[Federal Register Volume 62, Number 197 (Friday, October 10, 1997)]
[Proposed Rules]
[Pages 52953-52959]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-26857]
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Proposed Rules
Federal Register
________________________________________________________________________
This section of the FEDERAL REGISTER contains notices to the public of
the proposed issuance of rules and regulations. The purpose of these
notices is to give interested persons an opportunity to participate in
the rule making prior to the adoption of the final rules.
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Federal Register / Vol. 62, No. 197 / Friday, October 10, 1997 /
Proposed Rules
[[Page 52953]]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-251985-96]
RIN 1545-AU79
Source of Income From Sales of Inventory Partly From Sources
Within a Possession of the United States; Also, Source of Income
Derived From Certain Purchases From a Corporation Electing Section 936
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
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SUMMARY: This document contains proposed regulations under section 863
governing the source of income from sales of inventory produced in the
United States and sold in a possession of the United States or produced
in a possession of the United States and sold in the United States. It
also contains proposed regulations under section 863 governing the
source of income from sales of inventory purchased in a possession of
the United States and sold in the United States. This document affects
persons who produce (in whole or in part) inventory in the United
States and sell in a possession, or produce (in whole or in part)
inventory in a possession and sell in the United States, as well as
persons who purchase inventory in a possession and sell in the United
States. This document also contains proposed regulations under section
936 governing the source of income of a taxpayer from the sale in the
United States of property purchased from a corporation that has an
election under section 936 in effect. This document also provides
notice of a public hearing on these proposed regulations.
DATES: Comments and outlines of oral comments to be presented at the
public hearing scheduled for January 29, 1998, at 10 a.m. must be
received by January 8, 1998.
ADDRESSES: Send submissions to: CC:DOM:CORP:R (INTL-0003-95), room
5228, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. In the alternative, submissions may be hand
delivered between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R
(REG-251985-96), Courier's Desk, Internal Revenue Service, 1111
Constitution Avenue NW., Washington, DC, or electronically, via the IRS
Internet site at: http://www.irs.ustreas.gov/prod/tax__regs/
comments.html. The public hearing will be held in room 2615, Internal
Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Anne
Shelburne, (202) 622-3880; concerning submissions and the hearing, Ms.
Evangelista Lee, (202) 622-7190 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained in this notice of proposed
rulemaking has been submitted to the Office of Management and Budget
(OMB) for review in accordance with the Paperwork Reduction Act of 1995
(44 U.S.C. 3507(d)).
Comments on the collection of information should be sent to the
Office of Management and Budget, Attn: Desk Officer for the Department
of Treasury, Office of Information and Regulatory Affairs, Washington,
DC 20503, with copies to the Internal Revenue Service, Attn: IRS
Reports Clearance Officer, T:FP, Washington, DC 20224. Comments on the
collection of information should be received by December 9, 1997.
Comments are specifically requested concerning:
Whether the proposed collection of information is necessary for the
proper performance of the functions of the IRS, including whether the
information will have practical utility;
The accuracy of the estimated burden associated with the proposed
collection of information (see below);
How the quality, utility, and clarity of the information to be
collected may be enhanced;
How the burden of complying with the proposed collection of
information may be minimized, including through the application of
automated collection techniques or other forms of information
technology; and
Estimates of capital or start-up costs and costs of operation,
maintenance, and purchase of services to provide information.
The collection of information requirements are in proposed
Sec. 1.863-3(f)(6). This information is required by the IRS to monitor
compliance with the federal tax rules for determining the source of
income from the sale of inventory produced in the United States and
sold in a possession of the United States or produced in a possession
of the United States and sold in the United States, or from the sale of
inventory purchased in a possession of the United States and sold in
the United States. The likely respondents are taxpayers who produce
inventory in the United States and sell in a possession, or who produce
inventory in a possession and sell in the United States, or who
purchase inventory in a possession and sell in the United States.
Responses to this collection of information are required to properly
determine the source of a taxpayer's income from such sales.
Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.
Estimated total annual reporting burden: 500 hours. The estimated
annual burden per respondent varies from 1 hour to 5 hours, depending
on individual circumstances, with an estimated average of 2.5 hours.
Estimated number of respondents: 200.
Estimated annual frequency of responses: One time per year.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless the collection of
information displays a valid control number assigned by the Office of
Management and Budget.
Background
These proposed regulations contain rules under section 863 relating
to the source of income from cross-border sales of certain property.
