||2008 Tax Year
Possession Source Income
In order to determine where to file your return and which form(s) you need to complete, you must determine the source of each
item of income you
received during the tax year. Income you received from sources within, or that was effectively connected with the conduct
of a trade or business in,
the relevant possession must be identified separately from U.S. or foreign source income.
This chapter discusses the rules for determining if the source of your income is:
The Commonwealth of the Northern Mariana Islands (CNMI),
The Commonwealth of Puerto Rico (Puerto Rico),
The U.S. Virgin Islands (USVI).
Generally, the same rules that apply for determining U.S. source income also apply for determining possession source income.
However, there are
some important exceptions to these rules. Both the general rules and the exceptions are discussed in this chapter.
The rules for determining possession source income are generally effective for income earned after December 31, 2004. The
basis of these rules is
the “U.S. income rule.”
U.S. income rule.
This rule states that income is not possession source income if, under the rules of Internal Revenue Code sections
861-865, it is treated as
From sources in the United States, or
Effectively connected with the conduct of a trade or business in the United States.
Table 2-1 shows the general rules for determining whether income is from sources within the United States.
Table 2-1. General Rules for Determining U.S. Source of Income
Item of Income
Factor Determining Source
Salaries, wages, and other compensation for labor or personal services
Where labor or services performed
Where services were performed that earned the pension
Residence of payer
Where corporation created or organized
Location of property
Location of property
Patents, copyrights, etc.
Where property is used
Sale of business inventory—purchased
Sale of business inventory—produced
Allocation if produced and sold in different locations
Sale of real property
Location of property
Sale of personal property
Seller's tax home (but see Special rules for gains from dispositions of certain property, earlier, for
Sale of natural resources
Allocation based on fair market value of product at export terminal. For more information, see Regulations section
This section looks at the most common types of income received by individuals, and the rules for determining the source of
the income. Generally,
the same rules shown in Table 2-1 are used to determine if you have possession source income.
Compensation for Labor or Personal Services
Income from labor or personal services includes wages, salaries, commissions, fees, per diem allowances, employee allowances
and bonuses, and
fringe benefits. It also includes income earned by sole proprietors and general partners from providing personal services
in the course of their trade
Services performed wholly within a relevant possession.
Generally, all pay you receive for services performed in a relevant possession is considered to be from sources within
that possession. However,
there is an exception for income earned as a member of the U.S. Armed Forces.
U.S. Armed Forces.
If you are a bona fide resident of a relevant possession, your military service pay will be sourced in that possession
even if you perform the
services in the United States or another possession. However, if you are not a bona fide resident of a possession, your military
service pay will be
income from the United States even if you perform services in a possession.
Services performed partly inside and partly outside a relevant possession.
If you are an employee and receive compensation for labor or personal services performed both inside and outside the
relevant possession, special
rules apply in determining the source of the compensation. Compensation (other than certain fringe benefits) is sourced on
a time basis. Certain
fringe benefits (such as housing and education) are sourced on a geographical basis.
Or, you may be permitted to use an alternative basis to determine the source of compensation. See Alternative basis
If you are self-employed, you determine the source of your income for labor or personal services from self-employment
on the basis that most
correctly reflects the proper source of that income under the facts and circumstances of your particular case. In many cases,
the facts and
circumstances will call for an apportionment on a time basis.
Use a time basis to figure your compensation for labor or personal services from the relevant possession (other than
the fringe benefits discussed
later). Do this by multiplying your total compensation (other than the fringe benefits discussed later) by the following fraction:
Number of days you performed
services in the relevant
possession during the year
Total number of days you
performed services during the year
You can use a unit of time less than a day in the above fraction, if appropriate. The time period for which the income
is made does not have to be
a year. Instead, you can use another distinct, separate, and continuous time period if you can establish to the satisfaction
of the IRS that this
other period is more appropriate.
In 2007, you worked in your employer's office in the United States for 60 days and in the Puerto Rico office for 175 days,
earning a total of
$50,000 for the year. Your Puerto Rico source income is $37,234, figured as follows.
The source of multi-year compensation is generally determined on a time basis over the period to which the compensation
is attributable. Multi-year
compensation is compensation that is included in your income in 1 tax year but that is attributable to a period that includes
2 or more tax years. You
determine the period to which the income is attributable based on the facts and circumstances of your case. For more information
compensation, see Regulations section 1.861-4, 2005-35 I.R.B. 429, available at
Certain fringe benefits sourced on a geographical basis.
