EFTA00577260.pdf

[4830-01-p] DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1, 301, and 602 [TD 9194] RIN 1545-BE22 Residence and Source Rules Involving U.S. Possessions and Other Conforming Changes AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Final and temporary regulations. SUMMARY: This document contains temporary regulations that provide rules under section 937(a) of the Internal Revenue Code (Code) for determining whether an individual is a bona fide resident of the following U.S. possessions: American Samoa, Guam, the Northern Mariana Islands, Puerto Rico, and the United States Virgin Islands. The temporary regulations also provide rules under section 937(b) for determining whether income is derived from sources within a U.S. possession and whether income is effectively connected with the conduct of a trade or business within a U.S. possession. Section 937 was added to the Code by section 908 of the American Jobs Creation Act (2004 Act). The temporary regulations also provide updated 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 (1986 Act) and the 2004 Act. Conforming changes are also made to regulations under sections 170A, 243, 702, 861, 863, 871, 901, 1402, 6038, 6046, and 7701 of the Code. The text of EFTA00577260 the temporary regulations also serves as the text of the proposed regulations set forth in the cross-referenced notice of proposed rulemaking on this subject in the Proposed Rules section in this issue of the Federal Register. DATES: Effective Date: These regulations are effective April 11, 2005. FOR FURTHER INFORMATION CONTACT: J. David Varley (202) 435-5165 (not a toll-free number). SUPPLEMENTARY INFORMATION: Paperwork Reduction Act These temporary regulations are being issued without prior notice and public procedure pursuant to the Administrative Procedure Act (5 U.S.C. 553). For this reason, the collection of information contained in these regulations has been reviewed and pending receipt and evaluation of public comments, approved by the Office of Management and Budget under control number 1545-1930. Responses to this collection of information are mandatory. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid control number. For further information concerning this collection of information, and where to submit comments on the collection of information and the accuracy of the estimated burden, and suggestions for reducing this burden, please refer to the preamble to the cross-referencing notice of proposed rulemaking published in the Proposed Rules section of this issue of the Federal Register. 2 EFTA00577261  Books and records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103. Background The income tax laws of the United States have always contained special provisions concerning the income taxation of individuals residing in U.S. possessions and corporations created or organized in U.S. possessions. See e.g., sections 260 and 261 of Public Law 65-254 (40 Stat. 1057). The current rules for residents of the Commonwealth of Puerto Rico (Puerto Rico) were first enacted in 1950. See sections 220 and 221 of Public Law 81-814 (64 Stat. 906) (enacting the predecessors to sections 876 and 933 of the Code). Special rules for residents of the United States Virgin Islands (USVI) were added in 1960. See section 4 of Public Law 86-779 (74 Stat. 998) (enacting section 934 of the Code). Special rules for residents of Guam were added in 1972. See Public Law 92-606 (86 Stat. 1494) (1972 Act) (enacting sections 935 and 7654 of the Code). These special rules for residents of Guam were made applicable to residents of the Commonwealth of the Northern Mariana Islands (NMI) for tax years beginning after December 31, 1978. See section 601 of Public Law 94-241 (90 Stat. 263) and Presidential Proclamation 4534. The 1986 Act substantially revised the provisions governing the income taxation of individuals residing in U.S. possessions. See sections 1271 through 1277 of Public Law 99-514 (amending sections 876, 931 through 935, 957(c), 3 EFTA00577262 and 7654 of the Code). The 2004 Act restated and supplemented certain aspects of these provisions. See section 908 of Public Law 108-357 (enacting section 937 of the Code). These regulations conform the existing regulations to the amended statutes and provide additional guidance on the proper application of the statutory provisions. This document contains amendments to 26 CFR parts 1, 301, and 602. The cross-referenced notice of proposed rulemaking is published elsewhere in this issue of the Federal Register. Explanation of Provisions I. Operative Provisions Many of the substantive and procedural provisions of the Code specifically relating to the possessions were amended by the 1986 Act. The 2004 Act further amended certain of these provisions. These regulations implement the statutory changes by modifying or replacing existing regulations as discussed below. A. Puerto Rico Individuals who are U.S. citizens generally are subject to U.S. Federal income tax on their worldwide income, regardless of source, under section 1 of the Code. As discussed in section I.F. of this explanation, alien individuals who qualify as bona fide residents of Puerto Rico (and certain other possessions) likewise are subject to U.S. Federal income tax on their worldwide income under section 1. Under section 933, income from sources within