[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2003 Edition]
[From the U.S. Government Printing Office]



[[Page i]]



                    26


          Part 1 (Secs. 1.908 to 1.1000)

                         Revised as of April 1, 2003

Internal Revenue





          Containing a codification of documents of general 
          applicability and future effect
          As of April 1, 2003
          With Ancillaries
          Published by
          Office of the Federal Register
          National Archives and Records
          Administration

A Special Edition of the Federal Register



[[Page ii]]

                                      




                     U.S. GOVERNMENT PRINTING OFFICE
                            WASHINGTON : 2003



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[[Page iii]]




                            Table of Contents



                                                                    Page
  Explanation.................................................       v

  Title 26:
          Chapter I--Internal Revenue Service, Department of 
          the Treasury (Continued)                                   5
  Finding Aids:
      Table of CFR Titles and Chapters........................     739
      Alphabetical List of Agencies Appearing in the CFR......     757
      Table of OMB Control Numbers............................     767
      List of CFR Sections Affected...........................     785



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                     ----------------------------

                     Cite this Code:  CFR
                     To cite the regulations in 
                       this volume use title, 
                       part and section number. 
                       Thus,  26 CFR 1.911-1 
                       refers to title 26, part 
                       1, section 911-1.

                     ----------------------------

[[Page v]]



                               EXPLANATION

    The Code of Federal Regulations is a codification of the general and 
permanent rules published in the Federal Register by the Executive 
departments and agencies of the Federal Government. The Code is divided 
into 50 titles which represent broad areas subject to Federal 
regulation. Each title is divided into chapters which usually bear the 
name of the issuing agency. Each chapter is further subdivided into 
parts covering specific regulatory areas.
    Each volume of the Code is revised at least once each calendar year 
and issued on a quarterly basis approximately as follows:

Title 1 through Title 16.................................as of January 1
Title 17 through Title 27..................................as of April 1
Title 28 through Title 41...................................as of July 1
Title 42 through Title 50................................as of October 1

    The appropriate revision date is printed on the cover of each 
volume.

LEGAL STATUS

    The contents of the Federal Register are required to be judicially 
noticed (44 U.S.C. 1507). The Code of Federal Regulations is prima facie 
evidence of the text of the original documents (44 U.S.C. 1510).

HOW TO USE THE CODE OF FEDERAL REGULATIONS

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Register page number of the latest amendment of any given rule.

EFFECTIVE AND EXPIRATION DATES

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OMB CONTROL NUMBERS

    The Paperwork Reduction Act of 1980 (Pub. L. 96-511) requires 
Federal agencies to display an OMB control number with their information 
collection request.

[[Page vi]]

Many agencies have begun publishing numerous OMB control numbers as 
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requirements.

OBSOLETE PROVISIONS

    Provisions that become obsolete before the revision date stated on 
the cover of each volume are not carried. Code users may find the text 
of provisions in effect on a given date in the past by using the 
appropriate numerical list of sections affected. For the period before 
January 1, 2001, consult either the List of CFR Sections Affected, 1949-
1963, 1964-1972, 1973-1985, or 1986-2000, published in 11 separate 
volumes. For the period beginning January 1, 2001, a ``List of CFR 
Sections Affected'' is published at the end of each CFR volume.

CFR INDEXES AND TABULAR GUIDES

    A subject index to the Code of Federal Regulations is contained in a 
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    The Federal Register Index is issued monthly in cumulative form. 
This index is based on a consolidation of the ``Contents'' entries in 
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the revision dates of the 50 CFR titles.

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in the Code of Federal Regulations.

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[[Page vii]]

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                              Raymond A. Mosley,
                                    Director,
                          Office of the Federal Register.

April 1, 2003.



[[Page ix]]



                               THIS TITLE

    Title 26--Internal Revenue is composed of twenty volumes. The 
contents of these volumes represent all current regulations issued by 
the Internal Revenue Service, Department of the Treasury, as of April 1, 
2003. The first thirteen volumes comprise part 1 (Subchapter A--Income 
Tax) and are arranged by sections as follows: Secs. 1.0-1-1.60; 
Secs. 1.61-1.169; Secs. 1.170-1.300; Secs. 1.301-1.400; Secs. 1.401-
1.440; Secs. 1.441-1.500; Secs. 1.501-1.640; Secs. 1.641-1.850; 
Secs. 1.851-1.907; Secs. 1.908-1.1000; Secs. 1.1001-1.1400; 
Secs. 1.1401-1.1503-2A; and Sec. 1.1551-1 to end. The fourteenth volume 
containing parts 2-29, includes the remainder of subchapter A and all of 
Subchapter B--Estate and Gift Taxes. The last six volumes contain parts 
30-39 (Subchapter C--Employment Taxes and Collection of Income Tax at 
Source); parts 40-49; parts 50-299 (Subchapter D--Miscellaneous Excise 
Taxes); parts 300-499 (Subchapter F--Procedure and Administration); 
parts 500-599 (Subchapter G--Regulations under Tax Conventions); and 
part 600 to end (Subchapter H--Internal Revenue Practice).

    The OMB control numbers for Title 26 appear in Sec. 602.101 of this 
chapter. For the convenience of the user, Sec. 602.101 appears in the 
Finding Aids section of the volumes containing parts 1 to 599.

[[Page x]]





[[Page 1]]



                       TITLE 26--INTERNAL REVENUE




           (This book contains part 1, Secs. 1.908 to 1.1000)

  --------------------------------------------------------------------
                                                                    Part

chapter i--Internal Revenue Service, Department of the 
  Treasury (Continued)......................................           1

[[Page 3]]



    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)




  --------------------------------------------------------------------


  Editorial Note: IRS published a document at 45 FR 6088, Jan. 25, 1980, 
deleting statutory sections from their regulations. In Chapter I cross-
references to the deleted material have been changed to the 
corresponding sections of the IRS Code of 1954 or to the appropriate 
regulations sections. When either such change produced a redundancy, the 
cross-reference has been deleted. For further explanation, see 45 FR 
20795, March 31, 1980.

                  SUBCHAPTER A--INCOME TAX (CONTINUED)
Part                                                                Page
1               Income taxes................................           5

Supplementary Publications: Internal Revenue Service Looseleaf 
  Regulations System.

  Additional supplementary publications are issued covering Alcohol and 
Tobacco Tax Regulations and Regulations Under Tax Conventions.

[[Page 5]]



                  SUBCHAPTER A--INCOME TAX (CONTINUED)





PART 1--INCOME TAXES--Table of Contents




                        Normal Taxes and Surtaxes

  Tax Based on Income From Sources Within or Without the United States

         Earned Income of Citizens or Residents of United States

1.911-1  Partial exclusion for earned income from sources within a 
          foreign country and foreign housing costs.
1.911-2  Qualified individuals.
1.911-3  Determination of amount of foreign earned income to be 
          excluded.
1.911-4  Determination of housing cost amount eligible for exclusion or 
          deduction.
1.911-5  Special rules for married couples.
1.911-6  Disallowance of deductions, exclusions, and credits.
1.911-7  Procedural rules.
1.911-8  Former deduction for certain expenses of living abroad.

               earned income of citizens of united states

1.912-1  Exclusion of certain cost-of-living allowances.
1.912-2  Exclusion of certain allowances of Foreign Service personnel.
1.921-1T  Temporary regulations providing transition rules for DISCs and 
          FSCs.
1.921-2  Foreign Sales Corporation--general rules.
1.921-3T  Temporary regulations; Foreign Sales Corporation general 
          rules.
1.922-1  Requirements that a corporation must satisfy to be a FSC or a 
          small FSC.
1.923-1T  Temporary regulations; exempt foreign trade income.
1.924(a)-1T  Temporary regulations; definition of foreign trading gross 
          receipts.
1.924(c)-1  Requirement that a FSC be managed outside the United States.
1.924(d)-1  Requirement that economic processes take place outside the 
          United States.
1.924(e)-1  Activities relating to the disposition of export property.
1.925(a)-1T  Temporary regulations; transfer pricing rules for FSCs.
1.925(b)-1T  Temporary regulations; marginal costing rules.
1.926(a)-1  Distributions to shareholders.
1.926(a)-1T  Temporary regulations; distributions to shareholders.
1.927(a)-1T  Temporary regulations; definition of export property.
1.927(b)-1T  Temporary regulations; definition of gross receipts.
1.927(d)-1  Other definitions.
1.927(d)-2T  Temporary regulations; definitions and special rules 
          relating to Foreign Sales Corporation.
1.927(e)-1  Special sourcing rule.
1.927(e)-2T  Temporary regulations; effect of boycott participation on 
          FSC and small FSC benefits.
1.927(f)-1  Election and termination of status as a Foreign Sales 
          Corporation.

                    possessions of the united states

1.931-1  Citizens of the United States and domestic corporations 
          deriving income from sources within a certain possession of 
          the United States.
1.932-1  Status of citizens of U.S. possessions.
1.933-1  Exclusion of certain income from sources within Puerto Rico.
1.934-1  Limitation on reduction in income tax liability incurred to the 
          Virgin Islands.
1.935-1  Coordination of U.S. and Guam individual income taxes.
1.936-1  Elections.
1.936-4  Intangible property income in the absence of an election out.
1.936-5  Intangible property income when an election out is made: 
          Product, business presence, and contract manufacturing.
1.936-6  Intangible property income when an election out is made: cost 
          sharing and profit split options; covered intangibles.
1.936-7  Manner of making election under section 936 (h)(5); special 
          election for export sales; revocation of election under 
          section 936(a).
1.936-8T  Qualified possession source investment income (temporary). 
          [Reserved]
1.936-9T  Source of qualified possession source investment income 
          (temporary). [Reserved]
1.936-10  Qualified investments.
1.936-11  New lines of business prohibited.

                      china trade act corporations

1.941-1  Special deduction for China Trade Act corporations.
1.941-2  Meaning of terms used in connection with China Trade Act 
          corporations.
1.941-3  Illustration of principles.
1.943-1  Withholding by a China Trade Act corporation.

                     controlled foreign corporations

1.951-1  Amounts included in gross income of United States shareholders.
1.951-2  Coordination of subpart F with election of a foreign investment 
          company to distribute income.

[[Page 6]]

1.951-3  Coordination of subpart F with foreign personal holding company 
          provisions.
1.952-1  Subpart F income defined.
1.952-2  Determination of gross income and taxable income of a foreign 
          corporation.
1.953-1  Income from insurance of United States risks.
1.953-2  Actual United States risks.
1.953-3  Risks deemed to be United States risks.
1.953-4  Taxable income to which section 953 applies.
1.953-5  Corporations not qualifying as insurance companies.
1.953-6  Relationship of sections 953 and 954.
1.954-0  Introduction.
1.954-1  Foreign base company income.
1.954-2  Foreign personal holding company income.
1.954-3  Foreign base company sales income.
1.954-4  Foreign base company services income.
1.954-5  Increase in qualified investments in less developed countries; 
          taxable years of controlled foreign corporations beginning 
          before January 1, 1976.
1.954-6  Foreign base company shipping income.
1.954-7  Increase in qualified investments in foreign base company 
          shipping operations.
1.954-8  Foreign base company oil related income.
1.955-0  Effective dates.
1.955-1  Shareholder's pro rata share of amount of previously excluded 
          subpart F income withdrawn from investment in less developed 
          countries.
1.955-2  Amount of a controlled foreign corporation's qualified 
          investments in less developed countries.
1.955-3  Election as to date of determining qualified investments in 
          less developed countries.
1.955-4  Definition of less developed country.
1.955-5  Definition of less developed country corporation.
1.955-6  Gross income from sources within less developed countries.
1.955A-1  Shareholder's pro rata share of amount of previously excluded 
          subpart F income withdrawn from investment in foreign base 
          company shipping operations.
1.955A-2  Amount of a controlled foreign corporation's qualified 
          investments in foreign base company shipping operations.
1.955A-3  Election as to qualified investments by related persons.
1.955A-4  Election as to date of determining qualified investment in 
          foreign base company shipping operations.
1.956-1  Shareholder's pro rata share of a controlled foreign 
          corporation's increase in earnings invested in United States 
          property.
1.956-1T  Shareholder's pro rata share of a controlled foreign 
          corporation's increase in earnings invested in United States 
          property (temporary).
1.956-2  Definition of United States property.
1.956-2T  Definition of United States property (temporary).
1.956-3T  Certain trade or service receivables acquired from United 
          States persons (temporary).
1.957-1  Definition of controlled foreign corporation.
1.957-2  Controlled foreign corporation deriving income from insurance 
          of United States risks.
1.957-3  Corporations organized in United States possessions.
1.957-4  United States person defined.
1.958-1  Direct and indirect ownership of stock.
1.958-2  Constructive ownership of stock.
1.959-1  Exclusion from gross income of United States persons of 
          previously taxed earning and profits.
1.959-2  Exclusion from gross income of controlled foreign corporations 
          of previously taxed earnings and profits.
1.959-3  Allocation of distributions to earnings and profits of foreign 
          corporations.
1.959-4  Distributions to United States persons not counting as 
          dividends.
1.960-1  Foreign tax credit with respect to taxes paid on earnings and 
          profits of controlled foreign corporations.
1.960-2  Interrelation of section 902 and section 960 when dividends are 
          paid by third-, second-, or first-tier corporation.
1.960-3  Gross-up of amounts included in income under section 951.
1.960-4  Additional foreign tax credit in year of receipt of previously 
          taxed earnings and profits.
1.960-5  Credit for taxable year of inclusion binding for taxable year 
          of exclusion.
1.960-6  Overpayments resulting from increase in limitation for taxable 
          year of exclusion.
1.960-7  Effective dates.
1.961-1  Increase in basis of stock in controlled foreign corporations 
          and of other property.
1.961-2  Reduction in basis of stock in foreign corporations and of 
          other property.
1.962-1  Limitation of tax for individuals on amounts included in gross 
          income under section 951(a).
1.962-2  Election of limitation of tax for individuals.
1.962-3  Treatment of actual distributions.
1.962-4  Transitional rules for certain taxable years.
1.963-0  Repeal of section 963; effective dates.
1.963-1  Exclusion of subpart F income upon receipt of minimum 
          distribution.
1.963-2  Determination of the amount of the minimum distribution.

[[Page 7]]

1.963-3  Distributions counting toward a minimum distribution.
1.963-4  Limitations on minimum distribution from a chain or group.
1.963-5  Foreign corporations with variation in foreign tax rate because 
          of distributions.
1.963-6  Deficiency distribution.
1.963-7  Transitional rules for certain taxable years.
1.963-8  Determination of minimum distribution during the surcharge 
          period.
1.964-1  Determination of the earnings and profits of a foreign 
          corporation.
1.964-1T  Special rules for computing earnings and profits of controlled 
          foreign corporations in taxable years beginning after December 
          31, 1986 (temporary).
1.964-2  Treatment of blocked earnings and profits.
1.964-3  Records to be provided by United States shareholders.
1.964-4  Verification of certain classes of income.
1.964-5  Effective date of subpart F.

                        Export Trade Corporations

1.970-1  Export trade corporations.
1.970-2  Elections as to date of determining investments in export trade 
          assets.
1.970-3  Effective date of subpart G.
1.971-1  Definitions with respect to export trade corporations.
1.972-1  Consolidation of group of export trade corporations.
1.981-0  Repeal of section 981; effective dates.
1.981-1  Foreign law community income for taxable years beginning after 
          December 31, 1966, and before January 1, 1977.
1.981-2  Foreign law community income for taxable years beginning before 
          January 1, 1967.
1.981-3  Definitions and other special rules.
1.985-0  Outline of regulation.
1.985-1  Functional currency.
1.985-2  Election to use the United States dollar as the functional 
          currency of a QBU.
1.985-3  United States dollar approximate separate transactions method.
1.985-4  Method of accounting.
1.985-5  Adjustments required upon change in functional currency.
1.985-6  Transition rules for a QBU that uses the dollar approximate 
          separate transactions method for its first taxable year 
          beginning in 1987.
1.985-7  Adjustments required in connection with a change to DASTM.
1.985-8  Special rules applicable to the European Monetary Union 
          (conversion to the euro).
1.987-1  Profit and loss method of accounting for a qualified business 
          unit of a taxpayer having a different functional currency from 
          the taxpayer. [Reserved]
1.987-2  Accounting for gain or loss on certain transfers of property. 
          [Reserved]
1.987-3  Termination. [Reserved]
1.987-4  Special rules relating to QBU branches of foreign taxpayers. 
          [Reserved]
1.987-5  Transition rules for certain qualified business units using a 
          profit and loss method of accounting for taxable years 
          beginning before January 1, 1987.
1.988-0  Taxation of gain or loss from a section 988 transaction; table 
          of contents.
1.988-1  Certain definitions and special rules.
1.988-2  Recognition and computation of exchange gain or loss.
1.988-3  Character of exchange gain or loss.
1.988-4  Source of gain or loss realized on a section 988 transaction.
1.988-5  Section 988(d) hedging transactions.
1.989(a)-1  Definition of a qualified business unit.
1.989(b)-1  Definition of weighted average exchange rate.
1.989(c)-1  Transition rules for certain branches of United States 
          persons using a net worth method of accounting for taxable 
          years beginning before January 1, 1987.

                Domestic International Sales Corporations

1.991-1  Taxation of a domestic international sales corporation.
1.992-1  Requirements of a DISC.
1.992-2  Election to be treated as a DISC.
1.992-3  Deficiency distributions to meet qualification requirements.
1.992-4  Coordination with personal holding company provisions in case 
          of certain produced film rents.
1.993-1  Definition of qualified export receipts.
1.993-2  Definition of qualified export assets.
1.993-3  Definition of export property.
1.993-4  Definition of producer's loans.
1.993-5  Definition of related foreign export corporation.
1.993-6  Definition of gross receipts.
1.993-7  Definition of United States.
1.994-1  Inter-company pricing rules for DISC's.
1.994-2  Marginal costing rules.
1.995-1  Taxation of DISC income to shareholders.
1.995-2  Deemed distributions in qualified years.
1.995-3  Distributions upon disqualification.
1.995-4  Gain on disposition of stock in a DISC.
1.995-5  Foreign investment attributable to producer's loans.
1.995-6  Taxable income attributable to military property.
1.996-1  Rules for actual distributions and certain deemed 
          distributions.
1.996-2  Ordering rules for losses.
1.996-3  Divisions of earnings and profits.

[[Page 8]]

1.996-4  Subsequent effect of previous disposition of DISC stock.
1.996-5  Adjustment to basis.
1.996-6  Effectively connected income.
1.996-7  Carryover of DISC tax attributes.
1.996-8  Effect of carryback of capital loss or net operating loss to 
          prior DISC taxable year.
1.997-1  Special rules for subchapter C of the Code.

    Authority: 26 U.S.C. 7805.
    Section 1.911-7 also issued under 26 U.S.C. 911(d)(9).
    Sections 1.924(c)-1, 1.924(d)-1, and 1.924(e)-1 also issued under 26 
U.S.C. 924(d).
    Section 1.925(a)-1 also issued under 26 U.S.C. 925(b)(1) and (2) and 
927(d)(2)(B).
    Section 1.925(a)-1T is also issued under 26 U.S.C. 925(b)(1) and (2) 
and 927(d)(2)(B).
    Section 1.925(b)-1T is also issued under 26 U.S.C. 925(b)(1) and (2) 
and 927(d)(2)(B).
    Section 1.927(d)-1 also issued under 26 U.S.C. 927(d)(1)(B).
    Section 1.927(e)-1 also issued under 26 U.S.C. 927(e)(1).
    Section 1.927(e)-2T also issued under 26 U.S.C. 927(e)(2).
    Section 1.927(f)-1 also issued under 26 U.S.C. 927(f).
    Section 1.936-4 also issued under 26 U.S.C. 936(h).
    Section 1.936-5 also issued under 26 U.S.C. 936(h).
    Section 1.936-6 also issued under 26 U.S.C. 863(a) and (b), and 26 
U.S.C. 936(h).
    Section 1.936-7 also issued under 26 U.S.C. 936(h).
    Sections 1.936-11 also issued under 26 U.S.C. 936(j).
    Section 1.952-11T is also issued under 26 U.S.C. 852(b)(3)(C), 
852(b)(8), and 852(c).
    Section 1.953-2 also issued under 26 U.S.C. 7701(b)(11).
    Section 1.954-0 also issued under 26 U.S.C. 954 (b) and (c).
    Section 1.954-1 also issued under 26 U.S.C. 954 (b) and (c).
    Section 1.954-2 also issued under 26 U.S.C. 954 (b) and (c).
    Section 1.956-3T also issued under 26 U.S.C. 864(d)(8).
    Section 1.957-1 also issued under 26 U.S.C. 957.
    Section 1.960-1 also issued under 26 U.S.C. 960(a).
    Sectns 1.985-0 through 1.985-5 also issued under 26 U.S.C. 985.
    Sections 1.987-1 through 1.987-5 also issued under 26 U.S.C. 987.
    Sections 1.988-0 through 1.988-5 also issued under 26 U.S.C. 988.
    Sections 1.989(a)-0T and 1.989(a)-1T also issued under 26 U.S.C. 
989(c).
    Section 1.989(b)-1 also issued under 26 U.S.C. 989(b).
    Section 1.989-1(c) also issued under 26 U.S.C. 989(c).

    Source: T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 
1960, unless otherwise noted.

         Earned Income of Citizens or Residents of United States



Sec. 1.911-1  Partial exclusion for earned income from sources within a foreign country and foreign housing costs.

    (a) In general. Section 911 provides that a qualified individual may 
elect to exclude the individual's foreign earned income and the housing 
cost amount from the individual's gross income for the taxable year. 
Foreign earned income is excludable to the extent of the applicable 
limitation for the taxable year. The housing cost amount for the taxable 
year is excludable to the extent attributable to employer provided 
amounts. If a portion of the housing cost amount for the taxable year is 
attributable to non-employer provided amounts, such amount may be 
deductible by the qualified individual subject to a limitation. The 
amounts excluded under section 911(a) and the amount deducted under 
section 911(c)(3)(A) for the taxable year shall not exceed the 
individual's foreign earned income for such taxable year. Foreign earned 
income must be earned during a period for which the individual qualifies 
to make an election under section 911(d)(1). A housing cost amount that 
would be deductible except for the application of this limitation may be 
carried over to the next taxable year and is deductible to the extent of 
the limitation for that year. Except as otherwise provided, Secs. 1.911-
1 through 1.911-7 apply to taxable years beginning after December 31, 
1981. These sections do not apply to any item of income, expense, 
deduction, or credit arising before January 1, 1982, even if such item 
is attributable to services performed after December 31, 1981.
    (b) Scope. Section 1.911-2 provides rules for determining whether an 
individual qualifies to make an election under section 911. Section 
1.911-3 provides rules for determining the amount of foreign earned 
income that is excludable under section 911(a)(1). Section 1.911-4 
provides rules for determining the housing cost amount and the portions 
excludable under section

[[Page 9]]

911(a)(2) or deductible under section 911(c)(3). Section 1.911-5 
provides special rules applicable to married couples. Section 1.911-6 
provides for the disallowance of deductions, exclusions, and credits 
attributable to amounts excluded under section 911. Section 1.911-7 
provides procedural rules for making or revoking an election under 
section 911. Section 1.911-8 provides a reference to rules applicable to 
taxable years beginning before January 1, 1982.

(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 
U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2964, Jan. 23, 1985]



Sec. 1.911-2  Qualified individuals.

    (a) In general. An individual is a qualified individual if:
    (1) The individual's tax home is in a foreign country or countries 
throughout--
    (i) The period of bona fide residence described in paragraph 
(a)(2)(i) of this section, or
    (ii) The 330 full days of presence described in paragraph (a)(2)(ii) 
of this section, and
    (2) The individual is either--
    (i) A citizen of the United States who establishes to the 
satisfaction of the Commissioner or his delegate that the individual has 
been a bona fide resident of a foreign country or countries for an 
uninterrupted period which includes an entire taxable year, or
    (ii) A citizen or resident of the United States who has been 
physically present in a foreign country or countries for at least 330 
full days during any period of twelve consecutive months.
    (b) Tax home. For purposes of paragraph (a)(i) of this section, the 
term ``tax home'' has the same meaning which it has for purposes of 
section 162(a)(2) (relating to travel expenses away from home). Thus, 
under section 911, an individual's tax home is considered to be located 
at his regular or principal (if more than one regular) place of business 
or, if the individual has no regular or principal place of business 
because of the nature of the business, then at his regular place of 
abode in a real and substantial sense. An individual shall not, however, 
be considered to have a tax home in a foreign country for any period for 
which the individual's abode is in the United States. Temporary presence 
of the individual in the United States does not necessarily mean that 
the individual's abode is in the United States during that time. 
Maintenance of a dwelling in the United States by an individual, whether 
or not that dwelling is used by the individual's spouse and dependents, 
does not necessarily mean that the individual's abode is in the United 
States.
    (c) Determination of bona fide residence. For purposes of paragraph 
(a)(2)(i) of this section, whether an individual is a bona fide resident 
of a foreign country shall be determined by applying, to the extent 
practical, the principles of section 871 and the regulations thereunder, 
relating to the determination of the residence of aliens. Bona fide 
residence in a foreign country or countries for an uninterrupted period 
may be established, even if temporary visits are made during the period 
to the United States or elsewhere on vacation or business. An individual 
with earned income from sources within a foreign country is not a bona 
fide resident of that country if:
    (1) The individual claims to be a nonresident of that foreign 
country in a statement submitted to the authorities of that country, and
    (2) The earned income of the individual is not subject, by reason of 
nonresidency in the foreign country, to the income tax of that country.

If an individual has submitted a statement of nonresidence to the 
authorities of a foreign country the accuracy of which has not been 
resolved as of any date when a determination of the individual's bona 
fide residence is being made, then the individual will not be considered 
a bona fide resident of the foreign country as of that date.
    (d) Determination of physical presence. For purposes of paragraph 
(a)(2)(ii) of this section, the following rules apply.
    (1) Twelve-month test. A period of twelve consecutive months may 
begin with any day but must end on the day before the corresponding day 
in the twelfth succeeding month. The twelve-month period may begin 
before or after arrival in a foreign country and may end before or after 
departure.

[[Page 10]]

    (2) 330-day test. The 330 full days need not be consecutive but may 
be interrupted by periods during which the individual is not present in 
a foreign country. In computing the minimum 330 full days of presence in 
a foreign country or countries, all separate periods of such presence 
during the period of twelve consecutive months are aggregated. A full 
day is a continuous period of twenty-four hours beginning with midnight 
and ending with the following midnight. An individual who has been 
present in a foreign country and then travels over areas not within any 
foreign country for less than twenty-four hours shall not be deemed 
outside a foreign country during the period of travel. If an individual 
who is in transit between two points outside the United States is 
physically present in the United States for less than twenty-four hours, 
such individual shall not be treated as present in the United States 
during such transit but shall be treated as travelling over areas not 
within any foreign country. For purposes of this paragraph (d)(2), the 
term ``transit between two points outside the United States'' has the 
same meaning that it has when used in section 7701(b)(6)(C).
    (3) Illustrations of the physical presence requirement. The physical 
presence requirement of paragraph (a)(2)(ii) of this section is 
illustrated by the following examples:

    Example 1. B, a U.S. citizen, arrives in Venezuela from New York at 
12 noon on April 24, 1982. B remains in Venezuela until 2 p.m. on March 
21, 1983, at which time B departs for the United States. Among other 
possible twelve month periods, B is present in a foreign country an 
aggregate of 330 full days during each of the following twelve month 
periods: March 21, 1982 through March 20, 1983; and April 25, 1982 
through April 24, 1983.
    Example 2. C, a U.S. citizen, travels extensively from the time C 
leaves the United States on March 5, 1982, until the time C departs the 
United Kingdom on January 1, 1984, to return to the United States 
permanently. The schedule of C's travel and the number of full days at 
each location are listed below:

----------------------------------------------------------------------------------------------------------------
                                                                                                       Full days
                                                                                                           in
                   Country                      Time and date of arrival   Time and date of departure   foreign
                                                                                                        country
----------------------------------------------------------------------------------------------------------------
United States................................  ..........................  10 p.m. (by air) Mar. 5,
                                                                            1982.
United Kingdom...............................  9 a.m. Mar. 6, 1982.......  10 p.m. (by ship) June 25,        110
                                                                            1982.
United States................................  11 a.m. June 30, 1982.....  1 p.m. (by ship) July 19,           0
                                                                            1982.
France.......................................  3 p.m. July 24, 1982......  11 a.m. (by air) Aug. 22,         393
                                                                            1983.
United States................................  4 p.m. Aug. 22, 1983......  9 a.m. (by air) Sept. 4,            0
                                                                            1983.
United Kingdom...............................  9 a.m. Sept. 5, 1983......  9 a.m. (by air) Jan. 1,           117
                                                                            1984.
United States................................  1 p.m. Jan. 1, 1984.......  ..........................
----------------------------------------------------------------------------------------------------------------

    Among other possible twelve-month periods, C is present in a foreign 
country or countries an aggregate of 330 full days during the following 
twelve-month periods: March 2, 1982 through March 1, 1983; and January 
21, 1983 through January 20, 1984. The computation of days with respect 
to each twelve month period may be illustrated as follows:
    First twelve-month period (March 2, 1982 through March 1, 1983):

------------------------------------------------------------------------
                                                               Full days
                                                                   in
                                                                foreign
                                                                country
------------------------------------------------------------------------
Mar. 2, 1982 through Mar. 6, 1982............................          0
Mar. 7, 1982 through June 24, 1982...........................        110
June 25, 1982 through July 24, 1982..........................          0
July 25, 1982 through Mar. 1, 1983...........................        220
                                                              ----------
    Total full days..........................................        330
------------------------------------------------------------------------

    Second twelve-month period (January 21, 1983 through January 20, 
1984):

------------------------------------------------------------------------
                                                               Full days
                                                                   in
                                                                foreign
                                                                country
------------------------------------------------------------------------
Jan. 21, 1983 through Aug. 21, 1983..........................        213
Aug. 22, 1983 through Sept. 5, 1983..........................          0
Sept. 6, 1983 through Dec. 31, 1983..........................        117
Jan. 1, 1984 through Jan. 20, 1984...........................          0
                                                              ----------
    Total full days..........................................        330
------------------------------------------------------------------------

    (e) Special rules. For purposes only of establishing that an 
individual is a qualified individual under paragraph (a) of this 
section, residence or presence in a foreign country while there employed 
by the U.S. government or any agency or instrumentality of the U.S. 
government counts towards satisfaction of the requirements of 
Sec. 1.911-2(a). (But see section 911(b)(1)(B)(ii) and Sec. 1.911-
3(c)(3) for the rule excluding amounts paid by the U.S. government to an 
employee from the definition of

[[Page 11]]

foreign earned income.) Time spent in a foreign country prior to January 
1, 1982, counts toward satisfaction of the bona fide residence and 
physical presence requirements, even though no exclusion or deduction 
may be allowed under section 911 for income attributable to services 
performed during that time. For purposes or paragraph (a)(2)(ii) of this 
section, the term ``resident of the United States'' includes an 
individual for whom a valid election is in effect under section 6013 (g) 
or (h) for the taxable year or years during which the physical presence 
requirement is satisfied.
    (f) Waiver of period of stay in foreign country due to war or civil 
unrest. Notwithstanding the requirements of paragraph (a) of this 
section, an individual whose tax home is in, a foreign country, and who 
is a bona fide resident of, or present in a foreign country for any 
period, who leaves the foreign country after August 31, 1978, before 
meeting the requirements of paragraph (a) of this section, may as 
provided in this paragraph, qualify to make an election under section 
911(a) and Sec. 1.911-7(a). If the Secretary determines, after 
consultation with the Secretary of State or his delegate, that war, 
civil unrest, or similar adverse conditions existed in a foreign 
country, then the Secretary shall publish the name of the foreign 
country and the dates between which such conditions were deemed to 
exist. In order to qualify to make an election under this paragraph, the 
individual must establish to the satisfaction of the Secretary that the 
individual left a foreign country, the name of which has been published 
by the Secretary, during the period when adverse conditions existed and 
that the individual could reasonably have expected to meet the 
requirements of paragraph (a) of this section but for the adverse 
conditions. The individual shall attach to his return for the taxable 
year a statement that the individual expected to meet the requirements 
of paragraph (a) of this section but for the conditions in the foreign 
country which precluded the normal conduct of business by the 
individual. Such individual shall be treated as a qualified individual, 
but only for the actual period of residence or presence. Thus, in 
determining the number of the individual's qualifying days, only days 
within the period of actual residence or presence shall be counted.
    (g) United States. The term ``United States'' when used in a 
geographical sense includes any territory under the sovereignty of the 
United States. It includes the states, the District of Columbia, the 
possessions and territories of the United States, the territorial waters 
of the United States, the air space over the United States, and the 
seabed and subsoil of those submarine areas which are adjacent to the 
territorial waters of the United States and over which the United States 
has exclusive rights, in accordance with international law, with respect 
to the exploration and exploitation of natural resources.
    (h) Foreign country. The term ``foreign country'' when used in a 
geographical sense includes any territory under the sovereignty of a 
government other than that of the United States. It includes the 
territorial waters of the foreign country (determined in accordance with 
the laws of the United States), the air space over the foreign country, 
and the seabed and subsoil of those submarine areas which are adjacent 
to the territorial waters of the foreign country and over which the 
foreign country has exclusive rights, in accordance with international 
law, with respect to the exploration and exploitation of natural 
resources.

(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 
U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2965, Jan. 23, 1985]



Sec. 1.911-3  Determination of amount of foreign earned income to be excluded.

    (a) Definition of foreign earned income. For purposes of section 911 
and the regulations thereunder, the term ``foreign earned income'' means 
earned income (as defined in paragraph (b) of this section) from sources 
within a foreign country (as defined in Sec. 1.911-2(h)) that is earned 
during a period for which the individual qualifies under Sec. 1.911-2(a) 
to make an election. Earned income is from sources within a foreign 
country if it is attributable to services performed by an individual in 
a foreign

[[Page 12]]

country or countries. The place of receipt of earned income is 
immaterial in determining whether earned income is attributable to 
services performed in a foreign country or countries.
    (b) Definition of earned income--(1) In general. The term ``earned 
income'' means wages, salaries, professional fees, and other amounts 
received as compensation for personal services actually rendered 
including the fair market value of all remuneration paid in any medium 
other than cash. Earned income does not include any portion of an amount 
paid by a corporation which represents a distribution of earnings and 
profits rather than a reasonable allowance as compensation for personal 
services actually rendered to the corporation.
    (2) Earned income from business in which capital is material. In the 
case of an individual engaged in a trade or business (other than in 
corporate form) in which both personal services and capital are material 
income producing factors, a reasonable allowance as compensation for the 
personal services actually rendered by the individual shall be 
considered earned income, but the total amount which shall be treated as 
the earned income of the individual from such trade or business shall in 
no case exceed thirty percent of the individual's share of the net 
profits of such trade or business.
    (3) Professional fees. Earned income includes all fees received by 
an individual engaged in a professional occupation (such as doctor or 
lawyer) in the performance of professional activities. Professional fees 
constitute earned income even though the individual employs assistants 
to perform part or all of the services, provided the patients or clients 
are those of the individual and look to the individual as the person 
responsible for the services rendered.
    (c) Amounts not included in foreign earned income. Foreign earned 
income does not include an amount:
    (1) Excluded from gross income under section 119;
    (2) Received as a pension or annuity (including social security 
benefits);
    (3) Paid to an employee by an employer which is the U.S. government 
or any U.S. government agency or instrumentality;
    (4) Included in the individual's gross income by reason of section 
402(b) (relating to the taxability of a beneficiary of a nonexempt 
trust) or section 403(c) (relating to the taxability of a beneficiary 
under a nonqualified annuity or under annuities purchased by exempt 
organizations);
    (5) Included in gross income by reason of Sec. 1.911-6(b)(4)(ii); or
    (6) Received after the close of the first taxable year following the 
taxable year in which the services giving rise to the amounts were 
performed. For treatment of amounts received after December 31, 1962, 
which are attributable to services performed on or before December 31, 
1962, and with respect to which there existed on March 12, 1962, a right 
(whether forfeitable or nonforfeitable) to receive such amounts, see 
Sec. 1.72-8.
    (d) Determination of the amount of foreign earned income that may be 
excluded under section 911(a)(1)--(1) In general. Foreign earned income 
described in this section may be excluded under section 911(a)(1) and 
this paragraph only to the extent of the limitation specified in 
paragraph (d)(2) of this section. Income is considered to be earned in 
the taxable year in which the services giving rise to the income are 
performed. The determination of the amount of excluded earned income in 
this manner does not affect the time for reporting any amounts included 
in gross income.
    (2) Limitation--(i) In general. The term ``section 911(a)(1) 
limitation'' means the amount of foreign earned income for a taxable 
year which may be excluded under section 911(a)(1). The section 
911(a)(1) limitation shall be equal to the lesser of the qualified 
individual's foreign earned income for the taxable year in excess of 
amounts that the individual elected to exclude from gross income under 
section 911(a)(2) or the product of the annual rate for the taxable year 
(as specified in paragraph (d)(2)(ii) of this section) multiplied by the 
following fraction:
[GRAPHIC] [TIFF OMITTED] TC14NO91.137


[[Page 13]]


    (ii) Annual rate for the taxable year. The annual rate for the 
taxable year is the rate set forth in section 911(b)(2)(A).
    (3) Number of qualifying days. For purposes of section 911 and the 
regulations thereunder, the number of qualifying days is the number of 
days in the taxable year within the period during which the individual 
met the tax home requirement and either the bona fide residence 
requirement or the physical presence requirement of Sec. 1.911-2(a). 
Although the period of bona fide residence must include an entire 
taxable year, the entire uninterrupted period of residence may include 
fractional parts of a taxable year. For instance, if an individual who 
was a calendar year taxpayer established a tax home and a residence in a 
foreign country as of November 1, 1982, and maintained the tax home and 
the residence through March 31, 1984, then the uninterrupted period of 
bona fide residence includes fractional parts of the years 1982 and 
1984, and all of 1983. The number of qualifying days in 1982 is sixty-
one. The number of qualifying days in 1983 is 365. The number of 
qualifying days in 1984 is ninety-one. The period during which the 
physical presence requirement of Sec. 1.911-2(a)(2)(ii) is met is any 
twelve consecutive month period during which the individual is 
physically present in one or more foreign countries for 330 days and the 
individual's tax home is in a foreign country during each day of such 
physical presence. Such period may include days when the individual is 
not physically present in a foreign country, and days when the 
individual does not maintain a tax home in a foreign country. Such 
period may include fractional parts of a taxable year. Thus, if an 
individual's period of physical, presence is the twelve-month period 
beginning June 1, 1982, and ending May 31, 1983, the number of 
qualifying days in 1982 is 214 and the number of qualifying days in 1983 
is 151.
    (e) Attribution rules--(1) In general. Foreign earned income is 
considered to be earned in the taxable year in which the individual 
performed the services giving rise to the income. If income is earned in 
one taxable year and received in another taxable year, then, for 
purposes of determining the amount of foreign earned income that the 
individual may exclude under section 911(a), the individual must 
attribute the income to the taxable year in which the services giving 
rise to the income were performed. Thus, any reimbursement would be 
attributable to the taxable year in which the services giving rise to 
the obligation to pay the reimbursement were performed, not the taxable 
year in which the reimbursement was received. For example, tax 
equalization payments are normally received in the year after the year 
in which the services giving rise to the obligation to pay the tax 
equalization payment were performed. Therefore, such payments will 
almost always have to be attributed to the prior year. Foreign earned 
income attributable to services performed in a preceding taxable year 
shall be excludable from gross income in the year of receipt only to the 
extent such amount could have been excluded under paragraph (d)(1) in 
the preceding taxable year, had such amount been received in the 
preceding taxable year. The taxable year to which income is attributable 
will be determined on the basis of all the facts and circumstances.
    (2) Priority of use of the section 911(a)(1) limitation. Foreign 
earned income received in the year in which it is earned shall be 
applied to the section 911(a)(1) limitation for that year before 
applying income earned in that year that is received in any other year. 
Foreign earned income that is earned in one year and received in another 
year shall be applied to the section 911(a)(1) limitation for the year 
in which it was earned, on a year by year basis, in any order that the 
individual chooses. (But see section 911(b)(1)(B)(iv)). An individual 
may not amend his return to change the treatment of income with respect 
to the section 911(a)(1) exclusion after the period provided by section 
6511(a). The special period of limitation provided by section 6511(d)(3) 
does not apply for this purpose. For example, C, a qualified individual, 
receives an advance bonus of $10,000 in 1982, salary of $70,000 in 1983, 
and a performance bonus of $10,000 in 1984, all of which are foreign 
earned income for 1983. C has a section 911(a)(1) limitation for 1983 of 
$80,000, and has no housing cost amount exclusion. On his income

[[Page 14]]

tax return for 1983, C elects to exclude foreign earned income of 
$70,000 received in 1983. C may also exclude his $10,000 advance bonus 
received in 1982 (by filing an amended return for 1982), or he may 
exclude the $10,000 performance bonus received in 1984 on his 1984 
income tax return. However, C may not exclude part of the 1982 bonus and 
part of the 1984 bonus.
    (3) Exception for year-end payroll period. Notwithstanding paragraph 
(e)(1) of this section, salary or wage payments of a cash basis taxpayer 
shall be attributed entirely to the year of receipt under the following 
circumstances:
    (i) The period for which the payment is made is a normal payroll 
period of the employer which regularly applies to the employee;
    (ii) The payroll period includes the last day of the employee's 
taxable year;
    (iii) The payroll period does not exceed 16 days; and
    (iv) The payment is part of a normal payroll of the employer that is 
distributed at the same time, in relation to the payroll period, that 
such payroll would normally be distributed, and is distributed before 
the end of the next succeeding payroll period.
    (4) Attribution of bonuses and substantially nonvested property to 
periods in which services were performed--(i) In general. Bonuses and 
substantially nonvested property are attributable to all of the services 
giving rise to the income on the basis of all the facts and 
circumstances. If an individual receives a bonus or substantially 
nonvested property (as defined in Sec. 1.83-3(b)) and it is determined 
to be attributable to services performed in more than one taxable year, 
then, for purposes of determining the amount eligible for exclusion from 
gross income in the year the bonus is received or the property vests, a 
portion of such amount shall be treated as attributable to services 
performed in each taxable year (or portion thereof) during the period 
when services giving rise to the bonus or the substantially nonvested 
property were performed. Such portion shall be determined by dividing 
the amount of the bonus or the excess of the fair market value of the 
vested property over the amount paid, if any, for the vested property, 
by the number of months in the period when services giving rise to such 
amount were performed, and multiplying the quotient by the number of 
months in such period in the taxable year. For purposes of this section, 
the term ``month'' means a calendar month. A fraction of a calendar 
month shall be deemed a month if it includes fifteen or more days.
    (ii) Examples. The following examples illustrate the application of 
this paragraph (e)(4).

    Example 1. A, an employee of M Corporation during all of 1983 and 
1984, worked in the United States from January 1 through April 30, 1983, 
and received $12,000 of salary for that period. A worked in country F 
from May 1, 1983 through the end of 1984, and is a qualified individual 
under Sec. 1.911-2(a) for that period. For the period from May 1 through 
December 31, 1983, A received $32,000 of salary. M pays a bonus on 
December 20, 1983 to each of M's employees in an amount equal to 10 
percent of the employee's regular wages or salary for the 1983 calendar 
year. The amount of A's bonus is $4,400 for 1983. The portion of A's 
bonus that is attributable to services performed in country F and is 
foreign earned income for 1983 is $3,200, or $32,000x10 percent. The 
remaining $1,200 of A's bonus is attributable to services performed in 
the United States, and is not foreign earned income.
    Example 2. The facts are the same as in example 1, except that M 
determines bonuses separately for each country based on the productivity 
of the employees in that country. M pays a bonus to employees in country 
F, in the amount of 15 percent of each employee's wages or salary earned 
in country F. A's country F bonus is $4,800 for 1983 ($32,000x15 
percent), and is foreign earned income for 1983. If A also receives a 
bonus (or if A's bonus is increased) for working in the United States 
during 1983, that amount is not foreign earned income.
    Example 3. X corporation offers its employees a bonus of $40,000 if 
the employee accepts employment in a foreign country and remains in a 
foreign country for a period of at least four years. A, an employee of 
X, is a calendar year and cash basis taxpayer. A accepts employment with 
X in foreign country F. A begins work in F on July 1, 1983 and continues 
to work in F for X until June 30, 1987. In 1987 X pays A a $40,000 
bonus. The bonus is attributable to services A performed from July 1, 
1983 through June 30, 1987. The amount of the bonus attributable to 1987 
is $5,000 (($40,000/48)x6). The amount of the bonus attributable to 1986 
is $10,000

[[Page 15]]

(($40,000/48)x12). A may exclude the $10,000 attributable to 1986 only 
to the extent that amount could have been excluded under section 
911(a)(1) had A received it in 1986. The remaining $25,000 is 
attributable to services performed in taxable years before 1986. Such 
amounts may not be excluded under section 911 because they are received 
after the close of the taxable year following the taxable year in which 
the services giving rise to the income were performed.

    (iii) Special rule for elections under section 83(b). If an 
individual receives substantially nonvested property and makes an 
election under section 83(b) and Sec. 1.83-2(a) to include in his gross 
income the amount determined under section 83(b)(1)(A) and (B) and 
Sec. 1.83-2(a) for the taxable year in which the property is transferred 
(as defined in Sec. 1.83-3(a)), then, for the purpose of determining the 
amount eligible for exclusion in the year of receipt, the individual may 
elect either of the following options:
    (A) Substantially nonvested property may be treated as attributable 
entirely to services performed in the taxable year in which an election 
to include it in income is made. If so treated, then the amount 
otherwise included in gross income as determined under Sec. 1.83-2(a) 
will be excludable under section 911(a) for such year subject to the 
limitation provided in Sec. 1.911-3(d)(2) for such year.
    (B) A portion of the substantially nonvested property may be treated 
as attributable to services performed or to be performed in each taxable 
year during which the substantial risk of forfeiture (as defined in 
section 83(c) and Sec. 1.83-3(c)) exists. The portion treated as 
attributable to services performed or to be performed in each taxable 
year is determined by dividing the amount of the substantially nonvested 
property included in gross income as determined under Sec. 1.83-2(a) by 
the number of months during the period when a substantial risk of 
forfeiture exists. The quotient is multiplied by the total number of 
months in the taxable year during which a substantial risk of forfeiture 
exists. The amount determined to be attributable to services performed 
in the year the election is made shall be excluded from gross income for 
such year as provided in paragraph (d)(2) of this section. Amounts 
treated as attributable to services performed in subsequent taxable 
years shall be excludable in the year of receipt only to the extent such 
amounts could be excluded under paragraph (d)(2) of this section in such 
subsequent years. An individual may obtain such additional exclusion by 
filing an amended return for the taxable year in which the property was 
transferred. The individual may only amend his or her return within the 
period provided by section 6511(a) and the regulations thereunder.
    (5) Moving expense reimbursements--(i) Source of reimbursements. For 
the purpose of determining whether a moving expense reimbursement is 
attributable to services performed within a foreign country or within 
the United States, in the absence of evidence to the contrary, the 
reimbursement shall be attributable to future services to be performed 
at the new principal place of work. Thus, a reimbursement received by an 
employee from his employer for the expenses of a move to a foreign 
country will generally be attributable to services performed in the 
foreign country. A reimbursement received by an employee from his 
employer for the expenses of a move from a foreign country to the United 
States will generally be attributable to services performed in the 
United States. For purposes of this paragraph (e)(5), evidence to the 
contrary includes, but is not limited to, an agreement, between the 
employer and the employee, or a statement of company policy, which is 
reduced to writing before the move to the foreign country and which is 
entered into or established to induce the employee or employees to move 
to a foreign country. The writing must state that the employer will 
reimburse the employee for moving expenses incurred in returning to the 
United States regardless of whether the employee continues to work for 
the employer after the employee returns to the United States. The 
writing may contain conditions upon which the right to reimbursement is 
determined as long as the conditions set forth standards that are 
definitely ascertainable and the conditions can only be fulfilled prior 
to, or through completion of the employee's return move to the United 
States that is the subject of the writing. In no case

[[Page 16]]

will an oral agreement or statement of company policy concerning moving 
expenses be considered evidence to the contrary. For the purpose of 
determining whether a storage expense reimbursement is attributable to 
services performed within a foreign country, in the case of storage 
expenses incurred after December 31, 1983, the reimbursement shall be 
attributable to services performed during the period of time for which 
the storage expenses are incurred.
    (ii) Attribution of foreign source reimbursements to taxable years 
in which services are performed--(A) In general. If a reimbursement for 
moving expenses is determined to be from foreign sources under paragraph 
(e)(5)(i) of this section, then for the purpose of determining the 
amount eligible for exclusion in accordance with paragraphs (d)(2) and 
(e)(2) of this section, the reimbursement shall be considered 
attributable to services performed in the year of the move as long as 
the individual is a qualified individual for a period that includes 120 
days in the year of the move. The period that is used in determining the 
number of qualifying days for purposes of the individual's section 
911(a)(1) limitation (under paragraph (d)(2) of this section) must also 
be used in determining whether the individual is a qualified individual 
for a period that includes 120 days in the year of the move. If the 
individual is not a qualified individual for such period, then the 
individual shall treat a portion of the reimbursement as attributable to 
services performed in the year of the move, and a portion as 
attributable to services performed in the succeeding taxable year, if 
the move is from the United States to a foreign country, or to the prior 
taxable year, if the move is from a foreign country to the United 
States. The portion of the reimbursement treated as attributable to 
services performed in the year of the move shall be determined by 
multiplying the total reimbursement by the following fraction:
[GRAPHIC] [TIFF OMITTED] TC14NO91.138


The remaining portion of the reimbursement shall be treated as 
attributable to services performed in the year succeeding or preceding 
the year of the move. Amounts treated as attributable to services 
performed in a year succeeding or preceding the year of the move shall 
be excludable in the year of receipt only to the extent such amounts 
could be excluded under paragraph (d)(2) of this section in such 
succeeding or preceding year.
    (B) Moves beginning before January 1, 1984. Notwithstanding 
paragraph (e)(5)(ii)(A) of this section, this paragraph (e)(5)(ii)(B) 
shall apply for moves begun before January 1, 1984. If a reimbursement 
for moving expenses is determined to be from foreign sources under 
paragraph (e)(5)(i) of this section, then for the purpose of determining 
the amount eligible for exclusion in accordance with paragraphs (d)(2) 
and (e)(2) of this section, the reimbursement shall be considered 
attributable to services performed in the year of the move. However, if 
the individual does not qualify under section 911(d)(1) and Sec. 1.911-
2(a) for the entire taxable year of the move, then the individual shall 
treat a portion of the reimbursement as attributable to services 
performed in the succeeding taxable year, if the move is from the United 
States to a foreign country, or to the prior taxable year, if the move 
is from a foreign country to the United States. The portion of the 
reimbursement treated as attributable to services performed in the year 
succeeding or preceding the move shall be determined by multiplying the 
total reimbursement by the following fraction:

[[Page 17]]

[GRAPHIC] [TIFF OMITTED] TC14NO91.139


and subtracting the product from the total reimbursement. Amounts 
treated as attributable to services performed in a year succeeding or 
preceding the year of the move shall be excludable in the year of 
receipt only to the extent such amounts could be excluded under 
paragraph (d)(2) of this section in such succeeding or preceding year.
    (f) Examples. The following examples illustrate the application of 
this section.

    Example 1. A is a U.S. citizen and calendar year taxpayer. A's tax 
home was in foreign country F and A was physically present in F for 330 
days during the period from July 4, 1982 through July 3, 1983. The 
number of A's qualifying days in 1982 as determined under paragraph 
(d)(2) of this section is 181. In 1982 A receives $40,000 attributable 
to services performed in foreign country F in 1982. Under paragraph 
(d)(2) of this section A's section 911(a)(1) limitation is $37,192, that 
is the lesser of $40,000 (foreign earned income) or
[GRAPHIC] [TIFF OMITTED] TC09OC91.000

    Example 2. The facts are the same as in example 1 except that in 
1982 A receives $30,000 attributable to services performed in foreign 
country F. A excludes this amount from gross income under paragraph (d) 
of this section. In addition, in 1983 A receives $10,000 attributable to 
services performed in F in 1982 and $35,000 attributable to services 
performed in F in 1983. On his return for 1983, A must report $45,000 of 
income. A's section 911(a)(1) limitation for 1983 is the lesser of 
$35,000 (foreign earned income) or $49,329, the annual rate for the 
taxable year multiplied by a fraction the numerator of which is A's 
qualifying days in the taxable year and the denominator of which is the 
number of days in the taxable year ($80,000x184/365). On his tax return 
for 1983 A may exclude $35,000 attributable to services performed in 
1983. A may only exclude $7,192 of the $10,000 received in 1983 
attributable to services performed in 1982 because such amount is only 
excludable in 1983 to the extent such amount could have been excluded in 
1982 subject to the section 911(a)(1) limitation for 1982 which is 
$37,192 ($75,000x181/365). No portion of amounts attributable to 
services performed in 1982 may be used in calculating A's section 
911(a)(1) limitation for 1983. Thus, even though A could have excluded 
an additional $5,329 in 1983 if A had had more foreign earned income 
attributable to 1983, A may not exclude the $2,808 of remaining foreign 
earned income attributable to 1982.
    Example 3. C is a U.S. citizen and calendar year taxpayer. C 
establishes a bona fide residence and a tax home in foreign country J on 
March 1, 1982, and maintains a tax home and a residence in J until 
December 31, 1986. In March of 1982 C's employer, Y corporation, 
transfers stock in Y to C. The stock is subject to forfeiture if C 
returns to the U.S. before January 1, 1985. C elects under section 83(b) 
to include $15,000, the amount determined with respect to such stock 
under section 83(b)(1), in gross income in 1982. C's other foreign 
earned income in 1982 is $58,000. C elects under paragraph 
(e)(4)(iii)(B) of this section to treat the stock as if earned over the 
period of the substantial risk of forfeiture. The number of months in 
the period of the substantial risk of forfeiture is thirty-four. The 
number of months in the taxable year 1982 within the period of foreign 
employment is ten. For purposes of determining C's section 911(a)(1) 
limitation, $4,412 (($15,000/34)x10) of the amount included in gross 
income under section 83(b) is treated as attributable to services 
performed in 1982, $5,294 is treated as attributable to services to be 
performed in 1983, and $5,294 is treated as attributable to services to 
be performed in 1984. In 1982, C excludes $62,412 under section 
911(a)(1). That is the lesser of foreign earned income for 1982 
($58,000+$4,412) or the annual rate for the taxable year multiplied by a 
fraction the numerator of which is C's qualifying days in the taxable 
year and the denominator of which is the number of days in the taxable 
year ($75,000x306/365). C continues to perform services in foreign 
country J throughout 1983 and 1984. C would be able to exclude the 
remaining $5,294 attributable to

[[Page 18]]

services performed in 1983 and $5,294 attributable to services performed 
in 1984 if those amounts would be excludable if they had been received 
in 1983 or 1984 respectively. If C is entitled to exclude the additional 
amounts, C must claim the exclusion by filing an amended return for 
1982.
    Example 4. D is a U.S. citizen and a calendar year taxpayer. In 
September, 1984 D moves to a foreign country K. D is physically present 
in K, and D's tax home is in K, from September 15, 1984 through December 
31, 1985. D receives $6,000 in April, 1985 from his employer, as a 
reimbursement for expenses of moving to K, pursuant to a written 
agreement that such moving expenses would be reimbursed to D upon 
successful completion of 6 months employment in K. Under paragraph 
(e)(15)(i) of this section, the reimbursement is attributable to 
services performed in K. Under the physical presence test of Sec. 1.911-
2(a)(2)(ii), among other periods D is a qualified individual for the 
period of August 10, 1984 through August 9, 1985, which includes 144 
days in 1984. Under paragraph (e)(5)(ii)(A) of this section, for the 
purpose of determining the amount eligible for exclusion, the 
reimbursement is considered attributable to services performed in 1984 
(the year of the move) because D is a qualified individual under 
Sec. 1.911-2(a) for a period that includes 120 days in 1984. The 
reimbursement may be excluded under paragraphs (d)(2) and (e)(2) of this 
section, to the extent that D's foreign earned income for 1984 that was 
earned and received in 1984 was less than the annual rate for the 
taxable year multiplied by the number of D's qualifying days in the 
taxable year over the number of days in D's taxable year ($80,000x144/
366), or $31,475.
    Example 5. The facts are the same as in example 4 except that D is 
not a qualified individual under the physical presence test, but is a 
qualified individual under the bona fide residence test for the period 
of September 15, 1984 through December 31, 1985. Under paragraph 
(e)(5)(ii)(A) of this section, for the purpose of determining the amount 
eligible for exclusion, the reimbursement is considered attributable to 
services performed in 1984 and 1985 because D is not a qualified 
individual for a period that includes 120 days in 1984 (the year of the 
move). The portion of the reimbursement treated as attributable to 
services performed in 1984 is $6,000x108/366, or $1,770, and may be 
excluded, subject to D's 1984 section 911(a)(1) limitation. The balance 
of the reimbursement, $4,230, is treated as attributable to services 
performed in 1985, and may be excluded to the extent provided in 
paragraphs (d)(2) and (e)(2) of this section.
    Example 6. The facts are the same as in example 4, with the 
following additions. Before D moved to K, D and his employer signed a 
written agreement that D would perform services for the employer for at 
least one year, primarily in country K, and, if D did not voluntarily 
cease to work for the employer primarily in country K before one year 
had elapsed, the employer would reimburse D for one half of D's 
expenses, up to a maximum of $4,000, of moving back to the United 
States. The agreement also stated that, if D did not voluntarily leave 
the employment in K before two years had elapsed, the employer would 
reimburse D for all of D's reasonable expenses of moving back to the 
United States. The agreement further stated that D's right to 
reimbursement would not be conditioned upon the performance of services 
after D ceased to work in K. D worked in country K for all of 1985. On 
January 1, 1986, D left K and moved to the United States. In February, 
1986 the employer paid D $3,500 as reimbursement for one-half of D's 
expenses of moving to the United States. Although D did not fulfill the 
condition in the agreement to receive full reimbursement, all of the 
conditions in the agreement set forth definitely ascertainable standards 
and no condition could be fulfilled after D moved back to the United 
States. The agreement fulfills the requirements of paragraph (e)(5)(i) 
of this section, and therefore is evidence that the reimbursement should 
not be attributable to future services to be performed at D's new 
principal place of work. Under the facts and circumstances, the 
reimbursement is attributable to services performed in K. Under 
paragraph (e)(5)(ii)(A) of this section, the entire reimbursement is 
attributable to services performed in 1985. The amount attributable to 
1985 may be excluded to the extent provided in paragraphs (d)(2) and 
(e)(2) of this section.

(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 
U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2966, Jan. 23, 1985]



Sec. 1.911-4  Determination of housing cost amount eligible for exclusion or deduction.

    (a) Definition of housing cost amount. The term ``housing cost 
amount'' means an amount equal to the reasonable expenses paid or 
incurred (as defined in section 7701(a)(25)) during the taxable year by 
or on behalf of the individual attributable to housing in a foreign 
country for the individual and any spouse or dependents who reside with 
the individual (or live in a second foreign household described in 
paragraph (b)(5) of this section) less the base housing amount as 
defined in paragraph (c) of this section. The housing cost amount must 
be reduced by the amount of any military or section

[[Page 19]]

912 allowance or similar allowance excludable from gross income that is 
intended to compensate the individual or the individual's spouse in 
whole or in part for the expenses of housing during the same period for 
which the individual claims a housing cost amount exclusion or 
deduction.
    (b) Housing expenses--(1) Included expenses. For purposes of 
paragraph (a) of this section, housing expenses include rent, the fair 
rental value of housing provided in kind by the employer, utilities 
(other than telephone charges), real and personal property insurance, 
occupancy taxes not described in paragraph (b)(2)(v) of this section, 
nonrefundable fees paid for securing a leasehold, rental of furniture 
and accessories, household repairs, and residential parking.
    (2) Excluded expenses. Housing expenses do not include:
    (i) The cost of house purchase, improvements, and other costs that 
are capital expenditures;
    (ii) The cost of purchased furniture or accessories or domestic 
labor (maids, gardeners, etc.);
    (iii) Amortized payments of principal with respect to an evidence of 
indebtedness secured by a mortgage on the taxpayer's housing;
    (iv) Depreciation of housing owned by the taxpayer, or amortization 
or depreciation of capital improvements made to housing leased by the 
taxpayer;
    (v) Interest and taxes deductible under section 163 or 164 or other 
amounts deductible under section 216(a) (relating to deduction of 
interest and taxes by cooperative housing corporation tenant);
    (vi) The expenses of more than one foreign household except as 
provided in paragraph (b)(5) of this section;
    (vii) Expenses excluded from gross income under section 119;
    (viii) Expenses claimed as deductible moving expenses under section 
217; or
    (ix) The cost of a pay television subscription.
    (3) Limitation. Housing expenses are taken into account for purposes 
of this section only to the extent attributable to housing for portions 
of the taxable year within the period during which the individual 
satisfies the requirements of Sec. 1.911-2(a). Housing expenses are not 
taken into account for the period during which the value of the 
individual's housing is excluded from gross income under section 119, 
unless the individual maintains a second foreign household described in 
paragraph (b)(5) of this section. If an individual maintains two foreign 
households, only expenses incurred with respect to the abode which bears 
the closest relationship, not necessarily geographic, with respect to 
the individual's tax home shall be taken into account, unless one of the 
households is a second foreign household.
    (4) Reasonableness. An amount paid for housing shall not be treated 
as reasonable, for purposes of paragraph (a) of this section, to the 
extent that the expense is lavish or extravagant under the 
circumstances.
    (5) Expenses of a second foreign household--(i) In general. The term 
``second foreign household'' means a separate abode maintained by an 
individual outside of the U.S. for his or her spouse or dependents (who, 
if minors, are in the individual's legal custody or the joint custody of 
the individual and the individual's spouse) at a place other than the 
tax home of the individual because of adverse living conditions at the 
individual's tax home. If an individual maintains a second foreign 
household the expenses of the second foreign household may be included 
in the individual's housing expenses under paragraph (b)(1) of this 
section. Under no circumstances shall an individual be considered to 
maintain more than one second foreign household at the same time.
    (ii) Adverse living conditions. Solely for purposes of paragraph 
(b)(5)(i) of this section, adverse living conditions are living 
conditions which are dangerous, unhealthful, or otherwise adverse. 
Adverse living conditions include a state of warfare or civil 
insurrection in the general area of the individual's tax home. Adverse 
living conditions exist if the individual resides on the business 
premises of the employer for the convenience of the employer and, 
because of the nature of the business (for example, a construction site 
or drilling rig), it is not feasible for the employer to provide housing 
for the individual's spouse or dependents.

[[Page 20]]

The criteria used by the Department of State in granting a separate 
maintenance allowance are relevant, but not determinative, for purposes 
of determining whether a separate household is provided because of 
adverse living conditions.
    (c) Base housing amount--(1) In general. The base housing amount is 
equal to the product of 16 percent of the annual salary of an employee 
of the United States who is compensated at a rate equal to the annual 
salary rate paid for step 1 of grade GS-14, multiplied by the following 
fraction:
[GRAPHIC] [TIFF OMITTED] TC14NO91.140


For purposes of the above fraction, the number of qualifying days is 
determined in accordance with Sec. 1.911-3(d)(3).
    (2) Annual salary of step 1 of grade GS-14. The annual salary rate 
for a step 1 of grade GS-14 is determined on January first of the 
calendar year in which the individual's taxable year begins.
    (d) Housing cost amount exclusion--(1) Limitation. A qualified 
individual who has elected to exclude his or her housing cost amount may 
only exclude the lesser of the full amount of either the individual's 
housing cost amount attributable to employer provided amounts or the 
individual's foreign earned income for the taxable year. A qualified 
individual who elects to exclude his or her housing cost amount may not 
claim less than the full amount of the housing cost exclusion determined 
under this paragraph.
    (2) Employer provided amounts. For purposes of this section, the 
term ``employer provided amounts'' means any amounts paid or incurred on 
behalf of the individual by the individual's employer which are foreign 
earned income included in the individual's gross income for the taxable 
year (without regard to section 911). Employer provided amounts include, 
but are not limited to, the following amounts: Any salary paid by the 
employer to the employee; any reimbursement paid by the employer to the 
employee for housing expenses, educational expenses for the individual's 
dependents, or as part of a tax equalization plan; the fair market value 
of compensation provided in kind (including lodging, unless excluded 
under section 119, relating to meals and lodging furnished for the 
convenience of the employer); and any amount paid by the employer to any 
third party on behalf of the employee. An individual will only have 
earnings that are not employer provided amounts if the individual has 
earnings from self-employment.
    (3) Housing cost amount attributable to employer provided amounts. 
For the purpose of determining what portion of the housing cost amount 
is excludable and what portion is deductible the following rules apply. 
If the individual has no income from self-employment, then the entire 
housing cost amount is attributable to employer provided amounts and is, 
therefore, excludable to the extent of the limitation provided in 
paragraph (d)(1) of this section. If the individual only has income from 
self-employment, then the entire housing cost amount is attributable to 
non-employer provided amounts and is, therefore, deductible to the 
extent of the limitation provided in paragraph (e) of this section. In 
all other instances, the housing cost amount attributable to employer 
provided amounts shall be determined by multiplying the housing cost 
amount by the following fraction: Employer provided amounts over foreign 
earned income for the taxable year. The housing cost amount attributable 
to non-employer provided amounts shall be determined by subtracting the 
portion of the housing cost amount attributable to employer provided 
amounts from the total housing cost amount.
    (e) Housing cost amount deduction--(1) In general. If a portion of 
the individual's housing cost amount is determined under paragraph 
(d)(3) of this section to be attributable to non-employer provided 
amounts, the individual may deduct that amount from gross income for the 
taxable year but only to the extent of the individual's foreign earned 
income (as defined in Sec. 1.911-3) for the taxable year in excess of 
foreign earned income excluded and the housing cost amount excluded from 
gross income for the taxable year under Sec. 1.911-3 and this section.

[[Page 21]]

    (2) Carryover. If any portion of the individual's housing cost 
amount deduction is disallowed for the taxable year under paragraph 
(e)(1) of this section, such portion shall be carried over and treated 
as a deduction from gross income for the succeeding taxable year (but 
only for the succeeding taxable year) to the extent of the excess, if 
any, of:
    (i) The amount of foreign earned income for the succeeding taxable 
year less the foreign earned income and the housing cost amount excluded 
from gross income under Sec. 1.911-3 and this section for the succeeding 
taxable year over,
    (ii) The portion, if any, of the housing cost amount that is 
deductible under paragraph (e)(1) of this section for the succeeding 
taxable year.
    (f) Examples. The following examples illustrate the application of 
this section. In all examples the annual rate for a step 1 of GS-14 as 
of January first of the calendar year in which the individual's taxable 
year begins is $39,689.

    Example 1. B, a U.S. citizen is a calendar year taxpayer who was a 
bona fide resident of and whose tax home was located in foreign country 
G for the entire taxable year 1982. B receives an $80,000 salary from 
B's employer for services performed in G. B incurs no business expenses. 
B receives housing provided by B's employer with a fair rental value of 
$15,000. The value of the housing furnished by B's employer is not 
excluded from gross income under section 119. B pays $10,000 for housing 
expenses. B's gross income and foreign earned income for 1982 is 
$95,000. B elects the foreign earned income exclusion of section 
911(a)(1) and the housing cost amount exclusion of section 911(a)(2). B 
must first compute his housing cost amount exclusion. B's housing cost 
amount is $18,650 determined by reducing B's housing expenses, $25,000 
($15,000 fair rental value of housing and $10,000 of other expenses), by 
the base housing amount of $6,350 (($39,689x.16)x365/365). Because B has 
no income from self-employment, the entire amount is attributable to 
employer provided amounts and therefore, is excludable. B's section 
911(a)(1) limitation is $75,000. That is the lesser of $75,000x365/365 
or $95,000-18,650. B's total exclusion for 1982 under section 911(a)(1) 
and (2) is $93,650.
    Example 2. The facts are the same as in example 1 except that B's 
salary for 1982 is $70,000. B's foreign earned income for 1982 is 
$85,000. B's housing cost amount is $18,650, all of which is 
attributable to employer provided amounts. B's housing cost amount is 
excludable to the extent of the lesser of B's housing cost amount 
attributable to employer provided amounts, $18,650, or the foreign 
earned income for the taxable year, $85,000. Thus, B excludes $18,650 
under section 911(a)(2). B's section 911(a)(1) limitation for 1982 is 
$66,350 (the lesser of $75,000x365/365 or $85,000-18,650). B's total 
exclusion for 1982 under section 911(a)(1) and (2) is $85,000.
    Example 3. The facts are the same as in example 2 except that in 
1983, B receives $5,000 attributable to services performed in 1982. B 
may exclude the entire $5,000 in 1983 because such amount would have 
been excludable under Sec. 1.911-3(d)(1) had it been received in 1982.
    Example 4. C is a U.S. citizen self-employed and a calendar year and 
cash basis taxpayer. C arrived in foreign country H on October 3, 1982, 
and departed from H on March 8, 1984. C's tax home was located in H 
throughout that period. C was physically present for 330 full days 
during the twelve consecutive month period August 30, 1982, through 
August 29, 1983. The number of C's qualifying days in 1982 is 124. 
During 1982 C had $35,000 of foreign earned income, none of which was 
attributable to employer provided amounts and $8,000 of reasonable 
housing expenses. C's housing cost amount is $5,843 ($8,000-
((39,689x.16)x124/365)). C elects to exclude her foreign earned income 
under Sec. 1.911-3(d)(1). C's section 911(a)(1) limitation for 1982 is 
$25,479 (the lesser of C's foreign earned income for the taxable year 
($35,000) or the annual rate for the taxable year multiplied by the 
number of C's qualifying days over the number of days in the taxable 
year ($75,000x124/365=$25,479). C may not claim the housing cost amount 
exclusion under section 911(a)(2) because no portion of the housing cost 
amount is attributable to employer provided amounts. C may deduct the 
lesser of her housing cost amount ($5,843) or her foreign earned income 
in excess of amounts excluded under section 911(a) ($35,000-
25,479=$9,521). Thus, C's housing cost amount deduction is $5,843.
    Example 5. The facts are the same as in example 4 except that C had 
$30,000 of foreign earned income for 1982, none of which was 
attributable to employer provided amounts. C elects to exclude $25,479 
under Sec. 1.911-3(d)(1). C may only deduct $4,521 of her housing cost 
amount under paragraph (e)(1) of this section because her foreign earned 
income in excess of amounts excluded under section 911(a) is 
$4,521($30,000-25,479). The $1,322 of unused housing cost amount 
deduction may be carried over to the subsequent taxable year.
    Example 6. The facts are the same as in example 4 except that C had 
$15,000 of foreign earned income of 1982, none of which was attributable 
to employer provided amounts. C elects to exclude the entire $15,000 
under Sec. 1.911-3(d)(1). C is not entitled to a housing cost amount 
deduction for 1982 since she has no foreign earned income in excess of

[[Page 22]]

amounts excluded under section 911(a). C may carry over her entire 
housing cost amount deduction to 1983.
    Example 7. The facts are the same as in example 6. In addition, 
during taxable year 1983 C had $115,000 of foreign earned income, none 
of which was attributable to employer provided amounts, and $40,000 of 
reasonable housing expenses C elects to exclude her foreign earned 
income under Sec. 1.911-3(d)(1). C's section 911(a)(1) limitation is the 
lesser of $115,000 or $80,000 ($80,000x365/365). C's housing cost amount 
for 1983 is $33,650 (40,000-(39,689x.16)x365/365). Since no portion of 
that amount is attributable to employer provided amounts, C may not 
claim a housing cost amount exclusion. C may deduct the lesser of her 
housing cost amount ($33,650) or her foreign earned income in excess of 
amounts excluded under section 911(a) ($115,000-80,000=35,000). Thus, C 
may deduct her $33,650 housing cost amount in 1983. In addition, C may 
deduct $1,350 of the housing cost amount deduction carried over from 
taxable year 1982.

(($115.000-80,000)-33,650=$1,350). The remaining $4,493 ($5,843-1,350) 
of the housing cost amount deduction carried over from taxable year 1982 
may not be deducted in 1983 or carried over to 1984.
    Example 8. D is a U.S. citizen and a calendar year and cash basis 
taxpayer. D is a bona fide resident of and maintains his tax home in 
foreign country J for all of taxable year 1984. In 1984, D earns $80,000 
of foreign earned income, $60,000 of which is an employer provided 
amount and $20,000 of which is a non-employer provided amount. D's total 
housing cost amount for 1984 is $25,000. D elects to exclude, under 
section 911(a)(2), the portion of his housing cost amount that is 
attributable to employer provided amounts. D's excludable housing cost 
amount is $18,750; that is the total housing cost amount ($25,000) 
multiplied by employer provided amounts for the taxable year ($60,000) 
over foreign earned income for the taxable year ($80,000). D also elects 
to exclude his foreign earned income under Sec. 1.911-3(d)(1). D's 
section 911(a)(1) limitation for 1984 is $61,250 (the lesser of $80,000-
$18,750 or $80,000x366/366). D's total exclusion for 1984 under section 
911(a)(1) and (2) is $80,000. D cannot claim a housing cost amount 
deduction in 1984 because D has no foreign earned income in excess of 
his foreign earned income and housing cost amount excluded from gross 
income for the taxable year under Sec. 1.911-3 and this section. D may 
carry over his housing cost amount deduction of $6,250, the total 
housing cost amount less the portion attributable to employer provided 
amounts ($25,000-18,750), to taxable year 1985.

(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 
U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2970, Jan. 23, 1985]



Sec. 1.911-5  Special rules for married couples.

    (a) Married couples with two qualified individuals--(1) In general. 
In the case in which a husband and wife both are qualified individuals 
under Sec. 1.911-2(a), each individual may make one or more elections 
under Sec. 1.911-7 and exclude from gross income foreign earned income 
and exclude or deduct housing cost amounts subject to the rules of 
paragraphs (a)(2) and (3) of this section.
    (2) Computation of excluded foreign earned income. The amount of 
excludable foreign earned income is determined separately for each 
spouse under the rule of Sec. 1.911-3 on the basis of the income 
attributable to the services of that spouse. If the spouses file 
separate returns each may exclude the amount of his or her foreign 
earned income attributable to his or her services subject to the 
limitations of Sec. 1.911-3(d)(2). If the spouses file a joint return, 
the sum of these foreign earned income amounts so determined for each 
spouse may be excluded. For example, H and W both qualify under 
Sec. 1.911-2(a)(2)(i) for the entire 1983 taxable year. During 1983 W 
earns $100,000 of foreign earned income and H earns $45,000 of foreign 
earned income. H and W file a joint return for 1983. On their joint 
return H and W may exclude from gross income a total of $125,000. That 
amount is determined by adding W's section 911(a)(1) limitation, $80,000 
(the lesser of $80,000x365/365 or $100,000), and H's section 911(a)(1) 
limitation, $45,000 (the lesser of $80,000x365/365 or $45,000).
    (3) Computation of housing cost amount--(i) Spouses residing 
together. If the spouses reside together, and file a joint return, they 
may compute their housing cost amount either jointly or separately. If 
the spouses reside together and file separate returns, they must compute 
their housing cost amounts separately. If the spouses compute their 
housing cost amounts

[[Page 23]]

separately, they may allocate the housing expenses to either of them or 
between them for the purpose of calculating separate housing cost 
amounts, but each spouse claiming a housing cost amount exclusion or 
deduction must use his or her full base housing amount in such 
computation. If the spouses compute their housing cost amount jointly, 
then only one of the spouses may claim the housing cost amount exclusion 
or deduction.

Either spouse may claim the housing cost amount exclusion or deduction; 
however, if the spouses have different periods of residence or presence 
and the spouse with the shorter period of residence or presence claims 
the exclusion or deduction, then only the expenses incurred in that 
shorter period may be claimed as housing expenses. The spouse claiming 
the exclusion or deduction may aggregate the couple's housing expenses, 
and subtract his or her base housing amount. For example, H and W reside 
together and file a joint return. H was a bona fide resident of and 
maintained his tax home in foreign country M from August 17, 1982, 
through December 31, 1983. W was a bona fide resident of and maintained 
her tax home in foreign country M from September 15, 1982, through 
December 31, 1983. During 1982, H and W earn and receive, respectively, 
$25,000 and $10,000 of foreign earned income. H paid $10,000 for 
qualified housing expenses in 1982, $7,500 of that was for qualified 
housing expenses incurred from September 15, 1982, through December 31, 
1982. W paid $3,000 for qualified housing expenses in 1982 all of which 
were incurred during her period of residence. H and W may choose to 
compute their housing cost amount jointly. If they do so and H claims 
the housing cost amount exclusion his exclusion would be $10,617. H's 
housing expenses would be $13,000 ($10,000+$3,000) and his base housing 
amount would be $2,383 ((39,689x.16)x137/365=$2,383). If instead W 
claims the housing cost amount exclusion her exclusion would be $8,621. 
W's housing expenses would be $10,500 ($7,500+3,000) and her base 
housing amount would be $1,879 (($39,689x.16)x108/365=$1,879). If H and 
W file jointly and both claim a housing cost amount exclusion, then H's 
and W's housing cost amounts would be, respectively, $7,617 ($10,000-
2,383) and $1,121 ($3,000-1,879).
    (ii) Spouses residing apart. If the spouses reside apart, both 
spouses may exclude or deduct their housing cost amount if the spouses 
have different tax homes that are not within reasonable commuting 
distance (as defined in Sec. 1.119-1(d)(4)) of each other and neither 
spouse's residence is within a reasonable commuting distance of the 
other spouse's tax home. If the spouses' tax homes, or one spouse's 
residence and the other spouse's tax home, are within a reasonable 
commuting distance of each other, only one spouse may exclude or deduct 
his or her housing cost amount. Regardless of whether the spouses file 
joint or separate returns, the amount of the housing cost amount 
exclusion or deduction must be determined separately for each spouse 
under the rules of Sec. 1.911-4. If both spouses claim a housing cost 
amount exclusion or deduction directly as qualified individuals, neither 
may claim any such exclusion or deduction under section 
911(c)(2)(B)(ii), relating to a second foreign household maintained for 
the other spouse. If one spouse fails to claim a housing cost amount 
exclusion or deduction which that spouse could claim directly, the other 
spouse may claim such exclusion or deduction under section 
911(c)(2)(B)(ii), relating to a second foreign household maintained for 
the first spouse, provided that all the requirements of that section are 
met. Spouses may not claim more than one second foreign household and 
the expenses of such household may only be claimed by one spouse. For 
example, if both H and W are qualified individuals and H's tax home is 
in London and W's tax home is in Paris, then both H and W may exclude or 
deduct their housing cost amounts; however, H and W must compute these 
amounts separately regardless of whether they file joint or separate 
returns. If instead of living in Paris, W lives in an area where there 
are adverse living conditions and W maintains H's home in London, then W 
may add those housing expenses to her housing expenses and compute one 
base housing amount. In that case H may

[[Page 24]]

not claim a housing cost amount exclusion or deduction.
    (iii) Housing cost amount attributable to employer provided amounts. 
Each spouse claiming a housing cost amount exclusion or deduction shall 
compute the portion of the housing cost amount that is attributable to 
employer provided amounts separately, based on his or her separate 
foreign earned income, in accordance with Sec. 1.911-4(d)(3).
    (b) Married couples with community income. The amount of excludable 
foreign earned income of a husband and wife with community income is 
determined separately for each spouse in accordance with paragraph (a) 
of this section on the basis of income attributable to that spouse's 
services without regard to community property laws. See sections 879 and 
6013 (g) and (h) for special rules regarding treatment of community 
income of a nonresident alien individual married to a U.S. citizen or 
resident.

(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 
U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2972, Jan. 23, 1985]



Sec. 1.911-6  Disallowance of deductions, exclusions, and credits.

    (a) In general. No deduction or exclusion from gross income under 
subtitle A of the Code or credit against the tax imposed by chapter 1 of 
the Code shall be allowed to the extent the deduction, exclusion, or 
credit is properly allocable to or chargeable against amounts excluded 
from gross income under section 911(a). For purposes of the preceding 
sentence, deductions, exclusions, and credits which are definitely 
related (as provided in Sec. 1.861-8), in whole or in part, to earned 
income shall be allocated and apportioned to foreign earned income and 
U.S. source earned income in accordance with the rules contained in 
Sec. 1.861-8. Deductions, exclusions, and credits which are definitely 
related to all gross income under Sec. 1.861-8, including deductions for 
interest described in Sec. 1.861-8(e)(2)(ii), are definitely related, in 
whole or in part, to earned income. In the case of interest expense 
allocable, in whole or in part, to foreign earned income under 
Sec. 1.861-8(e)(2)(ii), the expense shall normally be apportioned under 
option one of the optional gross income methods of apportionment 
(Sec. 1.861-8(e)(2)(v)i(A)), but without regard to conditions (1) and 
(2) of subdivision (vi)(A) (the fifty percent conditions). Such interest 
expense shall not normally be apportioned under the asset method of 
Sec. 1.861-8(e)(2)(v). This is because, where section 911 is the 
operative section, the expense normally relates more closely to gross 
income generated from activities than to the amount of capital utilized 
or invested in activities or property. Deductions that are allocated and 
apportioned to foreign earned income must then be allocated and 
apportioned to foreign earned income that is excluded under section 
911(a). If an individual has foreign earned income from both self-
employment and other employment, the amount excluded under section 
911(a)(1) shall be deemed to include a pro rata amount of the self-
employment income and the income from other employment; thus, a pro rata 
portion of deductible expenses attributable to self-employment income 
must be disallowed. For purposes of section 911 (d)(6) and this section 
only, deductions, exclusions, or credits which are not definitely 
related to any class of gross income shall not be allocable or 
chargeable to excluded amounts and are, therefore, deductible to the 
extent allowed by chapter 1 of the Code. Examples of deductions that are 
not definitely related to a class of gross income are personal and 
family medical expenses, qualified retirement contributions (but see 
section 219(b)(1)), real estate taxes and mortgage interest on a 
personal residence, charitable contributions, alimony payments, and 
deductions for personal exemptions. In addition, for purposes of this 
section, amounts excludable or deductible under section 911 or 119 shall 
not be allocable or chargeable to other amounts excluded under section 
911(a). Thus, an individual's housing cost amount which is excludable or 
deductible under Sec. 1.911-4(d) for a taxable year is not apportioned 
in part to the individual's foreign earned income which is excluded for 
such year under Sec. 1.911-3(d). Therefore, the entire amount of such 
exclusion or deduction is allowed to the extent provided in Sec. 1.911-
4. This section does not affect the time for

[[Page 25]]

claiming any deduction, exclusion, or credit that is not allocated or 
apportioned to excluded amounts.
    (b) Moving expenses--(1) In general. No deduction shall be allowed 
for moving expenses under section 217 to the extent the deduction is 
properly allocable to or chargeable against amounts of foreign earned 
income excluded from gross income under section 911(a). If an 
individual's new principal place of work is in a foreign country, 
deductible moving expenses will be allocable to foreign earned income. 
If an individual treats a reimbursement from his employer for the 
expenses of a move from a foreign country to the United States as 
attributable to services performed in a foreign country under 
Sec. 1.911-3(e)(5)(i), then deductible moving expenses attributable to 
that move will be allocable to foreign earned income. If the individual 
is a qualified individual who elects to exclude foreign earned income 
under section 911(a), then some or all of such moving expenses must be 
disallowed as a deduction.
    (2) Attribution of moving expense deduction to taxable years in 
which services are performed. If a moving expense deduction is properly 
allocable to foreign earned income, the deduction shall be considered 
attributable to services performed in the year of the move as long as 
the individual is a qualified individual under Sec. 1.911-2(a) for a 
period that includes 120 days in the year of the move. If the individual 
is not a qualified individual for such period, then the individual shall 
treat the deduction as attributable to services performed in both the 
year of the move and the succeeding taxable year, if the move is from 
the United States to the foreign country, or the prior taxable year, if 
the move is from a foreign country to the United States. Notwithstanding 
the preceding two sentences, storage expenses incurred after December 
31, 1983 shall be treated as attributable to services performed in the 
year in which the expenses are incurred.
    (3) Formula for disallowance of moving expense deduction. The 
portion of the moving expense deduction that is disallowed shall be 
determined by multiplying the moving expense deduction by a fraction the 
numerator of which is all amounts excluded under section 911(a) for the 
year or years to which the deduction is attributable (under paragraph 
(b)(2) of this section) and the denominator of which is foreign earned 
income (as defined in Sec. 1.911-3(a)) for that year or years.
    (4) Effect of disallowance based on attribution of deduction to 
subsequent year's income. An individual may claim a moving expense 
deduction in the taxable year in which the amount of the expense is paid 
or incurred even if attributable, in part, to the succeeding year. 
However, at such time as the individual excludes income under section 
911(a) for the year or years to which the deduction is attributable, the 
individual shall either--
    (i) File an amended return for the year in which the deduction was 
claimed that does not claim the portion of the deduction that is 
disallowed because it is chargeable against excluded income, or
    (ii) Include in income for the year following the year in which the 
deduction was claimed an amount equal to the amount of the deduction 
that is disallowed.

Any amount included in income under paragraph (b)(4)(ii) of this section 
is not foreign earned income.
    (5) Moves beginning before January 1, 1984. Notwithstanding 
paragraphs (b)(1) through (3) of this section, the rules of this 
paragraph (b)(5) shall apply for moves beginning before January 1, 1984.
    (i) Individual qualifies for the entire taxable year of the move. If 
the individual is a qualified individual for the entire taxable year of 
the move, then the amount of moving expense disallowed shall be 
determined by multiplying the moving expense deduction otherwise 
allowable by a fraction the numerator of which is the foreign earned 
income excluded under section 911(a) for the taxable year of the move 
and the denominator of which is the foreign earned income for the same 
taxable year.
    (ii) Individual qualifies for less than the entire taxable year of 
the move. If the individual is a qualified individual for less than the 
entire taxable year of the move, then, for the purpose of determining 
the portion of the otherwise allowable moving expense deduction that

[[Page 26]]

is disallowed, the individual must attribute a portion of the otherwise 
allowable moving expense deduction either to the succeeding taxable 
year, if the move is from the United States to a foreign country, or to 
the prior taxable year, if the move is from a foreign country to the 
United States. The

portion of the moving expense deduction treated as attributable to 
services performed in the year of the move shall be determined by 
multiplying the otherwise allowable moving expense deduction by the 
following fraction:
[GRAPHIC] [TIFF OMITTED] TC14NO91.141


The portion of the moving expense deduction treated as attributable to 
the year succeeding or preceding the move shall be determined by 
subtracting the portion of the moving expense deduction that is 
attributable to the year of the move from the total moving expense 
deduction. The allocation of a portion of the moving expense deduction 
to a succeeding or preceding taxable year does not affect the time for 
claiming the allowable moving expense deduction. The portion of the 
moving expense deduction that is disallowed shall be determined by 
multiplying the moving expense deduction attributable to the year of the 
move or the succeeding or preceding year, as the case may be, by a 
fraction the numerator of which is amounts excluded under section 911(a) 
for that year and the denominator of which is foreign earned income for 
that year.
    (c) Foreign taxes--(1) Amount disallowed. No deduction or credit is 
allowed for foreign income, war profits, or excess profits taxes paid or 
accrued with respect to amounts excluded from gross income under section 
911. To determine the amount of disallowed foreign taxes, multiply the 
foreign tax imposed on foreign earned income (as defined in Sec. 1.911-
3(a)) received or accrued during the taxable year by a fraction, the 
numerator of which is amounts excluded under section 911(a) in such 
taxable year less deductible expenses properly allocated to such amounts 
(see paragraphs (a) and (b) of this section), and the denominator of 
which is foreign earned income (as defined in Sec. 1.911-3(a)) received 
or accrued during the taxable year less deductible expenses properly 
allocated or apportioned thereto. For the purpose of determining the 
extent to which foreign taxes are disallowed, the housing cost amount 
deduction is treated as definitely related to foreign earned income that 
is not excluded. If the foreign tax is imposed on foreign earned income 
and some other income (for example earned income from sources within the 
United States or an amount not subject to tax in the United States), and 
the taxes on the other amount cannot be segregated, then the denominator 
equals the total of the amounts subject to tax less deductible expenses 
allocable to all such amounts.
    (2) Definitions and special rules--(i) Taxable year. For purposes of 
paragraph (c)(1) of this section, the term ``taxable year'' means the 
individual's taxable year for U.S. tax purposes. Such term includes the 
portion of any foreign taxable year within the individual's U.S. taxable 
year and excludes the portion of any foreign taxable year not within the 
individual's U.S. taxable year.
    (ii) Apportionment of foreign taxes. For purposes of this paragraph 
(c), foreign taxes imposed on foreign earned income shall be deemed to 
accrue, on a pro rata basis, to income as the income is received or 
accrued. The taxes so accrued shall be apportioned to the taxable year 
during which the income is received or accrued. This rule applies for 
all individuals, regardless of their method of accounting.
    (iii) Effect of disallowance. The disallowance of foreign taxes 
under this paragraph (c) shall not affect the time for claiming any 
deduction or credit

[[Page 27]]

for foreign taxes paid. Rather, the disallowance shall only affect the 
amount of taxes considered paid or accrued to any foreign country.
    (iv) Interest on foreign taxes. Any interest expense incurred on a 
liability for foreign taxes is allocated and apportioned not under this 
paragraph (c) but under paragraph (a) of this section to foreign earned 
income and then to excluded foreign earned income and to that extent 
disallowed as a deduction under paragraph (a). In that regard, see also 
Sec. 1.861-8(e)(2) for the specific rules for allocation and 
apportionment of interest expense.
    (d) Examples. The following examples illustrate the application of 
this section.

    Example 1. In 1982 A, an architect, operates his business as a sole 
proprietorship in which capital is not a material income producing 
factor. A receives $1,000,000 in gross receipts, all of which is foreign 
source earned income, and incurs $500,000 of otherwise deductible 
business expenses definitely related to the foreign earned income. A 
elects to exclude $75,000 under section 911(a)(1). The expenses must be 
apportioned to excluded earned income as follows: $500,000x$75,000/
1,000,000. Thus, $37,500 of the business expenses are not deductible.
    Example 2. The facts are the same as in example 1, except that 
$100,000 of A's gross receipts is U.S. source earned income and $68,000 
of A's business expenses are attributable to the U.S. source earned 
income. Thus, A has $900,000 of foreign earned income and $432,000 of 
deductions allocated to foreign earned income. The expenses apportioned 
to excluded earned income are $432,000x$75,000/$900,000, or $36,000, 
which are not deductible.
    Example 3. B is a U.S. citizen, calendar year and cash basis 
taxpayer. B moves to foreign country N and maintains a tax home and is 
physically present there from July 1, 1984 through May 26, 1985. Among 
other possible periods, B is a qualified individual for 219 days in the 
year of the move. B pays $6,000 of otherwise deductible moving expenses 
in 1984. For 1984, B's foreign earned income is $60,000 and B excludes 
$47,869 ($80,000x219/366) under section 911(a). Under paragraph (b)(2) 
of this section, B's moving expenses are attributable to services 
performed in 1984. Under paragraph (b)(3) of this section, 
$6,000x$47,869/$60,000, or $4,789, of B's moving expense deduction is 
disallowed. B may deduct $1,211 of moving expenses on his 1984 return.
    Example 4. The facts are the same as in example 3 except that B 
maintains a tax home and is physically present in foreign country N from 
October 9, 1984 through September 3, 1985. Among other possible periods, 
B is a qualified individual for no more than 119 days in 1984 and 281 
days in 1985. B's foreign earned income for 1984 is $60,000. B's foreign 
earned income for 1985 is $150,000. Because B is a qualified individual 
for less than 120 days in the year of the move, under paragraph (b)(2) 
of this section, B's moving expenses are attributable to services 
performed in 1984 and 1985. At the close of 1984, B may either seek an 
extension of time to file under Sec. 1.911-7(c) or may file an income 
tax return without claiming the exclusions or deduction under section 
911. B does not seek an extension and files without excluding foreign 
earned income; thus B may deduct his moving expenses in full. B later 
amends his 1984 return and excludes foreign earned income for that year. 
B excludes foreign earned income for 1985. B must determine the portion 
of the moving expense deduction that is disallowed. The portion of the 
moving expense deduction that is disallowed is determined by multiplying 
the otherwise allowable moving expense deduction by a fraction. The 
numerator of the fraction is the sum of amounts excluded under section 
911(a) for 1984 and 1985, that is $26,082 or $80,000x119/365, plus 
$61,589, or $80,000x281/365, which totals $87,671. The denominator of 
the fraction is the sum of foreign earned income for 1984 and 1985, that 
is $60,000 plus $150,000, or $210,000. B's allowable moving expense 
deduction is $3,495, or $6,000-($6,000x$87,671/$210,000). If B does not 
file an amended 1984 return (and does not exclude foreign earned income 
for 1984), but excludes foreign earned income under section 911(a) for 
1985, a portion of his moving expense deduction is disallowed, based on 
the same formula. The amount disallowed is $6,000x$61,589/$210,000, or 
$1,760. This amount may be recaptured either by filing an amended return 
for 1984 or by including it in income for 1985 (in which case it is not 
foreign earned income).
    Example 5. C is a U.S. citizen, a self-employed individual, and a 
cash basis and calendar year taxpayer. For the entire 1982 taxable year 
C maintained his tax home and his bona fide residence in foreign country 
P. During 1982 C earned and received $120,000 of foreign earned income, 
none of which was attributable to employer provided amounts. C paid 
$40,000 of business expenses. C elected to exclude foreign earned income 
under section 911(a)(1) and claimed a housing cost amount deduction of 
$15,000. C received $10,000 of foreign source interest income which was 
included with C's earned income in a single tax base and taxed at 
graduated rates. For 1982, C paid $30,000 in income tax to foreign 
country P. The amount of C's business expenses that is properly 
apportioned to excluded amounts (and therefore, not deductible) equals 
$25,000, which is determined by multiplying the otherwise allowable 
deductions by

[[Page 28]]

C's excluded amounts over C's foreign earned income ($40,000x75,000/
120,000). The amount of country P tax that is properly apportioned to 
excluded amounts (and therefore, not deductible or creditable) equals 
$20,000, which is determined by multiplying the tax of $30,000 by the 
following fraction:
[GRAPHIC] [TIFF OMITTED] TC14NO91.142

    Example 6. D is a U.S. citizen and an accrual basis and calendar 
year taxpayer for U.S. tax purposes. For the entire period from January 
1, 1982 through December 31, 1983, D maintains his tax home and his bona 
fide residence in foreign country R. For purposes of R's income tax, D 
is a cash basis taxpayer and uses a fiscal year that begins on April 1 
and ends on the following March 31. During his entire period of 
residence in R, D receives foreign earned income of $10,000 each month, 
all of which is attributable to employer provided amounts. For his 
foreign taxable year ending March 31, 1982, D pays $10,000 of income tax 
to R. For his foreign taxable year ending March 31, 1983, D pays $54,000 
of income tax to R. Under paragraph (c)(2)(ii) of this section, all of 
the $10,000 of tax paid for this foreign taxable year ending March 31, 
1982 is imposed on foreign earned income received in 1982, as is 
$40,500, or \9/12\x$54,000, of tax paid for his foreign taxable year 
ending March 31, 1983. (D received $10,000 per month for the last 3 
months of his foreign taxable year ending March 31, 1982, all of which 
are within his U.S. taxable year ending December 31, 1982 under 
paragraph (c)(2)(i) of this section, and $10,000 per month for each 
month of his foreign taxable year ending March 31, 1983, of which the 
first 9 months are within his U.S. taxable year ending December 31, 
1982. Under paragraph (c)(2)(ii) of this section, foreign taxes are 
deemed to accrue on a pro rata basis to income as it is received or 
accrued. Thus, all of the $10,000 of foreign taxes imposed on the income 
received during D's foreign taxable year ending March 31, 1982 accrue to 
D's 1982 foreign earned income, as do \9/12\ (or $90,000/120,000) of 
foreign taxes imposed on income received during D's foreign taxable year 
ending March 31, 1983, for purposes of determining the amount of D's 
foreign taxes that is disallowed.) For 1982, D has no deductible 
expenses, and elects to exclude his housing cost amount of $21,000 under 
section 911(a)(2) and foreign earned income of $75,000 under section 
911(a)(1). The amount of D's foreign taxes disallowed for deduction or 
credit purposes for 1982 is $8,000 (that is, $10,000x$96,000/$120,000) 
of the taxes for his foreign taxable year ending March 31, 1982, plus 
$32,400 (that is, $40,500x$96,000/$120,000) of the taxes for his foreign 
taxable year ending March 31, 1983, or $40,400. From 1982, D has $2,000 
($10,000-$8,000) of deductible or creditable taxes accrued on March 31, 
1982, and $8,100 ($40,500-$32,400) of deductible or creditable taxes 
accrued on March 31, 1983, after the disallowance based on his 1982 
excluded income.
    Example 7. E is a United States citizen, calendar year and cash 
basis taxpayer. E is physically present in and establishes his tax home 
in foreign country S on May 1, 1981. For purposes of country S, E's 
taxable year begins on April 1 and ends the following March 31. E 
receives foreign earned income of $15,000 each month beginning on May 1, 
1981. At the end of his foreign taxable year ending on March 31, 1982, E 
pays $70,000 of income tax to S on $165,000 of foreign earned income. 
Under section 911, as in effect for taxable years beginning before 
January 1, 1982, E may not exclude any income that is earned or received 
during 1981. None of E's taxes paid in 1982 that are attributable to 
income earned or received in 1981 are subject to disallowance because, 
under paragraph (c)(2)(ii) of this section, the only taxes disallowed 
are those deemed to accrue on income earned and received after December 
31, 1981, and excluded from gross income. The amount of E's taxes paid 
in 1982 that are attributable to 1981 is $50,909, or $70,000x$120,000/
$165,000. E elects to exclude foreign earned income for 1982. The amount 
of E's taxes paid to S in 1982 that accrue to 1982 foreign earned 
income, and are therefore subject to disallowance based on excluded 
income, is $19,091, or $70,000x$45,000/$165,000.

(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 
U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2973, Jan. 23, 1985]

[[Page 29]]



Sec. 1.911-7  Procedural rules.

