[Federal Register Volume 61, Number 92 (Friday, May 10, 1996)]
[Rules and Regulations]
[Pages 21366-21370]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-11639]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 8669]
RIN 1545-AR18
Computation of Combined Taxable Income Under The Profit Split
Method When the Possession Product is a Component Product or an End-
Product Form for Purposes of the Possessions Credit Under Section 936
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains final regulations relating to the
computation of combined taxable income under the profit split method.
These regulations amend the current regulations and provide revised
rules for taxpayers to compute combined taxable income under the profit
split method when the possession product chosen for purposes of section
936(h)(5) of the Internal Revenue Code is a component product or an
end-product form. These regulations are necessary to provide guidance
to taxpayers electing the profit split method of computing taxable
income under section 936(h)(5).
DATES: These regulations are effective May 10, 1996. See Supplementary
Information for applicability dates.
FOR FURTHER INFORMATION CONTACT: Jacob Feldman, 202-622-3870 (not a
toll-free number).
SUPPLEMENTARY INFORMATION:
Background
On January 12, 1994, the IRS published a notice of proposed
rulemaking in the Federal Register (INTL-0068-92, 59 FR 1690, 1994-1
C.B. 820) relating to the computation of combined taxable income under
the profit split method under section 936(h)(5) (relating to the
possessions credit for U.S. companies doing qualified business in
Puerto Rico and certain U.S. possessions). A number of written public
comments were received concerning the proposed regulations and a public
hearing was held on July 11, 1994. After consideration of all the
comments, the proposed regulations are adopted as revised by this
Treasury decision. The revisions are discussed below.
Discussion
The proposed regulations would amend Sec. 1.936-6(b)(1), Q&A 12.
Under the proposed regulations, combined taxable income for a taxpayer
that elects the profit split method for a possession product that is
either a component product or an end-product form would be determined
by multiplying the combined taxable income of the integrated product
that includes the possession product by a production cost ratio. In the
case of a component product, the combined taxable income of the
integrated product would be multiplied by a ratio the numerator of
which is the production costs of the component product and the
denominator of which is the production costs of the integrated product.
The combined taxable income of an end-product form would be determined
in a similar manner using the production costs of the end-product form.
The regulations were proposed to be effective for taxable years
beginning after 1993.
Taxpayers have argued that the regulations should not be adopted as
proposed because they would violate the arm's length standard under
section 482 and that a necessary consequence of the abandonment of the
arm's length standard would be distortions in taxpayers' income. That
is, income would be computed inconsistently for related versus
unrelated party sales of the same product, under the same terms and in
the same market.
The proposed regulations did not apply the arm's length standard to
component products and end-product forms under the profit-split method
because application of section 482 in this context is inconsistent with
the statutory framework. The effect of the profit split method when
applied to possession products is to minimize disputes between
taxpayers and the IRS because, unlike section 482 methods, there is no
need to perform functional analyses to allocate income among the
parties. Because Congress eliminated the section 482 analysis from the
profit split method, the proposed regulations did not reinject this
analysis into the area of intermediate products.
In response to taxpayer comments, however, the IRS and Treasury are
providing an election to taxpayers that sell the same possession
product in both component form and integrated form if the transactions
meet certain section 482 standards. This method is both simple to apply
and produces consistent results with respect to related and unrelated
party transactions. Under this method, the combined taxable income from
covered sales of the component product shall be determined by using the
same per unit combined taxable income as is derived from uncontrolled
sales of the product as an integrated product. Taxpayers may elect to
compute the combined taxable income for an end-product form in a
similar manner if all excluded components are manufactured by a member
of the affiliated group that includes the possession corporation and
also sold by the group separately in uncontrolled transactions. In that
case, the combined taxable income of the end-product form will be
computed by reducing the combined taxable income of the integrated
product that includes the end-product form by the combined taxable
income of the excluded components determined under the rules of section
936 as if the excluded components were possession products. In order to
make the election, the uncontrolled sales must meet the comparability
standards of the fourth sentence of Sec. 1.482-3(b)(2)(ii)(A), which
requires that the uncontrolled and controlled transactions have no
differences or minor differences for which adjustment can be made.
However, under a no loss limitation, in no case can the taxpayer use as
its per
[[Page 21367]]
unit combined taxable income for a component product or an end-product
form an amount that exceeds the per unit combined taxable income of the
integrated product that includes the component product or end-product
form.
