[Federal Register Volume 60, Number 237 (Monday, December 11, 1995)]
[Proposed Rules]
[Pages 63478-63489]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-30087]



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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[INTL-0003-95]
RIN 1545-AT92


Source of Income From Sales of Inventory and Natural Resources 
Produced in One Jurisdiction and Sold in Another Jurisdiction

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations governing the 
source of income from sales of natural resources or other inventory 
produced in the United States and sold in a foreign country or produced 
in a foreign country and sold in the United States. This document 
affects persons who produce natural resources or other inventory in the 
United States and sell in a foreign country, or produce natural 
resources or other inventory in a foreign country and sell in the 
United States. This document also provides notice of a public hearing 
on these proposed regulations.

DATES: Written comments and outlines of oral comments to be presented 
at the public hearing scheduled for April 10, 1996, at 10 a.m. must be 
received by March 11, 1996.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (INTL-0003-95), 

[[Page 63479]]
room 5228, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. In the alternative, submissions may be hand 
delivered between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R 
(INTL-0003-95), Courier's Desk, Internal Revenue Service, 1111 
Constitution Avenue NW., Washington, DC. The public hearing will be 
held in the IRS Auditorium, Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Anne 
Shelburne, (202) 622-3880; concerning submissions and the hearing, Ms. 
Christina Vasquez, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
(OMB) for review in accordance with the Paperwork Reduction Act of 1995 
(44 U.S.C. 3507).
    Comments on the collection of information should be sent to the 
Office of Management and Budget, Attn: Desk Officer for the Department 
of Treasury, Office of Information and Regulatory Affairs, Washington, 
DC 20503, with copies to the Internal Revenue Service, Attn: IRS 
Reports Clearance Officer, T:FP, Washington, DC 20224. Comments on the 
collection of information should be received by February 9, 1996.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number.
    The collection of information requirements are in proposed 
Secs. 1.863-1(b)(6) and 1.863-3(e)(2). This information is required by 
the IRS to monitor compliance with the federal tax rules for 
determining the source of income from the sale of natural resources or 
other inventory produced in the United States and sold in a foreign 
country or produced in a foreign country and sold in the United States. 
The likely respondents are taxpayers who produce natural resources or 
other inventory in the United States and sell in a foreign country, or 
who produce natural resources or other inventory in a foreign country 
and sell in the United States. Responses to this collection of 
information are required to properly determine the source of a 
taxpayer's income from such sales.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.
    Estimated total annual reporting burden: 1125 hours. The estimated 
annual burden per respondent varies from 1 hour to 5 hours, depending 
on individual circumstances, with an estimated average of 2.6 hours.
    Estimated number of respondents: 425.
    Estimated annual frequency of responses: One time per year.

Background

    These proposed regulations contain rules relating to the source of 
income from the sale of certain natural resources and other inventory. 
These regulations are proposed to be effective for taxable years 
beginning 30 days after publication of final regulations. However, 
taxpayers may elect to apply these regulations for taxable years 
beginning after July 11, 1995.

Explanation of Provisions

I. Natural Resources

A. Current Regulations

    Section 863 authorizes the Secretary to promulgate regulations 
allocating or apportioning to sources within or without the United 
States all items of gross income, expenses, losses, and deductions 
other than those items specified in sections 861(a) and 862(a).
    Section 1.863-1 of the existing regulations contains rules for 
determining the source of income derived from the sale of certain 
natural resources. Generally, under paragraph (b)(1) of those 
regulations, income derived from the ownership or operation of any 
farm, mine, oil or gas well, other natural deposit, or timber located 
within the United States and from the sale by the producer of the 
products within or without the United States ordinarily must be 
included in gross income from sources within the United States. 
However, if a taxpayer can show to the satisfaction of the District 
Director that, due to peculiar conditions of production and sale or for 
other reasons, not all of the gross income derived therefrom should be 
allocated to sources within the United States, the source of the income 
generally is determined under the 50/50 method described in Sec. 1.863-
3(b)(2) Example 2. The regulations do not define ``peculiar conditions 
of production and sale.'' In addition, Sec. 1.863-1(b)(2) permits the 
Commissioner to make an allocation or apportionment that more clearly 
reflects the proper source of a taxpayer's income, if the Commissioner 
determines that the application of paragraph (b)(1) does not result in 
the proper allocation or apportionment of income. Similar rules apply 
in the case of natural resources produced without the United States and 
sold within the United States. See Sec. 1.863-6. Thus, income from the 
sale of such products ordinarily will be allocated entirely to foreign 
sources.

B. Issues Under Current Regulations

    The IRS and Treasury have reexamined the existing regulations under 
section 863 regarding natural resources and arrived at several 
conclusions. First, certain ambiguities in existing Sec. 1.863-1 should 
be clarified. For example, the regulation does not define the term 
``peculiar conditions of production and sale,'' and there is virtually 
no authoritative guidance as to the scope of that term. To the extent 
that ``peculiar conditions of production and sale'' is defined 
narrowly, the regulation may lead to inappropriate results when 
determining the source of income from the sale of processed natural 
resources. For example, if a U.S. corporation harvests timber to 
manufacture furniture for export, all of its income may be from sources 
within the United States. However, if another U.S. corporation 
purchases cut timber to manufacture furniture for export from the 
United States, one-half of that taxpayer's income may be from sources 
without the United States under the 50/50 method.
    Second, the interaction of the existing regulations and the 
recently-issued consolidated return regulations may cause inappropriate 
sourcing results. On July 11, 1995, the IRS and Treasury issued final 
regulations under Sec. 1.1502-13 [TD 8597 (60 FR 36671)], treating 
members of a U.S. consolidated group as a single entity for purposes of 
determining the source of a taxpayer's income. The IRS and Treasury 
understand that inappropriate results may occur when the current 
section 863 regulations are applied to certain consolidated groups on a 
single entity basis. For example, a U.S. corporation that is a member 
of a consolidated group may extract oil abroad. The oil is then 
transported to the United States where it is refined by another member 
of the consolidated group. It is sold in the United States through 
other members of the consolidated group. Under Sec. 1.1502-13 of the 
consolidated return rules, the consolidated group is treated as a 
single entity, and the source of income from the sale of oil must be 
determined under 

[[Page 63480]]
section 863. Because the consolidated group refines the oil outside the 
country of extraction, it may be that peculiar conditions of production 
and sale exist, and the exclusive sourcing rules of paragraph (b)(1) do 
not apply. Thus, the taxpayer would generally determine the source of 
its income under the 50/50 method described in Sec. 1.863-3(b)(2) 
Example 2. Under this method, 50 percent of the consolidated group's 
income would be U.S. source income based on the place of sale. However, 
this calculation may understate the appropriate amount of the 
taxpayer's foreign source income because the value of the oil as 
extracted may represent more than 50 percent of the total value of the 
product that is finally sold in the United States. The preamble to the 
regulations under Sec. 1.1502-13 indicated that the IRS and Treasury 
would consider amending the regulations under section 863 to address 
these concerns.
    Accordingly, the IRS and Treasury are issuing proposed regulations 
under section 863 to clarify ambiguities in the existing regulation and 
to address concerns created by the new Sec. 1.1502-13 regulations.