    (a) Elections of a qualified individual --(1) In general. In order 
to receive either exclusion provided by section 911(a), a qualified 
individual must elect, separately with respect to each exclusion, to 
exclude foreign earned income under section 911(a)(1) and the housing 
cost amount under section 911(a)(2). Any such elections may be made on 
Form 2555 or on a comparable form. Each election must be filed either 
with the income tax return, or with an amended return, for the first 
taxable year of the individual for which the election is to be 
effective. An election once made remains in effect for that year and all 
subsequent years unless revoked under paragraph (b) of this section. 
Each election shall contain information sufficient to determine whether 
the individual is a qualified individual as provided in Sec. 1.911-2. 
The statement shall include the following information:
    (i) The individual's name, address, and social security number;
    (ii) The name of the individual's employer;
    (iii) Whether the individual claimed exclusions under section 911 
for earlier years after 1981 and within the five preceding taxable 
years;
    (iv) Whether the individual has revoked a previously made election 
and the taxable year for which such revocation was effective;
    (v) The exclusion or exclusions the individual is electing;
    (vi) The foreign country or countries in which the individual's tax 
home is located and the date when such tax home was established;
    (vii) The status (either bona fide residence or physical presence) 
under which the individual claims the exclusion;
    (viii) The individual's qualifying period of residence or presence;
    (ix) The individual's foreign earned income for the taxable year 
including the fair market value of all noncash remuneration; and,
    (x) If the individual elects to exclude the housing cost amount, the 
individual's housing expenses.
    (2) Requirement of a return--(i) In general. In order to make a 
valid election under this paragraph (a), the election must be made:
    (A) With an income tax return that is timely filed (including any 
extensions of time to file),
    (B) With a later return filed within the period prescribed in 
section 6511(a) amending the foregoing timely filed income tax return,
    (C) With an original income tax return that is filed within one year 
after the due date of the return (determined without regard to any 
extension of time to file); this one year period does not constitute an 
extension of time for any purpose--it is merely a period during which a 
valid election may be made on a late return, or
    (D) With an income tax return filed after the period described in 
paragraphs (a)(2)(i)(A), (B), or (C) of this section provided--
    (1) The taxpayer owes no federal income tax after taking into 
account the exclusion and files Form 1040 with Form 2555 or a comparable 
form attached either before or after the Internal Revenue Service 
discovers that the taxpayer failed to elect the exclusion; or
    (2) The taxpayer owes federal income tax after taking into account 
the exclusion and files Form 1040 with Form 2555 or a comparable form 
attached before the Internal Revenue Service discovers that the taxpayer 
failed to elect the exclusion.
    (3) A taxpayer filing an income tax return pursuant to paragraph 
(a)(2)(i)(D)(1) or (2) of this section must type or legibly print the 
following statement at the top of the first page of the Form 1040: 
``Filed Pursuant to Section 1.911-7(a)(2)(i)(D).''
    (ii) Election for 1982 and 1983 taxable years. Solely for purposes 
of paragraph (a)(2)(i)(A) of this section, an income tax return for any 
taxable year beginning before January 1, 1984, shall be considered 
timely filed if it is filed on or before July 23, 1985.
    (3) Housing cost amount deduction. An individual does not have to 
make an election in order to claim the housing cost amount deduction. 
However, such individual must provide the Commissioner with information 
sufficient to determine the individual's correct amount of tax. Such 
information shall

[[Page 30]]

include the following: The individual's name, address, and social 
security number; the name of the individual's employer; the foreign 
country in which the individual's tax home was established; the status 
under which the individual claims the deduction; the individual's 
qualifying period of residence or presence; the individual's foreign 
earned income for the taxable year; and the individual's housing 
expenses.
    (4) Effect of immaterial error or omission. An inadvertent error or 
omission of information required to be provided to make an election 
under this paragraph (a) shall not render the election invalid if the 
error or omission is not material in determining whether the individual 
is a qualified individual or whether the individual intends to make the 
election.
    (b) Revocation of election--(1) In general. An individual may revoke 
any election made under paragraph (a) of this section for any taxable 
year. A revocation must be made separately with respect to each 
election. The individual may revoke an election for any taxable year, 
including the first taxable year for which an election was effective, by 
filing a statement that the individual is revoking one or more of the 
previously made elections. The statement must be filed with the income 
tax return, or with an amended return, for the first taxable year of the 
individual for which the revocation is to be effective. A revocation 
once made is effective for that year and all subsequent years. If an 
election is revoked for any taxable year, including the first taxable 
year for which the election was effective, the individual may not, 
without the consent of the Commissioner, again make the same election 
until the sixth taxable year following the taxable year for which the 
revocation was first effective. For example, a qualified individual 
makes an election to exclude foreign earned income under section 
911(a)(1) and files it with his 1982 income tax return. The individual 
files 1983 and 1984 income tax returns on which he excludes his foreign 
earned income. Then, within 3 years after filing his 1982 income tax 
return, the individual files an amended 1982 income tax return with a 
statement revoking his election to exclude foreign earned income under 
section 911(a)(1). The revocation of the election is effective for 
taxable years 1982, 1983, and 1984. The individual may not elect to 
exclude income under section 911(a)(1) for any taxable year before 1988, 
unless he obtains consent to reelect under paragraph (b)(2) of this 
section.
    (2) Reelection before sixth taxable year after revocation. If an 
individual revoked an election under paragraph (b)(1) of this section 
and within five taxable years the individual wishes to reelect the same 
exclusion, then the individual may apply for consent to the reelection. 
The application for consent shall be made by requesting a ruling from 
the Associate Chief Counsel (Technical), National Office, Internal 
Revenue Service, 1111 Constitution Avenue NW., Washington, DC 20224. In 
determining whether to consent to reelection the Associate Chief Counsel 
or his delegate shall consider any facts and circumstances that may be 
relevant to the determination. Relevant facts and circumstances may 
include the following: a period of United States residence, a move from 
one foreign country to another foreign country with differing tax rates, 
a substantial change in the tax laws of the foreign country of residence 
or physical presence, and a change of employer.
    (c) Returns and extensions--(1) In general. Any return filed before 
completion of the period necessary to qualify an individual for any 
exclusion of deduction provided by section 911 shall be filed without 
regard to any exclusion or deduction provided by that section. A claim 
for a credit or refund of any overpayment of tax may be filed, however, 
if the taxpayer subsequently qualifies for any exclusion or deduction 
under section 911. See section 6012(c) and Sec. 1.6012-1(a)(3), relating 
to returns to be filed and information to be furnished by individuals 
who qualify for any exclusion or deduction under section 911.
    (2) Extensions. An individual desiring an extension of time (in 
addition to the automatic extension of time granted by Sec. 1.6081-2) 
for filing a return until after the completion of the qualifying period 
described in paragraph (c)(1) of this section for claiming any exclusion

[[Page 31]]

or deduction under section 911 may apply for an extension. An individual 
whose moving expense deduction is attributable to services performed in 
two years may apply for an extension of time for filing a return until 
after the end of the second year. The individual may make such 
application on Form 2350 or a comparable form. The application must be 
filed with the Director, Internal Revenue Service Center, Philadelphia, 
Pennsylvania 19255. The application must set forth the facts relied on 
to justify the extension of time requested and must include a statement 
as to the earliest date the individual expects to become entitled to any 
exclusion or deduction by reason of completion of the qualifying period.
    (d) Declaration of estimated tax. In estimating gross income for the 
purpose of determining whether a declaration of estimated tax must be 
made for any taxable year, an individual is not required to take into 
account income which the individual reasonably believes will be excluded 
from gross income under the provisions of section 911. In computing 
estimated tax, however, the individual must take into account, among 
other things, the denial of the foreign tax credit for foreign taxes 
allocable to the excluded income (see Sec. 1.911-6(c)).

(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 
U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2976, Jan. 23, 1985, as amended by T.D. 8480, 58 FR 
34885, June 30, 1993]



Sec. 1.911-8  Former deduction for certain expenses of living abroad.

    For rules relating to the deduction for certain expenses of living 
abroad applicable to taxable years beginning before January 1, 1982, see 
26 CFR 1.913-1 through 1.913-13 as they appeared in the Code of Federal 
Regulations revised as of April 1, 1982.

(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 
U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2977, Jan. 23, 1985

               earned income of citizens of united states



Sec. 1.912-1  Exclusion of certain cost-of-living allowances.

    (a) Amounts received by Government civilian personnel stationed 
outside the continental United States as cost-of-living allowances in 
accordance with regulations approved by the President are, by the 
provisions of section 912(1), excluded from gross income. Such 
allowances shall be considered as retaining their characteristics under 
section 912(1) notwithstanding any combination thereof with any other 
allowance. For example, the cost-of-living portion of a ``living and 
quarters allowance'' would be excluded from gross income whether or not 
any other portion of such allowance is excluded from gross income.
    (b) For purposes of section 912(1), the term ``continental United 
States'' includes only the 48 States existing on February 25, 1944 (the 
date of the enactment of the Revenue Act of 1943 (58 Stat. 21)) and the 
District of Columbia.



Sec. 1.912-2  Exclusion of certain allowances of Foreign Service personnel.

    Gross income does not include amounts received by personnel of the 
Foreign Service of the United States as allowances or otherwise under 
the provisions of chapter 9 of title I of the Foreign Service Act of 
1980 or the provisions of section 28 of the State Department Basic 
Authorities Act (formerly section 914 of title IX of the Foreign Service 
Act of 1946).

[T.D. 8256, 54 FR 28620, July 6, 1989]



Sec. 1.921-1T  Temporary regulations providing transition rules for DISCs and FSCs.

    (a) Termination of a DISC--(1) At end of 1984.
    Q-1: What is the effect of the termination on December 31, 1984, of 
a DISC's taxable year?
    A-1: Without regard to the annual accounting period of the DISC, the 
last taxable year of each DISC beginning during 1984 shall be deemed to 
close on December 31, 1984. The corporation's

[[Page 32]]

DISC election also shall be deemed revoked at the close of business on 
December 31, 1984. (A DISC that does not elect to be an interest charge 
DISC as of January 1, 1985, in addition to a corporation described in 
section 992(a)(3), shall be referred to as a ``former DISC''.) A 
corporation which wishes to be treated as a FSC, a small FSC, or an 
interest charge DISC must make an election as provided under paragraph 
(b) (Q & A 1) of this section.
    (2) Deemed distributions for short taxable years.
    Q-2: If the termination of the DISC's taxable year on December 31, 
1984, results in a short taxable year, how are the deemed distributions 
under section 995(b)(1)(E) determined?
    A-2: The deemed distributions are determined on the basis of the 
DISC's taxable income for its short taxable year ending on December 31, 
1984. In computing the incremental distribution under section 
995(b)(1)(E), the export gross receipts for the short taxable year must 
be annualized.
    (3) Qualification as a DISC for 1984.
    Q-3: Must the DISC satisfy all the tests set forth in section 
992(a)(1) for the DISC's taxable year ending December 31, 1984?
    A-3: All of the tests under section 992(a)(1), except the qualified 
assets test under section 992(a)(1)(B), must be satisfied.
    (4) Commissions for 1984.
    Q-4: Must commissions be paid by a related supplier to a DISC with 
respect to the DISC's taxable year ending December 31, 1984?
    A-4: No.
    Q-4A: Must commissions which were earned prior to January 1, 1985, 
be paid by a related supplier if the last date payment is required (as 
set forth in Sec. 1.994-1(e)(3)) is after December 31, 1984?
    A-4A: No.
    (5) Producer's loans of 1984.
    Q-5: Must the producer's loan rules under section 993(d) be 
satisfied with respect to the DISC's taxable year ending December 31, 
1984?
    A-5: Yes.
    (6) Accumulated DISC income.
    Q-6. Under what circumstances is any remaining accumulated DISC 
income treated as previously taxed income (and not taxed)?
    A-6. The accumulated DISC income of a DISC (but not a DISC described 
in section 992(a)(3)) as of December 31, 1984, is treated as previously 
taxed income when actually distributed after December 31, 1984. Any 
amounts distributed by the former DISC (including a DISC which has 
elected to be an interest charge DISC) after December 31, 1984, shall be 
treated as made first out of current earnings and profits and then out 
of previously taxed income to the extent thereof. For purposes of the 
preceding sentence, amounts distributed before July 1, 1985, shall be 
treated as made first out of previously taxed income to the extent 
thereof. If property other than money is distributed and if such 
property was a qualified export asset within the meaning of section 
993(b) on December 31, 1984, then for purposes of section 311, no gain 
or loss will be recognized on the distribution and the distributee will 
have the same basis in the property as the distributor.
    Q-7: May a DISC that was previously disqualified, but has 
requalified as of December 31, 1984, treat any accumulated DISC income 
as previously taxed income?
    A-7: If a DISC was previously disqualified, but has requalified as 
of December 31, 1984, any accumulated DISC income previously required to 
be taken into income upon prior disqualification shall not be treated as 
previously taxed income. All accumulated DISC income derived since 
requalification, however, will be treated as previously taxed income.
    (7) Distribution of previously taxed income.
    Q-8: What effect will the distribution of previously taxed income 
have on the earnings and profits of corporate shareholders of the former 
DISC?
    A-8: The earnings and profits of the corporate shareholders of the 
former DISC will be increased by the amount of money and the adjusted 
basis of any property which is distributed out of previously taxed 
income.
    Q-9: Will the distribution of the former DISC's accumulated DISC 
income as previously taxed income after December 31, 1984, result in a 
reduction

[[Page 33]]

in the shareholder's basis of the stock of the former DISC and 
consequent taxation of the excess of the distribution over such basis as 
capital gain under section 996(d)?
    A-9: No. This distribution will be treated both as amounts 
representing deemed distributions under section 995(b)(1) and as 
previously taxed income. Thus, no capital gain will arise.
    (8) Qualifying distributions.
    Q-10: How is a qualifying distribution to satisfy the qualified 
export receipts tests under section 992(c)(1)(A) which is made with 
respect to the DISC's taxable year ending on December 31, 1984, treated?
    A-10: The distribution will not be treated as previously taxed 
income but will be taxed to the shareholder of the former DISC, as 
provided under section 992(c) and 996(a)(2) and the regulations 
thereunder, in the shareholder's taxable year in which the distribution 
is made.
    (9) Deficiency distributions.
    Q-11: With respect to an audit adjustment made after December 31, 
1984, may a deficiency distribution be made, and if so, in what manner 
may it be made?
    A-11: A deficiency distribution may be made notwithstanding the fact 
that after December 31, 1984, the former DISC is a taxable corporation 
under subchapter C, has elected to be treated as an interest charge 
DISC, or has been liquidated, reorganized or is otherwise no longer in 
existence. However, such deficiency distribution shall be treated as 
made out of accumulated DISC income which is not previously taxed income 
because it will be treated as distributed prior to December 31, 1984, to 
the DISC's shareholders.
    Q-11A: Must a former DISC remain in existence in order for a former 
DISC shareholder to take advantage of the spread provided in section 
995(b)(2) with respect to DISC disqualification?
    A-11A: No. With respect to distributions deemed to be received by a 
former DISC shareholder under section 995(b)(2) for taxable years 
beginning after December 31, 1984, if the former DISC shareholder 
elects, the rules of section 995(b)(2)(B) shall apply even though the 
former DISC does not continue in existence. If the former DISC is no 
longer in existence, the former DISC's shareholders will be deemed to 
have received the distribution on the last day of their taxable years 
over the applicable period of time determined under section 995(b)(2) as 
if the former DISC had remained in existence.
    (10) Deemed distribution for 1984.
    Q-12: How is the deemed distribution to a shareholder for the DISC's 
taxable year ending December 31, 1984, taken into account?
    A-12 (i) If the taxable year of the DISC ending on December 31, 
1984, (A) is the first taxable year of the DISC which begins in 1984, 
(B) begins after the date in 1984 on which the taxable year of the 
DISC's shareholder begins, and (C) if the DISC's shareholder makes an 
election under section 805(b)(3) of the Tax Reform Act of 1984, the 
deemed distribution under section 995(b) with respect to income derived 
by the DISC for such taxable year of the DISC shall be treated as 
received by the shareholder in 10 equal installments (unless the 
shareholder elects to be treated as receiving the deemed distribution in 
income over a smaller number of equal installments). The first 
installment shall be treated as received by the shareholder on the last 
day of the shareholder's second taxable year beginning in 1984 (if any), 
or if the shareholder had only one taxable year which began in 1984, on 
the last day of the shareholder's first taxable year beginning in 1985. 
One installment shall be treated as received by the shareholder on the 
last day of each succeeding taxable year of the shareholder until the 
entire amount of the DISC's 1984 deemed distribution has been included 
in the shareholder's taxable income. To make the election under section 
805(b)(3) of the Tax Reform Act of 1984, the DISC shareholder must 
attach a statement to its timely filed tax return (including extensions) 
for its taxable year which includes December 31, 1984, indicating the 
total amount of the shareholder's pro rata share of the DISC's deemed 
distribution for 1984 (determined under section 995(b) of the Code 
without regard to the election under section 805(b)(3) of the Tax Reform 
Act of 1984), and the number of equal installments, if less than 10, 
over which the shareholder wishes to spread

[[Page 34]]

its pro rata share of the deemed distribution for 1984. If the election 
under section 805(b)(3) of the Tax Reform Act of 1984 is made, it may 
not be changed or revoked. In determining estimated tax payments, the 
portion of the deemed distribution includible in the shareholder's 
taxable income for any taxable year under this subdivision (i) shall be 
treated as received by the shareholder on the last day of such taxable 
year.
    (ii) Except as provided in subdivision (i), the deemed distribution 
under section 995(b) with respect to income derived by the DISC for its 
taxable year ending on December 31, 1984, shall be included in the 
shareholder's taxable income for its taxable year which includes 
December 31, 1984. Thus, if the taxable year of the DISC and the DISC's 
shareholder both begin on January 1, 1984, and end on December 31, 1984 
(or, if the taxable year of the DISC beginning in 1984 begins before the 
taxable year of the DISC's shareholder), the deemed distribution with 
respect to the DISC's taxable year ending on December 31, 1984, will be 
included in the DISC shareholder's taxable year ending on (or including) 
December 31, 1984, and the election described in subdivision (i) may not 
be made.
    (iii) The provisions of this Question and Answer-12 apply without 
regard to any existence of the DISC after December 31, 1984, as an 
interest charge DISC.
    Q-12A: If under section 805(b)(3) of the Tax Reform Act of 1984 the 
shareholders of the DISC are permitted to make an election to treat the 
DISC's 1984 deemed distribution as received over a 10-year period, must 
the DISC distribute that amount to its shareholders ratably over the 10-
year period?
    A-12A: No. Under section 805(b)(3) of the Tax Reform Act of 1984, if 
the DISC's deemed distribution for its taxable year which ended on 
December 31, 1984, is a qualified distribution, the shareholders of the 
DISC are permitted to make an election to treat the distribution as 
received over a 10-year period. The 10-year treatment applies even 
though the amount of the deemed distribution is distributed to the 
DISC's shareholders prior to the period in which the distribution is 
taken into income by the shareholders. In addition, under section 996(e) 
of the Code, the shareholder's basis in the stock of the DISC will be 
considered as increased, as of the date of liquidation, by the 
shareholder's pro rata share of the amount of the undistributed 
qualified distribution even though that amount is treated as received by 
the shareholder in later years. Further, the actual distribution in 
liquidation of the former DISC after 1984 will increase the earnings and 
profits of a corporate distributee, and the amount actually distributed 
shall be treated under the rules of section 996.
    (11) Conformity of accounting period.
    Q-13: May a DISC be established or change its annual accounting 
period for taxable years beginning after March 21, 1984, and before 
January 1, 1985?
    A-13: A DISC that is established or that changes its annual 
accounting period after March 21, 1984, must conform its annual 
accounting period to that of its principal shareholder (the shareholder 
with the highest percentage of voting power as defined in section 
441(h)).
    (12) DISC gains and distributions from U.S. sources.
    Q-14: What is the effective date of the amendment to section 996(g), 
made by section 801(d)(10) of the Tax Reform Act of 1984, which treats 
certain DISC gains and distributions as derived from sources within the 
United States?
    A-14: Under section 805(a)(3) of the Act, the amendment to section 
996(g) shall apply to all gains referred to in section 995(c) and all 
distributions out of accumulated DISC income including deemed 
distributions made on or after June 22, 1984.
    (b) Establishing and electing status as a FSC, small FSC or interest 
charge DISC--(1) Ninety-day period.
    Q-1: How does a corporation elect to be treated as a FSC, a small 
FSC, or an interest charge DISC?
    A-1: A corporation electing FSC or small FSC status must file Form 
8279. A corporation electing interest charge DISC status must file Form 
4876A. A corporation electing to be treated as a FSC, small FSC, or 
interest charge DISC for its first taxable year shall make its election 
within 90 days after

[[Page 35]]

the beginning of that year. A corporation electing to be treated as a 
FSC, small FSC, or interest charge DISC for any taxable year other than 
its first taxable year shall make its election during the 90-day period 
immediately preceding the first day of that taxable year. The election 
to be a FSC, small FSC, or interest charge DISC may be made by the 
corporation, however, during the first 90 days of a taxable year, even 
if that taxable year is not the corporation's first taxable year, if 
that taxable year begins before July 1, 1985. Likewise, the election to 
be a FSC (or a small FSC) may be made during the first 90 days of any 
taxable year of a corporation if the corporation had in a prior taxable 
year elected small FSC (or FSC) status and the corporation revokes the 
small FSC (or FSC) election within the 90 day period. A corporation 
which was a DISC for its taxable year ending December 31, 1984, which 
wishes to be treated as an interest charge DISC beginning with its first 
taxable year beginning after December 31, 1984, may make the election to 
be treated as an interest charge DISC by filing Form 4876A on or before 
July 1, 1987. Also, if a corporation which has elected FSC, small FSC or 
interest charge DISC status, or a shareholder of that corporation, is 
acquired in a qualified stock purchase under section 338(d)(3), and if 
an election under section 338(a) is effective with regard to that 
corporation, the corporation may re-elect FSC, small FSC or interest 
charge DISC status, (whichever is applicable) not later than the date of 
the election under section 338(a), see section 338(g)(i) and Sec. 1.338-
2(d). This re-election is necessary because the original elections are 
deemed terminated if an election is made under section 338(a). The rules 
contained in Sec. 1.992-2 (a)(1), (b)(1) and (b)(3) shall apply to the 
manner of making the election and the manner and form of shareholder 
consent.
    (2) FSC incorporated in a possession.
    Q-2: Where does a FSC which is incorporated in a U.S. possession 
file its election?
    A-2: The election is filed with the Internal Revenue Service Center, 
Philadelphia, Pennsylvania 19255.
    (3) Information returns.
    Q-3: Must Form 5471 be filed with respect to the organization of a 
FSC pursuant to section 6046 or to provide information with respect to a 
FSC pursuant to section 6038?
    A-3: A Form 5471 required under section 6046 need not be filed with 
respect to the organization of a FSC. The requirements of section 6046 
shall be satisfied by the filing of a Form 8279 dealing with the 
election to be treated as a FSC or small FSC. However, a Form 5471 will 
be required with respect to a reorganization of a FSC (or small FSC) or 
an acquisition of stock of a FSC (or small FSC), as required under 
section 6046 and the regulations thereunder. Provided that a Form 1120 
FSC is filed, a Form 5471 need not be filed to satisfy the requirements 
of section 6038.
    (4) Conformity of accounting period.
    Q-4: Since a FSC, small FSC, and interest charge DISC must use the 
same annual accounting period as the principal shareholder, must such 
corporation delay the beginning of its first taxable year beyond January 
1, 1985 if the principal shareholder (the shareholder with the highest 
percentage of voting power as defined in section 441(h)) is not a 
calendar year taxpayer?
    A-4: No. Where the principal shareholder is not a calendar year 
taxpayer, a corporation may elect to be treated as a FFSC, small FSC, or 
interest charge DISC for a taxable year beginning January 1, 1985. 
However, such corporation must close its first taxable year and adopt 
the annual accounting period of its principal shareholder as of the 
first day of the principal shareholder's first taxable year beginning in 
1985. A FSC, small FSC, or interest charge DISC need not obtain the 
consent of the Commissioner under section 442 to conform its annual 
accounting period to the annual accounting period of its principal 
shareholder.
    (5) Dollar limitations for short taxable years.
    Q-5: If a small FSC or an interest charge DISC has a short taxable 
year, how are the dollar limitations on foreign trading export gross 
receipts and qualified export gross receipts, respectively, determined 
for small FSCs and interest charge DISCs?

[[Page 36]]

    A-5: The dollar limitations are to be prorated on a daily basis. 
Thus, for example, if for its 1985 taxable year a small FSC has a short 
taxable year of 73 days, then in determining exempt foreign trade 
income, any foreign trading gross receipts that exceed $1 million (73/
365 x $5 million) will not be taken into account.
    (6) Change of accounting period.
    Q-6: If the principal shareholder of a FSC, a small FSC, or an 
interest charge DISC (hereinafter referred to as a ``FSC'') changes its 
annual accounting period or is replaced by a new principal shareholder 
during a taxable year, is it necessary for the FSC to change its annual 
accounting period?
    A-6: If the principal shareholder changes its annual accounting 
period, the FSC must also change its annual accounting period to conform 
to that of its principal shareholder. If the voting power of the 
principal shareholder is reduced by an amount equal to at least 10 
percent of the total shares entitled to vote and such shareholder is no 
longer the principal shareholder, the FSC must conform its accounting 
period to that of its new principal shareholder. However, in determining 
whether a shareholder is a principal shareholder, the voting power of 
the shareholders is determined as of the beginning of the FSC's taxable 
year. Thus, for example, assume that for 1985 a FSC adopts a calendar 
year period as its annual accounting period to conform to that of its 
principal shareholder. Assume further than in March 1985 there is a 10 
percent change in voting power and a different shareholder whose annual 
accounting period begins on July 1 becomes the new principal 
shareholder. The FSC will not be required to adopt the annual accounting 
period of its new principal shareholder until July 1, 1986. The FSC will 
have a short taxable year for the period January 1 to June 30, 1986.
    (7) Transition transfers.
    Q-7. Under what circumstances may a DISC or former DISC transfer its 
assets to a FSC or small FSC without incurring any tax liability on the 
transfer?
    A-7. A DISC or former DISC will recognize no income, gain, or loss 
on a transfer of its qualified assets (as defined in section 993(b)) to 
a FSC or small FSC if all of the following conditions are met:
    (i) The assets transferred were held by the DISC on August 4, 1983, 
and were transferred by the DISC or former DISC to the FSC or small FSC 
in a transfer completed before January 1, 1986; and
    (ii) The assets are transferred in a transaction which would qualify 
for nonrecognition under subchapter C of chapter 1 of the Code, or would 
so qualify but for section 367 of the Code.
    In such case, section 367 shall not apply to the transfer.
    In addition, other provisions of subchapter C will apply to the 
transfer, such as section 358 (basis to shareholders), section 362 
(basis to corporations), and section 381 (carryovers in corporate 
acquisitions). In determining whether a transfer by a DISC to a FSC or 
small FSC qualifies for nonrecognition under subchapter C, a liquidation 
of the assets of the DISC into a parent corporation followed by a 
transfer by the parent of those assets to the FSC or small FSC will be 
treated as a transaction described in section 368(a)(1)(D).
    Notwithstanding the foregoing answer, a taxpayer which transfers a 
right to use its corporate name to a FSC in a transaction described in 
sections 332, 351, 354, 356 and 361 shall not be treated as having sold 
that right under section 367(d) or as having transferred that right to 
an entity that is not a corporation under section 367(a) provided that 
the corporate name is used only by the FSC and is not licensed or 
otherwise made available to others by the FSC.
    (8) Completed contract method.
    Q-8: Under what conditions is a taxpayer using the completed 
contract method of accounting as defined in Sec. 1.451-3(d) exempted 
from satisfying the foreign management and foreign economic process 
requirements of subsections (c) and (d) of section 924?
    A-8: If the taxpayer has entered into a binding contract before 
March 16, 1984, or has on March 15, 1984, and at all times thereafter a 
firm plan, evidenced in writing, to enter the contract and enters into a 
binding contract by December 31, 1984, then the taxpayer will

[[Page 37]]

be treated as having satisfied the foreign management tests of section 
924(c) for periods before December 31, 1984, and the foreign economic 
process tests of section 924(d) with respect to costs incurred before 
December 31, 1984, with respect to the transaction. The FSC rules will 
apply to the income from the long-term contract if an election is made 
and the general FSC requirements under section 922 are satisfied. 
However, such taxpayer need not satisfy the activities test under 
section 925(c) for activities which occur before January 1, 1985 in 
order to use the transfer pricing rules under section 925.
    (9) Long-term contract--before March 15, 1984.
    Q-9: Under what conditions is a taxpayer who enters into a binding 
long-term contract (i.e., a contract which is not completed in the 
taxable year in which it is entered into) before March 15, 1984, but 
does not use the completed contract method of accounting exempted from 
satisfying the foreign management and economic process requirements of 
subsections (c) and (d) of section 924?
    A-9: If a taxpayer enters into a binding contract before March 15, 
1984, the taxpayer will be treated as having satisfied the foreign 
management tests of section 924(c) for periods before December 31, 1984, 
and the foreign economic process tests of section 924(d) with respect to 
costs incurred before December 31, 1984, but only with respect to income 
attributable to such contracts that is recognized before December 31, 
1986. The FSC rules will apply to the income from the long-term contract 
if an election is made and the general FSC requirements under section 
922 are satisfied. However, such taxpayer need not satisfy the 
activities test under section 925(c) for activities which occur before 
January 1, 1985, in order to use the transfer pricing rules under 
section 925.
    (10) Long-term contract--after March 15, 1984.
    Q-10: Under what conditions is a taxpayer who has a long-term 
contract (i.e., a contract which is not completed in the taxable year in 
which it is entered into) but does not use the completed contract method 
of accounting exempted from satisfying the foreign management and 
economic process requirements of subsections (c) and (d) of section 924 
if such taxpayer enters into a binding contract after March 15, 1984 and 
before January 1, 1985?
    A-10: If a taxpayer enters into a contract after March 15, 1984, and 
before January 1, 1985, the taxpayer will be treated as having satisfied 
the foreign management tests of section 924(c) for periods before 
December 31, 1984, and the foreign economic process tests of section 
924(d) with respect to costs incurred before December 31, 1984, but only 
with respect to income attributable to such contract that is recognized 
before December 31, 1985.
    The FSC rules will apply to the income from the long-term contract 
if an election is made and the general requirements under section 922 
are satisfied. However, such taxpayer need not satisfy the activities 
test under section 925(c) for activities which occur before January 1, 
1985 in order to use the transfer pricing rules under section 925.
    (11) Incomplete transactions.
    Q-11: In computing its foreign trade income, how should a FSC treat 
transfers of export property from a related supplier to a DISC which is 
subsequently resold by a FSC after the DISC's termination?
    A-11: In applying the gross receipts and combined taxable income 
methods under section 925 (a)(1) and (a)(2), the transaction is treated 
as if the transfer of export property were made by the related supplier 
to the FSC except that the foreign management and economic processes 
tests under section 924 and the activities test under section 925(c) 
shall be deemed to be satisfied for purposes of the transaction.
    (12) Pre-effective date costs and activities.
    Q-12: Are costs incurred and activities performed prior to January 
1, 1985 taken into account for purposes of satisfying the foreign 
management and foreign economic processes requirements of subsections 
(c) and (d) of section 924 and the activities test under section 925(c)?
    A-12: For purposes of determining the costs incurred and the 
activities performed to be taken into account with respect to contracts 
entered into after

[[Page 38]]

December 31, 1984, only those costs incurred and activities performed 
after December 31, 1984, are taken into consideration. Costs incurred 
and activities performed by a related supplier prior to January 1, 1985 
(or prior to the effective date of a corporation's election to be 
treated as a FSC if other than January 1, 1985) with respect to 
transactions occurring after January 1, 1985 (or after the effective 
date of a corporation's election to be treated as a FSC) need not be 
taken into account for purposes of computing the FSC's profit under 
section 925 but are treated for section 925(c) purposes as if they were 
performed on behalf of the FSC.
    (13) FSC and interest charge DISC.
    Q-13: Can a FSC and an interest charge DISC be members of the same 
controlled group?
    A-13: A FSC and an interest charge DISC cannot be members of the 
same controlled group. If any controlled group of corporations of which 
an interest charge DISC is a member establishes a FSC, then any interest 
charge DISC which is a member of such group shall be treated as having 
terminated its status as an interest charge DISC.
    (c) Export Trade Corporations--(1) Previously taxed income.
    Q-1: Under what circumstances are earnings of an export trade 
corporation that have not been included in income under section 951 
treated as previously taxed income previously included in the income of 
a U.S. shareholder for purposes of section 959 (and not taxed)?
    A-1: A corporation which qualifies as an export trade corporation 
(ETC) with respect to its last taxable year beginning before January 1, 
1985, and elects to discontinue operations as an ETC for all taxable 
years beginning after December 31, 1984, shall not be required to take 
into income earnings attributable to previously excluded export trade 
income, as defined in Sec. 1.970-1(b), derived with respect to taxable 
years beginning before January 1, 1985. However, any amounts distributed 
by the former ETC (i.e. a corporation which was an ETC for its last 
taxable year beginning before January 1, 1985) shall be treated as being 
made out of current earnings and profits and then out of previously 
taxed income. For purposes of determining the shareholder's basis in the 
ETC stock, distributions of previously excluded export trade income 
shall be treated as if made out of previously taxed income which has 
already been included in gross income under section 951(a)(1)(B). Thus, 
no basis adjustment under section 961 is necessary. In addition, upon 
the sale or exchange of the stock of such corporation in a transaction 
described in section 1248(a), the earnings and profits of the 
corporation attributable to such previously untaxed income shall not be 
subject to section 1248(a).
    (2) Qualification as an ETC for last year.
    Q-2: Must an ETC satisfy all of the tests set forth in section 
971(a)(1) for the ETC's last taxable year beginning before January 1, 
1985?
    A-2: All of the tests in section 971(a)(1) must be satisfied, except 
that for purposes of the working capital requirements set forth in 
section 971(c)(1), the working capital of the ETC at the close of its 
last taxable year beginning before January 1, 1985 shall be deemed 
reasonable.
    (3) Continuation of ETC status.
    Q-3: May a corporation which chooses to remain an ETC after December 
31, 1984, continue to do so?
    A-3: Yes. However, previously untaxed income of such ETC shall not 
be treated as previously taxed income in accordance with Q&A 1 
of this section.
    (4) Discontinuation of ETC status.
    Q-4: How does an ETC make an election to discontinue its operation 
as an ETC?
    A-4: The United States shareholders (as defined in section 951(b)) 
must file a statement of election on behalf of the ETC indicating the 
intent of the ETC to discontinue operations as an ETC for taxable years 
beginning after December 31, 1984. In addition, the statement of 
election must include the name, address, taxpayer identification number 
and stock interest of each United States shareholder. The statement must 
also indicate that the corporation on behalf of which the shareholders 
are making the election qualified as an ETC for its last taxable year 
beginning before January 1, 1985, and also the amount of earnings 
attributable to previously excluded export

[[Page 39]]

trade income. The statement must be jointly signed by each United States 
shareholder with each shareholder stating under penalties of perjury 
that he or she holds the stock interest specified for such shareholder 
in the statement of election. A copy of the statement of election must 
be attached to Form 5471 (information return with respect to a foreign 
corporation) filed with respect to the ETC's last taxable year beginning 
before January 1, 1985.
    (5) Transition transfers.
    Q-5: Under what circumstances may an electing ETC transfer its 
assets to a FSC without incurring any tax liability on the transfer?
    A-5: An electing ETC will recognize no income, gain, or loss on a 
transfer of its assets to a FSC but only if all of the following 
conditions are met:
    (i) The assets transferred were held by the ETC on August 4, 1983, 
and were transferred by the ETC to the FSC in a transfer completed 
before January 1, 1986; and
    (ii) The assets are transferred in a transaction which would qualify 
for nonrecognition under subchapter C of chapter 1 of the Code, or would 
so qualify but for section 367 of the Code.
    In such case, section 367 shall not apply to the transfer. In 
addition, other provisions of subchapter C will apply to the transfer 
such as section 358 (basis to shareholders), section 362 (basis to 
corporation) and section 381 (carryovers in corporate acquisitions). In 
determining whether a transfer by an ETC to a FSC qualifies for 
nonrecognition under subchapter C, a liquidation of the assets of the 
ETC into a parent corporation followed by a transfer by the parent of 
those assets to the FSC will be treated as a transaction described in 
section 368(a)(1)(D).

(Secs. 803 and 805 of the Tax Reform Act of 1984 (98 Stat. 1001) and 
sec. 7805 of the Internal Revenue Code of 1954 (68A Stat. 917; 26 U.S.C. 
7805); sec. 805 (b)(3)(C) and (D) of the Tax Reform Act of 1984 (98 
Stat. 1002), and sec. 7805 of the Code (68A Stat. 917; 26 U.S.C. 7805); 
secs. 367, 927, and 7805 of the Internal Revenue Code of 1954 (98 Stat. 
662, 26 U.S.C. 367; 98 Stat. 663, 26 U.S.C. 367; 98 Stat. 993, 26U.S.C. 
927; 98 Stat. 994, 26 U.S.C. 927; and 68A Stat. 917, 26 U.S.C. 7805); 
sec. 805 of the Tax Reform Act of 1984 (Pub. L. 98-69, 98 Stat. 1000))

[T.D. 7983, 49 FR 40013, Oct. 12, 1984, as amended by T.D. 7992, 49 FR 
48283, Dec. 12, 1984; T.D. 7993, 49 FR 48291, Dec. 12, 1984; T.D. 7992, 
49 FR 49450, Dec. 20, 1984; T.D. 8126, 52 FR 6434, 6435, Mar. 3, 1987; 
T.D. 8515, 59 FR 2984, Jan. 20, 1994; T.D. 8858, 65 FR 1237, Jan. 7, 
2000; T.D. 8940, 66 FR 9929, Feb. 13, 2001]



Sec. 1.921-2  Foreign Sales Corporation--general rules.

    (a) Definition of a FSC and the Effect of a FSC Election.
    Q-1. What is the definition of a Foreign Sales Corporation 
(hereinafter referred to as a ``FSC'' (All references to FSCs include 
small FSCs unless indicated otherwise))?
    A-1. As defined in section 922(a), an FSC must satisfy the following 
eight requirements.
    (i) The FSC must be a corporation organized or created under the 
laws of a foreign country that meets the requirements of section 
927(e)(3) (a ``qualifying foreign country'') or a U.S. possession other 
than Puerto Rico (an ``eligible possession''). See Q&As 3, 4, and 5 of 
Sec. 1.922-1.
    (ii) A FSC may not have more than 25 shareholders at any time during 
the taxable year. See Q&A 6 of Sec. 1.922-1.
    (iii) A FSC may not have any preferred stock outstanding during the 
taxable year. See Q&As 7 and 8 of Sec. 1.922-1.
    (iv) A FSC must maintain an office outside of the United States in a 
qualifying foreign country or an eligible possession and maintain a set 
of permanent books of account (including invoices or summaries of 
invoices) at such office. See Q&As 9, 10, 11, 12, 13, 14, and 15 of 
Sec. 1.922-1.
    (v) A FSC must maintain within the United States the records 
required under section 6001. See Q&A 16 of Sec. 1.922-1.
    (vi) The FSC must have a board of directors which includes at least 
one individual who is not a resident of the United States at all times 
during the

[[Page 40]]

taxable year. See Q&As 17, 18, 19, 20, and 21 of Sec. 1.922-1.
    (vii) A FSC may not be a member, at any time during the taxable 
year, of any controlled group of corporations of which an interest 
charge DISC is a member. See Q&A 2 of this section and Q&A 13, of 
Sec. 1.921-1T(b)(13).
    (viii) A FSC must have made an election under section 927(f)(1) 
which is in effect for the taxable year. See Q&A 1 of Sec. 1.921-
1T(b)(1) and Sec. 1.927(f)-1.

In addition, under section 441(h), the taxable year of a FSC must 
conform to the taxable year of its principal shareholder. See Q&A 4 of 
Sec. 1.921-1T(b)(4).

    Q-2. Does the reference to a DISC under section 922(a)(1)(F) which 
provides that a FSC cannot be a member, at any time during the taxable 
year, of any controlled group of corporations of which a DISC is a 
member refer solely to an interest charge DISC?
    A-2. Yes.
    (b) Small FSC.
    Q-3. What is a small FSC?
    A-3. A small FSC is a Foreign Sales Corporation which meets the 
requirements of section 922(a)(1) enumerated in Q&A 1 of this section as 
well as the requirements of section 922(b). Section 922(b) requires that 
a small FSC make a separate election to be treated as a small FSC. See 
Q&A 1 of Sec. 1.921-1T(b) and Sec. 1.927(f)-1. In addition, section 
922(b) requires that the small FSC not be a member, at any time during 
the taxable year, of a controlled group of corporations which includes a 
FSC unless such FSC is a small FSC.
    Q-4. What is the effect of an election as a small FSC?
    A-4. Under section 924(b)(2), a small FSC need not meet the foreign 
management and economic processes tests of section 924(b)(1) in order to 
have foreign trading gross receipts. However, in determining the exempt 
foreign trade income of a small FSC, any foreign trading gross receipts 
for the taxable year in excess of $5 million are not taken into account. 
If the foreign trading gross receipts of a small FSC for the taxable 
year exceed the $5 million limitation, the FSC may select the gross 
receipts to which the limitation is allocated. In order to use the 
administrative pricing rules under section 925(a), a small FSC must 
satisfy the activities test under section 925(c). In addition, under 
section 441(h), the taxable year of a small FSC must conform to the 
taxable year of its principal shareholder (defined in Q&A 4 of 
Sec. 1.921-1T(b)(4) as the shareholder with the highest percentage of 
its voting power).
    Q-5. What is the effect on a small FSC (or FSC) (``target'') if it 
is acquired, directly or indirectly, by a corporation if that acquiring 
corporation (``acquiring''), or a member of the acquiring corporation's 
controlled group, is a FSC (or small FSC)?
    A-5. Unless the corporations in the controlled group elect to 
terminate the FSC (or small (FSC) election of the acquiring corporation, 
the target's small FSC's (or FSC's) taxable year and election will 
terminate as of the day preceding the date the target small FSC and 
acquiring FSC became members of the same controlled group. The target 
small FSC will receive FSC benefits for the period prior to termination, 
but the $5 million small FSC limitation will be reduced to the amount 
which bears the same ratio to the $5 million as the number of days in 
the short year created by the termination bears to 365. The due date of 
the income tax return for the short taxable year created by this 
provision will be the date prescribed by section 6072(b), including 
extensions, starting with the last day of the short taxable year. If the 
short taxable year created by this provision ends prior to March 3, 
1987, the filing date of the tax return for the short taxable year will 
be automatically extended until the earlier of May 18, 1987 or the date 
under section 6072 (b) assuming a short taxable year had not been 
created by these regulations.
    (c) Comparison of FSC to DISC.
    Q-6. How does a FSC differ from a DISC?
    A-6. A DISC is a domestic corporation which is not itself taxable 
while a FSC must be created or organized under the laws of a 
jurisdiction which is outside of the United States (including certain 
U.S. possessions) and may be taxable on its income except for its exempt 
foreign trade income. The DISC provisions enable a shareholder to obtain 
a partial deferral of tax on income from export sales and certain 
services, if 95 percent of its receipts and assets

[[Page 41]]

are export related. The FSC provisions contain no assets test, but a 
portion of income for export sales and certain services is exempt from 
U.S. taxes if the FSC satisfies certain foreign presence, foreign 
management, and foreign economic processes tests.

    (d) Organization of a FSC.

    Q-7. Under the laws of what countries may a FSC be organized?
    A-7. A FSC may not be created or organized under the laws of the 
United States, a state, or other political subdivision. However, a FSC 
may be created or organized under the laws of a possession of the United 
States, including Guam. American Samoa, the Commonwealth of the Northern 
Mariana Islands and the Virgin Islands of the United States, but not 
Puerto Rico. These eligible possessions are located outside the U.S. 
customs territory. In addition, a FSC may incorporate under the laws of 
a foreign country that is a party to--
    (i) An exchange of information agreement that meets the standards of 
the Caribbean Basin Economic Recovery Act of 1983 (Code section 
274(h)(6)(C)), or
    (ii) A bilateral income tax treaty with the United States if the 
Secretary certifies that the exchange of information program under the 
treaty carries out the purpose of the exchange of information 
requirements of the FSC legislation as set forth in section 927(e)(3), 
if the company is covered under the exchange of information program 
under subdivision (i) or (ii). The Secretary may terminate the 
certification. Any termination by the Secretary will be effective six 
months after the date of the publication of the notice of such 
termination in the Federal Register.
    (e) Foreign Trade Income.

    Q-8. How is foreign trade income defined?

    A-8. Foreign trade income, defined in section 923(b), is gross 
income of an FSC attributable to foreign trading gross receipts. It 
includes both the profits earned by the FSC itself from exports and 
commissions earned by the FSC from products and services exported by 
others.

    (f) Investment Income and Carrying Charges.

    Q-9. What do the terms ``investment income'' and ``carrying 
charges'' mean?
    A-9.
    (i) Investment income means:
    (A) Dividends,
    (B) Interest,
    (C) Royalties,
    (D) Annuities,
    (E) Rents (other than rents from the lease or rental of export 
property for use by the lessee outside of the United States);
    (F) Gains from the sale of stock or securities,
    (G) Gains from future transactions in any commodity on, or subject 
to the rules of, a board of trade or commodity exchange (other than 
gains which arise out of a bona fide hedging transaction reasonably 
necessary to conduct the business of the FSC in the manner in which such 
business is customarily conducted by others),
    (H) Amounts includable in computing the taxable income of the 
corporation under part I of subchapter J, and
    (I) Gains from the sale or other disposition of any interest in an 
estate or trust.
    (ii) Carrying charges means:
    (A) Charges that are imposed by a FSC or a related supplier and that 
are identified as carrying charges, (``stated carrying charges'') and
    (B)(1) Charges that are considered to be included in the price of 
the property or services sold by an FSC or a related supplier, as 
provided under Q&As 1 and 2 of Sec. 1.927(d)-1, and
    (2) Any other unstated interest.
    Q-10. How are investment income and carrying charges treated?
    A-10. Investment income and carrying charges are not foreign trading 
gross receipts. Investment income and carrying charges are includable in 
the taxable income of an FSC, except in the case of a commission FSC 
where carrying charges are treated as income of the related supplier, 
and are treated as income effectively connected with a trade or business 
conducted through a permanent establishment within the United States. 
The source of investment income and carrying charges is determined under 
sections 861, 862, and 863 of the Code.
    (g) Small Businesses.

[[Page 42]]

    Q-11. What options are available to small businesses engaged in 
exporting?
    A-11. A small business may elect to be treated as either a small FSC 
or an interest charge DISC. See Q&As 3 & 4 of Sec. 1.921-2 relating to a 
small FSC. Rules with respect to interest charge DISCs are the subject 
of another regulations project.

[T.D. 8127, 52 FR 6469, Mar. 3, 1987]



Sec. 1.921-3T  Temporary regulations; Foreign sales corporation general rules.

    (a) Exclusion--(1) Classifications of income. The extent to which 
income of a FSC (any further reference to a FSC in this section shall 
include a small FSC unless indicated otherwise) is subject to the 
corporate income tax of section 11, or, in the alternative, section 
1201(a), is dependent upon the allocation of the FSC's income to the 
following five categories:
    (i) Exempt foreign trade income determined under section 923 and 
Sec. 1.923-1T;
    (ii) Non-exempt foreign trade income determined with regard to the 
administrative pricing rules of section 925(a)(1) or (2);
    (iii) Non-exempt foreign trade income determined without regard to 
the administrative pricing rules of section 925(a)(1) or (2) (section 
923(a)(2) non-exempt income as defined in section 927(d)(6));
    (iv) Investment income and carrying charges; and
    (v) Other non-foreign trade income.
    (2) Source and characterization of FSC income--(i) Exempt foreign 
trade income. The exempt foreign trade income of a FSC determined under 
section 923 and Sec. 1.923-1T is treated as foreign source income which 
is not effectively connected with a United States trade or business. See 
Sec. 1.923-1T(a) for the definition of foreign trade income and 
Sec. 1.923-1T(b) for the definition of exempt foreign trade income.
    (ii) Non-exempt foreign trade income determined with regard to the 
administrative pricing rules. The FSC's non-exempt foreign trade income 
with respect to a transaction or group of transactions will be treated 
as United States source income which is effectively connected with the 
FSC's trade or business which is conducted through its permanent 
establishment within the United States if either of the administrative 
pricing rules of section 925(a)(1) or (2) is used to determine the FSC's 
foreign trade income from a transaction or group of transactions. See 
Sec. 1.923-1T(b) for the definition of non-exempt foreign trade income.
    (iii) Non-exempt foreign trade income determined without regard to 
the administrative pricing rules. The source and taxation of the FSC's 
non-exempt foreign trade income not classified in paragraph (a)(2)(ii) 
of this section will be determined under the appropriate sections of the 
Internal Revenue Code and the regulations under those sections. This 
type of income (section 923(a)(2) non-exempt income) includes both 
income that is not effectively connected with the conduct of a trade or 
business in the United States and income that is effectively connected.
    (iv) Investment income and carrying charges. All of the FSC's 
investment income and carrying charges will be treated as income which 
is effectively connected with the FSC's trade or business which is 
conducted through its permanent establishment within the United States. 
The source of that income will be determined under the appropriate 
sections of the Internal Revenue Code and the regulations under those 
sections. See Sec. 1.921-2(f) (Q & A9) for definition of investment 
income and carrying charges.
    (v) Non-foreign trade income (other than investment income and 
carrying charges). The source and taxation of the FSC's non-foreign 
trade income (other than investment income and carrying charges) will be 
determined under the appropriate sections of the Internal Revenue Code 
and the regulations under those sections.
    (b) Allocation and apportionment of deductions. Expenses, losses and 
deductions incurred by the FSC shall be allocated and apportioned under 
the rules set forth in Sec. 1.861-8 to the FSC's foreign trade income 
and to the FSC's non-foreign trade income. Any deductions incurred by 
the FSC on a transaction, or group of transactions, which are allocated 
and apportioned to the FSC's foreign trade income from that transaction, 
or group of transactions,

[[Page 43]]

shall be allocated on a proportionate basis between exempt foreign trade 
income and non-exempt foreign trade income.
    (c) Net operating losses and capital losses--(1) General rule. (i) 
If a FSC for any taxable year incurs a deficit in earnings and profits 
attributable to foreign trade income determined without regard to the 
administrative pricing rules of section 925(a)(1) or (2), that deficit 
shall be applied to reduce current earnings and profits, if any, 
attributable to--
    (A) First, exempt foreign trade income determined with regard to the 
administrative pricing rules,
    (B) Second, non-exempt foreign trade income determined with regard 
to the administrative pricing rules,
    (C) Third, investment income and carrying charges, and
    (D) Fourth, other non-foreign trade income.
    (ii) If a FSC for any taxable year incurs a deficit in earnings and 
profits attributable to non-foreign trade income (other than investment 
income, carrying charges and net capital losses), that deficit shall be 
applied to reduce current earnings and profits, if any, attributable to-
-
    (A) First, investment income and carrying charges,
    (B) Second, exempt foreign trade income determined with regard to 
the administrative pricing rules,
    (C) Third, exempt foreign trade income determined without regard to 
the administrative pricing rules,
    (D) Fourth, non-exempt foreign trade income determined with regard 
to the administrative pricing rules, and
    (E) Fifth, section 923(a)(2) non-exempt income.
    (iii) If a FSC for any taxable year incurs a deficit in earnings and 
profits attributable to investment income and carrying charges, that 
deficit shall be applied to reduce current earnings and profits, if any, 
attributable to--
    (A) First, non-foreign trade income other than capital gains,
    (B) Second, exempt foreign trade income determined with regard to 
the administrative pricing rules,
    (C) Third, exempt foreign trade income determined without regard to 
the administrative pricing rules,
    (D) Fourth, non-exempt foreign trade income determined with regard 
to the administrative pricing rules, and
    (E) Fifth, section 923(a)(2) non-exempt income.
    (iv) Net capital losses will be available for carryback or carryover 
pursuant to paragraph (c)(2) of this section.
    (v) Because the no-loss rules provide that a related supplier may 
always compensate the FSC for its expenses either as part of the 
commission payment or as part of the transfer price if the 
administrative pricing rules are used (see Sec. 1.925(a)-1T(e)(1)(i)), a 
FSC will not have a deficit in its earnings and profits relating to 
foreign trade income determined with regard to the administrative 
pricing rules. To determine the amount of any division of earnings and 
profits for the purpose of determining under Sec. 1.926(a)-1T (a) and 
(b) the treatment and order of distributions, the portion of a deficit 
in earnings and profits chargeable under this paragraph to such division 
prior to such distribution shall be determined in a manner consistent 
with the rules in Sec. 1.316-2(b) for determining the amount of earnings 
and profits available on the date of any distribution.
    (2) Carryback or carryover of net operating losses and capital 
losses to other taxable years of a FSC (or former FSC). (i) The amount 
of the deduction for the taxable year under section 172 for a net 
operating loss carryback or carryover, or under section 1212 for a 
capital loss carryback or carryover, shall be determined in the same 
manner as if the FSC were a foreign corporation which had not elected to 
be treated as a FSC. Thus, the amount of the deduction will be the same 
whether or not the corporation was a FSC in the year of the loss or in 
the year to which the loss is carried.
    (ii) Any carryback or carryover of a FSC's (or former FSC's) net 
operating loss which is attributable to transactions which give rise to 
foreign trade income shall be charged--
    (A) First, to earnings and profits attributable to exempt foreign 
trade income which is determined without regard to the administrative 
pricing rules,

[[Page 44]]

    (B) Second, to earnings and profits attributable to section 
923(a)(2) non-exempt income,
    (C) Third, to earnings and profits attributable to exempt foreign 
trade income determined with regard to the administrative pricing rules,
    (D) Fourth, to earnings and profits attributable to non-exempt 
foreign trade income determined with regard to the administrative 
pricing rules,
    (E) Fifth, to earnings and profits attributable to investment income 
and carrying charges (other than capital gain income), and
    (F) Sixth, to earnings and profits attributable to non-foreign trade 
income (other than investment income, carrying charges and capital gain 
income).
    (iii) Any carryback or carryover of a FSC's (or former FSC's) net 
operating loss which is attributable to non-foreign trade income (other 
than capital gain income) shall be charged--
    (A) First, to earnings and profits attributable to non-foreign trade 
income (other than investment income, carrying charges and capital gain 
income),
    (B) Second, to earnings and profits attributable to investment 
income and carrying charges,
    (C) Third, to earnings and profits attributable to exempt foreign 
trade income determined with regard to the administrative pricing rules,
    (D) Fourth, to earnings and profits attributable to non-exempt 
foreign trade income determined with regard to the administrative 
pricing rules,
    (E) Fifth, to earnings and profits attributable to exempt foreign 
trade income which is determined without regard to the administrative 
pricing rules, and
    (F) Sixth, to earnings and profits attributable to section 923(a)(2) 
non-exempt income.
    (iv) Any carryback or carryover of a net operating loss to a year in 
which the corporation was (or is) a FSC from a taxable year in which the 
corporation was not a FSC shall be applied in a manner consistent with 
subdivision (iii) of this paragraph.
    (d) Credits against tax--(1) General rule. Notwithstanding any other 
provision of chapter 1, subtitle A, a FSC is allowed under section 
921(c) as credits against tax only the following credits:
    (i) The foreign tax credit, section 27(a);
    (ii) The credit for tax withheld at source on foreign corporations, 
section 33; and
    (iii) The certain uses of gasoline and special fuels credit, section 
34.
    (2) Foreign tax credit. (i) The direct foreign tax credit of section 
901(b)(4) as determined under section 906 for income, war profits, and 
excess profits taxes (or taxes in lieu thereof) paid or accrued to any 
foreign country or possession of the United States is allowed a FSC only 
to the extent that those taxes are attributable to the FSC's foreign 
source non-foreign trade income which is effectively connected with its 
conduct of a trade or business within the United States. See section 
906(b)(5).
    (ii) The foreign tax credit for domestic corporate shareholders in 
foreign corporations (the deemed paid credit) provided under section 
901(a) as determined under section 902 is allowed for income, war 
profits, and excess profits taxes deemed paid or accrued by a FSC (or 
former FSC) only to the extent those taxes are deemed paid or accrued 
with respect to the FSC's (or former FSC's) section 923(a)(2) non-exempt 
income and its non-foreign trade income.
    (iii) The foreign tax credit allowed by sections 901 and 903 for tax 
withheld at source is allowed only to the extent the dividends paid to 
the FSC's (or former FSC's) shareholder are attributable to the FSC's 
(or former FSC's) section 923(a)(2) non-exempt income and its non-
foreign trade income.
    (3) Foreign tax credit limitation. (i) For purposes of computation 
of the direct foreign tax credit of section 901(b)(4) as determined 
under section 906, the separate limitation of section 904(d)(1)(C) for 
the FSC's taxable income attributable to its foreign trade income will 
apply. The direct foreign tax credit is not allowed to a FSC with regard 
to taxes it paid which are attributable to its foreign trade income. 
Since the foreign tax credit is not allowed for that type of income, the 
effect of the separate limitation is to remove the FSC's foreign trade 
income from the numerator of the fraction used to compute the FSC's 
overall foreign tax credit limitation.

[[Page 45]]

    (ii) A separate limitation under section 904(d)(1)(D) is provided 
for distributions from a FSC (or former FSC) that arise through 
operation of the deemed paid credit of section 902 and are attributable 
to foreign trade income earned during the period when the distributing 
corporation was a FSC. This limitation is computed by multiplying the 
FSC's shareholder's tentative United States tax by a fraction the 
numerator of which is the foreign source dividend (determined with 
regard to section 78) attributable to the foreign trade income less 
dividends received deductions and other expenses allocated and 
apportioned under Sec. 1.861-8 allowed to the shareholder and the 
denominator of which is the shareholder's worldwide income. The effect 
of this separate limitation is to remove dividends attributable to the 
FSC's foreign trade income from the numerator of the fraction used to 
compute the overall foreign tax credit limitation of the FSC's 
shareholder.
    (iii) The separate limitation under section 904(d)(1)(D) also 
applies to the foreign tax credit allowed to a FSC shareholder by 
sections 901 and 903 for tax withheld at source on dividends paid by the 
FSC. The numerator of this fraction is the part of the dividend 
attributable to the FSC's foreign trade income and the denominator is 
the shareholder's worldwide income. The effect of this separate 
limitation is to remove dividends attributable to foreign trade income 
of a FSC (or former FSC) from the numerator of the fraction used to 
compute the overall foreign tax credit limitation of the FSC's 
shareholder.
    (e) Deduction for foreign income, war profits and excess profits 
taxes. Under section 275(a)(4)(B), income, war profits and excess 
profits taxes imposed by a foreign country or possession of the United 
States may not be deducted by a FSC to the extent those taxes are paid 
or accrued with respect to its foreign trade income.
    (f) Payment of estimated tax. Every FSC which is subject to tax 
under section 11 or 1201(a) and section 882 must make payment of its 
estimated tax in accordance with section 6154 and the regulations under 
that section. In determining the amount of the estimated tax, the FSC 
must treat the tax imposed by section 881 as though it were a tax 
imposed by section 11. See section 6154(g).
    (g) Accumulated earnings, personal holding company and foreign 
personal holding company. The provisions covering the accumulated 
earnings tax (sections 531 through 537), personal holding companies 
(sections 541 through 547) and foreign personal holding companies 
(sections 551 through 558) apply to FSCs to the extent they would apply 
to foreign corporations that are not FSCs.
    (h) Subpart F income and increase of earnings invested in U.S. 
property. For the mandatory inclusion in the gross income of the U.S. 
shareholders of the subpart F income and of the increase in earnings 
invested in U.S. property of a FSC, see sections 951 through 964 and the 
regulations under those sections. However, the foreign trade income 
(other than section 923(a)(2) non-exempt income) and, generally, the 
investment income and carrying charges of a FSC and any deductions which 
are allocated and apportioned to those classes of income, are not taken 
into account under sections 951 through 964. See sections 951(e) and 
952(b).
    (i) Certain accumulations of earnings and profits. For the inclusion 
in the gross income of U.S. persons as a dividend on the gain recognized 
on certain sales or exchanges of stock in a FSC, to the extent of 
certain earnings and profits attributable to the stock which were 
accumulated while the FSC was a controlled foreign corporation, see 
section 1248 and the regulations under that section. However, section 
1248 and the regulations under that section do not apply to a FSC's 
earnings and profits attributable to foreign trade income, see section 
1248(d)(6).
    (j) Limitations on certain multiple tax benefits. The provisions of 
section 1561, Limitations on Certain Multiple Tax Benefits in the Case 
of Certain Controlled Corporations, and section 1563, Definitions and 
Special Rules, and the regulations under those sections apply to a FSC 
and its controlled group.

[T.D. 8126, 52 FR 6435, Mar. 3, 1987]

[[Page 46]]



Sec. 1.922-1  Requirements that a corporation must satisfy to be a FSC or a small FSC.

    (a) FSC requirements.

    Q-1. What are the requirements that a corporation must satisfy to be 
an FSC?
    A-1. A corporation must satisfy all of the requirements of section 
922(a).
    (b) Small FSC requirements.
    Q-2. What are the requirements that a corporation must satisfy to be 
a small FSC?
    A-2. A corporation must satisfy all of the requirements of sections 
922(a)(1) and (b).
    (c) Definition of corporation.
    Q-3. What type of entity is considered a corporation for purposes of 
qualifying as an FSC or a small FSC under section 922?
    A-3. A foreign entity that is classified as a corporation under 
section 7701(a)(3) (other than an insurance company) is considered a 
corporation for purposes of this requirement.
    (d) Eligible possession.
    Q-4. For purposes of meeting the place of incorporation requirement 
of section 922(a)(1)(A), what is a possession of the United States?
    A-4. For purposes of section 922(a)(1)(A), the possessions of the 
United States are Guam, American Samoa, the Commonwealth of the Northern 
Mariana Islands, and the Virgin Islands of the United States (``eligible 
possessions''). Puerto Rico, although a possession for certain tax 
purposes, does not qualify as a jurisdiction in which a FSC or small FSC 
may be incorporated.
    (e) Qualifying countries.
    Q-5. For purposes of meeting the place of incorporation requirement 
of section 922(a)(1)(A), what is a foreign country and which foreign 
countries meet the requirements of section 927(e)(3)?
    A-5. (i) A foreign country is a jurisdiction outside the 50 states, 
the District of Columbia, the Commonwealth of Puerto Rico, and the 
possessions of the United States. (ii) A list of the foreign countries 
that meet the requirements of section 927(e)(3) (''qualifying 
countries'') will be published from time to time in the Federal Register 
and the Internal Revenue Bulletin. A corporation is considered to be 
created or organized under the laws of a foreign country that meets the 
requirements of section 927(e)(3) only if the foreign country is a party 
to (A) an exchange of information agreement under the Caribbean Basin 
Economic Recovery Act (Code section 274(h)((6)(C)), or (B) a bilateral 
income tax treaty with the United States if the Secretary certifies that 
the exchange of information program under the treaty carries out the 
purposes of the exchange of information requirements of the FSC 
legislation as set forth in Code section 927(e)(3) and if the 
corporation is covered under exchange of information program under 
subdivision (A) or (B).
    (f) Number of shareholders.
    Q-6. Who is counted as a shareholder of a corporation for purposes 
of determining whether a corporation meets the limitation on the number 
of shareholders to no more than 25 under section 922(a)(1)(B)?
    A-6. Solely for purposes of the limitation on the number of 
shareholders, the following rules apply:
    (i) In general, an individual who owns an interest in stock of the 
corporation is counted as a shareholder. In the case of joint owners, 
each joint owner is counted as a shareholder. A member of a 
corporation's board of directors who holds qualifying shares that are 
required to be owned by a resident of the country of incorporation is 
not counted as a shareholder.
    (ii) A corporation that owns an interest in stock of the corporation 
is counted as a single shareholder.
    (iii) An estate that owns an interest in stock of the corporation is 
counted as a single shareholder. If the limitation on number of 
shareholders is not satisfied by reason of the closing of an estate, the 
FSC will continue to qualify for the taxable year of the FSC in which 
the estate is closed.
    (iv) A trust is not counted as a shareholder. In the case of a trust 
all of which is treated as owned by one or more persons under sections 
671 through 679, those persons are counted as shareholders. In the case 
of all other trusts, a beneficiary is counted as a shareholder.

[[Page 47]]

    (v) A partnership is not counted as a shareholder. A general or 
limited partner is counted as a shareholder if it is a corporation, an 
individual, or an estate, under the rules contained in subdivisions (i) 
through (iii). A general or limited partner is not counted as a 
shareholder if it is a partnership or a trust; the rules contained in 
subdivision (iv) and this subdivision (v) apply to the determination of 
who is counted as a shareholder.
    (g) Class of stock.
    Q-7. What is preferred stock for purposes of determining whether a 
corporation satisfies the requirement under section 922(a)(1)(C) that no 
preferred stock be outstanding?
    A-7. Preferred stock is stock that is limited and preferred as to 
dividends or distributions in liquidation.
    Q-8. Can a corporation have outstanding more than one class of 
common stock?
    A-8. Yes. However, the rights of a class of stock will be 
disregarded if the right has the effect of avoidance of Federal income 
tax. For instance, dividend rights may not be used to direct dividends 
from exempt foreign trade income to shareholders that have taxable 
income and to direct other dividends to shareholders that have met 
operating loss carryovers.
    (h) Office.
    Q-9. What is an office for purposes of determining whether a 
corporation satisfies the requirement of section 922(a)(1)(D)(i)?
    A-9. An office is a place for the transaction of the business of the 
corporation. To be an office a place must meet all of the following 
requirements;
    (i) It must have a fixed location. A transient location is not a 
fixed location.
    (ii) It must be a building or a portion of a building consisting of 
at least one room. A room is a partitioned part of the inside of a 
building. The building or portion thereof used as the corporation's 
office must be large enough to accommodate the equipment required in 
subdivison (iii) of this answer 9 and the activity required in 
subdivision (iv) of this answer 9. However, an office is not limited to 
a room with communication equipment or an adjacent room. Non-contiguous 
space within the same building will also constitute an office if it is 
equipped for the retention of the documentation required to be stored by 
the FSC and if access to the necessary communication equipment is 
available for use by the FSC.
    (iii) It must be equipped for the performance of the corporation's 
business. An office must be equipped for the communication and retention 
of information and must be supplied with communication services.
    (iv) It must be regularly used for some business activity of the 
corporation. A corporation's business activities must include the 
maintenance of the documentation described in Q&A 12 of this section. 
These documents need not be prepared at the office. Any person, whether 
or not related to the corporation, may perform the business activities 
of the corporation at the office if the activity is performed pursuant 
to a contract, oral or written, for the performance of the activity on 
behalf of the corporation.
    (v) It must be operated, and owned or leased, by the corporation or 
by a person, whether or not related to the corporation, under contract 
to the corporation.
    (vi) It must be maintained by the corporation or by a person, 
whether or not related, to the corporation, under contract to the 
corporation at all times during the taxable year. In the case of a 
corporation newly organized as a FSC, thirty days may elapse between the 
time the corporation is organized as a FSC (i.e., the first day for 
which the FSC election is effective) and the time an office is 
maintained by the corporation or a person under contract with the 
corporation. A place that meets the requirements in subdivision (i) 
through (vi) of this answer 9 can also be used for activities that are 
unrelated to the business activity of the corporation.
    Q-10 Can a corporation locate an office in any foreign country if it 
has at least one office in a U.S. possession or in a foreign country 
that meets the requirements of section 927 (e)(3) as provided Q&A 5 of 
this section?
    A-10. Yes.
    Q-11. Must a corporation locate the office that is required under 
section 922(a)(1)(D)(i) in the country or possession of its 
incorporation?
    A-11. No.

[[Page 48]]

    (i) Documentation.
    Q-12. What documentation must be maintained at the corporation's 
office for purposes of section 922(a)(1)(D)(ii)?
    A-12. At least the following documentation must be maintained at the 
corporation's office under section 922(a)(1)(D)(ii):
    (i) The quarterly income statements, a final year-end income 
statement and a year-end balance sheet of the FSC; and
    (ii) All final invoices (or a summary of them) or statements of 
account with respect to (A) sales by the FSC, and (B) sales by a related 
person if the FSC realizes income with respect to such sales. A final 
invoice is an invoice upon which payment is made by the customer. A 
invoice must contain, at a minimum, the customer's name or idenfitying 
number and, with respect to the transaction or transactions, the date, 
product or product code or service of service code, quantity, price, and 
amount due. In the alternative, a document will be acceptable as a final 
invoice even though it does not include all of the above listed 
information if the FSC establishes that the document is considered to be 
a final invoice under normal commercial practices. An invoice forwarded 
to the customer after payment has been tendered or received pursuant to 
a letter of credit, as a receipt for payment, satisfies this definition. 
A single final invoice may cover more than one transaction with a 
customer.
    (iii) A summary of final invoices may be in any reasonable form 
provided that the summary contains all substantive information from the 
invoices. All substantive information includes the customer's name or 
identifying number, the invoice number, date, product or product code, 
and amount owed. In the alternative, all substantive information 
includes a summary of the information that is included on documents 
considered to be final invoices under normal commercial practice. A 
statement of account is any summary statement forwarded to a customer to 
inform of, or confirm, the status of transactions occurring within an 
accounting period during a taxable year that is not less than one month. 
A statement of account must contain, at a minimum, the customer's name 
or identifying number, date of the statement of account and the balance 
due (even if the balance due is zero) as of the last day of the 
accounting period covered by the statement of account. In the 
alternative, a document will be accepted as a statement of account even 
though it does not include all of the above listed information if the 
FSC establishes that the document is considered a statement of account 
under normal commercial practice. For these purposes, a document will be 
considered to be a statement of account under normal commercial practice 
if it is sent to domestic as well as to export customers in order to 
inform the customers of the status of transactions during an accounting 
period. With regard to quarterly income statements, a reasonable 
estimate of the FSC's income and expense items will be acceptable. If 
the FSC is a commission FSC, 1.83% of the related supplier's gross 
receipts will be considered a reasonable estimate of the FSC's income. 
The documents required by this Q&A 12 need not be prepared by the FSC. 
In addition they need not be prepared at the FSC's office.
    (iv) The FSC will satisfy the requirement that the documents be 
maintained at its office even if not all final invoices (or summaries) 
or statements of account or items to be included on statements of 
account are maintained at its office as long as it makes a good faith 
effort to do so and provided that any failure to maintain the required 
documents is cured within a reasonable time of discovery of the failure.
    Q-13. If the required documents are not prepared at the FSC's 
office, by what date must the documents be maintained at its office?
    A-13. With regard to the applicable quarters of years prior to March 
3, 1987, the quarterly income statements, final invoices (or summaries), 
or statements of account and the year-end balance sheet must be 
maintained at the FSC's office no later than the due date, including 
extensions, of the FSC tax return for the applicable taxable year in 
which the period ends. With regard to the applicable quarters or years 
ending after March 3, 1987, the quarterly income statements for the 
first three

[[Page 49]]

quarters of the FSC year must be maintained at the FSC's office no later 
than 90 days after the end of the quarter. The quarterly income 
statement for the fourth quarter of the FSC year, the final year-end 
income statement, the year-end balance sheet, and the final invoices (or 
summaries) or statements of account must be maintained at the FSC's 
office no later than the due date, including extensions, of the FSC tax 
return for the applicable taxable year.
    Q-14. In what form must the documentation required under section 
922(a)(1)(D)(ii) be maintained?
    A-14. The documentation required to be maintained by the office may 
be originals or duplicates and may be in any form that qualifies as a 
record under Rev. Rul. 71-20, 1971-1 C.B. 392. Therefore, documentation 
may be maintained in the form of punch cards, magnetic tapes, disks, and 
other machine-sensible media used for recording, consolidating, and 
summarizing accounting transactions and records within a taxpayer's 
automatic data processing system. The corporation need not maintain at 
its office equipment capable of reading the machine-sensible media. That 
equipment, however, must be situated in a location that is readily 
accessible to the corporation. The equipment need not be owned by the 
corporation.
    Q-15. How long must the documentation required under section 
922(a)(1)(D)(ii) be maintained?
    A-15. The documentation required under section 922(a)(1)(D)(ii) for 
a taxable year must be maintained at the FSC's office described in 
section 922(a)(1)(D)(i) until the period of limitations for assessment 
of tax for the taxable year has expired under section 6501.
    Q-16. Under what circumstances will a coporation be considered to 
satisfy the requirement of section 922(a)(1)(D)(iii) that it maintain 
the records it is required to keep under section 6001 at a location 
within the United States?
    A-16. A corporation will be considered to satify this requirement if 
the records required under section 6001 are kept by any person at any 
location in the United States provided that the records are retained in 
accordance with section 6001 and the regulations thereunder.
    (j) Board of directors.
    Q-17. What is a corporation's ``board of directors'' for purposes of 
the requirement under section 922(a)(1)(E) that, at all times during the 
taxable year, the corporation must have a board of directors which 
includes at least one individual who is not a resident of the United 
States?
    A-17. The ``board of directors'' is the body that manages and 
directs the corporation according to the law of the qualifying country 
or eligible possession under the laws of which the corporation was 
created or organized.
    Q-18. Can the member of the board of directors who is a nonresident 
of the United States be a citizen of the United States?
    A-18. Yes. For purposes of meeting the requirement under section 
922(a)(1)(E), the member of the board who cannot be a United States 
resident can be a United States citizen. The principles of section 
7701(b) shall be used to determine whether a United States citizen is a 
United States resident.
    Q-19. If the only member of the board of directors who is not a 
resident of the United States dies, or resigns, is removed from the 
board or becomes a resident of the United States will the corporation be 
considered to fail the requirement under section 922(a)(1)(E)?
    A-19. If the corporation appoints a new member who is a nonresident 
of the United States to the board within 30 days after the death, 
resignation or removal of the former nonresident member, the corporation 
will be considered to satisfy the requirement under section 
922(a)(1)(E). Also, the corporation will be considered to satisfy the 
requirement under section 922(a)(1)(E) if the corporation appoints a new 
member who is a nonresident of the United States to the board within 30 
days after the corporation has knowledge, or reason to know, that the 
board's former nonresident member was in fact a resident of the United 
States.
    Q-20. Is a nonresident alien individual who elects to be treated as 
a

[[Page 50]]

resident of the United States for a taxable year under section 6013(g) 
considered a nonresident of the United States for purposes of the 
requirement under section 922(a)(1)(E)?
    A-20. Yes.
    Q-21. Will the requirement that a FSC's board of directors have a 
nonresident member at all times during the taxable year be satisfied if 
the nonresident member is elected or appointed to the board of directors 
no later than 30 days after the first day for which the FSC election is 
effective?
    A-21. Yes.

[T.D. 8127, 52 FR 6470, Mar. 3, 1987]



Sec. 1.923-1T  Temporary regulations; exempt foreign trade income.

    (a) Foreign trade income. Foreign trade income of a FSC is the FSC's 
gross income attributable to its foreign trading gross receipts. (Any 
further reference to a FSC in this section shall include a small FSC 
unless indicated otherwise.) If the FSC is the principal on the sale of 
export property which it purchased from a related supplier, the FSC's 
gross income is determined by subtracting from its foreign trading gross 
receipts the transfer price determined under the transfer pricing 
methods of section 925(a). If the FSC is the commission agent on the 
sale of export property by its related supplier, the FSC's gross income 
is the commission paid or payable by the related supplier to the FSC 
with respect to the transactions that would have generated foreign 
trading gross receipts had the FSC been the principal on the 
transaction. See Sec. 1.925(a)-1T(f) Examples 1 and 6 for illustrations 
of the computation of a FSC's foreign trade income, exempt foreign trade 
income and taxable income.
    (b) Exempt foreign trade income--(1) Determination. (i) If a FSC 
uses either of the two administrative pricing rules, provided for by 
sections 925(a)(1) and (2), to determine its income from a transaction, 
or group of transactions, to which section 925 applies (see 
Sec. 1.925(a)-1T(b)(2) (ii) and (iii)), 15/23 of the foreign trade 
income that it earns from the transaction, or group of transactions, 
will be exempt foreign trade income. If a FSC has a non-corporate 
shareholder (shareholders), 16/23 of its foreign trade income 
attributable to the noncorporate shareholder's (shareholders') 
proportionate interest in the FSC will be exempt foreign trade income. 
See section 291(a)(4).
    (ii) If a FSC does not use the administrative pricing rules to 
determine its income from a transaction, or group of transactions, which 
gives rise to foreign trade income, 30 percent of its foreign trade 
income will be exempt foreign trade income. If a FSC has a non-corporate 
shareholder (shareholders), 32 percent of its foreign trade income 
attributable to the non-corporate shareholder's (shareholders') 
proportionate interest in the FSC will be exempt foreign trade income. 
See section 291(a)(4).
    (iii) Exempt foreign trade income so determined under subdivisions 
(1)(i) and (ii) of this paragraph is treated as foreign source income 
which is not effectively connected with the conduct of a trade or 
business within the United States. See section 921(a).
    (2) Special rule for foreign trade income allocable to a qualified 
cooperative. (i) Pursuant to section 923(a)(4), if a qualified 
cooperative is a shareholder of a FSC, the FSC's non-exempt foreign 
trade income determined by use of either of the administrative pricing 
methods of section 925(a)(1) or (2) which is allocable to the marketing 
of agricultural or horticultural products, or the providing of related 
services, for any taxable year will be treated as exempt foreign trade 
income to the extent that it is distributed to the qualified cooperative 
shareholder. A qualified cooperative is defined as any organization to 
which chapter 1, subchapter T, part 1 of the Code applies. See section 
1381(a).
    (ii) This special rule of section 923(a)(4) shall apply only if the 
distribution is made before the due date under section 6072(b), 
including extensions, for filing the FSC's income tax return for that 
year. Any distribution which satisfies this requirement will be treated 
as made on the last day of the FSC's taxable year. In addition, this 
special rule shall apply only if the income of the cooperative is based 
on arm's length transactions between the cooperative and its members or 
patrons.

[[Page 51]]

    (iii) Income attributable to the marketing of agricultural or 
horticultural products, or the providing of related services, shall be 
allocated to the FSC shareholders on a per share basis. See 
Sec. 1.926(a)-1T(b) for ordering rules for distributions from a FSC.
    (3) Special rule for military property. (i) Under section 923(a)(5), 
the exempt foreign trade income of a FSC relating to the disposition of, 
or services relating to, military property shall be equal to 50 percent 
of the amount which, but for section 923(a)(5), would be treated as 
exempt foreign trade income under section 923(a)(2) or (3). The foreign 
trade income no longer treated as exempt because of this special rule of 
section 923(a)(5) will remain income of the FSC and will be treated as 
non-exempt foreign trade income.
    (ii) The term ``military property'' is defined in section 
995(b)(3)(B) and includes any property which is an arm, ammunition, or 
implement of war designated in the munitions list published pursuant to 
section 38 of the International Security Assistance and Arms Export 
Control Act of 1976 (22 U.S.C. 2778) (which repealed and replaced the 
Military Security Act of 1954).

[T.D. 8126, 52 FR 6438, Mar. 3, 1987]



Sec. 1.924(a)-1T  Temporary regulations; definition of foreign trading gross receipts.

    (a) In general. The term ``foreign trading gross receipts'' means 
any of the five amounts described in paragraphs (b) through (f) of this 
section, except to the extent that any of the five amounts is an 
excluded receipt within the meaning of paragraph (g) of this section. 
These amounts will not be foreign trading gross receipts if the FSC is 
not managed outside the United States, pursuant to section 924(c), or if 
the economic processes with regard to a transaction, or group of 
transactions, that are required of a FSC by section 924(d) do not take 
place outside the United States. The requirement that these activities 
take place outside the United States does not apply to a small FSC. The 
activities required by sections 924 (c) and (d) may be performed either 
by the FSC or by any person (whether or not related to the FSC) acting 
under contract with the FSC for the performance of the required 
activities. Sections 1.924(c)-1 and 1.924(d)-1 provide rules to 
determine whether these requirements have been met. For purposes of this 
section--
    (1) FSC. All references to a FSC in this section mean a FSC, except 
when the context indicates that such term means a corporation in the 
process of meeting the conditions necessary for that corporation to 
become a FSC. All references to a FSC in this section shall include a 
small FSC unless indicated otherwise.
    (2) Sale and lease. The term ``sale'' includes an exchange or other 
disposition and the term ``lease'' includes a rental or a sublease. The 
term ``license'' includes a sublicense. All rules under this section 
applicable to leases of export property apply in the same manner to 
licenses of export property. See Sec. 1.927(a)-1T(f)(3) for a 
description of intangible property which cannot be export property.
    (3) Gross receipts. The term ``gross receipts'' is defined by 
section 927(b) and Sec. 1.927(b)-1T.
    (4) Export property. The term ``export property'' is defined by 
section 927(a) and Sec. 1.927(a)-1T.
    (5) Controlled group. The term ``controlled group'' is defined by 
paragraph (h) of this section.
    (6) Related supplier and related party. The terms related supplier 
and related party are defined by Sec. 1.927(d)-2T.
    (b) Sales of export property. Foreign trading gross receipts of a 
FSC include gross receipts from the sale of export property by the FSC, 
or by any principal for whom the FSC acts as a commission agent (whether 
or not the principal is a related supplier), pursuant to the terms of a 
contract entered into with a purchaser by the FSC or by the principal at 
any time or by any other person and assigned to the FSC or the principal 
at any time prior to the shipment of the property to the purchaser. Any 
agreement, oral or written, which constitutes a contract at law, 
satisfies the contractual requirements of this paragraph. Gross receipts 
from the sale of export property, whenever received, do not constitute 
foreign trading gross receipts unless the seller (or the corporation 
acting as commission agent for the seller) is a FSC at the time of

[[Page 52]]

the shipment of the property to the purchaser. For example, if a 
corporation which sells export property under the installment method is 
not a FSC for the taxable year in which the property is shipped to the 
purchaser, gross receipts from the sale do not constitute foreign 
trading gross receipts for any taxable year of the corporation.
    (c) Leases of export property--(1) In general. Foreign trading gross 
receipts of a FSC include gross receipts from the lease of export 
property provided that--
    (i) The property is held by the FSC (or by a principal for whom the 
FSC acts as commission agent with respect to the lease) either as an 
owner or lessee at the beginning of the term of the lease, and
    (ii) The FSC qualified (or was treated) as a FSC for its taxable 
year in which the term of the lease began.
    (2) Prepayment of lease receipts. If the gross receipts from a lease 
of export property are prepaid, then--
    (i) All the prepaid gross receipts are foreign trading gross 
receipts of a FSC if it is reasonably expected at the time of the 
prepayment that, throughout the term of the lease, the lease will meet 
the requirements of this paragraph and the property will be export 
property; or
    (ii) If it is reasonably expected at the time of the prepayment that 
the prepaid receipts would not be foreign trading gross receipts 
throughout the term of the lease if those receipts were not received as 
a prepayment, then only those prepaid receipts, for the taxable years of 
the FSC for which they would be foreign trading gross receipts, are 
foreign trading gross receipts. Thus, for example, if a lessee makes a 
prepayment of the first and last years' rent, and it is reasonably 
expected that the leased property will be export property for the first 
half of the lease period but not the second half of such period, the 
amount of the prepayment which represents the first year's rent will be 
considered foreign trading gross receipts if it would otherwise qualify, 
whereas the amount of the prepayment which represents the last year's 
rent will not be considered foreign trading gross receipts.
    (d) Related and subsidiary services--(1) In general. Foreign trading 
gross receipts of a FSC include gross receipts from services furnished 
by the FSC which are related and subsidiary to any sale or lease (as 
described in paragraph (b) or (c) of this section) of export property by 
the FSC or with respect to which the FSC acts as a commission agent, 
provided that the FSC derives foreign trading gross receipts from the 
sale or lease. The services may be performed within or without the 
United States.
    (2) Services furnished by the FSC. Services are considered to be 
furnished by a FSC for purposes of this paragraph if the services are 
provided by--
    (i) The person who sold or leased the export property to which the 
services are related and subsidiary, provided that the FSC acts as a 
commission agent with respect to the sale or lease of the property and 
with respect to the services,
    (ii) The FSC as principal, or any other person pursuant to a 
contract with the FSC, provided the FSC acted as principal or commission 
agent with respect to the sale or lease of the property, or
    (iii) A member of the same controlled group as the FSC if the sale 
or lease of the export property is made by another member of the 
controlled group provided, however, that the FSC acts as principal or 
commission agent with respect to the sale or lease and as commission 
agent with respect to the services.
    (3) Related services. Services which may be related to a sale or 
lease of export property include but are not limited to warranty 
service, maintenance service, repair service, and installation service. 
Transportation (including insurance related to such transportation) will 
be related to a sale or lease of export property, if the cost of the 
transportation is included in the sale price or rental of the property 
or, if the cost is separately stated, is paid by the FSC (or its 
principal) which sold or leased the property to the person furnishing 
the transportation service. Financing or the obtaining of financing for 
a sale

[[Page 53]]

or lease is not a related service for purposes of this paragraph. A 
service is related to a sale or lease of export property if--
    (i) The service is of the type customarily and usually furnished 
with the type of transaction in the trade or business in which the sale 
or lease arose, and
    (ii) The contract to furnish the service--
    (A) Is expressly provided for in or is provided for by implied 
warranty under the contract of sale or lease,
    (B) Is entered into on or before the date which is 2 years after the 
date on which the contract under which the sale or lease was entered 
into, provided that the person described in paragraph (d)(2) of this 
section which is to furnish the service delivers to the purchaser or 
lessor a written offer or option to furnish the services on or before 
the date on which the first shipment of goods with respect to which the 
service is to be performed is delivered, or
    (C) Is a renewal of the services contract described in subdivisions 
(ii)(A) and (B) of this paragraph.
    (4) Subsidiary services--(i) In general. Services related to a sale 
or lease of export property are subsidiary to the sale or lease only if 
it is reasonably expected at the time of the sale or lease that the 
gross receipts from all related services furnished by the FSC (as 
defined in this paragraph (d)(2)) will not exceed 50 percent of the sum 
of the gross receipts from the sale or lease and the gross receipts from 
related services furnished by the FSC (as described in this paragraph 
(d)(2)). In the case of a sale, reasonable expectations at the time of 
the sale are based on the gross receipts from all related services which 
may reasonably be performed at any time before the end of the 10-year 
period following the date of the sale. In the case of a lease, 
reasonable expectations at the time of the lease are based on the gross 
receipts from all related services which may reasonably be performed at 
any time before the end of the term of the lease (determined without 
regard to renewal options).
    (ii) Allocation of gross receipts from services. In determining 
whether the services related to a sale or lease of export property are 
subsidiary to the sale or lease, the gross receipts to be treated as 
derived from the furnishing of services may not be less than the amount 
of gross receipts reasonably allocated to the services as determined 
under the facts and circumstances of each case without regard to 
whether--
    (A) The services are furnished under a separate contract or under 
the same contract pursuant to which the sale or lease occurs, or
    (B) The cost of the services is specified in the contract of sale or 
lease.
    (iii) Transactions involving more than one item of export property. 
If more than one item of export property is sold or leased in a single 
transaction pursuant to one contract, the total gross receipts from the 
transaction and the total gross receipts from all services related to 
the transaction are each taken into account in determining whether the 
services are subsidiary to the transaction. However, the provisions of 
this subdivision apply only if the items could be included in the same 
product line, as determined under Sec. 1.925(a)-1T(c)(8).
    (iv) Renewed service contracts. If under the terms of a contract for 
related services, the contract is renewable within 10 years after a sale 
of export property, or during the term of a lease of export property, 
related services to be performed under the renewed contract are 
subsidiary to the sale or lease if it is reasonably expected at the time 
of the renewal that the gross receipts from all related services which 
have been and which are to be furnished by the FSC (as described in 
paragraph (d)(2) of this section) will not exceed 50 percent of the sum 
of the gross receipts from the sale or lease and the gross receipts from 
related services furnished by the FSC (as so described). Reasonable 
expectations are determined as provided in subdivision (i) of this 
paragraph.
    (v) Parts used in services. If a services contract described in 
paragraph (d)(3) of this section provides for the furnishing of parts in 
connection with the furnishing of related services, gross receipts from 
the furnishing of the parts are not taken into account in determining 
whether under this paragraph (d)(4) the services are subsidiary. See 
paragraph (b) or (c) of this section to

[[Page 54]]

determine whether the gross receipts from the furnishing of parts 
constitute foreign trading gross receipts. See Sec. 1.927(a)-1T (c)(2) 
and (e)(3) for rules regarding the treatment of the parts with respect 
to the manufacture of export property and the foreign content of the 
property, respectively.
    (5) Relation to leases. If the gross receipts for services which are 
related and subsidiary to a lease of property have been prepaid at any 
time for all the services which are to be performed before the end of 
the term of the lease, then the rules in paragraph (c)(2) of this 
section (relating to prepayment of lease receipts) will determine 
whether prepaid services under this paragraph (d)(5) are foreign trading 
gross receipts. Thus, for example, if it is reasonably expected that 
leased property will be export property for the first year of the term 
of the lease but will not be export property for the second year of the 
term, prepaid gross receipts for related and subsidiary services to be 
furnished in the first year may be foreign trading gross receipts. 
However, any prepaid gross receipts for the services to be furnished in 
the second year cannot be foreign trading gross receipts.
    (6) Relation with export property determination. The determination 
as to whether gross receipts from the sale or lease of export property 
constitute foreign trading gross receipts does not depend upon whether 
services connected with the sale or lease are related and subsidiary to 
the sale or lease. Thus, for example, assume that a FSC receives gross 
receipts of $1,000 from the sale of export property and gross receipts 
of $1,100 from installation and maintenance services which are to be 
furnished by the FSC within 10 years after the sale and which are 
related to the sale. The $1,100 which the FSC receives for the services 
would not be foreign trading gross receipts since the gross receipts 
from the services exceed 50 percent of the sum of the gross receipts 
from the sale and the gross receipts from the related services furnished 
by the FSC. The $1,000 which the FSC receives from the sale of export 
property would, however, be foreign trading gross receipts if the sale 
met the requirements of paragraph (b) of this section.
    (e) Engineering and architectural services--(1) In general. Foreign 
trading gross receipts of a FSC include gross receipts from engineering 
services (as described in paragraph (e)(5) of this section) or 
architectural services (as described in paragraph (e)(6) of this 
section) furnished by such FSC (as described in paragraph (e)(7) of this 
section) for a construction project (as defined in paragraph (e)(8) of 
this section) located, or proposed for location, outside the United 
States. Such services may be performed within or without the United 
States.
    (2) Services included. Engineering and architectural services 
include feasibility studies for a proposed construction project whether 
or not such project is ultimately initiated.
    (3) Excluded services. Engineering and architectural services do not 
include--
    (i) Services connected with the exploration for oil or gas, or
    (ii) Technical assistance or know-how. For purposes of this 
paragraph, the term ``technical assistance or know-how'' includes 
activities or programs designed to enable business, commerce, industrial 
establishments, and governmental organizations to acquire or use 
scientific, architectural, or engineering information.
    (4) Other services. Receipts from the performance of construction 
activities other than engineering and architectural services constitute 
foreign trading gross receipts to the extent that the activities are 
related and subsidiary services (within the meaning of paragraph (d) of 
this section) with respect to a sale or lease of export property.
    (5) Engineering services. For purposes of this paragraph, 
engineering services in connection with any construction project (within 
the meaning of paragraph (e)(8) of this section) include any 
professional services requiring engineering education, training, and 
experience and the application of special knowledge of the mathematical, 
physical, or engineering sciences to those professional services as 
consultation, investigation, evaluation, planning, design, or 
responsible supervision of construction for the purpose of assuring 
compliance with plans, specifications, and design.

[[Page 55]]

    (6) Architectural services. For purposes of this paragraph, 
architectural services include the offering or furnishing of any 
professional services such as consultation, planning, aesthetic and 
structural design, drawings and specifications, or responsible 
supervision of construction (for the purpose of assuring compliance with 
plans, specifications, and design) or erection, in connection with any 
construction project (within the meaning of paragraph (e)(8) of this 
section).
    (7) Definition of ``furnished by the FSC''. For purposes of this 
paragraph, the term ``furnished by the FSC'' means architectural and 
engineering services furnished:
    (i) By the FSC,
    (ii) By another person (whether or not that person is a United 
States person) pursuant to a contract entered into with the FSC at any 
time prior to the furnishing of the services, provided that the FSC acts 
as principal, or
    (iii) By another person (whether or not that person is a United 
States person) pursuant to a contract for the furnishing of the services 
entered into by, or assigned to, the person at any time, provided that 
the FSC acts as a commission agent for the furnishing of the services.
    (8) Definition of ``construction project''. For purposes of this 
paragraph, the term ``construction project'' includes the erection, 
expansion, or repair (but not including minor remodeling or minor 
repairs) of new or existing buildings or other physical facilities 
including, for example, roads, dams, canals, bridges, tunnels, railroad 
tracks, and pipelines. The term also includes site grading and 
improvement and installation of equipment necessary for the 
construction. Gross receipts from the sale or lease of construction 
equipment are not foreign trading gross receipts unless the equipment is 
export property.
    (f) Managerial services--(1) In general. Foreign trading gross 
receipts of a first FSC for its taxable year include gross receipts from 
the furnishing of managerial services provided for an unrelated FSC or 
unrelated interest charge DISC to aid the unrelated FSC or unrelated 
interest charge DISC in deriving foreign trading gross receipts or 
qualified export receipts, as the case may be, provided that at least 50 
percent of the first FSC's gross receipts for such year consists of 
foreign trading gross receipts derived from the sale or lease of export 
property and the furnishing of related and subsidiary services. For 
purposes of this paragraph, managerial services are considered furnished 
by a FSC if the services are provided--
    (i) By the first FSC,
    (ii) By another person (whether or not a United States person) 
pursuant to a contract entered into by that person with the first FSC at 
any time prior to the furnishing of the services, provided that the 
first FSC acts as principal with respect to the furnishing of the 
services, or
    (iii) By another person (whether or not a United States person) 
pursuant to a contract for the furnishing of services entered into at 
any time prior to the furnishing of the services provided that the first 
FSC acts as commission agent with respect to those services.
    (2) Definition of ``managerial services''. The term ``managerial 
services'' as used in this paragraph means activities relating to the 
operation of an unrelated FSC or an unrelated interest charge DISC which 
derives foreign trading gross receipts or qualified export receipts as 
the case may be from the sale or lease of export property and from the 
furnishing of services related and subsidiary to those sales or leases. 
The term includes staffing and operational services necessary to operate 
the unrelated FSC or unrelated interest charge DISC, but does not 
include legal, accounting, scientific, or technical services. Examples 
of managerial services are: conducting export market studies, making 
shipping arrangements, and contacting potential foreign purchasers.
    (3) Status of recipient of managerial services. Foreign trading 
gross receipts of a first FSC include receipts from the furnishing of 
managerial services during any taxable year of a recipient of such 
services if the recipient qualifies as a FSC or interest charge DISC for 
the taxable year. For purposes of this paragraph, a recipient is deemed 
to qualify as a FSC or interest charge DISC for its taxable year if the 
first FSC obtains from the recipient a copy

[[Page 56]]

of the recipient's election to be treated as a FSC or interest charge 
DISC together with the recipient's sworn statement that an election has 
been timely filed with the Internal Revenue Service Center. The 
recipient may mark out the names of its shareholders on a copy of its 
election to be treated as a FSC or interest charge DISC before 
submitting it to the first FSC. The copy of the election and the sworn 
statement of the recipient must be received by the first FSC within six 
months after the first FSC furnishes managerial services for the 
recipient. The copy of the election and the sworn statement of the 
recipient need not be obtained by the first FSC for subsequent taxable 
years of the recipient. A recipient of managerial services is not 
treated as a FSC or interest charge DISC with respect to the services 
performed during a taxable year for which the recipient does not qualify 
as a FSC or interest charge DISC if the first FSC performing such 
services does not believe or if a reasonable person would not believe 
(taking into account the furnishing FSC's managerial relationship with 
such recipient FSC or interest charge DISC) at the beginning of such 
taxable year that the recipient will qualify as a FSC or an interest 
charge DISC for such taxable year.
    (g) Excluded receipts--(1) In general. Notwithstanding the 
provisions of paragraphs (b) through (f) of this section, foreign 
trading gross receipts of a FSC do not include any of the six amounts 
described in paragraphs (g)(2) through (7) of this section.
    (2) Sales and leases of property for ultimate use in the United 
States. Property which is sold or leased for ultimate use in the United 
States does not constitute export property. See Sec. 1.927(a)-1T(d)(4) 
relating to determination of where the ultimate use of the property 
occurs. Thus, foreign trading gross receipts of a FSC described in 
paragraph (b) or (c) of this section do not include gross receipts of 
the FSC from the sale or lease of this property.
    (3) Sales or leases of export property and furnishing of services 
accomplished by subsidy. Foreign trading gross receipts of a FSC do not 
include gross receipts described in paragraphs (b) through (f) of this 
section if the sale or lease of export property or the furnishing of 
services is accomplished by a subsidy granted by the United States or 
any instrumentality thereof, see section 924(f)(1)(B). Subsidies covered 
by section 924(f)(1)(B) are listed in subdivisions (i) through (vi) of 
this paragraph.
    (i) The development loan program, or grants under the technical 
cooperation and development grants program of the Agency for 
International Development, or grants under the military assistance 
program administered by the Department of Defense, pursuant to the 
Foreign Assistance Act of 1961, as amended (22 U.S.C. 2151) unless the 
FSC shows to the satisfaction of the Commissioner that, under the 
conditions existing at the time of the sale (or at the time of lease or 
at the time the services were rendered), the purchaser (or lessor or 
recipient of the services) had a reasonable opportunity to purchase (or 
lease or contract for services) on competitive terms and from a seller 
(or lessor or performer of services) who was not a U.S. person, goods 
(or services) which were substantially identical to such property (or 
services) and which were not manufactured, produced, grown, or extracted 
in the United States (or performed by a U.S. person);
    (ii) The Public Law 480 program authorized under Title I of the 
Agricultural Trade Development and Assistance Act of 1954, as amended (7 
U.S.C. 1691, 1701-1714);
    (iii) The Export Payment program of the Commodity Credit Corporation 
authorized by sections 5 (d) and (f) of the Commodity Credit Corporation 
Charter Act, as amended (15 U.S.C. 714c (d) and (f));
    (iv) The section 32 export payment programs authorized by section 32 
of the Act of August 24, 1935, as amended (7 U.S.C. 612c);
    (v) The Export Sales program of Commodity Credit Corporation 
authorized by sections 5 (d) and (f) of the Commodity Credit Corporation 
Charter Act, as amended (15 U.S.C. 714c (d) and (f)), other than the 
GSM-4 program provided under 7 CFR part 1488, and section 407 of the 
Agricultural Act of 1949, as amended (7 U.S.C. 1427), for the purpose of 
disposing of surplus agricultural commodities and exporting or

[[Page 57]]

causing to be exported agricultural commodities; and
    (vi) The Foreign Military Sales direct credit program (22 U.S.C. 
2763) or the Foreign Military Sales loan guaranty program (22 U.S.C. 
2764) if--
    (A) The borrowing country is released from its contractual liability 
to repay the United States government with respect to those credits or 
guaranteed loans;
    (B) The repayment period exceeds twelve years; or
    (C) The interest rate charged is less than the market rate of 
interest as defined in 22 U.S.C. 2763(c)(2)(B);

unless the FSC shows to the satisfaction of the Commissioner that, under 
the conditions existing at the time of the sale, the purchaser had a 
reasonable opportunity to purchase, on competitive terms from a seller 
who was not a U.S. person, goods which were substantially identical to 
this property and which were not manufactured, produced, grown, or 
extracted in the United States. Information regarding whether an export 
is financed, in whole or in part, with funds derived from the programs 
identified in this subdivision may be obtained from the Comptroller, 
Defense Security Assistance Agency, Department of Defense, Washington, 
DC 20301.
    (4) Sales or leases of export property and furnishing of 
architectural or engineering services for use by the United States--(i) 
In general. Foreign trading gross receipts of a FSC do not include gross 
receipts described in paragraph (b), (c), or (e) of this section if a 
sale or lease of export property, or the furnishing of architectural or 
engineering services, is for use by the United States or an 
instrumentality thereof in any case in which any law or regulation 
requires in any manner the purchase or lease of property manufactured, 
produced, grown, or extracted in the United States or requires the use 
of architectural or engineering services performed by a United States 
person. See section 924(f)(1)(A)(ii). For example, a sale by a FSC of 
export property to the Department of Defense for use outside the United 
States would not produce foreign trading gross receipts for the FSC if 
the Department of Defense purchased the property from appropriated funds 
subject to either any provision of the Department of Defense Federal 
Acquisition Regulations Supplement (48 CFR chapter 2) or any 
appropriations act for the Department of Defense for the applicable year 
if the regulations or appropriations act requires that the items 
purchased must have been grown, reprocessed, reused, or produced in the 
United States. The Department of Defense's regulations do not require 
that items purchased by the Department for resale in post or base 
exchanges and commissary stores located on United States military 
installations in foreign countries be items grown, reprocessed, reused 
or produced in the United States. Therefore, receipts arising from the 
sale by a FSC to those post or base exchanges and commissary stores will 
not be excluded from the definition of foreign trading gross receipts by 
this paragraph (g)(4).
    (ii) Direct or indirect sales or leases. Any sale or lease of export 
property is for use by the United States or an instrumentality thereof 
if such property is sold or leased by a FSC (or by a principal for whom 
the FSC acts as commission agent) to--
    (A) A person who is a related person with respect to the FSC or such 
principal and who sells or leases the property for use by the United 
States or an instrumentality thereof, or
    (B) A person who is not a related person with respect to the FSC or 
such principal if, at the time of the sale or lease, there is an 
agreement or understanding that the property will be sold or leased for 
use by the United States or an instrumentality thereof (or if a 
reasonable person would have known at the time of the sale or lease that 
the property would be sold or leased for use by the United States or an 
instrumentality thereof) within 3 years after the sale or lease.
    (iii) Excluded programs. The provisions of subdivisions (4)(i) and 
(ii) of this paragraph do not apply in the case of a purchase by the 
United States or an instrumentality thereof if the purchase is pursuant 
to--
    (A) The Foreign Military Sales Act, as amended (22 U.S.C. 2751 et 
seq.), or a program under which the United States government purchases 
property for resale, on commercial terms, to a foreign

[[Page 58]]

government or agency or instrumentality thereof, or
    (B) A program (whether bilateral or multilateral) under which sales 
to the United States government are open to international competitive 
bidding.
    (5) Services. Foreign trading gross receipts of a FSC do not include 
gross receipts described in paragraph (d) of this section (concerning 
related and subsidiary services) if the services from which such gross 
receipts are derived are related and subsidiary to the sale or lease of 
property which results in excluded receipts under this paragraph.
    (6) Receipts within controlled group. (i) For purposes of the 
transfer pricing methods of section 925(a), gross receipts of a 
corporation do not constitute foreign trading gross receipts for any 
taxable year of the corporation if at the time of the sale, lease, or 
other transaction resulting in the gross receipts, the corporation and 
the person from whom the gross receipts are directly or indirectly 
derived (whether or not such corporation and such person are the same 
person) are members of the same controlled group, and either
    (A) The corporation and the person each qualifies as a FSC (or if 
related FSCs are commission agents of each party to the transaction) for 
its taxable year in which its receipts arise, or
    (B) With regard to sale transactions, a sale of export property to a 
FSC (or to a related person if the FSC is the commission agent of the 
related person) by a non-FSC within the same controlled group follows 
any sale of the export property to a FSC (or to a related person if the 
FSC is the commission agent of the related person) within the same 
controlled group if foreign trading gross receipts resulted from the 
sale. Thus for example, assume that R, S, X, and Y are members of the 
same controlled group and that X and Y are FSCs. If R sells property to 
S and pays X a commission relating to that sale and if S sells the same 
property to an unrelated foreign party and pays Y a commission relating 
to that sale, the receipts received by X from the sale of such property 
by R to S will be considered to be derived from Y, a FSC which is a 
member of the same controlled group as X, and thus will not result in 
foreign trading gross receipts to X. The receipts received by Y from the 
sale to an unrelated foreign party may, however, result in foreign 
trading gross receipts to Y. For another example, if R and S both assign 
the commissions to X, receipts derived from the sale from R to S will be 
considered to be derived from X acting as commission agent for S and 
will not result in foreign trading gross receipts to X. Receipts derived 
by X from the sale of property by S to an unrelated foreign party may, 
however, constitute foreign trading gross receipts.
    (ii) Section 1.927(a)-1T(f)(2) provides rules regarding property not 
constituting export property in certain cases where such property is 
leased to any corporation which is a member of the same controlled group 
as the lessor.
    (7) Factoring of receivables by a related supplier. If an account 
receivable arising with respect to export property is transferred to any 
person for an amount reflecting a discount from the selling price of the 
export property, then the gross receipts from the sale which are treated 
as foreign trading gross receipts for purposes of computing a FSC's 
profit under the administrative pricing methods of section 925(a)(1) and 
(2) shall be reduced by the amount of the discount. See Sec. 1.925(a)-
1T(f) Example 11 for illustration of how this special rule affects 
computation of combined taxable income of a FSC and its related 
supplier.
    (h) Definition of ``controlled group''. For purposes of sections 921 
through 927 and the regulations under those sections, the term 
``controlled group'' has the same meaning as is assigned to the term 
``controlled group of corporations'' by section 1563(a), except that (1) 
the phrase ``more than 50 percent'' is substituted for the phrase ``at 
least 80 percent'' each place the latter phrase appears in section 
1563(a), and (2) section 1563(b) shall not apply. Thus, for example, a 
foreign corporation subject to tax under section 882 may be a member of 
a controlled group. Furthermore, two or more corporations (including a 
foreign corporation) are members of a controlled group at any time such 
corporations meet the requirements of section 1563(a) (as modified by 
this paragraph).

