19350 Federal Register / Vol. 73, No. 69 / Wednesday, April 9, 2008 / Rules and Regulations 

DEPARTMENT OF THE TREASURY 

Internal Revenue Service 

26 CFR Parts 1 and 301 

[TD 9391] 

RIN 1545–BF85 

Source Rules Involving U.S. 

Possessions and Other Conforming 

Changes 

AGENCY: Internal Revenue Service (IRS), 

Treasury. 

ACTION: Final regulations and removal of 

temporary regulations. 

SUMMARY: This document contains final 

regulations that provide rules under 

section 937(b) of the Internal Revenue 

Code (Code) for determining whether 

income is derived from sources within 

a U.S. possession or territory specified 

in section 937(a)(1) (generally referred 

to in this preamble as a ‘‘territory’’) and 

whether income is effectively connected 

with the conduct of a trade or business 

within a territory. The final regulations 

also provide guidance under sections 

876, 881, 884, 931, 932, 933, 934, 935, 

957, and 6688 of the Code to reflect 

amendments made by the Tax Reform 

Act of 1986, Public Law 99–514 (100 

Stat. 2085) (the 1986 Act) and the 

American Jobs Creation Act of 2004, 

Public Law 108–357 (118 Stat. 1418) 

(the 2004 Act). Conforming changes are 

also made to regulations under sections 

1, 170A, 861, 871, 901, 1402, 6038, 

6046, and 7701 of the Code. 

DATES: Effective Date: These regulations 

are effective on April 9, 2008. 

Applicability Date: For dates of 

applicability, see §§ 1.1–1(d), 1.170A– 

1(k), 1.861–3(d), 1.861–8(h), 1.871–1(d), 

1.876–1(f), 1.881–1(f), 1.881–5(i), 1.884– 

0(b), 1.901–1(j), 1.931–1(d), 1.932–1(j), 

1.933–1(e), 1.934–1(e), 1.935–1(g), 

1.937–2(l), 1.937–3(f), 1.957–3(d), 

1.1402(a)–12(c), 1.6038–2(m), 1.6046– 

1(l), 301.6688–1(d), 301.7701(b)–9(b)(5). 

FOR FURTHER INFORMATION CONTACT: 

J. David Varley (202) 435–5262 (not a 

toll-free number). 

SUPPLEMENTARY INFORMATION: 

Background 

On April 11, 2005, the Treasury 

Department and the IRS published in 

the Federal Register temporary 

regulations (TD 9194, 70 FR 18920, as 

corrected at 70 FR 32589–01), which 

provided rules to implement section 937 

and to conform existing regulations to 

other legislative changes with respect to 

the territories. A notice of proposed 

rulemaking (REG–159243–03, 70 FR 

18949) cross-referencing the temporary 

regulations was published in the 

Federal Register on the same day. 

Written comments were received in 

response to the notice of proposed 

rulemaking and a public hearing on the 

proposed regulations was held on July 

21, 2005. 

After consideration of the comments, 

the Treasury Department and the IRS on 

January 31, 2006, published in the 

Federal Register final regulations (TD 

9248, 71 FR 4996, as corrected at 71 FR 

14099) under section 937(a) concerning 

the determination of bona fide residency 

in the territories. Following further 

comments and consideration, the 

Treasury Department and the IRS on 

November 14, 2006, published in the 

Federal Register final regulations (TD 

9297, 71 FR 66232, as corrected at 71 FR 

75882) under section 937(a) providing 

additional rules for determining bona 

fide residency in the territories. 

The proposed regulations relating to 

source and effectively connected 

income with respect to the territories 

(specifically, §§ 1.937–2 and 1.937–3) as 

well as the other rules concerning the 

territories are adopted as amended by 

this Treasury decision, and the 

corresponding temporary regulations are 

removed. 

Explanation of Provisions and 

Summary of Comments 

The final regulations under Code 

section 937(b) provide rules for 

determining whether income is from 

sources within a territory and whether 

income is effectively connected with the 

conduct of a trade or business within a 

territory (territory ECI). Section 

937(b)(1) provides that, except as 

provided in regulations, rules similar to 

the rules for determining whether 

income is from sources within the 

United States or is effectively connected 

with the conduct of a trade or business 

within the United States will apply for 

purposes of determining whether 

income is from sources within a 

specified territory or effectively 

connected with the conduct of a trade 

or business in any such territory. 

Section 937(b)(2) provides that, except 

as provided in regulations, any U.S. 

source income or U.S. effectively 

connected income will not be treated as 

territory source income or as territory 

ECI. 

The U.S. tax consequences of 

classifying income as being from 

sources within a territory or as being 

territory ECI vary from territory to 

territory. The final regulations under 

Code sections 931 through 935 contain 

rules implementing the operative 

substantive and procedural provisions 

of U.S. income tax law specifically 

applicable to each territory, including 

the rules regarding the filing 

requirements and the determination of 

the income tax liability of bona fide 

residents and other persons with 

territory source income. In addition to 

the rules under Code sections 937(b) 

and 931 through 935, the final 

regulations provide conforming changes 

to rules under related provisions of the 

Code. 

The Treasury Department and the IRS 

recognize that the interaction of section 

937 and other sections of the Code 

relating to the territories requires a 

balance between implementing the 

policies Congress intended in section 

937(b) while recognizing the territories’ 

efforts to retain and attract workers and 

businesses. As discussed in more detail 

in this preamble, the final regulations 

seek to achieve this balance. For 

example, the final regulations allow an 

individual to elect, under the special 

gain rule that applies to property owned 

by an individual before the individual 

became a bona fide resident of the 

territory, to treat as territory source the 

portion of the gain that accrued while 

the individual was a bona fide resident 

of the territory. The Treasury 

Department and the IRS will continue to 

consider comments received and 

anticipate that additional changes to the 

final regulations may be made. 

I. Territory Source Income and 

Territory ECI 

A. Territory Source Income 

Section 937(b)(1) expressly grants the 

Treasury Department and the IRS the 

regulatory authority to provide 

exceptions to the general territory 

source rule, which otherwise applies 

sourcing principles similar to those of 

the U.S. source rules. The legislative 

history to section 937 indicates that 

Congress intended that the Treasury 

Department and the IRS use this 

authority to provide exceptions to the 

general rules regarding territory source 

income and territory ECI as appropriate. 

H.R. Conf. Rep. 108–755, at 795 (2004). 

The legislative history indicates that 

Congress anticipated that the regulatory 

authority would be used to continue the 

existing treatment of income from the 

sale of goods manufactured in a territory 

and to prevent abuse, such as acquiring 

residence in a territory just prior to the 

disposition of appreciated property in 

order to avoid U.S. tax on such 

disposition. Id. 

Under the temporary and proposed 

regulations, except as otherwise 

specifically provided, the principles of 

sections 861 through 865 and the 

regulations under those provisions 


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generally apply for purposes of 

determining the gross and taxable 

income from sources within and 

without a territory. The temporary and 

proposed regulations further state that 

in the application of such principles, 

the name of the relevant territory will be 

used instead of the term ‘‘United 

States’’; the term ‘‘bona fide resident of’’

followed by the name of the relevant 

territory will be used instead of the term 

‘‘United States resident’’; and the term 

‘‘domestic’’ will be construed to mean 

created or organized in the relevant 

territory. 

The temporary and proposed 

regulations also provide exceptions to 

the general rule for determining whether 

income is from sources within a 

territory. In accordance with the 

legislative history to the 2004 Act, the 

temporary and proposed regulations 

preserve the manufacturing-sales 

income rules in § 1.863–3(f). In 

addition, the temporary and proposed 

regulations provide special rules 

preventing dividends and interest paid 

by certain closely held territory 

corporations from being territory source 

income. Similarly, the temporary and 

proposed regulations provide that gains 

from dispositions of appreciated 

property owned by an individual prior 

to becoming a resident is not territory 

source income under a special 10-year 

look-back rule, and there are special 

rules regarding compensation for 

military service. As discussed in more 

detail in part I.C., the temporary and 

proposed regulations also reflect section 

937(b)(2), which is the statutory 

exception to the general territory source 

rule. 

1. General Territory Source Rule 

In response to the temporary and 

proposed regulations, commentators 

requested further guidance regarding the 

application of the general rule for 

determining whether income is from 

sources within a territory. In particular, 

commentators questioned whether, in 

applying the principles of section 861 

through 865, the only permissible 

modifications to the U.S. source rules 

were the substitutions described in 

§ 1.937–2T(b). 

The Treasury Department and the IRS 

agree that the general rule for 

determining whether income is from 

sources within a territory should be 

modified to provide greater flexibility in 

applying the principles of sections 861 

through 865 as well as to prevent abuse. 

Consequently, the final regulations 

provide that it generally will be 

sufficient to make certain specified 

substitutions described in § 1.937–2(b) 

when determining whether income is 

from within or without a territory. 

However, the final regulations provide 

that additional substitutions may be 

necessary to accomplish the intent of 

section 937(b). 

The final regulations also provide a 

necessary limitation and rule of 

application to reflect the Congressional 

intent in enacting the rules of section 

937(b)(1). Under this limiting rule, in no 

event will a bona fide resident of a 

territory or other person have, as a result 

of the application of the principles of 

the U.S. source rules, more income from 

sources within the relevant territory 

than the amount of income from sources 

within the United States that a similarly 

situated U.S. person who is not a bona 

fide resident of a territory would have 

under the U.S. source rules. 

Conforming amendments are made to 

the territory ECI rules to reflect these 

amendments to the territory source 

rules. See part I.B. Taxpayers may 

choose to apply the amendments to the 

territory source and ECI rules 

retroactively to open taxable years 

ending after October 22, 2004. 

2. Space and Ocean Income and 

International Communications Income 

Section 863(d) provides that income 

derived from space or ocean activity is 

sourced within the United States if it is 

derived by a U.S. person and is sourced 

without the United States if derived by 

a foreign person. Section 863(e) 

generally provides that income derived 

from international telecommunications 

activity by a U.S. person is treated as 

one-half from sources within the United 

States and one-half from sources 

without the United States. 

Commentators specifically requested 

greater clarity regarding how the 

principles of sections 863(d) and (e) 

were to be applied to determine whether 

income from space and ocean activity 

and international communications is 

from sources within a territory. 

The Treasury Department and IRS 

agree that the kinds of further 

modifications to the general rule that are 

discussed in part I.A.1 would be 

specifically warranted with respect to 

applying the principles of the space and 

ocean and international 

communications source rules in the 

territories. Consequently, the final 

regulations provide that in applying the 

principles of section 863(d) and (e) to 

determine whether a bona fide 

resident’s income is within or without 

a territory, the term ‘‘bona fide resident 

of a possession’’ will be used instead of 

the term ‘‘United States person.’’

3. Transportation Income 

Under section 863(c)(1), 

transportation income is treated as U.S. 

source if it is attributable to 

transportation beginning and ending in 

the United States. However, section 

863(c)(2) provides that if the 

transportation begins or ends in the 

United States but is not described in 

section 863(c)(1), then one-half of the 

income is U.S. source (the 50–50 source 

rule). Section 863(c)(2) provides an 

exception to the 50–50 source rule in 

the case of transportation income 

derived from personal services of a 

taxpayer, unless such income is 

attributable to transportation that begins 

(or ends) in the United States and ends 

(or begins) in a territory. In the case of 

transportation income derived in 

connection with a vessel, the rules of 

section 863(c)(2) apply only in the case 

of taxpayers who are citizens or resident 

aliens. 

Commentators argued that the rules of 

section 863(c)(2) should not apply to 

transportation income derived from 

personal services of bona fide residents 

of the U.S. Virgin Islands. These 

commentators argued that the 

application of these rules to a bona fide 

resident of the U.S. Virgin Islands is 

contrary to Congressional intent in 

enacting section 934(b), as interpreted 

by the commentators. Accordingly, they 

maintained, the Treasury Department 

and the IRS should exercise their 

regulatory authority under section 

937(b)(1) to provide that transportation 

income that is derived from personal 

services of a bona fide resident of the 

U.S. Virgin Islands and that otherwise 

would be sourced under the 50–50 

source rule principles of section 

863(c)(2), should be sourced entirely 

within the U.S. Virgin Islands, 

regardless of the beginning or endpoint 

of the transportation to which the 

income is attributable. 

The Treasury Department and the IRS 

believe that their regulatory authority 

under section 937(b)(1) does not extend 

to deviating from the source rules of 

section 863(c)(2). Congress clearly 

contemplated territorial tax issues when 

enacting section 863(c) as it provided 

special source rules in the case of 

transportation income derived from 

transportation between the United 

States and the territories. See H.R. Conf. 

Rep. 98–861, at 1622 (1984). Congress 

intended that these rules also would 

apply for purposes of determining the 

source of income in territories that 

mirror the U.S. income tax. Id. When 

section 863(c)(2) was amended by the 

1986 Act, the same legislation that 

enacted sections 932 and 934(b) 


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applicable to the U.S. Virgin Islands, 

Congress preserved the special 50–50 

source rule applicable to transportation 

between the United States and a 

territory and specifically applied the 

rule to such income that is derived from 

personal services. See H.R. Conf. Rep. 

99–841, at II–599 (1986). 

Furthermore, the commentators 

premised their argument for changing 

the source of transportation income on 

section 934, which only applies to the 

U.S. Virgin Islands. In the 2004 Act, 

Congress sought to rationalize the 

source of income rules applicable to the 

territories. See H.R. Conf. Rep. 108–755, 

at 794 (2004). Thus, the rules set forth 

in section 937 for determining bona fide 

residency and source of income are 

intended to apply uniformly to the 

territories rather than to provide tailored 

exceptions applicable to only certain 

territories such as the U.S. Virgin 

Islands. 

Consequently, § 1.937–2 does not 

incorporate special rules with respect to 

transportation income between the 

United States and the U.S. Virgin 

Islands. 

4. De Minimis Rule 

Section 861(a)(3) generally provides 

that compensation for labor or personal 

services performed in the United States 

is U.S. source income. Under the 

principles of section 861(a)(3), income 

from services performed in a territory is 

treated as territory source income. 

However, while section 861(a)(3) 

provides a de minimis exception to this 

general rule for services performed by 

nonresident aliens in the United States 

for minimal compensation over a short 

period of time, the temporary and 

proposed regulations specifically 

provide that the de minimis exception 

does not apply for determining whether 

income from services is from sources 

within a territory. Consequently, a U.S. 

citizen or resident alien who is not a 

bona fide resident of the U.S. Virgin 

Islands, for example, may have to file an 

income tax return with and pay tax to 

the U.S. Virgin Islands under section 

932(a) even if the individual is engaged 

in only de minimis personal services in 

the territory. In this regard, the 

temporary and proposed regulations 

carry over the pre-existing rules in 

former § 1.863–6 for determining 

income within and without a territory. 

See § 1.863–6 (2004). 

Several commentators requested a de 

minimis exception to the general rules 

for the sourcing of income from 

personal services in a territory. The 

Treasury Department and the IRS agree 

that such a rule reduces taxpayer 

burden and promotes efficient tax 

administration. Accordingly, the final 

regulations eliminate the rule in the 

temporary and proposed regulations 

that specifically provides that in 

applying the principles of section 

861(a)(3), the de minimis exception 

does not apply. An example in the final 

regulations illustrates that a U.S. citizen 

or resident who is not a bona fide 

resident of a territory but who performs 

services in a territory temporarily for no 

more than 90 days during the taxable 

year and for no more than $3000 (in the 

aggregate) generally will not have 

income from sources within the 

territory. 

5. Gains From Certain Dispositions of 

Personal Property 

The temporary and proposed 

regulations provide a special rule for 

gains from dispositions of certain 

property held by a U.S. person prior to 

becoming a resident of a territory. See 

§ 1.937–2T(f)(1). Under this rule, gains 

from dispositions of such property 

within 10 years after becoming a 

territory resident generally are treated as 

income from sources outside of the 

territory. The special gain rule 

supplements, and does not supersede, 

the similar special gain rule of section 

1277(e) of the 1986 Act, which applies 

to individuals who become residents of 

American Samoa, Guam, or the 

Northern Mariana Islands (NMI) 

(collectively, the Pacific territories). 

Commentators noted that the special 

gain rule characterizes all gain from 

property of former U.S. residents as 

non-territory source income, including 

any gain attributable to appreciation 

that occurs while the individual is a 

bona fide resident of the relevant 

territory. For example, if a U.S. citizen 

and lifelong resident of a territory who 

owns stock in a corporation moves to 

the United States for a few years and 

then re-establishes bona fide residence 

in the territory and sells the stock 

within 10 years, most of the 

appreciation in the stock may be 

attributable to the period in which the 

individual was a bona fide resident of 

the territory. However, under the special 

gain rule, because of the period of U.S. 

residence, none of the gain would 

qualify as territory source income. 

The Treasury Department and the IRS 

agree that the special gain rule should 

be modified to target more precisely 

gain attributable to appreciation 

occurring during the time that an 

individual was not a bona fide resident 

of the relevant territory. Accordingly, 

the final regulations provide that an 

individual may elect to split the source 

of gains from the sale or other 

disposition of appreciated property 

subject to the special gain rule by using 

a mark-to-market allocation in the case 

of marketable securities and a timebased allocation rule in the case of other 

personal property. This election will 

more accurately target the abuse that the 

special gain rule was intended to 

address. The election also operates to 

modify the special gain rule of the 1986 

Act, as authorized therein. Individuals 

may retroactively apply the election to 

dispositions made after April 11, 2005. 

B. Territory ECI 

Section 937(b)(1) provides that rules 

similar to those for determining whether 

income is effectively connected with the 

conduct of a trade or business within 

the United States should also apply in 

determining whether income is territory 

ECI, except as provided in regulations. 

Accordingly, the temporary and 

proposed regulations generally provide 

that the principles of section 864(c)(4) 

apply for purposes of determining 

whether any income from sources 

without a territory (U.S. source or other 

non-territory source income) is treated 

as territory ECI. 

Section 864(c)(4) limits the types of 

income from foreign sources that can be 

effectively connected income to certain 

rents or royalties; dividends or interest 

connected with the conduct of a 

banking or financial business; gain from 

the sale or exchange of inventory; and 

insurance company income. Personal 

services income that is foreign source 

cannot be effectively connected income 

under section 864(c)(4). 

Commentators requested that, instead 

of applying the principles of section 

864(c)(4), the final regulations adopt the 

principles of section 864(c)(2) and (c)(5) 

for purposes of determining whether 

income from sources without a territory 

is territory ECI. This would expand the 

types of non-territory source income 

that could be treated as territory ECI and 

particularly would include income from 

personal services. For territories such as 

the U.S. Virgin Islands this would mean 

that additional types of non-territory 

source income may be eligible for 

reductions of territorial income tax 

because section 934(b) allows the U.S. 

Virgin Islands to reduce its territorial 

income tax on income that is effectively 

connected with the conduct of a trade 

or business in the U.S. Virgin Islands. 

These commentators believe that 

Congress intended for section 934 (and 

similar provisions applicable to other 

territories) to promote economic activity 

in the territories and that the section 

937 regulations should better reflect the 

policy choices that these commentators 

believe were made in section 934(b). 


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Congress provided in section 

937(b)(1) that rules similar to those for 

determining whether income is 

effectively connected with the conduct 

of a trade or business within the United 

States should also apply in determining 

whether income is territory ECI, except 

as provided in regulations. The 

legislative history to section 937 

indicates that Congress was concerned 

about U.S. citizens and residents 

claiming to be exempt from U.S. tax on 

their worldwide income and claiming 

reductions from territorial income tax 

when they did not live and work in the 

territories. H.R. Conf. Rep. 108–755, at 

793–94. Adopting the principles of 

section 864(c)(2) and (c)(5) to determine 

whether income is territory ECI would 

allow personal services income derived 

from sources outside a territory (for 

example, U.S. source income) to be 

treated as territory ECI, contrary to 

Congressional intent. The Treasury 

Department and the IRS do not believe 

their regulatory authority extends to 

prescribing the use of the principles of 

section 864(c)(2) and (c)(5) for purposes 

of determining whether income for 

sources without a territory is territory 

ECI. 

Furthermore, section 934 does not 

provide a basis for interpreting the 

regulatory authority under section 

937(b) in such a liberal manner. In 

enacting section 937, Congress amended 

the rules related to the territories 

notwithstanding section 934. Moreover, 

the legislative history to section 934 

does not reflect these commentators’

view of Congressional intent in enacting 

section 934. Even while recognizing the 

goal of encouraging economic 

development in the U.S. Virgin Islands 

through appropriate territorial income 

tax reductions, the legislative history of 

section 934 indicates that the statute 

was enacted in part because of concerns 

that certain territorial income tax 

programs, which were intended to 

provide incentives to corporations and 

residents of the U.S. Virgin Islands that 

made new investments in the U.S. 

Virgin Islands, were having the effect of 

reducing the tax liability attributable to 

not only income from sources within 

the territory but also income from 

sources within the United States. S. 

Rep. No. 1767, 86th Cong. 2nd Sess. 4 

(1960); see also H.R. Rep. No. 99–426, 

at 485–486 (1985); and S. Rep. No. 99–

313, at 479 (1986). The legislative 

history to section 934 indicates that 

economic development in the U.S. 

Virgin Islands should not be attained by 

granting tax reductions to taxpayers 

(other than certain U.S. Virgin Islands 

corporations) with respect to income 

derived from investments from sources 

outside of the territories. Id. 

Other commentators suggested that 

U.S. source services income should be 

treated differently from other nonterritory source services income. 

Specifically, they suggested that the 

rules of section 864(c)(4) should apply 

to U.S. source personal services income 

while the principles of section 864(c)(2) 

and (c)(5) should apply to other nonterritory source personal services 

income. The Treasury Department and 

the IRS note that the legislative history 

to section 937 indicates that Congress 

was concerned about U.S. citizens and 

residents claiming reduced rates of 

territorial income taxation on personal 

services income by individuals that 

were not living and working in the 

territories. H.R. Conf. Rep. 108–755, at 

793–94. Congress also expressed 

concern about possible opportunities for 

erosion of the U.S. tax base associated 

with the territory ECI rule. Id. 

For these reasons, the Treasury 

Department and IRS have not adopted 

the commentators’ suggestions regarding 

the determination of whether income is 

effectively connected with the conduct 

of a trade or business in a territory 

under section 937(b)(1). Accordingly, 

the general rule in the temporary and 

proposed regulations for determining 

territory ECI is adopted in the final 

regulations with minor modifications. 

Similar to the modifications made to 

the general rule for determining whether 

income is from sources within a 

territory, the final regulations amend the 

general territory ECI rule to provide that 

additional substitutions beyond the 

routine substitution of the name of the 

relevant territory for the term ‘‘United 

States’’ may be necessary in some cases 

to accomplish the intent of section 

937(b)(1). The final regulations also 

adopt a limitation similar to its 

counterpart in the general territory 

source rule, precluding any application 

of the principles of section 864(c) from 

resulting in a greater amount of territory 

ECI than the amount of U.S. effectively 

connected income that a similarly 

situated U.S. person who is not a bona 

fide resident of a territory would have 

under U.S. rules. Taxpayers may choose 

to apply these rules in § 1.937–3(b) 

retroactively to open taxable years 

ending after October 22, 2004. 

C. U.S. Income Rule 

Section 937(b)(2) provides that 

notwithstanding the general territory 

source rule, any income from sources 

within the United States or effectively 

connected with the conduct of a trade 

or business within the United States is 

not treated as income from sources 

within a territory or as territory ECI (the 

U.S. income rule). The legislative 

history to section 937(b)(2) indicates 

that Congress wanted the Treasury 

Department and the IRS to create 

regulatory exceptions to the general 

rules for determining territory source 

and territory ECI and to the U.S. income 

rule ‘‘as appropriate.’’ H.R. Conf. Rep. 