Puerto Rico is excluded from gross income of bona fide residents of Puerto Rico (whether U.S. citizens or 4 EFTA00577263 alien individuals) for U.S. Federal income tax purposes. Consequently, such individuals have a U.S. Federal income tax return filing obligation only if their income from sources outside Puerto Rico exceeds their deductions under section 151 relating to personal exemptions. To the extent such income constitutes income from sources outside the United States, such individuals generally may claim a foreign tax credit under section 901(b) for income taxes paid to foreign countries and U.S. possessions (including Puerto Rico) to offset their U.S. Federal income tax liability, subject to certain limitations. Deductions (other than the deduction under section 151, relating to personal exemptions) properly allocable to or chargeable against amounts excluded from gross income under section 933 generally have been disallowed since the statute was enacted in 1950. The 1986 Act amended section 933 to provide for a similar disallowance of credits. These regulations amend the existing regulations under section 933 to reflect this statutory change. B. American Samoa, Guam, and the Northern Mariana Islands Section 931, as enacted in the 1986 Act, operates in a similar fashion to section 933. For U.S. citizens and alien individuals who are bona fide residents of possessions to which it applies (section 931 possessions), income from sources within such possessions or effectively connected with the conduct of a trade or business in such possessions is excluded from gross income for U.S. Federal income tax purposes. Consequently, such individuals have a U.S. Federal income tax return filing obligation only if their income from sources outside section 931 possessions and not effectively connected with the conduct 5 EFTA00577264 of a trade or business in such possessions exceeds their deductions under section 151 relating to personal exemptions. To the extent such income constitutes income from sources outside the United States, U.S. citizens who are bona fide residents of section 931 possessions generally may claim a foreign tax credit under section 901(b) for income taxes paid to foreign countries and U.S. possessions (including section 931 possessions) to offset their U.S. Federal income tax liability, subject to certain limitations. As under section 933, any deductions (other than the deduction under section 151, relating to personal exemptions) and credits properly allocable or chargeable against amounts excluded from gross income under section 931 are disallowed. Although section 931 by its terms applies to bona fide residents of American Samoa, Guam, and the NMI (collectively, the Pacific possessions), the statute takes effect with respect to any such possession only when the possession enters into an implementing agreement with the Internal Revenue Service as required under the relevant effective date provisions of the 1986 Act. See sections 1271(b) and 1277(b) of Public Law 99-514. To date, only American Samoa has entered into such an agreement. Consequently, section 931 currently applies only to bona fide residents of American Samoa. Although section 935 was repealed by the 1986 Act, the effective date of its repeal is contingent on the entry into force of implementing agreements, as described above, by the possessions to which section 935 historically has applied (section 935 possessions), namely, Guam and the NMI. Given that 6 EFTA00577265 neither has agreed to the entry into force of such agreements, section 935 remains in force with respect to bona fide residents of Guam and the NMI. Section 935, as in effect prior to its repeal, refers only to Guam. Pursuant to section 601 of the Covenant to Establish a Commonwealth of the Northern Mariana Islands in Political Union with the United States, Public Law 94-241, however, the income tax laws of the United States entered into force in the NMI in the same manner as those laws are in force in Guam, and references in the Code to Guam generally are deemed also to refer to the NMI. Consequently, section 935 currently applies to bona fide residents of Guam and of the NMI. These regulations amend the existing regulations under section 935 to reflect the fact that the section currently applies not only to bona fide residents of Guam but also to bona fide residents of the NMI, and may in the future apply only to bona fide residents of one or the other and will not apply to bona fide residents of either possession if both enter into the implementing agreements contemplated in the 1986 Act. Similarly, these regulations set forth the post- 1986 Act statutory framework for residents of section 931 possessions in a manner that reflects the potential for bona fide residents of Guam and the NMI to be covered by its provisions upon entry into force of such implementing agreements. C. United States Virgin Islands Section 932, as enacted in the 1986 Act, provides two sets of operative rules: one for bona fide residents of the USVI, and one for U.S. citizens and resident alien individuals who are not bona fide residents of the USVI but have 7 EFTA00577266 income from sources within the USVI or income effectively connected with the conduct of a trade or business in the USVI. With respect to individuals who are bona fide residents of the USVI (whether