Rev. Rul. 76-535

Advice has been requested as to the proper application of the interest income source rules provided in section 861 of the Internal Revenue Code of 1954 under the circumstances described below in determining the application of section 931, as in effect prior to the enactment of section 1051 of the Tax Reform Act of 1976, Pub. L. 94-455, 94th Cong., 2d Sess. (October 4, 1976.)

M, a domestic corporation, was organized to do business in Puerto Rico. M constructed a manufacturing plant in Puerto Rico in 1974. For its first fiscal year of doing business in Puerto Rico, ending July 31, 1975, M earned 85 percent of its gross income from its manufacturing operations in Puerto Rico. The remaining 15 percent of its gross income was derived from sources within the United States. M qualified as a "possessions corporation" within the meaning of section 931 of the Code for the fiscal year ending July 31, 1975.

In 1974 M borrowed 2,500x dollars from T, an unrelated domestic corporation that has qualified since its inception as a possessions corporation under section 931 of the Code. The funds borrowed by M were used to refinance certain of its existing debts with respect to the construction of its manufacturing plant and to provide working capital. M is required to repay the loan principal and interest in quarterly installments that began on October 1, 1974. M made the required payments out of the funds derived from its business operations in Puerto Rico for its fiscal year ended July 31, 1975.

Section 931(a) of the Code provides, in part, that in the case of a domestic corporation, gross income means only gross income from sources within the United States if the conditions set forth in section 931(a)(1) and (2) are met.

Section 931(a)(1) and (2) of the Code provides, in part, that a domestic corporation qualifies for the benefits of that section of 80 percent or more of its gross income for the 3-year period immediately preceding the close of the taxable year (or for such period immediately preceding the close of the taxable year as may be applicable) was derived from sources within a possession of the United States; and if 50 percent or more of its gross income for such period was derived from the active conduct of a trade or business within a possession of the United States.

The specific question is whether the interest payments made by M to T will be treated as income from sources within the United States or income from sources within Puerto Rico for purposes of qualifying T as a possessions corporation under section 931 of the Code.

In order to determine the source of the interest paid by M to T, it is necessary to apply the source rules set forth in section 861(a)(1)(B), (C), and (D) of the Code. The source rule set forth in section 861(a)(1)(B) is used to determine whether the interest paid by M is from sources within or without the United States. If it is determined that the interest is from sources without the United States, it is also necessary to determine its geographic source in order to ascertain T's qualification under section 931. The source rules of section 861(a)(1)(C) and (D) are used to determine the geographic source of the interest paid by reason of the application of section 1.863-6 of the Income Tax Regulations.

Section 861(a)(1)(B) of the Code provides that interest received from a resident alien individual or a domestic corporation shall not be treated as income from sources within the United States when it is shown to the satisfaction of the Secretary of the Treasury or the Secretary's delegate that less than 20 percent of the gross income from all sources of such individual or such corporation has been derived from sources within the United States, as determined under the provisions of sections 861 through 864, for the 3-year period ending with the close of the taxable year of such individual or such corporation preceding the payment of such interest, or for such part of such period as may be applicable.

Section 1.861-2(c)(4) of the regulations provides that in making the determinations under section 861(a)(1)(B), (C), and (D) of the Code:

(i) The gross income of a domestic corporation or a resident alien individual is to be determined by excluding any items specifically excluded from gross income under chapter 1 of the Code, and

(ii) The gross income of a foreign corporation that is effectively connected with the conduct of a trade or business in the United States is to be determined under section 882(b)(2) and by excluding any items specifically excluded from gross income under chapter 1 of the Code, and

(iii) The gross income from all sources of a foreign corporation is to be determined without regard to section 882(b) and without excluding any items otherwise specifically excluded from gross income under chapter 1 of the Code.

The equation used to determine whether less than 20 percent of gross income from all sources of a taxpayer has been derived from sources within the United States is based upon the provisions of section 861(a)(1)(B) of the Code and section 1.861-2(c)(4)(i) of the regulations. The equation is as follows:

 U.S. sourced income less

      Income from United States Source           $150

If income not included in the definition of gross income for the purpose of section 931 of the Code is included in the denominator of the above equation, the provisions of the Code are not frustrated. The interest paid by the possessions corporation would be from sources without the United States. The equation would be as follows:

      United States sourced income     $   100

Inasmuch as it has been determined that the interest paid by M is from sources without the United States, it is necessary to determine the actual geographic source of such interest in order to ascertain T's qualification under section 931 of the Code.

