JOURNAL OF INTERNATIONAL TAXATION30 JOURNAL OF INTERNATIONAL TAXATION 31

The rules governing when the United Stateswill treat gain from the sale of property recog-nized by a foreign corporation or nonresidentalien as effectively connected with a U.S. tradeor business are in myriad provisions, most ofwhich are in Part I of Subchapter N of theInternal Revenue Code. Although these rulesare not particularly difficult to understand inconcept, they tend to be quite confusing inapplication.This is primarily because they arenot organized logically, so it is necessary tonavigate through a veritable maze of cross-ref-erences and exceptions. The purpose of thisarticle, and the accompanying flowcharts, is toprovide a roadmap to assist in that navigation.

GainfromProperty

R O B E R T P . R O T H M A N

SalesasEffectively

IncomeConnected

...aroadmap

The general rule for the source ofgain from the sale of property isthat it is determined by referenceto the taxpayer’s residence.If the general rule were controllingin all instances, there would be noneed for this article.

immediately before the property ceasedto be so used (Section 864(c)(7)).4

Force-of-attraction principle. Onceit is determined that a taxpayer is ETB(or is subject to one of the exceptionsdiscussed above), the general rule is thatwhether income is ECI depends on itssource. Thus, subject to a few excep-tions, U.S.-source income is ECI (Sec-t ion 864(c)(3)); non-U.S.-sourceincome is not (Section 864(c)(4)(A)).The first part of this proposition is fre-quently called the “unlimited force-of-attraction principle,” reflecting the ideathat once a U.S. trade or business isfound to exist, it attracts to it all U.S.-source income, whether or not theincome was actually generated by theoperations of the business.5

U.S.-source income not subject tounlimited force of attraction. A few cat-egories of U.S.-source income are notsubject to the unlimited force-of-attrac-tion principle.One consists of gain fromthe sale of capital assets. A second cate-gory consists of FDAPI (Section864(c)(2)). In general,however,gain fromthe sale of property is definitionallyexcluded from FDAPI (Reg. 1.1441-2(b)(2)(i)); the only exceptions are (1)for a sale of a debt instrument,an amountequal to the original issue discount that

accrued while held by the seller (Section871(a)(1)(C)(i)); (2) gains on the dispo-sition of certain natural resource proper-ty with a retained economic interest(Section 871(a)(1)(B)); and (3) gainsfrom the sale of certain intangibles wherethe consideration is contingent on pro-ductivity, use,or disposition of the prop-erty (Section 871(a)(1)(D)).If the property sold falls within one of

these categories and the gain on the saleis U.S. source, the gain is not automati-cally ECI. Instead, the Code provides that“the factors taken into account [in deter-mining whether the gain is ECI] shallinclude whether” (1) the gain is derivedfrom assets used or held for use in theconduct of the trade or business (“asset-use”test),or (2) the activities of the tradeor business were a material factor in therealization of the gain (“business-activi-ties” test) (Sections 864(c)(2)(A) and(B)).6This formulation suggests that nei-ther test is, in itself, determinative, andthat there may be other factors that arealso taken into account. However, somecommentators have taken the positionthat U.S.-source income in these cate-gories is, per se, ECI if it satisfies eitherthe asset-use or business-activities test.7In general, the asset-use test looks to

whether the asset was, prior to being

sold, used (or held for use) in the U.S.trade or business. If so, the test is satis-fied even if the sale itself did not haveanything to do with the trade or busi-ness (see Reg. 1.864-4(c)(2)).Converse-ly, the business-activities test looks at theextent to which the sale itself was con-nected with the U.S. trade or business—whether the property was used in thetrade or business before being sold isirrelevant (see Reg. 1.864-4(c)(3)).These rules do not mean that gain on

the sale of any capital asset will automat-ically be treated as ECI if the asset-usetest or the business-activities test is sat-isfied. Analy tically, these tests arereached only once it has been deter-mined that gain from the sale of a capi-tal asset (or another type of asset notsubject to the unlimited force-of-attrac-tion principle) is U.S. source. As dis-cussed below, the source of gain from thesale of property is a complex topic. Fre-quently, this gain will turn out to be for-eign source, in which event the asset-useand material-factor tests are irrelevant.

Foreign-source income. As notedabove, generally foreign-source incomeis not ECI (Section 864(c)(4)(A)). Sec-tion 864(c)(4) provides four exceptionsto this rule.Two of those exceptions,cov-ering certain rents, royalties, dividends,

GAIN FROM PROPERTY SALES AS EFFECTIVELY CONNECTED INCOME l JULY 2009 l JOURNAL OF INTERNATIONAL TAXATION 33

Basic FrameworkThe basic framework for the taxation offoreign persons is in Sections 871 (non-resident alien individuals) and 881 and882 (foreign corporations). In general,under these rules, income is classifiedin one of three basic categories. First,income that is effectively connectedwith the conduct of a U.S. trade or busi-ness (effectively connected income(ECI)) is subject to U.S. tax in essential-ly the same manner as it would be if itwere recognized by a U.S. person (Sec-tions 871(b), 882). Second, some typesof income that are not ECI are subjectto a 30% tax on gross income, but onlyif they are from U.S. sources (Sections871(a), 881). This generally applies tocertain categories of passive incomedescribed in Section 871(a)(1) (fixed ordeterminable annual or periodicalincome (FDAPI)).1 Finally all otherincome—that is, any income that is notECI or FDAPI—is not subject to U.S.tax when recognized by a foreign per-

son. This article is limited to a discus-sion of the application of the ECI net-basis taxation regime to income fromthe sale of property.2

