[Federal Register Volume 60, Number 237 (Monday, December 11, 1995)]
[Proposed Rules]
[Pages 63478-63489]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-30087]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[INTL-0003-95]
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: Notice of proposed rulemaking and notice of public hearing.
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SUMMARY: This document contains proposed regulations governing the
source of income from sales of natural resources or other inventory
produced in the United States and sold in a foreign country or produced
in a foreign country and sold in the United States. This document
affects persons who produce natural resources or other inventory in the
United States and sell in a foreign country, or produce natural
resources or other inventory in a foreign country and sell in the
United States. This document also provides notice of a public hearing
on these proposed regulations.
DATES: Written comments and outlines of oral comments to be presented
at the public hearing scheduled for April 10, 1996, at 10 a.m. must be
received by March 11, 1996.
ADDRESSES: Send submissions to: CC:DOM:CORP:R (INTL-0003-95),
[[Page 63479]]
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
(INTL-0003-95), Courier's Desk, Internal Revenue Service, 1111
Constitution Avenue NW., Washington, DC. The public hearing will be
held in the IRS Auditorium, 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.
Christina Vasquez, (202) 622-7180 (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).
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 February 9, 1996.
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 collection of information requirements are in proposed
Secs. 1.863-1(b)(6) and 1.863-3(e)(2). 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 natural resources or
other inventory produced in the United States and sold in a foreign
country or produced in a foreign country and sold in the United States.
The likely respondents are taxpayers who produce natural resources or
other inventory in the United States and sell in a foreign country, or
who produce natural resources or other inventory in a foreign country
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: 1125 hours. The estimated
annual burden per respondent varies from 1 hour to 5 hours, depending
on individual circumstances, with an estimated average of 2.6 hours.
Estimated number of respondents: 425.
Estimated annual frequency of responses: One time per year.
Background
These proposed regulations contain rules relating to the source of
income from the sale of certain natural resources and other inventory.
These regulations are proposed to be effective for taxable years
beginning 30 days after publication of final regulations. However,
taxpayers may elect to apply these regulations for taxable years
beginning after July 11, 1995.
Explanation of Provisions
I. Natural Resources
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).
Section 1.863-1 of the existing regulations contains rules for
determining the source of income derived from the sale of certain
natural resources. Generally, under paragraph (b)(1) of those
regulations, income derived from the ownership or operation of any
farm, mine, oil or gas well, other natural deposit, or timber located
within the United States and from the sale by the producer of the
products within or without the United States ordinarily must be
included in gross income from sources within the United States.
However, if a taxpayer can show to the satisfaction of the District
Director that, due to peculiar conditions of production and sale or for
other reasons, not all of the gross income derived therefrom should be
allocated to sources within the United States, the source of the income
generally is determined under the 50/50 method described in Sec. 1.863-
3(b)(2) Example 2. The regulations do not define ``peculiar conditions
of production and sale.'' In addition, Sec. 1.863-1(b)(2) permits the
Commissioner to make an allocation or apportionment that more clearly
reflects the proper source of a taxpayer's income, if the Commissioner
determines that the application of paragraph (b)(1) does not result in
the proper allocation or apportionment of income. Similar rules apply
in the case of natural resources produced without the United States and
sold within the United States. See Sec. 1.863-6. Thus, income from the
sale of such products ordinarily will be allocated entirely to foreign
sources.
B. Issues Under Current Regulations
The IRS and Treasury have reexamined the existing regulations under
section 863 regarding natural resources and arrived at several
conclusions. First, certain ambiguities in existing Sec. 1.863-1 should
be clarified. For example, the regulation does not define the term
``peculiar conditions of production and sale,'' and there is virtually
no authoritative guidance as to the scope of that term. To the extent
that ``peculiar conditions of production and sale'' is defined
narrowly, the regulation may lead to inappropriate results when
determining the source of income from the sale of processed natural
resources. For example, if a U.S. corporation harvests timber to
manufacture furniture for export, all of its income may be from sources
within the United States. However, if another U.S. corporation
purchases cut timber to manufacture furniture for export from the
United States, one-half of that taxpayer's income may be from sources
without the United States under the 50/50 method.
