable to a U.S. permanent establishment.
• A special rule treats a dependent agent in the United States that is deemed to be a U.S. trade
or business because of its U.S. activities as a QBU (without applying the Regs. §1.989(a)-
1(b) books and records requirement).
• Although interbranch and interdesk allocation agreements are disregarded (because a
taxpayer cannot enter into a contract with itself), such agreements (including risk transfer
agreements) may be used to determine the source of global dealing income from third parties.
C. Exception for Foreign Tax Credit Purposes on Deemed Disposition of Assets of Overall
Foreign Loss Branch
For the purpose of determining the foreign tax credits available to U.S. persons (and certain
foreign persons under Section 906), Section 904(f)(1) treats certain foreign source income as
U.S. source income, as an offset to previous overall foreign losses. The effect of the rules is to
reduce the numerator (foreign source taxable income) of the Section 904(a) limitation for the
applicable limitation category, which reduces the available foreign tax credit for foreign taxes.
Historical Note: Before 1976, foreign losses (typically incurred on start up of a foreign
branch) offset U.S. source income and reduced U.S. taxes. When the branch subsequently turned
profitable, its foreign profits permitted the creditability of foreign taxes under the Section 904(a)
limitation. In the absence of a foreign country net operating loss carryover similar to Section
172, U.S. taxes on the subsequent profits could be eliminated by either an offsetting foreign tax
credit and/or by carryover losses. In effect, the foreign branch losses reduced U.S. tax, while
subsequent foreign profits were not effectively taxed by the United States. Section 904(f)(1)
eliminated this result by recasting the source of subsequent foreign source profits as U.S. source,
resulting in the loss of foreign tax credits on subsequent foreign income until such income equals
the foreign branch losses previously taken.
The foreign loss recapture rule of Section904(f)(1) requires taxpayers with foreign source
losses to set up an overall foreign loss (OFL) account. To the extent all foreign source deductions
(other than net operating, expropriation, and casualty losses) exceed all foreign source income,
the excess is attributed to the OFL account. Up to 50% (or a larger amount if the taxpayer elects)
of foreign income of any subsequent taxable year is thereafter converted to U.S. source income,
to the extent of the then remaining OFL account balance (reducing it dollar for dollar). Similarly,

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under Section904(f)(5)(C), if a separate limitation loss from a Section 904(d)(1) income category
was allocated to any other income category, income thereafter derived in the first category is
recharacterized as income in the second category to such extent, in order to preserve the integrity
of the Section 904(d) separate limitation system.
To prevent the avoidance of Section904(f)(1) foreign loss recapture by incorporation or other
disposition of branch operations before they become profitable, Section 904(f)(3) provides a
disposition rule which requires both recognition and resourcing of the gain on any disposition of
foreign branch assets in order to recapture the OFL account losses. The disposition rule applies to
sales or exchanges (including, e.g., Section 351 incorporations, distributions, and gifts)945 of
property materially used predominantly outside the United States in a trade or business during
the preceding three years. The disposition rule provides that an amount of gain, equal to the
lesser of (i) the excess of the fair market value of the property over its adjusted basis or (ii) the
OFL account balance must be recognized regardless of any otherwise applicable nonrecognition
rule and be treated as U.S. source income. Such income is of the same character as if the
taxpayer had sold or exchanged the property (i.e., ordinary or capital gain, depending on the
circumstances of the disposition).946 Similarly, to prevent the avoidance of Section 904(f)(5)(C),
an analogous disposition rule applies to a disposition of foreign assets that had given rise to a
separate limitation loss that had been allocated against separate limitation income in a previous
year.947
945
Section904(f)(3)(B). Disposition for this purpose does not include distribution or transfer of
property to a domestic corporation described in Section 381(a). Section 904(f)(3)(C).
946
Section 904(f)(3)(B)(ii).
947
Section 904(f)(5)(F).

The American Jobs Creation Act of 2004 (P.L. 108-357, §895) extended the recapture of
overall foreign losses on asset dispositions to stock dispositions in a controlled foreign
corporation (CFC) controlled by the taxpayer. The amendment added §904(f)(3)(D) providing
for any stock disposition after October 22, 2004, to be treated generally in the manner described
above for an asset disposition if the taxpayer owned (directly, indirectly or constructively under
§958) more than 50% (by vote or by value) of the stock of the CFC and made an "applicable
disposition" of any such stock. The provision excludes several types of stock dispositions from
this treatment except to the extent gain is otherwise recognized, for example, because of the
receipt of boot. The excluded stock dispositions include certain internal restructurings
(contributions to controlled corporations or partnerships under §§351 or 721, for example),
certain stock and asset reorganizations where the controlling shareholder's underlying indirect
interest in the CFC does not change, and certain liquidations and reorganizations within a
consolidated return group. Where applicable, §904(f)(3)(D) results in the recognition of foreign
source income to the extent of the lesser of the potential gain on the stock or the unrecaptured
overall foreign losses and without being limited to 50% of the foreign source income in the year
of the disposition.
On the other hand, P.L. 108-357 (at §402) also enacted §904(g), providing for the resourcing
of income in cases in which the foreign tax credit had been reduced as a result of an overall
domestic loss. The added subsection applies for purposes of the foreign tax credit and §936
possessions credit if the taxpayer has an overall domestic source loss. An overall domestic loss is
defined for these purposes as an excess of properly allocated or apportioned deductions over U.S.
source income for a taxable year beginning after December 31, 2006, determined without regard

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to any loss carryback, to the extent the excess offsets foreign source taxable income for the
taxable year or for any preceding taxable year by reason of a carryback. The taxpayer must also
have elected the foreign tax credit for the taxable year of the overall domestic loss. In such a
situation, §904(g) recognizes the taxpayer has incurred foreign tax that has not been creditable
against U.S. federal income tax and attempts to mitigate this by recharacterizing as foreign
source income the lesser of the unrecharacterized overall domestic source losses or 50% of the
taxpayer's U.S. source income in each succeeding taxable year. The law authorizes regulations to
coordinate the operation of the overall foreign loss recapture rules of §904(f) with the operation
of the overall domestic loss rules of §904(g).
Historical Note: Section904(b)(3)(C), as in effect before TRA 86,948 treated certain capital
gains that would have been foreign source under the normal title-passage rules as U.S. source,
unless either subject to foreign tax at a rate of at least 10% or attributable to the taxpayer's
country of personal residence, trade or business, or predominant source of income.
948
See TRA 86, Section 1211(b)(3).

D. Production and Sale of Natural Resources or Farm Products

The extraction and/or production of natural resource or farm products and their sale involve
at least to some extent income from the sale of personal property.949 Where the extracted,
processed, or cultivated natural resource product is sold in a country other than that of its origin,
income is attributable to both the country of sale and the country of extraction. Since the source
of such composite income is not expressly provided for in Sections 861-862, it is subject to
apportionment under regulations promulgated pursuant to Section 863(a), except as provided in
Section 865(b).
949
A U.S. real property interest under Section 897 includes an interest in, among other things,
timber, a mine, a well, or other natural deposit in the United States or the Virgin Islands, but only
until the timber is severed from the land or the ores, minerals, or other natural deposits are
extracted from the ground. See Regs. Section 1.897-1(b)(2).

1. General
Regulations under Section 863(a) (which, as discussed below, one court has ruled to be
invalid as applied to the facts before it)950 state that the source of income from the ownership or
operation of any farm, mine, oil or gas well, other natural deposit, or timber located within the
United States and from the sale by the producer of the products thereof within or without the
United States must "ordinarily" be included as gross income from U.S. sources.951 For example,
livestock raised in the United States and sold in Canada or Mexico "ordinarily" would be treated
as from U.S. sources. Under the regulations, however, an apportionment of such income is made
to sources within and without the United States if either: (i) the taxpayer shows to the satisfaction
of the IRS that, "due to the peculiar conditions of production and sale or for other reasons," an
apportionment is proper;952 or (ii) the IRS determines that an apportionment will more clearly
reflect the proper source of the income.953
950
Phillips Petroleum Co. v. Comr., 97 T.C. 30 (1991). See also Phillips Petroleum Co. v.
Comr., 101 T.C. 78 (1993), aff'd, 70 F.3d 1282 (10th Cir. 1995).
951
Regs. Section 1.863-1(b).
952
Regs. Section 1.863-1(b)(1).
953
Regs. Section 1.863-1(b)(2). See GCM 36328(July 1, 1975).

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 By the same token, under the regulations, at least until a recent case, income from the sale of
goods in the United States derived from certain mining or farming operations outside the United
States generally could be treated as sourced entirely where the mining or farming operations
were located.954 For example, Rev. Rul. 67-194955 involved the foreign extraction and processing
of sylvinite into a commercially suitable muriate of potash. In such form, the processed mineral
was sold in the United States through an independent commission agent (who was authorized to
determine prices and to negotiate and conclude sales). The ruling sourced all income therefrom
to the country of extraction and processing.
954
See Regs. Sections 1.863-1(b)(1), 1.863-6; Rev. Rul. 67-194, 1967-1 C.B. 183; Rev. Rul. 71-
198, 1971-1 C.B. 210.
955
1967-1 C.B. 183.

The IRS has expressed the view, in a GCM, that the principle of Rev. Rul.67-194is limited to
situations in which no processing is done outside of the foreign country of extraction.956 That
GCM involved a foreign corporation which extracted copper ore from mines in its home
jurisdiction, milled and smelted the ore into blister copper in that country, shipped the blister
copper to the United States for refining there by an unrelated party on a subcontract basis, before
selling the refined copper within and without the United States using an indirectly related party
as sales agent. The IRS concluded that the refining in the United States constituted a "peculiar
condition of production and sale" within the meaning of Regs. Section1.863-1(b)(2), so that
apportionment under Section 863(b) and Regs. Sections1.863-2 and 1.863-3 was required.957
956
GCM 36328(July 1, 1975).
957
See GCM 36328, modifying GCM 35183(U.S. source in part or whole where processing in
United States).

One rationale for the presumed allocation of all income from natural resources to the country
of extraction under Regs. Section 1.863-1(b) appears to be that natural resource products are
generally fungible goods having an established market price in both the place of destination and
shipment.958 Assuming the destination price exceeds the price at the departure port only by,
approximately, insurance, freight, and commission costs, there generally would be no foreign
distributional "profit" earned by the extractor. Furthermore, this result is consistent with what
would be the result under the real property source rules.959 The fact that depletion of land value
by mineral extraction and processing is an activity so closely related to the commercial use or
exploitation of real property supports the argument that the real property situs rule generally
should apply in preference to the personal property place of sale rule or the manufacturing source
apportionment rules.960 To the extent that commission profits of an independent sales agent are
earned in the country of sale, that income is already allocable to such country under the services
source rule.
958
Rev. Rul. 67-194, 1967-1 C.B. 183; GCM 7545, 1930-1 C.B. 215.
959
See Section 861(a)(5).
960
Accord, GCM 36328, n.3; Dailey, above, fn. 937, 15 Tax L. Rev. at 450-51.

The IRS has exercised its discretion under the natural resources regulations to permit
apportionment of income to sources within and without the United States under Section 863(b)
under the following circumstances.961 A foreign corporation's principal office, saw mill, and
dressing plant were located in a foreign country, and the foreign corporation was engaged in
cutting timber in the United States. It purchased timber or cutting rights from U.S. landowners,

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dispatched its employees to cut the timber, and hauled the cut trees across the border to its
sawmill. The manufacturing processes known as slashing, dipping, debarking, cutting, and
dressing were completed at the sawmill and dressing plant. All sales of the finished product by
the foreign corporation occurred at the foreign plant F.O.B. foreign port. The IRS ruled that the
foreign corporation's gross income derived from the ownership of timber was properly allocated
to sources within and without the United States under Section 863(b)and Regs. Section 1.863-
3(b)(2).
961
See PLR 8314057.

The Tax Court in Phillips Petroleum Co. v. Comr.,962 however, held Regs. Section 1.863-1(b)
to be invalid. The Tax Court concluded that in light of Section 863(b), income from natural
resources extracted within the United States and sold abroad could not be considered U.S. source
per se.963 The court reasoned:964
Section 863(b)(2) states that income from the sale of personal property produced within and
sold without the United States shall be treated as mixed source. Natural resource income may
also come under this rule. For example, natural gas, once extracted, is considered "personal
property" and the term "produced" is broadly defined to include "manufactured," "extracted,"
and "processed." Phillips' LNG income clearly falls within this rule as well.
The conflict between sections 1.863-1(b) of the regulations and 863(b)(2) of the Code is thus
evident, as illustrated by the present case. As stated, we must resolve any such conflict in
favor of section 863(b)(2). We accordingly hold that Section 1.863-1(b), Income Tax Regs.,
to the extent it conflicts with section 863(b)(2), is invalid.
962
97 T.C. 30 (1991), aff'd, 70 F.3d 1282(10th Cir. 1995).
963
See id. (income from sales of Alaskan liquified natural gas to Japanese utility sourced in part
abroad).
964
97 T.C. at 35-36.

The taxpayer's victory in invalidating the natural resource regulation may have been largely
Pyrrhic, however, since the Tax Court went on to deny the taxpayer's motion for partial summary
judgment that it not be required to use the independent factory or production method under the
§863(b)(2) regulations. The taxpayer's victory was complete in a second trial on the issue of
whether an IFP existed. The Tax Court, in Phillips Petroleum Co. v. Comr., 101 T.C. 78 (1993),
aff'd, 70 F.3d 1282 (10th Cir. 1995), held that the taxpayer was entitled to use the 50-50 method
of Ex. 2 because an IFP was not established. The purchasers of the taxpayer's LNG were not
wholly independent distributors, and the record did not disclose any other wholly independent
distributors that purchased the LNG from the taxpayer so as to establish an IFP. Accordingly, the
Tax Court concluded, Ex. 1 was inapplicable. Where natural resources with a price quoted on the
commodities markets are involved, the manufacturing source rule under Section 863(b)(2)
generally would leave relatively modest distributional profit to be apportioned to the country of
sale, assuming the producer sells to independent distributors at a price in the neighborhood of
such quoted price, thus establishing it as an independent factory or production price.965
965
See Regs. Section 1.863-3(b)(2), Ex. (1). See GCM 7545, 1930-1 C.B. 215, declared
obsolete, Rev. Rul. 74-268, 1974-1 C.B. 367, revoked on other grounds, GCM 36328 (July 1,
1975). This GCM concluded that the value in Chile of electrolytic copper produced in Chile and
sold partly in the United States and partly in foreign countries was established by the New York
market price less ocean transportation from Chile, and other delivery costs, carrying charges,

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 insurance, and broker's commission. GCM 7545 was decided under the independent factory price
formula of the manufacturing source rules, but it allocated all of the gross profit to the country of
extraction and production of the ore.

Under certain circumstances, however, an exporter may not be bound by an independent

factory or production price, and so may achieve a more significant apportionment of income to
foreign sources. Persons selling into the United States, on the other hand, can generally achieve
wholly foreign source income by passing title abroad (subject to §865(e)(2)), thus bypassing the
apportionment rules. Consequently, the invalidation of Regs. §1.863-1(b) has some revenue
significance.
2. General Rules After 1996 Regulations

In T.D. 8687965.1 the IRS adopted as final the proposed regulations issued nearly a year earlier.
The final 1996 regulations provide significantly different rules for determining the source of
natural resources income from those provided in the prior regulations, as well as from those
provided in regulations for income derived from sales of other manufactured or produced
inventory property (discussed above). A taxpayer may not use the 50/50 method (provided for
sourcing income from import or export sales of produced inventory property) in determining the
natural resources income source. Instead, the regulations introduce the concept of "export
terminal" which is central to determining the source of natural resources income. The export
terminal is the final point in the United States from which goods are shipped to a foreign country
in cases where the farm, mine, well, deposit or uncut timber is located in the United States.
Where the farm, mine, well, deposit or uncut timber is located outside the United States, the
export terminal is the final point in a foreign country from where goods are shipped to the United
States. Note that the export terminal in such a case may or may not be located in the country in
which the natural resource is located (e.g., oil extracted from a well located in one country but
refined in another country before shipment to the United States).965.2
965.1
61 Fed. Reg. 60540 (11/29/96).
965.2
Regs. §1.863-1(b)(3)(iii).

The purpose of the export terminal concept is to segregate and allocate the income
attributable to the natural resources property either to the U.S. sources (where the property is
located in the United States) or to foreign sources (where the property is located outside the
United States). To accomplish this, the regulations provide that gross receipts derived from a sale
within the United States or outside the United States of products derived from the ownership or
operation of any farm, mine, oil or gas well, other natural deposit or timber located outside the
United States or within the United States respectively must be split between U.S. and foreign
sources based on the fair market value of the product at the export terminal.965.3 The rules
provided in the regulations for allocating income to U.S. and foreign sources, which focus on
whether or not additional production activities were performed either before or after shipment
from the export terminal, may be summarized as follows:
1. Where no additional production activities are performed either before or after shipment
from the export terminal the gross receipts equal to the fair market value of the product at the
export terminal are sourced to the place where the farm, mine, well, deposit or uncut timber

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 is located. The gross receipts from the sale of the product that are in excess of its fair market
value at the export terminal (excess gross receipts) are sourced to the place of sale. The place
of sale is determined in accordance with Regs. §1.861-7(c), which provides that the place of
sale is generally where the rights, title and interest in the property pass to the buyer.965.4 The
place of sale, however, will be presumed to be the United States if the property is wholly
produced in the United States and is sold for use, consumption, or disposition in the United
States.965.5
2. Where additional production activities are performed subsequent to shipment from the
export terminal in the country of sale, the excess gross receipts are sourced in the country of
sale. If the additional production activities after shipment from the export terminal are
performed in a country other than the country of sale, the source of excess gross receipts is
determined under the three methods provided for sourcing income from sale of produced
inventory property (i.e., the 50/50 method, the IFP method, and the books and records
method).965.6
3. Where additional production activities are performed before shipment of the product from
the export terminal, gross receipts derived from the sale of the product are allocated between
U.S. and foreign sources based on the fair market value of the product immediately before
the additional production activities are performed. Gross receipts equal to the fair market
value of the product immediately prior to the additional production activities are sourced to
the place where mine, well, deposit or uncut timber is located. The source of excess gross
receipts is determined under the three methods provided for sourcing income from sale of
inventory property (i.e., the 50/50 method, the IFP method, and the books and records
method).965.7
965.3
Regs. §1.863-1(b)(1).
965.4
Regs. §1.863-1(b)(1).
965.5
Regs. §1.861-3(c)(2).
965.6
Regs. §1.863-1(b)(1).
965.7
Regs. §1.863-1(b)(2).

The regulations do not provide much guidance as to the determination of fair market value
except to state that it depends upon all of the facts and circumstances and must be consistent with
the arm's length standards of §482.965.8
965.8
Regs. §1.863-1(b)(4).

The term "production activity" is defined as an activity that creates, fabricates, manufactures,
extracts, processes, cures, or ages inventory.965.9 Production activities are considered "additional
production activities" if such activities are substantial and are performed directly by the taxpayer
in addition to activities attributable to the ownership and operation of the farm, mine, well, other
natural deposit, or timber. Whether or not taxpayer is engaged in additional production activities
is determined under Regs. §1.954-3(a)(4). A taxpayer is considered to be engaged in additional
production activities under Regs. §1.954-3(a)(4) if there is a "substantial transformation" of the
property. The regulations and the examples thereunder draw a distinction between activities that
merely prepare the natural resources for export and those that constitute transformation.
Irrespective of the complexity of the process, liquefaction of natural gas, for example, prepares it
for export and therefore is not considered additional production activity. Processing timber into
furniture, on the other hand, results in substantial transformation of the product and is, therefore,

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considered additional production activity.965.10
965.9
Regs. §1.863-1(b)(3)(i).
965.10
Regs. §1.863-1(b)(3)(ii) and (b)(7).

The regulations provide special rules for partnerships. These rules, which apply equally to
production and sale of inventory property, are discussed above (VII, B, 2) in conjunction with the
discussion of final regulations relating to the production and sale of inventory property.965.11
965.11
Regs. §1.863-3(g)(1).

A taxpayer that determines the source of its income under these regulations must attach a
statement to its return providing: (i) an explanation of the methodology used to determine the fair
market value of the products at the export terminal, (ii) an explanation of any additional
production activities performed by the taxpayer, and (iii) any other information required under
Regs. §1.863-3.965.12
965.12
Regs. §1.863-1(b)(6).

The final regulations are effective for taxable years beginning after December 29, 1996.
However, taxpayers have the option of applying the new rules to taxable years beginning after
July 11, 1995, and before December 30, 1996.965.13
965.13
Regs. §1.863-1(e).

3. Continental Shelf
As discussed I, C, above, §638 provides that, with respect to the exploration and exploitation
of inanimate natural resources, the terms United States and possession of the United States each
include the respective adjacent continental shelves, and the term "foreign country" includes any
adjacent continental shelf, provided the foreign country exercises taxing jurisdiction with respect
thereto. Consequently, in applying Regs. §1.863-1(b), the expanded scope of the relevant
jurisdiction under §638 must be taken into account.
4. Ocean Activities
Income from the extraction of natural resources, the leasing of drilling rigs and the
performance of related personal services with respect to deposits located beyond the jurisdiction
of the United States, its possessions, or any foreign country (including the continental shelf
adjoining the United States, its possessions, or any foreign country to the extent provided in
§638) is considered income from ocean activities. Thus, the source rules of §863(d), discussed in
X, below, apply to such income.
VIII. Insurance Underwriting Income
The source rules for insurance premium income are contained in §§861(a)(7) and 862(a)(7).
The rules sourcing insurance premiums by location of risk are contained in §953 (dealing with
certain insurance income derived by controlled foreign corporations).
A. General
Sections 861(a)(7) and 862(a)(7) provide that the source of insurance "underwriting income"
is, in general, the location of the insured risk.

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 Underwriting income is defined by §832(b)(3) to mean premiums earned on insurance
contracts during the taxable year less losses and expenses incurred. Underwriting income from
issuing or reinsuring any insurance or annuity contract is treated as from U.S. sources if it is
received:
(A) in connection with property in, liability arising out of an activity in, or in connection with
the lives of health of residents of, the United States, or
(B) in connection with risks not described in subparagraph (A) as a result of any arrangement
whereby another corporation receives a substantially equal amount of premiums or other
consideration in respect to issuing (or reinsuring) any insurance or annuity contract in
connection with property in, liability arising out of activity in, or in connection with the lives
or health of residents of, the United States.
Underwriting income from all other risks generally is foreign source income under §862(a)
(7). Underwriting income from the insurance of risks involving ocean or space activities,
however, should be sourced under the §863(d) rules as income from an "ocean or space activity."
966

966
S. Rep. No. 313, 99th Cong., 2d Sess. 359 (1986); TRA 86 Blue Book at 934-35. See
discussion in X, below.

For purposes of §861(a)(7), the §638 definition of the United States applies with respect to
insuring activities connected with the exploration or exploitation of inanimate natural resources
on the outer continental shelf of the United States.967
967
Cf. TAM 8412010 (premiums from casualty insurance with respect to the operation of
mobile drilling rigs over the outer continental shelf were income from the insurance of U.S. risks
for purposes of pre-TRA 86 §953.

Historical Note: Prior to TAMRA,968 §861(a)(7) treated as U.S. source income amounts
received as §832(b)(3) underwriting income "derived from the insurance of U.S. risks (as defined
in §953(a))." TRA 86 amended §953(a) to encompass within subpart F income the income from
insuring risks in any country other than the country in which the controlled foreign corporation
was organized. Consequently, post-TRA 86 §953(a) does not define U.S. risks. The amendment
to §861(a)(7) addressed this technical problem and was not intended to make a substantive
change.969
968
TAMRA, §1012(i)(10), effective as if included in TRA 86.
969
See Staff of Joint Committee on Taxation, Description of the Technical Corrections Act of
1988 (March 31, 1988) 275.

For the decade following TAMRA the language in §861(a)(7), with the exception of the
reference to the United States, was essentially identical to that of §953(a) and, as noted, §861(a)
(7) simply cross-referenced §953(a) prior to the TAMRA amendment. Consequently, the
regulations on risk location under §953(a) have been determinative for §861(a)(7). The language
of §953(a) was changed in 1998,969.1 but this was done to provide a temporary exemption from
subpart F for insurance income derived under exempt contracts by qualified insurance companies
with no apparent intention to alter the sourcing rules. In connection with the changes made by
TRA 86 to §953(a), however, the Treasury Department has proposed regulations under §953(a)
that make changes to, among other things, the provisions dealing with location of risks in ways
that were not simply a reflection of the TAMRA statutory change.970 In view of the statement by

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the Staff of the Joint Committee on Taxation that no substantive change was intended to §861(a)
(7)971 an issue could be raised whether, for §§861(a)(7) and 862(a)(7) purposes, taxpayers may
continue to rely, if to their advantage, on the existing regulations for §861(a)(7) purposes even
following finalization of the proposed §953 regulations.
969.1
The Tax and Trade Relief Extension Act of 1998, P.L. 105-277, §1005(b)(1)(A).
970
See discussion in VIII, B.
971
See fn. 969.

Section 861(a)(7) does not affect foreign insurers or reinsurers who do not engage in business
in the United States. U.S. source underwriting income is not treated as annual or periodic fixed
or determinable income subject to tax or withholding under §§871(a), 881, 1441, and 1442
because the premiums are subject to excise tax under §4371.972 Section 861(a)(7), however, does
affect foreign insurers or reinsurers who are engaged in business in the United States, since U.S.
source underwriting income is deemed to be effectively connected with a U.S. trade or business
under the §864(c)(3) force of attraction rule.973
972
See Rev. Rul. 89-91, 1989-2 C.B. 129, modifying Rev. Rul. 80-222, 1980-2 C.B. 211 (which
had stated an additional ground for exemption); GCM 38052 (underlying Rev. Rul. 80-222). For
example, nonresident aliens may engage in the direct underwriting of U.S. risks through a
syndicate formed on the New York Insurance Exchange. Williams, "Tax Consequences of Foreign
Investment in the New York Insurance Exchange," 1980 Insurance L. J. 433 (1980).
973
See TAM 9209001 and PLR 8248119.

Insurers are taxed on both underwriting and investment income. The location-of-the-risk rule
has no application to insurance investment income, which is sourced under the source rules for
interest, dividends, and sale of property. Under those rules, to the extent permitted by state
insurance law, foreign insurers (other than foreign life insurance companies taxable under §§801,
842, and 864(c)(4)(C)) may invest premiums from the insurance of U.S. risks in obligations
exempt from U.S. tax under §§881(c) and 881(d), and casualty insurers not engaged in business
in the United States may invest premiums from the reinsurance of U.S. risks in such obligations.
Historical Note: The location-of-the-risk source rule of §§861(a)(7) and 862(a)(7)
legislatively overruled (for years after 1976) the previous place-of-negotiation rule, which had
determined the source of underwriting income since 1922.974 The enactment was justified as
necessary to avoid manipulation of the source of underwriting income and to avoid double
taxation of domestic corporations who execute contracts in the United States, the underwriting
income of which is again taxed in the country of insured risk.
974
A.R.R. 723, I-1 C.B. 113 (1922); cf. I.T. 1359, I-1 C.B. 292 (1922); I.T. 3061, 1937-1 C.B.
114; Staff of the Joint Committee on Taxation "Description of Provisions Listed for Further
Hearings by the Committee on Finance on July 20, 21, and 22, 1976" (July 19, 1976) 21-22
(relating to H.R. 10612).

B. Controlled Foreign Corporations

In general, §953 treats insurance income derived by a controlled foreign corporation (CFC)
from the insurance or reinsurance of risks located outside the jurisdiction in which it is organized
as subpart F income.975 On April 17, 1991, regulations were proposed to replace the existing
regulations under §953. The proposed regulations include, as do the existing regulations, detailed
rules locating the source of the risk.976
975
In addition, §953 generally treats "related person insurance income" (as defined in §953(c)

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 (2)) as includible in income under §951(a)(1) by any U.S. person (as defined in §957(c) who owns
any stock of a foreign corporation at least 25% owned by U.S. persons. However, if the foreign
corporation elects to treat the related person insurance income as effectively connected with a
trade or business in the United States, such income is taxable to the corporation, and not to the
shareholders under §951. See §953(c)(3)(C).
976
The proposed regulations contain other, more controversial rules, including those that would
eliminate the ability of a CFC to apportion expenses (principally, loss reserves and loss adjustment
expenses, in the case of a property casualty insurer) between investment income and premium
income based on the ratio of premium or investment income to total income ("gross-to-gross"
method).

The existing §953(a) regulations include a 50%/30% mechanical test for defining activity of
an insured "ordinarily carried on in, but partly carried on outside, the United States."977 Under this
test, such activity is presumed to occur within the United States if more than 50% of the insured's
"total assets, personal services, and sales, if any, connected with such activity are located,
performed, or occur in the United States." Conversely, such activity is presumed not to exist if
less than 30% of the assets, etc., are within the United States. A similar rule applies to insurance
of property ordinarily located within, but partly without, the United States. Among other
important changes, these bright-line tests would be dropped under the proposed regulations.
977
Regs. §1.953-2(c)(3)(ii).

The risk location rules of Prop. Regs. §1.953-2 are proposed to replace the existing
regulations only with respect to periods of coverage that begin on or after June 17, 1991.978
978
Prop. Regs. §1.953-0(b).

1. Section 953 Insurance Income

To implement the TRA 86 changes to §953(a), the proposed regulations require that
premiums derived by a CFC on any insurance, reinsurance, or any annuity contract be classified
as either §953 insurance income or same country insurance (SCI) income.979 Section 953
insurance income is income attributable to issuing or reinsuring any insurance or annuity
contract in connection with risks located in a country other than the country (the home country)
under the laws of which the CFC is organized and which would be taxed under subchapter L of
the Code if the income were income of a domestic insurance company.980 Such income is
included in subpart F income.981 Premiums constitute §953 insurance income if they relate to
risks that are in connection with:
(i) property located in a country other than the home country;
(ii) a liability arising out of an activity conducted in a country other than the home country;
(iii) the life or health of a resident of a country other than the home country; or
(iv) risks not described in paragraphs (i) through (iii) above as a result of any arrangement
whereby another person receives a substantially equal amount of premiums or other
consideration in respect of issuing (or reinsuring) a contract described in such paragraphs.982
979
Prop. Regs. §1.953-1(a).
980
Id.
981
§952(a).
982
Prop. Regs. §1.953-2(a)(1).

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 Premiums constitute SCI income if they relate to risks that are in connection with:
(a) property located in the home country;
(b) a liability arising out of an activity conducted in the home country; or
(c) the life or health of a resident of the home country.983
983
Prop. Regs. §1.953-2(a)(2).

2. Risk Location Rules

a. General
Whether the premiums from an insurance, reinsurance, or annuity contract constitute §953
insurance income or SCI income "is determined by the location of the risks" (within or without
the home country) during the period or periods of coverage under the contract to which the
premiums relate.984 A period of coverage is a period no longer than one year during which
insurance coverage is provided or an annuity contract is in force and which begins or ends with
or within the taxable year of the CFC.985 Allocation of premiums to risks to which they directly
relate and apportionment of premiums between risks where no correlation exists generally is
required if risks are located both in and outside the home country during a period of coverage.986
If 80% or more of the premiums for a period of coverage of a particular contract are apportioned
to risks located in the home country or to risks located outside the home country, however, then
all of the premiums for the period of coverage are apportioned to risks incurred in or outside the
home country, as the case may be.987
984
Prop. Regs. Section 1.953-2(b)(1).
985
Id.
986
Prop. Regs. Section 1.953-2(d)(1).
987
Prop. Regs. Section 1.953-2(d)(3).

The Section 953 insurance income of a CFC includes any insurance income from issuing or
reinsuring insurance policies or annuity contracts covering risks located in the home country if
the insurance, reinsurance, or annuity contracts "are attributable to any direct or indirect cross-
insurance arrangement whereby the [CFC] provides insurance, reinsurance, or annuity contracts
relating to home country risks and, in exchange, another person provides insurance, reinsurance,
or annuity contracts relating to risks located outside the home country."988
988
Prop. Regs. Section 1.953-2(h).

b. Specific Risks
(1) Property Generally
Risks in connection with property covered by a contract of insurance or reinsurance are
located where the property is located during the period or periods of coverage applicable to the
taxable year.989
989
Prop. Regs. Section 1.953-2(e)(1). Comments filed with the IRS by the American Insurance
Association state that the proposed rules impose unreasonable, largely unworkable requirements
and suggests that CFCs be permitted to site property and casualty risks for Section 953 purposes
on the basis of normal business practices (which include geographical situs of the risk as an
important factor). Letter by Allen Stein to Carol Dunahoo (IRS) dated June 25, 1992, reprinted in

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 The Insurance Tax Review, August 1992, at 940.

Commercial transportation property: Premiums related to insuring or reinsuring risks in

connection with any motor vehicle, ship or boat, aircraft, railroad rolling stock, or any container
transported thereby (commercial transportation property) that is "used predominantly in the
commercial transportation of persons or property" are attributable to risks located in the home
country if the property is located in the home country for the entire period of coverage, or outside
the home country if the property is located outside the home country for the entire period of
coverage.990
990
Prop. Regs. Section 1.953-2(e)(2)(i).

If the commercial transportation property is located both in and outside the home country,
then the premiums [must] be allocated or apportioned between risks located in the home country
and risks located outside the home country on any reasonable basis (such as time or mileage) that
gives due regard to the risk being insured."991
991
Id.

Noncommercial transportation property: Premiums related to risks incurred in connection

with any motor vehicle, ship or boat, aircraft, or railroad rolling stock not used predominantly in
the commercial transportation of persons or property are attributable to risks located outside the
home country "if the noncommercial transportation property is registered during the period of
coverage with a country other than the home country (including any political subdivision or
agency of such country) or if the owner of the property is a citizen of, resident of, or entity
organized under the laws of a country other than the home country."992 In all other cases,
noncommercial transportation property is deemed to be located in the home country.
992
Prop. Regs. Section 1.953-2(e)(2)(iii).

Property exported by ship or aircraft: Premiums related to risks in connection with property
exported from the home country by ship or aircraft are attributable to risks incurred while the
exported property is located in the home country "if the insured risks terminate when the
exported property is placed aboard the ship or aircraft for export."993 Premiums are attributable to
risks incurred while the exported property is located outside the home country "if the insured
risks commence when the exported property is placed aboard the ship or aircraft for export."994 If
the insured risks commence before the exported property is placed aboard the ship or aircraft for
export and terminate after the departure of the ship or aircraft from the home country, the
premiums must be allocated or apportioned between risks incurred while the exported property is
located in the home country and risks incurred while the property is located outside the home
country on any reasonable basis (such as time or mileage) that gives due regard to the risk being
insured.995
993
Prop. Regs. Section 1.953-2(e)(2)(iv).
994
Id.
995
Id.

Property imported by ship or aircraft: Premiums related to risks in connection with property
imported into the home country by ship or aircraft are attributable to risks incurred outside the
home country if the insured risks terminate when the imported property is unloaded at the home
country port of entry.996 If the insured risks commence after the imported property is unloaded

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from the ship or aircraft at the home country port of entry, the premiums are attributable to risks
incurred while the imported property is in the home country.997 If the insured risks commence
before and terminate after the imported property is unloaded from the ship or aircraft at the home
country port of entry, the premiums "must be allocated or apportioned to or between risks
incurred while the imported property is located in the home country and risks incurred while the
imported property is located outside the home country on any reasonable basis (such as time or
mileage) that gives due regard to the risk being insured.998
996
Prop. Regs. Section 1.953-2(e)(2)(v).
997
Id.
998
Id.

Property transported between two points within a country: Premiums related to risks incurred
in connection with property transported from one place in the home country to another place in
the home country on or over another country, or on or over the high seas outside territorial waters
of the home country are attributable to risks in the home country "unless the premiums are
allocated, in a reasonable manner, under the terms of the insurance contract to risks incurred
while the property is located in the home country and risks incurred while the property is located
outside the home country."999 Similarly, premiums related to risks in connection with property
transported on or over the home country to and from points outside the home country are
attributable to risks located outside the home country "unless the premiums are allocated, in a
reasonable manner, under the terms of the insurance contract to risks incurred while the property
is located in the home country and risks incurred while the property is located outside the home
country."1000
999
Prop. Regs. Section 1.953-2(e)(2)(vi).
1000
Prop. Regs. Section 1.953-2(e)(2)(vii).

Related property: If a contract of insurance or reinsurance covers a group of related assets,

such as inventory, which are located in and outside the home country, premiums under the
contract "may be allocated or apportioned, on any reasonable basis, between risks located in the
home country and risks located outside the home country by reference to such property taken in
the aggregate."1001
1001
Prop. Regs. Section 1.953-2(e)(3)(i).

Movable property: If a contract of insurance or reinsurance covers movable property (other

than noncommercial transportation property), such as a ship leased by the owner to third parties
on a per-voyage basis, and "the determination of the location of the property in or outside the
home country during a period of coverage cannot practically be made" by the close of the CFC's
taxable year, the CFC may apportion the premiums "in conformance with a reasonable
expectation of where the property will be located during the period of coverage," provided that
the apportionments made on all such contracts "do not result in a material distortion." 1002
1002
Prop. Regs. Section 1.953-2(e)(3)(iii). In order to avail itself of this method, the controlled
foreign corporation must maintain records that demonstrate the reasonableness of its
apportionment, disclose the actual location of the property as ascertained within 90 days after the
end of the period of coverage, and demonstrate that the apportionment did not result in a material
distortion.

(2) Activities

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 A risk in connection with an activity1003 is located where the activity that could give rise to a
liability or loss is performed.1004 For purposes of allocating and apportioning premiums between
risks located in and outside the home country, where an activity is performed depends on the
facts and circumstances of each case. Among the factors to be considered in making the
determination are the location of the assets associated with the activity, the place where services
comprising the activity are performed, the place where activities intended to result in a sale
occur, and the place where sales actually occur.1005
1003
A risk covered by a contract of insurance or reinsurance is "in connection with" liability
arising out of an activity "if the insured is covered against a liability resulting from the actions of a
person or a juridical entity, including actions that result in a tort, violation of contract, violation of
property rights, or any other cause of action pursuant to the operation of law." Prop. Regs. Section
1.953-2(f)(1).
1004
Prop. Regs. Section 1.953-2(f)(2)(i).
1005
Id.

Manufactured products: Premiums under a policy of insurance or reinsurance that insures a

person that manufactures, produces, constructs, or assembles property against claims arising
from the consumption or use of such property are attributable to risks from an activity performed
"where the consumption or use of the property takes place, or if the place of consumption or use
cannot be known, where the property is manufactured, produced, constructed, or assembled."1006
If the consumption or use of the property could arise in or outside the home country, the
premiums "must be allocated to or apportioned between risks located in the home country and
risks located outside the home country on any reasonable basis that gives due regard to the risk
being insured."1007
1006
Prop. Regs. Section 1.953-2(f)(3)(i).
1007
Id.

Transportation: Premiums under a contract of insurance or reinsurance covering risks in

connection with the operation of a motor vehicle, ship or boat, aircraft, or railroad rolling stock
are attributable to risks in connection with an activity performed where the transportation
property is located under the principles relating to the location of transportation property.1008
1008
Prop. Regs. Section 1.953-2(f)(3)(iii).

Selling activity: Premiums received on a contract of insurance or reinsurance covering risks

in connection with selling activity "are attributable to risks incurred where the selling activity
takes place regardless of whether the property passes through, or is delivered in, the country in
which the selling activity is carried on."1009 Selling activity takes place where the activities
preparatory to the sale, such as advertising, negotiating, and distributing, take place. 1010
1009
Prop. Regs. Section 1.953-2(f)(3)(v).
1010
Id.

(3) Life or Health

The risk under any insurance, reinsurance, or annuity contract covering risks in connection
with life or health is located in the country where the person with respect to whom the risk is
located is resident.1011 Risks in connection with an annuity are deemed to be located in their
entirety outside a CFC's home country if either the purchaser of the contract or the recipient of
the annuity payments resides outside the home country.1012 Premiums received under a contract of

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group life or health insurance must be apportioned between risks located in the home country
and risks outside the home country on the basis of the last known addresses of the residences of
the persons insured under the contract or, in the case where the contract is issued to an employer,
where the persons covered by the contract are employed.1013
1011
Prop. Regs. Section 1.953-2(g)(1).
1012
Id.
1013
Id.

IX. Income from Transportation

The "transportation income" rules are contained generally in §863(c). Under §887, a 4% tax
is imposed on U.S. source gross transportation income. There are "equivalent exemption"
provisions in the Code ( §§872(b) and 883(a)) for shipping and aviation income, and there are
treaty counterparts to such provisions. Finally, there are certain rules governing land
transportation.
A. Transportation Income (Shipping and Aviation)
Section 863(c) sets forth the source rules governing "transportation income," defined for this
purpose to include income derived from the use, or hiring or leasing for use, of a vessel or
aircraft (including any container used in connection with a vessel or aircraft), or from the
performance of services directly related to the use of a vessel or aircraft. Thus, transportation
income includes not only income from operating a vessel or aircraft, but also certain leasing
income and certain income from personal services. This definition is discussed below in IX, A, 2.
1. General Rule
Under §863(c), transportation income is allocated based entirely on whether the points of
departure and points of destination are within or without the United States. This approach reflects
the fact that, looking at distance covered, in general, most transportation between the United
States and a foreign country, and even some transportation income between two points within the
United States, occurs outside the jurisdiction of either country, so that an apportionment to U.S.
sources based on distance traveled within the United States (or its airspace) would not accurately
reflect the share of transportation income properly taxable by the United States. Congress
believed that the failure of the United States to treat certain income not subject to tax by another
jurisdiction as from U.S. sources had the effects of permitting U.S. persons to generate untaxed
foreign source income against which excess foreign tax credits could be credited, and permitting
foreign persons to avoid tax on income properly within the tax jurisdiction of the United States.
1014
Thus, income from cruise ships departing a U.S. port but not calling on a foreign port is
entirely U.S. source.1014.1
1014
Blue Book, TRA 86, at 927.
1014.1
See TAM 9348001.

For purposes of §863(c), the term "United States" generally includes only the 50 states and
the District of Columbia, including the territorial waters extending for three miles therefrom. 1015
In the case of income related to the exploration and exploitation of natural resources, however,
the term United States includes the outer continental shelf.1016
1015
See §7701(a)(9). See I, C, above.

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 1016
See §638. See discussion at I, C, and IV, C, 3, above.

a. Between Two Points Within the United States

Under §863(c)(1), transportation income derived from transportation which begins and ends
in the United States is treated as derived from sources within the United States. For example,
income of seamen and flight personnel for services performed with respect to transportation
beginning and ending in the United States is considered U.S. source under §863(c)(1).1017
1017
TRA 86 Blue Book, at 928-29. See IV, C, 1, c, above.

b. Between the United States and a Foreign Country or Possession

Under §863(c)(2), in general, 50% of all transportation income attributable to transportation
which begins or ends in the United States is treated as derived from sources within the United
States.1018 This 50-50 split, while arbitrary, presumably is intended to do rough justice, avoid
disputes, and be easily administrable.1019 Transportation governed by this 50-50 rule would
include income from round-trip travel between the United States and a foreign country. 1020
1018
§863(c)(2)(A).
1019
Compare the 50-50 rule under §863(e) for international communications income.
1020
S. Rep. No. 313, 99th Cong., 2d Sess. 341-42 (1986); TRA 86 Blue Book at 929.

The 50-50 rule of §863(c)(2), however, does not apply to any transportation income which is
income derived from personal services performed by the taxpayer, unless such income is
attributable to transportation which begins in the United States and ends in a possession of the
United States, or begins in a possession of the United States and ends in the United States.1021
Rather, the general source rules governing income from services1021.1 apply. Consequently, as
discussed above,1022 income of flight personnel and ship personnel derived from flights or
voyages between the United States and a foreign country is allocated under the general source
rules for service income rather than under §863(c).1023
1021
§863(c)(2)(B).
1021.1
§§861(a)(3), 862(a)(3), and Regs. §1.861-4.
1022
See IV, C, 1, c, above.
1023
Service income derived by a corporation through its employees or other agents should be
considered "personal services" for purposes of this provision. See discussion at IV, C, 1, d, above.
However, the Joint Committee on Taxation refers only to "seamen or airline employees." See TRA
86 Blue Book at 928-29.

In the case of transportation that begins in the United States and ends in a foreign country (or
vice versa), but involves intermediate stops, the 50-50 rule applies only to the portion of the
income attributable to freight or passengers carried from a U.S. point to a foreign point (or vice
versa). Income attributable to freight or passengers carried solely between two foreign
destinations or two domestic destinations is wholly foreign source or wholly domestic source,
respectively.1024 For example, if a voyage originates abroad and has a U.S. destination, but
passengers disembark or goods are delivered at intermediate foreign points, income derived from
such passengers and goods are treated as from wholly foreign sources. By the same token,
income attributable to transportation originating and ending within one or more foreign
countries, with no U.S. stops, is treated as entirely from foreign sources.1025
1024
S. Rep. No. 313, 99th Cong., 2d Sess. 341 (1986); TRA 86 Blue Book at 729.

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 1025
Insofar as the transportation income includes income from leasing property or income from
personal services, this treatment is consistent with what would be the treatment under the general
source rules governing rental income and service income, respectively.

2. Definition of Transportation Income

The term "transportation income" means "any income derived from, or in connection with --
(A) The use (or hiring or leasing for use) of a vessel or aircraft" or any container used in
connection therewith, or
(B) "The performance of services directly related to the use of a vessel or aircraft" or any
container used in connection therewith.1026 Transportation income does not include income
from the disposition of vessels, aircraft or containers.1027
1026
§ 863(c)(3).
1027
Rev. Proc. 91-12, §2.03, 1991-1 C.B. 473.

Rev. Proc. 91-12 expands upon certain terms in this definition. The term "income derived
from or in connection with . . . the use (or hiring or leasing for use) of any vessel or aircraft"
means income derived:
(i) from transporting passengers or property by vessel or aircraft;
(ii) from hiring or leasing a vessel or aircraft for use in the transportation of passengers or
property on the vessel or aircraft; and
(iii) by an "operator" of vessels or aircraft1028 from the rental or use of containers and related
equipment ("container-related income") in connection with, or incidental to, the
transportation of cargo on such vessels or aircraft by the operator.1029 The term "transportation
of passengers" does not necessarily imply transportation of passengers from one port to
another port of destination. Thus, for example, income derived from the operation of a cruise
ship from a U.S. port in international waters and not calling on any foreign port qualifies as
transportation income.1029.1
1028
For purposes of the Rev. Proc. 91-12 rules, the term "operator" includes the actual operator
of a vessel or aircraft, as well as a time or voyage charterer of such vessel or aircraft. Id. at §2.06.
Accord S. Rep. No. 313, 99th Cong., 2d Sess. 341 (1986) (bareboat charter income is
transportation income).
1029
Rev. Proc. 91-12 at §2.04. Only an operator of a vessel or aircraft is considered as deriving
container-related income; such income derived by others is treated as rental income, not
transportation income. Id.
1029.1
See TAM 9348001.

The term income derived from or in connection with "the performance of services directly
related to the use of a vessel or aircraft" includes the following categories of income.
(i) On-board services: Income in this category is derived from services performed on board a
vessel or aircraft by the operator (or person related to the operator within the meaning of
§954(d)(3)) in the course of the actual transportation of passengers or property aboard vessels
or aircraft. Examples of income in this category include income from renting staterooms,
berths, or living accommodations; furnishing meals and entertainment; operating shops and
casinos; providing excess baggage storage; and income from the performance of personal

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 services by individuals. The term also includes income derived from demurrage, dispatch,
and dead freight.
Note: If the on-board services are provided by a person other than (and unrelated to) the
operator of the vessel or aircraft, the income derived from such services is not transportation
income.1029.2
(ii) Off-board services: Income in this category is derived from services performed off board
any vessel or aircraft by an operator of a vessel or aircraft, provided such services are
incidental to the operation of vessels or aircraft by such operator. The term does not include
income from services performed by persons other than an operator. Examples of off-board
services include: terminal services such as dockage, wharfage, storage, lights, water,
refrigeration, refueling, and similar services; stevedoring and other cargo handling services;
maintenance and repairs; and services performed as a travel or booking agent.1030
1029.2
See e.g, TAMs 9327001, 9327003, and 9327004, where income derived by a CFC from the
operation of casino, food and beverage concessions on board cruise ships did not qualify as
transportation income because the CFC was not the operator of the ships.
1030
Id. at §2.05.

To the extent that income is included within the §863(c) definition of transportation income,
it is excluded from the §863(d) definition of "ocean or space activity."1031 In other words, when
applicable, the transportation income rules take precedence over the ocean or space activity
rules. Income not meeting the definition of transportation income, however, which would be
treated as income from a space or ocean activity includes income from leasing a vessel for a
purpose other than to transport cargo or persons for hire, such as income from leasing a vessel to
a lessee engaged only in research activities thereon.1032 Another example is income from leasing a
vessel for a fishing expedition.
1031
§863(d)(2)(B)(i).
1032
S. Rep. No. 313, 99th Cong. 2d Sess. 341, 359 (1986); TRA 86 Blue Book at 934.

Other examples include income from the operation of casinos on cruise ships by persons
unrelated to the operators of the ships1032.1 and income derived from food and beverage
concessions on cruise ships by persons unrelated to the operators.1032.2
1032.1
TAM 9327001.
1032.2
TAMs 9327003 and 9327004.

Historical Note: Under pre-TRA 84 law, Regs. §1.863-4 generally allocated all transportation
services income between U.S. sources and foreign sources in proportion to the expenses incurred
in providing the services. Expenses incurred outside the three-mile limit of U.S. territorial waters
were treated as foreign for purposes of such calculation. Income from coastwise transportation
thus was predominantly foreign source income if the route of transport lay primarily beyond the
United States territorial limits, as, for example, in the case of income derived from the
transportation of crude oil from Alaska to West Coast points.
TRA 841033 added §863(c) providing source rules for income derived from coastwise
transportation and from transportation which began in the United States and ended in a
possession, or vice versa (effective for transportation beginning after July 18, 1984, in taxable
years ending after that date). Section 863(c)(1) instituted the rule that transportation income

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attributable to transportation which begins in the United States and ends in the United States is
treated as U.S. source income. Under §863(c)(2) as in effect after TRA 84 but before TRA 86,
transportation income attributable to transportation which began in the United States and ended
in a possession of the United States, or vice versa, generally was apportioned between the United
States and the possession on a 50-50 basis. Transportation income included any income derived
from or in connection with the use, or hiring or leasing for use, of a vessel or aircraft, or the
performance of services directly related to the use of such vessel or aircraft. Income derived from
the lease of an aircraft to an unrelated regularly scheduled air carrier, however, was treated as
entirely U.S. source income if the aircraft was operated between the United States and a
possession of the United States.
1033
TRA 84, §124.

TRA 861034 amended §863(c)(2) to provide as set forth above. In general, such amendments to
§863(c)(2) applied to taxable years beginning after December 31, 1986.1035 Special effective date
rules apply, however, with respect to leased property and certain ships leased by the U.S. Navy.
1036

1034
TRA 86, §1212(a).
1035
TRA 86, §1212(f)(1).
1036
TRA 86, §§1212(f)(2), (f)(3).

B. Four Percent Tax on U.S. Source Gross Transportation Income

Under §887(a), in the case of a nonresident alien individual or foreign corporation, a tax
equal to 4% of such taxpayer's U.S. source gross transportation income (USSGTI) is imposed for
each taxable year. Income that is taxable under §871(b) or §882 as income effectively connected
with a U.S. trade or business is excluded from the base of the §887 tax, but the determination of
whether transportation income from U.S. sources is effectively connected is made under the
special rules of §887(b)(4). Conversely, any income taxable under §887 is not taxable under
§871, §881, or §882.1037
1037
§887(c). Thus, except to the extent of income treated as effectively connected under §887(b)
(4), the §887 4% gross income tax supersedes the withholding tax and regular tax regimes with
respect to U.S. source transportation income.

USSGTI is defined in §887(b)(1) as any gross income which is transportation income (as
defined in §863(c)(3)), to the extent such income is treated as from sources in the United States
under §863(c)(2).1038 This includes 50% of (i) transportation income from transportation
beginning in the United States and ending abroad, or vice versa, and (ii) transportation income
derived by an individual from the performance of personal services attributable to transportation
beginning in the United States and ending in a possession, or vice versa. Such term does not
include any income that, unless treaty-exempt, is taxable (pursuant to the special rule of §887(b)
(4)) under §871(b) or §882, which provisions subject income effectively connected with a U.S.
trade or business to the regular income tax.1039 The term also excludes income taxable in a
possession of the United States under the "mirror" system of possession taxation.1040 Finally, the
Treasury Department is authorized to publish regulations excluding from such term any income
that would not be eligible for reciprocal exemption under §883(a).1041
1038
Any income from the lease of a vessel or aircraft held by the taxpayer on January 1, 1986,
and first leased before that date, in a lease to which §863(c)(2)(B) or §861(e) (as in effect before
January 1, 1987) applied is considered wholly from sources within the United States, and the 50%

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 source rule of §863(c)(2) does not apply. Rev. Proc. 91-12, §3.04. Therefore, such income is not
subject to the 4% tax under §887. Id.
1039
§887(b)(2); Rev. Proc. 91-12, §§3.01, 4.01.
1040
§887(b)(3).
1041
§887(b)(1).

A determination whether USSGTI is effectively connected with a trade or business within the
United States must be made under the rules provided in §887(b)(4), rather than those under
§864(c).1042 USSGTI of any taxpayer is not treated as "effectively connected" with the conduct of
a trade or business within the United States unless:
(i) the taxpayer has a "fixed place of business in the United States involved in the earning" of
the income, and
(ii) substantially all of the USSGTI of the taxpayer (including, in applying the test, income
otherwise excludable as effectively connected income under §887(b)(2)) "is attributable to
regularly scheduled transportation (or, in the case of income from the leasing of a vessel or
aircraft, is attributable to a fixed place of business in the United States)." 1043
1042
Rev. Proc. 91-12, §4.02. Thus, transportation income which was effectively connected with
a trade or business within the United States during pre-1987 years under the rules of §864(c),
might not be effectively connected USSGTI in post-1986 years under the rules of §887. Id.
1043
§887(b)(4). See PLR 9131050 (foreign transportation's income from transporting cargo
between U.S. and foreign ports not effectively connected since shipments were made on demand
and were not regularly scheduled).

Certain terms used in §887(b)(4) are clarified in Rev. Proc. 91-12:

(a) The term "fixed place of business" has the same meaning as in Regs. §1.864-7.1044
(b) The term "substantially all" means at least 90%.1045
(c) In general, transportation is "regularly scheduled" when a ship or aircraft follows a
published schedule with repeated sailings or flights, as the case may be, at regular intervals
between the same points for voyages or flights which begin or end in the United States.1046
With respect to air transportation, this rule includes both scheduled and chartered air carriers.
1047
Liner operations tend to be regularly scheduled, but vessels engaged in tramp operations
usually are not.1048
(d) The term "leasing" means the bareboat charter of a vessel or aircraft. Time or voyage
charter income is not considered income from leasing for this purpose, but rather is
considered income from the use (or operation) of a vessel or aircraft.1049
(e) Transportation income derived from the bareboat lease of aircraft or vessels is considered
attributable to a fixed place of business in the United States if it is treated as effectively
connected with a fixed place of business in the United States under the principles of Regs.
§1.864-6.1050
1044
Rev. Proc. 91-12, §4.05.
1045
Id. at §4.06.
1046
Rev. Proc. 91-12, §4.07.
1047
Id.
1048
Id.

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 1049
Id. at §4.08.
1050
Id. at §4.09.

Finally, Rev. Proc. 91-12 sets forth the following rules for determining the amount of
USSGTI from rental (charter) income:1051
Nonresident alien or foreign corporate lessors must establish the actual amount of USSGTI
derived from a charter under a reasonable method and disclose that method with their return.
Where a vessel or aircraft is under charter, one reasonable method of determining the portion
of such charter income which is USSGTI is to apply to such charter income the ratio of (a)
the number of days of uninterrupted travel on voyages or flights between the United States
and the farthest point(s) where cargo or passengers are loaded en route to, or discharged en
route from, the United States, to (b) the number of days in the smaller of the taxable year or
the particular charter period. When determining USSGTI, the number of days the vessel is
located in United States waters for repairs or maintenance should not be included in either
the numerator or in the denominator of the ratio. Another reasonable method would be to use
a ratio based on the USSGTI earned from the operation of the vessel or aircraft by the lessee-
operator, compared with the total gross income of the lessee-operator from the operation of
the vessel or aircraft during the smaller of the taxable year or the term of the charter.
However, an allocation based on the net income of the lessee-operator will not be considered
reasonable for this purpose.
1051
Id. at §5.02.

Historical Note: Before TRA 86, the United States (in contrast to a number of countries) did
not impose a gross basis tax on domestic source shipping income of foreign persons. Section
1212(b) of TRA 86 imposed a tax on "gross transportation income" by enacting §887 of the
Code, generally effective for taxable years beginning after 1986.1052
1052
TRA 86, §1212(f)(1).

C. Code and Treaty Exemptions of Shipping and Aviation Income

The source of income derived by nonresident aliens and foreign corporations from
international sea and air transportation can be of little or no significance if such income is
granted a reciprocal exemption by Code or applicable tax treaty provisions. Consequently, the
provisions relating to such reciprocal exemptions should be considered in conjunction with the
source rules.
1. Code Exemptions
The Code exemptions for such income are found in §872(b) and 883(a). Section 872(b)
excludes from the gross income of a nonresident alien who is a resident of a foreign country
income derived from the "international operation" of ships or aircraft1053 if such foreign country
grants an equivalent exemption to U.S. citizens. Similarly, §883(a) excludes from the gross
income of a corporation organized in a foreign country income derived from the international
operation of ships or aircraft if such foreign country grants an equivalent exemption to U.S.
citizens. A foreign country may grant an equivalent exemption by domestic law (which may or
may not be confirmed by an exchange of diplomatic notes or by a letter issued by the IRS to the
foreign government) or by income tax treaty.1054 For the purpose of the exemptions, eligible

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income includes (subject to reciprocity by the foreign country) income derived from the rental on
a full or bareboat basis of ships or aircraft.1055 Eligible income also includes income derived by a
foreign corporation from the operation of a cruise ship between a U.S. and a foreign port. Such
income, however, does not include income derived from the operation of a cruise ship out of a
U.S. port on a cruise to nowhere (i.e., where the ship stays in international waters and does not
call on any foreign port).1055.1
1053
Operational income from coastwise (as opposed to international) trade has been held to not
be reciprocally exempt. See M/V Nonsuco, Inc. v. Comr., 23 T.C. 361 (1954), aff'd, 234 F.2d 583
(4th Cir. 1956). Also, income from the sale of real property used in the business of the U.S. branch
of an Argentine shipping company is not considered to be from the international operation of ships
or aircraft. Rev. Rul. 90-37, 1990-1 C.B. 141. See also fn. 1064 below.
1054
Rev. Proc. 91-12, 1991-1 C.B. 473, § 8.01. See, e.g., Rev. Rul. 97-31, 1997-2 C.B. 77
(listing in chart form countries known to grant equivalent exemptions).
1055
§§872(b)(6) (as redesignated from §872(b)(5) by §419 of P.L. 108-357), 883(a)(4). The
agreement with Turkey, for example, while exempting profits from the use of containers if
incidental to other exempt transportation profits, expressly excludes profits from the rental of
ships or aircraft on a full (time and voyage) or bareboat basis. Rev. Rul. 87-18, 1987-1 C.B. 709.
1055.1
See TAM 9348001.