These regulations also contain rules under
[[Page 52954]]
section 936 relating to the source of income of a taxpayer from the
sale in the United States of property purchased from a corporation that
has an election under section 936 in effect. These regulations are
proposed to be effective for taxable years beginning 30 days after
publication of final regulations.
Explanation of Provisions
I. Income Partly From Sources Within a Possession
A. Current Regulations
Section 863 authorizes the Secretary to promulgate regulations
allocating or apportioning to sources within or without the United
States all items of gross income, expenses, losses, and deductions
other than those items specified in sections 861(a) and 862(a).
Guidance to determine the source of possession income is divided
into two types of transactions: transactions described in section
863(b)(2) for property produced in the United States and sold in a
possession (or vice versa), and transactions described in section
863(b)(3) for property purchased in a possession and sold in the United
States (collectively, Section 863 Possession Sales).
Section 1.863-3 of the income tax regulations contains rules for
determining the source of income derived from sales of certain
property. These regulations were published in the Federal Register on
November 29, 1996 (61 FR 60540), and the prior regulations were
renumbered Secs. 1.863-3A and 1.863-3AT. The new regulations retain the
prior rules for Section 863 Possession Sales by providing in paragraph
Sec. 1.863-3(f) that taxpayers must apply the rules of Sec. 1.863-3A(c)
in allocating and apportioning income derived from sources partly
within the United States and partly within a possession of the United
States. These proposed regulations would modify the existing rules for
allocating and apportioning income between the United States and a
possession.
1. Property Produced and Sold
Currently, income derived from sales of inventory produced in the
United States and sold in a possession of the United States or produced
in a possession of the United States and sold in the United States
(Possession Production Sales), is allocated or apportioned between the
United States and a possession according to one of three methods. Such
income is allocated under the independent factory price method,
apportioned under an apportionment method, or, with permission of the
District Director, allocated or apportioned on the basis of the
taxpayer's books and records.
Under the current regulations, if an independent factory or
production price (IFP) exists for Possession Production Sales,
taxpayers must use the IFP method to determine the income attributable
to production activities in both the sale establishing the IFP and in
sales of similar products.
If an IFP does not exist, the current possessions regulations
provide that the taxable income from Possession Production Sales is
first computed and then apportioned between the United States and the
possession. One-half of the taxable income is apportioned on the basis
of the taxpayer's property within the United States and within the
possession. In applying the property fraction, the taxpayer's property
includes property held or used to produce income derived from
Possession Production Sales. The other half of the taxpayer's taxable
income is apportioned between U.S. and possession sources on the basis
of the business of the taxpayer within the United States and within the
possession. Currently, business of the taxpayer is measured by the sum
of certain expenses, including amounts paid for labor, and the purchase
of certain supplies, plus receipts from Possession Production Sales.
Finally, as a third method, the existing regulations allow a taxpayer
to request permission from the District Director to use the taxpayer's
books and records to allocate or apportion income to sources within or
without the United States if those books reflect more clearly than the
other methods the taxable income derived from sources within the United
States.
2. Property Purchased and Sold
The second type of possession transaction governed by the existing
regulations is the sale of inventory purchased in a possession and sold
in the United States (Possession Purchase Sales) as described in
section 863(b)(3). Under the current regulations, the income from such
sales is divided between the United States and possession sources under
one of two methods. The income can be apportioned, or, with permission
of the District Director, allocated or apportioned on the basis of the
taxpayer's books and records.
Under the apportionment method, taxable income is first determined,
and then apportioned by a fraction, the numerator being the business of
the taxpayer in the United States, the denominator being the total
business of the taxpayer in the United States and in the possession.
The fraction is computed in the same manner as the business fraction
discussed previously, except that such expenses, purchases, and sales
are limited to those attributable to Possession Purchase Sales.
B. Issues Under Current Regulations
The IRS and Treasury believe the rules for allocating and
apportioning income between the United States and the possessions of
the United States should be amended to reflect certain changes made to
the regulations under Sec. 1.863-3 governing cross-border sales of
inventory involving the United States and a foreign country (other than
those involving possessions). Thus, for example, under the
apportionment method provided in the proposed regulations, the property
and business activity fractions apportioning income between the United
States and a possession are modified to apportion gross income
attributable to an activity, rather than to apportion net income.