C. Proposed Regulations

    Section 1.863-1(b) provides special rules for determining the 
source of income from the sale of products derived from the ownership 
or operation of any farm, mine, oil or gas well, other natural deposit, 
or timber, within the United States and the sale of these products 
without the United States. The proposed regulations also provide 
special rules for determining the source of income from the sale of 
products derived from the ownership or operation of any farm, mine, oil 
or gas well, other natural deposit, or timber, without the United 
States and the sale of these products within the United States. The 
export terminal rule of paragraph (b)(1) provides that the source of 
gross receipts from the sale of such products equal to the fair market 
value of the product immediately prior to export (referred to in the 
proposed regulations as the export terminal) is determined according to 
where the farm, mine, oil or gas well, other natural deposit or timber 
is located. Separate rules are provided for determining the source of 
any gross receipts in excess of the fair market value of the product at 
the export terminal. Paragraph (b)(2) provides an exception to the 
approach of paragraph (b)(1) where, prior to export, the taxpayer 
engages in substantial production activities in addition to activities 
related to the ownership or operation of a farm, mine, oil or gas well, 
other natural deposit, or timber.
1. Export Terminal Rule
    Under the export terminal rule of paragraph (b)(1), gross receipts 
derived from the ownership or operation of any farm, mine, oil or gas 
well, other natural deposit, or timber, and sale of the products 
derived therefrom, are allocated between sources within and without the 
United States based on the fair market value of the product at the 
export terminal. The export terminal is the last point from which the 
product is sent from the United States to a foreign country or the last 
point from which goods are sent from a foreign country to the United 
States. For example, if a U.S. corporation extracts oil in one foreign 
country, sends the crude oil to a port in a second foreign country via 
pipeline, and delivers the oil to a U.S. refinery by ship, the export 
terminal would be the port in the second foreign country where the 
crude oil was loaded onto the ship.
    Under the export terminal rule, the source of gross receipts equal 
to the fair market value of the product at the export terminal is 
determined by the location of the farm, mine, well, deposit, or uncut 
timber. The source of gross receipts in excess of the fair market value 
of the product at the export terminal (excess gross receipts) is 
determined according to whether the taxpayer engages in any additional 
production activity following export. A taxpayer will be treated as 
performing production activities in addition to the activities of 
owning or operating a farm, mine, oil or gas well, other natural 
deposit, or timber based on the principles of Sec. 1.954-3(a)(4). 
However, activities that prepare the natural resource itself for 
export, including those that are designed to facilitate the 
transportation of the natural resource to or from the export terminal, 
will not be considered additional production activities. Thus, 
Sec. 1.863-1 Example 2 illustrates that liquefaction of natural gas 
would not constitute additional production activities. In addition, 
activities such as delimbing and debarking trees, sorting grain, and 
treating and stabilizing oil would ordinarily not constitute additional 
production activities. In contrast, the transformation of timber into 
furniture is not done to prepare the natural resource itself for 
export, and would constitute additional production activity. Production 
activities are defined in Sec. 1.863-1(b)(3)(i).
    If no additional production occurs following export, paragraph 
(b)(1)(i) requires that the source of the excess gross receipts be 
determined according to where the farm, mine, well, deposit, or uncut 
timber is located.
    However, under paragraph (b)(1)(ii), if the taxpayer engages in 
additional production activities after the export terminal and outside 
the country of sale, the source of excess gross receipts is determined 
under the rules of Sec. 1.863-3. For example, if a U.S. corporation 
extracts oil in a foreign country, refines the oil in the United 
States, and sells the refined product in another foreign country, the 
source of gross receipts in excess of the fair market value of the 
product when it is exported from the first foreign country must be 
determined under one of the three methods described in Sec. 1.863-3 
(i.e., the 50/50 method as described in Sec. 1.863-3(b)(1), the IFP 
method described in Sec. 1.863-3(b)(2), or, if permitted by the 
District Director, the books and records method as described in 
Sec. 1.863-3(b)(3)).
    In any case not described in either paragraph (b)(1) (i) or (ii) of 
the proposed regulations, the source of the excess gross receipts is 
determined according to the place of sale pursuant to paragraph 
(b)(1)(iii). This rule would apply, for example, in the case where the 
taxpayer engages in additional production activities in the country of 
sale.
    Paragraph (b)(1) addresses the concerns of U.S. corporations 
involved in the production of natural resources abroad and the 
application of the new Sec. 1.1502-13 consolidated return regulations, 
by allowing them to treat the value of the natural resources at the 
point of export as income from sources where the farm, mine, well, 
deposit, or uncut timber is located. This rule has no effect on the 
rules governing foreign oil and gas extraction income under section 
907(c)(1).
    On November 28, 1995, the Tenth Circuit affirmed the Tax Court 
decision in Phillips Petroleum v. Comm'r, 97 T.C. 30 (1991), which held 
existing Sec. 1.863-1(b)(1) invalid to the extent it allocates income 
from the sale of U.S. natural resources solely to sources within the 
United States. Phillips Petroleum v. Comm'r, No. 94-9021 (10th Cir. 
Nov. 28, 1995). The IRS and Treasury will consider the implications of 
this decision when finalizing these proposed regulations.
2. Additional Production Prior to Export Terminal
    Paragraph (b)(2) provides a special rule for determining the source 
of income where a taxpayer performs substantial additional production 
activities before the product leaves the export terminal. Under 
paragraph (b)(2), 