[[Page 59]]

    (i) FSC's entitlement to income--(1) Application of administrative 
pricing rules of section 925(a). A corporation which meets the 
requirements of section 922(a) (or section 922(b) if the corporation 
elects small FSC status) and Sec. 1.921-2(a) (Q&A1) to be treated as a 
FSC (or small FSC) for a taxable year is entitled to income, and the 
administrative pricing rules of section 925(a)(1) or (2) apply, in the 
case of any transaction described in Sec. 1.925(a)-1T(b)(iii) between 
the FSC and its related supplier (as defined in Sec. 1.927(d)-2T(a)) as 
long as the FSC, or someone under contract to it, satisfies the 
requirements of section 925(c). The requirements of section 925(c) must 
be met by a commission FSC as well as by a buy-sell FSC. See Sec. 1.925 
(a)-1T(a)(3)(i) and (b)(2)(ii).
    (2) Other transactions. In the case of a transaction to which the 
provisions of paragraph (i)(1) of this section do not apply but from 
which a FSC derives gross receipts, the income to which the FSC is 
entitled as a result of the transaction is determined pursuant to the 
terms of the contract for the transaction and, if applicable, section 
482 and the regulations under that section. For applicability of the 
section 482 transfer pricing method, see Sec. 1.925(a)-1T (a)(3)(ii) and 
(b)(2)(i).
    (j) Small FSC limitation--(1) In general. Under section 
924(b)(2)(B), in determining exempt foreign trade income of a small FSC, 
the foreign trading gross receipts of the small FSC for the taxable year 
which exceed $5 million are not taken into account. The foreign trading 
gross receipts of the small FSC not taken into account for purposes of 
computing the small FSC's exempt foreign trade income shall be taken 
into account in computing the small FSC's non-exempt foreign trade 
income. If the foreign trading gross receipts of the small FSC exceed 
the $5 million limitation, the small FSC may select the gross receipts 
to which the limitation is allocated. See section 922(b) and Sec. 1.921-
2(b) (Q&A3) for a definition of a small FSC.
    (2) Members of a controlled group limited to one $5 million amount--
(i) General rule. All small FSCs which are members of a controlled group 
on a December 31, shall, for their taxable years which include that 
December 31, be limited to one $5 million amount. The $5 million amount 
shall be allocated equally among the member small FSCs of the controlled 
group for their taxable years including that December 31, unless all of 
the member small FSCs consent to an apportionment plan providing for an 
unequal allocation of the $5 million amount. The apportionment plan 
shall provide for the apportionment of a fixed dollar amount to one or 
more of the corporations, and the sum of the amounts so apportioned 
shall not exceed the $5 million amount. If the taxable year including 
the December 31 of any member small FSC is a short period (as defined in 
section 443), the portion of the $5 million amount allocated to that 
member small FSC for that short period under the preceding sentence 
shall be reduced to the amount which bears the same ratio to the amount 
so allocated as the number of days in such short period bears to 365. 
The consent of each member small FSC to the apportionment plan for the 
taxable year shall be signified by a statement which satisfies the 
requirements of and is filed in the manner specified in Sec. 1.1561-
3(b). An apportionment plan may be amended in the manner prescribed in 
Sec. 1.1561-3(c), except that an original or an amended plan may not be 
adopted with respect to a particular December 31 if at the time the 
original or amended plan is sought to be adopted, less than 12 full 
months remain in the statutory period (including extensions) for the 
assessment of a deficiency against any shareholder of a member small FSC 
the tax liability of which would change by the adoption of the original 
or amended plan. If less than 12 full months of the period remain with 
respect to any such shareholder, the director of the service center with 
which the shareholder files its income tax return will, upon request, 
enter into an agreement extending the statutory period for the limited 
purpose of assessing any deficiency against that shareholder 
attributable to the adoption of the original or amended apportionment 
plan.
    (ii) Membership determined under section 1563(b). For purposes of 
this paragraph (j)(2), the determination of whether a small FSC is a 
member of a

[[Page 60]]

controlled group of corporations with respect to any taxable year shall 
be made in the manner prescribed in section 1563(b) and the regulations 
under that section.
    (iii) Certain short taxable years--(A) General rule. If a small FSC 
has a short period (as defined in section 443) which does not include a 
December 31, and that small FSC is a member of a controlled group of 
corporations which includes one or more other small FSC's with respect 
to the short period, then the amount described in section 924(b)(2)(B) 
with respect to the short period of that small FSC shall be determined 
by--
    (1) Dividing $5 million by the number of small FSCs which are 
members of that group on the last day of the short period, and
    (2) Multiplying the result by a fraction, the numerator of which is 
the number of days in the short period and the denominator of which is 
365.

For purposes of the preceding sentence, section 1563(b) shall be applied 
as if the last day of the short period were substituted for December 31. 
Except as provided in subdivision (2)(iii)(B) of this paragraph, the 
small FSC having a short period not including a December 31 may not 
enter into an apportionment plan with respect to the short period.
    (B) Exception. If the short period not including a December 31 of 
two or more small FSCs begins on the same date and ends on the same date 
and those small FSCs are members of the same controlled group, those 
small FSCs may enter into an apportionment plan for such short period in 
the manner provided in subdivision (2)(i) of this paragraph with respect 
to the combined amount allowed to each of those small FSCs under 
subdivision (2)(iii)(A) of this paragraph.

[T.D. 8126, 52 FR 6438, Mar. 3, 1987]



Sec. 1.924(c)-1  Requirement that a FSC be managed outside the United States.

    (a) In general. Section 924(b)(1)(A) provides that a FSC shall be 
treated as having foreign trading gross receipts for the taxable year 
only if the management of the FSC during the year takes place outside 
the United States, as provided in section 924(c). Section 924(c) and 
this section set forth the management activities that must take place 
outside the United States in order to satisfy the requirement of section 
924(b)(1)(A). Paragraph (b) of this section provides rules for 
determining whether the requirements of section 924(c)(1) have been met. 
Section 924(c)(1) requires that all meetings of the board of directors 
of the FSC during the taxable year and all meetings of the shareholders 
of the FSC during the taxable year take place outside the United States. 
Paragraph (c) of this section provides rules for maintaining the FSC's 
principal bank account outside the United States as provided in section 
924(c)(2). Paragraph (d) of this section provides rules for 
disbursements required by section 924(c)(3) to be made from bank 
accounts of the FSC maintained outside the United States.
    (b) Meetings of board of directors and meetings of shareholders must 
be outside the United States. All meetings of the board of directors of 
the FSC and all meetings of the shareholders of the FSC that take place 
during a taxable year must take place outside the United States to meet 
the requirements of section 924(c)(1). Only meetings that are formally 
convened as meetings of the board of directors or as shareholder 
meetings will be taken into account in determining whether those 
requirements have been met. In addition, all such meetings must comply 
with the local laws of the foreign country or possession of the United 
States in which the FSC was created or organized. The local laws 
determine whether a meeting must be held, when and where it must be held 
(if it is held at all), who must be present, quorum requirements, use of 
proxies, and so on. Where the local law permits action by the board of 
directors or shareholders to be taken by written consent without a 
meeting, use of such procedure will not constitute a meeting for 
purposes of section 924(c)(1). Section 924(c)(1) and this section impose 
no other requirements except the requirement that meetings that are 
actually held take place outside the United States. If the participants 
in a meeting are not

[[Page 61]]

all physically present in the same location, the location of the meeting 
is determined by the location of the persons exercising a majority of 
the voting power (including proxies) participating in the meeting. For 
example, a FSC has five directors, and is organized in country A. 
Country A's law requires that a majority of the directors of a 
corporation must participate in a meeting to constitute a quorum (and, 
thus, a meeting), but there is no requirement that the meeting be held 
in country A or that the directors must be physically present to 
participate. One director is in country A, another director is in 
country B, and a third director is in the United States.
    These three directors convene a meeting by telephone that 
constitutes a meeting under the law of country A. The meeting occurs 
outside the United States because the persons exercising a majority of 
the voting power participating in the meeting are located outside the 
United States.
    (c) Maintenance of the principal bank account outside the United 
States--(1) In general. For purposes of section 924(c), the bank account 
that shall be regarded as the principal bank account of a FSC is the 
bank account from which the disbursements described in paragraph (d) of 
this section are made. A FSC may have more than one principal bank 
account. The bank account that is regarded as the principal bank account 
must be maintained in a foreign country which meets the requirements of 
section 927(e)(3), or in any possession of the United States (as defined 
in section 927(d)(5)), and it must be so maintained at all times during 
the taxable year. For taxable years beginning on or after February 19, 
1987, a principal bank account or accounts must be designated on the 
annual return of the FSC by providing the bank name(s) and account 
number(s).
    (2) Maintenance of the account in a bank. The bank account that is 
regarded as the principal bank account must be maintained in an 
institution that is engaged in the conduct of a banking, financing, or 
similar business, as defined in Sec. 1.954-2(d)(2)(ii) (without regard 
to whether it is a controlled foreign corporation). The institution may 
be a U.S. bank, provided that the account is maintained in a branch 
outside the United States.
    (3) Maintenance of an account outside the United States. Maintenance 
of the principal bank account outside the United States means that the 
account regarded as the principal bank account must be an account 
maintained on the books of the banking institution at an office outside 
the United States, but does not require that access to the account may 
be made only outside the United States. Instructions providing for 
deposits into or disbursements from the account may originate in the 
United States without affecting the status of maintenance of the account 
outside the United States.
    (4) Maintenance of the account at all times during the taxable year. 
The term ``at all times during the taxable year'' generally means for 
each day of the taxable year. In the case of a newly created or 
organized corporation, thirty days may elapse between the effective date 
of the corporation's election to be treated as a FSC and the date a bank 
account is opened without causing the FSC to fail the requirement that 
it maintain its principal bank account outside the United States at all 
times during the taxable year. For example, if a corporation is created 
or organized prior to January 1, 1985, and makes an election to be 
treated as a FSC within the first 90 days of 1985, the election is 
effective as of January 1, 1985. Thus, the FSC must open a bank account 
within 30 days of January 1, or as of January 31, 1985, to satisfy this 
requirement. Also, a FSC shall be treated as satisfying this requirement 
if the account that is regarded as its principal bank account is 
terminated during the taxable year, provided that (i) such termination 
is the result of circumstances beyond the FSC's control, and (ii) the 
FSC establishes a new principal bank account within thirty days after 
such termination. A FSC may close its principal bank account and replace 
it with another account that qualifies under this paragraph (c) as a 
principal bank account at any time provided that no lapse of time occurs 
between the closing of the principal bank account and the opening of the 
replacement account.

[[Page 62]]

    (5) Other accounts. The FSC may maintain other bank accounts in 
addition to its principal bank account. Such other accounts may be 
located anywhere, without limitation. The mere existence of such other 
accounts will not cause the FSC to fail to satisfy the requirements of 
section 924(c).
    (d) Disbursement of dividends, legal and accounting fees, and 
salaries of officers and directors out of the principal bank account of 
the FSC--(1) In general. All dividends, legal fees, accounting fees, 
salaries of officers of the FSC, and salaries or fees paid to members of 
the board of directors of the FSC that are disbursed during the taxable 
year must be disbursed out of bank account(s) of the FSC maintained 
outside the United States. Such an account is treated as the principal 
bank account of the FSC for purposes of section 924(c). Dividends, 
however, may be netted against amounts owed to the FSC (e.g., 
commissions) by a related supplier through book entries. If the FSC 
regularly disburses its legal or accounting fees, salaries of officers, 
and salaries or fees of directors out of its principal bank account, the 
occasional, inadvertent payment by mistake of fact or law of such 
amounts out of another bank account will not be considered a 
disbursement by the FSC if, upon determination that such payment was 
made from another account, reimbursement to such other account is made 
from the principal bank account of the FSC within a reasonable period 
from the date of the determination. Disbursement out of the principal 
bank account of the FSC may be made by transferring funds from the 
principal bank account to a U.S. account of the FSC provided that (i) 
the payment of the dividends, salaries or fees to the recipients is made 
within 12 months of the transfer, (ii) the purpose of the expenditures 
is designated and, (iii) the payment of the dividends, salaries or fees 
is actually made out of the same U.S. account that received the 
disbursement from the principal bank account.
    (2) Reimbursement. Legal or accounting fees, salaries of officers, 
and salaries or fees of directors that are paid by a related person 
wholly or partially on behalf of a FSC must be reimbursed by the FSC. 
The amounts paid by the related person are not considered disbursed by 
the FSC until the related person is reimbursed by the FSC. The related 
person must be reimbursed no later than the last date prescribed for 
filing the FSC's tax return (including extensions) for the taxable year 
to which the reimbursement relates. Any reimbursement for amounts paid 
on behalf of the FSC must be disbursed out of the FSC's principal bank 
account (and not netted against any obligation owed by the related 
person to the FSC), as set forth in paragraph (c) of this section. To 
determine the amounts paid on behalf of the FSC, the FSC may rely upon a 
written statement or invoice furnished to it by the related person which 
shows the following:
    (i) The actual fees charged for performing the legal or accounting 
services for the FSC or, if such fees cannot be ascertained by the 
related person, a good faith estimate thereof, and the actual salaries 
or fees paid for services as officers and directors of the FSC, and
    (ii) The person who performed or provided the services.
    (3) Good faith exception. If, after the FSC has filed its tax 
return, a determination is made by the Commissioner that all or a part 
of the legal or accounting fees, salaries of officers, and salaries or 
fees of directors of the FSC were paid by a related person without 
receiving reimbursement, the FSC may, nonetheless, satisfy the 
requirements of section 924(c)(3) if the fees and salaries were paid by 
the related person in good faith, and the FSC reimburses the related 
person for the fees and salaries paid within 90 days after the 
determination. The reimbursement shall be treated as made as of the end 
of the taxable year of the FSC for which the reimbursement is made.
    (4) Dividends--(i) Definition. For purposes of section 924(c) and 
this section only, the term ``dividends'' refers solely to cash 
dividends (including a dividend paid in a foreign functional currency) 
actually paid pursuant to a declaration or authorization by the FSC. 
Accordingly, a ``dividend'' will not include a constructive dividend 
that is deemed to be paid (regardless of the source of such constructive 
dividend) or a distribution of property that is a dividend under section 
316 other than a

[[Page 63]]

distribution of U.S. dollars or a foreign functional currency.
    (ii) Offset accounting entries. Payment of dividends by the FSC to 
its related supplier may be in the form of an accounting entry 
offsetting an amount payable to the related supplier for the dividend 
against an existing debt owed to the FSC. The offset accounting entries 
must be clearly identified in the books of account of both the related 
supplier and the FSC.
    (5) Legal and accounting fees. For purposes of this section, legal 
and accounting fees do not include salaries paid to legal and accounting 
employees of the FSC (or a related person). Legal and accounting fees 
are limited to fees paid to independent persons performing legal or 
accounting services for or with respect to the FSC.
    (6) Salaries of officers and directors. For purposes of this 
section, salaries of officers and salaries or fees of directors are only 
those salaries or fees paid for services as officers or directors of the 
FSC. Salaries do not include reimbursed travel and entertainment 
expenses. If an individual officer, director, or employee of a related 
person is also an officer or director of a FSC and receives additional 
compensation for services performed for the FSC, the portion of the 
compensation paid to the individual which is for services performed for 
the FSC is required to be disbursed out of the FSC's principal bank 
account. For purposes of this section, the term ``compensation'' is 
defined as set forth in paragraphs (d)(1) and (2) of Sec. 1.415-2.

[T.D. 8125, 52 FR 5089, Feb. 19, 1987]



Sec. 1.924(d)-1  Requirement that economic processes take place outside the United States.

    (a) In general. Section 924(b)(1)(B) provides that a FSC has foreign 
trading gross receipts from any transaction only if economic processes 
with respect to such transaction take place outside the United States as 
provided in section 924(d). Section 924(d) and this section set forth 
the rules for determining whether a sufficient amount of the economic 
processes of a transaction take place outside the United States. 
Generally, a transaction will qualify if the FSC satisfies two different 
requirements: Participation outside the United States in the sales 
portion of the transaction, and satisfaction of either the 50-percent or 
the 85-percent foreign direct cost test. The activities comprising these 
economic processes may be performed by the FSC or by any other person 
acting under contract with the FSC. (All references to ``FSC'' in 
Secs. 1.924(d)-1 and 1.924(e)-1 shall mean the FSC or, if applicable, 
the person performing the relevant activity under contract on behalf of 
the FSC.) The FSC may act upon standing instructions from another person 
in the performance of any activity, whether a sales activity under 
paragraph (c) of this section or an activity relating to the disposition 
of export property under paragraph (d) of this section and 
Sec. 1.924(e)-1. The identity of the FSC as a separate entity is not 
required to be disclosed in the performance of any of the activities 
comprising the economic processes. Except as otherwise provided, the 
location of any activity is determined by the place where the activity 
is initiated by the FSC, and not by the location of any person 
transmitting instructions to the FSC.
    (b) Activities performed by another person--(1) In general. Any 
person, whether domestic or foreign, and whether related or unrelated to 
the FSC, may perform any activity required to satisfy this section, 
provided that the activity is performed pursuant to a contract for the 
performance of that activity on behalf of the FSC. Such a contract may 
be any oral or written agreement which constitutes a contract at law. 
The person performing the activity is not required to enter into a 
contract directly with the FSC and, thus, may be a direct or indirect 
subcontractor of a person under contract with the FSC. For example, 
assume that a buy-sell FSC enters into an agreement with its related 
supplier in which the related supplier agrees to perform on behalf of 
the FSC all sales activities with respect to the FSC's transactions with 
its foreign customers. Through its existing agreements with a domestic 
unrelated person, the related supplier subcontracts the performance of 
these activities to the domestic unrelated person, who, in turn, 
subcontracts the performance of

[[Page 64]]

the sales activities to foreign sales agents. The sales activities 
performed by the foreign sales agents are considered to be performed on 
behalf of the FSC for purposes of meeting the requirements of section 
924(d)(1)(A).
    (2) Proof of compliance. If the FSC does not perform the activity 
itself, it must maintain records adequate to establish, with respect to 
each transaction or group of transactions, that the activity was 
performed and that the performance of such activity took place outside 
the United States. If the person who performed the activity on behalf of 
the FSC is an independent contractor, the FSC may rely upon a written 
declaration from that person stating that the activities were performed 
by that person on behalf of the FSC, and were performed outside the 
United States. An invoice or a receipt for payment will be considered to 
be such a written declaration if it specifies that the activities were 
performed outside the United States or specifies a particular place 
outside the United States where the activities were performed. If the 
person performing the activities on behalf of the FSC is a related 
person, the FSC must maintain records adequate to establish that the 
activities were actually performed and where the activities were 
performed. Such records may be stored with the related person provided 
that the FSC makes such records available to the Commissioner upon 
request.
    (c) Participation outside the United States in the sales portion of 
the transaction--(1) In general. The requirement of section 924(d)(1)(A) 
is met with respect to the gross receipts of a FSC derived from any 
transaction if the FSC has participated outside the United States in the 
solicitation, the negotiation, or the making of the contract relating to 
such transaction (hereinafter described as ``sales activities''), as 
provided in this paragraph (c). A sale need not occur in order that the 
solicitation or negotiation tests be satisfied. Once the FSC has 
participated outside the United States in an activity that constitutes 
the solicitation, negotiation, or the making of the contract with 
respect to a transaction, any prior or subsequent activity by the FSC 
with respect to such transaction that would otherwise constitute the 
sales activity will be disregarded for purposes of determining whether 
the FSC has met the requirements of section 924(d)(1)(A). For example, 
if a FSC sells a product to a foreign customer by first meeting with the 
customer in New York to discuss the product and then by mailing to it 
from outside the United States a brochure describing the product, the 
prior meeting is disregarded and only the mailing is considered in 
determining whether there was solicitation outside the United States by 
the FSC with respect to the transaction which has occurred.
    (2) Solicitation (other than advertising). For purposes of this 
paragraph (c), ``solicitation'' refers to any communication (by any 
method, including, but not limited to, telephone, telegraph, mail, or in 
person) by the FSC, at any time during the 12 month period (measured 
from the date the communication is mailed or transmitted) immediately 
preceding the execution of a contract relating to the transaction to a 
specific, targeted customer or potential customer, that specifically 
addresses the customer's attention to the product or service which is 
the subject of the transaction. For purposes of paragraph (c)(2) of this 
section, communication by mail means depositing the communication in a 
mailbox. Except as provided in Sec. 1.924(e)-1(a)(1) with respect to 
second mailings, activities that would otherwise constitute advertising 
(such as sending sales literature to a customer or potential customer) 
will be considered solicitation if the activities are directed at a 
specific, targeted customer or potential customer, and the costs of the 
activity are not taken into account as advertising under the foreign 
direct cost tests. Activities that would otherwise constitute sales 
promotion (such as a promotional meeting in person with a customer) will 
be considered to be solicitation if the activities are directed at a 
specific, targeted customer or potential customer, and the costs of the 
activity are not taken into account as sales promotion under the foreign 
direct cost tests. Except as provided in Sec. 1.924(e)-1(a)(1) with 
respect to second mailings, the same or similar activities cannot be 
considered both solicitation

[[Page 65]]

and advertising, or both solicitation and sales promotion, with respect 
to the same customer. Solicitation, however, may take place at the same 
time as, and in conjunction with, another sales activity. Additionally, 
it may take place with respect to any person, whether domestic or 
foreign, and whether or not related to the FSC.
    (3) Negotiation. For purposes of this paragraph (c), ``negotiation'' 
refers to any communication by the FSC to a customer or potential 
customer aimed at an agreement on one or more of the terms of a 
transaction, including, but not limited to, price, credit terms, 
quantity, or time or manner of delivery. For purposes of this paragraph 
(c)(3), communication by mail has the same meaning as provided in 
paragraph (c)(2) of this section. Negotiation does not include the mere 
receipt of a communication from a customer (such as an order) that 
includes terms of a sale. Negotiation may take place at the same time 
as, and in conjunction with, another sales activity. Additionally, it 
may take place with respect to any person, whether domestic or foreign, 
and whether or not related to the FSC.
    (4) Making of a contract. For purposes of this paragraph (c), 
``making of a contract'' refers to performance by the FSC of any of the 
elements necessary to complete a sale, such as making an offer or 
accepting an offer. A requirements contract is considered an open offer 
to be accepted from time to time when the customer submits an order for 
a specified quantity. Thus, the acceptance of such an order will be 
considered the making of a contract. The written confirmation by the FSC 
to the customer of the acceptance of the open order will also be 
considered the making of a contract. Acceptance of an unsolicited bid or 
order is considered the ``making of a contract'' even if no solicitation 
or negotiation occurred with respect to the transaction. The written 
confirmation by the FSC to the customer of an oral or written agreement 
which confirms variable contract terms, such as price, credit terms, 
quantity, or time or manner of delivery, or specifies (directly or by 
cross-reference) additional contract terms will be considered the making 
of a contract. A written confirmation is any confirmation expressed in 
writing, including a telegram, telex, or other similar written 
communication. The making of a contract may take place at the same time 
as, and in conjunction with, another sales activity. Additionally, it 
may take place with respect to any person, whether domestic or foreign, 
and whether or not related to the FSC.
    (5) Grouping transactions. Generally, the sales activities under 
this paragraph (c) are to be applied on a transaction-by-transaction 
basis. By annual election of the FSC, however, any of the sales 
activities may be applied on the basis of a group as set forth in this 
paragraph (c)(5). Any groupings used must be supported by adequate 
documentation of performance of activities relating to the groupings 
used. An election by the FSC to group transactions must be made on its 
annual income tax return. The FSC, however, may amend its tax return to 
group in a manner different from that elected on its original return 
before the expiration of the statute of limitations.
    (i) Standards of groups. A determination by a FSC as to a grouping 
will be accepted by a district director if such determination conforms 
to any of the following standards:
    (A) Product or product line groupings. A product or product line 
grouping may be based upon either a recognized trade or industry usage, 
or upon a two digit major group (or on any inferior classification or 
combination of inferior classifications within a major group) of the 
Standard lndustrial Classification as prepared by the Statistical Policy 
Division of the Office of Management and Budget, Executive Office of the 
President. For taxable years beginning on or before February 19, 1987, 
any sales activity that is performed outside the United States with 
respect to any transaction covered by the product or product line 
grouping during the FSC's taxable year shall apply to all transactions 
covered by the product or product line. However, for taxable years 
beginning after February 19, 1987, the requirement of section 
924(d)(1)(A) is met with respect to all transactions covered by the 
product or product line grouping only if the sales activities are 
performed outside

[[Page 66]]

the United States with respect to customers with sales representing 
either:
    (i) 20 percent or more of the foreign trading gross receipts of the 
product or product line grouping during the current year or
    (ii) 50 percent or more of the foreign trading gross receipts of the 
product or product line grouping for the prior year irrespective of 
whether any sales occurred within the current year to the prior year 
customers.

If during the prior taxable year, the controlled group of which the FSC 
is a member had a DISC or interest charge DISC, the FSC may use the 50 
percent rule with respect to the preceding DISC or interest charge DISC 
year, substituting qualified export receipts for foreign trading gross 
receipts. A corporation which has not been treated in the prior year as 
a FSC, interest charge DISC, or DISC does not have to meet either the 20 
percent test or the 50 percent test for the first year in which it is 
treated as a FSC.
    (B) Customer groupings. A customer grouping includes all 
transactions of the FSC with a particular customer during the FSC's 
taxable year. Thus, any sales activity that is performed outside the 
United States with respect to any transaction with the customer during 
the taxable year shall apply to all transactions within the customer 
grouping.
    (C) Contract groupings. A contract grouping includes all 
transactions of the FSC under a particular contract for a taxable year. 
Thus, any sales activity that is performed outside the United States 
with respect to any transaction under the contract will apply to all 
transactions under the contract for such taxable year. For long-term 
contracts between unrelated parties, the sales activities tests need be 
satisfied only once for the life of the contract. With respect to 
requirements contracts and long-term contracts between related parties, 
the sales activities test must be satisfied annually.
    (D) Product or product line groupings within customer or contract 
groupings. Groupings may be based upon product or product line groupings 
within customer or contract groupings. If, however, the primary grouping 
is a customer or contract grouping, the 20 percent test set forth in 
subdivision (A) of this paragraph relating to product or product line 
grouping will not be applicable.
    (ii) Transactions included in a grouping. A choice by a FSC to group 
transactions shall generally apply to all transactions within the scope 
of that grouping. The choice of a grouping, however, applies only to 
transactions covered by the grouping and, for transactions not 
encompassed by the grouping, the determinations may be made on a 
transaction-by-transaction basis or other grouping basis. For example, a 
FSC may choose a product grouping with respect to one product and use 
the transaction-by-transaction method for another product within the 
same taxable year. In addition, if a FSC applies sales activity rules on 
the basis of other types of groupings, such as all sales to a particular 
customer, transactions included in those other groupings shall be 
excluded from product groupings.
    (iii) Different groupings allowed for different purposes. A choice 
by the FSC to group transactions may be made separately for each of the 
sales activities under section 924(d)(1)(A). Groupings used for purposes 
of section 924(d)(1)(A) will have no relationship to groupings used for 
other purposes, such as satisfying the foreign direct cost tests. This 
paragraph (c)(5) does not apply for purposes of section 925.
    (6) Examples. The provisions of this paragraph (c) may be 
illustrated by the following examples:

    Example 1. In November, a calendar year FSC mailed from its foreign 
office its catalog to a potential foreign customer. The catalog 
displayed numerous products along with a brief description and the price 
of each. In February of the following year, the FSC sold to the customer 
a product displayed in the catalog. Since the FSC communicated with the 
customer during the 12-month period prior to the sale, although during 
the previous taxable year, the FSC participated outside the United 
States in the solicitation relating to the transaction.
    Example 2. A FSC with a taxable year ending April 30, 1986, solicits 
customer X during that taxable year with respect to Product A. In the 
previous taxable year, the FSC sold product A to customers V, W, X, Y, 
Z, none of whom were customers in the taxable year ending April 30, 
1986. The sales proceeds from sales to customer X represented 50 percent 
of

[[Page 67]]

the foreign trading gross receipts for the previous FSC year. The FSC 
meets the 50 percent test for product or product line grouping for the 
taxable year ending April 30, 1986. If the facts were changed so that 
there was not a FSC, DISC or interest charge DISC in the same controlled 
group in the previous taxable year, the single solicitation directed to 
any customer would qualify all transactions within the product group as 
meeting the solicitation requirement for that taxable year. For 
subsequent taxable years, the 50 percent test or the 20 percent test 
would be applicable.
    Example 3. A FSC earns commissions on the sale of export property by 
its domestic related supplier to United States wholesalers for final 
sale to foreign customers. The related supplier receives an order from 
one of its United States wholesalers. The related supplier telephones 
the United States wholesaler to inform it of the new price and the 
probability of another price increase soon. The United States wholesaler 
orally agrees to the new price and the related supplier instructs the 
FSC to telex the wholesaler from its foreign office a confirmation that 
the product will be sold at the current new price. The written 
confirmation by the FSC of an oral agreement on a variable contract term 
constitutes the making of a contract. Thus, the requirements of section 
924(d)(1)(A) are met with respect to the transaction relating to the 
product.

    (d) Satisfaction of either the 50-percent or the 85-percent foreign 
direct cost test--(1) In general. Section 924(d)(1)(B) requires, in 
order for the gross receipts of a transaction to qualify as foreign 
trading gross receipts, that the foreign direct costs incurred by the 
FSC attributable to the transaction equal or exceed 50 percent of the 
total direct costs incurred by the FSC attributable to the transaction. 
The direct costs are those costs attributable to activities described in 
the five categories of section 924(e). Section 924(d)(2) provides that, 
instead of satisfying the 50-percent foreign direct cost test of section 
924(d)(1)(B), the FSC may incur foreign direct costs attributable to 
activities described in each of two of those categories that equal or 
exceed 85 percent of the total direct costs incurred by the FSC 
attributable to the activity described in each of the two categories. If 
no direct costs are incurred by the FSC in a particular category, that 
category shall not be taken into account for purposes of determining 
satisfaction of either the 50-percent or the 85-percent foreign direct 
cost test. If any amount of direct costs is incurred in a particular 
category, that category shall be taken into account for purposes of the 
foreign direct costs tests.
    (2) Direct costs--(i) Definition of direct costs. For purposes of 
section 924 (d), direct costs are those costs which are incident to and 
necessary for the performance of any activity described in section 
924(e). Direct costs include the cost of materials which are consumed in 
the performance of the activity, and the cost of labor which can be 
identified or associated directly with the performance of the activity 
(but only to the extent of wages, salaries, fees for professional 
services, and other amounts paid for personal services actually 
rendered, such as bonuses or compensation paid for services on the basis 
of a percentage of profits). Direct costs also include the allowable 
depreciation deduction for equipment or facilities (or the rental cost 
for use thereof) that can be specifically identified or associated with 
the activity, as well as the contract price of an activity performed on 
behalf of the FSC by a contractor. If costs of services or the use of 
facilities are only incidentally related to the performance of an 
activity described in section 924(e), only the incremental cost is 
considered to be identified directly with the activity. For example, 
supervisory, administrative, and general overhead expenses, such as 
telephone service, normally are not identified directly with particular 
activities described in section 924(e). The cost of a long distance 
telephone call made to arrange for delivery of export property, however, 
is identified directly with the activities described in section 
924(e)(2). Direct costs for purposes of section 924(d) do not 
necessarily include all of the expenses taken into account for purposes 
of determining the taxable income of the FSC or the combined taxable 
income of the FSC and its related supplier.
    (ii) Allocation of direct costs. For purposes of this section only, 
if costs are identified with more than one activity (whether or not all 
of the activities are described in section 924(e)), the portion of the 
costs attributable to each activity shall be determined by allocating 
the costs among the activities in any manner that is consistently 
applied

[[Page 68]]

and, if applicable, that reasonably reflects relative costs that would 
be incurred by performing each activity independently. If costs of an 
activity are attributable to more than one transaction or grouping of 
transactions, the portion of the costs attributable to each transaction 
or grouping shall be determined by allocating the costs among the 
transactions or groupings in any manner that is consistently applied 
and, if applicable, that reasonably reflects relative costs that would 
be incurred by performing the activity independently with respect to 
each transaction or grouping.
    (3) Total direct costs. The term ``total direct costs'' means all of 
the direct costs of any transaction attributable to activities described 
in any paragraph of section 924(e). For purposes of the 50-percent 
foreign direct cost test of section 924(d)(1)(B), total direct costs are 
determined based on the direct costs of all activities described in all 
of the paragraphs of section 924(e). For purposes of the 85-percent 
foreign direct cost test of section 924(d)(2), however, the total direct 
costs are determined separately for each paragraph of section 924(e). If 
more than one activity is included within a paragraph of section 924(e), 
direct costs must be incurred with respect to at least one activity 
listed in the paragraph. If costs are incurred with respect to more than 
one activity, all direct costs must be considered for purposes of 
satisfying the direct costs test.
    (4) Foreign direct costs. The term ``foreign direct costs'' means 
the portion of the total direct costs of any transaction which is 
attributable to activities performed outside the United States. For 
purposes of the 50-percent foreign direct cost test, foreign direct 
costs are determined based on the direct costs of all activities 
described in all of the paragraphs of section 924(e). For purposes of 
the 85-percent foreign direct cost test, however, foreign direct costs 
are determined separately for each paragraph of section 924(e).
    (5) Fifty percent foreign direct cost test. To satisfy the 
requirement of section 924(d)(1)(B), the foreign direct costs incurred 
by the FSC attributable to the transaction must equal or exceed 50 
percent of the total direct costs attributable to the transaction. This 
test looks to the cost of the activities described in section 924(e) on 
an aggregate basis; therefore, it is not necessary that the foreign 
direct costs of each activity, or of each paragraph of section 924(e), 
equal or exceed 50 percent of the total direct costs of that activity or 
paragraph.
    (6) Eighty-five percent foreign direct cost test--(i) General rule. 
To satisfy the requirement of section 924(d)(2), the foreign direct 
costs of a transaction incurred by the FSC attributable to activities 
described in each of at least two paragraphs of section 924(e) must 
equal or exceed 85 percent of the total direct costs attributable to 
activities described in that paragraph. This test looks to costs of the 
activities on a paragraph-by-paragraph basis (but not on an activity-by-
activity basis). As an example, the foreign direct costs of advertising 
and sales promotion are aggregated with each other for this purpose, but 
they are not aggregated with the foreign direct costs of transportation.
    (ii) Satisfaction of the 85-percent test. If, after the FSC files 
its tax return indicating that it has satisfied the 85-percent foreign 
direct cost test with respect to each of at least two paragraphs of 
subsection 924(e) and a determination is made by the Commissioner that 
the foreign direct costs attributable to one or both of the two 
paragraphs of section 924(e) specified on the return did not equal or 
exceed 85 percent of the total direct costs attributable to such 
activities, the FSC may, nonetheless, satisfy the 85-percent foreign 
direct cost test if the foreign direct costs attributable to any two 
paragraphs of section 924 (e) equal or exceed 85 percent of the total 
direct costs attributable to those other paragraphs.
    (e) Grouping transactions. Generally, the foreign direct cost tests 
under paragraph (d) of this section are to be applied on a transaction-
by-transaction basis. By annual election of the FSC, however, the 
foreign direct cost tests may be applied on a customer, contract or 
product or product line grouping basis. Any groupings used must be 
supported by adequate documentation of performance of activities

[[Page 69]]

and costs of activities relating to the groupings used. An election by 
the FSC to group transactions must be made on its annual income tax 
return. The FSC may, however, amend its tax return before the expiration 
of the statute of limitations under section 6501 of the Code to group in 
a manner different from that elected on its original return.
    (1) Standards for groupings. A determination by a FSC as to a 
grouping will be accepted by the district director if such determination 
conforms to any of the following standards:
    (i) Product or product line groupings. A product or product line 
grouping may be based either on a recognized trade or industry usage, or 
on a two digit major grouping (or on any inferior classification or 
combination of inferior classifications within a major grouping) of the 
Standard Industrial Classification as prepared by the Statistical Policy 
Division of the Office of Management and Budget, Executive Office of the 
President.
    (ii) Customer groupings. A customer grouping includes all 
transactions of the FSC with a particular customer during the FSC's 
taxable year.
    (iii) Contract groupings. A contract grouping includes all 
transactions of the FSC under a particular contract, including a 
requirements contract. The tests will be applied to all transactions 
within a contract grouping during each taxable year of the FSC; however, 
by election of the FSC, all transactions under a contract that occur in 
the first or the last year of the contract may be included with, 
respectively, the next succeeding or the immediately preceding taxable 
year in applying these tests. For example, if with respect to 
transactions during the first calendar year of a 5-year contract, a 
calendar year FSC incurs direct costs attributable to the transactions 
of $100X for advertising, all of which are foreign direct costs, and 
$10X for processing of customers orders and for arranging for delivery, 
$9X (or 90 percent of the total direct costs) of which are foreign 
direct costs, the FSC has satisfied the 85-percent foreign direct cost 
test with respect to those transactions for the taxable year. If with 
respect to transactions during the second year of the contract, the FSC 
only incurs $18X of direct costs for processing of customer orders and 
arranging for delivery, $15X (83.3 percent of the total direct costs) of 
which are foreign direct costs, the FSC may include the transactions 
from the first year of the contract to meet the 85-percent foreign 
direct cost test in the second taxable year. Thus, with respect to the 
transactions in the second year, the FSC satisfies the foreign direct 
costs test for advertising (because the entire $100X of direct costs are 
foreign direct costs) and for processing of customer orders and 
arranging for delivery (because of the $28X of direct costs, $24X or 
85.7 percent of the total direct costs are foreign direct costs). If, 
however, with respect to transactions in the third year, the FSC 
satisfies the foreign direct costs test, those transactions cannot be 
included with the transactions in the fourth year. The FSC may aggregate 
the direct costs in the fourth and fifth years in the same manner as for 
the first and second years as described above in order to satisfy the 85 
percent foreign direct costs test.
    (iv) Product or product line groupings within customer or contract 
groupings. Groupings may be based on product or product line groupings 
within customer or contract groupings.
    (2) Transactions included in a grouping. An election by the FSC to 
group transactions shall generally apply to all transactions within the 
scope of that grouping. The election of a grouping, however, applies 
only to transactions covered by the grouping and, as to transactions not 
encompassed by the grouping, the determinations may be made on a 
transaction-by-transaction basis or other grouping basis. For example, 
the FSC may elect a product grouping with respect to one product and 
elect the transaction-by-transaction method for another product within 
the same taxable year. In addition, if a FSC is permitted to apply 
either the 50-percent or the 85-percent foreign direct cost test on the 
basis of other types of groupings, such as all transactions with respect 
to a particular customer, transactions included in those other groupings 
shall be excluded from product groupings.

[[Page 70]]

    (3) Different groupings allowed for different purposes. An election 
by the FSC to group transactions may be made separately for each of the 
activities relating to disposition of export property under section 
924(d)(1)(B) or section 924(d)(2). Groupings used for purposes of 
section 924 will have no bearing on groupings for other purposes. This 
paragraph (e) does not apply for purposes of section 925.
    (f) Exception for foreign military property--(1) General rule. The 
requirements of this section do not apply to any activities performed in 
connection with foreign military sales except those activities described 
in section 924(e). The FSC is deemed to have satisfied the requirements 
of section 924(d)(1)(A).
    (2) Example. The principles of paragraph (f)(1) of this section may 
be illustrated by the following example:

    Example. A FSC earns commissions on foreign military sales by its 
related supplier. All solicitation, negotiation, and contract making 
activities occur in the United States solely between the related 
supplier and the United States government. The property is delivered, 
title passes, and payment is made in the United States in accordance 
with standard United States government practices. The FSC incurs direct 
costs in the amount of $155X to process the government's orders and 
arrange for delivery of the goods, all of which are foreign direct 
costs. In addition, it incurs foreign direct costs in the amount of 
$250X for assembling and transmitting its final invoice to the 
government from outside the U.S. and foreign direct costs of $200X 
associated with receiving payment from the related supplier in 
accordance with the rules of Sec. 1.924(e)-1(d)(2)(iii). No other 
activities occur with respect to the foreign military sales. The FSC has 
satisfied the 85-percent foreign direct cost test and thus has foreign 
trading gross receipts with respect to the foreign military sales. The 
fact that the FSC did not participate outside the United States in any 
of the sales activities has no bearing on the qualification of the 
receipts since the FSC is deemed to have met the requirements of section 
924(d)(1)(A).

[T.D. 8125, 52 FR 5090, Feb. 19, 1987]



Sec. 1.924(e)-1  Activities relating to the disposition of export property.

    (a) Advertising and sales promotion. For purposes of section 924(e), 
advertising and sales promotion are defined as follows.
    (1) Advertising--(i) Advertising defined--(A) General rule. 
Advertising means the announcement or description of property or 
services described in section 924(a), in some medium of mass 
communication (such as radio, television, newspaper, trade journals, 
mass mailings, or billboards), in order to induce multiple customers or 
potential customers to buy or rent the property or services from the FSC 
or related supplier. Advertising is not required to be directed to the 
general public, but may be focused toward any group of export customers 
or potential export customers. Advertising except for the advertising 
described in Sec. 1.924(e)-1(a)(1)(B) must describe one or more specific 
products or product lines (or services) and identify the product as a 
product offered by the FSC or related supplier. Advertising intended 
solely to build a favorable image of a company or group of companies is 
not included in this definition of advertising. Additionally, 
advertising primarily directed at customers or potential customers in 
the United States is not included in this definition of advertising, nor 
is advertising related to property or services not described in section 
924(a).
    (B) Special rules for sales to distributors. If the customer is a 
distributor (whether domestic or foreign, related or unrelated to the 
FSC), an expense that is incurred by the distributor and charged to the 
FSC or related supplier as a reduction in the purchase price or as a 
separate charge for an announcement or description described in 
paragraph (a)(1)(A) of this section to induce the distributor's 
customers, potential customers, or the ultimate users to buy or rent the 
property or services is advertising for these purposes (i) if the FSC 
incurs 20 percent or more of the total advertising costs of the 
distributor or (ii) if the FSC pays the total charge of an advertisement 
either directly or indirectly. For these purposes, a distributor is 
anyone other than an end user or a final consumer. A FSC may incur 
direct advertising costs to a foreign end consumer even though the FSC 
sells to a U.S. distributor.
    (ii) Direct costs of advertising. Direct costs of advertising 
include costs of

[[Page 71]]

transmitting, displaying, or distributing the advertising to customers 
or potential customers and the costs of printing in the case of sales 
literature, but do not include fees paid to an independent advertising 
agency to develop the announcement or description, translation costs, or 
costs of preparing the announcement or description for potential use as 
advertising. Direct costs of sending sales literature to customers or 
potential customers may be taken into account as advertising costs as 
long as the activity is not taken into account for purposes of the sales 
activity requirements of Sec. 1.924(d)-1(c).
    (iii) Location of advertising--(A) General rule. The location of 
advertising activity is the place to which the advertising is 
transmitted, displayed, distributed, mailed, or otherwise conveyed to 
the customers or potential customers (or in the case of advertising 
described in paragraph (a)(i)(B) of this section, the distributor's 
customers, or the ultimate users). For example, a television 
advertisement that is broadcast to a foreign country constitutes 
advertising activity outside the United States even though the broadcast 
signal originates in the United States. Therefore, the cost of that 
advertising activity is a foreign cost. The FSC may rely upon the 
distribution statistics of the publisher of print media or the 
broadcaster of broadcast media through which the advertising is 
distributed. If the distribution statistics show that 85 percent or more 
of the readership, radio listeners, or viewership are outside the United 
States, all direct costs of advertising are considered foreign direct 
costs of advertising.
    (B) Foreign editions of journals, magazines, etc. Costs related to 
advertising in foreign English editions of U.S. publications as well as 
advertising in any publication in a foreign language are foreign direct 
costs.
    (C) United States editions. Costs related to advertising in United 
States publications are not treated as direct costs even if the 
publication also has a foreign edition in English.
    (iv) Second mailings. In general, direct costs of sending sales 
literature to customers may be treated as solicitation or advertising, 
but not both. A distinction may be made, however, between a first and 
second mailing so that one may be treated as advertising and the other 
may be treated as solicitation. To qualify under this second mailing 
rule, the two mailings must be generically different items such as a 
price list and a description of the product itself. An amended price 
list would not be distinguishable from an original price list and would, 
therefore, not constitute a second mailing.
    (v) Examples. The principles of paragraph (a)(1) of this section may 
be illustrated by the following examples:

    Example 1. The related supplier, under contract with a buy-sell FSC 
to advertise export product D on the ``FSC's'' behalf to its foreign 
unrelated customers, engaged a French advertising agency to develop an 
advertising campaign to induce French customers to buy the product. As a 
part of the advertising campaign, the agency places a one-page 
advertisement in a relevant French trade journal. The advertisement 
constitutes advertising within the meaning of paragraph (a)(1) of this 
section.
    Example 2. A United States weekly magazine publishes, in addition to 
its United States edition, a Canadian edition in English and a Mexican 
edition in Spanish. A FSC incurs costs of $200 X for a one-page display 
in each of the three editions for a total advertising cost of $600 X. 
The $200 X cost relating to the advertising in the United States edition 
is not a direct cost because it relates to United States sales. The 
total costs of $400 X relating to advertising in the English language 
Canadian edition and the Spanish language Mexican edition are foreign 
direct costs.
    Example 3. A FSC earns commissions on the sale of export product E 
by its domestic related supplier to United States distributors for 
resale to Canadian retail customers. The related supplier, under 
contract with the FSC to advertise product E, pays an amount equal to 1 
percent of its annual gross receipts with respect to product E under a 
cooperative advertising arrangement with the distributor. The amount, 
which represents 20 percent of the total advertising costs for product 
E, is reimbursed by the FSC. The 20-percent amount represents a 
significant portion of the total advertising costs and thus constitutes 
advertising within the meaning of paragraph (a)(1)(i) of this section.
    Example 4. A FSC mails two items to each customer on its customer 
list within one taxable year. The first mailing consists of a price list 
which merely lists the various products by name and provides a price 
next to each product name. The second mailing consists of a brochure 
which fully describes

[[Page 72]]

and illustrates each product. The two mailings are generically 
different. Therefore, one mailing may be counted as advertising while 
the other mailing may be counted as solicitation.

    (2) Sales promotion--(i) Sales promotion defined. Sales promotion 
means an appeal made in person to an export customer or potential export 
customer for the sale or rental of property or services described in 
section 924(a), made in the context of a trade show or customer meeting. 
A customer meeting means a periodic meeting (e.g., quarterly, semi-
annual, or annual) in which 10 or more customers or potential customers 
are reasonably expected to attend. However, for taxable years beginning 
before February 19, 1987, a customer meeting may, at the option of the 
taxpayer, mean any meeting with a customer or potential customer 
regardless of the frequency of the meetings or the number of customers 
or potential customers in attendance. A meeting, show or event in the 
United States that is primarily aimed at the export of goods or services 
described in section 924(a) constitutes sales promotion. Sales promotion 
does not include an appeal made in the context of any meeting, show or 
event primarily aimed at U.S. customers or an appeal for the sale or 
rental of property or services not described in section 924(a). Whether 
any meeting, show or event is primarily aimed at U.S. customers or at 
the export of goods or services described in section 924(a) shall be 
determined by all of the facts and circumstances including the announced 
objective of the meeting, show or event; the attendees; the location of 
the meeting, show or event; and the product or special feature of the 
product.
    (ii) Direct costs of sales promotion. Direct costs of sales 
promotion include costs such as rental of space at trade shows, payments 
to organizers or other persons hired for the event, rental of display 
equipment and decorations for the event, and costs of maintaining a 
showroom. Direct costs of sales promotion also include costs for travel, 
meals, and lodging for direct sales people attending the event if these 
costs are paid by the FSC or related supplier. In the case of a customer 
meeting, direct costs of sales promotion include the costs of materials 
printed specifically for the meeting and the costs of travel, lodging, 
and food for both the direct sales people and customers or potential 
customers attending the meeting. Direct costs of sales promotion do not 
include the cost of salaries and commissions of direct sales people or 
the cost of discount coupons, samples of the product, or printed 
advertising materials that are used for general advertising as well as 
sales promotion.
    (iii) Location of sales promotion. The location of sales promotion 
activity is the place where the trade show or customer meeting is held.
    (iv) Examples. The principles of paragraph (a)(2)(i) of this section 
may be illustrated by the following examples:

    Example 1. The related supplier sells various export products 
described in section 924(a) to its foreign customers. As a commission 
agent for the related supplier with respect to such sales, the FSC 
performs sales promotion. It contracts with the related supplier to 
serve as its agent for such purposes. To stimulate the sale of its 
export products, the related supplier conducts semi-annual meetings with 
the purchasing agents of its customers at its Kansas City headquarters. 
Ten or more purchasing agents are reasonably expected to attend each 
meeting. At such meetings, the purchasing agents see the related 
supplier's manufacturing facilities, visit with its executives, attend 
technical updates, and see new export products. These semi-annual 
customer meetings constitute sales promotion within the meaning of 
paragraph (a)(2)(i) of this section. Direct costs incurred with respect 
to the customer meetings are U.S. direct costs because the sales 
promotion activities occur within the United States.
    Example 2. Assume the same facts as in Example 1, except that the 
related supplier exhibits products that only operate on 220 volts at a 
trade show in the United States. According to the trade show sponsors, 
the purpose of the show is to increase sales abroad of United States-
manufactured products. Since the products exhibited are designed for 
operation in foreign countries and the purpose of the trade show is to 
boost sales in those countries, the trade show held in the United States 
is primarily aimed at the export products described in section 924(a) 
and not at United States customers. Thus, the trade show constitutes 
sales promotion within the meaning of paragraph (a)(2)(i) of this 
section and the direct costs incurred in connection

[[Page 73]]

with the trade show are treated as United States direct costs.

    (b) Processing of customer orders and arranging for delivery of the 
export property. For purposes of section 924(e), the processing of 
customer orders and the arranging for delivery of the export property 
are defined in paragraph (b)(1) and paragraph (b)(2), respectively, of 
this section. For taxable years beginning after February 19, 1987, if 
the FSC performs the activities of processing of customer orders and 
arranging for delivery of the export property and elects to group its 
transactions, it is considered to have performed the activities with 
respect to all transactions in the grouping elected by the FSC under 
Sec. 1.924(d)-1(e) during the taxable year if it performs the activities 
of processing of customer orders and arranging for delivery of the 
export property with respect to customers generating 20 percent or more 
of foreign trading gross receipts within the elected grouping.
    (1) Processing of customer orders--(i) Processing of customer orders 
defined. The processing of customer orders means notification by the FSC 
to the related supplier of the order and of the requirements for 
delivery. The related supplier may have independent knowledge of the 
order and requirements for delivery. If the FSC does not have a related 
supplier, the processing of customer orders means communication with the 
customer by any method such as telephone, telegram, or mail to 
acknowledge receipt of the order and requirements for delivery. Once the 
related supplier has been notified by the FSC, or the customer has 
received an acknowledgement from the FSC, of the order and requirements 
for delivery, subsequent or prior communications with respect to an 
order (such as changes in quantity or prospective delivery date) are not 
included in the definition of processing of customer orders.
    (ii) Direct costs of processing customer orders. Direct costs of 
processing of customer orders include salaries of clerical personnel and 
costs of telephone, telegram, mail, or other communication media 
(including the costs of operating transmission equipment).
    (iii) Location of processing of customer orders. The location of 
this activity is the place where the communication is initiated by the 
FSC.
    (iv) Examples. The principles of paragraph (b)(1) of this section 
may be illustrated by the following examples:

    Example 1. A domestic related supplier, using a FSC as its 
commission agent on the sale of export property to foreign customers, 
receives an order from one of its foreign customers. Information 
concerning the receipt of such order and its requirements for delivery 
are transmitted to the FSC. The FSC from its office outside the United 
States notifies the related supplier of the order and the requirements 
for delivery by telex. This notification by the FSC to the related 
supplier constitutes the processing of the customer's order within the 
meaning of paragraph (b)(1)(i) of this section. In addition, its direct 
costs of processing the customer's order are foreign direct costs 
because the communication is initiated by the FSC from outside the 
United States.
    Example 2. A domestic unrelated supplier manufactures a product 
which it sells to a buy-sell FSC located in Germany for resale to the 
FSC's German customers. Upon receiving an order from one of its 
customers, the FSC telephones the customer from its German office to 
acknowledge receipt of the order and the requirements for delivery. The 
acknowledgement constitutes the processing of the customer's order 
within the meaning of paragraph (b)(1)(i) of this section and the direct 
costs attributable thereto are foreign direct costs.

    (2) Arranging for delivery--(i) Arranging for delivery defined. The 
arranging for delivery of export property means the taking of necessary 
steps to have the export property delivered to the customer in 
accordance with the requirements of the order. Arranging for delivery 
does not include preparation of shipping documents (e.g., bill of 
lading) or the property for shipment (i.e., packaging or crating), or 
shipment of property (i.e., transportation). Arranging for delivery does 
include communications with a carrier or freight forwarder to provide 
transportation (as defined in Sec. 1.924(e)-1(c)(1), but without regard 
to when the commission relationship for purposes of transportation 
begins) for the export property from the FSC or related supplier to the 
place where the customer takes possession of the property. Arranging for 
delivery also includes communications with the customer to notify the 
customer of the time and place of delivery. The carrier or freight 
forwarder and the customer

[[Page 74]]

may already have knowledge of the information communicated. If the FSC 
has communicated with the carrier or freight forwarder, where 
applicable, and the customer to notify it of the time and place of 
delivery, prior or subsequent communications to either about delivery 
are not included in the definition of arranging for delivery.
    (ii) Direct costs of arranging for delivery. The direct costs of 
arranging for delivery include salaries of clerical personnel and costs 
of telephone, telegraph, mail, and other communications media, but do 
not include any actual shipping costs.
    (iii) Location of arranging for delivery. The location of arranging 
for delivery activity is the place where the activity is initiated by 
the FSC.
    (iv) Examples. The principles of paragraph (b)(2)(i) of this section 
may be illustrated by the following examples:

    Example 1. A FSC earns commissions on the sale of export property by 
its domestic related supplier to foreign customers. The shipment term of 
all of the related supplier's sales is F.O.B. (Free on Board) its 
manufacturing plant in Gary, Indiana. Thus, there is no transportation 
as defined in Sec. 1.924(e)-1(c)(1) with respect to its sales. From its 
shipping department at the plant, the related supplier telephones 
carriers to arrange for delivery. It also notifies the FSC by mail of 
the time and place of delivery of the customer's orders. The FSC from 
its office outside the United States transmits the received information 
to the customers. Because there is no transportation to be arranged, 
this communication alone by the FSC to the customers to notify them of 
the time and place of delivery constitutes arranging for delivery within 
the meaning of paragraph (b)(2)(i) of this section.
    Example 2. Assume the same facts as in Example 1, except that the 
shipment term of all of the related supplier's sales is C.I.F. (Cost, 
Insurance, Freight) and that the commission relationship for 
transportation begins after the export property leaves the United States 
customs territory. The related supplier telephones a trucking firm and 
an overseas carrier from its plant in Gary, Indiana to ascertain 
information on transporting its property by truck to the docks, and by 
overseas carrier from the docks to the place where the customer takes 
possession. Upon receiving the necessary information, the related 
supplier electronically transmits to the FSC the shipping information 
and the time and place of delivery to the customer. In addition, it 
instructs the FSC to communicate the necessary shipping information to 
the carriers to ensure shipment and to notify the customer of the time 
and place of delivery. The FSC does both from its office located outside 
of the United States. The communications by the FSC to the carriers and 
the customer constitute arranging for delivery within the meaning of 
paragraph (b)(2)(i) of this section.

    (c) Transportation--(1) Transportation defined. For purposes of 
section 924(e), transportation means moving or shipping the export 
property during the period when the FSC owns or is responsible for the 
property, or, if the FSC is acting as a commission agent, during the 
period when the related supplier owns or is responsible for the property 
but after the commission relationship for purposes of transportation 
begins (even if the relationship begins after the property leaves the 
U.S. customs territory). The FSC or related supplier is treated as 
responsible for the property when it either has title, bears the risk of 
loss, or insures the property during shipment. Since a commission FSC 
will not generally have title or bear the risk of loss, it will, 
nevertheless, satisfy the transportation test if the related supplier 
has either title, bears the risk of loss, or insures the property during 
shipment. Examples of methods of shipping which would qualify as 
transportation include F.O.B. (Free on Board) destination, C.I.F. (Cost, 
Insurance, Freight), Ex Ship, and Ex Quay, but do not include C. & F. 
(Cost and Freight) or F.O.B. shipping point.
    (2) Direct costs of transportation. The direct costs of 
transportation include the expenses of shipping, such as fees paid to 
carriers and freight forwarders, costs of freight insurance, and 
documentation fees. With respect to fungible commodities, direct costs 
include only those costs incurred after the goods have been identified 
to a contract. Transportation costs do not include any of the costs of 
arranging for delivery. The FSC is considered to engage in 
transportation activity whenever it pays the costs of shipping the 
export property and the property is shipped during the period when the 
FSC owns or is responsible for the property as provided in paragraph 
(c)(1) of this section. If the customer pays the shipping costs 
directly, the FSC is not considered to engage in transportation 
activity. If, however, the FSC

[[Page 75]]

pays the shipping costs, the ultimate transfer of those costs to the 
customer will not disqualify the FSC from engaging in transportation for 
purposes of section 924(e) regardless of whether the costs are included 
in the sale price of the export property or separately stated.
    (3) Location of transportation. The location of transportation 
activity is the area over which the property is transported. Thus, the 
portion of total direct costs of transportation treated as foreign 
direct costs is the portion attributable to transportation outside the 
United States, determined on the basis of the ratio of mileage outside 
the U.S. customs territory to total mileage. For purposes of determining 
mileage outside U.S. customs territory, goods are treated as leaving 
U.S. customs territory when they have been tendered to an international 
carrier for shipment to a foreign location, as long as they are not 
removed from the custody of the carrier before they reach a point 
outside U.S. customs territory. The same rule for determining mileage 
outside the U.S. customs territory will apply to freight forwarders if 
(i) the forwarder has the risk of loss or is an insurer of the goods, 
and (ii) the property is shipped on a single bill of lading issued to 
the FSC or its agent as the shipper.
    (4) Examples. The principles of paragraph (c) of this section may be 
illustrated by the following examples:

    Example 1. A buy-sell FSC sells export property to a customer 
located in Canada. The contract between the FSC and the customer 
requires that the property be shipped F.O.B. its Canadian destination. 
Under this shipment term, the FSC holds title and bears the risk of loss 
until the property is tendered at its Canadian destination. Thus, it is 
responsible for the property during shipment. The FSC instructs its 
related supplier to ship the property from its manufacturing facilities 
in St. Louis. The related supplier negotiates two contracts, one for 
domestic transportation and the second for foreign transportation. A 
domestic trucking firm transports the property to the Canadian border 
where a Canadian trucking company is used to transport the property to 
its Canadian destination. The documentation fees and the fees for the 
two trucking firms are paid by the FSC. Because the FSC paid the costs 
of shipping and the property was shipped during the period when the FSC 
was responsible for the property, the FSC has engaged in transportation 
activity, the direct costs of which are the fees paid by the FSC. If 70 
percent of the mileage from St. Louis to the Canadian destination is 
associated with the transportation from the Canadian border to the 
Canadian destination, 70 percent of the FSC's direct transportation 
costs are foreign direct costs. If, instead of using two trucking firms, 
the FSC had tendered the goods to a freight forwarder for shipment to a 
foreign location and the freight forwarder assumed the risk of loss for 
the goods and issued a single bill of lading, all of the fees paid by 
the FSC to the freight forwarder would be foreign direct costs.
    Example 2. A related supplier sells export property to its foreign 
customer in Liverpool, England. The contract between the related 
supplier and the customer requires that the property be shipped C.I.F. 
Liverpool. The related supplier engages the FSC as its commission agent 
with respect to its sales to the customer, requiring the FSC to provide 
transportation to the customer. The FSC contracts with the related 
supplier to provide the transportation on behalf of the FSC. The 
commission agreement between the related supplier and the FSC provides 
that the FSC's responsibilities with respect to transportation of the 
export property begins after the property leaves the U.S. customs 
territory. The related supplier hires a domestic trucking firm to 
transport the shipment to a New York City port where it is loaded on a 
cargo ship destined for Liverpool at a total cost of $3,000X, $2,750X of 
which is allocable to mileage from the U.S. customs territory to 
Liverpool, England. Because the related supplier insures the property 
during shipment under C.I.F., the property is shipped during the period 
when the related supplier is treated as responsible for the property. 
Thus, the FSC, as the related supplier's commission agent, has satisfied 
the transportation test. In addition, because the FSC's responsibilities 
with respect to transportation begins when the property leaves U.S. 
customs territory, the FSC's payment of $2,750X is a foreign direct cost 
of transportation. The remaining $250X is not a direct cost of 
transportation to the FSC because the amount was expended before the 
commission relationship between the FSC and related supplier began.
    Example 3. A FSC earns commissions on sales by the related supplier 
of export property, all of which falls within a single two-digit SIC 
group. The related supplier is under contract to the FSC to perform on 
the FSC's behalf all of the section 924(e) activities attributable to 
the sales. Of all of the sales made during the year, the FSC has no 
transportation costs with respect to the sales to customer R because the 
shipment term is F.O.B. the related supplier's Chicago plant. With 
respect to the sales to customer S, the

[[Page 76]]

FSC ships the property F.O.B. its destination and pays 100 percent of 
the transportation costs, all of which are foreign direct costs because 
the commission relationship for transportation begins outside the U.S. 
customs territory. For purposes of determining whether the FSC has 
satisfied the 85-percent foreign direct cost test for transportation, 
the FSC groups the sales by product. Because the transportation costs 
for sales to customer S are 100-percent foreign direct costs and because 
there are no transportation costs on sales to customer R, the FSC is 
considered to have met the 85-percent foreign direct cost test for 
transportation for all the sales in the single two-digit SIC group.

    (d) Determination and transmittal of a final invoice or statement of 
account and receipt of payment. For purposes of section 924(e), the 
determination and transmittal of a final invoice or statement of account 
and the receipt of payment are defined as follows.
    (1) Determination and transmittal of a final invoice or statement of 
account--(i) Definitions--(A) In general. The determination and 
transmittal of a final invoice or statement of account means the 
assembly of either a final invoice or statement of account and the 
forwarding of that document to the customer. A FSC may elect to send 
either final invoices or statements of account and disregard any costs 
of the alternative not elected. For taxable years beginning after 
February 19, 1987, a special grouping rule is provided. If the FSC 
assembles and forwards either a statement of account or a final invoice 
from outside the United States to customers with sales representing 50 
percent of the current year foreign trading gross receipts within a 
product or product line grouping or to customers with sales representing 
50 percent of the prior year foreign trading gross receipts within a 
product or product line grouping utilized for the current year, all 
other U.S. costs will be disregarded and the FSC will be deemed to have 
no U.S. costs with respect to the determination and transmittal of a 
final invoice or statement of account. If, during the prior taxable 
year, the controlled group of which the FSC is a member had a DISC or 
interest charge DISC, the FSC may apply the 50 percent rule by taking 
into account the customers and sales of the DISC or interest charge DISC 
for the preceding taxable year. If no foreign trading gross receipts (or 
qualified export receipts for DISC purposes) were received in the prior 
year either by the FSC or by a DISC or interest charge DISC within the 
controlled group of which the FSC is a member, the FSC must apply the 50 
percent rule taking into account customers and foreign trading gross 
receipts for the current year. In the event that the 50 percent rule is 
not satisfied, all costs associated with assembly and forwarding of the 
selected documents (invoices or statements of account) must be included 
in the costs attributable to activities described in section 924(e)(4).
    (B) Final invoice defined. A final invoice is an invoice upon which 
payment is made by the customer. A final invoice must contain the 
customer's name or identifying number and, with respect to the 
transaction or transactions, the date, product or service, quantity, 
price, and amount due. In the alternative, a document will be acceptable 
as a final invoice even though it does not include all of the above 
listed information if the FSC establishes that the document is 
considered to be a final invoice under normal commercial practices. An 
invoice forwarded to the customer after payment has been tendered or 
received pursuant to a letter of credit as a receipt for payment 
satisfies this definition.
    (C) Statement of account defined. A statement of account is any 
summary statement forwarded to a customer to inform of, or confirm, the 
status of transactions occurring within an accounting period during a 
taxable year that is not less than one month. A statement of account 
must contain, at a minimum, the customer's name or identifying number, 
date of the statement of account as of the last day of the accounting 
period covered by the statement of account and the balance due (even if 
the balance due is zero). A single final invoice or statement of account 
can cover more than one transaction with one customer. In the 
alternative, a document will be accepted as a statement of account even 
though it does not include all of the above listed information if the 
FSC establishes that

[[Page 77]]

the document is considered a statement of account under normal 
commercial practice. For these purposes, a document will be considered 
to be a statement of account under normal commercial practices if it is 
sent to domestic as well as to export customers in order to inform the 
customers of the status of transactions during an accounting period. 
Additional information may be sent separately, such as summary 
statements forwarded to a related party for purposes of reconciling 
intercompany accounts for financial reporting requirements. If the 
information is sent separately, the direct costs associated with the 
assembly and forwarding of that information are not considered for 
purposes of section 924(d).
    (D) Assembly and forwarding defined. Assembly means folding the 
documents (where applicable), filling envelopes, and addressing 
envelopes (if window envelopes are not used). Forwarding means mailing 
or delivery.
    (ii) Direct costs of determination and transmittal of final invoice 
or statement of account. Direct costs of this activity include costs of 
office supplies, office equipment, clerical salaries and costs of 
mailing or other delivery services, if the costs can be identified or 
associated directly with the assembly and transmittal of a final invoice 
or statement of account. Costs of establishing a price, or of 
communicating prices or other billing information between the FSC and a 
related supplier are not direct costs of this activity. In addition, the 
costs of preparing and mailing the final invoices or statements of 
account to the FSC and the costs of accumulating and formatting data for 
invoicing or statements of account on computer discs, tapes, or some 
other storage media along with the costs of transmitting or transporting 
this data to the FSC are not direct costs of this activity.
    (iii) Location of determination and transmittal of a final invoice 
or statement of account. For taxable years beginning before February 19, 
1987, the location of this activity is the place where the final invoice 
or statement of account is assembled for forwarding to the customer or 
the place from which it is forwarded to the customer. Thus, the 
forwarding of the final invoice or statement of account from outside the 
United States is sufficient to source this activity outside the United 
States. For all other taxable years, the location of this activity is 
the place where the final invoice or statement of account is both 
assembled and forwarded to the customer.
    (iv) Examples. The principles of paragraph (d)(1) of this section 
may be illustrated by the following examples, all of which apply to 
taxable years beginning on or after February 19, 1987.

    Example 1. A related supplier sells export property to its foreign 
customers. The related supplier engages the FSC as its commission agent 
with respect to the sales, requiring the FSC to determine and transmit 
final invoices or statements of account to the customers with respect to 
the sales. Annually, the FSC assembles and forwards statements of 
account to customers representing 40 percent of current year export 
sales and 35 percent of prior year sales. The statements are sent from 
its office outside of the United States. The remaining statements of 
account are sent from the Albany, New York office of the related 
supplier. The statements are recognized in its industry as a statement 
of account. Although the statement does not contain all of the 
information described in Sec. 1.924(e)-1(d)(1)(i), it is sent to both 
domestic and foreign customers of the related supplier to inform the 
customer of the status of its transactions with the related supplier. 
The document qualifies as a statement of account under Sec. 1.924(e)-
1(d)(1)(i); however, the 50 percent test set forth in Sec. 1.924(e)-
1(d)-1(d)(1)(i)(A) is not satisfied. Therefore, the FSC must take into 
account all domestic direct costs attributable to assembly and 
forwarding of statements of account from its domestic office in 
determining whether the FSC has satisfied the direct costs test with 
respect to section 924(e)(4) and Sec. 924 (e)-1(d).
    Example 2. Employees of a FSC, in the FSC's foreign office, fold and 
place in envelopes the sheet or sheets that constitute the final 
invoices provided by the related supplier. In addition, the employees 
address, affix postage to, and mail the envelopes. These activities 
constitute the determination and transmittal of the final invoices 
within the meaning of paragraph (d)(1)(i) of this section and, because 
the final invoices are assembled and forwarded to the customers from 
outside the United States, all the direct costs of the activities are 
foreign direct costs.
    Example 3. The related supplier sends to the FSC's foreign office a 
computer tape to be used to prepare a statement of account. A

[[Page 78]]

management company, working under contract with the FSC, transcribes the 
data to a piece of paper which is a statement of account for purposes of 
Sec. 1.924(d)(1)(i), folds the document, and fills, affixes postage to, 
and mails the envelopes. Only the costs performed by the management 
company under contract with the FSC that constitute the assembly and 
forwarding of a statement of account under Sec. 1.924(e)-1(d)(1)(i)(D) 
are direct costs. Therefore, the costs attributable to transcribing the 
data to a piece of paper are not direct costs for purposes of section 
924(e)(4).

    (2) Receipt of payment--(i) Receipt of payment defined. Receipt of 
payment means the crediting of the FSC's bank account by an amount which 
is not less than 1.83 percent of the gross receipts (``gross receipts 
amount'') associated with the transaction. The FSC's bank account is not 
credited unless the FSC has the authority to withdraw the amount 
deposited. Where sales proceeds are factored or where payments from 
related foreign subsidiaries are netted against amounts owed to these 
foreign subsidiaries in an intercompany account, crediting of the FSC's 
bank account with no less than the gross receipts amount of the 
factoring proceeds or the proceeds, net of offsets, respectively, 
qualifies as receipt of payment. In addition, where a FSC is precluded 
from receiving a portion of the proceeds of the export transaction, the 
FSC may satisfy receipt of payment by receiving no less than the gross 
receipts amount of the remaining portion of the proceeds in its bank 
account. In the case of advance or progress payments, each payment 
constitutes a payment for receipt of payment purposes.
    (ii) Direct costs of receipt of payment. Direct costs of receiving 
payment include the expenses of maintaining a bank account of the FSC in 
which payment is deposited, any fees or service charges incurred for 
converting the payment into U.S. currency, and any transfer fees 
incurred with respect to the transfer of funds into and out of the FSC's 
bank account in accordance with the 35 calendar day rule in paragraph 
(d)(2)(iii) of this section. The transfer fees and the fees or service 
charges incurred for currency conversion are considered to be foreign 
direct costs of receiving payment; however, exchange losses are not 
costs of receiving payment.
    (iii) Location of receipt of payment. The location of this activity 
is the office of the banking institution at which the account is 
maintained. If payment is made by the purchaser directly to the FSC or 
the related supplier in the United States, and the FSC or related 
supplier transfers the gross receipts amount associated with the 
transaction to a bank account of the FSC outside the United States after 
receipt of payment (i.e., cash, check, wire transfer, etc.), but no 
later than 35 calendar days after receipt of good funds (i.e., the 
clearance of the check) the FSC is considered to have received payment 
outside the United States. Therefore, all transfer fees and the costs of 
the foreign bank account are treated as foreign direct costs. The United 
States bank costs are disregarded. If, however, the related supplier 
does not transfer the gross receipts amount within 35 calendar days, 
United States bank costs are not disregarded and are domestic direct 
costs. In either case, the transfer costs, currency conversion charges, 
and foreign bank costs remain foreign direct costs. The preceding rules 
apply both to commission FSCs and buy-sell FSCs.
    (iv) Examples. The principles of paragraph (d)(2) of this section 
may be illustrated by the following examples:

    Example 1. A FSC earns commissions on sales of export property by 
its related supplier. The related supplier manufactures and sells its 
export property to its foreign subsidiaries for resale in their 
respective countries. From time to time, the foreign subsidiaries will 
return products to the related supplier for credit and, from time to 
time, the foreign subsidiaries purchase products in their respective 
countries and sell such products to the related supplier. These 
transactions result in various amounts being owed to the foreign 
subsidiaries. Each month the various inter-company obligations are 
reviewed. The result of such review of inter-company indebtedness is a 
netting out of the various intercompany liabilities on the books, to the 
extent possible, and a flow of funds for the net obligation. Due to the 
nature of these transactions, the amounts owed by the foreign 
subsidiaries exceed the amounts which the related supplier owes to the 
foreign subsidiaries. The gross receipts amount (i.e., 1.83 percent of 
this net amount) is credited to the FSC's bank account. This

[[Page 79]]

constitutes receipt of payment for purposes of paragraph (d)(2)(i) of 
this section.
    Example 2. In a leveraged lease transaction, a FSC-lessor obtains 
purchase financing from a lending institution. The lending institution 
retains a security interest in the proceeds and requires that a portion 
of each rental payment be paid by the lessee directly to the lending 
institution. Since the FSC is precluded from receiving a portion of the 
proceeds of the export transaction, the FSC may satisfy the receipt of 
payment requirement by receiving the gross receipts amount with respect 
to the remaining proceeds.
    Example 3. A buy-sell FSC sells its export property to a foreign 
customer and is paid by means of a ``draw-down'' letter of credit. Over 
a substantial period of time prior to delivery of the export property, 
amounts are advanced to the FSC under the letter of credit. At delivery, 
the remaining amount available is paid. Each payment made to the FSC 
constitutes a payment for receipt of payment purposes and thus the gross 
receipts amount related to each payment must be credited to the FSC's 
bank account.
    Example 4. An FSC earns commissions on sales of export property by 
its related supplier. The related supplier regularly collects payments 
from its foreign customers in a San Francisco bank account and, after 
the San Francisco bank has collected on the checks, transfers, within 35 
calendar days, the gross receipts amounts from its New York bank account 
to the FSC's bank account located outside the United States. The FSC 
incurred transfer fees of $160X in addition to a fee of $35X for the 
maintenance of the FSC's bank account outside the United States during 
the 35 calendar day period. The maintenance fee relating to the United 
States bank account for the 35 calendar day period is $45X. The receipt 
of payment test is met because the gross receipts amounts are 
transferred after payment but within 35 calendar days to the FSC's bank 
account located outside the United States. The transfer fees of $160X 
and the maintenance fee of $35X relating to the FSC's foreign bank 
account are foreign direct costs. The $45X maintenance fee related to 
the United States bank account is not a direct cost. If the gross 
receipts amounts had not been transferred to the FSC's foreign bank 
account within 35 calendar days, the $45X maintenance fee related to the 
United States bank account would be considered a United States direct 
cost. The transfer fee of $160X and the maintenance fee of $35X relating 
to the FSC's foreign bank account, however, would, nonetheless, be 
considered as foreign direct costs. The same funds received in San 
Francisco need not be transferred to the FSC's foreign bank account 
because money is fungible. For the same reason, the gross receipts 
amounts need not be transferred from the same bank account in which the 
payments are received.

    (e) Assumption of credit risk--(1) Assumption of credit risk 
defined. For purposes of section 924(e), the assumption of credit risk 
means bearing the economic risk of nonpayment with respect to a 
transaction. If the FSC is acting as a commission agent for the related 
supplier, this risk is borne by the FSC if the commission contract 
transfers the costs of the economic risk of nonpayment with respect to 
the transaction from the related supplier to the FSC. The FSC may elect 
on its annual return to bear the economic risk of nonpayment with 
respect to its transactions during a taxable year by either--
    (i) Assuming the risk of a bad debt in accordance with the rules of 
paragraph (e)(4)(i) of this section,
    (ii) Obtaining insurance to cover nonpayment,
    (iii) Investigating credit of a customer or a potential customer,
    (iv) Factoring trade receivables, or
    (v) Selling by means of letters of credit or banker's acceptances.

Only the alternative elected to be performed by the FSC during a taxable 
year is relevant for purposes of section 924(d). For example, if a buy-
sell FSC elects to bear the economic risk of nonpayment with respect to 
its transaction during a taxable year by assuming the risk of a bad debt 
in accordance with the rules of paragraph (e)(4)(i) of this section, and 
also factors the transaction's trade receivables, only the direct costs 
of assuming the risk of a bad debt are relevant for purposes of section 
924(d). For purposes of this paragraph, a potential customer is an 
unrelated person who is engaged in the purchase or sale of export 
property on whom an investigation is performed, but with whom no export 
sales contract is executed.
    (2) Direct costs of assumption of credit risk. (i) With respect to 
assuming the risk of a bad debt, the direct costs of the assumption of 
credit risk in the case of a buy-sell FSC include debts that become 
uncollectible and charges taken into account in determining additions to 
bad debt reserves of the FSC. In the case of a commission FSC, the 
direct costs of the assumption of credit risk include the assumption of 
the

[[Page 80]]

debts and charges of the related supplier attributable to export sales 
that are allowed as deductions under section 166.
    (ii) With respect to insurance, the direct costs of the assumption 
of credit risk are the costs of obtaining insurance against the risk of 
nonpayment. Qualifying insurance must be obtained from an unrelated 
insurer and must cover the risk of nonpayment due to default and 
bankruptcy by the purchaser. Insurance obtained from a related insurer, 
or insurance that covers default and bankruptcy due to risks of war or 
political unrest without covering ordinary default or bankruptcy is not 
sufficient.
    (iii) With respect to investigating credit, the direct costs of 
assumption of credit risk are the external costs of investigating credit 
for customers or potential customers, including costs of membership in a 
credit agency or association for that purpose (but not the costs of 
approving credit by an internal credit agency).
    (iv) With respect to factoring trade receivables, the direct costs 
of assumption of credit risk are the costs of factoring trade 
receivables of related and unrelated customers (e.g. the amount of the 
discount and the fees relating to factoring).
    (v) With respect to letters of credit or banker's acceptances, the 
direct costs of assumption of credit risk are the costs of letters of 
credit or banker's acceptances and the documentary collection costs.
    (3) Location of assumption of credit risk. The location of the 
activity of assumption of credit risk is the location of the customer or 
obligor whose payment is at risk, except that the location of 
investigating credit is the location of the credit agency or association 
performing the investigation. A foreign branch of a United States 
corporation and a foreign office of the United States government are not 
foreign obligors for purposes of this test. A foreign branch of a United 
States credit investigation agency or association, however, is treated 
as located outside the United States.
    (4) Special rules--(i) Assuming the risk of a bad debt--(A) In 
general. If a FSC chooses to bear the economic risk of nonpayment by 
assuming the risk of a bad debt with respect to a transaction or 
grouping of transactions and an actual bad debt loss on a foreign 
trading gross receipt is not incurred in any three consecutive years, 
the FSC will be deemed to have performed this activity during the first 
two years of the three year period. For the third year, the FSC will not 
be deemed to have performed this activity and must satisfy the 85 
percent foreign direct costs test by satisfying any two paragraphs 
included within section 924(e) other than assumption of credit risk 
activity under section 924(e)(5). An actual bad debt loss will only 
satisfy the activity test with respect to a single three consecutive 
year period.
    (B) Example. The principles of this paragraph may be illustrated by 
the following example:

    Example. In year 1, a related supplier of a commission FSC incurs a 
bad debt with respect to foreign trading gross receipts owed by a 
foreign obligor. This expense is the only bad debt incurred with respect 
to foreign trading gross receipts in year 1. Therefore, the direct costs 
for the bearing of the economic risk of nonpayment for year 1 are all 
foreign direct costs and the 85-percent test is satisfied. In year 2, 
the FSC incurs a bad debt with respect to a U.S. broker/consolidator. 
The direct costs for year 2 are U.S. direct costs and, therefore, the 
85-percent test is not satisfied. No bad debt is incurred in year 3. 
Because a bad debt with respect to a foreign obligor is incurred in year 
1, the FSC is deemed to have satisfied the economic risk of nonpayment 
for each of years 1, 2 and 3.

    (ii) Grouping with respect to other risk activities. For taxable 
years beginning after February 19, 1987, if a FSC elects to bear the 
economic risk of nonpayment by performing one of the activities 
described in paragraph (e) of this section and elects to group 
transactions, it is considered to have performed the elected activity 
with respect to all transactions within the group during the taxable 
year if it performs the activity in accordance with the following rules. 
If a FSC elects to factor trade receivables, at least 20 percent of the 
face amount of a group's receivables must be factored. If a FSC elects 
to sell by means of letters of credit or banker's acceptances, a fee 
must be incurred with respect to 20

[[Page 81]]

percent of the foreign trading gross receipts attributable to sales 
within the group. If the FSC elects to obtain insurance to cover 
nonpayment, 20 percent of the face amount of receivables attributable to 
sales included in the Sec. 1.924(d)-1(e) grouping elected by the FSC 
must be insured. If a FSC elects to investigate credit of customers or 
potential customers, 20 percent of new or potential customers for which 
a credit investigation is performed must be investigated.

[T.D. 8125, 52 FR 5094, Feb. 19, 1987]



Sec. 1.925(a)-1  Transfer pricing rules for FSCs.

    (a) through (c)(7) [Reserved] For further guidance, see 
Sec. 1.925(a)-1T(a) through (c)(7).
    (c)(8) Grouping transactions. (i) The determinations under this 
section are to be made on a transaction-by-transaction basis. However, 
at the annual choice made by the related supplier if the administrative 
pricing methods are used, some or all of these determinations may be 
made on the basis of groups consisting of products or product lines. The 
election to group transactions shall be evidenced on Schedule P of the 
FSC's U.S. income tax return for the taxable year. No untimely or 
amended returns filed later than one year after the due date of the 
FSC's timely filed (including extensions) U.S. income tax return will be 
allowed to elect to group, to change a grouping basis, or to change from 
a grouping basis to a transaction-by-transaction basis (collectively 
``grouping redeterminations''). The rule of the previous sentence is 
applicable to taxable years beginning after December 31, 1999. For any 
taxable year beginning before January 1, 2000, a grouping 
redetermination may be made no later than the due date of the FSC's 
timely filed (including extensions) U.S. income tax return for the FSC's 
first taxable year beginning on or after January 1, 2000. 
Notwithstanding the time limits for filing grouping redeterminations 
otherwise specified in the previous three sentences, a grouping 
redetermination may be made at any time during the one-year period 
commencing upon notification of the related supplier by the Internal 
Revenue Service of an examination, provided that both the FSC and the 
related supplier agree to extend their respective statutes of 
limitations for assessment by one year. In addition, any grouping 
redeterminations made under this paragraph must meet the requirements 
under Sec. 1.925(a)-1T(e)(4) with respect to redeterminations other than 
grouping. The language ``or grouping of transactions'' is removed from 
the fourth sentence of Sec. 1.925(a)-1T(e)(4), applicable to taxable 
years beginning after December 31, 1997. See also Sec. 1.925(b)-
1T(b)(3)(i).
    (c)(8)(ii) through (f) [Reserved] For further guidance, see 
Sec. 1.925(a)-1T(c)(8)(ii) through (f).
    (g) Effective date. The provisions of this section apply on or after 
March 2, 2001.

[T.D. 8944, 66 FR 13428, Mar. 6, 2001]



Sec. 1.925(a)-1T  Temporary regulations; transfer pricing rules for FSCs.

    (a) Scope--(1) Transfer pricing rules. In the case of a transaction 
described in paragraph (b) of this section, section 925 permits a 
related party to a FSC to determine the allowable transfer price charged 
the FSC (or commission paid to the FSC) by its choice of the three 
transfer pricing methods described in paragraphs (c)(2), (3), and (4) of 
this section: The ``1.83 percent'' gross receipts method and the ``23 
percent'' combined taxable income method (the administrative pricing 
rules) of section 925(a)(1) and (2), respectively, and the section 482 
method of section 925(a)(3). (Any further reference to a FSC in this 
section shall include a small FSC unless indicated otherwise.) Subject 
to the special no-loss rule of Sec. 1.925(a)-1T(e)(1)(iii), any, or all, 
of the transfer pricing methods may be used in the same taxable year of 
the FSC for separate transactions (or separate groups of transactions). 
If either of the administrative pricing methods (the gross receipts 
method or combined taxable income method) is applied to a transaction, 
the Commissioner may not make distributions, apportionments, or 
allocations as provided by section 482 and the regulations under that 
section. The transfer price charged the FSC (or the commission paid to 
the FSC) on a transaction with a person that is not a

[[Page 82]]

related party to the FSC may be determined in any manner agreed to by 
the FSC and that person. However, the Commissioner will use special 
scrutiny to determine whether a person selling export property to a FSC 
(or paying a commission to a FSC) is a related party to the FSC with 
respect to a transaction if the FSC earns a profit on the transaction in 
excess of the profit it would have earned had the administrative pricing 
rules applied to the transaction.
    (2) Special rules. For rules as to certain ``incomplete 
transactions'' and for computing full costing combined taxable income, 
see paragraphs (c)(5) and (6) of this section. For a special rule as to 
cooperatives and computation of their combined taxable incomes, see 
paragraph (c)(7) of this section. Grouping of transactions for purposes 
of applying the administrative pricing method chosen is provided for by 
paragraph (c)(8) of this section.

The rules in paragraph (c) of this section are directly applicable only 
in the case of sales or exchanges of export property to a FSC for 
resale, and are applicable by analogy to leases, commissions, and 
services as provided in paragraph (d) of this section. For a rule 
providing for the recovery of the FSC's costs in an overall loss 
situation, see paragraph (e)(1)(i) of this section. Paragraph (e)(2) of 
this section provides for the applicability of section 482 to resales by 
the FSC to related persons or to sales between related persons prior to 
the sale to the FSC. Paragraph (e)(3) of this section provides for the 
creation of receivables if the transfer price, rental payment, 
commission or payment for services rendered is not paid by the due date 
of the FSC's income tax return for the taxable year under section 
6072(b), including extensions provided for by section 6081. Provisions 
for the subsequent determination and further adjustment to the relevant 
amounts are set forth in paragraphs (e)(4) and (5) of this section. 
Paragraph (f) of this section has several examples illustrating the 
provisions of this section. Section 1.925(b)-1T prescribes the marginal 
costing rules authorized by section 925(b)(2). Section 1.927(d)-2T 
provides definitions of related supplier and related party.
    (3) Performance of substantial economic functions--(i) 
Administrative pricing methods. The application of the administrative 
pricing methods of section 925 (a)(1) and (2) does not depend on the 
extent to which the FSC performs substantial economic functions beyond 
those required by section 925(c). See paragraph (b)(2)(ii) of this 
section and Sec. 1.924(a)-1T(i)(1).
    (ii) Section 482 method. In order to apply the section 482 method of 
section 925(a)(3), the arm's length standards of section 482 and the 
regulations under that section must be satisfied. In applying the 
standards of section 482, all of the rules of section 482 will apply. 
Thus, if the FSC would not be recognized as a separate entity, it would 
also not be recognized on application of the section 482 method. 
Similarly, if a FSC performs no substantial economic function with 
respect to a transaction, no income will be allocable to the FSC under 
the section 482 method. See Sec. 1.924(a)-1T(i)(2). If a related 
supplier performs services under contract with a FSC, the FSC will not 
be deemed to have performed substantial economic functions for purposes 
of the section 482 method unless it compensates the related supplier 
under the provisions of Sec. 1.482-2(b)(1) through (7). See 
Sec. 1.925(a)-1T(c)(6)(ii) for the applicability of the regulations 
under section 482 in determination of the FSC's profit under the 
administrative pricing methods.
    (b) Transactions to which section 925 applies--(1) In general. The 
transfer pricing methods of section 925 (the administrative pricing 
methods and the section 482 method) will apply, generally, only if a 
transaction, or group of transactions, gives rise to foreign trading 
gross receipts (within the meaning of section 924(a) and Sec. 1.924(a)-
1T) to the FSC (or small FSC, as defined in section 922(b) and 
Sec. 1.921-2(b) (Q&A3)). However, the transfer pricing methods will 
apply as well if the FSC is acting as commission agent for a related 
supplier with regard to a transaction, or group of transactions, on 
which the related supplier is the principal if the transaction, or group 
of transactions, would have resulted in foreign trading gross receipts 
had the FSC been the principal.

[[Page 83]]

    (2) Application of the transfer pricing rules--(i) Section 482 
method. The section 482 transfer pricing method may be applied to any 
transaction between a related supplier and a FSC if the requirements of 
paragraph (a)(3)(ii) of this section have been met.
    (ii) Administrative pricing methods. The administrative pricing 
methods may be applied in situations in which the FSC is either the 
principal or commission agent on the transaction, or group of 
transactions, only if the requirements of section 925(c) are met. 
Section 925(c) requires that the FSC performs all the activities 
described in subsections (d)(1)(A) and (e) of section 924 that are 
attributable to a particular transaction, or group of transactions. The 
FSC need not perform any activities with respect to a particular 
transaction merely to comply with section 925(c) if that activity would 
not have been performed but for the requirements of that subsection. The 
FSC need not perform all of the activities outside the United States. 
None of the activities need be performed outside the United States by a 
small FSC. Rather than the FSC itself performing the activities required 
by section 925(c), another person under contract, written or oral, 
directly or indirectly, with the FSC may perform the activities (see 
Sec. 1.924(d)-1(b)). If a related supplier is performing the required 
activities on behalf of the FSC with regard to a transaction, or group 
of transactions, the requirements of section 925(c) will be met if the 
FSC pays the related supplier an amount equal to the direct and indirect 
expenses related to the required activities. See paragraph (c)(6)(ii) of 
this section for the amount of compensation due the related supplier. 
The payment made to the related supplier must be reflected on the FSC's 
books and must be taken into account in computing the FSC's and related 
supplier's combined taxable income. If it is determined that the related 
supplier was not compensated for all the expenses related to the 
required activities or if the entire payment is not reflected on the 
FSC's books or in computing combined taxable income, the administrative 
pricing methods may be used but proper adjustments will be made to the 
FSC's and related supplier's books or income. At the election of the FSC 
and related supplier, the requirements of section 925(c) will be deemed 
to have been met if the related supplier is paid by the FSC an amount 
equal to all of the costs under paragraph (c)(6)(iii)(D) of this section 
(limited by paragraph (c)(6)(ii) of this section) related to the export 
sale, other than expenses relating to activities performed directly by 
the FSC or by a person other than the related supplier, and if that 
payment is reflected on the FSC's books and in computing the FSC's and 
related supplier's combined taxable income on the transaction, or group 
of transactions. If it is determined that the related supplier was not 
compensated for all its expenses or if the entire payment is not 
reflected on the FSC's books or in computing combined taxable income, 
the administrative pricing methods may be used but proper adjustments 
will be made to the FSC's and related supplier's books or income. All 
activities that are performed in connection with foreign military sales 
are considered to be performed by the FSC, or under contract with the 
FSC, if they are performed by the United States government even though 
the United States government has not contracted for the performance of 
those activities. All actual costs incurred by the FSC and related 
supplier in connection with the performance of those activities must be 
taken into account, however, in determining the combined taxable income 
of the FSC and related supplier.
    (iii) Allowable transactions for purposes of the administrative 
pricing methods. If the required performance of activities has been met, 
the administrative pricing methods may be applied to a transaction 
between a related supplier and a FSC only in the following 
circumstances.
    (A) The related supplier sells export property (as defined in 
section 927(a) and Sec. 1.927(a)-1T) to the FSC for resale or the FSC 
acts as a commission agent for the related supplier on sales by the 
related supplier of export property to third parties, whether or not 
related parties. For purposes of this section, references to sales 
include references to exchanges or other dispositions.

[[Page 84]]

    (B) The related supplier leases export property to the FSC for 
sublease for a comparable period with comparable terms of payment, or 
the FSC acts as commission agent for the related supplier on leases of 
export property by the related supplier, to third parties whether or not 
related parties.
    (C) Services are furnished by a FSC as principal or by a related 
supplier if a FSC is a commission agent for the related supplier which 
are related and subsidiary to any sale or lease by the FSC, acting as 
principal or commission agent, of export property under subdivision 
(iii)(A) and (B) of this paragraph.
    (D) Engineering or architectural services for construction projects 
located (or proposed for location) outside of the United States are 
furnished by the FSC if the FSC is acting as principal, or by the 
related supplier if the FSC is a commission agent for the related 
supplier, with respect to the furnishing of the services to a third 
party whether or not a related party.
    (E) The FSC acting as principal, or the related supplier where the 
FSC is a commission agent, furnishes managerial services in furtherance 
of the production of foreign trading gross receipts of an unrelated FSC 
or the production of qualified export receipts of an unrelated interest 
charge DISC.

This subdivision (iii)(E) shall not apply for any taxable year unless at 
least 50 percent of the gross receipts for such taxable year of the FSC 
or of the related supplier, whichever party furnishes the managerial 
services, is derived from activities described in subdivision (iii)(A), 
(B), or (C) of this paragraph.
    (c) Transfer price for sales of export property--(1) In general. 
Under this paragraph, rules are prescribed for computing the allowable 
price for a transfer from a related supplier to a FSC in the case of a 
sale, described in paragraph (b)(2)(iii)(A) of this section, of export 
property.
    (2) The ``1.83 percent'' gross receipts method. Under the gross 
receipts method of pricing, described in section 925(a)(1), the transfer 
price for a sale by the related supplier to the FSC is the price as a 
result of which the profit derived by the FSC from the sale will not 
exceed 1.83 percent of the foreign trading gross receipts of the FSC 
derived from the sale of the export property. Pursuant to section 
925(d), the amount of profit derived by the FSC under this method may 
not exceed twice the amount of profit determined under, at the related 
supplier's election, either the combined taxable income method of 
Sec. 1.925(a)-1T(c)(3) or the marginal costing rules of Sec. 1.925(b)-
1T. For FSC taxable years beginning after December 31, 1986, if the 
related supplier elects to determine twice the profit determined under 
the combined taxable income method using the marginal costing rules, 
because of the no-loss rule of Sec. 1.925(a)-1T(e)(1)(i), the profit 
that may be earned by the FSC is limited to 100% of the full costing 
combined taxable income as determined under Sec. 1.925(a)-1T(c)(3) and 
(6). Interest or carrying charges with respect to the sale are not 
foreign trading gross receipts.
    (3) The ``23 percent'' combined taxable income method. Under the 
combined taxable income method of pricing, described in section 
925(a)(2), the transfer price for a sale by the related supplier to the 
FSC is the price as a result of which the profit derived by the FSC from 
the sale will not exceed 23 percent of the full costing combined taxable 
income (as defined in paragraph (c)(6) of this section) of the FSC and 
the related supplier attributable to the foreign trading gross receipts 
from such sale.
    (4) Section 482 method. If the methods of paragraph (c)(2) and (3) 
of this section are inapplicable to a sale or if the related supplier 
does not choose to use them, the transfer price for a sale by the 
related supplier to the FSC is to be determined on the basis of the 
sales price actually charged but subject to the rules provided by 
section 482 and the regulations for that section and by Sec. 1.925(a)-
1T(a)(3)(ii).
    (5) Incomplete transactions. (i) For purposes of the gross receipts 
and combined taxable income methods, if export property which the FSC 
purchased from the related supplier is not resold by the FSC before the 
close of either the FSC's taxable year or the taxable year of the 
related supplier during

[[Page 85]]

which the export property was purchased by the FSC from the related 
supplier, then--
    (A) The transfer price of the export property sold by the FSC during 
that year shall be computed separately from the transfer price of the 
export property not sold by the FSC during that year.
    (B) With respect to the export property not sold by the FSC during 
that year, the transfer price paid by the FSC for that year shall be the 
related supplier's cost of goods sold (see paragraph (c)(6)(iii)(C) of 
this section) with respect to the property.
    (C) For the subsequent taxable year during which the export property 
is resold by the FSC, an additional amount shall be paid by the FSC (to 
be treated as income for the later year in which it is received or 
accrued by the related supplier) equal to the excess of the amount which 
would have been the transfer price under this section had the transfer 
to the FSC by the related supplier and the resale by the FSC taken place 
during the taxable year of the FSC during which it resold the property 
over the amount already paid under subdivision (B) of this paragraph.
    (D) The time and manner of payment of transfer prices required by 
subdivisions (i)(B) and (C) of this paragraph shall be determined under 
paragraphs (e)(3), (4) and (5) of this section.
    (ii) For purposes of this paragraph, a FSC may determine the year in 
which it received property from a related supplier and the year in which 
it resells property in accordance with the method of identifying goods 
in its inventory properly used under section 471 or section 472 
(relating respectively to the general rule for inventories and to the 
rule for LIFO inventories). Transportation expense of the related 
supplier in connection with a transaction to which this paragraph 
applies shall be treated as an item of cost of goods sold with respect 
to the property if the related supplier includes the cost of 
intracompany transportation between its branches, divisions, plants, or 
other units in its cost of goods sold (see paragraph (c)(6)(iii)(C) of 
this section).
    (6) Full costing combined taxable income--(i) In general. For 
purposes of section 925 and this section, if a FSC is the principal on 
the sale of export property, the full costing combined taxable income of 
the FSC and its related supplier from the sale is the excess of the 
foreign trading gross receipts of the FSC from the sale over the total 
costs of the FSC and related supplier including the related supplier's 
cost of goods sold and its and the FSC's noninventoriable costs (see 
Sec. 1.471-11(c)(2)(ii)) which relate to the foreign trading gross 
receipts. Interest or carrying charges with respect to the sale are not 
foreign trading gross receipts.
    (ii) Section 482 applicability. Combined taxable income under this 
paragraph shall be determined after taking into account under paragraph 
(e)(2) of this section all adjustments required by section 482 with 
respect to transactions to which the section is applicable. If a related 
supplier performs services under contract with a FSC, the FSC shall 
compensate the related supplier an arm's length amount under the 
provisions of Sec. 1.482-2(b) (1) through (6). Section 1.482-2(b)(7), 
which provides that an arm's length charge shall not be deemed equal to 
costs or deductions with respect to services which are an integral part 
of the business activity of either the member rendering the services 
(i.e., the related supplier) or the member receiving the benefit of the 
services (i.e., the FSC), shall not apply if the administrative pricing 
methods of section 925(a)(1) and (2) are used to compute the FSC's 
profit and if the related supplier is the person rendering the services. 
Section 1.482-2(b)(7) shall apply, however, if a related person other 
than the related supplier is the person rendering the services or if the 
section 482 method of section 925(a)(3) is used to compute the FSC's 
profit. See Sec. 1.925(a)-1T(a)(3)(ii). For a special rule for 
computation of combined taxable income where the related supplier is a 
qualified cooperative shareholder of the FSC, see paragraph (c)(7) of 
this section.
    (iii) Rules for determination of gross receipts and total costs. In 
determining the gross receipts of the FSC and the total costs of the FSC 
and related supplier which relate to such gross receipts, the rules set 
forth in subdivisions (iii)(A)

[[Page 86]]

through (E) of this paragraph shall apply.
    (A) Subject to the provisions of subdivisions (iii)(B) through (E) 
of this paragraph, the methods of accounting used by the FSC and related 
supplier to compute their taxable incomes will be accepted for purposes 
of determining the amounts of items of income and expense (including 
depreciation) and the taxable year for which those items are taken into 
account.
    (B) A FSC may, generally, choose any method of accounting 
permissible under section 446(c) and the regulations under that section. 
However, if a FSC is a member of a controlled group (as defined in 
section 927(d)(4) and Sec. 1.924(a)-1T(h)), the FSC may not choose a 
method of accounting which, when applied to transactions between the FSC 
and other members of the controlled group, will result in a material 
distortion of the income of the FSC or of any other member of the 
controlled group. Changes in the method of accounting of a FSC are 
subject to the requirements of section 446(e) and the regulations under 
that section.
    (C) Cost of goods sold shall be determined in accordance with the 
provisions of Sec. 1.61-3. See sections 471 and 472 and the regulations 
thereunder with respect to inventories. With respect to property to 
which an election under section 631 applies (relating to cutting of 
timber considered as a sale or exchange), cost of goods sold shall be 
determined by applying Sec. 1.631-1 (d)(3) and (e) (relating to fair 
market value as of the beginning of the taxable year of the standing 
timber cut during the year considered as its cost).
    (D) Costs (other than cost of goods sold) which shall be treated as 
relating to gross receipts from sales of export property are the 
expenses, losses, and deductions definitely related, and therefore 
allocated and apportioned thereto, and a ratable part of any other 
expenses, losses, or deductions which are not definitely related to any 
class of gross income, determined in a manner consistent with the rules 
set forth in Sec. 1.861-8. The deduction for depletion allowed by 
section 611 relates to gross receipts from sales of export property and 
shall be taken into account in computing the combined taxable income of 
the FSC and its related supplier.
    (7) Cooperatives and combined taxable income method. If a qualified 
cooperative, as defined in section 1381(a), sells export property to a 
FSC of which it is a shareholder, the combined taxable income of the FSC 
and the cooperative shall be computed without taking into account 
deductions allowed under section 1382 (b) and (c) for patronage 
dividends, per-unit retain allocations and nonpatronage distributions. 
The FSC and cooperative must take into account, however, when computing 
combined taxable income, the cooperative's cost of goods sold, or cost 
of purchases.
    (8) Grouping transactions. (i) [Reserved] For further guidance, see 
Sec. 1.925(a)-1(c)(8)(i).
    (ii) A determination by the related supplier as to a product or a 
product line will be accepted by a district director if such 
determination conforms to either of the following standards: Recognized 
trade or industry usage, or the two-digit major groups (or any inferior 
classifications or combinations thereof, within a major group) of the 
Standard Industrial Classification as prepared by the Statistical Policy 
Division of the Office of Management and Budget, Executive Office of the 
President. A product shall be included in only one product line for 
purposes of this section if a product otherwise falls within more than 
one product line classification.
    (iii) A choice by the related supplier to group transactions for a 
taxable year on a product or product line basis shall apply to all 
transactions with respect to that product or product line consummated 
during the taxable year. However, the choice of a product or product 
line grouping applies only to transactions covered by the grouping and, 
as to transactions not encompassed by the grouping, the determinations 
are to be made on a transaction-by-transaction basis. For example, the 
related supplier may choose a product grouping with respect to one 
product and use the transaction-by-transaction method for another 
product within the same taxable year. Sale transactions may not be 
grouped, however, with lease transactions.

