[Federal Register Volume 61, Number 231 (Friday, November 29, 1996)]
[Rules and Regulations]
[Pages 60540-60551]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-30617]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
[TD 8687]
RIN 1545-AT92
Source of Income From Sales of Inventory and Natural Resources
Produced in One Jurisdiction and Sold in Another Jurisdiction
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final and temporary regulations.
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SUMMARY: This document contains regulations governing the source of
income from sales of natural resources or other inventory produced in
the United States and sold outside the United States or produced
outside the United States and sold in the United States. This document
affects persons who produce natural resources or other inventory in the
United States and sell outside the United States, or produce natural
resources or other inventory outside the United States and sell in the
United States.
DATES: Effective date: December 30, 1996.
Applicability: Taxpayers may apply these regulations for taxable
years beginning after July 11, 1995, and on or before December 30,
1996.
FOR FURTHER INFORMATION CONTACT: Anne Shelburne, (202) 622-3880 (not a
toll free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained in this final regulation
has been reviewed and approved by the Office of Management and Budget
in accordance with the requirements of the Paperwork Reduction Act (44
U.S.C. 3507) under control number 1545-1476. Responses to this
collection of information are mandatory.
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.
The estimated average annual burden per respondent is approximately
2.6 hours.
[[Page 60541]]
Comments concerning the accuracy of this burden estimate and
suggestions for reducing this burden should be sent to the Internal
Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington,
DC 20224, and the Office of Management and Budget, Attn: Desk Officer
for the Department of the Treasury, Office of Information and
Regulatory Affairs, Washington, DC, 20503.
Books or records relating to this 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.
Background
This document contains final regulations to be added to the Income
Tax Regulations (26 CFR part 1) under section 863 of the Internal
Revenue Code (Code). The final regulations provide rules for allocating
and apportioning income between U.S. and foreign sources from natural
resources and other inventory produced in the United States and sold
outside the United States, or produced outside the United States and
sold in the United States.
On December 11, 1995, proposed regulations [INTL-0003-95] were
published in the Federal Register (60 FR 63478). The IRS received
written comments on the proposed regulations and held a public hearing
on April 10, 1996. Having considered the comments and the statements
made at the hearing, the IRS and the Treasury Department adopt the
proposed regulations as modified by this Treasury decision. The
comments and revisions are discussed below.
Explanation of Provisions
I. Allocation of Gross Income From Sales of Natural Resources Under
Section 863(a)
Section 1.863-1(b) of the proposed regulations relate to the rules
governing natural resources. The proposed regulations provide three
methods for determining the amount of United States or foreign source
income from sales of natural resources. One method (derived from the
existing regulations) sources income in its entirety to the location of
the natural resources, and applies where the taxpayer does not engage
in substantial additional production beyond production of the natural
resources. The second method, the export terminal rule, splits sales
income at the export terminal, sourcing gross receipts equal to the
fair market value at the export terminal to the location of the natural
resources, and gross receipts in excess of that amount either to the
place of sale or according to the rules in Sec. 1.863-3, depending on
the circumstances. The third method requires taxpayers performing
additional production in the country where the natural resources are
located, to split gross receipts at the point of the additional
production, sourcing gross receipts equal to the fair market value
prior to that point to the location of the natural resources and gross
receipts in excess of that amount according to the rules in Sec. 1.863-
3.
1. Implications of the Tenth Circuit's Order in Phillips
Section 1.863-1(b)(1)(i) of the proposed regulations sources
certain income from natural resources in its entirety to the location
of the resources. The preamble to the proposed regulations states that
Treasury and the IRS would consider the Tenth Circuit's unpublished
opinion in its Order and Judgment in Phillips Petroleum v. Comm'r, 97
T.C. 30 (1991), 101 T.C. 78 (1993), aff'd. without published opinion,
70 F.3d 1282 (10th Cir., 1995), in finalizing the regulations. In
Phillips, the Tax Court ruled Sec. 1.863-1(b)'s natural resource
regulation, generally sourcing income from U.S. natural resources in
its entirety to the United States, invalid to the extent it conflicted
with the Court's interpretation of section 863(b)(2). That section
provides that gains, profits and income from the sale of inventory
property produced within and sold without the United States (or vice
versa) shall be treated as derived partly from sources within and
partly from sources without the United States. The Tenth Circuit
affirmed the Tax Court.
In view of Phillips, the final regulations modify the proposed
regulations to eliminate the 100 percent allocation rule, making the
determination of the source of income subject instead to the export
terminal rule. Thus, gross receipts equal to the fair market value of
the product at the export terminal are allocated to the location of the
farm, mine, well, deposit or uncut timber, with the source of gross
receipts from such sales in excess of the product's fair market value
at the export terminal allocated to the country of sale.
Several commentators requested that any change to the natural
resource rules made in light of Phillips be done in proposed form,
providing opportunity to comment on the regulations. However, because
the final regulations merely eliminate the rule which required a single
source of income for sales of natural resources, and because Treasury
and the IRS believe that there has been adequate opportunity to comment
on the proposed regulations' export terminal rule, the natural
resources rules are issued in final form.
2. Availability of the 50/50 Method for Natural Resources
Several commentators wrote that there is no basis for treating
natural resources differently than other inventory. Therefore,
producers of natural resources should be permitted to determine the
source of their income under the 50/50 method described in Sec. 1.863-
3(b)(1). They point to legislation enacted in the Tax Reform Act of
1986, arguing that Congress, in enacting section 865 to govern personal
property sales, drew no distinction between sales of natural resources
and sales of other inventory. Commentators have also pointed to section
865(b), enacted in 1993, providing that income from sales of U.S.
softwood must be U.S. source in its entirety. They conclude that
Congress was aware of the Tax Court's decision in Phillips, overruling
Phillips only for softwood, but intending that all other natural
resources be sourced under the 50/50 method.
Treasury and the IRS do not believe that Congress in the 1986 Act
evidenced an intent to source all income from sales of natural
resources under the 50/50 method. Rather, Congress merely referred to
the 50/50 method to generally describe the methods for sourcing income
from certain types of inventory sales. In addition, the legislative
history to the 1993 Act, requiring income from softwood sales to be
allocated in its entirety to the United States, does not suggest that
Congress intended to overturn the longstanding regime governing sales
of other natural resources. Moreover, the Small Business Job Protection
Act of 1996, Public Law 104-188 (August 20, 1996) (the 1996 Act),
further clarifies that the Service is not required to apply the 50/50
method. Prior to the 1996 Act, section 865(b) provided that income from
inventory sales was to be sourced under sections 861(a)(6), 862(a)(6),
and 863(b). The 1996 Act, in section 1704(f)(4)(A), amended Code
section 865(b)(2) by striking 863(b) and inserting 863. The Act makes
this amendment effective as if included in amendments made by section
1211 of the Tax Reform Act of 1986 (Public Law 99-514). This technical
correction to the 1986 Act clarifies that Treasury has broad authority
to provide rules sourcing income from sales of inventory under
[[Page 60542]]
section 863, and is not restricted to any particular method.
Treasury and the IRS also believe longstanding distinctions have
been made in the tax treatment of natural resources and other property,
both in our tax laws and in our tax treaties. Most treaties, for
example, grant primary or exclusive taxing jurisdiction to the country
where natural resources are located. Thus, income from sales of natural
resources is treated differently than income derived from sales of
other inventory, which is normally subject to the business profits
article of a treaty. See, e.g., Article 6 of the United States Model
Income Tax Convention (September 20, 1996), which provides that income
from real property, ``including income from agriculture and forestry''
may be taxed by the country where the resources are located.
