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.

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.
1All section references herein are to the Internal Revenue Code, as amended, and the regulations promulgated thereunder, unless otherwise indicated.
2See 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.
3See generally 901 T.M., The Creditability of Foreign Taxes -- General 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
4See 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
5See generally 918 T.M., U.S. Income Taxation of Citizens and Residents Abroad.
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
6See Sections 864, 871(b), 882(a).
7See 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
8See, 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
9See 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. Also, the IRS has issued final and temporary regulations under §937(b) in T.D. 9194, 70 Fed. Reg. 18919 (4/11/05). Certain of the regulations published at that time (as now reflected in Regs. §§1.937-1 and 1.881-5(f)(4), concerning bona fide residency in the possessions) were made final in T.D. 9248, 71 Fed. Reg. 4996 (1/31/06).
10See 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
11See generally 933 T.M., The Possession Tax Credit Under Section 936.
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
12Special 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.
13P.L. 98-369 (hereafter referred to as TRA 84).
14P.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 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 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 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.
15See, 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
16Section 7701(a)(9).
17See,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).
18See, e.g., Sections 7701(a)(9), 865(i)(3), 1441(e).
19Regs. 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."
20This economic definition of the United States was first expressed in the Outer Continental 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
21Regs. 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).
22Regs. Section 1.638-1(d).
23Id.
24This 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 rules of Section 863(c) or the ocean activity rules of Section 863(d), as discussed below at IX and X, respectively.
25Rev. 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.
26Cf. Plaisance v. U.S., 433 F. Supp. 936 (E.D. La.1977).
27But 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
28See, 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).
29No 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).
30Under the Chinese treaty, however, recognition of the Chinese continental shelf is conditioned upon Chinese tax laws in fact being in force with respect thereto.
31CCH 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.
321976-2 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.
33See 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.
34See §§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).
35See 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).
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.
36Regs. Section 1.861-2(a)(1).
37Section 7701(a)(4).
38See 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).
39See Regs. Section 1.861-2(a)(2).
40See, 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).
41Regs. 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 security, if any, is physically located are not relevant.43
42See Regs. Section 1.861-2(a)(3); A.C. Monk & Co., Inc. v. Comr., 10 T.C. 77, 82-83 (1948).
43A.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
44Id.
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
45Regs. Section 1.861-2(a)(2).
46As discussed in II, C, below, original issue discount is considered interest for purposes of Section 861(a)(1).
47Section 871(g)(3). The Treasury Department may provide otherwise by regulation. Id.
48Regs. 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 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.
49Section 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).
50Section 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.
51Section 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
52See 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
53See 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 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 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
54See §§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
56For 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 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
57TRA 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).
58See 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
59In 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.
59.1This 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. branch for purposes of the branch profits tax. For a discussion of the requirements to terminate a U.S. branch, see 909 T.M., The Branch-Related Taxes of Section 884.
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
59.2Former §861(a)(1)(F), as in effect before TRA 86.
Accordingly, a basic understanding of the branch profits tax regime is important in assessing 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 
59.3A 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
60Whether 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., The Branch-Related Taxes of Section 884.
61Regs. §1.884-4(a)(1). See generally 909 T.M., The Branch-Related Taxes of Section 884.
62Regs. §1.884-4(a)(1).
62.1Form 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.
63Regs. §§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 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
64Regs. §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. 
65Regs. §1.884-4(b)(1).
65.1Note 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.
65.2The 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 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
65.3Regs. §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
66Regs. §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
67Regs. §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
68Regs. §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. 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.
69See 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.
69.1Regs. §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
70See 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
71Regs. §1.884-4(b)(6)(i).
72Regs. §1.884-4(b)(6)(ii),  (iii).
73Regs. §1.884-4(b)(6)(i).
Under certain circumstances, a foreign corporation may elect to treat interest that is paid in a 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
74See 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
75Regs. §1.884-4(a)(2)(i). See generally 909 T.M., The Branch-Related Taxes of Section 884. 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 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.
76Regs. §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
77Regs. §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
77.1See 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 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
77.2See 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
77.3See 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
77.4See 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
77.5See 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
(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.
78Regs. §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
79See 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).
80Rev. 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
81TRA 86, §§1214(c), (d)(1).
82TRA 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
(ii) Income derived by a foreign central bank of issue from bankers' acceptances. 
Section 881(d), relating to foreign corporations, provides that no tax shall be imposed under §881 on any amount described in §871(i)(2).
The term "deposits" in §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 §591 (determined without regard to §§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
83See fn. 79 above. With regard to §§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.
84See fn. 79 above.
85See Regs. §1.861-2(b)(1)(ii).
86Regs. §1.861-2(b)(1)(iii).
87Id.; 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 §871(i)/§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 §§861(a)(1)(B) and 862(a)(1).88
88See 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
89Regs. §1.861-2(b)(4).
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 §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
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.90 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 rule has no application to a domestic partnership (that is, one formed under domestic law). This places particular significance on whether the partnership is organized under domestic law, which is not always clear.
90§861(a)(1)(C), added by §410 of P.L. 108-357 (the 2004 American Jobs Creation Act).
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 §861(a)(1), interest includes (i) original issue discount, as defined in §1273(a)(1), and (ii) amounts treated as interest under §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 instrument93 (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 §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
91Dailey, "The Concept of the Source of Income," 15 Tax L. Rev. 415 (1960); see Regs. §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.
92Regs. §1.861-2(a)(4); PLR 8802038.
93§§1273(a)(1), 1272(a)(1). See generally 535 T.M., Time Value of Money: OID and Imputed Interest.
94See §§871(a)(1)(C), 881(a)(3), 871(g)(3).
95See 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 §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 §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§7872(a).
97§7872(b).
98Regs. §1.7872-5T(c)(2).
99Id.
A production payment "carved out" of mineral property is treated as a mortgage loan on the property under §636(a), and a production payment retained on the sale of real property is treated as a purchase money mortgage on the property under §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 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
100Eitingon v. Comr., 27 B.T.A. 1341 (1933); Rev. Rul. 65-290, 1965-2 C.B. 241.
101Astor v. Comr., 10 B.T.A. 1009 (1935).
102Helvering 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. §1.861-2(a)(1) includes interest on tax refunds paid by the United States or any state or local government.
103Lang 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).
104A.C. Monk & Co., Inc. v. Comr., 10 T.C. 77 (1948).
105Iglesias v. U.S., 88-1 USTC ¶9389 (2d Cir. 1988), rev'g 658 F. Supp. 856 (S.D.N.Y. 1987). The Second Circuit held Regs. §1.861-2(a)(1) to be void to the extent it implied that interest referred only to amounts owed on indebtedness voluntarily incurred.
106See §1271(a)(1); Rev. Rul. 74-172, 1974-1 C.B. 178. To the extent that the "premium" corresponds to market discount, it may be treated as interest for various purposes, though not for purposes of §§871(a), 881, 1441, and 1442. See §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." §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 §1278(a)(4)) over the basis of the debt instrument immediately after its acquisition by the taxpayer.107
107§1278(a)(2).
Absent promulgation of regulations under §1276 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 [§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
108Cf. 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).
It appears that acquisition premium under §1272(a)(7) reduces the amount of original issue discount treated as interest generally, including for source purposes. Similarly, amortizable bond premium reduces the amount of taxable interest payments.109
109§171(e). Nevertheless, in the case of a foreign holder, a withholding agent often would not be in a position to take §1272(a)(7) or §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 issued regulations under which substitute payments on debt securities are sourced identically to interest paid on the securities.110 These regulations are discussed in XII, C, below.
110Regs. §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§864(d); Regs. §1.864-8T(a)(1).
112Regs. §1.861-8T(c)(3).
113§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 §861(a)(1)(A) is met).115 Otherwise, it is not, even if the individual is a U.S. citizen.
114Regs. §1.861-2(a)(2).
115See the discussion in II, A, and II, B, 1, above.
Section 7701(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 §7701(b) fill this gap by extending the scope of the §7701(b) statutory rules to citizens, although there is some question whether this was intended by Congress.116
116Regs. §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 §911 purposes. Id. Accord H.R. Rep. No. 432 (Part 2), 98th Cong., 2d Sess., p. 1528 (1984). Cases under §911 undertake a "facts and circumstances" analysis along the lines of that set forth in Regs. §1.871-2(b), which governed the determination of residency status of aliens prior to the enactment of §7701(b). See, e.g., Jones v. Comr., 91-1 USTC ¶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 §7701(b), an alien is generally treated as a resident of the United States for a calendar year if such alien satisfies one of the following 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); (2) the alien satisfies the "substantial presence" test; or (3) the alien makes a valid first-year election under §7701(b)(4).
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 present in the United States for fewer than 183 days in the current calendar year, and he can establish that he has closer connections with and a tax home in a foreign country.117
117§7701(b)(3). See generally 907 T.M., U.S. Income Taxation of Nonresident Alien Individuals.
For source of interest income purposes, the trade or business status of an individual has no 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.
118Regs. §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 §861(a)(1)(A) is met or the interest is paid by a foreign banking branch described in §861(a)(1)(B).120
119§7701(a)(4).
120See 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 §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).
121See§§7701(a)(4),  (a)(5).
122Strictly from the standpoint of §861, the foreign corporation could be the equivalent of a nonresident even if engaged in trade or business in the United States. (Regs. §1.861-2(a)(2), which treats such a foreign corporation as a "resident of the United States," does not reflect TRA 86 changes.) On the other hand, §861(a)(1) should not be read in isolation from §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.
According the the regulations, a partnership, whether domestic or foreign, 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 The location of the partnership's place of organization is also not relevant.125
123Regs. §1.861-2(a)(2). But cf. §988(a)(3)(B) (partnership residence for foreign currency purposes).
124Regs. §301.7701-5.
125Id.
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 the American Jobs Creation Act of 2004, §861(a)(1) and 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 was, at least in the case of a foreign partnership, unnecessarily broad and produced 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 is desirable that foreign corporations and partnerships be treated similarly.
126§884(f)(1).
Consistent with this analysis, Congress enacted §861(a)(1)(C),126.1 which provides that the interest received from a foreign partnership predominantly engaged in the active conduct of a trade or business outside the United States is not U.S. source income unless the interest either is paid by a U.S. trade or business conducted by the partnership or is allocable to partnership income treated as effectively connected with the conduct of a U.S. trade or business. 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.
126.1American Jobs Creation Act of 2004, P.L. 108-357, §410(a). Section 861(a)(1)(C) is effective for taxable years beginning after 2003.
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
127See §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).
128See, 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 §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 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 §§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
129Regs. §1.707-1(c).
13052 T.C. 752 (1969).
131In 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.
132Carey v. U.S., 427 F.2d 763 (Ct. Cl. 1970).
133Compare 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
134Regs. §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.
134.146 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
1351960-1 C.B. 257.
136See 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
136.5For 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 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.
137If 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
138Section 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.
138.1See Rev. Rul. 81-112, 1981-1 C.B. 598; Rev. Rul. 62-154, 1962-2 C.B. 148.
139See, 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
140Other 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 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.
141Regs. §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).
14239 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.
1431978-1 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.
144462 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).
145378 F.2d 222 (9th Cir. 1967), rev'g 239 F. Supp. 794 (D. Ore.1965).
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.
146See 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
146.1P.L. 103-66, §13238.
146.2T.D. 8611, 60 Fed. Reg. 40997 (8/11/95).
146.3Regs. §1.881-3(a)(3)(ii)(B).
146.4Regs. §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.
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
146.7Regs. §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
146.8Regs. §1.881-3(c)(2)(i).
146.9Regs. §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.
14756 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 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
1481984-2 C.B. 381.
1491984-2 C.B. 383.
1501987-2 C.B. 195.
151Compare 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).
152See, 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").
153See 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
153.11995-2 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
154Rev. 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.
155See Rev. Rul. 74-464, 1974-2 C.B. 46.
156TRA 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).
1571986-1 C.B. 286. Accord, e.g., PLR 8449060; PLR 8530050.
158Accord 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
159See 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.
160See, 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 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
161Rev. 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
162Rev. 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.
163See 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. 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
164See 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).
165See III, B, 8, below.
166See §§1366(b), 1373(a). See also XIII, A, 2, below.
167See §853.
168See III, B, 9, b, below.
169See 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.
170See §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.
171See §671.
172Rev. 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
173See §§651- 52.
174See §§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).
176E.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 beneficiary179 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.
177Section 661(b).
178See 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).
179Sections 662(b), 667(e).
180See 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.
181See 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 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
18275 T.C. 381 (1980), acq., 1981-2 C.B. 2.
183See 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
184Rev. 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
185Rev. Rul. 86-76, 1986-1 C.B. 284 (situation 2); GCM 39506 (underlying Rev. Rul. 86-76); PLR 8324015.
186See 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.
187PLR 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
188See the discussion in II, B, 4, above.
III. Dividend Income
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.
189See Sections 861(a)(2)(A) and  (B), 862(a)(2).
190See 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
191See 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 deduction for purposes of the shareholder's regular U.S. income tax liability.194
192Section 936(a)(2).
193See Section 936(a)(1), (b).
194Section 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
195See 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 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
196Sections 861(a)(2)(B), 884(d)(2).
197Regs. 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
198Section 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
199See Section 884(e)(3)(A). See also 909 T.M., The Branch-Related Taxes of Section 884.
200TRA 86, Section 1241(e).
201Section 884(e)(1).
202The income tax treaties with Korea, the Philippines, and Sweden are examples of this type of treaty.
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.
203S. 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.
204Id.
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
205TRA 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 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
206Another 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).
207Section 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.
208Cf. 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
209See generally Regs. Section 1.921-1T(a); Prop. Regs. Section 1.991-1(e).
210Section 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 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
211Section 995(b)(1)(A).
212Section 995(b)(1)(B).
213Section 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        
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  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 income218 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                     

