26 U.S.C. 988 Treatment of certain foreign currency transactions

TITLE 26 > Subtitle A > CHAPTER 1 > Subchapter N > PART III > Subpart J > 988

988. Treatment of certain foreign currency transactions

(a) General rule

Notwithstanding any other provision of this chapter—

(3) Source

(A) In general

Except as otherwise provided in regulations, in the case of any amount treated as ordinary income or loss under paragraph (1) (without regard to paragraph (1)(B)), the source of such amount shall be determined by reference to the residence of the taxpayer or the qualified business unit of the taxpayer on whose books the asset, liability, or item of income or expense is properly reflected.

(B) Residence

For purposes of this subpart—

(i) In general The residence of any person shall be—

(I) in the case of an individual, the country in which such individual’s tax home (as defined in section 911 (d)(3)) is located,

(II) in the case of any corporation, partnership, trust, or estate which is a United States person (as defined in section 7701 (a)(30)), the United States, and

(III) in the case of any corporation, partnership, trust, or estate which is not a United States person, a country other than the United States.

 If an individual does not have a tax home (as so defined), the residence of such individual shall be the United States if such individual is a United States citizen or a resident alien and shall be a country other than the United States if such individual is not a United States citizen or a resident alien.


Recall in our previous discussion that in the case of United States v. Burke (504 U.S. 229, 119 L Ed 2d 34, 112 S Ct. 1867), the Supreme Court ruled that "gross income" that was to be taxed had to come from a source.  Why? Because otherwise the income tax laws would be so broad as to tax EVERYONE in the world!   Federal government income taxes are imposed on sources with specific geographical boundaries, and not the income itself, per United States v. Burke.  The income is just a way to compute the amount of tax but the tax itself is on a geographical and situational source.   Clearly, there has to be some section of the Internal Revenue Code that ties the taxes we pay to some geographical boundary.  This section deals with that subject.

There is often a lot of confusion in people’s mind over the significance of the word “source” that we’d like to clear up before we go on.  Therefore we’d like to refine the use of the term before continuing on with an explanation of specific “sources”.  Merriam Webster Dictionary of Law defines “source” as follows:

a point of origin
Example: the source of the conflict

There are actually two uses of the word “source” in the Internal Revenue Code.  “Source” is used to describe a TAX source (a source for government revenue) in 26 U.S.C. Sec. 861, the 16th Amendment, and the IRS regulations (1.861) we discuss subsequently.  Tax sources for the government are always tied to a geographical boundary and the occurrence of a specific event or situation.  This is especially true of excise taxes, which occur on the happening of a specific event.  For instance, there is a federal excise tax on gasoline.  The event of buying gasoline by consumers within the geographical boundaries of the United States of America is an occasion for paying that particular federal excise tax.  If the event occurs outside of the geographical boundaries of the U.S.A. or doesn’t involve the buying of gasoline, then the tax can’t be imposed.

“Source” is also used to describe an INCOME source for individuals or “persons” (and not necessarily the government) in Chapter 24 of the I.R.C, which is entitled “CHAPTER 24 - COLLECTION OF INCOME TAX AT SOURCE ON WAGES “ and section 3402 of the I.R.C.   These sections deal with withholding, but the withholding is occurring on the citizen’s income source, which then becomes the government’s revenue/tax source upon receipt by the government.  In this case, the withholding on wages occurs as an imputed “excise tax” based on the “event” of a citizen receiving income from their employer within the geographical boundaries of the United States of America.  Note, however, that excise taxes that are Constitutional always occur on business transactions and businesses.  Excise taxes  are referred to in the Constitution as indirect taxes, as we learned in our discussion of the Supreme Court case of Pacific Ins. Co. v. Soule, 74 U.S. 433, 1868 in section 6.4.2 and they always fall on  consumers of the product made by the business.  Valid federal excise taxes CANNOT fall on natural persons or citizens because then they become direct taxesDirect taxes on citizens violate Article 1, Section 9, Clause 4 of the Constitution, which states “No Capitiation or other direct tax shall be laid unless in proportion to the Census or Enumeration herein before directed to be taken.”  In this case, the income taxes on wages are deducted and paid by the employer (the business) with the consent or permission of the employee (W-4), but in actuality they also REDUCE the income of the recipient and the taxes must be accounted for and a return prepared by the citizen/recipient, not the business, which makes them into a direct tax that is clearly unconstitutional.  It is very important to understand this distinction.  A good way to think about this is if a tax reduces the income of a citizen from what they otherwise would have received and if it is involuntary and not discretionary, then it’s a direct tax.  This issue was settled in the Supreme Court Case of Pollack v. Farmer’s Loan and Trust Company, 157 U.S. 429 and 158 U.S. 601, 1883.