108–755, at 794. Congress anticipated 

that these exceptions would be used ‘‘to 

prevent abuse.’’ Id. at 795. Congress was 

‘‘concerned that the general rules for 

determining whether income is 

effectively connected with the conduct 

of a trade or business in a [territory] 

present numerous opportunities for 

erosion of the U.S. tax base.’’ Id. at 794. 

The temporary and proposed 

regulations generally adopt the U.S. 

income rule without exception. 

However, the temporary and proposed 

regulations tighten the provision by 

adding an anti-conduit rule to prevent 

the avoidance of the U.S. income rule. 

In response to the temporary and 

proposed regulations, commentators 

requested that the Treasury Department 

and the IRS exercise their regulatory 

authority to provide additional 

exceptions to the U.S. income rule. 

1. Scope of the U.S. Income Rule 

Numerous commentators argued that 

the scope of the U.S. income rule should 

be narrowed. The commentators argued 

that without additional regulatory 

exceptions, the U.S. income rule will 

hamper efforts to promote private sector 

economic development in the territories 

because it does not permit a territory to 

provide tax reductions for U.S. source 

business income even if all of the 

activity generating that income occurs 

in the territory. In addition, these 

commentators argued that Congress 

intended to encourage the economic 

development of the territories by 

allowing, for example, the U.S. Virgin 

Islands to provide territory tax 

incentives under section 934 with 

respect to income effectively connected 

with the conduct of a trade or business 

in the U.S. Virgin Islands, even where 

that income is from U.S. sources. 

Commentators proposed various 

amendments to the general scope of the 

U.S. income rule. For example, one 

commentator essentially suggested that 

the U.S. income rule should not apply 

to income that is already treated as 

territory ECI under the general rule of 

section 937(b)(1), which applies the 

principles of section 864(c)(4) to income 

from U.S. sources. Thus, under this 

suggestion, the U.S. income rule would 

have no application to the 

determination of whether U.S. source 

income may be treated as territory ECI. 


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The commentator further argued that 

Congress was only concerned about U.S. 

source personal services income being 

treated as territory ECI and that such 

income is already prevented from being 

treated as territory ECI if the principles 

of section 864(c)(4) apply under the 

general rule. 

This purportedly limited purpose for 

enacting section 937(b)(2) is difficult to 

reconcile with the statute’s breadth, as 

a broad application to U.S. source 

income appears to be the most 

significant effect of the U.S. income 

rule. If adopted, such a rule would 

render the U.S. income rule largely 

unnecessary. The legislative history to 

section 937 indicates that Congress 

clearly intended that the U.S. income 

rule would apply to prevent U.S. source 

income from being treated as territory 

ECI. The legislative history also 

indicates that Congressional concern 

about the erosion of the U.S. tax base 

through the source and effectively 

connected income rules was a more 

general concern and not limited to 

personal services income. Consequently, 

the Treasury Department and the IRS do 

not believe that their regulatory 

authority under section 937(b)(2) 

extends to providing such a broad 

exception to the U.S. income rule. 

Other commentators suggested that 

the U.S. income rule should apply only 

when an item of income is U.S. source 

or attributable to a U.S. permanent 

establishment, as determined under the 

U.S. model treaty rules, as opposed to 

income effectively connected with the 

conduct of a U.S. trade or business. In 

the case of territory source income or 

territory ECI, this suggested change 

would essentially limit the application 

of the U.S. income rule to income that 

is attributable to a fixed place of 

business in the United States. 

This suggestion would permit a trade 

or business to carry on significant 

activities in the United States as long as 

it does not do so through a fixed 

physical location, such as an office, 

branch, factory, or place of management, 

or as long as it maintains a facility in the 

U.S. that is used for certain permissible 

activities such as storing, displaying, or 

delivering goods, purchasing or 

collecting information, or other 

activities of a preparatory or auxiliary 

nature, such as advertising or supplying 

information. See U.S. Treasury 

Department, Model Income Tax Treaty 

art. 5 (2006). A territory business could 

also utilize independent agents to carry 

on business in the United States without 

triggering the U.S. income rule. Id. 

If the U.S. income rule did not apply, 

income attributable to these activities 

could be eligible for territory tax 

incentives, a result that potentially 

could lead to an erosion of the U.S. tax 

base with respect to income that is from 

U.S. sources or effectively connected 

with the conduct of a U.S. trade or 

business. In light of the Congressional 

concerns with U.S. base erosion and the 

consequent lack of authority to provide 

such a broad regulatory exception, the 

final regulations do not adopt a 

permanent establishment standard as 

part of the U.S. income rule. 

Some commentators similarly 

suggested that the U.S. income rule 

should apply only when an item of 

income is both U.S. source and 

attributable to a U.S. office or fixed 

place of business. Thus, any U.S. source 

income not effectively connected with a 

trade or business in the United States 

could be treated as territory ECI and 

therefore qualify for tax incentives in 

certain territories. This suggested 

change also would render the U.S. 

income rule inapplicable to all territory 

source income that is effectively 

connected with the conduct of a U.S. 

trade or business. The legislative history 

to section 937 does not suggest that 

Congress intended the Treasury 

Department to exercise its regulatory 

authority to allow income earned by a 

U.S. trade or business to receive 

territory tax benefits. Therefore, the 

Treasury Department and the IRS do not 

believe there is adequate regulatory 

authority to adopt this suggestion. 

Other commentators requested 

exceptions to the U.S. income rule for 

certain classes of non-territory source 

income that may otherwise be territory 

ECI. For example, commentators 

requested that insurance income from 

insuring U.S. risks, interest income from 

U.S. payors to finance centers, or rents 

and royalties from the use of intangible 

property in the United States be 

excepted from the scope of the U.S. 

income rule to the extent income is 

territory ECI. These commentators 

asserted that, notwithstanding that such 

income is generally U.S. source, the 

economic activity that gives rise to the 

income occurs in the territories. 

Accordingly, these commentators 

argued, this income does not provide 

the opportunities to erode the U.S. tax 

base that the U.S. income rule was 

intended to prevent. 

Even though the activities giving rise 

to these classes of income may result 

from sufficient economic activity in the 

territory so that the income otherwise 

would constitute territory ECI, the 

Treasury Department and the IRS note 

that these classes of income often arise 

in part from U.S.-based activities such 

as marketing. Thus, the Treasury 

Department and the IRS do not believe 

that their regulatory authority extends to 

removing income derived from the 

specified activities from the express 

coverage of the U.S. income rule under 

section 937(b)(2). However, the final 

regulations do provide additional 

examples illustrating that income from 

personal services that, for example, lead 

to the development of intangible 

property is not subject to the U.S. 

income rule if such services income is 

from territory sources. See part I.C.2. 

2. Examples Illustrating the U.S. Income 

Rule 

Although the proposed and temporary 

regulations include several examples 

applying section 937(b) and temporary 

regulations §§ 1.937–2T and –3T, 

comments received by the Treasury 

Department and the IRS indicated a 

need for additional examples 

illustrating the operation of the U.S. 

income rule. In Notice 2006–76 (2006–

38 IRB 459) (see § 601.601(d)(2)(ii)(b)), 

the Treasury Department and the IRS 

provided two additional examples in 

response to this concern and explained 

that taxpayers may treat the examples 

set forth in the notice as illustrative of 

the rules in the temporary regulations. 

The Treasury Department and the IRS 

also signaled in the notice that these 

two additional examples, or 

substantially similar examples, would 

be included in the final regulations. 

Commentators responded positively 

to the publication of the examples in 

Notice 2006–76, and the Treasury 

Department and the IRS did not receive 

any substantive questions or comments. 

Accordingly, the examples in Notice 

2006–76 are included in the final 

regulations. 

The final regulations also provide a 

new example with respect to the 

provision of contingent-payment 

contractual terms for services performed 

in a territory. This example clarifies that 

compensation income received for 

providing personal services that lead to 

the development of intangible property 

for the service recipient is not subject to 

the U.S. income rule to the extent that 

the compensation income is from 

sources within the territory. 

II. Operative Provisions 

A. American Samoa 

Under section 931(a), income from 

sources in a section 931 possession 

generally is excluded from the gross 

income of a bona fide resident of a 

section 931 possession. (American 

Samoa currently is the only section 931 

possession because it is the only 

territory that has entered into an 

implementing agreement under sections 


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1271(b) and 1277(b) of the 1986 Act.) 

However, under section 931(d), the 

exclusion does not apply to amounts 

received for services performed as an 

employee of the United States or any 

agency thereof. The final regulations 

clarify that for this purpose under 

current law, an employee of the 

government of a section 931 possession 

is not an employee of the United States 

or of an agency of the United States. 

Thus, compensation received as an 

employee of the territorial government 

of a section 931 possession is properly 

excluded from U.S. gross income. A 

conforming clarification with respect to 

Puerto Rico is included in the final 

regulations under section 933. 

The effect of this rule change will be 

mainly administrative. Employees of the 

territorial government now will report 

their compensation as gross income on 

only the territorial income tax return 

and thus, depending on their other 

income, may be spared a U.S. filing 

obligation, and all tax on such 

compensation will be paid directly to 

the territorial government rather than 

potentially through a cover-over 

mechanism under section 7654. The 

Treasury Department and the IRS 

believe that this change will reduce 

overall taxpayer burden and enhance 

the efficiency of Federal tax 

administration, while also more fully 

reflecting the independent operation of 

the territorial taxing authority. 

Rev. Rul. 56–127 (1956–1 CB 323) (see 

§ 601.601(d)(2)(ii)(b)), which held under 

prior law that employees of the 

government of American Samoa are 

considered employees of the United 

States or an agency thereof, is no longer 

determinative and is obsoleted by this 

Treasury decision. 

B. Guam and the Northern Mariana 

Islands 

Although section 935 was repealed by 

the 1986 Act, neither Guam nor the NMI 

has agreed to the entry into force of the 

implementing agreement required under 

sections 1271(b) and 1277(b) of the 1986 

Act, and therefore neither of those 

territories is a section 931 possession as 

defined in § 1.931–1(c)(1). Rather, 

section 935 remains in effect with 

respect to bona fide residents of Guam 

and the NMI. The final regulations 

under section 935 generally retain the 

provisions of the temporary and revised 

regulations without modification. 

C. Puerto Rico 

The final regulations generally retain 

the provisions of the temporary and 

proposed regulations under section 933 

without modification. However, the 

final regulations explicitly provide that 

for purposes of the section 933 

exclusion, employees of the Puerto Rico 

territorial government are not treated as 

employees of the United States or of a 

Federal agency. This language, which 

comports with the consistent historical 

understanding that the compensation of 

such employees is excludable from 

Federal gross income, is added only for 

conformity with the revision being 

made to the final section 931 regulations 

to address certain obsolete guidance 

with respect to American Samoa, as 

explained in part II.A. 

D. United States Virgin Islands 

Section 932(c) generally provides that 

an individual (whether a U.S. citizen or 

alien) who is a bona fide resident of the 

U.S. Virgin Islands must file an income 

tax return with the U.S. Virgin Islands 

tax authorities. If the individual 

properly reports income from all 

sources identifying the source of each 

item of income on this return and pays 

all tax properly due with respect to such 

income, then such income is excluded 

from gross income for Federal income 

tax purposes. Consequently, such 

individuals have a Federal income tax 

return filing obligation if they fail to 

report or properly identify the source of 

any of their income on their U.S. Virgin 

Islands income tax return or if they fail 

to pay all of the tax properly due with 

respect to their income. The temporary 

and proposed regulations reflect this 

statutory filing regime. 

Commentators asked for additional 

guidance with respect to the U.S. filing 

obligations of individuals who take the 

position that they are bona fide 

residents of the U.S. Virgin Islands and 

file their income tax returns with the 

U.S. Virgin Islands under section 932(c). 

In particular, commentators asked for 

clarification with respect to correcting 

inadvertent errors on U.S. Virgin Islands 

income tax returns, determining the 

amount of any residual Federal income 

tax liability for individuals who fail to 

pay all the tax properly due to the U.S. 

Virgin Islands, and clarification of the 

application of the statute of limitations 

on assessments of Federal income tax by 

the IRS. 

Although the final regulations 

generally continue to reflect the 

statutory regime under 932(c) as set 

forth in the temporary and proposed 

regulations, the Treasury Department 

and the IRS agree that additional 

guidance with respect to the Federal 

filing requirements and obligations 

under section 932(c) is warranted. The 

final regulations provide an example 

illustrating that a bona fide resident of 

the U.S. Virgin Islands will not be 

subject to any U.S. filing requirement if, 

in order to correct a return previously 

filed with the U.S. Virgin Islands, that 

individual timely files an amended 

return with the U.S. Virgin Islands. The 

Treasury Department and the IRS 

believe that individuals generally 

should first avail themselves of similar 

administrative remedies that the U.S. 

Virgin Islands may provide. 

The final regulations also provide a 

new rule for purposes of determining 

the residual Federal income tax liability, 

if any, of individuals who are bona fide 

residents of the U.S. Virgin Islands. 

Under this new rule, such individuals 

are allowed a credit for amounts already 

paid to the U.S. Virgin Islands. Thus, 

their residual Federal income tax 

liability should equal the difference 

between their entire income tax liability 

and the amount of income tax already 

paid to the U.S. Virgin Islands. 

Section 932(b) provides a similar 

credit for U.S. citizens and resident 

aliens who are not bona fide residents 

of the U.S. Virgin Islands. If such 

individuals have income from sources 

within the U.S. Virgin Islands or income 

that is effectively connected with the 

conduct of a trade or business in the 

U.S. Virgin Islands, then sections 932(a) 

and (b) generally require such 

individuals to file an income tax return 

with both the IRS and the U.S. Virgin 

Islands tax authorities, paying an 

applicable percentage of taxes 

attributable to such income to the U.S. 

Virgin Islands. The individual may 

claim a credit for the tax required to be 

paid to the U.S. Virgin Islands, so that 

only the balance is due to the United 

States. Like the temporary and proposed 

regulations, the final regulations reflect 

these statutory rules. In the event that 

an individual who is not a bona fide 

resident pays more tax to the U.S. Virgin 

Islands than is required, Rev. Proc. 

2006–23 (2006–1 CB 900) (see 

§ 601.601(d)(2)(ii)(b)) provides 

procedures for requesting U.S. 

competent authority assistance for 

resolving inconsistent tax treatment 

with respect to such payments by the 

IRS and the U.S. Virgin Islands tax 

authorities. 

With respect to the Federal statute of 

limitations, the final regulations 

incorporate the interim rules announced 

in Notice 2007–31 (2007–16 IRB 971) 

under the authority of section 7654(e). 

Accordingly, the final regulations under 

section 932(c) provide that the Federal 

statute of limitations under section 

6501(a) for a U.S. citizen or resident 

alien who claims to be a bona fide 

resident of the U.S. Virgin Islands 

generally will start running upon the 

filing of an income tax return with the 

U.S. Virgin Islands. This general rule 


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applies as long as the IRS and U.S. 

Virgin Islands have in place an 

agreement for the automatic exchange of 

information satisfying the requirements 

of the Commissioner of the IRS. Because 

the working arrangement announced in 

Notice 2007–31 satisfies this condition, 

this general rule applies to years ending 

on or after December 31, 2006. In the 

event that the working arrangement is 

terminated and in the absence of a 

successor agreement, an individual 

claiming to be a bona fide resident of 

the U.S. Virgin Islands generally must 

file an income tax return with the IRS 

in order to start the Federal statute of 

limitations period. In such 

circumstances, however, the 

Commissioner may by administrative 

pronouncement specify other rules for 

this purpose. For years ending before 

December 31, 2006, the U.S. filing 

requirements provided in Notice 2007–

19 (2007–11 IRB 689) continue to apply. 

See § 601.601(d)(2)(ii)(b). 

The temporary and proposed 

regulations amend the regulations under 

section 6688 (concerning assessable 

penalties with respect to information 

reporting under section 7654) to 

conform to changes made by the 2004 

Act. The temporary and proposed 

regulations provide that the penalty 

applies to individuals who are subject to 

reporting requirements promulgated 

under the authority of section 937(c) 

(concerning individuals who become or 

cease to be bona fide residents of a 

territory) or section 7654 (concerning 

the coordination of United States and 

territorial income taxes). This 

information reporting includes the 

requirement to file Form 8689, 

‘‘Allocation of Individual Income Tax to 

the U.S. Virgin Islands,’’ and the 

requirement to file Form 8898, 

‘‘Statement for Individuals Who Begin 

or End Residence in a U.S. Possession.’’

One commentator noted that section 

6688 applies only to ‘‘individuals 

described in section 7654(a)’’ and 

therefore should not extend to Form 

8689, which is required of only U.S. 

citizens or residents (other than bona 

fide residents of the U.S. Virgin Islands) 

who have income derived from sources 

within the U.S. Virgin Islands or 

effectively connected with the conduct 

of a trade or business in the U.S. Virgin 

Islands, or spouses who file joint returns 

with such individuals. The Treasury 

Department and the IRS agree that such 

individuals are not described in section 

7654(a), which generally applies only to 

bona fide residents of an applicable 

territory. The final regulations under 

section 6688 are amended accordingly. 

E. Application of Subpart F to Bona 

Fide Residents of a Territory 

In general, corporations created or 

organized in a territory are treated as 

foreign corporations for Federal income 

tax purposes, including the subpart F 

provisions relating to controlled foreign 

corporations. Section 957(c), however, 

provides a significant exception for 

bona fide residents of Puerto Rico and 

section 931 possessions. In cases where 

the exception applies, such an 

individual is not treated as a U.S. 

person for purposes of subpart F. 

Consequently, such an individual is not 

treated as a U.S. shareholder under 

section 951(b), and where such 

individuals own more than 50 percent 

of the vote or value of a corporation 

created or organized under the laws of 

Puerto Rico (a Puerto Rico corporation) 

or a section 931 possession (a section 

931 corporation), as the case may be, 

such a corporation is not treated as a 

controlled foreign corporation under 

section 957(a). 

In the case of a bona fide resident of 

Puerto Rico, the exception applies 

under section 957(c)(1) with respect to 

a Puerto Rico corporation if a dividend 

received by such individual during the 

taxable year from such corporation 

would, for purposes of section 933(1), 

be treated as income derived from 

sources within Puerto Rico. With 

respect to bona fide residents of a 

section 931 possession, the exception 

applies under section 957(c)(2) with 

respect to a corporation organized or 

created in the section 931 possession if: 

(1) 80 percent or more of the gross 

income of the corporation during the 

three-year testing period ending at the 

close of the taxable year (or applicable 

part) was derived from sources within 

such territory or was effectively 

connected with the conduct of a trade 

or business in such a territory; and (2) 

50 percent of more of the gross income 

of the corporation for such period (or 

part) was derived from the active 

conduct of a trade or business within 

such territory (the 80/50 conditions). 

For purposes of determining whether 

income is from sources within Puerto 

Rico, the temporary and proposed 

regulations generally apply the territory 

source rules in § 1.937–2T, including 

the special rules for determining 

whether dividends to individuals who 

own more than 10 percent of the total 

voting of a territory corporation are from 

sources within the relevant territory. 

Those dividend source rules treat only 

a ratable portion of any dividend paid 

or accrued by a territory corporation to 

such a shareholder as territory source 

income unless the corporation meets the 

same 80/50 conditions as those applied 

under section 957(c)(2). Consequently, 

under the temporary and proposed 

regulations, unless a Puerto Rico 

corporation’s gross income is derived 

entirely from sources within Puerto 

Rico, the corporation must meet the 

same 80/50 conditions applicable to a 

section 931 corporation in order for 

section 957(c)(1) to apply. 

Commentators from Puerto Rico 

objected to the effect of the temporary 

and proposed regulations with respect 

to the application of section 957(c)(1). 

The commentators noted that since 

1986, all dividends from Puerto Rico 

corporations were treated as income 

from sources within Puerto Rico, and 

therefore such corporations were not 

treated as controlled foreign 

corporations for 10 percent shareholders 

who were bona fide residents of Puerto 

Rico. Commentators noted that the 

legislative history to neither the 2004 

Act nor the 1986 Act, which amended 

section 957(c) by applying the 80/50 

conditions with respect to section 931 

corporations but did not specifically 

apply those conditions to Puerto Rico 

corporations, makes any reference to 

Congressional intent to apply the 80/50 

conditions to Puerto Rico corporations. 

The Treasury Department and the IRS 

believe that given the distinct statutory 

tests under sections 957(c)(1) and (c)(2), 

the 80/50 conditions should apply only 

to section 931 corporations. Therefore, 

the final regulations provide that the 

special dividend source rules of 

§ 1.937–2(g)(1) (including the 80/50 

conditions) will not apply when 

determining, for purposes of section 

957(c)(1), whether a dividend received 

by the Puerto Rico corporation during 

the taxable year would be treated under 

section 933(1) as derived from sources 

within Puerto Rico. Rather, the 

principles of section 861(a)(2)(A) under 

the general territory source rules will 

apply, and consequently dividends from 

Puerto Rico corporations generally will 

be treated as income from sources 

within Puerto Rico for purposes of 

applying section 957(c)(1) unless the 

U.S. income rule prevents the dividends 

from being sourced to Puerto Rico 

because, for example, the dividends are 

from sources within the United States 

under section 861(a)(2)(B). 

The temporary and proposed 

regulations contain related rules under 

sections 6038 and 6046 with respect to 

information reporting requirements 

concerning certain foreign corporations 

owned by a United States person who 

is a bona fide resident of Puerto Rico or 

a section 931 possession. Under the 

temporary regulations, the special 

definition of United States person under 


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section 957(c) also applies for purposes 

of sections 6038 and 6046. However, 

because the final regulations no longer 

apply the 80/50 conditions to bona fide 

residents of Puerto Rico (for purposes of 

subpart F), the Treasury Department and 

the IRS are concerned that such 

individuals may no longer have to 

provide information concerning their 

controlled foreign corporations, 

including those formed in Puerto Rico. 

The Treasury Department and the IRS 

believe that the information required 

under sections 6038 and 6046 is 

necessary for purposes of determining 

whether such individuals have a 

Federal income tax liability. Thus, the 

final regulations continue to apply the 

80/50 conditions of § 1.937–2(g)(1) 

when defining United States person for 

purposes of the information reporting 

requirements under sections 6038 and 

6046. 

With respect to bona fide residents of 

a section 931 possession, the final 

regulations continue to apply the same 

exception (with the 80/50 conditions) 

for purposes of section 957(c) and 

sections 6038 and 6046. 

F. Entity Status 

With respect to section 935 

possessions and the U.S. Virgin Islands 

(mirror code territories), the temporary 

and proposed regulations contain 

special rules requiring consistent 

treatment of certain business entities for 

U.S. and mirror code tax purposes. The 

rules generally apply to elections under 

section 1362(a) (subchapter S 

corporations), § 301.7701–3(c) (eligible 

entities), and other similar elections. 

The rules provide, among other things, 

that if an entity files an election with the 

IRS but not with the relevant mirror 

code territory, then the appropriate tax 

authority of the mirror code territory 

may, at its discretion, deem the election 

also to have been made for mirror code 

tax purposes. Similarly, if any such 

election is filed in a mirror code 

territory but not with the IRS, the 

Commissioner may, at his or her 

discretion, deem the election to have 

been made for U.S. Federal income tax 

purposes. 

The Treasury Department and the IRS 

specifically requested comments 

relating to elections that should be 

specifically mentioned or excluded from 

the entity status election rules. 

Commentators requested two limited 

exceptions to the requirement for 

making consistent elections in the case 

of a U.S. entity that files an election 

with the IRS but not with the relevant 

mirror code territory. 