Second, the interaction of the existing regulations and the
recently-issued consolidated return regulations may cause inappropriate
sourcing results. On July 11, 1995, the IRS and Treasury issued final
regulations under Sec. 1.1502-13 [TD 8597 (60 FR 36671)], treating
members of a U.S. consolidated group as a single entity for purposes of
determining the source of a taxpayer's income. The IRS and Treasury
understand that inappropriate results may occur when the current
section 863 regulations are applied to certain consolidated groups on a
single entity basis. For example, a U.S. corporation that is a member
of a consolidated group may extract oil abroad. The oil is then
transported to the United States where it is refined by another member
of the consolidated group. It is sold in the United States through
other members of the consolidated group. Under Sec. 1.1502-13 of the
consolidated return rules, the consolidated group is treated as a
single entity, and the source of income from the sale of oil must be
determined under
[[Page 63480]]
section 863. Because the consolidated group refines the oil outside the
country of extraction, it may be that peculiar conditions of production
and sale exist, and the exclusive sourcing rules of paragraph (b)(1) do
not apply. Thus, the taxpayer would generally determine the source of
its income under the 50/50 method described in Sec. 1.863-3(b)(2)
Example 2. Under this method, 50 percent of the consolidated group's
income would be U.S. source income based on the place of sale. However,
this calculation may understate the appropriate amount of the
taxpayer's foreign source income because the value of the oil as
extracted may represent more than 50 percent of the total value of the
product that is finally sold in the United States. The preamble to the
regulations under Sec. 1.1502-13 indicated that the IRS and Treasury
would consider amending the regulations under section 863 to address
these concerns.
Accordingly, the IRS and Treasury are issuing proposed regulations
under section 863 to clarify ambiguities in the existing regulation and
to address concerns created by the new Sec. 1.1502-13 regulations.
C. Proposed Regulations
Section 1.863-1(b) provides special rules for determining the
source of income from the sale 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 and the sale of these products
without the United States. The proposed regulations also provide
special rules for determining the source of income from the sale of
products derived from the ownership or operation of any farm, mine, oil
or gas well, other natural deposit, or timber, without the United
States and the sale of these products within the United States. The
export terminal rule of paragraph (b)(1) provides that the source of
gross receipts from the sale of such products equal to the fair market
value of the product immediately prior to export (referred to in the
proposed regulations as the export terminal) is determined according to
where the farm, mine, oil or gas well, other natural deposit or timber
is located. Separate rules are provided for determining the source of
any gross receipts in excess of the fair market value of the product at
the export terminal. Paragraph (b)(2) provides an exception to the
approach of paragraph (b)(1) where, prior to export, the taxpayer
engages in substantial production activities in addition to activities
related to the ownership or operation of a farm, mine, oil or gas well,
other natural deposit, or timber.
1. Export Terminal Rule
Under the export terminal rule of paragraph (b)(1), gross receipts
derived from the ownership or operation of any farm, mine, oil or gas
well, other natural deposit, or timber, and sale of the products
derived therefrom, are allocated between sources within and without the
United States based on the fair market value of the product at the
export terminal. The export terminal is the last point from which the
product is sent from the United States to a foreign country or the last
point from which goods are sent from a foreign country to the United
States. For example, if a U.S. corporation extracts oil in one foreign
country, sends the crude oil to a port in a second foreign country via
pipeline, and delivers the oil to a U.S. refinery by ship, the export
terminal would be the port in the second foreign country where the
crude oil was loaded onto the ship.
Under the export terminal rule, the source of gross receipts equal
to the fair market value of the product at the export terminal is
determined by the location of the farm, mine, well, deposit, or uncut
timber. The source of gross receipts in excess of the fair market value
of the product at the export terminal (excess gross receipts) is
determined according to whether the taxpayer engages in any additional
production activity following export. A taxpayer will be treated as
performing production activities in addition to the activities of
owning or operating a farm, mine, oil or gas well, other natural
deposit, or timber based on the principles of Sec. 1.954-3(a)(4).
However, 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,
will not be considered additional production activities. Thus,
Sec. 1.863-1 Example 2 illustrates that liquefaction of natural gas
would not constitute additional production activities. In addition,
activities such as delimbing and debarking trees, sorting grain, and
treating and stabilizing oil would ordinarily not constitute additional
production activities. In contrast, the transformation of timber into
furniture is not done to prepare the natural resource itself for
export, and would constitute additional production activity. Production
activities are defined in Sec. 1.863-1(b)(3)(i).
If no additional production occurs following export, paragraph
(b)(1)(i) requires that the source of the excess gross receipts be
determined according to where the farm, mine, well, deposit, or uncut
timber is located.
However, under paragraph (b)(1)(ii), if the taxpayer engages in
additional production activities after the export terminal and outside
the country of sale, the source of excess gross receipts is determined
under the rules of Sec. 1.863-3. For example, if a U.S. corporation
extracts oil in a foreign country, refines the oil in the United
States, and sells the refined product in another foreign country, the
source of gross receipts in excess of the fair market value of the
product when it is exported from the first foreign country must be
determined under one of the three methods described in Sec. 1.863-3
(i.e., the 50/50 method as described in Sec. 1.863-3(b)(1), the IFP
method described in Sec. 1.863-3(b)(2), or, if permitted by the
District Director, the books and records method as described in
Sec. 1.863-3(b)(3)).