The IRS and Treasury also believe certain ambiguities exist in the
current regulations. The possessions rules were originally promulgated
in 1926, and may not reflect current business practices. The current
regulations use examples to illustrate methods for allocating or
apportioning income between the United States and a possession, and
should be modified to state rules.
Further, although the apportionment method for allocating
Possession Production Sales income under the existing possessions
regulations treats half of the income as production income, the
production formula is not necessarily limited to production assets. The
current inclusion of sales assets in the formula apportioning
production income results in excessive income being allocated to sales
activities. The production income formula should only take into account
assets directly involved in production of inventory. In addition, the
IRS and Treasury have reexamined the business activity fraction, and
have concluded it should be revised to more clearly reflect the
taxpayer's business other than production. The current fraction, for
example, omits certain investments or expenses, such as marketing and
advertising expenses, although income attributable in part to such
expenses or investments is then included in the income apportioned by
the fraction. The current regulations also take into account production
expenses in the business activity fraction apportioning income from
Possession Production Sales. The Service and Treasury believe that this
is inappropriate in the context
[[Page 52955]]
of Possession Production Sales because the business activity fraction
is not intended to determine the source of income attributable to
production activity. In the proposed regulations, the fraction
apportioning Possession Production Sales is renamed the business sales
activity fraction and excludes factors reflecting production activity.
The current regulations also do not address issues in attributing
to the United States or to the possession, the activities reflected in
the business activity fraction. For example, the current regulations
provide no guidance on whether a particular expense should be
represented in the fraction as attributable to the United States or to
a possession.
Accordingly, the IRS and Treasury are issuing proposed regulations
under section 863 to make the possessions rules more consistent with
the other regulations governing the source of income from cross-border
sales of inventory, and to address certain ambiguities and problems in
the existing regulations.
C. Proposed Regulations
Section 1.863-3(f) generally retains the methods of the current
regulations for dividing income between the United States and a
possession of the United States, with several modifications.
1. Methods to Allocate Gross Income to Activities of the Taxpayer
a. Property Produced and Sold
i. The Possession 50/50 Method
Consistent with the final regulations under Sec. 1.863-3, paragraph
(f)(2)(i)(A) of the proposed regulations makes the 50/50 method the
general rule to allocate gross income from Possession Production Sales
between production and business sales activity, so that the income from
each type of activity can then be apportioned between U. S. and foreign
sources. The taxpayer, however, may elect to apply the IFP method
(described in paragraph (f)(2)(i)(B)), or, with the consent of the
District Director, the books and records method (described in paragraph
(f)(2)(i)(C)).
Under the possession 50/50 method, the proposed regulations
allocate half of the taxpayer's gross income from Possession Production
Sales to production activity and half to business sales activity. The
income is then apportioned between U.S. and possession sources based on
a property fraction and a business sales activity fraction. As
described below, the proposed regulations make certain changes to the
existing property fraction and to the existing business activity
fraction.
The proposed regulations apply the property fraction in Sec. 1.863-
3(c) to apportion the half of a taxpayer's income allocated to
production activity. Thus, income is apportioned to the United States
or to a possession based on the location of the taxpayer's production
assets. In a change from the current regulations, and consistent with
the changes made to the regulations under Sec. 1.863-3(c), production
assets are defined as tangible and intangible assets owned directly by
the taxpayer that are directly used by the taxpayer to produce
inventory sold in Possession Production Sales, instead of all its
assets that produce income from Possession Production Sales. Production
assets are included in the fraction at their adjusted tax basis.
The other half of the taxpayer's gross income is apportioned
according to a business sales activity fraction. The portion of this
income that is possession source income is determined by multiplying
the income by a fraction, the numerator being the business sales
activity of the taxpayer in the possession, and the denominator being
the business sales activity of the taxpayer within the possession and
outside the possession. The remaining income is sourced in the United
States. Although some of the business sales activity factors not
incurred in a possession may be incurred in a foreign country, Treasury
and the Internal Revenue Service believe that the business sales
activity fraction is only intended to source the business sales
activity portion of Possession Production Sales outside the United
States to the extent of business sales activity located in a
possession.
The proposed regulations make some modifications to the factors in
the fraction representing the business sales activity of the taxpayer.