214Amounts 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).
215Regs. Section 1.861-3(a)(5)(i).
216Regs. Section 1.861-3(a)(5)(iii)(a).
217Regs. Section 1.861-3(a)(5)(iii)(b).
218Regs. Section 1.861-3(a)(5)(iv)(a).
219Regs. Section 1.861-3(a)(5)(iv)(a).
220Regs. 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.
5.	Foreign Sales Corporations (FSCs)
TRA 84 added §§921-927, which generally replaced the system of DISCs with a simpler, territorial-type system of taxation for U.S. exports, the FSC. The FSC Repeal and Extraterritorial Income Exclusion Act of 2000,221 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 the American Jobs Creation Act of 2004,222 for transactions occurring after December 31, 2004, subject to certain transitional relief for transactions occurring in 2005 and 2006.
221P.L. 106-519.
222P.L. 108-357.
The FSC provisions exempted income from U.S. taxation only if certain economic processes giving rise to the income occurred outside the United States. To this end, the FSC provisions instituted foreign management and foreign economic process requirements.223 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.
223See former §924. See generally 934 T.M., Foreign Sales Corporations.
Former §926(b) provided 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 former §923(b)) to a shareholder which was a foreign corporation or a nonresident alien was 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 were treated as made directly to the partners or beneficiaries in proportion to their respective interests in the entity.224 FSC distributions made out of other earnings and profits were considered to be foreign source under the general source rule. Regs. §1.926(a)-1(b)(1) sets forth the order in which distributions were deemed made from the various categories of the FSC's earnings and profits.
224Regs. §1.926(a)-1T(a).
Dividends attributable to foreign trade income (within the meaning of former §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 §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 §904 foreign tax credit limitations in taxable years beginning before 2007, 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.225
225See §904(d)(1)(H), before amendment by P.L. 108-357, which reduced the number of separate limitation categories to two (passive and general) for taxable years beginning after 2006.
6.	Exception for Foreign Tax Credit Purposes for Dividends Eligible for §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 §245 dividends received deduction. This deduction generally is allowed, at the rate specified in §243, for the "U.S.-source portion" of dividends received from a foreign corporation, other than a 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).226 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 §245(a)(5)) bears to the total "post-1986 undistributed earnings" (as defined in §902(c)(1)).227
226§245(a)(1), (2).
227§245(a)(3).
First, for purposes of §904, §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 §245(a)(9) violates a treaty obligation of the United States, the taxpayer may elect the benefit of the treaty source rule (but §§902, 904(a)-(c), 907, and 960 must be applied separately with respect to such portion of the dividend).228
228§245(a)(10).
Second, §861(a)(2)(B) generally provides that, for purposes of the §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 §245(a) with respect to such dividend (100/80th in the case of dividends from a "20-percent owned corporation," as defined in §243(c)(2)). A technical modification is made to this rule in the regulations to treat as foreign source a corresponding portion of any §78 dividend.229 (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 §245(b).) The general rule was added to §861(a)(2)(B) at the time of the enactment of §245 to preclude both a foreign tax credit and a dividends received deduction attributable to the same income.230 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 §245 deduction; only the balance of the dividend is treated as foreign source income for foreign tax credit purposes.
229See Regs. §1.861-3(a)(3)(ii) (though still reflecting the 85% rate for the dividends received deduction).
230See 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 §245 to allow a deduction for dividends received from a foreign corporation attributable to earnings and profits arising in the United States.231 The provision was completely rewritten as part of TRA 86232 and further amended by the 1988 TAMRA.233
231Under the Revenue Act of 1918, the source of both dividends and interest was determined by the residency of the obligor. When this proved inequitable, §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 §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 (§217(a)(2)(B)). Since this credit was unavailable to foreign persons and corporations, the 1936 Act (§119(a)(2)(B)) added the current "50-50" pro rata predominant source rule applicable to foreign corporations. Finally, the 1951 Act added §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).
232TRA 86, §1226(a).
233Technical and Miscellaneous Revenue Act of 1988, P.L. 100-647 (hereinafter cited as "TAMRA"), §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(h),234 treats as U.S. source income, solely for purposes of computing 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 §904 limiting fraction) by routing it through a foreign corporation. Prime targets of the provision were international finance subsidiaries and offshore captive insurance companies.
234Redesignated from §904(g) by §402 of P.L. 108-357 for taxable years beginning after December 31, 2006.
235See generally 901 T.M., The Creditability of Foreign Taxes -- General Issues.
The resourcing rule applies to any foreign corporation as to which U.S. persons (as defined in §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§904(h)(6).
Under §904(h), for purposes of the §904 foreign tax credit limitations, the following four types of income that would otherwise constitute foreign source income are resourced as U.S. source income:237 
(i) Subpart F income, etc.
Income includible in the income of a U.S. shareholder of a controlled foreign corporation under §951(a) to the extent that such income is attributable to income of the controlled foreign corporation derived from U.S. sources.238
(ii) Passive foreign investment company currently includible income.
Income includible under §1293 to the extent that such income is attributable to income of the passive foreign investment company derived from U.S. sources.239
(iii) 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 §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 §861(c)(1) for purposes of §861(a)(1)(A).241
(iv) 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 §904(h), a dividend includes any amount treated as ordinary income under former §1246 (as in effect before its repeal by P.L. 108-357) or as a dividend under §1248.243
237U.S. source of a foreign personal holding company was included in this list until P.L. 108-357, the American Jobs Creation Act of 2004, repealed former §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.
238§904(h)(1)(A)(i) and (h)(2).
239§904(h)(1)(A)(ii) and (h)(2).
240§904(h)(1)(B) and  (h)(3).
241See §904(h)(9)(A).
242§904(h)(1)(C) and (g)(4).
243§904(h)(7).
If less than 10% of the earnings and profits of a U.S.-owned foreign 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 §904(h).244 This de minimis exception does not apply with respect to subpart F income or passive foreign investment company income.245
244See §904(h)(5).
245Id.
If characterization of an amount derived from a U.S.-owned foreign corporation is inconsistent with an obligation of the United States 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, §§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 §951(a)(1) 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§904(h)(10)(A).
247§904(h)(10)(B).
8.	Exception for Accumulated Earnings Tax Purposes
For purposes of the §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.248 This provision was added by TRA 84 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 86.249
248§535(d). See generally 796 T.M., Accumulated Earnings Tax.
249The 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 some or all of the income they receive.
a.	S Corporations
In the case of a qualifying corporation that has elected under §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.250
250§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. §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 §851 (RIC), the entity may pass through the character of certain tax-exempt interest251 and net capital gains252 to its shareholders. Dividends and capital gain dividends paid by a RIC generally are from U.S. sources.253 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 §852(a) for the year, the RIC may elect under §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.
251See §852(b)(5).
252§852(b)(3). See generally 740 T.M., Taxation of Regulated Investment Companies.
253See 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.254 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 §897(c)(1)).255 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.256 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.
254See §857(b)(3). See generally 742 T.M., Real Estate Investment Trusts.
255See §897(h)(1). See the discussion in VI, A, below.
256Id.
d.	Real Estate Mortgage Investment Conduits
In the case of a "real estate mortgage investment conduit" as defined in §860D (REMIC), which may or may not take the form of a corporation or other entity, 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.257 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.258 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.
257§860C(a)(1); Regs. §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. See generally 741 T.M., REMICs and Other Mortgage-Backed Securities.
258§860C(b)(1)(A); Regs. §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 percentage 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 §871(a) or §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.259 If the 80% 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.260 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.
259See §§871(i), 861(c). See the discussion of §861(c) in II, B, 1, above.
260See §§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 §861(c).261
261See 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.262
262See Rev. Rul. 72-230, 1972-1 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.263 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.264 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.265
263§§861(a)(2)(A) (as in effect prior to amendment by TRA 86), 862(a)(2).
264See TRA 86 Blue Book at 937.
265Id. at 938.
C. Definition of Dividend
1.	General
The source of income regulations state that the term "dividend" has the meaning set forth in §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.266 Earnings and profits are calculated in accordance with §312, and generally exceed undistributed taxable income.267
266See generally 764 T.M., Dividends -- Cash and Property; 762 T.M., Earnings and Profits.
267See generally 762 T.M., Earnings and Profits; 932 T.M., Foreign Corporation Earnings and Profits.
For source of income purposes, dividends include, e.g., constructive dividends, dividend equivalent redemptions under §302(d),268 stock dividends that are taxable under §305(b), proceeds of the redemption or sale of certain preferred stock ("§306 stock")269 to the extent deemed made out of §312 earnings and profits, property distributions with respect to a shareholder's stock, §356(a)(2) "boot" dividends, inclusions of earnings and profits required under §367(b),270 a shareholder's proportionate share of "undistributed foreign personal holding company income" includible under former §551(b),271 capital gain dividends from a regulated investment company,272 consent dividends under §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 §1248.273 On the other hand, redemptions which qualify for §302(a) "sale" treatment, distributions in complete liquidation taxable as capital gain under §331274 or as ordinary income from a "collapsible" corporation under former §341,275 distributions representing a return of capital under §301(c)(2), or gain under §301(c)(3) and nontaxable stock distributions under §305(a) are not dividends for source of income purposes.
268De 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).
269See VII, A, 2, f, below.
270See Regs. §1.367(b)-2(e).
271Section 413 of the American Jobs Creation Act of 2004, P.L. 108-357, repealed former §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. shareholders with or within which such taxable years of foreign corporations end.
272Rev. 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 §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).
273See VII, A, 2, h, below.
274In 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 §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 §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).
275Section 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.