[[Page 63481]]
the source of gross receipts equal to the fair market value of the 
product prior to the additional production activities is based on the 
location of the farm, mine, well, deposit, or uncut timber. The source 
of gross receipts in excess of the fair market value of the products at 
the beginning of the additional production activities is determined 
under the rules of Sec. 1.863-3.
3. Other Rules
    The proposed regulation contains rules for determining the fair 
market value of relevant products. For this purpose, fair market value 
depends on all of the facts and circumstances as they exist relative to 
a party in any particular case. Thus, these rules for determining fair 
market value are consistent with the foreign oil and gas rules 
contained in Sec. 1.907(c)-1(b)(6). In addition, fair market value 
determinations must be consistent with prices charged in sales, if any, 
to related parties in a transaction that is subject to section 482. For 
example, if a member of a U.S. consolidated group extracts natural 
resources in a foreign country and sells the natural resources to 
another member of the same group at the export terminal, the value of 
the natural resources determined at the export terminal should be the 
price charged by the producing member to the purchasing member for 
purposes of section 482.
    Under paragraph (b)(5), a taxpayer's gross income from sources 
within or without the United States is determined by reducing its gross 
receipts from sources within or without the United States by the cost 
of goods sold properly attributable to such gross receipts. Under 
paragraph (c), a taxpayer's taxable income from U.S. or foreign sources 
must be determined under the rules of Secs. 1.861-8 through 1.861-14T.
    Under paragraph (b)(6), taxpayers must fully explain the 
methodology used, the facts describing substantial additional 
production activities (if any), and the determination of fair market 
value in a statement attached to the taxpayer's return. In addition, 
taxpayers must provide such other information as is required by 
Sec. 1.863-3(e)(2).
    Taxpayers may elect to apply the rules of these regulations for 
taxable years beginning after July 11, 1995. Otherwise, these 
regulations are effective for taxable years beginning 30 days after the 
publication of this regulation as a final regulation.

II. Inventory Other Than Natural Resources

A. Current Regulations

    Section 863 authorizes the Secretary to promulgate regulations 
allocating or apportioning to sources within or without the United 
States all items of gross income, expenses, losses, and deductions 
other than those specified in sections 861(a) and 862(a).
    Section 1.863-3 of the current regulations governs the source of 
income from the sale of inventory produced (in whole or in part) in the 
United States and sold in a foreign country, or produced (in whole or 
in part) in a foreign country and sold in the United States (Section 
863 Sales). Section 1.863-3 provides three methods, set forth in the 
form of three examples, to determine the source of income from Section 
863 Sales.
    Sec. 1.861-3(b)(2) Example 1 of the current regulations illustrates 
how an independent factory or production price (IFP) applies to 
determine the income attributable to production (IFP method). An IFP 
generally is established if a taxpayer regularly sells part of its 
output to wholly independent distributors in such a way as to 
reasonably reflect the income attributable to production activity. If 
an IFP exists, taxpayers must use the IFP method to determine the 
income attributable to production activities in both the sale 
establishing the IFP and in sales of similar products. See Phillips 
Petroleum v. Comm'r, 97 T.C. 30 (1991), aff'd, No. 94-9021 (10th Cir. 
Nov. 28, 1995); Rev. Rul. 88-73 (1988-2 C.B. 173). Gross receipts in 
excess of the IFP are attributable to sales activity. Taxpayers can 
otherwise establish an IFP by showing to the satisfaction of the 
District Director that an IFP exists. Notice 89-10 (1989-1 C.B. 631) 
contains additional rules regarding the application of the IFP method. 
Section 1.863-3(b)(2) Example 1 of the current regulations does not 
provide explicit guidance as to how to determine the source of income 
attributable to production activities under the IFP method. However, 
the source of income attributable to sales activities is based 
generally on where title to the inventory passes to the purchaser as 
defined in Sec. 1.861-7(c).
    Section 1.863-3(b)(2) Example 2 of the current regulations divides 
a taxpayer's income from Section 863 Sales equally between production 
activity and sales activity (50/50 method). The source of income 
attributable to production activity is based on the location of the 
taxpayer's property. The portion of this production income attributable 
to sources within the United States is determined by a fraction, the 
numerator of which is the taxpayer's property located within the United 
States used to produce income from Section 863 Sales, and the 
denominator of which is the taxpayer's property both within the United 
States and within a foreign country used to produce income from Section 
863 Sales. The source of the taxpayer's income attributable to sales 
activity is based on where title to the inventory passes to the 
purchaser as defined in Sec. 1.861-7(c).
    Section 1.863-3(b)(2) Example 3 of the current regulations allows a 
taxpayer to request permission from the District Director to use the 
taxpayer's books and records to allocate income to sources within and 
without the United States if those books reflect more clearly than the 
other methods the taxable income derived from sources within the United 
States (books and records method).

B. Issues Under Current Regulations

    On July 12, 1995, the IRS and Treasury issued regulations under 
Sec. 1.1502-13, treating members of a consolidated group as a single 
entity for purposes of determining the source of a taxpayer's income. 
The IRS and Treasury understand that the current section 863 
regulations may raise questions when applied to certain consolidated 
groups on a single entity basis. The preamble to the regulations under 
Sec. 1.1502-13 indicated that the IRS and Treasury would reevaluate 
part of the regulations under section 863. As part of this process, the 
IRS and Treasury also have reexamined the remainder of the existing 
section 863 regulations and have concluded that several additional 
changes are necessary.
    First, the existing regulations were drafted more than 70 years 
ago, and have not been amended to reflect the evolution of business 
practices. As a result, the regulations have been the source of 
controversies in recent years. See Intel Corporation v. Comm'r, 100 
T.C. 39 (1993), aff'd, No. 94-70105 (9th Cir. Oct. 16, 1995); Phillips 
Petroleum v. Comm'r, 97 T.C. 30 (1991), 101 T.C. 78, 104 (1993) 
(``there have been no cases interpreting [the 50/50 method] and no 
administrative pronouncements regarding its application since the 
regulation was promulgated in 1922 except for necessary inferences to 
be drawn from Intel * * *''), aff'd, No. 94-9021 (10th Cir. Nov. 28, 
1995). In part, these controversies may be due to the structure of the 
current regulations, which do not contain operative rules to describe 
the methods of allocating and 

