SECTION 2. BACKGROUND

.01 Section 937(b) Section 937 was added to the Internal Revenue Code by section 908 of the American Jobs Creation Act (Public Law 108–357). Section 937(a) provides rules for determining whether an individual is a bona fide resident of a U.S. territory. Section 937(b) provides rules for determining whether income is derived from sources within a U.S. territory and whether income is effectively connected with the conduct of a trade or business within a U.S. territory. Section 937(b)(1) provides that, except as provided in section 937(b)(2), rules similar to the rules for determining whether income is income from sources within the United States or is effectively

connected with the conduct of a trade or business within the United States shall apply for purposes of determining whether income is from sources within a U.S. territory or effectively connected with the conduct of a trade or business within a U.S. territory.

Section 937(b)(2) sets forth the U.S. income rule, which provides that income treated as income from sources within the United States or as effectively connected with the conduct of a trade or business within the United States is not treated as income from sources within a U.S. territory or as effectively connected with the conduct of a trade or business within a U.S. territory. Section 937(b) grants the Secretary regulatory authority to provide exceptions to the rules provided in sections 937(b)(1) and (b)(2).

.02 Treasury Regulations under section 937(b) On April 11, 2005, Treasury and the IRS published in the Federal Register temporary regulations (T.D. 9194, 2005–1 C.B. 1016 [70 FR 18920–01], as corrected at 70 FR 32489–01), which provided rules to implement section 937 and to conform existing regulations to other legislative changes with respect to U.S. territories. A notice of proposed rulemaking (REG–159243–03, 2005–1 C.B. 1075

[70 FR 18949–01]) cross-referencing the temporary regulations was published in the Federal Register on the same day. A public hearing was held on July 21, 2005. Final regulations relating to the residence rules under section 937(a) were issued as T.D. 9248, 2006–9 I.R.B. 524, on January 31, 2006. Final regulations under section 937(b) will be issued in a forthcoming Treasury decision.

In general, the proposed and temporary regulations under section 937(b)(1) provide that the principles of sections 861 through 865 and the regulations thereunder are to be applied in determining gross and taxable income from sources within and without a U.S. territory. See Temp. Treas. Reg. § 1.937–2T(b). The proposed and temporary regulations further provide that the principles of section 864(c) and the regulations thereunder are to be applied in determining whether income is effectively connected with the conduct of a trade or

business in a U.S. territory. See Temp. Treas. Reg. § 1.937–3T(b).

The proposed and temporary regulations under section 937(b)(2) incorporate the U.S. income rule, which limits application of the principles of the source and effectively connected income rules under sections 861 through 865 in order to prevent erosion of the U.S. tax base. See Temp. Treas. Reg. §§ 1.937–2T(c)(1) and –3T(c)(1); see also H.R. Rep. No. 108–755, at 794 (2004). Although the proposed and temporary regulations include several examples applying section 937(b) and Temp. Treas. Reg. §§ 1.937–2T and –3T, some of the comments received by Treasury and the IRS indicate an urgent need for additional examples illustrating the operation of the U.S. income rule. Accordingly, this notice provides two such examples.

Treasury and the IRS plan to include these or substantially similar examples in final regulations. Until regulations under section 937(b) are issued in final form, taxpayers may treat the examples set forth in this notice as illustrative of the rules in the temporary regulations. In addition, Treasury and the IRS continue to consider comments received that have requested exceptions or other modifications to the U.S. income rule.