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. Under the regulations, substitute interest payments are treated identically to interest paid on the loaned securities for purposes of §§861 and 862.276 This regulation is discussed in greater detail in XII, C, below.
276See Regs. §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 §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 §871(i)(2) exclusion for the same reason that interest from deposits would not be.277
277See 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" 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 §§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 generally irrelevant to the source of such income,278 as are the place in which the contract was made or the place or time of payment.279
278See 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).
279Regs. §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." 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).
a.	General Tax Regime and Exemptions
Compensation for services performed by a typical foreign employee stationed temporarily in the United States is considered to be from U.S. sources. It also is considered to be effectively connected with a U.S. trade or business under §864 and, unless exempt under an income tax treaty, subject to regular U.S. income tax under §871(b)(1).280 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.
280See, e.g., PLR 8319044. See generally 907 T.M., U.S. Income Taxation of Nonresident Alien Individuals. 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 §911 exclusion for foreign earned income.281
281See generally 918 T.M., Citizens and Resident Aliens Employed Abroad.
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.282
282See I, C, 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 §911`s exclusion of foreign source personal service income earned by U.S. citizens and resident aliens living abroad.283 While possessions income is not excludable under §911, services performed within such possessions may be eligible for the income exclusionary rules of §§931- 36 relating to the taxation of possessions citizens, residents, or income.284
283See the discussion in I, C, above.
284See generally 933 T.M., The Possession 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 include 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.285
285See 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 §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.)286
286In 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 §1402(a)(5), per §879(a)(2). See generally 907 T.M., U.S. Income Taxation of Nonresident Alien Individuals.
For purposes of applying the §911 exclusion in the case of community income, a similar approach is taken. Under §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 §§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-§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. citizen or resident and who file separate returns.
Historical Note: Before the enactment of §879 in 1976 (by 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.287 As originally enacted, §879 did not apply where both spouses (rather than one) were nonresident aliens from a community property country. To prevent such taxpayers from splitting their income to obtain a lower effective tax rate, §879 was amended by TRA 84.288
287See, e.g., Crawford v. U.S., 84-1 USTC ¶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).
288See TRA 84, §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.289
289For 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 §861(a)(3), income from services performed in the United States is not 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;290 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.291 While a corporation can perform personal services through its employees, the §861(a)(3) exception applies only to nonresident alien individuals and not to corporations.
290The excess of travel advances over expenses is included, but pensions and retirement pay attributable to United States services is excluded. Regs. §1.861-4(a)(4).
291See 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 §861(a)(3). Under §864(b)(1), the nonresident alien individual 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 §§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 §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.292 Were it not for this exception, not only might the employee not satisfy the requirements of §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.293
292See Regs. §1.864-2(b)(2)(ii).
293But cf. Regs. §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,294 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).295 An individual's commercial traveler status will be unaffected by the status of other individuals, but the §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.
294Regs. §1.864-2(b)(3), Ex. 2; Rev. Rul. 69-479, 1969-2 C.B. 149.
295Dailey, "The Concept of Source of Income," 15 Tax L. Rev. 415, 435 (1960).
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.296 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 substantial presence test, any day such a crew member is present in that capacity is disregarded, provided that he does not otherwise engage in any U.S. trade or business on that day.297
296§861(a)(3), as amended by §1174 of the 1997 Taxpayer Relief Act and applicable for services performed in taxable years beginning after 1997.
297§7701(b)(7)(D).
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.
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,298 and (ii) the employee is present in the other country for no more than 180299 to 183300 days (90 days in some treaties).301 In addition, under certain treaties, the individual may not receive more than a stated dollar amount as compensation (e.g., $3,000302 or $10,000303). Treaties often distinguish between dependent and independent personal services.
298E.g., Germany (Art. 15), New Zealand (Art. IX), and Luxembourg (Art. XII).
299E.g., Luxembourg (Art. XII) and Sweden (Art. XI).
300E.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).
301E.g., Italy (Art. XI).
302E.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).
303E.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.304
304TAM 8748003.
Students, teachers, and trainees are also subject to specific, usually more limited, exemptions.305 The "commercial traveler's" provisions generally do not apply, or apply in a more restricted fashion, to artists (including entertainers) and athletes.306 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.307 Certain treaties also provide specific rules which source income derived from personal services to the treaty country of performance.308 These treaty rules parallel rather than depart from the Code source rule.
305See generally MacDonald, "Annotated Topical Guide to U.S. Income Tax Treaties" (Prentice Hall Law & Business) (1990).
306E.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).
307E.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).
308E.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 §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.309
309Regs. §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 that "In many cases the facts and circumstances will be such that an apportionment on the time basis will be acceptable."310 The regulations were amended in 2005, most importantly to deal with the sourcing of fringe benefits. 311 The facts and circumstances rule, with the stated sanction of time basis apportionment, was retained in the amended regulations.
310Regs. §1.861-4(b)(1)(i),  (2)(i).
311See T.D. 9212, 70 Fed. Reg. 40663 (7/14/05). The amendments are effective for taxable years beginning on or after July 14, 2005.
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.312 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.313 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.314 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.315 
312An example of a different approach is in PLR 8711107 (discussed below).
313Cini v. Comr., 67 T.C. 857(1977). Cf. Levy v. Comr., 1 T.C.M. 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).
314Regs. §1.861-4(b)(2)(ii)(E). 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. §1.861-4(b); Stemkowski v. Comr., 82-2 USTC ¶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).
315See Stemkowski, 76 T.C. at 298-99, aff'd on this issue, ¶9589 (2d Cir. 1982) (days during hockey player's off season excludable notwithstanding general negative covenants operative during such time).
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 revised regulations provide rules for apportioning service income in three general cases: (1) services performed by persons other than individuals, (2) compensation for services performed by individuals, and (3) certain fringe benefits for services performed by individuals.
(1)	Persons Other than Individuals
Under the revised regulations, compensation for services performed partly within and partly without the United States by a person other than an individual is allocated on the basis that most correctly reflects the proper source of the income under the particular facts and circumstances. The regulations state that in many cases, the facts and circumstances will be such that apportionment on a time basis will be acceptable.316
316Regs. §1.861-4(b)(1).
The rules for allocating compensation on a time basis are contained in Regs. §1.861-4(b)(2)(ii)(E). Under that provision, the time period used for allocations is generally presumed to be the calendar year in which the services are performed. However, the taxpayer may establish to the satisfaction of the IRS, or the IRS may determine, that a distinct, separate and continuous period of time is more appropriate. Thus, the time period used can be less than a day, or it can be a period that includes more than one calendar year.
(2)	Compensation of Individuals
Under Regs. §1.861-4(b)(2), income derived from the compensation for personal services paid to an individual is also required to be allocated on the basis that most correctly reflects the proper source of the income under the facts and circumstances. 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.317
317Regs. §1.861-4(b)(2)(ii)(A). This rule does not apply to certain fringe benefits, discussed below; also, an employee is permitted to use, and the IRS may require, an alternative basis for allocating compensation if that basis more properly determines the source of the compensation. See Regs. §1.861-4(b)(2)(ii)(B) and (C).
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.317.1
317.1Regs. §1.861-4(b)(2)(ii)(E).
In most cases, identifying the services for which an employee's compensation must be allocated will be straightforward. For example, in the context of a service contract with an entity, the entity's accounting system, in particular its time reporting system, should yield sufficient information to determine the services performed, dates, and location. There are situations, however, where it is not clear whether incidental services performed for an employer should be considered to relate to the employee's compensation, and therefore whether those services should be included in allocating that compensation between U.S. and foreign sources. For example, there is the question of whether a sports player's preparations for a season (e.g., training camp) should be included. Also, it is not clear whether compensation that is not directly related to particular services, such as a signing bonus, should be allocated. The regulations do not address these issues,317.2 but case law and IRS rulings provide some guidance.
317.2Regs. §1.861-4(b)(2)(ii)(C)(3) reserves on the treatment of artists and athletes.
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 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.
318690 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.
319The 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.
320763 F.2d 171 (4th Cir. 1985), aff'g, rev'g, and rem'g 76 T.C. 252 (1981).
32116 Cl. Ct. 700 (1989).
3221987-1 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.
323Linseman v. Comr., 82 T.C. 514 (1984).
3241974-1 C.B. 248. Rev. Rul. 2004-109, 2004-50 I.R.B. 958, 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. §1.861-4(b), a similar result is provided under the regulations governing the §911 foreign earned income exclusion. Pursuant to Regs. §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 §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 vesting period.325 This concept is developed further in the discussion immediately below.
325See Regs. §1.911-3(e)(4)(ii), Ex. 3.
(3)	Fringe Benefits
Regs. §1.861-4(b)(2)(ii)(D) specifies six fringe benefits that are sourced on a geographical basis. THe first three, fringe benefits for housing, education, and local transportation are sourced to the location of the individual's principal place of work.325.1 A tax reimbursement fringe benefit is sourced to the jurisdiction that imposed the tax for which the individual is reimbursed.325.2 Hazardous or hardship duty pay is sourced to the location of the zone for which it is paid.325.3 A moving expense reimbursement fringe benefit is sourced to the employee's new principal place of work.325.4
325.1Regs. §1.861-4(b)(2)(ii)(D)(1)-(3). For this purpose, principal place of work has the same meaning as for §217. Regs. §1.861-4(b)(2)(ii)(D).
325.2Regs. §1.861-4(b)(2)(ii)(D)(4).
325.3Regs. §1.861-4(b)(2)(ii)(D)(5).
325.4Regs. §1.861-4(b)(2)(ii)(D)(6). The reimbursement can be sourced to the employee's former principal place of work if the employee establishes that such sourcing would be more appropriate under the facts and circumstances. Id.
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
326If 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.
327In 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 §§56, 57(a)(6), 58(g)(2) (prior to amendment by TEFRA); Regs. §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 §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 §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 §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 attributable entirely to the taxable year in which an election to include it in income is made.329
328See Regs. §1.911-3(e)(4)(ii), Ex. 3.
329Regs. §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, 2004, to vest in equal increments on each of the first two anniversaries of the grant date. Employee C is transferred abroad effective January 1, 2005, for two years. If C did not make a §83(b) election within 30 days of the grant, then, for purposes of §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 §83(b), all of the income realized upon the election would have been allocated to U.S. sources.
The approach taken in the §911 regulations (in situations not involving a §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
3309 T.C. 713 (1947), acq., 1948-1 C.B. 2.
331Id. at 718.
332Id.
333Id. 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 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
334See PLR 6701305110A.
335Accord 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.
336See PLR 6208215200A (corporation granted options to induce employee to remain with corporation; optionee could not exercise option until one year following grant).
337Id.
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 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.
338PLR 8711107.
339The 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
340See TRA 86 Blue Book at 929.
341Regs. 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.
342See IV, C, 3, below.
343See the discussion in IX, below.
344See 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 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.
3451977-1 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
3461979-1 C.B. 457, clarified in Rev. Rul. 79-206, 1979-2 C.B. 279.
347See 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.
348E.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
349See, 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.
350Id. (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).
351See 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 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
352127 F.2d 260 (5th Cir. 1942).
353Sections 861(a)(3), 861(a)(4).
354Accord 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.
355480 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
356An 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).
357480 F.2d at 1121.
358Id.
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
359A 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).
360See 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).
361Markus 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).
362See 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.)
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
363Regs. Section 1.638-1(f), Ex. 3.
364Regs. Section 1.638-1(f), Ex. 5.
365Regs. Section 1.638-1(f), Ex. 6.
366Regs. 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 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
367Regs. 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
368Rev. 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).
369Regs. Section 1.861-4(a).
370The 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.
371In 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
372Rev. Rul. 84-144, 1984-2 C.B. 129; PLR 7835003 (Navy pension).
373Rev. 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 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
374Section 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).
375Section 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).
376See 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.
377Regs. 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
378See 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
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).
379Rev. 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.
380See 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 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 ESOT382 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
381See 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.
382Such "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.
383PLR 8633081.
384Id. But cf. Clayton v. U.S., 95-2 USTC ¶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).
385See 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 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
386Helvering 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.
387Hawaiian 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
388See 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.
389If, 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.
390See 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 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.
391See 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.
39257 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.
39383 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.
394152 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 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
395See fns. 397-401 below.
396Rev. Rul. 74-555, 1974-2 C.B. 202, modified, Rev. Rul. 76-283, 1976-2 C.B. 222.
397Cf. 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
398See VII, B, 2, a, below.
399A 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.
400See, 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).
401This 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.
402See 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.
403See 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.
404U.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.
40560 T.C. 227 (1973), acq., 1979-1 C.B. 1.
406Either 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.
40760 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. (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
408599 F.2d 400 (Ct. Cl. 1979).
409It 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
410Rev. 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.
411See 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. Section 1.61-3(a)).
4121986-2 C.B. 134.
413See former Regs. Section 1.954-1T(e)(3).
4141983-2 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
415Guy 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).
416Id. 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.
417Id.
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
418See 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
419See TAM 8308005.
420Id.
421Marcor, Inc. v. Comr., 89 T.C. 181 (1987), nonacq., 1990-2 C.B. 1.
422See 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 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. §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.
423See the discussion in B, 2, a, (1), (B).
424Cf. TAM 9233003 (tangible personal property not excludible from inventory as services even if custom-made). But see Guy F. Atkinson Co., above.
425TAM 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).
426If 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 §865(i)(1). Note also that depreciable personal property would be taxed in the same manner under §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.
427See 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 provide certain examples of the meaning of ancillary, apparently drawn from Rev. Rul. 64-56.
428Regs. §1.482-2(b)(8).
429See 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) 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
4301964-1 (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).
431Accord Hooker Chemical and Plastics Corp. v. U.S., 79-1 USTC ¶9163 (Ct. Cl. 1979).
43255 T.C. 928 (1970).
433See also 887 T.M., Transfer Pricing: The Code 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 Philippine 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.
434See, 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).
435100 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
436See, 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 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
43782 T.C. 514 (1984).
43882 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
4391 T.C. 1180 (1943).
440Korfund 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. §1.861-4(b) should not take into account the offseason time.
44176 T.C. 252, 288-89, 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.
4421974-1 C.B. 248, revoked by Rev. Rul. 2004-109, 2004-50 I.R.B. 958.
443Had 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 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 concluded that none of the sign-on bonus would be sourced to the United States.
In Rev. Rul. 2004-109,443.1 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.
443.12004-50 I.R.B. 958.
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
444See generally Lowrey v. Comr., 24 T.C.M. 1078 (1965); Sinclair v. Comr., 19 T.C.M. 602 (1960).
445See 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
446See PLR 7808038.
447See 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 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
448See 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.
449Id.
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 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 personal services under §§861(a)(3) and 862(a)(3).
45082-1 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 §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.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
451See 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).
452See PLR 7712289960A.
453Id. Cf. §861(a)(7).
454GCM 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
455In 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
456Unlike §863(c), §863(e) does not expressly include "related" service.
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
457See  §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 the discussion 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.
458Cf. Cook v. U.S., 599 F.2d 400 (Ct. Cl. 1979).
459Miller 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
460Helvering 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. 
461See, e.g.,  Bank of America v. U.S., 680 F.2d 142 (Ct. Cl. 1982).
462107 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).
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 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
463415 F. Supp. 48 (S.D.N.Y. 1976), aff'd per curiam, 547 F.2d 9 (2d Cir. 1976).
464The 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.
465In 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.
466The 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
467The 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).
468See 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 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 force471 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.
46912 T.C. 880, 887 (1949); Accord Rev. Rul. 60-55, 1960-1 C.B. 270.
470Thus, the Section 863(b) split-source rules were inapplicable.
471The 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.
47240 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.
47312 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 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.
474See VIII, A, below.
475See 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 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.
476Regs. Section 1.638-1(c). See the discussion in I, C, above.
4771975-2 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
478See 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
479See 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
480As 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
4811968-2 C.B. 304.
482The 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.
483Rev. 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 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
4841980-2 C.B. 208.
485See 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 license487 was used in the foreign country, the lump sum payment was foreign source income to the U.S. corporation.
4861984-1 C.B. 173.
487The 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
488See, e.g., Missouri Pacific Railroad Co. v. U.S., 392 F.2d 592 (Ct. Cl. 1968).
489Rev. 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 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.
49047 B.T.A. 184 (1942).
4914 T.C.M. 951 (1945), aff'd, 156 F.2d 924 (2d Cir.1946).
492153 F.2d 61 (2d Cir. 1946), aff'g 5 T.C. 183 (1945), cert. denied, 328 U.S. 862 (1946).
493156 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).
494153 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.
4958 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).
496Wodehouse v. Comr., 177 F.2d 881 (2d Cir. 1949), rev'g 8 T.C. 637 (1947).
497178 F.2d 987 (4th Cir. 1949).
49815 T.C. 799 (1950). The IRS confirmed this in TAM 9730005.
49914 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
500Misbourne 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 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.
501See 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
502Rev. Rul. 60-226, 1960-1 C.B. 26. See VII, A, 2, a, (3), below.
503Id.
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
504See VII, A, 2, a, below.
505Sections 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.
506Section 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).
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
507Rev. 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.
508See 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
509See 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
510See 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 bilateral income tax treaties to which the United States is a signatory.
511Accord 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).
512P.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
513See 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
514Section 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.
515Section 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).
516Section 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 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
517Section 897(c)(2).
518See Section 897(c)(5).
519Section 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
520Section 897(c)(3); Regs. Section 1.897-1(c)(2)(iii); Regs. Section 1.897-9T.
521Section 897(h)(2), Regs. Section 1.897-1(c)(2)(i).
522Section 897(c)(1)(B); Regs. Section 1.897-1(c)(2)(ii).
523Section 897(c)(1)(A)(ii); Regs. Section 1.897-1(d)(1).
524Id.
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
525Id.
526Regs. 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).
527Id.
528Regs. 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
529The statute begins: "Under regulations prescribed by the Secretary . . ."
530Section 897(g).
531Regs. Section 1.897-7T. See also Regs. Section 1.897-1(c)(2)(iv) (publicly traded partnerships treated like corporations for Section 897 purposes).
532See 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 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, 1984536 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
533Taxation 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.
534But cf. Rev. Rul. 91-32, 1991-1 C.B. 107.
535Although 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.
536See FIRPTA, Section 1125(c).
537The 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 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
538See Staff of Joint Comm. on Tax'n, 97th Cong., 1st Sess., General Explanation of the Economic Recovery Tax Act of 1981, at 370 (1981).
539Id.
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
540Regs. Section 1.897-1(b)(1).
541Id. 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
542Regs. Section 1.897-1(b)(2).
543Id.
544Id.
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 former 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 former 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 former 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 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.
545Regs. Section 1.897-1(b)(3)(i).
546Regs. Section 1.897-1(b)(3)(ii).
547Regs. Section 1.897-1(b)(3)(iii).
548Id.
549Regs. Section 1.897-1(b)(3)(iii)(B).
550Id.
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
(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
551Regs. Section 1.897-1(b)(4)(i).
552Regs. Section 1.897-1(b)(4)(i)(A).
553Id.
554Id.
555Regs. Section 1.897-1(b)(4)(i)(B).
556Regs. Section 1.897-1(b)(4)(i)(C).
557Id.
558Regs. Section 1.897-1(b)(4)(i)(D).
559Id.
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.