Historical Note: Before TRA 86, income from bareboat charter hire was viewed as producing
investment rental income and not considered protected, unless the lessor was actively engaged in
a shipping business and temporarily chartered the vessel during the idle period.1056 However, time
and voyage charter income (since the lessor provides crew, supplies, insurance, repairs, and
maintenance) and gain from the disposition of vessels and aircraft were ruled to be reciprocally
exempt.1057
1056
Rev. Rul. 74-170, 1974-1 C.B. 175. But cf. Diefenthal v. U.S., 367 F. Supp. 506 (E.D. La.
1973) (investment charter hire may be exempt).
1057
Rev. Rul. 74-170, 1974-1 C.B. 175 (time and voyage charter); Rev. Rul. 72-624, 1972-2
C.B. 659 (disposition gain). Compare Rev. Rul. 70-263, 1970-1 C.B. 158 (interest on working
capital exempt) with Rev. Rul. 274, 1953-2 C.B. 81 (interest on short-term investment of surplus
cash not exempt).

To the extent provided in regulations, a possession of the United States is treated as a foreign
corporation for purposes of the reciprocal exemption provisions.1058
1058
§§872(b)(8) as redesignated from §872(b)(7) by §419 of P.L. 108-357), 883(a)(4).

Under §883(c), the reciprocal exemption does not apply to any foreign corporation if 50% or
more of the value of the stock of such corporation is owned by individuals who are not residents
of the foreign country in which the corporation is organized (and which grants an equivalent
exemption) or another foreign country satisfying the equivalent exemption requirement unless
either the corporation is a controlled foreign corporation1059 or the corporation satisfies a public
trading exception.
1059
§883(c)(2). For taxable years of foreign corporations beginning after Dec. 31, 2004 (and for
taxable years of U.S. shareholders with or within which such taxable years of such foreign
corporations end), the American Jobs Creation Act of 2004 (P.L. 108-357) repealed §954(a)(4) and
(f), which included foreign base company shipping income in the subpart F income of U.S.
shareholders, and added §954(c)(2)(A), which provides a safe harbor from subpart F whereby the
rental income from leasing an aircraft or vessel in foreign commerce is treated as derived in the
active conduct of a trade or business if the active leasing expenses are not less than 10% of the
profit on the lease. Prior to this amendment going into effect, the situation was quite different, as

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 described in the remainder of this footnote. In the case of a controlled foreign corporation,
shipping income would be subpart F income under §954(f), taxable in the year earned directly to
the U.S. shareholders meeting the 10% ownership threshold of §951(b), even if the shipping
income is exempt under §883. See Rev. Rul. 87-15, 1987-1 C.B. 248. For example, if more than
50% of the shares of a shipping company resident in a country granting an equivalent exemption
are held by U.S. resident members of a family who are U.S. shareholders within the meaning of
§951(b), such shareholders generally would be taxed on their pro rata share of the corporation's
income annually. A corporate tax, however, would be avoided (with an effect similar to that of an
S corporation). If the remaining shares were widely held or held by foreign persons, the income
allocable thereto would escape any U.S. federal income tax (until distributed, in the case of
domestic shareholders who had not previously included the distributed amount in income).

The public trading exception is met if the stock of a foreign corporation that is organized in a
country meeting the equivalent exemption requirement is either:
(i) "primarily and regularly traded on an established securities market" in such country, any
other foreign country which grants an equivalent exemption to U.S. corporations, or the
United States; or
(ii) owned directly or indirectly by a second foreign corporation meeting such requirements
and primarily and regularly traded on an established securities market either in a country
which grants an equivalent exemption to U.S. corporations or the United States.1060 For these
purposes, stock owned, directly or indirectly, by or for a corporation, partnership, trust, or
estate is treated as being owned proportionately by its shareholders, partners, or beneficiaries.
1061

1060
§883(c)(3), as amended by TAMRA, §1012(e), effective as if included in the 1986 TRA.
(The residence test is similar to that of §884 and of the limitation-on-benefits provision in Article
16 of the 1981 Model U.S. income tax treaty.) The IRS has interpreted this provision perhaps
overly strictly with respect to a situation in which a corporation of a country providing an
equivalent exemption is owned by residents of a second country, the equivalent exemption of
which is provided by treaty and requires registration of the ship or aircraft in such country. The
IRS takes the position that §883(c) will not bar the §883(a) exemption only if the registration
requirement is complied with. Notice 88-5, 1988-1 C.B. 476. See also TAM 9639010 ("primarily
and regularly traded" language in §883(c)(3) construed under regulations interpreting same phrase
in §884(e)(4)(B)).
1061
§883(c)(4). A corporation claiming the §883 exemption must comply with the procedural
requirements set forth in Rev. Proc. 91-12, 1991-1 C.B. 473, § 8.

In February 2000, the IRS proposed regulations under §883(a) and (c), generally defining
the circumstances under which a foreign corporation may avail itself of the §883(a) exemption
for shipping income.1061.1 The proposed regulations focused on the ownership requirements under
§883(c) and described the reporting requirements for foreign corporations that qualify for the
exclusion.
1061.1
REG-208280-86, 65 Fed. Reg. 6065 (2/8/00).

In August, 2002, these proposed regulations were withdrawn and reproposed.1061.2 The IRS
noted that it expanded the concept of incidental activity relating to international operation of a
ship or aircraft to include: (i) container rental and storage activity for a period not to exceed five
days; (ii) some limited incidental inland U.S. travel; (iii) certain limited inland legs of passenger
transportation; and (iv) hotel accommodations for one night before the international carriage of a
passenger.

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 1061.2
REG-136311-01, 67 Fed. Reg. 50509 (8/2/02).

On August 26, 2003, the rules proposed a year earlier were finalized in T.D. 9087,1061.3
effective for taxable years beginning 30 days or more after publication date, but also applicable
retroactively at the taxpayer's election to all open taxable years beginning after 1986. In addition
to providing guidance on the stock ownership and the substantiation and reporting standards
needed to qualify for the exemption, the principal focus of the regulations concerns which
activities qualify as the international operation of ships and aircraft or are so closely related as to
give rise to income that would be treated as incidental to such operation. Regs. §1.883-1(e)(3)
gives several examples of activities not considered the operation of ships or aircraft, such as ship
or aircraft management, acting as a ship's agent, freight forwarding, and the activities of a
concessionaire.
1061.3
68 Fed. Reg. 51394 (8/26/03); Regs. §1.883-5.

Some of the rules draw rather detailed lines. Regs. §1.883-1(g)(1) lists a number of activities
that are considered incidental to the international operation of ships or aircraft when conducted
by the foreign corporation engaged in such operation, such as ticket sales for international
operation, contracting with concessionaires for onboard services during the international
operation, certain ticket sales for transportation preceding or following the international carriage,
port city hotel accommodations within the United States for a passenger for one night before or
after international carriage, and the provision of containers and other related equipment in
connection with the international carriage. On the other hand, Regs. §1.883-1(g)(2) lists activities
that are not considered incidental to the international operation of ships or aircraft, such as the
sale of single day shore excursions or tour packages, the sale of airline tickets by a ship operator
or cruise tickets by an airline other than as noted above, the sale of hotel accommodations other
than as noted above, and "cruises to nowhere."
The other parts of these regulations provide guidance on the determination whether the
foreign corporation is a resident of a country that provides an equivalent exemption for U.S.
operators of ships or aircraft. Regs. §1.883-2 contains detailed rules for determining whether the
foreign corporation meets the publicly traded requirements discussed above. Although the statute
provides an exclusion to CFCs, Regs. §1.883-3 limits the availability of that exclusion to those
CFCs that have at least half of the subpart F income from the international operation of ships and
aircraft includible in income by U.S. individual residents and citizens and domestic corporations.
Finally, Regs. §1.883-4 provides detailed guidance on determining whether a foreign corporation
is more than half owned by qualified shareholders for at least half the days of the taxable year
and to what extent pension funds and not-for-profit organizations are taken into account for this
purpose.
Historical Note: Under pre-TRA 86 law, the United States did not tax the earnings of foreign
persons derived from the operation of ships and aircraft registered in foreign countries that
granted equivalent tax exemptions to U.S. citizens and U.S. corporations. Since the foreign
owners were not required to have any connection with the jurisdiction under the laws of which
the ship or aircraft was registered, U.S. tax was easily avoided. Section 1212(c) of the 1986 Act
modified such rule, generally effective for taxable years beginning after December 31, 1986. 1062
For post-TRA 86 years, the reciprocal exemption turns on whether a foreign person's country of
residence provides the equivalent exemption, not on whether the country where the ship or

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aircraft is registered provides such an exemption.
1062
TRA 86, §1212(f)(1). Rev. Rul. 97-31, 1997-2 C.B. 77 modified and superseded by Rev.
Rul. 2001-48, 2001-42 I.R.B. 324, lists in chart form countries known to grant equivalent
exemptions by treaty or otherwise.

2. Treaty Exemptions
Exemption from tax on international shipping or aircraft income generally is granted to treaty
country residents under the "business profits" ("industrial or commercial profits") or "shipping
and aircraft" articles of U.S. income tax treaties with foreign countries. A foreign person who is
eligible for benefits both under a treaty and under §872(b) or §883(a) may choose either as a
basis for exemption.1063 For example, the IRS has ruled that leasing income derived by a foreign
corporation resident in an unspecified treaty country (and not having a permanent establishment
in the United States) from leasing aircraft within and without the United States on a "bareboat"
basis is exempt from U.S. tax under the "industrial or commercial profits" article of the treaty. 1064
1063
See, e.g., Proposed Model Convention Between the United States and ____________ for the
Avoidance of Double Taxation and the Prevention of Fiscal Evasion Art. 1(2) (1981); Rev. Rul.
80-147, 1980-1 C.B. 168; and GCM 38193 (same as Rev. Rul. 80-147).
1064
PLR 9107029. The IRS ruled that the income was not covered by the "shipping and aircraft
income" article of the treaty since the taxpayer was not engaged in the business of operating
aircraft. Accord Rev. Rul. 74-170, 1974-1 C.B. 175. See fn. 1053 above.

The regulations provide that if the taxpayer is eligible to exclude income under both a tax
treaty and §883, the taxpayer may concurrently claim an exemption under both provisions.1064.1
1064.1
Regs. §1.883-1(h)(3)(i).

D. Land Transportation
1. General Rule
The regulations under §863(b) apply to income from transporting passengers or property by
bus, rail, or truck between the United States and another country (in particular, Mexico or
Canada).1065 In the case of income from land transportation as opposed to sea and air
transportation, these regulations have not been supplanted by §863(c).
1065
Regs. §1.863-4(a).

The regulations first allocate gross income to U.S. sources according to a proportion of gross
transportation revenues, based on the ratio of (i) the sum of the costs or expenses of such
transportation business carried on by the taxpayer within the United States and a "reasonable"
return on the property used in such business while within the United States, to (ii) worldwide
expenses plus a reasonable return on the total property used worldwide in such business.1066
Income from operations incidental to transportation services is apportioned on the same basis. 1067
1066
Regs. §1.863-4(b).
1067
Id.

Taxable income is then determined by allocating direct expenses and apportioning indirect
expenses under the §863(b) regulations.1068 Directly allocable expenses include U.S. rentals,
office expense, salaries, and loading costs.1069 Expenses not directly allocable (e.g., insurance) are
"ordinarily" prorated for each trip on the basis of the ratio of the number of days the vehicle is

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within the territorial limits of the United States to the total number of trip days. 1070 Fuel is
prorated on the basis of the total number of miles within U.S. territorial limits to total miles. 1071
Expenses and taxes allocated or apportioned to non-international transportation revenues (under
the allocation and apportionment of expense regulations) are excluded from the expense ratio. 1072
However, a ratable part of expenses which cannot be definitely allocated to any item of income
(e.g., general overhead and interest) can be deducted, based on the ratio of U.S. source gross
income to worldwide gross income.1073 Similarly, taxes on transportation income are excluded
from the apportionment process; but a ratable part may be deducted based on the ratio of the U.S.
source gross income from transportation services to the worldwide gross income from
transportation services.1074
1068
Regs. §1.863-4(c).
1069
Id.
1070
Id.
1071
Id.
1072
Regs. §1.863-4(d)(2).
1073
Id.
1074
Regs. §1.863-4(f)(2).

2. Special Rule for Use of Railroad Rolling Stock

Under §883(a)(3) income from payments by a common carrier for the temporary use (not to
exceed 90 days in any taxable year) of railroad rolling stock owned by a corporation formed in a
foreign country which grants an equivalent exemption to U.S. corporations may be exempt. The
foreign corporation must satisfy the §883(c) requirements described in IX, C, 1, above.
3. Canadian Income Tax Treaty
The income tax treaty between Canada and the United States addresses the right to tax cross-
border land transportation income (though not expressly in terms of its source). Article VIII(4) of
that treaty reserves the right to tax such income to the country of the taxpayer's residence. In
pertinent part, it provides that:
profits of a resident of a Contracting State engaged in the operation of motor vehicles or a
railway as a common carrier or contract carrier derived from: (a) the transportation of
passengers or property between a point outside the other Contracting State and any other
point . . .

shall be exempt from tax in that other Contracting State.

The provision applies if a taxpayer embarks passengers or property in one or more places in
one contracting state and delivers them in one or more places in the other contracting state; it
does not apply if the taxpayer both embarks and delivers passengers or property within the
contracting state of which it is not resident.1075 The provision also exempts certain income derived
from the rental of motor vehicles, railway rolling stock, and containers.
1075
See PLR 8750014.

Article VIII(6) of the Canadian treaty expands the protection afforded by §883(a)(3),
discussed above, as follows:

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 6. Notwithstanding the provisions of Article XII (Royalties), profits derived by a resident of a
Contracting State from the use, maintenance or rental of railway rolling stock, motor
vehicles, trailers or containers (including trailers and related equipment for the transport of
containers) used in the other Contracting State for a period or periods not expected to exceed
in the aggregate 183 days in any twelve-month period shall be exempt from tax in the other
Contracting State except to the extent that such profits are attributable to a permanent
establishment in the other State and liable to tax in the other State by reason Article VII
(Business Profits).
Historical Note: Rev. Rul. 54-51076 provided for the allocation of U.S.-Canadian bus revenues
and taxable income according to formulas agreed upon by the United States and Canada. Cross-
border revenues were allocated according to passenger mile and bus mile (for cargo revenues)
bases, and taxable income was determined by subtracting directly allocable expenses and a
portion of all other expenses according to a bus-mile ratio or a more preferable basis.
1076
1954-1 C.B. 130.

X. Income from Space or Ocean Activity

Legislative Change Note: The American Jobs Creation Act of 2004, P.L. 108-357, enacted a
number of provisions that could have a direct or indirect impact on the treatment of income from
space or ocean activity, including the repeal (at Act §415) of §954(a)(4) and (f) and revision of
§954(c)(2)(A) concerning the application of subpart F to shipping income and rental income
from aircraft and vessels, the general reduction (at Act §404) of the number of foreign tax credit
baskets to two, and the delay (at Act §423) in the effective date of final regulations governing the
international operation of ships or aircraft.
Under §863(d), except as otherwise provided in regulations, any income derived from a
"space or ocean activity," if derived by a U.S. person, is sourced in the United States.1077 Thus,
any such income derived by a U.S. citizen, a resident alien individual, a domestic corporation, a
domestic partnership, and a trust or estate the income from which is subject to U.S. tax
regardless of source1078 is treated as income from U.S. sources. Conversely, any income derived
from a space or ocean activity, if derived by a person other than a U.S. person, is sourced outside
the United States.1079 Thus, for example, income from a space activity performed by a foreign
corporation is considered to be foreign source income even if the activity is performed on behalf
and at the expense of a U.S. person. For these purposes, the term "space or ocean activity"
means:
(i) any activity conducted in space;
(ii) any activity conducted on or under water not within the jurisdiction (as recognized by the
United States) of a foreign country, possession of the United States, or the United States; and
(iii) any activity conducted in Antarctica.1080
1077
§863(d)(1)(A).
1078
See §§7701(a)(3), (a)(31).
1079
§863(d)(1)(B). See, e.g., PLR 9610015 (services of foreign nationals performed for U.S.
corporation exclusively on U.S. vessels more than 12 miles offshore were performed outside the
U.S.).
1080
§863(d)(2)(A).

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 The conduct of an activity in space, on or under the high seas or in Antarctica for this
purpose generally includes:
(i) performing or providing services at any such location;
(ii) leasing equipment for use at any such location (other than in connection with providing
transportation);
(iii) licensing technology or other intangibles for use at any such location; and
(iv) manufacturing property at any such location.1081
1081
S. Rep. No. 313, 99th Cong., 2d Sess. 358-59 (1986); TRA 86 Blue Book at 934.

On the other hand, the term "space or ocean activity" does not include:
(i) any activity giving rise to "transportation income," as defined in §863(c) (which includes
personal services in connection with providing transportation which begins in the United
States and ends in a possession, or vice versa);
(ii) any activity giving rise to "international communications income," as defined in §863(e)
(2); or
(iii) any activity with respect to mines, oil and gas wells, or other natural deposits to the
extent within the United States or any foreign country or possession of the United States as
defined in §638 (for which purpose the jurisdiction of any foreign country does not include
any jurisdiction not recognized by the United States).1082
1082
§863(d)(2)(B).

As these exclusions indicate, income from a space or ocean activity is to some extent a
residual category of offshore income or above-surface income that does not fall within
transportation income (sourced under §863(c)), international communication income (sourced
under §863(e)), or income from exploring or exploiting inanimate natural resources on the outer
continental shelf (sourced under Regs. §1.863-1(b)). The distinctions can be very significant
since, in the case of a foreign person, for example, income from a space or ocean activity is
wholly foreign source, whereas income from transportation beginning or ending in the United
States and international communications income each is 50% U.S. source, and income from
exploring inanimate natural resources on the outer continental shelf of the United States is
wholly U.S. source.
An example of an ocean activity governed by §863(d) is income derived by a fishery from
fishing operations conducted outside of the three-mile territorial limit of the United States. Since
§638 does not apply with respect to income from harvesting fish or other animal or plant life,
fishing over the continental shelf should be considered an ocean activity.1083 Another example is
income from ocean research beyond the three-mile territorial limit (and, if with regard to
inanimate natural resources, beyond the outer continental shelf).
1083
See Regs. §1.638-1(d). The phrase in §863(d), "on or under water not within the jurisdiction
(as recognized by the United States)" should be construed consistently with the three-mile limit
traditionally recognized by the United States as delimiting its territory, subject to the exception set
forth in §638 for matters described therein. See I, C, above.

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 Space or ocean activity income also includes income derived from the operation of casino
gambling, food and beverage concessions on board cruise ships operating in international waters
by persons other than the operators of the ships. In TAMS 9327001, 9327003 and 9327004,
controlled foreign corporations operated casino, restaurant and bar concessions on board cruise
ships sailing in international waters. The CFCs were neither the operators of the ships nor were
related (within the meanings of §954(d)(3)) to the operators of the ships. The taxpayers claimed
that their income was not space or ocean activity income because: (i) the legislative intent behind
§863(d) was to limit the definition of space and ocean activities to those activities which were
inextricably connected with space or ocean environment and casino, restaurant and bar activities
were not so connected as they could be operated anywhere; and (ii) since the income qualified as
transportation income it was excluded from the space and ocean activity income under §863(d)
(2)(B)(i). As the space and ocean activity income does not include income from the sale of
property, the IRS first tackled the issue of whether the provision of food and beverages services
constitutes the sale of property or performance of services. Since there is no direct authority on
this point, by analogy to former Regs. §1.954-1T(e), the IRS concluded that the operation of
food and beverage concessions constitutes performance of personal services because the
predominant character of such activities is furnishing of personal services. The IRS then went on
to dismiss the taxpayer's arguments and concluded: (i) the Senate Report reflected a broader
intent than the taxpayers theorized and that the performance of services on the ocean was clearly
intended to be covered whether or not such services could be performed elsewhere; and (ii) the
taxpayers' income did not qualify as transportation income because they were neither the
operators of the ships nor were related to the operators of the ships.
Neither §863(d) nor its legislative history provides guidance on the meaning of the term
"space," and they provide little guidance on how to draw the line between activities governed or
not governed by §863(d). For example, it is not clear whether a space activity includes research
and development activities in the upper stratosphere.1084 Examples of a space activity, however,
seem to include manufacturing a product in space (e.g., one that is unstable or potentially
infectious) and leasing a satellite located in space.
1084
See Kelly, "Federal Income Taxation of Space and Ocean Activities," 14 Int'l Tax J. 69, 71,
74 (1988).

Based on the legislative history, it appears that income from leasing satellites or underwater
cable is considered income from a space or ocean activity rather than international
communications income even if the satellites or cable are used in international communications.
1085
On the other hand, the lessee's income from using a communications satellite to, e.g., relay
television signals is international communications income.
1085
See S. Rep. No. 313, 99th Cong., 2d Sess. 358-59 (1986); TRA 86 Blue Book at 934
(referring to leasing spacecraft or satellites).

Underwriting income from the insurance of risks relating to activities in space or on or

beneath the ocean in Antarctica should be treated as income from an ocean or space activity. 1086
1086
S. Rep. No. 313, 99th Cong., 2d Sess. 359 (1986); TRA 86 Blue Book at 934-35.

Under Section 863(d)(1), the Treasury Department is authorized to issue regulations

providing exceptions from the general rule. Regulations might include rules that would prevent
U.S. persons from using foreign entities to earn income from an ocean or space activity in order

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to alter the source of the income.1087 Anticonduit rules for this purpose would not appear
necessary, however, in view of the fact that income from an ocean or space activity is required to
be included in the separate limitation category for shipping income (which generally is subject to
low effective rates of foreign tax) rather than included in the general basket. 1088 Thus, even if a
U.S. taxpayer earned foreign source income from an ocean or space activity, there is little or no
ability to use excess credits from high-taxed foreign source income.1089 Note that a domestic
shareholder of a foreign corporation which is not a controlled foreign corporation may still enjoy
the benefit of deferring U.S. tax on income from an ocean or space activity, even though such
income may be subject to little or no foreign tax.
1087
See TRA 86 Blue Book at 934.
1088
Sections 904(d)(2)(D), 954(f). Both of these provisions were repealed by the American Jobs
Creation Act of 2004, P.L. 108-357. The Act (at §415) repealed §954(f) for taxable years of
foreign corporations beginning after Dec. 31, 2004, and for taxable years of U.S. shareholders
with or within which such taxable years of such foreign corporations end. The Act (at §404(d))
repealed §904(d)(2)(D) for taxable years beginning after Dec. 31, 2006, although there is some
ambiguity because §904(d)(2)(D) cross references §954(f) for its content.
1089
For this reason, the House and Senate conferees deleted an anticonduit provision that was
contained in the House and Senate versions of Section 863(d). See H.R. Rep. No. 841 (Conf.
Rep.), 99th Cong., 2d Sess. II-600 (1986).

In REG-106030-98, 66 Fed. Reg. 3903 (1/17/01), the IRS issued Prop. Regs. §§1.863-8 and -
9 for determining the source of income from ocean, space, and international communications
income. The proposed regulations provide source rules for international communications income
that are more harsh for controlled foreign corporations and other foreign corporations that are
50%-or-more U.S. owned ("U.S.-owned foreign corporations") than for U.S. persons. Although
the legislative history clearly contemplated anti-abuse rules to prevent U.S. persons from
resourcing income through the use of a foreign entities, the anti-abuse rules contained in these
proposed rules would provide for 100% U.S. source income rather than the 50/50 split that is
provided for U.S. persons.
Further, the proposed regulations create a new class of hybrid income, i.e., space/ocean
communications income that is treated as income from transmitting communications in space or
the ocean. This new hybrid income consists of income from communications between two points
in space, two points on or under international waters, or a point in space and a point on or under
international waters. Such income is distinguished from income from U.S. communications,
foreign communications, and international communications, the last of which (defined as
transmission of communications between a point in the United States and a point in a foreign
country or in a U.S. possession) is expressly not subject to §863(d) under §863(d)(2)(B)(ii). The
significance of the characterization of this hybrid income as space or ocean income is that
income from space and ocean activity is subpart F foreign base company shipping income. As
subpart F income, it is subject to resourcing under §904(h), as redesignated from §904(g) by
§402 of the American Jobs Creation Act of 2004 (P.L. 108-357). Accordingly, even though the
income may be assigned a foreign source under Prop. Regs. §1.863-8(b)(1), to the extent that the
income is attributable to U.S. source income of the U.S.-owned foreign corporation the income
will be treated as U.S. source income for purposes of the foreign tax credit limitation fraction
under §904. Nevertheless, for other purposes, such as withholding tax purposes, the income is
not resourced.
The proposed regulations apply different source rules for income from space, ocean, and

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 215

communications (including international communications) activities depending on the identity of
the taxpayer. Taxpayers are divided into the following three groups for purposes of these
regulations: (1) U.S. persons; (2) controlled foreign corporations and U.S.-owned foreign
corporations; and (3) foreign persons (other than persons in the second category). However, for
purposes of Prop. Regs. §1.863-8, controlled foreign corporations are not subject to special rules
as are U.S.-owned foreign corporations. The legislative history indicates that the special source
rules for U.S.-owned foreign corporations do not apply to CFCs because space and ocean income
of a CFC is subject to a separate basket under §904(d) for foreign tax credit purposes, thus
limiting any cross-crediting.
The term "space" is defined as any area not within the jurisdiction of a foreign country (but
only as recognized by the United States), a U.S. possession, or the United States and not within
international waters. Ocean activity includes any activity conducted on or under water that is
outside the jurisdiction of a foreign country (but only as recognized by the United States), a U.S.
possession or the United States.
These proposed regulations broadly define the following as space and ocean activity:
• The performance and provision of services in space;
• The leasing of equipment located in space, including satellites and spacecraft and
transponders;
• The licensing of technology or other intangible property for use in space;
• The production, processing, or creation of property in space;
• Communications activity (but not including international communications activity);
• The insurance of risks on activities that produce space income; and
• The sale of property in space.
Ocean activity includes the following activities:
• The performance and provision of services in international waters;
• The leasing of equipment located in international waters, such as underwater cables;
• The licensing of technology or other intangible property for use in international waters;
• The production, processing, or creation of property in international waters;
• The sale of property in international waters, but excluding sales of inventory property;
• Communications activity that occurs in international waters, but excluding international
communications activity;
• The insurance of risks on activities that produce ocean income;
• Any activities that occur in Antarctica;
• The leasing of any vessels that do not transport cargo or persons for hire between ports-of-

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 216

 call (such as the lease of a vessel for research purposes); and
• The leasing of drilling rigs, extraction of minerals, and the performance of related services
except where the location of the leased property is within the jurisdiction of a foreign country
as recognized by the United States, a U.S. possession, or the United States.
All of these proposed rules are proposed to become effective for taxable years beginning on
or after the date that is 30 days after the date of publication of final regulations in the Federal
Register.
. With respect to income from space and ocean activities, Prop. Regs. §1.863-8 restates the
residence based statutory rules that such income is treated as U.S. source when derived by a U.S.
person and foreign source when derived by a foreign person and, through amendment of Regs.
§1.863-3, establishes certain priorities over the existing income apportionment rules on inventory
sales. The proposed regulations, however, provide the following exceptions to the basic source
rules, not all of which were expressly contemplated by the statute or legislative history.
The first exception is in Prop. Regs. §1.863-8(b)(2), which provides that all of the income of
a U.S.-owned foreign corporation from space or ocean activity is U.S. source income. Controlled
foreign corporations ("CFCs") are excluded from the application of this rule. The proposed
legislation originally included CFCs in this exception, but ultimately excluded them because
income from ocean and space activity is subpart F shipping income and, for foreign tax credit
purposes, is shipping basket income. The fact that the income is taxed currently to U.S.
shareholders and placed in the shipping income basket means that the income will not escape
U.S. taxation and that opportunities for cross-crediting for purposes of the foreign tax credit are
extremely limited, and perhaps impossible from a practical standpoint. The preamble to the
proposed regulations justifies this proposed rule on the basis that broad regulatory authority was
granted to the IRS to prevent taxpayers from circumventing the purposes of §863(d). While that
statement is correct, it is not immediately clear why all of the income should be sourced as U.S.
income, instead of applying the 50/50 source rule that would have applied had the U.S.
shareholders directly engaged in the activity. Informally, the government has stated the
explanation for the 100% rule is that, because U.S. persons are taxed on worldwide income, in
order to provide similar treatment for these special foreign persons, all of their international
communications income must be treated as U.S. source so that it is subject to U.S. taxation.
The second exception contained in Prop. Regs. §1.863-8(b)(3) applies to a foreign person
that is engaged in a U.S. trade or business and provides a rebuttable presumption that all the
income of that person from space or ocean activity is U.S. source income. For residents of a
treaty country, the presumption would apply only to income attributable to a U.S. permanent
establishment. The preamble states that the Treasury and IRS recognize that the presumption
may be "over-inclusive." As a result, a taxpayer may demonstrate (on a facts and circumstances
basis) that the income, or a portion of it, is not U.S. source income based upon functions
performed, resources employed, risks assumed, or other contributions to value. Here, the
proposed regulations apply basic §482 concepts that would otherwise apply to the allocation of
income and expenses between two entities to allocate the income of one taxpayer between U.S.
and foreign income.
Under the third exception, source rules are provided for income from the sale of purchased
and produced property. A sale takes place in space or on international waters if either (i) the

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property is located in space or the ocean at the time the rights, title, and interests to the property
pass to the buyer or (ii) the property is sold for use in space or the ocean. Income from sales of
purchased property is sourced by reference to the identity of the taxpayer. Income from the sale
of inventory property on the ocean, however, is excluded from this rule in accordance with the
legislative history.
Income from sales of produced property is first allocated on a gross income basis equally
between production income and sales income. The portion of the gross income that is allocated
to production income is sourced on the basis of where the property is produced. If the property is
produced entirely in space or the ocean, the source of income from that production is determined
under the proposed regulations. If, however, the property is produced entirely outside space or
the ocean, the source of income from that production is determined under Prop. Regs. §1.863-
3(c)(1). If the property is produced partially in space or the ocean and partially outside space and
the ocean, the gross income must be allocated between such production based on all the facts and
circumstances. The proposed regulations again require a §482-type analysis. The source of
income allocated to production in space or the ocean is determined under the proposed §863(d)
regulations. The source of income allocated to production other than in space or the ocean is
determined under Prop. Regs. §1.863-3(c)(1).
Another exception concerns the source of income from the performance of services that is
treated as a space or ocean activity under the proposed regulations because part of the services is
performed in space or the ocean. Even if a de minimis part of the services performed is in space
or on the ocean, the entire service activity will be treated as a space or service activity. However,
a taxpayer may allocate income between space and ocean services and non-space and ocean
activities based upon a §482-type analysis. In that case, the source of the income from those
services is determined under the other applicable Code source rules.
Income from communications between two points in space, two points on the ocean, or a
point in space and a point on the ocean (or vice versa) is sourced under the above-described
provisions of Prop. Regs. §1.863-8, although the path to that rule is circuitous. Prop. Regs.
§1.863-8(b)(6) provides that income from such activities is characterized as a communications
activity under Prop. Regs. §1.863-9(d) and sourced under Prop. Regs. §1.863-9(b). Prop. Regs.
§1.863-9(b)(5) provides, in turn, that such income is sourced under §863(d) and the regulations
without regard to Prop. Regs. §1.863-8(b)(6).
For U.S. partnerships, the source of income from space and ocean activity is determined at
the partnership level. For foreign partnerships, source is determined at the partner level. See
Prop. Regs. §1.863-8(e).
Taxpayers who elect to allocate income under a §482-type analysis of the facts and
circumstances as authorized by the particular proposed regulations governing the treatment of
income from ocean and space activities attributable to a U.S. trade or business, income from
production activities, or services income must make the allocation on a timely filed original
return (including extensions). A taxpayer may not make such allocations of income on an
amended return and is not eligible for relief under Regs. §301.9100-1. Additionally,
contemporaneous documentation must be maintained for the allocations made for gross income
and expenses and losses, the methodology used, and the circumstances justifying the
methodology. The documentation must be produced within 30 days of a request for it, thus

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 218

eliminating the need for the IRS to issue a summons for the documentation. This rule is similar
to the one contained in the Regs. §301.6111-1T governing the "list" requirement for corporate tax
shelters that requires a taxpayer to provide a list within 10 days of an IRS request.
Examples are provided to illustrate the application of the proposed regulations. The examples
also raise some questions. In Prop. Regs. §1.863-8(f) Ex. 13, the foreign taxpayer uses an
independent agent in the United States to engage in certain activities. The example draws a rather
unusual conclusion that the foreign taxpayer is engaged in a U.S. trade or business because of the
independent agent's activities in the United States. See Regs. §1.864-7(d)(2). Prop. Regs. §1.863-
8(f) Exs. 2 and 4 attempt to illustrate the difference between communications transmissions
through space that constitute a separate service and similar transmissions that facilitate the
delivery of a service but do not do so very successfully, particularly as to a taxpayer distributing
content through a technically superior or more versatile means of communication. These
examples raise uncertainties for CFCs that provide internet access for cable TV services entirely
outside the United States.
. With respect to communications income, Prop. Regs. §1.863-9 provides proposed guidance
relating to §863(e). Prop. Regs. §1.863-9(d)(1) defines the term "communications activity" for
purposes of the source rules under §§861-865 as an activity that consists solely of the delivery by
transmission of communications or data or the provision of the capacity to transmit
communications. This definition excludes the delivery of physical packages and letters and
requires that any other additional service (such as the delivery of content) provided with, or in
connection with, a communications activity is required to be treated as a separate non-
communications activity unless de minimis in nature. A taxpayer derives communications
income only if the taxpayer is paid to transmit, and bears the risk of transmitting, the
communications, even if a taxpayer does not perform the transmission function. Aside from the
IRS's discretion to segregate or integrate transactions under an anti-abuse rule, taxpayers are
required to segregate communications and non-communications activities into separate
transactions if neither activity is de minimis.
Prop. Regs. §1.863-9(d)(3) identifies four types of communications income: (1) international
communications income; (2) U.S. communications income; (3) foreign communications income;
and (4) space/ocean communications income. The type of communications income is determined
by identifying the two points between which the communications is made. The burden is on the
taxpayer to establish what the two points are. If a taxpayer, whether a U.S. or foreign person,
cannot establish the two points between which the taxpayer is paid to transmit a communication,
Prop. Regs. §1.863-9(b)(6) provides that all of the income derived from the transmission is U.S.
source income. The proposed regulations do not provide any guidance what documentation is
required to establish the two points. If the documentation is required for each transmission, the
documentation requirement would be extremely burdensome.
International communications income, which §863(e)(2) defines as all income derived from a
transmission between a point in the United States and a point in a foreign country or U.S.
possession, is sourced by reference to the residence of the taxpayer who earns the income.
International communications income derived by a U.S. person is treated in Prop. Regs. §1.863-
9(b)(2)(i) as 50% from U.S. sources and 50% from foreign sources. On the other hand, Prop.
Regs. §1.863-9(b)(2)(ii) provides that unless one of the exceptions described below applies all
international communications income of a foreign person is treated as foreign source income.

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 There are three exceptions concerning the international communications income of a foreign
person. First, all international communications income derived by a CFC or a U.S.-owned
foreign corporation is treated as U.S. source income. Second, the same is proposed for the
international communications income of any other foreign person not engaged in a U.S. trade or
business if the income is attributable under the principles of §864(c)(5) to a U.S. office or other
fixed place of business maintained by the foreign person. This appears to create FDAP income
that would be subject to §1441 withholding by the customer who pays the income, with no
foreign tax credit likely to the recipient of the payment because the income is U.S. source
income. Third, the international communications income of a foreign person engaged in a U.S.
trade or business is presumed to be U.S. source income unless the taxpayer shows that some of
the income may be allocated to foreign sources under a §482-type analysis, a provision the
preamble acknowledges was inserted to prevent over-inclusive U.S. sourcing. Note that this rule,
like the U.S. office rule described above, does not apply to a 50% or more U.S.-owned foreign
corporation (including a CFC).
U.S. communications income, defined by Prop. Regs. §1.863-9(d)(3)(iii) as income derived
from transmission between two points in the United States or between the United States and a
point in space or in international water, is treated as U.S. source income. Foreign
communications income, defined by Prop. Regs. §1.863-9(d)(3)(iv) as income derived from
transmission between two points in a foreign country or countries (including a U.S. possession)
or between a foreign country or U.S. possession and a point in space or in international water, is
treated as foreign source income. Space/ocean communications income, defined by Prop. Regs.
§1.863-9(d)(3)(v) as income derived from transmission between a point in space or in
international water and another point in space or in international water, is treated by Prop. Regs.
§1.863-8(b) as U.S. source to a U.S. person or a U.S.-owned foreign corporation and, because
the activity appears to be space or ocean activity, is treated as subpart F foreign base company
shipping income under §954(f), with source determined under Regs. §1.863-8(b), as such law
was in effect before its repeal by the American Jobs Creation Act of 2004 (P.L. 108-357, §413).
Under that provision, the income is treated as U.S. source if the taxpayer is a U.S. person and
foreign source if the taxpayer is a foreign person other than a 50% U.S. owned foreign
corporation. For a 50% U.S. owned foreign corporation, all of the income is treated as U.S.
source income.
The proposed regulations under §1.863-9(d) provide the same general rule as Prop. Regs.
§1.863-8 with regard to the treatment of partnerships. The source of income described in Prop.
Regs.§1.863-9 of a U.S. partnership will be determined at the partnership level, while that of a
foreign partnership will be determined at the partner level. In addition, a special rule is provided
for U.S. partnerships in which 50% or more of the partnership interests are owned by foreign
persons. In that case, the source of income described in Prop. Regs. §1.863-9 will be determined
at the partner level.
Historical Note: Under pre-TRA 86 law, income derived by U.S. residents from activities
conducted on the high seas or in space generally was treated by the United States as foreign
source income, by reference to the rules governing rental income, service income, and other
business income, and yet generally was not subject to foreign tax.1090 This permitted a taxpayer to
credit foreign taxes against U.S. tax liability on income not potentially subject to double taxation
(or, alternatively, to defer tax on the income indefinitely by earning it through an offshore
subsidiary). To address this concern, TRA 86 added Section 863(d) (generally effective for

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taxable years beginning after 1986),1091 providing special source rules for income derived from
space and certain ocean activities, and included such income in the definition of "foreign base
company shipping income" (and thus removed it from the general basket for foreign tax credit
limitation purposes).1092
1090
H.R. Rep. No. 426, 99th Cong., 1st Sess. 381-82 (1985); S. Rep. No. 313, 99th Cong., 2d
Sess. 357-58 (1986); TRA 86 Blue Book at 932-33. But cf. Rev. Rul. 70-304, 1970-1 C.B. 163
(insurance proceeds for pilferage on vessel on high seas en route to Cuba treated as domestic
source; discussed below at fns. 1269-70 and accompanying text). A statutory exception applied for
certain income from leasing spacecraft (and aircraft) manufactured in the United States that was
eligible for the investment tax credit and leased to a U.S. person. See Section 861(e) of the Internal
Revenue Code of 1954, repealed by TRA 86.
1091
TRA 86, Section 1213.
1092
See Sections 904(d)(2)(D), 954(f). Both of these provisions were repealed by the American
Jobs Creation Act of 2004, P.L. 108-357. The Act (at §415) repealed §954(f) for taxable years of
foreign corporations beginning after Dec. 31, 2004, and for taxable years of U.S. shareholders
with or within which such taxable years of such foreign corporations end. The Act (at §404(d))
repealed §904(d)(2)(D) for taxable years beginning after Dec. 31, 2006, although there is some
ambiguity because §904(d)(2)(D) cross references §954(f) for its content.

XI. International Communications Income

Section 863(e) sets forth the rules for sourcing "international communications income,"
which generally includes income from the transmission of communications or data between the
United States and a foreign country or possession.
A. General Rule
In general, Section 863(e) sources international communications income by reference to the
location of the ground facilities involved. For example, the country over which a satellite
involved in the transmission may be located is irrelevant (and properly so, since such location
would generally not give the underlying country the right to tax the income, and since such
location could easily be manipulated in many circumstances). In the case of foreign persons,
however, for jurisdictional reasons, an exception is made if the foreign person itself does not own
any facilities in the United States to which the income could be attributed.
1. U.S. Persons
Under Section 863(e)(1)(A), in the case of any U.S. person,1093 50% of any "international
communications income" is sourced in the United States and 50% of such income is sourced
outside of the United States. This 50-50 split is obviously arbitrary but reflects the difficulty in
arriving at a more exact apportionment of income in such a case.1094
1093
A "United States person" includes a U.S. citizen or resident, a domestic corporation or
partnership, and a trust or estate the income of which is subject to United States tax regardless of
its source. Section 7701(a)(30), (31).
1094
Compare the similar approach in allocating transportation income under Section 863(c)(2)
as discussed above at IX, A, 1, b.

2. Foreign Persons
In general, under Section 863(e)(1)(B), international communications income derived by a
person is sourced wholly outside of the United States, but only if the income is not attributable to

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an "office or other fixed place of business" (FPB) of the taxpayer in the United States.1095
1095
Section 863(e)(1)(B)(i).

In the case of any foreign person who maintains a FPB in the United States, any international
communications income attributable to such FPB is sourced wholly within the United States. 1096
The term FPB presumably is defined by reference to the definition of the identical term under
Regs. Section 1.864-7. In determining whether international communications income is
"attributable" to an FPB in the United States, regulations to be issued under Section 863(e)(1)(B)
might start from Section 864(c)(5)(B) and Regs. Section 1.864-6(b)(1), which relate to whether
certain income from foreign sources is considered effectively connected. Under those provisions,
income is attributable to an FPB only if the FPB is a "material factor" in the realization of the
income and the income is realized in the ordinary course of the trade or business carried on
through the FPB.1097 Without substantially more specificity, however, such a test would certainly
give rise to disputes. Perhaps a better approach would have been to treat such income as having a
50-50 split source, as in the case of such income derived by a U.S. person.
1096
Section 863(e)(1)(B)(ii).
1097
See VII, A, 2, c, above.

The Section 863(e)(1)(B) rules for foreign persons reflect certain long-standing case law.
Piedras Negras Broadcasting Co. v. Comr.1098 involved a Mexican corporation, which operated a
radio broadcasting station located on the Mexican side of the Rio Grande, but which maintained
in the United States bank accounts, a mailing address, and a hotel room for the collection of
advertising income. Ninety-five percent of the taxpayer's income was received from U.S.
advertisers (secured through an independent contractor in the United States), pursuant to
contracts executed in Mexico. The remaining 5% of its income was received from the rental of
its Mexican broadcast facilities pursuant to contracts executed in Mexico for the sale of such
"radio time." The court found that the taxpayer's income was exclusively derived from the
operation or rental of its broadcast facilities in Mexico, and thus allocated all of the taxpayer's
income to sources outside the United States according to the place-of-performance and place-of-
use source rules applicable to personal services and the rental of property, respectively,1099
notwithstanding the U.S. contacts.1100
1098
127 F.2d 260 (5th Cir. 1942).
1099
See Sections 861(a)(3), 861(a)(4). See IV and V, above.
1100
Accord PLR 8147001.

Congress has authorized the Treasury Department to create exceptions from the general rule
in the case of foreign persons. In particular, Congress was concerned that a U.S. person not be
able to avail itself of the Section 863(e)(1)(B)(i) source rule for foreign persons by earning
international communications income through a foreign entity.1101
1101
H.R. Rep. No. 841 (Conf. Rep.), 99th Cong., 2d Sess. II-600 (1986); TRA 86 Blue Book at
935.

B. Definition of International Communications Income

For purposes of Section 863(e), the term "international communications income" includes
"all income derived from the transmission of communications or data from the United States to
any foreign country (or possession of the United States) or from any foreign country (or

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possession of the United States) to the United States."1102 This includes income from transmitting
telephone calls or other signals, images, sounds, or data by buried or underwater cable or by
satellite.1103 To the extent international communications income is also within the description of
income from an ocean or space activity (e.g., income from operating a satellite or underseas
cable), it is treated as international communications income and not as income from a space or
ocean activity.1104 Income from leasing a satellite or cable, however, does not appear to be income
from the "transmission" of communications or data and hence generally should be sourced as
income from an ocean or space activity.
1102
Section 863(e)(2).
1103
S. Rep. No. 313, 99th Cong., 2d Sess. 359 (1986); TRA 86 Blue Book at 935.
1104
Section 863(d)(2)(B)(ii).

Income from international communications between two points within the United States, or
between two points without the United States, is not within the definition of international
communications income, and is treated as wholly U.S. source or wholly foreign source,
respectively.1105 This is the case even if the transmission is made through a satellite regardless of
where in space it is located.1106 Furthermore, communications between a point in the United
States and an airborne plane or a vessel at sea are considered as between two U.S. points and,
accordingly, sourced wholly to U.S. sources.1107
1105
S. Rep. No. 313, 99th Cong., 2d Sess. 359 (1986); TRA 86 Blue Book at 935.
1106
Id.
1107
Id.

Historical Note: Pre-TRA 86 law provided an apportionment rule for income from cable and
telegraph services. The gross income from sources in the United States derived from such
services was determined by adding the gross revenues derived from messages originating in the
United States and amounts collected abroad on collect messages originating in the United States
and then deducting from such sum amounts paid or accrued for transmission of messages beyond
the taxpayer's own circuit. Special rules were provided with respect to the deductions permitted
to be taken from this gross income in reaching taxable income from sources within the United
States.1108 In addition to the regulations on cable and telegraph services, certain case law had
developed with respect to the source of broadcasting income of foreign persons from
transmissions into the United States. TRA 86 added subsection (e) to Section 863, applicable to
taxable years beginning after 1986.1109
1108
See Regs. Section 1.863-5.
1109
TRA 86, Section 1213(a).

C. Proposed Regulations (2001)

In early 2001, the Treasury and IRS issued proposed regulations on the source of income
from international communications and other communications and from space and ocean
activity. These proposed regulations are discussed at X, above.
XII. Income from Certain Financial Transactions
A. Certain Foreign Currency Transactions
Section 988 sets forth the treatment of items of foreign currency gain or loss in certain

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specified situations. The provision applies to any Section 988 transaction, which, in general, is
defined as any of the following transactions if the amount which the taxpayer is entitled to
receive (or is required to pay) by reason of the transaction is denominated in terms of a
nonfunctional currency (or is determined by reference to the value of one or more nonfunctional
currencies):1110
(i) Acquiring a debt instrument or becoming the obligor under a debt instrument.
(ii) Incurring or otherwise taking into account for income tax purposes any item of expense
or gross income or receipts which is to be paid or received after the date taken into account.
(iii) Entering into or acquiring any forward contract, futures contract, option, or similar
financial instrument. Section 988(c)(1)(C) specifically includes in the definition of Section
988 transaction the disposition of any nonfunctional currency. Pursuant to Section 988(e),
Section 988 does not apply to personal transactions of an individual.
1110
Section 988(c)(1). See generally 921 T.M., Tax Aspects of Foreign Currency.

In general, foreign currency gain or loss attributable to a Section 988 transaction is

considered ordinary income or loss (subject to an election to treat such gain or loss from certain
forward contracts, futures contracts, and options as capital gain or loss).1111 Foreign currency gain
or loss from a Section 988 transaction is treated as interest income or expense if, in particular, the
transaction qualifies for integrated treatment as a Section 988 hedging transaction, in which case
such gain or loss is sourced in accordance with the interest sourcing rules rather than the special
rules described below.1112
1111
Section 988(a)(1).
1112
See Regs. Sections 1.988-3(c)(1), 1.988-4(f).

Special source rules for foreign currency gain or loss from a Section 988 transaction are set
forth in Section 988(a)(3)(A) and the regulations thereunder and take precedence over the
Section 865 rules.1113
(a) If, as will typically be the case, an item of foreign currency gain or loss is derived by a
qualified business unit (QBU) of the taxpayer (as defined in Section 989(a)), the country
where the principal place of business of the QBU on whose books the asset, liability, or item
of income or expense giving rise to such gain or loss is "properly reflected" (as opposed to
the country of residence of the taxpayer) governs the source of the item.1114 In general, under
Regs. Section 1.989(a)-1(b), a corporation, partnership, trust, and estate, as well as any trade
or business (including that of an individual) for which a separate set of books and records is
maintained, is considered a QBU. It is presumed that an asset, liability, or item of income or
expense is not properly reflected on the books of the QBU if the taxpayer and the QBU
employ inconsistent booking practices with respect thereto, in which case the IRS may make
adjustments to "properly reflect the source (or realization) of exchange gain or loss." 1115
(b) In the relatively few cases not covered by (a) above (i.e., if the currency gain or loss is not
properly reflected on the books of any QBU), the residence of the taxpayer (as specially
defined in Section 988(a)(3)(B)) generally determines the source of foreign currency gain or
loss.1116 Whether an asset, liability, or an item of income or expense is properly reflected on
the books of the taxpayer or its QBU is a question of fact. In PLR 9348015, the IRS found

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 that forward currency contracts were properly reflected on the books of C (a foreign
corporation incorporated in foreign country X) rather than on the books of its QBU (a U.S.
limited partnership) because: (i) C was the only party that negotiated and entered into the
contracts; (ii) the forward contracts were intended to offset foreign currency risk borne solely
by C; and (iii) the forward contracts were booked exclusively in X by C. Accordingly, the
IRS ruled, the exchange gain or loss resulting from the forward currency contracts must be
sourced in accordance with the residence of C. Since, under the facts of the ruling, the
exception provided in Regs. Section 1.988-4(c) for exchange gain or loss that is analogous to
income treated as ECI under Regs. Section 1.864-4(c) was also inapplicable, the exchange
gain (or loss) was foreign source. The residence of a person for this purpose generally is as
follows:1117
(i) Individuals are resident in the country in which the individual's tax home (as defined
in Section 911(d)(3)) is located.
(ii) Any corporation, partnership, trust, or estate which is a U.S. person (as defined in
Section 7701(a)(30)) is resident in the United States.
(iii) Any corporation, partnership, trust, or estate which is not a U.S. person is the resident
of a country other than the United States.
(iv) An individual who does not have a tax home is resident in the United States if the
individual is a U.S. citizen or a resident alien, and otherwise a country other than the United
States. Notwithstanding the foregoing rules on partnership residence, in the case of a
partnership "formed or availed of to avoid tax by altering the source of exchange gain or
loss," the determination of residence is made at the partner level.1118
(c) Notwithstanding the statutory rules described in (a) and (b) above, foreign currency gain
or loss that "under principles similar to those set forth in [Regs.] Section 1.864-4(c) arises
from the conduct of a United States trade or business" is treated as U.S. source and, in
addition, is treated under the regulations as effectively connected with the conduct of a U.S.
trade or business.1119
(d) Finally, in the case of non-U.S. partners in a partnership engaged in trading stock,
securities, or commodities in the United States who are not engaged in a trade or business in
the United States by reason of Section 864(b)(2), currency gain or loss is sourced at the
partner rather than the partnership level notwithstanding the rules in (a) and (b) above
(whether or not the partnership is a QBU of the partners).1120
1113
Regs. Section 1.988-4(a). In the case of an individual's personal transaction, the Section 865
rules rather than the special Section 988 rules apply.
1114
Section 988(a)(3)(A); Regs. Sections 1.988-4(b), 1.988-4(d)(2) (treating the principal place
of business of a qualified business unit as its residence). A similar result was reached under prior
law. See, e.g., PLR 8127100; PLR 8004115 (applying the place-of-sale rule of Regs. Section
1.861-7(a)).
1115
Regs. Section 1.988-4(b)(2)(ii).
1116
Section 988(a)(3)(A); Regs. Section 1.988-4(a).
1117
Section 988(a)(3)(B).
1118
Regs. Section 1.988-4(d)(1). The regulations, however, refer only to partnerships described
in (ii) above though, presumably, partnerships described in (iii) are intended in the case of gain.
1119
Regs. Section 1.988-4(c).

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 1120
Regs. Section 1.988-4(d)(3). Income from certain securities transactions entered into by the
qualified business unit of a foreign taxpayer in the United States for its own account may be
properly reflected on its books and yet, under Section 864(c)(2), not be treated as effectively
connected with a U.S. trade or business. In such a situation, to avoid a withholding obligation, it
would be necessary to conclude that the foreign currency items either are not "fixed or
determinable annual or periodical income" (FDAPI) or are foreign source. By testing residence at
the level of the foreign partner, the regulations avoid the FDAPI issue. In any event, such items,
though assigned an ordinary rather than capital character under Section 988(a)(1)(A), should not
be treated as FDAPI, since foreign currency gain or loss should be considered gain or loss from
the sale of property. See generally Regs. Section 1.1441-2(b)(2)(i) (gain from sale of property not
taxed as FDAPI).

A special rule is provided under Section 988(a)(3)(C) for certain related party loans. Except
to the extent provided in regulations, in the case of a loan by a U.S. person or a related person to
a "10-percent owned foreign corporation " which is denominated in a currency other than the
dollar and bears interest at a rate at least 10 percentage points higher than the federal mid-term
rate (determined under Section 1274(d)) at the time such loan is entered into, the following rules
apply:1121
(i) For purposes of Section 904 only, such loan must be marked to market on an annual basis.
(ii) Any interest income earned with respect to such loan for the taxable year is treated as
income from sources within the United States to the extent of any loss determined under (i).
For this purpose, the term related person has the meaning given such term by Section 954(d)
(3) (applied by substituting U.S. person for controlled foreign corporation each place such
term appears).1122 The term 10% owned foreign corporation means any foreign corporation in
which the U.S. person owns directly or indirectly at least 10% of the voting stock.1123
1121
Section 988(a)(3)(C).
1122
Id.
1123
Section 988(a)(3)(D).

In nearly all cases, the residence-based source rules of Regs. Section 1.988-4 eliminate
withholding risks: a foreign person generally receives foreign source payments in respect of
foreign currency gain or loss.1124 If the payee is a foreign person with a U.S. trade or business,
withholding is not required provided that the payments are effectively connected with such trade
or business and the payee timely files IRS Form 4224 with the payor.1125
1124
This is the case even if the other party to the transaction is required to apportion all or part
of its expense to U.S. source income under Regs. Section 1.861-9T. See Regs. Section 1.988-4(g).
1125
See Regs. Section 1.1441-4(a)(2).

An area of possible concern with respect to payments to foreign taxpayers relates to the third
source rule listed above ((c), above), which states that foreign currency gain (or loss) that, "under
principles similar to those set forth in [Regs.] Section 1.864-4(c) arises from the conduct of a
United States trade or business" automatically is sourced to the United States and treated as
effectively connected with the conduct of a U.S. trade or business (notwithstanding the residence
of the taxpayer or the extent of the taxpayer's operations in the United States).1126 Under these
principles, which generally prescribe an "asset-use" and a "business-activities" test, gain is
effectively connected in any situation, e.g., in which the instrument is considered held in a
"direct relationship" to the U.S. trade or business.1127 This provision thus goes beyond the general,

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and analogous, rule contained in Section 865(e)(2)(A). It is not clear what, if any, characteristics
of foreign currency gain or loss from a Section 988 transaction justify a special rule. From the
payor's standpoint, if foreign currency items were considered FDAPI, a withholding tax exposure
would exist unless IRS Form 4224 had been obtained from the payee before the payment (which,
presumably, would be highly unlikely except in the clearest cases) or, if applicable, obtain IRS
Form 1001.1128
1126
See Regs. Section 1.988-4(c).
1127
See Regs. §§1.864-4(c)(2), (c)(3). In the case of a taxpayer in a banking, financing, or
similar business, however, the gain would be effectively connected only if the taxpayer's U.S.
office actively and materially participated in soliciting, negotiating, or performing other activities
required to arrange the acquisition of the securities to which the gain relates, and the securities are
of certain types (but without regard to where the transaction is booked). See Regs. Section 1.864-
4(c)(5).
1128
See fns. 1141-45, below.

With respect to U.S. persons, the interaction of the general source rules of Regs. Section
1.988-4(a) with the interest allocation and apportionment rules may create problems under
Section 904 (foreign tax credit limitation) in certain cases. The latter rules govern not only
interest per se but any deductible expense or loss incurred in a transaction or series of related
transactions in which the taxpayer secures the use of funds for a period of time.1129 One example
of an "interest equivalent" required to be allocated and apportioned under these rules is net
foreign currency loss on a currency rate swap entered into to hedge foreign currency exposure on
a nonfunctional currency borrowing.1130 A taxpayer is required to allocate and apportion the loss
under these rules in such a circumstance regardless of whether the swap could be integrated with
the borrowing under Section 988(d).1131 Assuming a typical multinational domestic taxpayer (or
any taxpayer doing business in the United States and abroad), part of the taxpayer's interest
expense generally would have to be allocated against foreign source income. Even if the
proceeds were used entirely in a business in the United States, tracing of the interest expense
against U.S. source income is permitted in only very narrow circumstances under Regs. Section
1.861-10T.
1129
Regs. Section 1.861-9T(b)(1)(i).
1130
Regs. Section 1.861-9T(b)(1)(ii), Ex. 2.
1131
Id.

On the other hand, under Regs. Section 1.988-4(a), a foreign currency gain on the same
transaction is required to be allocated entirely to U.S. sources (assuming such gain is properly
reflected on the books of a U.S. QBU) unless the transaction were to qualify for integrated
treatment under Section 988(d) (in which case any net receipts from the swap would reduce
interest expense on the borrowing, and any net payments on the swap would increase interest
expense on the borrowing). Thus, if integrated treatment is not available, the taxpayer is subject
to "whipsaw" treatment with regard the determination of its foreign source income for Section
904 purposes.
The regulations under Section 988(d) permit integrated treatment of a hedge instrument (e.g.,
a currency swap contract or forward contract) and a debt instrument only in limited
circumstances.1132 In circumstances in which integrated treatment is permitted, the interest paid on
the resulting "synthetic" debt instrument has the same source under Sections 861(a)(1) and
862(a)(1) (and character for Section 904 purposes) as the underlying debt instrument.1133

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 1132
See Regs. Section 1.988-5(a).
1133
Regs. Section 1.988-5(a)(9)(iii).