In 1993, Congress adopted limitations on the amount of the section
936 credit; the taxpayer may be subject to an activity based limitation
or may elect a percentage limitation. The election for the percentage
limitation had to be made for the first taxable year beginning after
December 31, 1993. Taxpayers commented that the proposed regulations
created uncertainty with respect to the consequences of making the
percentage limitation election and, therefore, the period for making
the election should be extended until after the regulations are
finalized. This comment is adopted. Taxpayers that have not elected the
percentage limitation under section 936(a)(1) for the first taxable
year beginning after December 31, 1993, may so elect if the taxpayer
has elected the profit split method and the computation of combined
taxable income is affected by Sec. 1.936-6(b)(1) Q&A 12.
With respect to the proposed effective date, taxpayers commented
that the regulations should not be applied retroactively. One of the
justifications for the proposed rule was that it would simplify the
computation of combined taxable income and applying the regulation
retroactively would not simplify the computation because it would
require filing amended returns. This comment is adopted in part. The
regulation is effective for taxable years ending 30 days after May 10,
1996. If however, the election under paragraph (v) of A. 12 of
Sec. 1.936-6(b)(1) is made, this election must be made for the
taxpayer's first taxable year beginning after December 31, 1993, and if
not made effective for that year, the election cannot be made for any
later taxable year.
The last sentence of paragraph (vi) of A. 13 of Sec. 1.936-6(b)(1)
in the proposed regulations provided that, for purposes of determining
the estimated tax liability of an affiliate of the possessions
corporation with respect to income allocated to it from the possessions
corporation, the income would be deemed received on the last day of the
taxable year of each such affiliate in which or with which the taxable
year of the possessions corporation ended. This rule is limited to
taxable years beginning prior to January 1, 1995. For taxable years
beginning after December 31, 1994, quarterly estimated tax payments
will be required as provided under section 711 of the Uruguay Round
Agreements, Public Law 103-465 (1994), page 230, and any administrative
guidance issued by the IRS thereunder. See Rev. Proc. 95-23 (1995-1
C.B. 693).
Accordingly, the proposed regulations are finalized as proposed
except with respect to the changes discussed above and the necessary
conforming changes.
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 has also been determined that
this regulation does not have a significant impact on a substantial
number of small entities. Thus, the Regulatory Flexibility Act (5
U.S.C. chapter 6) does not apply to these regulations, and therefore, 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 authors of these regulations are Jacob Feldman and
Mary Gillmarten of the Office of Associate Chief Counsel
(International), IRS. 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.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. In Sec. 1.936-6, paragraph (b)(1) is amended by:
1. Revising Q. 10.
2. Amending A. 10 by:
a. Redesignating the text of A. 10 as paragraph A. 10(i).
b. Removing the last two sentences of newly designated A.
10(i).
c. Adding paragraphs A. 10 (ii) through (v).
3. Revising the first sentence of A. 11.
4. Revising Q&A. 12.
5. Revising A. 13.
The revisions and addition read as follows:
Sec. 1.936-6 Intangible property income when an election out is made;
cost sharing and profit split options; covered intangibles.
* * * * *
(b) * * *
(1) * * *
Q. 10: If the possessions corporation is entitled to use the profit
split method in the situation described in Q. 9 (leasing units of the
possession product or use of such units in the taxpayer's own trade or
business), how should it compute combined taxable income with respect
to such units?
A. 10: (i) * * *
(ii) If the possession product is a component product or an end-
product form, the combined taxable income with respect to the
possession product shall be determined under Q&A. 12 of this paragraph
(b)(1).
(iii) For purposes of determining the basis of a component product
or an end-product form, the deemed sales price of such product must be
determined. The deemed sales price of the component product shall be
determined by multiplying the deemed sales price of the integrated
product that includes the component product by a ratio, the numerator
of which is the production costs of the component product and the
denominator of which is the production costs of the integrated product
that includes the component product. The deemed sales price of an end-
product form shall be determined by multiplying the deemed sales price
of the integrated product that includes the end-product form by a
ratio, the numerator of which is the production costs of the end-
product form and the denominator of which is the production costs of
the integrated product that includes the end-product form. For the
definition of production costs, see Q&A. 12 of this paragraph (b)(1).
(iv)(A) If combined taxable income is determined under paragraph
(v) of A. 12 of this paragraph (b)(1), in the case of a component
product, the deemed sales price shall be determined by using the actual
sales price of that product when sold as an integrated product (as
adjusted under the rules of the fourth sentence of Sec. 1.482-
3(b)(2)(ii)(A)).