U.S. citizens or alien individuals), section 932(c) generally provides that an income tax return must be filed with the USVI tax authorities. If the individual properly reports on this return his or her income from all sources and identifies the source of each item of income, and pays all of the tax properly due with respect to such income, then such income is excluded from gross income for U.S. Federal income tax purposes. Consequently, such individuals have a U.S. Federal income tax return filing obligation only if they fail to report or properly identify the source of some of their income on their USVI income tax return, or if they fail to pay all of the tax properly due with respect to their income (for example, by improperly claiming the benefit of a tax credit or exemption provided under USVI law but subject to the limitations of section 934(b)). With respect to U.S. citizens and resident alien individuals who are not bona fide residents of the USVI but have income from sources within the USVI or income effectively connected with the conduct of a trade or business in the USVI, section 932(a) generally provides that each such individual must file his or her income tax return with both the IRS and with the USVI Bureau of Internal Revenue. In addition, under section 932(b), such an individual must pay to the USVI the "applicable percentage" of the taxes imposed under Chapter 1 of the Code. For this purpose, the term applicable percentage means the percentage which the individual's Virgin Islands adjusted gross income bears to the 8 EFTA00577267 individual's adjusted gross income; the term Virgin Islands adiusted gross income means the individual's adjusted gross income determined by taking into account only income derived from sources within the Virgin Islands and deductions properly apportioned or allocable thereto. On the individual's U.S. Federal income tax return, he or she may claim a credit for the tax required to be paid to the USVI, so that only the remainder is due to the United States. In general, 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 (commonly referred to as the mirror code). However, subject to the limitations of section 934(b), as amended by the 1986 Act, the USVI has the authority to reduce or remit tax liabilities under the mirror code in certain situations. First, under section 934(b)(1), the USVI may reduce or remit the tax otherwise imposed on the income of any person (other than a U.S. citizen or resident alien individual who is not a bona fide resident of the USVI) from sources within the USVI or effectively connected with the conduct of a trade or business in the USVI. Second, under section 934(b)(3), the USVI may reduce or remit the tax otherwise imposed on the income (other than income from sources within the United States or effectively connected with the conduct of a trade or business in the United States) of a foreign corporation, provided that less than ten percent of its stock (by vote and value) is owned by United States persons. Given that a corporation created or organized outside of the USVI can only have a mirror code 9 EFTA00577268 tax liability with respect to income from sources within the USVI or effectively connected with the conduct of a trade or business within the USVI (all of which is within the scope of section 934(b)(1)), the additional waiver of the limitations of section 934(a) provided by section 934(b)(3) generally will have no practical effect for such corporations. Instead, section 934(b)(3) generally is relevant only to corporations created or organized in the USVI (which are treated as "foreign" corporations for U.S. Federal income tax purposes). These regulations amend the existing regulations under section 934 and provide new regulations under section 932 to reflect this post-1986 Act statutory framework. D. U.S. tax liabilities of certain possessions corporations Section 881(a) generally imposes a 30 percent tax on U.S.-source fixed or determinable annual or periodical income of foreign corporations. Section 884 imposes certain branch-level taxes on foreign corporations that are engaged in a trade or business in the United States. Section 881(b) provides for the reduction or elimination of the taxes otherwise imposed under sections 881(a) and 884 on corporations created or organized in U.S. possessions (possessions corporations) under certain circumstances. Section 881(b), as enacted by the 1972 Act, provides the rules currently in effect for corporations created or organized in section 935 possessions. Under these rules, such corporations effectively are exempt from tax under section 881(a), provided that the following conditions are satisfied-- 10 EFTA00577269  (1) At all times during the 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 Secretary 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). Section 881(b), as enacted by the 1972 Act, also provides the rules currently in effect for corporations created or organized in the United States that otherwise might incur a tax liability to a section 935 possession under a mirrored version of section 881(a). Under these rules, such corporations effectively are exempt from tax in the section 935 possession in all cases. Section 881(b), as amended by the 1986 Act, provides the rules currently in effect for corporations created or organized in section 931 possessions