In any case not described in either paragraph (b)(1) (i) or (ii) of
the proposed regulations, the source of the excess gross receipts is
determined according to the place of sale pursuant to paragraph
(b)(1)(iii). This rule would apply, for example, in the case where the
taxpayer engages in additional production activities in the country of
sale.
Paragraph (b)(1) addresses the concerns of U.S. corporations
involved in the production of natural resources abroad and the
application of the new Sec. 1.1502-13 consolidated return regulations,
by allowing them to treat the value of the natural resources at the
point of export as income from sources where the farm, mine, well,
deposit, or uncut timber is located. This rule has no effect on the
rules governing foreign oil and gas extraction income under section
907(c)(1).
On November 28, 1995, the Tenth Circuit affirmed the Tax Court
decision in Phillips Petroleum v. Comm'r, 97 T.C. 30 (1991), which held
existing Sec. 1.863-1(b)(1) invalid to the extent it allocates income
from the sale of U.S. natural resources solely to sources within the
United States. Phillips Petroleum v. Comm'r, No. 94-9021 (10th Cir.
Nov. 28, 1995). The IRS and Treasury will consider the implications of
this decision when finalizing these proposed regulations.
2. Additional Production Prior to Export Terminal
Paragraph (b)(2) provides a special rule for determining the source
of income where a taxpayer performs substantial additional production
activities before the product leaves the export terminal. Under
paragraph (b)(2),
[[Page 63481]]
the source of gross receipts equal to the fair market value of the
product prior to the additional production activities is based on the
location of the farm, mine, well, deposit, or uncut timber. The source
of gross receipts in excess of the fair market value of the products at
the beginning of the additional production activities is determined
under the rules of Sec. 1.863-3.
3. Other Rules
The proposed regulation contains rules for determining the fair
market value of relevant products. For this purpose, fair market value
depends on all of the facts and circumstances as they exist relative to
a party in any particular case. Thus, these rules for determining fair
market value are consistent with the foreign oil and gas rules
contained in Sec. 1.907(c)-1(b)(6). In addition, fair market value
determinations must be consistent with prices charged in sales, if any,
to related parties in a transaction that is subject to section 482. For
example, if a member of a U.S. consolidated group extracts natural
resources in a foreign country and sells the natural resources to
another member of the same group at the export terminal, the value of
the natural resources determined at the export terminal should be the
price charged by the producing member to the purchasing member for
purposes of section 482.
Under paragraph (b)(5), a taxpayer's gross income from sources
within or without the United States is determined by reducing its gross
receipts from sources within or without the United States by the cost
of goods sold properly attributable to such gross receipts. Under
paragraph (c), a taxpayer's taxable income from U.S. or foreign sources
must be determined under the rules of Secs. 1.861-8 through 1.861-14T.
Under paragraph (b)(6), taxpayers must fully explain the
methodology used, the facts describing substantial additional
production activities (if any), and the determination of fair market
value in a statement attached to the taxpayer's return. In addition,
taxpayers must provide such other information as is required by
Sec. 1.863-3(e)(2).
Taxpayers may elect to apply the rules of these regulations for
taxable years beginning after July 11, 1995. Otherwise, these
regulations are effective for taxable years beginning 30 days after the
publication of this regulation as a final regulation.
II. Inventory Other Than Natural Resources
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 specified in sections 861(a) and 862(a).
Section 1.863-3 of the current regulations governs the source of
income from the sale of inventory produced (in whole or in part) in the
United States and sold in a foreign country, or produced (in whole or
in part) in a foreign country and sold in the United States (Section
863 Sales). Section 1.863-3 provides three methods, set forth in the
form of three examples, to determine the source of income from Section
863 Sales.
Sec. 1.861-3(b)(2) Example 1 of the current regulations illustrates
how an independent factory or production price (IFP) applies to
determine the income attributable to production (IFP method). An IFP
generally is established if a taxpayer regularly sells part of its
output to wholly independent distributors in such a way as to
reasonably reflect the income attributable to production activity. If
an IFP exists, 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. See Phillips
Petroleum v. Comm'r, 97 T.C. 30 (1991), aff'd, No. 94-9021 (10th Cir.
Nov. 28, 1995); Rev. Rul. 88-73 (1988-2 C.B. 173). Gross receipts in
excess of the IFP are attributable to sales activity. Taxpayers can
otherwise establish an IFP by showing to the satisfaction of the
District Director that an IFP exists. Notice 89-10 (1989-1 C.B. 631)
contains additional rules regarding the application of the IFP method.