B. Notional Principal Contracts

Regs. Section 1.863-7 provides rules for determining the source of income "attributable to"
notional principal contracts. A notional principal contract is a financial instrument that "provides
for payments of amounts by one party to another at specified intervals calculated by reference to
a specified index upon a notional principal amount in exchange for specified consideration or a
promise to pay similar amounts."1134 Thus, notional principal contracts include interest rate swaps,
caps, floors, and collars, commodity swaps, and similar financial instruments.1135
1134
Regs. Section 1.863-7(a)(1); Prop. Regs. Section 1.446-3(c)(1)(i).
1135
See generally Prop. Regs. Section 1.446-3(d).

The source of notional principal contract income is determined under the following rules.
(i) Generally, the source of notional principal contract income is determined by the residence
of the taxpayer (i.e., the recipient of the payment) determined under Section 988(a)(3)(B)(i).
1136

(ii) The source of notional principal contract income is determined by reference to the
residence of a QBU of the taxpayer if each of the following conditions is satisfied: the
taxpayer's residence (determined under Section 988(a)(3)(B)(i)) is in the United States; the
QBU's residence (determined under Section 988(a)(3)(B)(ii)) is outside the United States; the
QBU is engaged in the conduct of a trade or business at the place of its residence outside the
United States; and the notional principal contract is "properly reflected" on the books of the
QBU.1137
(iii) Notwithstanding the foregoing rules, notional principal contract income that "under
principles similar to those set forth in [Regs.] Section 1.864-4(c) arises from the conduct of a
United States trade or business" is sourced in the United States.1138
1136
Regs. Section 1.863-7(b)(1).
1137
Regs. Section 1.863-7(b)(2). In determining whether the "properly reflected" requirement is
met, the degree of the qualified business unit's participation in the negotiation or acquisition of a
notional principal contract is considered (unless the IRS district director determines that such
participation had a tax motivation). Regs. Section 1.863-7(b)(2)(iv).
1138
Regs. Section 1.863-7(b)(3).

These rules are similar, though not identical, to the rules for Section 988 transactions.1139 As
discussed in that connection, the third rule -- for notional principal contract income arising from
the conduct of a trade or business in the United States -- could be applicable in situations in
which, e.g., the contract is considered held in a "direct relationship" with the U.S. business of the
foreign payee.1140 This rule creates a risk for a domestic payor making payments to a foreign party
under the contract. If the foreign party's U.S. activities in fact meet the test under Regs. Section
1.864-4(c) with respect to the income, the payment of the income could be subject to a
requirement to withhold U.S. tax, with joint and several liability for the tax if it fails to do so,
unless it obtains, prior to making the payments, IRS Form W-8ECI.1141 There is no withholding
tax obligation if payments under a notional principal contract are not "fixed or determinable
annual or periodical" income. Whether they are or not, however, is not clear.1142

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 1139
See XII, A.
1140
See Regs. §§1.864-4(c)(2), (c)(3), and (c)(5). See fn. 1127 and accompanying text above.
1141
See Section 1463; Regs. Section 1.1441-4(a)(1); Casa De La Jolla Park, Inc. v. Comr., 94
T.C. 384 (1990).
1142
See, e.g., Notice 87-4, 1987-1 C.B. 416.

Withholding of tax is clearly required if the payments are protected under a treaty (e.g., under
the "other income" provision of the treaty with the United Kingdom and, if the foreign party is a
bank or qualifying financial institution, the "industrial or commercial profits" or "business
profits" articles of other income tax treaties).1143 The domestic payor is required to obtain IRS
Form W-8 from the foreign party claiming treaty protection,1144 but the form need not necessarily
be in hand before the payments are made. In the case of nontreaty foreign payees, a U.S. payor is
advised to either obtain Form W-8ECI annually in advance of payment from the foreign payee or
obtain representations that the income is not effectively connected with a U.S. trade or business
(in order to lay the foundation for an indemnification claim if, in fact, a tax is payable). 1145
1143
See Rev. Rul. 87-5, 1987-1 C.B. 180.
1144
Regs. Section 1.1441-6(a).
1145
See the standard forms published by the International Swap Dealers Association.

Certain payments under notional principal contracts are not sourced under the above rules.
For example, stated interest on such a contract (and, to the extent "broken out" for tax purposes,
the unstated interest component of such a contract providing for accelerated or uneven payments)
1146
is sourced under interest income source rules (generally, the residence of the obligor).1147 At
least in the case of notional principal contracts involving stated or deemed interest payments by a
U.S. payor, the parties are advised to satisfy the requirements for the portfolio interest exemption
under Sections 871(h) and 881(c), as the case may be, or, if the payee is resident in a foreign
country with which the United States has entered into an income tax treaty providing an
exemption, the payor should obtain IRS Form W-8.
1146
See generally Regs. §1.446-3.
1147
Similarly, the imputed interest component of a lump sum payment (or other uneven
payments) on an interest rate swap would be required to be allocated and apportioned under the
rules governing the allocation and apportionment of interest expense. See Regs. Section 1.861-
9T(b)(1)(ii), Ex. (3).

Note: Forms W-8, 1001, 1078, and 4224 are obsolete in the 2001 filing season; taxpayers
should use replacement Forms W-8BEN, W-8ECI, W-8EXP, W-8IMY, W-9, and 8233. See §VI,
Notice 2001-4, 2001-2 I.R.B. 267.
Second, fees for late payments are not sourced under Regs. Section 1.863-7.1148
1148
See Regs. Section 1.863-7(d), Ex. (2).

Third, as is the case of foreign currency hedges that are related to a borrowing,1149 other
derivative financial products (derivatives) used to hedge the effective cost of a borrowing (e.g.,
interest rate swaps, caps, dollars, and floors) are subject to special rules. These can give rise to
the potential for whipsaw treatment for a domestic multinational borrower for Section 904
(foreign tax credit limitation) purposes. The rules for allocating and apportioning interest
expense require allocation and apportionment of any deductible expense or loss incurred in a
transaction or series of related transactions in which the taxpayer secures the use of funds for a

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period of time.1150 Consequently, part of any loss on the swap is allocated against foreign source
income. On the other hand, if the derivative is not identified (or is not eligible to be identified) as
hedging a particular interest-bearing obligation, the entire amount of any income received by the
domestic borrower is treated as from U.S. sources under Regs. Section 1.863-7(b)(1).1151 This
issue is substantially more manageable than in the case of foreign currency gain, however, in
view of the relative ease in identifying derivatives as hedges under Regs. Section 1.861-9T(b)(6).
Such identification (other than in the case of a person acting in the capacity of a regular dealer in
the financial products)1152 permits treatment of payments received under the derivative as a
reduction of interest expense.
1149
See the discussion above in XII, A.
1150
Regs. Section 1.861-9T(b)(1)(i).
1151
Regs. Section 1.861-9T(b)(6)(vii), Ex. (1).
1152
Regs. Section 1.861-9T(b)(6)(vi). In addition, the temporary regulations have reserved with
respect to financial service entities.

Example: X, which is not a financial services entity or regular dealer in the derivatives, and
which has a dollar functional currency, incurred $200 of interest expense in 1991. On January
1, 1991, X entered into an interest rate swap agreement with Y, in order to hedge its interest
rate exposure with respect to a pre-existing floating rate liability. On the same day, X
properly identified the agreement as a hedge of such liability pursuant to Regs. Section
1.861-9T(b)(6)(iv)(C). Under the agreement, X is required to pay Y an amount equal to a
fixed rate of 10% on a notional principal amount of $1,000, and Y is required to pay X an
amount equal to a floating rate of interest on the same notional principal amount. Under the
agreement, X received from Y during 1991 a net payment of $25. Because X properly
identified the swap agreement as a hedge, X may effectively reduce its total allocable interest
expense for 1991 to $175 by directly allocating $25 of interest expense to the swap income.
Had X not so identified the swap as a hedge, this swap payment would have been treated as
domestic source income in accordance with the rule of Regs. Section 1.863-7(b).1153
1153
Regs. Section 1.861-9T(b)(6)(vii), Ex. (1).

Fourth, Regs. Section 1.863-7 does not apply to income attributable to Section 988
transactions (i.e., certain nonfunctional currency transactions including, e.g., interest rate swaps
denominated in other than the taxpayer's functional currency).1154 The source of such income,
including with respect to nonfunctional currency notional principal contracts, is governed by the
rules provided in Regs. Section 1.988-4, which generally parallel those for notional principal
contracts.1155 Thus, for example, payments received by a U.S. party under a U.S.-denominated
interest rate swap would be sourced under Regs. Section 1.863-7, but payments received by a
foreign counterparty whose functional currency is not the U.S. dollar would be sourced under
Regs. Section 1.988-4. Note however, that, since commodity-indexed notional principal contracts
are not treated as section 988 transactions,1156 income derived therefrom is sourced under Regs.
§1.863-7 even if denominated in a nonfunctional currency.
1154
Regs. Section 1.863-7(a)(1).
1155
See Regs. Section 1.863-7(b). See XII, A, above.
1156
Regs. Section 1.988-1(a)(2)(iii)(A).

Fifth, transactions between a taxpayer and a QBU of such taxpayer or among QBUs of such
taxpayer are excluded from the source rules under Regs. §1.863-7 "because a taxpayer cannot

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contract with itself."1157
1157
See Regs. §1.863-7(a)(1). Cf., e.g., Regs. §§1.882-5(b)(1)(iv), 1.988-1(a)(10).

Finally, the IRS has requested comments concerning whether and to what extent the dividend
component of equity-based notional principal contracts (in particular, equity swaps and equity-
indexed swaps) should be sourced in accordance with the rules governing substitute payments
under securities loans (see C, 3 below).1158 The IRS' motivation presumably is a concern that U.S.
dividend equivalents are escaping U.S. withholding tax.
1158
See Preamble to Prop. Regs. Section 1.446-3 reprinted in Highlights & Documents, July 9,
1991, 283, 284.

Historical Note: Regs. Section 1.863-7 applies to notional principal contract income
includible in income on or after 2/13/91.1159 In general, Regs. Section 1.863-7T governed amounts
includible in income on or after 12/24/86 but before 2/13/91. Before the issuance of Regs.
Section 1.863-7T, Notice 87-41160 provided similar rules for interest rate swap income and
expense derived on or after 12/24/86. In addition, a U.S. resident taxpayer could elect by 3/15/91
to apply the final regulations to all (but not part) of the taxpayer's notional principal contract
income attributable to all taxable years (or a portion thereof) beginning before 12/24/86
(provided the statute of limitations under Section 6511(a) had not expired). Similarly, a taxpayer
who was not a resident of the United States and who was engaged in a U.S. trade or business
could elect by 2/15/91 to apply these rules to all (but not part) of the taxpayer's effectively
connected notional principal contract income attributable to all taxable years (or a portion
thereof) beginning before 12/24/86 (provided the statute of limitations under Section 6511(a) had
not expired).1161 If the appropriate election was not made, income includable before 12/24/86 is
sourced under the principles of law in effect before the notice.1162 Which principles were
determinative, however, was extremely unclear.
1159
Regs. Section 1.863-7(a)(2).
1160
1987-1 C.B. 416.
1161
Regs. Section 1.863-7(c).
1162
Notice 87-4.

C. Securities Loans -- Substitute Payments and Loan Fees

Legislative Change Note: The American Jobs Creation Act of 2004, P.L. 108-357, expands
the types of foreign source income of a nonresident alien individual or foreign corporation that is
treated under §864(c)(4)(B) as effectively connected with the conduct of a trade or business
within the United States (ECI). Before amendment, §864(c)(4)(B) included foreign income
attributable to a U.S. office or fixed place of business if it consisted of one of the following three
types of foreign source income: (1) rents or royalties for the use of intangible property derived in
the active conduct of the business; (2) dividends or interest that is either derived in the active
conduct of a banking, financing, or similar business within the United States or received by a
corporation the principal business of which is trading in stocks or securities for its own account;
and (3) income derived from the sale or exchange outside the United States through such U.S.
office or fixed place of business of personal property constituting inventory or stock in trade (but
not if sold for use, consumption, or disposition outside the United States and a foreign office or
fixed place of business of the taxpayer participated materially in the sale). P.L. 108-357 (at §894)
expands this to include foreign source economic equivalents of these categories of income
attributable to a U.S. office or other fixed place of business for taxable years beginning after

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October 22, 2004. This would have the effect of including these economic equivalents in the U.S.
business income of the foreign taxpayer regardless of the source or character of such economic
equivalents.
1. Substitute Payments
Loans of securities (which often are made in accordance with the rules of Section 1058 so as
to avoid recognition of any appreciation) are commonplace transactions in the securities industry.
A substitute payment in connection with a securities lending transaction is a payment made by
the securities borrower to the securities lender of an amount equivalent to the dividend
distributions or interest payments that the lender would have received on the securities during the
term of the loan. Securities loan payments are not considered interest on a loan; the U.S.
Supreme Court has held that substitute payments for dividends on a loan of stock are not
compensation for the use or forbearance of monies and thus are not interest.1163
1163
Deputy v. DuPont, 308 U.S. 488 (1940). Accord Rev. Rul. 80-135, 1980-1 C.B. 18 (not
interest for Section 103 purposes). (An interest notion, however, underlies Section 246A(d)(3)(B).)

Regulations have been issued with respect to the source of substitute payments under Section
8611164 and, in the case of such payments made from U.S. sources to foreign persons, the taxation
of such payments.1165 These regulations address substitute payments made in a "securities lending
transaction," defined as a transaction which is described in Section 1058(a) or a "substantially
similar transaction."1166 Section 1058 and the regulations thereunder provide for the
nonrecognition of gain or loss upon the transfer of a security pursuant to an agreement which
requires that (i) the borrower return to the lender securities identical to those borrowed; (ii) the
borrower make substitute payments to the lender during the term of the securities loan; and (iii)
the lender's risk of loss or opportunity for gain not be reduced (which the proposed regulations
construe as mandating that the lender be able to terminate the loan upon notice of not more than
five business days).1167
1164
Regs. §§1.861-2(a)(7), 1.861-3(a)(6).
1165
Regs. §§1.871-7(b)(2), 1.881-2(b)(2), 1.894-1(c), 1.1441-2(a)(1). The regulations are
proposed to be issued under the authority of Section 7805 rather than under Section 863 in order to
characterize the substitute payments as "dividends" or "interest" (rather than simply U.S. source to
avoid exemptions for "other income" under certain income tax treaties. Query whether such
authority sanctions the redefinition of such basic concepts?
1166
Regs. §§1.861-2(a)(7), 1.861-3(a)(6).
1167
Prop. Regs. Section 1.1058-1(b).

Under the regulations, a substitute dividend payment or substitute interest payment received
by a foreign person from a U.S. person (or received by a U.S. person from a foreign person)
pursuant to a securities lending transaction is treated as having the same source and
characterization for Section 1441 withholding, foreign tax credit, and income tax treaty purposes
as payments on the underlying security would have had if made directly to the securities lender.
For example, substitute dividend payments with respect to U.S. corporate stock transferred in a
cross-border securities lending transaction is treated as U.S.-source dividends for Section 1441
withholding, foreign tax credit limitation, and income tax treaty purposes1168 (but, as the
regulations are worded, only if the substitute payments are paid or received by a U.S. person).1169
Similarly, substitute interest payments with respect to bonds, notes, or other debt obligations of
U.S. residents, U.S. corporations, or the U.S. government transferred in a cross-border securities

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lending transaction are treated as U.S.-source interest for Section 1441 withholding, foreign tax
credit limitation, and income tax treaty purposes (but, as the proposed regulations are worded,
only if received by or from a U.S. person). In addition, where a foreign person transfers in a
securities lending transaction U.S. securities the interest on which qualifies as portfolio interest
under Section 871(h) or Section 881(c), the substitute interest payments also qualify as portfolio
interest, provided a Form W-8 or substantially similar form executed by the payee has been
received by the withholding agent.
1168
Accordingly, for example, under the proposed regulations, such payments received by a
U.K. resident could not be treated as "other income" exempt under Article 22 of the U.S.-U.K.
income tax treaty, or as "business profits" exempt under Article 7 of that treaty, though they would
be eligible for a reduced rate of withholding under the dividend provisions of that treaty. It is not
clear, however, whether the IRS has the authority to promulgate regulations that on their face
appear to conflict with the definition of "dividend" under this (and certain other) treaties. It also is
not clear whether the regulations are valid even in the case of those treaties that refer generally to
the law of the country imposing the tax, since the definitions of dividend and interest contained
therein were not the law when the treaties were ratified. Further, the terms are not so defined for
U.S. tax purposes generally.
1169
This suggests that, for example, substitute dividend payments made on a securities loan a
U.S. stock by a Swiss corporation to a Kuwaiti corporation could avoid withholding tax at the
nontreaty rate. Note also that substitute payments on loans of securities between U.S. persons are
not affected by the regulations.

Adoption of a look-through rule for substitute payments seems consistent with the policy of
Section 1058, which by retaining the lender's holding period and basis keeps the lender in the
same position it would have been without the transfer. A look-through rule, to the extent valid in
an income tax treaty context, also prevents a foreign securities lender of U.S. securities from
avoiding U.S. withholding tax based on the "business profits" or "other income" provision of
income tax treaties. A look-through rule would prevent a U.S. lender of U.S. securities to a
foreign borrower from increasing the U.S. foreign tax credit limitation. Finally, a look-through
rule would permit a foreign lender in a nontreaty jurisdiction to lend foreign securities or
portfolio-interest domestic securities to a domestic borrower without withholding tax concerns.
Because the scope of Section 1058 may not encompass many securities-lending transactions,
the regulations cover transactions "substantially similar" to Section 1058 transactions.
A look-through approach generally has been rejected for purposes of characterizing substitute
payments in a domestic context.1170 This treatment is not changed by the proposed regulations.
1170
See Prop. Regs. Section 1.1058-1(d); Rev. Rul. 80-135, 1980-1 C.B. 18 (for purposes of
Section 103); Rev. Rul. 60-177, 1960-1 C.B. 9 (for purposes of Section 243). Income from
securities loans, however, is qualifying income for RICs under Section 851. Also, based on the
legislative intent to facilitate RICs' securities lending activity, the IRS in PLR 9030048 applied the
look-through approach to RICs to conclude that the securities loaned remained the assets of the
RIC for purposes of Section 851(b)(4) (redesignated §851(b)(3) by the 1997 TRA).

2. Fees
The preamble to the regulations requests comments concerning the source, character and
income tax treatment of fees paid to a securities lender. Such loan fees or "borrow fees" are paid
by the borrower to induce the lender to lend the securities. If the borrower posts as collateral cash
rather than securities or a letter of credit, the fees are simply drawn from the income earned from

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investing the cash collateral, less an agreed percent of such income rebated to the borrower (and
sourced to the borrower as interest income).
Generally, from the securities lender's point of view, there is indirect support for treating loan
fees the same as substitute payments where all such payments are made by the same borrower to
the same lender.1171 However, a look-through rule, proposed by the IRS for substitute payments, is
not appropriate for loan fees, which bear no relationship to the income on the underlying
securities. Several comment letters submitted to the IRS have made the case on policy grounds
for sourcing such fees by reference to the residence of the securities lender, since loans into the
U.S. markets then could be made by foreign persons without U.S. withholding tax (which is
important in order that domestic brokers may have access to foreign securities on an equal
footing with foreign brokers), and the rule would be easily administrable.
1171
See Section 512(a)(5)(A) (which, for unrelated business taxable income purposes, defines
payments with respect to Section 1058 securities loans to include substitute payments, loan fees,
and income from the collateral securing the securities loan); GCM 36948 ("A preferable analysis
is to consider both the dividend and interest equivalents and the loan premium as amounts paid by
the broker-dealer for the right to delay completing the exchange for the period of the contract . . .
Therefore, the only thing for which the broker-dealer can be compensating the trust is its
forbearance.")

3. Possible Extension to "Repo" Transactions and Equity Swaps

The preamble to the regulations requests comments on whether sale and repurchase ("repo")
agreements involving securities lending regulations as "substantially similar" transactions.
Almost no substantive distinction appears to exist between most repo transactions, in which the
purchase may and regular does dispose of the "purchased" securities, and securities loans.
Consequently, it has been suggested that the regulations treat repos having such terms as similar
transactions.1172
1172
New York State Bar Association Tax Section, Report on Proposed Regulations on Certain
Payments Made Pursuant to Securities Lending Transactions (July 7, 1992), reprinted in
Highlights & Documents, July 27, 1992, 1393, 1400. In situations in which the purchaser may not
and does not dispose of the collateral, however, such as the situations addressed in certain IRS
rulings (Rev. Rul. 79-180, 1979-1 C.B. 75; Rev. Rul. 77-59, 1977-1 C.B. 59; Rev. Rul. 74-27,
1974-1 C.B. 24), the Bar Association would not apply the rule of the proposed regulations.

The preamble also requests comments concerning whether certain notional principal
contracts that generate analogous payments should be covered by the regulations, using the
example of an equity index swap structured to replicate the cash flows that would arise from an
installment purchase of one or more equity securities. A more typical example would be where a
"long" party pays on a periodic basis any increase in value of the notional principal amount
deemed invested in one or more equities or an equity index, together with dividend equivalents,
and a counterpart pays on the same periodic basis any decrease in value of such notional
principal amount, together with an interest equivalent on such notional principal amount. Apart
from reservations as to whether statutory authority for so extending the regulations exists, it has
been noted that it would be extremely difficult to draw lines between types of equity swaps. For
example, payments on equity index swaps where the specified index is a broadly based U.S.
equity index with respect to which other derivative contracts (such as regulated futures contracts)
are actively traded are the "least compelling" case for imposition of a withholding tax. 1173 This is
because investment alternatives -- regulated futures contracts and exchange-traded options,

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which are priced so as to reflect dividends during the term of the contract -- are available without
being subject to withholding.1174 On the other hand, if the contract relates to stock of a single
issuer, and one party initially pays to the other the then trading price of the stock in exchange for
the right to payments in respect of all dividends and the right to terminate the contract at any
time for a payment equal to the termination-date trading price of the stock, the rule of the
proposed regulations (or at least, U.S. sourcing) is arguably correct policy result (although even
in such cases no capital has been paid into the issuer).
1173
Id. at 1400-01 & n.45. Further, substitute dividend components of equity swaps may be
measured by expected or historical dividends, may be subject to a cap and/or floor, etc. Id. at
1401.
1174
Id. Accord, New York State Bar Association Tax Section, Committee on Financial
Instruments, Report on Proposed Regulations on Methods of Accounting for Notional Principal
Contracts (January 6, 1992), reprinted in Highlights & Documents, January 16, 1992, 633, 640.
No withholding would be imposed because gain would be taxable as gain from the sale of
property under Sections 1234, 1234A, and 1256(a)(3).

4. Effective Date/Existing Law

The preamble to the regulations states that they will be effective with respect to transfers of
securities made more than 30 days after the date they are published in final form in the Federal
Register. The preamble also states that "[s]ource, character and income tax treaty treatment of
substitute payments made prior to the effective date of [the] regulations will be determined under
all the facts and circumstances of a particular transaction."
In the case of pre-effective date securities loans, look-through treatment may be the most
appropriate treatment for substitute payments. Alternatively, a taxpayer may argue that such
payments, as well as loan fees, should be sourced by reference to the location or place of use of
the securities.
Regulations under Section 1058 treat a substitute payment as fees paid by the borrower for
the use of the securities.1175 (These regulations do not address fees paid in a securities loan.) In the
domestic context, this approach prevents multiple dividends received deductions and municipal
bond interest exemptions with respect to the same income from the respective security. The
approach taken under these regulations apparently would relieve from withholding tax in certain
cases (under the "business profits" or "industrial or commercial profits"1176 or "other income"1177
provisions of certain income tax treaties) payments made in substitution for otherwise taxable
U.S.-source dividends. Thus, certain foreign lenders have effectively avoided U.S. withholding
tax on dividends on U.S. stock by lending the stock to a U.S. borrower in return for substitute
payments (and may continue to avoid such tax with respect to, e.g., dividend equivalent
payments with respect to equity index swaps). Conversely, assuming securities loan payments
are fixed or determinable annual or periodical income, this treatment could have subjected to
U.S. withholding tax payments made in substitution for otherwise exempt U.S.-source portfolio
interest where no treaty provision applied. The rule of Prop. Regs. Section 1.1058-1(d) is
difficult to administer because the physical location of the transferred securities is subject to
change and may have no relationship to the place where the securities actually are used by the
borrower, and a borrower's use may take different forms and may be even more difficult to verify
than the location of the securities.
1175
Prop. Regs. Section 1.1058-1(d).
1176
In PLR 8822061, the IRS ruled that, for purposes of applying U.S. income tax treaties,

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 securities loan fees were "industrial and commercial profits" in the hands of a foreign securities
lender that engaged in the life insurance business. The IRS reasoned that, since the securities
lending was undertaken to maximize the lender's return on its investment portfolio in order to
permit it to meet future claims, the fee income was derived in the active conduct of the lender's
insurance business. However, the ruling expressly did not address the character or source of fees.
1177
E.g., treaty with United Kingdom (Art. 22).

In addition to the look-through approach and the place-of-use approach, certain other
analyses1178 remain relevant for substitute payments and loan fees not subject to the regulations.
First, sourcing by reference to the place where the lending activity occurs has some support in
case law;1179 because the lending activity may occur in more than one place, however, this rule is
subject to manipulation and would be difficult to enforce. Second, securities loan fees and pre-
effective date substitute payments might be treated as compensation for the use of the securities
in the borrower's jurisdiction of residence. While not interest, as noted above, such payments are
analogous to interest, especially when paid in connection with a short sale.1180 This approach
could allow foreign investors in U.S. securities to avoid U.S. withholding on loans of their
securities to non-U.S. brokers. Third, the residence of the lender may be the appropriate referent,
as in the case of notional principal contract income payments and foreign currency income. 1181
This approach results in no U.S. withholding tax with respect to loan payments from U.S.
borrowers of U.S. securities to foreign lenders, but is disadvantageous to certain taxpayers, such
as U.S. lenders of foreign securities (for foreign tax credit purposes).
1178
See ABA Section of Taxation, Financial Transaction Committee, Subcommittee on
Securities Investors and Broker Dealers, "Securities Loans Task Force Report on Securities
Lending Transactions" (March 27, 1991), reprinted in Highlights & Documents, May 15, 1991,
1659.
1179
See Bank of America v. U.S., 680 F.2d 142 (Ct. Cl. 1982)(letter of credit fees); Helvering v.
Stein, 115 F.2d 468 (4th Cir. 1940)(interest arbitrage); Zander & Cia v. Comr., 42 B.T.A. 50 (1940)
(commodity futures trading).
1180
See Comr. v. Watson, 163 F.2d 680 (9th Cir. 1947), cert. denied, 332 U.S. 842; Comr. v.
Weisler, 161 F.2d 997 (6th Cir. 1947), cert. denied, 332 U.S. 842; Rev. Rul. 72-521, 1972-2 C.B.
178 (dealing with loan premiums and dividend substitutes). Various statutory provisions recognize
the analogy on the borrower's side. See Sections 163(d)(3)(C), 246A(d)(3)(B), 265(a)(5).
1181
See Regs. §1.863-7(b)(1), referring to §988(a)(3)(B); T.D. 8330, 1991-1 C.B. 105; Regs.
§1.988-4.

5. Final Regulations
In T.D. 8735,1181.1 the IRS finalized without significant changes the proposed regulations
issued in 1992 under §§861, 871, 881, 894, and 1441. The final regulations provide that a
substitute payment made with respect to a securities lending or sale-repurchase transaction (as
defined in Regs. §§1.861-2(a)(7) and 1.861-3(a)(6)) is sourced using the general rules governing
the source of interest or dividend income contained in §§861 and 862. This source rule applies
for all purposes of the Code. The regulations define a substitute payment as one made to a
transferor of a security of an amount equal to any distributions of dividends or interest which the
owner of the transferred security would otherwise receive. Under a transparency rule, the
regulations provide that substitute interest or dividend payments have the same character as
interest or dividend income, respectively, for purposes of applying §§864(c)(4)(B), 871, 881,
894, 4948(a), and the withholding provisions under chapter 3 of the Code. The final regulations
generally apply to payments made after November 13, 1997.

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 1181.1
62 Fed. Reg. 53498 (10/14/97), finalizing regulations proposed in INTL-106-89 (1/9/92).

The final regulations do not address the tax treatment of fees or interest paid to the transferee
in securities lending or sale-repurchase transactions. Hence the transparency rule does not extend
to characterize the interest component of the repurchase price of a sale-repurchase agreement,
which is treated as interest and sourced under the general rules for interest in §§861 and 862.
Although the source rule applies whether the recipient is U.S. or foreign and applies for all
Code purposes (including, for example, foreign tax credit limitations under §§904 and 906), the
transparency rule determines the character of the payment only with respect to foreign taxpayers
and only for certain purposes of the Code sections referenced above. For example, substitute
payments to a foreign person which, without the securities lending transaction, would generate
foreign source ECI in that person's hands retain their character as dividend or interest income for
purposes of determining whether the income is effectively connected to the U.S. trade or
business of that person.
The transparency rule does not, however, apply to characterize the U.S. source income of
U.S. trades or businesses of foreign taxpayers. Thus, U.S. source ECI of foreign taxpayers and
U.S. source income of U.S. taxpayers are treated the same. In this regard the final regulations do
not alter existing guidance applicable to both domestic and foreign taxpayers concerning the
characterization of substitute payments for purposes of other sections not specifically mentioned
in these regulations (e.g., §§103, 243, 901, 903).
The final regulations provide that a foreign lender's substitute interest payments received
from a U.S. person qualify as portfolio interest, provided that the interest would qualify under
§871(h) or §881(c) in the hands of the lender, if, in the case of an obligation in registered form,
the lender provides the withholding agent with a beneficial owner withholding certificate or
documentary evidence in accordance with Regs. §1.871-14(c) and no exception from the
portfolio interest exemption applies.
The IRS notes that the transparency rule adversely affects foreign taxpayers that might
otherwise rely on a different (non-interest or -dividend) characterization of substitute payments
in order to claim benefits under certain income tax treaties but states in the Preamble its position
that the rule is properly issued under §7805 and also under the authority of §7701(l).
6. Notice 97-66
In Notice 97-66,1181.2 the IRS published guidance for withholding on substitute payments
pursuant to securities lending or sale-repurchase transactions. The Notice states that the Treasury
and the Service intend to propose new regulations to provide specific guidance on how substitute
dividend payments made by one foreign person to another foreign person ("foreign-to-foreign
payments") are to be treated. Until the proposed regulations are promulgated, the Notice clarifies
how the amount of the tax imposed under Regs. §§1.871-7(b)(2) and 1.881-2(b)(2) will be
determined with respect to foreign-to-foreign payments.
1181.2
1997-2 C.B. 328.

Under Notice 97-66 as later extended, the statement requirement of §871(h)(5) is satisfied
with respect to substitute interest payments made (as explained below) after November 13, 1997
(or after December 31, 1998, if elected) and before January 1, 2001, if any written, electronic, or

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oral statement that reasonably establishes that the payee is a foreign person is given or made to
the payor prior to, or within a reasonable period of time after, the payment. The statement
requirement is deemed to be satisfied if the payor is subject to, and satisfies with respect to the
payee, the regulatory rules in the jurisdiction in which the payor is operating regarding
establishing the identity of a customer (i.e., "know your customer" rules). Also, if a taxpayer
makes an election under Regs. §1.1441-1(f)(2)(ii), the election is effective, pursuant to the
Notice, to allow a withholding agent to apply retroactively the documentation requirements of
Regs. §1.871-14(c) with respect to one or more substitute interest payments made after
November 13, 1997.
Under the Notice, the amount of U.S. withholding tax to be imposed under Regs. §§1.871-
7(b)(2) and 1.881-2(b)(2) with respect to a foreign-to-foreign payment is the amount of the
underlying dividend multiplied by a rate equal to the excess of the rate of U.S. withholding tax
that would be applicable to U.S. source dividends paid by a U.S. person directly to the recipient
of the substitute payment over the rate of U.S. withholding tax that would be applicable to U.S.
source dividends paid by a U.S. person directly to the payor of the substitute payment. This
amount may be reduced or eliminated to the extent that the total U.S. tax actually withheld on the
underlying dividend and any previous substitute payments is greater than the amount of U.S.
withholding tax that would be imposed on U.S. source dividends paid by a U.S. person directly
to the payor of the substitute payment. As a result of this formula, substitute payments with
respect to foreign-to-foreign securities loans and sale-repurchase transactions that do not reduce
the overall U.S. withholding tax generally are not subject to withholding tax. For example, no
withholding tax is required in situations where transactions are entered into between residents of
the same country.
Each person who makes a foreign-to-foreign payment is treated as a withholding agent under
Regs. §1.1441-7 with respect to the payment. If a U.S. withholding agent withholds the highest
rate of tax which would be imposed on all foreign recipients of dividends and substitute
payments in a chain of such payments, each foreign withholding agent is treated as having
satisfied its withholding obligation under Regs. §1.1441-7.
The Notice provides several examples of the operation of its principles. The effective date of
the Notice was extended for one year by Notice 98-16.1181.3 and for another year by Notice 99-25
1181.4
Originally, the provisions of the Notice were effective for purposes of applying the final
regulations as of November 14, 1997, the initial effective date of those regulations. Because
some withholding agents required additional time to adjust their business practices to implement
the provisions of the final regulations and this Notice, a withholding agent could elect under
Notice 98-16 to defer the application of the final regulations, other than Regs. §1.864-5(b)(2)(ii),
and Notice 97-66 until January 1, 1998. A withholding agent made this election by attaching a
statement to that effect to a timely filed tax return (Form 1042) for the period that included
November 14, 1997, or if no such return is otherwise required for the period including that date,
on a timely filed return (Form 1042) for the period that included January 1, 1998. Withholding
agents making this election must apply the provisions of the final regulations and Notice 97-66
for substitute payments made after December 31, 1997.
1181.3
1998-15 I.R.B. 12, as implemented by T.D. 8804, 63 Fed. Reg. 72183 (12/31/98).
1181.4
1999-20 I.R.B. 75, as implemented by T.D. 8856, 64 Fed. Reg. 73408 (12/30/99).

XIII. Distributive Share of Income from Certain Pass-Through Entities and S

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 Corporations
A. Partnerships and S Corporations
1. Partnerships
A partnership, unlike a corporation, is not a taxable entity. Under §702(a), items of
partnership gross income are considered to belong to the partners in accordance with their
respective "distributive shares," as determined in accordance with §704. Each partner must report
individually its distributive share of partnership income, gains, losses, deductions, or credits for
the partnership's taxable year ending with or within its taxable year whether or not any actual
distribution is made.
Even though a partnership is not a taxable entity, it is considered a "person" for federal
income tax purposes.1182 Consequently, in the case of income sourced by reference to the
residence of the recipient (e.g., income from ocean or space activity), in general, income derived
by a partnership apparently is sourced by reference to the residence of the partnership. In the
case of a sale of property by a partnership, however, income is sourced at the partner level,
except as provided in regulations.1183 The legislative history suggests that regulations may
determine source at the partnership level, for example, in the case of a publicly traded
partnership with hundreds of partners.1184
1182
See, e.g., §7701(a)(30).
1183
§865(i)(5).
1184
House Report, TAMRA.

The character and source of partnership income carries over to the partners in their
distributive shares of partnership income. Section 702(a)(7) provides that each partner shall take
into account separately his distributive share of all items of income gain, loss, deduction, or
credit as provided by regulation. The regulations1185 provide that each partner must take into
account separately his distributive share of any partnership item that, if separately taken into
account by any partner, would result in an income tax liability for that partner different than that
which otherwise would result. Under §702(b):
The character of any item of income, gain, loss, deduction, or credit included in a partner's
distributive share . . . shall be determined as if such item were realized directly from the
source from which realized by the partnership, or incurred in the same manner as incurred by
the partnership.
1185
Regs. §1.702-1(a)(8)(ii). See generally 712 T.M., Partnerships--Taxable Income; Allocation
of Distributive Shares; Capital Accounts (U.S. Income Series).

Accordingly, the character and source of income earned by a partnership passes through to
the partners. 1186 For example, a partner's distributive share of the partnership's foreign source
dividend income is income from foreign sources to the partner.
1186
Accord, PLR 8802038 (interest and OID on obligations of international development bank).
Section 702(b) was intended to reflect existing case law with respect to source of income. See
Craik v. U.S., 31 F. Supp. 132 (Ct. Cl. 1940) (under the more general language of the Revenue
Acts of 1916 and 1918, a nonresident alien partner in a U.S. partnership was entitled to exclude
his share of partnership foreign source income). See also fn. 457 above.
U.S. partnerships must withhold tax on U.S. source "fixed or determinable annual or

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 periodical" income that is included in the distributive share of partners who are nonresident aliens,
foreign fiduciaries of trusts, foreign partnerships, or foreign corporations, whether or not such
amounts are actually distributed. See Regs. §1.1441-3(f); Rev. Rul. 89-33, 1989-1 C.B. 269; Rev.
Rul. 89-17, 1989-1 C.B. 269.

In the case of a partnership that is engaged in a trade or business in the United States, each
partner is considered, under §875(1), to be so engaged, with the result that income derived by the
partnership that is effectively connected with its trade or business is taxed to each partner as
effectively connected income. In addition, any office or other fixed place of business of such
partnership is considered to be the office of each partner.1187
1187
See, e.g., Johnston v. Comr., 24 T.C. 920 (1955) (Chicago office of domestic partnership
attributed to Canadian partner who supplied Canadian cattle to it for sale). See fn. 711 and text
accompanying fns. 711-20 above. A partnership having taxable income effectively connected with
a U.S. trade or business must withhold tax on amounts of such income allocable under §704 to a
foreign partner. Rates of withholding on amounts allocable to foreign partners are at the highest
U.S. rates applicable to individuals and corporations, respectively. See §1446(a), (b); Rev. Proc.
89-31, 1989-1 C.B. 895.

Since a partner's distributive share of partnership income retains the same character and
source as such income has at the partnership level, the foreign source (or U.S. source) portion of
such share is that proportion of such share which the partnership's total net foreign source (or
U.S. source) income bears to its total net income.
Example: A partnership is engaged in a trade or business in the United States. During the
taxable year in question its ratio of net foreign source income to total net income is three-to-
four. It distributes $1,000 to a partner. If the payment is the payment of a distributive share,
$250 is U.S. source income to the partner and the balance of $750 is foreign source income.
(A payment of $1,000 of interest on a loan made by the partner would have been considered
entirely U.S. source.)
A partnership agreement may specially allocate U.S. or foreign source income to a particular
partner provided such allocation has "substantial economic effect" under the §704(b) regulations.
1188

1188
See Regs. §1.704-1(b)(2), (b)(5), Ex. (10).

An obligation of a partnership to pay an amount, determined without regard to the income of

the partnership, for services or for the use of capital may be a "guaranteed payment" under
§707(c). Such payments are discussed in II, D, 3, above.
2. S Corporations
A corporation that has elected under §1362(a) to be treated as an "S corporation" generally1189
is not subject to tax on its income but, rather, passes those items through to its shareholders under
rules similar to those governing partnerships.1190
1189
See §1363(a). But see §§1363(d), 1374-75.
1190
See §§1373(a), 1366.

B. Trusts and Estates

1. Trusts

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 For tax purposes, trusts may be divided into two overall categories: grantor trusts and
ordinary trusts. Grantor trusts are disregarded for tax purposes, and trust income is taxed directly
to the grantor.1191 Consequently, when a grantor trust derives income, the grantor is deemed to
have received the income directly from the source from which the trust derived it.
1191
See §671. See generally 858 T.M., Grantor Trusts: Sections 671-79 (EGT Series).

Ordinary trusts, in turn, may be subdivided into two categories: simple trusts and complex
trusts.1192 Simple trusts are those whose income is required to be currently distributed in its
entirety to beneficiaries.1193 Complex trusts are those in which the trustee has the discretion or is
required to accumulate income.1194 Income from complex trusts is taxed to the trust but not to the
beneficiaries while it is being accumulated.1195 When such income is eventually distributed, it is
taxed to the beneficiaries. In the case of a foreign trust, such an accumulation distribution is
taxed by reference to the years in which it was accumulated under special throwback rules. 1196
1192
Regs. §1.651(a)-1. See generally 852 T.M., Income Taxation of Trusts and Estates (EGT
Series).
1193
See §§651-52.
1194
See §661 et seq.
1195
Id.
1196
See §§665-67. See generally 856 T.M., Subchapter J -- Throwback Rules (EGT Series).

With respect to simple trusts, §652(b) provides that taxable distributions "shall have the same
character in the hands of the beneficiary as in the hands of the trust." Since the term "character"
has been read to include geographic source, receipt of income through a trust does not change the
source of the income item.1197 Thus, when a simple trust receives foreign source income and
distributes the income to its beneficiaries, the income retains its character as foreign source
income in the hands of the beneficiaries. If a trust has both U.S. and foreign source income, each
beneficiary's share will reflect each source ratably.1198
1197
Isidro Martin-Montis Trust v. Comr., 75 T.C. 381 (1980), acq., 1981-2 C.B. 2; Bence v. U.S.,
18 F. Supp. 848 (Ct. Cl. 1937); Rev. Rul. 81-244, 1981-2 C.B. 151; cf. Rev. Rul. 70-599, 1970-2
C.B. 172 (capital gain distributed currently by trust not subject to withholding).
1198
Regs. §1.652(b)-2. Accord Muir v. Comr., 10 T.C. 307, 311-12 (1948), aff'd and rem'd, 182
F.2d 819 (4th Cir. 1950).

Example: Beneficiary A is to receive currently one-half of the trust income and beneficiaries
C and D are each to receive currently one-quarter of the income under the governing
instrument. Distributable net income of the trust includes $10,000 of interest from U.S.
sources and $6,000 of interest from foreign sources. Beneficiary C, who is a nonresident
alien, will be deemed to have received $2,500 U.S. source interest income and $1,500 foreign
source interest income.
A trust instrument may specifically provide for a beneficiary's entire share of, e.g., interest
income to be derived from the trust's foreign source interest income. The regulations provide that
such an allocation can be made only to the extent it has an economic effect independent of its
income tax consequences.1199
1199
Regs. §1.652(b)-2(b).

With respect to a complex trust, current distributions are governed by the rules discussed
above relating to distributions by a simple trust.1200 In the case of accumulation distributions from

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a foreign complex trust (i.e., distributions of income made in a taxable year subsequent to that in
which the income was derived by and taxed to the trust),1201 the amounts retain their character in
the hands of a nonresident alien or foreign corporate beneficiary1202 when taxed to the beneficiary
(with a credit for the tax paid by the trust) under the "throwback" rules.1203 Therefore, an
accumulation distribution made from foreign or domestic source income at the trust level retains
its character as such in the hands of a nonresident alien or foreign corporate beneficiary.
1200
§661(b).
1201
See Maximov v. U.S., 373 U.S. 49 (1963) (capital gain taxed to trust since not distributed
even though, had gain been distributed currently, U.K. beneficiaries would have been exempt from
tax thereon under the U.S.-U.K. income tax treaty).
1202
§§662(b), 667(e).
1203
See generally §§665-68. These throwback rules also apply to certain domestic trusts created
before March 1, 1989. §665(c)(2)(B).

Despite the rule that even certain accumulation distributions retain the source of the income
from which they are made, special considerations apply in the case of distributions of interest
from certain bank and other deposits, since the provisions characterizing that income as foreign
source (under the law prior to TRA 86) or exempting it from taxation (under current law) apply
only if the taxpayer is a nonresident alien or a foreign corporation. These rules are discussed in
II, F, 3, above.
2. Estates
Estates are taxed like complex trusts, except that beneficiaries of estates are not subject to
taxation on accumulation distributions.1204 The rules discussed above, insofar as they relate to
complex trusts, apply equally to estates.
1204
See §§641, 661, and 667.

C. Other
The source rules applicable to certain other pass-through entities, such as RICs, REITs, and
REMICs, are discussed in III, B, 9, above.
XIV. Other Income and Special Rules
A. Miscellaneous Statutory and Regulatory Rules
1. U.S. Social Security Benefits
Section 861(a)(8) provides that any "social security benefit" (as defined in §86(d)) is treated
as income from U.S. sources. A "social security benefit" (as so defined) includes any amount
received by reason of entitlement to a monthly benefit under title II of the Social Security Act or
to a tier 1 railroad retirement benefit.1205
1205
§86(d)(1).

Historical Note: This provision was added by §121(d) of the Social Security Amendments of
1983,1206 effective for benefits received after 1983 in taxable years ending after 1983.
1206
P.L. 98-21.

2. Amounts Includible from Controlled Foreign Corporations and Certain Passive Foreign

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 Investment Companies
a. General Rules
Under Section 951(a), a U.S. shareholder (as defined in Section 951(b)) of a controlled
foreign corporation (CFC) who owns stock in such CFC on the last day in the taxable year on
which such corporation is a controlled foreign corporation generally must include in income, as
ordinary income, the shareholder's pro rata share of the CFC's subpart F income and certain other
amounts. An explicit source rule for this income is provided only for purposes of Section 904,
apparently since by far the most common reason for determining the source of such income for a
U.S. shareholder is for foreign tax credit purposes. Accordingly, under Regs. Section 1.960-1(h),
for purposes of Section 904, the amount included in gross income by a domestic corporation
under Section 951, plus any Section 78 dividend from which such Section 951 amount gives rise
by reason of taxes deemed paid by such domestic corporation under Section 960(a)(1), generally
1207
is deemed to be derived from sources within the foreign country or U.S. possession under the
laws of which the CFC is organized.1208 If the CFC that generated the subpart F income is held
indirectly through other CFCs, the amount included is treated for purposes of Section 904 as if it
had been paid through such entities and as received from the first-tier CFC.1209
1207
An exception is provided in Section 904(g), as discussed below.
1208
In addition, Section 960(b) and Regs. Section 1.960-4 increase the applicable Section 904
limitation of the domestic shareholder for the taxable year in which it received a distribution of
earnings and profits in respect of which it was required to include an amount in income under
Section 951(a) for a prior taxable year. It is interesting to note that the amounts are foreign source
even though not all subpart F income is foreign source. See generally Section 952(b).
1209
Section 1.960-1(h).

The source of subpart F income, however, can be important in at least one situation not
involving the foreign tax credit.
Example: A domestic partnership holds 60% of the stock of a foreign corporation, not
engaged in a trade or business in the United States, all of the income of which is foreign
source foreign base company sales income as defined in Section 954(d). The corporation is a
controlled foreign corporation by reason of the domestic partnership's ownership, even if
some or all of its partners are not U.S. persons.1210 Assuming, however, the subpart F income
allocable to the partnership under Section 951(a)(1) is foreign source, and since the income
retains that source in the hands of the partners of a partnership (even if the partnership is
domestic),1211 the subpart F income allocable to the foreign partners is foreign source and
hence not subject to U.S. taxation. This is the correct result. Accordingly, to the extent
relevant outside the foreign tax credit arena, inclusions under Section 951(a)(1) should be
considered to be from foreign sources.
1210
See Sections 957(a), 957(c), and 951(b).
1211
See fns. 1185-86 and accompanying text.

Under Section 1293, rules are provided governing amounts includible in income by a U.S.
person who is a shareholder of a passive foreign investment company (PFIC) and who has made
an election under Section 1295 to treat the corporation as a qualified electing fund (QEF). In
general, an electing shareholder must include in gross income, "(i) as ordinary income, such
shareholder's pro rata share of the ordinary earnings of such fund for such year, and (ii) as long-
term capital gain, such shareholder's pro rata share of the net capital gain of the fund for such

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year." Section 1293(f)(1) permits a 10% or greater shareholder of a QEF a foreign tax credit
under Section 960 for such shareholder's ratable share of foreign income taxes paid by the QEF
by treating, for purposes of Section 960, amounts included in income by such shareholder under
Section 1293(a) as if they were included under Section 951(a). Thus, such amounts generally1212
are treated as foreign source income. While express guidance has not been provided on the
source of income inclusions under Section 1293(a) by other shareholders, foreign source
classification seems appropriate.1213
1212
An exception is provided in Section 904(g), discussed immediately below. The American
Jobs Creation Act of 2004 (P.L. 108-357, §402) redesignated §904(g) as §904(h).
1213
Cf. Prop. Regs. Section 1.1291-5(b)(1) (excess distribution treated as foreign source
income, passive basket). Section 904(g)(1)(A)(iii) also provides support, by implication. The
American Jobs Creation Act of 2004 (P.L. 108-357, §402) redesignated §904(g) as §904(h).

In the case of an actual distribution by a PFIC in respect of a taxable year for which a QEF
election has not been made (a "Section 1291 fund"), or by a CFC to the extent not excludible
under Section 959 as "previously taxed income," in general, the normal rules governing the
source of dividends paid by a foreign corporation apply (see II, above). An "excess distribution"
(as defined in Section 1291(b)), however, including all or part of an excess distribution resulting
from a disposition of PFIC shares (see VII, A, 2, h above), is deemed to be foreign source
income, subject to Section 904(g), under proposed regulations under Section 1291(g).1214
1214
See Prop. Regs. Section 1.1291-5(b)(1), (e)(1), (d), (e). Curiously, Prop. Regs. Section
1.1291-5(b)(1) does not refer to Section 904(g). The American Jobs Creation Act of 2004 (P.L.
108-357, §402) redesignated §904(g) as §904(h).

b. Exception Where Foreign Corporation Is U.S.-Owned and Has Significant U.S. Income
If 10% or more of the earnings and profits of (1) a PFIC as to which 50% or more of either
the combined voting power of all classes of voting stock or the total value of all stock is owned
by U.S. persons, or (2) a CFC (which by definition is majority-owned by U.S. persons) is
attributable to U.S. sources, a portion of the amount included in income under Section 1293 or
Section 951(a), respectively, which otherwise would be treated as from foreign sources, is treated
under Section 904(g) as from U.S. sources for purposes of Section 904 (see discussion of Section
904(g) in III, B, 7, above). A similar rule is set forth in Section 904(g) for undistributed foreign
personal holding company income included by a U.S. shareholder under Section 551,1215 but that
provision seems redundant of the more general rule under which Section 904(g) may apply to
any dividend, in light of the characterization of amounts included under Section 551 as
dividends.1216 The American Jobs Creation Act of 2004 (P.L. 108-357, §413) repealed the foreign
personal holding company provisions (§§551-558) and the foreign investment company
provisions (§§1246-1247) for taxable years of foreign corporations beginning after December 31,
2004, and for taxable years of U.S. shareholders with or within which such taxable years of
foreign corporations end and (at Act §402) redesignated §904(g) as §904(h).
1215
See the discussion in III, B, 7, above.
1216
More specifically, Section 551(b) provides that each U.S. shareholder, who was a
shareholder on the last day in the taxable year on which a U.S. group (as defined in Section 552(a)
(2)) existed with respect to a "foreign personal holding company" (as defined in Section 552),
must include in his gross income, as a dividend, for the taxable year in which or with which the
taxable year of the company ends, the shareholder's proportionate share of the "undistributed
foreign personal holding company income" (as defined in Section 556). Thus, the income included
generally would have to be treated as foreign source income under the rules described in III,

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 above. Amounts treated as dividends under Section 1248 or as ordinary income under Section
1246 are also subject to Section 904(g); as a drafting matter, this is accomplished by defining such
amounts as dividends for such purpose. See Section 904(g)(7). The American Jobs Creation Act of
2004 (P.L. 108-357, §402) redesignated §904(g) as §904(h).

3. Income Earned by an FSC or by Related Supplier on Sales Through an FSC

As discussed above,1217 the FSC (foreign sales corporation) provisions of the Code are
intended to provide export incentives to U.S. manufacturers by exempting a portion of an FSC's
income from U.S. taxation.
1217
See III, B, 5, above.

Section 921(a) provides that exempt foreign trade income of an FSC as determined under
Section 923 is treated as foreign source income which is not effectively connected with the
conduct of trade or business within the United States.1218
1218
See Regs. Section 1.921-3T(a)(2)(i).

Under Section 921(d), nonexempt foreign trade income determined with regard to the
administrative pricing rules of Section 925(a)(1) and (2)1219 is treated as income effectively
connected with a U.S. trade or business conducted through a permanent establishment in the
United States.1220 Such income is also treated as U.S. source income.1221
1219
I.e., in the words of the statute, "foreign trade income" (as defined in Section 923(b)) of an
FSC, other than (A) "exempt foreign trade income" (as defined in Section 923(a)) and (B) the
portion of income described in Section 923(a)(2) (foreign trade income determined without regard
to the administrative pricing rules of Section 925(a)(1) or (2)) that is not exempt.
1220
Regs. Section 1.921-3T(a)(2)(ii).
1221
Id.

Also under Section 921(d), "investment income" and "carrying charges" (as defined in Temp.
Regs. Section 1.921-2(f) Q & A 9) derived by an FSC are treated as income effectively
connected with the FSC's trade or business conducted through its permanent establishment
within the United States. The source of such income is determined under the normal Code rules.
1222

1222
Regs. Section 1.921-3T(a)(2)(iv).

The source of the FSC's nonexempt foreign trade income determined without regard to the
administrative pricing rules of Section 925(a)(1) or (2) is determined under the normal Code
rules.1223 Similarly, the source and character of the FSC's nonforeign trade income (other than
investment income and carrying charges) is determined under the normal Code rules.1224
1223
Regs. Section 1.921-3T(a)(2)(iii).
1224
Regs. Section 1.921-3T(a)(2)(v).

Section 927(e) limits the amount of foreign source income that may be realized by a related
supplier, such as the domestic parent of an FSC, from qualifying export sales made by or through
the FSC. More exactly, Section 927(e) provides that, under regulations, income derived by a
person having the relationship to an FSC described in Section 482, from a transaction giving rise
to "foreign trading gross receipts" (as defined in Section 924(a)) of the FSC which is treated as
from sources outside the United States, must not exceed the amount which would be treated as
foreign source income earned by such person if the Section 994 transfer-pricing rule under the

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DISC provisions that corresponds to the Section 925 FSC transfer-pricing rule used with respect
to such transaction applied.
In Notice 89-111225 and Notice 89-87,1226 the IRS addressed the application of Regs. Section
1.863-3(b)(2) to an FSC. Notice 89-11 states that regulations to be issued under Section 927 will
provide that, if inventory is sold to an FSC, or through an FSC acting as commission agent, the
50-50 rule of Regs. Section 1.863-3(b)(2), Ex. 2 (and not an independent factory price, if any)
applies for purposes of determining the foreign source income of the related supplier to the FSC.
However, in Notice 89-87, the IRS stated that, if the FSC's taxable income is determined under
the Section 482 transfer pricing methods rather than the administrative pricing rules, Notice 89-
11 does not apply and if an independent factory price exists, it must be used to determine the
related supplier's foreign source income from sales made by or through the FSC. In either case,
under Section 927(e)(1), such foreign source income cannot exceed the amount that would have
been earned had the sale been made to or by a DISC.
1225
1989-1 C.B. 632.
1226
1989-2 C.B. 405.

In most situations, U.S. exporters must sacrifice foreign source income in order to receive
FSC benefits. For example, as discussed above,1227 a manufacturer that produces goods in the
United States and sells them overseas normally may treat 50% of the income as foreign source
under Section 863(b). However, if the manufacturer uses an FSC, the Section 927(e) resourcing
rule discussed above greatly limits the portion of the manufacturer's taxable income that may be
treated as foreign source.1228
1227
See VII, B, 2, a, (1), (B).
1228
See S. Rep. No. 169 (Vol. 1), 98th Cong., 2d Sess. 655-56 (1984); 934 T.M., Foreign Sales
Corporations.

The trade-off between foreign source income (which would increase a taxpayer's foreign tax
credit limitation) and FSC benefits generally motivates taxpayers to favor the credit up to the
point where the creditable foreign taxes are not limited by Section 904, and to favor FSC benefits
after such point. Since many U.S.-based multinational corporations have had excess general
basket foreign tax credits for periods following the effective date of TRA 86, many such
corporations have not pursued FSC benefits, but instead have sought to increase their foreign
source general basket income to increase the limitation.
Regulations permit subsequent redeterminations after the return has been filed on a limited
basis.1229 A private ruling1230 can be read to permit an FSC and its related supplier to enlarge or
reduce FSC benefits as desired, by changing transfer pricing methods and amending pricing
determinations, after the FSC tax return has been filed. Thus, a U.S. multinational corporation
might claim foreign source income at the expense of FSC benefits but, if the situation changes,
redetermine its transfer pricing method, etc., to increase FSC benefits.
1229
See Regs. Section 1.925(a)-1T(e)(4).
1230
PLR 9029068.

Special rules governing the source of certain dividends paid by an FSC are discussed in III,
B, 5, above.
4. Section 306 Stock

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 Provisions under Section 306, dealing with the sale of certain preferred stock, are discussed
in VII, A, 2, f, above.
5. Section 338(h)(16)
This provision, which is relevant to certain elections under Section 338, is discussed in VII,
A, 2, k, above.
6. Certain Section 367 Inclusions, Section 1248 Gain, and Section 1291 Gain
Section 367, which, in general deals with certain transfers to or from foreign corporations in
transactions described in certain nonrecognition provisions, is discussed above in VII, A, 2, g.
Sections 1248 and 1291, which, in general, deal with gain from the disposition of an interest in a
controlled foreign corporation or a passive foreign investment company, respectively, are
discussed in VII, A, 2, h, above.
7. Accumulated Earnings Tax
Section 535(d), which re-sources certain foreign source income as U.S. source income for
purposes of determining the §531 accumulated earnings tax liabilities of a U.S.-owned foreign
corporation, is discussed in III, B, 8, above.
8. Section 864(e)(7) -- Affiliated Groups
Section 864(e)(7) authorizes the Treasury Department to issue such regulations as may be
necessary or appropriate to carry out the purpose of the §864(e) rules for allocating and
apportioning certain expenses, including regulations for the re-sourcing of income of any
member of an affiliated group. Under the regulations, for example, interest income received by a
member of an affiliated group from another member is treated as having the same source and as
in the same §904 separate limitation category as the income against which the debtor member
allocates or apportions the corresponding interest expense.1231 This rule may also apply to certain
"back-to-back" loans.1232 Furthermore, in the case of members of an affiliated group (as defined
for purposes of the §864(e) rules)1233 that are not included in a consolidated income tax return
with other members of such group, special rules are provided to achieve the effect of netting of
losses (resulting from the allocation of expenses, including interest) of one member in a separate
limitation category against income of another member in such category.1234 To accomplish this, in
the case of a member with losses in a separate limitation category, the losses are eliminated and
income of that member in its other separate limitation categories is increased. 1235 Corresponding
increases or decreases in the separate limitation categories of other members are made so that the
group overall has the same amount of income in any given separate limitation category as if all
members had been included in a consolidated return.1236 Regulations under §1502 generally
impose single entity treatment for determining the source of income or loss from an
intercompany transaction, except when an applicable treaty provides for a different result. 1236.1
1231
See Regs. §1.861-11T(e)(2)(i); Notice 89-21, 1989-2 C.B. 408.
1232
See Regs. §1.861-11T(e)(3).
1233
Such members would include those corporations described in Regs. §1.861-11T(d)(6).
1234
See Regs. §1.861-11T(g). The regulations governing the allocation and apportionment of
interest deductions also contain, in effect, an anti-deconsolidation rule, because they define
affiliated members expansively to include, e.g., members of which 80% of the stock by vote or
value is owned. See Regs. §1.861-11T(d)(6).