and in the USVI. Under these rules, such corporations effectively are exempt from tax under section 881(a) and section 884, provided that the following conditions (1986 conditions) are satisfied-- (1) At all times during the 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 Secretary 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 II EFTA00577270 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 is used (directly or indirectly) to satisfy obligations to persons who are not bona fide residents of such a possession or the United States. Corporations that are created or organized in section 935 possessions and satisfy the 1986 conditions also are exempt from the U.S. tax imposed under section 884. Similarly, corporations that are created or organized in the United States and satisfy the 1986 conditions are exempt from the tax imposed under mirrored versions of section 884 in section 935 possessions. Section 881(b), as amended by the 2004 Act, provides a special rule for corporations created or organized in Puerto Rico. Under this rule, such corporations are subject to tax under section 881(a) at a rate of 10 percent (rather than the generally applicable rate of 30 percent) on their U.S.-source dividend income, provided that the 1986 conditions are satisfied. However, if, on or after October 22, 2004, there is an increase in the rate of Puerto Rico's withholding tax which is generally applicable to dividends paid to United States corporations not engaged in a trade or business in Puerto Rico to a rate greater than 10 percent, this special rule shall not apply to dividends received on or after the effective date of the increase. These regulations amend the existing regulations under sections 881 and 884 to reflect this post-1986 Act and post-2004 Act statutory framework. These regulations also provide rules similar to the 1972 Act rules applicable to section 12 EFTA00577271 935 possessions for purposes of determining tax liability incurred to the USVI by corporations created or organized in the United States, pursuant to section 1274(c) of the 1986 Act. E. Application of subpart F to bona fide residents of a possession With respect to bona fide residents of section 935 possessions and the USVI (mirror code possessions), corporations created or organized in the possession in which they reside are treated as domestic corporations for mirror code tax purposes. Thus, provisions such as subpart F of part Ill of subchapter N of chapter 1 of the Code (relating to controlled foreign corporations) as mirrored do not apply with respect to their ownership of such corporations. With respect to bona fide residents of section 931 possessions and Puerto Rico, corporations created or organized in the possession in which they reside are treated as foreign corporations for U.S. Federal income tax purposes. Thus, in cases where, after the application of section 931 or 933 as the case may be, such individuals are required to file U.S. Federal income tax returns, they generally must treat such corporations as foreign corporations for purposes of applying provisions, such as subpart F, to determine their U.S. Federal income tax liability. Section 957(c), however, provides a significant exception for bona fide residents of section 931 possessions and Puerto Rico. In cases where it applies, the individual is not treated as a United States person for purposes of subpart F. Consequently, such individual is not treated as a United States shareholder under section 951(b), and possession corporations described in section 957(c) 13 EFTA00577272 that are controlled by such individuals are not treated as controlled foreign corporations under section 957(a). In the case of a bona fide resident of Puerto Rico, section 957(c)(1) applies with respect to a corporation organized under the laws of the Commonwealth of Puerto Rico 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. (As discussed in more detail below in section II.B. of this explanation, such would be the case if, during a three-year testing period ending with the taxable year, the corporation's gross income was derived entirely from sources within Puerto Rico or the corporation met certain gross income and trade or business requirements.) In the case of a bona fide resident of a section 931 possession, section 957(c)(2) applies with respect to a corporation organized under the laws of such a possession if the following conditions are satisfied-- (1) 80 percent or more of the gross income of the corporation 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 such a possession or was effectively connected with the conduct of a trade or business in such a possession; and (2) 50 percent or 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 a possession. 