[[Page 63482]]
apportioning income, but instead rely on examples.
    Second, the existing regulations raise important administrative 
concerns. For example, the IFP method requires an analysis of each of 
the taxpayer's sales transactions to identify an IFP. If one or more 
IFPs are so identified, a second analysis is required of each of the 
taxpayer's sales transactions to identify which transactions are 
similar to the IFP sale. In some cases, this process may require a 
review of a multitude of transactions. The IFP method may, therefore, 
be difficult for both taxpayers and the government to apply. The 
existing 50/50 method also presents administrative concerns. For 
example, the 50/50 method may require the taxpayer to determine the 
fair market value of each of its assets at the end of every tax year. 
Taxpayers have often commented to the IRS about the difficulties of 
determining the fair market value of their assets.
    Third, the existing regulations result in disparate treatment of 
similarly situated taxpayers. Although an IFP must be used under 
current rules if one exists, the mandate applies only to taxpayers 
selling inventory to certain independent distributors. Taxpayers 
selling exclusively to related parties are not required to use the IFP 
method since the IRS may not establish an IFP based on such sales. 
Instead, these taxpayers use the 50/50 method to source their income 
from export sales. Thus, taxpayers selling inventory exclusively to 
related parties may be deemed to generate far more foreign source 
income than taxpayers selling a portion of their inventory to 
independent distributors, even though the two taxpayers may perform the 
same functions. The IRS and Treasury believe that this differing 
treatment of similarly situated taxpayers is not justified.
    Fourth, the existing 50/50 method can result in apportionment of 
income that is inconsistent with the common understanding of that 
method. The  50/50 method is generally characterized as a method that 
would source export sales income one-half in the United States and one-
half in a foreign country. For example, in 1984 the Treasury Department 
stated: ``Generally, [income derived from manufacture and sale of 
property] is allocated one-half on the basis of the place of 
manufacture and half on the basis of the place of sale * * *'' Treasury 
Department, Tax Reform for Fairness, Simplicity, and Economic Growth, 
Nov. 1984 at 364. In addition, Congress understands the 50/50 method to 
operate in this fashion. In 1986, the House, Senate and Conference 
Committees each stated: ``[Under the existing 50/50 method], half of 
such income generally is sourced in the country of manufacture, and 
half of the income is sourced on the basis of the place of sale''. 
House Rep. No. 426, 99th Cong. 1st Sess. 359 (1985); S. Rep. No. 313, 
99th Cong. 2d Sess. 329 (1986); H.R. Conf. Rep. No. 841, 99th Cong. 2d 
Sess. II-595 (1986). The staff of the Joint Committee on Taxation has 
referred to the 50/50 method as the ``production/marketing split'' and 
stated that under this method ``50 percent of such income generally is 
attributed to the place of production * * *'' Staff of the Joint Comm. 
on Taxation, Factors Affecting International Competitiveness of the 
United States 148 (1991).
    The existing regulations may, however, allow taxpayers to use the 
50/50 method to obtain results that are inconsistent with this common 
understanding. Under the existing regulations, 50 percent of the income 
is treated as sales income and sourced on the basis of title passage. 
The remaining 50 percent is treated as production income and sourced 
based on the location of assets. This half of the formula is not 
necessarily, however, limited to production assets. For example, 
goodwill and accounts receivables are counted as assets in allocating 
production income. The inclusion of sales assets in the formula 
allocating production income results in additional income being 
allocated to sales activities. The contribution of the sales assets to 
sales income should be reflected only in the 50 percent of the income 
that is allocated to sales and sourced under title passage. Thus, the 
production income formula should only take into account assets directly 
involved in the production of inventory.

B. Proposed Regulations

1. Overview
    Section 1.863-3 provides rules for allocating and apportioning 
income from Section 863 Sales. Generally, Sec. 1.863-3(b) provides 
three methods for determining the amount of gross income attributable 
to production activity and the amount of gross income attributable to 
sales activity. The source of gross income attributable to each 
activity is then determined under the rules of paragraph (c). Paragraph 
(d) provides rules to determine the source of taxable income. Reporting 
and election rules are set forth under paragraph (e) of the proposed 
regulations. The proposed regulations reserve on paragraph (f) (prior 
paragraph (c)), dealing with income partly from sources within a 
possession of the United States. The IRS and Treasury solicit comments 
from taxpayers regarding changes that should be made to new paragraph 
(f) (if any) to conform to the other changes in  Sec. 1.863-3.
    The proposed regulations generally apply an aggregate approach in 
taking into account a taxpayer's interest in a partnership. The IRS and 
Treasury solicit comments on the appropriate treatment of partnerships, 
including whether there should be special rules for limited 
partnerships, de minimis interests in partnerships, and tiered 
partnerships.
2. Methods To Determine Gross Income Attributable to Production 
Activity and Sales Activity
    Section 1.863-3 generally retains the three methods of the current 
regulations for splitting income between production and sales activity, 
with several modifications.
a. 50/50 Method
    The proposed regulations do not change the allocation of half of 
the taxpayer's income from Section 863 Sales to production activity and 
half to sales activity. As described below, the proposed regulations 
modify and clarify the determination of the location of assets. In 
addition, paragraph (b)(1) of the proposed regulations makes the  50/50 
method the general rule to determine the amount of income attributable 
to production and sales activities. The taxpayer, however, may elect to 
apply the IFP method, described in paragraph (b)(2), or, with the 
consent of the District Director, the books and records method, 
described in paragraph (b)(3).
b. IFP Method
    By making the IFP method elective, the proposed regulations 
significantly reduce administrative burdens related to its application 
and eliminate any bias against taxpayers choosing to export through 
independent distributors.
    Under the proposed regulations, the taxpayer may elect to apply the 
IFP method if it is able to establish an IFP. As in the current 
regulations, an IFP is fairly established by actual sales of the 
taxpayer if the taxpayer regularly sells part of its output to wholly 
independent distributors or other selling concerns in such a way as to 
reasonably reflect the income attributable to production activity. Once 
the IFP is established, it can be used to determine the amount of 
income attributable to production activity in other Section 863 Sales 
if the inventory sold in the other sales is substantially similar in 
physical characteristics and function, and is sold at a similar level 
of distribution as the 