(B) If combined taxable income is determined under paragraph (v) of
A. 12 of this paragraph (b)(1), in the case of an end-product form, the
deemed sales price shall be determined by subtracting from the deemed
sales price of the integrated product that includes the end-product
form (e.g., the leased property) the actual sales price of the excluded
component when sold as an
[[Page 21368]]
integrated product to an unrelated person (as adjusted under the rules
of the fourth sentence of Sec. 1.482-3(b)(2)(ii)(A)).
(v) The full amount of income received under the lease shall be
treated as income of (and be taxed to) the U.S. affiliate and not the
possessions corporation.
* * * * *
A. 11: The U.S. affiliate shall be treated, for purposes of
computing its basis in such units, as if it had repurchased such units
immediately following the deemed sale and at the deemed sales price as
provided in Q&A. 10 of this paragraph (b)(1). * * *
Q. 12: If the possession product is a component product or an end-
product form, how is the combined taxable income for such product to be
determined?
A. 12: (i) Except as provided in paragraph (v) of this A. 12,
combined taxable income for a component product or an end-product form
is computed under the production cost ratio (PCR) method.
(ii) Under the PCR method, the combined taxable income for a
component product will be the same proportion of the combined taxable
income for the integrated product that includes the component product
that the production costs attributable to the component product bear to
the total production costs (including costs incurred by the U.S.
affiliates) for the integrated product that includes the component
product. Production costs will be the sum of the direct and indirect
production costs as defined under Sec. 1.936-5(b)(4) except that the
costs will not include any costs of materials. If the possession
product is a component product that is transformed into an integrated
product in whole or in part by a contract manufacturer outside of the
possession, within the meaning of Sec. 1.936-5(c), the denominator of
the PCR shall be computed by including the same amount paid to the
contract manufacturer, less the costs of materials of the contract
manufacturer, as is taken into account for purposes of the significant
business presence test under Sec. 1.936-5(c) Q&A. 5.
(iii) Under the PCR method the combined taxable income for an end-
product form will be the same proportion of the combined taxable income
for the integrated product that includes the end-product form that the
production costs attributable to the end-product form bear to the total
production costs (including costs incurred by the U.S. affiliates) for
the integrated product that includes the end-product form. Production
costs will be the sum of the direct and indirect production costs as
defined under Sec. 1.936-5(b)(4) except that the costs will not include
any costs of materials. If the possession product is an end-product
form and an excluded component is contract manufactured outside of the
possession, within the meaning of Sec. 1.936-5(c), the denominator
shall be computed by including the same amount paid to the contract
manufacturer, less cost of materials of the contract manufacturer, as
is also taken into account for purposes of the significant business
presence test under Sec. 1.936-5(c) Q&A. 5.
(iv) This paragraph (iv) of A. 12 illustrates the computation of
combined taxable income for a component product or end-product form
under the PCR method. S, a possessions corporation, is engaged in the
manufacture of microprocessors. S obtains a component from a U.S.
affiliate, O. S sells its production to another U.S. affiliate, P,
which incorporates the microprocessors into central processing units
(CPUs). P transfers the CPUs to a U.S. affiliate, Q, which incorporates
the CPUs into computers for sale to unrelated persons. S chooses to
define the possession product as the CPUs. The combined taxable income
for the sale of the possession product on the basis of the given
production, sales, and cost data is computed as follows:
Production costs (excluding costs of materials):
1. O's costs for the component......................... 100
2. S's costs for the microprocessors................... 500
3. P's costs for the CPU's (the possession
product).............................................. 200
4. Q's costs for the computers......................... 400
5. Total production costs for the computer (Add lines 1
through 4)............................................ 1,200
6. Combined production costs for the CPU (the
possession product) (Add lines 1 through
3).................................................... 800
7. Ratio of production costs for the CPUs (the
possession product) to the production costs for the
computer.............................................. 0.667
Determination of combined taxable income for computers:
Sales:
8. Total possession sales of computers to unrelated
customers and foreign affiliates...................... 7,500
Total costs of O, S, P, and Q incurred in production of a
computer:
9. Production costs (enter from line
5).................................................... 1,200
10. Material costs .................................... 100
11. Total costs (line 9 plus line 10).................. 1,300
12. Combined gross income from sale of computers (line
8 minus line 11)...................................... 6,200
Expenses of the affiliated group (other than foreign
affiliates) allocable and apportionable to the computers
or any component thereof under the rules of Secs. 1.861-
8 through 1.861-14T and 1.936-6 (b)(1), Q&A. 1:
13. Expenses (other than research expenses)............ 980
Research expenses of the affiliated group allocable and
apportionable to the computers:
14. Total sales in the 3-digit SIC Code................ 12,500
15. Possession sales of the computers (enter from line
8).................................................... 7,500
16. Cost sharing fraction (divide line 15 by line
14)................................................... 0.6
17. Research expenses incurred by the affiliated group
in 3-digit SIC Code multiplied by 120
percent............................................... 700
18. Cost sharing amount (multiply line 16 by line
17)................................................... 420
19. Research of the affiliated group (other than
foreign affiliates) allocable and apportionable under
Secs. 1.861-17 and 1.861-14T(e)(2) to the
computers............................................. 300
20. Enter the greater of line 18 or line 19............ 420
Computation of combined taxable income of the computer and
the CPU:
21. Combined taxable income attributable to the
computer (line 12 minus line 13 and line
20)................................................... 4,800
22. Combined taxable income attributable to CPUs
(multiply line 21 by line 7) (production cost
ratio)................................................ 3,200
23. Share of combined taxable income apportioned to S
(50 percent of line 22)............................... 1,600
Share of combined taxable income apportioned to U.S.