14 EFTA00577273  These regulations amend the existing regulations under section 957 to reflect this post-1986 Act statutory framework. These regulations also make corresponding changes to the regulations under sections 6038 and 6046 (relating to information reporting requirements with respect to certain foreign corporations owned by United States persons). F. Taxation of aliens residing in a possession Under section 876, individuals who are nonresident aliens with respect to the United States and are bona fide residents of certain possessions are subject to U.S. Federal income tax on their worldwide income under section 1 (rather than solely on their income from sources within the United States or effectively connected with the conduct of a trade or business in the United States under section 871). Prior to the 1986 Act, section 876 applied only to alien individuals who were bona fide residents of Puerto Rico. As amended by the 1986 Act, section 876 applies also to alien individuals who are bona fide residents of section 931 possessions. These regulations amend the existing regulations under section 876 to reflect this post-1986 Act statutory framework. G. Entity Status The IRS and Treasury are aware that some taxpayers have deliberately treated business entities in an inconsistent manner for U.S. Federal income tax purposes and for purposes of determining income tax liabilities incurred to mirror code possessions, in order to reduce their overall tax liability below what otherwise would be due in the absence of the mirror system. The IRS and 15 EFTA00577274 Treasury believe that such inconsistent treatment is inappropriate and contrary to the purpose of the mirror system. Accordingly, these regulations contain special rules requiring consistent treatment of business entities for U.S. and mirror code tax purposes. Under these rules, if an entity status election (such as a subchapter S election or an election under §301.7701-3(c)) is filed with the IRS but not with the relevant mirror code possession, then the appropriate tax authority of the mirror code possession may, at his or her 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 possession but not with the IRS, the Commissioner may, at his discretion, deem the election to have been made for U.S. Federal income tax purposes. In the event that inconsistent elections are filed with the IRS and the mirror code possession, both the Commissioner and the appropriate tax authority of the mirror code possession may, at their individual discretion, deem the elections they received to be invalid and may deem the election filed with the other jurisdiction to have been made also for tax purposes in their own jurisdiction. Further, in the absence of an election, the default characterization of an eligible entity organized in a mirror code possession shall be determined under the rules applicable to domestic eligible entities under §301.7701-3(b). These consistency rules apply to elections under section 1362(a) and §301.7701-3(c), and to other similar elections. The IRS and Treasury request comments relating to elections that should be specifically mentioned or excluded from the regulations. 16 EFTA00577275  These special rules generally apply to elections made after, and entities created after, April 11, 2005. Transition rules are provided for existing entities, under which these special rules generally apply as of the beginning of the next taxable year. H. Effective date To the extent they provide rules under the operative provisions of the Code relating to the possessions, as amended by 1986 Act and the 2004 Act, these regulations generally apply to taxable years ending after October 22, 2004. The underlying statutory rules, however, generally apply to taxable years beginning after December 31, 1986. Accordingly, taxpayers may rely upon the guidance provided in these regulations with respect to prior years for which the underlying statutory rules are in effect, provided that they do so consistently. II. Definitional Provisions As indicated above in section I of this explanation, when applying the operative provisions of the Code relating to the possessions, determinations must be made regarding whether an individual is a bona fide resident of a particular possession, or whether income is derived from sources within a particular possession or is effectively connected with the conduct of a trade or business in a particular possession. Section 937 and these regulations provide guidance on these issues, as discussed below. A. Bona fide residency in a possession The term bona fide resident has been an integral part of the special provisions of the Code relating to U.S. possessions since 1950. See sections 220 17 EFTA00577276 and 221 of Public Law 81-814. From the beginning, this term has been used to identify the class of persons entitled to Federal tax exemptions or other special treatment under these provisions, and its meaning has remained essentially unchanged through all of the expansions and revisions of these provisions. Historically, the determination of whether an individual is a bona fide resident of a possession has turned on the facts and circumstances and, specifically, on an individual's intentions with respect to the length and nature of his or her stay in the possession. See, e.g., §§1.933-1(a), 1.934-1(c)(2), and 1.935-1(a)(3) (generally applying the principles of §§1.871-2 through 1.871-5). But see §301.7701(b)-1(d) (applying the rules of section 7701(b) for determining whether alien individuals qualified as residents of mirror code possessions for taxable years beginning after December 31, 1984). The qualifier "bona fide" indicates that a claim of residence in a possession is respected for Federal tax purposes when it is made in good faith. As enacted by the 2004 Act, section 937(a) provides that an individual generally will be considered a bona fide resident of a possession only if he or she satisfies all three of the following