The legislative history to section 863's predecessor, section
217(e) of the Revenue Act of 1921, also reflects an intention that
natural resources be treated differently from other property. The House
version of section 217 (H.R. 8245, 67th Cong., 1st Sess. (Aug.20,
1921)) included a provision sourcing income from natural resources in
its entirety to the location of the resources. However, based on
testimony raising the possibility of a case where such a single source
rule should not apply, the Senate struck the provision that allocated
all of the income from natural resources to a single country. (H.R.
8245 (67th Cong., 1st Sess. (November 4, 1921)); Hearings Before The
Committee on Finance, United States Senate, H.R. 8245, 67th Cong., 1st
Sess. (September 1 to October 1, 1921), at 309-310. A provision similar
to that considered by the House, but with flexibility available for
unusual cases, was then added to the regulations promulgated in 1922.
Thus, Treasury and the IRS believe that income from natural
resources should be sourced differently than income from other sales of
inventory.
3. Clarification of Language in Sec. 1.863-2
In response to a comment, the final regulations are modified to
clarify that the source of income from sales of natural resources must
be determined solely under the rules set forth in Sec. 1.863-1(b) of
the final regulations. Treasury and the IRS clarified this point in
corrections to the proposed regulations, published on August 27, 1996,
in the Federal Register (61 FR 44023).
4. Additional Production Activities
The proposed regulations define additional production activities in
Sec. 1.863-1(b)(3)(ii) as substantial production activities performed
by the taxpayer in addition to activities relating to the ownership or
operation of any farm, mine, oil or gas well, other natural deposit, or
timber. The proposed regulations provide that generally the principles
of Sec. 1.954-3(a)(4) apply in determining whether an activity
qualifies as such additional production. However, in no case will
activities that prepare the natural resource itself for export,
including those that are designed to facilitate transportation of the
natural resource to or from the export terminal, be considered
additional production. Thus, the proposed regulations in an example
indicate liquefaction of natural gas would not constitute additional
production activities.
Liquefaction is the process of liquefying natural gas so that it
can be transported by tanker for sales abroad. Several commentators
urged us to reconsider our position, arguing that liquefaction is an
expensive, complex activity. Treasury and the IRS, however, continue to
believe that liquefaction is an activity preparing the natural resource
itself for export within the meaning of Sec. 1.863-1(b)(3)(ii) of the
final regulations, and that it is appropriate to exclude such
activities from the definition of additional production. Even though
liquefaction may be an expensive, complex process, liquefied natural
gas retains its character as a natural resource, so that liquefaction
should be treated no differently than other processes that prepare
natural resources for export.
Several commentators requested that the regulations more precisely
define the processes that constitute production of natural resources,
to better differentiate those activities described in Sec. 1.863-
1(b)(1) of the proposed regulations, as being from the ownership or
operation of any farm, mine, oil or gas well, other natural deposit, or
timber, from those that qualify as additional production activities
within the meaning of Sec. 1.863- 1(b)(3)(ii) of the proposed
regulations. In particular, a commentator requested that the final
regulations specifically address this issue in the case of mining. In
response to this comment, the final regulations include an example
describing certain mining processes that would not qualify as
additional production activities in the case of copper.
5. Treatment of Partnerships
The proposed regulations provide that, in applying the rules in
Sec. 1.863-3 of the proposed regulations, a partner would be treated as
engaged in the production activity of its partnership. However, that
provision was not extended to Sec. 1.863-1 of the proposed regulations,
which generally provides rules for determining the source of income
from sales of natural resources. The final regulations provide rules
for transactions involving partners and partnerships, which apply in
the same manner to sales of natural resources and to sales of other
inventory. See II. 3. of this preamble for a discussion of those rules.
6. Genetically-Engineered Agricultural Products
One commentator requested that final regulations state that natural
resources do not include products, such as certain seeds, where the
premium value of the product is derived from genetic traits produced by
biotechnology or traditional methods, and the seeds themselves are not
grown for consumption. The inherent nature of products as agricultural
products, however, does not change because they may be subject to
research and development. Because they remain natural resources,
Treasury and the IRS rejected this comment.
II. Allocation and Apportionment of Income From Sales of Inventory
Other Than Natural Resources
Section 1.863-3 of the proposed regulations provides rules for
allocating and apportioning income from inventory sales other than
natural resources where the taxpayer produces property in the United
States and sells outside the United States, or produces property
outside the United States and sells in the United States (Section 863
Sales). The proposed regulations provide three methods: the 50/50
method, the independent factory price method, and the books and records
method.
1. Sales in International Waters or in Space
Consistent with the existing regulations, the proposed regulations
limit the methods in Sec. 1.863-3 to sales within a foreign country.
The preamble, however, requests comments on whether the regulation
should be expanded to cover sales made in international waters or in
space. Although the statute refers to sales outside the United States,
Treasury and the IRS expressed concern in that preamble that expanding
the scope of the regulations to include all such sales could lead to
abuses where, for example, a taxpayer produced goods in the United
States, passed title to those
[[Page 60543]]
goods outside the United States, and then sold the goods to U.S.
customers. In considering whether to expand the scope of the final
regulations to include such sales, Treasury and the IRS requested
comments on whether to include an exception to the title passage rule
for sales of goods produced in the United States and destined for the
U.S. market.
In response to comments and consistent with the preamble to the
proposed regulations, the final regulations expand the scope of the
existing and proposed regulations to include sales outside the United
States. Moreover, to prevent abuse from this expanded rule, the final
regulations provide that sales of goods wholly produced in the United
States and sold for use, consumption, or disposition in the United
States, will be considered to take place in the United States. Income
from such sales will be treated as from U.S. sources. The final
regulations rely on rules in Sec. 1.864-6(b)(3)(ii) (relating to the
determination of whether foreign source income is effectively connected
with a U.S. trade or business under section 864(c)(4)(iii)), for
determining the country of use, consumption, or disposition. Also,
property will be treated as wholly produced in the United States for
this purpose if it is subject to no more than packaging, repackaging,
labeling, or other minor assembly operations outside the United States.
See also Sec. 1.861-7(c) to determine the source of income in any case
in which the sales transaction is arranged in a particular manner for
the primary purpose of tax avoidance.
Treasury and the IRS are considering whether the rules of the final
regulations are appropriate where a product is produced in one country
but is destined for use either on the high seas or in space. Until
additional guidance is provided, taxpayers may rely upon the general
rules of the final regulations for these cases.
2. Segregation and Aggregation of Sales
Once a taxpayer selects a method under Sec. 1.863-3(b) for dividing
gross income derived from Section 863 Sales between production activity
and sales activity, Sec. 1.863-3(a) of the proposed regulations provide
that a taxpayer must separately apply that method to Section 863 Sales
in the United States and to Section 863 Sales outside the United
States. The proposed regulations also provide in Sec. 1.863-3(a) that
taxpayers must determine the source of gross income under paragraph (c)
and taxable income under paragraph (d) by aggregating all Section 863
Sales to which a method described in paragraph (b) applies.