560See 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
561See 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.
562See PLR 8726061.
Real property generally does not include an interest in a corporation, partnership, or other entity.563
563But 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 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
564See, 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).
565See, 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).
566See, 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
567Section 865(i)(5) (added by TAMRA, Section 1012(d)(3)(B); changed the TRA 86 rule which had looked to the partnership's residence).
568S. 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
569Section 865(i)(3).
Historical Note: Section865, added by TRA 86 and generally effective for taxable years 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
570In 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.
571See, 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
572These 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
573It is assumed that the sale is not governed by Section1248.
574See 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, 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
575Sections 865(g)(1)(A), 865(g)(2).
576Section 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
577Section865(i)(5), added by TAMRA, Section 1012(d)(3)(B).
578See 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 necessarily mean that an individual's abode is in the United States.580
579Regs. 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.
580Regs. 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.
581Rev. Rul. 83-82, 1983-1 C.B. 45.
582Id.
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 business.586
583Id.
584Id. 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.
585Rev. Rul. 83-82 1983-2 C.B. 45.
586Id.
(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
587Section865(g)(2).
588Section865(g)(3), added by TAMRA, Section 1012(d)(6)(A).
589Section865(j)(3), added by TAMRA, Section 1012(d)(6)(B).
590Staff 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 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
591Section 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
592Section 865(c)(4)(A).
593Section 865(c)(4)(B).
594Section865(c)(4)(C).
595Section 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.
596Section 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).
598§865(d)(4)(B).
599See 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.
601Regs. §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.
602Regs. §1.861-8(e)(7).
603See id.
604See, 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).
605See, 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 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.
606TRA 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.
6071991-1 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.
6081989-1 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.
608.1T.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, 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.
608.2108 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.
609Regs. §1.861-9T(b)(3)(i).
609.164 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.
609.21989-1 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
609.3See  Regs. §1.865-2(e).
The regulations follow the general residence of the seller rule. Commentators had criticized 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
609.4The 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
609.5See 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 
609.6Regs. §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
609.7Regs. §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
609.8Regs. §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. §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.
609.9Regs. §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
609.10Regs. §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
609.11Regs. §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).
609.12See 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 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
609.13Regs. §1.865-1(c)(4).
609.14Regs. §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
609.15Regs. §1.865-2(a)(1).
609.16Regs. §1.865-2(a)(2).
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
609.17Regs. §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
609.18Regs. §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
609.19Regs. §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
609.20Regs. §1.865-2(a)(5).
609.21Regs. §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
609.22Regs. §1.865-2(d)(2).
609.23Regs. §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
609.24Regs. §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 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
609.25Regs. §1.865-2(d)(3).
609.26Regs. §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
609.27Regs. §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).
609.28Regs. §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
609.29Regs. §1.865-2(b)(4)(i).
609.30Regs. §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 
609.31Regs. §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.
609.32Regs. §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 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
610See VII, A, 2, a, (2) and (3), below, for a discussion of these terms.
611§865(d)(1)(B).
612If 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
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.
614See 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.
616See VII, A, 2, b, below.
617See 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.
619See 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.
620See 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 (§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
621See discussion below in VII, A, 2, g.
622See §§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.
623See VII, A, 2, a, (3).
624P.L. 89-809.
625It 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.
626Section 865(d)(2).
627Rev. 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).
628Rev. Rul. 68-443, 1968-2 C.B. 304 (legal protection of trademarks in country of transferee assumed).
629Cf. 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
630See, 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.
631See 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
6326 T.C. 258 (1946).
63328 T.C. 1189, 1190 (1957).
634Rev. 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.
6351960-1 C.B. 26.
In Rev. Rul.84-78,636 the IRS ruled that payments received by a U.S. corporation from a 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.
636Rev. 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.
637I.T. 2735, 1933-2 C.B. 131, 134, declared obsolete, Rev. Rul.70-293, 1970-1 C.B. 282.
63898 F.2d 753 (2d Cir. 1938).
639153 F.2d 61 (2d Cir. 1946), cert. denied, 328 U.S. 862 (1946).
640337 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
641Rev. Rul. 71-564, 1971-2 C.B. 179; Rev. Rul. 64-56, 1964-1 (Part 1) C.B. 133 (know-how).
642Rev. 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).
643Cf. 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
644See generally 558 T.M., Tax Planning for the Development and Licensing of Copyrights, Computer Software, Trademarks and Franchises (U.S. Series).
645Coplan v. Comr., 28 T.C. 1189, 1190 (1957).
646Myers 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
647Section865(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)).
648See 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.
649See 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).
650TAMRA, 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 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
651Section 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
652See VII, B, 1, b, (1), below.
The IRS has ruled privately653 that U.S. residents who sold a substantial limited partnership 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 §865(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. §1.954-1T(d)(2)). The property was not depreciable personal property described in §865(c) and was the only property of the partnership.654 On these facts, the IRS ruled that, under §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 §865(e)(1). As discussed below, the IRS has issued a public ruling reaching a similar result under §865(e)(2) with respect to the sale of an interest in a domestic partnership by a foreign person.655
653PLR 9142032. Cf. PLR 9612017 (foreign office of S corporation attributed to its shareholders; gain on the sale of their shares ruled foreign source).
654The importance of this fact is that, by its terms, §865(e)(1) does not apply to gain sourced under the §865 rules governing the sale of, e.g., inventory property, depreciable personal property, or goodwill.
655Rev. 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 §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 §865(e)(2)(A) rule does not apply for purposes of sourcing income of export trade corporations under §971.657
656See VII, B, 1, b, (2).
657§865(e)(2).
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 §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 §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 §864(c)(5)(B), and hence is U.S. source income under §865(e)(2) (as well as effectively connected income under §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
658See Rev. Rul. 91-32, 1991-1 C.B. 107, discussed in greater detail below in VII, A, 2, (1).
659See VII, A, 2, c, (1).
660See 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 §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 §1504(a), applied without regard to §1504(b).662
661Under 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§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 §865(f).
663§865(f).
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.
664See 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 §865(d)(2)) would be treated as U.S. source income under §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 §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 §865, the treaty provision should govern even without an election under §865(h). Treaties for which the §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§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 §865(h)to treat the gain recognized by its U.S. subsidiary (a member of its consolidated return group) as foreign source gain, although §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 §865(h) income category for purposes of the §904 foreign tax credit limitation.
666See §7852(d); S. Rep. No. 445, 100th Cong., 2d Sess. 239 (1988).
667Cyprus (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§865(h)(1),  (h)(2)(B).
In each case, §§902, 904(a)- (c), 907 and 960 must be applied separately to such gain.669
669§865(h)(1)(B).
f.	Section 306 Stock
Under §306(a)(1), all or part of the amount realized from the sale of certain preferred stock (§306 stock) received in certain transactions deemed to give rise to the potential for "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 §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 §§871(a)(1) and 881(a), as may be relevant. Thus, for example, in the case of §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 §§1441-1442. The portion of the amount realized from the sale of §306 stock that is not treated as a dividend under these rules is sourced under the rules governing the sale of personal property.
Under §306(a)(2), the amount realized upon the redemption of §306 stock is treated as a distribution of property under §301 (without regard to whether any of the §302(b) tests for nondividend treatment are met). Consequently, as in the case of any §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§§301, 316.
g.	Certain §367 Inclusions
Section  367(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 §904(f)(3) overall foreign loss rule. Any gain recognized under §367(a)(3)(C) is treated as from sources outside the United States and as having the same character as the losses had.
Section 367(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 §351 or §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 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§367(d)(1). A contribution to capital would be described in §351 for this purpose. See §367(c)(2).
672§367(d)(2)(A).
673§367(d)(2)(C). The earnings and profits of the foreign transferee are reduced by the amount characterized as U.S. source ordinary income. §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.
674See §367(d)(3).
The §367(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 §367(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 §367(d) source rule does not apply in the context of §482 reallocations.678 (In fact, the "commensurate with . . . income" standard itself does not apply to sales if §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).
675See §§861(a)(4), 862(a)(4), 865(d)(1)(B).
676See S. Rep. No. 169 (Vol. 1), 98th Cong., 2d Sess. 361, 368 (1984).
677See 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.
678S. 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 §351 transfer (with boot), subject to §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 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.
682See Regs. §1.367(b)-3T(b)(4)(i)(B).
683Regs. §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
684Although §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.
685See, 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 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.
686See §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.
687See 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 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.
688Regs. §§1.338-3(b)(4) and - 4(h)(8), Ex. 4.
689Regs. §1.338-4(h)(3).
690§1293 deals with inclusions by a PFIC that has made a QEF election.
691See  Regs. §§1.338-9(b) and - 4(h)(8), Ex. 4.
692See 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 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
694See 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.
695Accord PLR 8938036 (reference to §951 in ruling 6).
696Regs. §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.
697If 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.
698TAMRA, §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 936(a)(2)(A) begins again for new T on the day following T's acquisition date.700
699Section 936(a)(2)(B).
700Thus, 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
701U.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.
702Regs. Section 1.897-7T. See also Regs. Section 1.897-1(c)(2)(iv) (publicly traded partnerships treated like corporations for Section 897 purposes).
703See 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.
704Uniform Partnership Act, Section 26; Uniform Limited Partnership Act, Section 701.
705Section 865(a).
706Section 865(e)(1).
707Section 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 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
708Accord, 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).
709Section 954(c)(1)(B)(ii), added by TAMRA, Section 1012(i)(18).
710See, 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).
711Accord, 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
7121991-1 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.
7131991-1 C.B. 107.
714The ruling notes that this is the effective date of Section 865, upon which the ruling is based.
715The 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 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
716Rev. Rul. 91-32, 1991-1 C.B. 107.
717Id. 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.
718Further, 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
719The 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.
720Section865(e)(3).
Regardless of the merits of the IRS' position, it should be noted that enforceability will be a 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
721PLR 9142032.
722Presumably, 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.
723The 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 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.
724Section 865(e)(1).
725See, 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.
726See, e.g., Section 865(c)(2).
727Sections865(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 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
728See 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
729See 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).
730Section 865(i)(1), cross-referenced in Sections 861(a)(6), 862(a)(6), and 863(b).
731See 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
732Section 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.
733See A, 1, a, (2), above.
734No 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 purchased and sold within a foreign country or possession is foreign source income under the principle of Section862(a)(6).739
735The 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.
736Carding 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).
737In order to conform with Section 863(b)(3), Section 861(a)(6) expressly excludes purchases in U.S. possessions.
738Unlike Section 861(a)(6), Section 862(a)(6) does not exclude United States possessions.
739See 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).
740Regs. 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.
741See 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.
742The 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.
743Regs. 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." See also TAM 200539026 (place of title passage controlled, even though seller retained some risk of loss, where such risk was equivalent to that borne by the seller under C.I.F. terms of sale).
744See 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., 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
745The 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).
746The 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.
747See 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).
748The 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.
749Treasury 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).
750S. Rep. No. 313, 99th Cong., 2d Sess. 329 (1986).
751TRA 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
752Kates 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).
(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.
753See, 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.
754See 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.
755See, 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).
756See discussion in VII, B, 1, a, (2), below.
757Regs. 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 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").
758To 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.
759In 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.
760284 F.2d 383, 388 (Ct. Cl. 1960).
761Rev. 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.
762See, e.g., American Food Products Corp. v. Comr., 28 T.C. 14, 18 (1957).
763See, 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
764UCC Section 2-105(1).
765Securities 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 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.
766See, 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).
767Rev. 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).
768See, 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).
769Various 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).
770See 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
771Whiteside, "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).
772See 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 for tax purposes. This is illustrated by the analytical approach taken in certain post-UCC cases.778
773As 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.
774G. Gilmore & C. Black, Law of Admiralty Section 3-8 (2d ed.).
775See Galler, 17 Int'l Tax J. at 86.
776See Kates Holding Co., 79 T.C. at 707.
777There 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.
778See 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
779UCC Section 2-105(1).
780See 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
781UCC 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 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).
782See UCC Section 2-504; Liggett, T.C. Memo 1990-18.
783See 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).
784U.S. v. Balanovski, 236 F.2d 298 (2d Cir. 1956); American Food Products Corp. v. Comr., 28 T.C. 14 (1957).
785Section 2-401(3).
786See 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").
787UCC Section 2-401(1).
788UCC 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).
789See 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 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
790See 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).
791UCC 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).
792UCC Section 2-319(1)(c).
793UCC Section 2-509(1)(a).
794UCC Section 2-319(1)(b).
795UCC Section 2-509(1)(b).
796UCC Section 2-319(2).
797UCC 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).
798UCC 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).
799UCC 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.
80076 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 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.
80179 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.
80258 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
803See 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).
804Besides 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
805CISG, 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).
806Id.
8072 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: Applicability of the United Nations Convention," 69 Iowa L. Rev. 209 (1983).
808CISG, 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
809E.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
810See 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.
811See 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.
812See 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 delivery to the buyer at the destination.813 Sample title passage and title retention contract language is contained in the Worksheets, below.
813This 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
814See fn. 752 above.
815A.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.
816Regs. 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.
817236 F.2d 298 (2d Cir. 1956).
818Id. at 306-307 (footnotes omitted). Accord Comr. v. Pfaudler Inter-American Corp., 330 F.2d 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
81935 T.C. 365, 386-87 (1960).
820Id. at 388.
821Galler, 17 Int'l Tax J. at 89 (citations omitted).
822Id.
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
823Id.
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 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.
824284 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:
825Comr. 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.
826Rev. 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).
827GCM 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
828Although 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 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
829356 F.2d 157 (Ct. Cl. 1980).
830Accord Comr. v. Pfaudler Inter-American Corp., 330 F.2d 471 (2d Cir. 1964).
831Curiously, 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.
832See 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
833See e.g., U.S. v. Balanovski, 236 F.2d 298 (2d Cir. 1956)(dicta).
834See discussion above in B, 1, a, (1), (A).
83566-1 USTC Para.9421 (S.D.N.Y. 1966).
836Id. at 86,001.
837Id. 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
838492 F. Supp. 27 (M.D. Pa. 1979) (for purposes of foreign tax credit limitation).
839For years after TRA 86, this income would be sourced under Section 865.
840See, 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 passage is not relevant for stock sales, other than for dealers and as provided in Section 865(f), for post-TRA 86 years.)
841Regs. Section 1.58-8(d), Ex. 10, T.D. 7564 (September 11, 1978).
842Cf. 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
84358 T.C.M. 1167 (1990).
844The 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.
845A.O.D. CC-1991-03 (February 11, 1991).
846Id.
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.
847UCC Section 2-401(1).
848See 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.
849It 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.
850Section 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.
851See 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.
852See, e.g., Rev. Rul. 74-63, 1974-1 C.B. 374.
853See 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.
854As 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.
855Section865(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
856Regs. Section 1.864-7(b)(1).
857Id.
858Regs. 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
859Section864(c)(5)(A); Regs. Section 1.864-7(d)(2).
860Regs. Section 1.864-7(d)(3)(i).
861Regs. Section 1.864-7(d)(3)(ii).
862Regs. 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 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
863Section864(c)(5)(A); Regs. Section 1.864-7(d)(1).
864Regs. 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
865Regs. 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
866Id.
867Regs. §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.
(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).
868TAMRA (§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
871As 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)).
872Regs. §1.864-6(b)(3)(i).
873Id.
(b)	Use, Consumption, or Disposition Outside the United States
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
874Regs. §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
875Id.
876Id.
877Id.
878Id.
879Id.
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
880Former §865(e)(2)(ii).
881TAMRA, §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: 
(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.
882Section 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.
883See VII, B, 2, c.
884See 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
885In 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.
886Section 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 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).
888See §§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
889See 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
890See Lokken, "The Source of Income From International Uses and Dispositions of Intellectual Property," 36 Tax L. Rev. 233, 286, 292 (1981).
891TRA 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, 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
891.2Regs. §1.863-3(b)(2)(i).
891.3Regs. §1.863-3(b)(2)(ii).
891.4Regs. §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
891.5Regs. §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
891.6Regs. §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
891.7Id.
891.8Regs. §1.863-3(c)(1)(ii)(A).
891.9Regs. §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
891.10Regs. §1.863-3(c)(1)(i)(B).
891.11Regs. §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
891.12Regs. §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
891.13Regs. §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
891.14Regs. §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.
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
891.15Regs. §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
891.16Regs. §1.863-3(g)(1).
891.17Regs. §1.863-3(g)(2)(i).
891.18Id.
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
891.19Regs. §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
892Regs. §1.863-3(b).
893Regs. §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).
894Regs. §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
895For 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).
896Matthews, "Treasury Meeting with CEOs Presages Export-Source Rule Guidance," Tax Notes 983, 984 (9/5/89).
897See 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
898See 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.
8991988-2 C.B. 173.
90097 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.
901See T.D. 8228, 1988-2 C.B. 136 (9/9/88).
901.1100 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.
901.2101 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.
902See Matthews, above, at 983.
903Numerous letters are reprinted in Highlights & Documents, Oct. 6, 1988, at pages 189-210.
9041989-1 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.
905Id.
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.
906Unless otherwise indicated, the statements in paragraphs (i) through (vi) derive from Notice 89-10.
907For purposes of Notice 89-10, the term "manufacturer or producer" includes manufacturing or producing operations conducted by members of the same affiliated group.
908An 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
909For 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.
910Nonproduction, income-generating activities include marketing and selling activities (at any stage of distribution), and similar activities. Id.
911In 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.
911.1101 T.C. 78 (1993), aff'd, 70 F.3d 1282 (10th Cir. 1995).
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
912See 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
913See Regs. §1.863-3(b)(1). 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 Regs. §1.863-3(b)(2), 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 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.,918 the 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.
914Former Regs. §1.863-3(b)(2), Ex. (2) (ii).
915Regs. §1.863-3(c)(1). 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.
916Regs. §1.863-3(c)(2).
917Regs. §1.863-3(d).
918101 T.C. 78 (1993), aff'd, 70 F.3d 1282 (10th Cir. 1995).
919Regs. §1.863-3(d).
(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.
920Regs. §1.863-3(b)(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.922 If 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.
921Regs. §1.863-3(f)(1).
922Regs. §1.863-3(f)(2)(i)(B).
92363 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: 
(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 Former Regs. §1.863-3(c)(3) Ex. (2).
925Id.
926Id.
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          