affiliate(s) of S:
24. Adjustments for research expenses (line 18 minus
line 19 multiplied by line 7)......................... 80
25. Adjusted combined taxable income (line 22 plus line
24)................................................... 3,280
26. Share of combined taxable income apportioned to
affiliates of S (line 25 minus line 23)............... 1,680
[[Page 21369]]
(v)(A) If a possession product is sold by a taxpayer or its
affiliate to unrelated persons in covered sales both as an integrated
product and as a component product and the conditions of paragraph
(v)(C) of this A. 12 are satisfied, the taxpayer may elect to determine
the combined taxable income derived from covered sales of the component
product under this paragraph (v). In that case, the combined taxable
income derived from covered sales of the component product shall be
determined by using the same per unit combined taxable income as is
derived from covered sales of the product as an integrated product, but
subject to the limitation of paragraph (v)(D) of this A. 12.
(B) In the case of a possession product that is an end-product
form, if all of the excluded components are also separately sold by the
taxpayer or its affiliate to unrelated persons in uncontrolled
transactions and the conditions of paragraph (v)(C) of this A. 12 are
satisfied, the taxpayer may elect to determine the combined taxable
income of such end-product form under this paragraph (v). In that case,
the combined taxable income derived from covered sales of the end-
product form shall be determined by reducing the per unit combined
taxable income from the integrated product that includes the end-
product form by the per unit combined taxable income for excluded
components determined under the rules of this paragraph (v), but
subject to the limitation of paragraph (v)(D) of this A. 12. For this
purpose, combined taxable income of the excluded components must be
determined under section 936 as if the excluded components were
possession products.
(C) In the case of component products, this paragraph (v) applies
only if the sales price of the possession product sold in covered sales
as an integrated product (i.e., in uncontrolled transactions) would be
the most direct and reliable measure of an arm's length price within
the meaning of the fourth sentence of Sec. 1.482-3(b)(2)(ii)(A) for the
component product. For purposes of applying the fourth sentence of
Sec. 1.482-3(b)(2)(ii)(A), the sale of the integrated product that
includes the component product is treated as being immediately preceded
by a sale of the component (i.e. without further processing) in a
controlled transaction. In the case of end-product forms, this
paragraph (v) applies only if the sales price of excluded components
separately sold in uncontrolled transactions would be the most direct
and reliable measure of an arm's length price within the meaning of the
fourth sentence of Sec. 1.482-3(b)(2)(ii)(A) for all excluded
components of an integrated product that includes an end-product form.
For purposes of applying the fourth sentence of Sec. 1.482-
3(b)(2)(ii)(A), the sale of the integrated product that includes
excluded components is treated as being immediately preceded by a sale
of the excluded components (i.e. without further processing) in a
controlled transaction. Under the fourth sentence of Sec. 1.482-
3(b)(2)(ii)(A), the uncontrolled transactions referred to in this
paragraph (v)(C) must have no differences with the controlled
transactions that would affect price, or have only minor differences
that have a definite and reasonably ascertainable effect on price and
for which appropriate adjustments are made (resulting in appropriate
adjustments to the computation of combined taxable income). If such
adjustments cannot be made, or if there are more than minor differences
between the controlled and uncontrolled transactions, the method
provided by this paragraph (v)(C) cannot be used. Thus, for example,
these uncontrolled transactions must involve substantially identical
property in the same or a substantially identical geographic market,
and must be substantially identical to the controlled transaction in
terms of their volumes, contractual terms, and market level. See
Sec. 1.482-3(b)(2)(ii)(B).