With that out of the way, we’ll spend the remainder of this section talking about government “sources” of income, so let's review: the “income tax” is imposed on “taxable income,” which means “gross income” minus deductions.  “Gross income” is defined in 26 USC 61 as “all income from whatever source derived.”  The phrase “from whatever source derived” may initially appear all-encompassing, but for the specifics about “income from sources,” the reader of the law is repeatedly referred to Section 861 and following (of the statutes) and the related regulations.  For example, in the full version of Title 26 (with all notes and amendments) which appears on Congress’ own web site, Section 61 itself has the following cross-reference:

Income from sources -
      Within the United States, see section 861 of this title.
      Without the United States, see section 862 of this title.”

So the section which generally defines “gross income” specifically refers to 26 USC 861 regarding income from “sources” within the United States** (the federal zone).  A similar reference is also found in the indexes of the United States Code, which (although they vary somewhat in the exact wording) have entries such as:

“Income tax
     Sources of income
          Determination, 26 861 et seq.
          Within the U.S., 26 861

Again, income from “sources” within the United States** (the federal zone) is specifically dealt with by Section 861, and “determination” of sources of income is also dealt with by Section 861 and the following sections.  In addition, Sections 79, 105, 410, 414 and 505 each identify Section 861 as the section which determines what constitutes “income from sources within the United States,” and Section 306 even uses the phrase “part I of subchapter N (sec. 861 and following, relating to determination of sources of income).”

As shown, 26 USC 861 and following (which make up Part I of Subchapter N of the Code) are very relevant to determining what is considered a “source of income,” and Section 861 in particular deals with income from “sources” within the United States** (the federal zone).  Not surprisingly, Section 861 is entitled “Income from sources within the United States,” and the first two subsections of Section 861 are entitled “Gross income from sources within the United States” and “Taxable income from sources within the United States.”  Section 861 is also the first section of Subchapter N of the Code, which is entitled “Tax based on income from sources within or without the United States.”  Clearly this is relevant to a tax on “income from whatever source derived.”

As mentioned before, the statutes passed by Congress are interpreted and implemented by regulations published in the Code of Federal Regulations (“CFR”) by the Secretary of the Treasury.  The Index of the CFR, under “Income taxes,” has an entry that reads “Income from sources inside or outside U.S., determination of sources of income, 26 CFR 1 (1.861-1--1.864-8T).”  This is the only entry in the Index relating to income from sources within the United States** (the federal zone), and the regulations listed (26 CFR 1.861-1 and following) correspond to Section 861 of the statutes.  (The “26” refers to Title 26, the “1” after “CFR” refers to Part 1 of the regulations (“Income Taxes”), and the “.861” refers to Section 861 of the statutes.)  These regulations fall under the heading “Determination of sources of income.”  The following is how these regulations begin:

“Sec. 1.861-1   Income from sources within the United States.
(a) Categories of income. Part I (section 861 and following), subchapter N, chapter 1 of the Code, and the regulations thereunder determine the sources of income for purposes of the income tax.” [26 CFR 1.861-1]