[[Page 63483]]
inventory sold in a sale establishing an IFP. A sale will not be 
considered to establish an IFP if sales activity for the relevant 
product is significant in relation to all of the activities for that 
product. The IRS and Treasury intend to supersede Notice 89-10 upon 
publication of final regulations.
    The proposed regulations would also eliminate the existing rule 
permitting taxpayers to otherwise establish an IFP by showing to the 
satisfaction of the District Director that a sale reasonably reflecting 
the income attributable to production exists. This ``otherwise 
established'' IFP is rarely, if ever, used. American Law Institute, 
International Aspects of United States Income Taxation 31 (1987). The 
IRS and Treasury solicit comments from taxpayers on the continued 
utility of the otherwise established IFP.
    The proposed regulations omit the reference in the existing 
regulation to a sales branch. A taxpayer may elect to use the IFP 
method even if it does not maintain a sales branch in a foreign 
country.
c. Books and Records Method
    The proposed regulations retain the books and records method of the 
existing regulations, permitting taxpayers to request permission from 
the District Director to use their books and records to determine the 
income attributable to production and sales activities. The District 
Director will consider a taxpayer's request if the taxpayer maintains a 
detailed allocation of receipts and expenditures, clearly reflecting 
the amount of income from production and sales activities.
    The books and records method is rarely, if ever, used. American Law 
Institute, International Aspects of United States Income Taxation, 31 
(1987). The IRS and Treasury solicit comments from taxpayers on the 
continued utility of the books and records method, or whether the books 
and records method should be replaced by another method of economic 
sourcing.
3. Determination of Source of Gross Income
    Unlike the current regulations which provide specific rules for 
determining the source of income attributable to production activity 
and sales activity only for purposes of the 50/50 method, the proposed 
regulations adopt rules applicable to each of the three methods. Under 
the proposed regulations, once gross income attributable to production 
activity and sales activity has been determined under one of the 
methods described in paragraph (b), the source of the income is 
determined separately for each type of income under paragraph (c). The 
source of gross income attributable to production activity is 
determined under paragraph (c)(1), based on the location of production 
assets, and the source of gross income attributable to sales activity 
is determined under paragraph (c)(2) based on the location of the sale.
a. Source of Gross Income Attributable to Production Activity
    The proposed regulations generally adopt the approach set forth in 
the current regulations under the 50/50 method, but with modifications 
and clarifications.
    Under Sec. 1.863-3(c)(1), the source of income attributable to 
production activity is determined based on the location of the 
taxpayer's production assets. Thus, if a taxpayer manufactures 
inventory exclusively in the United States, all of its income 
attributable to production activity will be considered from sources 
within the United States. The rules described below are intended to 
apply only to taxpayers that produce inventory both within and without 
the United States.
    Under the proposed regulations, the source of a taxpayer's income 
from production activities is determined by reference to the taxpayer's 
production assets, instead of all of its assets that produce income 
from Section 863 Sales. The IRS and Treasury believe that this change 
is appropriate to ensure that the source of production income 
corresponds to the location of production activity. Production assets 
are defined to include tangible and intangible property owned by the 
taxpayer that are used to produce inventory sold in Section 863 Sales. 
Any property not directly used to produce inventory is excluded. Thus, 
accounts receivable and marketing intangibles are excluded because they 
are sales assets and not production assets. Other assets excluded 
because they do not directly produce inventory are transportation 
assets, warehouses, inventory, work-in-process, raw materials, cash, 
investment assets, and stock of a subsidiary. Working capital is 
excluded to avoid uncertainty arising from determinations of the 
appropriate amount of working capital. In addition, working capital 
would generally be apportioned pro rata in accordance with a taxpayer's 
production assets. As under the current regulations, leased assets are 
excluded; only assets owned by the taxpayer are included.
    The proposed regulations also provide specific rules for 
determining where a production asset is located. Tangible assets are 
located where the assets are used by the taxpayer. Intangible Assets 
are located where the tangible production assets to which they relate 
are located.
    Where production takes place both within the United States and 
within a foreign country, the regulations apply a property fraction to 
apportion production income between U.S. and foreign sources. The 
taxpayer's foreign source gross production income is determined by 
multiplying its gross production income by a fraction, the numerator of 
which is the taxpayer's production assets located within a foreign 
country, and the denominator of which is the taxpayer's production 
assets located both within the united States and within a foreign 
country.
    The current regulations generally include assets in the property 
formula at fair market value. The proposed regulations modify this rule 
to provide that an asset must be included in the property formula at 
its average adjusted basis (see section 1011). The IRS and Treasury 
believe that this change to adjusted basis will significantly simplify 
the application of this formula for both taxpayers and the IRS.
    The proposed regulations also contain more detailed guidance than 
the current regulations for determining the amounts to be included in 
the property fraction. For example, the proposed regulations would 
require that if the asset is used to produce inventory sold in Section 
863 Sales and is also used to produce other property, the basis of the 
asset must be prorated to account for such other uses.
    The purpose of the property formula is to attribute the source of 
the taxpayer's production income to the location of its production 
activity. The IRS and Treasury are concerned that taxpayers may be able 
to affect the location of assets without changing the sit us of 
economic activity. Accordingly, comments are solicited about whether 
there should be rules to prevent manipulation of this formula in a 
manner inconsistent with the purpose of the regulation.
b. Source of Gross Income Attributable to Sales Activity
    The source of gross income that is attributable to sales activity 
is determined under paragraph (c)(2). As under the current regulations, 
the source of this income is generally based on where a sale takes 
place. See Sec. 1.861-7(c). Accordingly, if a U.S. producer sells its 
goods in a foreign country, the income attributable to sales activity 
is generally foreign source income.

[[Page 63484]]