Section 1.863-3(b)(2) Example 1 of the current regulations does not
provide explicit guidance as to how to determine the source of income
attributable to production activities under the IFP method. However,
the source of income attributable to sales activities is based
generally on where title to the inventory passes to the purchaser as
defined in Sec. 1.861-7(c).
Section 1.863-3(b)(2) Example 2 of the current regulations divides
a taxpayer's income from Section 863 Sales equally between production
activity and sales activity (50/50 method). The source of income
attributable to production activity is based on the location of the
taxpayer's property. The portion of this production income attributable
to sources within the United States is determined by a fraction, the
numerator of which is the taxpayer's property located within the United
States used to produce income from Section 863 Sales, and the
denominator of which is the taxpayer's property both within the United
States and within a foreign country used to produce income from Section
863 Sales. The source of the taxpayer's income attributable to sales
activity is based on where title to the inventory passes to the
purchaser as defined in Sec. 1.861-7(c).
Section 1.863-3(b)(2) Example 3 of the current regulations allows a
taxpayer to request permission from the District Director to use the
taxpayer's books and records to allocate income to sources within and
without the United States if those books reflect more clearly than the
other methods the taxable income derived from sources within the United
States (books and records method).
B. Issues Under Current Regulations
On July 12, 1995, the IRS and Treasury issued regulations under
Sec. 1.1502-13, treating members of a consolidated group as a single
entity for purposes of determining the source of a taxpayer's income.
The IRS and Treasury understand that the current section 863
regulations may raise questions when applied to certain consolidated
groups on a single entity basis. The preamble to the regulations under
Sec. 1.1502-13 indicated that the IRS and Treasury would reevaluate
part of the regulations under section 863. As part of this process, the
IRS and Treasury also have reexamined the remainder of the existing
section 863 regulations and have concluded that several additional
changes are necessary.
First, the existing regulations were drafted more than 70 years
ago, and have not been amended to reflect the evolution of business
practices. As a result, the regulations have been the source of
controversies in recent years. See Intel Corporation v. Comm'r, 100
T.C. 39 (1993), aff'd, No. 94-70105 (9th Cir. Oct. 16, 1995); Phillips
Petroleum v. Comm'r, 97 T.C. 30 (1991), 101 T.C. 78, 104 (1993)
(``there have been no cases interpreting [the 50/50 method] and no
administrative pronouncements regarding its application since the
regulation was promulgated in 1922 except for necessary inferences to
be drawn from Intel * * *''), aff'd, No. 94-9021 (10th Cir. Nov. 28,
1995). In part, these controversies may be due to the structure of the
current regulations, which do not contain operative rules to describe
the methods of allocating and
[[Page 63482]]
apportioning income, but instead rely on examples.
Second, the existing regulations raise important administrative
concerns. For example, the IFP method requires an analysis of each of
the taxpayer's sales transactions to identify an IFP. If one or more
IFPs are so identified, a second analysis is required of each of the
taxpayer's sales transactions to identify which transactions are
similar to the IFP sale. In some cases, this process may require a
review of a multitude of transactions. The IFP method may, therefore,
be difficult for both taxpayers and the government to apply. The
existing 50/50 method also presents administrative concerns. For
example, the 50/50 method may require the taxpayer to determine the
fair market value of each of its assets at the end of every tax year.
Taxpayers have often commented to the IRS about the difficulties of
determining the fair market value of their assets.
Third, the existing regulations result in disparate treatment of
similarly situated taxpayers. Although an IFP must be used under
current rules if one exists, the mandate applies only to taxpayers
selling inventory to certain independent distributors. Taxpayers
selling exclusively to related parties are not required to use the IFP
method since the IRS may not establish an IFP based on such sales.
Instead, these taxpayers use the 50/50 method to source their income
from export sales. Thus, taxpayers selling inventory exclusively to
related parties may be deemed to generate far more foreign source
income than taxpayers selling a portion of their inventory to
independent distributors, even though the two taxpayers may perform the
same functions. The IRS and Treasury believe that this differing
treatment of similarly situated taxpayers is not justified.
Fourth, the existing 50/50 method can result in apportionment of
income that is inconsistent with the common understanding of that
method. The 50/50 method is generally characterized as a method that
would source export sales income one-half in the United States and one-
half in a foreign country. For example, in 1984 the Treasury Department
stated: ``Generally, [income derived from manufacture and sale of
property] is allocated one-half on the basis of the place of
manufacture and half on the basis of the place of sale * * *'' Treasury
Department, Tax Reform for Fairness, Simplicity, and Economic Growth,
Nov. 1984 at 364. In addition, Congress understands the 50/50 method to
operate in this fashion. In 1986, the House, Senate and Conference
Committees each stated: ``[Under the existing 50/50 method], half of
such income generally is sourced in the country of manufacture, and
half of the income is sourced on the basis of the place of sale''.