conditions-- (1) He or she is physically present in the possession for 183 days during the taxable year (physical presence test); (2) He or she does not have a tax home (determined under the principles of section 911(d)(3) without regard to the second sentence thereof) outside the possession during the taxable year (tax home test); and 18 EFTA00577277  (3) He or she does not have a closer connection (determined under the principles of section 7701(b)(3)(B)(ii)) to the United States or a foreign country than to the possession (closer connection test). Section 937(a) further provides that, for purposes of the physical presence test, the determination as to whether a person is present for any day shall be made under the principles of section 7701(b). The legislative history explains that, under this rule, an individual is to be considered present in a possession for a particular day if he is physically present in such possession during any time during such day, and in certain circumstances (e.g., certain medical emergencies), an individual's presence outside a possession is ignored. See H.R. Rep. No. 108-755, at 780 (2004). The tax home and closer connection tests are similar to the conditions that individuals historically have needed to meet to be considered residents of a possession. Congress also provided regulatory authority for the IRS and Treasury to create exceptions to this general definition, for cases in which an individual's absence from the possession is motivated by reasons other than tax avoidance. In particular, the legislative history indicates that Congress anticipated that exceptions would be provided for military personnel, workers in the fisheries trade, and retirees who may travel outside of a possession for personal reasons. At the same time, the legislative history makes clear that Congress wished to ensure that individuals who live and work stateside cannot avail themselves of 19 EFTA00577278 the tax benefits that Congress intended to provide only to individuals who actually reside in the possessions. See H.R. Rep. No. 108-755, at 780 (2004). Consistent with this legislative history, these regulations include several exceptions to the general statutory rules of section 937(a). First, these regulations provide several alternatives to the 183-day rule for purposes of satisfying the physical presence test. One alternative is that the individual spend no more than 90 days in the United States during the taxable year. Thus, for example, workers in the fisheries trade who spend considerable periods at sea, and individuals who travel extensively to neighboring islands to provide goods and services, may satisfy the physical presence requirement under this alternative. Another alternative is that the individual spend more days in the possession than in the United States and have no earned income (as defined in §1.911-3(b)) in the United States during the taxable year. Thus, for example, retirees who spend several months each year stateside for vacation, for medical treatment, or to visit relatives, and some time traveling in foreign countries, may satisfy the physical presence requirement under this alternative. A final alternative is that the individual have no permanent connection to the United States. For this purpose, the term permanent connection to the United States includes a permanent residence and a spouse or dependent with a principal place of abode in the United States. In other words, the absence of a permanent connection will enable an individual to satisfy the physical presence test. Thus, for example, an individual who lives in a possession but travels 20 EFTA00577279 extensively in the United States for business reasons or to receive medical treatment may satisfy the physical presence requirement under this alternative. For purposes of determining whether the above-mentioned alternatives are satisfied, certain days spent in the United States are disregarded. In particular, days spent as a full-time student, as a full-time government official or employee of a possession, or as a professional athlete participating in a charitable event generally are disregarded. In addition, days spent in transit and days that an individual is prevented from leaving the United States because of a medical condition that arose while the individual was present in the United States generally will also be disregarded. The above-mentioned alternatives apply with respect to individuals who are U.S. citizens or resident aliens (as defined in section 7701(b)). A different approach is appropriate in the case of individuals who are nonresident aliens with respect to the United States. For such individuals, in lieu of the above-mentioned alternatives, a mirrored version of the section 7701(b) substantial presence test applies. For purposes of the tax home test, these regulations provide a special rule for seafarers. Under this special rule, an individual will not be considered to have a tax home outside the relevant possession solely by reason of employment on a ship or other seafaring vessel that is predominantly used in local and international waters. For purposes of the closer connection test, these regulations provide a special rule under which another possession is not considered a foreign country. 