Business sales activity is measured by the sum of certain expenses,
including amounts paid for labor, materials, advertising, and marketing
(but excluding any expenses or other amounts that are nondeductible
under section 263A, interest, and research and development), plus
receipts for the sale of goods. This formula is intended to reflect
better the business sales activity producing the income by including
more of the factors responsible for producing that income. Cost of
goods sold is also excluded from the business sales activity fraction
apportioning income from Possession Production Sales, because such
costs generally reflect production activity. Production activity is
already represented in the formula by the one-half of the taxpayer's
income apportioned according to the location of production assets.
Finally, the proposed regulations provide more explicit guidance
for attributing business sales activity between the United States and a
possession. Expenses are allocated and apportioned between the United
States and a possession based on the rules in Secs. 1.861-8 through
1.861-14T. Gross sales are allocated to the United States or a
possession based on the place of sale.
ii. The IFP Method
The proposed regulations make the IFP method elective, and thus
eliminate any bias against taxpayers choosing to export through
independent distributors. The regulations rely upon the revised
regulations under Sec. 1.863-3 for rules in applying the IFP method.
iii. Books and Records Method
The proposed regulations retain the books and records method of the
existing regulations, permitting taxpayers to request permission from
the District Director to use their books and records to determine the
source of their income. The proposed regulations refer to revised
Sec. 1.863-3(b)(3) in applying the method to Possession Production
Sales.
b. Property Purchased and Sold
i. The Business Activity Method
Paragraph (f)(3)(i)(A) makes the business activity method the
general rule to apportion income from Possession Purchase Sales between
the United States and a possession. The taxpayer may, however, elect to
apply, with consent of the District Director, the books and records
method.
The proposed regulations retain the structure of the existing
regulations by apportioning the taxpayer's income from Possession
Purchase Sales on the basis of a business activity fraction. The
portion of this income that is possession source income is determined
by multiplying the income by a fraction, the numerator being the
business of the taxpayer in the possession, and the denominator being
the business of the taxpayer within the possession and outside the
possession. The remaining income is sourced in the United States.
The business activity fraction is similar to that discussed
previously, used to apportion the taxpayer's income in Possession
Production Sales, except that the fraction applies only to expenses,
cost of goods sold, and sales attributable to Possession Purchase
Sales. In addition, the business activity
[[Page 52956]]
fraction apportioning Possession Purchase Sales includes amounts paid
for cost of goods sold. Such costs are attributed to the possession,
however, only to the extent the property purchased is manufactured,
produced, grown, or extracted in the possession. Treasury and the
Internal Revenue Service anticipate that if a taxpayer acts in the
reasonable belief that the products were manufactured in the
possession, the taxpayer could act on that basis in preparing its tax
return. As modified, the business activity fraction reflects the view
of Treasury and the Internal Revenue Service that section 863(b)(3)'s
purchase rule was intended to apply only to purchase and resale
transactions, where the goods purchased are created or derived from the
possession.
ii. Books and Records Method
The proposed regulations retain the books and records method of the
existing regulations, permitting taxpayers to request permission from
the District Director to use their books and records to determine the
source of their income. The proposed regulations refer to revised
Sec. 1.863-3(b)(3) in applying the method to Possession Purchase Sales.
2. Determination of Source of Gross Income
Unlike the current regulations which provide specific rules for
determining the source of income attributable to production activity
and business activity only for purposes of the 50/50 method, the
proposed regulations adopt rules applicable to each of the methods.
Under the proposed regulations, once gross income attributable to
production activity, business activity, or sales activity has been
determined under one of the prescribed methods, the source of the gross
income is determined separately for each type of income. The source of
gross income attributable to production activity (when applying the
possession 50/50 method) is determined under paragraph (c)(1), based on
the location of production assets. The source of gross income
attributable to sales activity (when applying the IFP method or the
books and records method) is determined under paragraph (c)(2), based
generally on the location of the sale. The source of gross income
attributable to business sales activity (when applying the possession
50/50 method) is determined under paragraph (f)(2)(ii)(B), based on
expenses, and gross sales attributable to Possession Production Sales.
The source of gross income attributable to business activity (when
applying the business activity method) is determined under paragraph
(f)(3)(ii), based on expenses, cost of goods sold, and gross sales
attributable to Possession Purchase Sales.
3. Determination of Source of Taxable Income
Once the source of gross income is determined under paragraph
(f)(2) or (3), taxpayers then determine the source of taxable income.