The final regulations clarify that the rules of paragraphs (c) and
(d) apply separately to Section 863 Sales in the United States and to
Section 863 Sales outside the United States, so that taxpayers are
required to aggregate all Section 863 Sales under paragraphs (c) and
(d) after the taxpayer has first separately applied the method under
paragraph (b) to Section 863 Sales in the United States and to Section
863 Sales outside the United States.
3. Transactions With Partnerships
The proposed regulations provide in Sec. 1.863-3(a) that a
taxpayer's production activity includes production activities conducted
through a partnership of which the taxpayer is a partner either
directly or through one or more partnerships. One commentator
recommended that final regulations extend the partnership rules to
natural resources. However, the commentator suggested that an aggregate
approach to partnerships should apply only in cases where the
partnership, instead of selling the property and distributing the
proceeds to the partner, distributes the property to a partner. In
response to the comments, the final regulations modify the proposed
regulations. Under the final regulations, the aggregate approach
applies to a partnership's production or sales activity only for two
purposes. First, the aggregate approach applies for purposes of
determining the source of a partner's distributive share of partnership
income. Thus, if a partnership engages in the production of inventory
property in the United States and sells such property outside the
United States, a partner will be considered to have produced and sold
that inventory property in the same manner as the partnership when
determining the source of its distributive share of such sales income.
Second, the aggregate approach applies for purposes of sourcing income
from the sale of inventory property that is transferred in kind from or
to a partnership. Thus, for example, where the partnership makes an in
kind distribution of inventory property to its partners, the source of
the partner's income from the sale of such property is determined based
on both its own activity and on the partnership's activity. Similarly,
the aggregate approach applies in cases where a partner contributes
inventory produced by it to its partnership, if the partnership then
sells the inventory (e.g., as a distributor or after further
processing).
The entity approach applies for all other purposes. For example,
where a partnership manufactures inventory property and sells the
property to one of its partners, the source of that partner's income
from the resale of the property is determined without regard to the
partnership's manufacturing activity. Consistent with this
modification, the final regulations also specify that assets owned by a
partnership (or a partner) are not deemed owned by the partner (or the
partnership) unless the aggregate approach applies to the transaction
at issue.
4. Taxable Income Method
In response to comments, Sec. 1.863-2(b) of the proposed
regulations is clarified to provide that taxpayers may elect the
principles of Sec. 1.863-3 (b)(1) and (c) to determine the source of
taxable income (rather than gross income) from sales of inventory
property.
5. Independent Factory Price (IFP) Method
One commentator requested clarification that the sale establishing
an IFP must be sourced under the IFP method only if a taxpayer elects
the IFP method. The proposed and final regulations intend this result.
The IFP method applies to either the sale establishing the IFP or to a
sale applying the IFP only if the taxpayer elects the IFP method.
The proposed regulations eliminated the provision in existing
regulations permitting taxpayers to establish an IFP by methods other
than by sales to independent distributors. The preamble, however,
requested comments on the continued utility of such a provision. Two
commentators recommended that the provision be retained and expanded to
permit taxpayers to establish an IFP by any method that is appropriate
under section 482. The commentators stated that any evidence acceptable
for proving an arm's length price under section 482 should be
acceptable as an IFP. The commentators also stated that taxpayers who
cannot use the IFP method must use the 50/50 method, and that the 50/50
method may not produce an equitable result for nonresidents importing
goods into the United States.
After further consideration, Treasury and the IRS have decided to
finalize the regulations on this point as proposed. No convincing
evidence has been presented for the need of a broad-based rule
permitting taxpayers to establish an IFP by any method that would
otherwise be appropriate under section 482 when they can use books and
records to demonstrate a more appropriate sourcing result. In view of
[[Page 60544]]
the absence of a clearly identified benefit for taxpayers and the
availability of the books and records method, Treasury and the IRS
believe that expansion of the IFP rule is not justified.
6. Books and Records
Under both the existing and proposed regulations, taxpayers can
request permission from the District Director to use a taxpayer's books
and records to allocate or apportion income between U.S. and foreign
sources if this method more clearly reflects the taxpayer's income. The
preamble to the proposed regulations requests comments on retaining the
books and records method. Two commentators asked for retention of this
method because instances may arise where a taxpayer does not have third
party sales, thereby making the IFP method unavailable. In such cases,
a taxpayer may find it advantageous to determine the source of its
income on the basis of its books and records. These comments were
accepted. The final regulations retain the books and records method,
subject to an election and prior approval of the method by the District
Director.
7. Determination of Source of Gross Income From Production Activities
a. Definition of Production Assets
i. Contract manufacturing. Under the proposed regulations,
production assets are limited to those owned directly by the taxpayer
that are directly used by the taxpayer to produce the relevant
inventory. These rules are intended to insure that taxpayers do not
attribute the assets or activities of related or unrelated parties
manufacturing under contract with the taxpayer. One commentator asked
that the definition of production assets be expanded to include
production assets owned by related or unrelated contract manufacturers.
The commentator contends that by limiting production assets to those
owned by the taxpayer, the regulations source income differently
depending upon the form in which the taxpayer conducts business.
Treasury and the IRS, however, believe it is appropriate to limit
production assets in the apportionment formula to assets owned by the
taxpayer and used by the taxpayer to produce the inventory. In
addition, taxpayers generally do not know the contract manufacturer's
basis in its production assets. Further, it would be very difficult to
draw a clear line between contract manufacturers and other suppliers.
Thus, Treasury and the IRS do not believe the source of a taxpayer's
income should take into account activities of others or assets owned by
others with whom the taxpayer has manufacturing arrangements. The final
regulations clarify, however, that this rule does not override the
single entity rules set forth under Sec. 1.1502-13 (dealing with
members of an affiliated group filing on a consolidated basis), or the
rules under Sec. 1.863-3(g) dealing with partnerships.
ii. Accounts receivable. One commentator also asserted that
accounts receivable should be included as a production asset. This
comment was rejected. The production formula is intended to approximate
the location of the taxpayer's production activity. Thus, assets not
directly involved in production should not be included.
b. Anti-Abuse Rule
The preamble to the proposed regulations indicated that the purpose
of the property fraction is to attribute the source of production
income to the location of production activity. Treasury and the IRS,
however, were concerned that taxpayers would attempt to artificially
affect the location of assets to manipulate the rules, and so solicited
comments on whether an anti-abuse rule was needed. No comments were
received that objected to such anti-abuse rule. After further
considering the issue, Treasury and the IRS have included an anti-abuse
rule in the final regulations to prevent taxpayers from manipulating
the property formula to achieve inappropriate results. Therefore, the
anti-abuse rule provides that if a taxpayer has entered into or
structured one or more transactions with a principal purpose of
reducing its U.S. tax liability by affecting the formula in a manner
inconsistent with the purpose of the regulation, the District Director
may make appropriate adjustments so that the source of the taxpayer's
income from production activity more clearly reflects the source of
that income. An example in the regulations demonstrates circumstances
where the anti-abuse rule may apply. In that example, with a principal
purpose of reducing its U.S. tax liability, the taxpayer leases all of
its U.S. property so that it owns only property located in a foreign
country. The example concludes that the District Director may ignore a
sale-leaseback transaction to more clearly reflect the source of the
taxpayer's production income.
8. Determination of Taxable Income
One commentator requested that the calculation of taxable income,
when applying the 50/50 method along with the research and experimental
(R&E) expense allocation rules in Sec. 1.861-17, be clarified. The
commentator suggests that the last sentence of Sec. 1.863-3(d) of the
proposed regulations can be read to conflict with the R&E set aside in
Sec. 1.861-17. The final regulations clarify that the R&E set aside
remains available to taxpayers using the 50/50 method.