ECI RulesThe starting point for determiningwhether gain from the sale of propertyis ECI is determining whether the tax-payer is engaged in a U.S. trade or busi-ness (“ETB”) in the first place. Whatconstitutes a U.S. trade or business isthe subject of a large body of law, andis beyond the scope of this article.3What is important to understand—andmay not always be quite as obvious asit would seem—is that, in general,income cannot be effectively connect-ed with a U.S. trade or business unlessthe taxpayer is engaged in such a tradeor business (Section 864(c)(1)(B)).

Non-ETB taxpayers. As always, how-ever, there are exceptions. One excep-t ion (derived from the ForeignInvestment in Real Property Tax Act(FIRPTA)) applies when the propertysold constitutes a “U.S. real propertyinterest.” In that event, the taxpayer istreated as though it were ETB and thegain were ECI, even if the taxpayer isnot otherwise ETB (Section 897(a)).

In addition to FIRPTA, there are afew other circumstances where a tax-payer can have ECI without being ETB.The most important of these deals withtwo situations where a taxpayer is notETB in the year in which gain was rec-ognized, but was previously so engaged.Section 864(c)(6) applies where prop-erty is sold in a year in which the tax-payer was ETB, but some or all of thegain is recognized in a year in which thetaxpayer is not ETB (for example,wherethe gain from the sale was reported onthe installment method and the taxpay-er is no longer ETB in the year that pay-ments are received). In this situation,the tests for determining whether thegain is ECI (discussed in detail below)are applied as though the gain were rec-ognized in the year of sale (Section864(c)(6)).A similar rule applies where the

property had previously been used (orheld for use) in connection with a U.S.trade or business but ceased to be soused before it was sold. In this situation,if the sale takes place within ten yearsof the time that the property ceased tobe used in a U.S. trade or business, thetests for determining whether the gainis ECI (discussed in detail below) areapplied as though the sale occurred

JOURNAL OF INTERNATIONAL TAXATION l JULY 2009 l GAIN FROM PROPERTY SALES AS EFFECTIVELY CONNECTED INCOME32

ROBERT P. ROTHMAN is Senior Counsel in the NewYork office of Akin Gump Strauss Hauer & Feld LLP,where he practices in the area of federal income tax-ation. He thanks Stuart Leblang, Daniel Paulos, andA. Elijah Green for their helpful comments and assis-tance in the preparation of this article. The viewsexpressed herein are solely those of the author, as isresponsibility for any errors.

The rules can be quiteconfusing in applicationbecause they are not organizedlogically, so it is necessary to

navigate through averitable maze of cross-references and exceptions

EXHIBIT 2Source Rules—Office or Fixed Place of Business

EXHIBIT 1General ECI Rules

GAIN FROM PROPERTY SALES AS EFFECTIVELY CONNECTED INCOME l JULY 2009 l JOURNAL OF INTERNATIONAL TAXATION 3534

ECI

Got to Exhibit 4

Not ECI

Got to Exhibit 5

YesYes Yes

No

Yes Yes

Go to Exhibit 1,Location B

No

Go to Exhibit 1,Location A

No

Go to Exhibit 7

No

Go to Exhibit 7

No

Go to Exhibit 7

Go to Exhibit 5

No

No No

Yes

Yes

No No

C

A

B

No Yes

Yes

Yes

Yes

Go to Exhibit 6 Got to Exhibit 2 Got to Exhibit 3

Is the property aUSRPI? Is the taxpayer ETB?

Does the taxpayerhave a U.S. officeor other fixed place

of business?

Is the propertydepreciable personal

property?

Is the propertyinventory?

Is the property anintangible describedin Section 865(d)(2)?

Is the saleattributable tothe U.S. office?

Is the propertyinventory?

Was therematerialparticipation bya foreign officeor fixed place ofbusiness?

Was the propertysold for use,disposition, orconsumptionoutside the U.S?

Is the propertypersonalproperty?

EXHIBIT 4Source Rules—Intangibles

Is the propertygoodwill?

Are paymentscontingent on

productivity, use,or disposition?

No

No

Yes Yes

Will property beused in U.S.?

No

Not ECI

Was the goodwillgenerated in the

U.S.?

No

Yes Yes

EXHIBIT 3Source Rules—Depreciable Personal Property

No

Recapture portionof gain

YesGain in excess ofdepreciation

Is the propertyan intangibledescribed in

Section 865 (d)(2)?