21 EFTA00577280 Thus, for example, an individual who has a tax home in the USVI and a closer connection to Puerto Rico, and who satisfies the presence test with respect to both possessions, generally will be considered a bona fide resident of the USVI, and not of Puerto Rico. Special rules apply under Federal law for determining the residence of military personnel for tax purposes. See 50 App. U.S.C. 571(a). Consistent with these special rules, these regulations provide that an individual's absence from or presence in a possession in compliance with military orders generally does not affect whether the individual qualifies as a bona fide resident of such possession. Finally, consistent with existing law (see Notice 2000-61 (2000-2 C.B. 569)), these regulations provide that only natural persons may be considered bona fide residents of a possession for U.S. Federal income tax purposes. Thus, juridical persons such as corporations, partnerships, trusts, and estates cannot be considered bona fide residents of a possession for U.S. Federal income tax purposes. It should be noted that the 2004 Act modified sections 932 and 935, to conform the treatment of individuals who acquire or relinquish residency in mirror code possessions with the historical treatment of individuals who acquire or relinquish residency in Puerto Rico and section 931 possessions. Thus, for example, in order to be subject to the special rules of section 932(c), an individual must qualify as a bona fide resident of the USVI during the entire year. Accordingly, an individual generally is not subject to such special rules for any year during which he or she moves to or from the USVI. 22 EFTA00577281  The 2004 Act provisions and these regulations as they relate to the determination of bona fide residency in a possession generally apply to taxable years ending after October 22, 2004, except that the physical presence requirement applies only to taxable years beginning after October 22, 2004. In addition, taxpayers may choose to apply the rules set forth in these regulations in their entirety (including the physical presence test) to any open taxable years by notifying the IRS upon examination of their intent to do so. Alternatively, for such years, U.S. citizens and resident alien individuals (as well as nonresident aliens in possessions other than mirror code possessions) may continue to apply the principles of §§1.871-2 through 1.871-5, and nonresident alien individuals in mirror code possessions may continue to apply the rules of §301.7701(b)-1(d) (as in effect for such years). B. Income from sources in a possession In general, the rules for determining whether income is derived from sources within the United States have applied for purposes of determining whether income is derived from sources within a possession. See §1.863-6. The 2004 Act codified this rule in section 937(b), with two exceptions. First, section 937(b)(2) (U.S. income rule) provides that an item of income shall not be considered to be derived from sources within a possession (or effectively connected with the conduct of a trade or business within a possession) if such item of income constitutes income from sources within the United States or income effectively connected with the conduct of a trade or 23 EFTA00577282 business in the United States under the general rules of sections 861 through 865. Second, section 937(b) provides an express grant of authority, consistent with the authority contained in sections 931, 934, and 957 as amended by the 1986 Act, for Treasury and the IRS to provide appropriate exceptions to the general source rules. The legislative history to the 2004 Act indicates that Congress intended for Treasury and the IRS to use this authority to continue the existing treatment of income from the sale of goods manufactured in a possession. The 2004 Act legislative history further indicates that Congress intended for this authority to be used to prevent abuse, for example, to prevent U.S. persons from avoiding U.S. tax on appreciated property by acquiring residency in a possession prior to its disposition. See H.R. Rep. No. 108-755, at 781 (2004). The legislative history to the 1986 Act reflects similar concerns. For example, Congress did not believe that a mainland resident who moves to a possession while owning appreciated personal property such as corporate stock or precious metals and who sells that property in the possession should escape all tax, both in the United States and the possession, on that appreciation. Similarly, Congress did not believe that a resident of a possession who owns financial assets such as stocks or debt of companies organized in, but the underlying value of which is primarily attributable to activities performed outside, the possession should escape tax on the income from those assets. Accordingly, Congress anticipated that regulations would treat such income as 24 EFTA00577283 sourced outside the possession where the taxpayer resides. See H.R. Rep. No. 99-426, at 487 and 489 (1985); S. Rep. No. 99-313, at 481 and 484 (1986). These regulations include several exceptions to the general statutory rules of section 937(b). First, the regulations provide that the U.S. income rule only applies for income earned after December 31, 2004. Second, the regulations contain a special conduit rule to prevent the avoidance of the U.S. income rule. Under this special conduit rule, income is considered to be from