9. Reporting Requirements
The proposed regulations, in Sec. 1.863-3(e), require a taxpayer to
fully explain the methodology used to determine the source of income,
the circumstances justifying use of that method, the extent that sales
are aggregated, and the amount of income so allocated. One commentator
wrote that the reporting requirements in Sec. 1.863-3(e) of the
proposed regulations are unnecessary and excessively burdensome. The
regulations clarify that the requirement is limited to a statement
attached to the tax return, explaining the methodology used, the
circumstances justifying that use, the aggregation of sales, and the
amount of income allocated. Treasury and the IRS believe the reporting
requirements in Sec. 1.863-3(e) of the proposed regulations are
reasonable, and serve legitimate administrative purposes.
Special Analyses
It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required. It is hereby 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, the
notice of proposed rulemaking preceding these regulations was submitted
to the Small Business Administration for comment on its impact on small
business.
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.
[[Page 60545]]
List of Subjects
26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 602
Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR parts 1 and 602 are amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended by adding
entries in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.863-2 also issued under 26 U.S.C. 863.
Section 1.863-3 also issued under 26 U.S.C. 863.
Section 1.863-4 also issued under 26 U.S.C. 863.
Section 1.863-6 also issued under 26 U.S.C. 863. * * *
Par. 2. Sections 1.863-3 and 1.863-3T are redesignated as
Secs. 1.863-3A and 1.863-3AT, respectively, and an undesignated center
heading is added preceding the redesignated sections to read as
follows:
Regulations Applicable to Taxable Years Prior to December 30, 1996
Par. 3. Section 1.863-0 is added to read as follows:
Sec. 1.863-0 Table of contents.
This section lists captions contained in Secs. 1.863-1, 1.863-2,
and 1.863-3.
Sec. 1.863-1 Allocation of gross income.
(a) In general.
(b) Natural resources.
(1) In general.
(2) Additional production prior to export terminal.
(3) Definitions.
(i) Production activity.
(ii) Additional production activities.
(iii) Export terminal.
(4) Determination of fair market value.
(5) Determination of gross income.
(6) Tax return disclosure.
(7) Examples.
(c) Determination of taxable income.
(e) Effective dates.
Sec. 1.863-2 Allocation and apportionment of taxable income.
(a) Determination of taxable income.
(b) Determination of source of taxable income.
(c) Effective dates.
Sec. 1.863-3 Allocation and apportionment of income from certain sales
of inventory.
(a) In general.
(1) Scope.
(2) Special rules.
(b) Methods to determine income attributable to production
activity and sales activity.
(1) 50/50 method.
(i) Determination of gross income.
(ii) Example.
(2) IFP method.
(i) Establishing an IFP.
(ii) Applying the IFP method.
(iii) Determination of gross income.
(iv) Examples.
(3) Books and records method.
(c) Determination of the source of gross income from production
activity and sales activity.
(1) Income attributable to production activity.
(i) Production only within the United States or only within
foreign countries.
(A) Source of income.
(B) Definition of production assets.
(C) Location of production assets.
(ii) Production both within the United States and within foreign
countries.
(A) Source of income.
(B) Adjusted basis of production assets.
(iii) Anti-abuse rule.
(iv) Examples.
(2) Income attributable to sales activity.
(d) Determination of source of taxable income.
(e) Election and reporting rules.
(1) Elections under paragraph (b) of this section.
(2) Disclosure on tax return.
(f) Income partly from sources within a possession of the United
States.
(g) Special rules for partnerships.
(h) Effective dates.
Par. 4. In Sec. 1.863-1, paragraphs (a), (b) and (c) are revised
and paragraph (e) is added to read as follows:
Sec. 1.863-1 Allocation of gross income.
(a) In general. Items of gross income other than those specified in
section 861(a) and section 862(a) will generally be separately
allocated to sources within or without the United States. See
Sec. 1.863-2 for alternate methods to determine the income from sources
within or without the United States in the case of items specified in
Sec. 1.863-2(a). See also sections 865(b) and (e)(2). In the case of
sales of property involving partners and partnerships, the rules of
Sec. 1.863-3(g) apply.
(b) Natural resources--(1) In general. Notwithstanding any other
provision, except to the extent provided in paragraph (b)(2) of this
section, gross receipts from the sale outside the United States of
products derived from the ownership or operation of any farm, mine, oil
or gas well, other natural deposit, or timber within the United States,
must be allocated between sources within and without the United States
based on the fair market value of the product at the export terminal
(as defined in paragraph (b)(3)(iii) of this section). Notwithstanding
any other provision, except to the extent provided in paragraph (b)(2)
of this section, gross receipts from the sale within the United States
of products derived from the ownership or operation of any farm, mine,
oil or gas well, other natural deposit, or timber outside the United
States must be allocated between sources within and without the United
States based on the fair market value of the product at the export
terminal. For place of sale, see Secs. 1.861-7(c) and 1.863-3(c)(2).
The source of gross receipts equal to the fair market value of the
product at the export terminal will be from sources where the farm,
mine, well, deposit, or uncut timber is located. The source of gross
receipts from the sale of the product in excess of its fair market
value at the export terminal (excess gross receipts) will be determined
as follows--
(i) If the taxpayer engages in additional production activities
subsequent to shipment from the export terminal and outside the country
of sale, the source of excess gross receipts must be determined under
Sec. 1.863-3. For purposes of applying Sec. 1.863-3, only production
assets used in additional production activity subsequent to the export
terminal are taken into account.
(ii) In all other cases, excess gross receipts will be from sources
within the country of sale. This paragraph (b)(1)(ii) applies to a
taxpayer that engages in additional production activities in the
country of sale, as well as to a taxpayer that does not engage in
additional production activities at all.
(2) Additional production prior to export terminal. Notwithstanding
any other provision of this section, gross receipts from the sale of
products derived by a taxpayer who performs additional production
activities as defined in paragraph (b)(3)(ii) of this section before
the relevant product is shipped from the export terminal are allocated
between sources within and without the United States based on the fair
market value of the product immediately prior to the additional
production activities. The source of gross receipts equal to the fair
market value of the product immediately prior to the additional
production activities will be from sources where the farm, mine, well,
deposit, or uncut timber is located. The source of gross receipts from
the sale of the product in excess of the fair market value immediately
prior to the additional production activities must be determined under
Sec. 1.863-3. For purposes of applying Sec. 1.863-3, only production
assets used in the additional production activities are taken into
account.
[[Page 60546]]
(3) Definitions--(i) Production activity. For purposes of this
section, production activity means an activity that creates,
fabricates, manufactures, extracts, processes, cures, or ages
inventory. See Sec. 1.864-1. Except as otherwise provided in
Secs. 1.1502-13 or 1.863-3(g)(2), only production activities conducted
directly by the taxpayer are taken into account.
(ii) Additional production activities. For purposes of this
section, additional production activities are substantial production
activities performed directly by the taxpayer in addition to activities
from the ownership or operation of any farm, mine, oil or gas well,
other natural deposit, or timber. Whether a taxpayer's activities
constitute additional production activities will be determined under
the principles of Sec. 1.954-3(a)(4). However, in no case will
activities that prepare the natural resource itself for export,
including those that are designed to facilitate the transportation of
the natural resource to or from the export terminal, be considered
additional production activities for purposes of this section.
(iii) Export terminal. Where the farm, mine, well, deposit, or
uncut timber is located without the United States, the export terminal
will be the final point in a foreign country from which goods are
shipped to the United States. If there is no such final point in a
foreign country (e.g., the property is extracted and produced on the
high seas), the export terminal will be the place of production. Where
the farm, mine, well, deposit, or uncut timber is located within the
United States, the export terminal will be the final point in the
United States from which goods are shipped from the United States to a
foreign country. The location of the export terminal is determined
without regard to any contractual terms agreed to by the taxpayer and
without regard to whether there is an actual sale of the products at
the export terminal.