JOURNAL OF INTERNATIONAL TAXATION l JULY 2009 l GAIN FROM PROPERTY SALES AS EFFECTIVELY CONNECTED INCOME

ECI in proportionto U.S. depreciation

as a fractionof total

Go to Exhibit 4

Go to Exhibit 5

Go to Exhibit 2,Location A Not ECI

Go to Exhibit 7

Apply asset useand businessactivities tests

and interest (Sections 864(c)(4)(B)(i)and (ii)) are, by their terms, inapplicableto gain on the sale of property. A thirdexception is limited to certain insurancecompanies, and is beyond the scope ofthis article (see Section 864(c)(4)(C)).The fourth exception,which appears

on its face potentially to apply to gainson the sale of property, is something ofa red herring. Section 864(c)(4)(B)(iii)provides that foreign-source incomefrom the sale of inventory outside theUnited States that is attributable to anoffice or fixed place of business in theUnited States is ECI. There is an excep-tion where (1) the property is sold foruse, disposition, or consumption out-side the United States, and (2) a foreignoffice or fixed place of business mate-rially participated in the sale.However, as discussed below, under

Section 865(e)(2), a sale of any prop-erty (whether or not it is inventory andregardless of where the sale takes place)by a nonresident that is attributable toa U.S. office or fixed place of business istreated as U.S.-source income (subjectto an exception identical to the excep-tion under Section 864(c)(4)(B)(iii)).Thus, any gain that otherwise would be

subject to Section 864(c)(4)(B)(iii) is,in almost all instances, preempted bySection 865(e)(2). Section 865(e)(2)characterizes that gain as U.S. source,whereupon it becomes ECI under theunlimited force-of-attraction principle.The analysis never gets as far as Section864(c)(4)(B)(ii i), which (if it didapply) would treat foreign-sourceincome as ECI.8

Source RulesThe foregoing discussion shows that acrucial step in the analysis of whethergain from the sale of property is ECI isthe determination of whether that gainis U.S. or foreign source.That is the nextissue discussed below.

General source rule. The general rulefor the source of gain from the sale ofproperty is that it is determined by refer-ence to the taxpayer’s residence. That is,gain recognized by a U.S. resident is U.S.source,and gain recognized by a nonres-ident is foreign source (Section 865(a)).For this purpose,a corporation is deemedto be a resident in the jurisdiction whereit is organized (Sections 865(g)(1)(A)(ii),865(g)(1)(B), 7701(a)(30)(C)).

If the general rule were controllingin all instances, there would be no needfor this article. Gain recognized by aforeign person on the sale of propertywould automatically be foreign sourceand, therefore, would (except for gainrecognized by certain insurance com-panies) be non-ECI. Alas, all is not sosimple. Several exceptions to the gener-al source rule all but swallow up thegeneral rule.

Office or other fixed place of busi-ness. Under the first exception, whichapplies “[n]othwithstanding any otherprovisions of this part,” if gain from asale of personal property (including,but not limited to, inventory) is“attrib-utable to” an office or other fixed placeof business in the United States, the gainis sourced in the United States (Section865(e)(2)(A)).However, this special ruledoes not apply if (1) the property sold isinventory, (2) it is sold for use, disposi-tion, or consumption outside the UnitedStates, and (3) in addition to the U.S.office, an office or fixed place of businessmaintained by the taxpayer in a foreigncountry also materially participated inthe sale (Section 865(e)(2)(B)). If thisexception applies, the effect is not to

JOURNAL OF INTERNATIONAL TAXATION l JULY 2009 l GAIN FROM PROPERTY SALES AS EFFECTIVELY CONNECTED INCOME36 37GAIN FROM PROPERTY SALES AS EFFECTIVELY CONNECTED INCOME l JULY 2009 l JOURNAL OF INTERNATIONAL TAXATION

EXHIBIT 5Source Rules—Inventory

Is the propertyunprocessed softwoodtimber cut in the U.S.?

Was the propertyproduced in U.S.and sold abroad(or vice versa)?*

Does sale occurin U.S.?

No No

Yes

No

Yes

Non-U.S.-source portion

U.S.-sourceportion

No

Go to Exhibit 7,Location D Not ECI

Not ECIECI

Go to Exhibit 7,Location E

*Allocation under Section 863(b) also applies where inventory is purchased in a possession and sold in U.S. (but not vice versa).

Allocation of sourceunder Section 863(b)

EXHIBIT 7ECI Rules—U.S-Source Property

Is the propertya capital asset?

Yes

Yes

Remainderof gain

No

Is the property a debtinstrument with OID?

No

Is the propertydescribed in Section631(b) or (c) (naturalresource property soldwith retained interest)?

No

OID accrued whiletaxpayer held

D

E

ECI

Not ECI

Apply asset useand businessactivities tests

EXHIBIT 6ECI Rules—Non-ETB Taxpayers

Was the taxpayerETB in the year

of sale?

Was the taxpayerETB within ten years

prior to sale?

Was the propertyused in trade orbusiness withinten-year period?