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 1235
See Regs. §1.861-11T(g)(2)(ii). See, e.g., Bank of America v. U.S., 680 F.2d 142 (Ct. Cl.
1982).
1236
See Regs. §1.861-11T(g)(3)(iv).
1236.1
See T.D. 8597, 60 Fed. Reg. 36671 (7/18/95); Regs. §1.1502-13(c)(7)(ii), Exs. 14 and 15.

Section 401 of the American Jobs Creation Act of 2004, P.L. 108-357, authorized further
regulations to prevent abuse and expand the reporting options for taxpayers with regard to the
allocation of interest expense. This authority included the opportunity for taxable years
beginning after December 31, 2008, to make a one-time election for allocation and
apportionment of interest expense on a worldwide affiliated group basis under the fungibility-of-
money principles as if the domestic and foreign members of the group were all a single
corporation, with the option to apply the rules separately to a subgroup of certain financial
affiliates.
9. Expatriates
Section 877 sets forth rules for the taxation of certain nonresident alien individuals who have
given up U.S. citizenship within the 10 years immediately preceding the close of the taxable year
in question. Section 877(d)(1)(A) contains a special source rule that treats as U.S. source gain on
the sale or exchange of property (other than stock or debt) located in the United States.
10. Income from Countries Supporting International Terrorism or with Which the United
States Lacks Diplomatic Relations
Section 901(j)(1) denies the benefit of the foreign tax credit in respect of taxes paid or
accrued (or deemed paid under §902 or §960) to any country if such taxes are with respect to
income attributable to a period during which (subject to certain exceptions, including waiver by
the President after notice to Congress) the United States does not recognize the government of
such country, the United States has severed diplomatic relations or does not conduct such
relations with such country, or the Secretary of State has designated such country as a foreign
country which repeatedly provides support for acts of international terrorism.1236.2 Section 952(a)
(5) treats as subpart F income the income derived by a controlled foreign corporation from a
country during any period during which §901(j) applies to such foreign country. Sections 901(j)
(4) and 952(d) authorize the Treasury Department to issue such regulations as may be necessary
or appropriate to, among other things, treat income paid through one or more entities as derived
from a foreign country to which §901(j) applies if such income was, without regard to such
entities, derived from such country.
1236.2
See Rev. Rul. 92-62, 1992-2 C.B. 193, and Rev. Rul. 92-63, 1992-2 C.B. 195.

11. Special §904 Loss and Deconsolidation Rules

For foreign tax credit purposes, the resourcing of foreign source income as U.S. source
income under §904(f) and (h) (the latter of which was redesignated from §904(g) by P.L. 108-
357, §402) and the resourcing of certain U.S. source income as foreign source income under
§904(g) (as added by P.L. 108-357, §402), are discussed in VII, C, and III, B, 7, above,
respectively.
Section 904(j) (redesignated from §904(i) by P.L. 108-357, §402) provides a special rule
designed to prevent taxpayers from avoiding the effects of calculating the foreign tax credit on a

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consolidated basis by intentionally deconsolidating. For example, if a domestic parent
corporation has net operating losses and a domestic subsidiary derives foreign source income, the
parent might consider transferring the domestic subsidiary to a foreign holding company so that
the parent's losses do not prevent the subsidiary from crediting foreign taxes against U.S. income
tax liability. Section 904(i), however, makes such a structure ineffective. Specifically, §904(i)
provides that, if two or more domestic corporations would be members of the same affiliated
group if §1504(b) were applied without regard to the exceptions contained therein and the
constructive ownership rules of §1563(e) applied for purposes of §1504(a), the Treasury
Department may issue regulations re-sourcing the income of any of such corporations, or
modifying the consolidated return regulations, to the extent necessary to prevent the avoidance of
the foreign tax credit provisions.1236.3 It should be noted that an actual economic deconsolidation
(through a transfer of sufficient ownership to unrelated parties) is not affected by §904(i).
1236.3
For a complete discussion of §904(i) and related regulations, see 904 T.M., The Foreign
Tax Credit Limitation--Section 904.

12. Intangible Property Income of Possessions Corporation

Section 936 provides a credit against U.S. tax liability for certain domestic corporations
deriving substantially all of their gross income from the active conduct of a business within
Puerto Rico or the U.S. Virgin Islands. Under §936(h), the "intangible property income" (as
defined in §936(h)(3)) of a corporation electing such credit is treated as income from U.S.
sources. (To the extent the shareholders of the corporation are U.S. persons and are subject to
U.S. income tax on such intangible property income, it must be included by them in income
annually, and is excluded from the income of the corporation.)
13. Market Discount
As discussed in II, C, 2, above, absent promulgation of regulations under §1276 to the
contrary, it appears that "market" discount is treated as interest for source of income purposes,
though not for purposes of the 30% withholding tax on payments to foreign persons.
14. Transactions Involving the Transfer of Computer Programs
In November 1996 the IRS issued proposed rules for classifying transactions involving the
transfer of computer programs as sales, licenses, leases, or the provision of services or of know-
how under certain Code provisions (including those for determining the source of income) and
tax treaties.1236.4 The regulations appeared in final form in T.D. 8785 as Regs. §1.861-18,
characterizing transactions involving computer programs.1237 Generally, the final regulations
adopted the provisions of the proposed regulations, but provided a number of important
amendments to the proposed regulations in response to comments.
1236.4
REG-251520-96, 61 Fed. Reg. 58152 (11/13/96).
1237
63 Fed. Reg. 52971 (10/2/98). Regs. §1.861-18(a)(1) provides that the rules apply for
purposes of subchapter N of chapter 1 of the Code (§§861-999, the rules for tax based on income
from sources within or without the United States), §§367, 404A, 482, 551 (repealed by §413 of
P.L. 108-357 for taxable years beginning after Dec. 31, 2004), 679, 1057, and 1059A, chapter 3 of
the Code (§§1441-1464, the withholding rules for payments to nonresident aliens and foreign
corporations), chapter 5 of the Code (§§1491-1494, the rules for the former tax on transfers to
avoid income tax), §§842 and 845 (to the extent involving a foreign person), and transfers to
foreign trusts not covered by §679.

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 Under the regulations, the source of income derived from transfers of computer software
depends on the transaction's classification. The final regulations provide explicit source rules for
income derived from computer program transactions. Income from the sale or exchange of
copyrighted articles is sourced under the rules applicable to sales of personal property (§§861(a)
(6), 862(a)(6), 863, 865(a), 865(b), 865(c), and 865(e), as appropriate), whereas income derived
from the lease of a copyrighted article is sourced under the rules applicable to rents (either
§861(a)(4) or 862(a)(4)). Income derived from the sale or exchange of a copyright right is
sourced under §865(a), (c), (d), (e), or (h), as appropriate, whereas income derived from the
license of a copyright right is sourced under either §861(a)(4) or §862(a)(4).1237.1
1237.1
See Regs. §1.861-18(a)(2). See also 558 T.M., Tax Planning for the Development and
Licensing of Copyrights, Computer Software, Trademarks and Franchises (U.S. Income Series).

The regulations define the term computer program as a set of statements or instructions to be
used directly or indirectly in a computer in order to bring about a certain result.1237.2 A computer
program includes any media, user manuals, documentation, data base or similar item if such item
is incidental to the operation of the program.1237.3
1237.2
Regs. §1.861-18(a)(3).
1237.3
Id.

Under the regulations, a transaction involving the transfer of a computer program is classified
in one of four categories:1237.4
• the transfer of a copyright right in the computer program;
• the transfer of a copy of the computer program (a copyrighted article);1237.5
• the provision of services for the development or modification of the computer program; or
• the provision of know-how relating to computer programming techniques.
1237.4
Regs. §1.861-18(b)(1). Neither the form adopted by the parties to a transaction nor the
classification of the transaction under copyright law is determinative for tax purposes. Regs.
§1.861-18(g)(1). In addition, the method of transferring the computer program, for example by
disk or electronically, is not relevant in classifying the transfer. Regs. §1.861-18(g)(2).
1237.5
A copyrighted article is defined as a copy of a computer program from which the work can
be perceived, reproduced, or otherwise communicated. Prop. Regs. §1.861-18(c)(3).

A transaction involving computer programs which consists of more than one of the categories
listed above is treated as a separate transaction.1237.6 However, any resulting transaction that is de
minimis, taking into account all the facts and circumstances, will not be treated as a separate
transaction.1237.7
1237.6
Regs. §1.861-18(b)(2).
1237.7
Regs. §1.861-18(b)(2).

The regulations classify the transfer of a computer program as the transfer of a copyright
right if the transferee acquires one or more of the following rights:1237.8
• the right to make copies of the computer program for purposes of distribution to the public
by sale or other transfer of ownership, or by rental, lease or lending;
• the right to prepare derivative computer programs based upon the copyrighted computer

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 program;
• the right to make a public performance of the computer program; or
• the right to publicly display the computer program. action is classified as a license (which
generates royalty income).
1237.8
Regs. §1.861-18(c)(1)(i) and (2).

In response to concerns from commentators that the transfer of a software development tool
or the grant of a right to correct minor errors in a source code may constitute the right to create a
derivative program (and, thus, constitute the transfer of a copyright right instead of a copyrighted
article), final Regs. §1.861-18(c)(1)(ii) provides that the de minimis transfer of a copyright right
(such a right to use software development tools to create an insubstantial component of a new
program) will not affect the classification of the transfer of a copy of the computer program as
solely a transfer of a copyrighted article. The preamble states that the transfer of a right for
public display or performance of a computer program, such as for marketing or advertising
purposes, to the extent that such a transfer is considered to be the transfer of a copyright right, is
considered to be a de minimis grant of a copyright right under Regs. §1.861-18(c)(1)(ii).
The final regulations also clarified the meaning of the term "to the public" as used in the
description of the first of the four copyright rights (described above) enumerated in Regs.
§1.861-18(c)(2) that, if transferred, cause the transfer of the computer program to be
characterized as a transfer of copyright rights, rather than a transfer of a copyrighted article. The
clarification is intended to exclude the distribution of the copyright program to related parties
(including transfers to non-controlled joint ventures) from the definition. Thus, Regs. §1.861-
18(g)(3) provides that a transferee of a computer program will not be treated as distributing the
computer program "to the public" if the transferee distributes the computer program only to a
related party or to identified persons (identified either by name or legal relationship to the
transferee). A related party is defined as a person that is related to the transferee within the
meaning of §267(b)(3), (10), (11), or (12), 267(f), 707(b)(1)(B), or 1563(a), substituting "10%"
for "50%."
A transfer that involves copyright rights is further classified as either a sale or a license of
copyright rights.1237.9 If, taking into account all the facts and circumstances, all substantial rights
have passed to the transferee, the transfer constitutes a sale. If all substantial rights are not
transferred, the transaction is classified as a license which generates royalty income.
1237.9
Regs. §1.861-18(f)(1). See also Regs. §1.861-18(f)(3).

If a person acquires a copy of a computer program but does not acquire any of the rights
described in the preceding paragraph (and the transaction does not involve or involves only
minimally the provision of services or know-how, as described below), the transfer of the copy
of the computer program is classified solely as a transfer of a copyrighted article. 1237.10 A transfer
that involves a copyrighted article is further classified as either a sale or a lease of a copyrighted
article.1237.11 If, taking into account all the facts and circumstances, the benefits and burdens of
ownership have been transferred, then the transfer is treated as a sale. If insufficient benefits and
burdens of ownership are transferred (so that the transferor is properly treated as the owner), then
the transaction is classified as a lease (generating rental income).
1237.10
Regs. §1.861-18(c)(1)(ii). See also PLR 200229030 (substantive limitations in software

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 license on subsequent transfers and reverse engineering resulted in U.S. purchasers not acquiring
any intangible property rights described in Regs. §1.861-18(c)(2); IRS concluded that software
license should be viewed as sale of a copyrighted article, also noting that Regs. §1.861-18(h), Ex.
1, provides similar example). PLR 200411016 revoked PLR 200229030 prospectively. Comment:
The IRS did not give a reason for the revocation but it appears that the IRS analysis under Regs.
§1.861-18(c)(2) was sound and the potential defect in the ruling likely related to the §956 issue
addressed in the ruling.
1237.11
Regs. §1.861-18(f)(2). See also Regs. § 1.861-18(f)(3).

The regulations provide that the determination of whether a transaction involving a newly
developed or modified computer program is treated as the provision of services or one of the
three other types of transactions described above is based on all the facts and circumstances,
including how risk of loss is allocated and the intent of the parties as to ownership of the
copyright rights in the computer program.1237.12
1237.12
Regs. §1.861-18(d).

The provision of information with respect to a computer program is treated as the provision
of know-how only if the information is:1237.13
• information relating to computer programming techniques;
• furnished subject to contractual conditions preventing unauthorized disclosure; and
• subject to trade secret protection.
1237.13
Regs. §1.861-18(e).

The regulations are effective generally for transactions occurring under contracts entered into
after November 30, 1998. 1237.14 However, two elective transition rules are provided.1237.15 For
transactions occurring under contracts entered into in taxable years ending after October 1, 1998,
a taxpayer may elect to apply the regulations to all contracts entered into after October 1, 1998.
For transactions occurring in taxable years ending after October 1, 1998, under contracts entered
into prior to October 2, 1998, a taxpayer may elect to apply the final regulations for all
transactions occurring in taxable years ending after October 1, 1998, if either (i) the taxpayer
would not be required to change its method of accounting as a result of the election or (ii) the
taxpayer would be required to change its method of accounting, but the §481(a) adjustment
would be zero. The application of these rules may result in a change in the method of accounting
for certain transactions involving computer programs by certain taxpayers.
1237.14
Regs. §1.861-18(i)(1).
1237.15
Regs. §1.861-18(i)(2).

A taxpayer may make either transition election by treating the transactions for which the
election applies in accordance with the final regulations on the original tax return for the taxable
years in question.
If a taxpayer must change its method of accounting for contracts involving computer
programs to conform with the classification required under the final regulations, consent is
granted for such change, 1237.16 whether for years to which the general effective date of the final
regulations applies or for years for which the elective transition rule is elected. The year of
change is either the taxable year that includes December 1, 1998 (for the general effective date)

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or the taxable year that includes October 2, 1998 (for taxable years for which an election is
made.) To change its method of accounting, a taxpayer must file Form 3115 (Application for
Change in Method of Accounting) in duplicate. The following statement must be placed at the
top of page 1 of Form 3115: "FILED UNDER TREASURY REGULATION §1.861-18." The
original Form 3115 must be attached to the original tax return of the taxpayer for the year of
change. The duplicate Form 3115 must be sent to the national office of the IRS. A change in
method of accounting is subject to review by both the district director and the national office.
The change may be modified or revoked in accordance with Rev. Proc. 99-49.1237.17
1237.16
Regs. §1.861-18(j).
1237.17
1999-52 I.R.B. 725.

B. Rules Derived by Analogy

In the case of certain income items, no source rule is provided under the Code or the
regulations. These items nonetheless must be allocated or apportioned to sources within or
without the United States for purposes of the operative provisions referred to in I, A, above. The
courts and the IRS generally have allocated such items of income to either U.S. or foreign
sources by analogizing to the source rules provided in the Code and regulations.1238 Where no
statutory provision appears analogous, income has been sourced "in terms of the business
activities generating the income or to the place where the income was produced." 1239 Other
relevant factors are (i) whether the income may be said to be in lieu of other income for which a
source rule exists, (ii) whether the income economically corresponds to deductions required to be
allocated under specific source rules, (iii) the potential for abuse, and (iv) ease of administration.
1238
See, e.g., Bank of America v. U.S., 680 F.2d 142 (Ct. Cl.1982); Rev. Rul. 70-304, 1970-1
C.B. 163.
1239
See Hunt v. Comr., 90 T.C. 1289, 1301 (1988). Accord Howkins v. Comr., 49 T.C. 689, 693
(1968). In Helvering v. Stein, 115 F.2d 468 (4th Cir. 1940), private German bankers obtained funds
by negotiating their German customers' drafts to New York banks for acceptance based on the
private bankers' promise to pay the drafts two days before maturity. The funds so obtained were
then reloaned to the private bankers' German customers at higher rates. The court held that the net
interest differential income (the interest received by the private bankers from their customers less
the cost of money to them in New York) was from foreign sources, because the arbitrage activities
were carried on in Germany where their customers were located. (It would seem that, technically,
the gross interest or discount income received by the private bankers from their German customers
should have been classified as German source interest under the rule of §862(a)(1).)

1. Certain Financing Fees

a. Letter of Credit Fees
In Bank of America v. U.S.,1240 the Court of Claims addressed the source of various types of
commissions paid to a U.S. bank in connection with commercial letter of credit transactions
involving foreign banks. The court ruled that acceptance and confirmation commissions were
foreign source income by analogy to the interest rules under §§861(a)(1) and 862(a)(1) because
the taxpayer bank assumed the credit risk of the foreign bank and guaranteed payment to the
holder of the draft. The fact that fees varied according to the creditworthiness of the customer
reflected the credit risk assumed. The provision of incidental administrative services did not
change the fact that the predominant feature of the transactions continued to be the substitution
of the taxpayer's credit for that of foreign banks. On the other hand, negotiation commissions

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paid to the taxpayer in connection with letters of credits were sourced by analogy to personal
services under §§861(a)(3) and 862(a)(3), since they were charged for the personal service of
document review only.
1240
680 F.2d 142 (Ct. Cl. 1982).

The fact that the taxpayer received the fees in respect of a risk located abroad also justified
sourcing of the fees abroad, by analogy to the insurance premium rules.1241 The trial court in the
Bank of America case1242 had relied on the location of the risk rather than on an interest analogy.
1241
Cf. §861(a)(7). See VIII, above.
1242
81-1 USTC ¶9161 at 86,237 (Ct. Cl. Tr. Div. 1981).

On the other hand, one might question whether the foreign sourcing of the confirmation and
acceptance fees is proper. The position could be reasonably taken that, while such fees would not
have been earned without the customers (i.e., the foreign banks which needed the letters of
credit), a more significant economic nexus to the earning of the fees was the taxpayer's own
creditworthiness and its agreement to draw on that credit standing to earn the fees, which credit
standing could be considered to be U.S. based.
b. Loan Guarantee Fees
While no juridical decision deals directly with the source of fees paid for a loan guarantee,
guarantee fees are very similar conceptually to the letter of credit acceptance and confirmation
commissions dealt with in the Bank of America case (discussed immediately above). By analogy
to that case, guarantee fees could be sourced by reference to the interest sourcing rules because
the fees are paid to compensate the guarantor for assumption of the credit risk of the borrower.
Of particular relevance is Centel Communications Co. v. Comr.,1243 in which the Tax Court and
Seventh Circuit held that warrants issued to shareholder-guarantors in consideration of the
increased risk assumed by the guarantors were not transferred in connection with the
performance of "services" within the meaning of §83. The opinions of each court cited the Bank
of America case in holding that the guarantees involved the substitution of credit and the
assumption of increased risk by the guarantors rather than a performance of services.1244 Under
this approach, for example, a loan guarantee fee paid by a U.S. subsidiary to its foreign parent
would be considered to be from U.S. sources.
1243
92 T.C. 612 (1989), aff'd, 920 F.2d 1335 (7th Cir.1990).
1244
920 F.2d at 1343-44; TAM 9020002 (relying on Centel and Bank of America, warrants
issued to guarantors not within §83).

Before the Centel case, however, the IRS had characterized guarantee fees as income for
services for purposes of the §163(d) investment interest limitation and §482.1245 One explanation
for this treatment in the §482 context is that the IRS may have felt constrained by the limited
scope of the §482 regulations dealing with loans and advances, and had little alternative but to
treat guarantee fees as service income.1246 In one of the rulings, the IRS sourced guarantee fees to
the place of the obligor, i.e., the location of the risk.1247 By 1980, when the Bank of America case
was being litigated, the IRS declined to take a position on the source of guarantee fees pending
the outcome of that case.1248
1245
See TAM 8508003 (ruling that a guarantee fee was compensation rather than investment
income for purposes of §163(d)(3)(B)); GCM 38499 (9/19/80), dealing with confirmation and
acceptance commissions); PLR 7822005 (§482); PLR 7712289960A (§482).

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 1246
See PLR 7712289960A.
1247
Id. Compare Section 861(a)(7).
1248
GCM 38499. See FSA 200147033 (loan guarantee fees sourced under interest sourcing
rules, but the fees were not eligible for the exemption from withholding applicable to interest
under the US-Japan tax treaty).

As discussed above in connection with letter of credit fees, a taxpayer could reasonably take
the position that guarantee fees should be sourced by reference to the residence of the guarantor
(or of the branch office involved in the guarantee) on the theory that a key element in earning the
fee is the credit standing of the guarantor.
c. Standby Loan Commitment Fees
A standby commitment fee is a fee charged by a potential lender before the establishment of
any indebtedness and regardless of whether or not an indebtedness is ever established. A charge
for the availability of money is distinct from an interest charge, which is a charge for the "use or
forbearance of money."1249 Thus, the IRS has ruled that a nonrefundable commitment fee paid to
make a loan available at a certain date and at a certain interest rate was not interest but rather a
"charge for agreeing to make funds available"; the fee was therefore includable in the income of
a cash basis lender when received and in the income of an accrual basis lender when due or
actually received, if earlier.1250
1249
See Old Colony Railroad Co. v. Comr., 284 U.S. 552 (1932); Deputy v. Dupont, 308 U.S.
488 (1940).
1250
See Rev. Rul. 70-540, 1970-2 C.B. 101 (Situation 3). Accord Rev. Rul. 56-136, 1956-1 C.B.
92, revoked on another issue, Rev. Rul. 81-160 (fee paid pursuant to a bond sale agreement under
which funds in a fixed amount were made available to the taxpayer at a stated interest rate and for
a specified period of time was not compensation for the use or forbearance of money and so was
not interest paid or accrued by the borrower within the meaning of Section 163); Rev. Rul. 74-258,
1974-1 C.B. 168 ("loan funding fee" received by a real estate investment trust in return for the
trust's commitment to advance construction funds over a specified time for a specified rate of
interest was not interest to the lender for purposes of Section 856(c)).

The IRS also takes the position that a fee charged for the availability of money is not a
service charge. Rev. Rul. 81-160 involved commitment fees incurred pursuant to an agreement
making funds for construction available in stated amounts over a specified period. The ruling
characterized the fee not as an interest charge or a service charge, but as a charge for the
acquisition of a property right. The ruling states:1251
A loan commitment fee in the nature of a standby charge is an expenditure that results in the
acquisition of a property right, that is, the right to the use of money. Such a loan commitment
fee is similar to the cost of an option, which becomes part of the cost of the property acquired
upon exercise of the option. Therefore, if the right is exercised, the commitment fee becomes
a cost of acquiring the loan and is to be deducted ratably over the term of the loan. See Rev.
Rul. 75-172, 1975-1 C.B. 145, and Francis v. Comr., T.C.M. 1977-170. If the right is not
exercised, the taxpayer may be entitled to a loss deduction under Section 165 of the Code
when the right expires. See Rev. Rul. 71-191, 1971-1 C.B. 77.
1251
Rev. Rul. 81-160, above at 313.

While Rev. Rul. 81-160 addressed the treatment of a standby loan commitment fee to the
borrower, the character of the fee should be the same on both the income and expenditure sides.

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This is illustrated by a GCM1252 dealing with the time at which a credit card issuer was required to
include annual credit card fees in income. The fee was charged to all card holders as a condition
of holding the credit card and was charged whether or not the credit card was ever actually used.
Therefore, the IRS viewed the annual fee as akin to a nonrefundable standby loan commitment
fee such as that addressed in Rev. Rul. 81-160, that is, a fee for making money available for a
loan, payable whether or not money is borrowed. Accordingly, the fee was considered charged
for the acquisition of a property right, the right to the use of money, and not for services.
1252
GCM 39434 (October 25, 1985), underlying TAM 8543004.

Assuming, then that a standby loan commitment fee in fact is paid for the acquisition of a
property right analogous to an option from the potential lender, it arguably should be sourced by
reference to the residence of the potential lender (the "seller" of the right) under Section 865(a)
(assuming no office or other fixed place of business in a country other than the country of such
residence materially participates in the sale). An option generally is considered to be personal
property, and Section 865 governs the source of transfers of personal property.
On the other hand, it could be argued that a loan commitment fee is not paid for the sale of
property but rather, should be sourced in the manner of a sign-on bonus or in the manner of a
negative covenant, such as a covenant not to compete. Under this approach, the fee would be
sourced by reference to where the loan might otherwise have been made.1253 While this might be
determined on the basis of where the taxpayer actually had made loans over some period of time,
an administratively simpler approach would be to deem the source to be the potential lender's
residence.
1253
Cf. Korfund Co. v. Comr., T.C. 1180 (1943); Rev. Rul. 74-108, 1974-1 C.B. 248. These
authorities are discussed in IV, E, 2, e and below in XIV, B, 7.

d. Loan Fees for Services

Lenders impose various other fees in connection with approving or making loans, such as
fees for credit approvals or loan processing fees. Such fees are considered fees for services.1254
Payment or reimbursement of the lender's legal fees would also fall into this category.1255 Fees for
services performed in connection with a financing are sourced by reference to the place of
performance of the services.
1254
See, e.g., Lay v. Comr., 69 T.C. 421 (1977); Enoch v. Comr.,57 T.C. 781 (1972); Rev. Rul.
75-172, 1975-1 C.B. 145.
1255
See PLR 7947117; cf. Rev. Rul. 70-360, 1970-2 C.B. 103 (deductibility).

2. Tax Refunds
The regulations state that interest received on any refund of tax imposed by the United States,
a State or any political subdivision thereof or the District of Columbia is from domestic sources,
1256
but do not address the source of a tax refund.
1256
Regs. Section 1.861-2(a)(1).

In Helvering v. Suffolk Co.,1257 a foreign corporation received, pursuant to a plan of

reorganization, a New York City refund of taxes paid by a predecessor domestic corporation. The
court held that the refund was derived from U.S. sources pursuant to the residuary clause of the
predecessor of Section 863(a), which provided that items of gross income other than those

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allocated by the source rules of Sections 861 and 862 "shall be allocated to sources within or
without the United States, under rules and regulations prescribed by the Commissioner, with the
approval of the Secretary."1258 Since no such regulations had then been issued, the court attributed
the tax refund to U.S. sources based on what the court perceived to be the refund's predominant
economic relationship to the United States.
1257
104 F.2d 505 (4th Cir. 1939).
1258
Section 119(e) of Revenue Act of 1932.

Under regulations issued in temporary form in 19881259 and in final form in 1991,1260 however,
the deduction for state, local, and foreign income taxes is required to be allocated and
apportioned between the U.S. and foreign sources, rather than allocated wholly to U.S. sources.
1261
It would be neither fair nor logical to treat a refund of such tax as domestic source to the
extent it was deductible against foreign source income. Under general "recapture" or "tax
benefit" principles, refunds of taxes should be considered to be domestic or foreign source to the
extent the taxes were deductible against domestic or foreign source income, respectively. 1262
1259
T.D. 8236, Dec. 7, 1988.
1260
T.D. 8337, March 11, 1991.
1261
Regs. Sections 1.861-8(e)(6), - 8(g), Exs. (25)-(33).
1262
Cf. Regs. Section 1.861-11T(e)(2)(i) (source of income on intragroup loans); Regs. Sections
1.904-5(c)(2)(i), - 5(c)(3) (categorization of interest and royalties under CFC look-through rule).

3. Damages and Settlement Payments

In Rev. Rul. 83-177,1263 the IRS ruled that, for purposes of determining the source of
settlement payments, the nature of the item for which such payments are made governs with
respect to that component of the payments which constitutes principal. The interest component of
the payments must be sourced according to the source of interest rules.
1263
1983-2 C.B. 112. See also, e.g., PLR 9623045 (applying Rev. Rul. 83-177 principles to
damages paid to foreign corporation in action against U.S. corporation for breach of franchise
agreement).

In Rev. Rul. 83-177, a foreign partnership formed by two nonresident aliens entered into a
joint venture agreement with a U.S. corporation for purposes of rendering engineering services
for the construction of a manufacturing plant abroad. All of the services to be performed by the
foreign partnership were to be performed abroad; hence, it would have earned foreign source
income. Following the domestic corporation's repudiation of the agreement, the foreign
partnership filed suit for breach of contract and a settlement was reached. The IRS ruled that,
since the agreement giving rise to the action would have caused the partnership to receive
foreign source service income, the payments of principal made under the settlement are also
considered foreign source service income.1264
1264
Accord Rev. Rul. 80-15, 1980-1 C.B. 365 (amounts paid to Italian corporation in settlement
of suit to recover royalties were treated as royalties for treaty purposes); Rev. Rul. 64-206, 1964-2
C.B. 591 (amounts received by Swiss individual as damages for patent infringement treated as
royalties for treaty purposes); PLR 8317031 (same facts as Rev. Rul. 83-177). But see NV
Koninklijke Hollandische Lloyd,34 B.T.A. 830 (1936), nonacq., 1937-2 C.B. 43 (foreign shipping
corporation's damages from United States for unlawful detention of ship in U.S. harbor treated as
wholly foreign source rather than sourced by reference to rental income that would have been
earned). See FSA 200139022 (patent settlement treated as all U.S. source notwithstanding some
foreign use because there was no contractual allocation to foreign use in the settlement agreement

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 nor reasonable method presented to allocate part of settlement to foreign use).

4. Expropriation Recoveries
The source of payments made by the government of a foreign country for the expropriation
of property located therein to the former owners of such property was the issue in Rev. Rul. 76-
154.1265 The IRS concluded that the payment was foreign source in light of the fact that the
expropriated property was located abroad and the decree giving rise to the payment occurred
abroad. The result reached in the ruling remains generally correct on its facts. A more accurate
statement of the proper rule, however, is that expropriation income should be sourced in the same
manner as the proceeds of a sale of the expropriated assets would have been sourced or, possibly,
as income from the assets would have been sourced.1266 Under current law, the proceeds of a sale
of certain personal property is sourced under Section 865 by reference to the residence of the
taxpayer rather than by reference to the situs of the property.
1265
1976-1 C.B. 191.
1266
Cf. Torrington Co. v. U.S., 149 F. Supp. 172 (Ct. Cl. 1957)(loss from expropriation of
domestic corporation's German subsidiary's operating assets by Nazis treated as foreign source for
foreign tax credit purposes since loss arose out of a business that would have produced foreign
source income); Ferro Enamel Corp. v. Comr., 134 F.2d 564 (6th Cir. 1943) (in sourcing loss on
worthless stock that was purchased to secure a source of raw materials, since any gain on
disposition of underlying corporate property would have been from Canadian sources, loss on
stock allocated to same source).

A proposed extension of this principle to income from the sale of oil purchased under an
agreement providing a substitute source of supply following nationalization of the taxpayer's
interest in the oil production of a country has been rejected in Hunt v. Comr.1267 In that case, the
taxpayer entered into an agreement entitling it to purchase "back-up" Persian crude oil if Libyan
oil was unavailable. In 1973, Libya nationalized the oil industry. The taxpayer purchased oil
under the agreement and resold it F.O.B. Persian Gulf ports. A per-country limitation under
Section 904 applied for the taxable years in question. The taxpayer argued that the income
should be sourced to Libya under Regs. Section 1.863-1(b)1268 on the theory that it was indirectly
derived from, and in substitution for, income from oil the taxpayer would have extracted and sold
but for the nationalization. The court refused, sourcing the income to the Persian Gulf countries
under the title-passage rule.
1267
90 T.C. 1289 (1988).
1268
See discussion in VII, D, above.

5. Property and Casualty Insurance Recoveries

The insurance recovery for the net profit lost due to theft of the taxpayer's goods en route
from the United States to Cuba was allocated to U.S. sources in Rev. Rul. 70-304.1269 The IRS
reasoned that the situs of the property, rather than the residence of the insurance company or any
other factor, determined the source of the gain. The IRS then analogized from a rule it extracted
from certain cases dealing with personal property taxes, to the effect that the situs of goods in
transit remains at their original situs until the time when a permanent situs elsewhere is acquired.
1269
1970-1 C.B. 163.

Insurance proceeds received in respect of stolen or damaged goods are very analogous to

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proceeds received from a sale of the goods or from an expropriation of the goods (which may be
considered an involuntary "sale").
Historical Note: Under pre-TRA 86 law, the situs rule enunciated in Rev. Rul. 70-304
generally resulted in the same sourcing of the income as would have resulted had a place-of-sale
rule been applied.1270 An exception would seem to be the result reached in Rev. Rul. 70-304 itself,
in which the IRS did not recognize goods in transit as having any changed situs prior to their
arrival at their destination, at least where title was to pass at the destination. 1271 This approach
seems wrong, since the property tax analogy applied by the IRS seems much less appropriate
than the source rules for a sale of property.
1270
See fn. 574 and fns. 747-48 and accompanying text.
1271
It appears that though unusual, title and beneficial ownership to goods could pass on the
high seas. Compare, e.g., the apportionment approach generally taken in Regs. §1.953-2, sourcing
insurance premiums by reference to the location of the risk.

If insurance proceeds in respect of stolen or damaged goods are considered properly

analogous to sale proceeds, under post-TRA 86 law, insurance proceeds for theft or damage to
personal property should be sourced in the same manner as proceeds of a sale of the property
would be sourced under §865, including under §§861(a)(6) and 862(a)(6) in the case of
inventory property.1272 Insurance proceeds for damage to real property should be sourced by
reference to the situs of the real property under §§861(a)(5) and 862(a)(5).
1272
Accord 1 Kuntz & Peroni, U.S. International Taxation ¶A2.03[26] (1992).

Insurance proceeds attributable to lost business profits are characterized and sourced by
reference to the underlying activities.1273 For example, insurance proceeds received by a
corporation which had an election under §936 in effect for the year in question to cover
"expenses incurred to temporarily continue as normal as practicable the conduct of the insured's
business" have been privately ruled to be derived from the active conduct of the corporation's
business within Puerto Rico.1274
1273
See Miller v. Hocking Glass Co., 80 F.2d 436 (6th Cir. 1935); Rev. Rul. 73-252, 1973-1
C.B. 337; PLR 9204045.
1274
PLR 9204045.

6. Life Insurance Proceeds and Annuities

To the extent life insurance proceeds payable upon the surrender or at maturity of a life
insurance contract are taxable under §61(a)(10) and not exempt under §101, they are subject to
withholding if they are from sources within the United States.1275 The ruling, however, does not
provide guidance on how such proceeds should be sourced.
1275
See Rev. Rul. 64-51, 1964-1 (Part 1) C.B. 322.

Life insurance contracts offer protection against the premature death of the insured combined
with a savings element. While the former characteristic distinguishes life insurance contracts
from other investment products, the latter characteristic means that life insurance proceeds
include substantial amounts of investment income.
If an insurance contract qualifies as providing life insurance under §7702, the normal rule
that amounts paid under the contract by reason of the death of the insured generally are excluded

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from gross income applies (and the holder is not required to include currently in income the
investment earnings).1276 If the contract does not qualify under §7702, however, the "income on
the contract" (investment earnings) for each taxable year is includible in income annually by the
holder.1277 If such income is analogized to interest, factors that could be taken into account (in
determining its source) are the place of incorporation of the insurance company and whether the
policy is written by a domestic or foreign branch of the insurance company.1278
1276
See §§101(a)(1), 7701(a).
1277
§7702(g)(1).
1278
Cf. §861(a)(1)(A), (a)(1)(B). See also §871(h), (i). In PLR 8543046, the IRS ruled that the
investment income on certain single premium annuity contracts sold by a life insurance company
was interest that qualified for the exemption from U.S. tax under the statutory predecessor of
§871(i)(3)(C).

In Rev. Rul. 2004-75, 2004-31 I.R.B. 109, the IRS ruled with respect to life insurance and
annuity policies sold by a U.S. life insurance company's branches in foreign countries and Puerto
Rico that amounts withdrawn by policyholders that constituted gross income under §72 were
from sources within the United States. Such amounts were therefore subject to tax under
§§871(a) and 1441 in the hands of a nonresident alien and under §1 in the hands of a bona fide
resident of Puerto Rico (because §876 provides that §871 does not apply to such individual). The
ruling acknowledged that the source of such items is not specified in the Code, but that the
investment return on a life insurance or annuity contract is analogous to interest, dividends, and
pension fund earnings, each of which is U.S. source when paid by a U.S. obligor. In Rev. Rul.
2004-97, 2004-39 I.R.B. 516, the IRS ruled that Rev. Rul. 2004-75 would not be applied to
policies issued prior to July 13, 2004, until January 1, 2005, because of concerns expressed about
its potential impact on some existing operations.
The same factors could be relevant even to the "windfall" portion of life insurance income,
by analogy to the sourcing of lottery income.1279 On the other hand, the residence of the insured
party may have a bearing on the source of at least such portion of the insurance proceeds, by
analogy to, e.g., §865(a) and Regs. §1.863-7.1280 Of less significance would seem to be where the
underwriting and servicing of the contracts occurred.
1279
See XIV, B, 11, below.
1280
There is a windfall element to certain capital gains and income from certain types of
notional principal contracts by virtue of the unpredictable nature of the income.

In the case of key-man life insurance, special considerations may apply. Such proceeds may
be analyzed as a surrogate for the business profits the deceased would have generated, and hence
arguably should be sourced (to the extent determinable) by reference to the sources of income
generated during the appropriate period by the business units over which such individual had
control.
Many products described as annuities contain a mortality element and thus should be
analyzed in the same manner as any other life insurance contracts. To the extent the annuity does
not contain a mortality element, income derived therefrom is closely analogous to interest
income and should be sourced under the same rules.1281
1281
See, e.g., PLR 8543046 (addressing "single premium annuity contracts").

7. Noncompetition Payments

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 In general, payments received under a negative covenant have the same character as the
amounts they are intended to replace.1282 In the case of covenants not to perform services for
competitors, as discussed above,1283 the payments are sourced to where the performance is
proscribed.
1282
See Korfund Co. v. Comr., 1 T.C. 1180, 1187 (1943).
1283
See IV, E, 2, e, above.

In the case of covenants not to engage in business activities, the same rule should apply. The
IRS has addressed this issue in a private ruling involving payments made to an Italian resident
under an agreement not to engage in the business of manufacturing, selling, distributing, or
promoting beauty products anywhere in the world.1284 The ruling held that the payments (other
than any interest component thereof) would qualify as "industrial or commercial profits" under
the treaty with Italy since they were in lieu of business income. Implied is that the payments, in
part, may have been from U.S. sources.
1284
PLR 8401041.

The IRS took a somewhat different position in TAM 199947031, which involved an
agreement by a Swiss corporation not to compete in North America with a U.S. corporation. The
primary issue was the nature of the payments from the U.S. corporation to the Swiss corporation
under the U.S. - Swiss treaty, and whether withholding was required. The memorandum assumed
that the payments were sourced to the United States, but concluded that they could not be treated
as industrial or commercial profits under the treaty, because the Swiss corporation was not
engaged in a trade or business within the United States. The National Office also concluded that,
for treaty purposes, the payments were not royalties because they were not made for the use of
property.
8. Unemployment Benefits
Rev. Rul. 73-2521285 addresses the source of supplemental unemployment benefits paid by a
U.S. employees' beneficiary association to a citizen and resident of Canada who at all times had
lived and worked in Canada. The IRS stated that the main factor in considering the source of the
income "is whether the location of the property to which the payment related or the situs of the
activities that resulted in its being made was in the United States or abroad." Since the income
was treated as relating to the performance of activities rather than property, the status of the
payor was irrelevant and the income was from sources outside the United States.
1285
1973-1 C.B. 333.

9. Alimony
Under various authorities, the source of alimony income is the residence of the spouse
obligated to make the payments.1286 The rationale for these holdings has been that such spouse's
residence best corresponds to where the income is produced (or at least is the best
administratively feasible alternative), and not the source of such spouse's income, the location of
the divorce court, the origin of the funds used to make payment, or the residence of the payee.1287
1286
See, e.g., Manning v. Comr., 38 T.C.M. 646 (1979), aff'd, 614 F.2d 815 (1st Cir. 1980)
(alimony paid by U.S. resident to Puerto Rican resident was U.S. source), and Housden v. Comr.,
T.C. Memo 1992-91.
1287
See, e.g., id., 38 T.C.M. at 648, and Housden v. Comr., T.C. Memo 1992-91 (payments by

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 resident alien from his foreign bank account to former wives was U.S. source).

For example, in Gallatin Welsh Trust v. Comr.,1288 the court attributed to U.S. sources alimony
payments from the corpus of a U.S. resident trust to a nonresident alien. This decision was
followed in Howkins v. Comr.,1289 which concluded that the place of payment and source of funds
were irrelevant.
1288
16 T.C. 1398 (1951), aff'd per curiam, 194 F.2d 708 (3d Cir.1952), cert. denied, 344 U.S.
821 (1952).
1289
49 T.C. 689 (1968). Accord Rev. Rul. 69-108, 1969-1 C.B. 192 (alimony payments from
U.S. administrator of nonresident alien estate to nonresident alien treated as foreign source though
decedent was U.S. resident at death).

10. Fellowships, Scholarships, Awards, and Prizes

Under §117, gross income does not include certain scholarships or fellowship grants. When
this exclusion does not apply, however, source becomes an issue for nonresident aliens.
In Rev. Rul. 89-67,1290 the IRS ruled that, if a fellowship, scholarship, or prize in a puzzle-
solving contest is paid to someone who is not required to perform services for the payor, the
income is sourced by reference to the residence of the payor. Under Rev. Rul. 89-67, awards paid
by a noncorporate resident of the United States, a domestic corporation, the United States, a
state, or any other political subdivision thereof, or the District of Columbia are U.S. source. 1291
Such awards paid by other persons, including certain types of international organizations,1292 were
ruled to be foreign source. The IRS reasoned that, unless services were required to be performed,
the residence of the payor had a stronger economic nexus to the income than the place where the
recipient studied or conducted the research.1293
1290
1989-1 C.B. 233. The IRS issued the ruling under the authority of §863(a), which allows the
IRS to issue regulations concerning income not governed by §§861- 62.
1291
See II, E, above for the determination of residence.
1292
For example, in Rev. Rul. 89-67, the IRS noted that an award paid by an international
organization under the International Organizations Immunities Act is considered foreign source.
1293
Rev. Rul. 89-67, 1989-1 C.B. at 234.

In T.D. 8615, the IRS finalized regulations generally providing that scholarships, fellowship
grants, grants, prizes, and awards are sourced according to the residence of the payor.
Scholarships and fellowship grants (as defined in Regs. §1.117-3) awarded after 1986 by a U.S.
citizen or resident, a domestic corporation partnership, estate, or trust, the United States (or an
instrumentality or agency thereof), a state (or any political subdivision thereof), or the District of
Columbia are treated as U.S. source income.1293.1 Scholarships and fellowship grants awarded by a
nonresident alien, a foreign corporation, a foreign government (or an instrumentality, agency, or
any political subdivision thereof), or an international agency are treated as foreign source
income.1293.2
1293.1
Regs. §1.863-1(d)(2)(i).
1293.2
Regs. §1.863-1(d)(2)(ii).

One exception to the general grantor residence rule applies when nonresident aliens study or
perform research outside the United States. The grant is foreign source in that situation. 1293.3
1293.3
Regs. §1.863-1(d)(2)(iii).

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 The regulations are effective for scholarship and fellowship payments made after 1986.1293.4
1293.4
However, the residence of the payor rule may be applied, without application of the special
place of study or research rule of Regs. §1.863-1(d)(2)(iii), to payments made after May 14, 1989
(the effective date of Rev. Rul. 89-67) and before June 16, 1993 (the day after the proposed
regulations were published in the Federal Register). The regulations apply to payments made for
grants, prizes, and awards (as defined in Regs. §1.863-1(d)(3)) after Sept. 26, 1995, subject to a
taxpayer election to apply them to such payments made after 1986.

Comment: Rev. Rul. 89-67 involved prizes given in puzzle-solving contests, but the
regulations do not separately address these prizes. It would appear that as long as services are
not required to be performed in connection with the puzzle solving contest (which was
concluded generally to be the case in Rev. Rul. 89-67), the residence of the grantor rule of
Rev. Rul. 89-67 continues to apply.
To the extent services are required to be performed in connection with such an award, the
source of the income would be determined by the place in which the services are required to be
performed, as discussed in IV, above.1294
1294
See, e.g., Rev. Rul. 61-2, 1961-1 C.B. 393 (compensation paid by Puerto Rican agency to its
employee to study temporarily in the United States); cf. Rev. Rul. 56-268, 1956-1 C.B. 317 (salary
paid to employee's dependents while employee studied in the United States sourced in United
States under services rules.

A purse for a prize fight or a prize for a golfing tournament is treated as compensation and
sourced accordingly.1295
1295
See Rev. Rul. 70-543, 1970-2 C.B. 172 (situations 1 and 2), amplified, Rev. Rul. 73-107,
1973-1 C.B. 376; GCM 34331.

The winner's purse paid to the owner of a horse entered in a horse race in the United States is
considered to be commercial profits from U.S. sources (though not compensation for services).1296
1296
See Rev. Rul. 70-543, 1970-2 C.B. 172 (situation 3); Rev. Rul. 85-4, 1985-1 C.B. 294,
amplifying Rev. Rul. 60-249, 1960-2 C.B. 264 (30% withholding required unless recipient either
provides Form 1001 and indicates thereon that it has not entered and does not intend to enter
another race in the United States during the taxable year, or provides Form 4224 (Form 4224 has
been replaced by Form W-8ECI , but payors could still use Form 4224 through 2001, see Notice
2001-4, 2001-2 I.R.B. 267).

Historical Note: By analogy to the source rules for services income, prior to Rev. Rul. 89-67,
prizes for contests requiring the contestant to perform some act of skill, such as puzzle solving,
were sourced to the country where such act was performed.1297 However, where the requirements
for entry were merely clerical (such as filling in an entry blank or the name of a company or
product), the country in which the contest was conducted governed the source of income.1298
1297
Rev. Rul. 66-291, 1966-2 C.B. 279, revoked, Rev. Rul. 89-67, 1989-1 C.B. 233.
1298
Id.

11. Wagers and Lotteries

Income from gambling has been sourced to the situs of the gambling house.1299 This result
seems appropriate since, in general, gambling involves a substantial amount of personal activity
at such situs.1300
1299
See Barba v. U.S., 83-1 USTC ¶9404 (Cl. Ct. 1983) (amounts derived from playing keno).

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 1300
Cf. H.R. Rep. No. 795, 100th Cong., 2d Sess. 573 (1988) (winnings of nonresident aliens
from gambling "in the United States" should be subject to U.S. tax). See generally Comr. v.
Groetzinger, 480 U.S. 23 (1987), and Zarin v. Comr., 916 F.2d 110 (3d Cir. 1990), rev'g 92 T.C.
1984 (1989).

Income from lotteries presumably are sourced, at least in the IRS's view, to the payor's place
of residence.1301 It seems appropriate that such income be sourced by the residence of the payor
rather than by the situs of the lottery (although in most cases the two will be identical) since the
situs of the lottery is unlikely to be of economic significance unless also the residence of the
payor.
1301
See Rev. Rul. 89-67, 1989-1 C.B. 233, revoking Rev. Rul. 66-291, 1966-1 C.B. 279 (which
had sourced prizes awarded in contests merely requiring the completion of an entry form by
reference to the country in which the contest was conducted). In an amicus brief filed in
International Lottery Fund v. Virginia State Lottery Dep't. (E.D. Va. Aug. 28, 1992), the Justice
Department argued that the source of winnings under the Virginia State Lottery is where the
tickets are sold and the lottery held.

Although income from gambling in the United States is considered to be from U.S. sources,
§871(j) (effective November 10, 1988) provides for an exemption in the case of proceeds from a
wager placed in blackjack, baccarat, craps, roulette, or big-6 wheel, from the §871(a)(1) 30% tax
that generally1302 otherwise would be required to be withheld, unless the Treasury Department
determines by regulation that collection of the tax is "administratively feasible."
1302
In the case of a professional gambler, the taxpayer may be considered to be engaged in a
gambling business within the United States. Cf. Comr. v. Groetzinger, 480 U.S. 23 (1987) (full-
time gambler was engaged in business for purposes of §162 and statutory predecessor of §62(a)
(1)). In such case, the U.S. source income generally is taxable as income "effectively connected"
with such business.

In addition, the American Jobs Creation Act of 2004, P.L. 108-357, at §419, provides in
§872(b)(5) (effective for wagers made after October 22, 2004) that the gross income of a
nonresident alien individual excludes any amount derived from a legal wager initiated outside
the United States in a parimutuel pool on a live horse or dog race in the United States, regardless
whether the pool is a separate foreign pool or a merged U.S. and foreign pool. The same
exclusion does not apply to a foreign corporation under §883.
12. Option Payments
An option generally is considered to be personal property. Consequently, assuming that the
issuance of an option may be considered a contingent the "sale" of the option (subject to the
option not being exercised),1303 the rules of §865 (or, if the option is inventory property, §861(a)
(6)) should govern the source of any income realized by the writer of an option in connection
with its lapse (or any other transaction other than exercise, terminating the option). 1304
1303
See generally Rev. Rul. 78-182, 1978-1 C.B. 265 (consequences of options to issuer and
holder); Rev. Rul. 58-234, 1958-1 C.B. 279 (same).
1304
See fns. 765-70, above (place of sale test applied to securities).

If an option is exercised, the issue price of the option is not considered income from the sale
of the option. If the option is a call option, since the writer (seller) of the option is the same as
the potential seller of the underlying property and if the option is exercised, the issue price
becomes part of the sale price of the property. In the case of a put option, the writer (seller) of the

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option is the potential purchaser of the underlying property, and if the option is exercised, the
payment received for the put is not income but simply a reduction of the purchase price of the
property. Similarly, if a call option is exercised, the holder (grantee) of the option treats the
option price, together with the amount paid on exercise, as part of its cost basis in the property
acquired by exercise of the option. In the event of exercise of a put option, the holder treats the
option price as a reduction in its sale proceeds.
In the event of a sale of an option as to which the underlying property is stock, securities,
commodities or commodity futures, the gain or loss realized generally (subject to certain
exceptions, including where the option is held by a dealer in such options),1305 has the same
"character" as would gain or loss on a sale of the underlying property.1306 One might question
whether this fiction should be extended so as to treat, for example, the proceeds as from a sale of
inventory property for purposes of §865(b) if the underlying property would be considered
inventory property within the meaning of §865(b) if held by the holder (for example, if a gold
producer sells an option to acquire gold). It seems quite unlikely under current law, however, that
the characterization of the proceeds by reference to the underlying property is only for purposes
of determining whether the income is capital or ordinary and not for purposes of determining its
source.1307 In any event, it is unclear how a place of sale rule could apply to payments made under
a cash settlement option since ownership of the inventory property never would change hands
and it never would be delivered.
1305
§1234(a)(3).
1306
§1234(a)(1).
1307
See, e.g., Regs. §1.1234-1(a). (But see fn. 1197 and accompanying test, above.)

Certain options provide that, in lieu of the delivery of the underlying property on exercise of
the option, the writer may elect, or is required, to settle the option by delivery of cash in an
amount equal to the net value due the holder. Thus, the holder of a valuable call option would not
acquire property and the holder of a valuable put option would not sell property, but would
simply receive a cash payment corresponding to the profit in the option contract. In general,
payments in connection with cash settlement options are analyzed similarly to payments pursuant
to more traditional options1308 Subject to certain statutory exceptions,1309 the "character" of the
income realized by the holder from a cash settlement exercise of an option of which the
underlying property is stock, securities, commodities or commodity futures generally is
determined by the character of gain or loss that would have been realized on a sale of the
underlying property.1310
1308
See Rev. Rul. 88-31, 1988-1 C.B. 302.
1309
§1234(a)(3).
1310
See id. (treating cash settlement as a sale or exchange of the option, based on legislative
history to Section 1234(c)(2).

There may be little economic difference between a series of short-term cash-settlement

options and a notional principal contract, at least in certain cases.1311 In general, notional principal
contracts are sourced under the rules set forth in Regs. Section 1.863-7.1312
1311
See, e.g., Prop. Regs. Section 1.446-3(e)(3)(ii)(C), and -3(e)(4)(v), Ex. (1).
1312
See XII, B, above.

The IRS has addressed payments made by a domestic corporation to a foreign supplier for
the privilege of having the option to purchase a reduced volume of natural gas under a "take or

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 265

pay" contract.1313 Such payment may be analyzed as paid for an option or simply as paid to
modify the contract. The IRS ruled that the payments are exempt from U.S. tax as "business
profits" not attributable to a U.S. permanent establishment under the income tax treaty with
Canada. By implication, such payments may be considered to be from U.S. sources.
1313
PLR 8614056.

13. Cancellation of Indebtedness Income

Cancellation of indebtedness income realized by a foreign corporation from the purchase of
its bonds in the United States before maturity at less than face value has been held to be from
foreign sources.1314 Under today's Code, cancellation of indebtedness income realized by a
foreign person is not considered "fixed or determinable annual or periodical income" within the
meaning of Sections 871(a)(1) and 881(a) and hence, assuming the income is not effectively
connected with a trade or business conducted by the foreign person in the United States, should
not be subject to U.S. tax.
1314
Corporacion de Ventas de Salitre Y Yoda de Chile v. Comr.,44 B.T.A. 393, 405 (1941), rev'd
on other grounds, 130 F.2d 141 (2d Cir.1942). Accord I.T. 3119 declared obsolete in Rev. Rul. 70-
293, 1970-1 C.B. 292.

The source issue, however, may still have relevance for foreign tax credit purposes. For
example, if a domestic corporation were to repurchase its bonds on a foreign exchange or from
foreign persons abroad at a discount from their adjusted issue price, should the resulting
cancellation of indebtedness income be considered income from foreign sources under the
approach of the authorities referred to above? The proper answer should be the situs having the
principal economic nexus with the income. That would not seem to be the place where the bonds
are repurchased. A better answer is the residence of the debtor, by analogy to the market discount
source rules.1315 The ability to buy in the debt at a discount generally is attributable to a rise in
interest rates, a drop in the taxpayer's creditworthiness, or a combination of the two. Apart from
administrative difficulties, however, the best answer may be to source such income in the same
manner as deductions with respect to such indebtedness have been sourced (or as deductions
with respect to replacement indebtedness would be sourced).1316 This is clearly the right result,
and administrable, to the extent the cancellation of indebtedness income represents in effect a
recapture, under the tax benefit rules, of deductions for interest accrued but never paid. The same
approach could be taken even for cancellation of indebtedness income in respect of the principal
amount. Under circumstances in which such income economically corresponds to higher interest
deductions in the future, the projected source of such future interest deductions theoretically
(though probably not practically) might serve as a referent.
1315
These are discussed above at II, C, 2.
1316
Cf. Regs. Section 1.861-11T(e)(2)(i) (source of income on intragroup loans); Regs. Sections
1.904-5(c)(2)(i), - 5(c)(3) (categorization of interest and royalties under controlled foreign
corporation look-through rule). One difficulty, however, is that the sourcing of interest deductions
generally would change annually depending upon the taxpayer's asset mix. See Regs. Section
1.861-9T. But see Regs. Section 1.861-10T (certain exceptions to the general rule).

14. Agricultural Export Subsidies

In G.A. Stafford and Co. v. Pedrick,1317 the Second Circuit upheld the IRS' allocation of cotton
export subsidies paid by the United States to a domestic corporation under the Agricultural

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 266

Adjustment Act1318 and the Soil Conservation and Domestic Allotment Act1319 to U.S. sources. The
court found it significant that every act the exporter was required to do to become entitled to the
subsidy occurred in the United States and that the payor's residence was the United States.
1317
171 F.2d 42 (2d Cir. 1948).
1318
7 USC Section 612(c).
1319
16 USC Section 590(l).

15. Futures Trading Income, etc.

Of historical interest (and possibly of interest for purposes of possible analogy) is the
decision in Zander & Cia v. Comr.,1320 where the court held that profit realized by the purchase of
commodities futures on the New York Coffee & Sugar Exchange and their subsequent
disposition by a domestic broker was from U.S. sources. Declining to apply a title passage test to
the income from futures contracts (since delivery of the underlying commodities is rarely made),
the court based its holding on the U.S. origin or location of all the transactions responsible for
generating the profit.
1320
42 B.T.A. 50 (1940).

Historical Note: For the years before the court in Zander & Cia, no statutory exception
exempted commodity trading income from U.S. tax. The Revenue Act of 1936 added an
exemption for gains from the sale of property1321 and excluded from the definition of trade or
business in the United States the effecting of transactions in commodities, stock, or securities
through a resident broker, commission agent, or custodian.1322 This exception was continued and
expanded in Section 864(b)(2) of the 1954 and 1986 Codes.
1321
Former Sections 211(a), 231(a).
1322
Former Section 211(b).

16. Loan Assistance Payments

In PLR 200403033, the IRS ruled that loan assistance payments made by a U.S. college to
foreign nationals would be treated as foreign source income by the recipient. The loan assistance
payments were inducements to the foreign nationals to attend the college and as a means to help
pay student loans after the student graduated. The IRS noted that the loan assistance program is
not addressed in the Code or regulations and did not meet the definition of a scholarship or
fellowship grant within the meaning of §117. The IRS reasoned that the loan assistance payments
most nearly resembled compensation for services, since the recipients would only receive such
payments if they worked, and continued to work outside the United States. Accordingly, under
the sourcing principles applicable to compensation, the IRS concluded that the income from the
loan assistance payments would be foreign source income to the recipients.

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 267

 WORKING PAPERS
Item Description Sheet
Worksheet 1 Staff of the Joint Committee on Taxation, General Explanation of
the Tax Reform Act of 1986, 100th Cong., 1st Sess., 916-
914 (1987) (Excerpts on Source Rules).
Worksheet 2 Staff of the Joint Committee on Taxation, Description of the
Technical Corrections Act of 1988, 101st Cong., (H.R.
4333 and S. 2238), 245-66 (1988) (Excerpts on Source
Rules).
Worksheet 3 The Uniform Commercial Code (Excerpts from Article 2).
Worksheet 4 Sample Title Retention and Title Transfer Clauses.
Worksheet 5 United Nations Convention on Contracts for the International Sale
of Goods.
Worksheet 6 Client Letter: Proposed Transfer of Intangibles for Foreign Joint
Venture.
Worksheet 7 Client Letter: Foreign Corporation's Investment in Indebtedness of
Partnership Engaged in the U.S. Business.
Worksheet 8 Election by U.S. Resident on Sale of Stock of Foreign Affiliate.