(4) Determination of fair market value. For purposes of this
section, fair market value depends on all of the facts and
circumstances as they exist relative to a party in any particular case.
Where the products are sold to a related party in a transaction subject
to section 482, the determination of fair market value under this
section must be consistent with the arm's length price determined under
section 482.
(5) Determination of gross income. To determine the amount of a
taxpayer's gross income from sources within or without the United
States, the taxpayer's gross receipts from sources within or without
the United States determined under this paragraph (b) must be reduced
by the cost of goods sold properly attributable to gross receipts from
sources within or without the United States.
(6) Tax return disclosure. A taxpayer that determines the source of
its income under this paragraph (b) shall attach a statement to its
return explaining the methodology used to determine fair market value
under paragraph (b)(4) of this section, and explaining any additional
production activities (as defined in paragraph (b)(3)(ii) of this
section) performed by the taxpayer. In addition, the taxpayer must
provide such other information as is required by Sec. 1.863-3.
(7) Examples. The following examples illustrate the rules of this
paragraph (b):
Example 1. No additional production. U.S. Mines, a U.S.
corporation, operates a copper mine and mill in country X. U.S.
Mines extracts copper-bearing rocks from the ground and transports
the rocks to the mill where the rocks are ground and processed to
produce copper-bearing concentrate. The concentrate is transported
to a port where it is dried in preparation for export, stored and
then shipped to purchasers in the United States. Because title to
the property is passed in the United States and, under the facts and
circumstances, none of U.S. Mine's activities constitutes additional
production prior to the export terminal within the meaning of
paragraph (b)(3)(ii) of this section, under paragraph (b)(1) and
(b)(1)(ii) of this section, gross receipts equal to the fair market
value of the concentrate at the export terminal will be from sources
without the United States, and excess gross receipts will be from
sources within the United States.
Example 2. No additional production. US Gas, a U.S. corporation,
extracts natural gas within the United States, and transports the
natural gas to a U.S. port where it is liquified in preparation for
shipment. The liquified natural gas is then transported via
freighter and sold without additional production activities in a
foreign country. Liquefaction of natural gas is not an additional
production activity because liquefaction prepares the natural gas
for transportation from the export terminal. Therefore, under
paragraph (b)(1) and (b)(1)(ii) of this section, gross receipts
equal to the fair market value of the liquefied natural gas at the
export terminal will be from sources within the United States, and
excess gross receipts will be from sources without the United
States.
Example 3. Sale in third country. US Gold, a U.S. corporation,
mines gold in country X, produces gold jewelry in the United States,
and sells the jewelry in country Y. Assume that the fair market
value of the gold at the export terminal in country X is $40, and
that US Gold ultimately sells the gold jewelry in country Y for
$100. Under Sec. 1.863-1(b), $40 of US Gold's gross receipts will be
allocated to sources without the United States. Under paragraph
(b)(1)(i) of this section, the source of the remaining $60 of gross
receipts will be determined under Sec. 1.863-3. If US Gold applies
the 50/50 method described in Sec. 1.863-3, $20 of cost of goods
sold is properly attributable to activities subsequent to the export
terminal, and all of US Gold's production assets subsequent to the
export terminal are located in the United States, then $20 of gross
income will be allocated to sources within the United States and $20
of gross income will be allocated to sources without the United
States.
Example 4. Production in country of sale. US Oil, a U.S.
corporation, extracts oil in country X, transports the oil via
pipeline to the export terminal in country Y, refines the oil in the
United States, and sells the refined product in the United States to
unrelated persons. Assume that the fair market value of the oil at
the export terminal in country Y is $80, and that US Oil ultimately
sells the refined product for $100. Under paragraph (b)(1) of this
section, $80 of US Oil's gross receipts will be allocated to sources
without the United States, and under paragraph (b)(1)(ii) of this
section the remaining $20 of gross receipts will be allocated to
sources within the United States.
Example 5. Additional production prior to export. The facts are
the same as in Example 1, except that U.S. Mines also operates a
smelter in country X. The concentrate output from the mill is
transported to the smelter where it is transformed into smelted
copper. The smelted copper is exported to purchasers in the United
States. Under the facts and circumstances, all of the processes
applied to make copper concentrate are considered mining. Therefore,
under paragraph (b)(2) of this section, gross receipts equal to the
fair market value of the concentrate at the smelter will be from
sources without the United States. Under the facts and
circumstances, the conversion of the concentrate into smelted copper
is an additional production activity in a foreign country within the
meaning of paragraph (b)(3)(ii) of this section. Therefore, the
source of U.S. Mine's excess gross receipts will be determined
pursuant to paragraph (b)(2) of this section.
(c) Determination of taxable income. The taxpayer's taxable income
from sources within or without the United States will be determined
under the rules of Secs. 1.861-8 through 1.861-14T for determining
taxable income from sources within the United States.
* * * * *
(e) Effective dates. The rules of paragraphs (a), (b) and (c) of
this section will apply to taxable years beginning December 30, 1996.
However, taxpayers may apply the rules of this section for taxable
years beginning after July 11, 1995, and before December 30, 1996. For
years beginning before December 30, 1996, see Sec. 1.863-1 (as
contained in 26 CFR part 1 revised as of April 1, 1996).
Par. 5. Section 1.863-2 is revised to read as follows:
Sec. 1.863-2 Allocation and apportionment of taxable income.
(a) Determination of taxable income. Section 863(b) provides an
alternate method for determining taxable income from sources within the
United States in
[[Page 60547]]
the case of gross income derived from sources partly within and partly
without the United States. Under this method, taxable income is
determined by deducting from such gross income the expenses, losses, or
other deductions properly apportioned or allocated thereto and a
ratable part of any other expenses, losses, or deductions that cannot
definitely be allocated to some item or class of gross income. The
income to which this section applies (and that is treated as derived
partly from sources within and partly from sources without the United
States) will consist of gains, profits, and income
(1) From certain transportation or other services rendered partly
within and partly without the United States to the extent not within
the scope of section 863(c) or other specific provisions of this title;
(2) From the sale of inventory property (within the meaning of
section 865(i)) produced (in whole or in part) by the taxpayer in the
United States and sold outside the United States or produced (in whole
or in part) by the taxpayer outside the United States and sold in the
United States; or
(3) Derived from the purchase of personal property within a
possession of the United States and its sale within the United States,
to the extent not excluded from the scope of these regulations under
Sec. 1.936-6(a)(5),
Q&A 7.
(b) Determination of source of taxable income. Income treated as
derived from sources partly within and partly without the United States
under paragraph (a) of this section may be allocated to sources within
and without the United States pursuant to Sec. 1.863-1 or apportioned
to such sources in accordance with the methods described in other
regulations under section 863. To determine the source of certain types
of income described in paragraph (a)(1) of this section, see
Sec. 1.863-4. To determine the source of gross income described in
paragraph (a)(2) of this section, see Sec. 1.863-1 for natural
resources and see Sec. 1.863-3 for other inventory. Taxpayers, at their
election, may apply the principles of Sec. 1.863-3 (b)(1) and (c) to
determine the source of taxable income (rather than gross income) from
sales of inventory property (other than natural resources). To
determine the source of income partly from sources within a possession
of the United States, including income described in paragraph (a)(3) of
this section, see Sec. 1.863-3(f).