sources within the United States for purposes of the U.S. income rule 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. This rule supplements, and does not supersede, other potentially applicable conduit rules. See, for example, Aiken Indus. Inc. v. Commissioner 56 T.C. 925 (1971). Unlike more generally applicable conduit rules, however, the special conduit rule in these regulations applies only for purposes of section 937 (and provisions for which the rules of section 937 apply); it does not cause the income to be treated as income from sources within the United States for other purposes of the Code. Third, the regulations preserve the existing treatment of income from the sale of goods manufactured in a possession under §1.863-3(f). These existing rules reflect a careful consideration of the relevant policy considerations arising 25 EFTA00577284 with respect to the transactions to which they apply, and Congress did not intend for this result to be changed through a mechanical application of the general source rules of section 937(b). For the same reason, these regulations contain rules to preserve the results with respect to the allocation of income between the United States and its possessions under sections 863(c), 863(e), 865(g)(3), and 865(h)(2)(B)• Fourth, the regulations provide special rules for gains from dispositions of certain property held by a U.S. person prior to becoming a resident of a possession. Under these rules, such gains generally are treated as income from sources outside of the possession. These rules supplement, and do not supersede, the special source rule of section 1277(e) of the 1986 Act, which applies to individuals who become residents of Pacific possessions. Under this 1986 Act special source rule, gains from dispositions of certain property held by a U.S. person prior to becoming a resident in a Pacific possession is treated as income from sources within the United States for all purposes of the Code (including section 7654 of the 1954 Code as applicable to Guam and the NMI). The regulations also contain rules that are designed to prevent the avoidance of these special gain rules. Fifth, the regulations provide special rules for dividends from corporations created or organized in a possession (possessions corporations). In general, such dividends constitute income from sources within a possession under the principles of section 861(a)(2)(A). A special look-through rule applies, however, when the shareholder owns, directly or indirectly, at least 10 percent of the voting 26 EFTA00577285 stock of the corporation. Under this special rule, only a ratable portion of any dividend paid or accrued by a possessions corporation to such a shareholder is treated as income from sources within the possession. The ratable portion is determined by applying to the dividend the ratio of the corporation's income from sources within the possession over its total income over a three-year testing period ending with the year in which the dividend is paid. (See also sections 881(b) and 957(c) for which a similar three-year testing period applies.) This look-through rule does not apply, however, if the corporation meets the following conditions (the 80/50 conditions)-- (1) 80 percent or more of the gross income of the corporation for the three-year testing period was derived from sources within the possession or was effectively connected with the conduct of a trade or business in the possession; and (2) 50 percent or more of the gross income of the corporation for such period was derived from the active conduct of a trade or business within the possession. Sixth, the regulations provide rules for determining the extent to which income inclusions (for example, under section 951(a)) may be considered to be derived from sources within a possession. Specifically, for shareholders owning at least 10 percent of the voting stock of the corporation, the regulations generally apply the principles of section 904(h)(2), under which the source of income inclusions ordinarily is determined for foreign tax credit purposes. For all 27 EFTA00577286 other shareholders, income inclusions are considered to be derived from sources within the jurisdiction in which the corporation is created or organized. Seventh, the regulations provide rules for determining the extent to which interest payments may be considered to be derived from sources within a possession. In general, interest paid by possessions corporations and noncorporate residents of a possession constitutes income from sources within the possession under the principles of section 861(a)(1). A special look-through rule applies, however, when the interest is paid by a possessions corporation to a shareholder who owns, directly or indirectly, at least 10 percent of the voting stock of the corporation. Under this special rule, which is applied in accordance with the principles of §§1.861-9 through 1.861-12, the interest is treated as income from sources within the possession only to the extent that such interest is allocable to assets giving rise to income from sources within the possession or income effectively connected with the conduct of a trade or business within the possession. This look-through rule does not apply, however, if the corporation meets the 80/50 conditions described above. The regulations further provide that interest pai