[[Page 87]]

    (iv) For purposes of this section, transactions involving military 
property, as defined in section 923(a)(5) and Sec. 1.923-1T(b)(3)(ii), 
may be grouped only with other military property included within the 
same product or product line grouping determined under the standards of 
subdivision (8)(ii) of this paragraph. Non-military property included 
within a product or product line grouping which includes military 
property may be grouped, at the election of the related supplier, under 
the general grouping rules of subdivisions (i) through (iii) of this 
paragraph.
    (v) A special grouping rule applies to agricultural and 
horticultural products sold to the FSC by a qualified cooperative if the 
FSC satisfies the requirements of section 923(a)(4). Section 923(a)(4) 
increases the amount of the FSC's exempt foreign trade income with 
regard to sales of these products, see Sec. 1.923-1T(b)(2). This special 
grouping rule provides that if the related supplier elects to group 
those products that no other export property may be included within that 
group. Export property which would have been grouped under the general 
grouping rules of subdivisions (i) through (iii) of this paragraph with 
the export property covered by this special grouping rule may be 
grouped, however, at the election of the related supplier, under the 
general grouping rules.
    (vi) For rules as to grouping certain related and subsidiary 
services, see paragraph (d)(3)(ii) of this section.
    (vii) If there is more than one FSC (or more than one small FSC) 
within a controlled group of corporations, the same grouping of 
transactions, if any, must be used by all FSCs (or small FSCs) within 
the controlled group. If the same grouping of transactions is required 
by this subdivision, and if grouping is elected, the same transfer 
pricing method must be used to determine each FSC's (or small FSC's) 
taxable income with respect to that grouping.
    (viii) The product or product line groups that are established for 
purposes of determining combined taxable income may be different from 
the groups that are established with regard to economic processes (see 
Sec. 1.924(d)-1(e)).
    (d) Rules under section 925(a)(1) and (2) for transactions other 
than sales by a FSC. The following rules are prescribed for purposes of 
applying the gross receipts method or combined taxable income method to 
transactions other than sales by a FSC.
    (1) Leases. In the case of a lease of export property by a related 
supplier to a FSC for sublease by the FSC, the amount of rent the FSC 
must pay to the related supplier shall be computed in a manner 
consistent with the rules in paragraph (c) of this section for computing 
the transfer price in the case of sales and resales of export property 
under the gross receipts method or combined taxable income method. 
Transactions may not be so grouped on a product or product line basis 
under the rules of paragraph (c)(8) of this section as to combine in any 
one group of transactions both lease transactions and sale transactions.
    (2) Commissions. If any transaction to which section 925 applies is 
handled on a commission basis for a related supplier by a FSC and if 
commissions paid to the FSC give rise to gross receipts to the related 
supplier which would have been foreign trading gross receipts under 
section 924(a) had the FSC made the sale directly then--
    (i) The administrative pricing methods of section 925(a)(1) and (2) 
may be used to determine the FSC's commission income only if the 
requirements of section 925(c) (relating to activities that must be 
performed in order to use the administrative pricing methods) are met, 
see Sec. 1.925(a)-1T(b)(2)(ii).
    (ii) The amount of the income that may be earned by the FSC in any 
year is the amount, computed in a manner consistent with paragraph (c) 
of this section, which the FSC would have been permitted to earn under 
the gross receipts method, the combined taxable income method, or the 
section 482 method if the related supplier had sold (or leased) the 
property or service to the FSC and the FSC had in turn sold (or 
subleased) to a third party, whether or not a related party.
    (iii) The combined taxable income of a FSC and the related supplier 
from the transaction is the excess of the related supplier's gross 
receipts from the

[[Page 88]]

transaction which would have been foreign trading gross receipts had the 
sale been made by the FSC directly over the related supplier's and the 
FSC's total costs, excluding the commission paid or payable to the FSC, 
but including the related supplier's cost of goods sold and its and the 
FSC's noninventoriable costs (see Sec. 1.471-11(c)(2)(ii)) which relate 
to the gross receipts from the transaction. The related supplier's gross 
receipts for purposes of the administrative pricing methods shall be 
reduced by carrying charges, if any, as computed under Sec. 1.927(d)-
1(a)(Q&A2). These carrying charges shall remain income of the related 
supplier.
    (iv) The maximum commission the FSC may charge the related supplier 
is the amount of income determined under subdivisions (ii) and (iii) of 
this paragraph plus the FSC's total costs for the transaction as 
determined under paragraph (c)(6) of this section.
    (3) Receipts from services--(i) Related and subsidiary services 
attributable to the year of the export transaction. The gross receipts 
for related and subsidiary services described in paragraph 
(b)(2)(iii)(C) of this section shall be treated as part of the receipts 
from the export transaction to which such services are related and 
subsidiary, but only if, under the arrangement between the FSC and its 
related supplier and the accounting method otherwise employed by the 
FSC, the income from such services is includible for the same taxable 
year as income from such export transaction.
    (ii) Other services. Income from the performance of related and 
subsidiary services will be treated as a separate type of income if 
subdivision (i) of this paragraph does not apply. Income from the 
performance of engineering and architectural services and certain 
managerial services, as defined in paragraphs (b)(2)(iii)(D) and (E), 
respectively, of this section, will in all situations be treated as 
separate types of income. If this subdivision (ii) applies, the amount 
of taxable income which the FSC may derive for any taxable year shall be 
determined under the arrangement between the FSC and its related 
supplier and shall be computed in a manner consistent with the rules in 
paragraph (c) of this section for computing the transfer price in the 
case of sales for resale of export property under the transfer pricing 
rules of section 925. Related and subsidiary services to which the above 
subdivision (i) of this paragraph does not apply may be grouped, under 
the rules for grouping of transactions in paragraph (c)(8) of this 
section, with the products or product lines to which they are related 
and subsidiary, so long as the grouping of services chosen is consistent 
with the grouping of products or product lines chosen for the taxable 
year in which either the products or product lines were sold or in which 
payment for the services is received or accrued. Grouping of 
transactions shall not be allowed with respect to the determination of 
taxable income which the FSC may derive from services described in 
paragraph (b)(2)(iii)(D) or (E) of this section whether performed by the 
FSC or by the related supplier. Those determinations shall be made only 
on a transaction-by-transaction basis.
    (e) Special rules for applying paragraphs (c) and (d) of this 
section--(1) Limitation on FSC income (``no loss'' rules). (i) If there 
is a combined loss on a transaction or group of transactions, a FSC may 
not earn a profit under either the combined taxable income method or the 
gross receipts method. Also, for FSC taxable years beginning after 
December 31, 1986, in applying the gross receipts method, the FSC's 
profit may not exceed 100% of full costing combined taxable income 
determined under the full costing method of Sec. 1.925(a)-1T(c)(3) and 
(6). This rule prevents pricing at a loss to the related supplier. The 
related supplier may in all situations set a transfer price or rental 
payment or pay a commission in an amount that will allow the FSC to 
recover an amount not in excess of its costs, if any, even if to do so 
would create, or increase, a loss in the related supplier.
    (ii) For purposes of determining whether a combined loss exists, the 
basis for grouping transactions chosen by the related supplier under 
paragraph (c)(8) of this section for the taxable year shall apply.
    (iii) If a FSC recognizes income while the related supplier 
recognizes a loss on a sale transaction under the section

[[Page 89]]

482 method, neither the combined taxable income method nor the gross 
receipts method may be used by the FSC and related supplier (or by a FSC 
in the same controlled group and the related supplier) for any other 
sale transaction, or group of sale transactions, during a year which 
fall within the same three digit Standard Industrial Classification as 
the subject sale transaction. The reason for this rule is to prevent the 
segregation of transactions for the purposes of allowing the related 
supplier to recognize a loss on the subject transactions, while allowing 
the FSC to earn a profit under the administrative pricing methods on 
other transactions within the same three digit Standard Industrial 
Classification.
    (2) Relationship to section 482. In applying the administrative 
pricing methods, it may be necessary to first take into account the 
price of a transfer (or other transaction) between the related supplier 
(or FSC) and a related party which is subject to the arm's length 
standard of section 482. Thus, for example, if a related supplier sells 
to a FSC export property which the related supplier purchased from 
related parties, the costs taken into account in computing the combined 
taxable income of the FSC and the related supplier are determined after 
any necessary adjustment under section 482 of the price paid by the 
related supplier to the related parties. In applying section 482 to a 
transfer by a FSC to a related party, the parties are treated as if they 
were a single entity carrying on all the functions performed by the FSC 
and the related supplier with respect to the transaction. The FSC shall 
be allowed to receive under the section 482 standard the amount the 
related supplier would have received had there been no FSC.
    (3) Creation of receivables. (i) If the amount of the transfer price 
or rental payment actually charged by a related supplier to a FSC or the 
sales commission actually charged by a FSC to a related supplier has not 
been paid, an account receivable and payable will be deemed created as 
of the due date under section 6072(b), including extensions provided for 
under section 6081, of the FSC's tax return for the taxable year of the 
FSC during which a transaction to which section 925 is applicable 
occurs. The receivable and payable will be in an amount equal to the 
difference between the amount of the transfer price or rental payment or 
commission determined under section 925 and this section and the amount 
(if any) actually paid or received. For example, a calendar year FSC's 
related supplier paid the FSC on July 1, 1985, a commission of $50 on 
the sale of export property. On September 15, 1986, the extended due 
date of the FSC's income tax return for taxable year 1985, the related 
supplier determined that the commission should have been $60. The 
additional $10 of commission had not been paid. Accordingly, an 
interest-bearing payable to the FSC from the related supplier in the 
amount of $10 was created as of September 15, 1986. A $10 interest 
bearing receivable was also created on the FSC's books.
    (ii) An indebtedness arising under the above subdivision (i) shall 
bear interest at an arm's length rate, computed in the manner provided 
by Sec. 1.482-2(a)(2), from the due date under section 6072(b), 
including extensions provided for under section 6081, of the FSC's tax 
return for the taxable year of the FSC in which the transaction occurred 
which gave rise to the indebtedness to the date of payment of the 
indebtedness. The interest so computed shall be accrued and included in 
the taxable income of the person to whom the indebtedness is owed for 
each taxable year during which the indebtedness is unpaid if that person 
is an accrual basis taxpayer or when the interest is paid if a cash 
basis taxpayer. Because the transactions covered by this subdivision are 
between the related supplier and FSC, the carrying charges provisions of 
Sec. 1.927(d)-1(a) do not apply.
    (iii) Payment of dividends, transfer prices, rents, commissions, 
service fees, receivables, or payables may be in the form of money, 
property, sales discount, or an accounting entry offsetting the amount 
due the related supplier, or FSC, whichever applies, against an existing 
debt of the other party to the transaction. This provision does not 
eliminate the requirement that actual cash payments be made by the 
related supplier to a commission FSC if the receipt of payment

[[Page 90]]

test of section 924(e)(4) is used to meet the foreign economic process 
requirements of section 924(d). The offset accounting entries must be 
clearly identified in both the related supplier's and FSC's books of 
account.
    (4) Subsequent determination of transfer price, rental income or 
commission. The FSC and its related supplier would ordinarily determine 
under section 925 and this section the transfer price or rental payment 
payable by the FSC or the commission payable to the FSC for a 
transaction before the FSC files its return for the taxable year of the 
transaction. After the FSC has filed its return, a redetermination of 
those amounts by the Commissioner may only be made if specifically 
permitted by a Code provision or regulations under the Code. Such a 
redetermination would include a redetermination by reason of an 
adjustment under section 482 and the regulations under that section or 
section 861 and Sec. 1.861-8 which affects the amounts which entered 
into the determination. In addition, a redetermination may be made by 
the FSC and related supplier if their taxable years are still open under 
the statute of limitations for making claims for refund under section 
6511 if they determine that a different transfer pricing method may be 
more beneficial. Also, the FSC and related supplier may redetermine the 
amount of foreign trading gross receipts and the amount of the costs and 
expenses that are used to determine the FSC's and related supplier's 
profits under the transfer pricing methods. Any redetermination shall 
affect both the FSC and the related supplier. The FSC and the related 
suppler may not redetermine that the FSC was operating as a commission 
FSC rather than a buy-sell FSC, and vice versa.
    (5) Procedure for adjustments to redeterminations. (i) If a 
redetermination under paragraph (e)(4) of this section is made of the 
transfer price, rental payment or commission for a transaction, or group 
of transactions, the person who was underpaid under this redetermination 
shall establish (or be deemed to have established), at the date of the 
redetermination, an account receivable from the person with whom it 
engaged in the transaction equal to the difference between the amounts 
as redetermined and the amounts (if any) previously paid and received, 
plus the amount (if any) of the account receivable determined under 
paragraph (e)(3) of this section that remains unpaid. A corresponding 
account payable will be established by the person who underpaid the 
amount due.
    (ii) An account receivable established in accordance with the above 
subdivision (5)(i) of this paragraph shall bear interest at an arm's 
length rate, computed in the manner provided by Sec. 1.482-2(a)(2), from 
the day after the date the account receivable is deemed established to 
the date of payment. The interest so computed shall be accrued and 
included in the taxable income for each taxable year during which the 
account receivable is outstanding of an accrual basis taxpayer or when 
paid if a cash basis taxpayer.
    (iii) In lieu of establishing an account receivable in accordance 
with the above subdivision (5)(i) of this paragraph for all or part of 
an amount due a related supplier, the related supplier and FSC are 
permitted to treat all or part of any current or prior distribution 
which was made by the FSC as an additional payment of transfer price or 
rental payment or repayment of commission (and not as a distribution) 
made as of the date the distribution was made. Any additional amount 
arising on the redetermination due the related supplier after this 
treatment shall be represented by an account receivable established 
under the above subdivision (5)(i) of this paragraph. To the extent that 
a distribution is so treated under this subdivision (5)(iii), it shall 
cease to qualify as a distribution for any Federal income tax purpose. 
If all or part of any distribution made to a shareholder other than the 
related supplier is recharacterized under this subdivision (5)(iii), the 
related supplier shall establish an account receivable from that 
shareholder for the amount so recharacterized. The Commissioner may 
prescribe by Revenue Procedure conditions and procedures that must be 
met in order to obtain the relief provided by this subdivision (5)(iii).

[[Page 91]]

    (iv) The procedure for adjustments to transfer price provided by 
this paragraph does not apply to incomplete transactions described in 
paragraph (c)(5) of this section. Such procedure will, however, be 
applied to any such transaction with respect to the taxable year in 
which the transaction is completed.
    (f) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. In 1985, F, a FSC, purchases export property from R, a 
domestic manufacturer of export property A. R is F's related supplier. 
The sale from R to F is made under a written agreement which provides 
that the transfer price between R and F shall be that price which 
allocates to F the maximum amount permitted to be received under the 
transfer pricing rules of section 925. F resells property A in 1985 to 
an unrelated purchaser for $1,000. The terms of the sales contract 
between F and the unrelated purchaser provide that payment of the $1,000 
sales price will be made within 90 days after sale. The purchaser pays 
the entire sales price within 60 days. F incurs indirect and direct 
expenses in the amount of $260 attributable to the sale which relate to 
the activities and functions referred to in section 924 (c), (d) and 
(e). In addition, F incurs additional expenses attributable to the sale 
in the amount of $35. R's cost of goods sold attributable to the export 
property is $550. R incurred direct selling expenses in connection with 
the sale of $50. R's deductible general and administrative expenses 
allocable to all gross income are $200. Apportionment of those 
supportive expenses on the basis of gross income does not result in a 
material distortion of income and is a reasonable method of 
apportionment. R's direct selling expenses and its general and 
administrative expenses were not required to be incurred by F. R's gross 
income from sources other than the transaction is $17,550 resulting in 
total gross income of R and F (excluding the transfer price paid by F) 
of $18,000 ($450 plus $17,550). For purposes of this example, it is 
assumed that if R sold the export property to F for $690, the price 
could be justified as satisfying the standards of section 482. Under 
these facts, F may earn, under the combined taxable income method, the 
more favorable of the three transfer pricing rules, a profit of $23 on 
the sale. (Unless otherwise indicated, all examples in this section 
assume that the marginal costing method of Sec. 1.925(b)-1T does not 
result in a higher profit than the profit under the full costing 
combined taxable income method of paragraphs (c)(3) and (6) of this 
section.) F's profit and the transfer price to F from the transaction, 
using the administrative pricing methods, and F's profit if the transfer 
price is determined under section 482, would be as follows:

 
 
 
Combined taxable income:
  F's foreign trading gross receipts.......................   $1,000.00
  R's cost of goods sold...................................     (550.00)
                                                            ------------
      Combined gross income................................      450.00
                                                            ------------
  Less:
    R's direct selling expenses............................       50.00
    F's expenses...........................................      295.00
 
  Apportionment of R's general and administrative expenses:
    R's total G/A expenses.................................      200.00
    Combined gross income..................................      450.00
    R's and F's total gross income (foreign and domestic)..   18,000.00
 
  Apportionment of G/A expenses:
    $200x$450/$18,000......................................        5.00
                                                            ------------
      Total................................................     (350.00)
                                                            ------------
  Combined taxable income..................................      100.00
                                                            ============
 


 
 
 
The section 482 method--Transfer price to F and F's profit:
  Transfer price to F......................................     $690.00
                                                            ============
  F's profit:
    F's foreign trading gross receipts.....................    1,000.00
                                                            ------------
    Less:
      F's cost of goods sold...............................      690.00
      F's expenses.........................................      295.00
                                                            ------------
          Total............................................     (985.00)
                                                            ------------
    F's profit.............................................       15.00
                                                            ============
The gross receipts method--
F's profit and transfer price to F:
  F's profit--lesser of 1.83% of F's foreign trading gross        18.30
   receipts ($18.30) or two times F's profit under the
   combined taxable income method ($46.00) (See below)
   (Unless otherwise indicated, all examples in this
   section assume that the marginal costing method of Sec.
   1.925(b)-1T does not result in a higher profit than the
   profit under the full costing combined taxable income
   method).................................................
                                                            ============

[[Page 92]]

 
  Transfer price to F:
    F's foreign trading gross receipts.....................    1,000.00
                                                            ------------
    Less:
      F's expenses.........................................      295.00
      F's profit...........................................       18.30
                                                            ------------
          Total............................................     (313.30)
                                                            ------------
    Transfer price.........................................      686.70
                                                            ============
 


 
 
 
The combined taxable income method-- F's profit and
 transfer price to F:
  F's profit--23% of combined taxable income ($100)........      $23.00
                                                            ============
  Transfer price to F:
    F's foreign trading gross receipts.....................    1,000.00
                                                            ------------
    Less:
      F's expenses.........................................      295.00
      F's profit...........................................       23.00
                                                            ------------
        Total..............................................     (318.00)
                                                            ------------
  Transfer price...........................................      682.00
                                                            ============
 


With a profit of $23 under the most favorable of the transfer pricing 
methods, F's exempt foreign trade income under section 923 would be 
$207.39, computed as follows:

 
 
 
  F's foreign trading gross receipts.......................   $1,000.00
  F's costs of purchases (transfer price)..................     (682.00)
                                                            ------------
  F's foreign trade income.................................      318.00
                                                            ============
  F's exempt foreign trade income $318x15/23...............      207.39
                                                            ============
F's taxable income would be $8.00, computed as follows:
  F's foreign trade income.................................     $318.00
  F's exempt foreign trade income..........................     (207.39)
                                                            ------------
    F's non-exempt foreign trade income....................      110.61
 
  Less:
    F's expenses allocable to non-exempt foreign trade          (102.61)
     income $295x$110.61/$318..............................
                                                            ------------
    F's taxable income.....................................        8.00
                                                            ============
 

Of F's total expenses, $192.39 ($295x$207.39/$318) are allocated to F's 
exempt foreign trade income and are disallowed for purposes of computing 
F's taxable income.
    Example 2. Assume the same facts as in Example 1 except that the 
purchaser pays the entire sales price 96 days after delivery, well 
beyond the 60 day period in which payment must be made to avoid 
recharacterization of part of the contract price as carrying charges. 
Therefore, the contract price of $1,000 includes $10 of carrying 
charges, assuming a discount rate of 10%. See Sec. 1.927(d)-1(a) (Q & 
A2) for computation method for determining amount of carrying charges. 
Under these facts, F may earn, under the combined taxable income method, 
the most favorable of the three transfer pricing rules, a profit of 
$20.73 on the sale. F's profit and the transfer price to F under the 
transfer pricing rules, assuming that a carrying charge is incurred, 
would be as follows:

 
 
 
Combined taxable income:
  F's foreign trading gross receipts.......................     $990.00
  R's cost of goods sold...................................     (550.00)
                                                            ------------
      Combined gross income................................      440.00
                                                            ------------
Less:
  R's direct selling expenses..............................       50.00
R's apportioned G/A expenses:
  $200x$440/$18,000........................................        4.89
  F's expenses.............................................      295.00
                                                            ------------
      Total................................................     (349.89)
                                                            ------------
      Combined taxable income..............................       90.11
                                                            ============
The combined taxable income method--F's profit and transfer
 price to F:
  F's profit--23% of combined taxable income ($90.11)......      $20.73
                                                            ============
Transfer price to F:
  F's foreign trading gross receipts.......................      990.00
                                                            ------------
Less:
  F's expenses.............................................      295.00
  F's profit...............................................       20.73
                                                            ------------
      Total................................................     (315.73)
                                                            ------------
      Transfer price.......................................      674.27
                                                            ============
 


 
 
 
The gross receipts method--F's profit and transfer price to
 F:
  F's profit--lesser of 1.83% of F's foreign trading gross       $18.12
   receipts ($18.12) or two times F's profit under the
   combined taxable income method ($41.46).................
                                                            ============
  Transfer price to F: F's foreign trading gross receipts..      990.00
                                                            ------------

[[Page 93]]

 
    Less:
      F's expenses.........................................      295.00
      F's profit...........................................       18.12
                                                            ------------
        Total..............................................     (313.12)
                                                            ------------
  Transfer price...........................................      676.88
                                                            ============
The section 482 method--Transfer price to F and F's profit:
  Transfer price to F......................................      690.00
                                                            ============
  F's profit:
    F's foreign trading gross receipts.....................      990.00
                                                            ------------
    Less:
      F's cost of goods sold...............................      690.00
      F's expenses.........................................      295.00
                                                            ------------
        Total..............................................     (985.00)
                                                            ------------
  F's profit...............................................        5.00
                                                            ============
 

    Example 3. R and F are calendar year taxpayers. R, a domestic 
manufacturing company, owns all the stock of F, a FSC for the taxable 
year. During 1985, R produces and sells a product line of export 
property to F for $157, a price which can be justified as satisfying the 
arm's length price standard of section 482. The sale from R to F is made 
under a written agreement which provides that the transfer price between 
R and F shall be that price which allocates to F the maximum amount 
permitted to be received under the transfer pricing rules of section 
925. F resells the export property for $200. R's cost of goods sold 
attributable to the export property is $115 so that the combined gross 
income from the sale of the export property is $85 (i.e., $200 minus 
$115). R incurs $18 in direct selling expenses in connection with the 
sale of the property. R's deductible general and administrative expenses 
allocable to all gross income are $120. R's direct selling and its 
general and administrative expenses were not required to be incurred by 
F. R's gross income from sources other than the transaction is $5,015 
resulting in total gross income of R and F (excluding the transfer price 
paid by F) of $5,100 (i.e., $85 plus $5,015). F incurs $50 in direct and 
indirect expenses attributable to resale of the export property. Of 
those expenses, $45 relate to activities and functions referred to in 
section 924 (c), (d) and (e). The maximum profit which F may earn with 
respect to the product line is $3.66, computed as follows:

 
 
 
Combined taxable income:
  F's foreign trading gross receipts.......................     $200.00
  R's cost of goods sold...................................     (115.00)
                                                            ------------
    Combined gross income..................................       85.00
                                                            ------------
  Less:
    R's direct selling expenses............................       18.00
    R's apportioned G/A expenses: $120x$85/$5,100..........        2.00
    F's expenses...........................................       50.00
                                                            ------------
      Total................................................      (70.00)
                                                            ------------
  Combined taxable income..................................       15.00
                                                            ============
 


 
 
 
The combined taxable income method--F's profit:
  F's profit--23% of combined taxable income ($15).........     $  3.45
                                                            ============
The gross receipts method--F's profit:
  F's profit--lesser of 1.83% of F's foreign trading gross        $3.66
   receipts ($3.66) or two times F's profit under the
   combined taxable income method ($6.90)..................
                                                            ============
The section 482 method--F's profit:
  F's foreign trading gross receipts.......................      200.00
                                                            ------------
  Less:
    F's cost of goods sold.................................      157.00
    F's expenses...........................................       50.00
                                                            ------------
        Total..............................................     (207.00)
                                                            ------------
  F's profit (loss)........................................       (7.00)
                                                            ============
 


Since the gross receipts method results in a greater profit to F ($3.66) 
than does either the combined taxable income method ($3.45) or the 
section 482 method (a loss of $7), and does not exceed twice the profit 
under the combined taxable income method, F may earn a maximum profit of 
$3.66. Accordingly, the transfer price from R to F may be readjusted as 
long as the transfer price is not readjusted below $146.34, computed as 
follows:

 
 
 
Transfer price to F:
  F's foreign trading gross receipts.......................    $ 200.00
  Less:
    F's expenses...........................................       50.00
    F's profit.............................................        3.66
                                                            ------------
        Total..............................................      (53.66)
                                                            ------------
  Transfer price...........................................      146.34
                                                            ============
 

    Example 4. R and F are fiscal year May 31 year-end taxpayers. R, a 
domestic manufacturing company, owns all the stock of F, a FSC for the 
taxable year. During August of 1987, R produces and sells 100 units of 
export property A to F under a written agreement

[[Page 94]]

which provides that the transfer price between R and F shall be that 
price which allocates to F the maximum profit permitted to be received 
under the transfer pricing rules of section 925. Thereafter, the 100 
units are resold for export by F for $950. R's cost of goods sold 
attributable to the 100 units is $650. R incurs costs, both direct and 
indirect, in the amount of $270 with regard to activities and functions 
referred to in section 924 (c), (d) and (e) which it was under contract 
with F to perform for F. R's direct selling expenses are $40. Those 
expenses were not required to be incurred by F. For purposes of this 
example, assume that R has no general and administrative expenses other 
than those relating to the section 924 (c), (d) and (e) activities and 
functions. F incurs expenses in the amount of $290 attributable to the 
resale which relate to the activities and functions referred to in 
section 924 (c), (d) and (e). Of that amount, $270 was paid to R under 
contract to perform the activities in section 924. The remaining $20 was 
paid to independent contractors. R chooses not to apply the section 482 
transfer pricing method to determine F's profit on the transaction. F 
may not earn any income under either the gross receipts (see the special 
no-loss rule of paragraph (e)(1)(i) of this section) or the combined 
taxable income administrative pricing methods with respect to resale of 
the 100 units because there is a combined loss of $(30) on the 
transaction, computed as follows:

 
 
 
Combined taxable income:
  F's foreign trading gross receipts.......................    $ 950.00
  R's cost of goods sold...................................     (650.00)
                                                            ------------
      Combined gross income................................      300.00
                                                            ------------
  Less:
    R's direct selling expenses............................       40.00
    F's expenses...........................................      290.00
                                                            ------------
        Total..............................................     (330.00)
                                                            ------------
  Combined taxable income (loss)...........................      (30.00)
                                                            ============
 


Under paragraph (e)(1)(i) of this section, F is permitted to recover its 
expenses attributable to the sale ($290) even though such recovery 
results in a loss or increased loss to the related supplier. 
Accordingly, the transfer price from R to F may be readjusted as long as 
the transfer price is not readjusted below $660, computed as follows:

 
 
 
Transfer price to F:
  F's foreign trading gross receipts.......................     $950.00
  Less:
    F's expenses...........................................     (290.00)
                                                            ------------
      Transfer price.......................................      660.00
                                                            ============
 

    Example 5. Assume the same facts as in Example 4 except that F 
performs the section 924 (c), (d) and (e) activities and functions and 
that R chooses to apply the section 482 transfer pricing method. Under 
the standards of section 482, a transfer price from R to F of $650 is an 
arm's length price. Accordingly, the transfer price to F and F's profit 
on the subsequent resale of product A ($10) are as follows:

 
 
 
The section 482 method--Transfer price to F and F's profit:
  Transfer price to F......................................     $650.00
                                                            ============
F's profit:
    F's foreign trading gross receipts.....................      950.00
    F's cost of purchases..................................     (650.00)
                                                            ------------
    F's gross income.......................................      300.00
                                                            ------------
  Less:
    F's expenses...........................................     (290.00)
                                                            ------------
  F's profit...............................................       10.00
                                                            ============
 


This sale of product A results in a loss to R of $40 (transfer price of 
$650 less R's cost of goods sold of $650 and direct selling expenses of 
$40). Since R chose to use the section 482 transfer pricing method on 
this loss transaction, under the special no loss rule of paragraph 
(e)(1)(iii) of this section, the administrative pricing methods of 
section 925(a)(1) and (2) may not be used for any other sale 
transactions, or group of sale transactions, during the same year of 
other products which fall within the same three digit Standard 
Industrial Classification as product A. F's profit, if any, on these 
sales must be computed under the section 482 transfer pricing method.
    Example 6. R and F are calendar year taxpayers. R, a domestic 
manufacturing company, owns all the stock of F, a FSC for the taxable 
year. During 1985, R manufactures 100 units of export property A. R 
enters into a written agreement with F whereby F is granted a sales 
franchise with respect to export property A and F will receive 
commissions with respect to these exports equal to the maximum amount 
permitted to be received under the administrative pricing rules of 
section 925 (a)(1) and (2). Thereafter, the 100 units are sold for 
export by R for $1,000. The total sales price of $1,000 was paid by the 
purchaser to R within 60 days of the sales transaction. The entire 
$1,000 would have been foreign trading gross receipts had F been the 
principal on the sale. R's cost of goods sold attributable to the 100 
units is

[[Page 95]]

$650. R's direct selling expenses so attributable are $50. R's 
deductible general and administrative expenses, other than those 
attributable to the section 924 (c), (d) and (e) activities and 
functions, allocable to all gross income are $200. Apportionment of 
those supportive expenses on the basis of gross income does not result 
in a material distortion of income and is a reasonable method of 
apportionment. R's direct selling expenses and the portion of the 
general and administrative expenses not relating to the activities and 
functions referred to in section 924 (c), (d) and (e) were not required 
to be incurred by F. R's gross income from sources other than the 
transaction is $17,650 resulting in total gross income of $18,000 ($350 
plus $17,650). R and a related person perform on F's behalf the 
activities and functions referred to in section 924 (c), (d) and (e). In 
performing these activities, R and the related person incurred expenses, 
both direct and indirect, of $200 and $45, respectively. F pays $200 to 
R under contract and $50 to the related person. The maximum profit which 
F may earn under the franchise pursuant to the administrative pricing 
rules is $18.30, computed as follows:

 
 
 
Combined taxable income:
  R's gross receipts from the sale.........................   $1,000.00
  R's cost of goods sold...................................     (650.00)
                                                            ------------
    Combined gross income..................................      350.00
                                                            ------------
  Less:
    R's direct selling expenses............................       50.00
    F's expenses...........................................      250.00
 
    Apportionment of R's general and administrative
     expenses:
      R's total G/A expenses...............................      200.00
      Combined gross income................................      350.00
      R's and F's total gross income (foreign and domestic)   18,000.00
                                                            ============
      Apportionment of G/A expenses:
        $200x$350/$18,000..................................        3.89
 
          Total............................................     (303.89)
                                                            ------------
  Combined taxable income..................................       46.11
                                                            ============
 


As reflected in the above computation, F included on its books $200 of 
expenses related to the section 924 activities and performed by R on 
behalf of F. R incurred $253.89 of expenses. These expenses were 
reflected on its books. Under paragraph (b)(2)(ii) of this section, R 
and F may elect to include all of the expenses related to the export 
sales on F's books. This will satisfy the requirements of section 925(c) 
without requiring an allocation of the expenses between R and F. Under 
this election, as reflected in the following computation, combined 
taxable income will still be $46.11 but, as reflected in a later part of 
this example, the commission due F will be increased by $253.89:

 
 
 
Combined taxable income:
  R's gross receipts from the sale.........................   $1,000.00
  R's cost of goods sold...................................     (650.00)
                                                            ------------
      Combined gross income................................      350.00
                                                            ------------
Less:
  F's expenses.............................................     (303.89)
                                                            ------------
      Combined taxable income..............................       46.11
                                                            ============
 


 
 
 
The combined taxable income method--F's profit:
  F's profit--23% of combined taxable income ($46.11)......      $10.61
                                                            ============
The gross receipts method--F's profit:
  F's profit--lesser of 1.83% of R's gross receipts              $18.30
   ($18.30) or two times F's profit under the combined
   taxable income method ($21.22)..........................
                                                            ============
 
If the election provided for in paragraph (b)(2)(ii) of this section is
 not made, F may receive a commission from R in the amount of $268.30,
 computed as follows:
 
  F's expenses.............................................     $250.00
  F's profit...............................................       18.30
                                                            ------------
      F's commission.......................................      268.30
                                                            ============
 
This $268.30 is F's foreign trade income. F's exempt foreign trade
 income is $174.98 ($268.30x15/23). F's taxable income is $6.37,
 computed as follows:
 
  F's foreign trade income.................................     $268.30
  F's exempt foreign trade income..........................     (174.98)
                                                            ------------
      F's non-exempt foreign trade income..................       93.32
                                                            ------------
Less:
  F's expenses allocable to non-exempt foreign trade income      (86.95)
   $250x$93.32/$268.30.....................................
                                                            ------------
      F's taxable income...................................        6.37
                                                            ============
 

Of F's total expenses, $163.05 ($250x$174.98/$268.30) are allocated to 
F's exempt foreign trade income and are disallowed for purposes of 
computing F's taxable income.

[[Page 96]]

If R and F make the election provided for in paragraph (b)(2)(ii) of 
this section, F may receive a commission from R in the amount of 
$322.19, computed as follows:

 
 
 
  F's expenses.............................................     $303.89
  F's profit...............................................       18.30
                                                            ------------
    F's commission.........................................      322.19
                                                            ============
 
With this election, this $322.19 is F's foreign trade income. F's exempt
 foreign trade income is $210.12 ($322.19x15/23). F's taxable income is
 still $6.37, computed as follows:
 
  F's foreign trade income.................................     $322.19
  F's exempt foreign trade income..........................     (210.12)
                                                            ------------
    F's non-exempt foreign trade income....................      112.07
                                                            ------------
  Less:
    F's expenses allocable to non-exempt foreign trade          (105.70)
     income $303.89x$112.07/$322.19........................
                                                            ------------
    F's taxable income.....................................        6.37
                                                            ============
 
Of F's total expenses, $198.19 ($303.89x$210.12/$322.19) are allocated
 to F's exempt foreign trade income and are disallowed for purposes of
 computing F's taxable income.
 

    Example 7. Assume the same facts as in Example 6 except that R's 
direct selling expenses are $60. The profit which F may earn under the 
franchise pursuant to the administrative pricing rules is $16.62, 
computed as follows:

 
 
 
Combined taxable income:
  R's gross receipts from the sale.........................   $1,000.00
  R's cost of goods sold...................................     (650.00)
                                                            ------------
    Combined gross income..................................      350.00
                                                            ------------
  Less:
    R's direct selling expenses............................       60.00
    R's apportioned G/A expenses...........................        3.89
    F's expenses...........................................      250.00
                                                            ------------
                                                                (313.89)
 
  Combined taxable income..................................       36.11
                                                            ============
The combined taxable income method--F's profit:
  F's profit--23% of combined taxable income ($36.11)......        8.31
                                                            ============
The gross receipts method--F's profit:
  F's profit--lesser of 1.83% of R's gross receipts ($            16.62
   18.30) or two times F's profit under the combined
   taxable income method ($16.62)..........................
                                                            ============
 
F may receive a commission from R in the amount of $266.62, computed as
 follows:
 
  F's expenses.............................................     $250.00
  F's profit...............................................       16.62
                                                            ------------
    F's commission.........................................      266.62
                                                            ============
 


If the election provided for in paragraph (b)(2)(ii) of this section is 
made by R and F, the profit which F may earn under the franchise 
pursuant to the administrative pricing rules will remain at $16.62 but 
will be computed as follows:

 
 
 
Combined taxable income:
  R's gross receipts from the sale.........................   $1,000.00
  R's cost of goods sold...................................     (650.00)
                                                            ------------
    Combined gross income..................................      350.00
                                                            ------------
  Less: F's expenses.......................................     (313.89)
                                                            ------------
  Combined taxable income..................................       36.11
                                                            ============
The combined taxable income method--F's profit:
  F's profit--23% of combined taxable income ($36.11)......        8.31
                                                            ============
The gross receipts method--F's profit:
  F's profit--lesser of 1.83% of R's gross receipts               16.62
   ($18.30) or two times F's profit under the combined
   taxable income method ($16.62)..........................
                                                            ============
F may receive a commission from R in the amount of $330.51,
 computed as follows:
  F's expenses.............................................      313.89
  F's profit...............................................       16.62
                                                            ------------
    F's commission.........................................      330.51
                                                            ============
 

As illustrated by Example 6, F's exempt taxable income and taxable 
income will be the same regardless of which method is used to compute 
F's commission.
    Example 8. Assume the same facts as in Example 6 except that F's 
expenses are $300. With this assumption, there is a combined loss of 
$(3.89) on the transaction under the full costing combined taxable 
income method, computed as follows:

 
 
 
Combined taxable income:
  R's gross receipts from the sale.........................   $1,000.00
  R's cost of goods sold...................................     (650.00)
                                                            ------------
    Combined gross income..................................      350.00
                                                            ------------
  Less:
    R's direct selling expenses............................       50.00
    R's apportioned G/A expenses...........................        3.89
    F's expenses...........................................      300.00
                                                            ------------
                                                                (353.89)
                                                            ------------
  Combined taxable income (loss)...........................       (3.89)
                                                            ============
 


Since there is a combined loss, F will not have a profit under the full 
costing combined taxable income method. However, for purposes of this 
example, it is assumed that under the marginal costing rules of 
Sec. 1.925(b)-1T the maximum combined taxable income is $75 and the 
overall profit percentage limitation is $30. Accordingly, F's profit 
would be $6.90 (23% of $30) under the marginal costing rules. F's profit 
under the gross receipts method will be $13.80 (1.83% of $1,000 limited

[[Page 97]]

by section 925(d) to two times the profit determined under marginal 
costing). The commission F may receive from R is $313.80. Had all of the 
expenses been reflected on F's books pursuant to the election of 
paragraph (b)(2)(ii) of this section, F's commission would have been 
$367.69.
    Example 9. Assume the same facts as in Example 6 except that F's 
expenses are $300 and that the transaction occurred in 1987. F will not 
earn a profit under the sales franchise pursuant to the administrative 
pricing rules. This is shown by the following computation:

 
 
 
Combined taxable income:
  R's gross receipts from the sale................             $1,000.00
  R's cost of goods sold..........................              (650.00)
                                                   ---------------------
    Combined gross income.........................                350.00
                                                   ---------------------
  Less:
    R's direct selling expenses...................                 50.00
    R's apportioned G/A expenses..................                  3.89
    F's expenses..................................                300.00
                                                   ---------------------
                                                                (353.89)
                                                   ---------------------
  Combined taxable income (loss)..................                (3.89)
                                                   =====================
 


F will not have a profit under the full costing combined taxable income 
method since there is a combined loss of $(3.89). Also, F will not have 
a profit under the gross receipts method due to section 925(d) and the 
special no loss rule of paragraph (e)(1)(i) of this section. In 
addition, F will not have a profit under the marginal costing rules 
because the profit may not exceed full costing combined taxable income, 
see Sec. 1.925 (b)-1T(b)(4). Although F may not earn a profit, it is 
entitled to recoup its expenses. Therefore, the commission F may receive 
from R is $300.00. R will bear the entire loss. Had all of the expenses 
been reflected on F's books pursuant to the election of paragraph 
(b)(2)(ii) of this section, F's commission would have been $353.89.
    Example 10. Assume the same facts as in Example 6 except that R 
receives total payment of the sale price of $1,000 on the 96th day after 
delivery, well beyond the 60 day period in which payment must be made to 
avoid recharacterization of part of the contract price as carrying 
charges. Therefore, the contract price of $1,000 includes $10 of 
carrying charges, assuming a discount rate of 10%. See Sec. 1.927(d)-1 
(a) (Q & A2) for computation method for determining amount of carrying 
charges. This $10 of carrying charges is R's income. The profit which F 
may earn under the franchise pursuant to the administrative pricing 
rules is $16.66, computed as follows (the election of paragraph 
(b)(2)(ii) of this section is not made by R and F):

 
 
 
Combined taxable income:
  R's gross receipts from the sale..........................    $990.00
  R's cost of goods sold....................................    (650.00)
                                                             -----------
    Combined gross income...................................     340.00
                                                             -----------
  Less:
    R's direct selling expenses.............................      50.00
    R's apportioned G/A expenses: $200x$340/$18,000.........       3.78
    F's expenses............................................     250.00
                                                             -----------
      Total.................................................    (303.78)
                                                             -----------
  Combined taxable income...................................      36.22
                                                             ===========
The combined taxable income method-- F's profit: F's profit--     $8.33
 23% of combined taxable income ($36.22)
                                                             ===========
The gross receipts method--F's profit:
  F's profit--lesser of 1.83% of R's gross receipts ($18.12)     $16.66
   or two times F's profit under the combined taxable income
   method ($16.66)..........................................
                                                             ===========
F may receive a commission from R in the amount of $266.66,
 computed as follows:
  F's expenses..............................................    $250.00
  F's profit................................................      16.66
                                                             -----------
    F's commission..........................................     266.66
                                                             ===========
 

    Example 11. Assume the same facts as in Example 6. In addition, 
assume that R also manufactures products K, L, M, N, and P all of which 
are export property as defined in section 927(a). Product K is military 
property as defined in section 923(a)(5) and Sec. 1.923-1T(b)(3)(ii). 
Assume further that products A, L, and P are included within product 
line X and that products K, L, M, and N are included within product line 
W. R has entered into a written agreement with F under which F is 
granted a sales franchise with respect to exporting the products. Under 
this agreement, F will receive commissions with respect to those exports 
equal to the maximum amount permitted to be received under the 
administrative pricing rules. The table set forth below details F's 
foreign trading gross receipts, R's cost of goods sold and R's and F's 
expenses allocable and apportioned under Sec. 1.861-8 to the sale of 
products A, L, M, N, and P. For purposes of this example, it is assumed 
that R does not incur any general and administrative expenses. Because 
of the special grouping rule of paragraph (c)(8)(ii) of this section, 
product L may be included for purposes of the administrative pricing 
rules in only one product line, at the option of R. Also for these 
purposes, product K, which is military property, may not be grouped with 
products L, M, and N. See paragraph (c)(8)(iv) of this section. Under 
these facts, F will have profits under the franchise agreement from the 
sale of products A, L, M, N, and P and may receive commissions from R 
relating to the sale of those products, assuming the election of 
paragraph (b)(2)(ii) of this section is not made, in the following 
amounts:

[[Page 98]]



 
                                                      F's
                                          Profit   Expenses  Commissions
 
Product Line X (products A and P)......    $36.34   $490.00     $526.34
Product Line W (products L, M, and N)..    $40.48   $421.00     $461.48
 


On the sale of product K, R received gross receipts of $150. R's cost of 
goods sold was $130. R's and F's expenses allocable to product K totaled 
$10 ($7 of R's expenses and $3 of F's). Under the gross receipts method, 
F earned a profit of $2.75 (1.83% of $150) and $2.30 under the combined 
taxable income method. F may receive a commission, assuming the election 
of paragraph (b)(2)(ii) of this section is made by R and F, from R in 
the amount of $12.75, computed as follows:

 
 
 
F's expenses..................................................    $10.00
F's profit....................................................      2.75
                                                               ---------
    F's commission............................................    $12.75
                                                               =========
 


----------------------------------------------------------------------------------------------------------------
                                           Product A   Product L   Product M   Product N   Product P     Total
----------------------------------------------------------------------------------------------------------------
Product Line X
  Combined Taxable Income
    R's GR From sale....................    $1,000    ..........  ..........  ..........    $1,000      $2,000
    R's cost of goods sold..............      (650)   ..........  ..........  ..........      (650)     (1,300)
                                         -----------------------------------------------------------------------
      Combined gross income.............       350    ..........  ..........  ..........       350         700
                                         -----------------------------------------------------------------------
    Less:
      R's expenses......................        50    ..........  ..........  ..........        81         131
      F's expenses......................       250    ..........  ..........  ..........       240         490
                                         -------------
        Total...........................      (300)   ..........  ..........  ..........      (321)       (621)
                                         -------------
    Combined taxable income (loss)......       $50    ..........  ..........  ..........       $29         $79
                                         =============
  23% of CTI............................    $11.50    ..........  ..........  ..........     $6.67      $18.17
                                         =============
  1.83% of GR from sale.................    $18.30    ..........  ..........  ..........    $13.34      $36.34
                                         =============
Product Line W
  Combined Taxable Income
    R's GR from sale....................  ..........    $1,000        $625      $1,800    ..........    $3,425
    R's cost of goods sold..............  ..........      (650)       (445)     (1,600)   ..........    (2,695)
                                         -------------
      Combined gross income.............  ..........       350         180         200    ..........       730
                                         -------------
    Less:
      R's expenses......................  ..........        81          70          70    ..........       221
      F's expenses......................  ..........       230          60         131    ..........       421
                                         -------------
        Total...........................  ..........      (311)       (130)       (201)   ..........      (642)
                                         -------------
    Combined taxable income (loss)......  ..........       $39         $50         $(1)   ..........       $88
                                         =============
  23% of CTI............................  ..........     $8.97      $11.50          $0    ..........    $20.24
                                         =============
  1.83% of GR From sale.................  ..........    $17.94      $11.44          $0    ..........    $40.48
                                         =============
----------------------------------------------------------------------------------------------------------------

    Example 12. R and F are calendar year taxpayers. R owns all the 
stock of F, an FSC for the taxable year. During 1985, R purchases 100 
units of export property A from B, an unrelated domestic manufacturing 
company for $850. R's direct selling expenses so attributable are $20. R 
enters into a written agreement with F whereby F is granted a sales 
franchise with respect to export product A and F will receive 
commissions with respect to these exports equal to the maximum amount 
permitted to be received under the administrative pricing rules of 
section 925. Thereafter, the 100 units are sold for export by R for 
$1,050. R factors the trade receivable to unrelated person X for $1,000. 
Under Sec. 1.924(a)-1T(g)(7), total gross receipts for purposes of 
computing R's and F's combined taxable income is $1,000 (total receipts 
($1,050) less the discount ($50)). This $1,000 would have been foreign 
trading gross receipts had F been the principal on the sale. For 
purposes of this example, it is assumed that R did not incur any general 
and administrative expenses. F incurs expenses in the amount of $110, 
all of which were performed by R under contract to F. The profit which F 
may earn under the franchise pursuant to the administrative pricing 
rules is $9.20 computed as follows:

[[Page 99]]



 
 
 
Combined taxable income:
  R's gross receipts from the sale.........................   $1,000.00
  R's cost of goods sold...................................     (850.00)
                                                            ------------
                                                                 150.00
                                                            ------------
  Less:
    R's direct selling expenses............................       20.00
    F's expenses...........................................      110.00
                                                            ------------
      Total................................................      130.00
                                                            ------------
  Combined taxable income..................................      $20.00
                                                            ============
The combined taxable income method--F's profit:
  F's profit--23% of combined taxable income ($20).........       $4.60
                                                            ============
The gross receipts method--F's profit:
  F's profit--lesser of 1.83% of R's gross receipts               $9.20
   ($18.30) or two times F's profit under the combined
   taxable income, method ($9.20)..........................
                                                            ============
F may receive a commission from R in the amount of $119.20,
 computed as follows (the election of Sec.  1.925(a)-
 1T(b)(2)(ii) has not been made):
  F's expenses.............................................     $110.00
  F's profit...............................................        9.20
                                                            ------------
    F's commission.........................................     $119.20
                                                            ============
 

    Example 13. R and F are calendar year taxpayers. R, a domestic 
manufacturing company, owns all the stock of F, an FSC for the taxable 
year. During March 1985, R manufactures office equipment, export 
property within the definition of section 927(a)(1), which it leases on 
April 1, 1985, to F for a term of 1 year at a monthly rental of $1,000, 
a rent which satisfies the standard of arm's length rental under section 
482. F subleases the product on April 1, 1985, for a term of 1 year at a 
monthly rental of $1,200. R's cost for the product leased is $40,000. 
R's other deductible expenses attributable to the product are $200, all 
of which are incurred in 1985. Those expenses were not incurred under 
contract to F. F's expenses attributable to sublease of the export 
property are $1,150, all of which are incurred in 1985 directly by F. R 
depreciates the property on a straight line basis, using a half-year 
convention, assuming a 10 year recovery period (see section 
168(f)(2)(C), Sec. 1.48-1(g)). The profit which F may earn with respect 
to the transaction is $1,483.50 for 1985 and $600 for 1986, computed as 
follows:

                          Computation for 1985

 
 
 
Combined taxable income:
  F's sublease rental receipts for year ($1,200 x 9          $10,800.00
   months)................................................
                                                           -------------
Less:
  R's depreciation (($40,000 x1/10)x9/12).................     3,000.00
  R's expenses............................................       200.00
  F's expense.............................................     1,150.00
                                                           -------------
      Total...............................................    (4,350.00)
                                                           -------------
Combined taxable income...................................     6,450.00
                                                           =============
The combined taxable income method--F's profit:
  F's profit--23% of combined taxable income ($6,450).....    $1,483.50
                                                           =============
The gross receipts method--F's profit:
  F's profit--lesser of 1.83% of F's foreign trading gross      $197.64
   receipts ($197.64) or two times F's profit under the
   combined taxable income method ($2,967)................
                                                           =============
The section 482 method--F's profit:
  F's sublease rental receipts for year...................   $10,800.00
                                                           -------------
Less:
  F's lease rental payments for year......................     9,000.00
  F's expenses............................................     1,150.00
                                                           -------------
      Total...............................................   (10,150.00)
                                                           -------------
      F's profit..........................................       650.00
                                                           =============
 


Since the combined taxable income method results in greater profit to F 
($1,483.50) than does either the gross receipts method ($197.64) or the 
section 482 method ($650), F may earn a profit of $1,483.50 for 1985. 
Accordingly, the monthly rental payable by F to R for 1985 may be 
readjusted as long as the monthly rental payable is not readjusted below 
$907.39, computed as follows:

 
 
 
Monthly rental payable by F to R for 1985:
  F's sublease rental receipts for year...................   $10,800.00
                                                           -------------
Less:
  F's expenses............................................     1,150.00
  F's profit..............................................     1,483.50
                                                           -------------
      Total...............................................    (2,633.50)
                                                           -------------
      Rental payable for 1985.............................     8,166.50
                                                           =============

[[Page 100]]

 
      Rental payable each month ($8,166.50/9 months)......      $907.39
                                                           =============
 

                          Computation for 1986

 
 
 
Combined taxable income:
  F's sublease rental receipts for year ($1,200 x 3 months)   $3,600.00
                                                            ------------
Less:
  R's depreciation (($40,000 x \1/10\) x \3/12\)...........   (1,000.00)
                                                            ------------
      Combined taxable income..............................    2,600.00
                                                            ============
The combined taxable income method--F's profit:
  F's profit--23% of combined taxable income ($2,600)......      598.00
                                                            ============
The gross receipts method--F's profit:
  F's profit--lesser of 1.83% of F's foreign trading gross        65.88
   receipts ($3,600) or two times F's profit under the
   combined taxable income method ($1,196).................
                                                            ============
The section 482 method--F's profit:
  F's sublease rental receipts for year....................   $3,600.00
                                                            ------------
Less:
  F's lease rental payments for year.......................   (3,000.00)
                                                            ------------
      F's profit...........................................      600.00
                                                            ============
 

Since the section 482 method results in a greater profit to F ($600) 
than does either the combined taxable income method ($598) or the gross 
receipts method ($65.88), F may earn a profit of $600 for 1986. 
Accordingly, the monthly rental payable by F to R for 1986 may be 
readjusted as long as the monthly rental payable is not readjusted below 
$1,000, computed as follows:

 
 
 
Monthly rental payable by F to R for 1986:
  F's sublease rental receipts for year....................   $3,600.00
                                                            ------------
Less:
  F's profit...............................................     (600.00)
                                                            ------------
  Rental payable for 1986..................................    3,000.00
                                                            ============
  Rental payable for each month ($3,000/3 months)..........    1,000.00
                                                            ============
 


    (g) Effective date. The provisions of this section and 
Sec. 1.925(b)-1T apply with respect to taxable year ending after 
December 31, 1984, except that a corporation may not be a FSC for any 
taxable year beginning before January 1, 1985.

[T.D. 8126, 52 FR 6443, Mar. 3, 1987, as amended by T.D. 8764, 63 FR 
10306, Mar. 3, 1998; T.D. 8944, 66 FR 13426, Mar. 6, 2001]



Sec. 1.925(b)-1T  Temporary regulations; marginal costing rules.

    (a) In general. This section prescribes the marginal costing rules 
authorized by section 925(b)(2). If under paragraph (c)(1) of this 
section a FSC is treated for its taxable year as seeking to establish or 
maintain a foreign market for sales of an item, product, or product line 
of export property (as defined in Sec. 1.927(a)-1T) from which foreign 
trading gross receipts (as defined in Sec. 1.924(a)-1T) are derived, the 
marginal costing rules prescribed in paragraph (b) of this section may 
be applied at the related supplier's election to compute combined 
taxable income of the FSC and related supplier derived from those sales. 
(Any further reference to a FSC in this section shall include a small 
FSC unless indicated otherwise.) The combined taxable income determined 
under these marginal costing rules may be used to determine whether the 
``twice the amount determined under the combined taxable income method'' 
limitation for the 1.83% of gross receipts test of section 925(d) has 
been met.

For FSC taxable years beginning after December 31, 1986, if the marginal 
costing rules are used to determine the section 925(d) limitation, the 
FSC may not earn more than 100% of full costing combined taxable income 
determined under the full costing combined taxable income method of 
Sec. 1.925(a)-1T(c)(3) and (6). The marginal costing rules may be 
applied even if the related supplier does not manufacture, produce, 
grow, or extract the export property sold. The marginal costing rules do 
not apply to sales of export property which in the hands of a purchaser 
related under section 954(d)(3) to the seller give rise to foreign base 
company sales income as described in section 954(d) unless, for the 
purchaser's year in which it resells the export

[[Page 101]]

property, section 954(b)(3)(A) is applicable or that income is under the 
exceptions in section 954(b)(4). In addition, the marginal costing rules 
do not apply to leases of property or to the performances of any 
services even if they are related and subsidiary services (as defined in 
Sec. 1.924(a)-1T(d) and Sec. 1.925(a)-1T(b)(2)(iii)(C)).
    (b) Marginal costing rules--(1) In general. Marginal costing is a 
method under which only direct production costs of producing a 
particular item, product, or product line are taken into account for 
purposes of computing the combined taxable income of the FSC and its 
related supplier under section 925(a)(2). The costs to be taken into 
account are the related supplier's direct material and labor costs (as 
defined in Sec. 1.471-11(b)(2)(i)). Costs which are incurred by the FSC 
and which are not taken into account in computing combined taxable 
income are deductible by the FSC only to the extent of the FSC's non-
foreign trade income. If the related supplier is not the manufacturer or 
producer of the export property that is sold, the related supplier's 
purchase price shall be taken into account.
    (2) Overall profit percentage limitation. Under marginal costing, 
the combined taxable income of the FSC and its related supplier may not 
exceed the overall profit percentage (determined under paragraph (c)(2) 
of this section) multiplied by the FSC's foreign trading gross receipts 
if the FSC is the principal on the sale (or the related supplier's gross 
receipts if the FSC is a commission agent) from the sale of export 
property.
    (3) Grouping of transactions. (i) In general, for purposes of this 
section, an item, product, or product line is the item or group 
consisting of the product or product line pursuant to Sec. 1.925(a)-
1T(c)(8) used by the taxpayer for purposes of applying the full costing 
combined taxable income method of Sec. 1.925(a)-1T(c)(3) and (6).
    (ii) However, for purposes of determining the overall profit 
percentage under paragraph (c)(2) of this section, any product or 
product line grouping permissible under Sec. 1.925(a)-1T(c)(8) may be 
used at the annual choice of the FSC even though it may not be the same 
item or grouping referred to in subdivision (i) of this paragraph as 
long as the grouping chosen for determining the overall profit 
percentage is at least as broad as the grouping referred to in the above 
subdivision (i) of this paragraph. A product may be included for this 
purpose, however, in only one product group even though under the 
grouping rules it would otherwise fall in more than one group. Thus, the 
marginal costing rules will not apply with respect to any regrouping if 
the regrouping does not include any product (or products) that was 
included in the group for purposes of the full costing method.
    (4) Application of limitation on FSC income (``no loss'' rules). The 
marginal costing rules of this section will not apply if there is a 
combined loss of the related supplier and the FSC determined in 
accordance with paragraph (b)(1) of this section. In addition, for FSC 
taxable years beginning after December 31, 1986, the profit determined 
under the marginal costing method may be allowed to the FSC only to the 
extent it does not exceed the FSC's and the related supplier's full 
costing combined taxable income determined under the full costing 
combined taxable income method of Sec. 1.925(a)-1T(c)(3) and (6). This 
rule prevents pricing at a loss to the related supplier. If either of 
these ``no loss'' rules apply, the related supplier may nonetheless 
charge a transfer price or pay a commission in an amount that will allow 
the FSC to recover an amount not in excess of its full costs, if any, 
even if to do so would create or increase a loss in the related 
supplier. The effect of these no-loss rules and of the overall profit 
percentage limitation of paragraph (c)(2) of this section is that the 
FSC's profit under these marginal costing rules is limited to the lesser 
of the following:
    (i) 23% of maximum combined taxable income determined under the 
marginal costing rules,
    (ii) 23% of the overall profit percentage limitation, or
    (iii) For FSC taxable years beginning after December 31, 1986, 100% 
of the full costing combined taxable income determined under the full 
costing combined taxable income method of Sec. 1.925(a)-1T(c)(3) and 
(6).

[[Page 102]]

    (c) Definitions--(1) Establishing or maintaining a foreign market. A 
FSC shall be treated for its taxable year as seeking to establish or 
maintain a foreign market with respect to sales of an item, product, or 
product line of export property from which foreign trading gross 
receipts are derived if the combined taxable income computed under 
paragraph (b) of this section is greater than the full costing combined 
taxable income computed under the full costing combined taxable income 
method of Sec. 1.925(a)-1T(c)(3) and (6).
    (2) Overall profit percentage. (i) For purposes of this section, the 
overall profit percentage for a taxable year of the FSC for a product or 
product line is the percentage which--
    (A) The combined taxable income of the FSC and its related supplier 
from the sale of export property plus all other taxable income of its 
related supplier from all sales (domestic and foreign) of such product 
or product line during the FSC's taxable year, computed under the full 
costing method, is of
    (B) The total gross receipts (determined under Sec. 1.927(b)-1T) of 
the FSC and related supplier from all sales of the product or product 
line.
    (ii) At the annual option of the related supplier, the overall 
profit percentage for the FSC's taxable year for all products and 
product lines may be determined by aggregating the amounts described in 
subdivisions (i)(A) and (B) of this paragraph of the FSC, and all 
domestic members of the controlled group (as defined in section 
927(d)(4) and Sec. 1.924(a)-1T(h)) of which the FSC is a member, for the 
FSC's taxable year and for taxable years of the members ending with or 
within the FSC's taxable year.
    (iii) For purposes of determining the amounts in subdivisions (i) 
and (ii) of this paragraph, a sale of property between a FSC and its 
related supplier or between domestic members of the controlled group 
shall be taken into account only during the FSC's taxable year (or 
taxable year of the member ending within the FSC's taxable year) during 
which the property is ultimately sold to a person which is not related 
to the FSC or if related, is a foreign person that is not a FSC.
    (3) Full costing method. For purposes of section 925 and this 
section, the term ``full costing combined taxable income method'' is the 
method for determining full costing combined taxable income set forth in 
Sec. 1.925(a)-1T(c)(3) and (6).
    (d) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. R and F are calendar year taxpayers. R, a domestic 
manufacturing company, owns all the stock of F, a FSC for the taxable 
year. During 1985, R produces and sells 100 units of export property A 
to F under a written agreement which provides that the transfer price 
between R and F shall be that price which allocates to F the maximum 
profit permitted to be received under the administrative pricing rules 
of section 925(a)(1) and (2). Thereafter, the 100 units are resold for 
export by F for $950. R's cost of goods sold attributable to the 100 
units is $650 consisting in part of $400 of direct materials and $200 of 
direct labor. R incurs selling expenses directly attributable to the 
sale in the amount of $100. Those expenses were not required to be 
incurred by F. For purposes of this example, it is assumed that R does 
not have general and administrative expenses that are not definitely 
allocable to any item of gross income. F's expenses attributable to the 
resale of the 100 units are $120. For purposes of this example, R and F 
have gross receipts of $4,000 from all domestic and foreign sales. R's 
total cost of goods sold and total expenses relating to its foreign and 
domestic sales are $2,730 and $450, respectively. Under full costing, 
the combined taxable income will be $80, computed as follows:

 
 
 
Combined taxable income--full costing:
  F's foreign trading gross receipts........................    $950.00
  R's cost of goods sold....................................    (650.00)
                                                             -----------
    Combined gross income...................................     300.00
                                                             -----------
  Less:
    R's direct selling expenses.............................     100.00
    F's expenses............................................     120.00
                                                             -----------
      Total.................................................    (220.00)
                                                             -----------
  Combined taxable income (loss)............................      80.00
                                                             ===========
 


F's profit under the full costing combined taxable income method is 
$18.40, i.e., 23% of full costing combined taxable income ($80). F's 
profit under the gross receipts method will be $17.39, i.e., 1.83% of 
F's foreign trading gross receipts ($950). However, under the marginal 
costing rules, F would have a profit

[[Page 103]]

attributable to the export sale in the amount of $38.24, i.e., 23% of 
combined taxable income as determined under the marginal costing rules 
(23% of $166.25). As shown by the computation below, the combined 
taxable income under marginal costing is limited to the overall profit 
percentage limitation ($166.25) since that amount is less than the 
maximum combined taxable income amount ($350):

 
 
 
Maximum combined taxable income (determined under paragraph
 (b)(1) of this section):
 
  F's foreign trading gross receipts........................    $950.00
                                                             -----------
  Less:
    R's direct materials....................................     400.00
    R's direct labor........................................     200.00
                                                             -----------
      Total.................................................    (600.00)
                                                             -----------
  Maximum combined total income.............................     350.00
                                                             ===========
 


 
 
 
Overall profit percentage limitation calculation
 (determined under paragraph (c)(2) of this section):
  Gross receipts of R and F from all domestic and foreign     $4,000.00
   sales...................................................
  R's cost of goods sold...................................   (2,730.00)
                                                            ------------
      Combined gross income................................    1,270.00
                                                            ------------
  Less:
    R's expenses...........................................      450.00
    F's expenses...........................................      120.00
                                                            ------------
      Total................................................     (570.00)
                                                            ------------
      Total taxable income from all sales computed on a          700.00
       full costing method.................................
                                                            ============
  Overall profit percentage (total taxable income ($700)          17.5%
   divided by total gross receipts ($4,000)................
                                                            ============
  Overall profit percentage limitation Overall profit           $166.25
   percentage times F's foreign trading gross receipts
   (17.5% times $950.00)...................................
                                                            ============
 

The transfer price from R to F may be set at $791.76, computed as 
follows:

 
 
 
Transfer price to F:
  F's foreign trading gross receipts.......................     $950.00
                                                            ------------
Less:
  F's expenses.............................................      120.00
  F's profit...............................................       38.24
                                                            ------------
      Total................................................     (158.24)
                                                            ------------
  Transfer price...........................................      791.76
                                                            ============
 

    Example 2. Assume the same facts as in Example 1 except that F's 
expenses are $170. Under full costing, the combined taxable income will 
be $30, computed as follows:

 
 
 
Combined taxable income--full costing:
  F's foreign trading gross receipts.........................   $950.00
  R's cost of goods sold.....................................   (650.00)
                                                              ----------
      Combined gross income..................................    300.00
                                                              ----------
Less:
  R's expenses...............................................    100.00
  F's expenses...............................................    170.00
                                                              ==========
      Total..................................................   (270.00)
                                                              ----------
      Combined taxable income (loss).........................     30.00
                                                              ----------
 


F's profit under the full costing combined taxable income method is 
$6.90, i.e., 23% of combined taxable income, $30. Under the marginal 
costing rules, F may earn a profit attributable to the export sale in 
the amount of $35.51, i.e., 23% of combined taxable income as determined 
under the marginal costing rules (23% of $154.38). Had the transaction 
occurred in 1987, F would have had a profit attributable to the export 
sale under these marginal costing rules of only $30, i.e., 23% of 
combined taxable income as determined under the marginal costing rules 
(23% of $154.38) limited, for FSC taxable years beginning after December 
31, 1986, to combined taxable income determined under full costing 
($30), see paragraph (b)(4) of this section. F's profit under the gross 
receipts method will be $17.39 i.e., 1.83% of F's foreign trading gross 
receipts ($950). The computations are as follows:

 
 
 
Maximum combined taxable income (determined under paragraph
 (b)(1) of this section):
  F's foreign trading gross receipts.......................     $950.00
                                                            ------------
  Less:
    R's direct materials...................................      400.00
    R's direct labor.......................................      200.00
                                                            ------------
      Total................................................     (600.00)
                                                            ------------

[[Page 104]]

 
  Maximum combined taxable income                                350.00
                                                            ============
Overall profit percentage limitation calculation
 (determined under paragraph (c)(2) of this section):
  Gross receipts of R and F from all domestic and foreign      4,000.00
   sales...................................................
  R's cost of goods sold...................................   (2,730.00)
                                                            ------------
  Combined gross income....................................    1,270.00
                                                            ------------
  Less:
    R's expenses...........................................      450.00
    F's expenses...........................................      170.00
                                                            ------------
      Total................................................     (620.00)
                                                            ------------
  Total taxable income from all sales computed on a full         650.00
   costing method..........................................
                                                            ============
Overall profit percentage (total taxable income ($650)           16.25%
 divided by total gross receipts ($4,000)).................
                                                            ============
Overall profit percentage limitation Overall profit              154.38
 percentage times F's foreign trading gross receipts
 (16.25% times $950.00)....................................
                                                            ============
The transfer price from R to F may be set at $744.49,
 computed as follows:
 
  Transfer price to F:
    F's foreign trading gross receipts.....................      950.00
                                                            ------------
    Less:
      F's expenses.........................................      170.00
      F's profit...........................................       35.51
                                                            ------------
        Total..............................................     (205.51)
                                                            ------------
    Transfer price.........................................      744.49
                                                            ============
 

    Example 3. Assume the same facts as in Example 1 except that the 
transaction occurs in 1987 and that F incurs expenses in the amount of 
$250. Since a $50 combined loss, as computed below, is incurred, F will 
not have any profit under either the full costing combined taxable 
income method, the gross receipts method or the marginal costing rules:

 
 
 
  Combined taxable income--full costing:
    F's foreign trading gross receipts.....................     $950.00
    R's cost of goods sold.................................     (650.00)
                                                            ------------
      Combined gross income................................      300.00
                                                            ------------
    Less:
      R's expenses.........................................      100.00
      F's expenses.........................................      250.00
                                                            ------------
        Total..............................................     (350.00)
                                                            ------------
    Combined taxable income (loss).........................      (50.00)
                                                            ============
 


The transfer price to R may be set at $700 so that F may recover its 
expenses.
    Example 4. R and F are calendar year taxpayers. R, a domestic 
manufacturing company, owns all the stock of F, a FSC for the taxable 
year. During 1985, R manufactures export property A. R enters into a 
written agreement with F whereby F will receive a commission with 
respect to sales of export property A by R which result in gross 
receipts to R which would have been foreign trading gross receipts had F 
and not R been the principal on the sale. F will receive commissions 
with respect to such export sales equal to the maximum amount permitted 
to be received under the transfer pricing rules of section 925. The 
maximum commission may be earned by F under these marginal costing 
rules. In this example, R received $950 from the sale of export property 
A. R's cost of goods sold for that property was $620. R incurred direct 
selling expenses of $20. Also, it is assumed that R incurred total 
general and administrative expenses, in addition to those incurred 
relating to its contract to perform on behalf of F the functions and 
activities of section 924 (c), (d) and (e), of $50. R incurred direct 
and indirect expenses of $130 in performing those functions and 
activities on behalf of F. During 1985, R had gross receipts from all 
domestic and foreign sales of $3,500, total cost of goods sold and total 
expenses relating to the domestic and foreign sales of $1,600 and $259, 
respectively. The election provided for in Sec. 1.925(a)-1T(b)(2)(ii) 
was not made by R and F.

 
 
 
  Combined taxable income--full costing:
    R's gross receipts from the sale of the export  .......     $950.00
     property.....................................
    R's cost of goods sold........................  .......     (620.00)
                                                   ---------------------
      Combined gross income.......................  .......      330.00
                                                   ---------------------
    Less:
      R's direct selling expenses.................  .......       20.00
      F's expenses................................  .......      130.00
    Apportionment of R's general and
     administrative expenses:
      R's total G/A expenses......................      $50  ...........

[[Page 105]]

 
      Combined gross income.......................      330  ...........
      R's total gross income......................    1,900  ...........
      Apportionment of G/A expenses $50 x $330/     .......        8.68
       $1,900.....................................
                                                            ------------
        Total.....................................  .......     (158.68)
                                                            ------------
    Combined taxable income (loss)................  .......      171.32
                                                            ============
 


 
 
 
Maximum combined taxable income (determined under paragraph
 (b)(1) of this section):
  R's gross receipts from the sale of the export property..     $950.00
                                                            ------------
  Less:
    R's direct materials...................................      450.00
    R's direct labor.......................................      100.00
                                                            ------------
      Total................................................     (550.00)
                                                            ------------
  Maximum combined taxable income..........................      400.00
                                                            ============
Overall profit percentage limitation calculation
 (determined under paragraph (c)(2) of this section):
  Gross receipts of R from all domestic and foreign sales..    3,500.00
  R's cost of goods sold...................................   (1,600.00)
                                                            ------------
    Combined gross income..................................    1,900.00
                                                            ------------
  Less:
    R's total expenses.....................................      259.00
    F's total expenses.....................................      130.00
                                                            ------------
      Total................................................     (450.00)
                                                            ------------
  Total taxable income from all sales computed on a full       1,511.00
   costing method..........................................
                                                            ============
Overall profit percentage (total taxable income ($1,511)         43.17%
 divided by total gross receipts ($3,500)).................
                                                            ============
Overall profit percentage limitation Overall profit              410.12
 percentage times R's gross receipts from the sale of
 export property (i.e., 43.17% times $950.00)..............
                                                            ============
 


Since the overall profit percentage limitation ($410.12) is greater than 
the maximum combined taxable income ($400), combined taxable income 
under marginal costing and for purposes of computing F's commission is 
limited to $400. Under these marginal costing rules, F will have a 
profit attributable to the sale of $92, i.e., 23% of combined taxable 
income as determined under the marginal costing rules (23% of $400). 
Accordingly, the commission F receives from R is $222, i.e., F's 
expenses ($130) plus F's profit ($92).
    Example 5. Assume the same facts as in Example 4, except that R's 
gross receipts from the sale of export property which would have been 
foreign trading gross receipts had F been the principal on the sale are 
$1,050 and gross receipts from all sales, domestic and foreign, remain 
at $3,500. For purposes of applying the combined taxable income method, 
R and F may compute their combined taxable income attributable to the 
product line of export property under the marginal costing rules as 
follows:

 
 
 
  Combined taxable income--full costing:
  R's gross receipts from the sale of the export property..   $1,050.00
  R's cost of goods sold...................................     (620.00)
                                                            ------------
    Combined gross income..................................      430.00
                                                            ------------
  Less:
    R's direct selling expenses............................       20.00
    F's expenses...........................................      130.00
    Apportionment of R's G/A expenses $50 x $430/$1,900....       11.32
                                                            ------------
      Total................................................     (161.32)
                                                            ------------
  Combined taxable income (loss)...........................      268.68
                                                            ============
 


 
 
 
Maximum combined taxable income (determined under
 paragraph (b)(1) of this section):
  R's gross receipts from the sale of export property...   $1,050.00
                                                         ---------------
Less:
  R's direct materials..................................      450.00
  R's direct labor......................................      100.00
                                                         ---------------
      Total.............................................     (550.00)
                                                         ---------------
  Maximum combined taxable income.......................      500.00
                                                         ===============
  Overall profit percentage (see example 4).............       43.17%
                                                         ===============
  Overall profit percentage limitation (determined under      453.29
   paragraph (c)(2) of this section) (R's gross receipts
   from sale ($1,050.00) times the overall profit
   percentage (43.17%)).................................
                                                         ===============
 


[[Page 106]]


Since maximum combined taxable income ($500) is greater than the overall 
profit percentage limitation ($453.29), combined taxable income under 
marginal costing and for purposes of computing F's commission is limited 
to $453.29. Under these marginal costing rules, F will have a profit 
attributable to the sales of $104.26, i.e., 23% of combined taxable 
income (23% of $453.29). Accordingly, the commission F receives from R 
is $234.26, i.e., F's expenses ($130) plus F's profit ($104.26).
    Example 6. Assume the same facts as in Example 5, except that F has 
expenses of $140 and R's cost of goods sold for the export sale was 
$900. R does not incur any direct selling expenses. Since cost of goods 
sold has increased by $280, R's total gross income has been reduced from 
$1,900 to $1,620. For purposes of applying the combined taxable income 
method, R and F may compute their combined taxable income under the 
marginal costing rules as follows:

 
 
 
Combined taxable income--full costing:
  R's gross receipts from the sale of export property.....   $1,050.00
  R's cost of goods sold..................................     (900.00)
                                                           -------------
    Combined gross income.................................      150.00
                                                           -------------
Less:
  F's expenses............................................      140.00
  Apportionment of R's G/A expenses $50 x $150/$1,620.....        4.63
                                                           -------------
      Total...............................................     (144.63)
                                                           -------------
  Combined taxable income (loss)..........................        5.37
                                                           =============
Maximum combined taxable income (determined under
 paragraph (b)(1) of this section):
  R's gross receipts from the sale of export property.....   $1,050.00
                                                           -------------
Less:
  R's direct materials....................................      630.00
  R's direct labor........................................      200.00
                                                           -------------
      Total...............................................     (830.00)
                                                           -------------
  Maximum combined taxable income.........................      220.00
                                                           =============
 


 
 
 
Overall profit percentage limitation calculation
 (determined under paragraph (c)(2) of this section):
  Gross receipts of R and F from all domestic and foreign    $3,500.00
   sales..................................................
  R's cost of goods sold..................................   (1,880.00)
                                                           -------------
      Combined gross income...............................    1,620.000
                                                           -------------
Less:
  R's total expenses......................................      259.00
  F's total expenses......................................      140.00
                                                           -------------
      Total...............................................     (399.00)
                                                           -------------
  Total taxable income from all sales computed on a full     $1,221.00
   costing method.........................................
                                                           -------------
  Overall profit percentage (total taxable income ($1,221)       34.89%
   divided by total gross receipts ($3,500))..............
                                                           =============
  Overall profit percentage limitation--overall profit         $366.35
   percentage times R's gross receipts from the sale of
   export property (i.e., 34.89% times $1,050)............
                                                           =============
 


Since the overall profit percentage limitation ($366.35) is greater than 
the maximum combined taxable income ($220), combined taxable income 
under marginal costing and for purposes of computing F's commission is 
limited to $220. Under these marginal costing rules, F will have a 
profit attributable to the sale of $50.60, i.e., 23% of combined taxable 
income as determined under the marginal costing rules (23% of $220). If 
the transaction occurred in 1987, F's profit would be limited, however, 
by paragraph (b)(4) of this section to the full costing combined taxable 
income of $5.37.

[T.D. 8126, 52 FR 6455, Mar. 3, 1987, as amended by T.D.8764, 63 FR 
10306, Mar. 3, 1998; T.D. 8944, 66 FR 13429, Mar. 6, 2001]



Sec. 1.926(a)-1  Distributions to shareholders.

    (a) Treatment of distributions. [Reserved] For guidance, see 
Sec. 1.926(a)-1T(a).
    (b) Order of distribution--(1) In general--(i) Distributions by a 
FSC received by a shareholder in a taxable year of the shareholder 
beginning before January 1, 1990. Any actual distribution to a 
shareholder by a FSC (all references to a FSC in this section shall 
include a small FSC and a former FSC) that is received by the 
shareholder in a taxable year of the shareholder beginning before 
January 1, 1990, and made out of earnings and profits shall be treated 
as made in the following order, to the extent thereof--

[[Page 107]]

    (A) Out of earnings and profits attributable to exempt foreign trade 
income determined solely because of operation of section 923(a)(4),
    (B) Out of earnings and profits attributable to other exempt foreign 
trade income,
    (C) Out of earnings and profits attributable to non-exempt foreign 
trade income determined under either of the administrative pricing 
methods of section 925(a)(1) or (2),
    (D) Out of earnings and profits attributable to section 923(a)(2) 
non-exempt income, and
    (E) Out of other earnings and profits.
    (ii) Distributions by a FSC received by a shareholder in a taxable 
year of the shareholder beginning after December 31, 1989. Any actual 
distribution to a shareholder by a FSC that is received by the 
shareholder in a taxable year beginning after December 31, 1989, and 
that is made out of earnings and profits shall be treated as made in the 
following order, to the extent thereof--
    (A) Out of earnings and profits attributable to exempt foreign trade 
income determined solely because of the operation of section 923(a)(4),
    (B) Out of earnings and profits attributable to foreign trade income 
(other than exempt foreign trade income determined solely because of the 
operation of section 923(a)(4)) allocable to the marketing of 
agricultural or horticultural products (or the providing of related 
services) by a qualified cooperative which is a shareholder of the FSC,
    (C) Out of earnings and profits attributable to non-exempt foreign 
trade income and other exempt foreign trade income determined under 
either of the administrative pricing methods of section 925(a)(1) and 
(2). Distributions out of this classification will be made on a pro rata 
basis so that 15/23 (16/23 with regard to distribution to a non-
corporate shareholder) of each distribution will be out of earnings and 
profits attributable to exempt foreign trade income and the remainder 
will be out of earnings and profits attributable to non-exempt foreign 
trade income. To the extent the distributions are out of earnings and 
profits attributable to the disposition of, or services related to, 
military property, 7.5/23 (8/23 with regard to distributions to a non-
corporate shareholder) of each distribution will be out of earnings and 
profits attributable to exempt foreign trade income and the remainder 
will be out of earnings and profits attributable to non-exempt foreign 
trade income,
    (D) Out of earnings and profits attributable to other exempt foreign 
trade income determined under the transfer pricing method of section 
925(a)(3),
    (E) Out of earnings and profits attributable to section 923(a)(2) 
non-exempt income,
    (F) Out of earnings and profits attributable to effectively 
connected income, as defined in section 245(c)(4)(B), and
    (G) Out of other earnings and profits.
    (2) Determination of earnings and profits. [Reserved] For guidance, 
see Sec. 1.926(a)-1T(b)(1).
    (c) Definition of ``former FSC''. [Reserved] For guidance, see 
Sec. 1.926(a)-1T(c).
    (d) Personal holding company income. [Reserved] For guidance, see 
Sec. 1.926(a)-1T(d).
    (e) Sale of stock if section 1248 applies. [Reserved] For guidance, 
see Sec. 1.926(a)-1T(e).

[T.D. 8340, 56 FR 11093, Mar. 15, 1991]



Sec. 1.926(a)-1T  Temporary regulations; distributions to shareholders.

    (a) Treatment of distributions. Any distribution by a FSC (or former 
FSC) to its shareholder with respect to its stock will be includible in 
the shareholder's gross income in accordance with the provisions of 
section 301. (Any further reference to a FSC in this section shall 
include a small FSC unless indicated otherwise.) See section 245(c) for 
treatment of distributions to domestic corporate shareholders of the 
FSC. If earnings and profits of a FSC (or former FSC) attributable to 
foreign trade income are distributed to a shareholder which is a foreign 
person (or a nonresident alien individual), that distribution shall be 
treated as United States source income which is effectively connected 
with the conduct of a trade or business conducted through a permanent 
establishment of such shareholder within the United States. For this 
purpose, distributions to a foreign partnership, foreign trust,

[[Page 108]]

foreign estate or other foreign entities that would be treated as pass-
through entities under U.S. law shall be treated as made directly to the 
partners of beneficiaries in proportion to their respective interest in 
the entity.
    (b) Order of distributions--(1) In general. For guidance, see 
Sec. 1.926(a)-1(b)(1).
    (2) Determination of earnings and profits. For purposes of this 
section, the earnings and profits of a FSC (or former FSC) shall be the 
earnings and profits computed in accordance with the rules, where 
applicable, prescribed in Sec. 1.964-1 (relating to determination of the 
earnings and profits of a foreign corporation) other than subsections 
(d) and (e) of that section.
    (c) Definition of ``former FSC''. Under section 926(c), the term 
``former FSC'' refers to a corporation which is not a FSC for a taxable 
year but which was a FSC for a prior taxable year. However, a 
corporation is not a former FSC for a taxable year unless such 
corporation has, at the beginning of such taxable year, earnings and 
profits attributable to foreign trade income. A corporation which is a 
former FSC for a taxable year is a former FSC for all purposes of the 
Code.
    (d) Personal holding company income--(1) Treatment of dividends. Any 
amount includible in a shareholder's gross income as a dividend with 
respect to the stock of a FSC (or former FSC) under paragraph (a) of 
this section shall be treated as a dividend for all purposes of the 
Code, except that that part of the dividend attributable to foreign 
trade income, other than an amount attributable to section 923(a)(2) 
non-exempt income, shall not be considered in applying the personal 
holding company and foreign personal holding company provisions 
(sections 541 through 547 and 551 through 558, respectively).
    (2) Look through option. With regard to distributions from a FSC (or 
former FSC) which are not treated as personal holding company income 
under paragraph (d)(1) of this section, the shareholder may, however, 
treat any amount of that distribution as an item of income described 
under section 543 (or section 553) (for example, rents) if it 
establishes to the satisfaction of the Commissioner that such amount is 
attributable to earnings and profits of the FSC derived from such item 
of income. For example, distributions from a FSC relating to section 
923(a)(2) non-exempt income will be treated as dividends for purposes of 
the personal holding company provisions of sections 541 through 547 
unless the look through option is elected. Under this option, if 
earnings and profits out of which those distributions are made are 
attributable to the lease of export property, the FSC shareholder may 
treat the distribution for purposes of the personal holding company 
provisions as rents rather than as dividends. This may be beneficial to 
the shareholder because rents are not considered under section 543(a)(2) 
as personal holding company income, if in general, rents constitute 50% 
or more of the shareholder's adjusted ordinary gross income.
    (e) Sale of stock if section 1248 applies. For purposes of section 
1248, the earnings and profits of a FSC (or former FSC) shall not 
include earnings and profits attributable to foreign trade income.

[T.D. 8126, 52 FR 6458, Mar. 3, 1987, as amended by T.D. 8340, 56 FR 
11093, Mar. 15, 1991]



Sec. 1.927(a)-1T  Temporary regulations; definition of export property.

    (a) General rule. Under section 927 (a), except as otherwise 
provided with respect to excluded property in paragraphs (f), (g) and 
(h) of this section and with respect to certain short supply property in 
paragraph (i) of this section, export property is property in the hands 
of any person (whether or not a FSC) (any further reference to a FSC in 
this section shall include a small FSC unless indicated otherwise)--
    (1) U.S. manufactured, produced, grown or extracted. Manufactured, 
produced, grown, or extracted in the United States by any person or 
persons other than a FSC (see paragraph (c) of this section),
    (2) Foreign use, consumption or disposition. Held primarily for 
sale, lease or rental in the ordinary course of a trade or business by a 
FSC to a FSC or to any other person for direct use, consumption, or 
disposition outside the United States (see paragraph (d) of this 
section),

[[Page 109]]

    (3) Foreign content. Not more than 50 percent of the fair market 
value of which is attributable to articles imported into the United 
States (see paragraph (e) of this section), and
    (4) Non-related FSC purchaser or user. Which is not sold, leased or 
rented by a FSC, or with a FSC as commission agent, to another FSC which 
is a member of the same controlled group (as defined in section 
927(d)(4) and Sec. 1.924(a)-1T(h)) as the FSC.
    (b) Services. For purposes of this section, services (including the 
written communication of services in any form) are not export property. 
Whether an item is property or services shall be determined on the basis 
of the facts and circumstances attending the development and disposition 
of the item. Thus, for example, the preparation of a map of a particular 
construction site would constitute services and not export property, but 
standard maps prepared for sale to customers generally would not 
constitute services and would be export property if the requirements of 
this section were otherwise met.
    (c) Manufacture, production, growth, or extraction of property--(1) 
By a person other than a FSC. Export property may be manufactured, 
produced, grown, or extracted in the United States by any person, 
provided that that person does not qualify as a FSC. Property held by a 
FSC which was manufactured, produced, grown or extracted by it at a time 
when it did not qualify as a FSC is not export property of the FSC. 
Property which sustains further manufacture, production or processing 
outside the United States prior to sale or lease by a person but after 
manufacture, production, processing or extraction in the United States 
will be considered as manufactured, produced, grown or extracted in the 
United States by that person only if the property is reimported into the 
United States for further manufacturing, production or processing prior 
to final export sale. In order to be considered export property, the 
property manufactured, produced, grown or extracted in the United States 
must satisfy all of the provisions of section 927(a) and this section.
    (2) Manufactured, produced or processed. For purposes of this 
section, property which is sold or leased by a person is considered to 
be manufactured, produced or processed by that person or by another 
person pursuant to a contract with that person if the property is 
manufactured or produced, as defined in Sec. 1.954-3(a)(4). For purposes 
of this section, however, in determining if the 20% conversion test of 
Sec. 1.954-3(a)(4)(iii) has been met, conversion costs include assembly 
and packaging costs but do not include the value of parts provided 
pursuant to a services contract as described in Sec. 1.924(a)-1T(d)(3). 
In addition, for purposes of this section, the 20% conversion test is 
extended and applied to the export property's adjusted basis rather than 
to its cost of goods sold if it is leased or held for lease.
    (d) Foreign use, consumption or disposition--(1) In general. (i) 
Under paragraph (a)(2) of this section, export property must be held 
primarily for the purpose of sale, lease or rental in the ordinary 
course of a trade or business, by a FSC to a FSC or to any other person, 
and the sale or lease must be for direct use, consumption, or 
disposition outside the United States. Thus, property cannot qualify as 
export property unless it is sold or leased for direct use, consumption, 
or disposition outside the United States. Property is sold or leased for 
direct use, consumption, or disposition outside the United States if the 
sale or lease satisfies the destination test described in subdivision 
(2) of this paragraph, the proof of compliance requirements described in 
subdivision (3) of this paragraph, and the use outside the United States 
test described in subdivision (4) of this paragraph.
    (ii) Factors not taken into account. In determining whether property 
which is sold or leased to a FSC is sold or leased for direct use, 
consumption, or disposition outside the United States, the fact that the 
acquiring FSC holds the property in inventory or for lease prior to the 
time it sells or leases it for direct use, consumption, or disposition 
outside the United States will not affect the characterization of the 
property as export property. Fungible export property must be physically 
segregated from non-export property at all times

[[Page 110]]

after purchase by or rental by a FSC or after the start of the 
commission relationship between the FSC and related supplier with regard 
to the export property. Non-fungible export property need not be 
physically segregated from non-export property.
    (2) Destination test. (i) For purposes of paragraph (d)(1) of this 
section, the destination test of this paragraph is satisfied with 
respect to property sold or leased by a seller or lessor only if it is 
delivered by the seller or lessor (or an agent of the seller or lessor) 
regardless of the F.O.B. point or the place at which title passes or 
risk of loss shifts from the seller or lessor--
    (A) Within the United States to a carrier or freight forwarder for 
ultimate delivery outside the United States to a purchaser or lessee (or 
to a subsequent purchaser or sublessee),
    (B) Within the United States to a purchaser or lessee, if the 
property is ultimately delivered outside the United States (including 
delivery to a carrier or freight forwarder for delivery outside the 
United States) by the purchaser or lessee (or a subsequent purchaser or 
sublessee) within 1 year after the sale or lease,
    (C) Within or outside the United States to a purchaser or lessee 
which, at the time of the sale or lease, is a FSC or an interest charge 
DISC and is not a member of the same controlled group as the seller or 
lessor,
    (D) From the United States to the purchaser or lessee (or a 
subsequent purchaser or sublessee) at a point outside the United States 
by means of the seller's or lessor's own ship, aircraft, or other 
delivery vehicle, owned, leased, or chartered by the seller or lessor,
    (E) Outside the United States to a purchaser or lessee from a 
warehouse, storage facility, or assembly site located outside the United 
States, if the property was previously shipped by the seller or lessor 
from the United States, or
    (F) Outside the United States to a purchaser or lessee if the 
property was previously shipped by the seller or lessor from the United 
States and if the property is located outside the United States pursuant 
to a prior lease by the seller or lessor, and either (1) the prior lease 
terminated at the expiration of its term (or by the action of the prior 
lessee acting alone), (2) the sale occurred or the term of the 
subsequent lease began after the time at which the term of the prior 
lease would have expired, or (3) the lessee under the subsequent lease 
is not a related person with respect to the lessor and the prior lease 
was terminated by the action of the lessor (acting alone or together 
with the lessee).
    (ii) For purposes of this paragraph (d)(2) (other than paragraphs 
(d)(2)(i)(C) and (F)(3)), any relationship between the seller or lessor 
and any purchaser, subsequent purchaser, lessee, or sublessee is 
immaterial.
    (iii) In no event is the destination test of this paragraph (d)(2) 
satisfied with respect to property which is subject to any use (other 
than a resale or sublease), manufacture, assembly, or other processing 
(other than packaging) by any person between the time of the sale or 
lease by such seller or lessor and the delivery or ultimate delivery 
outside the United States described in this paragraph (d)(2).
    (iv) If property is located outside the United States at the time it 
is purchased by a person or leased by a person as lessee, such property 
may be export property in the hands of such purchaser or lessee only if 
it is imported into the United States prior to its further sale or lease 
(including a sublease) outside the United States. Paragraphs (a)(3) and 
(e) of this section (relating to the 50 percent foreign content test) 
are applicable in determining whether such property is export property. 
Thus, for example, if such property is not subjected to manufacturing or 
production (as defined in paragraph (c) of this section) within the 
United States after such importation, it does not qualify as export 
property.
    (3) Proof of compliance with destination test--(i) Delivery outside 
the United States. For purposes of paragraph (d)(2) of this section 
(other than subdivision (i)(C) thereof), a seller or lessor shall 
establish ultimate delivery, use, or consumption of property outside the 
United States by providing--
    (A) A facsimile or carbon copy of the export bill of lading issued 
by the carrier who delivers the property,

[[Page 111]]

    (B) A certificate of an agent or representative of the carrier 
disclosing delivery of the property outside the United States,
    (C) A facsimile or carbon copy of the certificate of lading for the 
property executed by a customs officer of the country to which the 
property is delivered,
    (D) If that country has no customs administration, a written 
statement by the person to whom delivery outside the United States was 
made,
    (E) A facsimile or carbon copy of the Shipper's Export Declaration, 
a monthly shipper's summary declaration filed with the Bureau of 
Customs, or a magnetic tape filed in lieu of the Shipper's Export 
Declaration, covering the property, or
    (F) Any other proof (including evidence as to the nature of the 
property or the nature of the property or the nature of the transaction) 
which establishes to the satisfaction of the Commissioner that the 
property was ultimately delivered, or directly sold, or directly 
consumed outside the United States within 1 year after the sale or 
lease.
    (ii) The requirements of subdivision (i)(A), (B), (C), or (E) of 
this paragraph will be considered satisfied even though the name of the 
ultimate consignee and the price paid for the goods is marked out 
provided that, in the case of a Shipper's Export Declaration or other 
document listed in subdivision (i)(E) of this paragraph or a document 
such as an export bill of lading, such document still indicates the 
country in which delivery to the ultimate consignee is to be made and, 
in the case of a certificate of an agent or representative of the 
carrier, that the document indicates that the property was delivered 
outside the United States.
    (iii) A seller or lessor shall also establish the meeting of the 
requirement of paragraph (d)(2)(i) of this section (other than 
subdivision (i)(C) thereof), that the property was delivered outside the 
United States without further use, manufacture, assembly, or other 
processing within the United States.
    (iv) For purposes of paragraph (d)(2)(i)(C) of this section, a 
purchaser or lessee of property is deemed to qualify as a FSC or an 
interest charge DISC for its taxable year if the seller or lessor 
obtains from the purchaser or lessee a copy of the purchaser's or 
lessee's election to be treated as a FSC or interest charge DISC 
together with the purchaser's or lessee's sworn statement that the 
election has been timely filed with the Internal Revenue Service Center. 
The copy of the election and the sworn statement of the purchaser or 
lessee must be received by the seller or lessor within 6 months after 
the sale or lease. A purchaser or lessee is not treated as a FSC or 
interest charge DISC with respect to a sale or lease during a taxable 
year for which the purchaser or lessee does not qualify as a FSC or 
interest charge DISC if the seller or lessor does not believe or if a 
reasonable person would not believe at the time the sale or lease is 
made that the purchaser or lessee will qualify as a FSC or interest 
charge DISC for the taxable year.
    (v) If a seller or lessor fails to provide proof of compliance with 
the destination test as required by this paragraph (d)(3), the property 
sold or leased is not export property.
    (4) Sales and leases of property for ultimate use in the United 
States--(i) In general. For purposes of paragraph (d)(1) of this 
section, the use test in this paragraph (d)(4) is satisfied with respect 
to property which--
    (A) Under subdivision (4)(ii) through (iv) of this paragraph is not 
sold for ultimate use in the United States, or
    (B) Under subdivision (4)(v) of this paragraph is leased for 
ultimate use outside the United States.
    (ii) Sales of property for ultimate use in the United States. For 
purposes of subdivision (4)(i) of this paragraph, a purchaser of 
property (including components, as defined in subdivision (4)(vii) of 
this paragraph) is deemed to use the property ultimately in the United 
States if any of the following conditions exist:
    (A) The purchaser is a related party with respect to the seller and 
the purchaser ultimately uses the property, or a second product into 
which the property is incorporated as a component, in the United States.
    (B) At the time of the sale, there is an agreement or understanding 
that the property, or a second product into

[[Page 112]]

which the property is incorporated as a component, will be ultimately 
used by the purchaser in the United States.
    (C) At the time of the sale, a reasonable person would have believed 
that the property or the second product would be ultimately used by the 
purchaser in the United States unless, in the case of a sale of 
components, the fair market value of the components at the time of 
delivery to the purchaser constitutes less than 20 percent of the fair 
market value of the second product into which the components are 
incorporated (determined at the time of completion of the production, 
manufacture, or assembly of the second product).

For purposes of subdivision (4)(ii)(B) of this paragraph, there is an 
agreement or understanding that property will ultimately be used in the 
United States if, for example, a component is sold abroad under an 
express agreement with the foreign purchaser that the component is to be 
incorporated into a product to be sold back to the United States. As a 
further example, there would also be such an agreement or understanding 
if the foreign purchaser indicated at the time of the sale or previously 
that the component is to be incorporated into a product which is 
designed principally for the United States market. However, such an 
agreement or understanding does not result from the mere fact that a 
second product, into which components exported from the United States 
have been incorporated and which is sold on the world market, is sold in 
substantial quantities in the United States.
    (iii) Use in the United States. For purposes of subdivision (4)(ii) 
of this paragraph, property (including components incorporated into a 
second product) is or would be ultimately used in the United States by 
the purchaser if, at any time within 3 years after the purchase of such 
property or components, either the property is or the components (or the 
second product into which the components are incorporated) are resold by 
the purchaser for use by a subsequent purchaser within the United States 
or the purchaser or subsequent purchaser fails, for any period of 365 
consecutive days, to use the property or second product predominantly 
outside the United States (as defined in subdivision (4)(vi) of this 
paragraph).
    (iv) Sales to retailers. For purposes of subdivision (4)(ii)(C) of 
this paragraph, property sold to any person whose principal business 
consists of selling from inventory to retail customers at retail outlets 
outside the United States will be considered to be used predominantly 
outside the United States.
    (v) Leases of property for ultimate use outside the United States. 
For purposes of subdivision (4)(i) of this paragraph, a lessee of 
property is deemed to use property ultimately outside the United States 
during a taxable year of the lessor if the property is used 
predominantly outside the United States (as defined in subdivision 
(4)(vi) of this paragraph) by the lessee during the portion of the 
lessor's taxable year which is included within the term of the lease. A 
determination as to whether the ultimate use of leased property 
satisfies the requirements of this subdivision is made for each taxable 
year of the lessor. Thus, leased property may be used predominantly 
outside the United States for a taxable year of the lessor (and thus, 
constitute export property if the remaining requirements of this section 
are met) even if the property is not used predominantly outside the 
United States in earlier taxable years or later taxable years of the 
lessor.
    (vi) Predominant use outside the United States. For purposes of this 
paragraph (d)(4), property is used predominantly outside the United 
States for any period if, during that period, the property is located 
outside the United States more than 50 percent of the time. An aircraft, 
railroad rolling stock, vessel, motor vehicle, container, or other 
property used for transportation purposes is deemed to be used 
predominantly outside the United States for any period if, during that 
period, either the property is located outside the United States more 
than 50 percent of the time or more than 50 percent of the miles 
traversed in the use of the property are traversed outside the United 
States. However, property is deemed to be within the United States at 
all times during which it is engaged in

[[Page 113]]

transport between any two points within the United States, except where 
the transport constitutes uninterrupted international air transportation 
within the meaning of section 4262(c)(3) and the regulations under that 
section (relating to tax on air transportation of persons). An orbiting 
satellite is deemed to be located outside the United States. For 
purposes of applying section 4262(c)(3) to this subdivision, the term 
``United States'' includes the Commonwealth of Puerto Rico.
    (vii) Component. For purposes of this paragraph (d)(4), a component 
is property which is (or is reasonably expected to be) incorporated into 
a second product by the purchaser of such component by means of 
production, manufacture, or assembly.
    (e) Foreign content of property--(1) The 50 percent test. Under 
paragraph (a)(3) of this section, no more than 50 percent of the fair 
market value of export property may be attributable to the fair market 
value of articles which were imported into the United States. For 
purposes of this paragraph (e), articles imported into the United States 
are referred to as ``foreign content.'' The fair market value of the 
foreign content of export property is computed in accordance with 
paragraph (e)(4) of this section. The fair market value of export 
property which is sold to a person who is not a related person with 
respect to the seller is the sale price for such property (not including 
interest, finance or carrying charges, or similar charges.)
    (2) Application of 50 percent test. The 50 percent test is applied 
on an item-by-item basis. If, however, a person sells or leases a large 
volume of substantially identical export property in a taxable year and 
if all of that property contains substantially identical foreign content 
in substantially the same proportion, the person may determine the 
portion of foreign content contained in that property on an aggregate 
basis.
    (3) Parts and services. If, at the time property is sold or leased 
the seller or lessor agrees to furnish parts pursuant to a services 
contract (as provided in Sec. 1.924(a)-1T(d)(3)) and the price for the 
parts is not separately stated, the 50 percent test is applied on an 
aggregate basis to the property and parts. If the price for the parts is 
separately stated, the 50 percent test is applied separately to the 
property and to the parts.
    (4) Computation of foreign content--(i) Valuation. For purposes of 
applying the 50 percent test, it is necessary to determine the fair 
market value of all articles which constitutes foreign content of the 
property being tested to determine if it is export property. The fair 
market value of the imported articles is determined as of the time the 
articles are imported into the United States.
    (A) General rule. Except as provided in paragraph (e)(4)(i)(B), the 
fair market value of the imported articles which constitutes foreign 
content is their appraised value, as determined under section 403 of the 
Tariff Act of 1930 (19 U.S.C. 1401a) in connection with their 
importation. The appraised value of the articles is the full dutiable 
value of the articles, determined, however, without regard to any 
special provision in the United States tariff laws which would result in 
a lower dutiable value.
    (B) Special election. If all or a portion of the imported article 
was originally manufactured, produced, grown, or extracted in the United 
States, the taxpayer may elect to determine the fair market value of the 
imported articles which constitutes foreign content under the provisions 
of this paragraph (e)(4)(i)(B) if the property is subjected to 
manufacturing or production (as defined in paragraph (c) of this 
section) within the United States after importation. A taxpayer making 
the election under this paragraph may determine the fair market value of 
the imported articles which constitutes foreign content to be the fair 
market value of the imported articles reduced by the fair market value 
at the time of the initial export of the portion of the property that 
was manufactured, produced, grown, or extracted in the United States. 
The taxpayer must establish the fair market value of the imported 
articles and of the portion of the property manufactured, produced, 
grown, or extracted in the United States at the time of the initial 
export in accordance with subdivision (4)(ii)(B) of this paragraph.