(c) Effective dates. This section will apply to taxable years
beginning December 30, 1996. However, taxpayers may apply the rules of
this section for taxable years beginning after July 11, 1995, and
before December 30, 1996. For years beginning before December 30, 1996,
see Sec. 1.863-2 (as contained in 26 CFR part 1 revised as of April 1,
1996).
Par. 6. Section 1.863-3 is added to read as follows:
Sec. 1.863-3 Allocation and apportionment of income from certain sales
of inventory.
(a) In general--(1) Scope. Paragraphs (a) through (e) of this
section apply to determine the source of income derived from the sale
of inventory property (inventory), which a taxpayer produces (in whole
or in part) within the United States and sells outside the United
States, or which a taxpayer produces (in whole or in part) outside the
United States and sells within the United States (Section 863 Sales). A
taxpayer must divide gross income from Section 863 Sales between
production activity and sales activity using one of the methods
described in paragraph (b) of this section. The source of gross income
from production activity and from sales activity must then be
determined under paragraph (c) of this section. Taxable income from
Section 863 Sales is determined under paragraph (d) of this section.
Paragraph (e) of this section describes the rules for electing the
methods described in paragraph (b) of this section and the information
that a taxpayer must disclose on a tax return. Paragraph (f) of this
section applies to determine the source of certain income derived from
a possession of the United States. Paragraph (g) of this section
provides special rules for partnerships for all sales subject to
Secs. 1.863-1 through 1.863-3. Paragraph (h) of this section provides
effective dates for the rules in this section.
(2) Rules of application for Section 863 Sales. Once a taxpayer has
elected a method described in paragraph (b) of this section, the
taxpayer must separately apply that method to Section 863 Sales in the
United States and to Section 863 Sales outside the United States. In
addition, the taxpayer must apply the rules of paragraphs (c) and (d)
of this section by aggregating all Section 863 Sales to which a method
described in paragraph (b) of this section applies, after separately
applying that method to Section 863 Sales in the United States and to
Section 863 Sales outside the United States. See section 865(i)(1) for
the definition of inventory property. See also section 865(e)(2). See
Sec. 1.861-7(c) and paragraph (c)(2) of this section for the time and
place of sale.
(b) Methods to determine income attributable to production activity
and sales activity--(1) 50/50 method--(i) Determination of gross
income. Generally, gross income from Section 863 Sales will be
apportioned between production activity and sales activity under the
50/50 method as described in this paragraph (b)(1). Under the 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 (c)(1) of this
section. The remaining one-half of such gross income will be considered
income attributable to sales activity and the source of that income
will be determined under the rules of paragraph (c)(2) of this section.
In lieu of the 50/50 method, the taxpayer may elect to determine the
source of income from Section 863 Sales under the IFP method described
in paragraph (b)(2) of this section or, with the consent of the
District Director, the books and records method described in paragraph
(b)(3) of this section.
(ii) Example. The following example illustrates the rules of this
paragraph (b)(1):
Example. 50/50 method. (i) P, a U.S. corporation, produces
widgets in the United States. P sells the widgets for $100 to D, an
unrelated foreign distributor, in another country. P's cost of goods
sold is $40. Thus, P's gross income is $60.
(ii) Pursuant to the 50/50 method, one-half of P's gross income,
or $30, is considered income attributable to production activity,
and one-half of P's gross income, or $30, is considered income
attributable to sales activity.
(2) IFP method--(i) Establishing an IFP. A taxpayer may elect to
allocate gross income earned from production activity and sales
activity using the independent factory price (IFP) method described in
this paragraph (b)(2) if an IFP is fairly established. An IFP is fairly
established based on a sale by the taxpayer only if the taxpayer
regularly sells part of its output to wholly independent distributors
or other selling concerns in such a way as to reasonably reflect the
income earned from production activity. A sale will not be considered
to fairly establish an IFP if sales activity by the taxpayer with
respect to that sale is significant in relation to all of the
activities with respect to that product.
(ii) Applying the IFP method. If the taxpayer elects to use the IFP
method, the amount of the gross sales price equal to the IFP will be
treated as attributable to production activity, and the excess of the
gross sales price over the IFP will be treated as attributable to sales
activity. If a taxpayer elects to use the IFP method, the IFP must be
applied to all Section 863 Sales of inventory that are
[[Page 60548]]
substantially similar in physical characteristics and function, and are
sold at a similar level of distribution as the inventory sold in the
sale fairly establishing an IFP. The IFP will only be applied to sales
that are reasonably contemporaneous with the sale fairly establishing
the IFP. An IFP cannot be applied to sales in other geographic markets
if the markets are substantially different. If the taxpayer elects the
IFP method, the rules of this paragraph will also apply to determine
the division of gross receipts between production activity and sales
activity in a Section 863 Sale that itself fairly establishes an IFP.
If the taxpayer elects to apply the IFP method, the IFP method must be
applied to all sales for which an IFP may be fairly established and
applied for that taxable year and each subsequent taxable year. The
taxpayer will apply either the 50/50 method described in paragraph
(b)(1) of this section or the books and records method described in
paragraph (b)(3) of this section to any other Section 863 Sale for
which an IFP cannot be established or applied for each taxable year.
(iii) Determination of gross income. The amount of a taxpayer's
gross income from production activity is determined by reducing the
amount of gross receipts from production activity by the cost of goods
sold properly attributable to production activity. The amount of a
taxpayer's gross income from sales activity is determined by reducing
the amount of gross receipts from sales activity by the cost of goods
sold (if any) properly attributable to sales activity. The source of
gross income from production activity is determined under the rules of
paragraph (c)(1) of this section, and the source of gross income from
sales activity will be determined under the rules of paragraph (c)(2)
of this section.
(iv) Examples. The following examples illustrate the rules of this
paragraph (b)(2):
Example 1. IFP method. (i) P, a U.S. producer, purchases cotton
and produces cloth in the United States. P sells cloth in country X
to D, an unrelated foreign clothing manufacturer, for $100. Cost of
goods sold for cloth is $80, entirely attributable to production
activity. P does not engage in significant sales activity in
relation to its other activities in the sales to D. Under these
facts, the sale to D fairly establishes an IFP of $100. Assume that
P elects to use the IFP method. Accordingly, $100 of the gross sales
price is treated as attributable to production activity, and no
amount of income from this sale is attributable to sales activity.
After reducing the gross sales price by cost of goods sold, $20 of
the gross income is treated as attributable to production activity
($100-$80).
(ii) P also sells cloth in country X to A, an unrelated foreign
retail outlet, for $110. Because P elected the IFP method and the
cloth is substantially similar to the cloth sold to D, the IFP
fairly established in the sales to D must be used to determine the
amount attributable to production activity in the sale to A.
Accordingly, $100 of the gross sales price is treated as
attributable to production activity and $10 ($110-$100) is
attributable to sales activity. After reducing the gross sales price
by cost of goods sold, $20 of the gross income is treated as
attributable to production activity ($100-$80) and $10 is
attributable to sales activity.
Example 2. Scope of IFP Method. (i) USCo manufactures three
dissimilar products. USCo elects to apply the IFP method. In year 1,
an IFP can be established for sales of product X, but not for
products Y and Z. In year 2, an IFP cannot be established for any of
USCo's products. In year 3, an IFP can be established for products X
and Y, but not for product Z.
(ii) In year 1, USCo must apply the IFP method to sales of
product X. In year 2, although USCo's IFP election remains in
effect, USCo is not required to apply the IFP election to any
products. In year 3, USCo is required to apply the IFP method to
sales of products X and Y.