No Yes Yes

Yes

Yes No No

Go to Exhibit 1,Location C; apply

remainder of tests asthough gain were re-cognized at time

of sale

Not ECI Not ECI

Go to Exhibit 1;Location C; applyremainder of tests

as though sale took placebefore cessation of U.S.trade or business

erty sold is an interest in a partnershipthat itself has a U.S. office or other fixedplaces of business. These facts were thesubject of Rev. Rul. 91-32, 1991-1 CB107, in which the Service concludedthat (1) the partnership’s office or oth-er fixed place of business is attributedto the selling partner,10 and (2) gain onthe sale of the partnership interest ispresumed to be attributable to thatoffice or other fixed place of business.In reaching the latter conclusion, theService first reasoned that the “aggre-gate” theory of partnership taxationshould apply for this purpose. It thenapplied the asset-use test of Reg. 1.864-4(c)(2) to conclude that a hypotheticalsale by the partnership of assets used inits trade or business would have givenrise to ECI and that, under the aggre-gate theory, gain from a sale of the part-nership interest should be similarlycharacterized.As discussed above, the asset-use

test, where applicable, applies only tocertain limited categories of assets and,more importantly, only once it has beendetermined that the income is U.S.source.Rev.Rul. 91-32 seems to assumethat gain from the sale of any asset bythe partnership would be U.S. sourceand subject to the asset-use test.

The Ruling does allow some leewayto rebut the all-ECI presumption. If theselling partner can establish that a por-tion of the gain that the partnershipwould have recognized on a hypothet-ical sale of all of its assets would not beECI, a corresponding portion of thegain from the sale of the partnershipinterest is not ECI. However, as dis-cussed throughout this article, whethergain from the sale of property is ECImay depend on several different factors.Therefore, absent an actual sale, it is notclear how to apply these factors.For example, as discussed below,

income from the sale of inventory is gen-erally sourcedwhere the sale takes place.11

Thus, an actual sale could give rise toeither ECI or non-ECI, depending onwhere the sale takes place (although, asnoted below, the place of sale could bedetermined based on all of the facts andcircumstances if the sale is arranged in aparticular manner for the primary pur-pose of tax avoidance). In applying thehypothetical sale approach of Rev. Rul.91-32 to a partnership that owns invento-ry, what is the assumed location of thesale? Since the Ruling places the burdenon the taxpayer to rebut the all-ECI pre-sumption, the Service conceivably couldtake the position that all gain from the

sale of the partnership interest is ECIexcept to the extent that the taxpayer canestablish, with respect to a particularasset, that gain from a hypothetical saleof that asset would be non-ECI regard-less of the circumstances of the sale.Thiswould lead to gain on the sale of the part-nership interest being ECI even if an actu-al sale of partnership assets could havebeen structured to produce non-ECI.The reasoning and conclusion of

Rev. Rul. 91-32 have been criticized12

and seem difficult to reconcile with thelanguage of the Code. Nonetheless, itevidently continues to represent theService’s position.

Depreciable personal property. Thesecond exception to the general sourcerule for sales of property applies whenthe property is depreciable personalproperty. Gains from the sale of thisproperty are bifurcated into two com-ponents. The first is an amount of gainup to the prior depreciation deduc-tions that are reflected in the basis ofthe property. This component is allo-cated between U.S. source and foreignsource by treating it as U.S. source inthe same proport ion that the U.S.depreciation adjustments with respectto the property bear to total deprecia-tion adjustments (Section 865(c)(1)).

GAIN FROM PROPERTY SALES AS EFFECTIVELY CONNECTED INCOME l JULY 2009 l JOURNAL OF INTERNATIONAL TAXATION 39

treat the gain automatically as foreignsource. Rather, it simply negates theeffect of the “office or fixed place ofbusiness” rule (which otherwise wouldhave caused the gain to be U.S. sourceautomatically). It is still necessary toapply the other relevant sourcing rules.In particular, since the exception isavailable only for inventory, the effectof qualifying for the exception from theoffice or fixed place of business rule isthat the source will be tested under therules applicable to sales of inventory.In determining whether (1) a taxpay-

er has an office or other fixed place ofbusiness, and (2) gain on a sale of prop-erty is “attributable to” such an office orother fixed place of business, the Codesays that the principles of Section864(c)(5) apply (Section 865(e)(3)).Sec-tion 864(c)(5),and theRegulations there-under, provide rules for applying Section864(c)(4)(B)(iii), under which foreign-source gains from sales of property canbe treated as ECI if they are attributable toa U.S. office or other fixed place of busi-ness. As discussed above, however, Sec-tion 864(c)(4)(B)(iii) itself has beenalmost entirely preempted by Section865(e)(2) and, in the context of propertysales, has extremely limited application.9Thus, in that context, Section 864(c)(5)

and the Regulations thereunder have lit-tle significance other than for purposesof applying Section 865(e)(2).In general, an office or other fixed

place of business is a “fixed facility”throughwhich a foreign taxpayer engagesin a trade or business.There is no require-ment that the facility be used continuous-ly (Reg.1.864-7(b)(1)).However,where aforeign taxpayer uses another person’soffice or fixed place of business (includingthose of a related person) to conduct itsbusiness, such use does not cause the tax-payer to have an office or other fixed placeof business if the taxpayer’s use of thefacilities is sporadic or infrequent (Reg.1.864-7(b)(2)). A fixed facility is nottreated as an office or other fixed place ofbusiness if the only activity conductedfrom the facility is general supervision orcontrol, including topmanagement deci-sions (Reg. 1.864-7(c)).Special rules apply to determine

whether an office or other fixed place ofbusiness of an agent is attributed to aprincipal that is a foreign taxpayer.Wherethe agent is an independent agent—thatis, a general commission agent,broker,orother agent of independent status actingin the ordinary course of its business(Reg. 1.864-7(d)(3))—the facility is notattributed to the principal (Reg. 1.864-