[[Page 114]]

    (ii) Evidence of fair market value-- (A) General rule. For purposes 
of subdivision (4)(i)(A) of this paragraph, the fair market value of the 
imported articles is their appraised value, which may be evidenced by 
the customs invoice issued on the importation of such articles into the 
United States. If the holder of the articles is not the importer (or a 
related person with respect to the importer), the appraised value of the 
articles may be evidenced by a certificate based upon information 
contained in the customs invoice and furnished to the holder by the 
person from whom the articles (or property incorporating the articles) 
were purchased. If a customs invoice or certificate described in the 
preceding sentences is not available to a person purchasing property, 
the person shall establish that no more than 50 percent of the fair 
market value of such property is attributable to the fair market value 
of articles which were imported into the United States.
    (B) Special election. For purposes of the special election set forth 
in subdivision (4)(i)(B) of this paragraph, if the initial export is 
made to a controlled person within the meaning of section 482, the fair 
market value of the imported articles and of the portion of the articles 
that are manufactured, produced, grown, or extracted within the United 
States shall be established by the taxpayer in accordance with the rules 
under section 482 and the regulations under that section. If the initial 
export is not made to a controlled person, the fair market value must be 
established by the taxpayer under the facts and circumstances.
    (iii) Interchangeable component articles. (A) If identical or 
similar component articles can be incorporated interchangeably into 
property and a person acquires component articles that are imported into 
the United States and other component articles that are not imported 
into the United States, the determination whether imported component 
articles were incorporated in the property that is exported from the 
United States shall be made on a substitution basis as in the case of 
the rules relating to drawback accounts under the customs laws. See 
section 313(b) of the Tariff Act of 1930, as amended (19 U.S.C. 
1313(b)).
    (B) The provisions of subdivision (4)(iii)(A) of this paragraph may 
be illustrated by the following example:

    Example. Assume that a manufacturer produces a total of 20,000 
electronic devices. The manufacturer exports 5,000 of the devices and 
subsequently sells 11,000 of the devices to a FSC which exports the 
11,000 devices. The major single component article in each device is a 
tube which represents 60 percent of the fair market value of the device 
at the time the device is sold by the manufacturer. The manufacturer 
imports 8,000 of the tubes and produces the remaining 12,000 tubes. For 
purposes of this subdivision, in accordance with the substitution 
principle used in the customs drawback laws, the 5,000 devices exported 
by the manufacturer are each treated as containing an imported tube 
because the devices were exported prior to the sale to the FSC. The 
remaining 3,000 imported tubes are treated as being contained in the 
first 3,000 devices purchased and exported by the FSC. Thus, since the 
50 percent test is not met with respect to the first 3,000 devices 
purchased and exported by the FSC, those devices are not export 
property. The remaining 8,000 devices purchased and exported by the FSC 
are treated as containing tubes produced in the United States, and those 
devices are export property (if they otherwise meet the requirements of 
this section).

    (f) Excluded property--(1) In general. Notwithstanding any other 
provision of this section, the following property is not export 
property--
    (i) Property described in subdivision (2) of this paragraph 
(relating to property leased to a member of controlled group),
    (ii) Property described in subdivision (3) of this paragraph 
(relating to certain types of intangible property),
    (iii) Products described in paragraph (g) of this section (relating 
to oil and gas products), and
    (iv) Products described in paragraph (h) of this section (relating 
to certain export controlled products).
    (2) Property leased to member of controlled group--(i) In general. 
Property leased to a person (whether or not a FSC) which is a member of 
the same controlled group as the lessor constitutes export property for 
any period of time only if during the period--
    (A) The property is held for sublease, or is subleased, by the 
person to a third person for the ultimate use of the third person;

[[Page 115]]

    (B) The third person is not a member of the same controlled group; 
and
    (C) The property is used predominantly outside the United States by 
the third person.
    (ii) Predominant use. The provisions of paragraph (d)(4)(vi) of this 
section apply in determining under subdivision (2)(i)(C) of this 
paragraph whether the property is used predominantly outside the United 
States by the third person.
    (iii) Leasing rule. For purposes of this paragraph (f)(2), leased 
property is deemed to be ultimately used by a member of the same 
controlled group as the lessor if such property is leased to a person 
which is not a member of the controlled group but which subleases the 
property to a person which is a member of the controlled group. Thus, 
for example, if X, a FSC for the taxable year, leases a movie film to Y, 
a foreign corporation which is not a member of the same controlled group 
as X, and Y then subleases the film to persons which are members of the 
controlled group for showing to the general public, the film is not 
export property. On the other hand, if X, a FSC for the taxable year, 
leases a movie film to Z, a foreign corporation which is a member of the 
same controlled group as X, and Z then subleases the film to Y, another 
foreign corporation, which is not a member of the same controlled group 
for showing to the general public, the film is not disqualified from 
being export property.
    (iv) Certain copyrights. With respect to a copyright which is not 
excluded by subdivision (3) of this paragraph from being export 
property, the ultimate use of the property is the sale or exhibition of 
the property to the general public. Thus, if A, a FSC for the taxable 
year, leases recording tapes to B, a foreign corporation which is a 
member of the same controlled group as A, and if B makes records from 
the recording tape and sells the records to C, another foreign 
corporation, which is not a member of the same controlled group, for 
sale by C to the general public, the recording tape is not disqualified 
under this paragraph from being export property, notwithstanding the 
leasing of the recording tape by A to a member of the same controlled 
group, since the ultimate use of the tape is the sale of the records 
(i.e., property produced from the recording tape).
    (3) Intangible property. Export property does not include any 
patent, invention, model, design, formula, or process, whether or not 
patented, or any copyright (other than films, tapes, records, or similar 
reproductions, for commercial or home use), goodwill, trademark, 
tradebrand, franchise, or other like property. Although a copyright such 
as a copyright on a book or computer software does not constitute export 
property, a copyrighted article (such as a book or standardized, mass 
marketed computer software) if not accompanied by a right to reproduce 
for external use is export property if the requirements of this section 
are otherwise satisfied. Computer software referred to in the preceding 
sentence may be on any medium, including, but not limited to, magnetic 
tape, punched cards, disks, semi-conductor chips and circuit boards. A 
license of a master recording tape for reproduction outside the United 
States is not disqualified under this paragraph from being export 
property.
    (g) Oil and gas--(1) In general. Under section 927(a)(2)(C), export 
property does not include oil or gas (or any primary product thereof).
    (2) Primary product from oil or gas. A primary product from oil or 
gas is not export property. For purposes of this paragraph--
    (i) Primary product from oil. The term ``primary product from oil'' 
means crude oil and all products derived from the destructive 
distillation of crude oil, including--
    (A) Volatile products,
    (B) Light oils such as motor fuel and kerosene,
    (C) Distillates such as naphtha,
    (D) Lubricating oils,
    (E) Greases and waxes, and
    (F) Residues such as fuel oil.

For purposes of this paragraph, a product or commodity derived from 
shale oil which would be a primary product from oil if derived from 
crude oil is considered a primary product from oil.
    (ii) Primary product from gas. The term ``primary product from gas'' 
means all gas and associated hydrocarbon components from gas wells or 
oil wells, whether recovered at the

[[Page 116]]

lease or upon further processing, including--
    (A) Natural gas,
    (B) Condensates,
    (C) Liquefied petroleum gases such as ethane, propane, and butane, 
and
    (D) Liquid products such as natural gasoline.
    (iii) Primary products and changing technology. The primary products 
from oil or gas described in subdivisions (2)(i) and (ii) of this 
paragraph and the processes described in those subdivisions are not 
intended to represent either the only primary products from oil or gas, 
or the only processes from which primary products may be derived under 
existing and future technologies. For example, petroleum coke, although 
not derived from the destructive distillation of crude oil, is a primary 
product from oil derived from an existing technology.
    (iv) Non-primary products. For purposes of this paragraph, 
petrochemicals, medicinal products, insecticides and alcohols are not 
considered primary products from oil or gas.
    (h) Export controlled products--(1) In general. Section 927(a)(2)(D) 
provides that an export controlled product is not export property. A 
product or commodity may be an export controlled product at one time but 
not an export controlled product at another time. For purposes of this 
paragraph, a product or commodity is an ``export controlled product'' at 
a particular time if at that time the export of such product or 
commodity is prohibited or curtailed under section 7(a) of the Export 
Administration Act of 1979, to effectuate the policy relating to the 
protection of the domestic economy set forth in paragraph (2)(C) of 
section 3 of the Export Administration Act of 1979. That policy is to 
use export controls to the extent necessary to protect the domestic 
economy from the excessive drain of scarce materials and to reduce the 
serious inflationary impact of foreign demand.
    (2) Products considered export controlled products--(i) In general. 
For purposes of this paragraph, an export controlled product is a 
product or commodity, which is subject to short supply export controls 
under 15 CFR part 377. A product or commodity is considered an export 
controlled product for the duration of each control period which applies 
to such product or commodity. A control period of a product or commodity 
begins on and includes the initial control date (as defined in 
subdivision (2)(ii) of this paragraph) and ends on and includes the 
final control date (as defined in subdivision (2)(iii) of this 
paragraph).
    (ii) Initial control date. The initial control date of a product or 
commodity which is subject to short supply export controls is the 
effective date stated in the regulations to 15 CFR part 377 which 
subjects the product or commodity to short supply export controls. If 
there is no effective date stated in these regulations, the initial 
control date of the product or commodity will be thirty days after the 
effective date of the regulations which subject the product or commodity 
to short supply export controls.
    (iii) Final control date. The final control date of a product or 
commodity is the effective date stated in the regulations to 15 CFR part 
377 which removes the product or commodity from short supply export 
controls. If there is no effective date stated in those regulations, the 
final control date of the product or commodity is the date which is 
thirty days after the effective date of the regulations which remove the 
product or commodity from short supply export control.
    (iv) Expiration of Export Administration Act. An initial control 
date and final control date cannot occur after the expiration date of 
the Export Administration Act under the authority of which the short 
supply export controls were issued.
    (3) Effective dates--(i) Products controlled on January 1, 1985. If 
a product or commodity was subject to short supply export controls on 
January 1, 1985, this paragraph shall apply to all sales, exchanges, 
other dispositions, or leases of the product or commodity made after 
January 1, 1985, by the FSC or by the FSC's related supplier if the FSC 
is the commission agent on the transaction.
    (ii) Products first controlled after January 1, 1985. If a product 
or commodity becomes subject to short supply export controls after 
January 1, 1985, this paragraph applies to sales, exchanges,

[[Page 117]]

other dispositions, or leases of such product or commodity made on or 
after the initial control date of such product or commodity, and to 
owning such product or commodity on or after such date.
    (iii) Date of sales, exchange, lease, or other disposition. For 
purposes of this paragraph (h)(3), the date of sale, exchange, or other 
disposition of a product or commodity is the date as of which title to 
such product or commodity passes. The date of a lease is the date as of 
which the lessee takes possession of a product or commodity. The 
accounting method of a person is not determinative of the date of sale, 
exchange, other disposition, or lease.
    (i) Property in short supply. If the President determines that the 
supply of any property which is otherwise export property as defined in 
this section is insufficient to meet the requirements of the domestic 
economy, he may by Executive Order designate such property as in short 
supply. Any property so designated will be treated under section 
927(a)(3) as property which is not export property during the period 
beginning with the date specified in such Executive Order and ending 
with the date specified in an Executive Order setting forth the 
President's determination that such property is no longer in short 
supply.

[T.D. 8126, 52 FR 6459, Mar. 3, 1987]



Sec. 1.927(b)-1T  Temporary regulations; Definition of gross receipts.

    (a) General rule. Under section 927(b), for purposes of sections 921 
through 927, the gross receipts of a person for a taxable year are--
    (1) Business income. The total amounts received or accrued by the 
person from the sale or lease of property held primarily for sale or 
lease in the ordinary course of a trade or business, and
    (2) Other income. Gross income recognized from whatever source 
derived, such as, for example, from--
    (i) The furnishing of services (whether or not related to the sale 
or lease of property described in subdivision (1) of this paragraph),
    (ii) Dividends and interest (including tax exempt interest),
    (iii) The sale at a gain of any property not described in 
subdivision (1) of this paragraph, and
    (iv) Commission transactions to the extent described in paragraph 
(e) of this section.
    (b) Non-gross receipts items. For purposes of paragraph (a) of this 
section, gross receipts do not include amounts received or accrued by a 
person from--
    (1) Loan transactions. The proceeds of a loan or of the repayment of 
a loan, or
    (2) Non-taxable transactions. A receipt of property in a transaction 
to which section 118 (relating to contribution to capital) or section 
1032 (relating to exchange of stock for property) applies.
    (c) Non-reduction of total amounts. For purposes of paragraph (a) of 
this section, the total amounts received or accrued by a person are not 
reduced by costs of goods sold, expenses, losses, a deduction for 
dividends received, or any other deductible amounts. The total amounts 
received or accrued by a person are reduced by returns and allowances.
    (d) Method of accounting. For purposes of paragraph (a) of this 
section, the total amounts received or accrued by a person shall be 
determined under the method of accounting used in computing its taxable 
income. If, for example, a FSC receives advance or installment payments 
for the sale or lease of property described in paragraph (a)(1) of this 
section, for the furnishing of services, or which represent recognized 
gain from the sale of property not described in paragraph (a)(1) of this 
section, any amount of such advance payments is considered to be gross 
receipts of the FSC for the taxable year for which such amount is 
included in the gross income of the FSC.
    (e) Commission transactions--(1) In general--(i) With a related 
supplier. In the case of transactions which give rise to a commission 
from the FSC's related supplier on the sale or lease of property or the 
furnishing of services by a principal, the FSC's gross income from all 
such transactions is the commission paid or payable to the FSC by the 
related supplier. The FSC's gross receipts for purposes of computing its 
profit under the administrative pricing methods of section 925(a)(1) and 
(2) shall be the gross receipts (other than

[[Page 118]]

gross receipts which would not be foreign trading gross receipts had 
they been received by the FSC) derived by the related supplier from the 
sale or lease of the property or from the furnishing of services, with 
respect to which the commissions are derived. Also, in determining 
whether the 50% test in section 924(a) has been met, the relevant gross 
receipts are the gross receipts of the related supplier.
    (ii) With an unrelated principal. In the case of transactions which 
give rise to a commission from an unrelated principal to a FSC on the 
sale or lease of property or the furnishing of services by a principal, 
the amount recognized by the FSC as gross income from all such 
transactions shall be the commission received from the principal.
    (2) Selective commission arrangements--(i) In general. A commission 
arrangement between the FSC and its related supplier may provide that 
the FSC will not be the related supplier's commission agent with respect 
to sales or leases of export property, or the furnishing of services, 
which do not result in foreign trading gross receipts. In addition, the 
commission agreement may provide that the FSC will not be the related 
supplier's commission agent on transactions which would result in a loss 
to the related supplier under the transfer pricing rules of section 
925(a). In a buy-sell FSC situation, selective commission arrangements 
are not applicable. Determination of which transactions fall within the 
selective commission arrangement may be made up to the due date under 
section 6072(b), including extensions provided for under section 6081, 
of the FSC's income tax return for the taxable year of the FSC during 
which a transaction occurs.
    (ii) Example. The treatment of a selective commission arrangement 
may be illustrated by the following example:

    Example. A calendar year commission FSC (``F'') entered into a 
selective commission arrangement with related supplier RS which provided 
that F will not be RS's commission agent on transactions which would 
result in a loss to RS under the transfer pricing rules of section 
925(a). During 1987, RS sold three different articles of export property 
A, B and C, all of which fall within the same three digit Standard 
Industrial Classification. In July of 1988, while preparing the FSC's 
1987 income tax return, RS determined that the sale of export property A 
resulted in a loss to RS under the section 482 method of section 
925(a)(3) and that applying that method to the sales of export property 
B and C resulted in only a small amount of income to both RS and F. In 
addition, RS determined that grouping export property B and C, while 
excluding export property A from the grouping, resulted in the highest 
profit to F under the combined taxable income administrative pricing 
method of section 925(a)(2). Using the same grouping, the gross receipts 
method of section 925(a)(1) would result in a lower profit to F. Under 
the special no-loss rule of Sec. 1.925(a)-1T(e)(1)(iii), RS would be 
prohibited from using the combined taxable income administrative pricing 
method to determine F's profit for the grouping of export property B and 
C if it used the section 482 method on the sale of export property A. 
This results because there was a loss to RS on the sale of export 
property A. Under the selective commission arrangement, RS could 
exercise its option and exclude the sale of export property A. Since F 
is no longer deemed to have been operating as RS's commission agent on 
that sale, the combined taxable income method may be used to compute F's 
profit on the grouping of the sales of export property B and C.

    (f) Example. The definition of gross receipts under this section may 
be illustrated by the following example:

    Example. During 1985, M, a related supplier of N, is engaged in the 
manufacture of machines in the United States. N, a calendar year FSC, is 
engaged in the sale and lease of such machines in foreign countries. N 
furnishes services which are related and subsidiary to its sale and 
lease of those machines. N also acts as a commission agent in foreign 
countries for Z, an unrelated supplier, with respect to Z's sale of 
products. N receives dividends on stock owned by it, interest on loans, 
and proceeds from sales of business assets located outside the United 
States resulting in recognized gains and losses. N's gross receipts for 
1985 are $3,550, computed on the basis of the additional facts assumed 
in the table below:

 
 
 
N's sales receipts for machines manufactured by M (without        $1,500
 reduction for cost of goods sold and selling expenses).......
N's lease receipts for machines manufactured by M (without           500
 reduction for depreciation and leasing expenses).............
N's gross income from related and subsidiary services for            400
 machines manufactured by M (without reduction for service
 expenses)....................................................

[[Page 119]]

 
N's sales receipts for products manufactured by Z (without           550
 reduction for Z's cost of goods sold, commissions on sales
 and commission sales expenses)...............................
Dividends received by N.......................................       150
Interest received by N........................................       200
Proceeds received by N representing recognized gain (but not         250
 losses) for sales of business assets located outside the
 United States................................................
                                                               ---------
N's gross receipts............................................     3,550
                                                               =========
 


[T.D. 8126, 52 FR 6464, Mar. 3, 1987]



Sec. 1.927(d)-1  Other definitions.

    (a) Carrying Charges.
    Q-1. Under what circumstances is the sales price of property or 
services sold by a FSC or a related supplier considered to include 
carrying charges as defined in subdivision (ii)(B)(1) of Q&A-9 of 
Sec. 1.921-2?
    A-1. (i) The proceeds received from a sale of export property by a 
FSC or a related supplier (or the amount paid for services rendered or 
from rental of export property) may include carrying charges if any part 
of the sale proceeds (or service or rental payment) is paid after the 
end of the normal payment period. If the export property is sold or 
leased by, or if the services are rendered by, the FSC, the entire 
carrying charges amount as determined in Q&A-2 of this section will be 
the income of the FSC. If, however, the FSC is the commission agent of a 
related supplier on these transactions, the carrying charges amount so 
determined is income of the related supplier. The commission payable to 
the FSC will be computed by reducing the related supplier's gross 
receipts from the transaction by the amount of the carrying charges. No 
carrying charges will be assessed on the commissions paid by the related 
supplier to the FSC. The carrying charges provisions, likewise, do not 
apply to any other transaction that does not give rise to foreign 
trading gross receipts.
    (ii) The normal payment period for a sale transaction is 60 days 
from the earlier of date of sale or date of exchange of property under 
the contract. For this purpose, the date of sale will be the date the 
sale is recorded on the seller's books of account under its normal 
accounting method. The date the transaction was recorded on the seller's 
books of account shall be disregarded if recording is delayed in order 
to delay the start of the normal payment period. In these circumstances, 
the earlier of the date of the contract or date of exchange of property 
will be deemed the date of sale. For related and subsidiary services 
that are not separately stated from the sale or lease transaction, the 
earlier of the date of the sale or date the export property is delivered 
to the purchaser is the applicable date. For related and subsidiary 
services which are separately stated from the sale or lease transaction 
and for other services, such as engineering and architectural services, 
the normal payment period is 60 days from the earlier of the date 
payment is due for the services or the date services under the contract 
are completed. The date of completion of a services contract is the date 
of final approval of the services by the recipient. With regard to 
transactions involving the lease or rental of export property, the 
normal payment period will begin on the date the rental payment is due 
under the lease. The date the normal payment period begins under this 
subdivision (ii) will be the same whether or not the transaction is with 
a related person.
    (iii) The carrying charges are computed for the period beginning 
with the first day after the end of the normal payment period and ending 
with the date of payment. A FSC may elect at any time prior to the close 
of the statute of limitations of section 6501(a) for the FSC taxable 
year to treat the final date of payment stated in the contract as the 
date of payment if--
    (A) The contracts for all transactions completed during the taxable 
year require that payment be received within the normal payment period,
    (B) No more than 20% of transactions for which final payment is 
received in the taxable year involve payment after the end of the normal 
payment period. For FSC taxable years beginning after March 3, 1987, the 
20% test will apply only to the dollar value of the transactions and not 
to the number of transactions. For prior taxable years, the 20% test 
will apply to either the dollar

[[Page 120]]

value of the transactions or to the number of transactions. The special 
grouping rules applicable to determination of the FSC's profit under the 
administrative pricing rules of section 925 may be applied to this 
elective provision. Accordingly, transactions may be grouped into 
product or product-line groupings to determine whether 20% or less of 
the dollar value (or number of transactions, if applicable) of the 
grouped transactions involve payment after the end of the normal payment 
period.
    Q-2. How are carrying charges as defined in subdivision (ii)(B)(1) 
of Q&A 9 of Sec. 1.921-9 computed?
    A-2. If carrying charges as defined in subdivision (ii)(B)(1) of Q&A 
9 of Sec. 1.921-9 are considered to be included in the sale price of 
property income or rental payment services, the amount of the carrying 
charges is equal to the amount in subdivision (i) of this answer if the 
contract provides for stated interest or the amount in subdivisions (ii) 
or (iii) of this answer, whichever is applicable, if the contract does 
not so provide.
    (i) If a contract provides for stated interest beginning on the day 
after the end of the normal payment period, carrying charges will accrue 
only if the stated interest rate is less than the short-term, monthly 
Federal rate as of the day after the end of normal payment period and 
then only to the extent the stated interest is less than the short-term, 
monthly Federal rate. The short-term, monthly Federal rate is that rate 
as determined for purposes of section 1274(d) and which is published in 
the Internal Revenue Bulletin. Carrying charges will not accrue, 
however, unless payments are made after the end of the normal payment 
period.
    (ii) If a contract for a transaction does not provide for stated 
interest, and if the taxpayer does not elect the method described in 
subdivision (iii) of this answer, the amount of carrying charges is 
equal to the excess of--
    (A) The amount of the sales price of property, services income or 
rental payment that is unpaid on the day after the end of the normal 
payment period, over
    (B) The present value, as of the day after the end of the normal 
payment period, of all payments that are required to be made under the 
contract and that are unpaid on the day after the end of the normal 
payment period. The amount of the sales price of property, service 
income or rental payment is the amount under the contract whether it be 
the sales price, amount paid for services or the rental amount 
determined as of the actual payment date unless a FSC makes the election 
provided under subdivision (iii) of Q&A 1. If a FSC makes the election 
provided under subdivision (III) of Q&A 1, the amount of the sales price 
is the sales price, services income or rental payment under the contract 
determined as of the final payment date stated in the contract. All 
payments that are required to be made under the contract include the 
stated sales price, services income or rental payment as well as stated 
amounts of interest and carrying charges. The discount rate for the 
present value computation is simple interest at the short-term monthly 
Federal rate published in the Internal Revenue Bulletin, determined as 
of the day after the end of the normal payment period. The present value 
of a payment is calculated as follows:
[GRAPHIC] [TIFF OMITTED] TC14NO91.143

P=present value of a payment that is required and unpaid after the end 
          of the normal payment period
S=amount of a payment that is required and unpaid after the end of the 
          normal payment period
i=the short-term monthly Federal rate
t=the number of days after the end of the normal payment period and 
          before date of payment divided by 365.

If a sale is made, or if services are completed, or if rent is due under 
a lease in a taxable year and the required date of payment is in a later 
taxable year, carrying charges for the first taxable year are computed 
for the number of days after the end of the normal payment period and 
before the end of the taxable year. For the following taxable year, 
carrying charges are computed for the number of days after the beginning 
of the taxable year and before the date of payment.
    (iii) At the election of the taxpayer, the amount of carrying 
charges may be

[[Page 121]]

determined under the method described in this subdivision (iii). If the 
taxpayer elects this method, it must be used for all applicable 
transactions within the taxable year of the FSC. If this optional method 
is used, the computation of carrying charges must be made separately for 
transactions involving related persons and for those transactions 
involving unrelated persons. In addition, the computation of carrying 
charges must be made separately for each of the five types of income of 
the FSC (or of the related supplier if the related supplier is the 
principal on the transaction) listed in subparagraph (1) through (5) of 
section 924(a). These groupings are separate and distinct from the 
groupings that are established for purposes of determining the FSC's 
profit on the export transactions. The optional method allowed in this 
subdivision provides that the amount of carrying charges for a taxable 
year of a FSC (or related supplier if the related supplier is the 
principal on the export transaction) is computed using the average of 
receivables of unrelated persons (or of related persons) and the average 
time those receivables are outstanding. Receivables are included in this 
computation only if they are from transactions on which foreign trading 
gross receipts, as defined in section 924(a), are received by the FSC 
(or which are received by a related supplier of a FSC and which would 
have been foreign trading gross receipts had they been received by the 
FSC). Carrying charges are calculated under this method as follows:

CC=(AR) (I/365) (X) (Y)
CC=Carrying charges
AR=Average monthly receivables balance for the taxable year
I=The average short-term, monthly Federal rate for the year
X=The number of times receivables turn over in the year
Y=The number of days the average receivables are outstanding over 60 
          days.


This optional method is illustrated in Example 5 in subdivision (v) of 
this answer.
    (iv) The computation of carrying charges under this answer 2 applies 
only to the determination of carrying charges under subdivision 
(ii)(B)(1) of Q&A 9 of Sec. 1.921-2 and does not apply to the 
determination of any other unstated interest or for any other purpose.
    (v) The following examples illustrate the computation of carrying 
charges under this section:

    Example 1. On January 1, 1985, a FSC sells export property for 
$10,000. The export property is delivered to the purchaser on January 
10, 1985. The terms of the contract require payment within 90 days after 
sale. The normal payment period is 60 days. The FSC does not make an 
election under subdivision (iii) of Q&A. The contract does not require 
the payment of any interest or carrying charges. The purchaser pays the 
entire sales price on March 1, 1985. The sales price is not considered 
to include any carrying charges because the purchase paid the entire 
sales price within the normal payment period.
    Example 2. The facts are the same as in example 1 except that the 
purchaser pays the entire sales price on April 6, 1985, 96 days after 
the earlier of the date of sale or date of delivery (i.e., January 1, 
1985). Therefore, the sales price is considered to include carrying 
charges computed as follows:
    Step 1: Determines the short-term monthly Federal rate as of the 
earlier of date of sale or date of delivery. For purposes of this 
example, the rate is 10%.
    Step 2: Determine the fraction of the year represented by the number 
of days after 60 days and before date of payment. In this example, the 
number of days beyond 60 is 96-60=36, which is divided by 365
[GRAPHIC] [TIFF OMITTED] TC09OC91.001

    Step. 3: Using the short-term monthly Federal rate and the fraction 
of the year, compute the present value of the payment.
[GRAPHIC] [TIFF OMITTED] TC09OC91.002

[GRAPHIC] [TIFF OMITTED] TC09OC91.003

P=$10,000 (.99)
P=$9,900
    Step 4: Using the present value of all payments, compute the 
carrying charges.
    Carrying Charges=Sales Price less Present Value.
    [GRAPHIC] [TIFF OMITTED] TC09OC91.004
    

[[Page 122]]


    Example 3. On October 15, 1985, F, a FSC, leases export property to 
X for one month with a total rental due of $20,000. Under the terms of 
the lease, A agreed to pay F $10,000 on October 15, 1985, and the 
remaining $10,000 on January 15, 1986. The contract does not require the 
payment of any interest or carrying charges. The second $10,000 payment 
is made on January 3, 1986. This payment does not include any carrying 
charges because X paid the $10,000 before the start of the normal 
payment period.
    Example 4. On October 15, 1985, F, a FSC, leases export property to 
X, for one month with a total amount due under the lease of $10,000, 
payable on October 15, 1985. X delays payment until January 19, 1986, 
which was 96 days after the start of the normal payment period. The 60 
day normal payment period terminated on December 14, 1985. Therefore, 
the lease payment is considered to include carrying charges of $100 
computed in the same manner as in Example 2. Of this $100, 17/36, or 
$47.22, is carrying charges for 1985 (i.e., 17 days in December), and 
19/36, or $52.78, is carrying charges for 1986.
    Example 5. During 1986, F, a FSC, sold on account export properties 
A and B to related and unrelated persons.
    (A) Unrelated persons. During 1986, the sales on account to 
unrelated persons totaled $6,000. On the last day of each of the months 
of 1986, F had total receivables from unrelated persons from sales of 
export properties A and B, as follows:

 
 
 
January 31.....................................................   $1,400
February 28....................................................    1,400
March 31.......................................................    1,000
April 30.......................................................    1,000
May 31.........................................................    1,200
June 30........................................................    1,300
July 31........................................................    1,000
August 31......................................................    1,300
September 30...................................................    1,500
October 31.....................................................    1,100
November 30....................................................    1,200
December 31....................................................    1,000
                                                                --------
                                                                  14,400
                                                                ========
 


Carrying charges for 1986 with unrelated persons under the optional 
method of subdivision (iii) of this answer will be $19.23, computed as 
follows:
    Step 1: Determine the average short-term, monthly Federal rate for 
the year. For purposes of this example, the rate is assumed to be 9%.
    Step 2: Determine the average receivables for the year. This average 
is calculated by totaling the end of the month receivables balance of 
each month of the year and dividing by twelve. In this example, the 
average monthly receivables balance is $1,200, calculated as follows:

                    $1,200=$14,400/12

    Step 3: Determine the number of times the receivables turn over 
during the year. This is calculated by dividing the sales on account for 
the year by the average monthly receivables balance for the year. For 
purposes of this example, receivables turned over 5 times for 1986, 
computed as follows:
[GRAPHIC] [TIFF OMITTED] TC09OC91.005

    Step 4: Determine the number of days the average receivables are 
outstanding in excess of 60 days. In this example, there are 13 
receivable days in excess of 60 days, computed as follows:
[GRAPHIC] [TIFF OMITTED] TC09OC91.071

    Step 5: The amount of carrying charges, $19.23, is calculated by 
using the following equation:
CC=(AR) (I/365) (X)(Y)
CC=Carrying charges
AR=Average monthly receivables balance for the taxable year (step 2)
I=The average short-term monthly Federal rate for the year (step 1)
X=The number of times receivables turn over in the year (step 3)
Y=The number of days the average receivables are outstanding over 60 
days (step 4).
CC=$19.23=($1,200) (.09/365) (5) (13)
    (B) Related persons. Carrying charges, if any, on the sales on 
account to related persons must be computed separately using this 
optional method.

    Q-3. Is a discount from the sales price of property or services for 
prompt payment considered to be stated carrying charges as defined in 
subdivision (ii)(A) of Q&A 9 of Sec. 1.921-2?
    A-3. No.
    Q-4. Is the receipt of an arm's length factoring payment from an 
unrelated person considered a payment of the sales proceeds for purposes 
of determining whether payment is made within the normal payment period 
and the possible imposition of carrying charges?
    A-4. Yes.

[T.D. 8127, 52 FR 6473, Mar. 3, 1987]



Sec. 1.927(d)-2T  Temporary regulations; definitions and special rules relating to Foreign Sales Corporation.

    (a) Definition of related supplier. For purposes of sections 921 
through 927 and the regulations under those sections, the term ``related 
supplier'' means a related party which directly supplies to a FSC any 
property or services which

[[Page 123]]

the FSC disposes of in a transaction producing foreign trading gross 
receipts, or a related party which uses the FSC as a commission agent in 
the disposition of any property or services producing foreign trading 
gross receipts. A FSC may have different related suppliers with respect 
to different transactions. If, for example, X owns all the stock of Y, a 
corporation, and of F, a FSC, and X sells a product to Y which is resold 
to F, only Y is the related supplier of F. If, however, X sells directly 
to F and Y also sells directly to F, then, as to the transactions 
involving direct sales to F, each of X and Y is a related supplier of F.
    (b) Definition of related party. The term ``related party'' means a 
person which is owned or controlled directly or indirectly by the same 
interests as the FSC within the meaning of section 482 and Sec. 1.482-
1(a).

[T.D. 8126, 52 FR 6465, Mar. 3, 1987]



Sec. 1.927(e)-1  Special sourcing rule.

    (a) Source rules for related persons--(1) In general. The income of 
a person described in section 482 from a sale of export property giving 
rise to foreign trading gross receipts of a FSC that is treated as from 
sources outside the United States shall not exceed the amount that would 
be treated as foreign source income earned by such person if the pricing 
rule under section 994 that corresponds to the rule used under section 
925 with respect to such transaction applied to such transaction. This 
special sourcing rule also applies if the FSC is acting as a commission 
agent for the related supplier with respect to the transaction described 
in the first sentence of this paragraph (a)(1) that gives rise to 
foreign trading gross receipts and the transfer pricing rules of section 
925 are used to determine the commission payable to the FSC. No 
limitation results under this section with respect to a transaction to 
which the section 482 pricing rule under section 925(a)(3) applies.
    (2) Grouping of transactions. If, for purposes of determining the 
FSC's profits under the administrative pricing rules of sections 925(a) 
(1) and (2), grouping of transactions under Sec. 1.925(a)-1T(c)(8) was 
elected, the same grouping shall be used for making the determinations 
under the special sourcing rule in this section.
    (3) Corresponding DISC pricing rules--(i) In general. For purposes 
of this section--
    (A) The DISC gross receipts pricing rule of section 994(a)(1) 
corresponds to the gross receipts pricing rule of section 925(a)(1);
    (B) The DISC combined taxable income pricing rule of section 
994(a)(2) corresponds to the combined taxable income pricing rule of 
section 925(a)(2); and
    (C) The DISC section 482 pricing rule of section 994(a)(3) 
corresponds to the section 482 pricing rule of section 925(a)(3).
    (ii) Special rules. For purposes of this section--
    (A) The DISC pricing rules of section 994(a)(1) and (2) shall be 
determined without regard to export promotion expenses;
    (B) Qualified export receipts under section 994(a)(1) and
    (2) Shall be deemed to be an amount equal to the foreign trading 
gross receipts arising from the transaction; and
    (C) Combined taxable income for purposes of section 994(a)(2) shall 
be deemed to be an amount equal to the combined taxable income for 
purposes of section 925(a)(2) arising from the transaction.
    (b) Examples. The provisions of this section may be illustrated by 
the following examples:
    Example 1. (i) R and F are calendar year taxpayers. R, a domestic 
manufacturing company, owns all the stock of F, which is a FSC acting as 
a commission agent for R. For the taxable year, R and F used the 
combined taxable income pricing rule of section 925(a)(2). For the 
taxable year, the combined taxable income of R and F is $100 from the 
sale of export property, as defined in section 927(a), manufactured by R 
using production assets located in the United States. Title to the 
export property passed outside of the United States.
    (ii) Under section 925(a)(2), 23 percent of the $100 combined 
taxable income of R and F ($23) is allocated to F and the remaining $77 
is allocated to R. Absent the special sourcing rule, under section 
863(b) the $77 income allocated to R would be sourced $38.50 U.S. source 
and $38.50 foreign source. Under the special sourcing rule, the amount 
of foreign source income earned by a related supplier of a FSC shall not 
exceed the amount that

[[Page 124]]

would result if the corresponding DISC pricing rule applied. The DISC 
combined taxable income pricing rule of section 994(a)(2) corresponds to 
the combined taxable income pricing rule of section 925(a)(2). Under 
section 994(a)(2), $50 of the combined taxable income ($100 x .50) would 
be allocated to the DISC and the remaining $50 would be allocated to the 
related supplier. Under section 863(b), the $50 income allocated to the 
DISC's related supplier would be sourced $25 U.S. source and $25 foreign 
source. Accordingly, under the special sourcing rule, the foreign source 
income of R shall not exceed $25.
    Example 2. (i) Assume the same facts as in Example 1 except that R 
and F used the gross receipts pricing rule of section 925(a)(1). In 
addition, for the taxable year foreign trading gross receipts derived 
from the sale of the export property are $2,000.
    (ii) Under section 925(a)(1), 1.83 percent of the $2,000 foreign 
trading gross receipts ($36.60) is allocated to F and the $63.40 
remaining combined taxable income ($100-$36.60) is allocated to R. 
Absent the special sourcing rule, under section 863(b) the $63.40 income 
allocated to R would be sourced $31.70 U.S. source and $31.70 foreign 
source. Under the special sourcing rule, the amount of foreign source 
income earned by a related supplier of a FSC shall not exceed the amount 
that would result if the corresponding DISC pricing rule applied. The 
DISC gross receipts pricing rule of section 994(a)(1) corresponds to the 
gross receipts pricing rule of section 925(a)(1). Under section 
994(a)(1), $80 ($2,000 x .04) would be allocated to the DISC and the $20 
remaining combined taxable income would be allocated to the related 
supplier. Under section 863(b), the $20 income allocated to the DISC's 
related supplier would be sourced $10 U.S. source and $10 foreign 
source. Accordingly, under the special sourcing rule, the foreign source 
income of R shall not exceed $10.
    (c) Effective date. The rules of this section are applicable to 
taxable years beginning after December 31, 1997.

[T.D. 8782, 63 FR 50144, Sept. 21, 1998]



Sec. 1.927(e)-2T  Temporary regulations; effect of boycott participation on FSC and small FSC benefits.

    (a) International boycott factor. If the FSC (or small FSC) or any 
member of the FSC's (or small FSC's) controlled group participates in or 
cooperates with an international boycott within the meaning of section 
999, the FSC's (or small FSC's) exempt foreign trade income as 
determined under section 923 (a) shall be reduced by an amount equal to 
the product of the FSC's (or small FSC's) exempt foreign trade income 
multiplied by the international boycott factor determined under section 
999. The amount of the reduction will be considered as non-exempt 
foreign trade income.
    (b) Specifically attributable taxes and income method. If the 
taxpayer clearly demonstrates that the income earned for the taxable 
year is attributable to specific operations, then in lieu of applying 
the international boycott factor for such taxable year, the amount of 
the exempt foreign trade income as determined under section 923(a) that 
will be reduced by this section shall be the amount specifically 
attributable to the operations in which there was participation in or 
cooperation with an international boycott under section 999(b)(1). The 
amount of the reduction will be considered as non-exempt foreign trade 
income.

[T.D. 8126, 52 FR 6465, Mar. 3, 1987]



Sec. 1.927(f)-1  Election and termination of status as a Foreign Sales Corporation.

    (a) Election of status as a FSC or a small FSC.
    Q-1. What is the effect of an election by a corporation to be 
treated as a FSC or small FSC?
    A-1. A valid election to be treated as a FSC or a small FSC applies 
to the taxable year of the corporation for which made and remains in 
effect for all succeeding taxable years in which the corporation 
qualifies to be a FSC unless revoked by the corporation or unless the 
corporation fails for five consecutive years to qualify as a FSC (in 
case of a FSC election) or as a small FSC (in case of a small FSC 
election).
    Q-2. Can a corporation established prior to January 1, 1985 be 
treated as a FSC or a small FSC prior to making a FSC or a small FSC 
election?
    A-2. A corporation cannot be treated as a FSC or a small FSC until 
it has made a FSC or a small FSC election. An election made within the 
first 90 days of 1985 relates back to January 1, 1985 unless the 
taxpayer indicates otherwise.
    Q-3. If a shareholder who has not consented to a FSC or small FSC 
election transfers some or all of its shares before or during the first 
taxable year for which the election is made, may the

[[Page 125]]

holder of the transferred shares consent to the election?
    A-3. A holder of the transferred shares may consent to a FSC or 
small FSC elction under the circumstances described in Sec. 1.922-
2(c)(1). The rules contained in Sec. 1.992-(c) shall apply to the 
consent by a holder of transferred shares.
    Q-4. If a shareholder who has consented to a FSC or a small FSC 
election transfers some or all of its shares before the first taxable 
year for which the election is made, must the holder of the transferred 
shares consent to the election?
    A-4. Yes. Consent must be made by any recipient of such shares on or 
before the 90th day after the first day of such first taxable year. If 
such recipient fails to file his consent on or before such 90th day, and 
extension of time for filing such consent may be granted in the manner, 
and subject to the conditions, described in paragraph (b)(3) of 
Sec. 1.992-2.
    Q-5. May an election of a corporation to be a FSC or a small FSC be 
effective as of a time other than the start of the corporation's taxable 
year?
    A-5. No.
    Q-6. If a fiscal year foreign corporation was in existence on 
December 31, 1984, must it wait until the first day of its taxable year 
beginning after January 1, 1985, to elect FSC status?
    A-6. No. If a fiscal year foreign corporation was in existence on 
December 31, 1984, its taxable year will be deemed to have terminated on 
that date if the foreign corporation elects FSC status to be effective 
January 1, 1985. An income tax return will be required for any short 
years created by the deemed closing of the taxable year unless the 
corporation is relieved from the necessity of making a return by section 
6012 and the regulations under that section. If the corporation's 
taxable year is deemed closed by operation of this regulation, the 
filing date of tax returns for the short taxable year ended on December 
31, 1984, will be automatically extended until May 18, 1987.
    Q-7. What is the effect of an election to be treated as a FSC or as 
a small FSC if the corporation or any other member of the controlled 
group has in effect an election to be treated as an interest charge 
DISC?
    A-7. The interest charge DISC election shall be treated as revoked 
for all purposes under the Code as of the date the FSC election is 
effective. An affirmative revocation of the DISC election is 
unnecessary. The FSC election shall take effect. As long as the FSC 
election remains in effect, neither the corporation nor any other member 
of the controlled group is permitted to elect to be treated as an 
interest charge DISC for any taxable year including any part of a 
taxable year during which the corporation's FSC election continues to be 
effective.
    Q-8. What is the effect of an election to be treated as a small FSC 
if the corporation or any other member of the controlled group has in 
effect an election to be treated as a FSC?
    A-8. As long as a FSC election remains in effect, neither the 
corporation nor any other member of the controlled group is permitted to 
elect to be treated as a small FSC for any taxable year including any 
part of a taxable year during which a FSC election continues to be 
effective. Any FSC within the controlled group must affirmatively revoke 
its FSC election for a taxable year including any part of a taxable year 
for which small FSC status is elected.
    Q-9. What is the effect of an election to be treated as a FSC if the 
corporation or any other member of the controlled group has in effect an 
election to be treated as a small FSC?
    A-9. As long as a small FSC election remains in effect, neither the 
corporation nor any other member of the controlled group is permitted to 
elect to be treated as a FSC for any taxable year including any part of 
the taxable year during which a small FSC election continues to be 
effective. Any small FSC within the controlled group must affirmatively 
revoke its small FSC election for a taxable year including any part of a 
taxable year for which FSC status is elected. An election to be treated 
as a small FSC is permitted if the corporation or any other member of 
the controlled group has in effect an election to be treated as a small 
FSC. For a special rule providing for conversion of a small FSC to a FSC 
within

[[Page 126]]

one taxable year, see Sec. 1.921-1T(b)(1) (Q&A-1).
    (b) Termination of election of status as a FSC or a small FSC.
    Q-10. How is the status of a corporation as a FSC or as a small FSC 
terminated?
    A-10. The status of a corporation as a FSC or as a small FSC is 
terminated through revocation or by its continued failure to be a FSC.
    Q-11. For what taxable year may a corporation revoke its election to 
be treated as a FSC or as a small FSC?
    A-11. A corporation may revoke its election to be treated as a FSC 
or as a small FSC for any taxable year of the corporation after the 
first taxable year for which the election is effective.
    Q-12. When must a corporation revoke a FSC or a small FSC election 
if revocation is to be effective for the taxable year in which 
revocation takes place?
    A-12. If a corporation files a statement revoking its election to be 
treated as a FSC or as a small FSC during the first 90 days of a taxable 
year (other than the first taxable year for which such election is 
effective), such revocation will be effective for such taxable year and 
all taxable years thereafter. If the corporation files a statement 
revoking its election to be treated as a FSC or a small FSC after the 
firs 90 days of a taxable year, the revocation will be effective for all 
taxable years following such taxable year.
    Q-13. Can a FSC change its status to a small FSC, or can a small FSC 
change its status to a FSC as of a date other than the first day of a 
taxable year?
    A-13. No. Since a revocation of an election to be a FSC or a small 
FSC is effective only for entire taxable year, a corporation's change 
between FSC and small FSC status is effective as of the first day of a 
taxable year.
    Q-14. How may a corporation revoke an election by a corporation to 
be treated as a FSC or a small FSC?
    A-14. A corporation may revoke its election by filing a statement 
that the corporation revokes its election under section 922(a) to be 
treated as a FSC or under section 922(b) to be treated as a small FSC. 
Such statement shall indicate the corporation's name, address, employer 
identification number, and the first taxable year of the corporation for 
which the revocation is to be effective. The statement shall be signed 
by any person authorized to sign a corporate return under section 6062. 
Such revocation shall be filed with the Service Center with which the 
corporation filed its return.
    Q-15. What if the effect is a corporation that has elected to be 
treated as a FSC or a small FSC fails to qualify as a FSC because it 
does not meet the requirements of section 922 for a taxable year?
    A-15. If a corporation that has elected to be treated as a FSC or a 
small FSC does not qualify as a FSC or a small FSC for a taxable year, 
the corporation will not be treated as a FSC or a small FSC for the 
taxable year. However, the failure of a corporation to qualify to be 
treated as a FSC or a small FSC for a taxable year does not terminate 
the election of the corporation to be treated as FSC or a small FSC 
unless the corporation does not qualify under section 922 for each of 5 
consecutive taxable years, as provided in Q&A 16 of this section.
    Q-16. Under what circumstances is the FSC or small FSC election 
terminated for continued failure to be a FSC?
    A-16. If a corporation that has elected to be treated as a FSC or a 
small FSC does not qualify under section 922 to be treated as a FSC or 
small FSC for each of 5 consecutive taxable years, such election 
terminates and will not be effective for any taxable year after such 
fifth taxable year. Such termination will be effective automatically 
without notice to such corporation or to the Internal Revenue Service.

[T.D. 8127, 52 FR 6475, Mar. 3, 1987]

                    possessions of the united states



Sec. 1.931-1  Citizens of the United States and domestic corporations deriving income from sources within a certain possession of the United States.

    (a) Definitions. (1) As used in section 931 and this section, the 
term ``possession of the United States'' includes American Samoa, Guam, 
Johnston Island, Midway Islands, the Panama

[[Page 127]]

Canal Zone, Puerto Rico, and Wake Island. However, the term does not 
include (i) the Virgin Islands and (ii), when used with respect to 
citizens of the United States, the term does not include Puerto Rico or, 
in the case of taxable years beginning after December 31, 1972, Guam.
    (2) As used in section 931 and this section, the term ``United 
States'' includes only the States, the Territories of Alaska and Hawaii, 
and the District of Columbia.
    (b) General rule--(1) Qualifications. In the case of a citizen of 
the United States or a domestic corporation satisfying the following 
conditions, gross income means only gross income from sources within the 
United States--
    (i) If 80 percent or more of the gross income of such citizen or 
domestic corporation (computed without the benefit of section 931) for 
the 3-year period immediately preceding the close of the taxable year 
(or for such part of such period immediately preceding the close of such 
taxable year as may be applicable) was derived from sources within a 
possession of the United States, and
    (ii) If 50 percent or more of the gross income of such citizen or 
domestic corporation (computed without the benefit of section 931) for 
such period or such part thereof was derived from the active conduct of 
a trade or business within a possession of the United States. In the 
case of a citizen, the trade or business may be conducted on his own 
account or as an employee or agent of another. The salary or other 
compensation paid by the United States to the members of its civil, 
military, or naval personnel for services rendered within a possession 
of the United States represents income derived from the active conduct 
of a trade or business within a possession of the United States. The 
salary or other compensation paid for services performed by a citizen of 
the United States as an employee of the United States or any agency 
thereof shall, for the purposes of section 931 and this section, be 
deemed to be derived from sources within the United States. Dividends 
received by a citizen from a corporation whose income was derived from 
the active conduct of a business within a possession of the United 
States, does not represent income derived from the active conduct of a 
trade or business within the possession of the United States even though 
such citizen was actively engaged in the management of such corporation. 
For a determination of income from sources within the United States, see 
part I (section 861 and following), subchapter N, chapter 1 of the Code, 
and section 931(i), and the regulations thereunder.
    (2) Relationship of sections 931 and 911. A citizen of the United 
States who cannot meet the 80-percent and the 50-percent requirements of 
section 931 but who receives earned income from sources within a 
possession of the United States, is not deprived of the benefits of the 
provisions of section 911 (relating to the exemption of earned income 
from sources outside the United States), provided he meets the 
requirements thereof. In such a case none of the provisions of section 
931 is applicable in determining the citizen's tax liability. For what 
constitutes earned income, see section 911(b).
    (3) Meaning of ``gross income'' on joint return. In the case of a 
husband and wife making a joint return, the term ``gross income,'' as 
used in this section, means the combined gross income of the spouses.
    (4) Returns. A citizen entitled to the benefits of section 931 is 
required to file with his individual return Form 1040 the schedule on 
Form 1040E. If a citizen entitled to the benefits of section 931 has no 
income from sources within the United States and does not receive within 
the United States any income derived from sources without the United 
States he is not required to file a return or the schedule on Form 
1040E.
    (5) Illustration of the operation of section 931. This section may 
be illustrated by the following example:

    Example. On July 1, 1954, A, who is a citizen of the United States, 
went to a possession of the United States and established a business 
there which he actively conducted during the remainder of that year. His 
gross income from the business during such period was $20,000. In 
addition, he made a profit of $12,000 from the sale during the latter 
part of 1954 of some real estate located in such possession and not 
connected with his trade or business. In the first six months of 1954 he 
also derived $8,000 gross income from rental

[[Page 128]]

property located in the United States. He derived a like amount of gross 
income from such property during the last six months of 1954. On these 
facts, A may exclude the $32,000 derived from sources within the 
possession of the United States, since he qualified under section 931 
with respect to that amount. The period of July 1, 1954, through 
December 31, 1954, constitutes the applicable part of the 3-year period 
immediately preceding the close of the taxable year (the calendar year 
1954), and for that period, 80 percent of A's gross income was derived 
from sources within a possession of the United States ($32,000, or 80 
percent of $40,000) and 50 percent or more of A's gross income was 
derived from the active conduct of a trade or business within a 
possession of the United States ($20,000, or 50 percent of $40,000). A 
is required to report on his return for 1954 only the gross income 
derived by him from sources within the United States ($16,000 from the 
rental property located in the United States).

    (c) Amounts received in the United States. Notwithstanding the 
provisions of section 931(a), there shall be included in the gross 
income of citizens and domestic corporations therein specified all 
amounts, whether derived from sources within or without the United 
States, which are received by such citizens or corporations within the 
United States. From the amounts so included in gross income there shall 
be deducted only the expenses properly apportioned or allocated thereto. 
For instance, if in the example set forth in paragraph (b)(5) of this 
section, the taxpayer during the latter part of 1954 returned to the 
United States for a few weeks and while there received the proceeds 
resulting from the sale of the real estate located in the possession, 
the profits derived from such transaction should be reported in gross 
income. Such receipt in the United States, however, would not deprive 
the taxpayer of the benefits of section 931 with respect to other items 
of gross income excluded by that section.
    (d) Deductions--(1) Individuals. In the case of a citizen entitled 
to the benefits of section 931, the deductions allowed in computing 
taxable income, except the standard deduction and a deduction for one 
personal exemption (see sections 142(b)(2) and 931(e), respectively), 
are allowed only if and to the extent that they are connected with 
income from sources within the United States. The provisions of section 
873 and the regulations thereunder, relating to the allowance to 
nonresident alien individuals, who at any time within the taxable year 
were engaged in trade or business within the United States, of the 
deductions provided in section 165(c)(2) and (3) for losses not 
connected with the trade or business, are applicable in the case of 
citizens entitled to the benefits of section 931. The provisions of 
section 873 (c) and the regulations thereunder pertaining to the 
allowance to such nonresident alien individuals of deductions for 
contributions provided in section 170 are also applied in the case of 
such citizens.
    (2) Corporations. Corporations entitled to the benefits of section 
931 are allowed the same deductions from their gross income arising from 
sources within the United States as are allowed to domestic corporations 
to the extent that such deductions are connected with such gross income, 
except that the so-called charitable contribution deduction provided by 
section 170 to corporations is allowed whether or not connected with 
income from sources within the United States. The proper apportionment 
and allocation of the deductions with respect to sources within and 
without the United States shall be determined as provided in part I 
(section 861 and following), subchapter N, chapter 1 of the Code, and 
the regulations thereunder.
    (e) Deduction for personal exemption. A citizen of the United States 
entitled to the benefits of section 931 is allowed a deduction for only 
one exemption under section 151.
    (f) Allowance of deductions and credits. Unless a citizen of the 
United States or a domestic corporation entitled to the benefits of 
section 931 shall file or cause to be filed with the district director a 
true and accurate return of total income from all sources within the 
United States, in the manner prescribed in subtitle F of the Code, the 
tax shall be collected on the basis of the gross income (not the taxable 
income) from sources within the United States. If such citizen or 
corporation fails to file a necessary income tax return, the 
Commissioner will cause a return to be made, including therein all

[[Page 129]]

income from sources within the United States and allowing no deductions 
or credits (except credit for tax withheld at source).
    (g) Foreign tax credit. Persons entitled to the benefits of section 
931 are not allowed the credits provided for in section 901 (relating to 
credits for taxes of foreign countries and possessions).
    (h) Internees. If a citizen of the United States--
    (1) Was interned by the enemy while serving as an employee within a 
possession of the United States; and
    (2) Was confined in any place not within a possession of the United 
States, then
    (i) Such place of confinement shall be considered as within a 
possession of the United States for the purposes of section 931; and
    (ii) Section 931 (b) shall not apply to any compensation received 
within the United States by such citizen attributable to the period of 
time during which such citizen was interned by the enemy.
    (i) Employees of the United States. For the purposes of section 931, 
amounts paid for services performed by a citizen of the United States as 
an employee of the United States or any agency thereof shall be deemed 
to be derived from sources within the United States.
    (j) Nonapplication to a DISC or shareholder thereof. Section 931 
does not apply to a corporation for a taxable year (1) for which it 
qualifies (or is treated) as a DISC or (2) during which it owns directly 
or indirectly at any time stock in a corporation which, at such time, is 
(or is treated as) a DISC or former DISC. (See section 992(a)(1) and 
(3), respectively, for the definitions of the terms ``DISC'' and 
``former DISC''.) For example, assume X Corporation and Y Corporation 
have the same taxable years. On the first day of its taxable year, X 
owns and sells all of the stock in Y, Y on such day owns and sells all 
of the stock in Z Corporation, and Z qualifies as a DISC as of such day. 
Section 931 will not apply to X and Y for their taxable years. Section 
931 will likewise not apply to Z for the taxable year for which it 
qualifies as a DISC.

(Secs. 7805 (68A Stat. 917; 26 U.S.C. 7805) and 7654(e) (86 Stat. 1496; 
26 U.S.C. 7654 (c)) of the Internal Revenue Code of 1954)

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 7283, 38 FR 
20825, Aug. 3, 1973; T.D. 7385, 40 FR 50260, Oct. 29, 1975]



Sec. 1.932-1  Status of citizens of U.S. possessions.

    (a) General rule--(1) Definition and treatment. A citizen of a 
possession of the United States (except Puerto Rico and, for taxable 
years beginning after December 31, 1972, Guam), who is not otherwise a 
citizen or resident of the United States, including only the States and 
the District of Columbia, is treated for the purpose of the taxes 
imposed by subtitle A of the Code (relating to income taxes) as if he 
were a nonresident alien individual. However, for purposes of the tax 
imposed on self-employment income by chapter 2 of the Code, the term 
``possession of the United States'' as used in section 932 and the 
preceding sentence does not include American Samoa, Guam, or the Virgin 
Islands. See section 1402(a)(9). See subpart A (section 871 and 
following), part II, subchapter N, chapter 1 of the Code, and the 
regulations thereunder, for rules relating to imposition of tax on 
nonresident alien individuals. For Federal income tax purposes, a 
citizen of a possession of the United States who is not otherwise a 
citizen of the United States is a citizen of a possession of the United 
States who has not become a citizen of the United States by 
naturalization in a State, Territory, or the District of Columbia. The 
fixed or determinable annual or periodical income from sources within 
the United States of a citizen of a possession of the United States who 
is treated as if he were a nonresident alien individual is subject to 
withholding. See section 1441.
    (2) Classification of citizens of United States possessions. For the 
purpose of this section citizens of the possessions of the United States 
who are not otherwise citizens of the United States are divided into two 
classes:
    (i) Citizens of possessions of the United States who at any time 
within

[[Page 130]]

the taxable year are not engaged in trade or business within the United 
States, and
    (ii) Citizens of possessions of the United States who at any time 
within the taxable year are engaged in trade or business within the 
United States.

The provisions of subpart A (section 871 and following) and the 
regulations thereunder, applicable to nonresident alien individuals not 
engaged in trade or business within the United States are applicable to 
the citizens of possessions falling within the first class, while the 
provisions of such sections applicable to nonresident alien individuals 
who at any time within the taxable year are engaged in trade or business 
within the United States are applicable to citizens of possessions 
falling within the second class.
    (b) Nonapplication to citizen of Puerto Rico or Guam. The provisions 
of section 932(a) and paragraph (a) of this section do not apply in the 
case of a citizen of Puerto Rico or, for taxable years beginning after 
December 31, 1972, a citizen of Guam. Thus, for example, any such 
citizen who is not a resident of the United States will not be treated 
by the United States as a nonresident alien individual for purposes of 
section 2 (b)(3)(A) or (d), relating to definitions and special rules; 
section 4(d)(1), relating to taxpayers not eligible to use the optional 
tax tables; section 37(h), relating to denial of retirement income 
credit; section 116(d), relating to taxpayers ineligible for dividend 
exclusion; section 142(b)(1), relating to taxpayers ineligible for 
standard deduction; section 152(b)(3), relating to definition of 
``dependent''; section 402(a)(4), relating to distributions by the 
United States to nonresident aliens; section 545(d), relating to certain 
foreign corporations; section 565(e), relating to certain consent 
dividends; section 861(a)(1), relating to interest from sources within 
the United States; sections 871 to 877, relating to nonresident alien 
individuals; section 1303(b), relating to individuals not eligible for 
income averaging; section 1371(a)(3), relating to definition of small 
business corporation; section 1402(b), relating to definition of ``self-
employment income''; section 1441, relating to withholding of tax on 
nonresident aliens; section 3401(a), relating to definition of wages; 
section 6013(a)(1), relating to inability to make a joint return; 
section 6015 (b) and (i), relating to declaration of estimated income 
tax by nonresident alien individuals; section 6017, relating to self-
employment tax returns; section 6042(b)(2), relating to returns 
regarding payments of dividends; section 6049(b)(2), relating to returns 
regarding payments of interest; section 6072 (c), relating to time for 
filing returns of nonresident alien individuals; section 6091(b), 
relating to place for filing returns of nonresident aliens; and section 
6096(a), relating to designation of tax payments to Presidential 
Election Campaign Fund. For other rules applicable to citizens of Puerto 
Rico, see Secs. 1.1-1(b) and 1.933-1. For other rules applicable to 
citizens of Guam, see Secs. 1.1-1(b) and 1.935-1 of this chapter (Income 
Tax Regulations) and Sec. 301.7654-1 of this chapter (Regulations on 
Procedure and Administration).

(Secs. 7805 (68A Stat. 917; 26 U.S.C. 7805) and 7654(e) (86 Stat. 1496; 
26 U.S.C. 7654 (e)) of the Internal Revenue Code of 1954)

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 7385, 40 FR 
50260, Oct. 29, 1975]



Sec. 1.933-1  Exclusion of certain income from sources within Puerto Rico.

    (a) General rule. An individual (whether a United States citizen or 
an alien), who is a bona fide resident of Puerto Rico during the entire 
taxable year, shall exclude from his gross income the income derived 
from sources within Puerto Rico, except amounts received for services 
performed as an employee of the United States or any agency thereof. 
Whether the individual is a bona fide resident of Puerto Rico shall be 
determined in general by applying to the facts and circumstances in each 
case the principles of Secs. 1.871-2, 1.871-3, 1.871-4, and 1.871-5, 
relating to what constitutes residence or nonresidence, as the case may 
be in the United States in the case of an alien individual. Once bona 
fide residence in Puerto Rico has been established, temporary absence 
therefrom in the United States or elsewhere on vacation or business 
trips will not necessarily deprive an individual of his status as a bona 
fide resident of Puerto Rico. An

[[Page 131]]

individual taking up residence in Puerto Rico during the course of the 
taxable year is not entitled for such year to the exclusion provided in 
section 933.
    (b) Taxable year of change of residence from Puerto Rico. A citizen 
of the United States who changes his residence from Puerto Rico after 
having been a bona fide resident thereof for a period of at least two 
years immediately preceding the date of such change in residence shall 
exclude from his gross income the income derived from sources within 
Puerto Rico which is attributable to that part of such period of Puerto 
Rican residence which preceded the date of such change in residence, 
except amounts received for services performed as an employee of the 
United States or any agency thereof.
    (c) Deductions. In any case in which any amount otherwise 
constituting gross income is excluded from gross income under the 
provisions of section 933, there shall not be allowed as a deduction 
from gross income any items of expenses or losses or other deductions 
(except the deduction under section 151, relating to personal 
exemptions) properly allocable to, or chargeable against, the amounts so 
excluded from gross income.



Sec. 1.934-1  Limitation on reduction in income tax liability incurred to the Virgin Islands.

    (a) General rule. Section 934(a) provides that tax liability 
incurred to the Virgin Islands shall not be reduced or remitted in any 
way, directly or indirectly, whether by grant, subsidy, or other similar 
payment, by any law enacted in the Virgin Islands, except to the extent 
provided in section 934 (b) or (c). For purposes of the preceding 
sentence, the term ``tax liability'' means the liability incurred to the 
Virgin Islands pursuant to subtitle A of the Code, as made applicable in 
the Virgin Islands by the Act of July 12, 1921 (48 U.S.C. 1397), or 
pursuant to section 28(a) of the Revised Organic Act of the Virgin 
Islands (48 U.S.C. 1642).
    (b) Exception for certain domestic and Virgin Islands corporations--
(1) General rule. Section 934(b) provides an exception to the 
application of section 934(a). Under this exception, section 934(a) does 
not apply with respect to tax liability incurred to the Virgin Islands 
by a domestic or Virgin Islands corporation for any taxable year (or for 
such part of such year as may be applicable) to the extent that such tax 
liability is attributable to income derived from sources without the 
United States, if such corporation satisfies the conditions provided in 
section 934(b)(1) and (2), and if the information required by section 
934(d) is supplied. These conditions are enumerated in the remainder of 
this paragraph, and the information requirement is set forth in 
paragraph (d) of this section.
    (2) Conditions to be satisfied for exception. A domestic or Virgin 
Islands corporation satisfies the conditions of section 934(b)(1) and 
(2) if--
    (i) Eighty percent or more of the gross income of such corporation 
for the 3-year period immediately preceding the close of the taxable 
year (or for such part of such period immediately preceding the close of 
such taxable year as may be applicable) was derived from sources within 
the Virgin Islands; and
    (ii) Fifty percent or more of the gross income of such corporation 
for such period (or such part thereof) was derived from the active 
conduct of a trade or business within the Virgin Islands.
    (3) Computation rule. Except as provided in subparagraph (5) of this 
paragraph, tax liability incurred to the Virgin Islands by a domestic or 
Virgin Islands corporation for the taxable year (or such part of such 
year as may be applicable) attributable to income derived from sources 
without the United States shall be computed as follows:
    (i) Add to the income tax liability incurred to the Virgin Islands 
any credit against the tax allowed under section 901(a);
    (ii) Multiply by taxable income from sources without the United 
States for the applicable period;
    (iii) Divide by total taxable income for the period;
    (iv) Subtract any credit against the tax allowed under section 
901(a). Tax liability incurred to the Virgin Islands attributable to 
income derived from sources without the United States, as

[[Page 132]]

computed in this subparagraph, however, shall not exceed the total 
amount of income tax liability actually incurred.
    (4) Examples. The rule of the preceding subparagraph may be 
illustrated by the following examples:

    Example 1. Corporation X, which satisfies the requirements of 
section 934(b), incurs an income tax liability to the Virgin Islands for 
taxable year 1963 of $290, as follows:

 
 
 
Taxable income from sources within the U.S....         $200
Taxable income from sources without the U.S...          800
                                               -------------
Total taxable income.......................................       $1,000
Credit allowed under section 901(a)........................           10
Tax liability incurred to the Virgin Islands...............          290
The income tax liability incurred to the Virgin Islands
 attributable to income derived from sources without the
 United States is $230, computed as follows:
  (i) Tax liability incurred to the Virgin              290
   Islands....................................
  Plus credit allowed under section 901(a)....           10
                                               -------------
                                                                     300
  (ii) Multiply by taxable income from sources          800
   without the U.S............................
                                               -------------
                                                                 240,000
  (iii) Divide by total taxable income........        1,000
                                               -------------
                                                                     240
  (iv) Subtract credit allowed under section             10
   901(a).....................................
                                               -------------
                                                                     230
 

    Example 2. Corporation Y, which satisfies the requirements of 
section 934(b), incurs an income tax liability to the Virgin Islands for 
taxable year 1963 of $140, as follows:

 
 
 
Taxable income from sources within the U.S....    ($300 net
                                                      loss)
Taxable income from sources without the U.S...          800
                                               -------------
Total taxable income.......................................         $500
Credit allowed under section 901(a)........................           10
Tax liability incurred to the Virgin Islands...............          140
The income tax liability incurred to the Virgin Islands
 attributable to income derived from sources without the
 United States is 140, computed as follows:
  (i) Tax liability incurred to the Virgin              140
   Islands....................................
  Plus credit allowed under section 901(a)....           10
                                               -------------
                                                                     150
  (ii) Multiply by taxable income from sources          800
   without the U.S............................
                                               -------------
                                                                 120,000
  (iii) Divide by total taxable income........          500
                                               -------------
                                                                     240
  (iv) Subtract credit allowed under section             10
   901(a).....................................
                                               -------------
                                                                     230
 


Since the $230 derived from the computation is in excess of the actual 
tax liability incurred, the income tax liability incurred to the Virgin 
Islands attributable to income derived from sources without the United 
States is limited to $140, the actual liability incurred.

    (5) Special computation rule for certain domestic corporations. For 
purposes of section 934(b) and this paragraph, tax liability incurred to 
the Virgin Islands by a domestic corporation which is required to file 
an income tax return with the United States for the taxable year (or 
such part of such year as may be applicable) attributable to income 
derived from sources without the United States shall be the actual 
income tax liability incurred to the Virgin Islands for such year.
    (6) Source of income. For purposes of section 934(b) and this 
paragraph, the income of a Virgin Islands corporation, and the sources 
from which the income of such corporation is derived, shall be 
determined as if such corporation were a domestic corporation. However, 
all amounts received by a corporation within the United States, whether 
derived from sources within or without the United States, shall be 
considered as being derived from sources within the United States. In 
determining the sources from which the income of a domestic or Virgin 
Islands corporation is derived, the principles of part 1 (section 861 
and following), subchapter N, chapter 1 of the Code, and the regulations 
thereunder shall apply.
    (c) Exception for certain residents of the Virgin Islands--(1) 
General rule. Section 934(c) provides another exception to the 
application of section 934(a). Under this exception, section 934(a) does 
not apply with respect to the tax liability incurred by an individual 
citizen of the United States to the Virgin Islands for any taxable year 
to the extent that such tax liability is attributable to income derived 
from sources within the Virgin Islands, if such individual is a bona 
fide resident of the Virgin Islands during the entire taxable year and 
if he

[[Page 133]]

supplies the information required under section 934(d).
    (2) Definition--bona fide resident and United States citizen. In 
determining whether a United States citizen is a bona fide resident of 
the Virgin Islands, the principles of Secs. 1.871-2, 1.871-3, 1.871-4, 
and 1.871-5, relating to the determination of residence and nonresidence 
in the United States, shall apply. Once a bona fide residence in the 
Virgin Islands is established by an individual, temporary absence 
therefrom will not necessarily deprive such individual of his status as 
a bona fide resident of the Virgin Islands. For purposes of section 
934(c), a citizen of the United States includes any individual who is a 
citizen of the United States by reason of being a citizen of any 
possession of the United States.
    (3) Computation rule. For purposes of section 934(c) and this 
paragraph, tax liability incurred to the Virgin Islands for the taxable 
year attributable to income derived from sources within the Virgin 
Islands shall be computed as follows:
    (i) Add to the income tax liability incurred to the Virgin Islands 
any credit against the tax allowed under section 901(a);
    (ii) Multiply by taxable income from sources within the Virgin 
Islands;
    (iii) Divide by total taxable income. Tax liability incurred to the 
Virgin Islands attributable to income derived from sources within the 
Virgin Islands, as computed in this subparagraph, however, shall not 
exceed the total amount of income tax liability actually incurred.
    (4) Examples. The rule of the preceding subparagraph may be 
illustrated by the following examples:

    Example 1. A, an individual who satisfies the requirements of 
section 934(c), incurs an income tax liability to the Virgin Islands for 
taxable year 1963 of $380, as follows:

 
 
 
Taxable income from sources within the Virgin          $1,200
 Islands..........................................
Taxable income from sources without the Virgin            800
 Islands..........................................
                                                   -----------
Total taxable income.........................................     $2,000
Credit allowed under section 901(a)..........................         20
Tax liability incurred to the Virgin Islands.................        380
The income tax liability incurred to the Virgin Islands
 attributable to income derived from sources within the
 Virgin Islands is $240, computed as follows:
  (i) Tax liability incurred to the Virgin Islands        380
  Plus credit allowed under section 901(a)........         20
                                                   -----------
                                                                     400
  (ii) Multiply by taxable income from sources          1,200
   within the Virgin Islands......................
                                                   -----------
                                                                 480,000
  (iii) Divide by total taxable income.......................     $2,000
                                                              ----------
                                                                     240
 

    Example 2. B, an individual who satisfies the requirements of 
section 934(c), incurs an income tax liability to the Virgin Islands for 
taxable year 1963 of $100, as follows:

 
 
 
Taxable income from sources within the Virgin          $800
 Islands......................................
Taxable income from sources without the Virgin     (200 net
 Islands......................................        loss)
                                               --------------
Total taxable income.......................................         $600
Credit allowed under section 901(a)........................           20
Tax liability incurred to the Virgin Islands...............          100
The income tax liability incurred to the Virgin Islands
 attributable to income derived from sources within the
 Virgin Islands is $100, computed as follows:
  (i) Tax liability incurred to the Virgin              100
   Islands....................................
  Plus credit allowed under section 901(a)....           20
                                               -------------
                                                                     120
  (ii) Multiply by taxable income from sources          800
   within the Virgin Islands..................
                                               -------------
                                                                  96,000
  (iii) Divide by total taxable income........          600
                                               -------------
                                                                     160
 


Since the $160 derived from the computation is in excess of the actual 
tax liability incurred, the income tax liability incurred to the Virgin 
Islands attributable to income derived from sources within the Virgin 
Islands is limited to $100, the actual liability incurred.

    (5) Source of income. For purposes of section 934(c) and this 
paragraph, in determining taxable income from sources within and without 
the Virgin Islands the principles of part 1 (section 861 and following), 
subchapter N, chapter 1 of the Code, and the regulations thereunder 
shall apply, except that--
    (i) Any deductions for personal exemptions allowable under section 
151 shall be deducted in computing taxable income from sources within 
the Virgin

[[Page 134]]

Islands but shall not be deducted in computing taxable income from 
sources without the Virgin Islands;
    (ii) Amounts received for services performed as an employee of the 
United States or any agency thereof shall not be considered as income 
derived from sources within the Virgin Islands;
    (iii) Gain or loss from the sale or exchange of any security (as 
defined in section 165(g)(2)) shall not be treated as derived from 
sources within the Virgin Islands.
    (6) Definition--``taxable income'' on a joint return. In the case of 
a husband and wife making a joint return, the term ``taxable income'', 
as used in this paragraph, means the combined taxable income of both 
spouses.
    (d) Information required. Section 934(d) provides that the 
exceptions in section 934 (b) and (c) shall apply only in the case of 
persons who supply such information as the Secretary or his delegate may 
by regulations prescribe for purposes of determining the applicability 
of such exceptions. The following portions of this paragraph, together 
with paragraphs (e) and (f) of this section, prescribe the information 
which must be filed. Any person seeking to come within an exception must 
provide the following information:
    (1) The name and address of such person;
    (2) If such person is one of two or more organizations, trades, or 
businesses (whether or not incorporated, whether or not organized in the 
United States, and whether or not affiliated) owned or controlled 
directly or indirectly by the same interests within the meaning of 
section 482 and the regulations thereunder--
    (i) The name and address of each such organization, trade, or 
business;
    (ii) The relationship which each such organization, trade, or 
business bears to the other organizations, trades, or businesses in such 
group;
    (iii) The nature of the activity or activities conducted by each 
such organization, trade, or business.
    (3) Any person seeking to come within an exception must make 
available for inspection by the Director of International Operations 
such records, and underlying contracts and documents, as are necessary 
to determine the applicability of section 934(b) or (c).
    (e) Information required--corporations. Corporations seeking to come 
within the exception provided in section 934(b) shall, in addition to 
the information required by paragraph (d) of this section, submit the 
following information with respect to each taxable year:
    (1) The date and place of incorporation;
    (2) The name and address of any shareholder of record owning at any 
time during the taxable year 5 percent or more of the voting stock of 
any class or 5 percent or more of the value of any class of outstanding 
stock, and the nature and amount of the stock owned;
    (3) For the 3-year period immediately preceding the close of the 
corporation's taxable year (or for such part of such period immediately 
preceding the close of such taxable year as may be applicable)--
    (i) The total amount of its gross income;
    (ii) The amount of such gross income derived from the active conduct 
of a trade or business within the Virgin Islands;
    (iii) The amount of such gross income from sources within (a) the 
Virgin Islands, (b) the United States (including therein and 
specifically itemizing all amounts received within the United States), 
and (c) all other countries as a group;
    (iv) The ratio which gross income derived from sources within the 
Virgin Islands bears to total gross income;
    (v) The ratio which gross income derived from the active conduct of 
a trade or business within the Virgin Islands bears to total gross 
income.
    (f) Information required--individuals. Individuals seeking to come 
within the exception provided in section 934(c) shall, in addition to 
the information required by paragraph (d) of this section, submit the 
following information with respect to each taxable year:
    (1) The date on which such individual became a bona fide resident of 
the Virgin Islands;
    (2) If such individual maintains a place of abode for himself or his 
family in the United States or elsewhere outside the Virgin Islands, the 
location of

[[Page 135]]

such place of abode and the purpose for which such place is maintained;
    (3) The beginning and the ending dates of each period of absence 
from the Virgin Islands during such taxable year;
    (4) The amount of gross income for such taxable year from sources 
within the Virgin Islands, excluding--
    (i) The amount of gain or loss from the sale or exchange of any 
security, as defined in section 165(g)(2);
    (ii) The amount of gross income received for services performed as 
an employee of the United States or any agency thereof.
    (5) Any amounts excluded from gross income from sources within the 
Virgin Islands under subparagraph (4)(i) and (ii) of this paragraph.
    (g) Time and place for filing statement. The statement, in 
duplicate, providing the information required under section 934(d) and 
paragraphs (d), (e), and (f) of this section shall be attached to the 
income tax return filed with the Government of the Virgin Islands for 
the taxable year with respect to which an exception is claimed under 
section 934 (b) or (c). If an exception is claimed with respect to any 
taxable year for which the time prescribed by law for filing the return 
expires prior to 30 days from the publication of these regulations, the 
required statement must be filed in duplicate on or before 90 days from 
the publication of these regulations. The return and statement must be 
available for examination by the Director of International Operations.
    (h) Effective date. The provisions of this section shall apply to 
taxable years beginning after December 31, 1959.

[T.D. 6629, 27 FR 12791, Dec. 28, 1962]



Sec. 1.935-1  Coordination of U.S. and Guam individual income taxes.

    (a) Application of section--(1) Scope. Section 935 and this section 
set forth the special rules relating to the filing of income tax 
returns, income tax liabilities, and estimated income tax of individuals 
described in subparagraph (2) of this paragraph. For additional rules 
relating to the collection of income tax at source on the wages of 
certain individuals, the furnishing of certain information with the 
returns of certain individuals, and the covering over to the treasury of 
Guam of net collections of income taxes imposed on certain individuals, 
see section 7654 and Sec. 301.7654-1 of this chapter (Regulations on 
Procedure and Administration).
    (2) Individuals covered. This section shall apply for a taxable year 
to any individual who--
    (i) Is a resident of Guam, whether or not he is a citizen of the 
United States,
    (ii) Is a citizen of Guam but not otherwise a citizen of the United 
States,
    (iii) Has income derived from Guam for the taxable year and is a 
citizen or resident of the United States, or
    (iv) Files a joint return for the taxable year with any individual 
described in subdivision (i), (ii), or (iii) of this subparagraph.
    (3) Determination of residence and citizenship. For purposes of this 
section, determinations of residence and citizenship for a taxable year 
shall be made (except as provided to the contrary in paragraphs (d)(1) 
and (2) of this section) as of the close of the taxable year. A citizen 
of the United States is any individual who is a citizen within the 
meaning of paragraph (c) of Sec. 1.1-1, except that the term does not 
include an individual who is a citizen of Guam but not otherwise a 
citizen of the United States. An individual who is a citizen of Guam but 
not otherwise a citizen of the United States is any individual who has 
become a citizen of the United States by birth or naturalization in 
Guam. Whether an individual is a resident of Guam or a resident of the 
United States shall generally be determined by applying to the facts and 
circumstances in each case the principles of Secs. 1.871-2 through 
1.871-5 relating to what constitutes residence or nonresidence, as the 
case may be, in the United States in the case of an alien individual. 
However, for special rules for determining the residence for tax 
purposes of individuals under military or naval orders, see section 514 
of the Soldiers' and Sailors' Civil Relief Act of 1940, 50 App. U.S.C. 
574. The residence of an individual, and, therefore, the jurisdiction 
with which he is required to file an income tax return under paragraph 
(b) of this section, may change from year to year.

[[Page 136]]

    (b) Filing requirement--(1) Tax jurisdiction. An individual 
described in paragraph (a)(2) of this section shall file his return of 
income tax for the taxable year--
    (i) With the United States if he is a resident of the United States, 
whether or not he is a citizen of the United States,
    (ii) With Guam if he is a resident of Guam, whether or not he is a 
citizen of Guam, or
    (iii) If neither subdivision (i) nor (ii) of this subparagraph 
applies,
    (A) With Guam if he is a citizen of Guam but not otherwise a citizen 
of the United States, as defined in paragraph (a)(3) of this section, or
    (B) With the United States if he is a citizen of the United States, 
as defined in paragraph (a)(3) of this section. Thus, for example, if a 
U.S. citizen employed by the United States in Guam becomes a resident of 
Guam for the taxable year, he must file his return of income tax for 
such year with Guam. The tax shown on the return shall be paid to the 
jurisdiction with which such return is required to be filed and shall be 
determined by taking into account any credit under section 31 for tax 
withheld by Guam or the United States on wages, any credit under section 
6402(b) for an overpayment of income tax to Guam or the United States, 
and any payments under section 6315 of estimated income tax paid to Guam 
or the United States. See paragraph (a)(3) of this section for the rule 
that determinations of residence and citizenship are to be made as of 
the close of the taxable year.
    (2) Joint returns. In the case of married persons, if one or both 
spouses is an individual described in paragraph (a)(2) of this section 
and they file a joint return of income tax, the spouses shall file their 
joint return with, and pay the tax due on such return to, the 
jurisdiction where the spouse who has the greater adjusted gross income 
for the taxable year would be required under subparagraph (1) of this 
paragraph to file his return if separate returns were filed. For this 
purpose, adjusted gross income of each spouse is determined under 
section 62 and the regulations thereunder but without regard to 
community property laws; and, if one of the spouses dies, the taxable 
year of the surviving spouse shall be treated as ending on the date of 
such death.
    (3) Place for filing returns--(i) U.S. returns. A return required 
under this paragraph to be filed with the United States shall be filed 
in accordance with Sec. 1.6091-2, except that such return of a citizen 
or resident of the United States who is described in Sec. 301.7654-
1(a)(2) of this chapter (Regulations on Procedure and Administration) 
shall be filed with the Internal Revenue Service Center, 11601 Roosevelt 
Boulevard, Philadelphia, Pennsylvania 19155.
    (ii) Guam returns. A return required under this paragraph to be 
filed with Guam shall be filed with the Commissioner of Revenue and 
Taxation, Agana, Guam 96910.
    (4) Tax accounting standards. A taxpayer who has filed his return 
with one of the jurisdictions named in subparagraph (1) of this 
paragraph for a prior taxable year and is required to file his return 
for a later taxable year with the other such jurisdiction may not, for 
such later taxable year, change his accounting period, method of 
accounting, or any election to which he is bound with respect to his 
reporting of taxable income to the first jurisdiction unless he obtains 
the consent of the second jurisdiction to make such change. However, 
such change will not be effective for returns filed thereafter with the 
first jurisdiction unless before such later date of filing he also 
obtains the consent of the first jurisdiction to make such change. Any 
request for consent to make a change pursuant to this subparagraph must 
be made to the office where the return is required to be filed under 
subparagraph (3) of this paragraph and in sufficient time to permit a 
copy of the consent to be attached to the return for the taxable year.
    (c) Extent of liability for income tax--(1) Extension of territory--
(i) General rule. With respect to an individual who, for a taxable year, 
is described in paragraph (a)(2) of this section--
    (A) For purposes of so much of the Internal Revenue Code of 1954 as 
relates to the normal taxes and the surtaxes imposed by chapter 1 
thereof, the United States shall be treated, in a

[[Page 137]]

geographical and governmental sense, as including Guam, and
    (B) For purposes of the Guam Territorial income tax (48 U.S.C. 
1421i), Guam shall be treated, in a geographical and governmental sense, 
as including the United States except that this subdivision shall not 
apply for purposes of this section, section 7651, and section 7654.
    (ii) Application of general rule. (A) The significance of the 
application of the rule of subdivision (i) of this subparagraph will 
depend upon the facts and circumstances of the particular case. The rule 
will not be applied where its application would be manifestly 
inapplicable or incompatible with the intent thereof. Thus, the rule 
will not be applied for purposes of section 3401, relating to definition 
of wages. Also, the rule will not be applied in determining the sources 
of dividends and interest from a domestic corporation. For example, if 
less than 20 percent of a domestic corporation's gross income is from 
U.S. sources for the period described in section 861(a)(1)(B) and 
(2)(A), but more than 20 percent of its gross income is from U.S. and 
Guam sources taken together for such period, the dividends and interest 
derived from it will be treated as derived from sources without the 
United States. In addition, for purposes of section 1372(e)(4), relating 
to whether an election of a small business corporation has been 
terminated because it derived more than 80 percent of its gross receipts 
from sources outside the United States, gross receipts from sources 
within Guam will be treated as gross receipts from sources outside the 
United States. On the other hand, some of the conclusions which may be 
reached as a result of the application of subdivision (i) of this 
subparagraph to a U.S. taxpayer (that is, an individual described in 
paragraph (b)(1)(i) or (iii)(B) of this section) are as follows. A U.S. 
taxpayer may not claim a foreign tax credit based upon his income from 
sources within Guam. Income tax paid to Guam may be taken into account 
under sections 31, 6315, and 6402(b) as payments to the United States. 
For purposes of section 116(a), relating to the partial exclusion of 
dividends received by individuals, dividends paid to a U.S. taxpayer by 
a corporation created or organized in Guam or under the law of Guam will 
be treated as dividends paid by a domestic corporation. Taxes paid to 
Guam and otherwise satisfying the requirements of section 164(a) will be 
allowed as a deduction under that section, but income taxes paid to Guam 
will be disallowed as a deduction under section 275(a).
    (B) If a U.S. taxpayer has a net operating loss carryback or 
carryover under section 172, a foreign tax credit carryback or carryover 
under section 904, an investment credit carryback or carryover under 
section 46, a capital loss carryover under section 1212, or a charitable 
contributions carryover under section 170, the United States will take 
such carryback or carryover into account for a taxable year for which 
the taxpayer's return is required to be filed with the United States, 
and make a refund to the extent required under section 6402, even though 
the return of the taxpayer for the taxable year (whether beginning on, 
before, or after December 31, 1972) giving rise to the carryback or 
carryover was required to be filed with Guam.
    (C) For purposes of income averaging of a U.S. taxpayer under 
sections 1301 through 1305, the taxpayer will not be denied status as an 
``eligible individual'' merely because he was during the base period 
defined in section 1302(c)(2) treated under section 932 as a nonresident 
alien individual because he was a citizen of Guam but not otherwise a 
citizen of the United States. See section 1303(b). Furthermore, in 
determining the base period of such a U.S. taxpayer under section 
1302(c)(2), taxable years for which a return was required to be filed 
with Guam shall be taken into account.
    (D) In applying the Guam Territorial income tax the converse of the 
preceding rules under this subdivision will apply. Thus, for example, 
income tax paid to the United States may be taken into account under 
sections 31, 6315, and 6402(b) as payments to Guam. Moreover, a citizen 
of the United States (as defined in paragraph (a)(3) of this section) 
not a resident of Guam will not be treated as a nonresident alien 
individual for purposes of the Guam Territorial income tax. Thus, for

[[Page 138]]

example, a citizen of the United States (as so defined), or a resident 
of the United States, will not be treated as a nonresident alien 
individual for purposes of section 1371(a)(3) of the Guamanian 
Territorial income tax.
    (2) Liability to other jurisdiction--(i) Filing with Guam. If for a 
taxable year an individual is required under paragraph (b)(1) of this 
section to file a return with Guam, he is relieved of liability to file 
an income tax return with, and to pay an income tax to, the United 
States for the taxable year.
    (ii) Filing with the United States. If for a taxable year an 
individual is required under paragraph (b)(1) of this section to file a 
return with the United States, he is relieved of liability to file an 
income tax return with, and to pay an income tax to, Guam for the 
taxable year.
    (d) Special rules for estimated income tax--(1) Declaration of 
estimated income tax. If, under all the facts and circumstances existing 
at the date an individual is required to file a declaration of estimated 
income tax, there is reason to believe that he will, for the taxable 
year, be an individual described in paragraph (a)(2) of this section, he 
must file his declaration of estimated income tax (and all amendments 
thereof) with the jurisdiction with which he would be required to file a 
return under paragraph (b)(1) of this section if his taxable year had 
closed on the date he is first required to file a declaration of 
estimated income tax for the taxable year. Except as provided in 
paragraph (6) of this section (relating to underpayments of estimated 
income tax), payments of estimated income tax shall be made to the 
jurisdiction with which he is required to file the declaration even 
though for the taxable year he is required under paragraph (b)(1) of 
this section to file his return with the other jurisdiction. In 
determining the amount of such estimated income tax, income tax paid to 
Guam may be taken into account under sections 31 and 6402(b) as payments 
to the United States, and vice versa. For rules relating to the 
determination of, and time for filing, declarations of estimated tax, 
see sections 6015 and 6073; for rules relating to the time for paying 
installments of the tax, see section 6153.
    (2) Joint declaration of estimated income tax. In the case of 
married persons, if, under all the facts and circumstances existing at 
the date a spouse is required to file a declaration of estimated income 
tax, there is reason to believe that he will, for the taxable year, be 
an individual described in paragraph (a)(2) of this section and the 
spouses file a joint declaration of estimated income tax, the spouses 
must file their joint declaration of estimated income tax (and all 
amendments thereof) with the jurisdiction where the spouse who has the 
greater estimated adjusted gross income for the taxable year would be 
required under subparagraph (1) of this paragraph to file his 
declaration of estimated income tax if separate declarations were filed. 
For this purpose, estimated adjusted gross income of each spouse for the 
taxable year is determined without regard to community property laws. 
Except as provided in paragraph (6) of this section, payments of 
estimated income tax shall be made to the jurisdiction with which the 
spouses are required to file the joint declaration.
    (3) Early filing of declarations. If the individual or spouses have 
in fact filed a declaration or joint declaration of estimated income tax 
earlier than the time he or they are first required to file the 
declaration and such declaration was not filed where it is required to 
be filed under paragraph (d)(1) or (2) of this section, as the case may 
be, of this paragraph, only subsequent amendments of the declaration are 
required to be filed pursuant to such paragraph (d)(1) or (2) of this 
section with the other jurisdiction and only subsequent installments of 
the estimated income tax are required to be paid to the other 
jurisdiction.
    (4) Place for filing declarations. A declaration of estimated income 
tax required under subparagraph (1) of this paragraph to be filed with 
Guam, shall be filed as prescribed in paragraph (b)(3)(ii) of this 
section. A declaration of estimated income tax required under 
subparagraph (1) of this paragraph to be filed with the United States 
shall be filed at the place prescribed by Sec. 1.6073-1(c).

[[Page 139]]

    (5) Liability to other jurisdiction--(i) Filing with Guam. If, for a 
taxable year, an individual is required under this paragraph to file a 
declaration of estimated income tax with Guam, he is relieved of 
liability to file a declaration of estimated income tax (and any 
amendments thereof) with, and to make payments of estimated income tax 
to, the United States for the taxable year.
    (ii) Filing with the United States. If, for a taxable year, an 
individual is required under this paragraph to file a declaration of 
estimated income tax with the United States, he is relieved of liability 
to file a declaration of estimated income tax (and any amendments 
thereof) with, and to make payments of estimated income tax to, Guam for 
the taxable year.
    (6) Underpayments. The liability of an individual described in 
paragraph (a)(2) of this section for underpayments of estimated income 
tax for a taxable year, as determined under section 6654 and the 
regulations thereunder, shall be to the jurisdiction with which he is 
required under paragraph (b) of this section to file his return for the 
taxable year.
    (e) Illustration. The application of this section may be illustrated 
by the following examples:

    Example 1. B, and individual, files returns on a calendar year 
basis. B is a resident of the United States at the time he is required 
to file his declaration of estimated income tax for 1974. If, under the 
facts and circumstances, B does not reasonably expect at the time he 
files his declaration of estimated income tax that he will be a resident 
of Guam at the close of 1974, he will not be subject to this section at 
the time of such filing. However, B subsequently receives Guam source 
income which necessitates an amendment of his declaration, and some time 
later in 1974 he becomes a resident of Guam for the remainder of the 
year. B is required under paragraph (d)(1) of this section to file his 
amended declaration with the United States and to make payments of the 
estimated tax to the United States. However, B is required to file his 
income tax return for 1974 with Guam and to make any underpayments of 
estimated tax to Guam, pursuant to paragraphs (b)(1) and (d)(6) of this 
section.
    Example 2. C, an individual, files returns on a calendar year basis. 
On March 1, 1974, C is a resident of the United States, files his 
declaration of estimated income tax for 1974 with the United States, and 
pays his first installment of estimated tax to the United States. Prior 
to the date C would otherwise be required to file his declaration of 
estimated income tax for 1974 (April 15, 1974), C becomes a resident of 
Guam for the remainder of the year. C is required under paragraph (d)(1) 
of this section to make only his remaining payments of installments of 
estimated tax to Guam. C is also required to file his income tax return 
for 1974 with Guam and to make any underpayments of estimated tax to 
Guam, pursuant to paragraphs (b)(1) and (d)(6) of this section.
    Example 3. D, an individual, files returns on a calendar year basis. 
On August 1, 1974, D ceases to be a resident of the United States for 
the year and becomes a resident of Guam for the remainder of the year. D 
is first required to file a declaration of estimated income tax for 1974 
on September 15, 1974, because of his receipt of an extraordinary item 
of income after June 15, 1974. D is required under paragraph (d)(1) of 
this section to file his declaration with Guam and to make payments of 
the estimated tax to Guam. D is also required to file his income tax 
return for 1974 with Guam and to make any underpayments of estimated tax 
to Guam, pursuant to paragraphs (b)(1) and (d)(6) of this section.

    (f) Effective date. This section shall apply for taxable years 
beginning after December 31, 1972.

(Secs. 7805 (68A Stat. 917; 26 U.S.C. 7805) and 7654(e) (86 Stat. 1496; 
26 U.S.C. 7654 (e)) of the Internal Revenue Code of 1954)

[T.D. 7385, 40 FR 50261, Oct. 29, 1975]



Sec. 1.936-1  Elections.

    (a) Making an election. A domestic corporation shall make an 
election under section 936(e), for any taxable year beginning after 
December 31, 1975, by filing Form 5712 on or before the later of--
    (1) The date on which such corporation is required, pursuant to 
sections 6072(b) and 6081, to file its Federal income tax return for the 
first taxable year for which the election is made; or
    (2) April 8, 1980.

Form 5712 shall be filed with the Internal Revenue Service Center, 11601 
Roosevelt Boulevard, Philadelphia, Pennsylvania 19155 (Philadelphia 
Center).
    (b) Revoking an election. Any corporation to which an election under 
section 936 (e) applies on February 8, 1980 is hereby granted the 
consent of the Secretary to revoke that election for the first taxable 
year to which the election

[[Page 140]]

applied. (The corporation may make a new election under Sec. 1.936-1 (a) 
for any subsequent taxable year.) The corporation shall make this 
revocation by sending to the Philadelphia Center a written statement of 
revocation on or before April 8, 1980.

(Secs. 7805 and 936(e) of the Internal Revenue Code of 1954 (68A Stat. 
917 and 90 Stat. 1644; 26 U.S.C. 7805 and 936(e)))

[T.D. 7673, 45 FR 8588, Feb. 8, 1980; T.D. 7673, 45 FR 16174, Mar. 13, 
1980]



Sec. 1.936-4  Intangible property income in the absence of an election out.

    The rules in this section apply for purposes of section 936(h) and 
also for purposes of section 934(e), where applicable.
    Q. 1: If a possessions corporation and its affiliates do not make an 
election under either the cost sharing or 50/50 profit split option, 
what rules will govern the treatment of income attributable to 
intangible property owned or leased by the possessions corporation?
    A. 1: Intangible property income will be allocated to the 
possessions corporation's U.S. shareholders with the proration of income 
based on shareholdings. If a shareholder of the possessions corporation 
is a foreign person or a tax-exempt person, the possessions corporation 
will be taxable on that shareholder's pro rata amount of the intangible 
property income. If any class of the stock of a possessions corporation 
is regularly traded on an established securities market, then the 
intangible property income will be taxable to the possessions 
corporation rather than the corporation's U.S. shareholders. For these 
purposes, a United States shareholder includes any shareholder who is a 
United States person as described under section 7701(a)(30). The term 
``intangible property income'' means the gross income of a possessions 
corporation attributable to any intangible property other than 
intangible property which has been licensed to such corporation since 
prior to 1948 and which was in use by such corporation on September 3, 
1982.
    Q. 2: What is the source of the intangible property income described 
in question 1?
    A. 2: The intangible property income is U.S. source, whether taxed 
to U.S. shareholders or taxed to the possessions corporation. Such 
intangible property income, if treated as income of the possessions 
corporation, does not enter into the calculation of the 80-percent 
possessions source test or the 65-percent active trade or business test 
of section 936(a)(2)(A) and (B).
    Q. 3: How will the amount of income attributable to intangible 
property be measured?
    A. 3: Income attributable to intangible property includes the amount 
received by a possessions corporation from the sale, exchange, or other 
disposition of any product or from the rendering of a service which is 
in excess of the reasonable costs it incurs in manufacturing the product 
or rendering the service (other than costs incurred in connection with 
intangibles) plus a reasonable profit margin. A reasonable profit margin 
shall be computed with respect to direct and indirect costs other than 
(i) costs incurred in connection with intangibles, (ii) interest 
expense, and (iii) the cost of materials which are subject to processing 
or which are components in a product manufactured by the possessions 
corporation. Notwithstanding the above, certain taxpayers who have been 
permitted by the Internal Revenue Service in taxable years beginning 
before January 1, 1983, to use the cost-plus method of pricing without 
reflecting a return from intangibles, but including the cost of 
materials in the cost base, will not be precluded from doing so. (Sec. 
3.02(3), Rev. Proc. 63-10, 1963-1 C.B. 490.) Thus, the Internal Revenue 
Service may continue in appropriate cases to permit such taxpayers to 
continue to report their income as they have been under existing 
procedures described in the previous sentence if it is appropriate under 
all the facts and circumstances and does not distort the income of the 
taxpayer.
    Q. 4: If there is no intangible property related to a product 
produced in whole or in part by a possessions corporation, what method 
may the possessions corporation use to compute its income?
    A. 4: The taxpayer may compute its income using the appropriate 
method as provided under section 482 and the regulations thereunder. The 
taxpayer

[[Page 141]]

may also elect the cost sharing or profit split method.

[T.D. 8090, 51 FR 21524, June 13, 1986]



Sec. 1.936-5  Intangible property income when an election out is made: Product, business presence, and contract manufacturing.

    The rules in this section apply for purposes of section 936(h) and 
also for purposes of section 934(e), where applicable.
    (a) Definition of product.

    Q. 1: What does the term ``product'' mean?
    A. 1: The term ``product'' means an item of property which is the 
result of a production process. The term ``product'' includes component 
products, integrated products, and end-product forms. A component 
product is a product which is subject to further processing before sale 
to an unrelated party. A component product may be produced from other 
items of property, and if it is so produced, may be treated as including 
or not including (at the choice of the possessions corporation) one or 
more of such other items of property for all purposes of section 
936(h)(5). An integrated product is a product which is not subject to 
any further processing before sale to an unrelated party and which 
includes all component products from which it is produced. An end-
product form is a product which--
    (1) Is not subject to any further processing before sale to an 
unrelated party;
    (2) Is produced from a component product or products; and
    (3) Is treated as not including certain component products for all 
purposes of section 936(h)(5).

A possessions corporation may treat a component product, integrated 
product, or end-product form as its possession product even though the 
final stage or stages of production occur outside the possession. 
Further processing includes transformation, incorporation, assembly, or 
packaging.
    Q. 2: If a possessions corporation produces both a component product 
and an integrated product (which by definition includes the end-product 
form), may the possessions corporation use the options under section 
936(h)(5) to compute its income with respect to either the component 
product, the integrated product or the end-product form?
    A. 2: Yes. The possessions corporation may choose to treat the 
component product, the integrated product, or the end-product form as 
the product for purposes of determining whether the possessions 
corporation satisfies the significant business presence test. The 
possessions corporation must treat the same item of property as its 
product (the possession product) for all purposes of section 936(h)(5) 
for that taxable year, including the significant business presence test 
under section 936(h)(5)(B)(ii), the possessions sales calculation under 
section 936(h)(5)(C)(i)(I), the determination of income under section 
936(h)(5)(C)(i)(II), and the combined taxable income computations under 
section 936(h)(5)(C)(ii). Although the possessions corporation must 
treat the same item of property as its product for all purposes of 
section 936(h)(5) in a particular taxable year, its choice of the 
component product, integrated product or end-product form may be 
different from year to year. The possessions corporation must specify 
the possession product on a statement attached to its return (Schedule P 
of Form 5735). The possessions corporation may specify its choice by 
either listing the components that are included in the possession 
product or the components that are excluded from the possession product. 
The possessions corporation must file a separate Schedule P with respect 
to each possession product. The possessions corporation must attach to 
each Schedule P detailed computations indicating how the significant 
business presence test is satisfied with respect to the possession 
product identified in that Schedule P.
    Q. 3: A possessions corporation produces a product that is sometimes 
sold to unrelated parties without further processing and is sometimes 
sold to unrelated parties after further processing. May the possessions 
corporation choose to treat the same item of property as the possession 
product even though in some cases it is an integrated product and in 
some cases it is a component product?

[[Page 142]]

    A. 3: Yes. Except as provided in questions and answers 4 and 5, the 
possessions corporation must designate a single possession product even 
though it is sometimes a component product and sometimes an integrated 
product.
    Q. 4: A possessions corporation produces a product that is sometimes 
sold without further processing by any member of the affiliated group to 
unrelated parties or to related parties for their own consumption and is 
sometimes sold after further processing by any member of the affiliated 
group to unrelated parties or to related parties for their own 
consumption. May the possessions corporation designate two products as 
possession products?
    A. 4: The possessions corporation may designate two or more 
possession products. The possessions corporation must use a consistent 
definition of the possession product for all items of property that are 
sold to unrelated parties or consumed by related parties at the same 
stage in the production process. The significant business presence test 
shall apply separately to each product designated by the possessions 
corporation. The possessions corporation shall compute its income 
separately with respect to each product.
    Q. 5: A possessions corporation produces a product in one taxable 
year and does not sell all of the units that it produced. In the next 
taxable year the possessions corporation produces a product which 
includes the product produced in the prior year. The possessions 
corporation could not have satisfied the significant business presence 
test with respect to the units produced the first taxable year if the 
larger possession product had been designated. May the possessions 
corporation designate two possession products in the second year?
    A. 5: Yes. The possessions corporation may designate two possession 
products. However, once a product has been designated for a particular 
year all sales of units produced in that year must be defined in the 
same manner. In addition, the taxpayer must maintain a significant 
business presence in a possession with respect to that product. Sales 
shall be deemed made first out of the current year's production. If all 
of the current year's production is sold and some inventory is 
liquidated, then the taxpayer's method of inventory accounting shall be 
applied to determine what year's layer of inventory is liquidated.