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 268

 Worksheet 1
Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform
Act of 1986, 100th Cong., 1st Sess., 916-914 (1987) (Excerpts on Source Rules).
(916)

B. Source Rules

1. Determination of source in case of sales of personal property (sec. 1211 of the Act and
secs. 861, 862, 863, 864, 871, 881, and 904, and new sec. 865 of the Code)1
1
For legislative background of the provision, see; H.R. 3838, as reported by the House
Committee on Ways and Means on December 7, 1985, sec. 611; H.Rep. 99-426. pp. 359-365; H.
R. 3838, as reported by the Senate Committee on Finance on May 29, 1986, sec. 911; S.Rep. 99-
313, pp. 328-333; and H.Rep. 99-841, Vol. II (September 18, 1986), pp. 595-596 (Conference
Report).

Prior law

Overview

Rules determining the source of income are important because the United States
acknowledges that foreign countries have the first right to tax foreign income, but the United
States generally imposes its full tax on U.S. income. With respect to foreign persons, the source
rules are primarily important in determining the income over which the United States asserts tax
jurisdiction (foreign persons are subject to U.S. tax on their U.S. source income and certain
foreign source income that is effectively connected with a U.S. trade or business). The United
States generally taxes the worldwide income of U.S. persons and the source rules are primarily
important for U.S. persons in determining their foreign tax credit limitation. A premise of the
foreign tax credit is that it should not reduce a taxpayer's U.S. tax on its U.S. income, but only a
taxpayer's U.S. tax on its foreign income. For the foreign tax credit mechanism to function, then,
every item of income must have a source: that is, it must arise either within the United States or
outside the United States.
Income derived from purchase and resale of property

Under prior law, income derived from the purchase and resale of personal property, both
tangible and intangible, generally was sourced at the location where the sale occurred. The place
of sale was deemed to be the place where title to the property passed purchaser (the "title
passage" rule). To the extent personal property was depreciable or subject to other basis
adjustments (e.g., amortization), the gain attributable to the recapture of such adjustments was
also sourced on the basis of the place of sale.

One type of foreign source income derived by a foreign person that was subject to U.S. tax

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was the sale or exchange of inventory property if the foreign person had an office or other fixed
place of business within the United States, the income was attributable to the office or other fixed
place of business, and the sale or exchange was conducted through the office or other fixed place
of business. This income was not, however, subject to U.S. tax if the property
917

was sold or exchanged for use, consumption, or disposition outside the United States and an
office or other fixed place of business of the taxpayer outside the United States materially
participated in the sale. In determining whether income of a foreign person is attributable to a
U.S. office or other fixed place of business within the United States, present and prior law
generally disregard the office of an independent agent, require the office to be a material factor in
the production of the income, and attribute to the office only the amount of income allocable to
it.
Income derived from manufacture and sale of property

Under present and prior law, income derived from the manufacture of products in one
country and their sale in a second country is treated as having a divided source. Under Treasury
regulations, half of this income generally is sourced in the country of manufacture, and half of
the income is sourced on the basis of the place of sale. The division of the income between
manufacturing and selling activities is required to be made on the basis of an independent factory
price rather than on a 50/50 basis, if such a price exists.
Income derived from intangible property

Under present and prior law, royalty income derived from the license of intangible property
generally is sourced in the country of use. For certain purposes, income derived from the sale of,
intangible property for an amount contingent on the use of the intangible is sourced as if it were
royalty income.
Withholding on certain intangible income

Present and prior law provide that certain types of U.S. source income paid to foreign
persons are subject to U.S. tax on a gross basis if they are not effectively connected with the
conduct of a trade or business in the United States. This method of taxation is generally based on
the premise that the foreign person does not have sufficient presence in the United States for an
accurate determination of the foreign person's expenses to impose tax on a net basis.

One of these types of income is gain from the sale of certain intangible property to the extent
that the payments for the intangible property are contingent on the productivity, use, or
disposition of the property (sec. 871(a)(1)(D)). A related provision (sec. 871(e)) treated gain on
the sale of intangible property as being contingent on the productivity, use, or disposition of the
property if more than 50 percent of the gain was actually from payments which were so

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contingent. This related provision also treated those gains as royalties for purposes of
determining their source.
Reasons for Change

Congress recognized the importance of providing appropriate source of income rules for
defining U.S. tax jurisdiction. Congress believed that source rules for sales of personal property
should generally reflect the location of the economic activity generating the income, taking into
account the jurisdiction in which those activities are performed. With regard to foreign persons,
Congress believed that prior law allowed foreign persons in certain circumstances to avoid U.S.
taxation despite the presence of a fixed U.S. business by manipulating the transfer of ownership
to their property. With regard to U.S. persons, Congress believed that, with the substantial
reduction of U.S. tax rates provided in the Act, more U.S. taxpayers would have excess foreign
tax credits and that, therefore, there would be more incentive after tax reform to generate low-
taxed foreign source income to absorb the excess foreign tax credits. Congress noted that the
foreign tax credit mechanism was originally established to eliminate double taxation of the same
income by the United States and foreign countries. Congress did not believe that the potential for
double taxation existed where income had little likelihood of attracting foreign tax. With the
above in mind, Congress modified prior law's source of income rules to ensure that the United
States will assert proper tax jurisdiction over the activities of foreign persons and, with respect to
U.S. persons, will treat as foreign source income only that income which is generated within a
foreign country and which is likely to be subject to foreign tax.

Congress recognized that prior law's source rules for income derived from sales of personal
property sometimes allowed U.S. taxpayers to freely generate foreign income subject to little or
no foreign tax, but was concerned that its repeal for sales of inventory property would create
difficulties for U.S. businesses competing in international commerce. Moreover, with the
substantial trade deficits of the United States, Congress did not want to impose any obstacles that
might exacerbate the problems of U.S. competitiveness abroad. Congress was concerned with the
tax policy implications of prior law, however, and directed the Treasury Department to study the
source rule for sales of inventory property taking into account not only the tax policy
implications of the rule but also Congress' concerns regarding the impact of this rule on U.S.
trade.

In other cases where manipulation of the place-of-sale rule was relatively easy (for example,
sales of portfolio stock investments), Congress did believe that the United States should assert
taxing jurisdiction by reference to more meaningful criteria than under prior law. Congress
realized that in cases where manipulation of source occurs, there is little likelihood that foreign
countries tax this income. Congress believed in these circumstances that the residence of the
seller should govern the source of the income since countries rarely tax personal property gains
on a source basis. Notwithstanding this general view, Congress was concerned that a strict
residence-of-the-seller rule would treat some income that properly should be foreign source as
U.S. source. In this regard, Congress did not intend that income likely to be subject to foreign
tax, or example, income derived from the disposition of assets used in a manufacturing operation

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by a U.S. corporation in a foreign country where the income is connected with that business, be
treated as U.S. source. Congress believed in these circumstances that income should be sourced
in the jurisdiction in which those assets are used in order to give the first right to tax that income
to a foreign country that properly exercises it.

Congress was also concerned with the application of the place-of-sale rule for foreign
persons. Congress was aware that some foreign
919

persons with U.S. businesses were able to engage in significant business operations through a
fixed place of business in the United States but were able to avoid paying U.S. tax. This was
accomplished through use of the place-of-sale rule to generate non-U.S. source income.
Moreover, Congress was aware that some U.S. income tax treaties precluded the United States
from taxing foreign source income attributable to a U.S. permanent establishment. Congress was
concerned that these results eroded the U.S. tax base and believed the place-of-sale rule was not
appropriate in defining U.S. tax jurisdiction in these cases. Congress recognized, however, that in
certain cases other jurisdictions assert tax jurisdiction over this income. In these situations,
Congress believed it appropriate to cede primary tax jurisdiction over sales income to a country
asserting jurisdiction as long as the property sold is used outside the United States and the
activities that generate the sales income are materially performed outside the United States.

Congress also believed that, to the extent payments from the sale of intangible property are
contingent on the use of the property, the sales income is more in the nature of a royalty for the
use of property than gain from a outright sale of the property. Congress believed, therefore, that
the source rules governing royalties should govern this kind of income.
Explanation of Provisions

General rule

Under the Act, income derived by U.S. residents from the sale of personal property, tangible
or intangible, is generally sourced in the United States. Similarly, income derived by a
nonresident of the United States from the sale of personal property, tangible or intangible is
generally treated as foreign source. For purposes of this provision, the term sale includes an
exchange or other disposition. For purposes of determining source, the term sale, however, does
not include a disposition of intangibles to the extent payments are contingent on the productivity,
use, or other disposition of the intangible. Payments at are so contingent are treated like royalties
in determining their source. Intangible property for purposes of source determination is any
patent, copyright, secret process or formula, trademark, trade name or other like property. Any
possession of the United States is treated as a foreign country for purposes of this provision.

The Act provides that an individual is a resident of the United States for purposes of this

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 272

provision if the individual has a tax home (as defined in sec.911(d)(3)) in the United States. Any
corporation, partnership, trust, or estate which is a United States person (as defined in sec.
7701(a)(30)) is a U.S. resident for this purpose. All other individuals and entities generally are
nonresidents for purposes of these source rules.

Congress was aware that some of the source rules in the Act may conflict with source rules
prescribed in U.S. income tax treaties. The source rules in the Act reflect Congress' policy that
income not taxed, or not likely to be taxed, by a foreign country generally should not be treated
as foreign source income for purposes of the foreign tax credit limitations. Congress did not
intend that treaty
920

source rules should apply in a manner which would frustrate the policy underlying the source
rules in the Act that untaxed income act increase a U.S. taxpayer's foreign tax credit limitation.
Congress intended this treatment for all of the Act's source rules, not only those governing sales
of personal property.
Exceptions to residence rule
Income derived from the sale of inventory property

The Act retains prior law's place-of-sale rule for sourcing income derived from the
disposition of inventor property. Inventory property for this purpose is defined as under prior law
(sec. 1221(1)). The place-of-sale rule is not retained, however, in certain cases where a
nonresident's sale of inventory is attributable to an office or other fixed place of business in the
United States, as described below.
Income derived from the sale of depreciable personal property

Subject to a special rule, income derived from the sale of depreciable personal property, to
the extent of prior depreciation deductions, is sourced under a recapture principle. Specifically,
gain to the extent of prior depreciation deductions from the sale of depreciable personal property
is sourced in the United States if the depreciation deductions giving rise to the gain were
previously allocated against U.S. source income. If the deductions giving rise to the gain were
previously allocated against foreign source income, gain from the sales (to the extent of prior
deductions) is sourced foreign. Any gain in excess of prior depreciation deductions is sourced
pursuant to the place of sale rule, as under prior law. These rules apply without regard to the
residence of the taxpayer.

Depreciation deductions, as defined in the Act, mean any depreciation or amortization or any
other deduction allowable under any provision of the Code which treats an otherwise capital
expenditure as a deductible expense. Thus, for example, depreciation deductions include
depreciation allowed for tangible property and amortization allowed for intangible property.

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Depreciable personal property means any personal property if the adjusted basis of the property
includes depreciation adjustments. Depreciation adjustments are adjustments reflected in the
adjusted basis of any property on account of depreciation deductions (whether allowed with
respect to such property or other property and whether allowed to the tax-payer or to any other
person). Income from the sale of intangible property that is attributable to the recapture of
previously allowed amortization deductions was intended to be sourced pursuant to this recapture
rule and not the residence of the seller rule.2 Income from such a sale in excess of previous
amortization deductions, to the extent payments are not contingent on the productivity, use, or
disposition of the intangible, is sourced under the residence-of-the seller rule, as described above.
2
A technical correction may be necessary so that the statute reflects this intent.

The Act provides a special rule for determining the source of recapture income from the sale
of certain depreciable personal property. If personal property is used predominantly in the United
921

States for any taxable year, the taxpayer must treat the allowable deductions for such year as
being allocable entirely against U.S. source income. If personal property is used predominantly
outside the United States for any taxable year, the taxpayer must treat the allowable deductions
for such year as being allocable entirely against foreign source income. This special rule does not
apply for certain personal property generally used outside the United States (personal property
described in sec. 48(a)(2)(B)). Consequently, a segregation of allowable deductions between the
sources of income the deductions previously offset is required for such property.
Income attributable to an office or other fixed place of business

The Act provides another exception to the residence rule for income derived from the sale of
personal property when the sale is attributable to an office or other fixed place of business.

For U.S. residents, this office rule applies only if income is not already sourced as U.S. or
foreign under the place-of-sale rule as retained under the Act (which applies to inventory
property, gain in excess of recapture income for certain depreciable personal property, and stock
of certain affiliates), or the recapture rule for depreciable personal property. Under this office
rule, U.S. residents that derive income from sales of personal property attributable to an office or
other fixed place of business maintained outside the United States generate foreign source
income. However, the office rule only applies to U.S. residents, individual or otherwise, if an
effective foreign income tax of 10 percent or more is paid to a foreign country on the income
from the sale. For this purpose, an income tax is intended to be defined as it is under the general
rules for determining creditable foreign taxes (secs. 901-908). Thus, for example, a "soak-up" tax
of 10 percent would not qualify for this purpose. The 10-percent tax rule is designed to reflect
Congress' general intent that the source of income for U.S. residents be the United States unless
the income is subject to meaningful foreign tax. The office rule was intended to apply to income
derived from the sale (for noncontingent payments) of intangible property by a U.S. resident if
the income is attributable to a fixed place of business in a foreign country and the U.S. resident

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 274

pays an income tax at an effective rate of 10 percent or more.3
3
A technical correction may be needed so that the statute reflects this intent.

United States citizens and resident aliens, even if not selling property attributable to a foreign
office, can also generate foreign source income if the individual has a tax home in a foreign
country. In either case, however, any income from a sale is not foreign source if the income is not
subject to an effective foreign income tax of 10 percent or more.

For nonresidents, the Act applies the office rule to income derived from the sale of any
personal property if the sale is attributable to a U.S. office or other fixed place of business. Thus,
regardless of the place of sale, income derived from sales of personal property that are
attributable to an office or other fixed place of business maintained in the United States by a
nonresident is treated as U.S.
922

source. Pursuant to the Code's rules defining effectively connected income, this income generally
will be treated as effectively connected and subject to U.S. tax.

Income derived by nonresidents from the sale of inventory property is not treated as U.S.
source under the office rule, however, if the property is sold or exchanged for use, consumption,
or disposition outside the United States, an office or other fixed place of business maintained
outside the United States by the person materially participates in the sale, and the sale occurs
outside the United States In this case, the income is sourced by reference to the place of sale.

In determining which income is attributable to an office or other fixed place of business, the
Act provides that the principles embodied in Code section 864(c)(5) apply. Thus, in general, the
office of an independent agent is not attributed to a taxpayer, an office must be a material factor
in the production of income, and income must be properly allocated to an office. Because prior
law applied these principles only to foreign persons with U.S. offices and to a limited category of
income items, these principles may have to be modified under regulations to properly take
account of the Act's expansion of the office rule to U.S. residents who maintain a foreign office
and to all income items. In addition, the prior law limit on the amount of income attributed to an
office may have to be modified to reflect the repeal of the place-of-sale rule. For example, a sale
of personal property which was primarily used in one jurisdiction is not generally to be attributed
to an office in another jurisdiction.
Income derived from the sale of stock in foreign affiliates

A place-of-sale rule applies to income derived by U.S. corporations from the sale of stock in
certain foreign corporations. If a U.S. corporation sells stock of a foreign affiliate in the foreign
country in which the affiliate derived from the active conduct of a trade or business more than 50

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percent of its gross income for the 3-year period ending with the close of the affiliate's taxable
year immediately preceding the year during which the sale occurred, any gain from the sale is
foreign source. An affiliate, for this purpose, is any foreign corporation whose stock is at least 80
percent owned (by both voting power and value).
Goodwill

Under the Act, payments in consideration for the sale of goodwill are treated as from sources
in the country in which the goodwill was generated.
Other rules

The Act clarifies that any portion of the gain from the sale of stock in a controlled foreign
corporation by a U.S. shareholder that is treated under section 1248(a) as a dividend is sourced
pursuant to the source rules governing dividends (generally residence of the payor).

The Act provides that regulations are to be prescribed by the Secretary carrying out the
purposes of the Act's source rule provisions, including the application of the provisions to losses
from
923

sales of personal property and to income derived from trading in futures contracts, forward
contracts, options contracts, and similar instruments. It is anticipated that regulations will
provide that losses from sales of personal property generally will be allocated consistently with
the source of income that gains would generate but that variations of this principle may be
necessary. Regulations may also be required to prevent persons from establishing partnerships or
corporations, for example, to change their residence to take advantage of these rules. It may be
appropriate to establish an anti-abuse rule to, for example, treat a foreign partnership as a U.S.
resident to the extent its partners are U.S. persons.

The Act repeals section 871(e). Consequently, taxpayers no longer can treat all of the gain
from the sale of certain intangible property as being from payments which are contingent on the
productivity, use, or disposition of the property if more than 50 percent of the payments from the
sale are so contingent. Instead, taxpayers are required to segregate the gain from the sale or
exchange of certain intangible property into gain contingent on the productivity, use, or the
disposition of property and gain which is not so contingent. Withholding is required only with
respect to U.S. source payments that are contingent on the productivity, use or disposition of the
property. As under prior law, gain to the extent of payments which are not contingent on the
productivity, use, or disposition of the property is treated as gain from the sale of personal
property.

Finally, the Act directs the Treasury Department to study the effect of the title passage rule as

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it applies in determining the source of income from the sale of inventory property. In the study,
the Treasury Department is directed to take into account the Act's lower tax rates and
Congressional trade concerns, and to report back to the House Committee on Ways and Means
and the Senate Committee on Finance not later than September 30, 1987.
Effective Date

The provisions affecting foreign persons (other than controlled foreign corporations) are
effective for transactions after March 18, 1986. The provisions affecting U.S. persons and
controlled foreign corporations are effective in taxable years beginning after December 31, 1986.
Revenue Effect

The provisions are estimated to increase fiscal year budget receipts by less than $5 million
annually.
924

2. Special rules for transportation income (sec. 1212 of the Act and secs. 861, 863, 872,
883, and new sec. 887 of the Code)4
4
For legislative background of the provision, see: H.R. 3838, as reported by the House
Committee on Ways and Means Committee on Ways and Means on December 7, 1985, sec. 613;
H.Rep. 99-426, pp. 369-372 and 443-448; H.R. 3838, as reported by the Senate Committee on
Finance on May 29, 1986, sec. 913; S.Rep. 99-313, pp. 336-344; and H.Rep. 99-841, Vol. II
(September 18, 1986), pp. 596-599 (Conference Report).

Prior Law

Overview

In general, the United States taxes the worldwide income of U.S. persons whether the income
is derived from sources within or our side the United States. On the other hand, nonresident
aliens and foreign corporations (even those which are owned, by U.S. persons) generally are
taxed by the United States only on income effectively connected with a U.S. trade or business
(which is taxed on a net income basis) and on their other U.S. source income (which is taxed on
a gross income basis). To eliminate double taxation, the United States permits certain foreign
income taxes to offset U.S. tax imposed on foreign source income.

The U.S. tax laws contained a number of special rules which frequently resulted in income
earned in transporting persons and cargo from one country to another, by both U.S and foreign
persons, being subject to very little U.S. tax. Some foreign countries tax U.S. persons on this
kind of income, however.
Source rule for transportation income

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 Under the Tax Reform Act of 1984, all income attributable to transportation which begins
and ends in the United States is treated as U.S. source income. Income attributable to
transportation which begins in the United States and ends in a U.S. possession for which begins
in a U.S. possession and ends in the United States) generally is treated as 50-percent U.S. source
income and 50-percent foreign source income. These provisions apply to both U.S. and foreign
persons. For purposes of these provisions, transportation income is defined as any income
derived from, or in connection with, the use, or hiring or leasing for use, of a vessel or aircraft or
the performance of services directly related to the use of such vessel or aircraft. Thus, these
source rules apply to income attributable to both rental income (e.g. bareboat charter hire) and
transportation services income (e.g., time or voyage charter hire). Also, these rules apply to both
companies earning transportation income and their employees, so that they apply to, for example,
the wages of personnel on carriers. Transportation income includes income from transporting
persons as well as income from transporting property. The term "vessel or aircraft" includes any
container used in connection with a vessel or aircraft. Income derived from the lease of a
container vessel is therefore transportation income under these rules.

For income earned in transporting persons and cargo from the United States to a foreign
country, or between two foreign countries, source determination under prior law was dependent
on the type of income produced. If the income was rental, income (e.g.,
925

bareboat charter hire), it was foreign source to the, extent allocable to periods when the vessel (or
aircraft) was outside the United States and its territorial waters (i.e., outside the three-mile limit).
If the income was from transportation services income (e.g., time or voyage charter hire) the
income was sourced under Treasury regulations. These regulations provided that taxable income
or loss generally was allocated between U.S. and foreign sources in proportion to the expenses
incurred in providing the services. Expenses incurred outside the territorial waters of the United
States were treated as foreign for purposes of this calculation. Therefore, under prior law, most of
the income earned in transporting persons and cargo from the United States to a foreign country,
or between two foreign countries, whether it was rental or transportation services income was
foreign source.

A special rule provided that income derived from the lease or disposition of vessels and
aircraft that were constructed in the United States and leased to U.S. persons was treated as
wholly U.S. source income (Code sec. 861(e)). Expenses, losses, and deductions incurred in
leasing the vessels and aircraft were allocated entirely against U.S. source income. These rules
applied regardless of where the vessel or aircraft was used.

Another special rule applied to transportation income (as defined under the 1984 Act) and
expenses associated with the lease of an aircraft (wherever constructed) to a regularly scheduled
U.S. air carrier, to the extent the aircraft was used on routes between the United States and U.S.

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possessions (sec. 863(c)(2)(B)). This rule provided that the gross income of the lessor was U.S.
source; the expenses associated with the gross income were allocated entirely against U.S. source
income.
Foreign flag transportation

Foreign owned transportation entities were often exempted from U.S. tax on certain income
by reciprocal exemption. Under the reciprocal exemption provisions, foreign owners were
exempt from U.S. tax on income derived from the operation of a ship or aircraft documented or
registered under the laws of a foreign country which granted an equivalent exemption to (or
imposed no tax on) U.S. citizens and domestic corporations (secs. 872(b)(1) and (2) and 883(a)
(1) and (2)). The determination that a foreign country granted an equivalent exemption was
usually confirmed by an exchange of notes between the two countries. Reciprocal exemptions
under these provisions were previously in effect with many foreign countries whose residents
engaged in international transportation activities. The reciprocal exemption provisions applied
independently with respect to shipping and aircraft income. Thus, while in most cases both types
of income were covered by the exemptions, in some cases the exemptions covered one but not
the other. As the exemptions applied only to income derived from the operation of vessels (or
aircraft), the Internal Revenue Service held in Revenue Ruling 74-170, 1974-1 C.B. 175 that the
exemptions did not apply to bareboat charter income.

In addition to reciprocal exemption provided in the Code, the United States has
approximately 35 income tax treaties providing for reciprocal exemption which exempt certain
income from trans-
926

porting persons and cargo from taxation by either country even if there is no statutory exemption.
(Although there generally is substantial overlap, the typical treaty reciprocal exemption
sometimes has a different scope from the statutory reciprocal exemption.) These treaties are in
effect with virtually all of the developed countries.

Despite the numerous Code and treaty reciprocal exemptions that the United States had
granted, there were several countries that had not entered into exemption agreements with the
United States. Some of these countries impose a tax (generally a gross basis tax) on the
transportation income of U.S. persons.

When a reciprocal exemption was not in force, the foreign tax burden on U.S. persons
earning income from transporting persons or cargo generally was greater than the U.S. tax on
persons from the other country who earned similar income from the United States. This occurred
because, as noted above, the United States treated only a small amount of this income as U.S.
source and attempted to tax this income on a net income basis; thus, the amount of U.S. source
gross income generally could be eliminated by depreciation and other deductions allocable to the

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income. Foreign countries that tax this income, on the other hand, generally treat as local source
the income attributable to either the entire inbound or entire outbound leg of the trip and often
imposed tax on a gross income basis. The absence of meaningful U.S. tax when a reciprocal
exemption was not in force consequently resulted in U.S. transportation companies being at a
competitive disadvantage, vis-a-vis their foreign counterparts.
U.S.-controlled foreign flag transportation

Benefits from the Code and treaty reciprocal exemption provisions were derived not only by
strictly foreign operators, but also by U.S. citizens and domestic corporations who operated their
ships and aircraft through controlled foreign subsidiaries. A substantial percentage of U.S.-owned
foreign ships were registered in one of three countries: Liberia, the United Kingdom, or Panama,
each of which qualified for a reciprocal exemption.

Operators who incorporated outside their residence countries and who registered their ships
or aircraft in a foreign country with no intention of operating the ships or aircraft in the domestic
or foreign commerce of that foreign country were often referred to as using "flags of
convenience". As a general rule, most flag of convenience shipping companies, including those
registered in Liberia and Panama, were able to obtain the reciprocal exemption provided in the
Code.
Reasons for Change

Source of income

Under prior law, a very small portion of income earned from transporting persons and cargo
from the United States to a foreign country was U.S. source. Congress believed that the U.S.
source portion of this income generally should be greater than the amount determined under prior
law. Consistent with its general reevaluation of prior law's source rules, Congress generally did
not believe
927

that U.S. persons should be allowed to generate foreign source income (or loss) unless the
income (or loss) is generated within a foreign country's tax jurisdiction and subject to foreign
tax. Congress believed that the United States has the right to assert primary tax jurisdiction over
income earned by its residents that is not within any other country's tax jurisdiction. (Prior law's
treatment of this income as foreign source had the effect of relinquishing primary tax jurisdiction
over a substantial amount of this income.)

The operation of prior law had two undesirable effects. First, for U.S. persons, income that
did not have a nexus with any foreign country and was only partially, if at all, subject to foreign
tax inappropriately increased the foreign tax credit limitation of the tax payer. (Conversely,

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losses treated as foreign source reduced the taxpayer's foreign tax credit limitation despite the
absence of a nexus with a foreign country.) A taxpayer with excess foreign tax credits from
unrelated foreign operations then was allowed, by characterization of income as foreign
operations then was allowed, by characterization of income as foreign rather than U.S. source, to
offset all or part of any U.S. tax that otherwise would have been imposed on this income. Thus, a
profitable taxpayer with excess foreign tax credits had a competitive advantage over a taxpayer
who did not have excess foreign tax credits. Second, prior law's understatement of U.S. source
income tended to subject foreign persons to too little U.S. tax. In Congress' view, prior law did
not allow the United States to assert proper tax jurisdiction.

Congress also believed that the prior law provisions that allowed lessors to treat losses (or
income) from the lease of an aircraft as wholly U.S. source income did not reflect economic
reality. Congress believed that the income or loss should be sourced under the rules that apply to
U.S. taxpayers generally.
Tax on transportation income

Congress recognized that expanding the source rule for income derived from transporting
person and cargo may subject foreign persons to a greater amount of U.S. tax. In Congress' view,
a further change in the U.S. taxing rules was also necessary. Congress believed that a tax based
on gross U.S. source income derived by foreign persons was the most practical way to collect
U.S. tax on such income, unless the foreign person has a substantial and regular presence in the
United States, more than that required under prior law. Congress further anticipated that
increased U.S. taxation of persons from foreign countries that have not entered into reciprocal
exemptions with the United States will encourage those countries to do so.
Reciprocal exemption

Under prior law, the reciprocal exemption provisions eliminated U.S. tax on foreign persons
(even U.S.-controlled foreign corporations) by allowing exemptions based on country of
documentation or registry, without regard to whether persons receiving the exemption resided in
that country or whether commerce was conducted in that country. This placed U.S. persons with
U.S.-based transportation operations and subject to U.S. tax at a competitive disadvantage vis-a-
vis their foreign counterparts who claimed exemption
928

from U.S. tax and who were not taxed in their countries of residence or in the countries where
the ships were registered. In cases where residents of a country with which the United States
might desire a reciprocal exemption used vessels or aircraft under another flag ("flagging out"),
the unilateral U.S. concession provided by prior law left the other country little incentive to
exempt U.S. shippers. Congress understood that the reciprocal exemption provisions were not
enacted to provide worldwide exemption from income tax. Instead, in Congress' view, the
reciprocal exemption provisions were enacted not only to promote international commerce by

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eliminating double taxation, but also to reserve the right to impose tax on income derived from
transporting persons and cargo to the country of residence of the taxpayer. International practice,
as reflected in tax treaties, is for the source country to provide reciprocal tax benefits to residents
of the other contracting country.

The Act repeals the prior law exception to Subpart F (which allowed controlling U.S.
shareholders of a foreign shipping corporation controlled by U.S. persons to avoid current U.S.
tax on some of the corporation's income). Congress believed that it generally was appropriate to
permit these corporations to claim exemption under the agreement between their country of
incorporation and the United States, notwithstanding that they are not owned by residents of that
country, as long as the corporations are organized in a country that does not tax U.S. residents.
Congress further believed that a corporation whose stock is publicly traded primarily in the
country of organization should be presumed to be owned by local residents. Thus, Congress
believed that corporations owned in this manner should be exempt from the tax as long as the
corporations are organized in a country that does not tax U.S. residents.

Finally, Congress believed that it was appropriate to extend the reciprocal exemption to types
of transportation income not clearly encompassed under prior law. For example, Congress
believed that it was appropriate that income from the bareboat charter of a ship or the lease of an
aircraft be eligible for reciprocal exemption. In addition, Congress believed that it would
generally be appropriate to treat different types of transportation income independently or
reciprocal exemption purposes. Congress therefore provided the Secretary authority to exempt
different types of transportation income on a reciprocal basis.
Explanation of Provision

Source of transportation income

The Act provides that 50 percent of all income attributable to transportation which begins or
ends in the United States is U.S. source. The provision applies to both U.S. and foreign persons.
The Act defines transportation income as under prior law. Therefore, the Act applies to income
derived from, or in connection with, the use, or hiring or leasing for use, of a vessel or aircraft or
the performance of services directly related to the use of such vessel or aircraft. The Act modifies
prior law, however, by excluding from transportation income from the performance of services
by seamen or airline employees for transportation that begins or ends
929

in the United States. Income from the performance of services attributable to transportation that
begins and ends in the United States and of services attributable to transportation between the
United States and a U.S. possession is still included in transportation income. Personal service
income excluded from transportation income under the Act is sourced as under prior law: income
attributable to services performed in the United States or within the U.S. territorial waters is U.S.
source.

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 282

 Income from the bareboat charter hire of vessels or aircraft is subject to the Act's provisions.
Congress intended, however, that income derived from the lease of a vessel not used to transport
cargo or persons for hire be characterized as ocean activity income and be sourced in the country
of residence of the person earning the income, as prescribed in section 1213 of the Act, rather
than as transportation income.

The Act also repeals the special rule relating to the lease or disposition of vessels, aircraft, or
spacecraft which are constructed in the United States (former sec. 861(e)) and the special rule
relating to the lease of an aircraft to a regularly scheduled U.S. air carrier (former sec. 863(c)(2)
(B)). The source of this income, to the extent treated as transportation income, is determined
under the general rule described above.

The source rules covered by the Act apply only to income attributable to transportation that
begins or ends in the United States. Thus, if a voyage that begins in Europe has intermediate
foreign stops before it arrives in the United States, 50 percent of the income that is attributable to
the cargo (or persons), carried from its port of origin or from any of the intermediate ports to the
United States is considered U.S. source. Cargo or passengers off-loaded at intermediate ports
before arrival in the United States will not give rise to U.S. source income.

Congress intended that income derived from furnishing round trip travel originating in or
ending in the United States be treated as income attributable to transportation that begins (for the
outbound portion), or ends (for the in bound portion), in the United States under the Act's
provision. Thus, 50 percent of the income attributable to the outbound transportation and 50
percent of the income attributable to the inbound transportation is U.S. source. For example, 50
percent of the income attributable to the first and last legs of round-trip travel by a cruise ship,
originating in the United States, calling on foreign ports, and ending in the United States, is to be
U.S. source. Similarly, 50 percent of the income attributable to both legs of an air voyage from
the United States, to a foreign country, and back to the United States (or from a foreign country,
to the United States, and back to a foreign country) is intended to be U.S. source.
Gross basis tax

The Act generally imposes a four percent tax on the gross U.S. source income (as defined
above) of foreign persons. The Code's 30 percent gross basis income withholding tax (under
secs. 871 and 881) does not apply to any income subject to the four percent tax. Thus, bareboat
charter income subject to the four percent tax is not also subject to 30 percent withholding.
930

If a foreign person is engaged in a trade or business in the United States and the foreign
person's transportation income is effectively connected with the trade or business, the foreign
person must, in lieu of paying the four percent gross basis tax, file a U.S. tax return and pay tax

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on its net effectively connected income. For a foreign person's transportation income (other than
leasing income) to be effectively connected with the conduct of a U.S. trade or business under
the Act, (1) the foreign person must provide regularly scheduled transportation into, out of, or
within the United States; (2) substantially all of the person's U.S. source transportation income
must be attributable to the regularly scheduled transportation; and (3) the foreign person must
maintain a fixed place of business in the United States through which the foreign person
conducts its U.S. transportation business. Thus, for example, an occasional flight or voyage to
the U.S. will not allow foreign persons to treat themselves as being engaged in a U.S. trade or
business and thereby avoid the gross basis tax. For a foreign person engaged in the leasing of
ships or aircraft to derive effectively connected transportation income, the foreign person must
maintain a fixed place of business in the United States and substantially all of the person's U.S.
source gross transportation income must be attributable to the fixed place of business.

If a foreign person's transportation income is effectively connected with the conduct of a U.S.
trade or business, this income, like other effectively connected income, is also subject to the Act's
branch profits tax (as provided in sec. 1241). However, if a foreign person's income is exempt
from tax because of a reciprocal exemption, the income is exempt from the branch profits tax.

The gross basis tax is to be collected by return. However, Congress was concerned that this
method of collecting the tax would not yield adequate compliance. Congress therefore intended
that the tax-writing committees of Congress study whether alternate, potentially more effective,
methods of collecting the tax are feasible. Congress also intended that the Secretary monitor
compliance with the Act's provisions and suggest to Congress alternative measures if return
filing does not result in adequate compliance.

The gross basis tax is not intended to override U.S. income tax treaties with foreign
countries. Therefore, a foreign person entitled to a treaty exemption is not subject to the tax.
Also, the residence based reciprocal exemption (described below) applies to gross income; thus,
any such exemption will apply to the gross basis tax.
Reciprocal exemption

Under the Act, the prior law reciprocal exemption is modified to cover only foreign persons
that are residents of a foreign country that reciprocally exempts U.S. residents and domestic
corporations. The exemption is, therefore, no longer based on the place of registry or
documentation.

The Act's reciprocal exemption extends to alien individuals who are residents of a foreign
country which grants U.S. citizens and domestic corporations an equivalent exemption. For a
foreign corporation to qualify for the reciprocal exemption, the corporation must be organized in
a foreign country which grants U.S. citizens and domestic corporations an equivalent exemption.
Congress in-
931

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tended that a country which, as a result of a treaty with the United States, exempts U.S. residents
and domestic corporations from tax on income derived from the operation of ships or aircraft,
qualify under the Act, even though the treaty technically contains certain additional requirements
other than residence such as registration or documentation of the ship or aircraft.

Congress did not intend to deny any benefits available under an income tax treaty between
the United States and a foreign country. For example, a treaty which extends reciprocal
exemption to U.S. residents but not to all U.S. citizens, is not overridden. Congress did intend,
however, that any treaties that do not contain residence-based exemptions be renegotiated by the
Treasury Department to comply with the Act's provisions.

In determining whether a reciprocal exemption is residence based, more than 50 percent of

the ultimate individual owners of the foreign corporation must be residents of a foreign country
that grants U.S. citizens and domestic corporations equivalent exemption (either by treaty or by
residence-based reciprocal exemption). Thus, it is not enough for the foreign corporation to be
organized in a foreign country which grants U.S. citizens and domestic corporations an
equivalent exemption: most of its owners must reside in such a country as well. Individuals that
reside in countries which have residence-based reciprocal exemptions with the United States
qualify for this purpose even if they are citizens or subjects of third countries that do not have
qualifying exemptions in place. Congress intended that residence, for this purpose, mean the
country of an individual's tax home, as defined in section 911(d)(3).

Ultimate individual ownership is determined under the Act by treating stock owned directly
or indirectly by or for any entity (for example, a corporation, partnership, or trust) as being
actually owned by the stockholder (or partner, grantor, or beneficiary, as the case may be) of that
entity and by further attributing that ownership to its owners if necessary to reach individual
owners.

The 50-percent ownership requirement does not apply if the foreign corporation is a
controlled foreign corporation (as defined in sec. 957(a)). Thus, a controlled foreign corporation
must only be organized in a foreign country which grants U.S. citizens and domestic
corporations a reciprocal exemption in order for the corporation to be exempt from U.S. tax. The
50-percent ownership requirement also does not apply to any foreign corporation if the stock of
the corporation is primarily and regularly traded on an established securities market in the
foreign country in which the corporation is organized and that country provides a reciprocal
exemption. For this purpose, "primarily" is intended to mean that more shares trade in the
country of organization than in any other country. The publicly traded exception also covers a
foreign corporation that is wholly owned by a second corporation organized in the same country
as the first foreign corporation if the stock of the second foreign corporation is primarily and
regularly traded on an established securities market in that country.

The Act expands the reciprocal exemption to income derived from the lease of vessels or

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aircraft as long as a foreign country exempts U.S. citizens and domestic corporations from its tax
on comparable income. The Secretary is also provided authority to
932

extend the reciprocal exemption to different types of transportation income on a case-by-case

basis. For example, if the United States and a foreign country agree that only income from
regularly scheduled transportation will be exempt from tax, then the Code's exemption can apply.
Effective Date

The provisions are generally effective for taxable years beginning after December 31, 1986.
Leasing income will continue to be sourced under prior law for income attributable an asset
owned on January 1, 1986, if the asset was first leased before such date.

The Act extends the ownership requirement of the special leasing rule to January 1, 1987 for
certain lessors.
Revenue Effect

The provisions are estimated to increase fiscal year budget receipts by $8 million in 1987,
$16 million in 1988, $18 million in 1989, $25 million in 1990, and $30 million in 1991.
3. Source rule for space and certain ocean activities (sec. 1213 of the Act and sec. 863 of
the Code)5
5
For legislative background of the provision, see: H.R. 3838, as reported by the House
Committee on Ways and Means on December 7, 1985, sec. 615; H.Rep. 99-426, pp. 381-383; H.R.
3838 as reported by the Senate Committee on Finance on May 29, 1986, sec, 915; S.Rep. 99-313,
pp. 357-360; and H.Rep. 99-841, Vol. II (September 18, 1986), pp. 599-600 (Conference Report).

Prior Law

Activities conducted in space or outside the territorial waters of foreign countries take many
forms: manufacturing occurs in space, spacecraft and satellites are leased, personal services are
performed in space, and payments are made for other actual business operations conducted in
space, such as research and development. Similarly, income from activities conducted outside the
territorial waters of foreign countries takes many of the same forms: lease income, personal
service income and business income.

The source of space and "high-seas" income depended under prior law on the type of activity
performed. Lease income was generally sourced in the place of use; personal service income was
generally sourced in the location in which the services were performed; and manufacturing and

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other business income was generally sourced where the activity took place. Therefore, because
the equipment was generally used, the services generally performed, and the activities generally
conducted outside the United States, the predominant part of income from space and high-seas
activities was generally treated as foreign source income under prior law. This is because the
United States considered within its primary tax jurisdiction only areas within the boundaries of
its States and its territorial waters.

A special rule provided that certain income from leasing vessels, aircraft, or spacecraft was
U.S. source (Code sec. 861(e)). This provision was applicable if the vessel, aircraft, or spacecraft
was leased to U.S. persons, was eligible for the investment tax credit, and was
933

manufactured or constructed in the United States. Because most tangible property used
predominantly outside the United States was not eligible for the investment tax credit, the special
rule had only limited application for spacecraft. Exceptions to the predominant use test existed
for, among others, vessels documented under the laws of the United States, certain
communications satellites, and certain property used in the Outer Continental Shelf or in certain
international waters (sec. 48(a)(2)(B)).
Reasons for Change

The foreign tax credit rules are designed to prevent double taxation of income by the United
States and foreign countries. The credit generally operates on the principle that the country in
which income arises has the primary right to tax the income. In order to prevent the foreign tax
credit from offsetting U.S. tax on U.S. source income, the credit is limited to the taxpayer's pre-
credit tax on its foreign source income. In view of the purpose of the foreign tax credit, the
source rules used in computing the foreign tax credit limitation are generally designed to identify
as foreign source income that income which arises within a foreign country's jurisdiction and
which might reasonably be subject to foreign tax.

Congress reevaluated prior law's policy in determining the source of various types of income
(see, for example, sec. 1212 of the Act, regarding the source of transportation income). Congress
concluded that asserting primary tax jurisdiction only over income generated within the United
States and its territorial waters was inappropriate. In this regard, Congress enacted source rules
the policy of which is to assert primary tax jurisdiction over income earned by U.S. residents that
is not within any foreign country's taxing jurisdiction (i.e., a foreign country's boundaries and its
territorial waters). In Congress' view, prior law treatment of this income as foreign source
inappropriately allowed taxpayers with excess foreign tax credits to shelter this income from
U.S. tax. Congress believed that the U.S. policy of the foreign tax credit will be after served by
these new standards.

More specifically, Congress did not believe the prior rules governing the source of income

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were appropriate in their application to income derived from space or high-seas activities by U.S.
residents. Congress noted that activities conducted in space and on or beneath the ocean had not
been very prevalent. With this in mind, Congress believed that the Code's general source rules
needed reexamination in their application to space and ocean activities. Moreover, when a U.S.
taxpayer conducted activities in space or international waters, Congress noted that foreign
countries had no apparent right to tax the income and generally did not tax the income. Thus, the
foreign tax credit limitation was inflated by income that was not within any foreign country's tax
jurisdiction such that a tax year with excess foreign tax credits from other operations could
eliminate all tax (U.S. and foreign) on this income rather than eliminating double tax. Similarly,
a taxpayer is foreign tax credit limitation might, have been inappropriately reduced if the
operations had been conducted at a loss.
934

Congress recognized, however, that international communications income had some potential
to be taxed in a foreign country and believed that prior law's source rules applicable to U.S.
persons with respect to this income warranted only partial modification. Congress also believed
that prior law source rules may not have appropriately dealt with the U.S. taxation of
international communications income derived by foreign persons. Congress noted that prior law
potentially allowed foreign persons to maintain a U.S. office, but to conduct their activities so as
to generate nontaxable foreign source income through their U.S. offices.

Congress recognized that sourcing income derived from space and high-seas activities in the
country of residence could have provided an unintended incentive for U.S. persons to conduct
such activities through controlled foreign corporations. Congress believed, however, that since
the Act included this income in the separate foreign tax credit limitation for shipping income (see
Act sec. 1201) and subjected this income to current U.S. tax under the subpart F rules (see Act
sec. 1221), its concerns that U.S. persons would conduct their space and ocean activities in a
low-tax jurisdiction through the use of foreign corporations were generally abated. The separate
foreign tax credit limitation generally provided Congress adequate assurance that high foreign
taxes on unrelated income would not inappropriately offset U.S. taxes on this generally low-
taxed income.
Explanation of Provision

The Act provides that all income derived from space or ocean activities is sourced in the
country of residence of the person generating the income: income derived by United States
persons (as de fined in Sec. 7701(a)(30)) is U.S. source income and income derived by persons
other than U.S. persons is sourced outside the United States. Congress, however, provided the
Secretary authority to pre-scribe anti-conduit provisions so as to treat certain foreign
corporations controlled by U.S. persons as U.S. persons for purposes of these rules in certain
circumstances.

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 Space or ocean activities as defined by the Act include any activities conducted in space, or
on, in, or beneath water not within the jurisdiction (as recognized by the United States) of any
country including the United States or its possessions. The term ocean activities also includes
any activities performed in Antarctica. In defining space or ocean activities, Congress intended
the term to include the following activities: the performance and provision of services in space or
on or beneath the ocean, the leasing of equipment for use on or beneath the ocean (for purposes
other than providing transportation) or in space (for example, spacecraft and satellites), the
licensing of technology or other intangibles for use in space or on or beneath the ocean. The term
ocean activities does not, however, include income derived from the operation or lease of
between ports-of-call.

The Act provides that regulations may describe other activities that may be considered space
or ocean activities. For example, Congress intended that underwriting income from the insurance
of risks on activities conducted in space or on or beneath the ocean be treated as derived from
space or ocean activities.

Under the Act, space or ocean activities do not include any activity which gives rise to
transportation income (as defined in sec. 863(c)) or any activity with respect to mines, oil and
gas wells, or other natural deposits to the extent the mines or wells are located within the
jurisdiction (as recognized by the United States) of any country, including the United States and
its possessions. In the case or mines, oil and gas wells, or other natural deposits to the extent
such mines or wells are not within the jurisdiction of the United States, U.S. possessions, or any
foreign country, Congress intended the leasing of drilling rigs, the extraction of minerals, and the
performance and provision of services related thereto to be ocean activities.

The Act also excludes from the definition of space or ocean activities international
communications income, as defined. The Act provides that international communications income
derived by U.S. persons is to be sourced 50 percent in the United States and 50 percent foreign if
the income is attributable to communications between the United States and a foreign country. If
the communication is between two points within the United States, the income attributable
thereto is not international communications income and is to be entirely U.S. source. Congress
intended the latter result even if the communication is routed through a satellite located in space,
regardless of the satellite's location. If the communication is between the United States and an
airborne plane or a vessel at sea outside the jurisdiction of any foreign country, Congress
intended the communication to be treated as between two U.S. points and, thus, to be sourced in
the United States. Finally, if the communication is between two foreign locations, Congress
intended income attributable thereto to be entirely foreign source. Congress intended that
international communication income include income attributable to any transmission between
two countries of signals, images, sounds, or data transmitted in whole or in part by buried or
under-water cable or by satellite. For example, the term includes income derived from the
transmission of telephone calls.

When derived by foreign persons, the Act generally treats international communication
income as foreign source. An exception to this general rule is provided if a foreign person

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maintains an office or other fixed place of business in the United States and the income is
attributable to the U.S. office or other U.S. fixed place of business. This exception treats the
income as entirely U.S. source. The Secretary is also given regulatory authority to treat other
international communication income derived by a foreign person (e.g., a controlled foreign
corporation) as other than foreign source. In particular, Congress anticipated that treatment of
this income in the hands of controlled foreign corporations like similar income in the hands of
U.S. persons would be necessary in certain circumstances to prevent manipulation of the
provision.

As provided in section 1212 of the Act, Code section 861(e), treating certain income from the
leasing of vessels or spacecraft as wholly U.S. source, is repealed.
936

Effective Date

The provision is effective for income earned in taxable years beginning after December 31,
1986.
Revenue Effect

The provision is estimated to increase fiscal year budget receipts by less than $5 million
annually.
4. Limitations on special treatment of 80/20 corporations (sec. 1214 of the Act and secs.
861, 871, 881, 1441. and 6049 of the Code)6
6
For legislative background of the provision, see: H.R. 3838, as reported by the House
Committee on Ways and Means on December 7, 1985, sec. 612, H.Rep. 99-426, pp. 365-369; H.R.
3838, as reported by the Senate Committee on Finance on May 29, 1986, sec. 912; S.Rep. 99-313,
pp. 333-336; H.Rep. 99-841, Vol. II (September 18, 1986), pp. 600-604 (Conference Report).

Prior Law

Under present and prior law, if U.S. source dividends and interest paid to foreign persons are
not effectively connected with the conduct of a trade or business within the United States the
withholding agent (which is generally the payor of such income) is generally required to
withhold tax on the gross amount of such income at a rate of 30 percent (secs. 871(a) and
881(a)). The withholding rate of 30 percent may be reduced or eliminated by tax treaties between
the United States and a foreign country. Furthermore, withholding is not required on certain
items of U.S. source interest income. For instance, the Tax Reform Act of 1984 eliminated
withholding on U.S. source portfolio interest. The United States does not impose any
withholding tax on foreign source dividend and interest payments made to foreign persons, even
if the payments are from U.S. persons.

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 Under present and prior law, dividend and interest income generally is sourced in the country
of incorporation of the payor. However, under prior law, if a U.S. corporation earned more than
80-percent of its income from foreign sources for a three-year period (such a corporation was
referred to as an "80/20 company"), then dividends and interest, paid by that corporation
generally were treated as foreign source income. Foreign countries generally do not tax
dividends and interest paid by U.S. corporations to U.S. persons even though those dividends and
interest may have been foreign source under prior law rules. The exception to the country-of-the
payor source rule also applied to resident alien individuals: if a resident alien received more than
80 percent of his or her income from foreign sources, interest paid by that individual was treated
as foreign source.

Other exceptions to the country-of-incorporation source rules were designed as tax

exemptions for limited classes of income earned by foreign persons. For instance, interest on
foreign persons U.S. bank accounts and deposits was exempt from U.S. withholding tax under
prior law. The prior method of exempting this income was to treat it as foreign source.
937

Reasons for Change

Congress was concerned that the prior rules for dividends and interest paid by 80/20
companies ceded primary tax jurisdiction away from the United States for income that should
have borne U.S. tax. For example, foreign persons were able to arrange to have a U.S. holding
company own the stock of a domestic operating subsidiary and the stock of a foreign operating
subsidiary. If the income distributed by the foreign operating subsidiary to the holding company
constituted at least 80 percent of the holding company's income such that the holding company
was an 80/20 company, the ultimate foreign owners were able to shelter dividends and interest
from the domestic operating subsidiary from U.S. withholding tax. If the foreign persons had
owned the stock of the domestic operating subsidiary themselves, U.S. withholding tax would
have been imposed. Congress believed that the United States should collect tax on the portion of
dividends and interest paid to foreign persons that is attributable to U.S. source income of the
payor. Moreover. in those cases where the U.S. corporation is not directly or indirectly
conducting an active foreign business, Congress believed that the United States should not cede
primary tax jurisdiction on any of the dividend or interest payments by that U.S. corporation.

Similarly, the prior treatment of dividends and interest paid by 80/20 companies had the
result of artificially inflating U.S. persons' foreign source income for foreign tax credit limitation
purposes. Congress was of the view that the United States should generally retain primary tax
jurisdiction over dividends and interest paid by its residents. Congress did not believe that
dividends paid by 80/20 companies to U.S. persons should be foreign source since the payor
computed its foreign tax credit limitation, accounted for its foreign source income, and credited
any foreign income taxes imposed on that income at the payor level. Under prior law, the full

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amount of the dividends (after reduction for any dividends received deduction) received by U.S.
shareholders from 80/20 companies was treated as foreign source income, thereby increasing the
foreign tax credit limitation of the U.S. shareholders. This was true even though up to 20 percent
of the earnings from which the dividends were derived may have been from U.S. sources, and
even though no foreign income taxes were likely to have been imposed on those dividends.
Excess foreign tax credits from other operations could then shelter from U.S. tax at the
shareholder level some or all of the dividends received from the 80/20 company (to the extent
those dividends were not already sheltered by the dividends received deduction in the case of
corporate shareholders).

With respect to interest payments made by an 80/20 company to U.S. persons, Congress
thought it was appropriate to treat interest paid in connection with an active foreign business
more favorably than dividends because that interest, unlike the dividends, was likely to reduce
foreign income taxes that the 80/20 company had to pay and that the United States may have had
to allow as a foreign tax credit. In these circumstances, however, Congress believed that income
earned by an 80/20 company should retain its source when interest was paid to related persons so
that the United States
938

could collect U.S. tax when the interest was attributable to U.S. source income of the payor.

In adopting the new 80/20 standards, Congress decided against requiring a minimum amount
of dividends and interest paid to foreign persons to be subject to U.S. tax because of the Act's
minimum tax provision which ensures that profitable U.S. 80/20 corporations pay some U.S. tax
(the provision that allows creditable foreign taxes to offset only 90 percent of the alternative
minimum tax). Congress was of the view that that provision achieved its policy objective: that
profits flowing though U.S. corporations not escape all U.S. tax at the corporate and shareholder
levels.

Congress also believed the prior 80/20 rule was generally inappropriate in the case of
individuals. If an individual received any U.S. income, U.S. tax should not be foregone upon
interest payments to foreign persons merely because the individual also earned substantial
foreign source income.

Furthermore, Congress believed that where it was desirable to provide a U.S. tax exemption
for specific classes of income, it should generally be done directly rather than through
modifications to the source rules. Congress, therefore, granted overt exemptions for appropriate
classes of income earned by foreign persons in lieu of the de facto exemptions provided under
prior law through the source rules.
Explanation of Provision

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 The Act repeals prior law as it applied to dividends paid by an 80/20 company (other than
dividends paid by a possessions corporation) and treats dividends paid by U.S. corporations as
U.S. source. When dividends paid by U.S. corporations are received by foreign persons,
however, the Act provides a look-through rule in allowing an exemption from U.S. withholding
tax by basing the amount of exemption on the source of the income earned by the 80/20
company when the 80/20 company satisfies an active foreign business requirement (discussed
below). With respect to interest payments by an 80/20 company, the Act generally treats the
interest as U.S. source unless the 80/20 company satisfies the active foreign business
requirement (discussed below). If the active foreign business requirement is met, the Act treats
interest paid by an 80/20 company as foreign source if the interest is paid to unrelated parties and
as having a prorated source based on the source of the income of the 80/20 company if the
interest is paid to related parties.

The active foreign business requirement is satisfied if at least 80 percent of the U.S.
corporation's gross income for the 3-year period preceding the year of the payment is derived
from foreign sources and is attributable to the active conduct of a trade or business in one or
more foreign jurisdictions (or U.S. possessions). If this requirement is satisfied, dividends paid
by a U.S. corporation to foreign shareholders of the U.S. corporation, though treated as U.S.
source, are subject to U.S. withholding tax only on the fraction of the dividends paid by that
corporation that the corporation's U.S. source gross income bears to the corporation's total gross
income measured over the 3-year period preceding the year of payment. Interest received from a
U.S. corporation that meets the above-described 80-percent active foreign business requirement
is foreign source (and therefore exempt from U.S. withholding tax in the case of foreign
recipients), as follows: unrelated recipients (U.S. or foreign) treat the entire interest payment as
foreign source; related recipients treat as U.S. source a percentage of the interest equal to the
ratio of the corporation's U.S. source gross income to the corporation's total gross income
(measured over the 3-year period preceding the year of payment). The Act provides similar rules
for interest paid by resident alien individuals engaged in active foreign businesses in one or more
foreign jurisdictions.

The Act provides that the 80-percent active foreign business requirement may be met by the
U.S. corporation alone or, instead, may be met by a group including domestic or foreign
subsidiaries in which the U.S. corporation owns a controlling interest (Congress intended that at
least a 50-percent ownership interest be required for a subsidiary's business to be attributed to a
U.S. shareholder). In allowing attribution of a subsidiary's active foreign business to a
controlling corporate shareholder, Congress intended that the character (i.e., active foreign
business income) of the subsidiary's gross income be attributed to the corporate shareholder only
on the actual receipt of income from the subsidiary, for example, dividends, interest, rents, or
royalties, for the purpose of determining the percentage of dividends paid by the shareholder that
are subject to U.S. withholding tax. Thus, for example, dividends received by a corporate
shareholder from controlled U.S. subsidiaries, though treated as U.S. source by the Act, are to be
characterized as active foreign business income for the purpose of this look-through rule in the
same proportion that the controlled subsidiaries, active foreign business income bears to their
total gross income. With respect to other items of income received from controlled subsidiaries,
those amounts shall be characterized as active foreign business income to the extent they are

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allocated against active foreign business income of the payor (i.e., this characterization follows
the principles of the look-through rules of the foreign tax credit, new Code sec. 904(d)(3)(C)).

The Act's provisions can be illustrated by the following example. Assume that a U.S.
corporation and an unrelated foreign corporation jointly incorporate a second U.S. corporation to
operate a mining business in a foreign country. The second U.S. corporation earns $450 of
income, all of which is foreign source, from the mining operation in its first year and $50 of U.S.
source income from investments in the United States. At the end of the year, the second
corporation distributes a $100 dividend to each of its two shareholders. The first U.S. corporation
in turn distributes $50 to its shareholders, all of whom are foreign residents. The Act treats the
$100 dividend to the first U.S. corporation as entirely U.S. source; the $100 dividend to the
foreign shareholder is treated as U.S. source but 90 percent of the dividend is exempted from
U.S. withholding tax. Since the first U.S. corporation owns a 50 percent interest in the second
U.S. corporation and the first U.S. corporation received a dividend from the second U.S.
corporation, the second U.S. corporation's active foreign business is attributed to the first U.S.
corporation; therefore, assuming that the first U.S. corporation has no other income, the first U.S.
corporation satisfies
940

the 80-percent active foreign business requirement. Even though it is treated as U.S. source, the
dividend from the second U.S. corporation retains the same character as the second U.S.
corporation's income in determining the amount of dividends paid by the first U.S. corporation
that is subject to U.S. withholding tax. Accordingly, since the first U.S. corporation has no other
income, 90 percent of the first U.S. corporation's dividends paid to its shareholders are exempt
from U.S. withholding tax and 10 percent are subject to U.S. withholding tax. If, however, for
example, the first U.S. corporation had $13 or more of income that is not active foreign business
income in that year, the first U.S. corporation would not satisfy the 80-percent active foreign
business requirement and all of its dividends would, therefore, be subject to U.S. withholding
tax. The fact that the first U.S. corporation is able to claim an 80-percent dividends received
deduction on the dividend received from the second U.S. corporation is of no relevance in
determining whether the first U.S. corporation satisfies the active foreign business requirement.

In determining whether interest recipients are related persons (for purposes of looking
through to the amount of U.S. source income of the payor), the Act defines a related person as
any individual, corporation, partnership, trust, or estate which owns a 10-percent interest in the
payor, or in which the payor owns a 10-percent interest, as well as any person who holds a 10-
percent interest in a corporation, partnership, trust, or estate which is owned by the same persons
that own a 10-percent interest in the payor.

The Act's source rules apply before the application of the resourcing rules enacted in the Tax
Reform Act of 1984. If a greater amount is treated as U.S. source under those provisions,
however, such amount is to be treated as U.S. source (but only for foreign tax credit limitation
purposes).

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 Prior law effectively exempted certain income paid by U.S. persons to foreign persons from
U.S. withholding tax by treating the income as foreign source income. Under the Act, the income
is treated as U.S. source, but the exemption from U.S. withholding tax is made explicit. The
interest affected includes interest on deposits with persons carrying on the banking business,
interest on deposits or withdrawable accounts with a Federal or State chartered savings
institution as long as such interest is a deductible expense to the savings institution under section
591, and interest on amounts held by an insurance company under an agreement to pay interest
thereon, but, in each case, only if such interest is not effectively connected with the conduct of a
trade or business within the United States by the recipient of the interest. The Act also makes an
explicit exemption from U.S. withholding tax for income derived by a foreign central bank of
issue from bankers' acceptances. By treating the interest on deposits as U.S. source, Congress did
not intend that the principal amounts which generate the income be includible in a foreign
person's estate.7
7
A technical correction may be needed so that the statute reflects this intent.

