[4830-01-u]
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.
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 [INSERT DATE 90 DAYS AFTER THE DATE
OF PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER].
ADDRESSES: Send submissions to: CC:DOM:CORP:R (INTL-0003-95),
room 5228, Internal Revenue Service, POB 7604, Ben Franklin
Station, Washington, DC 20044. In the alternative, submissions
may be hand delivered between the hours of 8 a.m. and 5 p.m. to:
CC:DOM:CORP:R (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 Consitution 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 [INSERT DATE 60 DAYS AFTER THE DATE OF
PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER].
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
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
1.863-3(b)(2)Example 2. The regulations do not define "peculiar
conditions of production and sale." In addition, 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 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 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 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 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 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 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 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
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 as defined
in 1.863-1(b)(3)(ii) 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
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, 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 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 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 1.863-3 (i.e., the 50/50 method as
described in 1.863-3(b)(1), the IFP method described in 1.863-
3(b)(2), or, if permitted by the District Director, the books and
records method as described in 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 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 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), 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 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 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 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 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.
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
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 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 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 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 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, 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 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 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 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 taxpayer's 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 situs 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 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.
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 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 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 pro rata 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 1.863-2
of the regulations. Under 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 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 1.936-6(a)(5), Q&A 7. Other
changes to 1.863-2 were intended to conform the language of the
regulation to the changes in 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 1.863-4 will only apply to services that are not
described in section 863(c) and the telegraph and cable rules
contained in 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 [INSERT DATE 90 DAYS AFTER DATE
OF PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER].
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:
1.863-0 Table of contents.
This section lists captions contained in 1.863-1, 1.863-2,
and 1.863-3.
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.
1.863-2 Allocation and apportionment of taxable income.
(a) Determination of taxable income.
(b) Determination of source of taxable income.
(c) Effective dates.
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:
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 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 1.863-2(a). See also sections 865(b)
and 865(e)(2).
(b) Natural resources--(1) In general. Notwithstanding
any other provision, except to the extent provided in paragraph
(b)(2) of this section, gross receipts from the sale outside the
United States of products derived from the ownership or operation
of any farm, mine, oil or gas well, other natural deposit, or
timber within the United States, 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 1.863-3. For purposes of applying
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 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 1.863-3. For purposes of
applying 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 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 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.
(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 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 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 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 1.863-1(b), $40 of US
Gold's gross receipts will be allocated to sources without the
United States. Under 1.863-1(b)(1)(ii), the source of the
remaining $60 of gross receipts will be determined under 1.863-
3. If US Gold applies the 50/50 method described in 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
1.863-1(b)(1), $80 of US Oil's gross receipts will be allocated
to sources without the United States, and under 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 1.863-
1(b)(3)(ii), the source of US Furniture's income will be
determined under 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 1.863-3. If US Furniture applies the 50/50
method described in 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 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 1.863-1 (as contained in 26 CFR part 1 revised as of April
1, 1995).
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 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 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 1.863-4. To
determine the source of gross income described in paragraph
(a)(2) of this section, see 1.863-1 for natural resources and
1.863-3 for other inventory. However, the principles of 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
1.863-3(f).
(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
1.863-2 (as contained in 26 CFR part 1 revised as of April 1,
1995).
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; 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, an unrelated foreign clothing manufacturer, for
$100. Cost of goods sold for cloth is $80, entirely attributable
to production activity. P does not engage in significant sales
activity in relation to its other activities in the sales to D.
Under these facts, the sale to D fairly establishes an IFP of
$100. Assume that P elects to use the IFP method. Accordingly,
$100 of the gross sales price is treated as attributable to
production activity, and no amount of income from this sale is
attributable to sales activity. After reducing the gross sales
price by cost of goods sold, $20 of the gross income is treated
as attributable to production activity ($100-$80).
(ii) P also sells cloth in country X to A, 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 1.864-1.
(B) Definition of production assets. For purposes of this
section, production assets include only tangible and intangible
assets owned directly by the taxpayer that are directly used by
the taxpayer to produce inventory described in paragraph (a) of
this section. Production assets do not include assets that are
not directly used to produce inventory described in paragraph (a)
of this section. Thus, production assets do not include such
assets as accounts receivables, intangibles not related to
production of inventory (e.g., marketing intangibles, including
trademarks and customer lists), transportation assets,
warehouses, the inventory itself, raw materials, or work-in-
process. In addition, production assets do not include cash or
other liquid assets (including working capital), investment
assets, prepaid expenses, or stock of a subsidiary. 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
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 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 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 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 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 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 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:
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.
* * * * * 1.863-5 [Removed]
Par. 5. Section 1.863-5 is removed 30 days after
publication of this regulation as a final regulation.
Margaret Milner Richardson
Commissioner of Internal Revenue