The first comment related to a U.S. 

entity that elects to be treated as a real 

estate mortgage investment conduit 

under section 860D(b) (a REMIC) for 

U.S. tax purposes. The commentator 

noted that a REMIC would be classified 

as a foreign corporation for mirror code 

tax purposes unless it either files an 

election in the mirror code territory or 

the appropriate tax authority of the 

relevant mirror code territory exercises 

his or her discretion to treat the entity 

as if an election had been made. The 

commentator requested that the entity 

consistency rules be restricted so as not 

to apply to a publicly traded REMIC 

unless five percent or more of the 

REMIC’s ownership is held by a bona 

fide resident of the relevant territory or 

a corporation created or organized in the 

relevant territory. 

The second comment similarly 

requested an exception to the consistent 

election requirement in the case of a 

U.S. corporation that, prior to the 

temporary and proposed regulations, 

made an election with the IRS under 

section 1362(a) to be an S corporation 

but had a shareholder who was a bona 

fide resident of a mirror code territory 

who treated the entity as a foreign C 

corporation for purposes of the 

individual’s taxation in the territory. 

The commentator requested that such 

individuals be allowed under these 

circumstances to make a one-time 

election in the mirror code territory to 

treat the U.S. entity for purposes of 

mirror code taxation as either a 

domestic S corporation or a foreign C 

corporation (as it would be in the 

absence of an affirmative election under 

section 1362(a) by the entity or a 

deemed election by the mirror code tax 

authority). 

The Treasury Department and the IRS 

are concerned about the possibility of 

inappropriate tax results from 

inconsistent treatment of entities in the 

United States and mirror code 

jurisdictions and believe that this 

problem exists even in circumstances in 

which the owners of the entity hold less 

than five percent of the interests in the 

entity. Furthermore, the Treasury 

Department and the IRS believe that 

treating the entity consistently in the 

territory and the United States should 

not impose an undue burden on the 

entity. Thus, the Treasury Department 

and the IRS do not believe that a special 

exception in the entity consistency rules 

is necessary in either case. 

As provided in the temporary and 

proposed regulations, which are 

finalized here without change, the 

ability of the tax authority in a mirror 

code jurisdiction to deem an election to 

have been made for territorial tax 

purposes is discretionary. The Treasury 

Department and the IRS anticipate that, 

to the extent the entity status rules 

apply, this discretion will be exercised 

in situations where taxpayers treat a 

business entity in an inconsistent 

manner with the result that it reduces 

their overall tax liability below what 

otherwise would be due in the absence 

of the mirror system. In addition, and as 

a general matter, the Treasury 

Department and the IRS encourage 

taxpayers to take consistent positions in 

both jurisdictions or, if this is not 

possible, to seek available 

administrative assistance from the 

relevant jurisdiction including, for 

example, requesting a pre-filing or 

similar agreement with respect to an 

entity’s classification as well as 

requesting competent authority 

assistance concerning any inconsistent 

positions taken by the IRS and a 

territory with respect to the entity 

classification of an entity. See, for 

example, Rev. Proc. 2007–17 (2007–4 

IRB 368) (IRS pre-filing agreement 

procedures) and Rev. Proc. 2006–23 

(2006–1 CB 900) (U.S. competent 

authority assistance procedures with 

respect to the territories). See 

§ 601.601(d)(2)(ii)(b). 

III. Miscellaneous Changes 

The final regulations also reflect 

various nonsubstantive stylistic edits to 

the proposed and temporary regulations 

to enhance clarity and readability. 

Effect on Other Documents 

Rev. Rul. 56–127 (1956–1 CB 323) is 

obsolete as of April 9, 2008. 

Special Analyses 

It has been determined that this 

Treasury decision is not a significant 

regulatory action as defined in 

Executive Order 12866. Therefore, a 

regulatory assessment is not required. It 

also has been determined that section 

553(b) of the Administrative Procedure 

Act (5 U.S.C. chapter 5) does not apply 

to these regulations. Because the 

regulations do not impose a collection 

of information on small entities, the 

Regulatory Flexibility Act (5 U.S.C. 

chapter 6) does not apply. Pursuant to 

section 7805(f) of the Internal Revenue 

Code, the notice of proposed rulemaking 

preceding these regulations was 

submitted to the Chief Counsel for 

Advocacy of the Small Business 

Administration for comment on its 

impact on small business. 

Drafting Information 

The principal author of these 

regulations is J. David Varley, Office of 

the Associate Chief Counsel 

(International), IRS. However, other 

personnel from the IRS and Treasury 


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Department participated in their 

development. 

List of Subjects 

26 CFR Part 1 

Income taxes, Reporting and 

recordkeeping requirements. 

26 CFR Part 301 

Employment taxes, Estate taxes, 

Excise taxes, Gift taxes, Income taxes, 

Penalties, Reporting and recordkeeping 

requirements. 

Adoption of Amendments to the 

Regulations 

■ Accordingly, 26 CFR parts 1 and 301 

are amended as follows: 

PART 1—INCOME TAXES 

■ Paragraph 1. The authority citation 

for part 1 is amended by adding entries 

in numerical order to read in part as 

follows: 

Authority: 26 U.S.C. 7805 * * * 

Section 1.931–1 also issued under 26 

U.S.C. 7654(e). 

Section 1.932–1 also issued under 26 

U.S.C. 7654(e). * * * 

Section 1.934–1 also issued under 26 

U.S.C. 934(b)(4). * * * 

Section 1.935–1 also issued under 26 

U.S.C. 7654(e). * * * 

Section 1.937–2 also issued under 26 

U.S.C. 937(b). 

Section 1.937–3 also issued under 26 

U.S.C. 937(b). * * * 

Section 1.957–3 also issued under 26 

U.S.C. 957(c). * * * 

■ Par. 2. Section 1.1–1 is amended by 

revising the second sentence of 

paragraph (b) and adding a new 

paragraph (d) to read as follows: 

§ 1.1–1 Income tax on individuals. 

* * * * * 

(b) * * * Pursuant to section 876, a 

nonresident alien individual who is a 

bona fide resident of a section 931 

possession (as defined in § 1.931–1(c)(1) 

of this chapter) or Puerto Rico during 

the entire taxable year is, except as 

provided in section 931 or 933 with 

respect to income from sources within 

such possessions, subject to taxation in 

the same manner as a resident alien 

individual. * * * 

* * * * * 

(d) Effective/applicability date. The 

second sentence of paragraph (b) of this 

section applies to taxable years ending 

after April 9, 2008. 

■ Par. 3. Section 1.170A–1 is amended 

by revising paragraph (j)(9) and the 

heading for paragraph (k) and adding a 

new sentence at the end of paragraph (k) 

to read as follows: 

§ 1.170A–1 Charitable, etc., contributions 

and gifts; allowance of deduction. 

* * * * * 

(j)(9) Charitable contributions paid by 

bona fide residents of a section 931 

possession as defined in § 1.931–1(c)(1) 

or Puerto Rico are deductible only to the 

extent allocable to income that is not 

excluded under section 931 or 933. For 

the rules for allocating deductions for 

charitable contributions, see the 

regulations under section 861. 

* * * * * 

(k) Effective/applicability date. * * * 

Paragraph (j)(9) of this section is 

applicable for taxable years ending after 

April 9, 2008. 

§ 1.170A–1T [Removed] 

■ Par. 4. Section 1.170A–1T is removed. 

■ Par. 5. Section 1.861–3 is amended by 

revising paragraph (a)(2) and revising 

the heading for paragraph (d) and 

adding a new sentence at the end of 

paragraph (d) to read as follows: 

§ 1.861–3 Dividends. 

* * * * * 

(a) * * * 

(2) Dividend from a domestic 

corporation. A dividend described in 

this paragraph (a)(2) is a dividend from 

a domestic corporation other than a 

corporation that has an election in effect 

under section 936. See paragraph (a)(5) 

of this section for the treatment of 

certain dividends from a DISC or former 

DISC. 

* * * * * 

(d) Effective/applicability date. * * * 

Paragraph (a)(2) of this section applies 

to taxable years ending after April 9, 

2008. 

§ 1.861–3T [Removed] 

■ Par. 6. Section 1.861–3T is removed. 

■ Par. 7. Section 1.861–8 is amended by 

adding paragraphs (f)(1)(vi)(E), 

(f)(1)(vi)(F), (f)(1)(vi)(H), and (h) to read 

as follows: 

§ 1.861–8 Computation of taxable income 

from sources within the United States and 

from other sources and activities. 

* * * * * 

(f) * * * 

(1) * * * 

(vi) * * * 

(E) The tax base for individuals 

entitled to the benefits of section 931 

and the section 936 tax credit of a 

domestic corporation that has an 

election in effect under section 936; 

(F) The exclusion for income from 

Puerto Rico for bona fide residents of 

Puerto Rico under section 933; 

* * * * * 

(H) The income derived from the U.S. 

Virgin Islands or from a section 935 

possession (as defined in § 1.935–

1(a)(3)(i)). 

* * * * * 

(h) Effective/applicability date. 

Paragraphs (f)(1)(vi)(E), (f)(1)(vi)(F), and 

(f)(1)(vi)(H) of this section apply to 

taxable years ending after April 9, 2008. 

■ Par. 8. Section 1.871–1 is amended by 

revising paragraph (b)(1)(iii) and 

revising the heading for paragraph (c) 

and adding a new sentence at the end 

of paragraph (c) to read as follows: 

§ 1.871–1 Classification and manner of 

taxing alien individuals. 

* * * * * 

(b) * * * 

(1) * * * 

(iii) Nonresident alien individuals 

who are bona fide residents of a section 

931 possession (as defined in § 1.931–

1(c)(1) of this chapter) or Puerto Rico 

during the entire taxable year. An 

individual described in paragraph 

(b)(1)(i) or (ii) of this section is subject 

to tax pursuant to the provisions of 

subpart A (section 871 and following), 

part II, subchapter N, chapter 1 of the 

Code, and the regulations under those 

provisions. The provisions of subpart A 

do not apply to individuals described in 

this paragraph (b)(1)(iii), but such 

individuals, except as provided in 

section 931 or 933, are subject to the tax 

imposed by section 1 or 55. See 

§ 1.876–1. 

* * * * * 

(c) Effective/applicability date. * * * 

Paragraph (b)(1)(iii) of this section 

applies to taxable years ending after 

April 9, 2008. 

■ Par. 9. Section 1.876–1 is revised to 

read as follows: 

§ 1.876–1 Alien residents of Puerto Rico, 

Guam, American Samoa, or the Northern 

Mariana Islands. 

(a) Scope. Section 876 and this 

section apply to any nonresident alien 

individual who is a bona fide resident 

of Puerto Rico or of a section 931 

possession during the entire taxable 

year. 

(b) In general. An individual to whom 

this section applies is, in accordance 

with the provisions of section 876, 

subject to tax under sections 1 and 55 

in generally the same manner as an 

alien resident of the United States. See 

§§ 1.1–1(b) and 1.871–1. The tax 

generally is imposed upon the taxable 

income of such individual, determined 

in accordance with section 63(a) and the 

regulations under that section, from 

sources both within and without the 

United States, except for amounts 

excluded from gross income under the 

provisions of section 931 or 933. For 

determining the form of return to be 


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used by such an individual, see section 

6012 and the regulations under that 

section. 

(c) Exceptions. Though subject to the 

tax imposed by section 1, an individual 

to whom this section applies will 

nevertheless be treated as a nonresident 

alien individual for the purpose of many 

provisions of the Internal Revenue Code 

(Code) relating to nonresident alien 

individuals. Thus, for example, such an 

individual is not allowed the standard 

deduction (section 63(c)(6)); is subject to 

withholding of tax at source under 

chapter 3 of the Code (for example, 

section 1441(e)); is generally excepted 

from the collection of income tax at 

source on wages for services performed 

in the possession (section 3401(a)(6)); is 

not allowed to make a joint return 

(section 6013(a)(1)); and, if described in 

section 6072(c), must pay his first 

installment of estimated income tax on 

or before the 15th day of the 6th month 

of the taxable year (section 6654(j) and 

(k)) and must pay his income tax on or 

before the 15th day of the 6th month 

following the close of the taxable year 

(sections 6072(c) and 6151(a)). In 

addition, under section 152(b)(3), an 

individual is not allowed a deduction 

for a dependent who is a resident of the 

relevant possession unless the 

dependent is a citizen or national of the 

United States. 

(d) Credits against tax. (1) Certain 

credits under the Internal Revenue Code 

are available to any taxpayer subject to 

the tax imposed by section 1, including 

individuals to whom this section 

applies. For example, except as 

otherwise provided under section 931 or 

933, the credits provided by the 

following sections are allowable to the 

extent provided under such sections 

against the tax determined in 

accordance with this section—

(i) Section 23 (relating to the credit for 

adoption expenses); 

(ii) Section 31 (relating to the credit 

for tax withheld on wages); 

(iii) Section 33 (relating to the credit 

for tax withheld at source on 

nonresident aliens); and 

(iv) Section 34 (relating to the credit 

for certain uses of gasoline and special 

fuels). 

(2) Certain credits under the Internal 

Revenue Code are not available to 

nonresident aliens or are subject to 

limitations based on such factors as 

principal place of abode in the United 

States. For example, the credits 

provided by the following sections are 

not allowable against the tax determined 

in accordance with this section except 

to the extent otherwise provided under 

such sections—

(i) Section 22 (relating to the credit for 

the elderly and disabled); 

(ii) Section 25A (relating to the Hope 

Scholarship and Lifetime Learning 

Credits); and 

(iii) Section 32 (relating to the earned 

income credit). 

(e) Definitions. For purposes of this 

section—

(1) ‘‘Bona fide resident’’ is defined in 

§ 1.937–1; and 

(2) ‘‘Section 931 possession’’ is 

defined in § 1.931–1(c)(1). 

(f) Effective/applicability date. This 

section applies to taxable years ending 

after April 9, 2008. 

§ 1.876–1T [Removed] 

■ Par. 10. Section 1.876–1T is removed. 

■ Par. 11. Section 1.881–1 is amended 

by revising the last sentence of 

paragraph (c) and the heading of 

paragraph (f) to read as follows: 

§ 1.881–1 Manner of taxing foreign 

corporations. 

* * * * * 

(c) * * * However, for special rules 

relating to possessions of the United 

States, see § 1.881–5. 

* * * * * 

(f) Effective/applicability date. * * * 

■ Par. 12. Section 1.881–5 is amended 

as follows: 

■ 1. Revise paragraphs (a), (b), (c), (d), 

(e), (f), (f)(1), (f)(2), (f)(3), (f)(5), (f)(6), 

(f)(7), (g), (h), and (i). 

■ 2. Remove paragraph (f)(8). 

The revisions read as follows: 

§ 1.881–5 Exception for certain 

possessions corporations. 

(a) Scope. Section 881(b) and this 

section provide special rules for the 

application of sections 881 and 884 to 

certain corporations created or 

organized in possessions of the United 

States. Paragraph (g) of this section 

provides special rules for the 

application of sections 881 and 884 to 

corporations created or organized in the 

United States for purposes of 

determining tax liability incurred to 

certain possessions that administer 

income tax laws that are identical 

(except for the substitution of the name 

of the possession for the term ‘‘United 

States’’ where appropriate) to those in 

force in the United States. See § 1.884–

0(b) for special rules relating to the 

application of section 884 with respect 

to possessions of the United States. 

(b) Operative rules. (1) Corporations 

described in paragraphs (c) and (d) of 

this section are not treated as foreign 

corporations for purposes of section 

881. Accordingly, they are exempt from 

the tax imposed by section 881(a). 

(2) For corporations described in 

paragraph (e) of this section, the rate of 

tax imposed by section 881(a) on U.S. 

source dividends received is 10 percent 

(rather than the generally applicable 30 

percent). 

(c) U.S. Virgin Islands and section 931 

possessions. A corporation created or 

organized in, or under the law of, the 

U.S. Virgin Islands or a section 931 

possession is described in this 

paragraph (c) for a taxable year when 

the following conditions are satisfied—

(1) At all times during such taxable 

year, less than 25 percent in value of the 

stock of such corporation is beneficially 

owned (directly or indirectly) by foreign 

persons; 

(2) At least 65 percent of the gross 

income of such corporation is shown to 

the satisfaction of the Commissioner 

upon examination to be effectively 

connected with the conduct of a trade 

or business in such a possession or the 

United States for the 3-year period 

ending with the close of the taxable year 

of such corporation (or for such part of 

such period as the corporation or any 

predecessor has been in existence); and 

(3) No substantial part of the income 

of such corporation for the taxable year 

is used (directly or indirectly) to satisfy 

obligations to persons who are not bona 

fide residents of such a possession or 

the United States. 

(d) Section 935 possessions. A 

corporation created or organized in, or 

under the law of, a section 935 

possession is described in this 

paragraph (d) for a taxable year when 

the following conditions are satisfied—

(1) At all times during such taxable 

year, less than 25 percent in value of the 

stock of such corporation is owned 

(directly or indirectly) by foreign 

persons; and 

(2) At least 20 percent of the gross 

income of such corporation is shown to 

the satisfaction of the Commissioner 

upon examination to have been derived 

from sources within such possession for 

the 3-year period ending with the close 

of the preceding taxable year of such 

corporation (or for such part of such 

period as the corporation has been in 

existence). 

(e) Puerto Rico. A corporation created 

or organized in, or under the law of, 

Puerto Rico is described in this 

paragraph (e) for a taxable year when 

the conditions of paragraphs (c)(1) 

through (c)(3) of this section are 

satisfied (using the language ‘‘Puerto 

Rico’’ instead of ‘‘such a possession’’). 

(f) Definitions and other rules. For 

purposes of this section—

(1) ‘‘Section 931 possession’’ is 

defined in § 1.931–1(c)(1);and 

(2) ‘‘Section 935’’ possession is 

defined in § 1.935–1(a)(3)(i). 


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(3) Foreign person means any person 

other than—

(i) A United States person (as defined 

in section 7701(a)(30) and the 

regulations under that section); or 

(ii) A person who would be a United 

States person if references to the United 

States in section 7701 included 

references to a possession of the United 

States. 

* * * * * 

(5) Source. The rules of § 1.937–2 will 

apply for determining whether income 

is from sources within a possession. 

(6) Effectively connected income. The 

rules of § 1.937–3 (other than paragraph 

(c) of that section) will apply for 

determining whether income is 

effectively connected with the conduct 

of a trade or business in a possession. 

(7) Indirect ownership. The rules of 

section 318(a)(2) will apply except that 

the language ‘‘5 percent’’ will be used 

instead of ‘‘50 percent’’ in section 

318(a)(2)(C). 

(g) Mirror code jurisdictions. For 

purposes of applying mirrored section 

881 to determine tax liability incurred 

to a section 935 possession or the U.S. 

Virgin Islands—

(1) The rules of paragraphs (b) 

through (d) of this section will not 

apply; and 

(2) A corporation created or organized 

in, or under the law of, such possession 

or the United States will not be 

considered a foreign corporation. 

(h) Example. The principles of this 

section are illustrated by the following 

example: 

Example. X is a corporation organized 

under the law of the U.S. Virgin Islands with 

a branch located in State F. At least 65 

percent of the gross income of X is effectively 

connected with the conduct of a trade or 

business in the U.S. Virgin Islands and no 

substantial part of the income of X for the 

taxable year is used to satisfy obligations to 

persons who are not bona fide residents of 

the United States or the U.S. Virgin Islands. 

Seventy-four percent of the stock of X is 

owned by unrelated individuals who are 

residents of the United States or the U.S. 

Virgin Islands. Y, a corporation organized 

under the law of State D, and Z, a partnership 

organized under the law of State F, each own 

13 percent of the stock of X. A, an unrelated 

foreign individual, owns 100 percent of the 

stock of corporation Y. B and C, unrelated 

foreign individuals, each own a 50 percent 

interest in partnership Z. Thus, the condition 

of paragraph (c)(1) of this section is not 

satisfied, because 26 percent of X is owned 

indirectly by foreign persons (A, B, and C). 

Accordingly, X is treated as a foreign 

corporation for purposes of section 881. 

(i) Effective/applicability dates. 

Except as otherwise provided in this 

paragraph (i), this section applies to 

payments made in taxable years ending 

after April 9, 2008. If, on or after April 

9, 2008, there takes effect an increase in 

the Commonwealth of Puerto Rico’s 

withholding tax generally applicable to 

dividends paid to United States 

corporations not engaged in a trade or 

business in the Commonwealth to a rate 

greater than 10 percent, the rules of 

paragraphs (b)(2) and (e) of this section 

will not apply to dividends received on 

or after the effective date of the increase. 

Paragraph (f)(4) of this section applies to 

payments made after January 31, 2006. 

Taxpayers may choose to apply 

paragraph (f)(4) of this section to 

payments made after October 22, 2004. 

■ Par. 13. Section 1.884–0 is amended 

by revising paragraph (b) to read as 

follows: 

§ 1.884–0 Overview of regulation 

provisions for section 884. 

* * * * * 

(b) Special rules for U.S. possessions. 

(1) Section 884 does not apply to a 

corporation created or organized in, or 

under the law of, American Samoa, 

Guam, the Northern Mariana Islands, or 

the U.S. Virgin Islands, provided that 

the conditions of § 1.881–5(c)(1) through 

(c)(3) are satisfied with respect to such 

corporation. The preceding sentence 

applies for taxable years ending after 

April 11, 2005. 

(2) Section 884 does not apply for 

purposes of determining tax liability 

incurred to a section 935 possession or 

the U.S. Virgin Islands by a corporation 

created or organized in, or under the 

law of, such possession or the United 

States. The preceding sentence applies 

for taxable years ending after April 9, 

2008. 

* * * * * 

§ 1.884–0T [Removed] 

■ Par. 14. Section 1.884–0T is removed. 

■ Par. 15. Section 1.901–1 is amended 

by revising paragraph (g) and adding 

new paragraph (j) to read as follows: 

§ 1.901–1 Allowance of credit for taxes. 

* * * * * 

(g) Taxpayers to whom credit not 

allowed. Among those to whom the 

credit for taxes is not allowed are the 

following: 

(1) Except as provided in section 906, 

a foreign corporation. 

(2) Except as provided in section 906, 

a nonresident alien individual who is 

not described in section 876 (see 

sections 874(c) and 901(b)(4)). 

(3) A nonresident alien individual 

described in section 876 other than a 

bona fide resident (as defined in section 

937(a) and the regulations under that 

section) of Puerto Rico during the entire 

taxable year (see sections 901(b)(3) and 

(4)). 

(4) A U.S. citizen or resident alien 

individual who is a bona fide resident 

of a section 931 possession (as defined 

in § 1.931–1(c)(1)), the U.S. Virgin 

Islands, or Puerto Rico, and who 

excludes certain income from U.S. gross 

income to the extent of taxes allocable 

to the income so excluded (see sections 

931(b)(2), 933(1), and 932(c)(4)). 

* * * * * 

(j) Effective/applicability date. 

Paragraph (g) of this section applies to 

taxable years ending after April 9, 2008. 

§ 1.901–1T [Removed] 

■ Par. 16. Section 1.901–1T is removed. 

■ Par. 17. Section 1.931–1 is revised to 

read as follows: 

§ 1.931–1 Exclusion of certain income 

from sources within Guam, American 

Samoa, or the Northern Mariana Islands. 

(a) General rule. (1) An individual 

(whether a United States citizen or an 

alien), who is a bona fide resident of a 

section 931 possession during the entire 

taxable year, will exclude from gross 

income the income derived from 

sources within any section 931 

possession and the income effectively 

connected with the conduct of a trade 

or business by such individual within 

any section 931 possession, except 

amounts received for services performed 

as an employee of the United States or 

any agency thereof. For purposes of 

section 931(d) and this section, an 

employee of the government of a section 

931 possession will not be considered 

an employee of the United States or of 

an agency of the United States. 