    Example 1. A possessions corporation S, manufactures a bulk 
pharmaceutical in a possession. S transfers the bulk pharmaceutical to 
its U.S. parent, P, for encapsulation and sale by P to customers. S 
satisifes the significant business presence test with respect to the 
bulk pharmaceutical (the component product) and the combination of the 
bulk pharmaceutical and the capsule (the integrated product). S may use 
the cost sharing or profit split method to compute its income with 
respect to either the component product or the integrated product.
    Example 2. The facts are the same as in example 1 except that S does 
not satisfy the significant business presence test with respect to the 
integrated product. S may use the cost sharing or profit split method to 
compute its income only with respect to the component product. However, 
if in a later taxable year S satisfies the significant business presence 
test with respect to the integrated product, then S may use the cost 
sharing or profit split method to compute its income with respect to 
that integrated product for that later taxable year.
    Example 3. P, a domestic corporation, produces in bulk form in the 
United States the active ingredient for a pharmaceutical product, P 
transfers the bulk form to S, a wholly owned possessions corporation. S 
uses the bulk form to produce in Puerto Rico the finished dosage form 
drug. S transfers the drug in finished dosage form to P, which sells the 
drug to unrelated customers in the U.S. The direct labor costs incurred 
in Puerto Rico by S during its taxable year in formulating, filling and 
finishing the dosage form are at least 65 percent of the total direct 
labor costs incurred by the affiliated group in producing the bulk and 
finished forms during that period. S manufactures (within the meaning of 
section 954(d)(1)(A)) the finished dosage form. S has elected out under 
section 936(h)(5) under the profit split option for the drug product 
area (SIC 283). P and S may treat the bulk and finished dosage forms as 
parts of an integrated product. Since S satisfies the significant 
business presence requirement with respect to the integrated product, it 
is entitled to 50 percent of the combined taxable income on the 
integrated product.
    Example 4. A possessions corporation, S. produces the keyboard of an 
electric typewriter and incorporates the keyboard with components 
acquired from a related corporation into finished typewriters. S does 
not satisfy the significant business presence test

[[Page 143]]

with respect to the typewriters (the integrated product). Therefore, S 
may use the cost sharing or profit split method to compute its income 
only with respect to a component product or end-product form. For 
taxable year 1983, S specifies on a statement attached to its return 
(Schedule P of Form 5735) that the possession product is the end-product 
form. The statement indentifies the components--for example, the 
keyboard structure and frame--which are included in the possession 
product. S's definition of the possession product will apply to all 
units of the electric typewriters which S produces in whole or in part 
in the possession and which are sold in 1983. Thus, all units of a given 
component incorporated into such typewriters will be treated in the same 
way. For example, all keyboards and all frames will be included in the 
possession product, and all electric drive mechanisms and rollers will 
be excluded from the possession product.
    Example 5. Possessions corporation A produces printed circuit boards 
in a possession. The printed circuit boards are sold to unrelated 
parties. A also uses the boards to produce personal computers in the 
possession. A may designate two possession products: printed circuit 
boards and personal computers. The significant business presence test 
applies separately with respect to each of these products. Thus, for 
those printed circuit boards that are sold to unrelated parties, only 
the costs of the possessions corporation and the other members of the 
affiliated group that are incurred with respect to units of the printed 
circuit boards which are produced in whole or in part in the possessions 
and sold to third parties shall be taken into account. Conversely, with 
respect to personal computers, only the costs incurred with respect to 
the personal computers shall be taken into account. This would include 
the costs with respect to printed circuit boards that are incorporated 
into personal computers but not the costs incurred with respect to 
printed circuit boards that are sold without further processing to 
unrelated parties.
    Example 6. Possessions corporation S produces integrated circuits in 
a possession. P, an affilate of S, produces circuit boards in the United 
States. P transfers the circuit boards to S. S assembles the integrated 
circuits and the circuit boards. S sells some of the loaded circuit 
boards to third parties. S retains some of the loaded circuit boards and 
incorporates them into central processing units. The central processing 
units are then sold to third parties. S may designate two possession 
products. S must use a consistent definition of the possession product 
for all units that are sold at the same stage in the production process. 
Thus, with respect to those units sold after assembly of the integrated 
circuits and the printed circuits boards, if S cannot satisfy the 
significant business presence test with respect to all the loaded 
circuit boards (the integrated product), then S must designate a lesser 
product, either the integrated circuit (the component product) or the 
loaded circuit board less the printed circuit board (the end-product 
form) as its possession product. With respect to the central processing 
units sold the same rule would apply. Thus, if S cannot satisfy the 
significant business presence test with respect to the entire central 
processing unit for all of the central processing units sold, S must 
designate some lesser product as its possession product.
    Example 7. S is a possession corporation. In 1985, S produced 100 
units of product X. Those units were finished into product Y in 1985 by 
affiliates of S. Product X is a component of product Y. In 1985, S 
satisfies the direct labor test with respect to product X but not with 
respect to product Y. S designates the component product X as its 
possession product. In 1986 S produces 100 units of product X and 
finishes those units into product Y. S would have satisfied the 
significant business presence test with respect to product X if S had 
designated product X as its possession product in 1986. In addition, in 
1986 S satisfies the significant business presence test with respect to 
the integrated product Y. In 1986, S sells 150 units of Y. One hundred 
of those units would be deemed to be produced in 1986. With respect to 
those units S may designate the integrated product Y as its possession 
product. Under S's method of inventory accounting the remaining 50 units 
were determined to have been produced in 1985. With respect to those 
units S must define its possession product as it did for the taxable 
year in which those units were produced. Thus, S's possession product 
would be the component product X.

    Q. 6: May an affiliated group establish groupings of possession 
products and treat the groupings as single products?
    A. 6: An affiliated group may establish reasonable groupings of 
possession products based on similarities in the production processes of 
the possession products. Possession products that are grouped shall be 
treated as a single product. The determination of whether the production 
processes involved in producing the products that are to be grouped are 
similar is based on the production processes of the components that are 
included in the possession product. The affiliated group may establish 
new groupings each year. Any grouping which materially distorts a 
taxpayer's income or the application of the significant business 
presence test

[[Page 144]]

may be disallowed by the Commissioner. The mere fact that a grouping 
results in an increased allocation of income to the possessions 
corporation does not, of itself, create a material distortion of income. 
If the Commissioner determines that the taxpayer's grouping is improper 
with respect to one or more products in a group, then those products 
shall be excluded from the group. The effect of excluding a product or 
products from the group is that the taxpayer must demonstrate that the 
group without the excluded products (and each excluded product itself) 
satisfies the significant business presence test. If the group without 
the excluded products, or any of the excluded products themselves, fails 
to satisfy the significant business presence test, then the possessions 
corporation's income from those products shall be determined under 
section 936(h)(1) through (4) and the regulations thereunder.

    Example 1. The following are examples of possession products the 
processes of production of which are sufficiently similar that they may 
be grouped and treated as a single product:
    (A) Beverage bases or concentrates for different soft drinks or soft 
drink syrups, regardless of whether some include sweeteners and some do 
not:
    (B) Different styles of clothing;
    (C) Different styles of shoes;
    (D) Equipment which relies on gravity to deliver solutions to 
patients intravenously;
    (E) Equipment which relies on machines to deliver solutions to 
patients intravenously;
    (F) Video game cartridges, even though the concept and design of 
each game title is, in part, protected against infringement by separate 
copyrights;
    (G) All integrated circuits;
    (H) All printed circuit boards; and
    (I) Hardware and software if the software is one of several 
alternative types of software offered by the manufacturer and sold only 
with the hardware, and a purchaser of the hardware would ordinarily 
purchase one or more of the manufacturer-provided alternative types of 
software. In all other cases, hardware and software may not be grouped 
and treated as a single product.

Groupings (D) and (E) do not include any solutions which are delivered 
through the equipment described therein.
    Example 2. A possessions corporation produces in Puerto Rico non-
programmable, interactive cathode ray tube computer terminals that vary 
in price. These terminals all interact with a computer or controller to 
perform their functions of data entry, graphics word processing, and 
program development. The terminals can be purchased with options that 
include a built-in printer, different language keyboards, specialized 
cathode ray tubes, and different power supply features. All terminals 
are produced in one integrated process requiring the same skills and 
operations. The differences in the production of the terminals include 
differences in the number of printed circuit boards incorporated in each 
terminal, the use of unique keyboards, and the installation and testing 
of the built-in printer. Some difference in direct labor time to 
manufacture the terminals occurs, primarily due to the differing number 
and complexity of printed circuit boards incorporated into each 
terminal. Different model numbers are assigned to various computer 
terminals. A grouping by the taxpayer of all of the terminals as one 
product will be respected by the Service, unless the Service establishes 
that substantial distortion results. This grouping is proper because the 
processes of producing each of the terminals are similar.
    Example 3. A possessions corporation, S produces several models of 
serial matrix impact printers and teleprinters. These products have 
differing performance standards based on such factors as speed (in 
characters per second), numbers of columns, and cost. The production 
process for all types of printers involves production of three basic 
elements: electronic circuitry, the printing head, and the mechanical 
parts. The process of producing all the printers is similar. Thus, all 
printers could be grouped and treated as a single product. S purchases 
electronic circuitry and mechanical parts from a U.S. affiliate. S 
performs manufacturing functions relative to the printing head and 
assembles and tests the finished printers. S does not satisfy the 
significant business presence test with respect to the integrated 
products. S therefore specifies on a statement attached to its return 
(Schedule P of Form 5735) that the possession product for both the 
serial matrix printers and the teleprinters is the end-product form. The 
statement identifies the components which are included in each 
possession product. S may group and treat as a single product the serial 
matrix printers and the teleprinters if both end-product forms include 
and exclude similar components. Thus, if the end-product form for both 
the serial matrix printers and the teleprinters includes the mechanical 
parts and excludes the electronic circuitry, then S may group and treat 
as a single product the two end-product forms. If, however, the end-
product forms for the two items of property contain components that are 
not similar and as a result of this definition of the end-product forms 
the production processes involved in producing the two end-product forms 
are

[[Page 145]]

not similar, then S may not group the end-product forms.

    Q. 7: Is the affiliated group permitted to include in a group an 
item of property that is not produced in whole or in part in a 
possession?
    A. 7: No.

    Example 1. Possessions corporation S produces 70 units of product A 
in a possession. P, an affiliate of S, produces 30 units of product A 
entirely in the United States. All of the units are sold to unrelated 
parties. The affiliated group is not permitted to group the 30 units of 
product A produced in the United States with the 70 units produced in 
the possession because those units are not produced in whole or in part 
in a possession.
    Example 2. The facts are the same as in example 1 except that the 30 
units of product A are transferred to possessions corporation S. S 
incorporates the 100 units of product A into product B. This 
incorporation takes place in the possession. S may group and treat as a 
single product all of the units of product B even though some of those 
units contain units of product A that were produced in the possession 
and some that were produced in the United States.

    Q. 8: What factors should be disregarded in determining whether a 
particular grouping of similar items of property is reasonable?
    A. 8: In general, differences in the following factors will be 
disregarded in determining whether a particular grouping of items of 
property is reasonable:
    (1) Differences in testing requirements (e.g., some products sold 
for military use may require more extensive or different testing than 
products sold for commercial use);
    (2) Differences in the product specifications that are designed to 
accommodate the product to its area of use or for conditions under which 
used (e.g., electrical products designed for ultimate use in the United 
States differ from electrical products designed for ultimate use in 
Europe);
    (3) Differences in packaging or labeling (e.g., differences in the 
number of units of the items shipped in one package); and
    (4) Minor differences in the operations of the items of property.
    Q. 9: What rules apply for purposes of determining whether 
pharmaceutical products are properly grouped and treated as a single 
product?
    A. 9: The rules contained in questions and answers 6 through 8 of 
this section shall apply. Thus, an affiliated group may establish 
reasonable groupings based on similarities in the production processes 
of two or more possession products. In establishing a group the 
affiliated group may only compare the production processes involved in 
producing the possession products. The fact that two pharmaceutical 
products contain different active or inert ingredients is not relevant 
to the determination of whether the pharmaceutical products may be 
grouped. For example, if the possession products are bulk chemicals and 
the production processes involved in producing the bulk chemicals are 
similar, those bulk chemicals may be grouped and treated as a single 
product even though they contain different active or inert ingredients. 
The affiliated group may also group and treat as a single product the 
finished dosage form drug as long as the production processes involved 
in producing the finished dosage forms are similar. For these purposes, 
the production processes involved in producing the following classes of 
items shall be considered to be sufficiently similar that possession 
products delivered in a form described in one of the categories may be 
grouped with other possession products delivered in a form described in 
the same category.
    The categories are:
    (1) Capsules, tablets, and pills;
    (2) Liquids, ointments, and creams; or
    (3) Injectable and intravenous preparations.

No distinctions should be based on packaging, list numbers, or size of 
dosage. The affiliated group may group and treat as a single product the 
integrated product (combination of the bulk and the delivery form) only 
if all the production processes involved in producing the integrated 
products are similar. The rules of this question and answer are 
illustrated by the following examples.

    Example 1. Possessions corporation S produces two chemical active 
ingredients X and Y. Both chemical ingredients are produced through the 
process of fermentation. The affiliated group is permitted to group and

[[Page 146]]

treat as a single product the two chemical ingredients.
    Example 2. The facts are the same as in example 1 and possessions 
corporation S finishes chemical ingredient X into tablets and chemical 
ingredient Y into capsules. The affiliated group is permitted to group 
and treat as a single product the combination of the bulk pharmaceutical 
and the finishing because the production processes involved in producing 
the integrated products are similar.
    Example 3. Possessions corporation S produces in a possession a bulk 
chemical X by fermentation. A United States affiliate, P, produces in 
the United States a bulk chemical, Y, by fermentation. Both bulk 
chemicals are finished by S in the possession. The finished dosage form 
of X is in pill form. The finished dosage form of Y is in injectable 
form. If S's possession product is the integrated product or the end-
product form then S may not group X and Y because the production 
processes involved in producing the finished dosage form of X and Y are 
not similar. If S's possession product is the component then S may not 
group X and Y because the bulk chemical Y is not produced in whole or in 
part in a possession.

    Q. 10: Will the fact that a manufacturer of a drug must submit a New 
Drug Application (``NDA'') or a supplemental NDA to the Food and Drug 
Administration have any effect on the definition or grouping of a 
product?
    A. 10: No.
    Q. 11: A possessions corporation which produced a product or 
rendered a type of service in a possession on or before September 3, 
1982, is not required to meet the significant business presence test in 
a possession with respect to such product or type of service for its 
taxable years beginning before January 1, 1986 (the interim period). 
During such interim period, how will the term ``product'' be defined for 
purposes of allocating income under the cost sharing or profit split 
methods?
    A. 11: During the interim period the product will be determined 
based on the activities performed by the possessions corporation within 
a possession on September 3, 1982. During the interim period the 
possessions corporation may compute its income under the cost sharing or 
profit split method only with respect to the product that is produced or 
manufactured within the meaning of section 954(d)(1)(A) within the 
possession. If the product is manufactured from a component or 
components produced by an affiliated corporation or a contract 
manufacturer, then the product will not be treated as including such 
component or components for purposes of the computation of income under 
the cost sharing or profit split methods. Thus, the possessions 
corporation is not entitled to any return on the intangibles associated 
with the component or components. Notwithstanding the preceding 
sentences, for taxable years beginning before January 1, 1986, a 
possessions corporation may compute its income under the cost sharing or 
profit split method with respect to a product which includes a component 
or components produced by an affiliated corporation or contract 
manufacturer if the possessions corporation satisfies with respect to 
such product the significant business presence test described in section 
936(h)(5)(B)(ii) and the regulations thereunder.

    Example 1. A possessions corporation, S, was manufacturing (within 
the meaning of section 954(d)(1)(A)) integrated circuits in a possession 
on September 3, 1982. S transferred those integrated circuits to related 
corporation P. P incorporated the integrated circuits into central 
processing units (CPUs in the United States) and sold the CPUs to 
unrelated parties. S continued to manufacture integrated circuits in the 
possession through Juanuary 1, 1986. For taxable years beginning before 
January 1, 1986, S may compute its income under the cost sharing or 
profit split method with respect to the integrated circuits regardless 
of whether S satisfies the significant business presence test. However, 
unless S satisfies the significant business presence test with respect 
to the central processing units, S may not compute its income under the 
cost sharing or profit split methods with respect to the CPUs, and thus, 
S is not entitled to any return on manufacturing intangibles associated 
with CPUs to the extent that they are not related to the integrated 
circuits produced by S, nor (except as provided in the profit split 
methods) to any return on marketing intangibles.
    Example 2. A possessions corporation, S, was engaged on September 3, 
1982, in the manufacture (within the meaning of section 954(d)(1)(A)) of 
a bulk pharmaceutical in Puerto Rico from raw materials. S sold the bulk 
pharmaceutical to its U.S. parent, P, for encapsulation and sale by P to 
customers as the product X. Because S was not engaged in the 
encapsulation of X, S is not considered to have manufactured the 
integrated product, X, in Puerto Rico. During the interim period, S may 
compute its income under the

[[Page 147]]

cost sharing or profit split methods with respect to the integrated 
product, X, only if S satisfies the significant business presence test 
with respect to X. S may compute its income under the cost sharing or 
profit split methods with respect to the component product (the bulk 
pharmaceutical).
    Example 3. P is a domestic corporation that is not a possessions 
corporation. P manufactures a bulk pharmaceutical in the United States. 
P transfers the bulk pharmaceutical to its wholly owned subsidiary, S, a 
possessions corporation. On September 3, 1982, S was engaged in the 
encapsulation of the bulk pharmaceutical in Puerto Rico in a manner 
which satisfies the test of section 954(d)(1)(A). For taxable years 
beginning before January 1, 1986, S may compute its income under the 
cost sharing or profit split methods with respect to the end-product 
form the (the encapsulated drug) regardless of whether S meets the 
significant business presence test. However, unless S satisfies the 
significant business presence test with respect to the integrated 
product, S may not compute its income under the cost sharing or profit 
split methods with respect to the integrated product, and thus, S is not 
entitled to any return on the intangibles associated with the bulk 
pharmaceutical.

    Q. 12: On September 3, 1982, a possessions corporation, S was 
engaged in the manufacture (within the meaning of section 954(d)(1)(A)) 
of X in a possession. During the interim period, after September 3, 
1982, but before January 1, 1986, S produced Y, which differs from X in 
terms of minor design features. S did not produce Y in a possession on 
September 3, 1982. Will S be considered to have commenced production of 
a new product after September 3, 1982, for purposes of the application 
of the significant business presence test for the interim period?
    A. 12: No. X and Y will be considered to be a single product, and 
therefore S will not be required to satisfy the business presence test 
separately with respect to Y during the interim period. In all cases in 
which the items of property produced on or before September 3, 1982 and 
the items of property produced after that date could have been grouped 
together under the guidelines provided in Sec. 1.936-5(a) questions and 
answers 6 through 10, the possessions corporation will not be considered 
to manufacture a new product after September 3, 1982.
    Q. 13: May the term ``product'' be defined differently for export 
sales than for domestic sales?
    A. 13: Yes. For rules concerning the application of the separate 
election for export sales see Sec. 1.936-7(b).
    (b) Requirement of significant business presence--(1) General rules.

    Q. 1: In general, a possessions corporation may compute its income 
under the cost sharing or profit split methods with respect to a product 
only if the possessions corporation has a significant business presence 
in a possession with respect to that product. When will a possession 
corporation be considered to have a significant business presence in a 
possession?
    A. 1: For purposes of the cost sharing method, the significant 
business presence test is met if the possessions corporation satisfies 
either a value added test or a direct labor test. For purposes of the 
profit split method, the significant business presence test is met if 
the possessions corporation satisfies either a value added test or a 
direct labor test and also manufactures the product in the possession 
within the meaning of section 954(d)(1)(A).
    Q. 2: How may a possessions corporation satisfy the direct labor 
test with respect to a product?
    A. 2: The possessions corporation will satisfy the direct labor test 
with respect to a product if the direct labor costs incurred by the 
possessions corporation as compensation for services performed in a 
possession are greater than or equal to 65 percent of the direct labor 
costs of the affiliated group for units of the possession product 
produced during the taxable year in whole or in part by the possessions 
corporation.
    Q. 3: How may a possessions corporation satisfy the value added 
test?
    A. 3: In order to satisfy the value added test, the production costs 
of the possessions corporation incurred in the possession with respect 
to units of the possession product produced in whole or in part by the 
possessions corporation in the possession and sold or otherwise disposed 
of during the taxable year by the affiliated group to unrelated parties 
must be greater than or equal to twenty-five percent of the difference 
between gross receipts from

[[Page 148]]

such sales or other dispositions and the direct material costs of the 
affilated group for materials purchased for such units from unrelated 
parties.
    Q. 4: Must the significant business presence test be met with 
respect to all units of the product produced during the taxable year by 
the affiliated group?
    A. 4: No. The significant business presence test must be met with 
respect to only those units of the product produced during the taxable 
year in whole or in part by the possessions corporation in a possession.
    Q. 5: For purposes of determining whether a possessions corporation 
satisfies the significant business presence test, how shall the 
possessions corporation treat the cost of components transferred to the 
possessions corporation by a member of the affiliated group?
    A. 5: The treatment of the cost of components transferred from an 
affiliate depends on whether the possession product is treated as 
including the components for purposes of section 936(h). If it is, then 
for purposes of the value added test, the production costs associated 
with the component shall be treated as production costs of the 
affiliated group that are not incurred by the possessions corporation. 
Those production costs, other than the cost of materials, shall not be 
treated as a cost of materials. For purposes of the direct labor test 
and the alternative significant business presence test, the direct labor 
costs associated with such components shall be treated as direct labor 
costs of the affiliated group that are not incurred by the possessions 
corporation. If the possession product is treated as not including such 
component for purposes of section 936(h), then, solely for purposes of 
determining whether the possessions corporation satisfies the value 
added test, the cost of the component shall not be treated as either a 
cost of materials or as a production cost. For purposes of the direct 
labor test and the alternative significant business presence test, the 
direct labor costs associated with such component shall not be treated 
as direct labor costs of the affiliated group. If the possession product 
is treated as not including such component, then the possessions 
corporation shall not be entitled to any return on the intangibles 
associated with the manufacturing or marketing of the component.
    Q. 6: May two or more related possessions corporations aggregate 
their production or direct labor costs for purposes of determining 
whether they satisfy the significant business presence test with respect 
to a single product?
    A. 6: No.
    Q. 7: A possessions corporation, S, purchases raw materials and 
components from an unrelated corporation which conducts business outside 
of a possession. The unrelated corporation is not a contract 
manufacturer. What is the treatment of such raw materials and components 
for purposes of the significant business presence test?
    A. 7: Where Company S purchases raw materials or components from an 
unrelated corporation which is not a contract manufacturer, the raw 
materials and components are treated as materials, and the costs related 
thereto are treated as a cost of materials.
    (2) Direct labor costs.

    Q. 1: How is the term ``direct labor costs'' to be defined?
    A. 1: The term ``direct labor costs'' has the same meaning which it 
has for purposes of Sec. 1.471-11(b)(2)(i). Thus, direct labor costs 
include the cost of labor which can be identified or associated with 
particular units or groups of units of a specific product. The elements 
of direct labor include such items as basic compensation, overtime pay, 
vacation and holiday pay, sick leave pay (other than payments pursuant 
to a wage continuation plan under section 105(d)), shift differential, 
payroll taxes, and payments to a supplemental unemployment benefit plan 
paid or incurred on behalf of employees engaged in direct labor.
    Q. 2: May a taxpayer treat a cost as a direct labor cost if it is 
not included in inventoriable costs under section 471 and the 
regulations thereunder?
    A. 2: No. A cost may be treated as a direct labor cost only if it is 
included in inventoriable costs. However, a cost may be considered a 
direct labor cost even though the activity to which it relates would not 
constitute manufacturing under section 954(d)(1)(A) as

[[Page 149]]

long as the cost is included in inventoriable costs.
    Q. 3: May the members of the affiliated group include as direct 
labor costs the labor element in indirect production costs?
    A. 3: No. The labor element of indirect production costs may not be 
considered as part of direct labor costs.
    Q. 4: Do direct labor costs include the costs which can be 
identified or associated with particular units or groups of units of a 
specific product if those costs could also be described as quality 
control and inspection?
    A. 4: Yes. Direct labor costs include costs which can be identified 
or associated with particular units or groups of units of a specific 
product. Thus, if quality control and inspection is an integral part of 
the production process, then the labor associated with that quality 
control and inspection shall be considered direct labor. For example, 
integrated circuits are soldered to printed circuit boards by passing 
the boards over liquid solder. Employees inspect each of the boards and 
repair any imperfectly soldered joints discovered on that inspection. 
The labor associated with this process is direct labor. However, if a 
person performs random inspections on limited numbers of products, then 
that labor associated with those inspections shall be considered quality 
control and therefore indirect labor.
    Q. 5: Do direct labor costs of the possessions corporation include 
only the costs which were actually incurred or do they take into 
account, in addition, any labor savings which result because the 
activities were performed in a possession rather than in the United 
States?
    A. 5: Direct labor costs include only the costs which were actually 
incurred.
    Q. 6: For purposes of determining whether a possessions corporation 
satisfies the significant business presence test for a taxable year with 
respect to a product, how shall the possessions corporation compute its 
direct labor costs of units of the product?
    A. 6: The direct labor test shall be applied separately to products 
produced in whole or in part by the possessions corporation in the 
possession during each taxable year. Sales shall be deemed to be made 
first out of the current year's production. If sales are made only out 
of the current year's production, then the direct labor costs of 
producing those units that are sold shall be the pro rata portion of the 
total direct labor costs of producing all the units that are produced in 
whole or in part in the possession by the possessions corporation during 
the current year. If all of the current year's production is sold and 
some inventory is liquidated, then the direct labor test shall be 
applied separately to the current year's production and the liquidated 
inventory. The direct labor costs of producing the liquidated inventory 
shall be the pro rata portion of the total direct labor costs that were 
incurred in producing all the units that were produced in whole or in 
part by the possessions corporation in the possessions in the layer of 
liquidated inventory determined under the member's method of inventory 
accounting.

    Example. S is a cash basis calendar year taxpayer that has made an 
election under section 936(a). In 1985 S produced 100 units of product 
X. Fifty percent of the direct labor costs of the affiliated group were 
incurred by S and were compensation for services performed in the 
possession. Thus, S did not satisfy the significant business presence 
test with respect to product X in taxable year 1985. During 1986 S 
produced 100 units of product X. One hundred percent of the direct labor 
costs of the affiliated group were incurred by S and were compensation 
for services performed in the possession. In 1986 S sells 150 units of 
product X. One hundred of those units are deemed to be from the units 
produced in 1986. With respect to those units S satisfies the 
significant business presence test. Under S's method of inventory 
accounting the remaining 50 units were determined to be produced in 
1985. With respect to those units S does not satisfy the significant 
business presence test because only 50% of the direct labor costs 
incurred in producing those units were incurred by S and were 
compensation for services performed in the possession.

    Q. 7: What is the result if in a particular taxable year the 
possessions corporation satisfies the significant business presence test 
with respect to units of the product produced in one year and fails the 
significant business with respect to units produced in another year?

[[Page 150]]

    A. 7: For those units of the product with respect to which the 
possession corporation satisfies the significant business presence test, 
the possessions corporation may compute its income under the provisions 
of section 936(h)(5). For those units of the product with respect to 
which the possessions corporations fails the significant business 
presence test, the possessions corporation must compute its income under 
section 936(h)(1) through (4).
    Q. 8: Do direct labor costs include costs incurred in a prior 
taxable year with respect to units of the possession product that are 
finished in a later taxable year?
    A. 8: Yes.
    (3) Direct material costs.

    Q. 1: How is the term ``direct material costs'' to be defined?
    A. 1: Direct material costs include the cost of those materials 
which become an integral part of the specific product and those 
materials which are consumed in the ordinary course of manufacturing and 
can be identified or associated with particular units or groups of units 
of that product. See Sec. 1.471-3 for the elements of direct material 
costs.
    Q. 2: May a taxpayer treat a cost as a direct material cost if it is 
not included in inventoriable costs under section 471 and the 
regulations thereunder?
    A. 2: A taxpayer may not treat such costs as direct material costs.
    (4) Production costs.

    Q. 1: How is the term ``production costs'' defined?
    A. 1: The term ``production costs'' has the same meaning which it 
has for purposes of Sec. 1.471-11(b) except that the term does not 
include direct material costs and interest. Thus, production costs 
include direct labor costs and fixed and variable indirect production 
costs (other than interest).
    Q. 2: With respect to indirect production costs described in 
Sec. 1.471-11(c)(2) (ii) and (iii), may a possessions corporation 
include these costs in production costs for purposes of section 936, if 
they are not included in inventoriable costs under section 471 and the 
regulations thereunder?
    A. 2: No. A possessions corporation may include these costs only if 
they are included for purposes of section 471 and the regulations 
thereunder. If a possessions corporation and the other members of the 
affiliated group include and exclude different indirect production costs 
in their inventoriable costs, then, for purposes of the significant 
business presence test, the possessions corporation shall compute its 
production costs and the production costs of the other members of the 
affiliated group by subtracting from the production costs of each member 
all indirect costs included by that member that are not included in 
production costs by all other members of the affiliated group.
    Q. 3: Does a change in a taxpayer's method of accounting for 
purposes of section 471 affect the taxpayer's computation of production 
costs for purposes of section 936?
    A. 3: Yes. If a taxpayer changes its method of accounting for 
purposes of section 471, then the same change shall apply for purposes 
of section 936.
    Q. 4: For purposes of determining whether a possessions corporation 
satisfies the significant business presence test for a taxable year with 
respect to a product, how shall the possessions corporation compute its 
costs of producing units of the product sold or otherwise disposed to 
unrelated parties during the taxable year?
    A. 4: All members of the affiliated group may elect to use their 
current year production costs regardless of whether the members use the 
FIFO or LIFO method of inventory accounting. If some or all of the 
current year's production of a product is sold, then the production 
costs of producing those units sold shall be the pro rata portion of the 
total production costs of producing all the units produced in the 
current year. If all of the current year's production of a product is 
sold and some inventory is liquidated, then the production costs of 
producing the liquidated inventory shall be the pro rata portion of the 
production costs incurred in producing the layer of liquidated inventory 
as determined under the member's method of inventory accounting.
    Q. 5: How should the members of the affiliated group determine the 
portion of their production costs that is allocable to units of the 
product sold or

[[Page 151]]

otherwise disposed of during the taxable year?
    A. 5: The members of the affiliated group may use either standard 
production costs (so long as variances are not material), average 
production costs, or FIFO production costs to determine the production 
costs that will be considered to be attributable to units of the product 
sold or otherwise disposed of during the taxable year. However, all 
members of the affiliated group must use the same method.
    Q. 6: When is the quality control and inspection of a product 
considered to be part of the production activity for that product?
    A. 6: Quality control and inspection of a manufactured product 
before its sale or other disposition by the manufacturer, or before its 
incorporation into other products, is considered to be part of the 
indirect production activity for that initial product. Subsequent 
testing of a product to ensure that the product is compatible with other 
products is not a part of the production activity for the initial 
product.

When a component is incorporated into an end-product form and the end-
product form is then tested, the latter testing will be considered to be 
a part of the indirect production activity for the end-product form and 
will not be considered to be a part of the production activity for the 
component.
    Q. 7: For purposes of the significant business presence test and the 
allocation of income to a possessions corporation, what is the treatment 
of the cost of installation of a product?
    A. 7: For purposes of the significant business presence test and the 
allocation of income to a possessions corporation, product installation 
costs need not be taken into account as costs incurred in the 
manufacture of that product, if the taxpayer keeps such permanent books 
of account or records as are sufficient to establish the fair market 
price of the uninstalled product. In such a case, the cost of 
installation materials, the cost of the labor for installation, and a 
reasonable profit for installation will not be included in the costs and 
income associated with the possession product. If the taxpayer does not 
keep such permanent books of account or records, then the cost of 
installation materials and the cost of labor for installation shall be 
treated as costs associated with the possession product and income will 
be allocated to the possessions corporation and its affiliates under the 
rules provided in these regulations.
    Q. 8: For purposes of the significant business presence test and the 
allocation of income to a product or service, what is the treatment of 
the cost of servicing and maintaining a possession product that is sold 
to an unrelated party?
    A. 8: The cost of servicing and maintaining a possession product 
after it is sold is not associated with the production of that product.
    Q. 9: For purposes of the significant business presence test and the 
allocation of income to a possessions corporation, what is the treatment 
of the cost of samples?
    A. 9: The cost of producing samples will be treated as a marketing 
expense and not as inventoriable costs for these purposes. However, for 
taxable years beginning prior to January 1, 1986, the cost of producing 
samples may be treated as either a marketing expense or as inventoriable 
costs.

    (5) Gross receipts.

    Q. 1: How shall the affiliated group determine gross receipts from 
sales or other dispositions by the affiliated group to unrelated parties 
of the possession product?
    A. 1: Gross receipts shall be determined in the same manner as 
possession sales under the rules contained in Sec. 1.936-6(a)(2).

    (6) Manufacturing within the meaning of section 954(d)(1)(A).
    Q. 1: What is the test for determining, within the meaning of 
section 954(d)(1)(A), whether a product is manufactured or produced by a 
possessions corporation in a possession?
    A. 1: A product is considered to have been manufactured or produced 
by a possessions corporation in a possession within the meaning of 
section 954(d)(1)(A) and Sec. 1.954-3(a)(4) if--
    (i) The property has been substantially transformed by the 
possessions corporation in the possession;
    (ii) The operations conducted by the possessions corporation in the 
possession in connection with the property

[[Page 152]]

are substantial in nature and are generally considered to constitute the 
manufacture or production of property; or
    (iii) The conversion costs sustained by the possessions corporation 
in the possession, including direct labor, factory burden, testing of 
components before incorporation into an end product and testing of the 
manufactured product before sales account for 20 percent or more of the 
total cost of goods sold of the possessions corporation.

In no event, however, will packaging, repackaging, labeling, or minor 
assembly operations constitute manufacture or production of property. 
See particularly examples 2 and 3 of Sec. 1.954-3(a)(4)(iii).
    Q. 2: Does the requirement that a possession product be produced or 
manufactured in a possession within the meaning of section 954(d)(1)(A) 
apply to taxable years beginning before January 1, 1986?
    A. 2: A possessions corporation must satisfy this requirement for 
taxable years beginning before January 1, 1986, in the following cases:
    (i) If the possessions corporation makes a separate election under 
section 936(h)(5)(F)(iv)(II) with respect to export sales;
    (ii) If the possessions corporation is electing as its possession 
product a product that is subject to the interim period rules of 
Sec. 1.936-5(a) question and answer (10); or
    (iii) If the possessions corporation is electing as its possession 
product a product that is not subject to the interim period rules of 
Sec. 1.936-5 (a) question and answer (10) and the possessions 
corporation computes its income under the profit split method with 
respect to that product.

For rules concerning products first produced in a possession after 
September 3, 1982, see Sec. 1.936-5(b)(7) question and answer (2).

    (7) Start-up operations.

    Q. 1: With respect to products not produced (and types of services 
not rendered) in the possession on or before September 3, 1982, when 
must a possessions corporation first satisfy the 25 percent value added 
test or the 65 percent direct labor test?
    A. 1: A transitional period is established such that a possessions 
corporation engaged in start-up operations with respect to a product or 
service need not satisfy the 25 percent value added test or the 65 
percent labor test until the third taxable year following the taxable 
year in which such product is first sold by the possessions corporation 
or such service is first rendered by the possessions corporation. During 
the transitional period, the applicable percentages for these tests will 
be as follows:

------------------------------------------------------------------------
                                                  Any year after 1982
                                              --------------------------
                                                  1        2        3
------------------------------------------------------------------------
Value added test.............................       10       15       20
Labor test...................................       35       45       55
------------------------------------------------------------------------

    Q. 2: Does the requirement that a possession product be produced or 
manufactured in a possessions within the meaning of section 954(d)(1)(A) 
apply to a product if the possessions corporation is engaged in start-up 
operations with respect to that product?
    A. 2: The possessions corporation must produce or manufacture the 
possessions product within the meaning of section 954(d)(1)(A) if the 
possessions corporation computes its income with respect to that product 
under the profit split method.
    Q. 3: When will a possessions corporation be considered to be 
engaged in start-up operations?
    A. 3: A possessions corporation is engaged in start-up operations if 
it begins operations in a possession with respect to a product or type 
of service after September 3, 1982. Subject to the further provisions of 
this answer, a possessions corporation will be considered to begin 
operations with respect to a product if, under the rules of Sec. 1.936-
5(a) questions and answers (6) through (10), such product could not be 
grouped with any other item of property manufactured in whole or in part 
in the possessions by any member of the affiliated group in any 
preceding taxable year. Any improvement or other change in a possession 
product which does not substantially change the production process would 
not be deemed to create a new product. A change in the division of 
manufacturing activity between the

[[Page 153]]

possessions corporation and its affiliates with respect to an item of 
property will not give rise to a new product. If a possessions 
corporation was producing a possession product that was either a 
component product or an end-product form and the possessions corporation 
expands its operations in the same possession so that it is now 
producing a product that includes the earlier possession product, the 
possessions corporation will not be entitled to use the start-up 
significant business presence test unless the production costs incurred 
by the possessions corporation in the possession in producing a unit of 
its new possession product are at least double the production costs 
incurred by the possessions corporation in the possession in producing a 
unit of the earlier possession product. If any member of an affiliated 
group actually groups two or more items of property then, solely for the 
purposes of determining whether any item of property in that group is a 
new product, that grouping shall be respected. However, the fact that an 
affiliated group does not actually group two or more items of property 
shall be disregarded in determining whether any item of property is a 
new product. Notwithstanding the above, if a possessions corporation is 
producing a possession product in one possession and such corporation or 
a member of its affiliated group begins operations in a different 
possession, regardless of whether the items of property could be 
grouped, the affiliated group may treat the units of the item of 
property produced at the new site of operations in the different 
possession as a new product.

    (8) Alternative significant business presence test.

    Q. 1: Will the Secretary adopt a significant business presence test 
other than those set forth in section 936(h)(5)(B)(ii)?
    A. 1: Yes. The following significant business presence test is 
adopted both for the transitional period and thereafter. A possessions 
corporation will have a significant business presence in a possession 
for a taxable year with respect to a product or type of service if--
    (i) No less than 50 percent of the direct labor costs of the 
affiliated group for units of the product produced, in whole or in part, 
during the taxable year by the possessions corporation or for the type 
of service rendered by the possessions corporation during the taxable 
year are incurred by the possessions corporation as compensation for 
services performed in the possession; and
    (ii) The direct labor costs of the possessions corporation for units 
of the product produced or the type of service rendered plus the base 
period construction costs are no less than 70 percent of the sum of such 
base period construction costs and the direct labor costs of the 
affiliated group for such units of the product produced or the type of 
service rendered.

Notwithstanding satisfaction of the above test, for purposes of 
determining whether a possessions corporation may compute its income 
under the profit split method, a possessions corporation will not be 
treated as having a significant business presence in a possession with 
respect to a product unless the possessions corporation manufactures the 
product in the possession within the meaning of section 954(d)(1)(A).
    Q. 2: How is the term ``base period construction costs'' defined?
    A. 2: The term ``base period construction costs'' means the average 
construction costs incurred by or on behalf of the possessions 
corporation for services in the possession during the taxable year and 
the preceding four taxable years for section 1250 property (as defined 
in section 1250(c) and the regulations thereunder) that is used for the 
production of the product or the rendering of the service in the 
possession, and which represents the original use of the section 1250 
property. For purposes of the preceding sentence, if the possessions 
corporation was not in existence during one or more of the four 
preceding taxable years, its construction costs for that year or years 
shall be deemed to be zero. Construction costs include architects' and 
engineers' fees, labor costs, and overhead and profit (if the 
construction is performed by a person that is not a member of the 
affiliated group).

    (c) Definition and treatment of contract manufacturing.


[[Page 154]]


    Q. 1: For purposes of determining whether a possessions corporation 
satisfies the significant business presence test with respect to a 
product, the costs incurred by the possessions corporation or by any of 
its affiliates in connection with contract manufacturing which is 
related to that product and is performed outside the possession shall be 
treated as direct labor costs of the affiliated group and shall not be 
treated as production costs of the possessions corporation or as 
material costs. How is the term ``contract manufacturing'' to be 
defined?
    A. 1: The term ``contract manufacturing'' includes any arrangement 
between a possessions corporation (or another member of the affiliated 
group) and an unrelated person if the unrelated person:
    (1) Performs work on inventory owned by a member of the affiliated 
group for a fee without the passage of title;
    (2) Performs production activities (including manufacturing, 
assembling, finishing, or packaging) under the direct supervision and 
control of a member of the affiliated group; or
    (3) Does not undertake any significant risk in manufacturing its 
product (e.g., it is paid by the hour).

    Q. 2: Does an arrangement between a member of the affiliated group 
and an unrelated party constitute contract manufacturing if the 
unrelated party uses an intangible owned or licensed by a member of the 
affiliated group?
    A. 2: Such an arrangement will be treated as contract manufacturing 
if the unrelated party makes use of a patent owned or licensed by a 
member of the affiliated group in producing the product which becomes 
part of the possession product of the possessions corporation. In 
addition, such use of manufacturing intangibles other than patents may 
be treated as contract manufacturing if it is established that the 
arrangement has the effect of materially distorting the application of 
the significant business presence test. However, the preceding sentence 
shall not apply if the possessions corporation establishes that the 
arrangement was entered into for a substantial business purpose (e.g., 
to obtain the benefit of special expertise of the manufacturer or 
economies of scale). These rules shall not apply to such contract 
manufacturing performed in taxable years beginning before January 1, 
1986, nor shall the rules apply to binding contracts for the performance 
of such contract manufacturing entered into before June 13, 1986.
    Q. 3: For purposes of the significant business presence test, how 
shall a possessions corporation treat the cost of contract manufacturing 
performed within a possession?
    A. 3: If the possessions corporation uses the value added test, it 
will be permitted to treat the cost of the contract manufacturing 
performed in a possession, not including material costs, as a production 
cost of the possessions corporation. If it uses the direct labor test or 
the alternative significant business presence test set forth in 
Sec. 1.936-5(b)(8), it is permitted to treat the direct labor costs of 
the contract manufacturer associated with such contract manufacturing as 
a cost of direct labor of the possessions corporation. The allowable 
amount of the direct labor cost shall be determined in accordance with 
question and answer 4 below.
    Q. 4: How are the amounts paid by a possessions corporation to a 
contract manufacturer for services rendered in a possession to be 
treated by the possessions corporation in computing the direct labor 
cost of the product to which such contract manufacturing relates?
    A. 4: If the possessions corporation can establish the contract 
manufacturer's direct labor cost which was incurred in the possession, 
such cost will be treated as incurred by the possessions corporation as 
compensation for services performed in the possession. If the 
possessions corporation cannot establish such cost, then 50 percent of 
the amount paid to such contract manufacturer may be treated as incurred 
by the possessions corporation as compensation for services performed in 
the possession: provided, that not more than 50 percent of the fair 
market value of the product manufactured by the contract manufacturer is 
attributable to articles shipped into the possession, and the 
possessions corporation receives a statement from the contract 
manufacturer that this test has

[[Page 155]]

been satisfied. If this fair market value test is not satisfied, then 
the cost of contract manufacturing performed within a possession shall 
not be treated as a production cost or a direct labor cost of either the 
possessions corporation or the affiliated group.
    Q. 5: For purposes of the significant business presence test, what 
is the treatment of costs which are incurred by a member of the 
affiliated group (including the possessions corporation) for contract 
manufacturing performed outside of the possession with respect to an 
item of property which is a component of the possession product?
    A. 5: If the possession product is treated as including such 
component, the cost of the contract manufacturing shall be treated as a 
direct labor cost of members of the affiliated group other than the 
possessions corporation for purposes of the direct labor test and the 
alternative significant business presence test, and shall not be treated 
as a production cost of the possessions corporation or as a cost of 
materials for purposes of the value added test. If the possession 
product is treated as not including such component, the cost of the 
contract manufacturing shall not be treated as a direct labor cost of 
any member of the affiliated group for purposes of the direct labor test 
and the alternative significant business presence test, and shall not be 
treated as a production cost of the possessions corporation or as a cost 
of materials for purposes of the value added test.

[T.D. 8090, 51 FR 21524, June 13, 1986; 51 FR 27174, July 30, 1986]



Sec. 1.936-6  Intangible property income when an election out is made: Cost sharing and profit split options; covered intangibles.

    The rules in this section apply for purposes of section 936(h) and 
also for purposes of section 934(e) where applicable.

    (a) Cost sharing option--(1) Product area research.

    Q. 1: Cost sharing payments are based on research undertaken by the 
affiliated group in the ``product area'' which includes the possession 
product. The term ``product area'' is defined by reference to the three-
digit classification under the Standard Industrial Classification (SIC) 
code. Which governmental agency has jurisdiction to decide the proper 
SIC category for any specfic product?
    A. 1: Solely for the purpose of determining the tax consequences of 
operating in a possession, the Secretary or his delegate has exclusive 
jurisdiction to decide the proper SIC category under which a product is 
classified. For this purpose, the product area under which a product is 
classified will be determined according to the 1972 edition of the SIC 
code. From time to time and in appropriate cases, the Secretary may 
prescribe regulations or issue rulings determining the proper SIC 
category under which a particular product is to be classified, and may 
prescribe regulations for aggregating two or more three-digit 
classifications of the SIC code and for classifying product areas 
according to a system other than under the SIC code.
    Q. 2: How is the term ``affiliated group'' defined for purposes of 
the cost sharing option?
    A. 2: For purposes of the cost sharing option, the term ``affiliated 
group'' means the possessions corporation and all other organizations, 
trades or businesses (whether or not incorporated, whether or not 
organized in the United States, and whether or not affiliated) owned or 
controlled directly or indirectly by the same interests, within the 
meaning of section 482.
    Q. 3: Are research and development expenditures that are included in 
product area research limited to research and development expenditures 
that are deductible under section 174 or that are incurred by U.S. 
affiliates?
    A. 3: No, product area research is not limited to product area 
research expenditures deductible under section 174 or to expenses 
incurred by U.S. affiliates. Product area research also includes 
deductions permitted under section 168 with respect to research property 
which are not deductible under section 174; qualified research expenses 
within the meaning of section 30(b); payments (such as royalities) for 
the use of, or right to use, a patent, invention, formula, process, 
design, pattern or know-how; and a proper allowance for amounts incurred 
in the acquisition of manufacturing intangible property.

[[Page 156]]

In the case of an acquisition of depreciable or amortizable 
manufacturing intangible property, the annual amount of product area 
research shall be be equal to the allowable depreciation or amortization 
on the intangible property for the taxable year. In the case of an 
acquisition of nondepreciable or nonamortizable manufacturing intangible 
property, the amount expended for the acquisition shall be deemed to be 
amortized over a five year period and included in product area research 
in the year of the deemed amortization. Any contingent payment made with 
respect to the acquisition of nonamortizable manufacturing intangible 
property shall be treated as amounts incurred in the acquisition of 
nonamortizable manufacturing intangible property when paid or accrued.
    Q. 4: Does royalty income from a person outside the affiliated group 
with respect to the manufacturing intangibles within a product area 
reduce the product area research pool within the same product area?
    A. 4: Yes.
    Q. 5: Does income received from a person outside the affiliated 
group from the sale of a manufacturing intangible reduce the product 
area research pool within the same product area?
    A. 5: In determining product area research, the income from the sale 
attributable to noncontingent payments will reduce product area research 
ratably over the remaining useful life of the property in the case of an 
amortizable intangible and ratably over a 5-year period in the case of a 
nonamortizable intangible. Any income attributable to contingent amounts 
received with respect to the sale of manufacturing intangible property 
shall be treated as amounts received from the sale of the manufacturing 
intangible property in the year in which such contingent amounts are 
received or accrued.
    Q. 6: If a member of an affiliated group incurs research and 
development expenses pursuant to a contract with an unrelated person who 
is entitled to exclusive ownership of all the technology resulting from 
the expenditures, is the amount of product area research reduced by the 
amount of such expenditures?
    A. 6: To the extent that the product area research expenditures can 
be allocated solely to the technology produced for the unrelated person, 
such expenditures will not be included in product area research 
expenditures provided, however, that the unrelated person has exclusive 
ownership of all the technology resulting from these expenditures, and 
further that no member of the affiliated group has a right to use any of 
the technology.
    Q. 7: What is the treatment of product area research expenditures 
attributable to a component where the component and the integrated 
product fall within different product areas?
    A. 7: For purposes of the computation of product area research 
expenditures in the product area by the affiliated group, the product 
area in which the component falls is aggregated with the product area in 
which the integrated product falls. However, if the component product 
and integrated product are in separate SIC codes and if the component 
product is not included in the definition of the possession product, 
then the product area research expenditures are not aggregated. The same 
rule applies where the taxpayer elects a component product which 
encompasses another component product and the two component products 
fall into separate SIC codes. In such case, the product area in which 
the first component falls is aggregated with the product area in which 
the second component falls.

    (2) Possession sales and total sales.

    Q. 1: The cost sharing payment is the same proportion of the total 
cost of product area research which the amount of ``possession sales'' 
of the affiliated group bears to the ``total sales'' of the affiliated 
group within the product area. How are ``possession sales'' defined for 
purposes of the cost sharing fraction?
    A. 1: The term ``possession sales'' means the aggregate sales or 
other dispositions of the possession product, to persons who are not 
members of the affiliated group, less returns and allowances and less 
indirect taxes imposed on the production of the product, for the taxable 
year. Except as otherwise

[[Page 157]]

indicated in Sec. 1.936-6(a)(2), the sales price to be used is the sales 
price received by the affiliated group from persons who are not members 
of the affiliated group.
    Q. 2: For purposes of the numerator of the cost sharing fraction, 
how are possession sales computed where the possession product is a 
component product or an end-product form?
    A. 2: (i) The sales price of the component product or end-product 
form is determined as follows. With respect to a component product, an 
independent sales price from comparable uncontrolled transactions must 
be used if such price can be determined in accordance with Sec. 1.482-
2(e)(2). If an independent sales price of the component product from 
comparable uncontrolled transactions cannot be determined, then the 
sales price of the component product shall be deemed to be equal to the 
transfer price, determined under the appropriate section 482 method, 
which the possessions corporation uses under the cost sharing method in 
computing the income it derives from the active conduct of a trade or 
business in the possession with respect to the component product. The 
possessions corporation in lieu of using the transfer price determined 
under the preceding sentence may treat the sales price for the component 
product as equal to the same proportion of the third party sales price 
of the integrated product which the production costs attributable to the 
component product bear to the total production cost for the integrated 
product. Production cost will be the sum of direct and indirect 
production costs as defined in Sec. 1.936-5(b)(4). If the possessions 
corporation determines the sales price of the component product using 
the production cost ratio, the transfer price used by the possessions 
corporation in computing its income from the component product under the 
cost sharing method may not be greater than such sales price.
    (ii) With respect to an end-product form, the sales price of the 
end-product form is equal to the difference between the third party 
sales price of the integrated product and the independent sales price of 
the excluded component(s) from comparable uncontrolled transactions, if 
such price can be determined under Sec. 1.482-2(e)(2). If an independent 
sales price of the excluded component(s) from uncontrolled transactions 
cannot be determined, then the sales price of the end-product form shall 
be deemed to be equal to the transfer price, determined under the 
appropriate section 482 method, which the possessions corporation uses 
under the cost sharing method in computing the income it derives from 
the active conduct of a trade or business in the possession with respect 
to such end-product form. The possessions corporation in lieu of using 
the transfer price determined under the preceding sentence may use the 
production cost ratio method described above to determine the sales 
price of the end-product form (i.e., the same proportion of the third 
party sales price of the integrated product which the production costs 
attributable to the end-product form bear to the total production costs 
for the integrated product). If the possessions corporation determines 
the sales price of the end-product form using the production cost ratio, 
the transfer price used by the possessions corporation in computing its 
income from the end-product form under the cost sharing method may not 
be greater than such sales price. For similar rules applicable to the 
profit split option see Sec. 1.936-6(b)(1), question and answer 12.
    Q. 3: For purposes of determining possessions sales in the numerator 
of the cost sharing fraction, will the replacement part price of the 
product be treated as a price from comparable uncontrolled transactions?
    A. 3: Prices for replacement parts are generally higher than prices 
for equipment sold as part of an original system. Thus, prices for 
replacement parts cannot generally be used directly as prices for 
comparable uncontrolled transactions. However, replacement part prices 
may be used for estimating comparable uncontrolled prices where the 
price differential can be reasonably determined and taken into account 
under Sec. 1.482-2(e)(2).
    Q. 4: For purposes of determining possession sales in the cost 
sharing

[[Page 158]]

fraction, what is the treatment of components that are purchased by one 
possessions corporation from an affiliated possessions corporation and 
which are incorporated into a possession product where the transferor 
possessions corporation treats the transferred component as a possession 
product?
    A. 4: When one possessions corporation purchases components from a 
second possessions corporation which is an affiliated corporation, the 
purchase price of the components paid to the second possessions 
corporation shall be subtracted from the sales proceeds of the product 
produced in the possession by the first possessions corporation, and 
only the remainder is included in the numerator of the cost sharing 
formula for the first corporation. For example, assume that N 
corporation manufactures a component for sale to O corporation for $100 
(a price which reflects prices in comparable uncontrolled transactions). 
Both N and O are affiliated possessions corporations. N has designated 
that component product as its possession product. O then incorporates 
that product into a second product which is sold to customers for $300 N 
and O must make separate cost sharing payments. The cost sharing payment 
of N corporation is determined by including $100 as possession sales, 
and the payment of O is determined by subtracting that $100 purchase 
price from the $300 received from customers. Thus, the possessions sales 
amount of O is $200. This rule is intended to prevent the double 
counting of the sales of a component produced by one possessions 
corporation and incorporated into another product by an affiliated 
possessions corporation.
    Q. 5: Are pre-TEFRA sales included in the cost sharing fraction?
    A. 5: No. Pre-TEFRA sales are sales of products produced by the 
possessions corporation and transferred to an affiliate prior to a 
possessions corporation's first taxable year beginning after December 
31, 1982. Pre-TEFRA sales are not included in either the numerator or 
denominator of the cost sharing fraction. If the U.S. affiliate uses the 
FIFO method of costing inventory, the pre-TEFRA inventory will be 
treated as the first inventory sold by the U.S. affiliate during the 
first year in which section 936(h) applies. If the U.S. affiliate uses 
the LIFO method of costing inventory (either dollar-value or specific 
goods LIFO), pre-TEFRA inventor will be treated as inventory sold by the 
U.S. affiliate in the year in which the U.S. afiliate's LIFO layer 
containing pre-TEFRA LIFO inventory is liquidated.
    Q. 6: How are ``possession sales'' determined under the cost sharing 
formula if members of the affiliated group (other than the possessions 
corporation) include purchases of the possession product, X, in a 
dollar-value LIFO inventory pool (as provided under Sec. 1.472-8)?
    A. 6: Possession sales may be determined by applying the revenue 
identification method provided under paragraph (b)(1) Question and 
Answer 18 of this section.
    Q. 7: Do possession sales include excise taxes paid by the 
possessions corporation when the product is sold for ultimate use or 
consumption in the possession?
    A. 7: No. The amount of excise taxes is excluded from both the 
numerator and denominator of the cost sharing fraction.
    Q. 8: How are ``total sales'' defined for purposes of the cost 
sharing fraction?
    A. 8: The term ``total sales'' means aggregate sales or other 
dispositions of products in the same product area as the possession 
product, less returns and allowances and less indirect taxes imposed on 
the production of the product, for the taxable year to persons who are 
not members of the affiliated group. The sales price to be used is the 
sales price received by the affiliated group from persons who are not 
members of the affiliated group.
    Q. 9: In computing that cost sharing payment, how are ``total 
sales'' computed if the dollar-value LIFO inventory pool includes some 
products which are not included in the product area (determined under 
the 3-digit SIC code) on which the denominator of the cost sharing 
fraction is based?
    A. 9: In such case, the amount of the total sales within the product 
area to

[[Page 159]]

persons who are not members of the affiliated group by persons who are 
members of the affiliated group is determined by multiplying the total 
sales of the products within the dollar-value LIFO inventory pool by a 
fraction. The numerator of the fraction includes the dollar-value of 
purchases by members of the affiliated group (including the possessions 
corporation) of products within the product area made during the year, 
plus any added production costs (as defined in Sec. 1.471-11(b), (c), 
and (d) but not including the costs of materials) incurred by the 
affiliates during the same period. The denominator of the fraction 
includes the dollar-value of purchases by members of the affiliated 
group (including the possessions corporation) of products within the 
dollar-value LIFO inventory pool made during the same period (including 
any production costs, as described above, incurred by the affiliate 
during the same period). For these purposes, purchases of a possession 
product are determined on the basis of the possessions corporation's 
cost for its inventory purposes.
    Q. 10: May a possessions corporation compute its income under the 
cost sharing method with respect to a possession product which the 
possessions corporation sells to a member of its affiliated group and 
which that member then leases to an unrelated person or uses in its own 
trade or business?
    A. 10: Yes, provided that an independent sales price for the 
possession product from comparable uncontrolled transactions can be 
determined in accordance with Sec. 1.482-2(e)(2), and, provided further, 
that such member complies with the requirements of Sec. 1.936-6(a)(2), 
question and answer 14. If, however, there is a comparable uncontrolled 
price for an integrated product and the possession product is a 
component product or end-product form thereof, the possessions 
corporation may, if such member complies with the requirements of 
Sec. 1.936-6(a)(2), question and answer 14, compute its income under the 
cost sharing method with respect to such possession product. In that 
case, the cost sharing payment shall be computed under the following 
question and answer.
    Q. 11: How are possession sales and total sales to be determined for 
purposes of computing the cost sharing payment with respect to a 
possession product which the possessions corporation sells to a member 
of its affiliated group where that member then leases the possession 
product to unrelated persons or uses it in its own trade or business?
    A. 11: If the possessions corporation is entitled to compute its 
income from such sales of the possession product under the cost sharing 
method, both possession sales and total sales shall be determined as if 
the possession product had been sold by the affiliate to an unrelated 
person at the time the possession product was first leased or otherwise 
placed in service by the affiliate. The sales price on such deemed sale 
shall be equal to the independent sales price from comparable 
uncontrolled transactions determined in accordance with Sec. 1.482-
2(e)(2), if any. If the possession product is a component product or an 
end-product form for which there is no such independent sales price but 
there is a comparable uncontrolled price for the integrated product 
which includes the possession product, the deemed sales price of the 
possession product shall be computed under the rules of Sec. 1.936-
6(a)(2) question and answer 2. The full amount of income received under 
the lease shall be treated as income of (and taxed to) the affiliate and 
not the possessions corporation.
    Q. 12: When may a possessions corporation take into account in 
computing total sales under the cost sharing method products in the same 
product area as the possession product (other than the possession 
product itself) where such products are leased by members of the 
affiliated group to unrelated persons or used by any such member in its 
own trade or business?
    A. 12: For purposes of computing total sales under the cost sharing 
method, the possessions corporation may take into account products in 
the same product area as the possession product itself where such 
products are leased by members of the affiliated group to unrelated 
persons or used in the trade or business of any such member, but only if 
an independent sales price of such products from comparable

[[Page 160]]

uncontrolled transactions may be determined under Sec. 1.482-2(e)(2). In 
such cases, the units of such products which are leased or otherwise 
used internally by members of the affiliated group may be treated as 
sold to unrelated persons for such independent sales price for purposes 
of computing total sales.
    Q. 13: Assuming that a possessions corporation is entitled to 
compute its income under the cost sharing method with respect to sales 
of a possession product to affiliates in cases where those affiliates 
lease units of the possession product to unrelated persons or use them 
internally, is the possessions corporation's income from the possession 
product any different than if the affiliates had sold the product to 
unrelated parties?
    A. 13: No.
    Q. 14: If a possessions corporation sells units of a possession 
product to a member of its affiliated group and that affiliate then 
leases those units to an unrelated person or uses the units in its own 
trade or business, what requirements must the affilate meet in order for 
the possessions corporation to be entitled to the benefits of the cost 
sharing method with respect to such units?
    A. 14: (i) For taxable years of the possessions corporation 
beginning on or before June 13, 1986, the affiliate need not meet any 
special requirements in order for the possessions corporation to be 
entitled to the beneifts of the cost sharing method with respect to such 
units. Thus, the affiliate's basis in such units shall be equal to the 
transfer price used for computing the possessions corporation's gross 
income with respect to such units under section 936(h)(5)(C)(i)(II), and 
the income derived by the affiliate from such lease or internal use 
shall be reported by the affiliate when and to the extent actually 
derived. The affiliate shall not be deemed to have sold such units to an 
unrelated party at the time they were first leased or otherwise placed 
in service for any purpose other than the computation of possession 
sales and total sales. A similar rule applies to other products in the 
same product area as the possession product which are sold by any member 
in its own trade or business and which the possessions corporation takes 
into account in computing total sales under the cost sharing method.
    (ii) For taxable years of the possessions corporations beginning 
after June 13, 1986, a possessions corporations will not be entitled to 
the benefits of the cost sharing method with respect to units of the 
possession product which the possessions corporation sells to an 
affiliate where the affiliate then leases such units to an unrelated 
person or uses them in its own trade or business, unless the affiliate 
agrees to be treated for all tax purposes as having sold such units to 
an unrelated party at the time they were first leased or otherwise 
placed in service by such affiliate. The affiliate must demonstrate such 
agreement by reporting its income from such units as if:
    (A) It had sold such units to an unrelated person at such time at a 
price equal to the price used to compute possessions sales under 
Sec. 1.936-6(a)(2), question and answer 11;
    (B) It had immediately repurchased such units for the same price; 
and
    (C) Its basis in such units for all subsequent purposes was equal to 
its cost basis from such deemed repurchase.

For treatment of other products in the same product area as the 
possession product see Sec. 1.936-6(a)(2), question and answer 12.
    (iii) The principles contained in questions and answers 11, 12, 13, 
and 14 are illustrated by the following example:

    Example. Possessions corporation S and its affiliate A are calendar 
year taxpayers. In 1985, S manufactures 100 units of possession product 
X. S sells 50 units of X to unrelated persons in arm's length 
transactions for $10 per unit. In applying the cost sharing method to 
determine the portion of its gross income from such sales which 
qualifies for the possessions tax credit, S determines that $8 of the 
$10 sales price may be taken into account. S sells the remaining 50 
units of X to A, and A then leases such units to unrelated persons. In 
1985, A also manufacturers 100 units of product Y, the only other 
product in the same product area as X manufactured or sold by any member 
of the affiliated group. A manufactured the 100 units of Y at a cost of 
$15 per unit, sold 50 units of Y to unrelated persons in arm's length 
transactions for $20 per unit, and leased the remaining 50 units of Y to 
unrelated persons.
    S may compute its income under the cost sharing method with respect 
to the 50 units

[[Page 161]]

of X it sold to A because S can determine an independent sales price of 
X from comparable uncontrolled transactions under Sec. 1.482-2(e)(2). 
For purposes of computing both possessions sales and total sales, the 50 
units of X sold to A will be deemed to have been sold by A to an 
unrelated person for $10 per unit. The income of S qualifying for the 
possessions tax credit from the sale of those 50 units of X to A, and 
A's basis in those units, will both be determined using the $8 transfer 
price determined under section 936 (h)(5)(C)(i)(II). For purposes of 
computing total sales in the denominator of the cost sharing fraction, S 
may also take into account the 50 units of Y leased by A to unrelated 
persons, as if A had sold those units for $20 per unit. A's basis in 
those units of Y will continue to be its actual cost basis of $15 per 
unit.
    If all of the above transactions had occurred in 1987, S would be 
entitled to compute its income under the cost sharing method with 
respect to the 50 units of X it sold to A only if A agreed to be treated 
for all tax purposes as if it had sold such units for $10 per unit, 
realized income on such deemed sale of $2 per unit, repurchased such 
units immediately for $10 per unit, and then leased such units, which 
would then have a $10 per unit basis in A's hands. For purposes of 
computing total sales, S would be entitled to take into account the 50 
units of X leased by A to unrelated persons as if A had sold such units 
for $20 per unit.

    (3) Credits against cost sharing payments.

    Q. 1: Is the cost of product area research paid or accrued by the 
possessions corporation in a taxable year creditable against the cost 
sharing payment?
    A. 1: Yes, if the cost of the product area research is paid or 
accrued solely by the possessions corporation. Thus, payments by the 
possessions corporation under cost sharing arrangements with, or 
royalties paid to, unrelated persons are so creditable. Amounts (such as 
royalties) paid directly or indirectly to, or on behalf of, related 
persons and amounts paid under any cost sharing agreements with related 
persons are not creditable against the cost sharing payment.
    Q. 2: Do royalties or other payments made by an affiliate of the 
possessions corporation to another member of the affiliated group reduce 
the cost sharing payment if such royalties or other payments are based, 
in part, on activity of the possessions corporation?
    A. 2: No. Payments made between affiliated corporations do not 
reduce the cost sharing payment. Thus, for example, if a possessions 
corporation sells a component to a foreign affiliate for incorporation 
by the foreign affiliate into an integrated product sold to unrelated 
persons, and the foreign affiliate pays a royalty to the U.S. parent of 
the possessions corporation based on the total value of the integrated 
product, the cost sharing payment of the possessions corporation is not 
reduced.

    (4) Computation of cost sharing payment.

    Q. 1: S is a possessions corporation engaged in the manufacture and 
sale of four products (A, B, C, and D) all of which are classified under 
the same three-digit SIC code. S sells its production to a U.S. 
affiliate, P, which resells it to unrelated parties in the United 
States. P's third party sales of each of these products produced in 
whole or in part by S (computed as provided under paragraph (a)(2) of 
Sec. 1.936-6) are $1 million or a total of $4 million for A, B, C, and 
D. P's other sales of products in the same SIC code are $3,000,000; and 
the defined worldwide product area research of the affiliated group is 
$350,000. How should S compute the cost sharing amount for products A, 
B, C, and D?
    A. 1: The cost sharing amount is computed separately for each 
product on Schedule P of Form 5735. S should use the following formula 
for each of the products A, B, C, and D:
[GRAPHIC] [TIFF OMITTED] TC09OC91.006


[[Page 162]]


[GRAPHIC] [TIFF OMITTED] TC09OC91.007

    Q. 2: The facts are the same as in question 1 except that S 
manufactures product D under a license from an unrelated person. S pays 
the unrelated party an annual license fee of $20,000. Thus, the 
worldwide product area research expense of the affiliated group is 
$370,000. How should the cost sharing payment be adjusted?
    A. 2: The cost sharing fee should be reduced by the $20,000 license 
fee made as a direct annual payment to a third party on account of 
product D. The cost sharing payment with respect to product D in this 
example will be adjusted as follows:
[GRAPHIC] [TIFF OMITTED] TC09OC91.008

[GRAPHIC] [TIFF OMITTED] TC09OC91.009

    Q. 3: The facts are the same as in question 1 except that S also 
manufactures and exports product E to a foreign affiliate, which resells 
it to unrelated persons for $1 million. S makes a separate election for 
its export sales. How should S compute the cost sharing amount for 
product E?
    A. 3: The numerator of the cost sharing fraction is the aggregate 
sales or other dispositions by members of the affiliated group of the 
units of product E produced in whole or in part in the possession to 
persons who are not members of the affiliated group. The cost sharing 
amount for product E would be computed as follows:
[GRAPHIC] [TIFF OMITTED] TC09OC91.010

    or
[GRAPHIC] [TIFF OMITTED] TC09OC91.011

    Q. 4: The facts are the same as in question 1, except that S also 
receives $10,000 in royalty income from unrelated persons for the 
licensing of certain manufacturing intangible property rights. What is 
the amount of the product area research that must be allocated in 
determining the cost sharing amount?
    A. 4: If the affiliated group receives royalty income from unrelated 
persons with respect to manufacturing intangibles in the same product 
area, then the product area research to be considered shall be first 
reduced by such royalty

[[Page 163]]

income. In this case, the amount of product area research to be used in 
determining S's cost sharing payment should be reduced by the $10,000 
royalty payment received to $340,000.
    Q. 5: May a possessions corporation redetermine the amount of its 
required cost sharing payment after filing its tax return?
    A. 5: If after filing its tax return, a possessions corporation 
files an amended return, or if an adjustment is made on audit, either of 
which affects the amount of the cost sharing payment required, then a 
redetermination of the cost sharing payment must be made. See, however, 
section 936(h)(5)(C)(i)(III)(a) with respect to the increase in the cost 
sharing payment due to interest imposed under section 6601(a).

    (5) Effect of election under the cost sharing method.

    Q. 1: What is the effect of the cost sharing method?
    A. 1: The cost sharing payment reduces the amount of deductions (and 
the amount of reductions in earnings and profits) otherwise allowable to 
the U.S. affiliates (other than tax-exempt affiliates) within the 
affiliated group as determined under section 936(h)(5)(C)(i)(I)(b) which 
have incurred research expenditures (as defined in Sec. 1.936-6(a)(1), 
question and answer (3) in the same product area for which the cost 
sharing option is elected, during the taxable year in which the cost 
sharing payment accrues. If there are no such U.S. affiliates, the 
reductions with respect to deductions and earnings and profits, as the 
case may be, are made with respect to foreign affiliates within the same 
affiliated group which have incurred product area research expenditures 
in such product area attributable to a U.S. trade or business. If there 
are no affiliates which have incurred research expenditures in such 
product area, the reductions are then made with respect to any other 
U.S. affiliate and, if there is no such U.S. affiliate, then to any 
other foreign affiliate. The allocations of these reductions in each 
case shall be made in proportion to the gross income of the affiliates. 
In the case of foreign affiliates, the allocation shall be made in 
proportion to gross income attributable to the U.S. trade or business or 
worldwide gross income, as the case may be. With respect to each group 
above, the reduction of deductions shall be applied first to deductions 
under section 174, then to deductions under section 162, and finally to 
any other deductions on a pro rata basis.
    Q. 2: For purposes of estimated tax payments, when is the cost 
sharing amount deemed to accrue?
    A. 2: The cost sharing amount is deemed to accrue to the appropriate 
affiliate on the last day of the taxable year of each such affiliate in 
which or with which the taxable year of the possessions corporation 
ends.
    Q. 3: If the cost sharing method is elected and the year of accrual 
of the cost sharing payment to the appropriate affiliate (described in 
question and answer 1 of this paragraph (a)(5)) differs from the year of 
actual payment by the possessions corporation, in what year are the 
deductions of the recipients reduced?
    A. 3: In the year the cost sharing payment has accrued.
    Q. 4: What is the treatment of income from intangibles under the 
cost sharing method?
    A. 4: Under the cost sharing method, a possessions corporation is 
treated as the owner, for purposes of obtaining a return thereon, of 
manufacturing intangibles related to a possession product. The term 
``manufacturing intangible'' means any patent, invention, formula, 
process, design, pattern, or know-how. The possessions corporation will 
not be treated as the owner, for purposes of obtaining a return thereon, 
of any manufacturing intangibles related to a component product produced 
by an affiliated corporation and transferred to the possessions 
corporation for incorporation into the possession product, except in the 
case that the possession product is treated as including such component 
product for all purposes of section 936(h)(5). Further, the possessions 
corporation will not be treated as the owner, for purposes of obtaining 
a return thereon, of any marketing intangibles except ``covered 
intangibles.'' (See Sec. 1.936-6(c).)

[[Page 164]]

    Q. 5: If the cost sharing option is elected, is it necessary for the 
possessions corporation to be the legal owner of the manufacturing 
intangibles related to the possession product in order for the 
possessions corporation to receive a full return with respect to such 
intangibles?
    A. 5: No. There is no requirement that manufacturing intangibles be 
owned by the possessions corporation.
    Q. 6: How is income attributable to marketing intangibles treated 
under the cost sharing method?
    A. 6: Except in the case of ``covered intangibles'' (see Sec. 1.936-
6(c)), the possessions corporation is not treated as the owner of any 
marketing intangibles, and income attributable to marketing intangible 
of the possessions corporation will be allocated to the possessions 
corporation's U.S. shareholders with the proration of income based on 
shareholdings. If a shareholder of the possessions corporation is a 
foreign, person or is otherwise tax exempt, the possessions corporation 
is taxable on that shareholder's pro rata amount of the intangible 
property income. If the possessions corporation is a corporation any 
class of the stock of which is regularly traded on an established 
securities market, then the income attributable to marketing intangibles 
will be taxable to the possessions corporation rather than the 
corporation's U.S. shareholders.
    Q. 7: What is the source of the intangible property income described 
in question and answer 6?
    A. 7: The intangible property income is U.S. source whether taxed to 
the U.S. shareholder or taxed to the possessions corporation and section 
863 (b) does not apply for this purpose. However, such intangible 
property income, if treated as income of the possessions corporation, 
does not enter into the calculation of the 80-percent possession source 
test or the 65-percent active trade or business test.
    Q.7a: What is the source of the taxpayer's gross income derived from 
a sale in the United States of a possession product purchased by the 
taxpayer (or an affiliate) from a corporation that has an election in 
effect under section 936, if the income from such sale is taken into 
account to determine benefits under cost sharing for the section 936 
corporation? Is the result different if the taxpayer (or an affiliate) 
derives gross income from a sale in the United States of an integrated 
product incorporating a possession product purchased by the taxpayer (or 
an affiliate) from the section 936 corporation, if the taxpayer (or an 
affiliate) processes the possession product or an excluded component in 
the United States?
    A.7a: Under either scenario, the income is U.S. source, without 
regard to whether the possession product is a component, end-product, or 
integrated product. Section 863 does not apply in determining the source 
of the taxpayer's income. This Q&A 7a is applicable for taxable years 
beginning on or after November 13, 1998.
    Q. 8: May marketing intangible income, if any, be allocated to the 
possessions corporation with respect to custom-made products?
    A. 8: No. If the cost sharing option is elected, then income 
attributable to marketing intangibles (other than ``covered 
intangibles'' described in Sec. 1.936-6(c)) will be taxed as discussed 
in questions and answers 6 and 7 of paragraph (a)(5) of this section. It 
is immaterial whether the product is custom-made.
    Q. 9: In order to sell a pharmaceutical product in the United 
States, a New Drug Application (``NDA'') for the product must be 
approved by the U.S. Food and Drug Administration. Is an NDA considered 
a manufacturing or marketing intangible for purposes of the allocation 
of income under the cost sharing method?
    A. 9: A manufacturing intangible.
    Q. 10: Can a copyright be, in whole or in part, a manufacturing 
intangible for purposes of the allocation of income under the cost 
sharing method?
    A. 10: In general, a copyright is a marketing intangible. See 
section 936(h)(3)(B)(ii). However, copyrights may be treated either as 
manufacturing intangibles or nonmanufacturing intangibles (or as partly 
each) depending upon the function or the use of the copyright. If the 
copyright is used in manufacturing, it will be treated as a 
manufacturing intangible; but if it is used in marketing, even if it is

[[Page 165]]

also classified as know-how, it will be treated as a marketing 
intangible.
    Q. 11: If the cost sharing option is elected and a patent is related 
to the product produced by the possessions corporation, does the return 
to the possessions corporation with respect to the manufacturing 
intangible include the make, use, and sell elements of the patent?
    A. 11: Yes. A patent confers an exclusive right for 17 years to sell 
a product covered by the patent. During this period, the return to the 
possessions corporation includes the make, use and sell elements of the 
patent.
    Q. 12: For purposes of the cost sharing option, may a safe haven 
rule be applied to determine the amount of marketing intangible income?
    A. 12: No. The amount of marketing intangible income is determined 
on the basis of all relevant facts and circumstances. The section 482 
regulations will continue to apply except to the extent modified by the 
election. Rev. Proc. 63-10 and Rev. Proc. 68-22 do not apply for this 
purpose.
    Q. 13: If a product covered by the cost sharing election is sold by 
a possessions corporation to an affiliated corporation for resale to an 
unrelated party, may the resale price method under section 482 be used 
to determine the intercompany price of the possessions corporation?
    A. 13: In general, the resale price method may be used if (a) no 
comparable uncontrolled price for the product exists, and (b) the 
affiliated corporation does not add a substantial amount of value to the 
product by manufacturing or by the provision of services which are 
reflected in the sales price of the product to the customer. The 
possessions corporation will not be denied use of the resale price 
method for purposes of such inter-company pricing merely because the 
reseller adds more than an insubstantial amount to the value of the 
product by the use of intangible property.
    Q. 14: If a possessions corporation makes the cost sharing election 
and uses the cost-plus method under section 482 to determine the arm's-
length price of a possession product, will the cost base include the 
cost of materials which are subject to processing or which are 
components in the possession product?
    A. 14: A taxpayer may include the cost of materials in the cost base 
if it is appropriate under the regulations under Sec. 1.482-2(e)(4).
    Q. 15: If the possessions corporation computes its income with 
respect to a product under the cost sharing method, and the price of the 
product is determined under the cost-plus method under section 482, does 
the cost base used in computing cost-plus under section 482 include the 
amount of the cost sharing payment?
    A. 15: The amount of the cost sharing payment is included in the 
cost base. However, no profit with respect to the cost sharing payment 
will be allowed.
    Q. 16: If a member of the affiliated group transfers to a 
possessions corporation a component which is incorporated into a 
possession product, how will the transfer price for the component be 
determined?
    A. 16: The transfer price for the component will be determined under 
section 482, and as follows. If the possession product is treated as not 
including such component for purposes of section 936(h)(5), the transfer 
price paid for the component will include a return on all intangibles 
related to the component product. If the posssession product is treated 
as including such component for purposes of section 936(h)(5), then the 
transfer price paid for the component by the possessions corporation 
will not include a return on any manufacturing intangible related to the 
component product, and the possessions corporation will obtain the 
return on the manufacturing intangibles associated with the component.
    Q. 17: If the possessions corporation computes its income with 
respect to a product under the cost sharing method, with respect to 
which units of the product shall the possessions corporation be treated 
as owning intangible property as a result of having made the cost 
sharing election?
    A. 17: The possessions corporation shall not be treated as owning 
intangible property, as a result of having made the cost sharing 
election, with respect to any units of a possession

[[Page 166]]

product which were not taken into account by the possessions corporation 
in applying the significant business presence test for the current 
taxable year or for any prior taxable year in which the possessions 
corporation also had a significant business presence in the possession 
with respect to such product.

    (b) Profit split option--(1) Computation of combined taxable income.

    Q. 1: In determining combined taxable income from sales of a 
possession product, how are the allocations and apportionments of 
expenses, losses, and other deductions to be determined?
    A. 1: (i) Expenses, losses, and other deductions are to be allocated 
and apportioned on a ``fully-loaded'' basis under Sec. 1.861-8 to the 
combined gross income of the possessions corporation and other members 
of the affiliated group (other than foreign affiliates). For purposes of 
the profit split option, the term ``affiliated group'' is defined the 
same as under Sec. 1.936-6 (a)(1) question and answer 2. The amount of 
research, development, and experimental expenses allocated and 
apportioned to combined gross income is to be determined under 
Sec. 1.861-8(e)(3). The amount of research, development and experimental 
expenses and related deductions (such as royalties paid or accrued with 
respect to manufacturing intangibles by the possessions corporation or 
other domestic members of the affiliated group to unrelated persons or 
to foreign affiliates) allocated and apportioned to combined gross 
income shall in no event be less than the amount of the cost sharing 
payment that would have been required under the rules set forth in 
section 936(h)(5)(C)(i)(II) and paragraph (a) of this section if the 
cost sharing option had been elected. Other expenses which are subject 
to Sec. 1.861-8(e) are to be allocated and apportioned in accordance 
with that section. For example, interest expense (including payments 
made with respect to bonds issued by the Puerto Rican Industrial, 
Medical and Environmental Control Facilities Authority (AFICA)) is to be 
allocated and apportioned under Sec. 1.861-8(e)(2). With the exception 
of marketing and distribution expenses discussed below, the other 
remaining expenses which are definitely related to a class of gross 
income shall be allocated to that class of gross income and shall be 
apportioned on the basis of any reasonable method, as described in 
Sec. 1.861-8 (b)(3) and (c)(1). Examples of such methods may include, 
but are not limited to, those specified in Sec. 1.861-8(c)(1)(i) through 
(vi).
    (ii) The class of gross income to which marketing and distribution 
expenses relate and shall be allocated is generally to be defined by the 
same ``product area'' as is determined for the relevant research, 
development, and experimental expenses (i.e., the appropriate 3-digit 
SIC code), but shall include only gross income generated or reasonably 
expected to be generated from the geographic area or areas to which the 
expenses relate. It shall be presumed that marketing and distribution 
expenses relate to all product sales within the same product area. If, 
however, it can be established that any of these expenses are separately 
identifiable expenses, such as advertising, and relate, directly or 
indirectly, solely to a specific product or a specific group of 
products, such expenses shall be allocated to the class of gross income 
defined by the specific product or group of products. Thus, advertising 
and other separately identifiable marketing expenses which relate 
specifically and exclusively to a particular product must be allocated 
entirely to the gross income from that product, even though the taxpayer 
or other members of an affiliated group which includes the taxpayer 
produce and market other products in the same 3-digit SIC code 
classification. The mere display of a company logo or mention of a 
company name solely in the context of identifying the manufacturer shall 
not prevent an advertisement from relating specifically and exclusively 
to a particular product or group of products.
    (iii) If marketing and distribution expenses are allocated to a 
class of gross income which consists both of income from sales of 
possession products (the statutory grouping) and other income such as 
from sale by U.S. affiliates of products not produced in the possession 
(the residual grouping), then these marketing and distribution expenses

[[Page 167]]

shall be apportioned on a ``fully loaded'' basis which reflects, to a 
reasonably close extent, the factual relationship between these 
deductions and the statutory and residual groupings of gross income. 
Apportionment methods based upon comparisons of amounts incurred before 
ultimate sale of a product (including apportionment on a comparison of 
costs of goods sold, other expenses incurred, or other comparisons set 
forth in Sec. 1.861-8 (c)(1)(v), such as time spent) are not on a 
``fully-loaded'' basis and do not reflect this required factual 
relationship. These deductions shall be apportioned on a basis of 
comparison of the amount of gross sales or receipts or another method if 
it is established that such method similarly reflects the required 
factual relationship. Thus, for example, a comparison of units sold may 
be used only where the units are of the same or similar value and are, 
thus, in fact comparable.
    (iv) The rules for allocation and apportionment of marketing and 
distribution expenses may be illustrated by the following examples:

    Example 1. Assume that possessions corporation A manufacturers 
prescription pharmaceutical product 1 for resale by P, its U.S. 
parent corporation, in the United States. Additionally, assume that P 
manufactures prescription pharmaceutical products 2 and 
3 in the United States for sale there. Further, assume that all 
three products are within the same product area, and that marketing and 
distribution expenses are internally divided by P among the three 
products on the basis of time spent by sales persons of P on marketing 
of the three products, as follows:

 
 
 
Product 1.............................................      50X
Product 2.............................................      80X
Product 3.............................................     110X
                                                                --------
    Total......................................................     240X
 


These expenses of 240X are allocated to gross income generated by all 
three products and shall be apportioned on the basis of gross sales or 
receipts of product 1 as compared to products 2 and 
3 or another method which similarly reflects the factual 
relationship between these expenses and gross income derived from 
product 1 and products 2 and 3. Thus, if a 
sales method were used and sales of product 1 accounted for 
one-third of sales receipts from the three products, 80X (240 / 3) of 
marketing and distribution expenses would be apportioned to the combined 
gross income from product 1.
    Example 2. Corporation B produces and sells Brand W whiskey, in the 
United States. B's subsidiary, S, which is a possessions corporation, 
produces soft drink extract in Puerto Rico which it sells to independent 
bottlers to produce Brand S soft drinks for sale in the United States. 
Corporation B's advertisements and other promotional materials for Brand 
W whiskey make no reference to Brand S soft drinks (or any other 
Corporation B products), and Brand S soft drink advertisements and other 
promotional materials make no reference to Brand W whiskey (or any other 
corporation B products). For purposes of section 936(h), the advertising 
and other promotional expenses for Brand W whiskey must be allocated 
entirely to the gross income from sales of Brand W whiskey and the 
advertising and other promotional expenses for Brand S soft drink must 
be allocated entirely to the gross income from the sales of soft drink 
extract, notwithstanding the fact that whiskey and soft drink extract 
are both included in SIC code 208. A similar result would apply, for 
example, to separately identifiable advertising and other marketing 
expenses which relate specifically and exclusively to one or the other 
of the following pairs of products: chewing gum and granulated sugar 
(SIC code 206); canned tuna fish and freeze-dried coffee (SIC code 209); 
children's underwear and ladies' brassieres (SIC code 234); aspirin 
tablets and prescription antibiotic tablets (SIC code 283); floor wax 
and perfume (SIC code 284); adhesives and inks (SIC code 289); semi-
conductors and cathode-ray tubes (SIC code 367); batteries and extension 
cords (SIC code 369); bandages and dental supplies (SIC code 384); 
stainless steel flatware and jewelry parts (SIC code 391); children's 
toys and sporting goods (SIC code 394); hair curlers and zippers (SIC 
code 396); and paint brushes and linoleum tiles (SIC code 399).
    Example 3. Assume the same facts as in Example 1 and that 
possessions corporation A also manufactures aspirin, a non-prescription 
product, for resale by its U.S. parent corporation, P. Further, assume 
that the advertising and separately identifiable marketing expenses 
which relate specifically and exclusively to aspirin sales total $100 
and that these expenses are allocable solely to gross income derived 
from aspirin sales. The sales method continues to be used to apportion 
the marketing and distribution expenses related, directly or indirectly, 
to products 1, 2, and 3, and the 
apportionment of such expenses to product 1 for purposes of 
determining combined taxable income from product 1 will remain 
as stated in Example 1. None of the advertising and other separately 
identifiable marketing expenses which relate specifically and 
exclusively to aspirin will be

[[Page 168]]

taken into account in allocating and apportioning the marketing and 
distribution expenses relating to the gross income attributable to 
products 1, 2, and 3. Gross income 
attributable to aspirin will be considered as a separate class of gross 
income, and all the advertising and separately identifiable marketing 
expenses which relate specifically and exclusively to aspirin sales of 
$100 will be allocated to the class of gross income derived from aspirin 
sales. Similarly, none of the marketing and distribution expenses, 
directly or indirectly, related solely to the group of products 
1, 2, and 3 will be taken into account in 
determining the combined taxable income from aspirin sales. the 
remaining marketing and distribution expenses which do not, directly or 
indirectly, relate solely to any specific product or group of products 
(e.g., the salaries of a Vice-President of Marketing who has 
responsibility for marketing all products and his staff) shall be 
allocated and apportioned on the basis of the gross receipts from the 
sales of all of the products (or a similar method) in determining 
combined taxable income of any product.

    Q. 2: How may the allocation and apportionment of expenses to 
combined gross income be verified?
    A. 2: Substantiation of the allocation and apportionment of expenses 
will be required upon audit of the possessions corporation and 
affiliates. Detailed substantiation may be necessary, particularly where 
the entities are engaged in multiple lines of business involving 
distinct product areas. Sources of substantiation may include certified 
financial reports. Form 10-K's, annual reports, internal production 
reports, product line assembly work papers, and other relevant 
materials. In this regard, see Sec. 1.861-8(f)(5).
    Q. 3: Does section 936(h) override the moratorium provided by 
section 223 of the Economic Recovery Tax Act of 1981 and any subsequent 
similar moratorium?
    A. 3: Yes. Thus, the allocation and apportionment of product area 
research described in question and answer 1 must be made without regard 
to the moratorium.
    Q. 4: Is the cost of samples treated as a marketing expense?
    A. 4: Yes. The cost of producing samples will be treated as a 
marketing expense and not as inventoriable costs for purposes of 
determining combined taxable income (and compliance with the significant 
business presence test). However, for taxable years beginning prior to 
January 1, 1986, the cost of producing samples may be treated as either 
a marketing expense or as inventoriable costs.
    Q. 5: If a possessions corporation uses the profit split method to 
determine its taxable income from sales of a product, how does it 
determine its gross income for purposes of the 80-percent possession 
source test and the 65-percent active trade or business test of section 
936(a)(2)?
    A. 5: One-half of the deductions of the affiliated group (other than 
foreign affiliates) which are used in determining the combined taxable 
income from sales of the product are added to the portion of the 
combined taxable income allocated to the possessions corporation in 
order to determine the possessions corporation's gross income from sales 
of such product.
    Q. 6: How will income from intangibles related to a possession 
product be treated under the profit split method?
    A. 6: Combined taxable income of the possessions corporation and 
affiliates from the sale of the possession product will include income 
attributable to all intangibles, including both manufacturing and 
marketing intangibles, associated with the product.
    Q. 7: Can a possessions corporation apply the profit split option to 
a possession product if no U.S. affiliates derive income from the sale 
of the possession product?
    A. 7: Yes.
    Q. 8: With respect to the factual situation discussed in question 
and answer 7 how is combined taxable income computed?
    A. 8: The profit split option is applied to the taxable income of 
the possessions corporation from sales of the possession product to 
foreign affiliates and unrelated persons. Fifty percent of that income 
is allocated to the possessions corporation, and the remainder is 
allocated to the appropriate affiliates as described in question and 
answer 13 of this paragraph (b)(1).
    Q. 9: May a possessions corporation compute its income under the 
profit split method with respect to units of a possession product which 
it sells to a U.S. affiliate if the U.S. affiliate leases such units to 
unrelated persons or to

[[Page 169]]

foreign affiliates or uses such units in its own trade or business?
    A. 9: Yes, provided that an independent sales price for the 
possession product from comparable uncontrolled transactions can be 
determined in accordance with Sec. 1.482-2 (e)(2). If, however, there is 
a comparable uncontrolled price for an integrated product and the 
possession product is a component product or end-product form thereof, 
the possessions corporation may compute its income under the profit 
split method with respect to such units. In either case, the possessions 
corporation shall compute combined taxable income with respect to such 
units under the following question and answer.
    Q. 10: If the possessions corporation is entitled to use the profit 
split method in the situation described in Q. 9 (leasing units of the 
possession product or use of such units in the taxpayer's own trade or 
business), how should it compute combined taxable income with respect to 
such units?
    A. 10: (i) Combined taxable income shall be computed as if the U.S. 
affiliate had sold the units to an unrelated person (or to a foreign 
affiliate) at the time the units were first leased or otherwise placed 
in service by the U.S. affiliate. The sales price on such deemed sale 
shall be equal to the independent sales price from comparable 
uncontrolled transactions determined in accordance with Sec. 1.482-
2(e)(2), if any.
    (ii) If the possession product is a component product or an end-
product form, the combined taxable income with respect to the possession 
product shall be determined under Q&A. 12 of this paragraph (b)(1).
    (iii) For purposes of determining the basis of a component product 
or an end-product form, the deemed sales price of such product must be 
determined. The deemed sales price of the component product shall be 
determined by multiplying the deemed sales price of the integrated 
product that includes the component product by a ratio, the numerator of 
which is the production costs of the component product and the 
denominator of which is the production costs of the integrated product 
that includes the component product. The deemed sales price of an end-
product form shall be determined by multiplying the deemed sales price 
of the integrated product that includes the end-product form by a ratio, 
the numerator of which is the production costs of the end-product form 
and the denominator of which is the production costs of the integrated 
product that includes the end-product form. For the definition of 
production costs, see Q&A. 12 of this paragraph (b)(1).
    (iv)(A) If combined taxable income is determined under paragraph (v) 
of A. 12 of this paragraph (b)(1), in the case of a component product, 
the deemed sales price shall be determined by using the actual sales 
price of that product when sold as an integrated product (as adjusted 
under the rules of the fourth sentence of Sec. 1.482-3(b)(2)(ii)(A)).
    (B) If combined taxable income is determined under paragraph (v) of 
A. 12 of this paragraph (b)(1), in the case of an end-product form, the 
deemed sales price shall be determined by subtracting from the deemed 
sales price of the integrated product that includes the end-product form 
(e.g., the leased property) the actual sales price of the excluded 
component when sold as an integrated product to an unrelated person (as 
adjusted under the rules of the fourth sentence of Sec. 1.482-
3(b)(2)(ii)(A)).
    (v) The full amount of income received under the lease shall be 
treated as income of (and be taxed to) the U.S. affiliate and not the 
possessions corporation.
    Q. 11: In the situation described in question 9, how does the U.S. 
affiliate determine its basis in such units for purposes of computing 
depreciation and similar items?
    A. 11: The U.S. affiliate shall be treated, for purposes of 
computing its basis in such units, as if it had repurchased such units 
immediately following the deemed sale and at the deemed sales price as 
provided in Q&A. 10 of this paragraph (b)(1).

The principles of questions and answers 10 and 11 are illustrated by the 
following example:

    Example: Possessions corporation S manufactures 100 units of 
possession product X. S sells 50 units of X to an unrelated person in an 
arm's length transaction for $10 per unit.

[[Page 170]]

S sells the remaining 50 units to its U.S. affiliate, A, which leases 
such units to unrelated persons. The combined taxable income for the 100 
units of X is computed below on the basis of the given production, 
sales, and cost data:

 
 
 
Sales:
  1. Total sales by S to unrelated persons (50 x $10)..........     $500
  2. Total deemed sales by A to unrelated persons (50 x $10)...      500
  3. Total gross receipts (line 1 plus line 2).................    1,000
Total costs:
  4. Material costs............................................      200
  5. Production costs..........................................      300
  6. Research expenses.........................................        0
  7. Other expenses............................................      100
  8. Total (add lines 4 through 7).............................      600
Combined taxable income attributable to the 100 units of X:
  9. Combined taxable income (line 3 minus line 8).............      400
  10. Share of combined taxable income apportioned to S (50% of      200
   line 9).....................................................
  11. Share of combined taxable income apportioned to A (line 9      200
   minus line 10)..............................................
A's basis in 50 units of X leased by it to unrelated persons:
  12. 50 units times $10 deemed repurchase price...............      500
 


Subsequent leasing income is entirely taxed to A.

    Q. 12: If the possession product is a component product or an end-
product form, how is the combined taxable income for such product to be 
determined?
    A. 12: (i) Except as provided in paragraph (v) of this A. 12, 
combined taxable income for a component product or an end-product form 
is computed under the production cost ratio (PCR) method.
    (ii) Under the PCR method, the combined taxable income for a 
component product will be the same proportion of the combined taxable 
income for the integrated product that includes the component product 
that the production costs attributable to the component product bear to 
the total production costs (including costs incurred by the U.S. 
affiliates) for the integrated product that includes the component 
product. Production costs will be the sum of the direct and indirect 
production costs as defined under Sec. 1.936-5(b)(4) except that the 
costs will not include any costs of materials. If the possession product 
is a component product that is transformed into an integrated product in 
whole or in part by a contract manufacturer outside of the possession, 
within the meaning of Sec. 1.936-5(c), the denominator of the PCR shall 
be computed by including the same amount paid to the contract 
manufacturer, less the costs of materials of the contract manufacturer, 
as is taken into account for purposes of the significant business 
presence test under Sec. 1.936-5(c) Q&A. 5.
    (iii) Under the PCR method the combined taxable income for an end-
product form will be the same proportion of the combined taxable income 
for the integrated product that includes the end-product form that the 
production costs attributable to the end-product form bear to the total 
production costs (including costs incurred by the U.S. affiliates) for 
the integrated product that includes the end-product form. Production 
costs will be the sum of the direct and indirect production costs as 
defined under Sec. 1.936-5(b)(4) except that the costs will not include 
any costs of materials. If the possession product is an end-product form 
and an excluded component is contract manufactured outside of the 
possession, within the meaning of Sec. 1.936-5(c), the denominator shall 
be computed by including the same amount paid to the contract 
manufacturer, less cost of materials of the contract manufacturer, as is 
also taken into account for purposes of the significant business 
presence test under Sec. 1.936-5(c) Q&A. 5.
    (iv) This paragraph (iv) of A. 12 illustrates the computation of 
combined taxable income for a component product or end-product form 
under the PCR method. S, a possessions corporation, is engaged in the 
manufacture of microprocessors. S obtains a component from a U.S. 
affiliate, O. S sells its production to another U.S. affiliate, P, which 
incorporates the microprocessors into central processing units (CPUs). P 
transfers the CPUs to a U.S. affiliate, Q, which incorporates the CPUs 
into computers for sale to unrelated persons. S chooses to define the 
possession product as the CPUs. The combined taxable income for the sale 
of the possession product on the

[[Page 171]]

basis of the given production, sales, and cost data is computed as 
follows:

Production costs (excluding costs of materials):
    1. O's costs for the component.........................          100
    2. S's costs for the microprocessors...................          500
    3. P's costs for the CPUs (the possession product).....          200
    4. Q's costs for the computers.........................          400
    5. Total production costs for the computer (Add lines 1        1,200
     through 4)............................................
    6. Combined production costs for the CPU (the                    800
     possession product) (Add lines 1 through 3)...........
    7. Ratio of production costs for the CPUs (the                 0.667
     possession product) to the production costs for the
     computer..............................................
Determination of combined taxable income for computers:
  Sales:
    8. Total possession sales of computers to unrelated            7,500
     customers and foreign affiliates......................
  Total costs of O, S, P, and Q incurred in production of a
   computer:
    9. Production costs (enter from line 5)................        1,200
    10. Material costs.....................................          100
    11. Total costs (line 9 plus line 10)..................        1,300
    12. Combined gross income from sale of computers (line         6,200
     8 minus line 11)......................................
  Expenses of the affiliated group (other than foreign
   affiliates) allocable and apportionable to the computers
   or any component thereof under the rules of Secs.  1.861-
   8 through 1.861-14T and 1.936-6 (b)(1), Q&A. 1:
    13. Expenses (other than research expenses)............          980
  Research expenses of the affiliated group allocable and
   apportionable to the computers:
    14. Total sales in the 3-digit SIC Code................       12,500
    15. Possession sales of the computers (enter from line         7,500
     8)....................................................
    16. Cost sharing fraction (divide line 15 by line 14)..          0.6
    17. Research expenses incurred by the affiliated group           700
     in 3-digit SIC Code multiplied by 120 percent.........
    18. Cost sharing amount (multiply line 16 by line 17)..          420
    19. Research of the affiliated group (other than                 300
     foreign affiliates) allocable and apportionable under
     Secs.  1.861-17 and 1.861-14T(e)(2) to the computers..
    20. Enter the greater of line 18 or line 19............          420
Computation of combined taxable income of the computer and
 the CPU:
    21. Combined taxable income attributable to the                4,800
     computer (line 12 minus line 13 and line 20)..........
    22. Combined taxable income attributable to CPUs               3,200
     (multiply line 21 by line 7) (production cost ratio)..
    23. Share of combined taxable income apportioned to S          1,600
     (50 percent of line 22)...............................
Share of combined taxable income apportioned to U.S.
 affiliate(s) of S:
    24. Adjustments for research expenses (line 18 minus              80
     line 19 multiplied by line 7).........................
    25. Adjusted combined taxable income (line 22 plus line        3,280
     24)...................................................
    26. Share of combined taxable income apportioned to            1,680
     affiliates of S (line 25 minus line 23)...............
 

