The Internal Revenue Service has issued final regulations for determining whether income is derived from sources within a U.S. possession or territory, and whether it is effectively connected with the conduct of a trade or business within a territory.

The U.S. tax consequences of classifying income as being from sources within a territory or as being effectively connected income vary from territory to territory. Section 937(b)(1) of the Tax Code 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 behind Section 937 indicates that Congress intended for the Treasury Department and the IRS to use this authority to provide exceptions to the general rules regarding territory source income and territory effectively connected income as appropriate.

The legislative history also 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 taxes. The regulations go into effect on April 9.

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