(2) The following example illustrates 

the application of the general rule in 

paragraph (a)(1) of this section: 

Example. D, a United States citizen, files 

returns on a calendar year basis. In April 

2008, D moves to American Samoa, where he 

purchases a house and accepts a permanent 

position with a local employer. For the 

remainder of the year and for the following 

three taxable years, D continues to live and 

work in American Samoa and has a closer 

connection to American Samoa than to the 

United States or any foreign country. 

Assuming that D otherwise meets the 

requirements under section 937(a) and 

§ 1.937–1(b) and (f)(1) (year-of-move 

exception), D is considered a bona fide 

resident of American Samoa for 2008. 

Accordingly, under section 931 and 

paragraph (a)(1) of this section, D should 

exclude from his 2008 Federal gross income 

any income from sources within American 

Samoa and any income that is effectively 

connected with the conduct of a trade or 

business within American Samoa, as 

determined under section 937(b) and 

§§ 1.937–2 and 1.937–3, as applicable. 


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(b) Deductions and credits. In any 

case in which any amount otherwise 

constituting gross income is excluded 

from gross income under the provisions 

of section 931, there will not be allowed 

as a deduction from gross income any 

items of expenses or losses or other 

deductions (except the deduction under 

section 151, relating to personal 

exemptions), or any credit, properly 

allocable to, or chargeable against, the 

amounts so excluded from gross 

income. For purposes of the preceding 

sentence, the rules of § 1.861–8 will 

apply (with creditable expenditures 

treated in the same manner as 

deductible expenditures). 

(c) Definitions. For purposes of this 

section—

(1) The term section 931 possession 

means a possession that is a specified 

possession and that has entered into an 

implementing agreement, as described 

in section 1271(b) of the Tax Reform Act 

of 1986, Public Law 99–514 (100 Stat. 

2085), with the United States that is in 

effect for the entire taxable year; 

(2) The term specified possession 

means Guam, American Samoa, or the 

Northern Mariana Islands; 

(3) The rules of § 1.937–1 will apply 

for determining whether an individual 

is a bona fide resident of a section 931 

possession; 

(4) The rules of § 1.937–2 will apply 

for determining whether income is from 

sources within a section 931 possession; 

and 

(5) The rules of § 1.937–3 will apply 

for determining whether income is 

effectively connected with the conduct 

of a trade or business within a section 

931 possession. 

(d) Effective/applicability date. This 

section applies to taxable years ending 

after April 9, 2008. 

§ 1.931–1T [Removed] 

■ Par. 18. Section 1.931–1T is removed. 

■ Par. 19. Section 1.932–1 is revised to 

read as follows: 

§ 1.932–1 Coordination of United States 

and Virgin Islands income taxes. 

(a) Scope—(1) In general. Section 932 

and this section set forth the special 

rules relating to the filing of income tax 

returns and income tax liabilities of 

individuals described in paragraph 

(a)(2) of this section. Paragraph (h) of 

this section also provides special rules 

requiring consistent treatment of 

business entities in the United States 

and in the United States Virgin Islands 

(Virgin Islands). 

(2) Individuals covered. This section 

will apply to any individual who—

(i) Is a bona fide resident of the Virgin 

Islands during the entire taxable year; 

(ii)(A) Is a citizen or resident of the 

United States (other than a bona fide 

resident of the Virgin Islands) during 

the entire taxable year; and 

(B) Has income derived from sources 

within the Virgin Islands, or effectively 

connected with the conduct of a trade 

or business within the Virgin Islands, 

for the taxable year; or 

(iii) Files a joint return for the taxable 

year with any individual described in 

paragraph (a)(2)(i) or (ii) of this section. 

(3) Definitions. For purposes of this 

section—

(i) The rules of § 1.937–1 will apply 

for determining whether an individual 

is a bona fide resident of the Virgin 

Islands; 

(ii) The rules of § 1.937–2 will apply 

for determining whether income is from 

sources within the Virgin Islands; and 

(iii) The rules of § 1.937–3 will apply 

for determining whether income is 

effectively connected with the conduct 

of a trade or business within the Virgin 

Islands. 

(b) U.S. individuals with Virgin 

Islands income—(1) Dual filing 

requirement. Subject to paragraph (d) of 

this section, an individual described in 

paragraph (a)(2)(ii) of this section must 

make an income tax return for the 

taxable year to the United States and file 

a copy of such return with the Virgin 

Islands. Such individuals must also 

attach Form 8689, ‘‘Allocation of 

Individual Income Tax to the U.S. 

Virgin Islands,’’ to the U.S. income tax 

return and to the income tax return filed 

with the Virgin Islands. 

(2) Tax payments. (i) Each individual 

to whom this paragraph (b) applies for 

the taxable year must pay the applicable 

percentage of the taxes imposed by this 

chapter for such taxable year 

(determined without regard to 

paragraph (b)(2)(ii) of this section) to the 

Virgin Islands. 

(ii) A credit against the tax imposed 

by this chapter for the taxable year will 

be allowed in an amount equal to the 

taxes that are required to be paid to the 

Virgin Islands under paragraph (b)(2)(i) 

of this section and are so paid. Such 

taxes will be considered creditable in 

the same manner as taxes paid to the 

United States (for example, under 

section 31) and not as taxes paid to a 

foreign government (for example, under 

sections 27 and 901). 

(iii) For purposes of this paragraph 

(b)(2)—

(A) The term applicable percentage 

means the percentage that Virgin Islands 

adjusted gross income bears to adjusted 

gross income; 

(B) The term Virgin Islands adjusted 

gross income means adjusted gross 

income determined by taking into 

account only income derived from 

sources within the Virgin Islands and 

deductions properly apportioned or 

allocable to such income. For purposes 

of the preceding sentence, the rules of 

§ 1.861–8 will apply; and 

(C) Pursuant to § 1.937–2(a), the rules 

of § 1.937–2(c)(1)(ii) and (c)(2) do not 

apply. 

(c) Bona fide residents of the Virgin 

Islands. Subject to paragraph (d) of this 

section, an individual described in 

paragraph (a)(2)(i) of this section will be 

subject to the following income tax 

return filing requirements: 

(1) Virgin Islands filing requirements. 

An individual to whom this paragraph 

(c) applies must file an income tax 

return for the taxable year with the 

Virgin Islands. On this return, the 

individual must report income from all 

sources and identify the source of each 

item of income shown on the return. 

(2) U.S. filing requirements. (i) For 

purposes of calculating the income tax 

liability to the United States of an 

individual to whom this paragraph (c) 

applies, gross income will not include 

any amount included in gross income 

on the return filed with the Virgin 

Islands pursuant to paragraph (c)(1) of 

this section, and deductions and credits 

allocable to such income will not be 

taken into account, provided that—

(A) The individual fully satisfied the 

reporting requirements of paragraph 

(c)(1) of this section; and 

(B) The individual fully paid the tax 

liability referred to in section 934(a) to 

the Virgin Islands with respect to such 

income. 

(ii) For purposes of the U.S. statute of 

limitations under section 6501(a), an 

income tax return filed with the Virgin 

Islands by an individual who takes the 

position that he or she is a bona fide 

resident of the Virgin Islands described 

in paragraph (a)(2)(i) of this section (or 

an individual who files a joint return 

with such an individual under 

paragraph (d) of this section) will be 

deemed to be a U.S. income tax return, 

provided that the United States and the 

Virgin Islands have entered into an 

agreement for the routine exchange of 

income tax information satisfying the 

requirements of the Commissioner. The 

working arrangement announced in 

Notice 2007–31 satisfies the condition 

of the preceding sentence. See Notice 

2007–31 (2007–16 IRB 971) (applicable 

to taxable years ending on or after 

December 31, 2006, unless and until 

arrangement terminates). In the absence 

of such an agreement, individuals to 

whom this paragraph (c) applies 

generally must file an income tax return 

for the taxable year with the United 

States to begin the period of limitations 


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for Federal income tax purposes as 

provided in section 6501(a), and in such 

circumstances the Commissioner may 

by revenue procedure, notice, or other 

administrative pronouncement specify 

U.S. filing and other information 

reporting requirements for such 

individuals. For taxable years ending 

before December 31, 2006, the rules 

provided in section 3 of Notice 2007–19 

(2007–11 IRB 689) will apply. See 

§ 601.601(d)(2)(ii)(b). 

(3) U.S. tax payments. In the case of 

an individual who is required to file an 

income tax return with the United 

States as a consequence of failing to 

satisfy the requirements of paragraphs 

(c)(2)(i)(A) and (B) of this section, there 

will be allowed as a credit against the 

tax imposed by this chapter for the 

taxable year an amount equal to the 

amount of the tax liability referred to in 

section 934(a) to the extent paid to the 

Virgin Islands. Such taxes shall be 

considered creditable in the same 

manner as taxes paid to the United 

States (for example, under section 31) 

and not as taxes paid to a foreign 

government (for example, under 

sections 27 and 901). 

(d) Joint returns. In the case of 

married persons, if one or both spouses 

is an individual described in paragraph 

(a)(2) of this section and they file a joint 

return of income tax, the spouses must 

file their joint return with, and pay the 

tax due on such return to, the 

jurisdiction (or jurisdictions) where the 

spouse who has the greater adjusted 

gross income for the taxable year would 

be required under paragraph (b) or (c) of 

this section to file a return if separate 

returns were filed and all of their 

income were the income of such spouse. 

For this purpose, adjusted gross income 

of each spouse is determined under 

section 62 and the regulations under 

that section but without regard to 

community property laws; and, if one of 

the spouses dies, the taxable year of the 

surviving spouse will be treated as 

ending on the date of such death. 

(e) Place for filing returns—(1) U.S. 

returns. Except as otherwise provided 

for returns filed under paragraph (c)(4) 

of this section, a return required under 

the rules of paragraphs (b) and (c) of this 

section to be filed with the United 

States must be filed as directed in the 

applicable forms and instructions. 

(2) Virgin Islands returns. A return 

required under the rules of paragraphs 

(b) and (c) of this section to be filed with 

the Virgin Islands must be filed as 

directed in the applicable forms and 

instructions. 

(f) Tax accounting standards—(1) In 

general. A dual filing taxpayer must use 

the same tax accounting standards on 

the returns filed with the United States 

and the Virgin Islands. A taxpayer who 

has filed a return only with the United 

States or only with the Virgin Islands as 

a single filing taxpayer for a prior 

taxable year and is required to file a 

return only with the other jurisdiction 

as a single filing taxpayer for a later 

taxable year may not, for such later 

taxable year, use different tax 

accounting standards unless the second 

jurisdiction consents to such change. 

However, such change will not be 

effective for returns filed thereafter with 

the first jurisdiction unless before such 

later date of filing the taxpayer also 

obtains the consent of the first 

jurisdiction to make such change. Any 

request for consent to make a change 

pursuant to this paragraph (f) must be 

made to the office where the return is 

required to be filed under paragraph (e) 

of this section and in sufficient time to 

permit a copy of the consent to be 

attached to the return for the taxable 

year. 

(2) Definitions. For purposes of this 

paragraph (f), the terms—

(i) Dual filing taxpayer means a 

taxpayer who is required to file returns 

with the United States and the Virgin 

Islands for the same taxable year under 

the rules of paragraph (b) or (c) of this 

section; 

(ii) Single filing taxpayer means a 

taxpayer who is required to file a return 

only with the United States (because the 

individual is not described in paragraph 

(a)(2) of this section) or only with the 

Virgin Islands (because the individual is 

described in paragraph (a)(2)(i) of this 

section and satisfies the conditions of 

paragraphs (c)(2)(i) and (ii) of this 

section) for the taxable year; and 

(iii) Tax accounting standards 

includes the taxpayer’s accounting 

period, methods of accounting, and any 

election to which the taxpayer is bound 

with respect to the reporting of taxable 

income. 

(g) Extension of territory—(1) Section 

932(a) taxpayers—(i) General rule. With 

respect to an individual to whom 

section 932(a) applies for a taxable year, 

for purposes of taxes imposed by 

Chapter 1 of the Internal Revenue Code 

(Code), the United States generally will 

be treated, in a geographical and 

governmental sense, as including the 

Virgin Islands. The purpose of this rule 

is to facilitate the coordination of the tax 

systems of the United States and the 

Virgin Islands. Accordingly, the rule 

will have no effect where it is 

manifestly inapplicable or its 

application would be incompatible with 

the intent of any provision of the Code. 

(ii) Application of general rule. 

Contexts in which the general rule of 

paragraph (g)(1)(i) of this section apply 

include—

(A) The characterization of taxes paid 

to the Virgin Islands. An individual to 

whom section 932(a) applies may take 

income tax required to be paid to the 

Virgin Islands under section 932(b) into 

account under sections 31, 6315, and 

6402(b) as payments to the United 

States. Taxes paid to the Virgin Islands 

and otherwise satisfying the 

requirements of section 164(a) will be 

allowed as a deduction under that 

section, but income taxes required to be 

paid to the Virgin Islands under section 

932(b) will be disallowed as a deduction 

under section 275(a); 

(B) The determination of the source of 

income for purposes of the foreign tax 

credit (for example, sections 901 

through 904). Thus, for example, after 

an individual to whom section 932(a) 

applies determines which items of 

income constitute income from sources 

within the Virgin Islands under the 

rules of section 937(b), such income will 

be treated as income from sources 

within the United States for purposes of 

section 904; 

(C) The eligibility of a corporation to 

make a subchapter S election (sections 

1361 through 1379). Thus, for example, 

for purposes of determining whether a 

corporation created or organized in the 

Virgin Islands may make an election 

under section 1362(a) to be a subchapter 

S corporation, it will be treated as a 

domestic corporation and a shareholder 

to whom section 932(a) applies will not 

be treated as a nonresident alien 

individual with respect to such 

corporation. While such an election is 

in effect, the corporation will be treated 

as a domestic corporation for all 

purposes of the Internal Revenue Code. 

For the consistency requirement with 

respect to entity status elections, see 

paragraph (h) of this section; 

(D) The treatment of items carried 

over from other taxable years. Thus, for 

example, if an individual to whom 

section 932(a) applies has for a taxable 

year a net operating loss carryback or 

carryover under section 172, a foreign 

tax credit carryback or carryover under 

section 904, a business credit carryback 

or carryover under section 39, a capital 

loss carryover under section 1212, or a 

charitable contributions carryover under 

section 170, the carryback or carryover 

will be reported on the return filed in 

accordance with paragraph (b)(1) of this 

section, even though the return of the 

taxpayer for the taxable year giving rise 

to the carryback or carryover was 

required to be filed with the Virgin 

Islands under section 932(c); and 

(E) The treatment of property 

exchanged for property of a like kind 


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(section 1031). Thus, for example, if an 

individual to whom section 932(a) 

applies exchanges real property located 

in the United States for real property 

located in the Virgin Islands, 

notwithstanding the provisions of 

section 1031(h), such exchange may 

qualify as a like-kind exchange under 

section 1031 (provided that all the other 

requirements of section 1031 are 

satisfied). 

(iii) Nonapplication of the general 

rule. Contexts in which the general rule 

of paragraph (g)(1)(i) of this section does 

not apply include—

(A) The application of any rules or 

regulations that explicitly treat the 

United States and any (or all) of its 

possessions as separate jurisdictions (for 

example, sections 931 through 937, 

7651, and 7654). 

(B) The determination of any aspect of 

an individual’s residency (for example, 

sections 937(a) and 7701(b)). Thus, for 

example, an individual whose principal 

place of abode is in the Virgin Islands 

is not considered to have a principal 

place of abode in the United States for 

purposes of section 32(c); 

(C) The characterization of a 

corporation for purposes other than 

subchapter S (for example, sections 367, 

951 through 964, 1291 through 1298, 

6038, and 6038B). Thus, for example, if 

an individual to whom section 932(a) 

applies transfers appreciated tangible 

property to a corporation created or 

organized in the Virgin Islands in a 

transaction described in section 351, he 

or she must recognize gain unless an 

exception under section 367(a) applies. 

Also, if a corporation created or 

organized in the Virgin Islands qualifies 

as a passive foreign investment 

company under sections 1297 and 1298 

with respect to an individual to whom 

section 932(a) applies, a dividend paid 

to such shareholder does not constitute 

qualified dividend income under 

section 1(h)(11)(B). 

(2) Section 932(c) taxpayers—(i) 

General rule. With respect to an 

individual to whom section 932(c) 

applies for a taxable year, for purposes 

of the territorial income tax of the Virgin 

Islands (that is, mirrored sections of the 

Code), the Virgin Islands generally will 

be treated, in a geographical and 

governmental sense, as including the 

United States. The purpose of this rule 

is to facilitate the coordination of the tax 

systems of the United States and the 

Virgin Islands. Accordingly, the rule 

will have no effect where it is 

manifestly inapplicable or its 

application would be incompatible with 

the intent of any provision of the Code. 

(ii) Application of general rule. 

Contexts in which the general rule of 

paragraph (g)(2)(i) of this section apply 

include—

(A) The characterization of taxes paid 

to the United States. A taxpayer 

described in section 932(c)(1) may take 

income tax paid to the United States 

into account under mirrored sections 

31, 6315, and 6402(b) as payments to 

the Virgin Islands; 

(B) The determination of the source of 

income for purposes of the foreign tax 

credit (for example, mirrored sections 

901 through 904). Thus, for example, 

any item of income that constitutes 

income from sources within the United 

States under the rules of sections 861 

through 865 will be treated as income 

from sources within the Virgin Islands 

for purposes of mirrored section 904; 

(C) The eligibility of a corporation to 

make a subchapter S election (mirrored 

sections 1361 through 1379). Thus, for 

example, for purposes of determining 

whether a corporation created or 

organized in the United States may 

make an election under mirrored section 

1362(a) to be a subchapter S 

corporation, it will be treated as a 

domestic corporation and a shareholder 

to whom section 932(c) applies will not 

be treated as a nonresident alien 

individual with respect to such 

corporation. While such an election is 

in effect, the corporation will be treated 

as a domestic corporation for all 

purposes of the territorial income tax. 

For the consistency requirement with 

respect to entity status elections, see 

paragraph (h) of this section; 

(D) The treatment of items carried 

over from other taxable years. Thus, for 

example, if an individual to whom 

section 932(c) applies has for a taxable 

year a net operating loss carryback or 

carryover under mirrored section 172, a 

foreign tax credit carryback or carryover 

under mirrored section 904, a business 

credit carryback or carryover under 

mirrored section 39, a capital loss 

carryover under mirrored section 1212, 

or a charitable contributions carryover 

under mirrored section 170, the 

carryback or carryover will be reported 

on the return filed in accordance with 

paragraph (c)(1) of this section, even 

though the return of the taxpayer for the 

taxable year giving rise to the carryback 

or carryover was required to be filed 

with the United States; and 

(E) The treatment of property 

exchanged for property of a like kind 

(mirrored section 1031). Thus, for 

example, if an individual to whom 

section 932(c) applies exchanges real 

property located in the United States for 

real property located in the Virgin 

Islands, notwithstanding the provisions 

of mirrored section 1031(h), such 

exchange may qualify as a like-kind 

exchange under mirrored section 1031 

(provided that all the other 

requirements of mirrored section 1031 

are satisfied). 

(iii) Nonapplication of general rule. 

Contexts in which the general rule of 

paragraph (g)(2)(i) of this section does 

not apply include—

(A) The determination of any aspect 

of an individual’s residency (for 

example, mirrored section 7701(b)). 

Thus, for example, an individual whose 

principal place of abode is in the United 

States is not considered to have a 

principal place of abode in the Virgin 

Islands for purposes of mirrored section 

32(c). 

(B) The determination of the source of 

income for purposes other than the 

foreign tax credit (for example, sections 

932(a) and (b), 934(b), and 937). Thus, 

for example, compensation for services 

performed in the United States and 

rentals or royalties from property 

located in the United States do not 

constitute income from sources within 

the Virgin Islands for purposes of 

section 934(b); and 

(C) The definition of wages (mirrored 

section 3401). Thus, for example, 

services performed by an employee for 

an employer in the United States do not 

constitute services performed in the 

Virgin Islands under mirrored section 

3401(a)(8). 

(h) Entity status consistency 

requirement—(1) In general. Taxpayers 

should make consistent entity status 

elections (as defined in paragraph (h)(3) 

of this section), where applicable, in 

both the United States and the Virgin 

Islands. In the case of a business entity 

to which this paragraph (h) applies—

(i) If an entity status election is filed 

with the Internal Revenue Service (IRS) 

but not with the Virgin Islands Bureau 

of Internal Revenue (BIR), the Director 

of the BIR or his delegate, at his 

discretion, may deem the election also 

to have been made for Virgin Islands tax 

purposes; 

(ii) If an entity status election is filed 

with the BIR but not with the IRS, the 

Commissioner, at his discretion, may 

deem the election also to have been 

made for Federal tax purposes; and 

(iii) If inconsistent entity status 

elections are filed with the BIR and the 

IRS, both the Commissioner and the 

Director of the BIR or his delegate may, 

at their individual discretion, treat the 

elections they each received as invalid 

and may deem the election filed in the 

other jurisdiction to have been made 

also for tax purposes in their own 

jurisdiction. See Rev. Proc. 2006–23 

(2006–1 CB 900) (see 

§ 601.601(d)(2)(ii)(b) of this chapter) for 

procedures for requesting the assistance 


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of the IRS when a taxpayer is or may be 

subject to inconsistent tax treatment by 

the IRS and a U.S. possession tax 

agency. 

(2) Scope. This paragraph (h) applies 

to the following business entities: 

(i) A business entity (as defined in 

§ 301.7701–2(a) of this chapter) that is 

domestic (as defined in § 301.7701–5 of 

this chapter), or otherwise treated as 

domestic for purposes of the Code, and 

that is owned in whole or in part by any 

person who is either a bona fide 

resident of the Virgin Islands or a 

business entity created or organized in 

the Virgin Islands. 

(ii) A business entity that is created or 

organized in the Virgin Islands and that 

is owned in whole or in part by any U.S. 

person (other than a bona fide resident 

of the Virgin Islands). 

(3) Definition. For purposes of this 

section, the term entity status election 

includes an election under § 301.7701–

3(c) of this chapter, an election under 

section 1362(a), and any other similar 

elections. 

(4) Default status. Solely for the 

purpose of determining classification of 

an eligible entity under § 301.7701–3(b) 

of this chapter and under that section as 

mirrored in the Virgin Islands, an 

eligible entity subject to this paragraph 

(h) will be classified for both Federal 

and Virgin Islands tax purposes using 

the rule that applies to domestic eligible 

entities. 

(5) Transition rules—(i) In the case of 

an election filed prior to April 11, 2005, 

except as provided in paragraph 

(h)(5)(ii) of this section, the rules of 

paragraph (h)(1) of this section will 

apply as of the first day of the first 

taxable year of the entity beginning after 

April 11, 2005. 

(ii) In the unlikely circumstance that 

inconsistent elections described in 

paragraph (h)(1)(iii) of this section are 

filed prior to April 11, 2005, and the 

entity cannot change its classification to 

achieve consistency because of the 

sixty-month limitation described in 

§ 301.7701–3(c)(1)(iv) of this chapter, 

then the entity may nevertheless request 

permission from the Commissioner or 

the Director of the BIR or his delegate 

to change such election to avoid 

inconsistent treatment by the 

Commissioner and the Director of the 

BIR or his delegate. 

(iii) Except as provided in paragraphs 

(h)(5)(i) and (h)(5)(ii) of this section, in 

the case of an election filed with respect 

to an entity before it became an entity 

described in paragraph (h)(2) of this 

section, the rules of paragraph (h)(1) of 

this section will apply as of the first day 

that such entity is described in 

paragraph (h)(2) of this section. 