    The proposed regulation would retain the language of the existing 
regulation, which only applies to sales that occur within a foreign 
country. The IRS and Treasury solicit comments as to whether the 
regulations should be expanded to apply to sales made in international 
waters or in space. The IRS and Treasury are concerned, however, that 
if such a change were made, a U.S. seller may try to use the 50/50 
method by selling inventory in international waters to U.S. purchasers, 
even when the goods were destined for the United States. In view of 
these concerns, the IRS and Treasury also solicit comments as to 
whether the regulations should provide an exception to the title 
passage rule in the case of sales of goods produced in the United 
States and destined for use in the United States.
4. Determination of Source of Taxable Income
    Once the amount and source of gross income are determined under 
paragraph (c), taxpayers then determine the source of their taxable 
income. Under proposed paragraph (d), taxpayers must allocate or 
apportion under Secs. 1.861-8 through 1.861-14T the amounts of 
expenses, losses and other deductions to its gross income determined 
under each method described in paragraph (b). In the case of amounts of 
expenses, losses and other deductions allocated or apportioned to gross 
income determined under the IFP method or the books and records method, 
the taxpayer must apply the rules of Secs. 1.861-8 through 1.861-14T to 
allocate or apportion these amounts between gross income from sources 
within and without the United States. For amounts of expenses, losses 
and other deductions allocated or apportioned to gross income 
determined under the 50/50 method, taxpayers must apportion expenses 
and other deductions prorata based on the relative amounts of U.S. and 
foreign source gross income. These rules are consistent with existing 
regulations.
5. Election and Reporting Rules
    Under paragraph (e) of the proposed regulations, a taxpayer must 
use the 50/50 method unless the taxpayer elects to use the IFP method, 
or elects the Books and Records method. The taxpayer makes the election 
by using the method on its tax return. Once The tax return is filed, 
the election is not revokable for that year. In addition, that method 
must be used in later taxable years unless the Commissioner or her 
delegate consents to a change. Permission to change methods in later 
years will not be withheld unless the change would result in a 
substantial distortion of the source of income.
    A taxpayer must fully explain the methodology used in paragraph 
(b), and the amount of income allocated or apportioned to U.S. and 
foreign sources in a statement attached to its tax return.
6. Conforming Changes
    The proposed regulations make conforming changes to Sec. 1.863-2 of 
the regulations. Under Sec. 1.863-2, the taxpayer may elect to apply 
the 50/50 method to its net taxable income, instead of its gross income 
as specified in Sec. 1.863-3. The proposed regulations clarify that 
income derived from the purchase of personal property within a 
possession of the United States and its sale within the United States 
is subject to these regulations only to the extent it is not excluded 
by Sec. 1.936-6(a)(5), Q&A 7. Other changes to Sec. 1.863-2 were 
intended to conform the language of the regulation to the changes in 
Sec. 1.863-3.
    Finally, the IRS and Treasury will reconsider the existing 
regulations issued under section 863 regarding transportation services 
and cable and telegraph services in light of the Tax Reform Act of 
1986. Accordingly, the transportation rules contained in Sec. 1.863-4 
will only apply to services that are not described in section 863(c) 
and the telegraph and cable rules contained in Sec. 1.863-5 are 
deleted. No inference is intended as to whether portions of the 
existing regulations continued to apply after the Tax Reform Act of 
1986.
7. Proposed Effective Dates
    These regulations are effective for taxable years beginning 30 days 
after publication of final regulations. However, taxpayers may apply 
these regulations for taxable years beginning after July 11, 1995, and 
before 30 days after publication of these regulations as final 
regulations.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in EO 12866. Therefore, 
a regulatory assessment is not required. It is hereby certified that 
these regulations will not have a significant economic impact on a 
substantial number of small entities. Accordingly, a regulatory 
flexibility analysis is not required. Pursuant to section 7805(f) of 
the Internal Revenue Code, this notice of proposed rulemaking will be 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) that are submitted timely to the IRS. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for April 10, 1996, at 10 a.m. 
in the IRS Auditorium. Because of access restrictions, visitors will 
not be admitted beyond the Internal Revenue Building lobby more than 15 
minutes before the hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons that wish to present oral comments at the hearing must 
submit written comments and an outline of topics to be discussed and 
the time to be devoted to each topic (signed original and eight (8) 
copies) by March 11, 1996.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these regulations is Anne Shelburne, Office 
of Associate Chief Counsel (International). However, other personnel 
from the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order to read as follows:

    Authority: 26 U.S.C. 7805 * * *

    Section 1.863-1 also issued under 26 U.S.C. 863.
    Section 1.863-2 also issued under 26 U.S.C. 863.
    Section 1.863-3 also issued under 26 U.S.C. 863.
    Section 1.863-4 also issued under 26 U.S.C. 863.
    Section 1.863-6 also issued under 26 U.S.C. 863. * * *

    Par. 2. Sections 1.863-0 is added to read as follows: 
    
[[Page 63485]]



Sec. 1.863-0  Table of contents.

    This section lists captions contained in Secs. 1.863-1, 1.863-2, 
and 1.863-3.

Sec. 1.863-1  Allocation of Gross Income.

(a) In general.
(b) Natural resources.
(1) In general.
(2) Additional production prior to export terminal.
(3) Definitions.
(i) Production activity.
(ii) Additional production activities.
(iii) Export terminal.
(4) Determination of fair market value.
(5) Determination of gross income.
(6) Tax return disclosure.
(7) Examples.
(c) Determination of taxable income.
(d) Effective dates.

Sec. 1.863-2  Allocation and Apportionment of Taxable Income.

(a) Determination of taxable income.
(b) Determination of source of taxable income.
(c) Effective dates.

Sec. 1.863-3  Allocation and Apportionment of Income from Certain 
Sales of Inventory.

(a) In general.
(b) Methods to determine income attributable to production activity 
and sales activity.
(1) 50/50 method.
(i) Determination of gross income.
(ii) Example.
(2) IFP method.
(i) Establishing an IFP.
(ii) Applying the IFP method.
(iii) Determination of gross income.
(iv) Examples.
(3) Books and records method.
(c) Determination of the source of gross income from production 
activity and sales activity.
(1) Income attributable to production activity.
(i) Production only within the United States or only within foreign 
countries.
(A) Source of income.
(B) Definition of production assets.
(C) Location of production assets.
(ii) Production both within the United States and within foreign 
countries.
(A) Source of income.
(B) Adjusted basis of production assets.
(iii)Examples.
(2) Income attributable to sales activity.
(d) Determination of source of taxable income.
(e) Election and reporting rules.
(1) Elections under paragraph (b) of this section.
(2) Disclosure on tax return.
(f) Income partly from sources within a possession of the United 
States. [Reserved]
(g) Effective dates.

    Par. 3. Sections 1.863-1, 1.863-2, and 1.863-3 are revised to read 
as follows:


Sec. 1.863-1  Allocation of gross income.