(3) Books and records method. A taxpayer may elect to determine the
amount of its gross income from Section 863 Sales that is attributable
to production and sales activities for the taxable year based upon its
books of account if it has received in advance the permission of the
District Director having audit responsibility over its tax return. The
taxpayer must establish to the satisfaction of the District Director
that the taxpayer, in good faith and unaffected by considerations of
tax liability, will regularly employ in its books of account a detailed
allocation of receipts and expenditures which clearly reflects the
amount of the taxpayer's income from production and sales activities.
If a taxpayer receives permission to apply the books and records
method, but does not comply with a material condition set forth by the
District Director, the District Director may, in its discretion, revoke
permission to use the books and records method. The source of gross
income treated as attributable to production activity under this method
may be determined under the rules of paragraph (c)(1) of this section,
and the source of gross income attributable to sales activity will be
determined under the rules of paragraph (c)(2) of this section.
(c) Determination of the source of gross income from production
activity and sales activity--(1) Income attributable to production
activity--(i) Production only within the United States or only within
foreign countries--(A) Source of income. For purposes of this section,
production activity means an activity that creates, fabricates,
manufactures, extracts, processes, cures, or ages inventory. See
Sec. 1.864-1. Subject to the provisions in Sec. 1.1502-13 or paragraph
(g)(2)(ii) of this section, the only production activities that are
taken into account for purposes of Secs. 1.863-1, 1.863-2, and this
section are those conducted directly by the taxpayer. Where the
taxpayer's production assets are located only within the United States
or only outside the United States, the income attributable to
production activity is sourced where the taxpayer's production assets
are located. For rules regarding the source of income when production
assets are located both within the United States and without the United
States, see paragraph (c)(1)(ii) of this section.
(B) Definition of production assets. Subject to the provisions of
Sec. 1.1502-13 and paragraph (g)(2)(ii) of this section, production
assets include only tangible and intangible assets owned directly by
the taxpayer that are directly used by the taxpayer to produce
inventory described in paragraph (a) of this section. Production assets
do not include assets that are not directly used to produce inventory
described in paragraph (a) of this section. Thus, production assets do
not include such assets as accounts receivables, intangibles not
related to production of inventory (e.g., marketing intangibles,
including trademarks and customer lists), transportation assets,
warehouses, the inventory itself, raw materials, or work-in-process. In
addition, production assets do not include cash or other liquid assets
(including working capital), investment assets, prepaid expenses, or
stock of a subsidiary.
(C) Location of production assets. For purposes of this section, a
tangible production asset will be considered located where the asset is
physically located. An intangible production asset will be considered
located where the tangible production assets owned by the taxpayer to
which it relates are located. (ii) Production both within the United
States and within foreign countries--(A) Source of income. Where the
taxpayer's production assets are located both within and without the
United States, income from sources without the United States will be
determined by multiplying the income attributable to the taxpayer's
production activity by a fraction, the numerator of which is the
average adjusted basis of production assets that are located outside
the United States and the denominator of which is the average adjusted
basis of all production assets within and without the United States.
The
[[Page 60549]]
remaining income is treated as from sources within the United States.
(B) Adjusted basis of production assets. For purposes of paragraph
(c)(1)(ii)(A) of this section, the adjusted basis of an asset is
determined under section 1011. The average adjusted basis is computed
by averaging the adjusted basis of the asset at the beginning and end
of the taxable year, unless by reason of material changes during the
taxable year such average does not fairly represent the average for
such year. In this event, the average adjusted basis will be determined
upon a more appropriate basis. If production assets are used to produce
inventory sold in Section 863 Sales and are also used to produce other
property during the taxable year, the portion of its adjusted basis
that is included in the fraction described in paragraph (c)(1)(ii)(A)
of this section will be determined under any method that reasonably
reflects the portion of the assets that produces inventory sold in
Section 863 Sales. For example, the portion of such an asset that is
included in the formula may be determined by multiplying the asset's
average adjusted basis by a fraction, the numerator of which is the
gross receipts from sales of inventory from Section 863 Sales produced
by the asset, and the denominator of which is the gross receipts from
all property produced by that asset.
(iii) Anti-abuse rule. The purpose of this paragraph (c)(1) is to
attribute the source of the taxpayer's production income to the
location of the taxpayer's production activity. Therefore, if the
taxpayer has entered into or structured one or more transactions with a
principal purpose of reducing its U.S. tax liability by manipulating
the formula described in paragraph (c)(1)(ii)(A) of this section in a
manner inconsistent with the purpose of this paragraph (c)(1), the
District Director may make appropriate adjustments so that the source
of the taxpayer's income from production activity more clearly reflects
the source of that income.
(iv) Examples. The following examples illustrate the rules of this
paragraph (c)(1):
Example 1. Source of production income. (i) A, a U.S.
corporation, produces widgets that are sold both within the United
States and within a foreign country. The initial manufacture of all
widgets occurs in the United States. The second stage of production
of widgets that are sold within a foreign country is completed
within the country of sale. A's U.S. plant and machinery which is
involved in the initial manufacture of the widgets has an average
adjusted basis of $200. A also owns warehouses used to store work-
in-process. A owns foreign equipment with an average adjusted basis
of $25. A's gross receipts from all sales of widgets is $100, and
its gross receipts from export sales of widgets is $25. Assume that
apportioning average adjusted basis using gross receipts is
reasonable. Assume A's cost of goods sold from the sale of widgets
in the foreign countries is $13 and thus, its gross income from
widgets sold in foreign countries is $12. A uses the 50/50 method to
divide its gross income between production activity and sales
activity.
(ii) A determines its production gross income from sources
without the United States by multiplying one-half of A's $12 of
gross income from sales of widgets in foreign countries, or $6, by a
fraction, the numerator of which is all relevant foreign production
assets, or $25, and the denominator of which is all relevant
production assets, or $75 ($25 foreign assets + ($200 U.S. assets
x $25 gross receipts from export sales/$100 gross receipts from all
sales)). Therefore, A's gross production income from sources without
the United States is $2 ($6 x ($25/$75)).
Example 2. Location of intangible property. Assume the same
facts as Example 1, except that A employs a patented process that
applies only to the initial production of widgets. In computing the
formula used to determine the source of income from production
activity, A's patent, if it has an average adjusted basis, would be
located in the United States.
Example 3. Anti-abuse rule. (i) Assume the same facts as Example
1. A sells its U.S. assets to B, an unrelated U.S. corporation, with
a principal purpose of reducing its U.S. tax liability by
manipulating the property fraction. A then leases these assets from
B. After this transaction, under the general rule of paragraph
(c)(1)(ii) of this section, all of A's production income would be
considered from sources without the United States, because all of
A's relevant production assets are located within a foreign country.
Since the leased property is not owned by the taxpayer, it is not
included in the fraction.
(ii) Because A has entered into a transaction with a principal
purpose of reducing its U.S. tax liability by manipulating the
formula described in paragraph (c)(1)(ii)(A) of this section, A's
income must be adjusted to more clearly reflect the source of that
income. In this case, the District Director may redetermine the
source of A's production income by ignoring the sale-leaseback
transactions.
(2) Income attributable to sales activity. The source of the
taxpayer's income that is attributable to sales activity will be
determined under the provisions of Sec. 1.861-7(c). However,
notwithstanding any other provision, for purposes of section 863, the
place of sale will be presumed to be the United States if personal
property is wholly produced in the United States and the property is
sold for use, consumption, or disposition in the United States. See
Sec. 1.864-6(b)(3)(ii) to determine the country of use, consumption, or
disposition. Also, in applying this paragraph, property will be treated
as wholly produced in the United States if it is subject to no more
than packaging, repackaging, labeling, or other minor assembly
operations outside the United States, within the meaning of Sec. 1.954-
3(a)(4)(iii) (property manufactured or produced by a controlled foreign
corporation).