(iv) In the case of an entity created or 

organized prior to April 11, 2005, 

paragraph (h)(4) of this section will take 

effect for Federal income tax purposes 

(or Virgin Islands income tax purposes, 

as the case may be) as of the first day 

of the first taxable year of the entity 

beginning after April 11, 2005. 

(i) Examples. The rules of this section 

are illustrated by the following 

examples: 

Example 1. (i) A is a U.S. citizen who 

resides in State R. For 2008, A files with the 

IRS a Form 1040, ‘‘U.S. Individual Income 

Tax Return,’’ reporting adjusted gross income 

of $90x, which includes $30x from sources 

in the Virgin Islands. The income tax liability 

reported on A’s Form 1040 is $18x. A files 

a copy of his Form 1040 with the Virgin 

Islands as required by section 932(a)(2) and 

paragraph (b)(1) of this section. A pays to the 

Virgin Islands the applicable percentage of 

his Federal income tax liability as required 

by section 932(b) and paragraph (b)(2) of this 

section, computed as follows: $30x/$90x × 

$18x = $6x income tax liability to the Virgin 

Islands. 

(ii) A claims a credit in the amount of $6x 

against his Federal income tax liability 

reported on his Form 1040. A attaches a 

Form 8689, ‘‘Allocation of Individual Income 

Tax to the U.S. Virgin Islands,’’ to the Form 

1040 filed with the IRS and to the copy filed 

with the Virgin Islands. 

Example 2. (i) B, a U.S. citizen, files 

returns on a calendar year basis. In November 

2008, B moves to the Virgin Islands, 

purchases a house, and accepts a permanent 

position with a local employer. For the 

remainder of the year and throughout 2009, 

B continues to live and work in the Virgin 

Islands and has a closer connection to the 

Virgin Islands than to the United States or 

any foreign country. As a consequence of his 

employment in the Virgin Islands, B earns 

income from the performance of services in 

the Virgin Islands during 2008 and 2009. 

(ii) For 2008, B does not qualify as a bona 

fide resident under section 937(a) and 

§ 1.937–1(b) and (f)(1). Therefore, B is subject 

to the rules of sections 932(a) and (b) and 

paragraph (b) of this section for 2008 because 

he has income derived from sources within 

the Virgin Islands as determined under the 

rules of section 937(b) and § 1.937–2. 

(iii) For 2009, assuming that B otherwise 

satisfies the requirements of section 937(a) 

and § 1.937–1(b), B qualifies as a bona fide 

resident of the Virgin Islands. Therefore, 

section 932(c) and paragraph (c) of this 

section apply to B for 2009, and he must file 

his income tax return with the Virgin Islands 

under paragraph (c)(1) of this section. 

Provided that B fully satisfies the reporting 

requirements of paragraph (c)(1) of this 

section and fully pays the tax liability 

referred to in section 934(a), B will have no 

Federal income tax filing requirement or 

liability under paragraphs (c)(2) and (3) of 

this section. 

Example 3. H and W are U.S. citizens. H 

resides in State T and W is a bona fide 

resident of the Virgin Islands. For 2008, H 

and W prepare a joint Form 1040, ‘‘U.S. 

Individual Income Tax Return,’’ reporting 

total adjusted gross income of $75x, of which 

$40x is attributable to compensation that W 

received for services performed in the Virgin 

Islands and $35x to compensation that H 

received for services performed in State T. 

Pursuant to section 932(d) and paragraph (d) 

of this section, because W would have the 

greater adjusted gross income if computed 

separately, H and W must file their joint 

Form 1040 with the Virgin Islands as 

required by section 932(c) and paragraph 

(c)(1) of this section. H and W may claim a 

tax credit on such return for income tax 

withheld during 2008 and paid to the IRS. 

Example 4. (i) The facts are the same as in 

Example 3, except that H also earns $25x for 

services performed in the Virgin Islands, so 

that H and W’s total adjusted gross income 

is $100x, and their total income tax liability 

is $20x. 

(ii) Pursuant to section 932(d) and 

paragraph (d) of this section, because H 

would have the greater adjusted gross income 

if computed separately, H and W must file 

their joint Form 1040 with the IRS and must 

file a copy of that joint Form 1040 with the 

Virgin Islands as required by section 

932(a)(2) and paragraph (b)(1) of this section. 

H and W must pay the applicable percentage 

of their Federal income tax liability to the 

Virgin Islands as required by section 932(b) 

and paragraph (b)(2) of this section, 

computed as follows: $65x /$100x × $20x = 

$13x income tax liability to the Virgin 

Islands. 

(iii) H and W claim a credit against their 

Federal income tax liability reported on their 

joint Form 1040 in the amount of $13x, the 

portion of their Federal income tax liability 

required to be paid to the Virgin Islands. H 

and W attach a Form 8689, ‘‘Allocation of 

Individual Income Tax to the U.S. Virgin 

Islands,’’ to their joint Form 1040 filed with 

the IRS and to the copy filed with the Virgin 

Islands. 

Example 5. N, a U.S. citizen and calendar 

year taxpayer, takes the position that he is a 

bona fide resident of the Virgin Islands for 

the 2007 taxable year. On April 15, 2008, N 

files a Form 1040, ‘‘U.S. Individual Income 

Tax Return,’’ with the Virgin Islands for his 

2007 taxable year. N does not file a Form 

1040 with the IRS. Because there is an 

agreement in force between the United States 

and the Virgin Islands for the routine 

exchange of income tax information, under 

paragraph (c)(2)(ii) of this section, the 

Federal 3-year period of limitations under 

section 6501(a) will expire on April 15, 2011, 

and the IRS will make no further assessment 

of income tax after that date for N’s 2007 

taxable year except as otherwise authorized 

by section 6501. 

Example 6. (i) J is a U.S. citizen and a bona 

fide resident of the Virgin Islands. In 2008, 

J receives compensation for services 

performed as an employee in the Virgin 

Islands in the amount of $40x. J files with the 

Virgin Islands a Form 1040, ‘‘U.S. Individual 

Income Tax Return,’’ reporting gross income 

of only $30x. Based on these facts, J has not 

satisfied the conditions of section 932(c)(4) 

and paragraph (c) of this section for an 

exclusion from gross income for Federal 

income tax purposes. 

(ii) The facts are the same as in paragraph 

(i) of this Example 6 except that on or before 


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the last day prescribed for filing an income 

tax return for J’s 2008 taxable year, J files 

with the Virgin Islands an amended Form 

1040 for 2008, correctly reporting the full 

$40x of compensation. Provided that J 

otherwise fully satisfies the reporting 

requirements of paragraph (c)(1) of this 

section and fully pays the tax liability 

referred to in section 934(a), J will have no 

Federal income tax filing requirement or 

liability under paragraphs (c)(2) and (3) of 

this section. 

Example 7. (i) N is a U.S. citizen and a 

bona fide resident of the Virgin Islands. In 

2008, N receives compensation for services 

performed in Country M. N files with the 

Virgin Islands a Form 1040, ‘‘U.S. Individual 

Income Tax Return,’’ reporting the 

compensation as income effectively 

connected with the conduct of a trade or 

business in the Virgin Islands. N claims a 

special credit against the tax on this 

compensation pursuant to a Virgin Islands 

law enacted within the limits of its authority 

under section 934. 

(ii) Under the principles of section 

864(c)(4) as applied pursuant to section 

937(b)(1) and § 1.937–3(b), compensation for 

services performed outside the Virgin Islands 

may not be treated as income effectively 

connected with the conduct of a trade or 

business in the Virgin Islands for purposes of 

section 934(b). Consequently, N is not 

entitled to claim the special credit under 

Virgin Islands law with respect to N’s income 

from services performed in Country M. 

Because N has not fully paid his tax liability 

referred to in section 934(a), he has not 

satisfied the conditions of section 932(c)(4) 

and paragraph (c) of this section for an 

exclusion from gross income for Federal 

income tax purposes. Therefore, income 

reported on the Form 1040 as filed with the 

Virgin Islands must be included in N’s 

Federal gross income. Under paragraph (c)(3) 

of this section, the amount of tax paid to the 

Virgin Islands on such income will be 

allowed as a credit against N’s Federal 

income tax liability. 

(j) Effective/applicability date. Except 

as otherwise provided in this paragraph 

(j), this section applies to taxable years 

ending after April 9, 2008. Taxpayers 

may choose to apply paragraph (c)(2)(ii) 

of this section to open taxable years 

ending on or after December 31, 2006. 

§ 1.932–1T [Removed] 

■ Par. 20. Section 1.932–1T is removed. 

■ Par. 21. Section 1.933–1 is amended 

by revising paragraphs (a), (c), (d), and 

(e) to read as follows: 

§ 1.933–1 Exclusion of certain income 

from sources within Puerto Rico. 

(a) General rule. (1) An individual 

(whether a United States citizen or an 

alien), who is a bona fide resident of 

Puerto Rico during the entire taxable 

year, will exclude from gross income the 

income derived from sources within 

Puerto Rico, except amounts received 

for services performed as an employee 

of the United States or any agency 

thereof. For purposes of section 933 and 

this section, an employee of the 

government of Puerto Rico will not be 

considered an employee of the United 

States or of an agency of the United 

States. 

(2) The following example illustrates 

the application of the general rule in 

paragraph (a)(1) of this section: 

Example. E, a United States citizen, files 

returns on a calendar year basis. In April 

2008, E moves to Puerto Rico, where he 

purchases a house and accepts a permanent 

position with a local employer. For the 

remainder of the year and for the following 

three taxable years, E continues to live and 

work in Puerto Rico and has a closer 

connection to Puerto Rico than to the United 

States or any foreign country. Assuming that 

E otherwise meets the requirements under 

section 937(a) and § 1.937–1(b) and (f)(1) 

(year-of-move exception), E is considered a 

bona fide resident of Puerto Rico for 2008. 

Accordingly, under section 933(1) and 

paragraph (a)(1) of this section, E should 

exclude from his 2008 Federal gross income 

any income from sources within Puerto Rico, 

as determined under section 937(b) and 

§ 1.937–2. 

* * * * * 

(c) Deductions and credits. In any 

case in which any amount otherwise 

constituting gross income is excluded 

from gross income under the provisions 

of section 933, there will not be allowed 

as a deduction from gross income any 

items of expenses or losses or other 

deductions (except the deduction under 

section 151, relating to personal 

exemptions), or any credit, properly 

allocable to, or chargeable against, the 

amounts so excluded from gross 

income. For purposes of the preceding 

sentence, the rules of § 1.861–8 will 

apply (with creditable expenditures 

treated in the same manner as 

deductible expenditures). 

(d) Definitions. For purposes of this 

section—

(1) The rules of § 1.937–1 will apply 

for determining whether an individual 

is a bona fide resident of Puerto Rico; 

and 

(2) The rules of § 1.937–2 will apply 

for determining whether income is from 

sources within Puerto Rico. 

(e) Effective/applicability date. 

Paragraphs (a), (c), (d), and (e) of this 

section apply to taxable years ending 

after April 9, 2008. 

§ 1.933–1T [Removed] 

■ Par. 22. Section 1.933–1T is removed. 

■ Par. 23. Section 1.934–1 is revised to 

read as follows: 

§ 1.934–1 Limitation on reduction in 

income tax liability incurred to the Virgin 

Islands. 

(a) General rule. Section 934(a) 

provides that tax liability incurred to 

the United States Virgin Islands (Virgin 

Islands) must not be reduced or remitted 

in any way, directly or indirectly, 

whether by grant, subsidy, or other 

similar payment, by any law enacted in 

the Virgin Islands, except to the extent 

provided in section 934(b). For purposes 

of the preceding sentence, the term ‘‘tax 

liability’’ means the liability incurred to 

the Virgin Islands pursuant to subtitle A 

of the Internal Revenue Code (Code), as 

made applicable in the Virgin Islands by 

the Act of July 12, 1921 (48 U.S.C. 

1397), or pursuant to section 28(a) of the 

Revised Organic Act of the Virgin 

Islands (48 U.S.C. 1642), as modified by 

section 7651(5)(B). 

(b) Exception for Virgin Islands 

income—(1) In general. Section 

934(b)(1) provides an exception to the 

application of section 934(a). Under this 

exception, section 934(a) does not apply 

with respect to tax liability incurred to 

the Virgin Islands to the extent that such 

tax liability is attributable to income 

derived from sources within the Virgin 

Islands or income effectively connected 

with the conduct of a trade or business 

within the Virgin Islands. 

(2) Limitation. Section 934(b)(2) limits 

the scope of the exception provided by 

section 934(b)(1). Pursuant to this 

limitation, the exception does not apply 

with respect to an individual who is a 

citizen or resident of the United States 

(other than a bona fide resident of the 

Virgin Islands). For the rules for 

determining tax liability incurred to the 

Virgin Islands by such an individual, 

see section 932(a) and the regulations 

under that section. 

(3) Computation rule—(i) Operative 

rule. For purposes of section 934(b)(1) 

and this paragraph (b), tax liability 

incurred to the Virgin Islands for the 

taxable year attributable to income 

derived from sources within the Virgin 

Islands or income effectively connected 

with the conduct of a trade or business 

within the Virgin Islands will be 

computed as follows: 

(A) Add to the income tax liability 

incurred to the Virgin Islands any credit 

against the tax allowed under mirrored 

section 901(a). 

(B) Multiply by taxable income from 

sources within the Virgin Islands and 

income effectively connected with the 

conduct of a trade or business within 

the Virgin Islands (applying the rules of 

§ 1.861–8 to determine deductions 

allocable to such income). 

(C) Divide by total taxable income. 


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(D) Subtract the portion of any credit 

allowed under mirrored section 901 

(other than credits for taxes paid to the 

United States) determined by 

multiplying the amount of taxable 

income from sources outside the Virgin 

Islands or the United States that is 

effectively connected to the conduct of 

a trade or business in the Virgin Islands 

divided by the total amount of taxable 

income from such sources. 

(ii) Limitation. Tax liability incurred 

to the Virgin Islands attributable to 

income derived from sources within the 

Virgin Islands or income effectively 

connected with the conduct of a trade 

or business within the Virgin Islands, as 

computed in this paragraph (b)(3), 

however, will not exceed the total 

amount of income tax liability actually 

incurred. 

(4) Definitions. For purposes of this 

section—

(i) Bona fide resident. The rules of 

§ 1.937–1 will apply for determining 

whether an individual is a bona fide 

resident of the Virgin Islands; 

(ii) Source. The rules of § 1.937–2 will 

apply for determining whether income 

is from sources within the Virgin 

Islands; and 

(iii) Effectively connected income. 

The rules of § 1.937–3 will apply for 

determining whether income is 

effectively connected with the conduct 

of a trade or business in the Virgin 

Islands. 

(c) Exception for qualified foreign 

corporations—(1) In general. Section 

934(b)(3) provides an exception to the 

application of section 934(a). Under this 

exception, section 934(a) does not apply 

with respect to tax liability incurred to 

the Virgin Islands by a qualified foreign 

corporation to the extent that such tax 

liability is attributable to income that is 

derived from sources outside the United 

States and that is not effectively 

connected with the conduct of a trade 

or business within the United States. 

(2) Qualified foreign corporation. For 

purposes of paragraph (c)(1) of this 

section, the term qualified foreign 

corporation means any foreign 

corporation if 1 or more United States 

persons own or are treated as owning 

(within the meaning of section 958) less 

than 10 percent of—

(i) The total voting power of the stock 

of such corporation; and 

(ii) The total value of the stock of such 

corporation. 

(3) Computation rule—(i) Operative 

rule. For purposes of section 934(b)(3) 

and this paragraph (c), tax liability 

incurred to the Virgin Islands for the 

taxable year attributable to income that 

is derived from sources outside the 

United States and that is not effectively 

connected with the conduct of a trade 

or business within the United States 

will be computed as follows: 

(A) Add to the income tax liability 

incurred to the Virgin Islands any credit 

against the tax allowed under mirrored 

section 901(a). 

(B) Multiply by taxable income that is 

derived from sources outside the United 

States and that is not effectively 

connected with the conduct of a trade 

or business within the United States 

(applying the rules of § 1.861–8 to 

determine deductions allocable to such 

income). 

(C) Divide by total taxable income. 

(D) Subtract any credit allowed under 

mirrored section 901 (other than credits 

for taxes paid to the United States or 

taxes for which a credit is allowable for 

Federal income tax purposes under 

section 906 of the Code). 

(ii) Limitation. Tax liability incurred 

to the Virgin Islands attributable to 

income that is derived from sources 

outside the United States and that is not 

effectively connected with the conduct 

of a trade or business within the United 

States, as computed in this paragraph 

(c)(3), however, will not exceed the total 

amount of income tax liability actually 

incurred. 

(4) U.S. income—(i) In general. For 

purposes of this section, except as 

provided in paragraph (c)(4)(ii) of this 

section, the rules of sections 861 

through 865 and the regulations under 

those provisions will apply for 

determining whether income is from 

sources outside the United States or 

effectively connected with the conduct 

of a trade or business within the United 

States. 

(ii) Conduit arrangements. Income 

will be considered to be from sources 

within the United States for purposes of 

paragraph (c)(1) of this section if, 

pursuant to a plan or arrangement—

(A) The income is received in 

exchange for consideration provided to 

another person; and 

(B) 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 income from 

sources within the United States. 

(d) Examples. The rules of this section 

are illustrated by the following 

examples: 

Example 1. (i) S is a U.S. citizen and a bona 

fide resident of the Virgin Islands. For 2008, 

S files a Form 1040INFO, ‘‘Non-Virgin 

Islands Source Income of Virgin Islands 

Residents,’’ with the Virgin Islands on which 

S reports total gross income as follows: 

Compensation for services performed in the 

Virgin Islands—$50,000 

Compensation for services performed in the 

United States—$40,000 

Compensation for services performed in 

Mexico—$30,000 

Income from inventory sales in Latin 

America attributable to Virgin Islands 

office—$20,000 

Interest on a U.S. bank account—$6,000 

Interest on a V.I. bank account—$5,000 

Dividends from a U.S. corporation—$4,000 

(ii) Accordingly, S has total gross income 

of $155,000, comprising income from sources 

within the Virgin Islands or effectively 

connected to the conduct of a trade or 

business in the Virgin Islands (Virgin Islands 

ECI) of $75,000, income from sources within 

the United States of $50,000, and income 

from other sources (not Virgin Islands ECI) of 

$30,000. After taking into account allowable 

deductions, S’s total taxable income is 

$120,000, of which $45,000 is taxable income 

from sources within the Virgin Islands, 

$15,000 is taxable income from other sources 

that is Virgin Islands ECI under the rules of 

section 937(b) and §§ 1.937–2 and 1.937–3, 

and $22,500 is taxable income from sources 

outside the Virgin Islands (and outside the 

United States) that is not Virgin Islands ECI. 

S’s tax liability incurred to the Virgin Islands 

pursuant to the Internal Revenue Code as 

applicable in the Virgin Islands (mirror code) 

is $30,000. S is entitled to claim a credit 

under section 901 of the mirror code in the 

amount of $10,000 for income tax paid to 

Mexico and other Latin American countries, 

for a net income tax liability of $20,000. 

(iii) Pursuant to a Virgin Islands law that 

was duly enacted within the limits of its 

authority under section 934, S may claim a 

special deduction relating to his business 

activities in the Virgin Islands. However, 

under section 934(b), S’s ability to claim this 

special deduction is limited. Specifically, the 

maximum amount of the reduction in S’s 

mirror code tax liability that may result from 

claiming this deduction, computed in 

accordance with paragraph (b)(3) of this 

section, is as follows: [($20,000 + $10,000) × 

(($45,000 + $15,000) / $120,000)] ¥ [$10,000 

× ($15,000 / ($15,000 + $22,500))] = [$30,000 

× ($60,000 / $120,000)] ¥ [$10,000 × 

($15,000 / $37,500)] = ($30,000 × 0.5) ¥ 

($10,000 × 0.4) = $15,000 ¥ $4,000 = $11,000 

(iv) Accordingly, S’s net tax liability 

incurred to the Virgin Islands must be at least 

$19,000 ($30,000 ¥ $11,000), prior to taking 

into account any foreign tax credit. 

Example 2. The facts are the same as 

Example 1, except that S is a U.S. citizen 

who resides in the United States. As required 

by section 932(a) and (b), S files with the 

Virgin Islands a copy of his Federal income 

tax return and pays to the Virgin Islands the 

portion of his Federal income tax liability 

that his Virgin Islands adjusted gross income 

bears to his adjusted gross income. Under 

section 934(b)(2), S may not claim the special 

deduction offered under Virgin Islands law 

relating to business activities like his in the 

Virgin Islands to reduce any of his tax 

liability payable to the Virgin Islands under 

section 932(b). 

Example 3. (i) Z is a nonresident alien who 

resides in Country FC. In 2008, Z receives 

dividends from a corporation organized 

under the law of the Virgin Islands in the 

amount of $90x. Z’s tax liability incurred to 

the Virgin Islands pursuant to section 871(a) 


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of the Code as applicable in the Virgin 

Islands (mirror code) is $27x. 

(ii) Pursuant to a Virgin Islands law that 

was duly enacted within the limits of its 

authority under section 934, Z may claim a 

special exemption for income relating to his 

investment in the Virgin Islands. The 

maximum amount of the reduction in Z’s 

mirror code tax liability that may result from 

claiming this exemption, computed in 

accordance with paragraph (b)(3) of this 

section, is as follows: $27x × ($90x/$90x) = 

$27x. 

(iii) Accordingly, depending on the terms 

of the exemption as provided under Virgin 

Islands law, Z’s net tax liability incurred to 

the Virgin Islands may be reduced or 

eliminated entirely. 

Example 4. (i) A Corp is organized under 

the laws of the Virgin Islands and is engaged 

in a trade or business in the United States 

through an office in State N. All of A Corp’s 

outstanding stock is owned by U.S. citizens 

who are bona fide residents of the Virgin 

Islands. During 2008, A Corp had $50x in 

gross income from sources within the Virgin 

Islands (as determined under section 937(b) 

and § 1.937–2) that is not effectively 

connected with the conduct of a trade or 

business in the United States; $20x in gross 

income from sources in Country H that is 

effectively connected with the conduct of A 

Corp’s trade or business in the United States; 

and $10x in gross income from sources in 

Country R that is not effectively connected 

with the conduct of A Corp’s trade or 

business in the United States. 

(ii) Section 934(b)(3) permits the Virgin 

Islands to reduce or remit the income tax 

liability of a qualified foreign corporation 

arising under the Code as applicable in the 

Virgin Islands (mirror code) with respect to 

income that is derived from sources outside 

the United States and that is not effectively 

connected with the conduct of a trade or 

business in the United States. A foreign 

corporation constitutes a ‘‘qualified foreign 

corporation’’ under section 934(b)(3)(B) if 

less than 10 percent of the total voting power 

and value of the stock of the corporation is 

owned or treated as owned (within the 

meaning of section 958) by one or more 

United States persons. A U.S. citizen is a 

‘‘United States person’’ as defined in section 

7701(a)(30)(A). Given that 10 percent or more 

of the voting power and value of its stock is 

owned by U.S. citizens, A Corp does not 

constitute a ‘‘qualified foreign corporation’’

under section 934(b)(3)(B). Accordingly, the 

Virgin Islands may only reduce or remit A 

Corp’s mirror code income tax liability with 

respect to its $50x in gross income from 

sources within the Virgin Islands. 