7(d)(2)).For a dependent agent, the facil-ity is attributed to the principal only ifthe agent (1) has, and regularly exercises,the authority to bind the principal con-tractually, or (2) maintains a stock ofmerchandise belonging to the principalfrom which it regularly fills orders (Reg.1.864-7(d)(1)). In determining whetheran agent is dependent or independent,that the agent may be related to or con-trolled by the principal is disregarded(Reg. 1.864-7(d)(3)(ii)); where there isan exclusive agency relationship betweenthe parties, all of the facts and circum-stances are considered (Reg. 1.864-7(d)(3)(iii)).Once it has been determined that a

foreign taxpayer has a U.S. office or oth-er fixed place of business, the next ques-tion is whether particular income isattributable to that office or other fixedplace of business. Gain is treated asattributable to an office or other fixedplace of business only if (1) the office orother fixed place of business is a mate-rial factor in the realization of the gain,and (2) the gain“is realized in the ordi-nary course of the trade or business car-ried on through the office or other fixedplace of business” (Reg. 1.864-6(b)).A special twist on the “attributable

to” standard may apply where the prop-

JOURNAL OF INTERNATIONAL TAXATION l JULY 2009 l GAIN FROM PROPERTY SALES AS EFFECTIVELY CONNECTED INCOME38

What may not always be asobvious as it would seem is

that, in general, incomecannot be effectively

connectedwith a U.S. trade orbusiness unless the taxpayer is

engaged in such a trade or business

secret processes or formulæ, goodwill,trademarks, trade brands, franchises,and “other like property” (Section865(d)(2)). If this exception applies, thegain is sourced as though it were a roy-alty (Section 865(d)(1)(B)). In general,royalties for the use of property (includ-ing intangible property) are sourcedaccording to where the property is used(see Sections 861(a)(4), 862(a)(4)).

Inventory. The general rule for sourc-ing gain from the sale of inventory14 isthat the source is where the sale occurs(Sections 861(a)(6), 862(a)(6); see Sec-tion 865(b)).15 This is generally where“the rights, title, and interest of the sell-er in the property are transferred to thebuyer.”However, if a sales transaction isarranged in a particular manner for“theprimary purpose” of tax avoidance, all

factors, including negotiations, execu-tion of the agreement, location of theproperty, and place of payment are con-sidered in determining where the sub-stance of the sale occurred.16

As always, there are exceptions, themost important of which applies whenthe taxpayer produced the propertywith-in theUnited States and sold it outside theUnited States, or vice versa. In that situa-

GAIN FROM PROPERTY SALES AS EFFECTIVELY CONNECTED INCOME l JULY 2009 l JOURNAL OF INTERNATIONAL TAXATION 41

In general, U.S. depreciation adjust-ments are those that were allowable incomputing U.S.-source taxable income(Section 865(c)(3)(A)).13

The component of gain that exceedsprior depreciation adjustments is gen-erally sourced under the rules for salesof inventory (Section 865(c)(2)). Asdiscussed below, these rules generallyconsider where the sale takes place,with

two exceptions. First, if the propertysold consists of intangibles described inSection 865(d)(2) and the price atwhich it is sold is contingent on the use,disposition, or productivity of theintangibles, special sourcing rules apply,discussed below (Section 865(d)(1)).Second, if the property consists ofgoodwill (and the price is not contin-gent on use, disposition, or productiv-

ity), the gain from the sale is sourcedaccording to where the goodwill wasgenerated (Section 865(d)(3)).

Contingent-price sales of intangibles.The third exception to the generalsource rule applies to sales of certainintangibles where the price is contingenton the use, disposition, or productivityof the property.The intangibles coveredby this rule are patents, copyrights,

JOURNAL OF INTERNATIONAL TAXATION l JULY 2009 l GAIN FROM PROPERTY SALES AS EFFECTIVELY CONNECTED INCOME40

Acrucial step in the analysis ofwhether gain from the sale of

property is effectively connected

income is the determination of

whether that gain is U.S. orforeign source

1 In theory, the gross-basis taxation regime alsoapplies to U.S.-source non-ECI capital gains recog-nized by a nonresident alien individual who is pres-ent in the U.S. for 183 days or more during thetax year. Section 871(a)(2). However, in almost allinstances, an alien who is present for that periodwill be treated as a resident under Section 7701(b),so it is extremely rare that Section 871(a)(2) willactually apply. There are theoretically circum-stances under which this is possible, which resultfrom different rules governing which days are tak-en into account under Sections 871(a)(2) and7701(b). For example, an individual who is unableto leave the United States due to a medical con-dition may be treated as present for purposes ofSection 871(a)(2) but not Section 7701(b). SeeSection 7701(b)(3)(D).