941

Effective Date

The provision is generally effective for dividends and interest paid in taxable years beginning
after December 31, 1986.

The provision is not effective for interest paid on debt obligations held on December 31,
1985, unless the interest is paid pursuant to an extension or renewal of that obligation agreed to
after December 31, 1985. In the case of interest paid to a related person that benefits from this
grandfather rule, the payments are treated as payments from a controlled foreign corporation for
foreign tax edit purposes. As such, they retain their character and source.

In addition, the Act provides a transition rule for all 80/20 companies. Under this rule, in
determining the amount of dividends paid to foreign shareholders and interest paid to related
persons in 1987 that is subject to U.S. withholding tax, a calendar year company which would
have been an 80/20 company under prior law (using the base period 1984, 1985, and 1986) may
use the prior law rules in computing the portion of dividends paid to foreign share holders in
1987 which is subject to U.S. withholding tax and the portion of interest paid to related payees in
1987 which is U.S. source and subject to U.S. withholding tax. Interest paid to unrelated persons
in 1987 is foreign source if paid by a corporation that is an 80/20 company under prior law. The
Act provides that, for 1988 and subsequent years, the amounts of dividends and interest that are
U.S. source and subject to U.S. withholding tax under the Act are determined by the payor's
income measured over a base period beginning in 1987. Similar rules apply to 80/20 individuals
(as defined under prior law).

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 For dividends paid by a certain 80/20 company, the provision is not effective until January 1,
1991, for dividends paid on stock outstanding on May 31, 1985.
Revenue Effect

The provision is estimated to increase fiscal year budget receipts by less than $5 million
annually.
Worksheet 2
Staff of the Joint Committee on Taxation, Description of the Technical Corrections
Act of 1988, 101st Cong., (H.R. 4333 and S. 2238), 245-66 (1988) (Excerpts on
Source Rules).
(245)

B. Source Rules

1. Determination of source in case of sales of personal property (sec. 112(d) of the bill,
sec. 1211 of the Reform Act, and secs. 864 and 865 of the Code)
Present Law

Overview

Prior to the Act, the source of income derived from the sale of personal property generally
was determined by the place of sale (commonly referred to as the "title passage" rule). While the
Act did not change the place of sale rule for most inventory sales, the Act generally did replace
the place of sale rule for sales of other personal property with a residence of the seller rule.

Under the residence of the seller rule (new sec. 865), income de-rived by U.S. residents from
the sale of personal property, tangible or intangible, generally is sourced in the United States.
Similarly, income derived by a nonresident of the United States from the sale of personal
property, tangible or intangible, generally is treated as foreign source. For purposes of
determining source, the term sale does not include a sale of intangible property to the extent
payments received in consideration for the sale are contingent on the productivity, use, or other
disposition of the property. Payments that are so contingent are treated like royalties in
determining their source.
Definition of resident

The Act provided new definitions of a U.S. resident and nonresident for source rule purposes
(sec. 865) that differ somewhat from the existing resident alien definitions (see, e.g., sec.
7701(b)).

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 An individual is a resident of the United States for purposes of section 865 if the individual
has a tax home (as defined in sec. 911(d X 3)) in the United States. Any corporation, partnership,
trust, or estate which is a United States person (as defined in sec. 7701(a X 30)) is a U.S. resident
for this purpose. Other individuals and entities generally are nonresidents for purposes of these
source rules. A U.S. citizen or resident alien can be treated as a nonresident for purposes of these
source rules if he or she has a tax home outside the United States. The same individual can also
be treated as a nonresident if he or she has no tax home (a condition that might be possible, for
example, in the case of a traveling salesperson). This latter result may occur even if the
individual pays only a minimal foreign tax on income covered by these source rules.

Under the Act, regulations are to be prescribed by the Secretary carrying out the purposes of
the Act's source rule provisions. One area where it was contemplated that regulations may be
required is to prevent persons from establishing partnerships or corporations, for example, to
change their residence to take advantage of the new rules. It was anticipated that the
establishment of an anti- abuse rule to treat, for example, a foreign partnership as a U.S. resident
to the extent its partners are U.S. persons would be appropriate.

United States citizens and resident aliens who have tax homes outside the United States are
nevertheless considered U.S. residents in one case. This case occurs when income from a sale is
not subject to an effective foreign income tax of 10 percent or more. This level of tax rule
prevents U.S. citizens and resident aliens from generating zero or low-taxed foreign source
income that might otherwise escape all tax. As a consequence of retaining prior law's place of
sale rule for income derived from the sale of inventory and gain in excess of recapture derived
from the sale of depreciable personal property, the level of tax rule does not apply to sales of
these types of personal property but does apply to sales of all other types of personal property.
Exceptions to residence rate
Income derived from the sale of depreciable personal property

The residence of the seller rule does not apply to income derived from the sale of depreciable
personal property, to the extent of prior depreciation deductions. This income is sourced under a
re capture principle. Specifically, gain to the extent of prior depreciation deductions from the sale
of depreciable personal property is sourced in the United States if the depreciation deductions
giving rise to the gain were previously allocated against U.S. source income. If the deductions
giving rise to the gain were previously al-located against foreign source income, gain from the
sale (to the extent of prior deductions) is sourced foreign. If personal property is used
predominantly in the United States for any taxable year, the taxpayer is to treat the allowable
deductions for the year as being allocable entirely against U.S. source income. If personal
property is used predominantly outside the United States for any taxable year, the taxpayer is to
treat the allowable deductions for such year as being allocable entirely against foreign source
income. (This special predominant-use rule does not apply for certain personal property
generally used outside the United States, namely, personal property described in sec. 48(a)(2 X
B).) These rules apply without regard to the residence of the taxpayer.

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 297

 Depreciable personal property is any personal property if the adjusted basis of the property
includes depreciation adjustments. Thus, intangible property for which an amortization deduction
is allowable is considered depreciable personal property. With respect to sales of intangible
property, however, it is unclear under the Act whether the recapture rule applies to gain to the
extent of amortization recapture, and whether the general intangible rules or the place of sale rule
as retained under the Act applies to gain in excess of amortization recapture.
247

Income attributable to an office or other fixed place of business

The residence-of-the-seller rule does not apply to income derived from the sale of personal
property when the sale is attributable to an office or other fixed place of business outside the
seller's residence.

For U.S. residents, this office rule applies to certain income de rived from the sale of personal
property when the sale is attributable to an office or other fixed place of business maintained by
the taxpayer outside the United States but only if an effective foreign income tax of 10 percent or
more is paid to a foreign country on the income from the sale. It is unclear under the Act if the
office rule applies to income (in the form of noncontingent payments) de-rived from the sale of
intangible property by a U.S. resident when the sale is attributable to a fixed place of business in
a foreign country and the U.S. resident pays an income tax at an effective rate of 10 percent or
more.
Income derived from the sale of stock in foreign affiliates

The residence of the seller rule does not apply to income derived by U.S. corporations from
the sale of stock in certain foreign affiliates. If a. U.S. corporation sells stock of a foreign affiliate
in the foreign country in which the affiliate derived from the active con- duct of a trade or
business more than 50 percent of its gross income for the 3-year period ending with the close of
the affiliate's taxable year immediately preceding the year during which the sale occurs, any gain
from the sale is foreign source. An affiliate, for this purpose, is any foreign corporation whose
stock is at least 80 percent owned (by both voting power and value). It is unclear under the Act if
this rule applies only to gain from the sale of stock in corporations directly engaged in an active
trade or business or also ape plies to gain from the sale of stock in corporations indirectly
engaged in an active trade or business (for example, through a locally incorporated subsidiary).
Other riles -

Prior to the Act, foreign source income derived from the sale of inventory property by a
foreign person generally was treated as effectively connected with the conduct of a U.S. trade or
business if the sale was attributable to a U.S. office (or other fixed place of business) and sold
through the U.S. office. The Act repealed this rule but generally made income derived from the
sale of any personal property (including inventory property) by a nonresident (as defined in

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section 865 for personal property source rule purposes) U.S. source when the sale is attributable
to a U.S. office (or other fixed place of business). Because the Act also generally retains the
place of sale rule for sales of inventory property by residents (as de fined in section 865), the
repeal of the effectively connected rule would allow these residents who are treated for general
purposes (outside section 865) as nonresident aliens to avoid U.S. tax on income attributable to a
U.S. office by placing sales of inventory property outside the United States.
248

The Act's legislative history indicated that Congress intended that the Act's source rule
changes prevail over treaty source rules for foreign tax credit limitation purposes to the extent
necessary to insure that income not taxed by a foreign country not escape U.S. tax as well. This
policy was to apply to all the source rule changes in the Act, not just those applicable to personal
property. Although the Act and its legislative history did not specifically address cases where
some foreign tax may be paid on income treated as U.S. source under the Act, application of the
later-in-time principle would result in the Act's rules prevailing over any conflicting pro existing
treaty provisions.
Explanation of Provision

Definition of resident

The bill modifies the definition of resident for source rule purposes in the case of individuals
and partnerships. First, the bill treats any U.S. citizen or resident alien as a U.S. resident if he or
she does not have a tax home in a foreign country and, as under present law, it treats any
nonresident alien as a U.S. resident if he or she has a tax home in the United States. A U.S.
citizen or resident alien who has a tax home in a foreign country is treated as a nonresident for
source rule purposes as is a nonresident alien who does not have a tax home in the United States.

Second, whereas the Act generally determined the source of income derived from sales of
personal property by treating a partnership as a U.S. resident or nonresident based on its situs,
the bill makes these determinations at the partner level, except as provided in regulations. In
determining source, it is intended that, consistent with the attribution of a U.S. trade or business
under section 875, a U.S. office or other fixed place of business of the partnership will be
attributed to its partners.

The bill provides regulatory authority to determine source at the partnership level, for
example, in cases where it is not administratively possible to apply the rules at the partner level.
For example, it may be appropriate to determine source at the partnership level in the case of a
publicly traded partnership which has hundreds of partners.

The bill modifies the 10-percent tax payment requirement (applicable to U.S. citizens and
resident aliens maintaining tax homes in a foreign country) for bona fide residents of Puerto

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 299

Rico. The 10- percent tax payment requirement is waived for an individual who is a bona fide
resident of Puerto Rico for the entire taxable year on the sale of stock of a corporation which
(directly or indirectly) (1) is engaged in an active trade or business in Puerto Rico, and (2) de-
rives from the active conduct of a trade or business in Puerto Rico more than 50 percent of its
gross income for the 3 years preceding the year of sale. Under this rule, bona fide residents of
Puerto Rico who sell stock in certain corporations doing business in Puerto Rico generate Puerto
Rican source income and, thus, retain the benefits of section 933.

The bill provides the Internal Revenue Service with authority to waive the 10-percent tax
payment requirement by regulation for purposes of determining the source of income from any
other sales
249

of personal property by bona fide residents of Puerto Rico and for purposes of determining the
source of income from sales of person-al property by bona fide residents of Guam, American
Samoa, and the Northern Mariana Islands, thus preserving benefits otherwise available under
sections 931 and 933. Under this authority, for ex-ample, the Service may provide that in
appropriate circumstances, gross income of a U.S. citizen who is a bona fide resident of Puerto
Rico, Guam, American Samoa, or the Northern Mariana Islands does not include the individual's
otherwise untaxed (or low-taxed) income from sales of personal property in the possession.
However, it is intended that regulations promulgated under this authority provide the exception
only in the case where the possession has "delinked" from the mirror Code. Moreover, it is
intended that regulations limit the exception to bona fide residents of one of these possessions
and not to U.S. citizens or residents who may be only temporarily resident in the possession. For
this purpose, it is anticipated that rules analogous to the special tax rules for nonresident aliens
who are U.S. tax-avoidance expatriates (sec. 877), to the extent those provisions do not already
apply because of section 1277(e) of the 1986 Act (which extends sec. 877 to certain U.S. citizens
who move to certain territories), be applied.
Exceptions to residence rule
Income derived from the sale of intangibles

The bill clarifies that income to the extent of previously allowed amortization deductions
derived from the sale of amortizable intangible property is sourced under the Act's recapture rule.
The recapture rule applies whether or not the payments in consideration for the sale are
contingent on the productivity, use, or disposition of the property. For sales where the payments
are so contingent, it is intended that the source of all payments will be determined under the
recapture rule until the entire recapture amount has been r captured, and that any remaining
payments will be sourced under the general intangible rules.

The bill also clarifies that gain derived from the sale of intangible property in excess of
amortization recapture is sourced under the residence-of-the-seller rule when the payments in

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consideration for the sale are not contingent on the productivity, use, or disposition of the
property. When payments are so contingent, the source rule for royalties applies to the gain.
Income attributable to an office or other fixed place of business

The bill clarifies that the office rule as it applies to U.S. persons also applies to a sale of
intangible property when the payments in consideration for the sale are not contingent on the
productivity, use, or disposition of the property. Thus, a U.S. resident who sells intangible
property for noncontingent payments generates foreign source income as long as the sale is
attributable to a foreign office and an effective rate of foreign income tax of at least 10 percent is
paid on the income derived from the sale.

The bill provides the Internal Revenue Service regulatory authority to waive the office rule's
10-percent tax payment requirement for purpose of determining whether a domestic corporation
has sufficient possession-source income to be eligible for the possessions tax credit (sec. 936).

The bill also modifies the office rule to conform with the Act's source rules governing space
and ocean activities. This modification provides that the office rule applies to U.S. persons only
if they maintain an office in a foreign country, rather than outside the United States. The bill
makes similar conforming amendments to the Act's other source rule provisions.
Income derived from the sale of stock in foreign affiliates

The bill clarifies that income derived from the sale of stock of a foreign affiliate which
wholly owns another foreign corporation is treated as foreign source income in certain cases.
Upon an election by the U.S. resident, as long as either the parent or the subsidiary is engaged in
an active trade or business in the country in which the sale occurs and 50 percent of the gross
income of the holding company and the subsidiary combined for a three year period is de-rived
from the active conduct of a trade or business in that foreign country, then gain on the sale of
stock in the holding company will be treated as foreign source.
Other rules

The bill reinstates the provision repealed by the Act that treats foreign source income derived
from certain sales of inventory property by a foreign person as effectively connected with the
conduct of a U.S. trade or business. This provision is necessary to ensure that foreign persons
who have a substantial presence in the United States, who may be treated as U.S. residents for
source rule purposes but as nonresidents for general purposes, are taxed oil income derived from
sales of inventory property.

The bill codifies and expands upon the Act's legislative history by providing (in connection
with the changes to sec. 7852(d)) that the Act's source rule changes generally prevail over any

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conflicting treaty source rules under the general later-in-time rule. The bill does provide,
however, an exception to the general later-in-time rule. Under this exception, a taxpayer may
elect to apply treaty source rules to treat as foreign source any gain derived from the sale of stock
in a treaty country corporation or of an intangible which would otherwise be treated as U.S.
source under the Act. In this case, foreign taxes on that gain cannot offset U.S. tax on any other
item of income, and foreign taxes on any other item of income cannot offset U.S. tax on that
gain. For example, under the Act, gain from the sale of stock in a less than-80 percent owned
foreign corporation by a U.S. resident is U.S. source. A treaty may treat that income as foreign
source. Under the bill, that income is subject to U.S. tax as foreign source income, but the U.S.
resident may credit only foreign tax imposed on that income against the U.S. tax imposed on that
income.

The bill also makes clerical and conforming amendments.

251

2. Special rules for exemption from U.S. tax on U.S. source transportation income (sec.
112(e) of the bill, sec. 1212 of the Reform Act, and secs. 862, 872, 883, and 887 of the Code)
Present Law

The Code's reciprocal exemption provisions sometimes exempt foreign persons from U.S. tax
on U.S. source transportation income. Prior to the Act, the reciprocal exemption provisions
exempted foreign persons from U.S. tax on earnings derived from the operation of ships (or
aircraft) documented under the laws of a foreign country if that country exempted U.S. citizens
and domestic corporations from its tax. The Act modified these provisions to provide the
exemption from U.S. tax only to alien individuals who are residents of, and foreign corporations
organized in, a foreign country which grants U.S. citizens and domestic corporations an
equivalent exemption.

A foreign corporation, in addition to having to be organized in a country that grants U.S.

persons an equivalent exemption, must also satisfy a residence based requirement to obtain U.S.
tax ex-emption. Under the residence based requirement, the ultimate individual owners of more
than 50 percent of the value of the stock of the foreign corporation must be residents of a foreign
country that grants U.S. citizens and domestic corporations an equivalent ex-emption. Thus, it is
not enough for the foreign corporation to be organized in a foreign country which grants U.S.
citizens and domestic corporations an equivalent exemption: individuals ultimately owning most
of its stock must reside in such a country as well. Ultimate individual ownership is determined
by treating stock owned directly or indirectly by or for any entity (for example, a corporation,
partnership, or trust) as being actually owned by the stockholder (or partner, grantor, or
beneficiary, as the case may be) of that entity and by further attributing that ownership to its
owners if necessary to reach individual owners.

The residence-based requirement does not apply to any foreign corporation organized in a

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foreign country that exempts U.S. per-sons from its tax if the stock of the corporation is
primarily and regularly traded on an established securities market in that foreign country. This
publicly traded exception also covers a foreign corporation that is wholly owned by a second
corporation organized in the same country as the first foreign corporation if the stock of the
second foreign corporation is primarily and regularly traded on an established securities market
in that country.

The Act also enacted a gross basis tax on certain transportation income derived by foreign
persons. The tax was intended to apply to income the source of which was modified by the Act.
That is, the tax was intended to apply to transportation income derived by foreign persons that is
treated as 50 percent U.S. source under the Act. Moreover, it was intended that the income on
which the gross basis tax would be imposed would he the same income that would be eligible for
the reciprocal exemption.
252

Explanation of ProvIsion

The bill modifies the reciprocal exemption provisions so that they operate independently with
respect to nonresident alien individuals and foreign corporations. Thus, for a foreign corporation
to be exempt from U.S. tax, its country of organization need exempt only U.S. corporations from
that country's tax. In addition, the bill refines the reciprocal nature of the exemptions for
individuals, so that an exemption applies if the residence country of the individual grants an
equivalent exemption to individual residents of the United States. The foreign country need not,
for example, exempt transportation income of U.S. citizens who are not residents of the United
States. A foreign country that exempts transportation income of U.S. citizens shall be treated as
exempting U.S. residents for this purpose, however, so that individual residents of that foreign
country will qualify for U.S. tax exemption.

The bill also modifies the publicly traded exception to the residence based requirement.
Under the bill, a foreign corporation qualifies for the reciprocal exemption if it is organized in a
country which exempts U.S. corporations from that country's tax and the foreign corporation's
stock is primarily and regularly traded on an established securities market in that country,
another foreign country that grants U.S. corporations the appropriate exemption, or the United
States. In addition, if stock of one foreign corporation, organized in a country which exempts
U.S. corporations from that country's tax, is owned by a second, publicly traded corporation
organized in either the same foreign country, a second foreign country that exempts U.S.
corporations from that country's tax, or the United States, and the second corporation's stock is
primarily and regularly traded on an established securities market in its country of organization,
another foreign country that grants U.S. corporations the appropriate exemption, or the United
States, then the bill treats the stock of the first corporation as owned by individuals who are
resident in the country in which the second corporation (i.e., the shareholder) is organized.

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 As an example, assume four foreign corporations own all the stock of another foreign
corporation, all five corporations are organized in countries which exempt U.S. corporations
from their tax, and the stock of the first four corporations is primarily and regularly traded on
established securities markets in their respective countries. In this case, the stock of each of the
four corporations shall he treated as owned by individuals resident in the four corporations'
respective countries of organization. (The same conclusion would follow if the stock of one or
more of the first four corporations were primarily and regularly traded on an established U.S.
securities market, or on an established securities market in any foreign country that exempts U.S.
corporations from their tax.) Since more than 50 percent of the value of the stock of the fifth
corporation is considered owned by residents of countries which exempt U.S. persons from their
tax, the fifth corporation is eligible under the bill for the reciprocal exemption.

The bill also clarifies that the U.S. tax exemption applies to gross income derived from
international operations only, and not to gross income derived from U.S. operations. That is,
transportation
253

income that would be sourced entirely in the United States under section 863(c)(1) is not eligible
for the exemption. For example, if a cargo company that is organized in a foreign country that
grants U.S. corporations exemption from its tax transports cargo to one U.S. port, and picks up
additional cargo in that port for transport to a second U.S. port, then the income attributable to
the transportation of the cargo picked up at the first U.S. port and delivered to the second U.S.
port is not eligible for U.S. tax exemption. The income attributable to the transportation of the
cargo from the foreign country to the second U.S. port is eligible for U.S. tax exemption. (As
indicated in Part XII.H.1 below, if a U.S. income tax treaty provides different jurisdictional
provisions that conflict with the statutory provisions described above, the treaty will generally
prevail.)

The bill further clarifies that the transportation income on which the gross basis tax is
imposed is that income that is treated as 50 percent U.S. source by the Act. In addition, the bill
provides that under regulations transportation income on which the tax is imposed may be
reduced to correspond to income that is eligible for the reciprocal exemption.
3. Source rule for space and certain ocean activities (sec. 112(f) of the bill, sec. 1213 of
the Reform Act, and Sec. 863 of the Code)
Present Law

The Act enacted source rules for activities conducted in space, on oar beneath the ocean, and
on Antarctica. In defining the term space or ocean activity", the Act excluded an activity giving
rise to international communications income. The Act defined international communications
income to include all income derived from the transmission of communications or data from the
United States to any foreign country or from any foreign country to the United States. The Act

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did not define foreign country for this purpose.
Explanation of Provision

The bill modifies the definition of international communications income to include all
income derived from the transmission of communications or data from the United States to any
possession of the United States (and vice-versa) as well as to any foreign country.
4. Limitations on special treatment of 80/20 corporations (sec. 112(g) of the bill, sec.
1214 of the Reform Act, and secs. 861, 864, 907, 1442, and 2105 of the Code)
Present Law

Prior to the Act, a U.S. corporation's dividend and interest payments were foreign source and
not subject to U.S. withholding tax when at least 80 percent of the U.S. corporation's income
over the prior three years was from foreign sources (this type of corporation was commonly
referred to as an 80/20 company). The Act repealed prior law as it applied to dividends paid by
an 80/20 company (other than dividends paid by a possessions corporation) and treats dividends
paid by U.S. corporations as U.S. source. Dividends received by foreign persons from U.S.
corporations, though treated as U.S. source, receive look-through treatment for U.S. withholding
tax purposes when the corporation satisfies an active foreign business requirement. In such a
case, the amount of the withholding tax exemption is based on the source of the income earned
by the U.S. corporation. With respect to interest payments by a U.S. corporation, the Act
generally treats the interest as U.S. source unless the corporation satisfies the active foreign
business requirement. If the active foreign business requirement is met, the Act treats inter-est
paid by a U.S. corporation as foreign source if the interest is paid to an unrelated party' and as
having a prorated source based on the source of the payor s income if the interest is paid to a
related party.

The active foreign business requirement is satisfied if at least 80 percent of the U.S.
corporation's gross income for the 3-year period preceding the year of the payment is derived
from foreign sources and is attributable to the active conduct of a trade or business in one or
more foreign jurisdictions (or U.S. possessions).

The 80-percent active- foreign business requirement may be met by the U.. corporation alone
or, instead, may be met by a group including domestic or foreign subsidiaries in which the U.S.
corporation owns a controlling interest. It is intended that at least a 50- percent ownership
interest be required for a subsidiary's business to be attributed to a U.S. shareholder. In allowing
attribution of a subsidiary's active foreign business to a controlling corporate shareholder, the
character (i.e., active foreign business income) of the subsidiary's gross income is intended to be
attributed to the corporate shareholder only on the actual inclusion of income from the
subsidiary, for example, dividends, interest, rents, or royalties, and for the purpose of
determining the percentage of dividends paid by the shareholder that are subject to U.S.
withholding tax. Thus, for example, dividends received by a corporate shareholder from

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controlled U.S. subsidiaries, though treated as U.S. source in the hands of the corporate
shareholder, are to be characterized as active foreign business income for the purpose of this
look-through rule in the same proportion that the controlled subsidiaries' active foreign business
income bears to their total income. With respect to other items of income received from
controlled subsidiaries, those amounts are to be characterized as active foreign business income
to the extent they are allocated against active foreign business income of the payor.

Prior to the Act, certain income paid by U.S. persons to foreign persons was effectively
exempted from U.S. withholding tax be-cause the income was treated as foreign source income.
Under the Act, the income is treated as U.S. source, but the exemption from U.S. withholding tax
is made explicit. The interest affected includes interest on deposits with persons carrying on the
banking business, interest on deposits or withdrawable accounts with a Federal or State chartered
savings institution as long as such interest is a deductible expense to the savings institution under
section 591, and interest on amounts held by an insurance company under an agreement to pay
interest thereon, but, in each case, only if such interest is not effectively connected with the
conduct of a trade or business within the United States by the recipient of the interest.
255

The Act also made an explicit exemption from U.S. withholding tax for income derived by a
foreign central bank of issue from bankers' acceptances. By treating the interest on deposits as
U.S. source, it -is not intended that the principal amounts which generate the income be
includible in a foreign person's estate.
Explanation of Provision

The bill clarifies that, for purposes of attributing a lower-tier corporation's active foreign
business income to an upper-tier U.S. corporation, the upper-tier corporation must own directly
or indirectly at least 50 percent of both the voting power and value of the stock of the lower-tier
corporation.

The bill also clarifies that, for purposes of attributing a lower- tier corporation's active
foreign business income to an upper-tier U.S. corporation, the source of the lower-tier
corporation's income, as well as its character, is attributed to the upper-tier corporation. Thus, for
example, if an upper-tier U.S. corporation receives a dividend from a qualifying lower-tier U.S.
corporation, the dividend shall, for purposes of determining whether any withholding tax will be
imposed on the upper-tier corporation's dividend distributions, be considered as having both the
character and the source of the lower-tier corporation's income. For foreign tax credit purposes,
the dividend from the lower-tier corporation is U.S. source, however.

The bill clarifies that the change in source for certain interest on deposits does not change its
treatment for estate tax purposes. Thus, for example, bank deposits the interest on which is not
effectively connected with a U.S. trade or business, though such interest is treated as U.S. source

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income, are not treated as property within the United States.

Further, the bill clarifies that the Act's provisions are generally effective for payments made
in taxable years of the payor beginning after December 31, 1986.

The bill also makes clerical and conforming amendments.

5. Rules for allocation of interest, etc., to foreign source income (sec. 112(h) of the bill,
sec. 1215 of the Reform Act, and sec. 864(e) of the Code)
Present Law

Basis of stock of nonaffiliated 10-percent owned corporations

When the tax book value method of expense apportionment is used, the Act provides a new
rule to allocate and apportion expenses on the basis of assets when the asset is stock in one of
certain corporations. If a 10-percent or more owned corporation is not included in the group
treated as one taxpayer, then, in general, the adjusted basis of the stock owned in such
corporation in the hands of a U.S. shareholder is increased by the amount of the earnings and
profits of the corporation attributable to that stock and accumulated during the period the
taxpayer held it. Earnings and prof-its are not limited to those accumulated in postenactment
years. (In general, two kinds of 10-percent owned corporations are not included in the
nontaxpayer group: foreign corporations, and U.S.
256

corporations that are more than 1- but less than 80-percent owned.) In the case of a deficit in
earnings and profits of the corporation that arose during the period when the U.S. shareholder
held the stock, that deficit reduces the adjusted basis of the asset in the hands of the shareholder.
In that case, however, the deficit cannot reduce the adjusted basis of the asset below zero.

Under prior law and under the Act, subpart F inclusions in-crease stock basis in but do not
decrease earnings and profits of a controlled foreign corporation (secs. 961 and 959). Congress
did not intend that the addition of such amounts to stock basis by virtue of a subpart F inclusion
(or another inclusion with an equivalent effect on basis) result in double counting.
Allocation of expenses to deductible dividends

The Act provides that for purposes of allocating or apportioning any deductible expense, any
taxexempt asset (and any income from such an asset) shall not be taken into account. A similar
rule applies in the case of any dividend from a U.S. corporation that is eligible under section 243
for the 80-percent dividends received deduction (but not in the case of a dividend from a U.S.
corporation that is eligible for the 100-percent dividends received deduction) and in the case of

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any dividend from a foreign corporation a fraction of which (that reflects its U.S. earnings) is
eligible under section 245(n) for an 80-percent dividends received deduction.
Treatment of bank holding companies and banks

While the Act generally requires an affiliated group to be treated as if all members of the
group were one taxpayer for purposes of allocating and apportioning interest expense, that
general rule does not apply to any financial institution (described in section 581 or 591) if the
business of the financial institution is predominantly with persons other than related persons or
their customers, and if the financial institution is required by State or Federal law to be operated
separately from any other entity which is not a financial institution. A bank to which this
exception applies is not treated as a member of the group for applying the Act's general
nontaxpayer rule for interest expense allocation and apportionment to other members of the
group; instead, that bank and all other banks in the group are to be treated as one taxpayer (rather
than each bank being treated as a separate taxpayer for this purpose).

Although treated separately from other group members for inter-est expense allocation, banks
were intended to be treated as part of the overall group that the Act treats as one taxpayer for
expenses other than interest.
Direct allocation of interest expense when deduction is denied

The Act provides that the Secretary is to prescribe such regulations as may be necessary or
appropriate to carry out the purposes of this section, including regulations providing for direct
allocation of-interest expense incurred to carry' out an integrated financial transaction to any
interest (or interest-type income) derived from such transaction.

In certain cases, the dividends received deduction is reduced in cases where portfolio stock is
debt financed (sec. 246A). In addition,
257

a life insurance company is allowed a dividends received deduction for its share of dividends
received, but this deduction is not allowed for the policyholders' share of dividends received.
Further, the reserve deduction and other deductible payments to policyholders of a life insurance
company are reduced by the policyholders' share of tax exempt interest. Moreover, in the case of
a property and casualty insurance company, 15 percent of the sum of tax exempt interest and the
deductible portion of dividends received reduces the deduction for losses incurred (sec. 832(b)
(4)).
Scope of expense allocation rules

For purposes of subchapter N of chapter 1 of the Code (secs. 861-999), except as provided in

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regulations, the Act provides a series of rules governing expense allocation and apportionment.
The intent of the grant of regulatory authority was to allow regulations to identify provisions of
this subchapter to which the new rules would not apply. The Act's rules literally apply for the
determination of taxable income from sources outside the United States. With one exception,
however, these rules were intended to apply for all determinations under subchapter N of chapter
1, whatever the source (U.S. or foreign) of the income against which expenses are allocated. The
exception relates to the possessions tax credit: Congress did not intend that new section 864(e)(1)
apply for purposes of computations under section 936(h)
Transition rules

The Act provides a number of transition rules designed to phase in the application of the new
expense allocation rules insofar as they relate to interest expenses.
Explanation of Provisions

Basis of stock of nonaffiliated 10-percent owned corporations

The bill clarifies the Act's rule governing the allocation and apportionment of expenses when
the tax book value method is used and the asset at issue is stock in one of certain corporations.
The adjusted basis of any stock in a nonaffiliated 10-percent owned corporation is increased by
the amount of earnings and profits of that corporation attributable to that stock and accumulated
during the period the taxpayer held the stock, or reduced, but not below zero, by any deficits in
earnings and profits in that corporation attributable to that stock for that period. For this purpose,
a "nonaffiliated 10-percent owned corporation" is one that is not included in the taxpayer's
affiliated group, and in which members of the affiliated group own 10 percent or more of the
voting power. The bill makes it clear that the adjustment to asset value on a look-through basis is
also applied to stock of foreign corporations that is not directly held by U.S. taxpayers but that is
indirectly 10-percent owned by U.S. taxpayers. Stock owned directly or indirectly by a
corporation, partnership, or trust is treated as being owned proportionately by its shareholders,
partners or beneficiaries. When a taxpayer is treated under this look-through rule as owning stock
in a lower-tier corporation, the adjustment to the basis of the upper-tier corporation in which the
taxpayer actually owns stock is to include an adjustment for the amount of the earnings and
profits (or deficit in earnings and profits) of the lower-tier corporation which were attributable to
the stock the taxpayer is treated as owning and to the period during which the taxpayer is treated
as owning that stock.

The bill provided that, for purposes of section 864(e), proper adjustment is to be made to the
earnings and profits of any corporation to take into account any earnings and profits included in
gross income under the subpart F current inclusion rules (or under any other provision) that are
reflected in the adjusted basis of the stock. Thus, a subpart F inclusion, which increases stock
basis but does not decrease earnings and profits of a controlled foreign corporation, is not to
result in double counting.
Allocation of expenses to deductible dividends

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 The bill makes it clear that to the extent any dividend benefits from the dividends received
deduction under section 243 (allowing an 80-percent dividends received deduction for certain
dividends from U.S. corporations) or section 245(a) (allowing an 80-percent dividends received
deduction for the U.S. source portion of certain dividends from foreign corporations), that
portion of the dividend is treated as tax exempt income for the purpose of the Act's expense
allocation rules and that portion of the related asset is treated as a tax exempt asset.
Treatment of bank holding companies and banks

The bill provides that, to the extent provided in regulations, a bank holding company (within
the meaning of section 2(a) of the Bank Holding Company Act of 1956), and any subsidiary of a
bank holding company (or of a financial institution described in section 581 or 591) that is
predominantly engaged (directly or indirectly) in the active conduct of a banking, financing, or
similar business, shall be treated as a financial institution for purposes of the exception that
applies in certain cases to financial institutions described in section 581 or 591. The bill also
makes it clear that any financial institution that is excluded from the general one-taxpayer group
and is included in a one-taxpayer group covering financial institutions is not so treated for
purposes of expenses other than interest. That is, financial institutions and all other affiliated
entities are treated as one taxpayer under the Act for expenses other than interest.
Direct allocation of interest expense when deduction is denied

The bill provides that the Secretary is to prescribe regulations for direct allocation of interest
expense in the case of indebtedness resulting in a disallowance under section 246A, which
reduces the dividends received deduction in cases where portfolio stock is debt financed. Thus,
to the extent that an interest deduction reduces the amount of the dividends received deduction,
the interest expense generating the loss of the dividends received deduction is to be treated as
directly allocable to the income resulting from the loss of the dividends received deduction.

The bill also provides that the Secretary is to prescribe regulations that make appropriate
adjustments in the application of the
259

rule that disregards tax-exempt assets and income derived therefrom in the case of an insurance
company.
Scope of expense allocation rules

The bill provides that new section 864(e) (relating to expense allocation) shall not apply for
purposes of any provision of subchapter N of chapter 1 of the Code (secs. 861-999) to the extent
the Secretary determines udder regulations that the application of this subsection for such

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purposes would not be appropriate. In a conform amendment, the bill deletes the provision for
exceptions to new section 864(e) in the introductory language to that subsection.

With one exception, the bill makes it clear that these rules apply for all determinations under
subchapter N of chapter 1, whatever the source of the income against which expenses are
allocated. The exception relates to the possessions tax credit: section 936(h) is to apply as if new
section 864(e)(1) had not been enacted.
Transition rules

The bill clarifies the operation of the Act's transition rules.

One set of the bill's provisions clarifies the Act's phase-in of the new rules governing interest
expense allocation generally. (This set of the bill's provisions does not affect the Act's phase-in of
the one-taxpayer rule of new Code Sec. 864(e)(1), which is described below.) These
clarifications, the bill's "general" phase-in provisions, apply to the aggregate amount of
indebtedness of the taxpayer outstanding on November 16, 1985. In the case of the first three
taxable years of the taxpayer beginning after December 31, 1986, the Act's amendments relating
to interest expense allocation (other than the one-taxpayer rule of view sec. 864(e)(1)) do not
apply to interest expenses paid or accrued by the taxpayer during the taxable year with respect to
an aggregate amount of indebtedness which does not exceed the general phase-in amount. Except
for certain reductions in indebtedness, the consequences of which are described below, the
general phase-in amount is the applicable percentage of the taxpayer's debt outstanding on
November 16, 1985. In the case of the first taxable year, the applicable percentage is 75; in the
case of the second tax taxable year, the applicable percentage is 50; in the base of the third
taxable year, the applicable percentage is 25.

The general phase-in amount eligible for relief for any period, however, is not to exceed the
lowest amount of indebtedness of the taxpayer outstanding as of the close of any preceding
month beginning after November 16, 1985. This limitation is designed to implement the Act's
intent to target transitional relief to corporate groups that had borrowed in reliance on prior law
and to deny transitional relief to the extent that the level of debt increases. To the extent provided
in regulations, the average amount of indebtedness outstanding during any month is to be used in
lieu of the amount outstanding as of the close of such month for this purpose. This grant of
regulatory authority is designed to allow the Internal Revenue Service to disallow transition
relief to taxpayers whose month-end debt levels are not representative of their monthly debt
levels generally. Reductions in debt as of a month's end are not to reduce phase-in relief for prior
months, however. For example, if a calendar year taxpayer's outstanding debt is $100 on
November 16,
260

1985 and at all times thereafter until December 1, 1987, at which time it pays off all its debt, the

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taxpayer is entitled to general phase-in treatment for interest on $75 during the first 11 months of
1987.

In addition, the bill's "special" phase-in rules clarify the Act's provisions that phase in the
one-taxpayer rule (new sec. 864(e)(1)). In the case of the taxpayer's first 5 taxable years
beginning after December 31, 1986, the Code's new one-taxpayer rule (sec. 864(e)(1)) is not to
apply to interest expenses paid or accrued by the taxpayer during the taxable year with respect to
an aggregate amount of indebtedness that does not exceed the special phase-in amount. The
special phase-in amount is generally the sum of three separate amounts: the general phase-in
amount, described above, the 5-year phase-in amount, and the 4-year phase-in amount. The
special phase-in amount, however, like the general phase-in amount, cannot exceed the lowest
amount of indebtedness of the taxpayer outstanding as of the close of any preceding month
beginning after November 16, 1985.

The 5-year phase-in amount is the lesser of two amounts. The first amount is an applicable
percentage of the "5-year base." The 5-year base is the excess (if any) of the amount of a
taxpayer's outstanding indebtedness on May 29, 1985, over the amount of the taxpayer's
outstanding indebtedness as of the close of December 31, 1983. For this purpose, however, the 5-
year base cannot exceed the aggregate amount of indebtedness of the taxpayer outstanding on
November 16, 1985. The applicable percentage, in each year, is the excess of the percentage
granted relief under the Act's 5-year phase-in over the percentage granted relief under the Act's
general (3-year) phase-in. In the case of the first taxable year beginning after December 31,
1986, the applicable percentage is 8-1/3 (83-1/3 -- 75); sin tee case of the second taxable year,
the applicable percentage 16-12/3 (66-2/3 -- 50); in the case of the third taxable year, the
applicable percentage 19 25 (50 -- 25); in the case of the fourth taxable year, the applicable
percentage is 33-1/3; and in the case of the fifth taxable year, the applicable percentage is 16-2/3.

The 5-year phase-in amount cannot exceed a second amount. That second amount, which is
in the nature of a limitation, caps the 5-year phase-in amount in cases where reductions of
indebtedness ("pay-downs") reduce the taxpayer's debt below the amount that would have been
eligible for 5-year relief had no paydown occurred. More specifically, the second amount is the
5-year base, reduced (but not below zero) by paydowns of debt, and then multiplied by a
percentage. The paydowns, that reduce the 5-year base for this purpose are defined as the excess
of the taxpayer's November 16, 1985 debt over the lowest amount of indebtedness of the
taxpayer outstanding as of the close of any preceding month beginning after November 16, 1985
(or to the extent provided in regulations, as under the general phase-in, the average amount of
indebtedness outstanding during any such month).

To compute this second amount, the (possibly reduced) 5-year base is multiplied by a
fraction the numerator of which is the applicable 5-year percentage (the excess of the 5-year
percentage under present law over the 3-year percentage), and the denominator of which is the
sum of the applicable percentage under the general (3-year) rule and the applicable percentage
under the 5-years rule. This second amount limits the 5-year base only in cases where paydowns
reduce the amount of the 5-year base be low the amount of relief that would be granted if no

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paydown had occurred. In the case of the first taxable year beginning after December 31, 1986,
this percentage is 10, i.e., 8-1/3 divided by the sum of 8-1/3 and 75; in the case of the second
taxable year, this percentage is 25, i.e., 16-2/3 divided by the sum of 50 and 16-2/3; in the case of
the third taxable year this percentage is 50, i.e., 25 divided by 50; in the case of the fourth
taxable year, this percentage is 100, i.e., 33-1/3 divided by 33-1/3; and in the case of the fifth
taxable year, this percentage is 100, i.e., 16-2/3 divided by 16-2/3.

This second amount preserves the full 5-year benefit in cases where the taxpayer's lowest
debt is equal to or greater than the product of the 5-year base (unreduced by paydowns) and Act's
5-year percentage. (The Act's 5-year percentage is restructured under the bill as the sum of two
applicable percentages: the applicable percentage for the purpose of the general (3-year) rule and
the add-in applicable percentage for the purpose of the 5-year rule.) If pay-downs have reduced
outstanding debt below the amounts that would have obtained full benefit under the 5-year rule
had no pay-downs occurred, this second amount reduces the 5-year benefit on a linear basis.

The 4-year phase-in amount is the lesser of two amounts. These amounts parallel the
principles set forth above in connection with the 5-year amounts. The first amount is the
applicable percentage of the "4-year base." The 4-year base is the excess (if any) of the amount
taxpayer's outstanding indebtedness on December 31, 1983, over the amount of the taxpayer's
outstanding indebtedness as of the close of December 31, 1982. For this purpose, however, the 4-
year base cannot exceed the excess of the aggregate amount of indebtedness of the taxpayer
outstanding on November 16, 1985 over the 5-year base. The applicable percentage, in each year,
is the excess of the percentage granted relief under the Act's 4-year phase-in over the percentage
granted relief under the Act's general (3-year) phase-in. In the case of the first taxable year
beginning after December 31, 1986, the applicable percentage is 5 (80 - 75); in the case of the
second taxable year, the applicable percentage is 10 (60 - 50); in the case of the third taxable
year, the applicable percentage is 15 (40 - 25); and in the case of the fourth taxable year, the
applicable percentage is 20.

The 4-year phase-in amount cannot exceed a second amount. That second amount is intended
to reduce the 4-year phase-in amount to the extent that paydowns reduce the taxpayer's debt
below the amount that would be eligible for 4-year relief had no paydown occurred. More
specifically, the second amount is the 4-year base, reduced (but not below zero) by certain
paydowns of debt, multiplied by a percentage. The paydowns that reduce the 4-year base for this
purpose are generally defined as the excess of the taxpayer's November 16, 1985, debt, over the
lowest amount of indebtedness of the taxpayer outstanding as of the close of any preceding
month beginning after November 16, 1985 (or to the extent provided in regulations, as under the
general phase-in, the average amount of indebtedness outstanding during any such month). This
262

paydown amount for 4-year purposes is reduced, but not below zero, by the amount of the 5-year
base.

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 For purposes of this second amount, the (possibly reduced) 4-year base is multiplied by a
fraction the numerator of which is the percentage added to general relief under the 4-year rule
and the denominator of which is the percentage granted relief after the application of both the 4-
year rule and the general (3-year) relief. In the case of the first taxable year beginning after
December 31, 1986, this percentage is 6.25, i.e., 5 divided by (5 + 75); in the case of the second
taxable year, this percentage is 16-2/3, i.e., 10 divided by 60; in the case of the third taxable year,
this percentage is 37.50, i.e., 15 divided by 40; and in the case of the fourth taxable year, this
percentage is 100, i.e., 20 divided by 20.

The bill provides that, to the extent possible, the general and special phase-in rules are to
apply to the same amount of indebtedness.

The bill clarifies that amounts eligible for relief under the Act's phase-in rules are determined
on the basis of indebtedness rather than interest expense. The bill is not intended to require that
specific interest expense be traced to specific indebtedness.

The following examples involve the application of the special phase-in rule for one-taxpayer
treatment and the general phase-in rule for the Act's other interest expense allocation rules.
Example 1

A U.S. parent company, a calendar year taxpayer, had outstanding third party interest-bearing
debt of $50 from 1980 until December 31, 1982. On July 1, 1983, the taxpayer's third party
interest-bearing debt increased to $70. On July 1, 1984, the taxpayer's third party interest-bearing
debt increased to $100. All this debt bore and bears annual interest at the same interest rate.

The U.S. parent corporation's third party debt is $100 on November 16, 1985, and at all
relevant times thereafter.

The general transition rule prevents application of any of the Act's interest expense allocation
rules (other than the one-taxpayer rule of sec. 864(e)(1)) to interest on 75 percent of $100, the
November 16, 1985 amount. That is, the new rules (other than the one-taxpayer rule of sec.
864(e)(1), discussed below) cannot apply to interest on $75 of debt. The bill's limitation on the
general phase-in amount does not affect this result because the taxpayer's debt level has not
dipped below the amount otherwise eligible for general phase-in treatment, i.e., $75.

The special phase-in rule, which governs the application of the one-taxpayer rule of section
864(e)(1), operates as follows. The special phase-in amount, that is, the amount eligible for
special phase-in treatment is the sum of the general phase-in amount (determined above to be
$75) and the 5- and 4-year amounts.

The 5-year phase-in amount is the lesser of two amounts. The first amount is the applicable

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percentage of the "5-year base." The 5-year base is $30, the excess of $100, the amount of the
taxpayer's outstanding indebtedness on May 29, 1985, over $70, the amount of the taxpayer's
outstanding indebtedness as of the close of December 31, 1983. The applicable percentage, in the
first taxable year
263

beginning after December 31, 1986, is 8-1/3. Thus, the first amount is $2.50, that is, 8-1/3
percent of $30.

The 5-year phase-in amount cannot exceed a second amount. In the case of the first taxable
year beginning after December 31, 1986, that second amount is the 5-year base, $30, unaffected
here by paydowns of debt since none have occurred, and then multiplied by 10 percent, i.e., 8-
1/3 divided by the sum of 8-1/3 and 75. Thus, the second amount is $3 ($30 multiplied by 10
percent).

In this case, the 5-year amount is thus $2.50, the lesser of $2.50 and $3.

The 4-year phase-in amount is the lesser of two amounts. The first amount is the applicable
percentage of the "4-year base." The 4-year base is $20, the excess of $70, the amount of the
taxpayer's outstanding indebtedness on December 31, 1983, over $50, the amount of the
taxpayer's outstanding indebtedness as of the close of December 31, 1982. The applicable
percentage, in the first taxable year beginning after December 31, 1986, is 5. Thus, the first
amount is $1, that is, 5 percent of $20.

The 4-year phase-in amount cannot exceed a second amount. In the case of the first taxable
year beginning after December 31, 1986, that second amount is the 4-year base, $20, unaffected
here by paydowns of debt since none have occurred, and then multiplied by 6.25 percent, i.e., 5
divided by the sum of 5 and 75. Thus, the second amount is $1.25 ($20 multiplied by 6.25
percent).

In this case, the 4-year amount is thus $1, the lesser of $1 and $1.25.

Thus, in this example, the amount of debt qualifying for relief from one-taxpayer treatment is
$78.50, which is the sum of $75, the general phase-in amount; $2.50, the 5-year phase-in
amount; and $1, the 4-year phase-in amount. In this example, then, since the indebtedness to
which the general phase-in applies is to be, to the extent possible, the same indebtedness to
which the special phase-in applies, interest expense on $75 of debt is to be allocated under old
law, interest expense on $3.50 of debt is to be allocated without use of the one-taxpayer rule but
with use of the Act's other rules governing interest allocation, and interest on $21.50 is to be
apportioned under the Act's new rules.

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 315

 Example 2

Assume the same facts as in the example above, except that the U.S. parent corporation's
third party debt is $100 on November 16, 1985, and until January 1, 1987, at which time it pays
its debt down to $85. Its debt remains $85 at all relevant times thereafter.

Again, the general transition rule prevents application of any of the Act's interest expense
allocation rules (other than the one-taxpayer rule of sec. 864(e)(1)) to interest on $75. That is, the
new rules (other than the one-taxpayer rule of sec. 864(e)(1), discussed below) cannot apply to
interest on $75 of debt. The bill's limitation on the general phase-in amount does not affect this
result because the taxpayer's lowest debt level, $85, has not dipped below the amount otherwise
eligible for general phase-in treatment, i.e., $75.

The special phase-in rule, which governs the application of the one-taxpayer rule of section
864(e)(1), operates as follows. The amount eligible for special phase-in treatment is the sum of
the
264

general phase-in amount (again determined above to be $75) and the 5- and 4-year amounts.

The 5-year phase-in amount is the lesser of two amounts. The first amount is again $2.50,
that is, 8-1/3 percent of $30.

The 5-year phase-in amount cannot exceed a second amount. In the case of the first taxable
year beginning after December 31, 1986, that second amount is the 5-year base, $30, reduced by
the $15 paydown of debt (representing the difference between the November 16, 1985, amount
and the $85 lowest monthly amount) to $15 and then multiplied by 10 percent. Thus, the second
amount is $1.50 ($15 multiplied by 10 percent).

In this case, the 5-year amount is thus $1.50, the lesser of $2.50 and $1.50.

The 4-year phase-in amount is again the lesser of two amounts. The first amount again is $1,
that is, 5 percent of $20.

The 4-year phase-in amount cannot exceed a second amount. In the case of the first taxable
year beginning after December 31, 1986, that second amount is the 4-year base, $20, subject to
reduction on account of the paydown of debt, multiplied by 6.25 percent. There is no reduction
on account of paydowns in this example, because the $15 paydown for 4-year purposes is
reduced, but not below zero, by the $30 amount of the 5-year base. Thus, the second amount is

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again $1.25 ($20 multiplied by 6.25 percent).

In this case, the 4-year amount is thus $1, the lesser of $1 and $1.25.

Thus, in this example, the amount of debt qualifying for relief from one-taxpayer treatment is
$77.50, which is the sum of $75, the general phase-in amount; $1.50, the 5-year phase-in
amount; and the 4-year phase-in amount. In this example, then, since the indebtedness to which
the general phase-in applies is to be, to the extent possible, the same indebtedness to which the
special phase-in applies, interest expense on $75 of debt is to be allocated under old law, interest
expense on $2.50 of debt is to be allocated without use of the one-taxpayer rule but with use of
the Act's other rules governing interest allocation, and interest on $22.50 is to be apportioned
under the Act's new rules.
Example 3

A third example examines the third taxable year beginning after 1986, the calendar year
1989. In this example, the facts are the same as in the first two examples, except that the
taxpayer paid its debt down to $80 on January 1, 1989. Its debt remains at $80 throughout 1989.

The general transition rule prevents application of any of the Act's interest expense allocation
rules (other than the one-taxpayer rule of sec. 864(e)(1)) to 25 percent of $100, the November
16, 1985 amount. That is, the new rules (other than the one-taxpayer rule of sec. 864(e)(1),
discussed below) cannot apply to interest on $25 of debt. The bill's limitation on the general
phase-in amount does not affect this result because the taxpayer's debt level has not dipped
below $25.

The special phase-in rule, which governs the application of the one taxpayer rule of section
864(e)(1), operates as follows. The amount eligible for special phase-in treatment is the sum of
the
265

general phase-in amount (determined above to be $25) and the 5- and 4-year amounts.

The 5-year phase-in amount is the lesser of two amounts. The first amount is the applicable
percentage (25) of the 5-year base ($30). Thus, the first amount is $7.50, that is, 25 percent of
$30.

The 5-year phase-in amount cannot exceed a second amount. In the case of the third taxable
year beginning after December 31, 1986, that second amount is $5 (the 5-year base, $30, reduced
by the $20 paydown) multiplied by 50 percent. Thus, the second amount is $5 ($10 multiplied by

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 317

50 percent).

In this case, the 5-year amount is thus $5, the lesser of $7.50 and $5.

The 4-year phase-in amount is the lesser of two amounts. The first amount is the applicable
percentage for the third taxable year beginning after 1986 of the 4-year base ($20). The
applicable percentage, in the third taxable year beginning after December 31, 1986, is 15. Thus,
the first amount is $3, that is, 15 percent of $20.

The 4-year phase-in amount cannot exceed a second amount. In the case of the third taxable
year beginning after December 31, 1986, that second amount is the 4-year base, $20, subject to
reduction on account of the paydown of debt, multiplied by 37.5 percent. There is no reduction
on account of paydowns in this example, because the $20 paydown for 4-year purposes is
reduced, but not below zero, by the $30 amount of the 5-year base. Thus, the second amount is
$7.50 ($20 multiplied by 37.5 percent).

In this case, the 4-year amount is thus $3, the lesser of $3 and 7.50.

Thus, in this example, the amount of debt qualifying for relief from one-taxpayer treatment is
$33, which is the sum of $25, the general phase-in amount; $5, the 5-year phase-in amount; and
$3, the 4-year phase-in amount. In this example, then, since the indebtedness to which the
general phase-in applies is to be, to the extent possible, the same indebtedness to which the
special phase-in applies, interest expense on $25 of debt is to be allocated under old law, interest
expense on $8 of debt is to be allocated without use of the one-taxpayer rule but with use of the
Act's other rules governing interest allocation, and interest on $67 is to be apportioned under the
Act's new rules.
Example 4

A U.S. parent company, a calendar year taxpayer, had no outstanding third party interest-
bearing debt until July 1, 1984, on which date the taxpayer's third party interest-bearing debt
became $100. All this debt bore and bears annual interest at the same interest rate.

The U.S. parent corporation's third party debt is $100 on November 16, 1985, and at all
relevant times thereafter until January 1, 1986, when it drops to $80. On January 1, 1987, the
U.S. parent corporation's third party debt increases to $85.

The general transition rule prevents application of any of the Act's interest expense allocation
rules (other than the one-taxpayer rule of sec. 864(e)(1)) to interest on 75 percent of $100, the
November 16, 1985 amount. That is, the new rules (other than the one-taxpayer rule of sec.
864(e)(1), discussed below) cannot apply to interest on $75 debt. The bill's limitation on the
general phase-in amount does not affect this result because the taxpayer's debt level has not

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 318

dipped below the amount otherwise eligible for general phase-in treatment, i.e., $75.

The special phase-in rule, which governs the application of the one-taxpayer rule of section
864(e)(1), operates as follows. The amount eligible for special phase-in treatment is the sum of
the general phase-in amount (determined above to be $75) and the 5-year amount, but subject on
these facts to a cap. (The 4-year amount is zero.

The 5-year phase-in amount is the lesser of two amounts. The first amount is the applicable
percentage of the "5-year base." The 5-year base is $100, the excess of $100, the amount of the
taxpayer's outstanding indebtedness on May 29, 1985, over $0, the amount of the taxpayer's
outstanding indebtedness as of the close of December 31, 1983. The applicable percentage, in the
first taxable year beginning after December 31, 1986, is 8-1/3. Thus, the first amount is $8.33,
that is, 8-1/3 percent of $100.

The 5-year phase-in amount cannot exceed a second amount. In the case of the first taxable
year beginning after December 31, 1986, that second amount is the 5-year base, $100, reduced
by the $20 paydown to $80, and then multiplied by 10 percent. Thus, the second amount is $8
($80 multiplied by 10 percent).

In this case, the 5-year amount is thus $8, the lesser of $8.33 and $8.

Before application of the cap to the special phase-in amount, the special phase-in amount is
$83, that is, the sum of $75 and $8. The special phase-in amount, however, cannot exceed $80,
the lowest amount of debt outstanding as of the close of any preceding month beginning after
November 16, 1985. Therefore, the amount of debt qualifying for relief from one-taxpayer
treatment is $80. In this example, then, since the indebtedness to which the general phase-in
applies is to be, to the extent possible, the same indebtedness to which the special phase-in
applies, interest expense on $75 of debt is to be allocated under old law, interest expense on $5 of
debt is to be allocated without use of the one-taxpayer rule but with use of the Act's other rules
governing interest allocation, and interest on $5 is to be apportioned under the Act's new rules.

The bill clarifies that for transition rule purposes, all members of an affiliated group of
corporations are to be treated as one corporation. Thus, the bill makes it clear that debt of all
members is to be aggregated in determining if a paydown that reduces phase-in benefits has
occurred. Similarly, the bill makes it clear that interest on interaffiliate debt is not eligible for
transition relief.

Finally, in view of the relative complexity of these transition rules, the bill allows taxpayers
to elect out of their application in prescribed circumstances.
Worksheet 3
The Uniform Commercial Code (Excerpts from Article 2).

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Copyright 1990 by The American Law Institute and the National Conference of
Commissioners on Uniform State Laws. Reprinted with the permission of the
Permanent Editorial Board for the Uniform Commercial Code.
Section 2-105. Definitions: Transferability; "Goods"; "Future" Goods; "Lot";
"Commercial Unit".

(1) "Goods" means all things (including specially manufactured goods) which are movable at
the time of identification to the contract for sale other than the money in which the price is to be
paid, investment securities (Article 8) and things in action. "Goods" also includes the unborn
young of animals and growing crops and other identified things attached to realty as described in
the section on goods to be severed from realty (Section 2-107).

(2) Goods must be both existing and identified before any interest in them can pass. Goods
which are not both existing and identified are "future" goods. A purported present sale of future
goods or of any interest therein operates as a contract to sell.

(3) There may be a sale of a part interest in existing identified goods.

(4) An undivided share in an identified bulk of fungible goods is sufficiently identified to be

sold although the quantity of the bulk is not determined. Any agreed proportion of such bulk or
any quantity thereof agreed upon by number, weight or other measure may to the extent of the
seller's interest in the bulk be sold to the buyer who then becomes an owner in common.

(5) "Lot" means a parcel or a single article which is the subject matter of a separate sale or
delivery, whether or not it is sufficient to perform the contract.

(6) "Commercial unit" means such a unit of goods as by commercial usage as a single whole
for purposes of sale and division of which materially impairs its character or value on the market
or in use. A commercial unit may be a single article (as a machine) or a set of articles (as a suite
of furniture or an assortment of sizes) or a quantity (as a bale, gross, or carload) or any other unit
treated in use or in the relevant market as a single whole.
Section 2-319. F.O.B. and F.A.S. Terms.

(1) Unless otherwise agreed the term F.O.B. (which means "free on board") at a named place,
even though used only in connection with the stated price, is a delivery term under which

(a) when the term is F.O.B. the place of shipment, the seller must at that place ship the goods
in the manner provided in this Article (Section 2-504) and bear the expense and risk of

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 putting them into the possession of the carrier; or

(b) when the term is F.O.B. the place of destination, the seller must at his own expense and
risk transport the goods to that place and there tender delivery of them in the manner
provided in this Article (Section 2-503);

(c) when under either (a) or (b) the term is also F.O.B. vessel, car or other vehicle, the seller
must in addition at his own expense and risk load the goods on board. If the term is F.O.B.
vessel the buyer must name the vessel and in an appropriate case the seller must comply with
the provisions of this Article on the form of bill of lading (Section 2-323).