Under proposed paragraph (f)(4), taxpayers must allocate or apportion
under Secs. 1.861-8 through 1.861-14T the amounts of expenses, losses
and other deductions to gross income determined under each of the
prescribed methods. In the case of amounts of expenses, losses and
other deductions allocated or apportioned to gross income determined
under the IFP method or the books and records method, the taxpayer must
apply the rules of Secs. 1.861-8 through 1.861-14T to allocate or
apportion these amounts between gross income from sources within the
United States and within a possession. For expenses, losses and other
deductions allocated or apportioned to gross income determined under
the possessions 50/50 method, taxpayers must apportion expenses and
other deductions pro rata based on the relative amounts of U.S. and
possession source gross income. The research and experimental (R&E)
expense allocation rules in Sec. 1.861-17 apply to taxpayers using the
50/50 method, so that the R&E set aside (described in Sec. 1.861-17)
remains available to such taxpayers.
4. Treatment of Gross Income Derived From Certain Purchases From a
Corporation That Has an Election in Effect Under Section 936
The proposed regulations clarify that section 863 does not apply to
determine the source of a taxpayer's gross income derived from a
purchase of inventory from a corporation that has an election in effect
under section 936, if the taxpayer's income from sales of that
inventory is taken into account to determine benefits under section
936(h)(5)(C) for the section 936 corporation.
5. Treatment of Partners and Partnerships
The proposed regulations rely on the rules in Sec. 1.863-3(g) for
determining the appropriate treatment in transactions involving
partnerships. Under those rules, the aggregate approach applies to a
partnership's production and sales activity for two purposes only.
First, the aggregate approach applies in determining the character of a
partner's distributive share of partnership income. Second, the
aggregate approach applies in sourcing income from sales of inventory
property that is transferred in-kind from or to a partnership.
6. Election and Reporting Rules
Under paragraph (f)(6)(i) of the proposed regulations, a taxpayer
must use the 50/50 method to determine the source of income from
Possession Production Sales unless the taxpayer elects to use the IFP
method, or elects the books and records method. For Possession Purchase
Sales, a taxpayer must use the business activity method, unless the
taxpayer elects the books and records method. The taxpayer makes an
election by using the method on its timely filed original tax return.
That method must be used in later taxable years unless the Commissioner
or his delegate consents to a change. Permission to change methods in
later years will not be withheld unless the change would result in a
substantial distortion of the source of income.
A taxpayer must fully explain the methodology used in applying
either paragraph (f)(2) or (3), and the amount of income allocated or
apportioned to U.S. and foreign sources, in a statement attached to its
tax return.
II. Income Derived From Certain Purchases From a Corporation That Has
an Election in Effect Under Section 936
These proposed regulations clarify that where a taxpayer purchases
a product from a corporation that has an election in effect under
section 936, the source of the taxpayer's gross income derived from
sales of that product (in whatever form sold) in the United States is
U.S. source, if the taxpayer's income from sales of that product is
taken into account to determine benefits under section 936(h)(5)(C)(i)
for the section 936 corporation. The taxpayer's income is U.S. source
without regard to whether a possession product is a component, end-
product form, or integrated product. No inference should be drawn from
the proposed effective date concerning the treatment of transactions
involving sales of property purchased from a section 936 corporation
entered into before the regulations are applicable.
Proposed Effective Dates
These regulations are proposed to be effective for taxable years
beginning on or after the date that is 30 days after the date of
publication of final regulations.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in EO 12866. Therefore,
a regulatory assessment is not required. It is hereby
[[Page 52957]]
certified that these regulations will not have a significant economic
impact on a substantial number of small entities. This certification is
based on the fact that the rules of this section principally impact
large multinationals who pay foreign taxes on substantial foreign
operations and therefore the rules will impact very few small entities.
Moreover, in those few instances where the rules of this section impact
small entities, the economic impact on such entities is not likely to
be significant. Accordingly, a regulatory flexibility analysis is not
required. Pursuant to section 7805(f) of the Internal Revenue Code,
this notice of proposed rulemaking will be submitted to the Chief
Counsel for Advocacy of the Small Business Administration for comment
on its impact on small business.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any comments that are submitted timely
(in the manner described under the ADDRESSES caption) to the IRS. All
comments will be available for public inspection and copying.
A public hearing has been scheduled for January 29, 1998, at 10
a.m., in room 2615, Internal Revenue Building, 1111 Constitution
Avenue, NW., Washington, DC. Because of access restrictions, visitors
will not be admitted beyond the Internal Revenue Building lobby more
than 15 minutes before the hearing starts.