House Rep. No. 426, 99th Cong. 1st Sess. 359 (1985); S. Rep. No. 313,
99th Cong. 2d Sess. 329 (1986); H.R. Conf. Rep. No. 841, 99th Cong. 2d
Sess. II-595 (1986). The staff of the Joint Committee on Taxation has
referred to the 50/50 method as the ``production/marketing split'' and
stated that under this method ``50 percent of such income generally is
attributed to the place of production * * *'' Staff of the Joint Comm.
on Taxation, Factors Affecting International Competitiveness of the
United States 148 (1991).
The existing regulations may, however, allow taxpayers to use the
50/50 method to obtain results that are inconsistent with this common
understanding. Under the existing regulations, 50 percent of the income
is treated as sales income and sourced on the basis of title passage.
The remaining 50 percent is treated as production income and sourced
based on the location of assets. This half of the formula is not
necessarily, however, limited to production assets. For example,
goodwill and accounts receivables are counted as assets in allocating
production income. The inclusion of sales assets in the formula
allocating production income results in additional income being
allocated to sales activities. The contribution of the sales assets to
sales income should be reflected only in the 50 percent of the income
that is allocated to sales and sourced under title passage. Thus, the
production income formula should only take into account assets directly
involved in the production of inventory.
B. Proposed Regulations
1. Overview
Section 1.863-3 provides rules for allocating and apportioning
income from Section 863 Sales. Generally, Sec. 1.863-3(b) provides
three methods for determining the amount of gross income attributable
to production activity and the amount of gross income attributable to
sales activity. The source of gross income attributable to each
activity is then determined under the rules of paragraph (c). Paragraph
(d) provides rules to determine the source of taxable income. Reporting
and election rules are set forth under paragraph (e) of the proposed
regulations. The proposed regulations reserve on paragraph (f) (prior
paragraph (c)), dealing with income partly from sources within a
possession of the United States. The IRS and Treasury solicit comments
from taxpayers regarding changes that should be made to new paragraph
(f) (if any) to conform to the other changes in Sec. 1.863-3.
The proposed regulations generally apply an aggregate approach in
taking into account a taxpayer's interest in a partnership. The IRS and
Treasury solicit comments on the appropriate treatment of partnerships,
including whether there should be special rules for limited
partnerships, de minimis interests in partnerships, and tiered
partnerships.
2. Methods To Determine Gross Income Attributable to Production
Activity and Sales Activity
Section 1.863-3 generally retains the three methods of the current
regulations for splitting income between production and sales activity,
with several modifications.
a. 50/50 Method
The proposed regulations do not change the allocation of half of
the taxpayer's income from Section 863 Sales to production activity and
half to sales activity. As described below, the proposed regulations
modify and clarify the determination of the location of assets. In
addition, paragraph (b)(1) of the proposed regulations makes the 50/50
method the general rule to determine the amount of income attributable
to production and sales activities. The taxpayer, however, may elect to
apply the IFP method, described in paragraph (b)(2), or, with the
consent of the District Director, the books and records method,
described in paragraph (b)(3).
b. IFP Method
By making the IFP method elective, the proposed regulations
significantly reduce administrative burdens related to its application
and eliminate any bias against taxpayers choosing to export through
independent distributors.
Under the proposed regulations, the taxpayer may elect to apply the
IFP method if it is able to establish an IFP. As in the current
regulations, an IFP is fairly established by actual sales of the
taxpayer 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 attributable to production activity. Once
the IFP is established, it can be used to determine the amount of
income attributable to production activity in other Section 863 Sales
if the inventory sold in the other sales is substantially similar in
physical characteristics and function, and is sold at a similar level
of distribution as the
[[Page 63483]]
inventory sold in a sale establishing an IFP. A sale will not be
considered to establish an IFP if sales activity for the relevant
product is significant in relation to all of the activities for that
product. The IRS and Treasury intend to supersede Notice 89-10 upon
publication of final regulations.
The proposed regulations would also eliminate the existing rule
permitting taxpayers to otherwise establish an IFP by showing to the
satisfaction of the District Director that a sale reasonably reflecting
the income attributable to production exists. This ``otherwise
established'' IFP is rarely, if ever, used. American Law Institute,
International Aspects of United States Income Taxation 31 (1987). The
IRS and Treasury solicit comments from taxpayers on the continued
utility of the otherwise established IFP.
The proposed regulations omit the reference in the existing
regulation to a sales branch. A taxpayer may elect to use the IFP
method even if it does not maintain a sales branch in a foreign
country.
c. 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
income attributable to production and sales activities. The District
Director will consider a taxpayer's request if the taxpayer maintains a
detailed allocation of receipts and expenditures, clearly reflecting
the amount of income from production and sales activities.