(2) Unless otherwise agreed the term F.A.S. vessel (which means "free alongside") at a
named port, even though used only in connection with the stated price, is a delivery term under
which the seller must

(a) at his own expense and risk deliver the goods alongside the vessel in the manner usual in
that port or on a dock designated and provided by the buyer; and

(b) obtain and tender a receipt for the goods in exchange for which the carrier is under a duty
to issue a bill of lading.

(3) Unless otherwise agreed in any case falling within subsection (1)(a) or (c) or subsection
(2) the buyer must seasonally give any needed instructions for making delivery, including when
the term is F.A.S. or F.O.B. the loading berth of the vessel and in an appropriate case its name
and sailing date. The seller may treat the failure of needed instructions as a failure of cooperation
under this Article (Section 2-311). He may also as his option move the goods in any reasonable
manner preparatory to delivery or shipment.

(4) Under the term F.O.B. vessel or F.A.S. unless otherwise agreed the buyer must make
payment against tender of the required documents and the seller may not tender nor the buyer
demand delivery of the goods in substitution for the documents.
Section 2-320. C.I.F. and C. & F. Terms.

(1) The term C.I.F. means that the price includes in a lump sum the cost of the goods and the
insurance and freight to the named destination. The term C. & F. or C.F. means that the price so
includes cost and freight to the named destination.

(2) Unless otherwise agreed and even though used only in connection with the stated price
and destination, the term C.I.F. destination or its equivalent requires the seller at his own expense
and risk to

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 321

 (a) put the goods into the possession of a carrier at the port for shipment and obtain a
negotiable bill or bills of lading covering the entire transportation to the named destination;
and

(b) load the goods and obtain a receipt from the carrier (which may be contained in the bill of
lading) showing that the freight has been paid or provided for; and

(c) obtain a policy or certificate of insurance, including any war risk insurance, of a kind and
on terms then current at the port of shipment in the usual amount, in the currency of the
contract, shown to cover the same goods covered by the bill of lading and providing for
payment of loss to the order of the buyer or for the account of whom it may concern; but the
seller may add to the price the amount of the premium for any such war risk insurance; and

(d) prepare an invoice of the goods and procure any other documents required to effect
shipment or to comply with the contract; and

(e) forward and tender with commercial promptness all the documents in due form and with
any indorsement necessary to perfect the buyer's rights.

(3) Unless otherwise agreed the term C. & F. or its equivalent has the same effect and
imposes upon the seller the same obligations and risks as a C.I.F. term except the obligation as to
insurance.

(4) Under the term C.I.F. or C. & F. unless otherwise agreed the buyer must make payment
against tender of the required documents and the seller may not tender nor the buyer demand
delivery of the goods in substitution for the documents
Part 4

TITLE, CREDITORS AND GOOD FAITH PURCHASERS

Section 2-401. Passing of Title; Reservation for Security; Limited Application of This
Section.

Each provision of this Article with regard to the rights, obligations and remedies of the seller,
the buyer, purchasers or other third parties applies irrespective of title to the goods except where
the provision refers to such title, Insofar as situations are not covered by the other provisions of
this Article and matters concerning title become material the following rules apply:

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 322

 (1) Title to goods cannot pass under a contract for sale prior to their identification to the
contract (Section 2-501), and unless otherwise explicitly agreed the buyer acquires by their
identification a special property as limited by this Act. Any retention or reservation by the seller
of the title (property) in goods shipped or delivered to the buyer is limited in effect to a
reservation of a security interest. Subject to these provisions and to the provisions of the Article
on Secured Transactions (Article 9), title to goods passes from the seller to the buyer in any
manner and on any conditions explicitly agreed on by the parties.

(2) Unless otherwise explicitly agreed title passes to the buyer at the time and place at which
the seller completes his performance with reference to the physical delivery of the goods, despite
any reservation of a security interest and even though a document of title is to be delivered at a
different time or place; and in particular and despite any reservation of a security interest by the
bill of lading

(a) if the contract requires or authorizes the seller to send the goods to the buyer but does not
require him to deliver them at destination, title passes to the buyer at the time and place of
shipment; but

(b) if the contract requires delivery at destination, title passes on tender there.

(3) Unless otherwise explicitly agreed where delivery is to be made without moving the
goods,

(a) if the seller is to deliver a document of title, title passes at the time when and the place
where he delivers such documents; or

(b) if the goods are at the time of contracting already identified and no documents are to be
delivered, title passes at the time and place of contracting.

(4) A rejection or other refusal by the buyer to receive or retain the goods, whether or not
justified, or a justified revocation of acceptance revests title to the goods in the seller. Such
revesting occurs by operation of law and is not a "sale".
Part 5

PERFORMANCE

Section 2-501. Insurable Interest in Goods; Manner of Identification of Goods.

(1) The buyer obtains a special property and an insurable interest in goods by identification
of existing goods as goods to which the contract refers even though the goods so identified are

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non-conforming and he has an option to return or reject them. Such identification can be made at
any time and in any manner explicitly agreed to by the parties. In the absence of explicit
agreement identification occurs

(a) when the contract is made if it is for the sale of goods already existing and identified;

(b) if the contract is for the sale of future goods other than those described in paragraph (c),
when goods are shipped, marked or otherwise designated by the seller as goods to which the
contract refers;

(c) when the crops are planted or otherwise become growing crops or the young are
conceived if the contract is for the sale of unborn young to be born within twelve months
after contracting or for the sale of crops to be harvested within twelve months or the next
normal harvest reason after contracting whichever is longer.

(2) The seller retains an insurable interest in goods so long as title to or any security interest
in the goods remains in him and where the identification is by the seller alone he may until
default or insolvency or notification to the buyer that the identification is final substitute other
gods for those identified.

(3) Nothing in this section impairs any insurable interest recognized under any other statute
or rule of law.
Section 2-509. Risk of Loss in the Absence of Breach.

(1) Where the contract requires or authorizes the seller to ship the goods by carrier

(a) if it does not require him to deliver them at a particular destination, the risk of loss passes
to the buyer when the goods are duly delivered to the carrier even though the shipment is
under reservation (Section 2-505); but

(b) if it does require him to deliver them at a particular destination and the goods are there
duly tendered while in the possession of the carrier, the risk of loss passes to the buyer when
the goods are there duly so tendered as to enable the buyer to take delivery.

(2) Where the goods are held by a bailee to be delivered without being moved, the risk of loss
passes to the buyer

(a) on his receipt of a negotiable document of title covering the goods; or

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 (b) on acknowledgment by the bailee of the buyer's right to possession of goods; or

(c) after his receipt of a non-negotiable document of title or other written direction to deliver,
as provided in subsection (4)(b) of Section 2-503.

(3) In any case not within subsection (1) or (2), the risk of loss passes to the buyer on his
receipt of the goods if the seller is a merchant; otherwise the risk passes to the buyer on tender of
delivery.

(4) The provisions of this section are subject to contrary agreement of the parties and to the
provisions of this Article on sale on approval (Section 2-327) and on effect of breach on risk of
loss (Section 2-510).
Worksheet 4
Sample Title Retention and Title Transfer Clauses.
A. Title Retention Clauses

Taxpayers exporting goods from the United States normally would prefer to pass title abroad
for U.S. tax purposes, in order to achieve foreign source sales income. See VII, B, 1, a, of the
Detailed Analysis.

Examples of clauses retaining title until arrival in the foreign destination are as follows:

1. If the sale is "F.O.B., [destination port]," the following provision could be included in the
relevant sales documents:

Title to the goods [, responsibility for their shipment and risk of loss]1 shall be in the seller
until delivery of the goods to the buyer in [destination port].
1
The bracketed language is not necessary if the shipping term is used in its conventional sense,
but may prove helpful. Of course, this language must be consistent with the business objectives of
the parties.

2. An "Ex-Ships Tackle, [destination port]" sale could include the following language in the
sales documents:

Title to the goods [, responsibility for their shipment and risk of loss]2 shall be in the seller
until arrival of [vessel] in [destination port].
2
Id.

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 3. If the sale is "C.I.F.," the following provision should be effective to retain title
notwithstanding the contrary presumption conveyed by the C.I.F. term:

Title to the goods, responsibility for their shipment and risk of loss shall be in [the seller]
until their delivery to the buyer in [destination port.]3
3
This provision is similar to that upheld by the Court of Claims in A.P. Green Export Company
v. U.S., 284 F.2d 383 (Ct. Cl. 1960).

4. If conventional shipping terms such as "F.O.B.," "C.I.F.," etc., are not contained in the
contract, the following clause could be used:

Title to the goods, responsibility for their shipment and risk of loss shall be in the seller until
delivery of the goods to the buyer in [foreign port].4
4
See Rev. Rul. 74-249, 1974-1 C.B. 189 (written agreement of seller to retain title to the goods,
responsibility for shipment, and risk of loss was effective to defer the time of sale even though the
sale was by straight bill of lading naming the customer as consignee).

B. Title Transfer Clauses

Taxpayers selling goods into the U.S. from abroad also often prefer to pass title abroad for
U.S. tax purposes in order to achieve foreign source sales income. (This would be the case if the
seller is a U.S. person, as in Liggett Group Inc. v. Comr.,5 or if the seller is a foreign person and
the sales are not attributable to a U.S. office or other fixed place of business but the foreign
person cannot rely on the permanent establishment rules of an income tax treaty with the U.S.)
Examples of clauses under which title would be transferred at the foreign place of shipment are
as follows:
5
58 T.C.M. 1167 (1992), discussed in VII, B, 1, a, (1) of the Detailed Analysis.

1. If the sale is "F.O.B., [place of shipment]," the following provision could be included in
the relevant sales documents:

Title to the goods, responsibility for their shipment and risk of loss shall pass to the buyer
upon delivery of the goods to the shipper at [place of shipment].

2. If the sale is "C.I.F.," the following provision could be included in the relevant sales
documents:

Title to the goods and risk of loss shall pass to the buyer upon delivery of the goods to [the
shipper] at [foreign place of shipment], provided, however, that the seller shall bear the costs
of [insurance and freight].

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 3. If the sale is "C. & F.," the following provision could be included in the relevant sales
documents:

Title to the goods and risk of loss shall pass to the buyer upon delivery of the goods to [the
shipper] at [place of shipment], provided, however, that the seller shall bear the costs of
[freight].
Worksheet 5
United Nations Convention on Contracts for the International Sale of Goods.
(April 11, 1980)

PART I

SPHERE OF APPLICATION AND GENERAL PROVISIONS

Chapter I

SPHERE OF APPLICATION

Article 1

(1) This Convention applies to contracts of sale of goods between parties whose places of
business are in different States:

(a) when the States are Contracting States; or

(b) when the rules of private international law lead to the application of the law of a
Contracting State.

(2) The fact that the parties have their places of business in different States is to be
disregarded whenever this fact does not appear either from the contract or from any dealings
between, or from information disclosed by, the parties at any time before or at the conclusion of
the contract.

(3) Neither the nationality of the parties nor the civil or commercial character of the parties or
of the contract is to be taken into consideration in determining the application of this Convention.
Article 2

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 This Convention does not apply to sales:

(a) of goods bought for personal, family or household use, unless the seller, at any time
before or at the conclusion of the contract, neither knew nor ought to have known that the
goods were bought for any such use;

(b) by auction;

(c) on execution or otherwise by authority of law;

(d) of stocks, shares, investment securities, negotiable instruments or money;

(e) of ships, vessels, hovercraft or aircraft;

(f) of electricity.
Article 3

(1) Contracts for the supply of goods to be manufactured or produced are to be considered
sales unless the party who orders the goods undertakes to supply a substantial part of the
materials necessary for such manufacture or production.

(2) This Convention does not apply to contracts in which the preponderant part of the
obligations of the party who furnishes the goods consists in the supply of labour or other
services.
Article 4

This Convention governs only the formation of the contract of sale and the rights and
obligations of the seller and the buyer arising from such a contract. In particular, except as
otherwise expressly provided in this Convention, it is not concerned with:

(a) the validity of the contract or of any of its provisions or of any usage;

(b) the effect which the contract may have on the property in the goods sold.
Article 5

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 This Convention does not apply to the liability of the seller for death or personal injury
caused by the goods to any person.
Article 6

The parties may exclude the application of this Convention or, subject to article 12, derogate
from or vary the effect of any of its provisions.
Chapter II

GENERAL PROVISIONS

Article 7

(1) In the interpretation of this Convention, regard is to be had to its international character
and to the need to promote uniformity in its application and the observance of good faith in
international trade.

(2) Questions concerning matters governed by this Convention which are not expressly
settled in it are to be settled in conformity with the general principles on which it is based or, in
the absence of such principles, in conformity with the law applicable by virtue of the rules of
private international law.
Article 8

(1) For the purposes of this Convention statements made by and other conduct of a party are
to be interpreted according to his intent where the other party knew or could not have been
unaware what that intent was.

(2) If the preceding paragraph is not applicable, statements made by and other conduct of a
party are to be interpreted according to the understanding that a reasonable person of the same
kind as the other party would have had in the same circumstances.

(3) In determining the intent of a party or the understanding a reasonable person would have
had, due consideration is to be given to all relevant circumstances of the case including the
negotiations, any practices which the parties have established between themselves, usages and
any subsequent conduct of the parties.
Article 9

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 (1) The parties are bound by any usage to which they have agreed and by any practices which
they have established between themselves.

(2) The parties are considered, unless otherwise agreed, to have impliedly made applicable to
their contract or its formation a usage of which the parties knew or ought to have known and
which in international trade is widely known to, and regularly observed by, parties to contracts of
the type involved in the particular trade concerned.
Article 10

For the purposes of this Convention:

(a) if a party has more than one place of business, the place of business is that which has the
closest relationship to the contract and its performance, having regard to the circumstances
known to or contemplated by the parties at any time before or at the conclusion of the
contract;

(b) if a party does not have a place of business, reference is to be made to his habitual
residence.
Article 11

A contract of sale need not be concluded in or evidenced by writing and is not subject to any
other requirement as to form. It may be proved by any means, including witnesses.
Article 12

Any provision of article 11, article 29 or Part II of this Convention that allows a contract of
sale or its modification or termination by agreement or any offer, acceptance or other indication
of intention to be made in any form other than in writing does not apply where any party has his
place of business in a Contracting State which has made a declaration under article 96 of this
Convention. The parties may not derogate from or vary the effect of this article.
Article 13

For the purposes of this Convention "writing" includes telegram and telex.
PART II

FORMATION OF THE CONTRACT

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 Article 14

(1) A proposal for concluding a contract addressed to one or more specific persons constitutes
an offer if it is sufficiently definite and indicates the intention of the offeror to be bound in case
of acceptance. A proposal is sufficiently definite if it indicates the goods and expressly or
implicitly fixes or makes provision for determining the quantity and the price.

(2) A proposal other than one addressed to one or more specific persons is to be considered
merely as an invitation to make offers, unless the contrary is clearly indicated by the person
making the proposal.
Article 15

(1) An offer becomes effective when it reaches the offeree.

(2) An offer, even if it is irrevocable, may be withdrawn if the withdrawal reaches the offeree
before or at the same time as the offer.
Article 16

(1) Until a contract is concluded an offer may be revoked if the revocation reaches the
offeree before he has dispatched an acceptance.

(2) However, an offer cannot be revoked:

(a) if it indicates, whether by stating a fixed time for acceptance or otherwise, that it is
irrevocable; or

(b) if it was reasonable for the offeree to rely on the offer as being irrevocable and the offeree
has acted in reliance on the offer.
Article 17

An offer, even if it is irrevocable, is terminated when a rejection reaches the offeror.

Article 18

(1) A statement made by or other conduct of the offeree indicating assent to an offer is an

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acceptance. Silence or inactivity does not in itself amount to acceptance.

(2) An acceptance of an offer becomes effective at the moment the indication of assent
reaches the offeror. An acceptance is not effective if the indication of assent does not reach the
offeror within the time he has fixed or, if no time is fixed, within a reasonable time, due account
being taken of the circumstances of the transaction, including the rapidity of the means of
communication employed by the offeror. An oral offer must be accepted immediately unless the
circumstances indicate otherwise.

(3) However, if, by virtue of the offer or as a result of practices which the parties have
established between themselves or of usage, the offeree may indicate assent by performing an
act, such as one relating to the dispatch of the goods or payment of the price, without notice to
the offeror, the acceptance is effective at the moment the act is performed, provided that the act is
performed within the period of time laid down in the preceding paragraph.
Article 19

(1) A reply to an offer which purports to be an acceptance but contains additions, limitations
or other modifications is a rejection of the offer and constitutes a counter-offer.

(2) However, a reply to an offer which purports to be an acceptance but contains additional or
different terms which do not materially alter the terms of the offer constitutes an acceptance,
unless the offeror, without undue delay, objects orally to the discrepancy or dispatches a notice to
that effect. If he does not so object, the terms of the contract are the terms of the offer with the
modifications contained in the acceptance.

(3) Additional or different terms relating, among other things, to the price, payment, quality
and quantity of the goods, place and time of delivery, extent of one party's liability to the other or
the settlement of disputes are considered to alter the terms of the offer materially.
Article 20

(1) A period of time for acceptance fixed by the offeror in a telegram or a letter begins to run
from the moment the telegram is handed in for dispatch or from the date shown on the letter or, if
no such date is shown, from the date shown on the envelope. A period of time for acceptance
fixed by the offeror by telephone, telex or other means of instantaneous communication, begins
to run from the moment that the offer reaches the offeree.

(2) Official holidays or non-business days occurring during the period for acceptance are
included in calculating the period. However, if a notice of acceptance cannot be delivered at the
address of the offeror on the last day of the period because that day falls on an official holiday or

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 332

a non-business day at the place of business of the offeror, the period is extended until the first
business day which follows.
Article 21

(1) A late acceptance is nevertheless effective as an acceptance if without delay the offeror
orally so informs the offeree or dispatches a notice to that effect.

(2) If a letter or other writing containing a late acceptance shows that it has been sent in such
circumstances that if its transmission had been normal it would have reached the offeror in due
time, the late acceptance is effective as an acceptance unless, without delay, the offeror orally
informs the offeree that he considers his offer as having lapsed or dispatches a notice to that
effect.
Article 22

An acceptance may be withdrawn if the withdrawal reaches the offeror before or at the same
time as the acceptance would have become effective.
Article 23

A contract is concluded at the moment when an acceptance of an offer becomes effective in

accordance with the provisions of this Convention.
Article 24

For the purposes of this Part of the Convention, an offer, declaration of acceptance or any
other indication of intention "reaches" the addressee when it is made orally to him or delivered
by any other means to him personally, to his place of business or mailing address or, if he does
not have a place of business or mailing address, to his habitual residence.
PART III

SALE OF GOODS

Chapter I

GENERAL PROVISIONS

Article 25

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 A breach of contract committed by one of the parties is fundamental if it results in such
detriment to the other party as substantially to deprive him of what he is entitled to expect under
the contract, unless the party in breach did not foresee and a reasonable person of the same kind
in the same circumstances would not have foreseen such a result.
Article 26

A declaration of avoidance of the contract is effective only if made by notice to the other
party.
Article 27

Unless otherwise expressly provided in this Part of the Convention, if any notice, request or
other communication is given or made by a party in accordance with this Part and by means
appropriate in the circumstances, a delay or error in the transmission of the communication or its
failure to arrive does not deprive that party of the right to rely on the communication.
Article 28

If, in accordance with the provisions of this Convention, one party is entitled to require
performance of any obligation by the other party, a court is not bound to enter a judgement for
specific performance unless the court would do so under its own law in respect of similar
contracts of sale not governed by this Convention.
Article 29

(1) A contract may be modified or terminated by the mere agreement of the parties.

(2) A contract in writing which contains a provision requiring any modification or

termination by agreement to be in writing may not be otherwise modified or terminated by
agreement. However, a party may be precluded by his conduct from asserting such a provision to
the extent that the other party has relied on that conduct.
Chapter II

OBLIGATIONS OF THE SELLER

Article 30

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 The seller must deliver the goods, hand over any documents relating to them and transfer the
property in the goods, as required by the contract and this Convention.
Section I. Delivery of the goods and handing over of documents

Article 31

If the seller is not bound to deliver the goods at any other particular place, his obligation to
deliver consists:

(a) if the contract of sale involves carriage of the goods - in handing the goods over to the
first carrier for transmission to the buyer;

(b) if, in cases not within the preceding subparagraph, the contract relates to specific goods,
or unidentified goods to be drawn from a specific stock or to be manufactured or produced,
and at the time of the conclusion of the contract the parties knew that the goods were at, or
were to be manufactured or produced at, a particular place - in placing the goods at the
buyer's disposal at that place;

(c) in other cases - in placing the goods at the buyer's disposal at the place where the seller
had his place of business at the time of the conclusion of the contract.
Article 32

(1) If the seller, in accordance with the contract or this Convention, hands the goods over to a
carrier and if the goods are not clearly identified to the contract by markings on the goods, by
shipping documents or otherwise, the seller must give the buyer notice of the consignment
specifying the goods.

(2) If the seller is bound to arrange for carriage of the goods, he must make such contracts as
are necessary for carriage to the place fixed by means of transportation appropriate in the
circumstances and according to the usual terms for such transportation.

(3) If the seller is not bound to effect insurance in respect of the carriage of the goods, he
must, at the buyer's request, provide him with all available information necessary to enable him
to effect such insurance.
Article 33

The seller must deliver the goods:

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 335

 (a) if a date is fixed by or determinable from the contract, on that date;

(b) if a period of time is fixed by or determinable from the contract, at any time within that
period unless circumstances indicate that the buyer is to choose a date; or

(c) in any other case, within a reasonable time after the conclusion of the contract.
Article 34

If the seller is bound to hand over documents relating to the goods, he must hand them over
at the time and place and in the form required by the contract. If the seller has handed over
documents before that time, he may, up to that time, cure any lack of conformity in the
documents, if the exercise of this right does not cause the buyer unreasonable inconvenience or
unreasonable expense. However, the buyer retains any right to claim damages as provided for in
this Convention.
Section II. Conformity of the goods and third party claims

Article 35

(1) The seller must deliver goods which are of the quantity, quality and description required
by the contract and which are contained or packaged in the manner required by the contract.

(2) Except where the parties have agreed otherwise, the goods do not conform with the
contract unless they:

(a) are fit for the purposes for which goods of the same description would ordinarily be used;

(b) are fit for any particular purpose expressly or impliedly made known to the seller at the
time of the conclusion of the contract, except where the circumstances show that the buyer
did not rely, or that it was unreasonable for him to rely, on the seller's skill and judgement;

(c) possess the qualities of goods which the seller has held out to the buyer as a sample or
model;

(d) are contained or packaged in the manner usual for such goods or, where there is no such
manner, in a manner adequate to preserve and protect the goods.

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 336

 (3) The seller is not liable under subparagraphs (a) to (d) of the preceding paragraph for any
lack of conformity of the goods if at the time of the conclusion of the contract the buyer knew or
could not have been unaware of such lack of conformity.
Article 36

(1) The seller is liable in accordance with the contract and this Convention for any lack of
conformity which exists at the time when the risk passes to the buyer, even though the lack of
conformity becomes apparent only after that time.

(2) The seller is also liable for any lack of conformity which occurs after the time indicated in
the preceding paragraph and which is due to a breach of any of his obligations, including a
breach of any guarantee that for a period of time the goods will remain fit for their ordinary
purpose or for some particular purpose or will retain specified qualities or characteristics.
Article 37

If the seller has delivered goods before the date for delivery, he may, up to that date, deliver
any missing part or make up any deficiency in the quantity of the goods delivered, or deliver
goods in replacement of any non-conforming goods delivered or remedy any lack of conformity
in the goods delivered, provided that the exercise of this right does not cause the buyer
unreasonable inconvenience or unreasonable expense. However, the buyer retains any right to
claim damages as provided for in this Convention.
Article 38

(1) The buyer must examine the goods, or cause them to be examined, within as short a
period as is practicable in the circumstances.

(2) If the contract involves carriage of the goods, examination may be deferred until after the
goods have arrived at their destination.

(3) If the goods are redirected in transit or redispatched by the buyer without a reasonable
opportunity for examination by him and at the time of the conclusion of the contract the seller
knew or ought to have known of the possibility of such redirection or redispatch, examination
may be deferred until after the goods have arrived at the new destination.
Article 39

(1) The buyer loses the right to rely on a lack of conformity of the goods if he does not give
notice to the seller specifying the nature of the lack of conformity within a reasonable time after

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he has discovered it or ought to have discovered it.

(2) In any event, the buyer loses the right to rely on a lack of conformity of the goods if he
does not give the seller notice thereof at the latest within a period of two years from the date on
which the goods were actually handed over to the buyer, unless this time-limit is inconsistent
with a contractual period of guarantee.
Article 40

The seller is not entitled to rely on the provisions of articles 38 and 39 if the lack of
conformity relates to facts of which he knew or could not have been unaware and which he did
not disclose to the buyer.
Article 41

The seller must deliver goods which are free from any right or claim of a third party, unless
the buyer agreed to take the goods subject to that right or claim. However, if such right or claim
is based on industrial property or other intellectual property, the seller's obligation is governed by
article 42.
Article 42

(1) The seller must deliver goods which are free from any right or claim of a third party
based on industrial property or other intellectual property, of which at the time of the conclusion
of the contract the seller knew or could not have been unaware, provided that the right or claim is
based on industrial property or other intellectual property:

(a) under the law of the State where the goods will be resold or otherwise used, if it was
contemplated by the parties at the time of the conclusion of the contract that the goods would
be resold or otherwise used in that State; or

(b) in any other case, under the law of the State where the buyer has his place of business.

(2) The obligation of the seller under the preceding paragraph does not extend to cases
where:

(a) at the time of the conclusion of the contract the buyer knew or could not have been
unaware of the right or claim; or

(b) the right or claim results from the seller's compliance with technical drawings, designs,

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 formulae or other such specifications furnished by the buyer.
Article 43

(1) The buyer loses the right to rely on the provisions of article 41 or article 42 if he does not
give notice to the seller specifying the nature of the right or claim of the third party within a
reasonable time after he has become aware or ought to have become aware of the right or claim.

(2) The seller is not entitled to rely on the provisions of the preceding paragraph if he knew
of the right or claim of the third party and the nature of it.
Article 44

Notwithstanding the provisions of paragraph (1) of article 39 and paragraph (1) of article 43,
the buyer may reduce the price in accordance with article 50 or claim damages, except for loss of
profit, if he has a reasonable excuse for his failure to give the required notice.
Section III. Remedies for breach of contract by the seller

Article 45

(1) If the seller fails to perform any of his obligations under the contract or this Convention,
the buyer may:

(a) exercise the rights provided in articles 46 to 52;

(b) claim damages as provided in articles 74 to 77.

(2) The buyer is not deprived of any right he may have to claim damages by exercising his
right to other remedies.

(3) No period of grace may be granted to the seller by a court or arbitral tribunal when the
buyer resorts to a remedy for breach of contract.
Article 46

(1) The buyer may require performance by the seller of his obligations unless the buyer has
resorted to a remedy which is inconsistent with this requirement.

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 (2) If the goods do not conform with the contract, the buyer may require delivery of
substitute goods only if the lack of conformity constitutes a fundamental breach of contract and a
request for substitute goods is made either in conjunction with notice given under article 39 or
within a reasonable time thereafter.

(3) If the goods do not conform with the contract, the buyer may require the seller to remedy
the lack of conformity by repair, unless this is unreasonable having regard to all the
circumstances. A request for repair must be made either in conjunction with notice given under
article 39 or within a reasonable time thereafter.
Article 47

(1) The buyer may fix an additional period of time of reasonable length for performance by
the seller of his obligations.

(2) Unless the buyer has received notice from the seller that he will not perform within the
period so fixed, the buyer may not, during that period, resort to any remedy for breach of
contract. However, the buyer is not deprived thereby of any right he may have to claim damages
for delay in performance.
Article 48

(1) Subject to article 49, the seller may, even after the date for delivery, remedy at his own
expense any failure to perform his obligations, if he can do so without unreasonable delay and
without causing the buyer unreasonable inconvenience or uncertainty of reimbursement by the
seller of expenses advanced by the buyer. However, the buyer retains any right to claim damages
as provided for in this Convention.

(2) If the seller requests the buyer to make known whether he will accept performance and
the buyer does not comply with the request within a reasonable time, the seller may perform
within the time indicated in his request. The buyer may not, during that period of time, resort to
any remedy which is inconsistent with performance by the seller.

(3) A notice by the seller that he will perform within a specified period of time is assumed to
include a request, under the preceding paragraph, that the buyer make known his decision.

(4) A request or notice by the seller under paragraph (2) or (3) of this article is not effective
unless received by the buyer.
Article 49

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 (1) The buyer may declare the contract avoided:

(a) if the failure by the seller to perform any of his obligations under the contract or this
Convention amounts to a fundamental breach of contract; or

(b) in case of non-delivery, if the seller does not deliver the goods within the additional
period of time fixed by the buyer in accordance with paragraph (1) of article 47 or declares
that he will not deliver within the period so fixed.

(2) However, in cases where the seller has delivered the goods, the buyer loses the right to
declare the contract avoided unless he does so:

(a) in respect of late delivery, within a reasonable time after he has become aware that
delivery has been made;

(b) in respect of any breach other than late delivery, within a reasonable time:

(i) after he knew or ought to have known of the breach;

(ii) after the expiration of any additional period of time fixed by the buyer in accordance with
paragraph (1) of article 47, or after the seller has declared that he will not perform his
obligations within such an additional period; or

(iii) after the expiration of any additional period of time indicated by the seller in accordance
with paragraph (2) of article 48, or after the buyer has declared that he will not accept
performance.
Article 50

If the goods do not conform with the contract and whether or not the price has already been
paid, the buyer may reduce the price in the same proportion as the value that the goods actually
delivered had at the time of the delivery bears to the value that conforming goods would have
had at that time. However, if the seller remedies any failure to perform his obligations in
accordance with article 37 or article 48 or if the buyer refuses to accept performance by the seller
in accordance with those articles, the buyer may not reduce the price.
Article 51

(1) If the seller delivers only a part of the goods or if only a part of the goods delivered is in

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conformity with the contract, articles 46 to 50 apply in respect of the part which is missing or
which does not conform.

(2) The buyer may declare the contract avoided in its entirety only if the failure to make
delivery completely or in conformity with the contract amounts to a fundamental breach of the
contract.
Article 52

(1) If the seller delivers the goods before the date fixed, the buyer may take delivery or refuse
to take delivery.

(2) If the seller delivers a quantity of goods greater than that provided for in the contract, the
buyer may take delivery or refuse to take delivery of the excess quantity. If the buyer takes
delivery of all or part of the excess quantity, he must pay for it at the contract rate.
Chapter III

OBLIGATIONS OF THE BUYER

Article 53

The buyer must pay the price for the goods and take delivery of them as required by the
contract and this Convention.
Section I. Payment of the price

Article 54

The buyer's obligation to pay the price includes taking such steps and complying with such
formalities as may be required under the contract or any laws and regulations to enable payment
to be made.
Article 55

Where a contract has been validly concluded but does not expressly or implicitly fix or make
provision for determining the price, the parties are considered, in the absence of any indication to
the contrary, to have impliedly made reference to the price generally charged at the time of the
conclusion of the contract for such goods sold under comparable circumstances in the trade
concerned.

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 Article 56

If the price is fixed according to the weight of the goods, in case of doubt it is to be
determined by the net weight.
Article 57

(1) If the buyer is not bound to pay the price at any other particular place, he must pay it to
the seller:

(a) at the seller's place of business; or

(b) if the payment is to be made against the handing over of the goods or of documents, at the
place where the handing over takes place.

(2) The seller must bear any increase in the expenses incidental to payment which is caused
by a change in his place of business subsequent to the conclusion of the contract.
Article 58

(1) If the buyer is not bound to pay the price at any other specific time, he must pay it when
the seller places either the goods or documents controlling their disposition at the buyer's
disposal in accordance with the contract and this Convention. The seller may make such payment
a condition for handing over the goods or documents.

(2) If the contract involves carriage of the goods, the seller may dispatch the goods on terms
whereby the goods, or documents controlling their disposition, will not be handed over to the
buyer except against payment of the price.

(3) The buyer is not bound to pay the price until he has had an opportunity to examine the
goods, unless the procedures for delivery or payment agreed upon by the parties are inconsistent
with his having such an opportunity.
Article 59

The buyer must pay the price on the date fixed by or determinable from the contract and this
Convention without the need for any request or compliance with any formality on the part of the
seller.

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 Section II. Taking delivery

Article 60

The buyer's obligation to take delivery consists:

(a) in doing all the acts which could reasonably be expected of him in order to enable the
seller to make delivery; and

(b) in taking over the goods.

Section III. Remedies for breach of contract by the buyer

Article 61

(1) If the buyer fails to perform any of his obligations under the contract or this Convention,
the seller may:

(a) exercise the rights provided in articles 62 to 65;

(b) claim damages as provided in articles 74 to 77.

(2) The seller is not deprived of any right he may have to claim damages by exercising his
right to other remedies.

(3) No period of grace may be granted to the buyer by a court or arbitral tribunal when the
seller resorts to a remedy for breach of contract.
Article 62

The seller may require the buyer to pay the price, take delivery or perform his other
obligations, unless the seller has resorted to a remedy which is inconsistent with this
requirement.
Article 63

(1) The seller may fix an additional period of time of reasonable length for performance by
the buyer of his obligations.

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 (2) Unless the seller has received notice from the buyer that he will not perform within the
period so fixed, the seller may not, during that period, resort to any remedy for breach of
contract. However, the seller is not deprived thereby of any right he may have to claim damages
for delay in performance.
Article 64

(1) The seller may declare the contract avoided:

(a) if the failure by the buyer to perform any of his obligations under the contract or this
Convention amounts to a fundamental breach of contract; or

(b) if the buyer does not, within the additional period of time fixed by the seller in
accordance with paragraph (1) of article 63, perform his obligation to pay the price or take
delivery of the goods, or if he declares that he will not do so within the period so fixed.

(2) However, in cases where the buyer has paid the price, the seller loses the right to declare
the contract avoided unless he does so:

(a) in respect of late performance by the buyer, before the seller has become aware that
performance has been rendered; or

(b) in respect of any breach other than late performance by the buyer, within a reasonable
time:

(i) after the seller knew or ought to have known of the breach; or

(ii) after the expiration of any additional period of time fixed by the seller in accordance with
paragraph (1) of article 63, or after the buyer has declared that he will not perform his
obligations within such an additional period.
Article 65

(1) If under the contract the buyer is to specify the form, measurement or other features of the
goods and he fails to make such specification either on the date agreed upon or within a
reasonable time after receipt of a request from the seller, the seller may, without prejudice to any
other rights he may have, make the specification himself in accordance with the requirements of
the buyer that may be known to him.

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 (2) If the seller makes the specification himself, he must inform the buyer of the details
thereof and must fix a reasonable time within which the buyer may make a different
specification. If, after receipt of such a communication, the buyer fails to do so within the time so
fixed, the specification made by the seller is binding.
Chapter IV

PASSING OF RISK

Article 66

Loss of or damage to the goods after the risk has passed to the buyer does not discharge him
from his obligation to pay the price, unless the loss or damage is due to an act or omission of the
seller.
Article 67

(1) If the contract of sale involves carriage of the goods and the seller is not bound to hand
them over at a particular place, the risk passes to the buyer when the goods are handed over to
the first carrier for transmission to the buyer in accordance with the contract of sale. If the seller
is bound to hand the goods over to a carrier at a particular place, the risk does not pass to the
buyer until the goods are handed over to the carrier at that place. The fact that the seller is
authorized to retain documents controlling the disposition of the goods does not affect the
passage of the risk.

(2) Nevertheless, the risk does not pass to the buyer until the goods are clearly identified to
the contract, whether by markings on the goods, by shipping documents, by notice given to the
buyer or otherwise.
Article 68

The risk in respect of goods sold in transit passes to the buyer from the time of the conclusion
of the contract. However, if the circumstances so indicate, the risk is assumed by the buyer from
the time the goods were handed over to the carrier who issued the documents embodying the
contract of carriage. Nevertheless, if at the time of the conclusion of the contract of sale the seller
knew or ought to have known that the goods had been lost or damaged and did not disclose this
to the buyer, the loss or damage is at the risk of the seller.
Article 69

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 (1) In cases not within articles 67 and 68, the risk passes to the buyer when he takes over the
goods or, if he does not do so in due time, from the time when the goods are placed at his
disposal and he commits a breach of contract by failing to take delivery.

(2) However, if the buyer is bound to take over the goods at a place other than a place of
business of the seller, the risk passes when delivery is due and the buyer is aware of the fact that
the goods are placed at his disposal at that place.

(3) If the contract relates to goods not then identified, the goods are considered not to be
placed at the disposal of the buyer until they are clearly identified to the contract.
Article 70

If the seller has committed a fundamental breach of contract, articles 67, 68 and 69 do not
impair the remedies available to the buyer on account of the breach.
Chapter V

PROVISIONS COMMON TO THE OBLIGATIONS OF THE SELLER AND OF THE

BUYER

Section I. Anticipatory breach and instalment contracts

Article 71

(1) A party may suspend the performance of his obligations if, after the conclusion of the
contract, it becomes apparent that the other party will not perform a substantial part of his
obligations as a result of:

(a) a serious deficiency in his ability to perform or in his creditworthiness; or

(b) his conduct in preparing to perform or in performing the contract.

(2) If the seller has already dispatched the goods before the grounds described in the
preceding paragraph become evident, he may prevent the handing over of the goods to the buyer
even though the buyer holds a document which entitles him to obtain them. The present
paragraph relates only to the rights in the goods as between the buyer and the seller.

(3) A party suspending performance, whether before or after dispatch of the goods, must
immediately give notice of the suspension to the other party and must continue with performance

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if the other party provides adequate assurance of his performance.
Article 72

(1) If prior to the date for performance of the contract it is clear that one of the parties will
commit a fundamental breach of contract, the other party may declare the contract avoided.

(2) If time allows, the party intending to declare the contract avoided must give reasonable
notice to the other party in order to permit him to provide adequate assurance of his performance.

(3) The requirements of the preceding paragraph do not apply if the other party has declared
that he will not perform his obligations.
Article 73

(1) In the case of a contract for delivery of goods by instalments, if the failure of one party to
perform any of his obligations in respect of any instalment constitutes a fundamental breach of
contract with respect to that instalment, the other party may declare the contract avoided with
respect to that instalment.

(2) If one party's failure to perform any of his obligations in respect of any instalment gives
the other party good grounds to conclude that a fundamental breach of contract will occur with
respect to future instalments, he may declare the contract avoided for the future, provided that he
does so within a reasonable time.

(3) A buyer who declares the contract avoided in respect of any delivery may, at the same
time, declare it avoided in respect of deliveries already made or of future deliveries if, by reason
of their interdependence, those deliveries could not be used for the purpose contemplated by the
parties at the time of the conclusion of the contract.
Section II. Damages

Article 74

Damages for breach of contract by one party consist of a sum equal to the loss, including loss
of profit, suffered by the other party as a consequence of the breach. Such damages may not
exceed the loss which the party in breach foresaw or ought to have foreseen at the time of the
conclusion of the contract, in the light of the facts and matters of which he then knew or ought to
have known, as a possible consequence of the breach of contract.
Article 75

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 If the contract is avoided and if, in a reasonable manner and within a reasonable time after
avoidance, the buyer has bought goods in replacement or the seller has resold the goods, the
party claiming damages may recover the difference between the contract price and the price in
the substitute transaction as well as any further damages recoverable under article 74.
Article 76

(1) If the contract is avoided and there is a current price for the goods, the party claiming
damages may, if he has not made a purchase or resale under article 75, recover the difference
between the price fixed by the contract and the current price at the time of avoidance as well as
any further damages recoverable under article 74. If, however, the party claiming damages has
avoided the contract after taking over the goods, the current price at the time of such taking over
shall be applied instead of the current price at the time of avoidance.

(2) For the purposes of the preceding paragraph, the current price is the price prevailing at
the place where delivery of the goods should have been made or, if there is no current price at
that place, the price at such other place as serves as a reasonable substitute, making due
allowance for differences in the cost of transporting the goods.
Article 77

A party who relies on a breach of contract must take such measures as are reasonable in the
circumstances to mitigate the loss, including loss of profit, resulting from the breach. If he fails
to take such measures, the party in breach may claim a reduction in the damages in the amount
by which the loss should have been mitigated.
Section III. Interest

Article 78

If a party fails to pay the price or any other sum that is in arrears, the other party is entitled to
interest on it, without prejudice to any claim for damages recoverable under article 74.
Section IV. Exemptions

Article 79

(1) A party is not liable for a failure to perform any of his obligations if he proves that the
failure was due to an impediment beyond his control and that he could not reasonably be
expected to have taken the impediment into account at the time of the conclusion of the contract

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or to have avoided or overcome it, or its consequences.

(2) If the party's failure is due to the failure by a third person whom he has engaged to
perform the whole or a part of the contract, that party is exempt from liability only if:

(a) he is exempt under the preceding paragraph; and

(b) the person whom he has so engaged would be so exempt if the provisions of that
paragraph were applied to him.

(3) The exemption provided by this article has effect for the period during which the
impediment exists.

(4) The party who fails to perform must give notice to the other party of the impediment and
its effect on his ability to perform. If the notice is not received by the other party within a
reasonable time after the party who fails to perform know or ought to have known of the
impediment, he is liable for damages resulting from such non-receipt.

(5) Nothing in this article prevents either party from exercising any right other than to claim
damages under this Convention.
Article 80

A party may not rely on a failure of the other party to perform, to the extent that such failure
was caused by the first party's act or omission.
Section V. Effects of avoidance

Article 81

(1) Avoidance of the contract releases both parties from their obligations under it, subject to
any damages which may be due. Avoidance does not affect any provision of the contract for the
settlement of disputes or any other provision of the contract governing the rights and obligations
of the parties consequent upon the avoidance of the contract.

(2) A party who has performed the contract either wholly or in part may claim restitution
from the other party of whatever the first party has supplied or paid under the contract. If both
parties are bound to make restitution, they must do so concurrently.
Article 82

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 (1) The buyer loses the right to declare the contract avoided or to require the seller to deliver
substitute goods if it is impossible for him to make restitution of the goods substantially in the
condition in which he received them.

(2) The preceding paragraph does not apply:

(a) if the impossibility of making restitution of the goods or of making restitution of the
goods substantially in the condition in which the buyer received them is not due to his act or
omission;

(b) if the goods or part of the goods have perished or deteriorated as a result of the
examination provided for in article 38; or

(c) if the goods or part of the goods have been sold in the normal course of business or have
been consumed or transformed by the buyer in the course of normal use before he discovered
or ought to have discovered the lack of conformity.
Article 83

A buyer who has lost the right to declare the contract avoided or to require the seller to
deliver substitute goods in accordance with article 82 retains all other remedies under the
contract and this Convention.
Article 84

(1) If the seller is bound to refund the price, he must also pay interest on it, from the date on
which the price was paid.

(2) The buyer must account to the seller for all benefits which he has derived from the goods
or part of them:

(a) if he must make restitution of the goods or part of them; or

(b) if it is impossible for him to make restitution of all or part of the goods or to make
restitution of all or part of the goods substantially in the condition in which he received them,
but he has nevertheless declared the contract avoided or required the seller to deliver
substitute goods.
Section VI. Preservation of the goods

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 Article 85

If the buyer is in delay in taking delivery of the goods or, where payment of the price and
delivery of the goods are to be made concurrently, if he fails to pay the price, and the seller is
either in possession of the goods or otherwise able to control their disposition, the seller must
take such steps as are reasonable in the circumstances to preserve them. He is entitled to retain
them until he has been reimbursed his reasonable expenses by the buyer.
Article 86

(1) If the buyer has received the goods and intends to exercise any right under the contract or
this Convention to reject them, he must take such steps to preserve them as are reasonable in the
circumstances. He is entitled to retain them until he has been reimbursed his reasonable expenses
by the seller.

(2) If goods dispatched to the buyer have been placed at his disposal at their destination and
he exercises the right to reject them, he must take possession of them on behalf of the seller,
provided that this can be done without payment of the price and without unreasonable
inconvenience or unreasonable expense. This provision does not apply if the seller or a person
authorized to take charge of the goods on his behalf is present at the destination. If the buyer
takes possession of the goods under this paragraph, his rights and obligations are governed by the
preceding paragraph.
Article 87

A party who is bound to take steps to preserve the goods may deposit them in a warehouse of
a third person at the expense of the other party provided that the expense incurred is not
unreasonable.
Article 88

(1) A party who is bound to preserve the goods in accordance with article 85 or 86 may sell
them by any appropriate means if there has been an unreasonable delay by the other party in
taking possession of the goods or in taking them back or in paying the price or the cost of
preservation, provided that reasonable notice of the intention to sell has been given to the other
party.

(2) If the goods are subject to rapid deterioration or their preservation would involve
unreasonable expense, a party who is bound to preserve the goods in accordance with article 85
or 86 must take reasonable measures to sell them. To the extent possible he must give notice to
the other party of his intention to sell.

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 (3) A party selling the goods has the right to retain out of the proceeds of sale an amount
equal to the reasonable expenses of preserving the goods and of selling them. He must account to
the other party for the balance.
PART IV

FINAL PROVISIONS

Article 89

The Secretary-General of the United Nations is hereby designated as the depositary for this
Convention.
Article 90

This Convention does not prevail over any international agreement which has already been or
may be entered into and which contains provisions concerning the matters governed by this
Convention, provided that the parties have their places of business in States parties to such
agreement.
Article 91

(1) This Convention is open for signature at the concluding meeting of the United Nations
Conference on Contracts for the International Sale of Goods and will remain open for signature
by all States at the Headquarters of the United Nations, New York until 30 September 1981.

(2) This Convention is subject to ratification, acceptance or approval by the signatory States.

(3) This Convention is open for accession by all States which are not signatory States as from
the date it is open for signature.

(4) Instruments of ratification, acceptance, approval and accession are to be deposited with
the Secretary-General of the United Nations.
Article 92

(1) A Contracting State may declare at the time of signature, ratification, acceptance,
approval or accession that it will not be bound by Part II of this Convention or that it will not be

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bound by Part III of this Convention.

(2) A Contracting State which makes a declaration in accordance with the preceding
paragraph in respect of Part II or Part III of this Convention is not to be considered a Contracting
State within paragraph (1) of article 1 of this Convention in respect of matters governed by the
Part to which the declaration applies.
Article 93

(1) If a Contracting State has two or more territorial units in which, according to its
constitution, different systems of law are applicable in relation to the matters dealt with in this
Convention, it may, at the time of signature, ratification, acceptance, approval or accession,
declare that this Convention is to extend to all its territorial units or only to one or more of them,
and may amend its declaration by submitting another declaration at any time.

(2) These declarations are to be notified to the depositary and are to state expressly the
territorial units to which the Convention extends.

(3) If, by virtue of a declaration under this article, this Convention extends to one or more but
not all of the territorial units of a Contracting State, and if the place of business of a party is
located in that State, this place of business, for the purposes of this Convention, is considered not
to be in a Contracting State, unless it is in a territorial unit to which the Convention extends.

(4) If a Contracting State makes no declaration under paragraph (1) of this article, the
Convention is to extend to all territorial units of that State.
Article 94

(1) Two or more Contracting States which have the same or closely related legal rules on
matters governed by this Convention may at any time declare that the Convention is not to apply
to contracts of sale or to their formation where the parties have their places of business in those
States. Such declarations may be made jointly or by reciprocal unilateral declarations.

(2) A Contracting State which has the same or closely related legal rules on matters governed
by this Convention as one or more non-Contracting States may at any time declare that the
Convention is not to apply to contracts of sale or to their formation where the parties have their
places of business in those States.

(3) If a State which is the object of a declaration under the preceding paragraph subsequently
becomes a Contracting State, the declaration made will, as from the date on which the
Convention enters into force in respect of the new Contracting State, have the effect of a

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declaration made under paragraph (1), provided that the new Contracting State joins in such
declaration or makes a reciprocal unilateral declaration.
Article 95

Any State may declare at the time of the deposit of its instrument of ratification, acceptance,
approval or accession that it will not be bound by subparagraph (1)(b) of article 1 of this
Convention.
Article 96

A Contracting State whose legislation requires contracts of sale to be concluded in or

evidenced by writing may at any time make a declaration in accordance with article 12 that any
provision of article 11, article 29, or Part II of this Convention, that allows a contract of sale or
its modification or termination by agreement or any offer, acceptance, or other indication of
intention to be made in any form other than in writing, does not apply where any party has his
place of business in that State.
Article 97

(1) Declarations made under this Convention at the time of signature are subject to
confirmation upon ratification, acceptance or approval.

(2) Declarations and confirmations of declarations are to be in writing and be formally

notified to the depositary.

(3) A declaration takes effect simultaneously with the entry into force of this Convention in
respect of the State concerned. However, a declaration of which the depositary receives formal
notification after such entry into force takes effect on the first day of the month following the
expiration of six months after the date of its receipt by the depositary. Reciprocal unilateral
declarations under article 94 take effect on the first day of the month following the expiration of
six months after the receipt of the latest declaration by the depositary.

(4) Any State which makes a declaration under this Convention may withdraw it at any time
by a formal notification in writing addressed to the depositary. Such withdrawal is to take effect
on the first day of the month following the expiration of six months after the date of the receipt
of the notification by the depositary.

(5) A withdrawal of a declaration made under article 94 renders inoperative, as from the date
on which the withdrawal takes effect, any reciprocal declaration made by another State under
that article.

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 Article 98

No reservations are permitted except those expressly authorized in this Convention.

Article 99

(1) This Convention enters into force, subject to the provisions of paragraph (6) of this
article, on the first day of the month following the expiration of twelve months after the date of
deposit of the tenth instrument of ratification, acceptance, approval or accession, including an
instrument which contains a declaration made under article 92.

(2) When a State ratifies, accepts, approves or accedes to this Convention after the deposit of
the tenth instrument of ratification, acceptance, approval or accession, this Convention, with the
exception of the Part excluded, enters into force in respect of that State, subject to the provisions
of paragraph (6) of this article, on the first day of the month following the expiration of twelve
months after the date of the deposit of its instrument of ratification, acceptance, approval or
accession.

(3) A State which ratifies, accepts, approves or accedes to this Convention and is a party to
either or both the Convention relating to a Uniform Law on the Formation of Contracts for the
International Sale of Goods done at The Hague on 1 July 1964 (1964 Hague Formation
Convention) and the Convention relating to a Uniform Law on the International Sale of Goods
done at The Hague on 1 July 1964 (1964 Hague Sales Convention) shall at the same time
denounce, as the case may be, either or both the 1964 Hague Sales Convention and the 1964
Hague Formation Convention by notifying the Government of the Netherlands to that effect.

(4) A State party to the 1964 Hague Sales Convention which ratifies, accepts, approves or
accedes to the present Convention and declares or has declared under article 92 that it will not be
bound by Part II of this Convention shall at the time of ratification, acceptance, approval or
accession denounce the 1964 Hague Sales Convention by notifying the Government of the
Netherlands to that effect.

(5) A State party to the 1964 Hague Formation Convention which ratifies, accepts, approves
or accedes to the present Convention and declares or has declared under article 92 that it will not
be bound by Part III of this Convention shall at the time of ratification, acceptance, approval or
accession denounce the 1964 Hague Formation Convention by notifying the Government of the
Netherlands to that effect.

(6) For the purpose of this article, ratifications, acceptances, approvals and accessions in
respect of this Convention by States parties to the 1964 Hague Formation Convention or to the
1964 Hague Sales Convention shall not be effective until such denunciations as may be required

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on the part of those States in respect of the latter two Conventions have themselves become
effective. The depositary of this Convention shall consult with the Government of the
Netherlands, as the depositary of the 1964 Conventions, so as to ensure necessary co-ordination
in this respect.
Article 100

(1) This Convention applies to the formation of a contract only when the proposal for
concluding the contract is made on or after the date when the Convention enters into force in
respect of the Contracting States referred to in subparagraph (1)(a) or the Contracting State
referred to in subparagraph (1)(b) of article 1.

(2) This Convention applies only to contracts concluded on or after the date when the
Convention enters into force in respect of the Contracting States referred to in subparagraph (1)
(a) or the Contracting State referred to in subparagraph (1)(b) of article 1.
Article 101

(1) A Contracting State may denounce this Convention, or Part II or Part III of the
Convention, by a formal notification in writing addressed to the depositary.

(2) The denunciation takes effect on the first day of the month following the expiration of
twelve months after the notification is received by the depositary. Where a longer period for the
denunciation to take effect is specified in the notification, the denunciation takes effect upon the
expiration of such longer period after the notification is received by the depositary.

DONE at Vienna, this day of eleventh day of April, one thousand nine hundred and eighty, in
a single original, of which the Arabic, Chinese, English, French, Russian and Spanish texts are
equally authentic.

IN WITNESS WHEREOF the undersigned plenipotentiaries, being duly authorized by their

respective Governments, have signed this Convention.
Worksheet 6
Proposed Transfer of Intangibles for Foreign Joint Venture.
Dear Sir/Madam:

We understand that the Company proposes to transfer the rights to use certain patents and
know-how (not including franchises, tradenames or trademarks) solely within Brazil to a joint
venture corporation to be formed under the laws of Brazil and owned equally by you and XYZ, a
Brazilian corporation, to conduct manufacturing operations in that country. You also would enter

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into a service agreement in connection with the know-how, under which you would provide
startup assistance and subsequent technical assistance and training. You have suggested that the
technology be transferred to the joint venture for shares; however, you are willing to consider a
sale or even a license of the technology to the joint venture. Sale proceeds or license royalties
would be a fixed amount per annum plus a percentage of gross sales. The Brazilian venturer
would contribute cash to the joint venture.

We understand that the patents and the know-how were developed by the Company in the
United States and that the total cost of development was deducted by you as incurred under
Section 174(a) of the Internal Revenue Code. You believe that the technology in the hands of the
Brazilian joint venture will give rise to very substantial amounts of income relative to the cost of
development properly allocable to it.

The joint venture would hold little in the way of passive assets and is unlikely to derive
significant passive income. Hence, this memorandum assumes that the joint venture will not be a
passive foreign investment company (PFIC).

You wish to determine how the transfer of technology may be best accomplished, taking into
account the Company's need to maximize creditability of foreign taxes from the joint venture.
We have assumed that the Company has not had an "overall foreign loss" within the meaning of
Section 904(f).

In general, under the circumstances present here, three forms of transfer, each with different
tax consequences, may be considered:

1. Transfer of the technology for joint venture shares.

2. Sale of the technology for cash or the joint venture's promissory note, with either a fixed or
a contingent purchase price.

3. License of the technology to the joint venture. For reasons discussed below, we believe
that a license of the technology for a limited term, with renewal options subject to agreement
of the parties, would be the preferable approach from a tax standpoint, although a sale for a
contingent purchase price may be more advantageous if that would avoid any Brazilian
withholding tax on royalties and/or would permit amortization of the technology in Brazil. 1
1
Although not relevant to the present question, to the extent that a foreign affiliate may require
technology in the future, it may be more advantageous to have it either develop the technology
itself (for which purpose it could use the U.S. group as a "contract manufacturer"), or develop the
technology under a "cost-sharing" arrangement with other affiliates pursuant to Prop. Regs.
Section 1.482-2(g).

As noted above, certain startup and other services would be performed by the Company for

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the joint venture in connection with the transfer of technology to it. It may be possible to
disregard the startup services for tax purposes, provided they would be merely "ancillary and
subsidiary" to the transfer of technology and would not be separately stated in the contract (Regs.
Section 1.482-2(b)(8)). On the other hand, the ongoing technical assistance and training likely
would not be disregarded as ancillary; furthermore, it may be advantageous to break out even the
startup services. If, for example, payments for the technology would be subject to Brazilian
withholding tax but payments for the services would not, and the Company were not in a
position to credit the withholding tax, it would be advantageous for the Company to charge
separately for the services in a separate contract. To the extent the services would be performed
in the United States, the income would be domestic source; to the extent the services would be
performed abroad, the income would be foreign source. Exactly which services could be
considered ancillary and the optimal way of contracting for them would depend on the particular
facts, and is beyond the scope of this memorandum.
1. Transfer of technology for shares on incorporation

"Superroyalty." A transfer of the technology for shares (or a contribution of the technology to
the capital of the corporation) in connection with the formation of the joint venture would be
unattractive from a U.S. tax standpoint. Under Section 367(d), the Company would be
considered to have sold the technology for contingent sums payable annually over the life of the
property (or until the earlier of its disposition by the joint venture to a party unrelated to the
Company or the Company's disposition of its interest in the joint venture to an unrelated party
for 20 years) in amounts "commensurate with the income" of the technology (as construed in
Prop. Regs. Section 1.482-2(d)). The amounts includible in income would be treated as ordinary
income from sources within the United States (and would reduce the earnings and profits of the
joint venture). Consequently, no ability to claim a foreign tax credit in respect of underlying
Brazilian taxes, or even to use excess credits otherwise available to the Company would be
present.

Special election. On the facts presented, it appears possible to avoid annual income
inclusions (and the inability to recover basis, though that does not appear to be very significant
here) by electing under Regs. Section 1.367-1T(g)(2) to treat the transfer as a sale. Nevertheless,
the gain would be taxable as U.S. source ordinary income.

Brazilian consequences. Although the point should be confirmed with Brazilian counsel, it
seems unlikely that a deduction would be available in Brazil in respect of these deemed royalties;
in fact, a dividend withholding tax may be imposed (if payment is permitted at all under
Brazilian law). Furthermore, if payment of the deemed royalty is blocked under Brazilian law,
the income would not be deferrable. (Section 1.367(d)-1T(c)(4)).
2. Sale of technology

General. A sale of the technology to the joint venture, in contrast to a transfer governed by
Section 367(d), would avoid the requirement to include annual royalties "commensurate with . . .
income" over the useful life of the technology, provided that the joint venture is not considered to

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 359

be "owned or controlled' by the Company for purposes of IRC Section 482. In the case of a 50-
50 joint venture with an unrelated party, such as the joint venture envisioned, ownership or
control for purposes of Section 482 should not be present (R.T. French v. Comr., 60 T.C. 836
(1973)), assuming the other party would not enter into a comparable transaction with the joint
venture whereby such other party would be indifferent to whether the technology sale is at arm's
length (B. Forman Co., Inc. v. Comr., 453 F.2d 1144 (2d Cir.), cert. denied, 407 U.S. 934
(1972)). We would caution, however, that no objective test is set forth in the statute or
regulations. The case could be weakened if the Company or its affiliates were to have decisional
or other rights not granted to its venturer or were to hold shares possessing in excess of 50% of
the value or voting power of the joint venture.

A second risk is that a sale to a newly formed corporation might be recharacterized as part of
a Section 351 transfer (with boot), and hence remain subject to Section 367(d). (The facts
probably could not be strengthened if the Company were to sell the technology to the Brazilian
venturer for contribution by it to the joint venture.) Under temporary regulations (Regs. Section
1.367(d)-1T(g)(4)(ii)), the IRS may disregard a sale if the terms of the sale, taking into account
the practice of the parties, "differ so greatly from the economic substance of the transaction or
the terms that would obtain between unrelated persons that the purported sale or license is a
sham."