Example 5. (i) The facts are the same as in 

Example 4, except that the outstanding stock 

of A Corp is owned by the following 

individuals: 

U.S. citizens who are bona fide residents of 

the Virgin Islands—5% 

U.S. citizens who are not bona fide residents 

of the Virgin Islands—3% 

Nonresident aliens who are bona fide 

residents of the Virgin Islands—42% 

Nonresident aliens who are not bona fide 

residents of the Virgin Islands—50% 

(ii) Given that less than 10 percent of the 

voting power and value of its stock is owned 

by United States persons, A Corp constitutes 

a qualified foreign corporation under section 

934(b)(3)(B). Accordingly, the Virgin Islands 

may reduce or remit A Corp’s mirror code 

income tax liability with respect to its $50x 

in gross income from sources within the 

Virgin Islands and its $10x in gross income 

from sources in Country R that is not 

effectively connected with the conduct of A 

Corp’s trade or business in the United States. 

In no event, however, may the Virgin Islands 

reduce or remit A Corp’s mirror code income 

tax liability with respect to its $20x in gross 

income from sources in Country H that is 

effectively connected with the conduct of A 

Corp’s trade or business in the United States. 

(e) Effective/applicability date. This 

section applies for taxable years ending 

after April 9, 2008. 

§ 1.934–1T [Removed] 

■ Par. 24. Section 1.934–1T is removed. 

■ Par. 25. Section 1.935–1 is amended 

by revising paragraphs (a), (b)(1), (b)(3), 

(b)(5), (b)(6), (b)(7), (c), (d), (e), (f), and 

(g) to read as follows: 

§ 1.935–1 Coordination of individual 

income taxes with Guam and the Northern 

Mariana Islands. 

(a) Application of section—(1) Scope. 

Section 935 and this section set forth 

the special rules relating to the filing of 

income tax returns, income tax 

liabilities, and estimated income tax of 

individuals described in paragraph 

(a)(2) of this section. Paragraph (e) of 

this section also provides special rules 

requiring consistent treatment of 

business entities in the United States 

and in section 935 possessions. 

(2) Individuals covered. This section 

applies to any individual who—

(i) Is a bona fide resident of a section 

935 possession during the entire taxable 

year, whether or not such individual is 

a citizen of the United States or a 

resident alien (as defined in section 

7701(b)(1)(A)); 

(ii) Is a citizen of a section 935 

possession but not otherwise a citizen of 

the United States; 

(iii) Has income from sources within 

a section 935 possession for the taxable 

year, is a citizen of the United States or 

a resident alien (as defined in section 

7701(b)(1)(A)) and is not a bona fide 

resident of a section 935 possession 

during the entire taxable year; or 

(iv) Files a joint return for the taxable 

year with any individual described in 

paragraph (a)(2)(i), (ii), or (iii) of this 

section. 

(3) Definitions. For purposes of this 

section, the following definitions apply: 

(i) The term section 935 possession 

means Guam or the Northern Mariana 

Islands, unless such possession has 

entered into an implementing 

agreement, as described in section 

1271(b) of the Tax Reform Act of 1986, 

Public Law 99–514 (100 Stat. 2085), 

with the United States that is in effect 

for the entire taxable year. 

(ii) The term relevant possession 

means—

(A) With respect to an individual 

described in paragraph (a)(2)(i) of this 

section, the section 935 possession of 

which such individual is a bona fide 

resident; 

(B) With respect to an individual 

described in paragraph (a)(2)(ii) of this 

section, the section 935 possession of 

which such individual is a citizen; and 

(C) With respect to an individual 

described in paragraph (a)(2)(iii) of this 

section, the section 935 possession from 

which such individual derives income. 

(iii) The rules of § 1.937–1 will apply 

for determining whether an individual 

is a bona fide resident of a section 935 

possession. 

(iv) The rules of § 1.937–2 generally 

will apply for determining whether 

income is from sources within a section 

935 possession. Pursuant to § 1.937–

2(a), however, the rules of § 1.937–

2(c)(1)(ii) and (c)(2) do not apply for 

purposes of section 935(a)(3) (as in 

effect before the effective date of its 

repeal) and paragraph (a)(2)(iii) of this 

section. 

(v) The term citizen of the United 

States means any individual who is a 

citizen within the meaning of § 1.1–1(c), 

except that the term does not include an 

individual who is a citizen of a section 

935 possession but not otherwise a 

citizen of the United States. The term 

citizen of a section 935 possession but 

not otherwise a citizen of the United 

States means any individual who has 

become a citizen of the United States by 

birth or naturalization in the section 935 

possession. 

(vi) With respect to the United States, 

the term resident means an individual 

who is a citizen (as defined in § 1.1–

1(c)) or resident alien (as defined in 

section 7701(b)) and who does not have 

a tax home (as defined in section 

911(d)(3)) in a foreign country during 

the entire taxable year. The term does 

not include an individual who is a bona 

fide resident of a section 935 

possession. 

(vii) The term U.S. taxpayer means an 

individual described in paragraph 

(b)(1)(i) or (iii)(B) of this section. 

(b) Filing requirement—(1) Tax 

jurisdiction. An individual described in 

paragraph (a)(2) of this section must file 

an income tax return for the taxable 

year—

(i) With the United States if such 

individual is a resident of the United 

States; 


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(ii) With the relevant possession if 

such individual is described in 

paragraph (a)(2)(i) of this section; or 

(iii) If neither paragraph (b)(1)(i) nor 

paragraph (b)(1)(ii) of this section 

applies—

(A) With the relevant possession if 

such individual is described in 

paragraph (a)(2)(ii) of this section; or 

(B) With the United States if such 

individual is a citizen of the United 

States, as defined in paragraph (a)(3) of 

this section. 

* * * * * 

(3) Place for filing returns—(i) U.S. 

returns. A return required under this 

paragraph (b) to be filed with the United 

States must be filed as directed in the 

applicable forms and instructions. 

(ii) Guam returns. A return required 

under this paragraph (b) to be filed with 

Guam must be filed as directed in the 

applicable forms and instructions. 

(iii) NMI returns. A return required 

under this paragraph (b) to be filed with 

the Northern Mariana Islands must be 

filed as directed in the applicable forms 

and instructions. 

* * * * * 

(5) Tax payments. The tax shown on 

the return must be paid to the 

jurisdiction with which such return is 

required to be filed and must be 

determined by taking into account any 

credit under section 31 for tax withheld 

by the relevant possession or the United 

States on wages, any credit under 

section 6402(b) for an overpayment of 

income tax to the relevant possession or 

the United States, and any payments 

under section 6315 of estimated income 

tax paid to the relevant possession or 

the United States. 

(6) Liability to other jurisdiction—(i) 

Filing with the relevant possession. In 

the case of an individual who is 

required under paragraph (b)(1) of this 

section to file a return with the relevant 

possession for a taxable year, if such 

individual properly files such return 

and fully pays his or her income tax 

liability to the relevant possession, such 

individual is relieved of liability to file 

an income tax return with, and to pay 

an income tax to, the United States for 

the taxable year. 

(ii) Filing with the United States. In 

the case of an individual who is 

required under paragraph (b)(1) of this 

section to file a return with the United 

States for a taxable year, such individual 

is relieved of liability to file an income 

tax return with, and to pay an income 

tax to, the relevant possession for the 

taxable year. 

(7) [Reserved]. 

(c) Extension of territory—(1) U.S. 

taxpayers—(i) General rule. With 

respect to a U.S. taxpayer, for purposes 

of taxes imposed by Chapter 1 of the 

Internal Revenue Code (Code), the 

United States generally will be treated, 

in a geographical and governmental 

sense, as including the relevant 

possession. The purpose of this rule is 

to facilitate the coordination of the tax 

systems of the United States and the 

relevant possession. Accordingly, the 

rule will have no effect where it is 

manifestly inapplicable or its 

application would be incompatible with 

the intent of any provision of the Code. 

(ii) Application of general rule. 

Contexts in which the general rule of 

paragraph (c)(1)(i) of this section apply 

include—

(A) The characterization of taxes paid 

to the relevant possession. Income tax 

paid to the relevant possession may be 

taken into account under sections 31, 

6315, and 6402(b) as payments to the 

United States. Taxes paid to the relevant 

possession and otherwise satisfying the 

requirements of section 164(a) will be 

allowed as a deduction under that 

section, but income taxes paid to the 

relevant possession will be disallowed 

as a deduction under section 275(a); 

(B) The determination of the source of 

income for purposes of the foreign tax 

credit (for example, sections 901 

through 904). Thus, for example, after a 

U.S. taxpayer determines which items of 

income constitute income from sources 

within the relevant possession under 

the rules of section 937(b), such income 

will be treated as income from sources 

within the United States for purposes of 

section 904; 

(C) The eligibility of a corporation to 

make a subchapter S election (sections 

1361 through 1379). Thus, for example, 

for purposes of determining whether a 

corporation created or organized in the 

relevant possession may make an 

election under section 1362(a) to be a 

subchapter S corporation, it will be 

treated as a domestic corporation and a 

U.S. taxpayer shareholder will not be 

treated as a nonresident alien individual 

with respect to such corporation. While 

such an election is in effect, the 

corporation will be treated as a domestic 

corporation for all purposes of the Code. 

For the consistency requirement with 

respect to entity status elections, see 

paragraph (e) of this section; 

(D) The treatment of items carried 

over from other taxable years. Thus, for 

example, if a U.S. taxpayer has for a 

taxable year a net operating loss 

carryback or carryover under section 

172, a foreign tax credit carryback or 

carryover under section 904, a business 

credit carryback or carryover under 

section 39, a capital loss carryover 

under section 1212, or a charitable 

contributions carryover under section 

170, the carryback or carryover will be 

reported on the return filed with the 

United States in accordance with 

paragraph (b)(1)(i) or (b)(1)(iii)(B) of this 

section, even though the return of the 

taxpayer for the taxable year giving rise 

to the carryback or carryover was 

required to be filed with a section 935 

possession; and 

(E) The treatment of property 

exchanged for property of a like kind 

(section 1031). Thus for example, if a 

U.S. taxpayer exchanges real property 

located in the United States for real 

property located in the relevant 

possession, notwithstanding the 

provisions of section 1031(h), such 

exchange may qualify as a like-kind 

exchange under section 1031 (provided 

that all the other requirements of section 

1031 are satisfied). 

(iii) Nonapplication of general rule. 

Contexts in which the general rule of 

paragraph (c)(1)(i) of this section does 

not apply include—

(A) The application of any rules or 

regulations that explicitly treat the 

United States and any (or all) of its 

possessions as separate jurisdictions (for 

example, sections 931 through 937, 

7651, and 7654); 

(B) The determination of any aspect of 

an individual’s residency (for example, 

sections 937(a) and 7701(b)). Thus, for 

example, an individual whose principal 

place of abode is in the relevant 

possession is not considered to have a 

principal place of abode in the United 

States for purposes of section 32(c); 

(C) The determination of the source of 

income for purposes other than the 

foreign tax credit (for example, sections 

935, 937, and 7654). Thus, for example, 

income determined to be derived from 

sources within the relevant possession 

under section 937(b) will not be 

considered income from sources within 

the United States for purposes of Form 

5074, ‘‘Allocation of Individual Income 

Tax to Guam or the Commonwealth of 

the Northern Mariana Islands (CNMI)’’; 

(D) The definition of wages (section 

3401). Thus, for example, services 

performed by an employee for an 

employer in the relevant possession do 

not constitute services performed in the 

United States under section 3401(a)(8); 

and 

(E) The characterization of a 

corporation for purposes other than 

subchapter S (for example, sections 367, 

951 through 964, 1291 through 1298, 

6038, and 6038B). Thus, for example, if 

a U.S. taxpayer transfers appreciated 

tangible property to a corporation 

created or organized in the relevant 

possession in a transaction described in 

section 351, he or she must recognize 


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gain unless an exception under section 

367(a) applies. Also, if a corporation 

created or organized in the relevant 

possession qualifies as a passive foreign 

investment company under sections 

1297 and 1298 with respect to a U.S. 

taxpayer, a dividend paid to such 

shareholder does not constitute 

qualified dividend income under 

section 1(h)(11)(B). 

(2) Application in relevant possession. 

In applying the territorial income tax of 

the relevant possession, such possession 

generally will be treated, in a 

geographical and governmental sense, as 

including the United States. Thus, for 

example, income tax paid to the United 

States may be taken into account under 

sections 31, 6315, and 6402(b) as 

payments to the relevant possession. 

Moreover, a citizen of the United States 

(as defined in paragraph (a)(3) of this 

section) not a resident of the relevant 

possession will not be treated as a 

nonresident alien individual for 

purposes of the territorial income tax of 

the relevant possession. Thus, for 

example, a citizen of the United States 

(as so defined), or a resident of the 

United States, will not be treated as a 

nonresident alien individual for 

purposes of section 1361(b)(1)(C) of the 

Guam territorial income tax. 

(d) Special rules for estimated income 

tax—(1) In general. An individual must 

make each payment of estimated income 

tax (and any amendment to the 

estimated tax payment) to the 

jurisdiction with which the individual 

reasonably believes, as of the date of 

that payment (or amendment), that he or 

she will be required to file a return for 

the taxable year under paragraph (b)(1) 

of this section. In determining the 

amount of such estimated income tax, 

income tax paid to the relevant 

possession may be taken into account 

under sections 31 and 6402(b) as 

payments to the United States, and vice 

versa. For other rules relating to 

estimated income tax, see section 6654. 

(2) Joint estimated income tax. In the 

case of married persons making a joint 

payment of estimated income tax, the 

taxpayers must make each payment of 

estimated income tax (and any 

amendment to the estimated tax 

payment) to the jurisdiction where the 

spouse who has the greater estimated 

adjusted gross income for the taxable 

year would be required under paragraph 

(d)(1) of this section to pay estimated 

income tax if separate payments were 

made. For this purpose, estimated 

adjusted gross income of each spouse 

for the taxable year is determined 

without regard to community property 

laws. 

(3) Erroneous payment. If the 

individual or spouses erroneously pay 

estimated income tax to the United 

States instead of the relevant possession 

or vice versa, only subsequent payments 

or amendments of the payments are 

required to be made pursuant to 

paragraph (d)(1) or (d)(2) of this section 

with the other jurisdiction. 

(4) Place for payment. Estimated 

income tax required under this 

paragraph (d) to be paid to Guam or the 

Northern Mariana Islands must be paid 

as directed in the applicable forms and 

instructions issued by the relevant 

possession. Estimated income tax 

required under paragraph (d)(1) of this 

section to be paid to the United States 

must be paid as directed in the 

applicable forms and instructions. 

(5) Liability to other jurisdiction—(i) 

Filing with Guam or the Northern 

Mariana Islands. Subject to paragraph 

(d)(6) of this section, an individual 

required under this paragraph (d) to pay 

estimated income tax (and amendments 

thereof) to Guam or the Northern 

Mariana Islands is relieved of liability to 

pay estimated income tax (and 

amendments thereof) to the United 

States. 

(ii) Filing with the United States. 

Subject to paragraph (d)(6) of this 

section, an individual required under 

this paragraph (d) to pay estimated 

income tax (and amendments thereof) to 

the United States is relieved of liability 

to pay estimated income tax (and 

amendments thereof) to the relevant 

possession. 

(6) Underpayments. The liability of an 

individual described in paragraph (a)(2) 

of this section for underpayments of 

estimated income tax for a taxable year, 

as determined under section 6654, will 

be to the jurisdiction with which the 

individual is required under paragraph 

(b) of this section to file his or her return 

for the taxable year. 

(e) Entity status consistency 

requirement—(1) In general. Taxpayers 

should make consistent entity status 

elections (as defined in paragraph 

(e)(3)(ii) of this section), when 

applicable, in both the United States 

and section 935 possessions. In the case 

of a business entity to which this 

paragraph (e) applies—

(i) If an entity status election is filed 

with the Internal Revenue Service (IRS) 

but not with the relevant possession, the 

appropriate tax authority of the relevant 

possession, at his discretion, may deem 

the election also to have been made for 

the relevant possession tax purposes; 

(ii) If an entity status election filed 

with the relevant possession but not 

with the IRS, the Commissioner, at his 

discretion, may deem the election also 

to have been made for Federal tax 

purposes; and 

(iii) If inconsistent entity status 

elections are filed with the relevant 

possession and the IRS, both the 

Commissioner and the appropriate tax 

authority of the relevant possession 

may, at their individual discretion, treat 

the elections they each received as 

invalid and may deem the election filed 

in the other jurisdiction to have been 

made also for tax purposes in their own 

jurisdiction. See Rev. Proc. 2006–23 

(2006–1 C.B. 900) (see 

§ 601.601(d)(2)(ii)(b) of this chapter) for 

procedures for requesting the assistance 

of the IRS when a taxpayer is or may be 

subject to inconsistent tax treatment by 

the IRS and a U.S. possession tax 

agency.) 

(2) Scope. This paragraph (e) applies 

to the following business entities: 

(i) A business entity (as defined in 

§ 301.7701–2(a) of this chapter) that is 

domestic (as defined in § 301.7701–5 of 

this chapter), or otherwise treated as 

domestic for purposes of the Code, and 

that is owned in whole or in part by any 

person who is either a bona fide 

resident of a section 935 possession or 

a business entity created or organized in 

a section 935 possession. 

(ii) A business entity that is created or 

organized in a section 935 possession 

and that is owned in whole or in part 

by any U.S. person (other than a bona 

fide resident of such possession). 

(3) Definitions. For purposes of this 

section—

(i) The term appropriate tax authority 

of the relevant possession means the 

individual responsible for tax 

administration in such possession or his 

delegate; and 

(ii) The term entity status election 

includes an election under § 301.7701–

3(c) of this chapter, an election under 

section 1362(a), and any other similar 

elections. 

(4) Default status. Solely for the 

purpose of determining classification of 

an eligible entity under § 301.7701–3(b) 

of this chapter and under that section as 

mirrored in the relevant possession, an 

eligible entity subject to this paragraph 

(e) will be classified for both Federal 

and the relevant possession tax 

purposes using the rule that applies to 

domestic eligible entities. 

(5) Transition rules—(i) In the case of 

an election filed prior to April 11, 2005, 

except as provided in paragraph 

(e)(5)(ii) of this section, the rules of 

paragraph (e)(1) of this section will 

apply as of the first day of the first 

taxable year of the entity beginning after 

April 11, 2005. 

(ii) In the unlikely circumstance that 

inconsistent elections described in 


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paragraph (e)(1)(iii) of this section are 

filed prior to April 11, 2005, and the 

entity cannot change its classification to 

achieve consistency because of the 

sixty-month limitation described in 

§ 301.7701–3(c)(1)(iv) of this chapter, 

then the entity may nevertheless request 

permission from the Commissioner or 

appropriate tax authority of the relevant 

possession to change such election to 

avoid inconsistent treatment by the 

Commissioner and the appropriate tax 

authority of the relevant possession. 

(iii) Except as provided in paragraphs 

(e)(5)(i) and (e)(5)(ii) of this section, in 

the case of an election filed with respect 

to an entity before it became an entity 

described in paragraph (e)(2) of this 

section, the rules of paragraph (e)(1) of 

this section will apply as of the first day 

that such entity is described in 

paragraph (e)(2) of this section. 

(iv) In the case of an entity created or 

organized prior to April 11, 2005, 

paragraph (e)(4) of this section will take 

effect for Federal income tax purposes 

(or the relevant possession income tax 

purposes, as the case may be) as of the 

first day of the first taxable year of the 

entity beginning after April 11, 2005. 

(f) Examples. The application of this 

section is illustrated by the following 

examples: 

Example 1. (i) B, a United States citizen, 

files returns on a calendar year basis. In 

November 2008, B moves to Possession G, a 

section 935 possession; purchases a house; 

and accepts a permanent position with a 

local employer. For the remainder of the year 

and throughout 2009, B continues to live and 

work in Possession G and has a closer 

connection to Possession G than to the 

United States or any foreign country. As a 

consequence of his employment in 

Possession G, B earns income from the 

performance of services in Possession G 

during 2008 and 2009. 

(ii) For 2008, B does not qualify as a bona 

fide resident of Possession G under section 

937(a) and § 1.937–1(b) and (f)(1). Therefore, 

B is subject to the rules applicable to 

individuals described in paragraph (a)(2)(iii) 

of this section for 2008 because he has 

income derived from sources within 

Possession G as determined under the rules 

of section 937(b) and § 1.937–2. 

(iii) For 2009, assuming that B otherwise 

satisfies the requirements of section 937(a) 

and § 1.937–1(b), B qualifies as a bona fide 

resident of Possession G. Therefore, section 

935(b)(1)(B) and paragraph (b)(1)(ii) of this 

section apply to B for 2009, and he must file 

his income tax return with Possession G 

under paragraph (b)(1) of this section. 

Provided that B properly files such return 

and pays his income tax liability to 

Possession G, B is relieved of liability to file 

an income tax return with, and to pay an 

income tax to, the United States for 2009 

under paragraph (b)(6) of this section. 

Example 2. (i) The facts are the same as in 

Example 1 except that B’s employment 

terminates in June 2011. B properly pays his 

April 2008 estimated tax to the United States, 

continues to pay estimated tax for the 2008 

taxable year to the United States under 

paragraph (d) of this section, and properly 

files his 2008 return with the United States. 

(ii)(A) On the date of each payment of 

estimated tax in 2009, B reasonably believes 

that he would be required to file his return 

for 2009 with Possession G under paragraph 

(b)(1) of this section. 

(B) In August 2009, B determines that he 

has overpaid tax for the previous year in the 

amount of $1000. B properly pays all 

estimated taxes to Possession G for 2009, 

subtracting the $1000 overpayment from his 

estimated tax payments pursuant to section 

6402(b), and properly files his tax return with 

Possession G. 

(iii) In April 2010, B reasonably believes 

that he would be returning to the United 

States in the Fall of 2010, and properly pays 

estimated tax to the United States. By June 

2010, B reasonably believes that he would 

not be moving from Possession G and would 

be a bona fide resident of Possession G for 

the entire taxable year. B makes his 

remaining estimated tax payments to 

Possession G. On his 2010 tax return filed 

with Possession G, pursuant to section 6315, 

B properly takes into account payments made 

to both the United States and Possession G 

as estimated taxes. 

(iv) In April 2011, B reasonably believes 

that he would be a bona fide resident of 

Possession G for the entire taxable year 2011 

and properly pays estimated taxes to 

Possession G. By the time B pays his 

estimated taxes for June 2011, B’s 

employment terminates and he moves to 

State H. B properly makes his remaining 

estimated tax payments to the United States. 

On his return for 2011, properly filed with 

the United States, B determines that he has 

underpaid estimated taxes throughout 2011 

in an amount subject to penalty under 

section 6654. B owes the United States an 

estimated tax penalty under section 6654. 

(g) Effective/applicability date. 

Paragraphs (a), (b)(1), (b)(3), (b)(5) 

through (b)(7), and (c) through (f) of this 

section apply to taxable years ending 

after April 9, 2008. 

§ 1.935–1T [Removed] 

■ Par. 26. Section 1.935–1T is removed. 

■ Par. 27. Section 1.937–1 is amended 

by revising paragraph (h)(3) and the 

heading of paragraph (i) to read as 

follows: 

§ 1.937–1 Bona fide residency in a 

possession. 

* * * * * 

(h)(3) Bona fide residents of Puerto 

Rico or a section 931 possession (as 

defined in § 1.931–1(c)(1)) who take a 

position for U.S. tax reporting purposes 

that they qualify as bona fide residents 

of that possession for a tax year 

subsequent to a tax year for which they 

were required to file income tax returns 

as bona fide residents of the U.S. Virgin 

Islands or a section 935 possession (as 

defined in § 1.935–1(a)(3)(i)). 

(i) Effective/applicability date. * * * 

■ Par. 28. Section 1.937–2 is added to 

read as follows: 

§ 1.937–2 Income from sources within a 

possession. 