The books and records method is rarely, if ever, used. American Law
Institute, International Aspects of United States Income Taxation, 31
(1987). The IRS and Treasury solicit comments from taxpayers on the
continued utility of the books and records method, or whether the books
and records method should be replaced by another method of economic
sourcing.
3. 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 sales activity only for purposes of the 50/50 method, the proposed
regulations adopt rules applicable to each of the three methods. Under
the proposed regulations, once gross income attributable to production
activity and sales activity has been determined under one of the
methods described in paragraph (b), the source of the income is
determined separately for each type of income under paragraph (c). The
source of gross income attributable to production activity is
determined under paragraph (c)(1), based on the location of production
assets, and the source of gross income attributable to sales activity
is determined under paragraph (c)(2) based on the location of the sale.
a. Source of Gross Income Attributable to Production Activity
The proposed regulations generally adopt the approach set forth in
the current regulations under the 50/50 method, but with modifications
and clarifications.
Under Sec. 1.863-3(c)(1), the source of income attributable to
production activity is determined based on the location of the
taxpayer's production assets. Thus, if a taxpayer manufactures
inventory exclusively in the United States, all of its income
attributable to production activity will be considered from sources
within the United States. The rules described below are intended to
apply only to taxpayers that produce inventory both within and without
the United States.
Under the proposed regulations, the source of a taxpayer's income
from production activities is determined by reference to the taxpayer's
production assets, instead of all of its assets that produce income
from Section 863 Sales. The IRS and Treasury believe that this change
is appropriate to ensure that the source of production income
corresponds to the location of production activity. Production assets
are defined to include tangible and intangible property owned by the
taxpayer that are used to produce inventory sold in Section 863 Sales.
Any property not directly used to produce inventory is excluded. Thus,
accounts receivable and marketing intangibles are excluded because they
are sales assets and not production assets. Other assets excluded
because they do not directly produce inventory are transportation
assets, warehouses, inventory, work-in-process, raw materials, cash,
investment assets, and stock of a subsidiary. Working capital is
excluded to avoid uncertainty arising from determinations of the
appropriate amount of working capital. In addition, working capital
would generally be apportioned pro rata in accordance with a taxpayer's
production assets. As under the current regulations, leased assets are
excluded; only assets owned by the taxpayer are included.
The proposed regulations also provide specific rules for
determining where a production asset is located. Tangible assets are
located where the assets are used by the taxpayer. Intangible Assets
are located where the tangible production assets to which they relate
are located.
Where production takes place both within the United States and
within a foreign country, the regulations apply a property fraction to
apportion production income between U.S. and foreign sources. The
taxpayer's foreign source gross production income is determined by
multiplying its gross production income by a fraction, the numerator of
which is the taxpayer's production assets located within a foreign
country, and the denominator of which is the taxpayer's production
assets located both within the united States and within a foreign
country.
The current regulations generally include assets in the property
formula at fair market value. The proposed regulations modify this rule
to provide that an asset must be included in the property formula at
its average adjusted basis (see section 1011). The IRS and Treasury
believe that this change to adjusted basis will significantly simplify
the application of this formula for both taxpayers and the IRS.
The proposed regulations also contain more detailed guidance than
the current regulations for determining the amounts to be included in
the property fraction. For example, the proposed regulations would
require that if the asset is used to produce inventory sold in Section
863 Sales and is also used to produce other property, the basis of the
asset must be prorated to account for such other uses.
The purpose of the property formula is to attribute the source of
the taxpayer's production income to the location of its production
activity. The IRS and Treasury are concerned that taxpayers may be able
to affect the location of assets without changing the sit us of
economic activity. Accordingly, comments are solicited about whether
there should be rules to prevent manipulation of this formula in a
manner inconsistent with the purpose of the regulation.
b. Source of Gross Income Attributable to Sales Activity
The source of gross income that is attributable to sales activity
is determined under paragraph (c)(2). As under the current regulations,
the source of this income is generally based on where a sale takes
place. See Sec. 1.861-7(c). Accordingly, if a U.S. producer sells its
goods in a foreign country, the income attributable to sales activity
is generally foreign source income.
[[Page 63484]]
The proposed regulation would retain the language of the existing
regulation, which only applies to sales that occur within a foreign
country. The IRS and Treasury solicit comments as to whether the
regulations should be expanded to apply to sales made in international
waters or in space. The IRS and Treasury are concerned, however, that
if such a change were made, a U.S. seller may try to use the 50/50
method by selling inventory in international waters to U.S. purchasers,
even when the goods were destined for the United States. In view of
these concerns, the IRS and Treasury also solicit comments as to
whether the regulations should provide an exception to the title
passage rule in the case of sales of goods produced in the United
States and destined for use in the United States.