2 There may be an issue as to whether a particularitem of income is from the sale of property. Forexample, Section 1234A treats gain attributableto the cancellation, lapse, expiration, or termina-tion of certain types of financial instruments asgain or loss from the sale of a capital asset.Wherean item of income is from a sale, there may beissues as to which particular type of income itshould be classified as. For example, a trader insecurities may elect, under Section 475(f), toaccount for its trading activities bymarking to mar-ket. A trader that so elects recognizes gain on its

securities as though it had sold them for fair mar-ket value at the end of each year. Section475(f)(1(A). Moreover, Section 475(f) incorporatesby reference Section 475(d)(3), which treats anysuch gain as ordinary. However, there may be anissue as to whether the gain should be tested forECI status under the unlimited force-of-attractionrule of Section 864(c)(3) or under the more limit-ed rule of Section 864(c)(2). See letter from LeonM. Metzger to Donald C. Lubick, Asst. SecretaryforTax Policy, February 11, 1999, 1999TNT 37-23.These issues are beyond the scope of this article.

3 For more on this issue, see Katz and Plambeck,908T.M. (BNA), U.S. Income Taxation of ForeignCorporations; Kuntz and Peroni, U.S. Internation-al Taxation (Thomson Reuters/WG&L), ¶ C1.04(4).

4 The Code provides a few other limited situationsin which a taxpayer can have ECI even withoutbeing ETB, but these are not relevant to gain onsales of property. Section 882(e), which appliesto banks organized in U.S. possessions, appliesonly to certain interest income. Sections 871(d)and 882(d), which allow taxpayers engaged in realestate activities to elect to be treated as ETB evenif they are not actually so engaged, is effectivelyirrelevant with respect to gain on sale since thegain is treated as ECI under FIRPTA regardless ofwhether the election is made.

5 One might designate the converse rule for non-U.S.-source income the “unlimited force-of-repul-sion principle.”

6 Regulations also provide a separate rule for gainon stocks or securities by a taxpayer engaged inthe active conduct of a banking, financing, or sim-ilar business. Reg. 1.864-4(c)(5). A detailed discus-sion of this rule is beyond the scope of this article.

7 See, e.g., Katz and Plambeck, supra note 3, pageA-24; Kuntz and Peroni, supra note 3,¶ C1.04[5][c][i].

8 Under very limited circumstances, Section864(c)(4)(B)(iii) can apply. Section 865(g) defines“resident” and “nonresident” for purposes ofSection 865 slightly differently from the Section7701(b) definition (which applies for other purpos-es, including Section 864). For example, if an indi-vidual who sells inventory property is anonresident alien under the general rule of Section7701(b) but has a tax home in the United States,he is a resident (for Section 865 purposes) underSection 865(g). Thus, the “office or other fixedplace of business” rule of Section 865(e)(2) doesnot apply. However, because the property is inven-tory, the general rule of Section 865(a), whichequates source to residence, does not apply (seeSection 865(b)); instead, the income is sourcedby the place of sale. Thus, if the sale takes place

abroad, the income would be foreign source. Inthat event, if the sale is attributable to a U.S. officeor other fixed place of business, Section864(c)(4)(B)(iii) would nonetheless characterize theincome as ECI.

9 As discussed in note 8, supra, Section864(c)(4)(B)(iii) can still apply in the rare instancewhere inventory is sold by a nonresident individ-ual who has a tax home in the United States (andwho is, therefore, not a resident for Section 865purposes). Section 864(c) is also relevant in deter-mining whether certain other categories of for-eign-source income, such as rents, royalties,dividends, and interest are ECI. See Sections864(c)(4)(B)(i) and (ii). Discussion of these othercategories of income is beyond the scope of thisarticle.

10 This conclusion is generally consistent with Sec-tion 875, which treats a partner as engaged in atrade or business if the partnership is so engaged.

11 As discussed in the text below, gain on deprecia-ble personal property (to the extent that it exceedsprior depreciation adjustments) is also generallysourced as if it were inventory.

12 See, e.g., Blanchard, “Rev. Rul. 91-32: Extrastatu-tory Attribution of Partnership Activities to Part-ners,” 97TNT 173-69.

13 For certain specifically enumerated types of prop-erty that were used predominantly within or out-side the U.S. during a given year, all depreciationadjustments for the year are treated as either U.S.or non-U.S., depending on the location of the pre-dominant use. See Section 865(c)(3)(B).

14 As noted in the text above, this rule also general-ly applies to gain on the sale of depreciable per-sonal property, to the extent that the gain exceedspreviously claimed depreciation deductions.