    (a) In general. Items of gross income other than those specified in 
section 861(a) and section 862(a) will generally be separately 
allocated to sources within or without the United States. See 
Sec. 1.863-2 for alternate methods to determine the income from sources 
within or without the United States in the case of items specified in 
Sec. 1.863-2(a). See also sections 865(b) and 865(e)(2).
    (b) Natural resources--(1) In general. Except to the extent 
provided in paragraph (b)(2) of this section, gross receipts from the 
sale outside the United States of products derived from the ownership 
or operation of any farm, mine, oil or gas well, other natural deposit, 
or timber within the United States, are allocated between sources 
within or without the United States based on the fair market value of 
the product at the export terminal (as defined in paragraph (b)(3)(iii) 
of this section). Except to the extent provided in paragraph (b)(2) of 
this section, gross receipts from the sale within the United States of 
products derived from the ownership or operation of any farm, mine, oil 
or gas well, other natural deposit, or timber outside the United States 
are also allocated between sources within or without the United States 
based on the fair market value of the product at the export terminal. 
The source of gross receipts equal to the fair market value of the 
product at the export terminal will be from sources where the farm, 
mine, well, deposit, or uncut timber is located. The source of gross 
receipts from the sale of the product in excess of its fair market 
value at the export terminal (excess gross receipts) will be determined 
as follows--
    (i) If the taxpayer does not engage in additional production 
activities (as defined in paragraph (b)(3)(ii) of this section), excess 
gross receipts will be from sources where the farm, mine, well, 
deposit, or uncut timber is located;
    (ii) If the taxpayer engages in additional production activities 
subsequent to shipment from the export terminal and outside the country 
of sale, the source of excess gross receipts must be determined under 
Sec. 1.863-3. For purposes of applying Sec. 1.863-3, only production 
assets used in additional production activity subsequent to the export 
terminal are taken into account; or
    (iii) In all other cases, excess gross receipts will be from 
sources within the country of sale, as described in Sec. 1.861-7(c). 
This paragraph (b)(1)(iii) applies, for example, to a taxpayer that 
engages in additional production activities in the country of sale.
    (2) Additional production prior to export terminal. Notwithstanding 
any other provision of this section, gross receipts from the sale of 
products derived by a taxpayer who performs additional production 
activities as defined in paragraph (b)(3)(ii) of this section before 
the relevant product is shipped from the export terminal are allocated 
between sources within and without the United States based on the fair 
market value of the product immediately prior to the additional 
production activities. The source of gross receipts equal to the fair 
market value of the product immediately prior to the additional 
production activities will be from sources where the farm, mine, well, 
deposit, or uncut timber is located. The source of gross receipts from 
the sale of the product in excess of the fair market value immediately 
prior to the additional production activities must be determined under 
Sec. 1.863-3. For purposes of applying Sec. 1.863-3, only production 
assets used in the additional production activities are taken into 
account.
    (3) Definitions--(i) Production activity. For purposes of this 
section, production activity means an activity that creates, 
fabricates, manufactures, extracts, processes, cures, or ages 
inventory. See Sec. 1.864-1.
    (ii) Additional production activities. For purposes of this 
section, additional production activities are substantial production 
activities performed by the taxpayer in addition to activities from the 
ownership or operation of any farm, mine, oil or gas well, other 
natural deposit, or timber. Whether a taxpayer performs such additional 
production activities will be determined under the principles of 
Sec. 1.954-3(a)(4). However, in no case will activities that prepare 
the natural resource itself for export, including those that are 
designed to facilitate the transportation of the natural resource to or 
from the export terminal, be considered additional production 
activities for purposes of this section.
    (iii) Export terminal. Where the farm, mine, well, deposit, or 
uncut timber is located without the United States, the export terminal 
will be the final point in a foreign country from which goods are 
shipped from a foreign country to the United States. Where the farm, 
mine, well, deposit, or uncut timber is located within the United 
States, the export terminal will be the final point in the United 
States from which goods are shipped from the United States to a foreign 
country. The export terminal is determined without regard to any 
contractual terms agreed to by the taxpayer and without regard to 
whether there is an actual sale of the products at the export terminal. 


[[Page 63486]]

    (4) Determination of fair market value. For purposes of this 
section, fair market value depends on all of the facts and 
circumstances as they exist relative to a party in any particular case. 
Where the products are sold to a related party in a transaction subject 
to section 482, the determination of fair market value under this 
section must be consistent with the arm's length price determined under 
section 482.
    (5) Determination of gross income. To determine the amount of a 
taxpayer's gross income from sources within or without the United 
States, the taxpayer's gross receipts from sources within or without 
the United States determined under this paragraph (b) must be reduced 
by the cost of goods sold properly attributable to gross receipts from 
sources within or without the United States.
    (6) Tax return disclosure. A taxpayer that determines the source of 
its income under this paragraph (b) shall attach a statement to its 
return explaining the methodology used to determine fair market value 
under paragraph (b)(4) of this section, and explaining any additional 
production activities (as defined in paragraph (b)(3)(ii) of this 
section) performed by the taxpayer. In addition, the taxpayer must 
provide such other information as is required by Sec. 1.863-3.
    (7) Examples. The following examples illustrate the rules of this 
paragraph (b):

    Example 1. No additional production. US Mines, a U.S. 
corporation, extracts coal in the United States and, without 
substantial additional production, sells the coal in a foreign 
country. Under Sec. 1.863-1(b) and (b)(1)(i), all of US Mines' 
income will be from sources within the United States.
    Example 2. Scope of additional production. US Gas, a U.S. 
corporation, extracts natural gas within the United States, and 
transports the natural gas to a U.S. port where it is liquified in 
preparation for shipment. The liquified natural gas is then 
transported via freighter and sold without additional production 
activities in a foreign country. Liquefaction of natural gas is not 
an additional production activity because liquefaction prepares the 
natural gas for transportation from the export terminal. Therefore, 
under Sec. 1.863-1(b) and (b)(1)(i), all of US Gas' income will be 
from sources within the United States.
    Example 3. Sale in third country. US Gold, a U.S. corporation, 
mines gold in country X, produces gold jewelry in the United States, 
and sells the jewelry in country Y. Assume that the fair market 
value of the gold at the export terminal in country X is $40, and 
that US Gold ultimately sells the gold jewelry in country Y for 
$100. Under Sec. 1.863-1(b), $40 of US Gold's gross receipts will be 
allocated to sources without the United States. Under Sec. 1.863-
1(b)(1)(ii), the source of the remaining $60 of gross receipts will 
be determined under Sec. 1.863-3. If US Gold applies the 50/50 
method described in Sec. 1.863-3, $20 of cost of goods sold is 
properly attributable to activities subsequent to the export 
terminal, and all of US Gold's production assets subsequent to the 
export terminal are located in the United States, then $20 of gross 
income will be allocated to sources within the United States and $20 
of gross income will be allocated to sources without the United 
States.
    Example 4. Production in country of sale. US Oil, a U.S. 
corporation, extracts oil in country X, transports the oil via 
pipeline to the export terminal in country Y, refines the oil in the 
United States, and sells the refined product in the United States to 
unrelated persons. Assume that the fair market value of the oil at 
the export terminal in country Y is $80, and that US Oil ultimately 
sells the refined product for $100. Under Sec. 1.863-1(b)(1), $80 of 
US Oil's gross receipts will be allocated to sources without the 
United States, and under Sec. 1.863-1(b)(1)(iii) the remaining $20 
of gross receipts will be allocated to sources within the United 
States.
    Example 5. Additional production prior to export. US Furniture, 
a U.S. corporation, cuts trees in the United States, converts the 
trees into lumber, uses the lumber to manufacture furniture in the 
United States, and sells the furniture in another country. Assume 
that the fair market value of the trees when the conversion into 
lumber begins is $40, and that US Furniture ultimately sells the 
furniture for $100. Because the conversion of the trees into lumber 
is an additional production activity within the United States within 
the meaning of Sec. 1.863-1(b)(3)(ii), the source of US Furniture's 
income will be determined under Sec. 1.863-1(b)(2). Thus, $40 of US 
Furniture's gross receipts will be allocated to sources within the 
United States. The source of the remaining $60 of gross receipts 
will be determined under Sec. 1.863-3. If US Furniture applies the 
50/50 method described in Sec. 1.863-3(b)(1), $20 of cost of goods 
sold is properly attributable to the additional production activity, 
and all of US Furniture's production assets used in the additional 
production activity are located in the United States, then $20 of 
gross income will be allocated to sources within the United States 
and $20 of gross income will be allocated to sources without the 
United States.