927Id.
928The term "property" for this purpose included only the property held or used to produce income derived from the sales in question. Former Regs. §1.863-3(c)(3) Ex. (2)(iii).
929The 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, 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
930Former Regs. §1.863-3(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
931See 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
932Regs. §1.863-3(f).
933Id.
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          

934Id.
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
935Regs. §1.863-3(f)(3),  (4).
As a possible alternative to this single-factor business formula, the regulations provide that a taxpayer may allocate gross income using the books and records method if advance permission is granted by the IRS.936
936Regs. §1.863-3(f)(2)(i)(C).
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
937Dailey, "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).
c.	Manufacturing (Processing) in Possession and Sale in Foreign Country (or Vice Versa)
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 source rules of §§861 through 865 are applied by substituting the name of the relevant possession for "United States" and the term "bona fide resident of" the possession for "United States resident."939 However, any income treated as from U.S. sources or effectively connected with a U.S. trade or business is not to be treated as from possession sources (the "U.S. income rule").940 In order to prevent avoidance of the U.S. income rule, the regulations characterize income as U.S. source if, pursuant to a plan or arrangement, (i) the income is received in exchange for consideration provided to another person, and (ii) such person (or another person) provides the same consideration (or consideration of a like kind) to a third person in exchange for one or more payments constituting U.S. source income.941
938§936(a)(2)(A). The source of such income can also be important in determining whether a bona fide resident of a possession is a U.S. person for purposes of subpart F. See §957(c); Regs. §1.957-3T.
939§937(b)(1); Regs. §1.937-2T(b). In addition, "domestic" in §§861 through 865 is construed to mean created or organized in the relevant possession. Id. Section 937 was enacted by the American Jobs Creation Act of 2004 (P.L. 108-357, §908), effective generally for taxable years ending after Oct. 22, 2004. The temporary regulations were issued in T.D. 9194, 70 Fed. Reg. 18919 (4/11/05).
940§937(b)(2); Regs. §1.937-2T(c)(1). Despite the Oct. 22, 2004 effective date of §937, the U.S. income rule applies only for income earned after Dec. 31, 2004. See Regs. §1.937-2T(l).
941Regs. §1.937-2T(c)(2). This conduit rule applies only to amounts paid or accrued after Apr. 11, 2005. See Regs. §1.937-2T(l).
Subject to the U.S. income rule and the conduit rule, income from sales of inventory property manufactured in a possession and sold in a foreign country is sourced under the rules of Regs. §1.863-3(f), discussed above.942
942Regs. §1.937-2T(d). See the discussion in VII, B, 2, a, above.
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.943 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.944
943REG-208299-90, 63 Fed. Reg. 11177 (3/6/98).
944For a complete discussion of Prop. Regs. §1.482-8, see 887 T.M., Transfer Pricing: The Code and the Regulations.
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 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 Loss Branch
For the purpose of determining the foreign tax credits available to U.S. persons (and certain foreign persons under §906), §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 §904(a) limitation for the applicable limitation category, which reduces the available foreign tax credit for foreign taxes.
The foreign loss recapture rule of §904(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, under §904(f)(5)(C), if a separate limitation loss from a §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 §904(d) separate limitation system.
To prevent the avoidance of §904(f)(1) foreign loss recapture by incorporation or other disposition of branch operations before they become profitable, §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., §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 §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§904(f)(3)(B). Disposition for this purpose does not include distribution or transfer of property to a domestic corporation described in §381(a). §904(f)(3)(C).
946§904(f)(3)(B)(ii).
947§904(f)(5)(F).
The recapture of overall foreign losses on asset dispositions extends to stock dispositions in a controlled foreign corporation (CFC) controlled by the taxpayer.948 Stock dispositions are 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.
948§904(f)(3)(D), added by the American Jobs Creation Act of 2004 (P.L. 108-357, §895). The amendment is effective for any stock disposition after October 22, 2004.
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 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 that 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).
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 §§861-862, it is subject to apportionment under regulations promulgated pursuant to §863(a), except as provided in §865(b).
949A U.S. real property interest under §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. §1.897-1(b)(2).
1.	General
Regulations under §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
950Phillips 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).
951Regs. §1.863-1(b).
952Regs. §1.863-1(b)(1).
953Regs. §1.863-1(b)(2). See GCM 36328(July 1, 1975).
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.
954See Regs. §§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.
9551967-1 C.B. 183.
The IRS has expressed the view, in a GCM, that the principle of Rev. Rul. 67-194 is 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. §1.863-1(b)(2), so that apportionment under §863(b) and Regs. §§1.863-2 and 1.863-3 was required.957
956GCM 36328 (July 1, 1975).
957See 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. §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.
958Rev. Rul. 67-194, 1967-1 C.B. 183; GCM 7545, 1930-1 C.B. 215.
959See §861(a)(5).
960Accord, GCM 36328, n.3; Dailey, "The Concept of the Source of Income," 15 Tax L. Rev. 415, 450-51 (1960).
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 §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, 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 §863(b) and Regs. §1.863-3(b)(2).
961See PLR 8314057.
The Tax Court in Phillips Petroleum Co. v. Comr.,962 however, held Regs. §1.863-1(b) to be invalid. The Tax Court concluded that in light of §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.
96297 T.C. 30 (1991), aff'd, 70 F.3d 1282(10th Cir. 1995).
963See id. (income from sales of Alaskan liquified natural gas to Japanese utility sourced in part abroad).
96497 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 §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
965See Regs. §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, 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
965.161 Fed. Reg. 60540 (11/29/96).
965.2Regs. §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 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
965.3Regs. §1.863-1(b)(1).
965.4Regs. §1.863-1(b)(1).
965.5Regs. §1.861-3(c)(2).
965.6Regs. §1.863-1(b)(1).
965.7Regs. §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
965.8Regs. §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, considered additional production activity.965.10
965.9Regs. §1.863-1(b)(3)(i).
965.10Regs. §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
965.11Regs. §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
965.12Regs. §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
965.13Regs. §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.
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
966S. 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
967Cf. 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
968TAMRA, §1012(i)(10), effective as if included in TRA 86.
969See 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 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.
969.1The Tax and Trade Relief Extension Act of 1998, P.L. 105-277, §1005(b)(1)(A).
970See discussion in VIII, B.
971See 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
972See 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).
973See 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.
974A.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
975In addition, §953 generally treats "related person insurance income" (as defined in §953(c)(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).
976The 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.
977Regs. §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
978Prop. 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
979Prop. Regs. §1.953-1(a).
980Id.
981§952(a).
982Prop. Regs. §1.953-2(a)(1).
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
983Prop. 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
984Prop. Regs. Section 1.953-2(b)(1).
985Id.
986Prop. Regs. Section 1.953-2(d)(1).
987Prop. 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
988Prop. 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
989Prop. 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 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
990Prop. 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
991Id.
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.
992Prop. 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
993Prop. Regs. Section 1.953-2(e)(2)(iv).
994Id.
995Id.
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 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
996Prop. Regs. Section 1.953-2(e)(2)(v).
997Id.
998Id.
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
999Prop. Regs. Section 1.953-2(e)(2)(vi).
1000Prop. 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
1001Prop. 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
1002Prop. 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
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
1003A 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).
1004Prop. Regs. Section 1.953-2(f)(2)(i).
1005Id.
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
1006Prop. Regs. Section 1.953-2(f)(3)(i).
1007Id.
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
1008Prop. 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
1009Prop. Regs. Section 1.953-2(f)(3)(v).
1010Id.
(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 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
1011Prop. Regs. Section 1.953-2(g)(1).
1012Id.
1013Id.
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
1014Blue Book, TRA 86, at 927.
1014.1See 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
1015See §7701(a)(9). See I, C, above.
1016See §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
1017TRA 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).
1019Compare the 50-50 rule under §863(e) for international communications income.
1020S. 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.
1022See IV, C, 1, c, above.
1023Service 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
1024S. Rep. No. 313, 99th Cong., 2d Sess. 341 (1986); TRA 86 Blue Book at 729.
1025Insofar 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).
1027Rev. 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 
1028For 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).
1029Rev. 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.
1029.1See 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 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
1029.2See 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. 
1030Id. 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).
1032S. 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
1032.1TAM 9327001.
1032.2TAMs 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 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.
1033TRA 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
1034TRA 86, §1212(a).
1035TRA 86, §1212(f)(1).
1036TRA 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
1038Any 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% 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
1042Rev. 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
1044Rev. Proc. 91-12, §4.05.
1045Id. at §4.06.
1046Rev. Proc. 91-12, §4.07.
1047Id.
1048Id.
1049Id. at §4.08.
1050Id. 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.
1051Id. 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
1052TRA 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 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
1053Operational 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.
1054Rev. 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.
1055.1See 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
1056Rev. 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).
1057Rev. 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 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.
1061.1REG-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.
1061.2REG-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.
1061.368 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 aircraft is registered provides such an exemption.
1062TRA 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
1063See, 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).
1064PLR 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
1064.1Regs. §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).
1065Regs. §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
1066Regs. §1.863-4(b).
1067Id.
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 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
1068Regs. §1.863-4(c).
1069Id.
1070Id.
1071Id.
1072Regs. §1.863-4(d)(2).
1073Id.
1074Regs. §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.
1075See PLR 8750014.
Article VIII(6) of the Canadian treaty expands the protection afforded by §883(a)(3), discussed above, as follows: 
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.
10761954-1 C.B. 130.
X. Income from Space or Ocean Activity
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.
1077§863(d)(1)(A).
1078See §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.).
Section 863(d) specifically allows the IRS to create exceptions to the space and ocean activity source rules by regulation. Although final regulations have not been issued, the IRS in 2001 issued proposed regulations under §863(d).1079.1 In 2005, those proposed regulations were withdrawn and reproposed with significant changes.1079.2 This discussion addresses the 2005 proposed regulations.
1079.1REG-106030-98, 66 Fed. Reg. 3903 (1/17/01).
1079.2REG-106030-98, 70 Fed. Reg. 54859 (9/19/05).
The proposed regulations would modify the Code source rules for income from space and ocean activities. A general rule would apply similarly to three groups of taxpayers: (1) U.S. persons; (2) foreign persons (including foreign corporations other than CFCs) engaged in a U.S. trade or business; (3) CFCs. In addition, special source rules would apply to income from the sale of property, from performance of services, and from communications income that does not constitute international communications income.
Under the general rule, space and ocean income of a U.S. person would generally be U.S. source, but would be foreign source to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in a foreign country or countries.1079.3 For foreign persons other than CFCs engaged in a U.S. trade or business, space and ocean income would generally be foreign source, but would be U.S. source to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in the United States.1079.4 Space and ocean income of a CFC would be sourced as if the CFC were a U.S. person.1079.5
1079.3Prop. Regs. §1.863-8(b)(1).
1079.4Prop. Regs. §1.863-8(b)(2)(i), (iii).
1079.5Prop. Regs. §1.863-8(b)(2)(ii).
The proposed regulations would provide source rules for income from the sale of property. Income from sales of purchased property in space or international water would ordinarily be sourced under the general rules of Prop. Regs. §1.863-8(b)(1) and (2). However, if the property is inventory property and is not sold for use, consumption, or disposition in space or international water, source would be determined under Regs. §1.861-7(c).1079.6
1079.6Prop. Regs. §1.863-8(b)(3)(i).
In the case of sales of property produced by the taxpayer, one-half of the income is allocated to production activity and one-half to sales activity (the 50/50 method).1079.7 When production occurs only in space or international water, income allocable to production activity would be sourced under the general rules of Prop. Regs. §1.863-8(b)(1) and (2), discussed above.1079.8 When production occurs only outside space and international water, income allocable to production activity would be sourced under Regs. §1.863-3(c)(1).1079.9 If production occurs partially in, and partially outside, space or international water, income would be allocated to production activity in space or international water to the extent that it is attributable to functions performed, resources employed, or risks assumed in space or international water. The remainder of the income would be allocated to production activity outside space or international water.1079.10
1079.7Prop. Regs. §1.863-8(b)(3)(ii)(A). For this purpose, production activity would be defined to mean creating, fabricating, manufacturing, extracting, processing, curing, or aging property within the meaning of §864(a). Prop. Regs. §1.863-8(d)(2)(i).
1079.8Prop. Regs. §1.863-8(b)(3)(ii)(B).
1079.9Id.
1079.10Prop. Regs. §1.863-8(b)(3)(ii)(C).
When property produced by the taxpayer is sold outside space and international water, the income allocable to sales activity would be sourced under Regs. §§1.861-7(c) and 1.863-3(c)(2). If the property is sold in space or international water, the income allocable to sales activity would ordinarily be sourced under the general rules of Prop. Regs. §1.863-8(b)(1) and (2). However, if the property is inventory property and is not sold for use, consumption, or disposition in space or international water, source would be determined under Regs. §§1.861-7(c) and 1.863-3(c)(2).1079.11
1079.11Prop. Regs. §1.863-8(b)(3)(ii)(D).
To the extent the performance of services constitutes a space or ocean activity, the income therefrom would be sourced under the general rules of Prop. Regs. §1.863-8(b)(1) and (2).1079.12 Generally, performance of a service would be treated as a space or ocean activity in its entirety if any part of the service is performed in space or international water. However, if the taxpayer can demonstrate the value of the service attributable to its performance in space or international water and the value attributable to its performance outside space or international water, the service would be treated as a space or ocean activity only to the extent of the activity performed in space or international water. The value of the service is attributable to space or international water to the extent that its performance is attributable to functions performed, resources employed, or risks assumed in space or international water. Also, if the taxpayer can demonstrate that, based on all the facts and circumstances, the value of the service attributable to performance in space or international water is de minimis, the service would not be treated as space or ocean activity.1080
1079.12Prop. Regs. §1.863-8(b)(4).
1080Prop. Regs. §1.863-8(d)(2)(ii).
Under the proposed regulations, communications activity that takes place in space or international water, but does not constitute international communications activity, constitutes space and ocean activity. If the income from the activity is also communications income as defined in Prop. Regs. §1.863-9(h)(2), the income would be sourced under Prop. Regs. §1.863-9 as international communications income. If the income is instead space/ocean communications income as defined in Prop. Regs. §1.863-9(h)(3)(v), it would be sourced under the general rules of Prop. Regs. §1.863-8(b)(1) and (2).1081
1081Prop. Regs. §1.863-8(b)(5).
For partnerships, the source of income from space and ocean activity would be determined at the partner level.1082
1082Prop. Regs. §1.863-8(e).
 The Code defines the term "space or ocean activity" to mean: 
(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.1083
1083§863(d)(2)(A).
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.1084
1084S. 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).1085
1085§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.1086 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).
1086See 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.
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.1087
1087See TAMs 9327001, 9327003 and 9327004.
The proposed regulations define ocean activity to include, but not be limited to, 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 for use, comsumption, or disposition outside space or international water;
• 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-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.1088
1088Prop. Regs. §1.863-8(d)(1)(ii).
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.1089