15 Technically, Sections 861(a)(6) and 862(a)(6) applythe place-of-sale rule when the property was notpurchased in the place (within or outside the Unit-ed States) where the sale takes place. It wouldseem that, a fortiori, this rule should also applywhen the purchase occurred in the same place;Reg. 1.861-7(a) so provides, and the cases are con-sistent with that interpretation. See, e.g., CardingGill Ltd., 38 BTA 669 (1938).

16 Reg. 1.861-7(c). On authorities applying the “titlepassage” rule, see Blessing and Lubkin, 905-2ndT.M. (BNA), Source of Income Rules, ¶ VII(B)(1)(a).

17 For similar rules where the production takes placein a U.S. possession and the sale in the UnitedStates (or vice versa), see Reg. 1.863-3(f)(2).

18 Section 863(b)(3). Unlike the rule for production,the purchased inventory rule applies only to pos-sessions (not foreign countries) and does not

apply in reverse (that is, where the purchaseoccurs in the United States and the sale is in apossession).

19 Please do not panic; the analysis of whether prop-erty is a USRPI can itself give rise to significantlegal fees.

20 If Section 865(e)(2) does not apply because theproperty is not personal property, when returningto Exhibit 1, skip testing whether it is depreciablepersonal property or intangible property since theanswer to those questions will necessarily be“no.”

21 This does not depend on whether the characterrecapture rules of Section 1245 or 1250 apply.

22 Since the only possible exception from the unlim-ited force-of-attraction principle that could applyto the property is that applicable to propertydescribed in Section 631(b), skip directly to thatexception.

23 By definition, inventory is not a capital asset;hence, Exhibit 7 skips over the test that looks tocapital asset status.

24 The exception is U.S.-source gain from contingent-payment sales of intangibles, where the determi-nation of whether it is ECI is covered in Exhibit 4.

sales; and (3) the amount of possessionpurchase sales (Reg. 1.863-3(f )(3)(ii)(B)).Alternatively, the taxpayer,withthe Service’s prior consent,may use thebooks-and-records method to allocatethe source of income (Reg. 1.863-3(f)(3)(i)(B)).

Putting it all TogetherThe flowcharts in the exhibits summa-rize the foregoing graphically, to pro-vide a literal map through the maze. InExhibit 1, the first inquiry is whetherthe property sold is a USRPI. If so, godirectly to ECI—do not pass Go, do notcollect large legal fees for analyzingsource rules.19

If the property is not a USRPI, thenext inquiry is whether the taxpayer isETB. If so, Exhibit 1 goes on to testwhether the sale is potentially subjectto any of the exceptions to the generalsale-of-property source rule. If noexceptions apply, under the generalsource rule, the source of income is for-eign (since a non-U.S. taxpayer isassumed); hence, the income is not ECI.Alternatively, if the taxpayer is not

ETB,Exhibit 1 tells us to go to Exhibit 6,which determines whether either of the“formerly ETB”rules applies. If not, the

conclusion is that the income is notECI; otherwise, return to Exhibit 1.The first possible exception to the

general source rule is where the tax-payer has a U.S. office or fixed place ofbusiness. If so, Exhibit 2 analyzes theapplication of Section 865(e)(2). Thethreshold requirements for this sectionto apply are that (1) the property mustbe personal property, and (2) the salemust be attributable to a U.S. office orother fixed place of business. If eitherof these two requirements is not satis-fied, the income will not be sourcedunder Section 865(e)(2), so return toExhibit 1 to see whether any of the oth-er exceptions to the general sourcingrule apply.20 If the basic requirementsfor application of Section 865(e)(2) aresatisfied, it still must be determinedwhether the except ion of Sect ion865(e)(2)(B) is available. If any of thethree requirements for that exceptionare not available, the income is U.S.source, so we go to Exhibit 7 (moreabout that below). If all of the require-ments for the Section 865(e)(2)(B)exception are available, it is still neces-sary to test whether it could be U.S.source under another rule; since it hasalready been determined (as one ofthe requirements for the Sect ion865(e)(2)(B) exception) that the prop-erty is inventory, go to Exhibit 5, whichaddresses the rules for inventory.Back to Exhibit 1, the next test is

whether the property is depreciable per-sonal property. If so, go to Exhibit 3,which applies the rules of Section865(c). The “recapture” portion of thegain (that is, gain up to the depreciationdeductions previously claimed)21 is U.S.source in proportion to the U.S.depreci-ation as a fraction of total depreciation.Moreover, depreciable personal proper-ty cannot qualify for any of the excep-tions to the unlimited force-of-attractionprinciple, so the U.S.-source portion isnecessarily ECI. Gain in excess of therecapture portion is tested under therules applicable to either inventory orintangibles, so the next step is Exhibit 4or 5, as appropriate.Returning to Exhibit 1, if the proper-

ty is an intangible described in Section865(d)(2), go to Exhibit 4, which

applies the rules of Section 865(d). Thefirst inquiry is whether the considera-tion for the sale is contingent on theuse, productivity, or disposition of theproperty. If, so, apply the royalty-sourc-ing rule,which looks to where the prop-erty will be used. If the use is outsidethe United States, the source is foreignand the gain is not ECI. If the use iswithin the United States, the source isU.S.; however, since gain from contin-gent-payment sales of intangibles is oneof the exceptions to the unlimitedforce-of-attraction rule, it is still neces-sary to apply the asset use and businessactivity tests to determine whether thegain is ECI.If the consideration for the sale is not