    (v)(A) If a possession product is sold by a taxpayer or its 
affiliate to unrelated persons in covered sales both as an integrated 
product and as a component product and the conditions of paragraph 
(v)(C) of this A. 12 are satisfied, the taxpayer may elect to determine 
the combined taxable income derived from covered sales of the component 
product under this paragraph (v). In that case, the combined taxable 
income derived from covered sales of the component product shall be 
determined by using the same per unit combined taxable income as is 
derived from covered sales of the product as an integrated product, but 
subject to the limitation of paragraph (v)(D) of this A. 12.
    (B) In the case of a possession product that is an end-product form, 
if all of the excluded components are also separately sold by the 
taxpayer or its affiliate to unrelated persons in uncontrolled 
transactions and the conditions

[[Page 172]]

of paragraph (v)(C) of this A. 12 are satisfied, the taxpayer may elect 
to determine the combined taxable income of such end-product form under 
this paragraph (v). In that case, the combined taxable income derived 
from covered sales of the end-product form shall be determined by 
reducing the per unit combined taxable income from the integrated 
product that includes the end-product form by the per unit combined 
taxable income for excluded components determined under the rules of 
this paragraph (v), but subject to the limitation of paragraph (v)(D) of 
this A. 12. For this purpose, combined taxable income of the excluded 
components must be determined under section 936 as if the excluded 
components were possession products.
    (C) In the case of component products, this paragraph (v) applies 
only if the sales price of the possession product sold in covered sales 
as an integrated product (i.e., in uncontrolled transactions) would be 
the most direct and reliable measure of an arm's length price within the 
meaning of the fourth sentence of Sec. 1.482-3(b)(2)(ii)(A) for the 
component product. For purposes of applying the fourth sentence of 
Sec. 1.482-3(b)(2)(ii)(A), the sale of the integrated product that 
includes the component product is treated as being immediately preceded 
by a sale of the component (i.e. without further processing) in a 
controlled transaction. In the case of end-product forms, this paragraph 
(v) applies only if the sales price of excluded components separately 
sold in uncontrolled transactions would be the most direct and reliable 
measure of an arm's length price within the meaning of the fourth 
sentence of Sec. 1.482-3(b)(2)(ii)(A) for all excluded components of an 
integrated product that includes an end-product form. For purposes of 
applying the fourth sentence of Sec. 1.482-3(b)(2)(ii)(A), the sale of 
the integrated product that includes excluded components is treated as 
being immediately preceded by a sale of the excluded components (i.e. 
without further processing) in a controlled transaction. Under the 
fourth sentence of Sec. 1.482-3(b)(2)(ii)(A), the uncontrolled 
transactions referred to in this paragraph (v)(C) must have no 
differences with the controlled transactions that would affect price, or 
have only minor differences that have a definite and reasonably 
ascertainable effect on price and for which appropriate adjustments are 
made (resulting in appropriate adjustments to the computation of 
combined taxable income). If such adjustments cannot be made, or if 
there are more than minor differences between the controlled and 
uncontrolled transactions, the method provided by this paragraph (v)(C) 
cannot be used. Thus, for example, these uncontrolled transactions must 
involve substantially identical property in the same or a substantially 
identical geographic market, and must be substantially identical to the 
controlled transaction in terms of their volumes, contractual terms, and 
market level. See Sec. 1.482-3(b)(2)(ii)(B).
    (D) In no case can the per unit combined taxable income as 
determined under paragraph (v)(A) or (B) of this A. 12 be greater than 
the per unit combined taxable income of the integrated product that 
includes the component product or end-product form.
    (E) The provisions of this paragraph (v) are illustrated by the 
following example. Taxpayer manufactures product A in a U.S. possession. 
Some portion of product A is sold to unrelated persons as an integrated 
product and the remainder is sold to related persons for transformation 
into product AB. The combined taxable income of integrated product A is 
$400 per unit and the combined taxable income of product AB is $300 per 
unit. The production cost ratio with respect to product A when sold as a 
component of product AB, is 2/3. Unless the taxpayer elects and 
satisfies the conditions of this paragraph (v), the combined taxable 
income with respect to A will be $200 per unit (combined taxable income 
for AB of $300 x the production cost ratio of 2/3). If, however, the 
comparability standards of paragraph (v)(C) of this A. 12 are met, the 
taxpayer may elect to determine combined taxable income of product A 
when sold as a component of product AB using the same per unit combined 
taxable income as product A when sold as an integrated product. However, 
the per unit combined taxable income from sales of product A as a 
component product may not exceed

[[Page 173]]

the per unit combined taxable income on the sale of product AB. 
Therefore, the combined taxable income of component product A may not 
exceed $300 per unit.
    (vi) Taxpayers that have not elected the percentage limitation under 
section 936(a)(1) for the first taxable year beginning after December 
31, 1993, may do so if the taxpayer has elected the profit split method 
and computation of combined taxable income is affected by Q&A.12 of this 
paragraph (b)(1).
    (vii) The rules of Q&A. 12 of this paragraph (b)(1) apply for 
taxable years ending after June 9, 1996. If, however, the election under 
paragraph (v) of A. 12 of Sec. 1.936-6(b)(1) is made, this election must 
be made for the taxpayer's first taxable year beginning after December 
31, 1993, and if not made effective for that year, the election cannot 
be made for any later taxable year. A successor corporation that makes 
the same or substantially similar products as its predecessor 
corporation cannot make an election under paragraph (v) of A.12 of 
Sec. 1.936-6(b)(1) unless the election was made by its predecessor 
corporation for its first taxable year beginning after December 31, 
1993.
    Q. 13: If the profit split option is elected, how is the portion of 
combined taxable income not allocated to the possessions corporation to 
be treated?
    A. 13: (i) The income shall be allocated to affiliates in the 
following order, but no allocations will be made to affiliates described 
in a later category if there are any affiliates in a prior category--
    (A) First, to U.S. affiliates (other than tax exempt affiliates) 
within the group (as determined under section 482) that derive income 
with respect to the product produced in whole or in part in the 
possession;
    (B) Second, to U.S. affiliates (other than tax exempt affiliates) 
that derive income from the active conduct of a trade or business in the 
same product area as the possession product;
    (C) Third, to other U.S. affiliates (other than tax-exempt 
affiliates);
    (D) Fourth, to foreign affiliates that derive income from the active 
conduct of a U.S. trade or business in the same product area as the 
possession product (or, if the foreign members are resident in a country 
with which the U.S. has an income tax convention, then to those foreign 
members that have a permanent establishment in the United States that 
derives income in the same product area as the possession product); and
    (E) Fifth, to all other affiliates.
    (ii) The allocations made under paragraph (i)(A) of this A. 13 shall 
be made on the basis of the relative gross income derived by each such 
affiliate with respect to the product produced in whole or in part in 
the possession. For this purpose, gross income must be determined 
consistently for each affiliate and consistently from year to year.
    (iii) The allocations made under paragraphs (i)(B) and (i)(D) of 
this A. 13 shall be made on the basis of the relative gross income 
derived by each such affiliate from the active conduct of the trade or 
business in the same product area.
    (iv) The allocations made under paragraphs (i)(C) and (i)(E) of this 
A. 13 shall be made on the basis of the relative total gross income of 
each such affiliate before allocating income under this section.
    (v) Income allocated to affiliates shall be treated as U.S. source 
and section 863(b) does not apply for this purpose.
    (vi) For purposes of determining an affiliate's estimated tax 
liability for income thus allocated for taxable years beginning prior to 
January 1, 1995, the income shall be deemed to be received on the last 
day of the taxable year of each such affiliate in which or with which 
the taxable year of the possessions corporation ends. For taxable years 
beginning after December 31, 1994, quarterly estimated tax payments will 
be required as provided under section 711 of the Uruguay Round 
Agreements, Public Law 103-465 (1994), page 230, and any administrative 
guidance issued by the Internal Revenue Service thereunder.
    Q. 14: What is the source of the portion of combined taxable income 
allocated to the possessions corporation?
    A. 14: Income allocated to the possessions corporation shall be 
treated as possession source income and as derived from the active 
conduct of a trade or business within the possession.

[[Page 174]]

    Q. 15: How is the profit split option to be applied to properly 
account for costs incurred in a year with respect to products which are 
sold by the possessions corporation to a U.S. affiliate during such 
year, but are not resold by the U.S. affiliate to persons who are not 
members of the affiliated group or to foreign affiliates until a later 
year?
    A. 15: The rules under Sec. 1.994-1(c)(5) are to be applied. 
Incomplete transactions will not be taken into consideration in 
computing combined taxable income. Thus, for example, if in 1983, A, a 
possessions corporation, sells units of a product with a cost to A of 
$5000 to B corporation, its U.S. affiliate, which use the dollar-value 
LIFO method of costing inventory, and B sells units with a cost of $4000 
(representing A's cost) to C corporation, a foreign affiliate, only 
$4000 of such costs shall be taken into consideration in computing the 
combined taxable income of the possessions corporation and U.S. 
affiliates for 1983. If a specific goods LIFO inventory method is used 
by B, the determination of whether A's goods remain in B's inventory 
shall be based on whether B's specific goods LIFO grouping has 
experienced an increment or decrement for the year on the specific LIFO 
cost of such units, rather than on an average unit cost of such units. 
If the FIFO method of costing inventory is used by B, transfers may be 
based on the cost of the specific units transferred or on the average 
unit production cost of the units transferred, but in each case a FIFO 
flow assumption shall be used to identify the units transferred. For a 
determination of which goods are sold by taxpayers using the LIFO 
method, see question and answer 19.
    Q. 16: If a possessions corporation purchases materials from an 
affiliate and computes combined taxable income for a possession product 
which includes such materials, how are those materials to be treated in 
the possessions corporation's inventory?
    A. 16: The cost of those materials is considered to be equal to the 
affiliate's cost using the affiliate's method of costing inventory.
    Q. 17: If the possessions corporation uses the FIFO method of 
costing inventory and the U.S. affiliate uses the LIFO method of costing 
inventory, or vice versa, what method of costing inventory should be 
used in computing combined taxable income?
    A. 17: The transferor corporation's method of costing inventory 
determines the cost of inventory for purposes of combined taxable income 
while the transferee corporation's method of costing inventory 
determines the flow. Assume, for example, that X corporation, a 
possessions corporation, using the FIFO method of costing inventory 
purchases materials from Y corporation, U.S. affiliate, also using the 
FIFO method. X corporation produces a product which it transfers to Z 
corporation, another U.S. affiliate using the LIFO method. Assume also 
that the final product satisfies the significant business presence test. 
Under the facts, the cost of the materials purchased by X from Y is Y's 
FIFO cost. The costs of the inventory transferred by X to Z are 
determined under X's FIFO method of accounting as is the flow of the 
inventory from X to Z. The costs added by Z are determined under Z's 
LIFO method of inventory, as is the flow of the inventory from Z to 
unrelated persons or foreign affiliates.
    Q. 18: How are the costs of a possession product and the revenues 
derived from the sale of a possession product determined if the U.S. 
affiliate includes purchases of the possessions product in a dollar-
value LIFO inventory pool (as provided under Sec. 1.472-8)?
    A. 18: The following method will be accepted in determining the 
revenues derived from the sale of a possession product and the costs of 
a possession product if the U.S. affiliate includes purchases of the 
possession product in a dollar-value LIFO inventory pool. The rules 
apply solely for the cost sharing and profit split options under section 
936(h).
    (i) Revenue identification. The identification of revenues derived 
from sales of a possession product must generally be made on a specific 
identification basis. The particular method employed by a taxpayer for 
valuing its inventory will have no impact on the determination of what 
units are sold or how much revenue is derived from such sales. Thus, if 
a U.S. affiliate sells both item A (a possession product) and item

[[Page 175]]

B (a non-possession product), the actual sales revenues received by the 
U.S. affiliate from item A sales would constitute possession product 
revenue for purposes of the profit split option and possession sales for 
purposes of the cost sharing option regardless of whether the U.S. 
affiliate values its inventories on the FIFO or the LIFO method. In 
instances where sales of item A (i.e., the possession product) cannot be 
determined by use of specific identification (for example, in cases 
where items A and B are identical except that one is produced in the 
possession (item A) and the other (item B) is produced outside of the 
possession and it is not possible to segregate these items in the hands 
of the U.S. affiliate), it will be necessary to identify the portion of 
the combined sales of items A and B (which together can be identified on 
a specific identification basis) which is attributed to item A sales and 
the portion which is attributed to item B sales. The determination of 
the portion of aggregated sales attributable to item A and item B is 
independent of the LIFO method used to determine the cost of such sales 
and may be made under the following approach. A taxpayer may, for 
purposes of this section of the regulations, use the relative purchases 
(in units) of items A and B by the U.S. affiliate during the taxable 
year (or other appropriate measuring period such as the period during 
the taxable year used to determine current-year costs, i.e., earliest 
acquisitions period, latest acquisitions period, etc.) in determining 
the ratio to apply against the combined items A and B sales revenue. If 
the sales exceed current purchases, the taxpayer can use a FIFO unit 
approach which identifies actual unit sales on a first-in, first-out 
basis. Revenue determination where specific identification is not 
possible is illustrated by the following example:

    Example. At the end of year 1, there are 600 units of combined items 
A and B which are to be allocated between A and B on the basis of annual 
purchases of A and B units during year 1. During year 1, 1,000 units of 
item A, a possession product, and 2,000 units of item B, a non-
possession product, were purchased. Thus, the 600 units in year 1 ending 
inventory are allocated 200 (i.e. \1/3\) to item A units and 400 (i.e. 
\2/3\) to item B units based on the relative purchases of A (1,000) and 
B (2,000) in year 1. These units appear as beginning inventory in year 
2.
    In year 2, 1,500 units of item A are purchased and 1,500 units of 
item B are purchased. However, 3,300 units of items A and B in the 
aggregate are sold for $600,000. The relative proportion of the $600,000 
attributable to item A and to item B sales would be determined as 
follows:

------------------------------------------------------------------------
                      Year 2 sales                        Item A  Item B
------------------------------------------------------------------------
Unit sales from opening inventory.......................     200     400
Unit sale from current-year purchases...................   1,350   1,350
                                                         ---------------
    Total unit sales (3,300)............................   1,550   1,750
    Percentage..........................................      47      53
------------------------------------------------------------------------

                                                                  [GRAPHIC] [TIFF OMITTED] TC14NO91.144
                                                                  

------------------------------------------------------------------------
                    Year 2 Closing Inventory                       Units
------------------------------------------------------------------------
Item A..........................................................     150
Item B..........................................................     150
------------------------------------------------------------------------



Thus, revenues from Item A sales for purposes of computing possession 
sales for the cost sharing option and revenues for the profit split 
option are $281,818.
    (ii) Cost identification. The determination of the cost of 
possession product sales by the U.S. affiliate must be based on the LIFO 
inventory method of the U.S. affiliate. The LIFO cost of possession 
product sales will, for purposes of this section of the regulations, be 
determined by maintaining a separate

[[Page 176]]

LIFO cost for possession products in a taxpayer's opening and closing 
LIFO inventory and using this cost to calculate an independent cost of 
possession product sales. This separate LIFO cost for possession 
products in the LIFO pool of a taxpayer is to be determined as follows:
    (A) Determine the base-year cost of possession products in ending 
inventory in a LIFO pool.
    (B) Determine the percentage of the base-year cost of possession 
products in the pool as compared to the total base-year cost of all 
items in the pool.
    (C) Multiply the percentage determined in step (B) of this 
subdivision (ii) by the ending LIFO inventory value of the pool to 
determine the deemed LIFO cost attributable to possession products in 
the pool.
    (D) Subtract the LIFO cost of possession products in ending 
inventory in the pool (as calculated in step (C) of this subdivision 
(ii)) from the sum of:
    (1) Possession product purchases for the year, plus
    (2) The portion of the opening LIFO inventory value of the pool 
attributed to possession products (i.e., the result obtained in step (C) 
of this subdivision (ii) for the prior year).

The number determined by this calculation is the LIFO cost of possession 
product sales from the taxpayer's LIFO pool.

    Example: Assume that item A is a possession product and item B is a 
non-possession product and also assume the inventory and purchases with 
respect to the LIFO pool as provided below:

                        Year 1--Ending Inventory
------------------------------------------------------------------------
                                No. of   Base-year  Base-year
                                units    cost/unit     cost     Percent
------------------------------------------------------------------------
Item A......................        100      $2.00       $200         20
Item B......................        200       4.00        800         80
------------------------------------------------------------------------


                           Year 1--LIFO Value
------------------------------------------------------------------------
                                         Base-year
                                            cost      Index    LIFO cost
------------------------------------------------------------------------
Increment layer 2......................       $300        3.0       $900
Increment layer 1......................        400        2.0        800
Base layer.............................        300        1.0        300
                                        -----------           ----------
      Pool total.......................     $1,000  .........     $2,000
------------------------------------------------------------------------


                       Year 1--LIFO Value Per Item
------------------------------------------------------------------------
                                                    Base-year     LIFO
                                                       cost      value
------------------------------------------------------------------------
      Total pool..................................     $1,000     $2,000
                                                   ---------------------
Item A............................................        200        400
Item B............................................        800      1,600
------------------------------------------------------------------------


                            Year 2--Purchases
------------------------------------------------------------------------
                                                                 Total
                                                               purchases
------------------------------------------------------------------------
Item A.......................................................     $6,000
Item B.......................................................      4,000
------------------------------------------------------------------------


                        Year 2--Ending Inventory
------------------------------------------------------------------------
                                No. of   Base-year  Base-year
                                units    cost/unit     cost     Percent
------------------------------------------------------------------------
Item A......................        200      $2.00       $400         50
Item B......................        100       4.00        400         50
------------------------------------------------------------------------


                           Year 2--LIFO Value
------------------------------------------------------------------------
                                         Base-year
                                            cost      Index    LIFO cost
------------------------------------------------------------------------
Increment layer 2......................       $100        3.0       $300
Increment layer 1......................        400        2.0        800
Base layer.............................       $300        1.0        300
                                        -----------           ----------
Pool total.............................        800  .........      1,400
------------------------------------------------------------------------
The year 2 LIFO cost of possession product A sales will be calculated as
  follows:
(1) Base-year cost of item in year 2 ending inventory=$400
(2) Percentage of item A base-year cost to total base-year cost ($400 /
  $800) = 50%
(3) LIFO value of item A ($1,400 x 50%) = $700
(4) LIFO cost of item A sales is determined by adding to the beginning
  inventory in year 2 the purchases of item A in year 2 and subtracting
  from this amount the ending inventory in year 2 ($400 + $6000 - $700 =
  $5700). The beginning inventory in year 2 is determined by multiplying
  the LIFO cost of the year 1 ending inventory by a percentage of item A
  base year cost to the total base-year cost in year 1. The ending
  inventory in year 2 is determined under (3) above.


    Q. 19: If a possession product is purchased from a possessions 
corporation by a U.S. affiliate using the dollar-value LIFO method of 
costing its inventory and is included in a LIFO pool of the U.S. 
affiliate which includes products purchased from the possessions 
corporation in pre-TEFRA years, how should the LIFO index computation of 
the U.S. affiliate be made in the first year in which section 936(h) 
applies and in subsequent taxable years?
    A. 19: The U.S. affiliate should treat the first taxable year for 
which section 936(h) applies as a new base year in accordance with 
procedures provided by regulations under section 472. Thus, the opening 
inventory for the first year

[[Page 177]]

for which section 936(h) applies (valuing possession products purchased 
from the possessions corporation on the basis of the cost of such 
possession products), would equal the new base year cost of the 
inventory of such pool of the U.S. affiliate. Increments and decrements 
at new base year cost would be valued for LIFO purposes pursuant to the 
procedures provided by regulations under section 472.
    Q. 20: If the possessions corporation computes its income with 
respect to a product under the profit split method, with respect to 
which units of the product shall the profit split method apply?
    A. 20: The profit split method shall apply to units of the 
possession product produced in whole or in part by the possessions 
corporation in the possession and sold during the taxable year by 
members of the affiliated group (other than foreign affiliates) to 
unrelated parties or to foreign affiliates. In no event shall the profit 
split method apply to units of the product which were not taken into 
account by the possessions corporation in applying the significant 
business presence test for the current taxable year or for any prior 
taxable year in which the possessions corporation also had a significant 
business presence in the possession with respect to such product.

    (2) Pre-TEFRA inventory.

    Q. 1: How is pre-TEFRA inventory to be determined if the profit 
split option is elected and the FIFO method of costing inventory is used 
by the U.S. affiliate?
    A. 1: Pre-TEFRA inventory is inventory which was produced by the 
possessions corporation and transferred to a U.S. affiliate prior to the 
possessions corporation's first taxable year beginning after December 
31, 1982. Pre-TEFRA inventory will not be included for purposes of the 
profit split option. If the U.S. affiliate uses the FIFO method of 
costing inventory, the pre-TEFRA inventory will be treated as the first 
inventory sold by the U.S. affiliate during the first year in which 
section 936(h) applies and will not be included in the computation of 
combined taxable income for purposes of the profit split option. The 
treatment of pre-TEFRA inventory when FIFO costing is used by both the 
U.S. affiliate and the possessions corporation is illustrated by the 
following example in which FIFO unit costing is used:

    Example. Assume the following:

------------------------------------------------------------------------
                                              X                 Y
                                     -----------------------------------
                                         Possessions     U.S. affiliate
                                         corporation   -----------------
                                     ------------------
                                       Number    Cost    Number    Cost
                                         of      per       of      per
                                       units     unit    units     unit
------------------------------------------------------------------------
Beginning inventory.................      500     $150      200     $225
Units produced during 1983..........    1,000      200  .......  .......
Ending inventory....................      400      200      300  .......
------------------------------------------------------------------------

    In 1983, the beginning inventory of X, a possessions corporation, is 
500 units with a unit cost of $150 and the beginning inventory of Y, the 
U.S. affiliate, is 200 units with a unit cost of $225, which represents 
the section 482 price paid by Y. Y's beginning inventory in 1983 
represents purchases made in 1982 of products produced by X in that 
year. Y sells all the units it purchases from X to Z, a foreign 
affiliate. In 1983, X produces 1000 units at a unit cost of $200 and 
sells 1100 units to Y (the difference between 1500 units, representing 
X's 1983 beginning inventory (500) and the units produced by X in 1983 
(1000), and X's ending inventory of 400 units). Of the 1100 units sold 
by X to Y in 1983 only 800 units (and not 1000 units) which were sold by 
Y to Z are taken into consideration in computing combined taxable income 
for 1983. Since FIFO costing by the possessions corporation is used, the 
cost is $150 per unit for the first 500 units and $200 per unit for the 
remaining 300 units. The 200 units sold by X to Y in 1982 are pre-TEFRA 
inventory and are not included in the computation of combined taxable 
income for 1983. They are also treated as the first units sold by Y to Z 
in 1983. This inventory has a unit cost of $225, which reflects the 
section 482 transfer price from X to Y in 1982. Y's 1983 ending 
inventory of 300 units will not be taken into consideration in computing 
the combined taxable income of X and Y for 1983 because the units have 
not been sold to a foreign affiliate or to persons who are not members 
of the affiliated group. In a subsequent year when the units are sold to 
Z, the cost to X and selling price to Z of these units will enter into 
the computation of combined taxable income for that year.

    (c) Covered Intangibles.

    Q. 1: What are ``covered intangibles'' under section 
936(h)(5)(C)(i)(II)?
    A. 1: The term ``covered intangibles'' means (1) intangible property 
developed in a possession solely by the possessions corporation and 
owned by it, (2) manufacturing intangible property

[[Page 178]]

(described in section 936(h)(3)(B)(i)) which is acquired by the 
possessions corporation from unrelated persons, and (3) any other 
intangible property (described in section 936(h)(3)(B) (ii) through (v), 
to the extent not described in section 936(h)(3)(B)(i)) which relates to 
sales of products or services to unrelated persons for ultimate 
consumption or use in the possession in which the possessions 
corporation conducts its business. The possessions corporation is 
treated as the owner of covered intangibles for purposes of obtaining a 
return thereon.
    Q. 2: Do covered intangibles include manufacturing intangible 
property which is acquired by an affiliate and subsequently transferred 
to the possessions corporation?
    A. 2: No. In order for a manufacturing intangible to be treated as a 
covered intangible, the intangible property must be acquired directly by 
the possessions corporation from an unrelated person unless the 
manufacturing intangible was acquired by an affiliate from an unrelated 
person and was transferred to the possessions corporation by the 
affiliate prior to September 3, 1982.
    Q. 3: If a possessions corporation licenses a manufacturing 
intangible from an unrelated party, will the licensed intangible be 
treated as a covered intangible?
    A. 3: No.
    Q. 4: How is ultimate consumption or use determined for purposes of 
the definition of covered intangibles?
    A. 4: A product will be treated as having its ultimate use or 
consumption in a possession if it is sold by the possessions corporation 
to a related or unrelated person in a possession and is not resold or 
used or consumed outside of the possession within one year after the 
date of the sale.
    Q. 5: Are sales of products that relate to covered intangibles 
excluded from the cost sharing fraction?
    A. 5: If no manufacturing intangibles other than covered intangibles 
are associated with the possession product, then sales of such product 
will be excluded from the cost sharing fraction. If both covered and 
non-covered manufacturing intangibles are associated with the possession 
product, then sales of such product will be included in the cost sharing 
fraction.
    Q. 6: If the cost sharing option is elected, is it necessary for the 
possessions corporation to be the legal owner of covered intangibles 
described in section 936(h)(5)(C)(i)(II)(c) related to the product in 
order for the possessions corporation to receive a full return with 
respect to such intangibles?
    A. 6: No. For purposes of section 936(h), it is immaterial whether 
such covered intangibles are owned by the possessions corporation or by 
another member of the affiliated group. Moreover, if the legal owner of 
such covered intangibles which are subject to section 936(h)(5) is an 
affiliate of the possessions corporation, such person will not be 
required to charge an arm's-length royalty under section 482 to the 
possessions corporation.

[T.D. 8090, 51 FR 21532, June 13, 1986; 51 FR 27174, July 30, 1986, as 
amended by T.D. 8669, 61 FR 21367, May 10, 1996; 61 FR 39072, July 26, 
1996; T.D. 8786, 63 FR 55025, Oct. 14, 1998]



Sec. 1.936-7  Manner of making election under section 936 (h)(5); special election for export sales; revocation of election under section 936(a).

    The rules in this section apply for purposes of section 936(h) and 
also for purposes of section 934(e), where applicable.

    (a) Manner of making election.

    Q. 1: How does a possessions corporation make an election to use the 
cost sharing method or profit split method?
    A. 1: A possessions corporation makes an election to use the cost 
sharing or profit split method by filing Form 5712-A and attaching it to 
its tax return. Form 5712-A must be filed on or before the due date 
(including extensions) of the tax return of the possessions corporation 
for its first taxable year beginning after December 31, 1982. The 
electing corporation must set forth on the form the name and the 
taxpayer identification number or address of all members of the 
affiliated group (including foreign affiliates not required to file a 
U.S. tax return). All members of the affiliated group must consent to 
the election. An authorized officer of the electing corporation must 
sign the statement of election and must declare that he has received a

[[Page 179]]

signed statement of consent from an authorized officer, director, or 
other appropriate official of each member of the affiliated group. The 
election is not valid unless all affiliates consent. However, a failure 
to obtain an affiliate's written consent will not invalidate the 
election out if the possessions corporation made a good faith effort to 
obtain all the necessary consents or the failure to obtain the missing 
consent was inadvertent. Subsequently created or acquired affiliates are 
bound by the election. If an election out is revoked under section 
936(h)(5)(F)(iii), a new election out with respect to that product area 
cannot be made without the consent of the Commissioner. The possessions 
corporation shall file an amended Form 5712-A with its timely filed 
income tax return to reflect any changes in the names or number of the 
members of the affiliated group for any taxable year after the first 
taxable year to which the election out applies. By consenting to the 
election out, all affiliates agree to provide information necessary to 
compute the cost sharing payment under the cost sharing method or 
combined taxable income under the profit split method, and failure to 
provide such information shall be treated as a request to revoke the 
election out under section 936(h)(5)(F)(iii).
    Q. 2: May the ``election out'' under section 936(h)(5) be made on a 
product-by-product basis, or must it be made on a wide basis?
    A. 2: An electing corporation is required to treat products in the 
same product area in the same manner. Similarly, all possessions 
corporations in the same affiliated group that produce any products or 
render any services in the same product area must make the same election 
for all products that fall within the same product area. However, 
Sec. 1.936-7(b) provides that the electing corporation may make a 
different election for export sales than for domestic sales. The 
electing corporation or corporations may also make different elections 
for products that fall within different product areas.
    Q. 3: May the possessions corporation elect to define product area 
more narrowly than the 3-digit SIC code?
    A. 3: No. Certain alternatives, such as the 4-digit SIC code, would 
not be permitted under the statute. However, other methods for defining 
product area may be considered by the Commissioner in the future.
    Q. 4: May a possessions corporation make an election out under the 
cost sharing method with respect to a product area if the affiliated 
group incurs no research, development or experimental costs in the 
product area?
    A. 4: Yes. In that case the cost sharing payment will be zero.
    Q. 5: If the significant business presence test is not satisfied for 
a product or type of service within the product area covered by the 
election out under section 936(h)(5) what rules will apply with respect 
to that product?
    A. 5: With respect to the product which does not satisfy the 
significant business presence test, the provisions of section 936 (h)(1) 
through (h)(4) will apply to the allocation of income. However, if a 
cost sharing or a profit split election has been made with respect to 
the product area, the cost sharing payment or the research and 
development floor under section 936(h)(5)(C)(ii)(II) will not be 
reduced.
    Q. 6: Is a taxpayer permitted to make a change of election with 
respect to the cost sharing and profit split methods?
    A. 6: In general, once the election is properly made, it is binding 
for the first year in which it applies and all subsequent years 
(including upon any later created or acquired affiliates), and 
revocation is only permitted with the consent of the Commissioner of 
Internal Revenue. However, a taxpayer will be permitted to change its 
election once from the cost sharing method to the profit split method or 
vice versa, or from the method permitted under section 936 (h)(1) 
through (h)(4) to cost sharing or profit split or vice versa, without 
the consent of the Commissioner if the change is made on the taxpayer's 
return for its first taxable year ending after June 13, 1986. Such 
change will apply to such taxable year and all subsequent taxable years, 
and, at the taxpayer's option, may also apply to all prior taxable years 
for which section 936(h) was in effect. A change of election will be 
treated as an election subject to the procedures set forth above and to 
section 481 of the Internal Revenue Code.

[[Page 180]]

    Q. 7: If the Commissioner determines that a possessions corporation 
does not meet the 80-percent possession source test or the 65-percent 
active trade or business test (the ``qualification tests'') for any 
taxable year beginning after 1982, under what circumstances is the 
possessions corporation permitted to make a distribution of property 
after the close of its taxable year to meet the qualification tests?
    A. 7: A possessions corporation may make a pro rata distribution of 
property to its shareholders after the close of the taxable year if the 
Commissioner determines that the possessions corporation does not 
satisfy the qualification tests (a) by reason of the exclusion from 
gross income of intangible income under section 936(h)(1)(B) or section 
936(h)(5)(C)(i)(II) or (b) by reason of the allocation to the 
shareholders of the possessions corporation of income under section 
936(h)(5)(C)(ii)(III); provided, however, that the determination of the 
Commissioner does not contain a finding that the failure of such 
corporation to satisfy the qualification tests was due, in whole or in 
part, to fraud with intent to evade tax or willful neglect on the part 
of the possessions corporation. The possessions corporation must 
designate the distribution at the time the distribution is made as a 
distribution to meet qualification requirements, and it will be subject 
to the provisions of section 936(h)(4). Such distributions will not 
qualify for the dividends received deduction.
    Q. 8: If a possessions corporation owns stock in a subsidiary 
possessions corporation, any intangible property income allocated to the 
parent possessions corporation under section 936(h) will be treated as 
U.S. source income and taxable to the parent possessions corporation. Is 
the intangible property income taken into consideration in determining 
whether the parent possessions corporation meets the income tests of 
section 936(a)(2)?
    A. 8: While taxable to the parent possessions corporation, the 
intangible property income does not enter into the calculation of the 
80-percent possession source test or the 65-percent active trade or 
business test of section 936(a)(2)(A) and (B). This would also be the 
case if the subsidiary possessions corporation made a qualifying 
distribution under section 936(h)(4).

    (b) Separate election for export sales.

    Q. 1: What methods of computing income can a possessions corporation 
use under the separate election for export sales?
    A. 1: The only two methods which are available under the separate 
election for export sales are the cost sharing method and the profit 
split method.
    Q. 2: What is the definition of export sales for purposes of the 
separate election for export sales?
    A. 2: The determination of export sales is based upon the 
destination of the product, i.e., where it is to be used or consumed. If 
the product is sold to a U.S. affiliate, it will be treated as an export 
sale only if resold or otherwise transferred abroad to a foreign person 
(including a foreign affiliate or foreign branch of a U.S. affiliate) 
within one year from the date of sale to the U.S. affiliate for ultimate 
use or consumption outside the United States as provided under 
Sec. 1.954-3(a)(3)(ii).
    Q. 3: Assume that a possessions corporation sells a product to both 
foreign affiliates and foreign branches of U.S. affiliates. In addition, 
it sells the product to its U.S. parent for resale in the U.S. The 
possessions corporation makes a profit split election for domestic sales 
and a cost sharing election of export sales. Will the sales to foreign 
branches of U.S. affiliates be treated as exports subject to the cost 
sharing method or as domestic sales subject to the profit split method?
    A. 3: The sales to a foreign branch of a U.S. corporation are 
exports if for ultimate use or consumption outside of the United States 
as provided under Sec. 1.954-3(a)(3)(ii).
    Q. 4: Under what circumstances may a possessions corporation make 
the separate election under section 936(h)(5)(F)(iv)(II) for computing 
its income from products exported to a foreign person when the income 
derived by such foreign person on the resale of such products is 
included in foreign base company income under section 954(a)?
    A. 4: If the income derived by a foreign person on the resale of 
products manufactured, in whole or in part, by a

[[Page 181]]

possessions corporation is included in foreign base company income under 
section 954(a), then the possessions corporation may make the separate 
export election under section 936(h)(5)(F)(iv)(II) for computing its 
income from such products only if such foreign person has been formed or 
is availed of for substantial business reasons that are unrelated to an 
affiliated corporation's U.S. tax liability. For purposes of the 
proceding sentence, a foreign person will be considered to be formed or 
availed of for such substantial business reasons if the foreign person 
in the normal course of business purchases substantial quantities of 
products from both the possessions corporation and its affiliates for 
resale, and, in addition provides support services for affiliated 
companies such as centralized testing, marketing of products, management 
of local currency exposures, or other similar services. However, a 
foreign person that purchases and resells products only from a 
possessions corporation is presumed to be formed or availed of for other 
than such substantial business reasons, even if the foreign person 
provides additional services.
    Q. 5: When will the ``manufacturing'' test set forth in subsection 
(d)(1)(A) of section 954 be applicable to the export sales of a product 
of a possessions corporation which makes a separate election for export 
sales?
    A. 5: An electing corporation will be required to meet the 
``manufacturing'' test set forth in subsection (d)(1)(A) of section 954 
with respect to export sales of its product in each taxable year in 
which the separate election for export sales is in effect.

    (c) Revocation of election under section 936(a).

    Q. 1: When may an election under section 936(a) be revoked?
    A. 1: An election under section 936(a) may be revoked during the 
first ten years of section 936 status only with the consent of the 
Commissioner, and without the Commissioner's consent after that time. 
The Commissioner hereby consents to all requests for revocation that are 
made with respect to the taxapayer's first taxable year beginning after 
December 31, 1982 provided that the section 936(a) election was in 
effect for the corporation's last taxable year beginning before January 
1, 1983, if the taxpayer agrees not to re-elect section 936(a) prior to 
its first taxable year beginning after December 31, 1988. A taxpayer 
that wishes to revoke a section 936(a) election under the terms of the 
blanket revocation must attach a ``Statement of Revocation--Section 
936'' to the taxpayer's timely filed return (including extensions) and 
must state that in revoking the election the taxpayer agrees not to re-
elect section 936(a) prior to its first taxable year beginning after 
December 31, 1988. Other requests to revoke not covered by the 
Commissioner's blanket consent should be addressed to the District 
Director having jurisdiction over the taxpayer's tax return.

[T.D. 8090, 51 FR 21545, June 13, 1986]



Sec. 1.936-8T  Qualified possession source investment income (temporary). [Reserved]



Sec. 1.936-9T  Source of qualified possession source investment income (temporary). [Reserved]



Sec. 1.936-10  Qualified investments.

    (a) In general. [Reserved]
    (b) Qualified investments in Puerto Rico. [Reserved]
    (c) Qualified investment in certain Caribbean Basin countries--(1) 
General rule. An investment of qualified funds described in this section 
shall be treated as a qualified investment of funds for use in Puerto 
Rico if the funds are used for a qualified investment in a qualified 
Caribbean Basin country. A qualified investment in a qualified Caribbean 
Basin country is a loan of qualified funds by a qualified financial 
institution (described in paragraph (c)(3) of this section) directly to 
a qualified recipient (described in paragraph (c)(9) of this section) or 
indirectly through a single financial intermediary for investment in 
active busines assets (as defined in paragraph (c)(4) of this section) 
in a qualified Caribbean Basin country (described in paragraph 
(c)(10)(ii) of this section) or for investment in development projects 
(as defined in paragraph (c)(5) of this section) in a qualified 
Caribbean Basin country, provided--

[[Page 182]]

    (i) The investment is authorized, prior to disbursement of the 
funds, by the Commissioner of Financial Institutions of Puerto Rico (or 
his delegate) pursuant to regulations issued by such Commissioner; and
    (ii) The agreement, certification, and due diligency requirements 
under paragraphs (c)(11), (12), and (13) of this section are met.

A loan by a qualified financial institution shall not be disqualified 
merely because the loan transaction is processed by the central bank of 
issue of the country into which the loan is made pursuant to, and solely 
for purposes of complying with, the exchange control laws or regulations 
of such country. Further, a loan by a qualified financial institution 
shall not be disqualified merely because the loan is acquired by another 
person, provided such other person is also a qualified financial 
institution.
    (2) Termination of qualification--(i) In general. An investment 
that, at any time after having met the requirements for a qualified 
investment in a qualified Caribbean Basin country under the terms of 
this paragraph (c), fails to meet any of the conditions enumerated in 
this paragraph (c) shall no longer be considered a qualified investment 
in a qualified Caribbean Basin country from the time of such failure, 
unless the investment satisfies the requirements for a timely cure 
described in paragraph (c)(2)(ii) of this section. Such a failure 
includes, but is not limited to, the occurrence of any of the following 
events:
    (A) Active business assets cease to qualify as such;
    (B) Proceeds from the investment are diverted for the financing of 
assets, projects, or operations that are not active business assets or 
development projects or are not the assests or the project of the 
qualified recipient;
    (C) The holder of the qualified recipient's obligation is not a 
qualified financial institution;
    (D) The qualified recipient's qualified business activity ceases to 
qualify as such; or
    (E) The qualified Caribbean Basin country ceases to be a country 
described in paragraph (c)(10)(ii) of this section.
    (ii) Timely cure--(A) In general. A timely cure shall be considered 
to have been made if the event or events that cause disqualification of 
the investment are corrected within a reasonable period of time. For 
purposes of this section, a reasonable period of time shall not exceed 
60 days after such event or events come to the attention of the 
qualified recipient or the qualified financial institution or should 
have some to their attention by the exercise of reasonable diligence.
    (B) Due diligence requirements. A time cure of a failure to comply 
with the due diligence requirements of paragraphs (c)(11), (12), and 
(13) of this section shall be considered to be made if the failure to 
comply is due to reasonable cause and, upon request of the Commissioner 
of Financial Institutions of Puerto Rico (or his delegate) or of the 
Assistant Commissioner (International) (or his authorized 
representative), the qualified financial institution (and its trustee or 
agent), if any), the financial intermediary, or the qualified recipient 
establishes to the satisfaction of the Commissioner of Financial 
Institutions of Puerto Rico (or his delegate) or of the Assistant 
Commissioner (International) (or his authorized representative) that it 
has exercised due diligence in ensuring that the funds were property 
disbursed to a qualified recipient and applied by or on behalf of such 
qualified recipient to uses that qualify the investment as an investment 
in qualified business assets or a development project under the 
provisions of this paragraph (c).
    (iii) Assumption of qualified recipient's obligation. An investment 
shall not cease to qualify merely because the qualified recipient's 
obligation to the qualified financial institution (or to a financial 
intermediary, if any) is assumed by another person, provided such other 
person assumes the qualified recipient's agreement and certification 
requirements under paragraph (c)(11)(i) of this section and is either--
    (A) A qualified recipient on the date of assumption, in which case 
such person shall be treated for purposes of this

[[Page 183]]

section as the original qualified recipient and shall be subject to all 
the requirements of this section for continued qualification of the loan 
as a qualified investment in a qualified Caribbean Basin country; or
    (B) An international organization, the principal purpose of which is 
to foster economic development in developing countries and which is 
described in section 1 of the International Organizations Immunities Act 
(22 U.S.C. 288), if the assumption of the obligation is pursuant to a 
bona fide guarantee agreement.
    (3) Qualified financial institution--(i) General rule. For purposes 
of section 936(d)(4)(A) and this section, a qualified financial 
institution includes only--
    (A) A banking, financing, or similar business defined in Sec. 1.864-
4(c)(5)(i) that is an eligible institution described in paragraph 
(c)(3)(ii) of this section, but not including branches of such 
institution outside of Puerto Rico;
    (B) A single-purpose entity described in paragraph (c)(3)(iii) of 
this section;
    (C) The Government Development Bank for Puerto Rico;
    (D) The Puerto Rico Economic Development Bank; and
    (E) Such other entity as may be determined by the Commissioner by 
Revenue Procedure or other guidance published in the Internal Revenue 
Bulletin.
    (ii) Eligible institution. An eligible institution means an 
institution--
    (A) That is an entity organized under the laws of the Commonwealth 
of Puerto Rico or is the Puerto Rican branch of an entity organized 
under the laws of another jurisdiction, if such entity is engaged in a 
banking, financing, or similar business defined in Sec. 1.864-
4(c)(5)(i), and
    (B) That is licensed as an eligible institution under Regulation No. 
3582 (or any successor regulation) issued by the Commissioner of 
Financial Institutions of Puerto Rico (hereinafter ``Puerto Rican 
Regulation No. 3582'').
    (iii) Single-purpose entity. A single-purpose entity is an entity 
that meets all of the following conditions:
    (A) The entity is organized under the laws of the Commonwealth of 
Puerto Rico and is a corporation, a partnership or a trust, which 
conducts substantially all of its activities in Puerto Rico.
    (B) The sole purpose of the entity is to use qualified funds from 
possessions corporations to make one or more qualified investments in a 
qualified Caribbean Basin country and the entity actually uses such 
funds only for such purpose.
    (C) In the case of an entity that is a trust, one of the trustees is 
a qualified financial institution described in paragraph (c)(3)(i) of 
this section.
    (D) The entity is licensed as an eligible institution under Puerto 
Rican Regulation No. 3582 (or any successor regulation).
    (E) Any temporary investment by the entity for its own account of 
funds received from a possessions corporation, and the income from the 
investment thereof, and any temporary investment by the entity for its 
own account of principal and interest paid by a borrower to the entity, 
and the income from the investment thereof, are limited to investments 
in eligible activities, as described in section 6.2.4 of Puerto Rican 
Regulation No. 3582, as in effect on September 22, 1989.
    (4) Investments in active business assets--(i) In general. For 
purposes of section 936(d)(4)(A)(i)(I) and this section and subject to 
the provisions of paragraph (c)(8) of this section, a loan qualifies as 
an investment in active business assets if--
    (A) The amounts disbursed to a qualified recipient under the loan or 
bond issue are promptly applied (as defined in paragraphs (c)(6) and (7) 
of this section) by (or on behalf of) the qualified recipient solely for 
capital expenditures for the construction, rehabilitation (including 
demolition associated therewith), improvement, or upgrading of qualified 
assets described in paragraphs (c)(4)(ii)(A), (B), (E), and (F) of this 
section, for the acquisition of qualified assets described in paragraphs 
(c)(4)(ii)(B), (C), (E), and (F) of this section, for the expenditures 
described in paragraphs (c)(4)(ii)(D), (E), and (F) of this section, 
and, if applicable, for the financing of incidental expenditures 
described in paragraph (c)(4)(iii) of this section;
    (B) The qualified recipient owns the assets for United States income 
tax

[[Page 184]]

purposes and uses them in a qualified business activity (as defined in 
paragraph (c)(4)(iv)); and
    (C) The requirements of paragraph (c)(6) of this section (regarding 
temporary investments and time periods within which the funds must be 
invested) and of paragraph (c)(7) of this section (regarding the 
refinancing of existing funding and the time periods within which 
funding for investments must be secured) are satisfied.
    (ii) Definition of qualified assets. For purposes of this paragraph 
(c), qualified assets mean--
    (A) Real property;
    (B) Tangible personal property (such as furniture, machinery, or 
equipment) that is not property described in section 1221(1) and that is 
either new property or property which at no time during the period 
specified in paragraph (c)(4)(v) of this section was used in a business 
activity in the qualified Caribbean Basin country in which the property 
is to be used;
    (C) Rights to intangible property that is a patent, invention, 
formula, process, design, pattern, know-how, or similar item, or rights 
under a franchise agreement, provided that such rights--
    (1) Were not at any time during the period specified in paragraph 
(c)(4)(v) of this section used in a business activity in the qualified 
Caribbean Basin country in which the rights are to be used,
    (2) Are not rights the use of which gives rise, or would give rise 
if used, to United States source income, and
    (3) Are not rights acquired by the qualified recipient from a person 
related (within the meaning of section 267(b), using ``10 percent'' 
instead of ``50 percent'' in the places where it appears) to the 
qualified recipient;
    (D) Exploration and development expenditures incurred by a qualified 
recipient for the purpose of ascertaining the existence, location, 
extent or quality of any deposit of ore, oil, gas, or other mineral in a 
qualified Caribbean Basin country, as well as for purposes of developing 
such deposit (within the meaning of section 616 of the Code and the 
regulations thereunder);
    (E) Living plants and animals (other than crops, plants, and animals 
that are acquired primarily to hold as inventory by the qualified 
recipient for resale in the ordinary course of trade or business) 
acquired in connection with a farming business (as defined in 
Sec. 1.263-1T(c)(4)(i)), expenditures of a preparatory nature to prepare 
the land or area for farming (such as planting trees, drilling wells, 
clearing brush, leveling land, laying pipes, building roads, 
constructing tanks and reservoirs), expenditures for soil and water 
conservation of a type described in section 175(c)(1), and expenditures 
of a development nature incurred in connection with, and during, the 
preproductive period of property produced in a farming business (as 
defined in Sec. 1.263-1T(c)(4)(ii));
    (F) Other assets or expenditures that are not described in 
paragraphs (c)(4)(ii)(A) through (E) of this section and that the 
Commissioner may, by Revenue Procedure or other guidance published in 
the Internal Revenue Bulletin or by ruling issued to a qualified 
financial institution or qualified recipient upon its request, determine 
to be qualified assets.
    (iii) Incidental expenditures. An amount in addition to the loan 
proceeds borrowed to make an investment in active business assets shall 
be considered an investment in active business assets if such amount is 
applied to finance expenditures that are incidental to making the 
investment in active business assets, provided such amount is disbursed 
at or about the same time the proceeds for making the investment in 
active business assets are disbursed. For purposes of this section, 
expenditures incidental to an investment in active business assets 
include only the following items:
    (A) A reasonable amount of costs (other than the cost of credit 
enhancement or bond insurance premiums) associated with arranging the 
financing of an investment in active business assets, not to exceed 3.5 
percent of the proceeds of the loan or bond issue.
    (B) A reasonable amount of installation costs and other reasonable 
costs associated with placing an active business asset in service in the 
qualified business activity.
    (C) An amount not in excess of 10 percent of the total amount of 
investment

[[Page 185]]

in qualified assets to finance the acquisition of inventory, and other 
working capital requirements, but if an investment is in connection with 
a manufacturing or farming business, the percentage limitation shall be 
50 percent rather than 10 percent provided the excess over the 10 
percent limitation is used to finance inventory property. For purposes 
of this paragraph (c), whether a business is a manufacturing business 
shall be determined under principles similar to those described in 
section 954(d)(1)(A) and the regulations thereunder; whether a business 
is a farming business shall be determined under Sec. 1.263-1T(c)(4)(i).
    (D) An amount not in excess of 5 percent of the sum of the 
investment in active business assets and the costs described in 
paragraphs (c)(4)(iii)(A), (B), and (C) of this section for the 
refinancing of an existing debt of the qualified recipient if such 
refinancing is incidental to an investment in active business assets. 
For this purpose, the replacement of an existing loan arrangement shall 
not be considered the refinancing of an existing indebtedness to the 
extent that the funds under such loan arrangement have not yet been 
disbursed to the qualified recipient.
    (iv) Qualified business activity. A qualified business activity is a 
lawful industrial or commercial activity that is conducted as an active 
trade or business (under principles similar to those described in 
Sec. 1.367(a)-2T(b) (2) and (3)) in a qualified Caribbean Basin country. 
A trade or business for purposes of this paragraph (c)(4)(iv) is any 
business activity meeting the principles of section 367 of the Code and 
described in Divisions A through I (excluding group 43 in Division E 
(relating to the United States Postal Service) and groups 84 (relating 
to museums, art galleries, and botanical and zoological gardens), 86 
(relating to membership organizations), and 88 (relating to private 
households in Division I) of the 1987 Standard Industrial Classification 
Manual issued by the Executive Office of the President, Office of 
Management and Budget, or in the comparable provisions of any successor 
Standard Industrial Classification Manual that is adopted by the 
Commissioner of Internal Revenue in a notice, regulation, or other 
document published in the Internal Revenue Cumulative Bulletin.
    (v) Period of use. The period referred to in paragraphs 
(c)(4)(ii)(B) and (C) of this section shall be a five year period 
preceding the date of acquisition with the loan proceeds, if the date of 
acquisition is on or before May 13, 1991. If the date of acquisition is 
after May 13, 1991, then the period specified in this paragraph 
(c)(4)(v) shall be three years preceding the date of acquisition with 
the loan proceeds.
    (5) Investments in development projects--(i) In general. Subject to 
the provisions of paragraph (c)(8) of this section, this paragraph 
(c)(5)(i) describes the requirements in order for a loan by a qualified 
financial institution to qualify as an investment in a development 
project for purposes of section 936(d)(4)(A)(i)(II) and for this 
section.
    (A) The amounts disbursed under the loan or bond issue must be 
promptly applied (as defined in paragraphs (c)(6) and (7) of this 
section) by (or on behalf of) the qualified recipient solely for one or 
more investments described in paragraph (c)(4)(i)(A) of this section and 
in any land, buildings, or other property functionally related and 
subordinate to a facility described in paragraph (c)(5)(ii) of this 
section (determined under principles similar to those described in 
Sec. 1.103-8(a)(3)), for use (under principles similar to those 
described in Sec. 1.367(a)-2T(b)(5)) in connection with one or more 
activities described in paragraph (c)(5)(i)(B) of this section.
    (B) The activities referred to in paragraph (c)(5)(i)(A) of this 
section are--
    (1) A development project described in paragraph (c)(5)(ii) of this 
section in a qualified Caribbean Basin country; or
    (2) The performance in a qualified Caribbean Basin country of a non-
commercial governmental function described in paragraph (c)(5)(iv) of 
this section;
    (C) The qualified recipient must own the assets for United States 
income tax purposes;
    (D) The requirements of paragraph (c)(6) of this section (regarding 
temporary investments and time periods within which the funds must be 
invested) and of paragraph (c)(7) of this

[[Page 186]]

section (regarding the refinancing of existing funding and time periods 
within which funding for investments must be secured) must be satisfied.
    (ii) Development project. For purposes of this paragraph (c), a 
development project is one or more facilities in a qualified Caribbean 
Basin country that support economic development in that country and that 
satisfy the public use requirement of paragraph (c)(5)(iii) of this 
section. Examples of facilities that may meet the public use requirement 
include, but are not limited to--
    (A) Transportation systems and equipment, including sea, surface, 
and air, such as roads, railways, air terminals, runways, harbor 
facilities, and ships and aircraft;
    (B) Communications facilities;
    (C) Training and education facilities related to qualified business 
activities;
    (D) Industrial parks, including necessary support facilities such as 
roads; transmission lines for water, gas, electricity, and sewage; 
docks; plant sites preparations; power generation; sewage disposal; and 
water treatment;
    (E) Sports facilities;
    (F) Convention or trade show facilities;
    (G) Sewage, solid waste, water, and electric facilities;
    (H) Housing projects pursuant to a government program designed to 
provide affordable housing to low or moderate income families, based 
upon local standards; and
    (I) Hydroelectric generating facilities.
    (iii) Public use requirement. To satisfy the public use requirement 
in paragraph (c)(5)(ii) of this section, a facility must serve or be 
available on a regular basis for general public use, as contrasted with 
similar types of facilities which are constructed for the exclusive use 
of a limited number of persons as determined under principles similar to 
those described in Sec. 1.103-8(a)(2).
    (iv) Non-commercial governmental functions. For purposes of 
paragraph (c)(5)(i)(B) of this section, the term ``non-commercial 
governmental functions'' refers to activities that, under U.S. 
standards, are not customarily attributable to or carried on by private 
enterprises for profit and are performed for the general public with 
respect to the common welfare or which relate to the administration of 
some phase of government. For example, the operation of libraries, toll 
bridges, or local transportation services, and activities substantially 
equivalent to those carried out by the Federal Aviation Authority, 
Interstate Commerce Commission, or United States Postal Service, are 
considered non-commercial governmental functions. For purposes of this 
section, non-commercial government functions shall not include military 
activities.
    (v) [Reserved]
    (6) Prompt application of borrowed proceeds. This paragraph (c)(6) 
provides rules for determining whether amounts disbursed to a qualified 
recipient by a qualified financial institution (or a financial 
intermediary) shall be considered to have been promptly applied for the 
purpose of paragraphs (c)(4)(i)(A) and (c)(5)(i)(A) of this section.
    (i) In general. Except as otherwise provided in paragraphs 
(c)(6)(ii) and (c)(7)(iii)(B) of this section, amounts disbursed to a 
qualified recipient by a qualified financial institution (or a financial 
intermediary) shall be considered to have been promptly applied for the 
purpose of paragraphs (c)(4)(i)(A) and (c)(5)(i)(A) of this section if 
the amounts are fully expended for any of the purposes described in 
paragraphs (c)(4)(i)(A) or (c)(5)(i)(A) of this section no later than 
six months from the date of such disbursement and any temporary 
investment of such funds by the qualified recipient during such period 
complies with the rules of paragraph (c)(6)(iii)(A) of this section. 
Where the amounts disbursed are bond proceeds described in paragraph 
(c)(6)(iv)(A) of this section, the six-month period shall begin on the 
date of issuance of the bonds. In the event the qualified financial 
institution (or financial intermediary) invests any part of the bond 
proceeds before disbursement of those proceeds to the qualified 
recipient, all earnings from any such investment shall be paid to the 
qualified recipient or applied for its benefit.
    (ii) Special rules for long term projects financed out of bond 
proceeds. In the case of a long term project described in paragraph 
(c)(6)(iv)(B) of this section that is financed out of bond proceeds,

[[Page 187]]

the six-month period described in paragraph (c)(6)(i) of this section 
shall be extended with respect to the amount of bond proceeds used to 
fund the project for such reasonable period of time as shall be 
necessary until completion of the project or until beginning of 
production (in the case of a farming business), but, in any event, not 
to exceed three years from the date of issuance of the bonds, and only 
if--
    (A) The project that is financed out of bond proceeds was identified 
as of the date of issue;
    (B) A construction and expenditure plan certified by an independent 
expert (such as an engineer, an architect, or a farming expert) is filed 
with, and approved by, the Commissioner of Financial Institutions of 
Puerto Rico (or his delegate) prior to the date of issue, which makes a 
reasonable estimate, as of the date of filing of the plan, of the 
amounts and uses of the bond proceeds and the time of completion or 
production, and includes a schedule of progress payments until such 
time;
    (C) The terms of the construction and expenditure plan are disclosed 
in the public offering memorandum, private placement memorandum, or 
similar document prepared for information or disclosure purposes in 
relation to the issuance of bonds; and
    (D) Any temporary investment of the bond proceeds complies with the 
rules of paragraph (c)(6)(iii)(A) and (B) of this section.
    (iii) Temporary investments--(A) During six-month period. During the 
six-month period described in paragraph (c)(6)(i) of this section, 
during the first six months of the period described in paragraph 
(c)(6)(ii) of this section, and during the 30-day period described in 
paragraph (c)(7)(iii)(A) of this section, loan proceeds disbursed to a 
qualified recipient, bond proceeds, and income from the investment 
thereof, may be held in unrestricted yield investments, provided such 
yield reflects normal market yield for such type of investments and 
provided the income from such investments, if any, is or would be 
sourced either in Puerto Rico or in a country in which the investment in 
active business assets or development project is to be made.
    (B) During other periods. During any other period, any temporary 
investment of bond proceeds, and of income from such investments, shall 
be limited to investments in eligible activities. For purposes of this 
paragraph (c)(6)(iii)(B), the term ``eligible activities'' shall mean 
those investments described in section 6.2.4 of Puerto Rican Regulation 
No. 3582, as in effect on September 22, 1989.
    (iv) Definitions--(A) Bond proceeds. For purposes of this paragraph 
(c), bond proceeds shall mean the proceeds from the issuance of 
obligations by way of a public offering or a private placement by a 
qualified financial institution for investment in active business assets 
or a development project that has been identified at the time of issue 
and is described in a public offering memorandum, private placement 
memorandum, or similar document prepared for information or disclosure 
purposes in relation to the issuance of the bonds.
    (B) Long term project. For purposes of this section, the term long 
term project means--
    (1) A project, whether or not under a contract, for the 
construction, rehabilitation, improvement, upgrading, or production of 
qualified assets, or for expenditures, described in paragraph (c)(4)(ii) 
of this section (other than paragraph (c)(4)(ii)(C) of this section), 
which is reasonably expected to require more than 12 months to complete; 
or
    (2) The production of property in a farming business referred to in 
paragraph (c)(4)(ii)(E) of this section, which is reasonably expected to 
require a preproductive period in excess of 12 months.
    (7) Financing of previously incurred costs. Loan or bond proceeds 
which are disbursed after a qualified recipient has paid or incurred 
part or all of the costs of acquiring active business assets or 
investing in a development project shall be considered to have been 
applied for such purposes only as provided in this paragraph (c)(7).
    (i) Replacement of temporary non-section 936 financing of a 
qualified investment. This paragraph (c)(7)(i) prescribes the maximum 
time limits within which temporary non-section 936 financing of 
qualified investments may be replaced

[[Page 188]]

with section 936 funds without being considered a prohibited refinancing 
transaction. This paragraph (c)(7)(i) applies to the refinancing of 
costs incurred with respect to investments that, at the time the costs 
were first incurred, were either qualified investments in a qualified 
Caribbean Basin country or were investments by a qualified recipient in 
active business assets or a development project in a qualified Caribbean 
Basin country. This paragraph (c)(7)(i) applies also to the refinancing 
of costs incurred with respect to any other investment. However, in the 
latter case, the amount of costs that may be refinanced with section 936 
funds is limited to the amount of costs that are incurred with respect 
to the investment after the investment becomes a qualified investment in 
a qualified Caribbean Basin country. For purposes of this paragraph 
(c)(7)(i), the time when costs are incurred shall be determined under 
principles similar to those applicable under section 461(h) dealing with 
the economic performance test for the accrual of deductible liabilities. 
This paragraph (c)(7)(i) applies only to the situations described in 
this paragraph (c)(7)(i).
    (A) In the case of an investment in active business assets or a 
development project, a loan shall be a qualified investment for purposes 
of this paragraph (c) if the loan proceeds are disbursed, or the 
obligations are issued, no later than six months after the date on which 
the qualified recipient takes possession of the asset or the facility 
or, if earlier, places the asset or the facility in service. However, in 
the case of a small project described in paragraph (c)(8)(v) of this 
section, the six-month period shall be one year.
    (B) In the case of an investment in active business assets or a 
development project that is part of a long term project described in 
paragraph (c)(6)(iv)(B) of this section, a loan shall also be a 
qualified investment for purposes of this paragraph (c) if the loan 
proceeds are disbursed, or the obligations are issued, no later than six 
months after completion of the project or, in the case of a farming 
business, after the beginning of production, and in any event, no later 
than three years after the date on which the first payment is made 
toward the eligible costs of the project. The amount of the qualified 
investment may not exceed the sum of--
    (1) The eligible costs relating to investments described in 
paragraph (c)(4)(i)(A) in the case of an investment in active business 
assets, or the eligible costs relating to investments described in 
paragraph (c)(5)(i) of this section in the case of a development 
project, but only to the extent of the costs that are incurred after the 
date described in paragraph (c)(7)(i)(D) of this section, and
    (2) The portion of unpaid interest that would be required to be 
capitalized under U.S. tax rules and that accrued on prior temporary 
non-section 936 financing from the date described in paragraph 
(c)(7)(i)(D) of this section through the date the section 936 loan 
proceeds are disbursed or the section 936 obligations are issued.
    (C) In order to qualify for the special rules of this paragraph 
(c)(7)(i), a plan must be filed with the Commissioner of Financial 
Institutions of Puerto Rico (or his delegate) stating the qualified 
recipient's intention to refinance the costs of the long term project 
with section funds.
    (D) The date referred to in paragraph (c)(7)(i)(B) (1) and (2) of 
this section is a date that is the later of--
    (1) The date the plan described in paragraph (c)(7)(i)(C) is filed, 
or
    (2) The date the investment becomes a qualified investment by a 
qualified recipient in active business assets or a development project 
in a qualified Caribbean Basin country.
    (ii) Refinancing of section 936 financing. A section 936 loan or 
bond issue used to finance a qualified investment described in paragraph 
(c)(1) of this section may be refinanced with section 936 funds through 
a new loan or bond issue to the extent of the remaining principal 
balance on such existing qualified financing, increased by the amount of 
unpaid interest accrued through the date the new loan proceeds are 
disbursed or the new obligations are issued and that would be required 
to be capitalized under U.S. tax rules.
    (iii) Prompt application of borrowed proceeds--(A) In general. In 
the case of a

[[Page 189]]

loan or bond issue described in paragraph (c)(7)(i) or (ii) of this 
section, the rules of paragraph (c)(6) of this section shall apply but 
the six-month period described in paragraph (c)(6)(i) of this section 
shall be limited to 30 days from the date of disbursement of loan 
proceeds to the qualified recipient or from the date of issuance in the 
case of a bond issue.
    (B) Special rules for long term projects financed out of bond 
proceeds. In the case of a long term project described in paragraph 
(c)(6)(iv)(B) of this section that is financed out of bond proceeds, the 
30-day period described in paragraph (c)(7)(iii)(A) of this section 
shall be extended with respect to the amount of bond proceeds used for 
the permanent financing of the long term project for such reasonable 
period of time as shall be necessary until completion of the project or 
beginning of production (in the case of a farming business), but, in any 
event, not to exceed three years from the date of issuance of the bonds. 
For purposes of this paragraph (c)(7)(iii)(B), the period of time shall 
be considered reasonable only if--
    (1) A construction and expenditure plan certified by an independent 
expert (such as an engineer, an architect, or a farming expert) is filed 
with, and approved by, the Commissioner of Financial Institutions of 
Puerto Rico (or his delegate) prior to the date of issue, which makes a 
reasonable estimate, as of the date of issue, of the amounts and uses of 
the bond proceeds and the time of completion or production, and includes 
a schedule of progress payments until such time; and
    (2) The terms of the construction and expenditure plan are disclosed 
in the public offering memorandum, private placement memorandum, or 
similar document prepared for information or disclosure purposes in 
relation to the bond issue.
    (8) Miscellaneous operating rules--(i) Sale and leaseback. An asset 
that is acquired and leased back to the person from whom acquired does 
not constitute an investment in an active business asset or an 
investment in a development project.
    (ii) Use of asset in qualified business activity. For purposes of 
paragraph (c)(4)(i)(B), an asset shall be considered used or held for 
use in a qualified business activity if it is used or held for use in 
such activity under principles similar to those described in 
Sec. 1.367(a)-2T(b)(5), or a successor provision.
    (iii) Definition of capital expenditures. For purposes of this 
paragraph (c), capital expenditures mean those expenditures described in 
section 263(a) of the Code (without regard to paragraphs (A) through (G) 
of section 263(a)(1)), and those costs required to be capitalized under 
section 263A with respect to property described in section 263A(b)(1), 
relating to self-constructed assets.
    (iv) Loans through certain financial intermediaries. A loan by a 
qualified financial institution shall not be disqualified from being an 
investment in active business assets or in a development project merely 
because the proceeds are first lent to a financial intermediary (as 
defined in paragraph (c)(8)(iv)(H) of this section) which, in turn, on-
lends the proceeds directly to a qualified recipient, provided the 
requirements of this paragraph (c)(8)(iv) are satisfied.
    (A) The loan to the qualified recipient must satisfy the 
requirements of paragraph (c)(4)(i) of this section in the case of an 
investment in active business assets, or of paragraph (c)(5)(i) of this 
section in the case of an investment in a development project.
    (B) The qualified recipient and the active business assets or 
development project in which the proceeds are to be invested must be 
identified prior to disbursement of any part of the proceeds by the 
qualified financial institution to the financial intermediary.
    (C) The effective interest rate charged by the qualified financial 
institution to the financial intermediary must not exceed the average 
interest rate paid by the qualified financial institution with respect 
to its eligible funds, increased by such number of basis points as is 
required to provide reasonable compensation to the qualified financial 
institution for services performed and risks assumed with respect to the 
loan to the financial intermediary that are not ordinarily required to 
be performed or assumed with respect to a deposit, loan, repurchase 
agreement or other transfer of eligible

[[Page 190]]

funds with another qualified financial institution. The average interest 
rate shall be the average rate, determined on a daily basis, paid by the 
qualified financial institution on its eligible funds over the most 
recent quarter preceding the date on which the rate on the loan to the 
financial intermediary is committed.
    (D) The effective interest rate charged by the financial 
intermediary to the qualified recipient must not exceed the effective 
interest rate charged to the financial intermediary by the qualified 
financial institution, increased by such number of basis points as is 
required to provide reasonable compensation to the financial 
intermediary for services performed and risks assumed with respect to 
the loan to the qualified recipient.
    (E) The financial intermediary must borrow from the qualified 
financial institution under substantially the same terms as it lends to 
the qualified recipient. In particular, both loans must have 
disbursement terms, repayment schedules and maturity dates for interest 
and principal amounts such that the financial intermediary does not 
retain for more than 48 hours any of the funds disbursed by the 
qualified financial institution nor any of the funds paid by the 
qualified recipient in repayment of principal or interest on the loan.
    (F) The financial institution and the financial intermediary must 
agree to comply with the due diligence requirements described in 
paragraphs (c)(11), (12), and (13) of this section;
    (G) The time periods and temporary investments rules in paragraphs 
(c)(6) and (7) of this section must be complied with; and
    (H) For purposes of this paragraph (c), the financial intermediary 
must be--
    (1) An active trade or business which a person maintains in a 
qualified Caribbean Basin country and which consists of a banking, 
financing or similar business as defined in Sec. 1.864-4(c)(5)(i) (other 
than a central bank of issue); or
    (2) A public international organization, the principal purpose of 
which is to foster economic development in developing countries and 
which is described in section 1 of the International Organizations 
Immunities Act (22 U.S.C. 288).

For purposes of paragraphs (c)(8)(iv)(C) and (D) of this section, the 
determination of whether compensation is reasonable shall be made in 
relation to normal commercial practices for comparable transactions 
carrying a similar degree of commercial, currency and political risk. 
Reasonable credit enhancement fees and other reasonable fees and amounts 
charged to the financial intermediary or the qualified recipient with 
respect to the loan transaction in addition to interest shall be added 
to the interest cost in determining the effective interest rate.
    (v) Small project. For purposes of this paragraph (c), a small 
project shall be a project (including the acquisition of an asset) for 
which the total amount of section 936 funds used for its financing does 
not exceed $1,000,000 in the aggregate, or such other amount as the 
Commissioner may publish, from time to time, in the Internal Revenue 
Bulletin.
    (9) Qualified recipient. For purposes of this section, a qualified 
recipient is any person described in paragraph (c)(9)(i) or (ii) of this 
section. The term ``person'' means a person described in section 
7701(a)(1) or a government (within the meaning of Sec. 1.892-2T(a)(1)) 
of a qualified Caribbean Basin country.
    (i) In the case of an investment described in paragraph (c)(4) of 
this section (relating to investments in active business assets), a 
qualified recipient is a person that carries on a qualified business 
activity in a qualified Caribbean Basin country, and complies with the 
agreement and certification requirements described in paragraph 
(c)(11)(i) of this section at all times during the period in which the 
investment remains outstanding.
    (ii) In the case of an investment described in pargraph (c)(5) of 
this section (relating to investments in development projects), a 
qualified recipient is the borrower (including a person empowered by the 
borrower to authorize expenditures for the investment in the development 
project) that has authority to comply, and complies, with the agreement 
and certification requirements described in paragraph (c)(11)(i) of this 
section at all times during the

[[Page 191]]

period in which the investment remains outstanding.
    (10) Investments in a qualified Caribbean Basin country--(i) Rules 
for determining the place of an investment. The rules of this paragraph 
(c)(10)(i) shall apply to determine the extent to which an investment in 
an active business asset or a development project will be considered 
made in qualified Caribbean Basin Country.
    (A) An investment in real property is considered made in the 
qualified Caribbean Basin country in which the real property is located.
    (B) Except as otherwise provided in this paragraph (c)(10)(i)(B), an 
investment in tangible personal property is considered made in a 
qualified Caribbean Basin Country so long as the tangible personal 
property is predominantly used in that country. Whether property is used 
predominantly in a qualified Caribbean Basin country shall be determined 
under principles similar to those described in Sec. 1.48-1(g)(1), 
(g)(2)(ii), (g)(2)(iv), (g)(2)(vi), (g)(2)(viii), and (g)(2)(x) 
(relating to investment tax credits for property used outside the United 
States) as in effect on December 31, 1985. A vessel, container, or 
aircraft shall be considered for use predominantly in a qualified 
Caribbean Basin country in any year if it is used for transport to and 
from such country with some degree of frequency during that year and at 
least 30 percent of the income from the use of such vessel, container or 
aircraft for that year is sourced in such country under principles 
similar to those described in section 863(c)(1) and (2) (relating to 
source rules for certain transportation income). Cables and pipelines 
which are premanently installed as part of a communication or 
transportation system between a qualified Caribbean Basin country and 
another country or among several countries which include a qualified 
Caribbean Basin country shall be considered used in a qualified 
Caribbean Basin country to the extent of 50 percent of the portion of 
the facility that directly links the qualified country to another 
country or to a hub, unless it is established by notice or other 
guidance published in the Internal Revenue Bulletin or by ruling issued 
to a qualified institution or qualified recipient upon request that it 
is appropriate to attribute a greater portion of the cost of the 
facility to the qualified Caribbean Basin country.
    (C) An investment in rights to intangible property is considered 
made in a qualified Caribbean Basin country to the extent such rights 
are used in that country. Where rights to intangible property are used 
shall be determined under principles similar to those described in 
Sec. 1.954-2T(b)(3)(vii) or a successor provision.
    (ii) Qualified Caribbean Basin country. For purposes of this 
section, the term ``qualified Caribbean Basin country'' means any 
beneficiary country (within the meaning of section 212(a)(1)(A) of the 
Caribbean Basin Economic Recovery Act, Public Law 98-67 (Aug. 5, 1983), 
97 Stat. 384, 19 U.S.C. 2702(a)(1)(A)), which meets the requirements of 
section 274(h)(6)(A)(i) and (ii) and the U.S. Virgin Islands, and 
includes the territorial waters and continental shelf thereof.
    (11) Agreements and certifications by qualified recipients and 
financial intermediaries--(i) In general. In order for an investment to 
be considered a qualified investment under section 936(d)(4) and 
paragraph (c)(1) of this section, a qualified recipient must certify to 
the qualified financial institution (or to the financial intermediary, 
if the loan is made through a financial intermediary) on the date of 
closing of the loan agreement and on each anniversary date thereof, that 
it is a qualified recipient described in paragraph (c)(9) of this 
section. In addition, the qualified recipient must agree in the loan 
agreement with the qualified financial institution (or with the 
financial intermediary, if the loan is made through a financial 
intermediary)--
    (A) To use the funds at all times during the period the loan is 
outstanding solely for the purposes and in the manner described in 
paragraph (c)(4) of this section (regarding investment in active 
business assets) or in paragraph (c)(5) of this section (regarding 
investment in development projects);
    (B) To comply with the requirements of paragraph (c)(6) of this 
section (regarding temporary investments and time periods within which 
the funds must be invested) and paragraph (c)(7)

[[Page 192]]

of this section (regarding the refinancing of existing funding and the 
time periods within which funding for investments must be secured);
    (C) To notify the Assistant Commissioner (International), the 
qualified financial institution (or the financial intermediary, if the 
loan is made through a financial intermediary), and the Commissioner of 
Financial Institutions of Puerto Rico (or his delegate) pursuant to 
paragraph (c)(14) of this section if it no longer is a qualified 
recipient or if, for any other reason, the investment has ceased to 
qualify as a qualified investment described in paragraph (c)(1) of this 
section, promptly upon the occurrence of such disqualifying event; and
    (D) To permit examination by the office of the Assistant 
Commissioner (International) (or by the office of any District Director 
authorized by the Assistant Commissioner (International)) and the 
Commissioner of Financial Institutions of Puerto Rico (or his delegate) 
of all necessary books and records that are sufficient to verify that 
the funds were used for investments in active business assets or 
development projects in conformity with the terms of the loan agreement.
    (ii) Certification by a financial intermediary. In the case of a 
loan by a qualified financial institution to a financial intermediary, 
the financial intermediary must certify to the qualified financial 
institution (using the procedures described in paragraph (c)(11)(i) of 
this section) that it is a financial intermediary described in paragraph 
(c)(8)(iv)(H) of this section, and must furnish to the qualified 
financial institution a copy of the qualified recipient's certification 
described in paragraph (c)(11)(i) of this section and of its loan 
agreement with the qualified recipient. In addition, the financial 
intermediary must agree in the loan agreement with the qualified 
financial institution:
    (A) To comply with the requirements of paragraph (c)(8)(iv) of this 
section; and
    (B) To permit examination by the office of the Assistant 
Commissioner (International) (or by the office of any District Director 
authorized by the Assistant Commissioner (International)) and the 
Commissioner of Financial Institutions of Puerto Rico (or his delegate) 
of all its necessary books and records that are sufficient to verify 
that the funds were used in conformity with the terms of the loan 
agreements.
    (12) Certification requirements. In order for an investment to be 
considered a qualified investment under section 936(d)(4), section 
936(d)(4)(C)(i) requires that both the person in whose trade or business 
such investment is made and the financial institution certify to the 
Secretary of the Treasury and the Commissioner of Financial Institutions 
of Puerto Rico that the proceeds of the loan will be promptly used to 
acquire active business assets or to make other authorized expenditures. 
This certification requirement is satisfied as to the qualified 
financial institution, the financial intermediary (if any), and the 
qualified recipient if the qualified financial institution submits a 
certificate to both the Assistant Commissioner (International) and to 
the Commissioner of Financial Institutions of Puerto Rico (or his 
delegate) pursuant to paragraph (c)(14) of this section upon 
authorization of the investment by the Commissioner of Financial 
Institutions and, in any event, prior to the first disbursement of the 
loan proceeds to the qualified recipient or to the financial 
intermediary (if any), in which the qualified financial institution--
    (i) Represents that, as of the date of the certification, the 
qualified recipient and the financial intermediary (if any) have 
complied with the requirements described in paragraph (c)(11) of this 
section;
    (ii) Describes the important terms of the loan to the financial 
intermediary (if any) and to the qualified recipient, including the 
amount of the loan, the nature of the investment, the basis for its 
qualification as an investment in active business assets or a 
development project under this section, the identity of the financial 
intermediary (if any) and of the qualified recipient, the qualified 
Caribbean Basin country involved, and the nature of the collateral or 
other security used, including any guarantee;

[[Page 193]]

    (iii) Agrees to permit examination by the Assistant Commissioner 
(International) (or by the office of any District Director authorized by 
the Assistant Commissioner (International)) and the Commissioner of 
Financial Institutions of Puerto Rico (or his delegate) of all its 
necessary books and records that are sufficient to verify that the funds 
were used for investments in active business assets or development 
projects in conformity with the terms of the loan agreement or 
agreements with the financial intermediary (if any) and with the 
qualified recipient; and
    (iv) In the case of a single-purpose entity that is a qualified 
financial institution, discloses the name and address of the entity's 
trustee or agent, if any, that assists the qualified financial 
institution in the performance of its due diligence requirement under 
paragraph (c) of this section, and represents that the trustee or agent 
has agreed with the qualified financial institution to permit 
examination by the Assistant Commissioner (International) (or by the 
office of any District Director authorized by the Assistant Commissioner 
(International)) and the Commissioner of Financial Institutions of 
Puerto Rico (or his delegate) of all necessary books and records of such 
trustee or agent that are sufficient to verify that the funds were used 
for investments in active business assets or development projects in 
conformity with the terms of the loan agreement or agreements with the 
financial intermediary (if any) and with the qualified recipient.
    (13) Continuing due diligence requirements. In order to maintain the 
qualification for an investment under paragraph (c)(1) of this section, 
the continuing due diligence requirements described in this paragraph 
(c)(13) must be satisfied.
    (i) Requirements of qualified recipient. A qualified recipient must-
-
    (A) Submit annually to the qualified financial institution or to the 
financial intermediary from which its qualified funds were obtained a 
copy of its most recent annual financial statement accompanied by an 
opinion of an independent accountant familiar with the financials of the 
qualified recipient disclosing the amount of the loan, the current 
outstanding balance of the loan, describing the assets financed with 
such loan and the qualified business activity in which such assets are 
used or the development project for which the loan is used, and stating 
that there are no reasons to doubt that the loan proceeds have been 
properly used and continue to be properly used, and
    (B) Act in a manner consistent with its representations and 
agreements described in paragraph (c)(11) of this section.
    (ii) Requirements of qualified financial institutions. Except as 
otherwise provided in paragraph (c)(13)(iii) of this section, a 
qualified financial institution described in paragraph (c)(3) of this 
section must maintain in its records and have available for inspection 
the documentation described in paragraph (c)(13)(ii)(A) or (B) of this 
section. In addition, the qualified financial institution is required to 
notify the Assistant Commissioner (International) and the Commissioner 
of Financial Institutions of Puerto Rico (or his delegate) pursuant to 
paragraph (c)(14) of this section upon becoming aware that a loan has 
ceased to be an investment in active business assets or a development 
project under this section. For purposes of this paragraph (c)(13)(ii), 
multiple loans for investment in a single qualified business activity or 
development project will be aggregated in determining what due diligence 
requirements apply.
    (A) In the case of a small project described in paragraph (c)(8)(v) 
of this section, the following documents must be maintained and 
available for inspection:
    (1) The loan application or other similar document;
    (2) The financial statements of the qualified recipient filed as 
part of the loan application;
    (3) The statement required by section 6.4.3(a)(iii) of Puerto Rican 
Regulation No. 3582 or any successor thereof, signed by the qualified 
recipient (or its duly authorized representative), acknowledging the 
receipt of the loan proceeds, describing the assets financed with such 
loan and the business activity in which such assets are to be used or 
the development project for

[[Page 194]]

which the funds will be utilized, the collateral to be provided for the 
transaction including any guarantee, and the basis for its qualification 
as a qualified recipient;
    (4) The loan documents; and
    (5) In the case of a qualified financial institution that is a 
single-purpose entity, a copy of the agreement with the entity's trustee 
or agent, if any, described in paragraph (c)(12)(iv) of this section.
    (B) In the case of a disbursement concerning a project that is not a 
small project described in paragraph (c)(8)(v) of this section, the 
following documents must be maintained and available for inspection, in 
addition to the documents required by paragraph (c)(13)(ii)(A) of this 
section:
    (1) A memorandum of credit prepared by an officer of the qualified 
financial institution (or, in the case of a single purpose entity, an 
agent of the entity or a trustee for the entity, if any) and signed by 
the officer of the qualified financial institution, containing the 
details of the investigation and review that the qualified financial 
institution, or its trustee or agent, if any, conducted in order to 
evaluate whether the investment is qualified under paragraph (c)(1) of 
this section and the opinion of the officer of the qualified financial 
institution, or the opinion of an officer of the agent of, or of the 
trustee for, the qualified financial institution, if any, that there is 
no reasonable ground for belief that the qualified funds will be 
diverted to a use that is not permitted under the provisions of this 
section; in making this investigation and review, factors that must be 
utilized are ones similar to those listed in Puerto Rico Regulation No. 
3582, section 6.4.2;
    (2) The annual financial statement of the qualified recipient; and
    (3) The written report of an officer of the qualified financial 
institution, or of an officer of an agent of, or of the trustee for, the 
qualified financial institution, if any, documenting discussions, both 
before and after the disbursement of the loan proceeds, with each 
recipient's accounting, financial and executive personnel with respect 
to the proposed and actual use of the loan proceeds and his analysis of 
the annual financial statements of the qualified recipient including an 
analysis of the statement of sources and uses of funds. After the loan 
disbursement, such discussions and review shall occur annually during 
the term of the loan. Such report shall include the conclusion that in 
such officer's opinion there is no reasonable ground for belief that the 
qualified recipient is improperly utilizing the funds.
    (iii) Requirements in the case of a financial intermediary. Where a 
qualified financial institution lends funds to a financial intermediary 
which are on-lent to a qualified recipient--
    (A) The obligation to maintain the documentation described in 
paragraph (c)(13)(ii)(A) or (B) of this section shall apply only to the 
financial intermediary and not to the qualified financial institution 
and the provisions of paragraph (c)(13)(ii)(A) or (B) of this section 
shall be read so as to impose on the financial intermediary any 
obligation imposed on the qualified financial institution.
    (B) The financial intermediary shall forward annually to the 
qualified financial institution a copy of the documentation it is 
required to maintain in its records pursuant to the provisions of this 
paragraph (c)(13)(iii) and shall notify the Assistant Commissioner 
(International), the Commissioner of Financial Institutions of Puerto 
Rico (or his delegate) and the qualified financial institution pursuant 
to paragraph (c)(14) of this section upon becoming aware that a loan has 
ceased to be an investment in active business assets or a development 
project under this section. The qualified financial institution must 
maintain in its records and have available for inspection the 
documentation furnished by the financial intermediary pursuant to this 
paragraph (c)(13)(iii)(B).
    (C) The qualified financial institution shall cause one of its 
officers (or one of the officers of its agent or trustee, if any) to 
prepare a written report documenting his analysis of the documentation 
furnished by the financial intermediary pursuant to paragraph 
(c)(13)(iii)(B) of this section, his discussions, both before and after 
the disbursement of the loan proceeds, with

[[Page 195]]

the financial intermediary's accounting, financial and executive 
personnel with respect to the proposed and actual use of the loan 
proceeds, and his analysis of the annual financial statements of the 
qualified recipient including an analysis of the statement of sources 
and uses of funds. After the loan disbursement, such discussions and 
review shall occur annually during the term of the loan. Such report 
shall include the conclusion that in such officer's opinion there is no 
reasonable ground for belief that the qualified recipient is improperly 
utilizing the funds.
    (14) Procedures for notices and certifications. Notices and 
certifications to the Assistant Commissioner (International) required 
under paragraphs (c)(11), (12) and (13) of this section shall be 
addressed to the attention of the Assistant Commissioner 
(International), Office of Taxpayer Service and Compliance, IN:C, 950 
L'Enfant Plaza South, SW., Washington, DC 20024. Notices and 
certifications to the Commissioner of Financial Institutions of Puerto 
Rico required under paragraphs (c)(11), (12), and (13) of this section 
shall be addressed as follows: Commissioner of Financial Institutions, 
GPO Box 70324, San Juan, Puerto Rico 00936.
    (15) Effective date. This paragraph (c) is effective May 13, 1991. 
It is applicable to investments by a possessions corporation in a 
financial institution that are used by a financial institution for 
investments in accordance with a specific authorization granted by the 
Commissioner of Financial Institutions of Puerto Rico (or his delegate) 
after September 22, 1989. However, the taxpayer may choose to apply 
Sec. 1.936-10T(c) for periods before June 12, 1991.

[T.D. 8350, 56 FR 21927, May 13, 1991]



Sec. 1.936-11  New lines of business prohibited.

    (a) In general. A possessions corporation that is an existing credit 
claimant, as defined in section 936(j)(9)(A) and this section, that adds 
a substantial new line of business during a taxable year, or that has a 
new line of business that becomes substantial during the taxable year, 
loses its status as an existing credit claimant for that year and all 
years subsequent.
    (b) New line of business--(1) In general. A new line of business is 
any business activity of the possessions corporation that is not closely 
related to a pre-existing business of the possessions corporation. The 
term closely related is defined in paragraph (b)(2) of this section. The 
term pre-existing business is defined in paragraph (b)(3) of this 
section.
    (2) Closely related. To determine whether a new activity is closely 
related to a pre-existing business of the possessions corporation all 
the facts and circumstances must be considered, including those set 
forth in paragraphs (b)(2)(i)(A) through (G) of this section.
    (i) Factors. The following factors will help to establish that a new 
activity is closely related to a pre-existing business activity of the 
possessions corporation--
    (A) The new activity provides products or services very similar to 
the products or services provided by the pre-existing business;
    (B) The new activity markets products and services to the same class 
of customers;
    (C) The new activity is of a type that is normally conducted in the 
same business location;
    (D) The new activity requires the use of similar operating assets;
    (E) The new activity's economic success depends on the success of 
the pre-existing business;
    (F) The new activity is of a type that would normally be treated as 
a unit with the pre-existing business' in the business accounting 
records; and
    (G) The new activity and the pre-existing business are regulated or 
licensed by the same or similar governmental authority.
    (ii) Safe harbors. An activity is not a new line of business if--
    (A) If the activity is within the same six-digit North American 
Industry Classification System (NAICS) code (or four-digit Standard 
Industrial Classification (SIC) code). The similarity of the NAICS or 
SIC codes may not be relied upon to determine whether the activity is 
closely related to a pre-existing business where the code indicates a 
miscellaneous category;
    (B) If the new activity is within the same five-digit NAICS code (or 
three-digit SIC code) and the facts relating

[[Page 196]]

to the new activity also satisfy at least three of the factors listed in 
paragraphs (b)(2)(i)(A) through (G) of this section; or
    (C) If the pre-existing business is making a component product or 
end-product form, as defined in Sec. 1.936-5(a)(1),Q&A1, and the new 
business activity is making an integrated product, or an end-product 
form with fewer excluded components, that is not within the same six-
digit NAICS code (or four-digit SIC code) as the pre-existing business 
solely because the component product and the integrated product (or two 
end-product forms) have different end-uses.
    (3) Pre-existing business--(i) In general. Except as provided in 
paragraph (b)(3)(ii) of this section, a business activity is a pre-
existing business of the existing credit claimant if--
    (A) The existing credit claimant was actively engaged in the 
activity within the possession on or before October 13, 1995; and
    (B) The existing credit claimant had elected the benefits of the 
Puerto Rico and possession tax credit pursuant to an election which was 
in effect for the taxable year that included October 13, 1995.
    (ii) Acquisition of an existing credit claimant. (A) If all the 
assets of one or more trades or businesses of a corporation of an 
existing credit claimant are acquired by an affiliated or non-affiliated 
existing credit claimant which carries on the business activity of the 
predecessor existing credit claimant, the acquired business activity 
will be treated as a pre-existing business of the acquiring corporation. 
A non-affiliated acquiring corporation will not be bound by any section 
936(h) election made by the predecessor existing credit claimant with 
respect to that business activity.
    (B) Where all of the assets of one or more trades or businesses of a 
corporation of an existing credit claimant are acquired by a corporation 
that is not an existing credit claimant, the acquiring corporation may 
make a section 936(e) election for the taxable year in which the assets 
are acquired with the following effects--
    (1) The acquiring corporation will be treated as an existing
    (2) The activity will be considered a pre-existing business of the 
acquiring corporation;
    (3) The acquiring corporation will be deemed to satisfy the rules of 
section 936(a)(2) for the year of acquisition; and
    (4) After making an election under section 936(e), a non-affiliated 
acquiring corporation will not be bound by elections under sections 
936(a)(4) and (h) made by the predecessor existing credit claimant.
    (C) For purposes of this section the assets of a trade or business 
are determined at the time of acquisition provided that the transferee 
actively conducts the trade or business acquired.
    (D) A mere change in the stock ownership of a possessions 
corporation will not affect its status as an existing credit claimant 
for purposes of this section.
    (4) Leasing of Assets. (i) The leasing of assets (and employees to 
operate leased assets) will not, for purposes of this section, be 
considered a new line of business of the existing credit claimant if--
    (A) the existing credit claimant used the leased assets in an active 
trade or business for at least five years;
    (B) the existing credit claimant does not through its own officers 
or staff of employees perform management or operational functions (but 
not including operational functions performed through leased employees) 
with respect to the leased assets; and
    (C) the existing credit claimant does not perform marketing 
functions with respect to the leasing of the assets.
    (ii) Any income from the leasing of assets not considered a new line 
of business pursuant to paragraph (b)(4)(i) of this section will not be 
income from the active conduct of a trade or business (and, therefore, 
the existing credit claimant may not receive a possession tax credit 
with respect to such income).
    (5) Timing rule. The tests for a new line of business in this 
paragraph (whether the new activity is closely related to a pre-existing 
business) are applied only at the end of the taxable year during which 
the new activity is added.

[[Page 197]]

    (c) Substantial--(1) In general. A new line of business is 
considered to be substantial as of the earlier of--
    (i) The taxable year in which the possessions corporation derives 
more than 15 percent of its gross income from that new line of business 
(gross income test); or
    (ii) The taxable year in which the possessions corporation directly 
uses in that new line of business more than 15 percent of its assets 
(assets test).
    (2) Gross income test. The denominator in the gross income test is 
the amount that is the gross income of the possessions corporation for 
the current taxable year, while the numerator is the amount that is the 
gross income of the new line of business for the current taxable year. 
The gross income test is applied at the end of each taxable year. For 
purposes of this test, if a new line of business is added late in the 
taxable year, the income is not to be annualized in that year. In the 
case of a new line of business acquired through the purchase of assets, 
the gross income of such new line of business for the taxable year of 
the acquiring corporation that includes the date of acquisition is 
determined from the date of acquisition through the end of the taxable 
year. In the case of a consolidated group election made pursuant to 
section 936(i)(5), the test applies on a company by company basis and 
not on a consolidated basis.
    (3) Assets test--(i) Computation. The denominator is the adjusted 
tax basis of the total assets of the possessions corporation for the 
current taxable year. The numerator is the adjusted tax basis of the 
total assets utilized in the new line of business for the current 
taxable year. The assets test is computed annually using all assets 
including cash and receivables.
    (ii) Exception. A new line of business of a possessions corporation 
will not be treated as substantial as a result of meeting the assets 
test if an event that is not reasonably anticipated causes assets used 
in the new line of business of the possessions corporation to exceed 15 
percent of the adjusted tax basis of the possessions corporation's total 
assets. For example, an event that is not reasonably anticipated would 
include the destruction of plant and equipment of the pre-existing 
business due to a hurricane or other natural disaster, or other similar 
circumstances beyond the control of the possessions corporation. The 
expiration of a patent is not such an event and will not permit use of 
this exception.
    (d) Examples. The following examples illustrate the rules described 
in paragraphs (a), (b), and (c) of this section. In the following 
examples, X Corp. is an existing credit claimant unless otherwise 
indicated:

    Example 1. X Corp. is a pharmaceutical corporation which 
manufactured bulk chemicals (a component product). In March 1997, X 
Corp. began to also manufacture pills (e.g., finished dosages or an 
integrated product). The new activity provides products very similar to 
the products provided by the pre-existing business. The new activity is 
of a type that is normally conducted in the same business location as 
the pre-existing business. The activity's economic success depends on 
the success of the pre-existing business. The manufacture of bulk 
chemicals is in NAICS code 325411, Medicinal and Botanical 
Manufacturing, while the manufacture of the pills is in NAICS code 
325412, Pharmaceutical Preparation Manufacturing. Although the products 
have a different end-use, may be marketed to a different class of 
customers, and may not use similar operating assets, they are within the 
same five-digit NAICS code and the activity also satisfies paragraphs 
(b)(2)(i)(A), (C), and (E) of this section. The manufacture of the pills 
by X Corp. will be considered closely related to the manufacture of the 
bulk chemicals. Therefore, X Corp. will not be considered to have added 
a new line of business for purposes of paragraph (b) of this section 
because it falls within the safe harbor rule of (b)(2)(ii)(B).
    Example 2. X Corp. currently manufactures printed circuit boards in 
a possession. As a result of a technological breakthrough, X Corp. could 
produce the printed circuit boards more efficiently if it modified its 
existing production methods. Because demand for its products was high, X 
Corp. expanded when it modified its production methods. After these 
modifications to the facilities and production methods, the products 
produced through the new technology were in the same six-digit NAICS 
code as products produced previously by X Corp. See paragraph 
(b)(2)(ii)(A) of this section. Therefore, X Corp. will not be considered 
to have added a new line of business for purposes of paragraph (b) of 
this section because it falls within the safe harbor rule of 
(b)(2)(ii)(A).
    Example 3. X Corp. has manufactured Device A in Puerto Rico for a 
number of years

[[Page 198]]

and began to manufacture Device B in Puerto Rico in 1997. Device A and 
Device B are both used to conduct electrical current to the heart and 
are both sold to cardiologists. There is no significant change in the 
type of activity conducted in Puerto Rico after the transfer of the 
manufacturing of Device B to Puerto Rico. Similar manufacturing 
equipment, manufacturing processes and skills are used in the 
manufacture of both devices. Both are regulated and licensed by the Food 
and Drug Administration. The economic success of Device B is dependent 
upon the success of Device A only to the extent that the liability and 
manufacturing prowess with respect to one reflects favorably on the 
other. Depending upon the heart abnormality, the cardiologist may choose 
to use Device A, Device B or both on a patient. The manufacture of 
Device B is treated as a unit with the manufacture of Device A in X 
Corp.'s accounting records. The manufacture of Device A is in the six-
digit NAICS code 339112, Surgical and Medical Instrument Manufacturing. 
The manufacture of Device B is in the six-digit NAICS code 334510, 
Electromedical and Electrotherapeutic Apparatus Manufacturing. (The 
manufacture of Device A is in the four-digit SIC code 3845, 
Electromedical and Electrotherapeutic Apparatus. The manufacture of 
Device B is in the four-digit SIC code 3841, Surgical and Medical 
Instruments and Apparatus.) The safe harbor of paragraph (b)(2)(ii)(B) 
of this section applies because the two activities are within the same 
three-digit SIC code and Corp. X satisfies paragraphs (b)(2)(i)(A), (B), 
(C), (D), (F), and (G) of this section.
    Example 4. X Corp. has been manufacturing house slippers in Puerto 
Rico since 1990. Y Corp. is a U.S. corporation that is not affiliated 
with X Corp. and is not an existing credit claimant. Y Corp. has been 
manufacturing snack food in the United States. In 1997, X Corp. 
purchased the assets of Y Corp. and began to manufacture snack food in 
Puerto Rico. House slipper manufacturing is in the six-digit NAICS code 
316212 (Four-digit SIC code 3142, House Slippers). The manufacture of 
snack foods falls under the six-digit NAICS code 311919, Other Snack 
Food Manufacturing (four-digit SIC code 2052, Cookies and Crackers 
(pretzels)). Because these activities are not within the same five or 
six digit NAICS code (or the same three or four-digit SIC code), and 
because snack food is not an integrated product that contains house 
slippers, the safe harbor of paragraph (b)(2)(ii) of this section cannot 
apply. Considering all the facts and circumstances, including the seven 
factors of paragraph (b)(2)(i) of this section, the snack food 
manufacturing activity is not closely related to the manufacture of 
house slippers, and is a new line of business, within the meaning of 
paragraph (b) of this section.
    Example 5. X Corp., a calendar year taxpayer, is an existing credit 
claimant that has elected the profit-split method for computing taxable 
income. P Corp. was not an existing credit claimant and manufactured a 
product in a different five-digit NAICS code than the product 
manufactured by X Corp. In 1997, X Corp. acquired the stock of P Corp. 
and liquidated P Corp. in a tax-free liquidation under section 332, but 
continued the business activity of P Corp. as a new business segment. 
Assume that this new business segment is a new line of business within 
the meaning of paragraph (c) of this section. In 1997, X Corp. has gross 
income from the active conduct of a trade or business in a possession 
computed under section 936(a)(2) of $500 million and the adjusted tax 
basis of its assets is $200 million. The new business segment had gross 
income of $60 million, or 12 percent of the X Corp. gross income, and 
the adjusted basis of the new segment's assets was $20 million, or 10 
percent of the X Corp. total assets. In 1997, X Corp. does not derive 
more than 15 percent of its gross income, or directly use more that 15 
percent of its total assets, from the new business segment. Thus, the 
new line of business acquired from P Corp. is not a substantial new line 
of business within the meaning of paragraph (c) of this section, and the 
new activity will not cause X Corp. to lose its status as an existing 
credit claimant during 1997. In 1998, however, the gross income of X 
Corp. grew to $750 million while the gross income of the new line of 
business grew to $150 million, or 20% of the X Corp. 1998 gross income. 
Thus, in 1998, the new line of business is substantial within the 
meaning of paragraph (c) of this section, and X Corp. loses its status 
as an existing credit claimant for 1998 and all years subsequent.

    (e) Loss of status as existing credit claimant. An existing credit 
claimant that adds a substantial new line of business in a taxable year, 
or that has a new line of business that becomes substantial in a taxable 
year, loses its status as an existing credit claimant for that year and 
all years subsequent.
    (f) Effective date--(1) General rule. This section applies to 
taxable years of a possessions corporation beginning on or after January 
25, 2000.
    (2) Election for retroactive application. Taxpayers may elect to 
apply retroactively all the provisions of this section for any open 
taxable year beginning after December 31, 1995. Such election will be 
effective for the year of the election and all subsequent taxable years. 
This section will not apply to activities of pre-existing businesses for

[[Page 199]]

taxable years beginning before January 1, 1996.

[T.D. 8868, 65 FR 3815, Jan. 25, 2000]

                      china trade act corporations



Sec. 1.941-1  Special deduction for China Trade Act corporations.

    In addition to the deductions from taxable income otherwise allowed 
such a corporation, a China Trade Act corporation is, under certain 
conditions, allowed an additional deduction in computing taxable income. 
This special deduction is an amount equal to the proportion of the 
taxable income derived from sources within Formosa and Hong Kong 
(determined without regard to this section and determined in a manner 
similar to that provided in part I (section 861 and following), 
subchapter N, chapter 1 of the Code, and the regulations thereunder) 
which the par value of the shares of stock of the corporation, owned on 
the last day of the taxable year by (a) persons resident in Formosa, 
Hong Kong, the United States, or possessions of the United States, and 
(b) individual citizens of the United States wherever resident, bears to 
the par value of the whole number of shares of stock of the corporation 
outstanding on that date. The decrease, by reason of such deduction, in 
the tax imposed by section 11 must not, however, exceed the amount of 
the special dividend referred to in section 941 (b), and is not 
allowable unless the special dividend has been certified to the 
Commissioner by the Secretary of Commerce.



Sec. 1.941-2  Meaning of terms used in connection with China Trade Act corporations.

    (a) A China Trade Act corporation is one organized under the 
provisions of the China Trade Act, 1922 (15 U.S.C. chapter 4).
    (b) The term ``special dividend'' means the amount which is 
distributed as a dividend to or for the benefit of such persons as on 
the last day of the taxable year were resident in Formosa, Hong Kong, 
the United States, or possessions of the United States, or were 
individual citizens of the United States, and owned shares of stock of 
the corporation. Such dividend must be distributed prior to or at the 
time fixed by law for filing the return of the corporation, including 
the period of any extension of time granted under rules and regulations 
prescribed by the Commissioner with the approval of the Secretary or his 
delegate. Such special dividend does not include any other amounts 
payable or to be payable to such persons or for their benefit by reason 
of their interest in the corporation and must be made in proportion to 
the par value of the shares of stock of the corporation owned by each.
    (c) For the purposes of section 941, the shares of stock of a China 
Trade Act corporation are considered to be owned by the person in whom 
the equitable right to the income from such shares is in good faith 
vested.
    (d) ``Taxable income derived from sources within Formosa and Hong 
Kong'' is the sum of the taxable income from sources wholly within 
Formosa and Hong Kong and that portion of the taxable income from 
sources partly within and partly without Formosa and Hong Kong which may 
be allocated to sources within Formosa and Hong Kong. The method of 
computing this income is similar to that described in part I (section 
861 and following), subchapter N, chapter 1 of the Code, and the 
regulations thereunder.



Sec. 1.941-3  Illustration of principles.

    The application of section 941 may be illustrated by the following 
example:

    Example. (1) The A Company, a China Trade Act corporation, has 
taxable income (computed without regard to the deduction under section 
941) for the calendar year 1954 of $200,000 and receives no dividends 
from domestic corporations. All of its stock on December 31, 1954, is 
owned on that date by persons resident in Formosa, Hong Kong, the United 
States, or possessions of the United States, or individual citizens of 
the United States. It distributes a special dividend amounting to 
$100,000 on February 15, 1955, which is certified by the Secretary of 
Commerce as provided in section 941(b). For the purpose of the tax 
imposed by section 11, it is necessary in this example to make two 
computations, first, without allowing the special deduction from taxable 
income on account of income derived from sources within Formosa and Hong 
Kong, and, second, allowing such deduction. The computations are as 
follows:

[[Page 200]]

    (2) First computation; without allowing the special deduction from 
taxable income.

 
 
 
Taxable income...............................................   $200,000
Normal tax (section 11 (b))..................................     60,000
Surtax (section 11 (c))......................................     38,500
Total income tax.............................................     98,500
 

    (3) Second computation; allowing the special deduction from taxable 
income.

 
 
 
Taxable income.............................................     $200,000
 


Since the total taxable income is derived from sources within Formosa 
and Hong Kong and since the par value of the shares of stock of the 
corporation owned on the last day of the taxable year by (a) persons 
resident in Formosa, Hong Kong, the United States, or possessions of the 
United States, and (b) individual citizens of the United States wherever 
resident, is 100 percent of the par value of the total number of shares 
of stock of the corporation outstanding on that day, 100 percent of such 
taxable income is deductible.

 
 
 
Special deduction from taxable income......................     $200,000
Amount of income subject to tax under section 11...........         None
 

    (4) Since the special dividend ($100,000) exceeds the diminution of 
the tax ($98,500) on account of the allowance of the special deduction 
from taxable income, the entire amount of the special deduction is 
allowable and the corporation has no income tax liability for 1954.



Sec. 1.943-1  Withholding by a China Trade Act corporation.

    Dividends paid by a China Trade Act corporation to a nonresident 
alien individual, foreign partnership, or foreign corporation are 
subject to withholding of tax at source under Sec. 1.1441-1. However, 
see paragraph (c) of Sec. 1.1441-4 for exemption applicable to dividends 
paid to residents of Formosa or Hong Kong.

[T.D. 6908, 31 FR 16769, Dec. 31, 1966]

                     controlled foreign corporations



Sec. 1.951-1  Amounts included in gross income of United States shareholders.

    (a) In general. If a foreign corporation is a controlled foreign 
corporation (within the meaning of section 957) for an uninterrupted 
period of 30 days or more (determined under paragraph (f) of this 
section) during any taxable year of such corporation beginning after 
December 31, 1962, every person--
    (1) Who is a United States shareholder (as defined in section 951(b) 
and paragraph (g) of this section) of such corporation at any time 
during such taxable year, and
    (2) Who owns (within the meaning of section 958(a)) stock in such 
corporation on the last day, in such year, on which such corporation is 
a controlled foreign corporation shall include in his gross income for 
his taxable year in which or with which such taxable year of the 
corporation ends, the sum of--
    (i) Except as provided in section 963, such shareholder's pro rata 
share (determined under paragraph (b) of this section) of the 
corporation's subpart F income (as defined in section 952) for such 
taxable year of the corporation,
    (ii) Such shareholder's pro rata share (determined under paragraph 
(c)(1) of this section) of the corporation's previously excluded subpart 
F income withdrawn from investment in less developed countries for such 
taxable year of the corporation,
    (iii) Such shareholder's pro rata share (determined under paragraph 
(c)(2) of this section) of the corporation's previously excluded subpart 
F income withdrawn from investment in foreign base company shipping 
operations for such taxable year of the corporation, and
    (iv) Such shareholder's pro rata share (determined under paragraph 
(d) of this section) of the corporation's increase in earnings invested 
in United States property for such taxable year of the corporation (but 
only to the extent such pro rata share is not excluded from such 
shareholder's gross income for his taxable year under section 
959(a)(2)).