4. Determination of Source of Taxable Income
Once the amount and source of gross income are determined under
paragraph (c), taxpayers then determine the source of their taxable
income. Under proposed paragraph (d), taxpayers must allocate or
apportion under Secs. 1.861-8 through 1.861-14T the amounts of
expenses, losses and other deductions to its gross income determined
under each method described in paragraph (b). 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 and without the United States. For amounts of expenses, losses
and other deductions allocated or apportioned to gross income
determined under the 50/50 method, taxpayers must apportion expenses
and other deductions prorata based on the relative amounts of U.S. and
foreign source gross income. These rules are consistent with existing
regulations.
5. Election and Reporting Rules
Under paragraph (e) of the proposed regulations, a taxpayer must
use the 50/50 method unless the taxpayer elects to use the IFP method,
or elects the Books and Records method. The taxpayer makes the election
by using the method on its tax return. Once The tax return is filed,
the election is not revokable for that year. In addition, that method
must be used in later taxable years unless the Commissioner or her
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 paragraph
(b), and the amount of income allocated or apportioned to U.S. and
foreign sources in a statement attached to its tax return.
6. Conforming Changes
The proposed regulations make conforming changes to Sec. 1.863-2 of
the regulations. Under Sec. 1.863-2, the taxpayer may elect to apply
the 50/50 method to its net taxable income, instead of its gross income
as specified in Sec. 1.863-3. The proposed regulations clarify that
income derived from the purchase of personal property within a
possession of the United States and its sale within the United States
is subject to these regulations only to the extent it is not excluded
by Sec. 1.936-6(a)(5), Q&A 7. Other changes to Sec. 1.863-2 were
intended to conform the language of the regulation to the changes in
Sec. 1.863-3.
Finally, the IRS and Treasury will reconsider the existing
regulations issued under section 863 regarding transportation services
and cable and telegraph services in light of the Tax Reform Act of
1986. Accordingly, the transportation rules contained in Sec. 1.863-4
will only apply to services that are not described in section 863(c)
and the telegraph and cable rules contained in Sec. 1.863-5 are
deleted. No inference is intended as to whether portions of the
existing regulations continued to apply after the Tax Reform Act of
1986.
7. Proposed Effective Dates
These regulations are effective for taxable years beginning 30 days
after publication of final regulations. However, taxpayers may apply
these regulations for taxable years beginning after July 11, 1995, and
before 30 days after publication of these regulations as 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 certified that
these regulations will not have a significant economic impact on a
substantial number of small entities. 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 written comments (a signed original
and eight (8) copies) that are submitted timely to the IRS. All
comments will be available for public inspection and copying.
A public hearing has been scheduled for April 10, 1996, at 10 a.m.
in the IRS Auditorium. 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 written comments and an outline of topics to be discussed and
the time to be devoted to each topic (signed original and eight (8)
copies) by March 11, 1996.
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 adding
entries in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.863-1 also issued under 26 U.S.C. 863.
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 1.863-0 is added to read as follows:
[[Page 63485]]
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.
(d) 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.
(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)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. [Reserved]
(g) Effective dates.
Par. 3. Sections 1.863-1, 1.863-2, and 1.863-3 are revised 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 865(e)(2).
(b) Natural resources--(1) In general. 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, are allocated between sources
within or 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). 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
are also allocated between sources within or without the United States
based on the fair market value of the product at the export terminal.
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 does not engage in additional production
activities (as defined in paragraph (b)(3)(ii) of this section), excess
gross receipts will be from sources where the farm, mine, well,
deposit, or uncut timber is located;
(ii) 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; or
(iii) In all other cases, excess gross receipts will be from
sources within the country of sale, as described in Sec. 1.861-7(c).
This paragraph (b)(1)(iii) applies, for example, to a taxpayer that
engages in additional production activities in the country of sale.
(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.
(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.
(ii) Additional production activities. For purposes of this
section, additional production activities are substantial production
activities performed 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 performs such 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 from a foreign country to the United States. 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 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.
[[Page 63486]]
(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. US Mines, a U.S.
corporation, extracts coal in the United States and, without
substantial additional production, sells the coal in a foreign
country. Under Sec. 1.863-1(b) and (b)(1)(i), all of US Mines'
income will be from sources within the United States.
Example 2. Scope of 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 Sec. 1.863-1(b) and (b)(1)(i), all of US Gas' income will be
from sources within 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 Sec. 1.863-
1(b)(1)(ii), 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 Sec. 1.863-1(b)(1), $80 of
US Oil's gross receipts will be allocated to sources without the
United States, and under Sec. 1.863-1(b)(1)(iii) the remaining $20
of gross receipts will be allocated to sources within the United
States.