Income from sources within a possession of the United States is to be determined under the provisions of section 1.863-6 of the regulations.

Section 1.863-1 of the regulations provides, in part, that the principles applied in sections 1.861-1 to 1.863-5, inclusive, for determining the gross and the taxable income from sources within and without the United States shall generally be applied, for purposes of the income tax, in determining the gross and the taxable income from sources within and without a foreign country, or within and without a possession of the United States. In the application of section 1.863-6, the name of the particular foreign country or possession of the United States shall be substituted for the term "United States", and the term "domestic" shall be construed to mean created or organized in such foreign country or possession.

Section 1.931-1(a) of the regulations provides, in part, that, as used in section 931 of the Code, the phrase "possession of the United States" includes Puerto Rico when used with respect to a domestic corporation. That section further provides that this phrase does not include Puerto Rico when used with respect to citizens of the United States.

Therefore, for the purpose of determining income from sources within Puerto Rico with respect to the provisions of section 861 of the Code and the regulations thereunder, the term "Puerto Rico" shall be substituted for the term "United States" and a domestic corporation operating in Puerto Rico shall be deemed to be a foreign corporation with respect to Puerto Rico. Section 861(a)(1)(C) and (D) of the Code is used to determine the source of interest received from a foreign corporation. Because these two subparagraphs are companion subparagraphs they are considered together in determining the source of interest paid by the possessions corporation in the instant case.

Section 861(a)(1)(C) of the Code provides that interest received from a foreign corporation (other than interest paid or credited by a domestic branch of a foreign corporation, if such branch is engaged in the commercial banking business) shall not be treated as income from sources within the United States when it is shown to the satisfaction of the Secretary or the Secretary's delegate that less than 50 percent of the gross income from all sources of such foreign corporation for the 3-year period ending with the close of its taxable year preceding the payment of such interest (or for such part of such period as the corporation has been in existence) was effectively connected with the conduct of a trade or business within the United States.

Section 861(a)(1)(D) of the Code provides that, in the case of interest received from a foreign corporation (other than interest paid or credited by a domestic branch of a foreign corporation, if such branch is engaged in the commercial banking business), 50 percent or more of the gross income of which from all sources for the 3-year period ending with the close of its taxable year preceding the payment of such interest (or for such part of such period as the corporation has been in existence) was effectively connected with the conduct of a trade or business within the United States, an amount of such interest that bears the same ratio to such interest as the gross income of such foreign corporation for such period that was not effectively connected with the conduct of a trade or business within the United States bears to its gross income from all sources shall not be treated as income from sources within the United States.

Section 861(d)(1) of the Code provides, in part, that for purposes of section 861(a)(1)(B), (C), and (D), if the resident alien individual, domestic corporation, or foreign corporation, as the case may be, has no gross income from any source for the 3-year period (or part thereof) specified, the 20-percent test or the 50-percent test, as the case may be, shall be applied with respect to the taxable year of the payor in which payment of the interest is made.

Section 862(a)(1) of the Code provides that interest other than that derived from sources within the United States as provided in section 861(a)(1) shall be treated as income from sources without the United States.

The source of M's interest payment is to be determined under the provisions of section 861(a)(1)(D) of the Code because in substituting the term "Puerto Rico" for the term "United States" and treating domestic corporation M as a foreign corporation to Puerto Rico, M has derived 50 percent or more of its gross income from Puerto Rico. Under the facts of the instant case 85 percent of M's gross income was earned from business operations in Puerto Rico. The equations for determining the source of the interest received from M are as follows:

 1. Percent of gross income from sources without Puerto Rico

              $100.

Accordingly, in the instant case, pursuant to the principles of section 861(a)(1)(D) of the Code, the amount of the interest payments received by T from M to be treated as sourced without Puerto Rico is that part of such interest that bears the same ratio to such interest as the gross income of M that was not effectively connected with the conduct of a trade or business within Puerto Rico bears to its gross income from all sources. Inasmuch as 15 percent of M's gross income was not effectively connected with the conduct of a trade or business within Puerto Rico, 85 percent of such interest payments received by T will be treated as income from sources within Puerto Rico for purposes of section 931 and 15 percent of such payments will be treated as income from sources without Puerto Rico.