contingent on use, productivity, or dis-position, the next question is whetherthe property is goodwill. If so, thesource is determined based on wherethe goodwill was generated. If thesource, as so determined, is foreign, thegain is not ECI; if the source is U.S., goto Exhibit 7. If the property is not good-will, return to Exhibit 1.Exhibit 5 applies the rules for sales

of inventory. The first quest ion iswhether the property is subject to thespecial rule for unprocessed softwoodtimber cut in the United States. If so, itis U.S. source, so go to Exhibit 7.22 Ifnot, ask whether the gain from theproperty is subject to allocation underSection 863(b), and, if appropriate,apply those rules. If the gain is not sub-ject to allocation,we fall through to thegeneral inventory-sourcing rule, whichlooks to the place of sale. If the saletakes place outside the United States,the gain is foreign source and is notECI. If the sale occurs within the Unit-ed States, the gain is U.S. source, whichsends us to Exhibit 7.23

Finally, Exhibit 7. This chart appliesonce gain from the sale of property hasbeen determined to be U.S. source, butwhere an exception to the unlimitedforce-of-attract ion principle mayapply.24 If one of the exceptions applies,the asset-use and business-activitiestests apply to determine whether theincome is ECI; otherwise, the unlimit-ed force-of-attraction principle applies,and the gain is ECI.�

GAIN FROM PROPERTY SALES AS EFFECTIVELY CONNECTED INCOME l JULY 2009 l JOURNAL OF INTERNATIONAL TAXATION 43

tion, the gain on sale is bifurcated into theportions allocable to the production andsales activities (Section 863(b)(2)).The first step in applying these rules

is to determine the amount of incomeallocable to sales and to production.The Regulations allow the taxpayer tochoose between two methods (or, withthe Service’s consent, a third method)for making this allocation (Reg. 1.863-3(b)). One method, always available, isto allocate gross income 50% each tosales and production (“50/50 method”)(Reg. 1.863-3(b)(1)).17 A secondmethod (“independent factory price(IFP) method”) generally allows a tax-payer that regularly sells part of its out-put to independent third parties toallocate gross sales price to the produc-tion activ ity based on the price atwhich the third-party sales occur; theremaining portion of the gross salesprice is allocated to sales activity. Todetermine the gross income attributa-ble to each activity, the gross proceedsmust then be reduced by the cost ofgoods sold attributable to each activi-ty (Reg. 1.863-3(b)(2)).A third method (“books-and-record

method”) al locates gross incomebetween production and sales activitybased on identification of specific

receipts and expenditures, as reflectedin the taxpayer’s books and records.This method is available only if the tax-payer obtains advance permission fromthe Service (Reg. 1.863-3(b)(3)).Once income has been allocated

between production and sales, differentsource rules apply to each component.The production component is sourcedaccording to where the productionassets are located (Reg. 1.863-3(c)(1)).Where production assets are locatedboth within and outside the UnitedStates, the income attributable to pro-duction is allocated in proportion to theadjusted basis of the production assetslocated in the two places (Reg. 1.863-3(c)(1)(ii)). For this purpose, intangibleproduction assets are treated as locat-ed in the same place as the taxpayer’stangible production assets to whichthey relate (Reg. 1.863-3(c)(1)(C)).In general, the component of income

attributable to sales activity is sourcedaccording to the general rule for salesof inventory (i.e., place of sale). How-ever, where the property is (1) whollyproduced in the United States (disre-garding, for this purpose only, packag-ing, repackaging, labeling, or otherminor assembly operations outside theUnited States), and (2) sold for use,

consumption, or disposition in theUnited States, the place of sale is “pre-sumed” to be the United States (Reg.1.863-3(c)(2)).There are two other exceptions to

the general source rule for inventorysales, both of quite limited scope. Oneapplies to sales of unprocessed soft-wood timber that was cut in the UnitedStates. Gain from these sales is, per se,U.S. source (Section 865(b)).The other exception applies where

the inventory property is purchased ina U.S. possession and sold within theUnited States (“possession purchasesales”).18 In that event, income from thesale is generally sourced to the posses-sion in proportion to the amount of“business activity”with respect to pos-session purchase sales that is in the pos-session (as compared to worldwidebusiness activity with respect to pos-session purchase sales), and the remain-der of the income is sourced to theUnited States (Reg. 1.863-3(f )(3)(ii)(A)). For this purpose, “businessactivity” is the sum of (1) the amountpaid for wages, salaries, other compen-sat ion, and other non-capitalizedexpenses attributable to possessionpurchase sales; (2) the cost of goodssold attributable to possession purchase

JOURNAL OF INTERNATIONAL TAXATION l JULY 2009 l GAIN FROM PROPERTY SALES AS EFFECTIVELY CONNECTED INCOME42