The rules of 26 CFR 601.601(a)(3) apply to the hearing.
Persons that wish to present oral comments at the hearing must
submit comments and an outline of topics to be discussed and the time
to be devoted to each topic (in the manner described under the
ADDRESSES caption of this preamble) by January 8, 1998.
A period of 10 minutes will be allotted to each person for making
comments.
An agenda showing the scheduling of the speakers will be prepared
after the deadline for receiving outlines has passed. Copies of the
agenda will be available free of charge at the hearing.
Drafting Information
The principal author of these regulations is Anne Shelburne, Office
of Associate Chief Counsel (International). However, other personnel
from the IRS and Treasury Department participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended by
revising the entry for ``Section 1.863-3'', removing the entry for
``Sections 1.936-4 through 1.936-7'', and adding entries in numerical
order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.863-3 also issued under 26 U.S.C. 863(a) and (b), and
26 U.S.C. 936(h).* * *
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).* * *
Par. 2. Section 1.863-3 is amended as follows:
1. Paragraph (f) is revised.
2. Paragraph (h) is amended by adding a sentence at the end of the
paragraph.
The revision and addition read as follows:
Sec. 1.863-3 Allocation and apportionment of income from certain sales
of inventory.
* * * * *
(f) Income partly from sources within a possession of the United
States--(1) In general. This paragraph (f) relates to gains, profits,
and income, which are treated as derived partly from sources within the
United States and partly from sources within a possession of the United
States (Section 863 Possession Sales). This paragraph (f) applies to
determine the source of income derived from the sale of inventory
produced (in whole or in part) by the taxpayer within the United States
and sold within a possession, or produced (in whole or in part) by a
taxpayer in a possession and sold within the United States (Possession
Production Sales). It also applies to determine the source of income
derived from the purchase of personal property within a possession of
the United States and its sale within the United States (Possession
Purchase Sales). A taxpayer subject to this paragraph (f) must divide
gross income from Section 863 Possession Sales using one of the methods
described in either paragraph (f)(2)(i) of this section (in the case of
Possession Production Sales) or paragraph (f)(3)(i) of this section (in
the case of Possession Purchase Sales). Once a taxpayer has elected a
method, the taxpayer must separately apply that method to the
applicable category of Section 863 Possession Sales in the United
States and to those in a possession. The source of gross income from
each type of activity must then be determined under either paragraph
(f)(2)(ii) or (3)(ii) of this section, as appropriate. The source of
taxable income from Section 863 Possession Sales is determined under
paragraph (f)(4) of this section. The taxpayer must apply the rules for
computing gross and taxable income by aggregating all Section 863
Possession Sales to which a method in this section applies after
separately applying that method to Section 863 Possession Sales in the
United States and to Section 863 Possession Sales in a possession. This
section does not apply to determine the source of a taxpayer's gross
income derived from a sale of inventory purchased from a corporation
that has an election in effect under section 936, if the taxpayer's
income from sales of that inventory is taken into account to determine
benefits under section 936 for the section 936 corporation. For rules
to be applied to determine the source of such income, see Sec. 1.936-
6(a)(5) Q&A 7a and (b)(1) Q&A 13.
(2) Allocation or apportionment for Possession Production Sales--
(i) Methods for determining the source of gross income for Possession
Production Sales--(A) Possession 50/50 method. Under the possession 50/
50 method, gross income from Possession Production Sales is allocated
between production activity and business sales activity as described in
this paragraph (f)(2)(i)(A). Under the possession 50/50 method, one-
half of the taxpayer's gross income will be considered income
attributable to production activity and the source of that income will
be determined under the rules of paragraph (f)(2)(ii)(A) of this
section. The remaining one-half of such gross income will be considered
income attributable to business sales activity and the source of that
income will be determined under the rules of paragraph (f)(2)(ii)(B) of
this section.
(B) IFP method. In lieu of the possession 50/50 method, a taxpayer
may elect the independent factory price (IFP) method. Under the IFP
method, gross income from Possession Production Sales is allocated to
production activity or sales activity using the IFP method, as
described in paragraph (b)(2) of this section, if an IFP is fairly
established under the rules of paragraph (b)(2) of this section. See
paragraphs (f)(2)(ii) (A) and (C) of this section for rules for
determining the source of gross income attributable to production
activity and sales activity.