If you received any of the following fringe benefits as compensation for labor or services performed as an employee
partly inside and partly
outside a relevant possession, you must source that income on a geographical basis.
For information on determining the source of the fringe benefits listed above, see Regulations section 1.861-4.
You can determine the source of your compensation under an alternative basis if you establish to the satisfaction
of the IRS that, under the facts
and circumstances of your case, the alternative basis more properly determines the source of your income than the time or
geographical basis. If you
use an alternative basis, you must keep (and have available for inspection) records to document why the alternative basis
more properly determines the
source of your income.
Pension income is sourced according to where services were performed that earned the pension. For example, if your
entire working career was spent
in the United States and then you retired to the USVI, your pension would be considered U.S. source income because all services
were performed in the
This category includes such income as interest, dividends, rents, and royalties.
The source of interest income is generally determined by the residence of the payer. Interest paid by corporations
created or organized in a
relevant possession (possession corporation) or by individuals who are bona fide residents of a relevant possession is considered
income from sources
within that possession.
However, there is an exception to this rule if you are a bona fide resident of a relevant possession, receive interest
from a corporation created
or organized in that possession, and are a shareholder of that corporation who owns, directly or indirectly, at least 10%
of the total voting stock of
the corporation. See Temporary Regulations section 1.937-2T(i) for more information.
Generally, dividends paid by a corporation created or organized in a relevant possession will be considered income
from sources within that
possession. There are additional rules for bona fide residents of a relevant possession who receive dividend income from possession
who own, directly or indirectly, at least 10% of the voting stock of the corporation. For more information, see Temporary
Rents from property located in a relevant possession are treated as income from sources within that possession.
Royalties from natural resources located in a relevant possession are considered income from sources within that possession.
Also considered possession source income are royalties received for the use of, or for the privilege of using, in
a relevant possession, patents,
copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises, and other like property.
Sales or Other Dispositions of Property
The source rules for sales or other dispositions of property are varied. The most common situations are discussed below.
Real property includes land and buildings, and generally anything built on, growing on, or attached to land. The location
of the property generally
determines the source of income from the sale. For example, if you are a bona fide resident of Guam and sell your home that
is located in Guam, the
gain on the sale is sourced in Guam. If, however, the home you sold was located in the United States, the gain is U.S. source
income. However, for
exceptions, see Special rules for gains from disposition of certain property
, on this page.
The term “personal property
” refers to property (such as machinery, equipment, or furniture) that is not real property. Generally, gain or
loss from the sale or other disposition is sourced according to the seller's tax home. If personal property is sold by a bona
fide resident of a
relevant possession, the gain or loss from the sale is treated as sourced within that possession.
This rule does not apply to the sale of inventory, intangible property, depreciable personal property, or property
sold through a foreign office or
fixed place of business. The rules applying to sales of inventory are discussed below. For information on sales of the other
types of property
mentioned, see Internal Revenue Code section 865.
Your inventory is personal property that is stock in trade or that is held primarily for sale to customers in the
ordinary course of your trade or
business. The source of income from the sale of inventory depends on whether the inventory was purchased or produced.
Income from the sale of inventory that you purchased is sourced where you sell the property. Generally, this is where
title to the property passes
to the buyer.
Income from the sale of inventory that you produced in a relevant possession and sold outside that possession (or
vice versa) is sourced based on
an allocation. For information on making the allocation, see Regulations section 1.863-3(f).
Special rules for gains from dispositions of certain property.
There are special rules for gains from dispositions of certain investment property (for example, stocks, bonds, debt
instruments, diamonds, and
gold) owned by a U.S. citizen or resident alien prior to becoming a bona fide resident of a possession. You are subject to
these special rules if you
meet both of the following conditions.
For the tax year for which the source of the gain must be determined, you are a bona fide resident of the relevant possession.
For any of the 10 years preceding that year, you were a citizen or resident alien of the United States (other than a bona
fide resident of
the relevant possession).