(a) Scope. Section 937(b) and this 

section set forth the rules for 

determining whether income is 

considered to be from sources within a 

particular possession (the relevant 

possession) for purposes of the Internal 

Revenue Code, including section 957(c) 

and Subpart D, Part III, Subchapter N, 

Chapter 1 of the Internal Revenue Code, 

as well as section 7654(a) of the 1954 

Internal Revenue Code (until the 

effective date of its repeal). Paragraphs 

(c)(1)(ii) and (c)(2) of this section do not 

apply, however, for purposes of sections 

932(a) and (b) and 935(a)(3) (as in effect 

before the effective date of its repeal). In 

the case of a possession or territory that 

administers income tax laws that are 

identical (except for the substitution of 

the name of the possession or territory 

for the term ‘‘United States’’ where 

appropriate) to those in force in the 

United States, these rules do not apply 

for purposes of the application of such 

laws. These rules also do not affect the 

determination of whether income is 

considered to be from sources without 

the United States for purposes of the 

Internal Revenue Code. 

(b) In general. Except as provided in 

paragraphs (c) through (i) of this section, 

the principles of sections 861 through 

865 and the regulations under those 

provisions (relating to the determination 

of the gross and the taxable income from 

sources within and without the United 

States) generally will be applied in 

determining the gross and the taxable 

income from sources within and 

without the relevant possession. In the 

application of such principles, it 

generally will be sufficient to substitute, 

where appropriate, the name of the 

relevant possession for the term ‘‘United 

States,’’ and to substitute, where 

appropriate, the term ‘‘bona fide 

resident of’’ followed by the name of the 

relevant possession for the term ‘‘United 

States resident.’’ Furthermore, the term 

domestic will be construed to mean 

created or organized in the relevant 

possession. In applying these principles, 

additional substitutions may be 

necessary to accomplish the intent of 

section 937(b) and this section. For 

example, in applying the principles of 

sections 863(d) and (e) to individuals 

under this paragraph (b), the term ‘‘bona 

fide resident of a possession’’ will be 

used instead of the term ‘‘United States 

person.’’ In no case, however, will a 


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bona fide resident or other person have, 

as a result of the application of these 

principles, more income from sources 

within the relevant possession than the 

amount of income from sources within 

the United States that a similarly 

situated U.S. person who is not a bona 

fide resident would have under sections 

861 through 865. 

(c) U.S. income—(1) In general. 

Except as provided in paragraph (d) of 

this section, income from sources 

within the relevant possession will not 

include any item of income determined 

under the rules of sections 861 through 

865 and the regulations under those 

provisions to be—

(i) From sources within the United 

States; or 

(ii) Effectively connected with the 

conduct of a trade or business within 

the United States. 

(2) Conduit arrangements. Income 

will be considered to be from sources 

within the United States for purposes of 

paragraph (c)(1) of this section 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 income from 

sources within the United States. 

(d) Income from certain sales of 

inventory property. For special rules 

that apply to determine the source of 

income from certain sales of inventory 

property, see § 1.863–3(f). 

(e) Service in the Armed Forces. In the 

case of a member of the Armed Forces 

of the United States, the following rules 

will apply for determining the source of 

compensation for services performed in 

compliance with military orders: 

(1) If the individual is a bona fide 

resident of a possession and such 

services are performed in the United 

States or in another possession, the 

compensation constitutes income from 

sources within the possession of which 

the individual is a bona fide resident 

(and not from sources within the United 

States or such other possession). 

(2) If the individual is not a bona fide 

resident of a possession and such 

services are performed in a possession, 

the compensation constitutes income 

from sources within the United States 

(and not from sources within such 

possession). 

(f) Gains from certain dispositions of 

property—(1) Property of former U.S. 

residents. (i) Except to the extent an 

election is made under paragraph 

(f)(1)(vi) of this section, income from 

sources within the relevant possession 

will not include gains from the 

disposition of property described in 

paragraph (f)(1)(ii) of this section by an 

individual described in paragraph 

(f)(1)(iii) of this section. See also section 

1277(e) of the Tax Reform Act of 1986, 

Public Law 99–514 (100 Stat. 2085) 

(providing that gains from the 

disposition of certain property by 

individuals who acquired residency in 

certain possessions will be considered 

to be from sources within the United 

States). 

(ii) Property is described in this 

paragraph (f)(1)(ii) when the following 

conditions are satisfied—

(A) The property is of a kind 

described in section 731(c)(3)(C)(i) or 

954(c)(1)(B); and 

(B) The property was owned by the 

individual before such individual 

became a bona fide resident of the 

relevant possession. 

(iii) An individual is described in this 

paragraph (f)(1)(iii) when the following 

conditions are satisfied—

(A) For the taxable year for which the 

source of the gain must be determined, 

the individual is a bona fide resident of 

the relevant possession; and 

(B) For any of the 10 years preceding 

such year, the individual was a citizen 

or resident of the United States (other 

than a bona fide resident of the relevant 

possession). 

(iv) If an individual described in 

paragraph (f)(1)(iii) of this section 

exchanges property described in 

paragraph (f)(1)(ii) of this section for 

other property in a transaction in which 

gain or loss is not required to be 

recognized (in whole or in part) under 

U.S. income tax principles, such other 

property will also be considered 

property described in paragraph (f)(1)(ii) 

of this section. 

(v) If an individual described in 

paragraph (f)(1)(iii) of this section owns, 

directly or indirectly, at least 10 percent 

(by value) of any entity to which 

property described in paragraph (f)(1)(ii) 

of this section is transferred in a 

transaction in which gain or loss is not 

required to be recognized (in whole or 

in part) under U.S. income tax 

principles, any gain recognized upon a 

disposition of the property by such 

entity will be treated as income from 

sources outside the relevant possession 

if any gain recognized upon a direct or 

indirect disposition of the individual’s 

interest in such entity would have been 

so treated under paragraph (f)(1)(iv) of 

this section. 

(vi) Notwithstanding the general rule 

of paragraph (f)(1)(i) of this section and 

section 1277(e) of the Tax Reform Act of 

1986, Public Law 99–514 (100 Stat. 

2085), an individual described in 

paragraph (f)(1)(iii) of this section may 

elect to treat as gain from sources within 

the relevant possession the portion of 

the gain attributable to the individual’s 

possession holding period. The election 

under this paragraph (f)(1)(vi) will be 

considered made if the individual’s 

income tax return for the year of 

disposition of the property reports the 

portion of gain attributable to the 

taxpayer’s possession holding period as 

determined in accordance with 

paragraph (f)(1)(vi)(A) or paragraph 

(f)(1)(vi)(B) of this section, as the case 

may be. 

(A) In the case of marketable 

securities, the portion of gain 

attributable to the possession holding 

period will be determined by reference 

to the fair market value of the 

marketable security at the close of the 

market on the first day of the 

individual’s possession holding period. 

In the event that the individual is a bona 

fide resident of the relevant possession 

for more than a single continuous 

period, the portion of gain described in 

this paragraph (f)(1)(vi)(A) will be the 

aggregate of the portions of gain (or 

offsetting loss) attributable to each 

possession holding period. 

(B) In the case of property other than 

marketable securities, the portion of 

gain attributable to the possession 

holding period in the relevant 

possession will be determined by 

multiplying the total gain on disposition 

of the property by a fraction, the 

numerator of which is the number of 

days in the possession holding period 

and the denominator of which is the 

total number of days in the individual’s 

holding period for the property. For 

purposes of the preceding sentence, in 

the event that the individual is a bona 

fide resident of the relevant possession 

for more than a single continuous 

period, the number of days in the 

numerator will be the aggregate of the 

number of days in each possession 

holding period. For purposes of this 

paragraph (f)(1)(vi)(B), the denominator 

will include days that are required to be 

included in an individual’s holding 

period under section 735(b), section 

1223, and any other applicable holding 

period rule in the Internal Revenue 

Code. 

(vii) For purposes of paragraph 

(f)(1)(vi) of this section—

(A) The term marketable securities 

means property described in paragraph 

(f)(1)(ii) of this section that is, 

throughout the individual’s holding 

period, actively traded within the 

meaning of § 1.1092(d)–1(a); and 

(B) The term possession holding 

period means the part of the 

individual’s holding period for the 


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property during which the individual is 

a bona fide resident of the relevant 

possession. However, for this purpose, 

the possession holding period will be 

considered to commence in all cases on 

the first day during such period that the 

individual does not have a tax home 

outside the relevant possession. In the 

event that the individual is a bona fide 

resident of the relevant possession for 

more than a single continuous period, 

each possession holding period prior to 

the one ending on the date of sale or 

other disposition will be considered to 

end on the first day that the individual 

has a tax home outside the relevant 

possession. With respect to the 

determination of tax home, see § 1.937–

1(d). 

(2) Special rules under section 865 for 

possessions—(i) Except as provided in 

paragraph (f)(1) of this section—

(A) Gain that is considered to be 

derived from sources outside of the 

United States under section 865(g)(3) 

will be considered income from sources 

within Puerto Rico; and 

(B) Gain that is considered to be 

derived from sources outside of the 

United States under section 865(h)(2)(B) 

will be considered income from sources 

within the possession in which the 

liquidating corporation is created or 

organized. 

(ii) In applying the principles of 

section 865 and the regulations under 

that section pursuant to paragraph (b) of 

this section, the rules of section 865(g) 

will not apply, but the special rule of 

section 865(h)(2)(B) will apply with 

respect to gain recognized upon the 

liquidation of corporations created or 

organized in the United States. 

(g) Dividends—(1) Dividends from 

certain possessions corporations—(i) In 

general. Except as provided in 

paragraph (g)(1)(ii) of this section, with 

respect to any possessions shareholder, 

only the possessions source ratio of any 

dividend paid or accrued by a 

corporation created or organized in a 

possession (possessions corporation) 

will be treated as income from sources 

within such possession. For purposes of 

this paragraph (g)—

(A) The possessions source ratio will 

be a fraction, the numerator of which is 

the gross income of the possessions 

corporation from sources within the 

possession in which it is created or 

organized (applying the rules of this 

section) for the testing period and the 

denominator of which is the total gross 

income of the corporation for the testing 

period; and 

(B) The term possessions shareholder 

means any individual who is a bona fide 

resident of the possession in which the 

corporation is created or organized and 

who owns, directly or indirectly, at least 

10 percent of the total voting stock of 

the corporation. 

(ii) Dividends from corporations 

engaged in the active conduct of a trade 

or business in the relevant possession. 

The entire amount of any dividend paid 

or accrued by a possessions corporation 

will be treated as income from sources 

within the possession in which it is 

created or organized when the following 

conditions are met—

(A) 80 percent or more of the gross 

income of the corporation for the testing 

period was derived from sources within 

such possession (applying the rules of 

this section) or was effectively 

connected with the conduct of a trade 

or business in such possession 

(applying the rules of § 1.937–3); and 

(B) 50 percent or more of the gross 

income of the corporation for the testing 

period was derived from the active 

conduct of a trade or business within 

such possession. 

(iii) Testing period. For purposes of 

this paragraph (g)(1), the term testing 

period means the 3-year period ending 

with the close of the taxable year of the 

payment of the dividend (or for such 

part of such period as the corporation 

has been in existence). 

(iv) Subsidiary look-through rule. For 

purposes of this paragraph (g)(1), if a 

possessions corporation owns (directly 

or indirectly) at least 25 percent (by 

value) of the stock of another 

corporation, such possessions 

corporation will be treated as if it—

(A) Directly received its proportionate 

share of the income of such other 

corporation; and 

(B) Actively conducted any trade or 

business actively conducted by such 

other corporation. 

(2) Dividends from other corporations. 

In applying the principles of section 861 

and the regulations under that section 

pursuant to paragraph (b) of this section, 

the special rules relating to dividends 

for which deductions are allowable 

under section 243 or 245 will not apply. 

(h) Income inclusions. For purposes of 

determining whether an amount 

described in section 904(h)(1)(A) 

constitutes income from sources within 

the relevant possession—

(1) If the individual owns (directly or 

indirectly) at least 10 percent of the total 

voting stock of the corporation from 

which such amount is derived, the 

principles of section 904(h)(2) will 

apply. In the case of an individual who 

is not a possessions shareholder (as 

defined in paragraph (g)(1)(i)(B) of this 

section), the preceding sentence will 

apply only if the corporation qualifies as 

a ‘‘United States-owned foreign 

corporation’’ for purposes of section 

904(h); and 

(2) In all other cases, the amount will 

be considered income from sources in 

the jurisdiction in which the 

corporation is created or organized. 

(i) Interest—(1) Interest from certain 

possessions corporations—(i) In general. 

Except as provided in paragraph 

(i)(1)(ii) of this section, with respect to 

any possessions shareholder (as defined 

in paragraph (g)(1)(i)(B) of this section), 

interest paid or accrued by a 

possessions corporation will be treated 

as income from sources within the 

possession in which it is created or 

organized to the extent that such 

interest is allocable to assets that 

generate, have generated, or could 

reasonably have been expected to 

generate income from sources within 

such possession (under the rules of this 

section) or income effectively connected 

with the conduct of a trade or business 

within such possession (under the rules 

of § 1.937–3). For purposes of the 

preceding sentence, the principles of 

§§ 1.861–9 through 1.861–12 will apply. 

(ii) Interest from corporations engaged 

in the active conduct of a trade or 

business in the relevant possession. The 

entire amount of any interest paid or 

accrued by a possessions corporation 

will be treated as income from sources 

within the possession in which it is 

created or organized when the 

conditions of paragraphs (g)(1)(ii)(A) 

and (B) of this section are met (applying 

the rules of paragraphs (g)(1)(iii) and (iv) 

of this section). 

(2) Interest from partnerships. Interest 

paid or accrued by a partnership will be 

treated as income from sources within a 

possession only to the extent that such 

interest is allocable to income 

effectively connected with the conduct 

of a trade or business in such 

possession. For purposes of the 

preceding sentence, the principles of 

§ 1.882–5 will apply (as if the 

partnership were a foreign corporation 

and as if the trade or business in the 

possession were a trade or business in 

the United States). 

(j) Indirect ownership. For purposes of 

this section, the rules of section 

318(a)(2) will apply except that the 

language ‘‘5 percent’’ will be used 

instead of ‘‘50 percent’’ in section 

318(a)(2)(C). 

(k) Examples. The provisions of this 

section may be illustrated by the 

following examples: 

Example 1. (i) X, a U.S. citizen, resides in 

State N and acquires stock of Corporation C, 

a domestic corporation, in 2008 for $10x. X 

moves to the Northern Mariana Islands (NMI) 

on March 1, 2009 and changes his principal 

place of business to NMI on that same date. 


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Assume for purposes of this example that, 

under § 1.937–1(b) and (f)(1) (year-of-move 

exception), X is considered a bona fide 

resident of NMI for 2009 through 2012. On 

March 1, 2009, the closing value of X’s stock 

in Corporation C, a marketable security 

(within the meaning of paragraph 

(f)(1)(vii)(A) of this section), is $20x. On 

January 3, 2012, X sells all his Corporation 

C stock for $70x. 

(ii) Pursuant to section 1277(e) of the Tax 

Reform Act of 1986, and absent an election 

under paragraph (f)(1)(vi) of this section, all 

of X’s gain ($60x) will be treated as income 

from sources within the United States for all 

purposes of the Internal Revenue Code 

(including section 7654, as in effect with 

respect to the NMI), and (under paragraph 

(f)(1)(i) of this section) not as income from 

sources in the NMI. However, pursuant to 

paragraph (f)(1)(vi) of this section, X may 

elect on his 2012 income tax return filed with 

NMI to treat the portion of this gain 

attributable to X’s possession holding period 

with respect to NMI as gain from sources 

within NMI. X’s possession holding period 

with respect to NMI begins on March 1, 2009, 

the date his tax home changes to the NMI. 

Under paragraph (f)(1)(vi)(A) of this section, 

the portion of X’s gain attributable to this 

possession holding period is $50x, the excess 

of the sale price of the stock ($70x) over its 

closing value ($20x) on the first day of the 

possession holding period. By reporting $50x 

of gain on his 2012 NMI return, X will elect 

under paragraph (f)(1)(vi) of this section to 

treat that amount as NMI source income. 

Example 2. (i) R, a U.S. citizen, resides in 

State F and acquires a 5 percent interest in 

Partnership P on January 1, 2009. R moves 

to Puerto Rico on June 1, 2010 and changes 

her principal place of business to Puerto Rico 

on that same date. Assume for purposes of 

this example that under § 1.937–1(b) and 

(f)(1) (year-of-move exception), R is 

considered a bona fide resident of Puerto 

Rico for 2010 through 2012. On June 1, 2010, 

R’s interest in Partnership P is not a 

marketable security within the meaning of 

section 731(c)(2). On December 31, 2012, 

having owned the interest in Partnership P 

for a period of 4 years (1461 days), R sells 

it, recognizing gain of $100x. 

(ii) Pursuant to paragraph (f)(1) of this 

section, and absent an election under 

paragraph (f)(1)(vi) of this section, the gain 

will not be treated as income from sources 

within Puerto Rico for purposes of the 

Internal Revenue Code (including section 

933(1)). However, pursuant to paragraph 

(f)(1)(vi) of this section, R may elect on her 

2012 return filed with the IRS to treat the 

portion of this gain attributable to R’s 

possession holding period with respect to 

Puerto Rico as gain from sources within 

Puerto Rico. R’s possession holding period 

with respect to Puerto Rico is the 945-day 

period from June 1, 2010, the date her tax 

home changes to Puerto Rico, through 

December 31, 2012, the date of sale. Under 

paragraph (f)(1)(vi)(B) of this section, the 

portion of R’s gain attributable to this 

possession holding period is $64.68x, 

computed as follows: 

$100 945× × gain days in possession holding period

1461 days in total holding period

(iii) By reporting $64.68x of gain on her 

2012 Federal return, R will elect under 

paragraph (f)(1)(vi) of this section to treat that 

amount as Puerto Rico source income. 

Example 3. X, a bona fide resident of 

Possession S, a section 931 possession (as 

defined in § 1.931–1(c)(1)), is engaged in a 

trade or business in the United States 

through an office in State H. In 2008, this 

office materially participates in the sale of 

inventory property in Possession S, such that 

the income from these inventory sales is 

considered effectively connected to this trade 

or business in the United States under 

section 864(c)(4)(B)(iii). This income will not 

be treated as income from sources within 

Possession S for purposes of section 931(a)(1) 

pursuant to paragraph (c)(1)(ii) of this 

section, but nonetheless will continue to be 

treated as income from sources without the 

United States under section 862 (for example, 

for purposes of section 904). 

Example 4. (i) X, a bona fide resident of 

Possession I, owns 25 percent of the 

outstanding shares of A Corp, a corporation 

organized under the laws of Possession I. In 

2010, X receives a dividend of $70x from A 

Corp. During 2008 through 2010, A Corp has 

gross income from the following sources: 

Possession 

I sources 

Sources 

outside possession I 

2008 .................. $10x $20x 

2009 .................. 20x 10x 

2010 .................. 25x 15x 

(ii) A Corp owns 50 percent of the 

outstanding shares of B Corp, a corporation 

organized under the laws of Country FC. 

During 2008 through 2010, B Corp has gross 

income from the following sources: 

Possession 

I sources 

Sources 

outside possession I 

2008 .................. $10x $6x 

2009 .................. 14x 8x 

2010 .................. 10x 4x 

(iii) A Corp is treated as having received 

50 percent of the gross income of B Corp. 

Therefore, for 2008 through 2010, the gross 

income of A Corp is from the following 

sources: 

Possession 

I sources 

Sources 

outside possession I 

2008 .................. $15x $23x 

2009 .................. 27x 14x 

2010 .................. 30x 17x 

Totals ......... $72x $54x 

(iv) Pursuant to paragraph (g) of this 

section, the portion of the dividend of $70x 

that X receives from Corp A in 2010 that is 

treated as income from sources within 

Possession I is 72/126 of $70x, or $40x. 

Example 5. X is a U.S. citizen and a bona 

fide resident of the Northern Mariana Islands 

(NMI). In 2008, X receives compensation for 

services performed as a member of the crew 

of a fishing boat. Ten percent of the services 

for which X receives compensation are 

performed in the NMI, and 90 percent of X’s 

services are performed in international 

waters. Under the principles of section 

861(a)(3) as applied pursuant to paragraph (b) 

of this section, the compensation that X 

receives for services performed in the NMI is 

treated as income from sources within the 

NMI. Under the principles of section 

863(d)(1)(A) as applied pursuant to 

paragraph (b) of this section, the 

compensation that X receives for services 

performed in international waters is treated 

as income from sources within the NMI for 

purposes of the Internal Revenue Code 

(including section 7654, as in effect with 

respect to the NMI). Thus, all of X’s 

compensation for services during 2008 is 

treated as income from sources within the 

NMI. 

Example 6. X, a U.S. citizen, resides in 

State L and receives $2,500 of compensation 

for services performed in Possession J during 

2008 for Y, X’s employer. X is temporarily 

present in Possession J in 2008 for a period 

(or periods) not exceeding a total of 90 days. 

Y, a U.S. citizen, is not a bona fide resident 

of Possession J and is not engaged in a trade 

or business within Possession J. Under the 

principles of section 861(a)(3) as applied 

pursuant to paragraph (b) of this section, the 

compensation that X receives for services 

performed in Possession J during 2008 is not 

treated as income from sources within 

Possession J. 

Example 7. (i) Company Y, a corporation 

organized in State C, produces, markets, and 

distributes music products. Y enters into a 

recording contract with Z, a recording artist 

who is a bona fide resident of the U.S. Virgin 

Islands (USVI). Pursuant to the contract 

between Y and Z, Z agrees to perform 

services as writer, musician, and vocalist on 

the recording of a new musical composition 

and related music video. Under the contract, 

all songs, recordings and related artwork, 

packaging copy, and liner notes, together 

with copyrights and other intellectual 

property in those works, are the sole property 

of Y, and Z obtains no proprietary rights in 

that property. As compensation for Z’s 

services, all of which are performed at a 

recording studio or other locations in the 

USVI, Y agrees to pay amounts designated as 


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the ‘‘writer’s share’’ to Z based on a 

percentage of the music products sold. Y also 

agrees to make an upfront payment to Z as 

an advance against future portions of Z’s 

writer’s share. 

(ii) To the extent that Z performs personal 

services within the USVI, the compensation 

that Z receives for his services is sourced to 

the USVI under the principles of section 

861(a)(3) and § 1.861–4 as applied pursuant 

to § 1.937–2(b). If all of Z’s services are 

performed in the USVI, none of the writer’s 

share is derived from sources within the 

United States under section 861(a)(3) and 

§ 1.861–4, nor is it effectively connected with 

the conduct of a trade or business in the 

United States under section 864(c)(3). 

Accordingly, the U.S. income rule of section 

937(b)(2) and paragraph (c)(1) of this section 

would not operate to prevent Z’s services 

income from being USVI source or USVI 

effectively connected income within the 

meaning of section 937(b)(1). If Z also 

performs services in the United States, 

however, then the U.S. income rule would 

apply to the part of Z’s compensation that is 

sourced to the United States under section 

861(a)(3) and § 1.861–4. In the event that Y 

and Z are controlled taxpayers within the 

meaning of § 1.482–1(i)(5), section 482 and 

the regulations under that section, including 

§ 1.482–9T(i), would apply to evaluate the 

arm’s length amount charged for Z’s 

controlled services. 

(l) Effective/applicability dates. 