[[Page 52958]]
(C) Books and Records method. A taxpayer may elect to allocate
gross income using the books and records method described in paragraph
(b)(3) of this section, if it has received in advance the permission of
the District Director having audit responsibility over its return. See
paragraph (f)(2)(ii) of this section for rules for determining the
source of gross income.
(ii) Determination of source of gross income from production,
business sales, and sales activity--(A) Gross income attributable to
production activity. The source of gross income from production
activity is determined under the rules of paragraph (c)(1) of this
section, except that the term possession is substituted for foreign
country wherever it appears.
(B) Gross income attributable to business sales activity--(1)
Source of gross income. Gross income from the taxpayer's business sales
activity is sourced in the possession in the same proportion that the
amount of the taxpayer's business sales activity for the taxable year
within the possession bears to the amount of the taxpayer's business
sales activity for the taxable year both within the possession and
outside the possession, with respect to Possession Production Sales.
The remaining income is sourced in the United States.
(2) Business sales activity. For purposes of this paragraph
(f)(2)(ii)(B), the taxpayer's business sales activity is equal to the
sum of--
(i) The amounts for the taxable period paid for wages, salaries,
and other compensation of employees, and other expenses attributable to
Possession Production Sales (other than amounts that are nondeductible
under section 263A, interest, and research and development); and
(ii) Possession Production Sales for the taxable period.
(3) Location of business sales activity. For purposes of
determining the location of the taxpayer's business activity within a
possession, the following rules apply:
(i) Sales. Receipts from gross sales will be attributed to a
possession under the provisions of paragraph (c)(2) of this section.
(ii) Expenses. Expenses will be attributed to a possession under
the rules of Secs. 1.861-8 through 1.861-14T.
(C) Gross income attributable to sales activity. The source of the
taxpayer's income that is attributable to sales activity, as determined
under the IFP method or the books and records method, will be
determined under the provisions of paragraph (c)(2) of this section.
(3) Allocation or apportionment for Possession Purchase Sales--(i)
Methods for determining the source of gross income for Possession
Purchase Sales--(A) Business activity method. Gross income from
Possession Purchase Sales is allocated in its entirety to the
taxpayer's business activity, and is then apportioned between U.S. and
possession sources under paragraph (f)(3)(ii) of this section.
(B) Books and records method. A taxpayer may elect to allocate
gross income using the books and records method described in paragraph
(b)(3) of this section, subject to the conditions set forth in
paragraph (b)(3) of this section. See paragraph (f)(2)(ii) of this
section for rules for determining the source of gross income.
(ii) Determination of source of gross income from business
activity--(A) Source of gross income. Gross income from the taxpayer's
business activity is sourced in the possession in the same proportion
that the amount of the taxpayer's business activity for the taxable
year within the possession bears to the amount of the taxpayer's
business activity for the taxable year both within the possession and
outside the possession, with respect to Possession Purchase Sales. The
remaining income is sourced in the United States.
(B) Business activity. For purposes of this paragraph (f)(3)(ii),
the taxpayer's business activity is equal to the sum of--
(1) The amounts for the taxable period paid for wages, salaries,
and other compensation of employees, and other expenses attributable to
Possession Purchase Sales (other than amounts that are nondeductible
under section 263A, interest, and research and development);
(2) Cost of goods sold attributable to Possession Purchase Sales
during the taxable period; and
(3) Possession Purchase Sales for the taxable period.
(C) Location of business activity. For purposes of determining the
location of the taxpayer's business activity within a possession, the
following rules apply:
(1) Sales. Receipts from gross sales will be attributed to a
possession under the provisions of paragraph (c)(2) of this section.
(2) Cost of goods sold. Payments for cost of goods sold will be
properly attributable to gross receipts from sources within the
possession only to the extent that the property purchased was
manufactured, produced, grown, or extracted in the possession (within
the meaning of section 954(d)(1)(A)).
(3) Expenses. Expenses will be attributed to a possession under the
rules of Secs. 1.861-8 through 1.861-14T.
(iii) Examples. The following examples illustrate the rules of
paragraph (f)(3)(ii) relating to the determination of source of gross
income from business activity:
Example 1. (i) U.S. Co. purchases in a possession product X for
$80 from A. A manufactures X in the possession. Without further
production, U.S. Co. sells X in the United States for $100. Assume
U.S. Co. has sales and administrative expenses in the possession of
$10.