If you meet these conditions, gains from the disposition of this property will not be treated as income from sources
within the relevant possession
for purposes of the Internal Revenue Code. Accordingly, bona fide residents of American Samoa and Puerto Rico, for example,
may not exclude the gain
on their U.S. tax return. (See chapter 3 for additional filing information.) With respect to the CNMI, Guam, and the USVI,
the gain from the
disposition of this property will not meet the requirements for certain tax rules that may allow bona fide residents of those
possessions to reduce or
obtain a rebate of taxes on income from sources within the relevant possessions.
These rules apply to dispositions after April 11, 2005. For details, see Temporary Regulations section 1.937-2T(f)(1)
and Example 2 of section
In 2002, Cheryl Jones, a U.S. citizen, lives in the United States and buys 100 shares of stock in the Rose Corporation, a
U.S. corporation. In
2005, she moves to Puerto Rico. In 2007, while a bona fide resident of Puerto Rico, Cheryl sells the Rose Corporation stock
at a gain. For income tax
purposes, this gain is not treated as income from sources within Puerto Rico.
The new source rules discussed in the preceding paragraphs supplement, and may apply in conjunction with, an existing special
rule. This existing
special rule applies if you are a U.S. citizen or resident alien who becomes a bona fide resident of American Samoa, the CNMI,
or Guam, and who has
gain from the disposition of certain U.S. assets during the 10-year period beginning when you became a bona fide resident.
The gain is U.S. source
income that generally is subject to U.S. tax if the property is either (1) located in the United States; (2) stock issued
by a U.S. corporation or a
debt obligation of a U.S. person or of the United States, a state (or political subdivision), or the District of Columbia;
or (3) property that has a
basis in whole or in part by reference to property described in (1) or (2). See chapter 3 for filing information.
Scholarships, Fellowships, Grants, Prizes, and Awards
The source of these types of income is generally the residence of the payer, regardless of who actually disburses the funds.
Therefore, in order to
be possession source income, the payer must be a resident of the relevant possession, such as an individual who is a bona
fide resident or a
corporation created or organized in that possession.
These rules do not apply to amounts paid as salary or other compensation for services. See Compensation for Labor or Personal
earlier in this chapter, for the source rules that apply.
Effectively Connected Income
In limited circumstances, some kinds of income from sources outside the relevant possession must be treated as effectively
connected with a trade
or business in that possession. These circumstances are listed below.
You have an office or other fixed place of business in the relevant possession to which the income can be attributed.
That office or place of business is a material factor in producing the income.
The income is produced in the ordinary course of the trade or business carried on through that office or other fixed place
An office or other fixed place of business is a material factor if it significantly contributes to, and is an essential economic
element in, the
earning of the income.
The three kinds of income from sources outside the relevant possession to which these rules apply are the following.
Rents and royalties for the use of, or for the privilege of using, intangible personal property located outside the relevant
from any interest in such property. Included are rents or royalties for the use of, or for the privilege of using, outside
the relevant possession,
patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises, and similar properties
if the rents or royalties
are from the active conduct of a trade or business in the relevant possession.
Dividends or interest from the active conduct of a banking, financing, or similar business in the relevant possession.
Income, gain, or loss from the sale or exchange outside the relevant possession, through the office or other fixed place of
business in the
relevant possession, of:
Stock in trade,
Property that would be included in inventory if on hand at the end of the tax year, or
Property held primarily for sale to customers in the ordinary course of business.
Item (3) will not apply if you sold the property for use, consumption, or disposition outside the relevant possession and
an office or other fixed
place of business in a foreign country was a material factor in the sale.
For tax years beginning after October 22, 2004 (beginning with tax year 2005 if a calendar year taxpayer), any income from
a source outside the
relevant possession that is equivalent to any item of income described in (1)-(3) above is treated as effectively connected
with a trade or
business in the relevant possession.
Marcy Jackson is a bona fide resident of American Samoa. Her business, which she conducts from an office in American Samoa,
is developing and
selling specialized computer software. A software purchaser will frequently pay Marcy an additional amount to install the
software on the purchaser's
operating system and to ensure that the software is functioning properly. Marcy installs the software at the purchaser's place
of business, which may
be in American Samoa, in the United States, or in another country. The income from selling the software is effectively connected
with the conduct of
Marcy's business in American Samoa, even though the product's destination may be outside the possession. However, the compensation
she receives for
installing the software (personal services) outside of American Samoa is not effectively connected with the conduct of her
business in the
possession—the income is sourced where she performs the services.
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