1089See Kelly, "Federal Income Taxation of Space and Ocean Activities," 14 Int'l Tax J. 69, 71, 74 (1988). The proposed regulations define space as any area not within the jurisdiction of a foreign country (as recognized by the United States), a U.S. possession, or the United States and not in international water. Prop. Regs. §1.863-8(d)(1)(i).
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.1090 On the other hand, the lessee's income from using a communications satellite to, e.g., relay television signals is international communications income.
1090See 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.1091
1091S. Rep. No. 313, 99th Cong., 2d Sess. 359 (1986); TRA 86 Blue Book at 934-35.
The proposed regulations broadly define space activity as including, but being limite to, the following: 
• 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, except for sales of inventory property for use, consumption, or disposition outside space or international water.1092
1092Prop. Regs. §1.863-8(d)(1)(i).
XI. International Communications Income
A. Sourcing of International Communications Income
1.	General Rules
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.
In general, §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.
For these source rules to apply, the income involved must be within the definition of international communications income, described in XI, B, below. 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.1093 This is the case even if the transmission is made through a satellite regardless of where in space it is located.1094 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.1095
1093S. Rep. No. 313, 99th Cong., 2d Sess. 359 (1986); TRA 86 Blue Book at 935.
1094Id.
1095Id.
Final regulations under §863(e) have not been issued. However, the IRS issued proposed regulations in 2001.1095.1 In 2005, those proposed regulations were withdrawn and reproposed with significant changes.1095.2 This discussion addresses the 2005 proposed regulations.
1095.1REG-106030-98, 66 Fed. Reg. 3903 (1/17/01).
1095.2REG-106030-98, 70 Fed. Reg. 54859 (9/19/05).
The proposed regulations define U.S. communications income 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.1095.3 Such income is treated as U.S. source income.1095.4 Foreign communications income is defined 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.1095.5 Such income is treated as foreign source income.1095.6
1095.3Prop. Regs. §1.863-9(h)(3)(iii).
1095.4Prop. Regs. §1.863-9(c).
1095.5Prop. Regs. §1.863-9(h)(3)(iv).
1095.6Prop. Regs. §1.863-9(d).
The proposed regulations also address two additional categories of communications income. Space/ocean communications income is defined as income derived from transmission between a point in space or international water and another point in space or international water,1095.7 and would be sourced as income from space and ocean activity, not as international communications income.1095.8 Finally, the proposed regulations provide that income of a U.S. or foreign person from communications activity would be U.S. source if the taxpayer cannot establish the two points between which the taxpayer is paid to transmit the communication.1095.9
1095.7Prop. Regs. §1.863-9(h)(3)(v).
1095.8Prop. Regs. §1.863-9(e). The source rules for income from space or ocean activities are discussed in X, above.
1095.9Prop. Regs. §1.863-9(f).
2.	U.S. Persons
In the case of any U.S. person,1096 50% of any "international communications income" is sourced in the United States and 50% of such income is sourced outside of the United States.1096.1 This 50-50 split is obviously arbitrary but reflects the difficulty in arriving at a more exact apportionment of income in such a case.1097
1096A "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).
1096.1§863(e)(1)(A). See also Prop. Regs. §1.863-9(b)(1).
1097Compare the similar approach in allocating transportation income under §863(c)(2) as discussed above at IX, A, 1, b.
Under the proposed regulations, the source of international communications income of a U.S. partnership would be determined at the partner level.1097.1
1097.1Prop. Regs. §1.863-9(i).
3.	Foreign Persons
In general, under §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 an "office or other fixed place of business" (FPB) of the taxpayer in the United States.1098
1098§863(e)(1)(B)(i).
In the case of any foreign person who maintains an FPB in the United States, any international communications income attributable to such FPB is sourced wholly within the United States.1099 The term FPB presumably is defined by reference to the definition of the identical term under Regs. §1.864-7.1099.1 In determining whether international communications income is "attributable" to an FPB in the United States, regulations to be issued under §863(e)(1)(B) might start from §864(c)(5)(B) and Regs. §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.1100 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.
1099§863(e)(1)(B)(ii).
1099.1The proposed regulations specify that §864(c)(5) and Regs. §1.864-7 apply in determining whether a foreign person has an FPB. Prop. Regs. §1.863-9(b)(2)(iii).
1100See VII, A, 2, c, above.
The proposed regulations take an approach that is reminiscent of a §482 analysis. As proposed, international communications income would be attributable to an FPB to the extent of functions performed, resources employed, or risks assumed by the FPB.1100.1
1100.1Prop. Regs. §1.863-9(b)(2)(iii).
The §863(e)(1)(B) rules for foreign persons reflect long-standing case law. Piedras Negras Broadcasting Co. v. Comr.1101 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,1102 notwithstanding the U.S. contacts.1103
1101127 F.2d 260 (5th Cir. 1942).
1102See §861(a)(3), 861(a)(4). See IV and V, above.
1103Accord 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 §863(e)(1)(B)(i) source rule for foreign persons by earning international communications income through a foreign entity.1104
1104H.R. Rep. No. 841 (Conf. Rep.), 99th Cong., 2d Sess. II-600 (1986); TRA 86 Blue Book at 935.
The proposed regulations contain two additional exceptions to the general rule of foreign sourcing for foreign persons. First, international communications income derived by a CFC would be treated as 50% U.S. source and 50% foreign source.1104.1 Second, the international communications income of a foreign person engaged in a U.S. trade or business would be U.S. source income to the extent the income is attributable to functions performed, resources employed, or risks assumed within the United States.1104.2 Note that this provision would apply even if the foreign person has no FPB in the United States.
1104.1Prop. Regs. §1.863-9(b)(2)(ii).
1104.2Prop. Regs. §1.863-9(b)(2)(iv).
The proposed regulations provide the same general rule for foreign partnerships as for U.S. partnerships. In both cases, the source of international communications income would be determined at the partner level.1104.3
1104.3Prop. Regs. §1.863-9(i).
B. Definition of International Communications Income
For purposes of §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 possession of the United States) to the United States."1105 This includes income from transmitting telephone calls or other signals, images, sounds, or data by buried or underwater cable or by satellite.1106 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.1107 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.1107.1
1105§863(e)(2).
1106S. Rep. No. 313, 99th Cong., 2d Sess. 359 (1986); TRA 86 Blue Book at 935.
1107§863(d)(2)(B)(ii).
1107.1The proposed regulations are in accord. See Prop. Regs. §1.863-8(d)(1)(i)(B) and (ii)(B), specifying that leasing of satellites and underwater cables, respectively, are space and ocean activities.
The proposed regulations define the term "communications activity" as an activity that consists solely of the delivery by transmission of communications or data or the provision of the capacity to transmit communications.1108 A taxpayer derives communications income under the proposed regulations only if the taxpayer is paid to transmit, and bears the risk of transmitting, the communications.1109
1108Prop. Regs. §1.863-9(h)(1)(i). 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 be treated as a separate non-communications activity unless de minimis in nature.
1109Prop. Regs. §1.863-9(h)(2). This applies even if the taxpayer does not actually perform the transmission function.
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 specified situations. The provision applies to any §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 §988 transaction the disposition of any nonfunctional currency. Pursuant to §988(e), §988 does not apply to personal transactions of an individual.
1110§988(c)(1). See generally 921 T.M., Tax Aspects of Foreign Currency.
In general, foreign currency gain or loss attributable to a §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 §988 transaction is treated as interest income or expense if, in particular, the transaction qualifies for integrated treatment as a §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§988(a)(1).
1112See Regs. §§1.988-3(c)(1), 1.988-4(f).
Special source rules for foreign currency gain or loss from a §988 transaction are set forth in §988(a)(3)(A) and the regulations thereunder and take precedence over the §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 §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. §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 §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 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. §1.988-4(c) for exchange gain or loss that is analogous to income treated as ECI under Regs. §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 §911(d)(3)) is located.
(ii) Any corporation, partnership, trust, or estate which is a U.S. person (as defined in §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.] §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 §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
1113Regs. §1.988-4(a). In the case of an individual's personal transaction, the §865 rules rather than the special §988 rules apply.
1114§988(a)(3)(A); Regs. §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. §1.861-7(a)).
1115Regs. §1.988-4(b)(2)(ii).
1116§988(a)(3)(A); Regs. §1.988-4(a).
1117§988(a)(3)(B).
1118Regs. §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.
1119Regs. §1.988-4(c).
1120Regs. §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 §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 §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. §1.1441-2(b)(2)(i) (gain from sale of property not taxed as FDAPI).
A special rule is provided under §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 §1274(d)) at the time such loan is entered into, the following rules apply:1121
(i) For purposes of §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 §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§988(a)(3)(C).
1122Id.
1123§988(a)(3)(D).
In nearly all cases, the residence-based source rules of Regs. §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
1124This 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. §1.861-9T. See Regs. §1.988-4(g).
1125See Regs. §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, and analogous, rule contained in §865(e)(2)(A). It is not clear what, if any, characteristics of foreign currency gain or loss from a §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 the proper documentation 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
1126See Regs. §1.988-4(c).
1127See 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. §1.864-4(c)(5).
1128See XII, B, , below.
With respect to U.S. persons, the interaction of the general source rules of Regs. §1.988-4(a) with the interest allocation and apportionment rules may create problems under §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 §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. §1.861-10T.
1129Regs. §1.861-9T(b)(1)(i).
1130Regs. §1.861-9T(b)(1)(ii), Ex. 2.
1131Id.
On the other hand, under Regs. §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 §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 §904 purposes.
The regulations under §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 §§861(a)(1) and 862(a)(1) (and character for §904 purposes) as the underlying debt instrument.1133
1132See Regs. §1.988-5(a).
1133Regs. §1.988-5(a)(9)(iii).
B. Notional Principal Contracts
Regs. §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
1134Regs. §1.863-7(a)(1); Prop. Regs. §1.446-3(c)(1)(i).
1135See generally Prop. Regs. §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 §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 §988(a)(3)(B)(i)) is in the United States; the QBU's residence (determined under §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
1136Regs. §1.863-7(b)(1).
1137Regs. §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. §1.863-7(b)(2)(iv).
1138Regs. §1.863-7(b)(3).
These rules are similar, though not identical, to the rules for §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. §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
1139See XII, A, above.
1140See Regs. §§1.864-4(c)(2),  (c)(3), and  (c)(5).
1141See §1463; Regs. §1.1441-4(a)(1); Casa De La Jolla Park, Inc. v. Comr., 94 T.C. 384 (1990).
1142See, 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
1143See Rev. Rul. 87-5, 1987-1 C.B. 180.
1144Regs. §1.1441-6(a).
1145See 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 §§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.
1146See generally Regs. §1.446-3.
1147Similarly, 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. §1.861-9T(b)(1)(ii), Ex. (3).
Second, fees for late payments are not sourced under Regs. §1.863-7.1148
1148See Regs. §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 §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 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. §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. §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.
1149See the discussion above in XII, A.
1150Regs. §1.861-9T(b)(1)(i).
1151Regs. §1.861-9T(b)(6)(vii), Ex. (1).
1152Regs. §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 2004. On January 1, 2004, 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. §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 2004 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 2004 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. §1.863-7(b).1153
1153Regs. §1.861-9T(b)(6)(vii), Ex. (1).
Fourth, Regs. §1.863-7 does not apply to income attributable to §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. §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. §1.863-7, but payments received by a foreign counterparty whose functional currency is not the U.S. dollar would be sourced under Regs. §1.988-4. Note however, that, since commodity-indexed notional principal contracts are not treated as §988 transactions,1156 income derived therefrom is sourced under Regs. §1.863-7 even if denominated in a nonfunctional currency.
1154Regs. §1.863-7(a)(1).
1155See Regs. §1.863-7(b). See XII, A, above.
1156Regs. §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 contract with itself."1157
1157See 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.
1158See Preamble to Prop. Regs. §1.446-3 reprinted in Highlights & Documents, July 9, 1991, 283, 284.
Historical Note: Regs. §1.863-7 applies to notional principal contract income includible in income on or after 2/13/91.1159 In general, former Regs. §1.863-7T governed amounts includible in income on or after 12/24/86 but before 2/13/91. Before the issuance of Regs. §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 §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 §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.
1159Regs. §1.863-7(a)(2).
11601987-1 C.B. 416.
1161Regs. §1.863-7(c).
1162Notice 87-4.
C. Securities Loans -- Substitute Payments and Loan Fees
1.	Substitute Payments
Loans of securities (which often are made in accordance with the rules of §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
1163Deputy v. DuPont, 308 U.S. 488 (1940). Accord Rev. Rul. 80-135, 1980-1 C.B. 18 (not interest for §103 purposes). (An interest notion, however, underlies §246A(d)(3)(B).)
Regulations have been issued with respect to the source of substitute payments under §8611164 and, in the case of such payments made from U.S. sources to foreign persons, the character of such payments.1165 These regulations address substitute payments made in (1) a "securities lending transaction," defined as a transaction which is described in §1058(a) or a "substantially similar transaction," and (2) a sale-repurchase transaction, defined as an agreement under which a person transfers a security in exchange for cash and simultaneously agrees to receive a substantially identical security from the purchaser in the future in exchange for cash1166 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
1164Regs. §§1.861-2(a)(7), 1.861-3(a)(6).
1165Regs. §§1.871-7(b)(2), 1.881-2(b)(2), 1.894-1(c), 1.1441-2(a)(1).
1166Regs. §§1.861-2(a)(7), 1.861-3(a)(6).
1167Prop. Regs. §1.1058-1(b).
Under the regulations, a substitute interest payment, whether received by a foreign person from a U.S. person or by a U.S. person from a foreign person, is treated as having the same source as the interest accruing on the transferred security.1168 Similarly, a substitute dividend payment is source in the same manner as distributions with respect to the transferred security.1169 These source rules are not limited to specific applications or Code sections, and therefore apply for all purposes of the Code.
1168Regs. §1.861-2(a)(7).
1169Regs. §1.861-3(a)(6).
The character of substitute payments to foreign persons is determined, for certain specified purposes, by applying a look-through rule. Thus, a substitute payment received by a foreign person engaged in a U.S. trade or business is characterized as interest or a dividend by reference to the underlying security in determining whether the income is effectively connected with that U.S. trade or business.1170 In the case of a foreign person not engaged in a U.S. trade or business, the look-through rule applies to determine the character of substitute payments for purposes of determining the foreign person's fixed or determinable annual or periodical income (FDAP).1171 If a foreign taxpayer transfers, in a sale-repurchase transaction or securities lending transaction, a security that qualifies for the portfolio interest exemption under §871(h) or §881(c), substitute interest payments are treated as portfolio interest.1172
1170Regs. §1.864-5(b)(2). Note that Regs. §1.864-5(b) deals only with foreign source income of a foreign person's U.S. trade or business. Thus, the look-through rule does not apply to characterize the U.S. source income of a foreign person's U.S. trade or business.
1171Regs. §§1.871-7(b)(2), 1.881-2(b)(2).
1172Id. If the underlying obligation is in registered form, this look-through rule applies only if the lender provides the withholding agent with a beneficial owner withholding certificate or other satisfactory documentary evidence, and no exception from the portfolio interest exemption applies.
Substitute payments that are characterized as FDAP and sourced in the United States, are subject to §1441 withholding,1173 but substitute interest payments with respect to a security that qualifies for the portfolio interest exemption are exempt from withholding.1174
1173Regs. §1.1441-2(b)(4).
1174Regs. §1.1441-1(b)(4)(i).
Any substitute payment characterized as interest or a dividend under the above applications of the look-through rule is treated as interest or a dividend under the provision of U.S. tax treaties.1175  The look-through rule can adversely affect 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.1176 However, the IRS takes the position that the rule is properly issued under §7805 and also under the authority of §7701(l).1177
1175Regs. §1.894-1(c).
1176For example, such payments could not be treated as "other income" or as "business profits," either of which could qualify for exemption under some treaties, though they would be eligible for a reduced rate of withholding under the interest or dividend provisions of the treaty. It is not clear, however, whether the IRS has the authority to promulgate regulation that on their face appear to conflict with the definition of "dividend" under 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, where those treaties existed before the regulations were issued, 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.
1177See Preamble to T.D. 8735, 62 Fed. Reg. 53498 (10/14/97).
The look-through rule does not apply to characterize the income of U.S. taxpayers or 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 concerning the characterization of substitute payments for purposes of other sections not specifically mentioned in these regulations.1178
1178See Prop. Regs. §1.1058-1(d); Rev. Rul. 80-135, 1980-1 C.B. 18 (substitute payment not eligible for exclusion under §103); Rev. Rul. 60-177, 1960-1 C.B. 9 (substitute payment not a dividend for purposes of §243). Income from securities loans, however, is qualifying income for RICs under §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 §851(b)(4) (redesignated §851(b)(3) by the 1997 TRA).
2.	Fees
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.
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.1179 However, a look-through rule 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.