(D) In no case can the per unit combined taxable income as
determined under paragraph (v)(A) or (B) of this A. 12 be greater than
the per unit combined taxable income of the integrated product that
includes the component product or end-product form.
(E) The provisions of this paragraph (v) are illustrated by the
following example. Taxpayer manufactures product A in a U.S.
possession. Some portion of product A is sold to unrelated persons as
an integrated product and the remainder is sold to related persons for
transformation into product AB. The combined taxable income of
integrated product A is $400 per unit and the combined taxable income
of product AB is $300 per unit. The production cost ratio with respect
to product A when sold as a component of product AB, is 2/3. Unless the
taxpayer elects and satisfies the conditions of this paragraph (v), the
combined taxable income with respect to A will be $200 per unit
(combined taxable income for AB of $300 x the production cost ratio
of 2/3). If, however, the comparability standards of paragraph (v)(C)
of this A. 12 are met, the taxpayer may elect to determine combined
taxable income of product A when sold as a component of product AB
using the same per unit combined taxable income as product A when sold
as an integrated product. However, the per unit combined taxable income
from sales of product A as a component product may not exceed the per
unit combined taxable income on the sale of product AB. Therefore, the
combined taxable income of component product A may not exceed $300 per
unit.
(vi) Taxpayers that have not elected the percentage limitation
under section 936(a)(1) for the first taxable year beginning after
December 31, 1993, may do so if the taxpayer has elected the profit
split method and computation of combined taxable income is affected by
Q&A.12 of this paragraph (b)(1).
(vii) The rules of Q&A. 12 of this paragraph (b)(1) apply for
taxable years ending 30 days after May 10, 1996. If, however, the
election under paragraph (v) of A. 12 of Sec. 1.936-6(b)(1) is made,
this election must be made for the taxpayer's first taxable year
beginning after December 31, 1993, and if not made effective for that
year, the election cannot be made for any later taxable year. A
successor corporation that makes the same or substantially similar
products as its predecessor corporation cannot make an election under
paragraph (v) of A.12 of Sec. 1.936-6(b)(1) unless the election was
made by its predecessor corporation for its first taxable year
beginning after December 31, 1993.
* * * * *
A. 13: (i) The income shall be allocated to affiliates in the
following order, but no allocations will be made to affiliates
described in a later category if there are any affiliates in a prior
category--
(A) First, to U.S. affiliates (other than tax exempt affiliates)
within the group (as determined under section 482) that derive income
with respect to the product produced in whole or in part in the
possession;
(B) Second, to U.S. affiliates (other than tax exempt affiliates)
that derive income from the active conduct of a trade or business in
the same product area as the possession product;
(C) Third, to other U.S. affiliates (other than tax-exempt
affiliates);
(D) Fourth, to foreign affiliates that derive income from the
active conduct of a U.S. trade or business in the same product area as
the possession product (or, if the foreign members are resident in a
country with which the U.S. has an income tax convention, then to those
foreign members that have a permanent establishment in the United
States that derives income in the same product area as the possession
product); and
(E) Fifth, to all other affiliates.
(ii) The allocations made under paragraph (i)(A) of this A. 13
shall be
[[Page 21370]]
made on the basis of the relative gross income derived by each such
affiliate with respect to the product produced in whole or in part in
the possession. For this purpose, gross income must be determined
consistently for each affiliate and consistently from year to year.
(iii) The allocations made under paragraphs (i)(B) and (i)(D) of
this A. 13 shall be made on the basis of the relative gross income
derived by each such affiliate from the active conduct of the trade or
business in the same product area.
(iv) The allocations made under paragraphs (i)(C) and (i)(E) of
this A. 13 shall be made on the basis of the relative total gross
income of each such affiliate before allocating income under this
section.
(v) Income allocated to affiliates shall be treated as U.S. source
and section 863(b) does not apply for this purpose.
(vi) For purposes of determining an affiliate's estimated tax
liability for income thus allocated for taxable years beginning prior
to January 1, 1995, the income shall be deemed to be received on the
last day of the taxable year of each such affiliate in which or with
which the taxable year of the possessions corporation ends. For taxable
years beginning after December 31, 1994, quarterly estimated tax
payments will be required as provided under section 711 of the Uruguay
Round Agreements, Public Law 103-465 (1994), page 230, and any
administrative guidance issued by the Internal Revenue Service
thereunder.
* * * * *
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved: April 4, 1996.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 96-11639 Filed 5-9-96; 8:45 am]
BILLING CODE 4830-01-U