(ii) To determine the source of U.S. Co.'s gross income, the
$100 gross income from sales of X is allocated entirely to U.S.
Co.'s business activity. Forty-seven dollars of U.S. Co.'s gross
income is sourced in the possession. [Possession expenses ($10) plus
possession purchases ($80) plus possessions sales ($0), divided by
total expenses ($10) plus total purchases ($80) plus total sales
($100).] The remaining $53 is sourced in the United States.
Example 2. (i) Assume the same facts as in Example 1, except
that A manufactures X outside the possession.
(ii) To determine the source of U.S. Co.'s gross income, the
$100 gross income is allocated entirely to U.S. Co.'s business
activity. Five dollars of U.S. Co.'s gross income is sourced in the
possession. [Possession expenses ($10) plus possession purchases
($0) plus possession sales ($0), divided by total expenses ($10)
plus total purchases ($80) plus total sales ($100).] The $80
purchase is not included in the numerator used to determine U.S.
Co.'s business activity in the possession, since product X was not
manufactured in the possession. The remaining $95 is sourced in the
United States.
(4) Determination of source of taxable income. Once the source of
gross income has been determined under paragraph (f)(2) or (3) of this
section, the taxpayer must properly allocate and apportion separately
under Secs. 1.861-8 through 1.861-14T the amounts of its expenses,
losses, and other deductions to its respective amounts of gross income
from Section 863 Possession Sales determined separately under each
method described in paragraph (f)(2) or (3) of this section. In
addition, if the taxpayer deducts expenses for research and development
under section 174 that may be attributed to its Section 863 Possession
Sales under Sec. 1.861-8(e)(3), the taxpayer must separately allocate
or apportion expenses, losses, and other deductions to its respective
amounts of gross income from each relevant product category that the
taxpayer uses in applying the rules of Sec. 1.861-8(e)(3)(i)(A). In the
case of gross income from Section 863 Possession Sales determined under
the IFP method or books and records method, a taxpayer must apply the
rules of Secs. 1.861-8 through 1.861-14T to properly allocate or
apportion amounts of expenses,
[[Page 52959]]
losses and other deductions, allocated and apportioned to such gross
income, between gross income from sources within and without the United
States. In the case of gross income from Possession Production Sales
determined under the possessions 50/50 method or gross income from
Possession Purchase Sales computed under the business activity method,
the amounts of expenses, losses, and other deductions allocated and
apportioned to such gross income must be apportioned between sources
within and without the United States pro rata based on the relative
amounts of gross income from sources within and without the United
States determined under those methods.
(5) Special rules for partnerships. In applying the rules of this
paragraph (f) to transactions involving partners and partnerships, the
rules of paragraph (g) of this section apply.
(6) Election and reporting rules--(i) Elections under paragraph
(f)(2) or (3) of this section. If a taxpayer does not elect one of the
methods specified in paragraph (f)(2) or (3) of this section, the
taxpayer must apply the possession 50/50 method in the case of
Possession Production Sales or the business activity method in the case
of Possession Purchase Sales. The taxpayer may elect to apply a method
specified in either paragraph (f)(2) or (3) of this section by using
the method on a timely filed original return (including extensions).
Once a method has been used, that method must be used in later taxable
years unless the Commissioner consents to a change. Permission to
change methods from one year to another year will be granted unless the
change would result in a substantial distortion of the source of the
taxpayer's income.
(ii) Disclosure on tax return. A taxpayer who uses one of the
methods described in paragraph (f)(2) or (3) of this section must fully
explain in a statement attached to the tax return the methodology used,
the circumstances justifying use of that methodology, the extent that
sales are aggregated, and the amount of income so allocated.
* * * * *
(h) Effective dates. * * * However, the rules of paragraph (f) of
this section apply to taxable years beginning on or after the date that
is 30 days after the date of publication of final regulations.
Par. 3. In Sec. 1.936-6, paragraph (a)(5) Q&A 7a is added to read
as follows:
Sec. 1.936-6 Intangible property income when an election out is made:
Cost sharing and profit split options; covered intangibles.
* * * * *
(a) * * *
(5) * * *
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 the date that is 30 days after the date of
publication of final regulations.
* * * * *
Michael P. Dolan,
Acting Commissioner of Internal Revenue.
[FR Doc. 97-26857 Filed 10-9-97; 8:45 am]
BILLING CODE 4830-01-P