1179See §512(a)(5)(A) (which, for unrelated business taxable income purposes, defines payments with respect to §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.	Foreign-to-Foreign Substitute Payments
In Notice 97-66,1180 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.
11801997-2 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 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 and for another year by Notice 99-25.1181.1 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.
11811998-15 I.R.B. 12, as implemented by T.D. 8804, 63 Fed. Reg. 72183 (12/31/98).
1181.11999-20 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 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, 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
1182See, e.g., §7701(a)(30).
1183§865(i)(5). But see Prop. Regs. §§1.863-8(e) and -9(i), which would determine the source of space and ocean income and international communications income, respectively, at the partner level.
1184House 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.
1185Regs. §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.
1186Accord, 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). 
U.S. partnerships must withhold tax on U.S. source "fixed or determinable annual or 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
1187See, 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). 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
1188See 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.
Proposed regulations in late 2005 would provide more stringent requirements concerning what constitutes "substantial economic effect" in the case of partners that are pass-through entities (including disregarded entities, S corporations, trusts, and, as to Subpart F items, controlled foreign corporations) or members of consolidated groups.1188.1
1188.1See Prop. Regs. §1.702-1(b)(2)(iii)(a)(2), issued in REG-144620-04, 70 Fed. Reg. 69919 (11/18/05), which, in determining whether the economic effects are substantial, would take into account an expanded "overall-tax effects" test that includes consideration of the after-tax economic consequences that result from the interaction of the allocation with the tax attributes of any direct or indirect owner of a partner or any member of a consolidated group.
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
1189See §1363(a). But see §§1363(d), 1374- 75.
1190See §§1373(a), 1366.
B. Trusts and Estates
1.	Trusts
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.
1191See §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
1192Regs. §1.651(a)-1. See generally 852 T.M., Income Taxation of Trusts and Estates (EGT Series).
1193See §§651- 52.
1194See §661 et seq.
1195Id.
1196See §§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
1197Isidro 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).
1198Regs. §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
1199Regs. §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 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).
1201See 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).
1203See 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.
1204See §§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.
1206P.L. 98-21.
2.	Amounts Includible from Controlled Foreign Corporations and Certain Passive Foreign Investment Companies
a.	General Rules
Under §951(a), a U.S. shareholder (as defined in §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 §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. §1.960-1(h), for purposes of §904, the amount included in gross income by a domestic corporation under §951, plus any §78 dividend from which such §951 amount gives rise by reason of taxes deemed paid by such domestic corporation under §960(a)(1), generally1207 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 §904 as if it had been paid through such entities and as received from the first-tier CFC.1209
1207An exception is provided in §904(h), as discussed below.
1208In addition, §960(b) and Regs. §1.960-4 increase the applicable §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 §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 §952(b).
1209Regs. §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 §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 §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 §951(a)(1) should be considered to be from foreign sources.
1210See §§957(a), 957(c), and 951(b).
1211See XIII, A, 1, above.
Under §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 §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 year." Section 1293(f)(1) permits a 10% or greater shareholder of a QEF a foreign tax credit under §960 for such shareholder's ratable share of foreign income taxes paid by the QEF by treating, for purposes of §960, amounts included in income by such shareholder under §1293(a) as if they were included under §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 §1293(a) by other shareholders, foreign source classification seems appropriate.1213
1212An exception is provided in §904(h), discussed immediately below. The American Jobs Creation Act of 2004 (P.L. 108-357, §402) redesignated former §904(g) as §904(h).
1213Cf. Prop. Regs. §1.1291-5(b)(1) (excess distribution treated as foreign source income, passive basket). Section 904(h)(1)(A)(iii) also provides support, by implication.
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 "§1291 fund"), or by a CFC to the extent not excludible under §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 §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 §904(h), under proposed regulations under §1291(g).1214
1214See Prop. Regs. §1.1291-5(b)(1), (e)(1), (d), (e). Curiously, Prop. Regs. §1.1291-5(b)(1) does not refer to §904(h) or to former §904(g), redesignated as §904(h) by the American Jobs Creation Act of 2004 (P.L. 108-357, §402).
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 §1293 or §951(a), respectively, which otherwise would be treated as from foreign sources, is treated under §904(h) as from U.S. sources for purposes of §904.1215 A similar rule was set forth in former §904(g) for undistributed foreign personal holding company income included by a U.S. shareholder under former §551.1216
1215See the discussion in III, B, 7, above.
1216The American Jobs Creation Act of 2004 (P.L. 108-357, §413) repealed the foreign personal holding company provisions (former §§551-558) and the foreign investment company provisions (former §§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 former §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 were intended to provide export incentives to U.S. manufacturers by exempting a portion of an FSC's income from U.S. taxation.
1217See III, B, 5, above.
Former §921(a) provided that exempt foreign trade income of an FSC as determined under former §923 was treated as foreign source income which was not effectively connected with the conduct of trade or business within the United States.1218
1218See Regs. §1.921-3T(a)(2)(i).
Under former §921(d), nonexempt foreign trade income determined with regard to the administrative pricing rules of former §925(a)(1) and (2)1219 was treated as income effectively connected with a U.S. trade or business conducted through a permanent establishment in the United States.1220 Such income was also treated as U.S. source income.1221
1219I.e., in the words of the statute, "foreign trade income" (as defined in former §923(b)) of an FSC, other than (A) "exempt foreign trade income" (as defined in former §923(a)) and (B) the portion of income described in former §923(a)(2) (foreign trade income determined without regard to the administrative pricing rules of former §925(a)(1) or (2)) that is not exempt.
1220Regs. §1.921-3T(a)(2)(ii).
1221Id.
Also under former §921(d), "investment income" and "carrying charges" (as defined in Temp. Regs. §1.921-2(f) Q & A 9) derived by an FSC were 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 was determined under the normal Code rules.1222
1222Regs. §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 former §925(a)(1) or (2) was 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) was determined under the normal Code rules.1224
1223Regs. §1.921-3T(a)(2)(iii).
1224Regs. §1.921-3T(a)(2)(v).
Former §927(e) limited the amount of foreign source income that could 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, former §927(e) provided that, under regulations, income derived by a person having the relationship to an FSC described in §482, from a transaction giving rise to "foreign trading gross receipts" (as defined in former §924(a)) of the FSC which was treated as from sources outside the United States, could not exceed the amount which would be treated as foreign source income earned by such person if the §994 transfer-pricing rule under the DISC provisions that corresponded to the former §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. §1.863-3(b)(2) to an FSC. Notice 89-11 states that regulations to be issued under former §927 would provide that, if inventory was sold to an FSC, or through an FSC acting as commission agent, the 50-50 rule of Regs. §1.863-3(b)(2), Ex. 2 (and not an independent factory price, if any) would apply 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 was determined under the §482 transfer pricing methods rather than the administrative pricing rules, Notice 89-11 would not apply and if an independent factory price existed, it had to be used to determine the related supplier's foreign source income from sales made by or through the FSC. In either case, under former §927(e)(1), such foreign source income could not exceed the amount that would have been earned had the sale been made to or by a DISC.
12251989-1 C.B. 632.
12261989-2 C.B. 405.
In most situations, U.S. exporters hada to 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 §863(b). However, if the manufacturer used an FSC, the former §927(e) resourcing rule discussed above greatly limited the portion of the manufacturer's taxable income that could be treated as foreign source.1228
1227See VII, B, 2, a, (1), (B).
1228See 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 motivated taxpayers to favor the credit up to the point where the creditable foreign taxes were not limited by §904, and to favor FSC benefits after such point. Since many U.S.-based multinational corporations had excess general basket foreign tax credits for periods following the effective date of TRA 86, many such corporations did not pursue FSC benefits, but instead sought to increase their foreign source general basket income to increase the limitation.
Regulations permitted subsequent redeterminations after the return was 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 changed, redetermine its transfer pricing method, etc., to increase FSC benefits.
1229See Regs. §1.925(a)-1T(e)(4).
1230PLR 9029068.
Special rules governing the source of certain dividends paid by an FSC are discussed in III, B, 5, above.
4.	Section 306 Stock
Provisions under §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 §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
1231See Regs. §1.861-11T(e)(2)(i); Notice 89-21, 1989-2 C.B. 408.
1232See Regs. §1.861-11T(e)(3).
1233Such members would include those corporations described in Regs. §1.861-11T(d)(6).
1234See 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).
1235See Regs. §1.861-11T(g)(2)(ii). See, e.g., Bank of America v. U.S., 680 F.2d 142 (Ct. Cl. 1982).
1236See Regs. §1.861-11T(g)(3)(iv).
1236.1See Rev. Rul. 2005-3, 2005-3 I.R.B. 334, modifying and superseding Rev. Rul. 92-63, 1992-2 C.B, 195.
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.
1236.2See 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 former §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 former §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 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(j), however, makes such a structure ineffective. Specifically, §904(j) 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(j).
1236.3For a complete discussion of §904(j) 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.
1236.4REG-251520-96, 61 Fed. Reg. 58152 (11/13/96).
123763 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.
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
1237.1See 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
1237.2Regs. §1.861-18(a)(3).
1237.3Id.
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. 
1237.4Regs. §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).
1237.5A copyrighted article is defined as a copy of a computer program from which the work can be perceived, reproduced, or otherwise communicated. 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
1237.6Regs. §1.861-18(b)(2).
1237.7Regs. §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 program;
• the right to make a public performance of the computer program; or
• the right to publicly display the computer program.
1237.8Regs. §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.
1237.9Regs. §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).
1237.10Regs. §1.861-18(c)(1)(ii). See also PLR 200229030 (substantive limitations in software 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.
1237.11Regs. §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
1237.12Regs. §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.
1237.13Regs. §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.
1237.14Regs. §1.861-18(i)(1).
1237.15Regs. §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.
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 various operative provisions. 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.
1238See, e.g., Bank of America v. U.S., 680 F.2d 142 (Ct. Cl. 1982); Rev. Rul. 70-304, 1970-1 C.B. 163.
1239See 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 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.
1240680 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.
1241Cf. §861(a)(7).  See VIII, above.
124281-1 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 judicial 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.
124392 T.C. 612 (1989), aff'd, 920 F.2d 1335 (7th Cir.1990).
1244920 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
1245See 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).
1246See PLR 7712289960A.
1247Id. Compare §861(a)(7).
1248GCM 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
1249See Old Colony Railroad Co. v. Comr., 284 U.S. 552 (1932); Deputy v. Dupont, 308 U.S. 488 (1940).
1250See 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 §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 §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 §165 of the Code when the right expires. See Rev. Rul. 71-191, 1971-1 C.B. 77.
1251Rev. 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. 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.
1252GCM 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 §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 §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.
1253Cf. 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.
1254See, 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.
1255See 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.
1256Regs. §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 §863(a), which provided that items of gross income other than those allocated by the source rules of §§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.
1257104 F.2d 505 (4th Cir. 1939).
1258§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
1259T.D. 8236, Dec. 7, 1988.
1260T.D. 8337, March 11, 1991.
1261Regs. §1.861-8(e)(6), - 8(g), Exs. (25)-(33).
1262Cf. Regs. §1.861-11T(e)(2)(i) (source of income on intragroup loans); Regs. §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.
12631983-2 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
1264Accord 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 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 §865 by reference to the residence of the taxpayer rather than by reference to the situs of the property.
12651976-1 C.B. 191.
1266Cf. 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 §904 applied for the taxable years in question. The taxpayer argued that the income should be sourced to Libya under Regs. §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.
126790 T.C. 1289 (1988).
1268See 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.
12691970-1 C.B. 163.
Insurance proceeds received in respect of stolen or damaged goods are very analogous to 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.
1270See VII, A, 1, above (sales of non-inventory property) and VII, B, 1 and 2, above (sales of inventory property).
1271It 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, 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).
1272Accord 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
1273See Miller v. Hocking Glass Co., 80 F.2d 436 (6th Cir. 1935); Rev. Rul. 73-252, 1973-1 C.B. 337; PLR 9204045.
1274PLR 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.
1275See 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 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
1276See §§101(a)(1), 7701(a).
1277§7702(g)(1).
1278Cf. §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. 2004-75,1278.1 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. 2004-97,1278.2 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.
1278.12004-31 I.R.B. 109.
1278.22004-39 I.R.B. 516
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.
1279See XIV, B, 11, below.
1280There 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
1281See, e.g., PLR 8543046 (addressing "single premium annuity contracts").
7.	Noncompetition Payments
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.
1282See Korfund Co. v. Comr., 1 T.C. 1180, 1187 (1943).
1283See 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.
1284PLR 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.
12851973-1 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
1286See, 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.
1287See, e.g.,  id., 38 T.C.M. at 648, and Housden v. Comr., T.C. Memo 1992-91 (payments by 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.
128816 T.C. 1398 (1951), aff'd per curiam, 194 F.2d 708 (3d Cir.1952), cert. denied, 344 U.S. 821 (1952).
128949 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
12901989-1 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.
1291See II, E, above for the determination of residence.
1292For 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.
1293Rev. 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
1293.1Regs. §1.863-1(d)(2)(i).
1293.2Regs. §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
1293.3Regs. §1.863-1(d)(2)(iii).
The regulations are effective for scholarship and fellowship payments made after 1986.1293.4
1293.4However, 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
1294See, 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
1295See 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
1296See 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
1297Rev. Rul. 66-291, 1966-2 C.B. 279, revoked, Rev. Rul. 89-67, 1989-1 C.B. 233.
1298Id.
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
1299See Barba v. U.S., 83-1 USTC ¶9404 (Cl. Ct. 1983) (amounts derived from playing keno).
1300Cf. 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.
1301See 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."
1302In 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 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.1302.1 The same exclusion does not apply to a foreign corporation under §883.
1302.1§872(b)(5), added by the American Jobs Creation Act of 2004, P.L. 108-357, at §419, effective for wagers made after October 22, 2004.
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
1303See 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).
1304See VII, B, 1, a, (1), (a), 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 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).
1307See, e.g., Regs. §1.1234-1(a). But see XIII, B, 1, 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
1308See Rev. Rul. 88-31, 1988-1 C.B. 302.
1309§1234(a)(3).
1310See id. (treating cash settlement as a sale or exchange of the option, based on legislative history to §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. §1.863-7.1312
1311See, e.g., Prop. Regs. §1.446-3(e)(3)(ii)(C), and -3(e)(4)(v), Ex. (1).
1312See 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 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.
1313PLR 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 §§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.
1314Corporacion 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.
1315These are discussed above at II, C, 2.
1316Cf. Regs. §1.861-11T(e)(2)(i) (source of income on intragroup loans); Regs. §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. §1.861-9T. But see Regs. §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 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.
1317171 F.2d 42 (2d Cir. 1948).
13187 USC §612(c).
131916 USC §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.
132042 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 §864(b)(2) of the 1954 and 1986 Codes.
1321Former §§211(a), 231(a).
1322Former §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.