Example 5. Additional production prior to export. US Furniture,
a U.S. corporation, cuts trees in the United States, converts the
trees into lumber, uses the lumber to manufacture furniture in the
United States, and sells the furniture in another country. Assume
that the fair market value of the trees when the conversion into
lumber begins is $40, and that US Furniture ultimately sells the
furniture for $100. Because the conversion of the trees into lumber
is an additional production activity within the United States within
the meaning of Sec. 1.863-1(b)(3)(ii), the source of US Furniture's
income will be determined under Sec. 1.863-1(b)(2). Thus, $40 of US
Furniture's gross receipts will be allocated to sources within the
United States. The source of the remaining $60 of gross receipts
will be determined under Sec. 1.863-3. If US Furniture applies the
50/50 method described in Sec. 1.863-3(b)(1), $20 of cost of goods
sold is properly attributable to the additional production activity,
and all of US Furniture's production assets used in the additional
production activity 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.
(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.
(d) Effective dates. The rules of this section will apply to
taxable years beginning 30 days after publication of these regulations
as final regulations. However, taxpayers may apply the rules of this
section for taxable years beginning after July 11, 1995, and before 30
days after publication of these regulations as final regulations. For
years beginning before 30 days after publication of these regulations
as final regulations, see Sec. 1.863-1 (as contained in 26 CFR part 1
revised as of April 1, 1995).
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 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 in a foreign country or produced (in whole or in
part) by the taxpayer in a foreign country 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. 1.863-3. However, the
principles of Sec. 1.863-3 (b)(1) and (c) may be applied to determine
the source of taxable income from sales of inventory property. To
determine the source of income described in paragraph (a)(3) of this
section, see Sec. 1.863-3(f).
[[Page 63487]]
(c) Effective dates. This section will apply to taxable years
beginning 30 days after publication of these regulations as final
regulations. However, taxpayers may apply the rules of this section for
taxable years beginning after July 11, 1995, and before 30 days after
publication of these regulations as final regulations. For years
beginning before 30 days after publication of these regulations as
final regulations, see Sec. 1.863-2 (as contained in 26 CFR part 1
revised as of April 1, 1995).
Sec. 1.863-3 Allocation and apportionment of income from certain sales
of inventory.
(a) In general. This section applies to determine the source of
income derived from the sale of inventory property (inventory) produced
(in whole or in part) by a taxpayer within the United States and sold
within a foreign country, or produced (in whole or in part) by a
taxpayer in one or more foreign countries and sold within the United
States (Section 863 Sales). For purposes of this section, a taxpayer's
production activity includes production activities conducted by members
of the same affiliated group as defined under section 1504(a). A
taxpayer's production activity also includes production activities
conducted through a partnership of which the taxpayer is a partner
either directly or through one or more partnerships. A taxpayer subject
to this section 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 effective dates for the rules in this section. 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 in foreign countries. 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. See section
865(i)(1) for the definition of inventory property; Sec. 1.861-7(c) for
the time and place of sale. See also section 865(e)(2).
(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 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. 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 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, a 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
[[Page 63488]]
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, a 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. Where the taxpayer's
production assets are located only within the United States or only
within a foreign country, 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 within one or more foreign
countries, see paragraph (c)(1)(ii) of this section. 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.
(B) Definition of production assets. For purposes of this section,
production assets include only tangible and intangible assets owned 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. A partner will be treated as owning its
proportionate share of the partnership's production assets, determined
by reference to the partner's distributive share of partnership income
for the year attributable to such production assets.
(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 the United States and within one or more
foreign countries, income from sources without the United States will
be determined by multiplying the income attributable to production
activity by a fraction, the numerator of which is the average adjusted
basis of production assets that are located in one or more foreign
countries and the denominator of which is the average adjusted basis of
all production assets in foreign countries and in the United States.
The 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. For purposes of this section, a
taxpayer'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).
(iii) 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
[[Page 63489]]
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.
(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).
(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.
(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 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. See e.g., paragraph (b)(2)(ii) Example 2 of this
section. 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
the methodology used, the circumstances justifying use of that method,
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. [Reserved]
(g) Effective dates. The rules of paragraphs (a) through (e) of
this section will apply to taxable years beginning 30 days after
publication of final regulations. However, taxpayers may apply these
regulations for taxable years beginning after July 11, 1995, and before
30 days after publication of these regulations as final regulations.
For years beginning before 30 days after the publication of these
regulations as final regulations, see Sec. 1.863-3 (as contained in 26
CFR part 1 revised as of April 1, 1995).
Par. 4. 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. 6. Section 1.863-5 is removed.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 95-30087 Filed 12-7-95; 2:00 pm]
BILLING CODE 4830-01-U