The meaning of this is unmistakable.  The “income tax” is imposed on “income from whatever source derived,” and Section 861 and following, and the related regulations, determine what is considered a “source” of income “for purposes of the income tax.”  The first sentence of the regulations under 26 USC 861 has stated this since 1954, when Section 861 first came into existence.  Note that these define “the” sources of income subject to the tax, meaning there are no others.  Therefore, the meaning of “income from whatever source derived” (the definition of “gross income” in Section 61) is limited by Section 861 (and following sections) and the related regulations.  The meaning of the phrase “whatever source” depends completely on the meaning of the word “source.”  The word “whatever” does not expand the meaning of “source” any more than the phrase “all firearms” (in the example above) expands the legal meaning of the word “firearm.”

The above section of regulations also refutes the common but incorrect position that the “items” of income listed in Section 61 are “sources,” since Section 61 is obviously not the section which determines the “sources” of income for purposes of the income tax.

(There is a chart at the end of this report showing the outline of Part I of Subchapter N and related regulations, and showing many of the citations used in this report.)

While the significance of Section 861 and the related regulations may be obvious, the point needs to be thoroughly proven, since most tax professionals concede that Section 861 and its regulations are not about the income of United States citizens living and working exclusively within the 50 states of the United States.  (Below it will be shown why it is so significant that “section 861 and following... and the regulations thereunder, determine the sources of income for purposes of the income tax.”).  The IRS’s own publications clarify the issue of “source” for us.  In IRS Publication 54 (for the year 2000, on page 4), we read the following:

Source of Earned Income

The source of your earned income is the place where you perform the services for which you received the income. Foreign earned income is income you receive for performing personal services in a foreign country. Where or how you are paid has no effect on the source of the income. For example, income you receive for work done in France is income from a foreign source even if the income is paid directly to your bank ac-count in the United States and your employer is located in New York City.

If you receive a specific amount for work done in the United States, you must report that amount as U.S. source income. If you cannot determine how much is for work done in the United States, or for work done partly in the United States and partly in a foreign country, determine the amount of U.S. source income using the method that most correctly shows the proper source of your income.

In most cases you can make this determination on a time basis. U.S. source income is the amount that results from multiplying your total pay (including allowances, re-imbursements other than for foreign moves, and noncash fringe benefits) by a fraction.  The numerator (top number) is the number of days you worked within the United States.  The denominator is the total number of days of work for which you were paid.

IMPORTANT NOTE:  All uses of the term “United States” in the context of natural persons actually mean the “federal zone” and not the 50 states of the United States.  This is in complete agreement with the definition of the terms “United States” and “State” found in 26 U.S.C. section 7700.  It is also consistent with Article 1, Section 9, Clause 4 and Article 1, Section 2, Clause 3 of the U.S. Constitution, which forbid direct taxes on natural persons without using apportionment.

This is also suggested by the title of Part I of Subchapter N (of which 861 is the first section), “Source rules and other general rules relating to foreign income.”  Under the usual overly-broad (and incorrect) interpretation of the legal scope of the term “gross income,” this would appear as a contradiction, since “Income from sources within the United States” (the title of Section 861) would at first glance seem to be the opposite of “foreign income.”  The specific taxable sources shown later demonstrate that income from within the United States** (the federal zone) can be taxable only if received by certain individuals outside of the United States** (the federal zone), thus making the income foreign income.  For the purposes of the income tax, as we discussed in section 5.3, income earned from within the 50 states is counted as “foreign income”.

While the title of a part of the statutes may indicate what that part is about, it should be mentioned that 26 USC 7806(b) states that such titles do not change the actual meaning of the law (“nor shall any… descriptive matter relating to the contents of this title be given any legal effect”).  The above explanation for the title of Part I, Subchapter N is therefore not crucial, but does give a possible explanation of why the title is as it is.

(Question for Doubters:  Does Part I (Section 861 and following) of Subchapter N, and related regulations, determine what is considered a “source” of income for purposes of the federal income tax?)