Except as otherwise provided in this 

paragraph (l), this section applies to 

income earned in taxable years ending 

after April 9, 2008. Taxpayers may 

choose to apply paragraph (b) of this 

section to income earned in open 

taxable years ending after October 22, 

2004. Taxpayers may choose to apply 

paragraph (f)(1) of this section to 

dispositions made after April 11, 2005. 

§ 1.937–2T [Removed] 

■ Par. 29. Section 1.937–2T is removed. 

■ Par. 30. Section 1.937–3 is added to 

read as follows: 

§ 1.937–3 Income effectively connected 

with the conduct of a trade or business in 

a possession. 

(a) Scope. Section 937(b) and this 

section set forth the rules for 

determining whether income is 

effectively connected with the conduct 

of a trade or business within a particular 

possession (the relevant possession) for 

purposes of the Internal Revenue Code, 

including sections 881(b) and 957(c) 

and Subpart D, Part III, Subchapter N, 

Chapter 1 of the Internal Revenue Code. 

Paragraph (c) of this section does not 

apply, however, for purposes of section 

881(b). In the case of a possession or 

territory that administers income tax 

laws that are identical (except for the 

substitution of the name of the 

possession or territory for the term 

‘‘United States’’ where appropriate) to 

those in force in the United States, these 

rules do not apply for purposes of the 

application of such laws. 

(b) In general. Except as provided in 

paragraphs (c) and (d) of this section, 

the principles of section 864(c) and the 

regulations under that section (relating 

to the determination of income, gain or 

loss that is effectively connected with 

the conduct of a trade or business 

within the United States) generally will 

be applied in determining whether 

income is effectively connected with the 

conduct of a trade or business within 

the relevant possession, without regard 

to whether the taxpayer qualifies as a 

nonresident alien individual or a foreign 

corporation with respect to such 

possession. Subject to the rules of this 

section, the principles of section 

864(c)(4) will apply for purposes of 

determining whether income from 

sources without the relevant possession 

is effectively connected with the 

conduct of a trade or business in the 

relevant possession. For purposes of the 

preceding sentence, all income other 

than income from sources within the 

relevant possession (as determined 

under the rules of § 1.937–2) will be 

considered income from sources 

without the relevant possession in the 

application of the principles of section 

864(c) under this paragraph (b), it 

generally will be sufficient to substitute 

the name of the relevant possession for 

the term ‘‘United States’’ where 

appropriate, but additional substitutions 

may be necessary to accomplish the 

intent of section 937(b) and this section. 

In no case, however, will a bona fide 

resident or other person have, as a result 

of the application of these principles, 

more income effectively connected with 

the conduct of a trade or business in the 

relevant possession than the amount of 

U.S. effectively connected income that a 

similarly situated U.S. person who is 

not a bona fide resident would have 

under section 864(c). 

(c) U.S. income—(1) In general. 

Except as provided in paragraph (d) of 

this section, income considered to be 

effectively connected with the conduct 

of a trade or business within the 

relevant possession will not include any 

item of income determined under the 

rules of sections 861 through 865 and 

the regulations under those provisions 

to be—

(i) From sources within the United 

States; or 

(ii) Effectively connected with the 

conduct of a trade or business within 

the United States. 

(2) Conduit arrangements. Income 

will be considered to be from sources 

within the United States for purposes of 

paragraph (c)(1) of this section 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 income from 

sources within the United States. 

(d) Income from certain sales of 

inventory property. Paragraph (c) of this 

section will not apply to income from 

sales of inventory property described in 

§ 1.863–3(f). 

(e) Examples. The provisions of this 

section may be illustrated by the 

following examples: 

Example 1. X is a bona fide resident of 

Possession I, a section 931 possession (as 

defined in § 1.931–1(c)(1)). X has an office in 

Possession I from which X conducts a 

business consisting of the development and 

sale of specialized computer software. A 

purchaser of software will frequently pay X 

an additional amount to install the software 

on the purchaser’s operating system and to 

ensure that the software is functioning 

properly. X performs the installation services 

at the purchaser’s place of business, which 

may be in Possession I, in the United States, 

or in another country. The provision of such 

services is not de minimis and constitutes a 

separate transaction under the rules of 

§ 1.861–18. Under the principles of section 

864(c)(4) as applied pursuant to paragraph (b) 

of this section, the compensation that X 

receives for personal services performed 

outside of Possession I is not considered to 

be effectively connected with the conduct of 

a trade or business in Possession I for 

purposes of section 931(a)(2). 

Example 2. (i) F Bank is organized under 

the laws of Country FC and operates an 

active banking business from offices in the 

U.S. Virgin Islands (USVI). In connection 

with this banking business, F Bank makes 

loans to and receives interest payments from 

borrowers who reside in the USVI, in the 

United States, and in Country FC. 

(ii) Under the principles of section 

861(a)(1) as applied pursuant to § 1.937–2(b), 

interest payments received by F Bank from 

borrowers who reside in the United States or 

in Country FC constitute income from 

sources outside of the USVI. Under the 

principles of section 864(c)(4) as applied 

pursuant to paragraph (b) of this section, 

interest income from sources outside of the 

USVI generally may constitute income that is 

effectively connected with the conduct of a 

trade or business within the USVI for 

purposes of the Internal Revenue Code. 

However, interest payments received by F 

Bank from borrowers who reside in the 

United States constitute income from sources 

within the United States under section 

861(a)(1). Accordingly, under paragraph 

(c)(1) of this section, such interest income 

will not be treated as effectively connected 

with the conduct of a trade or business in the 

USVI for purposes of the Internal Revenue 

Code (for example, for purposes of section 


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934(b)). Interest payments received by F Bank 

from borrowers who reside in Country FC, 

however, may be treated as effectively 

connected with the conduct of a trade or 

business in the USVI for purposes of the 

Internal Revenue Code (including section 

934(b)). 

(iii) To the extent that, as described in 

section 934(a), the USVI administers income 

tax laws that are identical (except for the 

substitution of the name of the USVI for the 

term ‘‘United States’’ where appropriate) to 

those in force in the United States, interest 

payments received by F Bank from borrowers 

who reside in the United States or in Country 

FC may be treated as income that is 

effectively connected with the conduct of a 

trade or business in the USVI for purposes of 

F Bank’s income tax liability to the USVI 

under mirrored section 882. 

Example 3. (i) G is a partnership that is 

organized under the laws of, and that 

operates an active financing business from 

offices in, Possession I. Interests in G are 

owned by D, a bona fide resident of 

Possession I, and N, an alien individual who 

resides in Country FC. Pursuant to a prearrangement, G loans $x to T, a business 

entity organized under the laws of Country 

FC, and T in turn loans $y to E, a U.S. 

resident. In accordance with the 

arrangement, E pays interest to T, which in 

turn pays interest to G. 

(ii) The arrangement constitutes a conduit 

arrangement under paragraph (c)(2) of this 

section, and the interest payments received 

by G are treated as income from sources 

within the United States for purposes of 

paragraph (c)(1) of this section. Accordingly, 

the interest received by G will not be treated 

as effectively connected with the conduct of 

a trade or business in Possession I for 

purposes of the Internal Revenue Code 

(including sections 931(a)(2) and 934(b), if 

applicable with respect to D). Whether such 

interest constitutes income from sources 

within the United States for other purposes 

of the Internal Revenue Code under generally 

applicable conduit principles will depend on 

the facts and circumstances. See, for 

example, Aiken Indus., Inc. v. Commissioner, 

56 T.C. 925 (1971). 

(iii) If Possession I administers income tax 

laws that are identical (except for the 

substitution of the name of the possession for 

the term ‘‘United States’’ where appropriate) 

to those in force in the United States, the 

interest received by G may be treated as 

income effectively connected with the 

conduct of a trade or business in Possession 

I under mirrored section 864(c)(4) for 

purposes of determining the Possession I 

territorial income tax liability of N under 

mirrored section 871. 

Example 4. (i) Corporation A, a corporation 

organized in Possession X, is engaged in a 

business consisting of the development of 

computer software and the sale of that 

software. Corporation A has its sole place of 

business in Possession X and is not engaged 

in the conduct of a trade or business in the 

United States. Corporation A receives orders 

for its software from customers in the United 

States and around the world. After orders are 

accepted, Corporation A’s software is either 

loaded onto compact discs at Corporation A’s 

Possession X facility and shipped via 

common carrier, or downloaded from 

Corporation A’s server in Possession X. The 

sales contract provides that the rights, title, 

and interest in the product will pass from 

Corporation A to the customer either at 

Corporation A’s place of business in 

Possession X (if shipped in compact disc 

form) or at Corporation A’s server in 

Possession X (if electronically downloaded). 

Assume for purposes of this example that 

each transaction is classified as a sale of a 

copyrighted article under § 1.861–18(c)(1)(ii) 

and (f)(2). 

(ii) Under the principles of section 863(a), 

as applied pursuant to § 1.937–2(b), because 

Corporation A passes the rights, title, and 

interest to the copyrighted articles in 

Possession X, Corporation A’s sales income 

is sourced to Possession X. Corporation A’s 

sales income is also effectively connected 

with the conduct of a trade or business in 

Possession X, under the principles of section 

864(c)(3) as applied pursuant to § 1.937–3(b). 

Corporation A’s income is not from sources 

within the United States, nor is it effectively 

connected with the conduct of a trade or 

business in the United States. Accordingly, 

the U.S. income rule of section 937(b)(2), 

§ 1.937–2(c)(1), and paragraph (c)(1) of this 

section does not operate to prevent 

Corporation A’s sales income from being 

Possession X source and Possession X 

effectively connected income under section 

937(b)(1). 

Example 5. (i) Corporation B, a corporation 

organized in Possession X, has its sole place 

of business in Possession X and is not 

engaged in the conduct of a trade or business 

in the United States. Corporation B employs 

a software business model generally referred 

to as an application service provider. 

Employees of Corporation B in Possession X 

develop software and maintain it on 

Corporation B’s server in Possession X. 

Corporation B’s customers in the United 

States and around the world transmit 

detailed data about their own customers to 

Corporation B’s server and electronic storage 

facility in Possession X. The customers pay 

a monthly fee to Corporation B under a 

Subscription Agreement, and they can use 

the software to generate reports analyzing the 

data at any time but do not receive a copy 

of the software. Corporation B’s software 

allows its customers to generate the reports 

from their location and to keep track of their 

relationships with their own customers. 

Assume for purposes of this example that 

Corporation B’s income from these 

transactions is derived from the provision of 

services. 

(ii) Under the principles of section 

861(a)(3) and § 1.861–4(a), as applied 

pursuant to § 1.937–2(b), because 

Corporation B performs personal services 

wholly within Possession X, the 

compensation Corporation B receives for 

services is sourced to Possession X. 

Corporation B’s services income is also 

effectively connected with the conduct of a 

trade or business in Possession X, under the 

principles of section 864(c)(3) as applied 

pursuant to § 1.937–3(b). Corporation B’s 

income is not from sources within the United 

States, nor is it effectively connected with the 

conduct of a trade or business in the United 

States. Accordingly, the U.S. income rule of 

section 937(b)(2), § 1.937–2(c)(1), and 

paragraph (c)(1) of this section does not 

operate to prevent Corporation B’s services 

income from being Territory X source or 

Possession X effectively connected income 

within the meaning of section 937(b)(1). 

(f) Effective/applicability date. Except 

as otherwise provided in this paragraph 

(f), this section applies to income earned 

in taxable years ending after April 9, 

2008. Taxpayers may choose to apply 

paragraph (b) of this section to income 

earned in open taxable years ending 

after October 22, 2004. 

§ 1.937–3T [Removed] 

■ Par. 31. Section 1.937–3T is removed. 

■ Par. 32. Section 1.957–3 is revised to 

read as follows: 

§ 1.957–3 United States person defined. 

(a) Basic rule—(1) In general. The 

term United States person has the same 

meaning for purposes of sections 951 

through 965 that it has under section 

7701(a)(30) and the regulations under 

that section, except as provided in 

paragraphs (b) and (c) of this section, 

which provide, with respect to 

corporations organized in possessions of 

the United States, that certain residents 

of such possessions are not United 

States persons. The effect of 

determining that an individual is not a 

United States person for such purposes 

is to exclude such individual in 

determining whether a foreign 

corporation created or organized in, or 

under the laws of, a possession of the 

United States is a controlled foreign 

corporation. See § 1.957–1 for the 

definition of the term ‘‘controlled 

foreign corporation.’’

(2) Special provisions applicable to 

possessions of the United States. For 

purposes of this section—

(i) The term possession of the United 

States means Puerto Rico or any section 

931 possession; 

(ii) The term section 931 possession 

has the same meaning that it has under 

§ 1.931–1(c)(1); 

(iii) The rules of § 1.937–1 will apply 

for determining whether an individual 

is a bona fide resident of a possession 

of the United States; 

(iv) Except as provided in paragraph 

(b)(2) of this section, the rules of 

§ 1.937–2 will apply for determining 

whether income is from sources within 

a possession of the United States; and 

(v) The rules of § 1.937–3 will apply 

for determining whether income is 

effectively connected with the conduct 

of a trade or business in a possession of 

the United States. 

(b) Puerto Rico corporation and 

resident. An individual (who, without 


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regard to this paragraph (b), is a United 

States person) will not be considered a 

United States person with respect to a 

foreign corporation created or organized 

in, or under the laws of, Puerto Rico for 

the taxable year of such corporation that 

ends with or within the taxable year of 

such individual if—

(1) Such individual is a bona fide 

resident of Puerto Rico during his entire 

taxable year in which or with which the 

taxable year of such foreign corporation 

ends; and 

(2) A dividend received by such 

individual from such corporation during 

the taxable year of such corporation 

would, for purposes of section 933(1), 

be treated as income derived from 

sources within Puerto Rico. For 

purposes of this paragraph (b)(2), the 

rules of § 1.937–2(g)(1) will not apply. 

(c) Section 931 possession corporation 

and resident. An individual (who, 

without regard to this paragraph (c), is 

a United States person) will not be 

considered a United States person with 

respect to a foreign corporation created 

or organized in, or under the laws of, a 

section 931 possession for the taxable 

year of such corporation that ends with 

or within the taxable year of such 

individual if—

(1) Such individual is a bona fide 

resident of such section 931 possession 

during his entire taxable year in which 

or with which the taxable year of such 

foreign corporation ends; and 

(2) Such corporation satisfies the 

following conditions—

(i) 80 percent or more of its gross 

income for the 3-year period ending at 

the close of the taxable year (or for such 

part of such period as such corporation 

or any predecessor has been in 

existence) was derived from sources 

within section 931 possessions or was 

effectively connected with the conduct 

of a trade or business in section 931 

possessions; and 

(ii) 50 percent or more of its gross 

income for such period (or part) was 

derived from the active conduct of a 

trade or business within section 931 

possessions. 

(d) Effective/applicability date. This 

section applies to taxable years ending 

after April 9, 2008. 

§ 1.957–3T [Removed] 

■ Par. 33. Section 1.957–3T is removed. 

■ Par. 34. Section 1.1402(a)–12 is 

revised to read as follows: 

§ 1.1402(a)–12 Continental shelf and 

certain possessions of the United States. 

(a) Certain possessions. For purposes 

of the tax on self-employment income, 

the exclusion from gross income 

provided by section 931 (relating to 

bona fide residents of certain 

possessions of the United States) will 

not apply. Net earnings from selfemployment are subject to the tax on 

self-employment income even if such 

amounts are excluded from gross 

income under section 931. 

(b) Continental shelf. For the 

definition of the term ‘‘United States’’

and for other geographical definitions 

relating to the continental shelf, see 

section 638 and § 1.638–1. 

(c) Effective/applicability date. This 

section applies to taxable years ending 

after April 9, 2008. 

§ 1.1402(a)–12T [Removed] 

■ Par. 35. Section 1.1402(a)–12T is 

removed. 

■ Par. 36. Section 1.6012–1 is amended 

by revising paragraph (a)(1)(iii) to read 

as follows: 

§ 1.6012–1 Individuals required to make 

returns of information. 

(a) * * * 

(1) * * * 

(iii) An alien bona fide resident of 

Puerto Rico or any section 931 

possession, as defined in § 1.931–

1(c)(1), during the entire taxable year. 

* * * * * 

■ Par. 37. Section 1.6038–2 is amended 

by revising paragraph (d) and adding a 

new sentence at the end of the 

paragraph (m) to read as follows: 

§ 1.6038–2 Information returns required of 

United States persons with respect to 

annual accounting periods of certain 

foreign corporations. 

* * * * * 

(d) U.S. person—(1) In general. For 

purposes of section 6038 and this 

section, the term United States person 

has the meaning assigned to it by 

section 7701(a)(30), except as provided 

in paragraphs (d)(2) and (3) of this 

section. 

(2) Special rule for individuals 

residing in certain possessions.—(i) 

With respect to an individual who is a 

bona fide resident of Puerto Rico, the 

term United States person has the 

meaning assigned to it by § 1.957–3 

except that the rules of § 1.937–2(g)(1) 

will apply. 

(ii) With respect to an individual who 

is a bona fide resident of any section 

931 possession, as defined in § 1.931–

1(c)(1), the term United States person 

has the meaning assigned to it by 

§ 1.957–3. 

(3) Special rule for certain 

nonresident aliens. An individual for 

whom an election under section 6013(g) 

or (h) is in effect will, subject to the 

exceptions contained in paragraph (d)(2) 

of this section, be considered a United 

States person for purposes of section 

6038 and this section. 

* * * * * 

(m) * * * Paragraph (d) of this section 

applies to taxable years ending after 

April 9, 2008. 

§ 1.6038–2T [Removed] 

■ Par. 38. Section 1.6038–2T, is 

removed. 

■ Par. 39. Section 1.6046–1 is amended 

by revising paragraph (f)(3) and adding 

a new paragraph (l) to read as follows: 

§ 1.6046–1 Returns as to organization or 

reorganization of foreign corporations and 

as to acquisitions of their stock. 

* * * * * 

(f) * * * 

(3) U.S. person—(i) In general. For 

purposes of section 6046 and this 

section, the term United States person 

has the meaning assigned to it by 

section 7701(a)(30), except as provided 

in paragraphs (f)(3)(ii) and (iii) of this 

section. 

(ii) Special rule for individuals 

residing in certain possessions.—(A) 

With respect to an individual who is a 

bona fide resident of Puerto Rico, the 

term United States person has the 

meaning assigned to it by § 1.957–3 

except that the rules of § 1.937–2(g)(1) 

will apply. 

(B) With respect to individuals who 

are bona fide residents of any section 

931 possession, as defined in § 1.931–

1(c)(1), the term United States person 

has the meaning assigned to it by 

§ 1.957–3. 

(iii) Special rule for certain 

nonresident aliens. An individual for 

whom an election under section 6013(g) 

or (h) is in effect will, subject to the 

exceptions contained in paragraph 

(f)(3)(ii) of this section, be considered a 

United States person for purposes of 

section 6046 and this section. 

* * * * * 

(l) Effective/applicability date. 

Paragraph (f)(3) of this section applies to 

taxable years ending after April 9, 2008. 

§ 1.6046–1T [Removed] 

■ Par. 40. Section 1.6046–1T is 

removed. 

PART 301—PROCEDURE AND 

ADMINISTRATION 

■ Par. 41. The authority citation for part 

301 continues to read, in part, as 

follows: 

Authority: 26 U.S.C. 7805 * * * 

■ Par. 42. Section 301.6688–1 is revised 

to read as follows: 


sroberts on PROD1PC70 with RULES
Federal Register / Vol. 73, No. 69 / Wednesday, April 9, 2008 / Rules and Regulations 19377 

§ 301.6688–1 Assessable penalties with 

respect to information required to be 

furnished with respect to possessions. 

(a) In general. Each individual 

described in section 7654(a) who is 

subject to an information reporting 

requirement promulgated under the 

authority of section 937(c) or 7654 and 

who fails to fully satisfy such 

requirement within the time prescribed 

for reporting such information must, in 

addition to any criminal penalty 

provided by law, pay a penalty of $1000 

for each such failure. Information 

reporting requirements promulgated 

under the authority of sections 937(c) 

and 7654(e) include the requirement for 

an individual to file Form 8898, 

‘‘Statement for Individuals who Begin or 

End Bona Fide Residence in a U.S. 

Possession,’’ under § 1.937–1(h) of this 

chapter, to report that he or she became 

or ceased to be a bona fide resident of 

a possession. 

(b) Manner of payment. The penalty 

set forth in paragraph (a) of this section 

must be paid in the same manner as tax 

upon the issuance of a notice and 

demand for the penalty. 

(c) Reasonable cause—(1) In general. 

The penalty set forth in paragraph (a) of 

this section will not apply if it is 

established to the satisfaction of the 

appropriate tax authority (as defined in 

paragraph (c)(2) of this section) that the 

failure to file the information return or 

furnish the information within the 

prescribed time was due to reasonable 

cause and not to willful neglect. An 

individual who wishes to avoid the 

penalty must make an affirmative 

showing of all facts alleged as a 

reasonable cause for failure to file the 

information return on time, or furnish 

the information on time, in the form of 

a written statement containing a 

declaration that it is made under 

penalties of perjury. This statement 

must be filed with Internal Revenue 

Service Center where Form 8898 must 

be filed. In determining whether there 

was reasonable cause for failure to 

furnish the required information, 

account will be taken of the fact that the 

individual was unable to furnish the 

required information in spite of the 

exercise of ordinary business care and 

prudence in his effort to furnish the 

information. An individual will be 

considered to have exercised ordinary 

business care and prudence in his effort 

to furnish the required information if he 

made reasonable efforts to furnish the 

information but was unable to do so 

because of a lack of sufficient facts on 

which to make a proper determination. 

(d) Effective/applicability date. This 

section applies to taxable years ending 

after April 9, 2008. 

§ 301.6688–1T [Removed] 

■ Par. 43. Section 301.6688–1T is 

removed. 

■ Par. 44. Section 301.7701(b)–1 is 

amended by revising paragraph (d) to 

read as follows: 

§ 301.7701(b)–1 Resident alien. 

* * * * * 

(d) Application of section 7701(b) to 

the possessions and territories—(1) 

Application to aliens for purposes of 

mirror systems. Section 7701(b) 

provides the basis for determining 

whether an alien individual is a resident 

of a United States possession or territory 

that administers income tax laws that 

are identical (except for the substitution 

of the name of the possession or 

territory for the term ‘‘United States’’

where appropriate) to those in force in 

the United States, for purposes of 

applying such laws with respect to 

income tax liability incurred to such 

possession or territory. 

(2) Non-application for bona fide 

resident determination. Section 7701(b) 

does not provide the basis for 

determining whether an individual 

(including an alien individual) is a bona 

fide resident of a United States 

possession or territory for Federal 

income tax purposes. For the applicable 

rules for making this determination, see 

section 937(a) and § 1.937–1 of this 

chapter. 

* * * * * 

§ 301.7701(b)–1T [Removed] 

■ Par. 45. Section 301.7701(b)–1T is 

removed. 

■ Par. 46. Section 301.7701(b)–9 is 

amended by revising the section 

heading and adding new paragraph 

(b)(5) to read as follows: 

§ 301.7701(b)–9 Effective/applicability 

dates of §§ 301.7701(b)–1 through 

301.7701(b)–7. 

* * * * * 

(b) * * * 

(5) Possessions and territories. For 

purposes of applying section 7701(b) 

and the regulations under that section, 

§ 301.7701(b)–1(d) applies to taxable 

years ending after April 9, 2008. 

Linda E. Stiff, 

Deputy Commissioner for Services and 

Enforcement. 

Approved: April 1, 2008. 

Eric Solomon, 

Assistant Secretary of the Treasury (Tax 

Policy). 

[FR Doc. 08–1105 Filed 4–4–08; 8:45 am] 

BILLING CODE 4830–01–P 


sroberts on PROD1PC70 with RULES