Character of Income. Assuming the sales price would be payable over a number of years,
unless the contract would treat a certain percent of each deferred payment as interest, at a rate not
less than the applicable Federal rate at the time of sale, interest at the applicable Federal rate
would be imputed (Sections 1274, 483). It should be determined whether it is preferable from a
Brazilian withholding tax standpoint to avoid stating interest.

Except to the extent of actual or imputed interest, income from the sale of the technology
would be taxable as capital gain (assuming that the technology is not considered held primarily
for sale to customers in the ordinary course of business). A provision (Section 1249) that taxes
certain sales of intangible property to related persons as ordinary income would not be applicable
since the Company would not own more than 50% of the combined voting power of the shares of
the joint venture.

Installment sale treatment. Assuming the sale price payable over a number of years, the
transaction would be reportable under the installment sales rules unless an election out was
timely filed. Under the installment sale rules any deferred tax liability would be subject to an
interest charge payable to the IRS to the extent that the sale price (together with the sale price for
other sales by the Company on the installment method during the taxable year) would exceed
$5,000,000 (Section 453A(c)); thus, a deferral benefit may be largely unavailable. Assuming the
sale price would involve fixed and contingent portions, Regs. Section 15a.453-1(c) governs the
allocation of tax basis (which here is very small) to the payments for purposes of determining the
amount of gain reportable in any year.

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 360

 If the Company instead would elect out of installment reporting, gain would be recognized
for the year of sale in an amount generally equal to the excess of the sum of the cash, the
principal amount of all deferred fixed payments and the fair market value of all contingent
payments required under the contract over the company's tax basis in the technology. To the
extent payments (excluding interest) thereafter exceed the gain reported, the excess would have
to be reported in the year received, and likely would be ordinary income.

Source. Gain (excluding interest) from a sale of the technology (whether or not the sale
would be subject to Section 482) would be sourced as follows:

(a) Under Section 865(d)(4), to the extent the gain would not exceed the "depreciation
adjustments" with respect to the technology, such gain (whether attributable to fixed or
contingent payments) would be sourced under Section 865(c). For this purpose, "depreciation
adjustments" would include deductions taken under IRC Section 174(a) for R & D expense
(Section 865(c)(4)(C)). Consequently, to the extent the gain attributable to each item of
technology would not exceed the aggregate amount of R & D deductions claimed (as well as
amortization deductions, if any), such gain would be sourced between domestic and foreign
sources in the same ratio as (A) the portion of such deductions allowable in computing
domestic source taxable income bears to (B) the aggregate amount of such deductions
(Sections 865(c)(1), (c)(3)(A)). If gain contingent in amount would be reported on the
installment basis, it appears likely that gain from installments received in a given taxable
year would be sourced under this provision in priority to gain from a subsequent year's
installments.

In a situation in which gain sourced under Section 865(d)(4) for a taxable year is attributable
to both fixed and contingent payments but is less than the sum of the payments for such year, it is
not clear what portion of the fixed and contingent portions of the gain, respectively, should be
sourced under this rule. One approach would be to apportion in the same ratio as the fixed and
contingent payments for the year (cf. Regs. Section 1.871-11(d)). Another approach would be to
match as closely as possible, source of gain against source of deduction.

(b) Any gain in excess of the portion of the gain described in paragraph (a) above would be:

(i) foreign source (based on place of use) in the same proportion that payments contingent on
gross sales bear to total payments for the taxable year (Sections 865(d)(1)(B), 862(a)(4)); and

(ii) domestic source (based on seller's residence) in the same ratio that noncontingent
payments bear to total payments for the taxable year. (Sections 865(d)(1)(A), 865(a).

As these source rules suggest, it could be advantageous from a U.S. tax standpoint to make
the purchase price contingent.

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 361

 The portion of each deferred payment treated as interest would be foreign source income
(Sections 861(a)(1), 862(a)(1)).

Foreign tax credit basket. Foreign source gain from the sale of the patents would be
considered general basket and not passive basket income for Section 904(d) purposes provided
they were developed as part of an active trade or business, and the Company and its affiliates do
not hold shares possessing over 50% of the vote or value of the joint venture. (Sections 904(d)(2)
(A), 954(c)(1)(B), 954(c)(2)(A)). Foreign source gain from the know-how may be considered to
fall within the passive income basket; in technical terms, temporary regulations (former Regs.
Section 1.954-2T(e)(3)) generally treat intangibles that are not subject to an allowance for
depreciation under Regs. Section 1.167(a)-3 as property that "does not give rise to any income"
within the meaning the Section 954(c)(1)(B). Nevertheless, if such gain is subject to a foreign
rate of income tax in excess of the U.S. rate, it could be "kicked" into the general basket (Section
904(d)(2)(A)(iii), (F)).2
2
If the joint venture were a controlled foreign corporation, the royalty income would be placed
in a particular basket to the extent the royalty expense would be allocable to the controlled foreign
corporation's income in that basket on a "look-through" basis (Section 904(d)(3)(C)).

The interest portion of the deferred payments would be classified as passive basket income,
unless reclassified as general basket income under the "high tax kickout" provision (Section
904(d)(2)(A), (F)).

Brazilian consequences. Two substantial Brazilian tax advantages may be obtained if the
transfer is by purchase. First, a royalty withholding tax might be avoided (although a contingent
purchase price may result in the tax). Second, the technology might well be amortizable for
Brazilian tax purposes. (If it were not, it may be desirable to draft the transfer as a license in
perpetuity and to make most of the purchase price contingent.) You should discuss these
considerations with your Brazilian tax advisors.
3. License of technology

Instead of transferring all substantial rights to the use of the technology in Brazil, an
alternative would be to transfer the rights for only a limited duration (e.g., 10 years if the
property's useful life is 13 years) and retain normal licensor rights. The parties could agree to
extend the license term at the end of the 10 years, if desired.

General. Such an arrangement should be respected as a license for U.S. tax purposes.
Provided the Company would not be considered to own or control the joint venture (see section 2
above), Section 482 (with its "commensurate with . . . income" test) would be inapplicable.
Under temporary regulations (Regs. Section 1.367(d)-1T(g)(4)(ii)), however, the IRS could treat
a license to a newly formed joint venture as subject to Section 367(d) (see section 1 above) if the
terms of the license, taking into account the practice of the parties, "differs so greatly from the
economic substance of the transaction or the terms that would obtain between unrelated persons
that the purported sale or license is a sham."

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 362

 The royalty income under the license would be foreign source (Section 862(a)(4)). Provided
the license of the technology is part of the Company's active trade or business and the Company
does not own stock possessing over 50% of the voting power or value of the joint venture, the
royalty income would qualify as general basket income for foreign tax credit purposes (Sections
904(d)(2)(A), 954(c)(2)(A)).3
3
If the joint venture were a controlled foreign corporation, the royalty income would be placed
in a particular basket to the extent the royalty expense would be allocable to the controlled foreign
corporation's income in that basket on a "look-through" basis (Section 904(d)(3)(C)). If the royalty
income were not to qualify under either the active trade or business rule or the look-through rule,
the income would be in the passive basket unless reclassified as general basket income under the
"high tax kickout" provision (Section 904(d)(2)(A), (F)).

Advantages over sales. A license approach may have certain advantages over a sale. First, the
risk of falling under the Section 367(d) domestic source income rule would be reduced. Second,
the Section 865(c) domestic source rule for recapture of certain deductions and the Section
865(d)(1)(A) domestic source rule for noncontingent amounts would be avoided. Third, in the
event of termination of the joint venture, the recovery of licensed technology generally is less
problematic than the recovery of transferred technology, both from a tax and nontax standpoint.

Brazilian considerations. The deductibility of the royalties for Brazilian tax purposes
presumably would be permitted by a license, but amortization deductions would not. A major
disadvantage to a license is that a license presumably would give rise to a Brazilian withholding
tax on the royalties at the rate of 25%. You should discuss these issues with your Brazilian
advisors.

License if over 50% ownership. The foregoing generally assumes that the Company would
not own shares representing more than 50% of the value or voting power of the joint venture. We
would advise you, however, to consider whether it would be advantageous from a foreign tax
credit standpoint to exceed this threshold (for example, by purchasing a few shares of preferred
stock). This would permit dividends, interest, rent, and royalties received from the joint venture
to be assigned baskets under Section 904(d)(3) on a "look-through" basis with reference to the
income of the joint venture (which we understand, would be largely or wholly general basket).
Otherwise, dividends are reported in a separate "noncontrolled section 902 corporation" basket,
and interest generally would be in a passive basket (unless the high tax kickout rule would apply)
(Sections 904(d)(2)(E), (d)(2)(A), 954(c)(1)(A), (d)(2)(A)). Furthermore, under this approach,
the treatment of the royalties as general basket income would not depend upon the technology
being held as part of an active trade or business. Although the joint venture would become a
controlled foreign corporation, that would not appear to be a significant detriment under the
circumstances. (If the technology were sold rather than licensed, in order to avoid taxation of
gain as ordinary income, the additional shares should be nonvoting (Section 1249).)

We would be pleased to discuss this matter with you further should you so desire.

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 363

 Very truly yours,
Worksheet 7
Foreign Corporation's Investment in Indebtedness of Partnership Engaged in the
U.S. Business.
Dear Sir/Madam:

We understand that EFGH, S.A. (the "Company") is a corporation formed under Mexican
law and is wholly owned by Holdco, S.A., also organized under Mexican law. Holdco also owns
40% of the shares of IJKM, S.A., a Mexican corporation. The Company proposes to purchase on
the open market certain publicly traded debt securities ("Notes") issued by the Mexican branch
of a general partnership formed under Mexican law. The partnership's partners are a Delaware
corporation unrelated to Holdco or the Company (holding a 30% interest), a Mexican corporation
similarly unrelated (holding a 45% interest) and IJKM (holding a 25% interest and unrelated to
either of the other two partners). The Company's sole place of business is in Mexico.

The partnership is engaged in the business of manufacturing and selling automobile radios
and has facilities in the United States and Mexico. The partnership has, during each of its taxable
years ending December 31, 1989, 1990, and 1991, derived approximately 85% of its income
from sources outside the United States. All principal and interest payments on the Notes are paid
by the partnership's Mexican branch.

The Notes have a 10-year term, pay fixed interest at 8% per annum, payable semiannually,
and were issued approximately three years ago with original issue discount. The 45% partner has
guaranteed the Notes. At the time the Notes were issued, it was reasonably anticipated that the
Notes would be repaid when due without recourse to the guarantor, and the partnership could
have issued the Notes without the guarantee.

You have inquired as to the U.S. tax consequences of a purchase of Notes by the Company.

Interest paid by the partnership likely would be treated as entirely from U.S. sources for U.S.
tax purposes under Section 861(a)(1) of the Internal Revenue Code. Under existing regulations
(Regs. Section 1.861-2(a)(2)), interest paid by a U.S. or foreign partnership engaged in business
in the U.S. at any time during the taxable year of the partnership in which the interest is paid is
treated as United States source. The fact that most of the partnership's business may be
conducted outside the United States, or that the interest and principal may be paid by the
partnership's Mexican branch out of earnings derived in Mexico, or that the loan proceeds may
have been used solely in Mexico would not be relevant. Even though the regulations antedate the
Tax Reform Act of 1986, the changes made by that Act to Section 861(a)(1) do not appear to
make this regulation inapplicable.

An exception to U.S. source treatment is provided under Section 861(a)(1) for resident alien

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 364

individuals and domestic corporations if at least 80% of their income is active foreign business
income (Sections 861(a)(1)(A), 861(c)). A similar exception, however, is not available for
partnerships.

Under certain case law, purported interest expense of a corporation with respect to
indebtedness guaranteed by a shareholder may be considered to be in substance interest expense
of the shareholder if the corporation could not reasonably have incurred the indebtedness
(whether or not at a higher interest cost) on the basis of its own credit standing. In this case, such
an argument would not seem fruitful, since the partnership could have borrowed without the
guarantee.

Even though the interest on the Notes is from U.S. sources, the public holders of the Notes
are eligible for the portfolio interest exemption from U.S. tax with respect to the Notes (Section
871(h)), assuming the Notes are issued in registered form. The interest, however, would not
qualify for the portfolio interest exemption in the hands of the Company. That exemption is
inapplicable to any holder of debt instruments if the holder owns (or, under rules attributing
ownership from certain related parties, is deemed to own) 10% or more of the capital or profits
of a partnership issuer (or 10% or more of the voting power of stock of a corporate issuer)
(Section 871(h)(3)). Under the relevant attribution rules, Holdco is deemed to own 10% of the
interests in the partnership, and the Company in turn is deemed to own the same partnership
interests. (Note that if Holdco disposed of one share of its interest in IJKM, or if IJKM slightly
reduced its interest in the capital and profits of the partnership, the portfolio interest exemption
would apply.)

Accordingly, U.S. tax would be required to be withheld at a 30% rate. It should be noted,
however, that this rate may be reduced by treaty.

The Notes pay current interest and bear original issue discount. Each payment in respect of
current interest would be required to be withheld in satisfaction of U.S. tax to the extent of the
withholding tax due in respect of the interest payment plus the withholding tax due in respect of
the original issue discount accreted as of the date of the interest payment (to the extent not
previously paid). If the Notes are purchased at a discount from their accreted value ("market
discount," within the meaning of Section 1278(a)(2)), that discount would not give rise to any
additional U.S. tax liability, even though it apparently would be treated as U.S. source income.

If the Notes are purchased at a premium over their accreted value, such "acquisition
premium" would reduce the amount taxable as original issue discount (Section 1272(a)(7)); if the
issuer were to withhold on the full amount of original issue discount, the Company would have
to apply for a refund in respect of the overwithheld amount.

Any currency gain realized by the Company with respect to the Notes would be considered
foreign source income (Section 988(a)(3)) and hence exempt from U.S. tax. Similarly, any non-
currency gain realized on the disposition of the Notes in excess of any market discount would be

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 365

considered to be foreign source income (Section 865(a)) and hence exempt from U.S. tax.

We would be pleased to discuss this matter further should you so desire.

Very truly yours,

Worksheet 8
Election by U.S. Resident on Sale of Stock of Foreign Affiliate

A U.S. resident may elect to treat a foreign affiliate and all other corporations that are wholly
owned (directly or indirectly) by the affiliate as a single corporation for purposes of determining
that the U.S. shareholder's gain from the sale of stock in the foreign affiliate is sourced outside
the United States under Section 865(f). A U.S. resident shareholder may elect this treatment if
either the foreign affiliate or its wholly owned affiliates are engaged in an active trade or
business in the country in which the sale occurs, and more than 50% of the combined gross
income of the foreign affiliate and its wholly owned affiliates for the three-year period ending
with the close of the affiliate's taxable year immediately preceding the year of the sale is derived
from the active conduct of a trade or business in that foreign country. If these tests are met, the
U.S. resident shareholder's gain on the sale of stock in its foreign affiliate is treated as foreign
source.

The election to treat a foreign affiliate and its wholly owned subsidiaries as one corporation
must be made by the due date (including extensions) of the return for the first year for which the
election is to be effective. The election is made by attaching a statement that contains
information similar to that included in the sample statement below.
Section 865(f) Election to Treat Foreign Affiliate and

Its Wholly Owned Subsidiary as a Single Corporation

USCo, Inc.

[address]

[EIN]

USCo, Inc., elects under I.R.C. Section 865(f) to treat the gain realized on the sale of 10,000
shares of DutchCo 1, a Netherlands corporation, consummated in the Hague, the Netherlands, on
July 1, 1994, as foreign source income.

DutchCo 2, another Netherlands corporation, is a wholly owned subsidiary of DutchCo 1,

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 366

which in turn is a wholly owned foreign affiliate of USCo. DutchCo 1 does not wholly own
(directly or indirectly) any other corporation. DutchCo 1 and DutchCo 2 are actively engaged in
their respective businesses in the Netherlands. More than 50% of the combined gross income of
DutchCo 1 and DutchCo 2 for the three-year period ending 12/31/93, the close of DutchCo 1's
taxable year immediately preceding the year in which the sale occurred, was derived from the
active conduct of their trades or businesses in the Netherlands.

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 367

 BIBLIOGRAPHY
OFFICIAL
Statutes:
Primary:
Sections 638, 861-63, 865, 884(f), and 904.
Secondary:
Sections 243(e), 245(a), 306(f), 338(h)(16), 367(a)(3)(C) and (d), 483, 535(d), 853, 864(e)(7),
871, 882, 883, 887, 897, 924, 927(e)(1), 936(h), 953, 957(c), 988(a)(3), 1247(f), 1248, 1273,
1274, 1276(a)(4), 1291, and 7701.
7 U.S.C. 612(c).
16 U.S.C. 590(1).
16 U.S.C. 1801.
43 U.S.C. 1301(b).
Uniform Commercial Code, Sections 2-319, 2-320, 2-401, 2-503, and 2-504,2-509.
Uniform Partnership Act,Section 26.
Uniform Limited Partnership Act,Section 701.
Uniform Sales Act, Sections 19 and 20(2)(a).
Treasury Regulations:
Regs. Sections 1.58-8, 1.61-7, 1.367(b), 15a.453-1(c), 1.638-1(d), (f), 1.652(b), 1.704-1, 1.707-
1(c), 1.861-2(a), 1.861-3(b), 1.861-4, 1.861-6, 1.861-8T(c)(3), 1.861-9T, 1.861-11T, 1.863-1,
1.863-3, 1.863-4, 1.864-8T(a)(1), 1.864-2, 1.864-3, 1.864-4, 1.864-6, 1.864-7, 1.871-2(b),
1.871-11, 1.884-4, 1.897-1, 1.897-7T, 1.911-3, 1.921-IT, 1.921-3T, 1.926(a)-1T(a), 1.936-
10(c)(3)(iii), 1.953-2, 1.954-1T(c)(3), 1.960-1, 1.988-4, 1.1441-2, 1.1441-3(b)(1)(ii), 1.1441-
4, 1.7872-5T(c)(2), 301.7701-4, 301.7701(b)-1(a). Prop. Regs. Sections 1.338, 1.367(b),
1.446-3(d), 1.483-5, 1.860C, 1.861-2(a)(7), 1.861-3, 1.871, 1.881, 1.882-5, 1.953, 1.1058,
1.1275-4(c), 1.1291-5.
Legislative History:
H.R. Rep. No. 1860, 75th Cong., 3d Sess. (1938).
Description of Provisions Listed for Further Hearings by the Committee on Finance on July 20,
21 and 22, 1976 (July 19, 1976).
Staff, Joint Committee on Taxation, 97th Cong., 1st Sess., General Explanation of the Economic
Recovery Act of 1981 (1981).
Treasury Report on Tax Simplification and Reform -- General Explanation of Treasury
Department Proposals (December 3, 1984).
S. Rep. No. 169 (Vol. 1), 98th Cong., 2d Sess. (1984).
H.R. Rep. No. 432 (Part 2), 98th Cong., 2d Sess. (1984).
The President's Tax Proposals to the Congress for Fairness, Growth and Simplicity (May 29,
1985).
H.R. Rep. No. 426, 99th Cong., 1st Sess. (1985).
S. Rep. No. 313, 99th Cong., 2d Sess. (1986).
H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. (1986).

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 368

Staff, Joint Committee on Taxation, 99th Cong. 2d Sess. General Explanation of the Tax Reform
Act of 1986 (May 4, 1987).
Staff, Joint Committee on Taxation, Description of the Technical Corrections Act of 1988 (March
31, 1988).
S. Rep. No. 445, 100th Cong., 2d Sess. (1988).
H.R. Rep. No. 795, 100th Cong., 2d Sess. (1988).
H.R. Rep. No. 247, 101st Cong., 1st Sess. (1989).
Treasury Rulings:
Rev. Proc. 69-19, 1969-2 C.B. 301.
Rev. Proc. 89-31, 1989-1 C.B. 895.
Rev. Proc. 91-12, 1991-1 C.B. 473.
Rev. Rul. 274, 1953-2 C.B. 81.
Rev. Rul. 54-5, 1954-1 C.B. 130.
Rev. Rul. 54-623, 1954-2 C.B. 14.
Rev. Rul. 55-17, 1955-1 C.B. 388.
Rev. Rul. 55-677, 1955-2 C.B. 289.
Rev. Rul. 56-136, 1956-1 C.B. 92.
Rev. Rul. 56-268, 1956-1 C.B. 317.
Rev. Rul. 56-269, 1956-1 C.B. 318.
Rev. Rul. 56-346, 1956-2 C.B. 330.
Rev. Rul. 57-69, 1957-1 C.B. 239.
Rev. Rul. 57-245, 1957-1 C.B. 286.
Rev. Rul. 58-232, 1958-1 C.B. 261.
Rev. Rul. 58-234, 1958-1 C.B. 279.
Rev. Rul. 58-353, 1958-2 C.B. 408.
Rev. Rul. 59-245, 1959-2 C.B. 172.
Rev. Rul. 60-55, 1960-1 C.B. 270.
Rev. Rul. 60-57, 1960-1 C.B. 620.
Rev. Rul. 60-177, 1960-1 C.B. 9.
Rev. Rul. 60-181, 1960-1 C.B. 257.
Rev. Rul. 60-226, 1960-1 C.B. 26.
Rev. Rul. 60-249, 1960-2 C.B. 264.
Rev. Rul. 61-2, 1961-1 C.B. 393.
Rev. Rul. 62-154, 1962-2 C.B. 148.
Rev. Rul. 64-51, 1964-1 (Part 1) C.B. 322.
Rev. Rul. 64-56, 1964-1 (Part 1) C.B. 133.
Rev. Rul. 64-198, 1964-2 C.B. 189.
Rev. Rul. 64-206, 1964-2 C.B. 591.
Rev. Rul. 65-290, 1965-2 C.B. 241.
Rev. Rul. 66-32, 1966-1 C.B. 174.
Rev. Rul. 66-291, 1966-2 C.B. 279.
Rev. Rul. 67-194, 1967-1 C.B. 183.
Rev. Rul. 68-226, 1968-1 C.B. 362.
Rev. Rul. 68-443, 1968-2 C.B. 304.
Rev. Rul. 69-45, 1969-1 C.B. 313.
Rev. Rul. 69-108, 1969-1 C.B. 192.

Foreign Income Series © 1995-2005 Tax Management® Inc. Pg. 369

Rev. Rul. 69-235, 1969-1 C.B. 190.
Rev. Rul. 69-479, 1969-2 C.B. 149.
Rev. Rul. 69-501, 1969-2 C.B. 233.
Rev. Rul. 70-67, 1970-1 C.B. 117.
Rev. Rul. 70-227, 1970-1 C.B. 155.
Rev. Rul. 70-242, 1970-1 C.B. 89.
Rev. Rul. 70-246, 1970-1 C.B. 156.
Rev. Rul. 70-263, 1970-1 C.B. 158.
Rev. Rul. 70-293, 1970-1 C.B. 282.
Rev. Rul. 70-304, 1970-1 C.B. 163.
Rev. Rul. 70-360, 1970-2 C.B. 103.
Rev. Rul. 70-377, 1970-2 C.B. 175.
Rev. Rul. 70-436, 1970-1 C.B. 148.
Rev. Rul. 70-540, 1970-2 C.B. 101.
Rev. Rul. 70-543, 1970-2 C.B. 172.
Rev. Rul. 70-599, 1970-2 C.B. 172.
Rev. Rul. 70-645, 1970-2 C.B. 273.
Rev. Rul. 71-198, 1971-1 C.B. 210.
Rev. Rul. 71-268, 1971-1 C.B. 58.
Rev. Rul. 71-516, 1971-2 C.B. 264.
Rev. Rul. 71-564, 1971-2 C.B. 179.
Rev. Rul. 72-104, 1972-1 C.B. 209.
Rev. Rul. 72-135, 1972-1 C.B. 200.
Rev. Rul. 72-149, 1972-1 C.B. 218.
Rev. Rul. 72-230, 1972-1 C.B. 209.
Rev. Rul. 72-232, 1972-1 C.B. 276.
Rev. Rul. 72-350, 1972-3 C.B. 394.
Rev. Rul. 72-495, 1972-2 C.B. 414.
Rev. Rul. 72-514, 1972-2 C.B. 440.
Rev. Rul. 72-521, 1972-2 C.B. 178.
Rev. Rul. 72-624, 1972-2 C.B. 659.
Rev. Rul. 73-107, 1973-1 C.B. 376.
Rev. Rul. 73-110, 1973-1 C.B. 454.
Rev. Rul. 73-252, 1973-1 C.B. 337.
Rev. Rul. 73-505, 1973-2 C.B. 224.
Rev. Rul. 74-27, 1974-1 C.B. 24.
Rev. Rul. 74-63, 1974-1 C.B. 374.
Rev. Rul. 74-108, 1974-1 C.B. 248.
Rev. Rul. 74-170, 1974-1 C.B. 175.
Rev. Rul. 74-172, 1974-1 C.B. 178.
Rev. Rul. 74-223, 1974-1 C.B. 23.
Rev. Rul. 74-227, 1974-1 C.B. 120.
Rev. Rul. 74-249, 1974-1 C.B. 189.
Rev. Rul. 74-258, 1974-1 C.B. 168.
Rev. Rul. 74-268, 1974-1 C.B. 367.
Rev. Rul. 74-331, 1974-2 C.B. 281.

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Rev. Rul. 74-464, 1974-2 C.B. 46.
Rev. Rul. 74-555, 1974-2 C.B. 202.
Rev. Rul. 75-7, 1975-1 C.B. 244.
Rev. Rul. 75-84, 1975-1 C.B. 236.
Rev. Rul. 75-85, 1975-1 C.B. 239.
Rev. Rul. 75-172, 1975-1 C.B. 145.
Rev. Rul. 75-254, 1975-1 C.B. 243.
Rev. Rul. 75-263, 1975-2 C.B. 287.
Rev. Rul. 75-310, 1975-2 C.B. 297.
Rev. Rul. 75-449, 1975-2 C.B. 285.
Rev. Rul. 75-483, 1975-2 C.B. 286.
Rev. Rul. 76-66, 1976-1 C.B. 189, revoked by Rev. Rul. 87-38, 1987-1 C.B. 176.
Rev. Rul. 76-154, 1976-1 C.B. 191.
Rev. Rul. 76-162, 1976-1 C.B. 197.
Rev. Rul. 76-192, 1976-1 C.B. 205.
Rev. Rul. 76-283, 1976-2 C.B. 222.
Rev. Rul. 76-300, 1976-2 C.B. 217.
Rev. Rul. 76-413, 1976-2 C.B. 213.
Rev. Rul. 77-59, 1977-1 C.B. 59.
Rev. Rul. 77-167, 1977-1 C.B. 239.
Rev. Rul. 77-197, 1977-1 C.B. 344.
Rev. Rul. 77-231, 1977-2 C.B. 241.
Rev. Rul. 78-118, 1978-1 C.B. 219.
Rev. Rul. 78-182, 1978-1 C.B. 265.
Rev. Rul. 79-4, 1979-1 C.B. 150.
Rev. Rul. 79-28, 1979-1 C.B. 457.
Rev. Rul. 79-180, 1979-1 C.B. 75.
Rev. Rul. 79-206, 1979-2 C.B. 279.
Rev. Rul. 79-352, 1979-2 C.B. 284.
Rev. Rul. 79-388, 1979-2 C.B. 270.
Rev. Rul. 79-389, 1979-2 C.B. 281.
Rev. Rul. 80-15, 1980-1 C.B. 365.
Rev. Rul. 80-64, 1980-1 C.B. 158.
Rev. Rul. 80-135, 1980-1 C.B. 18.
Rev. Rul. 80-147, 1980-1 C.B. 168.
Rev. Rul. 80-222, 1980-2 C.B. 211.
Rev. Rul. 80-362, 1980-2 C.B. 208.
Rev. Rul. 81-30, 1981-1 C.B. 388.
Rev. Rul. 81-112, 1981-1 C.B. 598.
Rev. Rul. 81-160, 1981-1 C.B. 312.
Rev. Rul. 81-244, 1981-2 C.B. 151.
Rev. Rul. 82-134, 1982-2 C.B. 88.
Rev. Rul. 83-9, 1983-1 C.B. 126.
Rev. Rul. 83-10, 1983-1 C.B. 127.
Rev. Rul. 83-51, 1983-1 C.B. 48.
Rev. Rul. 83-82, 1983-1 C.B. 45.

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Rev. Rul. 83-118, 1983-2 C.B. 27.
Rev. Rul. 83-175, 1983-2 C.B. 109.
Rev. Rul. 83-176, 1983-2 C.B. 111.
Rev. Rul. 83-177, 1983-2 C.B. 112.
Rev. Rul. 84-32, 1984-1 C.B. 129.
Rev. Rul. 84-78, 1984-1 C.B. 173.
Rev. Rul. 84-144, 1984-2 C.B. 129.
Rev. Rul. 84-152, 1984-2 C.B. 381.
Rev. Rul. 84-153, 1984-2 C.B. 383.
Rev. Rul. 85-4, 1985-1 C.B. 294.
Rev. Rul. 86-6, 1986-1 C.B. 286.
Rev. Rul. 86-76, 1986-1 C.B. 284.
Rev. Rul. 86-155, 1986-2 C.B. 134.
Rev. Rul. 87-5, 1987-1 C.B. 180.
Rev. Rul. 87-15, 1987-1 C.B. 248.
Rev. Rul. 87-18, 1987-1 C.B. 709.
Rev. Rul. 87-38, 1987-1 C.B. 176, revoking Rev. Rul. 76-66, 1976-1 C.B. 189.
Rev. Rul. 87-43, 1987-1 C.B. 252.
Rev. Rul. 87-89, 1987-2 C.B. 195.
Rev. Rul. 88-31, 1988-1 C.B. 302.
Rev. Rul. 88-73, 1988-2 C.B. 173.
Rev. Rul. 89-17, 1989-1 C.B. 269.
Rev. Rul. 89-33, 1989-1 C.B. 269.
Rev. Rul. 89-42, 1989-1 C.B. 234.
Rev. Rul. 89-67, 1989-1 C.B. 233.
Rev. Rul. 89-85, 1989-2 C.B. 218.
Rev. Rul. 89-91, 1989-2 C.B. 129.
Rev. Rul. 90-37, 1990-1 C.B. 141.
Rev. Rul. 91-32, 1991-1 C.B. 107.
Rev. Rul. 92-62, 1992-33 I.R.B. 1.
Rev. Rul. 92-63, 1992-33 I.R.B. 1.
Notice 87-4, 1987-1 C.B. 416.
Notice 87-65, 1987-2 C.B. 376.
Notice 89-10, 1989-1 C.B. 631.
Notice 89-80, 1989-2 C.B. 394.
Cases:
Aiken Industries Inc., 56 T.C. 925 (1971), acq., 1972-2 C.B. 1.
American Food Products Corp. v. Comr., 28 T.C. 14 (1957).
AMP, Inc. v. U.S., 492 F. Supp. 27 (M.D. Pa. 1979), aff'd in unpub. op. (3d Cir. 9/19/80).
Amtorg Trading Corp. v. Higgins, 150 F.2d 536 (2d Cir. 1945), rev'g and rem'g 58 F. Supp. 56
(D.N.Y. 1944).
Ardbern Co. v. Comr., 41 B.T.A. 910 (1940), modified, 120 F.2d 424 (4th Cir. 1941).
Arrigoni v. Comr., 73 T.C. 792 (1980), acq., 1980-2 C.B. 1, 2.
Ashland Oil, Inc. v. Comr., 95 T.C. 348 (1990).
Associated Telephone and Telegraph Co v. U.S., 199 F. Supp. 452 (S.D.N.Y. 1961), aff'd and
rev'd in parts, 306 F.2d 824 (2d Cir. 1962), cert. denied, 371 U.S. 950 (1963).

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Astor v. Comr., 31 B.T.A. 1009 (1935).
Atkinson Co. of California, Guy F., v. Comr., 82 T.C. 275 (1984), aff'd, 814 F.2d 1388 (9th Cir.
1987), cert. denied, 108 S. Ct. 1246 (1987).
Babson Bros. Export Co. v. Comr., 22 T.C.M. 677 (1963).
Balanovski, U.S. v., 131 F. Supp. 898 (S.D.N.Y. 1955), aff'd and rev'd in parts 236 F.2d 298 (2d
Cir. 1956), cert. denied, 352 U.S. 968 (1957).
Baldwin-Lima-Hamilton Corp. v. U.S., 435 F.2d 182 (7th Cir. 1970), aff'g, rev'g and rem'g 69-1
USTC Para.9269 (N.D. Ill 1967).
Balestreri v. Comr., 47 B.T.A. 241 (1942).
Bank of America v. U.S., 81-1 USTC Para.9161 (Ct. Cl. 1981), aff'd, rev'd, and rem'd, 680 F.2d
142 (Ct. Cl. 1982).
Barba v. U.S., 83-1 USTC Para.9404 (Ct. Cl. 1983).
Barber-Greene Americas, Inc. v. Comr., 35 T.C. 365 (1960), acq., 1964-2 C.B. 4, appeal dism'd
(7th Cir. 1961).
Bence v. U.S., 18 F. Supp. 848 (Ct. Cl. 1937).
Billwiller Est. v. Comr., 11 B.T.A. 841 (1928), aff'd, 31 F.2d 286 (2d Cir. 1929), cert. denied, 279
U.S. 866 (1929).
Birkin v. Comr., 5 B.T.A. 402 (1926).
Black & Decker v. Comr., T.C. Memo 1991-557, aff'd, 986 F.2d 60 (4th Cir. 1993).
Boekman, Helvering v., 107 F.2d 388 (2d Cir. 1939), rev'g 38 B.T.A. 541 (1938), nonacq., 1938-
2 C.B. 541.
Boulez v. Comr., 83 T.C. 584 (1984), cert. denied, 484 U.S. 896 (1987).
Briskey Co. v. Comr., 29 B.T.A. 987 (1934), aff'd, 78 F.2d 816 (3d Cir. 1935), acq., 1947-2 C.B.
1.
British-American Tobacco v. Helvering, 293 U.S. 95 (1935), aff'g 69 F.2d 528 (2d Cir. 1934),
rev'g 27 B.T.A. 226 (1933), nonacq., XII-1 C B. 14.
British Timken, Ltd. v. Comr., 12 T.C. 880 (1949), acq., 1942-2 C.B. 1.
Burk Bros. v. Comr., 20 B.T.A. 657 (1930).
Carding, Gill, Ltd. v. Comr., 38 B.T.A. 669 (1938).
Carey v. U.S., 427 F.2d 763 (Ct. Cl. 1970).
Casa De La Jolla Park, Inc. v. Comr., 94 T.C. 384 (1990).
Casco Bank & Trust Co. v. U.S., 403 F. Supp. 687 (D. Me. 1975), aff'd, 544 F.2d 528 (1st Cir.
1976), cert. denied, 430 U.S. 907 (1977).
Centel Communications Co. v. Comr., 92 T.C. 612 (1989), aff'd, 920 F.2d 1335 (7th Cir. 1990).
Cini v. Comr., 67 T.C. 857 (1977).
Compania General De Tobacos De Filipinas v. Collector, 279 U.S. 306 (1929).
Cook v. U.S., 599 F.2d 400 (Ct. Cl. 1979).
Coplan v. Comr., 28 T.C. 1189 (1957), acq., 1958-2 C.B. 4, appeal dism'd (2d Cir. 1958).
Corporacion De Ventas De Salitre Y Yoda De Chile v. Comr., 44 B.T.A. 393 (1941), rev'd, 130
F.2d 141 (2d Cir. 1942).
Craik v. U.S., 31 F. Supp. 132 (Ct. C1. 1940).
Crawford v. U.S., 84-1 USTC Para.9294 (Ct. Cl. 1984).
Dammers v. Comr., 76 T.C. 835 (1981), appeal dism'd (2d Cir. 1985).
De Nobili Cigar Co. v. Comr., 1 T.C. 673 (1943), acq., 1943 C.B. 6, aff'd, 143 F.2d 436 (2d Cir.
1944).
DeStuers v. Comr., 26 B.T.A. 201 (1932).

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Diefenthal v. U.S., 367 F. Supp. 506 (E.D. La. 1973).
Dillin v. Comr., 56 T.C. 228 (1971), acq., 1975-1 C.B. 1.
Dorn Co. v. Comr., 12 B.T.A. 1102 (1928).
Dowell v. Comr., 36 T.C.M. 470 (1977).
DuPont, Deputy v., 308 U.S. 488 (1940), rev'g 103 F.2d 257 (3d Cir. 1939), 22 F. Supp. 589 (D.
Del. 1938).
East Coast Oil Co., S.A. v. Comr., 31 B.T.A. 558 (1934), aff'd, 85 F.2d 322 (5th Cir. 1936), cert.
denied, 299 U.S. 608 (1936), acq., 1947-2 C.B. 2.
Eitingon v. Comr., 27 B.T.A. 1341 (1933).
Elston Co. v. Comr., 42 B.T.A. 208 (1940), nonacq., 1940-2 C.B. 10, appeal dism'd (4th Cir.
1941).
Enoch v. Comr., 57 T.C. 781 (1972), acq., 1974-1 C.B. 1.
Epic Metals Corp. v. Comr., T.C. Memo 1984-322.
Exolon Co. v. Comr., 45 B.T.A. 844 (1941), acq., 1947-2 C.B. 2, acq. and nonacq., 1942-1 C.B.
6, 22 (withdrawn).
Farley Realty Corp. v. Comr., 279 F.2d 701 (2d Cir. 1960), aff'g T.C. Memo 1959-93.
Favell v. U.S., 89-1 USTC Para.9287 (Ct. Cl. 1989), supp. op., 91-1 USTC Para.50,095 (Ct. Cl.
1991).
Ferro-Enamel Corp., Comr. v., 46 B.T.A. 1279 (1942), rev'd, 134 F.2d 564 (6th Cir. 1943).
Foster v. Comr., 42 T.C. 974 (1964).
Foster v. U.S., 329 F.2d 717 (2d Cir. 1964), aff'g 221 F. Supp. 291 (D.N.Y. 1963).
Gallatin Welsh Trust v. Comr., 16 T.C. 1398 (1951), aff'd per curiam, 194 F.2d 708 (3d Cir.
1952), cert. denied, 344 U.S. 821 (1952).
Georday Enterprises, Ltd. v. Comr., 126 F.2d 384 (4th Cir. 1942).
Green Export Co., A.P., v. U.S., 284 F.2d 383 (Ct. Cl. 1960)
Groetzinger v. Comr., 480 U.S. 23 (1987).
Hallmark Cards, Inc. v. Comr., 90 T.C. 26 (1988).
Hambuechen v. Comr., 43 T.C. 90 (1964).
Hammond Organ Western Export Corp. v. Comr., 327 F.2d 964 (7th Cir. 1964), aff'g T.C. Memo
1963-91.
Hanna v. Comr., 763 F.2d 171 (4th Cir. 1985), aff'g, rev'g and rem'g, 76 T.C. 252 (1981).
Hartman v. Comr., 17 T.C.M. 1020 (1958).
Hawaiian Philippine Co. v. Comr., 35 B.T.A. 173 (1936), nonacq., 1937-1 C.B. 1, aff'd, 100 F.2d
988 (9th Cir. 1939), cert. denied, 307 U.S. 635 (1939).
Hay v. Comr., 2 T.C. 460 (1943), aff'd, 145 F.2d 1001 (4th Cir. 1944), cert. denied, 324 U.S. 863
(1945).
Hazelton Corp. v. Comr., 36 B.T.A. 908 (1937), nonacq., 1938-1 C.B. 50, appeal dism'd (9th Cir.
1939).
Hocking Glass Co., Miller v., 80 F.2d 436 (6th Cir. 1935).
Hooker Chemical and Plastics Corp. v. U.S., 79-1 USTC Para.9163 (Ct. Cl. 1979).
Housden v. Comr., T.C. Memo 1992-91.
Howkins v. Comr., 49 T.C. 689 (1968).
Hughes v. Comr., 65 T.C. 566 (1975).
Hunt v. Comr., 90 T.C. 1289 (1988).
Iglesias v. U.S. 848 F.2d 362 (2d Cir. 1988), rev'g 658 F. Supp. (S.D.N.Y. 1987).
Ingram v. Bowers, 47 F.2d 925 (1931), aff'd, 57 F.2d 65 (2d Cir. 1932).

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Intel Corp. v. Comr., 100 T.C. 616 (1993) aff'd, 76 F.3d 976 (9th Cir. 1998).
International Canadian Corp., Frank, v., 308 F.2d 520 (9th Cir. 1962), aff'g 61-1 USTC Para.9405
(D. Wash. 1961).
International Lottery Fund v. Virginia State Lottery Dep't. (E.D. Va. Aug. 28, 1992).
Isidro Martin-Montis Trust, v. Comr., 75 T.C. 381 (1980), acq., 1981-2 C.B. 2.
Johnston v. Comr., 24 T.C. 920 (1955).
Jones v. Comr., 91-1 USTC Para.50,174 (5th Cir. 1991), rev'g and rem'g T.C. Memo 1989-616.
Jones Trust, B.W., v. Comr., 46 B.T.A. 531 (1942), aff'd, 132 F.2d 914 (4th Cir. 1943).
Karrer v. U.S., 152 F. Supp. 66 (Ct. Cl. 1957).
Kaspare Cohn Co., Inc. v. Comr., 35 B.T.A. 646 (1937).
Kates Holding Co. v. Comr., 79 T.C. 700 (1982), appeal dism'd (10th Cir. 1983).
Koninklijke Hollandische Lloyd, N.V., v. Comr., 34 B.T.A. 830 (1936), nonacq., 1937-2 C.B. 43.
Korfund Co. v. Comr., 1 T.C. 1180 (1943), appeal dism'd (2d Cir. 1944).
Lang v. Comr., 45 B.T.A. 256 (1941), nonacq., 1942-1 C.B. 25, rev'd sub nom. Raphael v. Comr.,
133 F.2d 442 (9th Cir. 1943), cert. denied, 320 U.S. 735 (1943).
Lay v. Comr., 69 T.C. 421 (1977).
Le Beau Tours Inter-America, Inc. v. U.S., 415 F. Supp. 48 (S.D.N.Y. 1976), aff'd per curiam,
547 F.2d 9 (2d Cir. 1976), cert. denied, 431 U.S. 904 (1977).
Lemay v. Comr., 53 T.C.M. 862 (1987), aff'd, 88-1 USTC Para.9182 (5th Cir. 1988).
Levy v. Comr., 1 T.C.M. 316 (1942).
Liggett Group, Inc. v. Comr., 58 T.C.M. 1167 (1990).
Linseman v. Comr., 82 T.C. 514 (1984).
Livingston v. Comr., 4 T.C.M. 943 (1945).
Lowrey v. Comr., 24 T.C.M. 1078 (1965).
Louisiana, U.S. v., 363 U.S. 1 (1960).
Lyeth v. Hoey, 305 U.S. 188 (1938), rev'g 96 F.2d 141 (2d Cir. 1938), rev'g 20 F. Supp. 519
(D.N.Y. 1937).
Manning v. Comr., 38 T.C.M. 646 (1979), aff'd, 614 F.2d 815.
Marcor, Inc. v. Comr., 89 T.C. 181 (1987), nonacq., 1990-2 C.B. 1.
Markus v. Comr., 30 T.C.M. 1346 (1971), rev'd, 486 F.2d 1314 (D.C. Cir. 1973).
Marton Est. v. Comr., 47 B.T.A. 184 (1942).
Maximov v. U.S., 373 U.S. 49 (1963), aff'g 299 F.2d 565 (2d Cir. 1962), rev'g and rem'g 61-1
USTC Para.9207 (D.N.Y. 1961).
Metz v. Comr., 49 T.C.M. 575 (1985).
Miami Purchasing Service Corp., Inc. v. Comr., 76 T.C. 818 (1981).
Miller v. Comr., 52 T.C. 752 (1969), acq., 1972-2 C.B. 2.
Misbourne Pictures, Ltd. v. Johnson, 189 F.2d 774 (2d Cir. 1951), aff'g 90 F. Supp. 978 (D.N.Y.
1950).
Missouri Pacific Railroad Co. v. U.S., 392 F.2d 592 (Ct. Cl. 1968).
Molnar v. Comr., 4 T.C.M. 951 (1945), aff'd, 156 F.2d 924 (2d Cir. 1946).
Monk & Co., A.C., v. Comr., 10 T.C. 77 (1948).
Mooney v. Comr., 9 T.C. 713 (1947), acq., 1948-1 C.B. 2.
Muhleman v. Hoey, 41-1 USTC Para.9465 (D.N.Y. 1941), aff'd, 124 F.2d 414 (2d Cir. 1942).
Muir v. Comr., 10 T.C. 307 (1948), acq., 1948-2 C.B. 3, aff'd and rem'd, 182 F.2d 819 (4th Cir.
1950).
Murphy Logging Co. v. U.S., 239 F. Supp. 794 (D. Ore. 1965), rev'd, 378 F.2d 222 (9th Cir.

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 1976).
Myers v. Comr. 6 T.C. 258 (1946), acq., 1946-1 C.B. 3, nonacq., 1950-1 C.B. 9.
M/V Nonsuco, Inc. v. Comr., 23 T.C. 361 (1954), acq., 1955-2 C.B. 8, rev'd, 234 F.2d 583 (4th
Cir. 1956).
Norfolk & Western Railway Co. v. Sims, 191 U.S. 441 (1903).
Oceanic Steam Navigation Co. v. Comr., 31 B.T.A. 781 (1934).
Old Colony Railroad Co. v. Comr., 248 U.S. 552 (1932), rev'g 50 F.2d 896 (1st Cir. 1931), rev'g
18 B.T.A. 267 (1930).
Otis Elevator Co. v. U.S., 356 F.2d 157 (Ct. Cl. 1980).
PPG Industries, Inc. v. Comr., 55 T.C. 928 (1970).
Pan American Eutectic Welding Alloys Co., Inc. v. Comr., 36 T.C. 284 (1961), acq., 1964-2 C.B.
6.
Perkins v. Comr. 40 T.C. 330 (1963), acq., 1964-1 (Part 1) C.B. 5.
Perry Group, Inc. v. U.S., 80-2 USTC Para.9603 (D.N.J. 1980), aff'd in unpub. op. (3d Cir.
1981).
Petroleum Corp. of Texas Inc. v. U.S., 939 F.2d 1165 (5th Cir. 1991), rev'g and rem'g 90-2 USTC
Para.50,395 (D. Tex. 1990).
Pfauder Inter-American Corp. v. Comr., 330 F.2d 471 (2d Cir. 1964), aff'g T.C. Memo 1963-109.
Philipp Bros. Inter-Continent Corp. v. U.S., 66-1 USTC Para.9421 (S.D.N.Y. 1966).
Phillips Petroleum Co. v. Comr., 97 T.C. 30 (1991).
Phillips Petroleum Co. v. Comr., 101 T.C. 78 (1993), aff'd, 70 F.3d 1282 (10th Cir. 1995).
Piedras Negras Broadcasting Co. v. Comr., 43 B.T.A. 297 (1941), nonacq., 1941-1 C.B. 18, aff'd,
127 F.2d 260 (5th Cir. 1942).
Plaisance v. U.S., 433 F. Supp. 936 (E.D. La. 1977).
Plantation Patterns, Inc. v. Comr., 29 T.C.M. 817 (1970), aff'd, 462 F.2d 712 (5th Cir. 1972), cert.
denied, 409 U.S. 1076 (1972).
Pratt v. Comr., 64 T.C. 203 (1975), aff'd, rev'd, and rem'd in part, 550 F.2d 1023 (5th Cir. 1977).
Raphael v. Comr., 133 F.2d 442 (9th Cir. 1943), rev'g and rem'g 45 B.T.A. 256 (1941), nonacq.,
1942-1 C.B. 25.
R.J. Dorn & Co. v. Comr., 12 B.T.A. 1102 (1928), acq., VIII-1 C.B. 13 (1929).
Redding v. Comr., 43 T.C.M. 719 (1982).
Roerich v. Comr., 38 B.T.A. 567 (1938), acq. and nonacq., 1938-2 C.B. 27, 56, aff'd, 115 F.2d 39
(D.C. Cir. 1940), cert. denied, 312 U.S. 700 (1941).
Rohmer v. Comr., 5 T.C. 183 (1945), aff'd, 153 F.2d 61 (2d Cir. 1946), cert. denied, 328 U.S. 862
(1946).
Ronrico Corp. v. Comr., 44 B.T.A. 1130 (1941), acq., 1944 C.B. 24, appeal dism'd (5th Cir.
1942).
Sabatini v. Comr., 32 B.T.A. 705 (1935), nonacq., XIV-2 C.B. 41 (1935), aff'd, revd, and
modified in part, 98 F.2d 753 (2d Cir. 1938).
Saint Jude Medical, Inc. v. Comr., 97 T.C. 457 (1991).
San Carlos Milling Co. v. Comr., 24 B.T.A. 1132 (1931), nonacq., XI-2 C.B. 16, aff'd, 63 F.2d
153 (9th Cir. 1933).
Sanchez v. Comr., 6 T.C. 1141 (1946), aff'd, 162 F.2d 58 (2d Cir. 1947), cert. denied, 332 U.S.
815 (1947).
Schonenberger v. Comr., 74 T.C. 1016 (1980).
Sinclair v. Comr., 19 T.C.M. 602 (1960).

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Sochurek v. Comr., 300 F.2d 34 (7th Cir. 1962), rev'g and rem'g 36 T.C. 131 (1961).
Stafford & Co., G.A. v. Pedrick, 78 F. Supp. 89 (S.D.N.Y. 1948), aff'd, 171 F.2d 42 (2d Cir.
1948).
Stanford v. Comr., 297 F.2d 298 (1961), aff'g 34 T.C. 1150 (1960).
State v. Ruvido, 15 A.2d 293 (S. Jud. Ct. Me. 1940).
Stein, Helvering v., 40 B.T.A. 848 (1939), nonacq., 1940-1 C.B. 8, aff'd, 115 F.2d 468 (4th Cir.
1940).
Stemkowski v. Comr., 76 T.C. 252 (1981), rev'd, rem'd, and aff'd in part, 690 F.2d 40 (2d Cir.
1982).
Stockholms Enskilda Eank, Helvering v., 25 B.T.A. 1328 (1932), nonacq., XI-1 C.B. 11, aff'd, 68
F.2d 407 (D.C. Cir. 1934), rev'd, 293 U.S. 84 (1934).
Stuart, Helvering v., 317 U.S. 154 (1942).
Suffolk Co., Helvering v., 104 F.2d 505 (4th Cir. 1939).
Sundstrand v. Comr., 96 T.C. 226 (1991).
Texas-Canadian Oil Corp. v. Comr., 44 B.T.A. 913 (1941).
Tipton & Kalmbach, Inc. v. U.S., 72-2 USTC Para.9563 (D. Colo. 1972), rev'd and rem'd, 480
F.2d 1118 (10th Cir. 1973).
Tobey v. Comr., 60 T.C. 227 (1973), acq., 1979-1 C.B. 1.
Tonopah & Tidewater R.R. Co. v. Comr., 39 B.T.A. 1043 (1939), rev'd, 112 F.2d 970 (9th Cir.
1940).
Tootal Broadhurst Lee Co., Ltd. v. Comr., 9 B.T.A. 321 (1927), aff'd, 30 F.2d 239 (2d Cir. 1929),
cert. denied, 279 U.S. 861 (1929).
Topps of Canada, Ltd. v. Comr., 36 T.C. 326 (1961).
Torrington Co. v. U.S., 149 F Supp. 172 (Ct. Cl. 1957).
Unger v. Comr., 936 F.2d 1316 (D.C. Cir. 1991), aff'g T.C. Memo 1990-15.
Vitale v. Comr., 72 T.C. 386 (1979).
Watson, Comr. v., 163 F.2d 680 (9th Cir. 1947), cert. denied, 332 U.S. 842 (1947).
Weisler v. Comr., 161 F.2d 997 (6th Cir. 1947), cert. denied, 332 U.S. 842 (1947).
Westerdahl v. Comr., 82 T.C. 83 (1984).
Wodehouse v. Comr., 8 T.C. 637 (1947), acq., 1947-2 C.B. 5, rev'd, 166 F.2d 986 (4th Cir. 1948),
rev'd and rem'd, 337 U.S. 369 (1949), on remand, 178 F.2d 987 (4th Cir. 1949), on remand,
15 T.C. 799 (1950).
Yokohoma Ki-Ito Kwaisha, Ltd. v. Comr., 5 B.T.A. 1248 (1927), acq., VI-2 C.B. 7 (1927).
Zander & Cia v. Comr., 42 B.T.A. 50 (1940).
Zarin v. Comr., 916 F.2d 110 (3d Cir. 1990), rev'g 92 T.C. 1984 (1989).
UNOFFICIAL
Books and Treatises:
ALl, Federal Income Tax Project: International Aspects of United States Income Taxation (1987).
Bischel (ed.), Income Tax Treaties (P.L.I. 1978).
Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders (5th ed. 1987).
Hancock (ed.), Corporate Counsel's Guide: Laws of International Trade, Business Laws, Inc.
(1992).
J. Honnold, Uniform Law for International Sales under the 1980 United Nations Convention
(Kluwer) (1982).
MacDonald, Annotated Topical Guide to U.S. Income Tax Treaties (Prentice Hall Law &

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 Business).
Periodicals:
1953
Surrey & Warren, "The Income Tax Project of the American Law Institute: Gross Income,
Deductions, Accounting, Gains and Losses, Cancellation of Indebtedness," 66 Harv. L. Rev.
761.
1960
Dailey, "The Concept of the Source of Income, 15 Tax L. Rev. 415.
1976
Williams, "Permanent Establishments in the United States, 29 Tax Law. 277.
1979
Harllee, "U.S. Income Taxation of Aliens on Current and Deferred Compensation," 37 N.Y. Inst.
Fed. Tax., ch. 21.
Lederman, "The Offshore Finance Subsidiary: An Analysis of the Current Benefits and
Problems," 50 J. Tax'n 86.
1980
Williams, "Tax Consequences of Foreign Investment in the New York Insurance Exchange,"
1980 Ins. L.J. 433.
1981
Lokken, "The Source of Income From International Uses and Dispositions of Intellectual
Property," 36 Tax L. Rev. 233.
1982
Green, "Sourcing Income from Export Financing Activities," 9 Int'1 Tax J. 31.
1983
Harwood, "Recent CA-2 Decision Focuses on Computing U.S. Activities," 9 Int'l Tax J. 31.
1984
Patrick, "Converting Income and Expenses to Domestic or Foreign Source," 62 TAXES 1045.
Hreha, "Update on the Passage-of-Title Test for Determining Source of Income," 10 Int'l Tax J.
259.
1985
Khokhar, "1984 TRA Modifies Character and Source of Income Rules," 14 Tax Mgmt. Int'l J. 3.
1987
Note, "Revising the Source of Income Rule for the Purchase and Sale of Personal Property: The
Tax Reform Act of 1986," 41 Tax Law. 169.
1988
Griffin & Calabrese, "The New Rules for International Contracts," ABA J., March 1.
Kelly, "Federal Income Taxation of Space and Ocean Activities," 14 Int'l Tax. J. 69.

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1989
Matthews, "Treasury Meeting with CEOs Presages Export-Source Rule Guidance," Tax Notes,
Sept. 5.
Oosterhuis & Cutrone, "The Export Source Rule: An Age-Old Rule with a Dubious New
Interpretation," Tax Notes, June 26.
1990
Sampson, "The Title-Passage Rule: Applicable Law under the CISG," 16 Int'l Tax J. 137.
1991
Galler, "Risk of Loss in Sourcing Profits from Sales of Personal Property," 17 Int'l Tax J. 77, 80-
81.
Galler, "An Historical and Policy Analysis of the Title Passage Rule in International Sales of
Personal Property," 52 U. Pitt. L. Rev. 521.
1992
Note, A Guide to the Source of Income Rules for the Sale and Purchase of Inventory Property, 45
Tax Lawyer 857.
1999
Goldstein & Danziger, "The Tax Jock's Guide to Loss Allocation," 28 Tax Mgmt. Int'l J. No. 11,
683 (Nov.)
Lebovitz & Kurland, "Final Regulations on Sourcing Stock Losses Are Generally Worth the
Wait," 10 J. Int'l Tax'n 10 (Apr.).
Macdonald, "The Administration's Proposed Revision to §863(b): The Administration Fails to
Make Its Best Case," 28 Tax Mgmt. Int'l J. 469 (Aug.).
Sprague, Chesler & Hersey, "The Final Software Revenue Characterization Regulations," 28 Tax
Mgmt. Int'l J. 59 (Feb.).
2000
Sprague & Reid, "U.S. Taxation of Income from International Electronic Commerce
Transactions," 41 Tax Mgmt. Memo. 503 (Dec. 4).
2001
Dougherty, "The Source of Income from Personal Services -- Not Always a Clear-Cut
Determination," 27 Int'l Tax J. 47 (Spring).
Ellis, "Satellites and the Proposed Regulations on Space and Communications Activities," 30 Tax
Mgmt. Int'l J. 347 (Aug.).
Littman, "Space, Ocean and Communications Income -- The Final Frontier?" 30 Tax Mgmt. Int'l
J. 195 (May).
Rudd, Lebovitz, et al., "Why the Proposed Regulations Under §863(d) and (e) Could Impact the
Internet Industry in Surprising Ways," 42 Tax Mgmt. Memo. 230 (May 21).
Tillinghast & Holm, "Proposed Regulations on Space and Ocean Income and International
Communications Income Raise Major Issues for U.S. and Foreign Companies," 79 TAXES 11
(June).
2002
Lainoff et al., "The Proposed Regulations Regarding the Taxation of Space, Ocean, and
Communications Activity: How the Failure to Follow Relevant Policy Guidelines Leads to

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 Quixotic Taxation," 80 TAXES 185 (Mar.).
Venuiti, Bates & Bowers, "Sourcing Royalties from the Licensing of Computer Software Rights:
Does FSA 200222011 Signal a Change in IRS Position?" 31 Tax Mgmt. Int'l J. 443 (Sept.).
2003
Glicklich & Miller, "Proposed Transportation Regulations-Suggestions for a Final Course
Correction," 32 Tax Mgmt. Int'l J. 235 (May).
Libin, "U.S.-Italy Treaty Resurfaces Questionable Anti-"Cherry Picking Rule" With Respect to
Royalty Payments," 32 Tax Mgmt. Int'l J. 156 (Mar.).
2004
Tillinghast, "The Source of E-Commerce Income Characterized as Services Income -- An
Everyday Problem with No Clear Solution," 33 Tax Mgmt. Int'l J. 429 (July).
Wielobob, "U.S. Taxation of Compensatory Stock Options in the International Context: An
Overview of Some Current Issues," 33 Tax Mgmt. Int'l J. 19 (Jan.).

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