WORKING PAPERS
Table of Worksheets
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.

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
1For 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 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
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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 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 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
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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 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
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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. 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
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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 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.
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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 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
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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 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.
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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

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.,
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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. 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-
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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 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
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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, 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
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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 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
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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.

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.
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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 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-
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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 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
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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
5For 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 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
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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 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.
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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.

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 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.
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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.

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.
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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 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
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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

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 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
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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).

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.
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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).

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).
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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)).

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.

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.
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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 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.
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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 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
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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 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 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.
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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 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.
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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.

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
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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 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 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.
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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 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.
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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 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,
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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 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

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
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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 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,
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1985 and at all times thereafter until December 1, 1987, at which time it pays off all its debt, the 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 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
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paydown amount for 4-year purposes is reduced, but not below zero, by the amount of the 5-year base.

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 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
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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.
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
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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 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
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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 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 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).

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 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

(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:

(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 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

(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].
1The 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].
2Id.

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
3This 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
4See 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:
558 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].

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

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

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

(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
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 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 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

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

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:

(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.

(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 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, 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.

(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

(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 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.
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.
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.

(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.

(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

(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 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

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 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

(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
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.

(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 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 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.
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 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 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
1Although 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 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 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.

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.

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
2If 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."

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
3If 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.

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 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 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, 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.

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).
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.
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.
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.
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).
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).
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).
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. 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).
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 & 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.
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 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.).
2005
Bates, "Reproposed §863(d) and (e) Regulations: A New and Improved Approach to Sourcing Income from Space, Ocean, and Communications Activities," 34 Tax Mgmt. Int'l J. 685 (Dec.).
Tanenbaum, "Sourcing Compensation and Allocating Charitable Contribution Deductions," 34 Tax Mgmt. Int'l J. 647 (Nov.).*
2006
Rubinger, "Revised Rules on Source of Income from Space, Oceans, and International Communications," 104 J. Tax'n 39 (Jan.).