(d) Determination of source of taxable income. Once the source of
gross income has been determined under paragraph (c) 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 Sales determined separately under each method described in
paragraph (b) 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 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 Sales determined under the IFP method or the books and records
method, the rules of Secs. 1.861-8 through 1.861-14T must apply to
properly allocate or apportion amounts of expenses, 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 Section 863 Sales determined under the 50/50
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 the 50/50 method. Research and
experimental expenditures qualifying under Sec. 1.861-17 are allocated
under that section, and are not allocated and apportioned pro rata
under the 50/50 method.
(e) Election and reporting rules--(1) Elections under paragraph (b)
of this section. If a taxpayer does not elect a method specified in
paragraph (b) (2) or (3) of this section, the taxpayer must apply the
method specified in paragraph (b)(1) of this section. The taxpayer may
elect to apply the method specified in paragraph (b)(2) of this section
by using the method on a timely filed original return (including
extensions). A taxpayer may elect to apply the method specified in
paragraph (b)(3) of this
[[Page 60550]]
section by using the method on a timely filed original return
(including extensions), but only if the taxpayer has received
permission from the District Director to apply that method. Once a
method under paragraph (b) of this section has been used, that method
must be used in later taxable years unless the Commissioner consents to
a change. However, if a taxpayer elects to change to or from the method
specified in paragraph (b)(3) of this section, the taxpayer must obtain
permission from the District Director instead of the Commissioner.
Permission to change methods from one year to another year will not be
withheld unless the change would result in a substantial distortion of
the source of the taxpayer's income.
(2) Disclosure on tax return. A taxpayer who uses one of the
methods described in paragraph (b) of this section must fully explain
in a statement attached to the return the methodology used, the
circumstances justifying use of that methodology, the extent that sales
are aggregated, and the amount of income so allocated.
(f) Income partly from sources within a possession of the United
States. Taxpayers with income partly from sources within a possession
of the United States must apply the rules of Sec. 1.863-3A(c).
(g) Special rules for partnerships--(1) General rule. For purposes
of Sec. 1.863-1 and this section, a taxpayer's production or sales
activity does not include production and sales activities conducted by
a partnership of which the taxpayer is a partner either directly or
through one or more partnerships, except as otherwise provided in
paragraph (g)(2) of this section.
(2) Exceptions--(i) In general. For purposes of determining the
source of the partner's distributive share of partnership income or
determining the source of the partner's income from the sale of
inventory property which the partnership distributes to the partner in
kind, the partner's production or sales activity includes an activity
conducted by the partnership. In addition, the production activity of a
partnership includes the production activity of a taxpayer that is a
partner either directly or through one or more partnerships, to the
extent that the partner's production activity is related to inventory
that the partner contributes to the partnership in a transaction
described under section 721.
(ii) Attribution of production assets to or from a partnership. A
partner will be treated as owning its proportionate share of the
partnership's production assets only to the extent that, under
paragraph (g)(2)(i) of this section, the partner's activity includes
production activity conducted through a partnership. A partner's share
of partnership assets will be determined by reference to the partner's
distributive share of partnership income for the year attributable to
such production assets. Similarly, to the extent a partnership's
activities include the production activities of a partner, the
partnership will be treated as owning the partner's production assets
related to the inventory that is contributed in kind to the
partnership. See paragraph (c)(1)(ii)(B) of this section for rules
apportioning the basis of assets to Section 863 Sales.
(iii) Basis. For purposes of this section, in those cases where the
partner is treated as owning its proportionate share of the
partnership's production assets, the partner's basis in production
assets held through a partnership shall be determined by reference to
the partnership's adjusted basis in its assets (including a partner's
special basis adjustment, if any, under section 743). Similarly, a
partnership's basis in a partner's production assets is determined with
reference to the partner's adjusted basis in its assets.
(iv) Separate application of methods. If, under paragraph (g)(2) of
this section, a partner is treated as conducting the activity of a
partnership, and is treated as owning its proportionate share of a
partnership's production assets, a partner must apply the method it has
elected under paragraph (b) of this section separately to Section 863
Sales described in this paragraph (g) and all other Section 863 Sales.
(3) Examples. The following examples illustrate the rules of this
paragraph (g):
Example 1. Distributive share of partnership income. A, a U.S.
corporation, forms a partnership in the United States with B, a
country X corporation. A and B each have a 50 percent interest in
the income, gains, losses, deductions and credits of the
partnership. The partnership is engaged in the manufacture and sale
of widgets. The widgets are manufactured in the partnership's plant
located in the United States and are sold by the partnership outside
the United States. The partnership owns the manufacturing facility
and all other production assets used to produce the widgets. A's
distributive share of partnership income includes 50 percent of the
sales income from these sales. In applying the rules of section 863
to determine the source of its distributive share of partnership
income from the export sales of widgets, A is treated as carrying on
the activity of the partnership related to production of these
widgets and as owning a proportionate share of the partnership's
assets related to production of the widgets, based upon its
distributive share of partnership income.
Example 2. Distribution in kind. Assume the same facts as in
Example 1 except that the partnership, instead of selling the
widgets, distributes the widgets to A and B. A then further
processes the widgets and then sells them outside the United States.
In determining the source of the income earned by A on the sales
outside the United States, A is treated as conducting the activities
of the partnership related to production of the distributed widgets.
Thus, the source of gross income on the sale of the widgets is
determined under section 863 and these regulations. A applies the
50/50 method described in paragraph (b)(1) of this section to
determine the source of income from the sales. In applying paragraph
(c)(1) of this section, A is treated as owning its proportionate
share of the partnership's production assets based upon its
distributive share of partnership income.
(h) Effective dates. The rules of this section apply to taxable
years beginning December 30, 1996. However, taxpayers may apply these
regulations for taxable years beginning after July 11, 1995, and before
December 30, 1996. For years beginning before December 30, 1996, see
Secs. 1.863-3A and 1.863-3AT.
Par. 7. Section 1.863-4 is amended by revising the section heading
and paragraph (a) to read as follows:
Sec. 1.863-4 Certain transportation services.
(a) General. A taxpayer carrying on the business of transportation
service (other than an activity giving rise to transportation income
described in section 863(c) or to income subject to other specific
provisions of this title) between points in the United States and
points outside the United States derives income partly from sources
within and partly from sources without the United States.
* * * * *
Sec. 1.863-5 [Removed]
Par. 8. Section 1.863-5 is removed.
PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT
Par. 9. The authority citation for part 602 continues to read as
follows:
Authority: 26 U.S.C. 7805.
Par. 10. In Sec. 602.101, paragraph (c) is amended by adding
entries for 1.863-1 and 1.863-3A, and revising the entry for 1.863-3 to
read as follows:
Sec. 602.101 OMB Control numbers.
* * * * *
(c) * * *
[[Page 60551]]
------------------------------------------------------------------------
Current OMB
CFR part or section where identified and described control No.
------------------------------------------------------------------------
* * * * *
1.863-1.................................................... 1545-1476
1.863-3.................................................... 1545-1476
* * * * *
1.863-3A................................................... 1545-0126
* * * * *
------------------------------------------------------------------------
Approved: November 25, 1996.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Donald C. Lubick,
Acting Assistant Secretary of Tax Policy.
[FR Doc. 96-30617 Filed 11-27-96; 8:45 am]
BILLING CODE 4830-01-U
