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Income Tax Regs., means that the taxpayer's interest
income, to the extent that it is offset by interest
expense, is not included in the groupings of gross income,
i.e. gross income from sources within and without the
United States, contrary to sections 861(a)(1) and
862(a)(1). Sec. 861(a)(1). Thus, in our view, interest
netting would subvert the operation of the source rules.
Generally, as discussed above, the source rules
operate by assigning items of gross income to different
groupings of gross income, such as income from sources
within and without the United States, in accordance with
standards set out in the statute, and by allocating and
apportioning the taxpayer's expenses, losses, and other
deductions to the different groupings. Items of gross
income that constitute interest are assigned to groupings
of gross income from sources within and without the United
States generally in accordance with the residence of the
payor. See sec. 1.861-2, Income Tax Regs.
Under interest netting, interest income is offset by
interest expense and only net interest expense is allocated
and apportioned under the source rules. In effect, the
source of the interest income that is offset is not taken
into account in the groupings of gross income and taxable
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