For purposes of determining whether a United States shareholder which is 
a domestic corporation is a personal holding company under section 542 
and Sec. 1.542-1, the character of the amount includible in gross income 
of such domestic corporation under this paragraph shall be determined as 
if such amount were realized directly by such corporation from the 
source from which it is realized by the controlled foreign corporation. 
See paragraph (a) of Sec. 1.957-2 for special limitation on the amount 
of subpart F income in the case of a controlled foreign corporation 
described in section 957(b). See section 970(a) and Sec. 1.970-1 which 
provides for

[[Page 201]]

the reduction of subpart F income of export trade corporations.
    (b) Limitation on a United States shareholder's pro rata share of 
subpart F income--(1) In general. For purposes of paragraph (a)(2)(i) of 
this section, a United States shareholder's pro rata share (determined 
in accordance with the rules of paragraph (e) of this section) of the 
foreign corporation's subpart F income for the taxable year of such 
corporation is--
    (i) The amount which would have been distributed with respect to the 
stock which such shareholder owns (within the meaning of section 958(a)) 
in such corporation if on the last day, in such corporation's taxable 
year, on which such corporation is a controlled foreign corporation it 
had distributed pro rata to its shareholders an amount which bears the 
same ratio to its subpart F income for such taxable year as the part of 
such year during which such corporation is a controlled foreign 
corporation bears to the entire taxable year, reduced by--
    (ii) The amount of distributions received by any other person during 
such taxable year as a dividend with respect to such stock, but only to 
the extent that such distributions do not exceed the dividend which 
would have been received by such other person if the distributions by 
such corporation to all its shareholders had been the amount which bears 
the same ratio to the subpart F income of such corporation for the 
taxable year as the part of such year during which such shareholder did 
not own (within the meaning of section 958(a)) such stock bears to the 
entire taxable year.
    (2) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. A, a United States shareholder, owns 100 percent of the 
only class of stock of M, a controlled foreign corporation throughout 
1963. Both A and M Corporation use the calendar year as a taxable year. 
For 1963, M Corporation derives $100 of subpart F income, has $100 of 
earnings and profits, and makes no distributions. A must include $100 in 
his gross income for 1963 under section 951(a)(1)(A)(i).
    Example 2. The facts are the same as in example 1, except that 
instead of holding 100 percent of the stock of M Corporation for the 
entire year, A sells 60 percent of such stock to B, a nonresident alien, 
on May 26, 1963. Thus, M Corporation is a controlled foreign corporation 
for the period January 1, 1963, through May 26, 1963. A must include $40 
($100x146/365) in his gross income for 1963 under section 
951(a)(1)(A)(i).
    Example 3. The facts are the same as in example 1, except that 
instead of holding 100 percent of the stock of M Corporation for the 
entire year, A holds 60 percent of such stock on December 31, 1963, 
having acquired such interest on May 26, 1963, from B, a nonresident 
alien, who owned such interest from January 1, 1963. Before A's 
acquisition of such stock, M Corporation had distributed a dividend of 
$15 to B in 1963 with respect to such stock. A must include $21 in his 
gross income for 1963 under section 951(a)(1)(A)(i), such amount being 
determined as follows:

 
 
 
Corporation M's Subpart F income for 1963.......................    $100
Less: Reduction under section 951(a)(2)(A) for period (1-1-63         40
 through 5-26-63) during which M Corporation is not a controlled
 foreign corporation ($100x146/365).............................
                                                         ---------
Subpart F income for 1963 as limited by section 951(a)(2)(A)....      60
A's pro rata share of subpart F income as determined under            36
 section 951 (a)(2)(A) (60 percent of $60)......................
Less: Reduction under section 951(a)(2)(B) for dividends
 received by B during 1963 with respect to the stock acquired by
 A in M Corporation:
  (i) Dividend received by B............................      15
  (ii) B's pro rata share of the amount which bears the       24
   same ratio to M Corporation's subpart F income for
   1963 ($100) as the period during which A did not own
   (within the meaning of section 958(a)) his stock (146
   days) bears to the entire taxable year (365 days) (60
   percent of ($100x146/365))...........................
  (iii) Amount of reduction (lesser of (i) or (ii)).....              15
                                                                 -------
A's pro rata share of Subpart F income as determined under            21
 section 951(a)(2)..............................................
 

    Example 4. A, a United States shareholder, owns 100 percent of the 
only class of stock of P, a controlled foreign corporation throughout 
1963, and P owns 100 percent of the only class of stock of R, a 
controlled foreign corporation throughout 1963. A and Corporations P and 
R each use the calendar year as a taxable year. For 1963, R Corporation 
derives $100 of subpart F income, has $100 of earnings and profits, and 
distributes a dividend of $20 to P Corporation. Corporation P has no 
income for 1963 other than the dividend received from R Corporation. A 
must include $100 in his gross income for 1963 under section 
951(a)(1)(A)(i) as subpart F income of R Corporation for such year. Such 
subpart F income is not reduced under section 951(a)(2)(B) for the 
dividend of $20 paid to P Corporation because there was no part of the 
year 1963 during which A did not own (within the meaning of section 
958(a)) the

[[Page 202]]

stock of R Corporation. By reason of the application of section 959(b), 
the $20 distribution from R Corporation to P Corporation is not again 
includible in the gross income of A under section 951(a).
    Example 5. The facts are the same as in example 4, except that 
instead of holding the stock of R Corporation for the entire year, P 
Corporation acquires 60 percent of the only class of stock of R 
Corporation on March 14, 1963, from C, a nonresident alien, after R 
Corporation distributes in 1963 a dividend of $35 to C with respect to 
the stock so acquired by P Corporation. The stock interest so acquired 
by P Corporation was owned by C from January 1, 1963, until acquired by 
P Corporation. A must include $36 in his gross income for 1963 under 
section 951(a)(1)(A)(i), such amount being determined as follows:

 
 
 
Corporation R's Subpart F income for 1963......................     $100
Less: Reduction under section 951(a)(2)(A) for period (1-1-63         20
 through 3-14-63) during which R Corporation is not a
 controlled foreign corporation ($100x73/365)..................
                                                       ----------
Subpart F income for 1963 as limited by section 951(a)(2)(A)...       80
A's pro rata share of subpart F income as determined under            48
 section 951 (a)(2)(A) (60 percent of $80).....................
Less: Reduction under section 951(a)(2)(B) for dividends
 received by C during 1963 with respect to the stock indirectly
 acquired by A in R Corporation:
  (i) Dividend received by C..........................       35
  (ii) C's pro rata share of the amount which bears          12
   the same ratio to R Corporation's Subpart F income
   for 1963 ($100) as the period during which A did
   not indirectly own (within the meaning of section
   958(a)(2)) his stock (73 days) bears to the entire
   taxable year (365 days) (60 percent of ($100x73/
   365))..............................................
                                                       ----------
  (iii) Amount of reduction (lesser of (i) or (ii))...                12
                                                                --------
A's pro rata share of Subpart F income as determined under            36
 section 951 (a)(2)............................................
 

    (c) Limitation on a United States shareholder's pro rata share of 
previously excluded subpart F income withdrawn from investments--(1) 
Investments in less developed countries. For purposes of paragraph 
(a)(2)(ii) of this section, a United States shareholder's pro rata share 
(determined in accordance with the rules of paragraph (e) of this 
section) of the foreign corporation's previously excluded subpart F 
income withdrawn from investment in less developed countries for the 
taxable year of such corporation shall not exceed an amount which bears 
the same ratio to such shareholder's pro rata share of such income 
withdrawn (as determined under section 955(a)(3), as in effect before 
the enactment of the Tax Reduction Act of 1975, and paragraph (c) of 
Sec. 1.955-1) for such taxable year as the part of such year during 
which such corporation is a controlled foreign corporation bears to the 
entire taxable year. See paragraph (c)(2) of Sec. 1.955-1 for a special 
rule applicable to exclusions and withdrawals occurring before the date 
on which the United States shareholder acquires his stock.
    (2) Investments in foreign base company shipping operations. For 
purposes of paragraph (a)(2)(iii) of this section, a United States 
shareholder's pro rata share (determined in accordance with the rules of 
paragraph (e) of this section) of the foreign corporation's previously 
excluded subpart F income withdrawn from investment in foreign base 
company shipping operations for the taxable year of such corporation 
shall not exceed an amount which bears the same ratio to such 
shareholder's pro rata share of such income withdrawn (as determined 
under section 955(a)(3) and paragraph (c) of Sec. 1.955A-1) for such 
taxable year as the part of such year during which such corporation is a 
controlled foreign corporation bears to the entire taxable year. See 
paragraph (c)(2) of Sec. 1.955A-1 for a special rule applicable to 
exclusions and withdrawals occurring before the date on which the United 
States shareholder acquires his stock.
    (d) Limitation on a United States shareholder's pro rata share of 
increase in investment in United States property. For purposes of 
paragraph (a)(2)(iv) of this section, a United States shareholder's pro 
rata share (determined in accordance with the rules of paragraph (e) of 
this section) of the foreign corporation's increase in earnings invested 
in United States property for the taxable year of such corporation shall 
not exceed an amount which bears the same ratio to such shareholder's 
pro rata share of such increase (as determined under section 956(a)(2) 
and paragraph (c) of Sec. 1.956-1) for such taxable year as the part of 
such year during which such corporation is a controlled foreign 
corporation bears to the entire taxable year. The amount determined 
under the preceding sentence, however, shall

[[Page 203]]

be taken into account under paragraph (a)(2)(iv) of this section only to 
the extent such amount is not excluded from such shareholder's gross 
income for his taxable year under section 959(a)(2) and the regulations 
thereunder.
    (e) ``Pro rata share'' defined--(1) In general. For purposes of 
paragraphs (b), (c), and (d) of this section, a United States 
shareholder's pro rata share of a controlled foreign corporation's 
subpart F income, previously excluded subpart F income withdrawn from 
investment in less developed countries, previously excluded subpart F 
income withdrawn from investment in foreign base company shipping 
operations, or increase in earnings invested in United States property, 
respectively, for any taxable year is his pro rata share determined 
under paragraph (a) of Sec. 1.952-1, paragraph (c) of Sec. 1.955-1, 
paragraph (c) of Sec. 1.955A-1, or paragraph (c) of Sec. 1.956-1, 
respectively.
    (2) More than one class of stock. If a controlled foreign 
corporation for a taxable year has more than one class of stock 
outstanding, the amount of such corporation's subpart F income, 
withdrawal, or increase in investment, for the taxable year which shall 
be taken into account with respect to any one class of such stock for 
purposes of subparagraph (1) of this paragraph shall be that amount 
which bears the same ratio to the total of such subpart F income, 
withdrawal, or increase in investment for such year as the earnings and 
profits which would be distributed with respect to such class of stock 
if all earnings and profits of such corporation for such year were 
distributed on the last day of such corporation's taxable year on which 
such corporation is a controlled foreign corporation bear to the total 
earnings and profits of such corporation for such taxable year. For 
purposes of the preceding sentence, if an arrearage in dividends for 
prior taxable years exists with respect to a class of preferred stock of 
such corporation, the earnings and profits for the taxable year shall be 
attributed to such arrearage only to the extent such arrearage exceeds 
the earnings and profits of such corporation remaining from prior 
taxable years beginning after December 31, 1962.
    (3) Discretionary power to allocate earnings to different classes of 
stock. If the allocation of a foreign corporation's earnings and profits 
for the taxable year between two or more classes of stock depends upon 
the exercise of discretion by that body of persons which exercises with 
respect to such corporation the powers ordinarily exercised by the board 
of directors of a domestic corporation, the allocation of earnings and 
profits to such classes shall be made for purposes of this paragraph as 
if such classes constituted one class of stock in which each share has 
the same rights to dividends as any other share, unless a different 
method of allocation of earnings and profits is established as proper by 
the United States shareholder.
    (4) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Throughout its taxable year 1964, controlled foreign 
corporation A has outstanding 40 shares of common stock and 60 shares of 
6-percent, nonparticipating, nonvoting, preferred stock with a par value 
of $100 per share. D, a United States citizen who uses the calendar year 
as a taxable year, owns 30 shares of the common, and 15 shares of the 
preferred, stock during 1964: Corporation A for 1964 has earnings and 
profits of $1,000, and income of $500 with respect to which amounts are 
required to be included in gross income of United States shareholders 
under section 951(a). In such case, if the total $1,000 of earnings and 
profits were distributed on December 31, 1964, $360 (0.06x$100x60) would 
be distributed with respect to A Corporation's preferred stock and $640 
($1,000 minus $360) would be distributed with respect to its common 
stock. Accordingly, of the $500 with respect to which amounts are 
required to be included in gross income of United States shareholders 
under section 951(a), $180 ($360/$1,000x $500) is allocated to the 
outstanding preferred stock and $320 ($640/$1,000x$500) is allocated to 
the outstanding common stock. D's pro rata share of such amounts for 
1964 is $285 [($180x15/60)+($320x 30/40)].
    Example 2. The facts are the same as in example 1, except that the 
preferred stock is cumulative and there is an arrearage in dividends 
with respect to such stock of $900; on December 31, 1963, Corporation A 
has accumulated earnings and profits for 1963 of $700; therefore, for 
purposes of this paragraph, Corporation A's earnings and profits for 
1964 attributable to such arrearage may not exceed $200 ($900 minus 
$700). In such case, for

[[Page 204]]

purposes of this paragraph, if the $1,000 earnings and profits for 1964 
were distributed on December 31, 1964, $560 [(0.06x$100x60)+$200] would 
be distributed with respect to A Corporation's preferred stock and $440 
($1,000 minus $560) would be distributed with respect to its common 
stock. Accordingly, of the $500 with respect to which amounts are 
required to be included in gross income of United States shareholders 
under section 951 (a), $280 ($560/$1,000x$500) is allocated to the 
outstanding preferred stock and $220 ($440/ $1,000x$500) is allocated to 
the outstanding common stock. D's pro rata share of such amounts for 
1964 is $235 [($280x15/ 60)+($220x30/40)].

    (f) Determination of holding period. For purposes of sections 951 
through 964, the holding period of an asset (including stock of a 
controlled foreign corporation) shall be determined by excluding the day 
on which such asset is acquired and including the day on which such 
asset is disposed of. The application of this paragraph may be 
illustrated by the following example:

    Example. On June 30, 1963, United States person E acquires 70 of the 
100 shares of the only class of stock of foreign corporation A from 
nonresident alien B, who until such time owns all such 100 shares. E 
sells 10 shares of stock of such corporation on November 30, 1963, and 
60 shares on December 31, 1963, to nonresident alien F. Corporation A is 
a controlled foreign corporation for the period beginning with July 1, 
1963, and extending through December 31, 1963. As to the 10 shares of 
stock sold on November 30, 1963, E is treated as not owning such shares 
at any time after November 30, 1963, nor before July 1, 1963. As to the 
remaining 60 shares of stock, E is treated as not owning them before 
July 1, 1963, or after December 31, 1963.

    (g) United States shareholder defined-- (1) In general. For purposes 
of sections 951 through 964, the term ``United States shareholder'' 
means, with respect to a foreign corporation, a United States person (as 
defined in section 957(d)) who owns within the meaning of section 
958(a), or is considered as owning by applying the rules of ownership of 
section 958(b), 10 percent or more of the total combined voting power of 
all classes of stock entitled to vote of such foreign corporation.
    (2) Percentage of total combined voting power owned by United States 
person--(i) Meaning of combined voting power. In determining for 
purposes of subparagraph (1) of this paragraph whether a United States 
person owns the requisite percentage of voting power of all classes of 
stock entitled to vote, consideration will be given to all the facts and 
circumstances in each case. In any case where--
    (a) A foreign corporation has more than one class of stock 
outstanding, and
    (b) One or more United States persons own (within the meaning of 
section 958) shares of any one class of stock which possesses the power 
to elect, appoint, or replace a person, or persons, who with respect to 
such corporation, exercise the powers ordinarily exercised by a member 
of the board of directors of a domestic corporation,

the percentage of the total combined voting power with respect to such 
corporation owned by any such United States person shall be his 
proportionate share of the percentage of the persons exercising the 
powers ordinarily exercised by members of the board of directors of a 
domestic corporation (described in (b) of this subdivision) which such 
class of stock (as a class) possesses the power to elect, appoint, or 
replace. In all cases, however, a United States person will be deemed to 
own 10 percent or more of the total combined voting power with respect 
to a foreign corporation if such person owns (within the meaning of 
section 958) 20 percent or more of the total number of shares of a class 
of stock of such corporation possessing one or more powers enumerated in 
paragraph (b)(1) of Sec. 1.957-1. Whether a foreign corporation is a 
controlled foreign corporation for purposes of sections 951 through 964 
shall be determined by applying the rules of section 957 and 
Secs. 1.957-1 through 1.957-4.
    (ii) Illustration. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Foreign corporation S has two classes of capital stock 
outstanding, consisting of 60 shares of class A stock and 40 shares of 
class B stock. Each class of the outstanding stock is entitled to 
participate on a share for share basis in any dividend distributions by 
S Corporation. The owners of a majority of the class A stock are 
entitled to elect 7 of the 10 corporate directors, and the owners of a 
majority of the class B stock are entitled to elect the other 3 of the

[[Page 205]]

10 directors. Thus, the class A stock (as a class) possesses 70 percent 
of the total combined voting power of all classes of stock entitled to 
vote of S Corporation, and the class B stock (as a class) possesses 30 
percent of such voting power. D, a United States person, owns 31 shares 
of the class A stock and thus owns 36,167 percent (31/60x70 percent) of 
the total combined voting power of all classes of stock entitled to vote 
of S Corporation. By reason of the ownership of such voting power, D is 
a United States shareholder of S Corporation under section 951(b). For 
purposes of section 957, S Corporation is a controlled foreign 
corporation by reason of D's ownership of a majority of the class A 
stock, as illustrated in example 2 of paragraph (c) of Sec. 1.957-1. E, 
a United States person, owns eight shares of the class A stock and thus 
owns 9.333 percent (8/60x70 percent) of the total combined voting power 
of all classes of stock entitled to vote of S Corporation. Since E owns 
only 9.333 percent of such voting power and less than 20 percent of the 
number of shares of the class A stock, he is not a United States 
shareholder of S Corporation under section 951(b). F, a United States 
person, owns 14 shares of the class B stock and thus owns 10.5 percent 
(14/40x30 percent) of the total combined voting power of all classes of 
stock entitled to vote of S Corporation. By reason of the ownership of 
such voting power, F is a United States shareholder of S Corporation 
under section 951(b).
    Example 2. Foreign corporation R has three classes of stock 
outstanding, consisting of 10 shares of class A stock, 20 shares of 
class B stock, and 300 shares of class C stock. Each class of the 
outstanding stock is entitled to participate on a share for share basis 
in any distribution by R Corporation. The owners of a majority of the 
class A stock are entitled to elect 6 of the 10 corporate directors, and 
the owners of a majority of the class B stock are entitled to elect the 
other 4 of the 10 directors. The class C stock is not entitled to vote. 
D, E, and F, United States persons, each own 2 shares of the class A 
stock and 100 shares of the class C stock. As owners of a majority of 
the class A stock, D, E, and F elect 6 members of the board of 
directors. D, E, and F are United States shareholders of R Corporation 
under section 951(b) since each owns 20 percent of the total number of 
shares of the class A stock which possesses the power to elect a 
majority of the board of directors of R Corporation. For purposes of 
section 957, R Corporation is a controlled foreign corporation by reason 
of the ownership by D, E, and F of a majority of the class A stock, as 
illustrated in example 2 of paragraph (c) of Sec. 1.957-1.

[T.D. 6795, 30 FR 935, Jan. 29, 1965, as amended by T.D. 7893, 48 FR 
22507, May 19, 1983]



Sec. 1.951-2  Coordination of subpart F with election of a foreign investment company to distribute income.

    A United States shareholder who for his taxable year is a qualified 
shareholder (within the meaning of section 1247(c)) of a foreign 
investment company with respect to which an election under section 
1247(a) and the regulations thereunder is in effect for the taxable year 
of such company which ends with or within such taxable year of such 
shareholder shall not be required to include any amount in his gross 
income for his taxable year under paragraph (a) of Sec. 1.951-1 with 
respect to such company for that taxable year of such company.

[T.D. 6795, 30 FR 937, Jan. 29, 1965]



Sec. 1.951-3  Coordination of subpart F with foreign personal holding company provisions.

    A United States shareholder (as defined in section 951(b)) who is 
required under section 551(b) to include in his gross income for his 
taxable year his share of the undistributed foreign personal holding 
company income for the taxable year of a foreign personal holding 
company (as defined in section 552) which for that taxable year is a 
controlled foreign corporation (as defined in section 957) shall not be 
required to include in his gross income for his taxable year under 
section 951(a) and paragraph (a) of Sec. 1.951-1 any amount attributable 
to the earnings and profits of such corporation for that taxable year of 
such corporation. If a foreign corporation is both a foreign personal 
holding company and a controlled foreign corporation for the same period 
which is only a part of its taxable year, then, for purposes of applying 
the immediately preceding sentence, such corporation shall be deemed to 
be, for such part of such year, a foreign personal holding company and 
not a controlled foreign corporation and the earnings and profits of 
such corporation for the taxable year shall be deemed to be that amount 
which bears the same ratio to its earnings and profits for the taxable 
year as such part of the taxable year bears to the entire taxable year. 
The application of this section may be illustrated by the following 
examples:


[[Page 206]]


    Example 1. A, a United States shareholder, owns 100 percent of the 
only class of stock of controlled foreign corporation M which, in turn, 
owns 100 percent of the only class of stock of controlled foreign 
corporation N. A and Corporations M and N use the calendar year as a 
taxable year. During 1963, N Corporation derives $40,000 of gross income 
all of which is foreign personal holding company income within the 
meaning of section 553; thus, N Corporation is a foreign personal 
holding company for such year within the meaning of section 552(a). For 
1963, N Corporation has undistributed foreign personal holding company 
income (as defined in section 556(a)) of $30,000, derives $25,000 of 
subpart F income, and has earnings and profits of $32,000. During 1963, 
M Corporation derives $100,000 of gross income (including as a dividend 
under section 555(c)(2) the $30,000 of N Corporation's undistributed 
foreign personal holding company income), 65 percent of which is foreign 
personal holding company income within the meaning of section 553. 
Therefore, M Corporation is a foreign personal holding company for such 
year. For 1963, M Corporation has undistributed foreign personal holding 
company income (as defined in section 556(a)) of $90,000, determined by 
taking into account under section 552(c)(1) N Corporation's $30,000 of 
undistributed foreign personal holding company income for such year; in 
addition, M Corporation derives $50,000 of subpart F income and has 
earnings and profits of $92,000. Neither M Corporation nor N Corporation 
makes any actual distributions during 1963. A is required under section 
551(b) to include in his gross income for 1963 as a dividend the $90,000 
of M Corporation's undistributed foreign personal holding company income 
for such year. For 1963, A is not required to include in his gross 
income under section 951(a) any of the $50,000 subpart F income of M 
Corporation or of the $25,000 subpart F income of N Corporation.
    Example 2. The facts are the same as in example 1, except that only 
45 percent of M Corporation's gross income (determined by including 
under section 555(c)(2) the $30,000 of N Corporation's undistributed 
foreign personal holding company income) is foreign personal holding 
company income within the meaning of section 553; accordingly, M 
Corporation is not a foreign personal holding company for 1963. Since 
for such year M Corporation is not a foreign personal holding company, 
the undistributed foreign personal holding company income ($30,000) of N 
Corporation is not required under section 555(b) to be included in the 
gross income of M Corporation for 1963; as a result, such income is not 
required under section 551(b) to be included in the gross income of A 
for such year even though N Corporation is a foreign personal holding 
company for that year. For 1963, A is required to include $75,000 in his 
gross income under section 951(a)(1)(A)(i) and paragraph (a) of 
Sec. 1.951-1, consisting of the $50,000 subpart F income of M 
Corporation and the $25,000 subpart F income of N Corporation.
    Example 3. The facts are the same as in example 1, except that in 
1963 N Corporation actually distributes $30,000 to M Corporation and M 
Corporation, in turn, actually distributes $90,000 to A. Under section 
556 the undistributed foreign personal holding company income of both M 
corporation and N Corporation is thus reduced to zero; accordingly, no 
amount is included in the gross income of A under section 551(b) by 
reason of his interest in corporations M and N. A must include $75,000 
in his gross income for 1963 under section 951(a)(1)(A)(i) and paragraph 
(a) of Sec. 1.951-1, consisting of the $50,000 subpart F income of M 
Corporation and the $25,000 subpart F income of N Corporation. Of the 
$90,000 distribution received by A from M Corporation, $75,000 is 
excludable from his gross income under section 959(a)(1) as previously 
taxed earnings and profits; the remaining $15,000 is includible in his 
gross income for 1963 as a dividend.
    Example 4. (a) A, a United States shareholder, owns 100 percent of 
the only class of stock of controlled foreign corporation P, organized 
on January 1, 1963. Both A and P Corporation use the calendar year as a 
taxable year. During 1963, 1964, and 1965, P Corporation is not a 
foreign personal holding company as defined in section 552(a); in each 
of such years, P Corporation derives dividend income of $10,000 which 
constitutes foreign personal holding company income (within the meaning 
of Sec. 1.954-2) but under 26 CFR 1.954-1(b)(1) (Revised as of April 1, 
1975) excludes such amounts from foreign base company income as 
dividends received from, and reinvested in, qualified investments in 
less developed countries. Corporation P's earnings and profits 
accumulated for 1963, 1964, and 1965 and determined under paragraph 
(b)(2) of Sec. 1.955-1 are $40,000. For 1966, P Corporation is a foreign 
personal holding company, has predistribution earnings and profits of 
$10,000, derives $10,000 of income which is both foreign personal 
holding company income within the meaning of section 553 and subpart F 
income within the meaning of section 952, distributes $8,000 to A, and 
has undistributed foreign personal holding company income of $2,000 
within the meaning of section 556. In addition, for 1966 P Corporation 
has a withdrawal (determined under section 955(a) as in effect before 
the enactment of the Tax Reduction Act of 1975 but without regard to its 
earnings and profits for such year) of $25,000 of previously excluded 
subpart F income from investment in less developed countries. A is 
required under section 551(b) to include in his gross income for 1966 as 
a dividend the $2,000 undistributed foreign personal holding company 
income. The $8,000

[[Page 207]]

distribution is includible in A's gross income for 1966 under sections 
61(a)(7) and 301 as a distribution to which section 316(a)(2) applies. 
Corporation P's $25,000 withdrawal of previously excluded subpart F 
income from investment in less developed countries is includible in A's 
gross income for 1966 under section 951(a)(1)(A)(ii) and paragraph 
(a)(2) of Sec. 1.951-1.
    (b) If P Corporation's earnings and profits accumulated for 1963, 
1964, and 1965 were $15,000, instead of $40,000, the result would be the 
same as in paragraph (a) of this example, except that a withdrawal of 
only $15,000 of previously excluded subpart F income from investment in 
less developed countries would be includible in A's gross income for 
1966 under section 951(a)(1)(A)(ii) and paragraph (a)(2) of Sec. 1.951-
1.
    (c) The principles of this example also apply to withdrawals 
(determined under section 955(a), as in effect before the enactment of 
the Tax Reduction Act of 1975) of previously excluded subpart F income 
from investment in less developed countries effected after the effective 
date of such Act, and to withdrawals (determined under section 955(a), 
as amended by such Act) of previously excluded subpart F income from 
investment in foreign base company shipping operations.
    Example 5. (a) The facts are the same as in paragraph (a) of example 
4, except that, instead of having a $25,000 decrease in qualified 
investments in less developed countries for 1966, P Corporation invests 
$20,000 in tangible property (not described in section 956(b)(2)) 
located in the United States and such investment constitutes an increase 
(determined under section 956(a) but without regard to the earnings and 
profits of P Corporation for 1966) in earnings invested in United States 
property. Corporation P's earnings and profits accumulated for 1963, 
1964, and 1965 and determined under paragraph (b)(1) of Sec. 1.956-1 are 
$22,000. The result is the same as in paragraph (a) of example 4, except 
that instead of including the $25,000 withdrawal, A must include $20,000 
in his gross income for 1966 under section 951(a)(1)(B) and paragraph 
(a)(2)(iv) of Sec. 1.951-1 as an investment of earnings in United States 
property.
    (b) If P Corporation's earnings and profits accumulated for 1963, 
1964, and 1965 were $9,000 instead of $22,000, the result would be the 
same as in paragraph (a) of this example, except that only $9,000 would 
be includible in A's gross income for 1966 under section 951(a)(1)(B) 
and paragraph (a)(2)(iv) of Sec. 1.951-1 as an investment of earnings in 
United States property.

[T.D. 6795, 30 FR 937, Jan. 29, 1965, as amended by T.D. 7893, 48 FR 
22508, May 19, 1983]



Sec. 1.952-1  Subpart F income defined.

    (a) In general. For purposes of sections 951 through 964, a 
controlled foreign corporation's subpart F income for any taxable year 
shall, except as provided in paragraph (b) of this section and subject 
to the limitations of paragraphs (c) and (d) of this section, consist of 
the sum of--
    (1) The income derived by such corporation for such year from the 
insurance of United States risks (determined in accordance with the 
provisions of section 953 and Secs. 1.953-1 through 1.953-6),
    (2) The income derived by such corporation for such year which 
constitutes foreign base company income (determined in accordance with 
the provisions of section 954 and Secs. 1.954-1 through 1.954-8),
    (3)(i) An amount equal to the product of--
    (A) The income of such corporation other than income which--
    (1) Is attributable to earnings and profits of the foreign 
corporation included in the gross income of a United States person under 
section 951 (other than by reason of this paragraph) (determined in 
accordance with the provisions of section 951 and Sec. 1.951-1), or
    (2) Is described in section 952(b),

multiplied by
    (B) The international boycott factor determined in accordance with 
the provisions of section 999(c)(1), or
    (ii) In lieu of the amount determined under paragraph (a)(3)(i) of 
this section, the amount described under section 999(c)(2) of such 
international boycott income, and
    (4) The sum of the amount of any illegal bribes, kickbacks, or other 
payments paid after November 3, 1976, by or on behalf of the corporation 
during the taxable year of the corporation directly or indirectly to an 
official, employee, or agent in fact of a government. An amount is paid 
by a controlled foreign corporation where it is paid by an officer, 
director, employee, shareholder or agent of such corporation for the 
benefit of such corporation. For purposes of this section, the 
principles of section 162(c) and the regulations thereunder shall apply. 
In the case of payments made after September 3, 1982, a payment is 
illegal if the payment would be unlawful under the Foreign Corrupt 
Practices Act of 1977 if the payor were a United States

[[Page 208]]

person. The fair market value of an illegal payment made in the form of 
property or services shall be considered the amount of such illegal 
payment.

Pursuant to section 951(a)(1)(A)(i) and Sec. 1.951-1, a United States 
shareholder of such controlled foreign corporation must include his pro 
rata share of such subpart F income in his gross income for his taxable 
year in which or with which such taxable year of the foreign corporation 
ends. See section 952(a). However, see paragraph (a) of Sec. 1.957-2 for 
special rule limiting the subpart F income to the income derived from 
the insurance of United States risks in the case of certain controlled 
foreign corporations described in section 957(b).
    (b) Exclusion of U.S. income--(1) Taxable years beginning before 
January 1, 1967. For rules applicable to taxable years beginning before 
January 1, 1967, see 26 CFR 1.952-1(b)(1) (Revisedof April 1, 1975).
    (2) Taxable years beginning after December 31, 1966. Notwithstanding 
paragraph (a) of this section, a controlled foreign corporation's 
subpart F income for any taxable year beginning after December 31, 1966, 
shall not include any item of income from sources within the United 
States which is effectively connected for that year with the conduct by 
such corporation of a trade or business in the United States unless, 
pursuant to a treaty to which the United States is a party, such item of 
income either is exempt from the income tax imposed by chapter 1 
(relating to normal taxes and surtaxes) of the Code or is subject to 
such tax at a reduced rate.

Thus, for example, dividends received from sources within the United 
States by a foreign corporation engaged in business in the United States 
during the taxable year, which are not effectively connected for that 
year with the conduct of a trade or business in the United States by 
that corporation, shall not be excluded from subpart F income under 
section 952(b) and this subparagraph even though such dividends are 
subject to the tax of 30 percent imposed by section 881 (a). Also, for 
example, if, by reason of an income tax convention to which the United 
States is a party, an amount of interest from sources within the United 
States which is effectively connected for the taxable year with the 
conduct of a business in the United States by a foreign corporation is 
subject to tax under chapter 1 at a flat rate of 15 percent, as provided 
in Sec. 1.871-12, such interest is not excluded from subpart F income 
under section 952(b) and this subparagraph. The deductions attributable 
to items of income which are excluded from subpart F income under this 
subparagraph shall not be taken into account for purposes of section 
952.
    (3) Rule applicable under section 956 (b)(2). For purposes only of 
paragraph (b)(1))(viii) of Sec. 1.956-2, an item of income derived by a 
controlled foreign corporation from sources within the United States 
with respect to which for the taxable year a tax is imposed in 
accordance with section 882(a) shall be considered described in section 
952(b) whether or not such item of income would have constituted subpart 
F income for such year.
    (c) Limitation on a controlled foreign corporation's subpart F 
income--(1) In general. A United States shareholder's pro rata share 
(determined in accordance with the rules of paragraph (e) of Sec. 1.951-
1) of a controlled foreign corporation's subpart F income for any 
taxable year shall not exceed his pro rata share of the earnings and 
profits (as defined in section 964(a) and Sec. 1.964-1) of such 
corporation for such taxable year, computed as of the close of such 
taxable year without diminution by reason of any distributions made 
during such taxable year, minus the sum of--
    (i) The amount, if any, by which such shareholder's pro rata share 
of--
    (a) The sum of such corporation's deficits in earnings and profits 
for prior taxable years beginning after December 31, 1962, plus
    (b) The sum of such corporation's deficits in earnings and profits 
for taxable years beginning after December 31, 1959, and before January 
1, 1963 (reduced by the sum of the earnings and profits (as so defined) 
of such corporation for any of such taxable years) exceeds
    (c) The sum of such corporation's earnings and profits for prior 
taxable years beginning after December 31,

[[Page 209]]

1962, which, with respect to such shareholder, are allocated to other 
earnings and profits under section 959(c)(3) and Sec. 1.959-3; and
    (ii) Such shareholder's pro rata share of any deficits in earnings 
and profits of other foreign corporations for a taxable year beginning 
after December 31, 1962, which are attributable to stock of such other 
foreign corporations owned by such shareholder within the meaning of 
section 958(a) and which, in accordance with section 952(d) and 
paragraph (d) of this section, are taken into account as a reduction in 
the controlled foreign corporation's earnings and profits for such 
taxable year.

For purposes of applying this subparagraph, the reduction (if any) 
provided by subdivision (i) of this subparagraph in a United States 
shareholder's pro rata share of the earnings and profits of a controlled 
foreign corporation shall be taken into account before the reduction 
provided by subdivision (ii) of this subparagraph. See section 952(c).
    (2) Special rules. For purposes only of determining the limitation 
under subparagraph (1) of this paragraph on a United States 
shareholder's pro rata share of a controlled foreign corporation's 
subpart F income for any taxable year--
    (i) Status of foreign corporation. The earnings and profits, or 
deficit in earnings and profits, of a foreign corporation for any 
taxable year shall be taken into account whether or not such foreign 
corporation is a controlled foreign corporation at the time such 
earnings and profits are derived or such deficit in earnings and profits 
is incurred.
    (ii) Deficits in earnings and profits taken into account only once. 
A controlled foreign corporation's deficit in earnings and profits for 
any taxable year preceding the taxable year shall be taken into account 
for the taxable year only to the extent such deficit has not been taken 
into account under this paragraph, paragraph (d) of this section, or 
paragraph (d)(2)(ii) of Sec. 1.963-2 (applied as if section 963 had not 
been repealed by the Tax Reduction Act of 1975) in computing a minimum 
distribution, for any taxable year preceding the taxable year, to reduce 
earnings and profits of such preceding year of such controlled foreign 
corporation or of any other controlled foreign corporation. To the 
extent a controlled foreign corporation's (the ``first corporation'') 
excess foreign base company shipping deductions for any taxable year 
(determined under Sec. 1.955A-3(c)(2)(i)) reduce the foreign base 
company shipping income of another member of a related group (as defined 
in Sec. 1.955A-2(b)), such deductions shall not be taken into account in 
determining the earnings and profits or deficits in earnings and profits 
of such first corporation for such taxable year for purposes of this 
paragraph (c) and paragraph (d) of this section. The rule of the 
preceding sentence shall not apply to the extent the excess foreign base 
company shipping deductions of the first corporation reduce the foreign 
base company shipping income of another member of a related group below 
zero.
    (iii) Determination of pro rata share. A United States shareholder's 
pro rata share of a controlled foreign corporation's earnings and 
profits, or deficit in earnings and profits, for any taxable year shall 
be determined in accordance with the principles of paragraph (e) of 
Sec. 1.951-1 and paragraph (d)(2)(ii) of Sec. 1.963-2.
    (3) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. (a) A is a United States shareholder who owns 100 percent 
of the only class of stock of M Corporation, a controlled foreign 
corporation organized on January 1, 1963. Both A and M Corporation use 
the calandar year as a taxable year.
    (b) During 1963, M Corporation derives $20,000 of subpart F income 
and has earnings and profits of $30,000. Corporation M makes no 
distributions to A during such year. The limitation under section 952(c) 
on M Corporation's subpart F income for 1963 is $30,000; and $20,000 is 
includible in A's gross income for such year under section 
951(a)(1)(A)(i).
    (c) On January 1, 1964, M Corporation acquires 100 percent of the 
only class of stock of N Corporation, a controlled foreign corporation 
which uses the calendar year as a taxable year. During 1964, N 
Corporation derives $6,000 of subpart F income, has $7,000 of earnings 
and profits, and distributes $5,000 to M Corporation. The limitation 
under section 952(c) on N Corporation's subpart F income

[[Page 210]]

for 1964 is $7,000; and $6,000 of subpart F income is includible in A's 
gross income for such year under section 951(a)(1)(A)(i).
    (d) During 1964, M Corporation derives $8,000 of rents which 
constitute subpart F income, makes a $10,000 distribution to A, and has 
earnings and profits of $12,000 (including the $5,000 dividend received 
from N Corporation). The limitation under section 952(c) on M 
Corporation's subpart F income for 1964 is $7,000, determined as 
follows:

 
 
 
Corporation M's earnings and profits for 1964 (determined        $12,000
 under section 964(a) and Sec.  1.964-1 as of the close of
 such year without diminution for any distributions made
 during such year).........................................
Less: Corporation M's earnings and profits for 1964                5,000
 described in section 959(b)...............................
                                                            ------------
Limitation on M Corporation's Subpart F income for 1964....        7,000
 


Thus, for 1964 with respect to A's interest in M Corporation, $7,000 of 
subpart F income is includible in his gross income under section 
951(a)(1)(A)(i). The $10,000 dividend received from M Corporation is 
excludible from A's gross income for 1964 under section 959(a)(1) and 
paragraph (b) of Sec. 1.959-1.
    Example 2. A is a United States shareholder who owns 100 percent of 
the only class of stock of R Corporation which was organized on January 
1, 1961. R Corporation is a controlled foreign corporation for the 
entire period after December 31, 1962, here involved. Both A and R 
Corporation use the calendar year as a taxable year. During 1963, R 
Corporation derives $25,000 of subpart F income and has $50,000 of 
earnings and profits. Corporation R has $15,000 of earnings and profits 
for 1961, and a deficit in earnings and profits of $45,000 for 1962. 
Thus, R Corporation has as of December 31, 1963, a net deficit in 
earnings and profits of $30,000 for the years 1961 and 1962. Corporation 
R makes no distributions to A during 1963. The limitation under section 
952(c) on R Corporation's subpart F income for 1963 is $20,000 ($50,000 
minus $30,000), and $20,000 of subpart F income is includible in A's 
gross income for 1963 under section 951(a)(1)(A)(i). During 1964, R 
Corporation derives $18,000 of subpart F income and has $30,000 of 
earnings and profits. Corporation R makes no distributions to A during 
1964. The entire $18,000 of subpart F income is includible in A's gross 
income for 1964 under section 951(a)(1)(A)(i).

    (d) Treatment of deficits in earnings and profits attributable to 
stock of other foreign corporation indirectly owned by a United States 
shareholder--(1) In general. For purposes of paragraph (c)(1)(ii) of 
this section, if--
    (i) A United States shareholder owns (within the meaning of section 
958(a)) stock in two or more foreign corporations in a chain of foreign 
corporations (as defined in subparagraph (2)(ii) of this paragraph), and
    (ii) Any of the corporations in such chain has a deficit in earnings 
and profits for a taxable year beginning after December 31, 1962,

then, with respect to such shareholder and only for purposes of 
determining the limitation on subpart F income under paragraph (c) of 
this section, the earnings and profits for the taxable year of each such 
foreign corporation which is a controlled foreign corporation shall, in 
accordance with the rules of subparagraph (2) of this paragraph, be 
reduced to take into account any deficit in earnings and profits 
referred to in subdivision (ii) of this subparagraph. See section 
952(d).
    (2) Special rules. For purposes of this paragraph--
    (i) Applicable rules. The special rules set forth in paragraph 
(c)(2) of this section shall apply.
    (ii) ``Chain'' defined. A chain of foreign corporations shall, with 
respect to a United States shareholder, include--
    (a) Any foreign corporation in which such shareholder owns (within 
the meaning of section 958(a)(1)(A)) stock but, only to the extent of 
the stock so owned and
    (b) All foreign corporations in which such shareholder owns (within 
the meaning of section 958(a)(2)) stock, but only to the extent of the 
stock so owned by reason of his ownership of the stock referred to in 
(a) of this subdivision.
    (iii) Allocation of deficit. If one or more foreign corporations 
(whether or not a controlled foreign corporation) includible in a chain 
of foreign corporations has a deficit in earnings and profits 
(determined under section 964(a) and Sec. 1.964-1) for the taxable year, 
the amount of deficit taken into account under section 952(d) with 
respect to a United States shareholder in such chain as a reduction in 
earnings and profits for the taxable year of a controlled foreign 
corporation includible in such chain shall be an amount which bears the 
same ratio to such shareholder's pro rata share of the total deficit in 
earnings and profits for the taxable year of all includible foreign 
corporations as his pro rata share of the

[[Page 211]]

earnings and profits (determined under paragraph (c) of this section but 
without regard to the provisions of subparagraph (1)(ii) of such 
paragraph) for the taxable year of such includible controlled foreign 
corporation bears to his pro rata share of the total earnings and 
profits (as so determined under paragraph (c) of this section) for the 
taxable year of all includible controlled foreign corporations. The 
amount of deficit taken into account under this subdivision with respect 
to any controlled foreign corporation includible in a chain of foreign 
corporations shall not exceed the United States shareholder's pro rata 
share of the controlled foreign corporation's earnings and profits for 
the taxable year.
    (iv) Taxable year. The taxable year from which a deficit is 
allocated under this paragraph, and the taxable year to which such 
deficit is allocated to reduce earnings and profits, shall be the 
taxable year of the foreign corporation ending with or within the 
taxable year of the United States shareholder described in subparagraph 
(1)(i) of this paragraph.
    (3) Illustration. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. (a) Domestic corporation M owns 100 percent, 20 percent, 
and 100 percent, respectively, of the only class of stock of foreign 
corporations A, B, and F, respectively. Corporation A owns 80 percent of 
the only class of stock of each of foreign corporations B and C, 
respectively. Corporation F owns 20 percent of such stock of C 
Corporation. Corporation B owns 75 percent of the only class of stock of 
foreign corporation D, and 50 percent of the only class of stock of each 
of foreign corporations G and H, respectively. C Corporation owns 75 
percent of the only class of stock of foreign corporation E. All the 
corporations use the calendar year as a taxable year, and all of the 
foreign corporations, except corporations G and H, are controlled 
foreign corporations throughout the period here involved.
    (b) The subpart F income, and the earnings and profits (determined 
under paragraph (c) of this section but without regard to subparagraph 
(1)(ii) of such paragraph) or deficit in earnings and profits 
(determined under section 964(a) and Sec. 1.964-1), of each of the 
foreign corporations for 1963 are as follows, the deficits being set 
forth in parentheses:

------------------------------------------------------------------------
                                                               Earnings
                                                   Subpart F      and
                                                    income      profits
                                                              (deficits)
------------------------------------------------------------------------
A Corporation...................................      $6,000     $18,000
B Corporation...................................  ..........     (7,500)
C Corporation...................................  ..........     (2,500)
D Corporation...................................       4,000       5,000
E Corporation...................................      12,000      15,000
F Corporation...................................       8,000      20,250
G Corporation...................................  ..........    (10,000)
H Corporation...................................  ..........       7,000
------------------------------------------------------------------------

    (c) The chains of foreign corporations (within the meaning of 
subparagraph (2)(ii) of this paragraph) for 1963 are the ``A'' chain, 
consisting of corporations, A, B, C, D, E, G, and H, but only to the 
extent of M Corporation's stock interest in such corporations under 
section 958(a) by reason of its ownership of stock in A Corporation; the 
``B'' chain, consisting of corporations B, D, G, and H, but only to the 
extent of M Corporation's stock interest in such corporations under 
section 958(a) by reason of its ownership of stock in B Corporation; and 
the ``F'' chain, consisting of corporations F, C, and E, but only to the 
extent of M Corporation's stock interest in such corporations under 
section 958(a) by reason of its ownership of stock in F Corporation.
    (d) Corporation M's stock interest under section 958(a) in each of 
the chains of foreign corporations is as follows for 1963:

                                                  [In percent]
----------------------------------------------------------------------------------------------------------------
                                                     A       B       C       D       E       F       G       H
----------------------------------------------------------------------------------------------------------------
A chain:
  Direct interest...............................     100  ......  ......  ......  ......  ......  ......  ......
  (100%x80%)....................................  ......      80  ......  ......  ......  ......  ......  ......
  (100%x80%)....................................  ......  ......      80  ......  ......  ......  ......  ......
  (80%x75%).....................................  ......  ......  ......      60  ......  ......  ......  ......
  (80%x75%).....................................  ......  ......  ......  ......      60  ......  ......  ......
  (80%x50%).....................................  ......  ......  ......  ......  ......  ......      40  ......
  (80%x50%).....................................  ......  ......  ......  ......  ......  ......  ......      40
B chain:
  Direct interest...............................  ......      20  ......  ......  ......  ......  ......  ......
  (20%x75%).....................................  ......  ......  ......      15  ......  ......  ......  ......
  (20%x50%).....................................  ......  ......  ......  ......  ......  ......      10  ......
  (20%x50%).....................................  ......  ......  ......  ......  ......  ......  ......      10
F chain:
  Direct interest...............................  ......  ......  ......  ......  ......     100  ......  ......
  (100%x20%)....................................  ......  ......      20  ......  ......  ......  ......  ......

[[Page 212]]

 
  (20%x75%).....................................  ......  ......  ......  ......      15  ......  ......  ......
                                                 ---------------------------------------------------------------
    Total interests.............................     100     100     100      75      75     100      50      50
----------------------------------------------------------------------------------------------------------------

    (e) Corporation M's pro rata share of the earnings and profits 
(determined under paragraph (c) of this section but without regard to 
subparagraph (1)(ii) of such paragraph), or of the deficit, of each 
controlled foreign corporation of each foreign corporation, 
respectively, includible in the respective chains for 1963 is as 
follows:

------------------------------------------------------------------------
                                                  Earnings
                                                and profits    Deficit
------------------------------------------------------------------------
A chain:
  A Corporation (100%)........................      $18,000  ...........
  B Corporation (80%).........................  ...........     ($6,000)
  C Corporation (80%).........................  ...........      (2,000)
  D Corporation (60%).........................        3,000  ...........
  E Corporation (60%).........................        9,000  ...........
  G Corporation (40%).........................  ...........      (4,000)
  H Corporation (40%).........................        (\1\)  ...........
                                               -------------------------
      Total...................................       30,000     (12,000)
                                               =========================
B chain:
  B Corporation (20%).........................  ...........     ($1,500)
  D Corporation (15%).........................         $750  ...........
  G Corporation (10%).........................  ...........      (1,000)
  H Corporation (10%).........................        (\1\)  ...........
                                               -------------------------
      Total...................................         $750     ($2,500)
                                               =========================
F chain:
  F Corporation (100%)........................       20,250  ...........
  C Corporation (20%).........................  ...........        (500)
  E Corporation (15%).........................        2,250  ...........
                                               -------------------------
    Total.....................................      $22,500        (500)
------------------------------------------------------------------------
\1\ The earnings and profits of H Corporation are not included in the
  total earnings and profits for the chain because H Corporation is not
  a controlled foreign corporation.

    (f) The amount by which M Corporation's pro rata share of the 
earnings and profits for 1963 of the controlled foreign corporations in 
each respective chain shall be reduced under section 952(d) by M 
Corporation's pro rata share of the deficits of corporations B, C, and G 
for 1963 is determined as follows:

 
                                                              Amount of
                                                              reduction
 
A chain:
  A Corporation ($12,000x$18,000/$30,000)..................       $7,200
  D Corporation ($12,000x$3,000/$30,000)...................        1,200
  E Corporation ($12,000x$9,000/$30,000)...................        3,600
                                               --------------
      Total................................................       12,000
                                               ==============
B chain:
  D Corporation ($2,500x$750/$750)............       $2,500
  Limitation: M Corporation's pro-rata share            750
   of D Corporation's earnings and profits....
  Allocation of used deficit ($750) to M
   Corporation's pro rata share of the
   deficits of corporations B and G:
    B Corporation ($750x ($1,500/$2,500)).....         $450
    G Corporation ($750x ($1,000/$2,500)).....          300
                                               -------------
      Total...................................          750         $750
                                               =========================
F chain:
  F Corporation ($500x$20,250/$22,500).....................          450
  E Corporation ($500x$2,250/$22,500)......................           50
                                               --------------
    Total..................................................          500
 

    (g) Corporation M's pro rata share of the earnings and profits 
(determined after reduction for deficits under section 952(d)) for 1963 
of each controlled foreign corporation in the respective chains, 
determined on a chain-by-chain basis, is determined as follows:

------------------------------------------------------------------------
                                          Earnings
                                            and     Reduction   Reduced
                                          profits     (sec.     earnings
                                           before    952(d))      and
                                         reduction              profits
------------------------------------------------------------------------
A chain:
  A Corporation........................    $18,000     $7,200    $10,800
  D Corporation........................      3,000      1,200      1,800
  E Corporation........................      9,000      3,600      5,400
B chain: D Corporation.................        750        750  .........
F chain:
  F Corporation........................     20,250        450     19,800
  E Corporation........................      2,250         50      2,200
------------------------------------------------------------------------

    (h) Corporation M's pro rata share of each controlled foreign 
corporation's subpart F income, limited as provided by section 952(c) 
and paragraph (c) of this section, for 1963 which is includible in its 
gross income for such year under section 951(a)(1)(A)(i) and Sec. 1.951-
1 is determined as follows:

------------------------------------------------------------------------
                                                    Earnings
                                       Subpart F      and       Amount
                                         income      profit   includible
                                        (before    (sec. 952   in income
                                      limitation)     (c))
------------------------------------------------------------------------
A Corporation (100%)................      $6,000     $10,800      $6,000
D Corporation (75%)                        3,000       1,800       1,800
E Corporation (75%)                        9,000       7,600       7,600
F Corporation (100%)                       8,000      19,800       8,000
                                     -----------------------------------

[[Page 213]]

 
  Total includible under sec.         ...........  .........      23,400
   951(a)(1)(A)(i)..................
------------------------------------------------------------------------

    Example 2. The facts are the same as in example 1 except that, in 
addition, for 1964, foreign corporations C, D, and E have no subpart F 
income and no earnings and profits and foreign corporations G and H have 
no earnings and profits. For 1964, B Corporation has subpart F income of 
$1,000 and earnings and profits (determined in accordance with section 
964(a) and Sec. 1.964-1) of $1,500; A Corporation has subpart F income 
of $800 and earnings and profits of $1,000; and F Corporation has 
subpart F income of $500 and earnings and profits of $1,000. Such 
earnings and profits are determined without regard to distributions for 
1964. Corporation B has an unused deficit in earnings and profits of 
$1,050 for 1963 ($1,500 minus $450) applicable to M Corporation's 
interest in such corporation (paragraph (f) of example 1), and, under 
paragraph (c)(1)(i)(a) of this section, with respect to M Corporation, 
such deficit reduces B Corporation's earnings and profits for 1964 to 
$450. Inasmuch as G Corporation is not a controlled foreign corporation 
for 1964, such corporation's unused deficit in earnings and profits of 
$700 for 1963 ($1,000 minus $300) applicable to M Corporation's interest 
in such corporation (paragraph (f) of example 1) may be used under 
paragraph (c)(1)(i)(a) of this section to reduce M Corporation's 
interest in G Corporation's earnings and profits in a later year or 
years for which G Corporation is a controlled foreign corporation. 
Corporation M's pro rata share of each controlled foreign corporation's 
subpart F income, limited as provided by section 952(c) and paragraph 
(c) of this section, for 1964 which is includible in its gross income 
for such year under section 951(a)(1)(A)(i) and Sec. 1.951-1 is 
determined as follows:

------------------------------------------------------------------------
                                                    Earnings
                                       Subpart F      and       Amount
                                         income     profits   includible
                                        (before      (sec.     in income
                                      limitation)   952(c))
------------------------------------------------------------------------
A Corporation.......................        $800      $1,000        $800
B Corporation.......................       1,000         450         450
F Corporation.......................         500       1,000         500
------------------------------------------------------------------------

    Example 3. The facts are the same as in example 2, except that for 
1964 B Corporation has subpart F income of $550 and earnings and profits 
(determined in accordance with section 964(a) and Sec. 1.964-1) of $550; 
such earnings and profits are determined without regard to distributions 
for 1964. Under paragraph (c)(1)(i)(a) of this section, B Corporation's 
unused deficit of $1,050 for 1963 reduces its earnings and profits for 
1964 with respect to M Corporation to zero. The remaining $500 of the 
unused deficit for 1963 applicable to M Corporation's interest in B 
Corporation may be used under paragraph (c)(1)(i)(a) of this section in 
later years to reduce M Corporation's interest in B Corporation's 
earnings and profits.

    (e) Application of current earnings and profits limitation--(1) In 
general. If the subpart F income (as defined in section 952(a)) of a 
controlled foreign corporation exceeds the foreign corporation's 
earnings and profits for the taxable year, the subpart F income 
includible in the income of the corporation's United States shareholders 
is reduced under section 952(c)(1)(A) in accordance with the following 
rules. The excess of subpart F income over current year earnings and 
profits shall--
    (i) First, proportionately reduce subpart F income in each separate 
category of the controlled foreign corporation, as defined in 
Sec. 1.904-5(a)(1), in which current earnings and profits are zero or 
less than zero;
    (ii) Second, proportionately reduce subpart F income in each 
separate category in which subpart F income exceeds current earnings and 
profits; and
    (iii) Third, proportionately reduce subpart F income in other 
separate categories.
    (2) Allocation to a category of subpart F income. An excess amount 
that is allocated under paragraph (e)(1) of this section to a separate 
category must be further allocated to a category of subpart F income if 
the separate category contains more than one category of subpart F 
income described in section 952(a) or, in the case of foreign base 
company income, described in Sec. 1.954-1(c)(1)(iii)(A) (1) or (2). In 
such case, the excess amount that is allocated to the separate category 
must be allocated to the various categories of subpart F income within 
that separate category on a proportionate basis.
    (3) Recapture of subpart F income reduced by operation of earnings 
and profits limitation. Any amount in a category of subpart F income 
described in section 952(a) or, in the case of foreign base company 
income, described in Sec. 1.954-1(c)(1)(iii)(A) (1) or (2) that is 
reduced by operation of the current year earnings and profits limitation 
of section 952(c)(1)(A) and this paragraph (e)

[[Page 214]]

shall be subject to recapture in a subsequent year under the rules of 
section 952(c)(2) and paragraph (f) of this section.
    (4) Coordination with sections 953 and 954. The rules of this 
paragraph (e) shall be applied after the application of sections 953 and 
954 and the regulations under those sections, except as provided in 
Sec. 1.954-1(d)(4)(ii).
    (5) Earnings and deficits retain separate limitation character. The 
income reduction rules of paragraph (e)(1) of this section shall apply 
only for purposes of determining the amount of an inclusion under 
section 951(a)(1)(A) from each separate category as defined in 
Sec. 1.904-5(a)(1) and the separate categories in which recapture 
accounts are established under section 952(c)(2) and paragraph (f) of 
this section. For rules applicable in computing post-1986 undistributed 
earnings, see generally section 902 and the regulations under that 
section. For rules relating to the allocation of deficits for purposes 
of computing foreign taxes deemed paid under section 960 with respect to 
an inclusion under section 951(a)(1)(A), see Sec. 1.960-1(i).
    (f) Recapture of subpart F income in subsequent taxable year--(1) In 
general. If a controlled foreign corporation's subpart F income for a 
taxable year is reduced under the current year earnings and profits 
limitation of section 952(c)(1)(A) and paragraph (e) of this section, 
recapture accounts will be established and subject to recharacterization 
in any subsequent taxable year to the extent the recapture accounts were 
not previously recharacterized or distributed, as provided in paragraphs 
(f)(2) and (3) of this section.
    (2) Rules of recapture--(i) Recapture account. If a category of 
subpart F income described in section 952(a) or, in the case of foreign 
base company income, described in Sec. 1.954-1(c)(1)(iii)(A) (1) or (2) 
is reduced under the current year earnings and profits limitation of 
section 952(c)(1)(A) and paragraph (e) of this section for a taxable 
year, the amount of such reduction shall constitute a recapture account.
    (ii) Recapture. Each recapture account of the controlled foreign 
corporation will be recharacterized, on a proportionate basis, as 
subpart F income in the same separate category (as defined in 
Sec. 1.904-5(a)(1)) as the recapture account to the extent that current 
year earnings and profits exceed subpart F income in a taxable year. The 
United States shareholder must include his pro rata share (determined 
under the rules of Sec. 1.951-1(e)) of each recharacterized amount in 
income as subpart F income in such separate category for the taxable 
year.
    (iii) Reduction of recapture account and corresponding earnings. 
Each recapture account, and post-1986 undistributed earnings in the 
separate category containing the recapture account, will be reduced in 
any taxable year by the amount which is recharacterized under paragraph 
(f)(2)(ii) of this section. In addition, each recapture account, and 
post-1986 undistributed earnings in the separate category containing the 
recapture account, will be reduced in the amount of any distribution out 
of that account (as determined under the ordering rules of section 
959(c) and paragraph (f)(3)(ii) of this section).
    (3) Distribution ordering rules--(i) Coordination of recapture and 
distribution rules. If a controlled foreign corporation distributes an 
amount out of earnings and profits described in section 959(c)(3) in a 
year in which current year earnings and profits exceed subpart F income 
and there is an amount in a recapture account for such year, the 
recapture rules will apply first.
    (ii) Distributions reduce recapture accounts first. Any distribution 
made by a controlled foreign corporation out of earnings and profits 
described in section 959(c)(3) shall be treated as made first on a 
proportionate basis out of the recapture accounts in each separate 
category to the extent thereof (even if the amount in the recapture 
account exceeds post-1986 undistributed earnings in the separate 
category containing the recapture account). Any remaining distribution 
shall be treated as made on a proportionate basis out of the remaining 
earnings and profits of the controlled foreign corporation in each 
separate category. See section 904(d)(3)(D).
    (4) Examples. The application of paragraphs (e) and (f) of this 
section may be illustrated by the following examples:


[[Page 215]]


    Example 1. (i) A, a U.S. person, is the sole shareholder of CFC, a 
controlled foreign corporation formed on January 1, 1998, whose 
functional currency is the u. In 1998, CFC earns 100u of foreign base 
company sales income that is general limitation income described in 
section 904(d)(1)(I) and incurs a (200u) loss attributable to activities 
that would have produced general limitation income that is not subpart F 
income. In 1998 CFC also earns 100u of foreign personal holding company 
income that is passive income described in section 904(d)(1)(A), and 
100u of foreign personal holding company income that is dividend income 
subject to a separate limitation described in section 904(d)(1)(E) for 
dividends from a noncontrolled section 902 corporation. CFC's subpart F 
income for 1998, 300u, exceeds CFC's current earnings and profits, 100u, 
by 200u. Under section 952(c)(1)(A) and paragraph (e) of this section, 
subpart F income is limited to CFC's current earnings and profits of 
100u, all of which is included in A's gross income under section 
951(a)(1)(A). The 200u of CFC's 1998 subpart F income that is not 
included in A's income in 1998 by reason of section 952(c)(1)(A) is 
subject to recapture under section 952(c)(2) and paragraph (f) of this 
section.
    (ii) For purposes of determining the amount and type of income 
included in A's gross income and the amount and type of income in CFC's 
recapture account, the rules of paragraphs (e)(1) and (2) of this 
section apply. Under paragraph (e)(1)(i) of this section, the amount by 
which CFC's subpart F income exceeds its earnings and profits for 1998, 
200u, first reduces from 100u to 0 CFC's subpart F income in the general 
limitation category, which has a current year deficit of (100u) in 
earnings and profits. Next, under paragraph (e)(1)(iii) of this section, 
the remaining 100u by which CFC's 1998 subpart F income exceeds earnings 
and profits is applied proportionately to reduce CFC's subpart F income 
in the separate categories for passive income (100u) and dividends from 
the noncontrolled section 902 corporation (100u). Thus, A includes 50u 
of passive limitation/foreign personal holding company income and 50u of 
dividends from the noncontrolled section 902 corporation/foreign 
personal holding company income in gross income in 1998. CFC has 100u in 
its general limitation/foreign base company sales income recapture 
account attributable to the 100u of foreign base company sales income 
that is not included in A's income by reason of the earnings and profits 
limitation of section 952(c)(1)(A). CFC also has 50u in its passive 
limitation recapture account, all of which is attributable to foreign 
personal holding company income, and 50u in its recapture account for 
dividends from the noncontrolled section 902 corporation, all of which 
is attributable to foreign personal holding company income.
    (iii) For purposes of computing post-1986 undistributed earnings, 
the rules of sections 902 and 960, including the rules of Sec. 1.960-
1(i), apply. Under Sec. 1.960-1(i), the general limitation deficit of 
(100u) is allocated proportionately to reduce passive limitation 
earnings of 100u and noncontrolled section 902 dividend earnings of 
100u. Thus, passive limitation earnings are reduced by 50u to 50u (100u 
passive limitation earnings/200u total earnings in positive separate 
categories x (100u) general limitation deficit=50u reduction), and the 
noncontrolled section 902 corporation earnings are reduced by 50u to 50u 
(100u noncontrolled section 902 corporation earnings/200u total earnings 
in positive separate categories x (100u) general limitation deficit=50u 
reduction). All of CFC's post-1986 foreign income taxes with respect to 
passive limitation income and dividends from the noncontrolled section 
902 corporation are deemed paid by A under section 960 with respect to 
the subpart F inclusions (50u inclusion/50u earnings in each separate 
category). After the inclusion and deemed-paid taxes are computed, at 
the close of 1998 CFC has a (100u) deficit in general limitation 
earnings (100u subpart F earnings + (200u) nonsubpart F loss), 50u of 
passive limitation earnings (100u of earnings attributable to foreign 
personal holding company income -50u inclusion) with a corresponding 
passive limitation/foreign personal holding company income recapture 
account of 50u, and 50u of earnings subject to a separate limitation for 
dividends from the noncontrolled section 902 corporation (100u earnings 
-50u inclusion) with a corresponding noncontrolled section 902 
corporation/foreign personal holding company income recapture account of 
50u.
    Example 2. (i) The facts are the same as in Example 1 with the 
addition of the following facts. In 1999, CFC earns 100u of foreign base 
company sales income that is general limitation income and 100u of 
foreign personal holding company income that is passive limitation 
income. In addition, CFC incurs (10u) of expenses that are allocable to 
its separate limitation for dividends from the noncontrolled section 902 
corporation. Thus, CFC's subpart F income for 1999, 200u, exceeds CFC's 
current earnings and profits, 190u, by 10u. Under section 952(c)(1)(A) 
and paragraph (e) of this section, subpart F income is limited to CFC's 
current earnings and profits of 190u, all of which is included in A's 
gross income under section 951(a)(1)(A).
    (ii) For purposes of determining the amount and type of income 
included in A's gross income and the amount and type of income in CFC's 
recapture accounts, the rules of paragraphs (e)(1) and (2) of this 
section apply. While CFC's general limitation post-1986 undistributed 
earnings for 1999 are 0 ((100u) opening balance + 100u subpart F 
income), CFC's general limitation subpart F income (100u) does not 
exceed its general

[[Page 216]]

limitation current earnings and profits (100u) for 1999. Accordingly, 
under paragraph (e)(1)(iii) of this section, the amount by which CFC's 
subpart F income exceeds its earnings and profits for 1999, 10u, is 
applied proportionately to reduce CFC's subpart F income in the separate 
categories for general limitation income, 100u, and passive income, 
100u. Thus, A includes 95u of general limitation foreign base company 
sales income and 95u of passive limitation foreign personal holding 
company income in gross income in 1999. At the close of 1999 CFC has 
105u in its general limitation/foreign base company sales income 
recapture account (100u from 1998 + 5u from 1999), 55u in its passive 
limitation/foreign personal holding company income recapture account 
(50u from 1998 + 5u from 1999), and 50u in its dividends from the 
noncontrolled section 902 corporation/foreign personal holding company 
income recapture account (all from 1998).
    (iii) For purposes of computing post-1986 undistributed earnings in 
each separate category, the rules of sections 902 and 960, including the 
rules of Sec. 1.960-1(i), apply. Thus, post-1986 undistributed earnings 
(or an accumulated deficit) in each separate category are increased (or 
reduced) by current earnings and profits or current deficits in each 
separate category. The accumulated deficit in CFC's general limitation 
earnings and profits (100u) is reduced to 0 by the addition of 100u of 
1999 earnings and profits. CFC's passive limitation earnings of 50u are 
increased by 100u to 150u, and CFC's noncontrolled section 902 
corporation earnings of 50u are decreased by (10u) to 40u. After the 
addition of current year earnings and profits and deficits to the 
separate categories there are no deficits remaining in any separate 
category. Thus, the allocation rules of Sec. 1.960-1(i)(4) do not apply 
in 1999. Accordingly, in determining the post-1986 foreign income taxes 
deemed paid by A, post-1986 undistributed earnings in each separate 
category are unaffected by earnings in the other categories. Foreign 
taxes deemed paid under section 960 for 1999 would be determined as 
follows for each separate category: with respect to the inclusion of 95u 
of foreign base company sales income out of general limitation earnings, 
the section 960 fraction is 95u inclusion/0 total earnings; with respect 
to the inclusion of 95u of passive limitation income the section 960 
fraction is 95u inclusion/150u passive earnings. Thus, no general 
limitation taxes would be associated with the inclusion of the general 
limitation earnings because there are no accumulated earnings in the 
general limitation category. After the deemed-paid taxes are computed, 
at the close of 1999 CFC has a (95u) deficit in general limitation 
earnings and profits ((100u) opening balance + 100u current earnings -
95u inclusion), 55u of passive limitation earnings and profits (50u 
opening balance + 100u current foreign personal holding company income -
95u inclusion), and 40u of earnings and profits subject to the separate 
limitation for dividends from the noncontrolled section 902 corporation 
(50u opening balance + (10u) expense).
    Example 3. (i) A, a U.S. person, is the sole shareholder of CFC, a 
controlled foreign corporation whose functional currency is the u. At 
the beginning of 1998, CFC has post-1986 undistributed earnings of 275u, 
all of which are general limitation earnings described in section 
904(d)(1)(I). CFC has no previously-taxed earnings and profits described 
in section 959(c)(1) or (c)(2). In 1998, CFC has a (200u) loss in the 
shipping category described in section 904(d)(1)(D), 100u of foreign 
personal holding company income that is passive income described in 
section 904(d)(1)(A), and 125u of general limitation manufacturing 
earnings that are not subpart F income. CFC's subpart F income for 1998, 
100u, exceeds CFC's current earnings and profits, 25u, by 75u. Under 
section 952(c)(1)(A) and paragraph (e) of this section, subpart F income 
is limited to CFC's current earnings and profits of 25u, all of which is 
included in A's gross income under section 951(a)(1)(A). The 75u of 
CFC's 1998 subpart F income that is not included in A's income in 1998 
by reason of section 952(c)(1)(A) is subject to recapture under section 
952(c)(2) and paragraph (f) of this section.
    (ii) For purposes of determining the amount and type of income 
included in A's gross income and the amount and type of income in CFC's 
recapture account, the rules of paragraphs (e)(1) and (2) of this 
section apply. Under paragraph (e)(1) of this section, the amount of 
CFC's subpart F income in excess of earnings and profits for 1998, 75u, 
reduces the 100u of passive limitation foreign personal holding company 
income. Thus, A includes 25u of passive limitation foreign personal 
holding company income in gross income, and CFC has 75u in its passive 
limitation/foreign personal holding company income recapture account.
    (iii) For purposes of computing post-1986 undistributed earnings in 
each separate category the rules of sections 902 and 960, including the 
rules of Sec. 1.960-1(i), apply. Under Sec. 1.960-1(i), the shipping 
limitation deficit of (200u) is allocated proportionately to reduce 
general limitation earnings of 400u and passive limitation earnings of 
100u. Thus, general limitation earnings are reduced by 160u to 240u 
(400u general limitation earnings/500u total earnings in positive 
separate categories x (200u) shipping deficit=160u reduction), and 
passive limitation earnings are reduced by 40u to 60u (100u passive 
earnings/500u total earnings in positive separate categories x (200u) 
shipping deficit=40u reduction). Five-twelfths of CFC's post-1986 
foreign income taxes with respect to passive limitation earnings are 
deemed paid by A under section

[[Page 217]]

960 with respect to the subpart F inclusion (25u inclusion/60u passive 
earnings). After the inclusion and deemed-paid taxes are computed, at 
the close of 1998 CFC has 400u of general limitation earnings (275u 
opening balance + 125u current earnings), 75u of passive limitation 
earnings (100u of foreign personal holding company income -25u 
inclusion), and a (200u) deficit in shipping limitation earnings.
    Example 4. (i) The facts are the same as in Example 3 with the 
addition of the following facts. In 1999, CFC earns 50u of general 
limitation earnings that are not subpart F income and 75u of passive 
limitation income that is foreign personal holding company income. Thus, 
CFC has 125u of current earnings and profits. CFC distributes 200u to A. 
Under paragraph (f)(3)(i) of this section, the recapture rules are 
applied first. Thus, the amount by which 1999 current earnings and 
profits exceed subpart F income, 50u, is recharacterized as passive 
limitation foreign personal holding company income. CFC's total subpart 
F income for 1999 is 125u of passive limitation foreign personal holding 
company income (75u current earnings plus 50u recapture account), and 
the passive limitation/foreign personal holding company income recapture 
account is reduced from 75u to 25u.
    (ii) CFC has 150u of previously-taxed earnings and profits described 
in section 959(c)(2) (25u attributable to 1998 and 125u attributable to 
1999), all of which is passive limitation earnings and profits. Under 
section 959(c), 150u of the 200u distribution is deemed to be made from 
earnings and profits described in section 959(c)(2). The remaining 50u 
is deemed to be made from earnings and profits described in section 
959(c)(3). Under paragraph (f)(3)(ii) of this section, the dividend 
distribution is deemed to be made first out of the passive limitation 
recapture account to the extent thereof (25u). Under paragraph 
(f)(2)(iii) of this section, the passive limitation recapture account is 
reduced from 25u to 0. The remaining distribution of 25u is treated as 
made out of CFC's general limitation earnings and profits.
    (iii) For purposes of computing post-1986 undistributed earnings, 
the rules of section 902 and 960, including the rules of Sec. 1.960-
1(i), apply. Thus, the shipping limitation accumulated deficit of (200u) 
reduces general limitation earnings and profits of 450u and passive 
limitation earnings and profits of 150u on a proportionate basis. Thus, 
100% of CFC's post-1986 foreign income taxes with respect to passive 
limitation earnings are deemed paid by A under section 960 with respect 
to the 1999 subpart F inclusion of 125u (100u inclusion (numerator 
limited to denominator)/100u passive earnings). No post-1986 foreign 
income taxes remain to be deemed paid under section 902 in connection 
with the 25u distribution from the passive limitation/foreign personal 
holding company income recapture account. One-twelfth of CFC's post-1986 
foreign income taxes with respect to general limitation earnings are 
deemed paid by A under section 902 with respect to the distribution of 
25u general limitation earnings and profits described in section 
959(c)(3) (25u inclusion/300u general limitation earnings). After the 
deemed-paid taxes are computed, at the close of 1999 CFC has 425u of 
general limitation earnings and profits (400u opening balance + 50u 
current earnings--25u distribution), 0 of passive limitation earnings 
(75u recapture account + 75u current foreign personal holding company 
income--125u inclusion--25u distribution), and a (200u) deficit in 
shipping limitation earnings.

    (5) Effective date. Paragraph (e) of this section and this paragraph 
(f) apply to taxable years of a controlled foreign corporation beginning 
after March 3, 1997.
    (g) Treatment of distributive share of partnership income--(1) In 
general. A controlled foreign corporation's distributive share of any 
item of income of a partnership is income that falls within a category 
of subpart F income described in section 952(a) to the extent the item 
of income would have been income in such category if received by the 
controlled foreign corporation directly. For specific rules regarding 
the treatment of a distributive share of partnership income under 
certain provisions of subpart F, see Secs. 1.954-1(g), 1.954-2(a)(5), 
1.954-3(a)(6), and 1.954-4(b)(2)(iii).
    (2) Example. The application of this paragraph (g) may be 
illustrated by the following example:

    Example. CFC, a controlled foreign corporation, is an 80-percent 
partner in PRS, a foreign partnership. PRS earns $100 of interest income 
that is not export financing interest as defined in section 
954(c)(2)(B), or qualified banking or financing income as defined in 
section 954(h)(3)(A), from a person unrelated to CFC. This interest 
income would have been foreign personal holding company income to CFC, 
under section 954(c), if it had received this income directly. 
Accordingly, CFC's distributive share of this interest income, $80, is 
foreign personal holding company income.

    (3) Effective date. This paragraph (g) applies to taxable years of a 
controlled

[[Page 218]]

foreign corporation beginning on or after July 23, 2002.

[T.D. 6795, 30 FR 938, Jan. 29, 1965, as amended by T.D. 6892, 31 FR 
11144, Aug. 23, 1966; T.D. 7293, 38 FR 32802, Nov. 28, 1973; T.D. 7545, 
43 FR 19652, May 8, 1978; T.D. 7862, 47 FR 56490, Dec. 17, 1982; T.D. 
7893, 48 FR 22508, May 19, 1983; T.D. 7894, 48 FR 22516, May 19, 1983; 
T.D. 8331, 56 FR 2846, Jan. 25, 1991; T.D. 8704, 62 FR 18, Jan. 2, 1997; 
T.D. 9008, 67 FR 48023, July 23, 2002]



Sec. 1.952-2  Determination of gross income and taxable income of a foreign corporation.

    (a) Determination of gross income--(1) In general. Except as 
provided in subparagraph (2) of this paragraph, the gross income of a 
foreign corporation for any taxable year shall, subject to the special 
rules of paragraph (c) of this section, be determined by treating such 
foreign corporation as a domestic corporation taxable under section 11 
and by applying the principles of section 61 and the regulations 
thereunder.
    (2) Insurance gross income--(i) Life insurance gross income. The 
gross income for any taxable year of a controlled foreign corporation 
which is engaged in the business of reinsuring or issuing insurance or 
annuity contracts and which, if it were a domestic corporation engaged 
only in such business, would be taxable as a life insurance company to 
which part I (sections 801 through 820) of subchapter L of chapter 1 of 
the Code applies, shall, subject to the special rules of paragraph (c) 
of this section, be the sum of--
    (a) The gross investment income, as defined under section 804(b), 
except that interest which is excluded from gross income under section 
103 shall not be taken into account;
    (b) The sum of the items taken into account under section 809(c), 
except that advance premiums shall not be taken into account; and
    (c) The amount by which the net long-term capital gain exceeds the 
net short-term capital loss.
    (ii) Mutual and other insurance gross income. The gross income for 
any taxable year of a controlled foreign corporation which is engaged in 
the business of reinsuring or issuing insurance or annuity contracts and 
which, if it were a domestic corporation engaged only in such business, 
would be taxable as a mutual insurance company to which part II 
(sections 821 through 826) of subchapter L of chapter 1 of the Code 
applies or as a mutual marine insurance or other insurance company to 
which part III (sections 831 and 832) of subchapter L of chapter 1 of 
the Code applies, shall, subject to the special rules of paragraph (c) 
of this section, be--
    (a) The sum of--
    (1) The gross income, as defined in section 832(b)(1);
    (2) The amount of losses incurred, as defined in section 832(b)(5); 
and
    (3) The amount of expenses incurred, as defined in section 
832(b)(6); reduced by
    (b) The amount of interest which under section 103 is excluded from 
gross income.
    (b) Determination of taxable income--(1) In general. Except as 
provided in subparagraph (2) of this paragraph, the taxable income of a 
foreign corporation for any taxable year shall, subject to the special 
rules of paragraph (c) of this section, be determined by treating such 
foreign corporation as a domestic corporation taxable under section 11 
and by applying the principles of section 63.
    (2) Insurance taxable income. The taxable income for any taxable 
year of a controlled foreign corporation which is engaged in the 
business of reinsuring or issuing insurance or annuity contracts and 
which, if it were a domestic corporation engaged only in such business, 
would be taxable as an insurance company to which subchapter L of 
chapter 1 of the Code applies shall, subject to the special rules of 
paragraph (c) of this section, be determined by treating such 
corporation as a domestic corporation taxable under subchapter L of 
chapter 1 of the Code and by applying the principles of Secs. 1.953-4 
and 1.953-5 for determining taxable income.
    (c) Special rules for purposes of this section--(1) Nonapplication 
of certain provisions. Except where otherwise distinctly expressed, the 
provisions of subchapters F, G, H, L, M, N, S, and T of chapter 1 of the 
Internal Revenue Code shall not apply and, for taxable years of a 
controlled foreign corporation beginning after March 3, 1997, the

[[Page 219]]

provisions of section 103 of the Internal Revenue Code shall not apply.
    (2) Application of principles of Sec. 1.964-1. The determinations 
with respect to a foreign corporation shall be made as follows:
    (i) Books of account. The books of account to be used shall be those 
regularly maintained by the corporation for the purpose of accounting to 
its shareholders.
    (ii) Accounting principles. Except as provided in subparagraphs (3) 
and (4) of this paragraph, the accounting principles to be employed are 
those described in paragraph (b) of Sec. 1.964-1. Thus, in applying 
accounting principles generally accepted in the United States for 
purposes of reflecting in the financial statements of a domestic 
corporation the operations of foreign affiliates, no adjustment need be 
made unless such adjustment will have a material effect, within the 
meaning of paragraph (a) of Sec. 1.964-1.
    (iii) Translation into United States dollars--(a) In general. Except 
as provided in (b) of this subdivision, the amounts determined in 
accordance with subdivision (ii) of this subparagraph shall be 
translated into United States dollars in accordance with the principles 
of paragraph (d) of Sec. 1.964-1.
    (b) Special rule. In any case in which the value of the foreign 
currency in relation to the United States dollar fluctuates more than 10 
percent during any translation period (within the meaning of paragraph 
(d)(6) of Sec. 1.964-1), the subpart F income and non-subpart F income 
shall be separately translated as if each constituted all the income of 
the controlled foreign corporation for the translation period.
    (iv) Tax accounting methods. The tax accounting methods to be 
employed are those established or adopted by or on behalf of the foreign 
corporation under paragraph (c) of Sec. 1.964-1. Thus, such accounting 
methods must be consistent with the manner of treating inventories, 
depreciation, and elections referred to in subdivisions (ii), (iii), and 
(iv) of paragraph (c)(1) of Sec. 1.964-1 and used for purposes of such 
paragraph; however, if, in accordance with paragraph (c)(6) of 
Sec. 1.964-1, a foreign corporation receives foreign base company income 
before any elections are made or before an accounting method is adopted 
by or on behalf of such corporation under paragraph (c)(3) of 
Sec. 1.964-1, the determinations of whether an exclusion set forth in 
section 954(b) applies shall be made as if no elections had been made 
and no accounting method had been adopted.
    (v) Exchange gain or loss--(a) Exchange gain or loss, determined in 
accordance with the principles of Sec. 1.964-1(e), shall be taken into 
account for purposes of determining gross income and taxable income.
    (b) Exchange gain or loss shall be treated as foreign base company 
shipping income (or as a deduction allocable thereto) to the extent that 
it is attributable to foreign base company shipping operations. The 
extent to which exchange gain or loss is attributable to foreign base 
company shipping operations may be determined under any reasonable 
method which is consistently applied from year to year. For example, the 
extent to which the exchange gain or loss is attributable to foreign 
base company shipping operations may be determined on the basis of the 
ratio which the foreign based company shipping income of the corporation 
for the taxable year bears to its total gross income for the taxable 
year, such ratio to be determined without regard to this subdivision 
(v).
    (c) The remainder of the exchange gain or loss shall be allocated 
between subpart F income and non-subpart F income under any reasonable 
method which is consistently applied from year to year. For example, 
such remainder may be allocated to subpart F income in the same ratio 
that the gross subpart F income (exclusive of foreign base company 
shipping income) of the corporation for the taxable year bears to its 
total gross income (exclusive of foreign base company shipping income) 
for the taxable year, such ratio to be determined without regard to this 
subdivision (v).
    (3) Necessity for recognition of gain or loss. Gross income of a 
foreign corporation (including an insurance company) includes gain or 
loss only if such gain or loss would be recognized under the provisions 
of the Internal Revenue Code if the foreign corporation were a domestic 
corporation taxable under

[[Page 220]]

section 11 (subject to the modifications of subparagraph (1) of this 
paragraph). See section 1002. However, a foreign corporation shall not 
be treated as a domestic corporation for purposes of determining whether 
section 367 applies.
    (4) Gross income and gross receipts. The term ``gross income'' may 
not have the same meaning as the term ``gross receipts''. For example, 
in a manufacturing, merchandising, or mining business, gross income 
means the total sales less the cost of goods sold, plus any income from 
investments and from incidental or outside operations or sources.
    (5) Treatment of capital loss and net operating loss. In determining 
taxable income of a foreign corporation for any taxable year--
    (i) Capital loss carryback and carryover. The capital loss carryback 
and carryover provided by section 1212(a) shall not be allowed.
    (ii) Net operating loss deduction. The net operating loss deduction 
under section 172(a) or the operations loss deduction under section 812 
shall not be allowed.
    (6) Corporations which have insurance income. For purposes of 
paragraphs (a)(2) and (b)(2) of this section, in determining whether a 
controlled foreign corporation which is engaged in the business of 
reinsuring or issuing insurance or annuity contracts and which, if it 
were a domestic corporation engaged only in such business, would be 
taxable as an insurance company to which subchapter L of chapter 1 of 
the Code applies, it is immaterial that--
    (i) The corporation would be exempt from taxation as an organization 
described in section 501(a),
    (ii) The corporation would not be taxable as an insurance company to 
which subchapter L of the Code applies, or
    (iii) The corporation would be subject to the alternative tax for 
small mutual insurance companies provided by section 821(c).

[T.D. 6795, 30 FR 941, Jan. 29, 1965, as amended by T.D. 7893, 48 FR 
22508, May 19, 1983; T.D. 7894, 48 FR 22516, May 19, 1983; T.D. 8704, 62 
FR 20, Jan. 2, 1997]



Sec. 1.953-1  Income from insurance of United States risks.

    (a) In general. The subpart F income of a controlled foreign 
corporation for any taxable year includes its income derived from the 
insurance of United States risks for such taxable year. See section 
952(a)(1). A controlled foreign corporation shall have income derived 
from the insurance of United States risks for such purpose of it has 
taxable income, as determined under Sec. 1.953-4 or Sec. 1.953-5, which 
is attributable to the reinsuring or the issuing of any insurance or 
annuity contract in connection with United States risks, as defined in 
Sec. 1.953-2 or Sec. 1.953-3, and if it satisfies the 5-percent minimum 
premium requirement prescribed in paragraph (b) of this section. It is 
immaterial for purposes of this section whether the person insured or 
the beneficiary of any insurance, annuity, or reinsurance contract is, 
as to such corporation, a related person or a United States shareholder. 
For definition of the term ``controlled foreign corporation'' for 
purposes of taking into account income derived from the insurance of 
United States risks under section 953, see section 957 (a) and (b) and 
Secs. 1.957-1 and 1.957-2.
    (b) 5-percent minimum premium requirement. A controlled foreign 
corporation shall not have income derived from the insurance of United 
States risks for purposes of this section unless the premiums received 
by such corporation during the taxable year which are attributable to 
the reinsuring and the issuing of insurance and annuity contracts in 
connection with the United States risks exceed 5 percent of the total 
premiums which are received by such corporation during such taxable year 
and which are attributable to the reinsuring and the issuing of 
insurance and annuity contracts in connection with all risks.
    (c) General definitions. For purposes of Secs. 1.953-1 to 1.953-6, 
inclusive--
    (1) Reinsurance, etc. The terms ``reinsurance'', ``insurance'', and 
``annuity contract'' have the same meaning which they have for purposes 
of applying section 809(c)(1) or section 832(b)(4), as the case may be.
    (2) Premiums. The term ``premiums'' means the items taken into 
account for

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the taxable year under section 809(c)(1), or the amount computed for the 
taxable year under section 832(b)(4) without the application of 
subparagraph (B) thereof, as the case may be; except that, for purposes 
of determining the amount of premiums received in applying paragraph (b) 
of this section or paragraph (a) of Sec. 1.953-3, advance premiums and 
deposits shall not be taken into account.
    (3) Insurance company. The term ``insurance company'' has the same 
meaning which it has for purposes of applying section 801(a), determined 
by applying the principles of paragraph (a) of Sec. 1.801-3.
    (4) Related person. The term ``related person'', when used with 
respect to a controlled foreign corporation, shall have the meaning 
assigned to it by paragraph (e) of Sec. 1.954-1.
    (5) Policy period. With respect to any insurance or annuity contract 
under which a corporation is potentially liable at any time during its 
taxable year, the term ``policy period'' means with respect to such year 
each period of coverage under the contract if such period begins or ends 
with or within the taxable year, except that, if such period of coverage 
is more than one year, such term means such of the following periods as 
are applicable, each one of which is a policy period with respect to the 
taxable year:
    (i) The one-year period which begins with the effective date of the 
contract and begins or ends with or within the taxable year,
    (ii) The one-year period which begins with an anniversary of the 
contract and begins or ends with or within the taxable year, and
    (iii) The period of less than one year if such period begins with an 
anniversary of the contract, ends with the date on which coverage under 
the contract terminates, and begins or ends with or within the taxable 
year.

For such purposes, the effective date of the contract is the date on 
which coverage under the contract begins, and the anniversary of the 
contract is the annual return of the effective date. The period of 
coverage under a contract is the period beginning with the effective 
date of the contract and ending with the date on which the coverage 
under the contract expires; except that, if the risk under the contract 
has been transferred by assumption reinsurance, the period of coverage 
shall end with the effective date of such transfer or, if the contract 
is canceled, with the effective date of cancellation. For this purpose, 
the term ``assumption reinsurance'' shall have the meaning provided by 
paragraph (a)(7)(ii) of Sec. 1.809-5. The application of this 
subparagraph may be illustrated by the following examples:

    Example 1. Controlled foreign corporation A issues to domestic 
corporation M an insurance contract which provides coverage for the 2\1/
2\ year period beginning on July 1, 1963. Corporation A uses the 
calendar year as the taxable year. For 1963, the policy period under 
such contract as to A Corporation is July 1, 1963, to June 30, 1964. For 
1964, the policy periods under such contract as to A Corporation are 
July 1, 1963, to June 30, 1964, and July 1, 1964, to June 30, 1965. For 
1965, the policy periods under such contract as to A Corporation are 
July 1, 1964, to June 30, 1965, and July 1, 1965, to December 31, 1965.
    Example 2. The facts are the same as in example 1 except that M 
Corporation cancels the contract on August 31, 1963. For 1963, the 
policy period under such contract as to A Corporation is July 1, 1963, 
to August 31, 1963.
    Example 3. The facts are the same as in example 1 except that on 
January 15, 1965, A Corporation cedes insurance under the contract to 
controlled foreign corporation B, which also uses the calendar year as 
the taxable year. For 1964, the policy periods under such contract as to 
A Corporation are July 1, 1963, to June 30, 1964, and July 1, 1964, to 
June 30, 1965. For 1965, the policy periods under such contract as to 
both A Corporation and B Corporation are July 1, 1964, to June 30, 1965, 
and July 1, 1965, to December 31, 1965.
    Example 4. Controlled foreign corporation C, which uses the calendar 
year as the taxable year, issues to domestic corporation N an insurance 
contract which covers the marine risks in connection with shipping a 
machine to Europe. The contract does not specify the dates during which 
the machine is covered, but provides coverage from the time the machine 
is delivered alongside a named vessel in Hoboken, New Jersey, until the 
machine is delivered alongside such vessel in Liverpool, England. Such 
deliveries in New Jersey and England take place on February 1, and 
February 28, 1963, respectively. For 1963, the policy period under such 
contract as to C Corporation is February 1, to February 28, 1963.

    (6) Foreign country. The term ``foreign country'' includes, where 
not otherwise

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expressly provided, a possession of the United States.

[T.D. 6781, 29 FR 18201, Dec. 23, 1964]



Sec. 1.953-2  Actual United States risks.

    (a) In general. For purposes of paragraph (a) of Sec. 1.953-1, the 
term ``United States risks'' means risks described in section 
953(a)(1)(A)--
    (1) In connection with property in the United States (as defined in 
paragraph (b) of this section),
    (2) In connection with liability arising out of activity in the 
United States (as defined in paragraph (c) of this section), or
    (3) In connection with the lives or health of residents of the 
United States (as defined in paragraph (d) of this section).

For purposes of section 953(a), the term ``United States'' is used in a 
geographical sense and includes only the States and the District of 
Columbia. Therefore, the reinsuring or the issuing of insurance or 
annuity contracts by a controlled foreign corporation in connection with 
property located in a foreign country or a possession of the United 
States, in connection with activity in a foreign country or a 
possession, or in connection with the lives or health of citizens of the 
United States who are not residents of the United States will not give 
rise to income to which paragraph (a) of Sec. 1.953-1 applies, unless 
the income derived by the controlled foreign corporation from such 
contracts constitutes income derived in connection with risks which are 
deemed to be United States risks, as defined in Sec. 1.953-3.
    (b) Property in the United States. The term ``property in the United 
States'' means property, as defined in subparagraph (1) of this 
paragraph, which is in the United States, within the meaning of 
subparagraph (2) of this paragraph.
    (1) Property defined. The term ``property'' means any interest of an 
insured in tangible (including real and personal) or intangible 
property. Such interests include, but are not limited to, those of an 
owner, landlord, tenant, mortgagor, mortgagee, trustee, beneficiary, or 
partner. Thus, for example, if insurance is issued against loss from 
fire and theft with respect to an insured's home and its contents, such 
risks are risks in connection with property, whether the insured is the 
owner or lessee and whether the contents include furniture or cash and 
securities. Furthermore, if insurance is issued against all risks of 
damage or loss with respect to the automobile of an insured, such risks 
are risks in connection with property, whether the risks insured against 
may be caused by the insured, another person, or natural forces.
    (2) United States location--(i) In general. Property will be 
considered property in the United States when it is exclusively located 
in the United States. Conversely, property will be considered property 
not in the United States when it is exclusively located outside the 
United States. In addition, property which is ordinarily located in, but 
temporarily located outside, the United States will be considered 
property in the United States both when it is ordinarily located in, and 
when it is temporarily located outside, the United States if the premium 
which is attributable to the reinsuring or issuing of any insurance 
contract in connection with such property cannot be allocated to, or 
apportioned between, risks incurred when such property is actually 
located in the United States and risks incurred when it is actually 
located outside the United States. If such premium can be so allocated 
or apportioned on a reasonable basis, however, such property will be 
considered property not in the United States when it is actually located 
outside the United States. However, property will not be considered 
property in the United States if it is neither property which is 
exclusively located in the United States nor property which is 
ordinarily located in, but temporarily located outside, the United 
States. The rules prescribed in subdivision (ii) of this subparagraph 
shall apply in determining whether a premium can be allocated or 
apportioned on a reasonable basis to or between risks incurred when 
property is actually located in the United States and risks incurred 
when such property is actually located outside the United States. The 
rules prescribed in subdivisions (iii) through (x)

[[Page 223]]

of this subparagraph shall apply in determining whether property is, or 
will be considered, exclusively located in or outside the United States 
and whether property is, or will be considered, ordinarily located in 
the United States; such rules also limit the rule of premium allocation 
and apportionment prescribed in this subdivision and subdivision (ii) of 
this subparagraph. The determinations required by this subparagraph 
shall be made with respect to the location of property during the policy 
period applicable to the taxable year of the insuring or reinsuring 
corporation, or, if more than one policy period exists with respect to 
such taxable year, such determinations shall be made separately with 
respect to the location of property during each such policy period.
    (ii) Premium allocation or apportionment. Whether a premium can be 
allocated or apportioned on a reasonable basis to or between risks 
incurred when property is actually located in the United States and 
risks incurred when such property is actually located outside the United 
States shall depend on the intention of the parties to the insurance 
contract, as determined from its provisions and the facts and 
circumstances preceding its execution. Contract provisions on the basis 
of which the premium reasonably may be so allocated or apportioned 
include, but are not limited to, provisions which separately describe 
each risk covered, the period of coverage of each risk, the special 
warranties for each risk, the premium for each risk (or the basis for 
determining such premium), and the conditions of paying the premium for 
each risk. For purposes of this subdivision, it shall be unnecessary 
formally to make a separate policy with respect to each risk covered or 
with respect to each clause attached to the policy, provided that the 
intention of the parties to the contract is reasonably clear. For 
example, if in the ordinary course of carrying on an insurance business 
an insurance policy is issued which covers fire, theft, and water damage 
risks incurred when property is actually located in the United States 
and marine risks incurred when such property is actually located outside 
the United States and which, pursuant to accepted insurance principles, 
properly describes the premium rates as percentages of the amount of 
coverage as ``.825% plus .3% fire, etc. risks plus .12% water risks = 
1.245%'', a reasonable basis exists to allocate a $124.50 premium paid 
for $10,000 of such coverage to $82.50 for foreign risks and $42.00 
($30.00+ $12.00) to United States risks.
    (iii) Property in general--(a) Ordinary and temporary location. 
Except as otherwise provided in subdivisions (iv) through (x) of this 
subparagraph, the determination of whether property is ordinarily 
located in the United States will depend on all the facts and 
circumstances in each case. Property is ordinarily located in the United 
States if its location in the United States is regular, usual, or often 
occurring. However, in all cases property will be considered ordinarily 
located in the United States if it is actually located in the United 
States for an aggregate of more than 50 percent of the days in the 
applicable policy period whereas property will, under no circumstances, 
be considered ordinarily located in the United States if it is actually 
located in the United States for an aggregate of not more than 30 
percent of the days in the applicable policy period. Property which is 
ordinarily located in the United States is temporarily located outside 
the United States when it is actually located outside the United States. 
For purposes of determining the number and percent of the days in an 
applicable policy period, the term ``day'' means, not any 24-
consecutive-hour period, but a continuous period of twenty-four hours 
commencing from midnight and ending with the following midnight; in 
determining the location of property for such purposes, an amount of 
time which is at least one-half of such a day, but less than the entire 
day, shall be considered a day, and an amount of time which is less than 
one-half of such a day shall not be considered a day.
    (b) Illustrations. The application of this subdivision may be 
illustrated by the following examples:

    Example 1. Controlled foreign corporation A issues to domestic 
corporation M a comprehensive blanket or floater insurance policy which, 
for one year, covers inventory

[[Page 224]]

samples which M Corporation regularly ships from the United States in 
order to encourage sales. Such shipments are made on the condition that 
they be returned to the United States within 5 days after they are 
received. During the one-year policy period, such samples are sent from, 
and returned to, the United States 50 times, and during such one-year 
period are actually located in the United States for an aggregate of 120 
days. Since the location of the samples in the United States during such 
one-year period is often recurring, they are property ordinarily located 
in, but temporarily located outside, the United States. Therefore, they 
will be considered property in the United States even though for such 
one-year period their location in the United States is not regular or 
usual and is not for an aggregate of more than 50 percent of the days in 
the policy period. However, if, by considering such factors as the terms 
and premium schedule of the insurance contract as well as the number, 
value, and duration of the location in and outside the United States, of 
such samples, the premium which is attributable to the issuing of such 
contract can be allocated to, or apportioned between, risks occurring 
when such samples are actually located in the United States and risks 
occurring when they are actually located outside the United States, such 
samples will be considered property not in the United States when they 
are actually located outside the United States.
    Example 2. A machine, located for several years in a foreign branch 
of a United States manufacturer, is permanently transferred to the home 
office of such manufacturer, where it arrives on January 1, 1963, and 
remains for the remainder of 1963. Under a separate insurance contract 
issued by a controlled foreign corporation, which uses the calendar year 
as the taxable year, such machine is insured against damage for the 
three-year period commencing on May 1, 1962. Because of the change in 
location of the machine, the premiums are increased as of January 1, 
1963. Since the machine is in the United States from January 1, 1963, to 
April 30, 1963, its location in the United States is regular and usual 
during the policy period of May 1, 1962, to April 30, 1963. Accordingly, 
the machine is ordinarily located in the United States for such policy 
period. However, since the premium which is attributable to the issuing 
of such contract is allocable to risks occurring when the machine is 
actually located in, and when it is actually located outside, the United 
States, such machine will be considered property not in the United 
States from May 1, 1962, through December 31, 1962.

    (iv) Commercial motor vehicles, ships, aircraft, railroad rolling 
stock, and containers. Any motor vehicle, ship, aircraft, railroad 
rolling stock, or any container transported thereby, which is used 
exclusively in the commercial transportation of persons or property to 
or from the United States (including such transportation from one place 
to another in the United States) and is ordinarily located in the United 
States will be considered property in the United States both when such 
property is ordinarily located in, and when such property is temporarily 
located outside, the United States. Whether such property is used in the 
transportation of persons or property to or from the United States and 
is ordinarily located in the United States are issues to be determined 
from all the facts and circumstances in each case. However, in all cases 
such transportation property will be considered ordinarily located in 
the United States if either more than 50 percent of the miles traversed 
during the applicable policy period in the use of such property are 
traversed within the United States or such property is located in the 
United States more than 50 percent of the time during such period. 
Further, such transportation property will not at any time be considered 
property in the United States if either not more than 30 percent of the 
miles traversed during the applicable policy period in the use of such 
property are traversed within the United States or such property is 
located in the United States for not more than 30 percent of the time 
during such period. Nevertheless, if not more than 30 percent of the 
miles traversed during the applicable policy period in the use of such 
transportation property are traversed within the United States, such 
property will be considered ordinarily located in the United States if 
it is located in the United States more than 50 percent of the time 
during such period Moreover, if such transportation property is located 
in the United States for not more than 30 percent of the time during the 
applicable policy period, such property will be considered ordinarily 
located in the United States if more than 50 percent of the miles 
traversed during such period in the use of such property are traversed 
within the United States. If such transportation property is considered 
property in the United States because more than 50 percent of the miles 
traversed during the applicable policy period in

[[Page 225]]

the use of such property are traversed within the United States, the 
apportionment of premium provided in subdivision (i) of this 
subparagraph shall be made on a mileage basis. If, however, such 
property is considered property in the United States because such 
property is located in the United States more than 50 percent of the 
time during the applicable policy period, the apportionment of premium 
provided in subdivision (i) of this subparagraph shall be made on a time 
basis.
    (v) Noncommercial motor vehicles, ships, aircraft, and railroad 
rolling stock. Except as provided in subdivision (iv) of this 
subparagraph, any motor vehicle, ship or boat, aircraft, or railroad 
rolling stock which at any time is actually located in the United States 
and which either (a) is registered with the United States, a State 
(including any political subdivision thereof), or any agency thereof or 
(b), if not so registered, is owned by a citizen, resident, or 
corporation of the United States will be considered property which is 
ordinarily located in the United States. Unless the premium which is 
attributable to the reinsuring or issuing of any insurance contract in 
connection with such property considered ordinarily located in the 
United States is specifically allocated under the contract to risks 
incurred when such property is actually located in the United States and 
to risks incurred when it is actually located outside the United States, 
such property will be considered property in the United States both when 
it is ordinarily located in, and when it is temporarily located outside, 
the United States; under no circumstances will such property be 
considered outside the United States on the basis of any apportionment 
of such premium.
    (vi) Property exported or imported by railroad or motor vehicle. Any 
property which is exported from, or imported to, the United States by 
railroad or motor vehicle will be considered property ordinarily located 
in the United States which, when such property is not actually located 
in the United States, is temporarily located outside the United States. 
For example, if an insurance contract reinsured or issued in connection 
with property exported from the United States by motor vehicle covers 
risks commencing when such property is loaded on the motor vehicle at 
the United States warehouse and terminating when such property is 
unloaded at the foreign warehouse, and if the premium payable with 
respect to risks incurred when the property is in the United States and 
risks incurred when the property is in the foreign country is not 
separately stated, such property will be considered property in the 
United States only until such property is actually located outside the 
United States, provided that the premium can be properly apportioned 
(for example) on the basis of time or mileage, between risks incurred 
when the property is actually located in the United States and risks 
incurred when it is actually located outside the United States. If in 
such case the premium is not so apportiona