    (c) Determination of taxable income. The taxpayer's taxable income 
from sources within or without the United States will be determined 
under the rules of Secs. 1.861-8 through 1.861-14T for determining 
taxable income from sources within the United States.
    (d) Effective dates. The rules of this section will apply to 
taxable years beginning 30 days after publication of these regulations 
as final regulations. However, taxpayers may apply the rules of this 
section for taxable years beginning after July 11, 1995, and before 30 
days after publication of these regulations as final regulations. For 
years beginning before 30 days after publication of these regulations 
as final regulations, see Sec. 1.863-1 (as contained in 26 CFR part 1 
revised as of April 1, 1995).


Sec. 1.863-2  Allocation and apportionment of taxable income.

    (a) Determination of taxable income. Section 863(b) provides an 
alternate method for determining taxable income from sources within the 
United States in the case of gross income derived from sources partly 
within and partly without the United States. Under this method, taxable 
income is determined by deducting from such gross income the expenses, 
losses, or other deductions properly apportioned or allocated thereto 
and a ratable part of any other expenses, losses, or deductions that 
cannot definitely be allocated to some item or class of gross income. 
The income to which this section applies (and that is treated as 
derived partly from sources within and partly from sources without the 
United States) will consist of gains, profits, and income--
    (1) From certain transportation or other services rendered partly 
within and partly without the United States to the extent not within 
the scope of section 863(c) or other specific provisions of this title;
    (2) From the sale of inventory property (within the meaning of 
section 865(i)) produced (in whole or in part) by the taxpayer in the 
United States and sold in a foreign country or produced (in whole or in 
part) by the taxpayer in a foreign country and sold in the United 
States; or
    (3) Derived from the purchase of personal property within a 
possession of the United States and its sale within the United States, 
to the extent not excluded from the scope of these regulations under 
Sec. 1.936-6(a)(5), Q&A 7.
    (b) Determination of source of taxable income. Income treated as 
derived from sources partly within and partly without the United States 
under paragraph (a) of this section may be allocated to sources within 
and without the United States pursuant to Sec. 1.863-1 or apportioned 
to such sources in accordance with the methods described in other 
regulations under section 863. To determine the source of certain types 
of income described in paragraph (a)(1) of this section, see 
Sec. 1.863-4. To determine the source of gross income described in 
paragraph (a)(2) of this section, see Sec. 1.863-3. However, the 
principles of Sec. 1.863-3 (b)(1) and (c) may be applied to determine 
the source of taxable income from sales of inventory property. To 
determine the source of income described in paragraph (a)(3) of this 
section, see Sec. 1.863-3(f).

[[Page 63487]]

    (c) Effective dates. This section will apply to taxable years 
beginning 30 days after publication of these regulations as final 
regulations. However, taxpayers may apply the rules of this section for 
taxable years beginning after July 11, 1995, and before 30 days after 
publication of these regulations as final regulations. For years 
beginning before 30 days after publication of these regulations as 
final regulations, see Sec. 1.863-2 (as contained in 26 CFR part 1 
revised as of April 1, 1995).


Sec. 1.863-3  Allocation and apportionment of income from certain sales 
of inventory.

    (a) In general. This section applies to determine the source of 
income derived from the sale of inventory property (inventory) produced 
(in whole or in part) by a taxpayer within the United States and sold 
within a foreign country, or produced (in whole or in part) by a 
taxpayer in one or more foreign countries and sold within the United 
States (Section 863 Sales). For purposes of this section, a taxpayer's 
production activity includes production activities conducted by members 
of the same affiliated group as defined under section 1504(a). A 
taxpayer's production activity also includes production activities 
conducted through a partnership of which the taxpayer is a partner 
either directly or through one or more partnerships. A taxpayer subject 
to this section must divide gross income from Section 863 Sales between 
production activity and sales activity using one of the methods 
described in paragraph (b) of this section. The source of gross income 
from production activity and from sales activity must then be 
determined under paragraph (c) of this section. Taxable income from 
Section 863 Sales is determined under paragraph (d) of this section. 
Paragraph (e) of this section describes the rules for electing the 
methods described in paragraph (b) of this section and the information 
that a taxpayer must disclose on a tax return. Paragraph (f) of this 
section applies to determine the source of certain income derived from 
a possession of the United States. Paragraph (g) of this section 
provides effective dates for the rules in this section. Once a taxpayer 
has elected a method described in paragraph (b) of this section, the 
taxpayer must separately apply that method to Section 863 Sales in the 
United States and to Section 863 Sales in foreign countries. In 
addition, the taxpayer must apply the rules of paragraphs (c) and (d) 
of this section by aggregating all Section 863 Sales to which a method 
described in paragraph (b) of this section applies. See section 
865(i)(1) for the definition of inventory property; Sec. 1.861-7(c) for 
the time and place of sale. See also section 865(e)(2).
    (b) Methods to determine income attributable to production activity 
and sales activity--(1) 50/50 method--(i) Determination of gross 
income. Generally, gross income from Section 863 Sales will be 
apportioned between production activity and sales activity under the 
50/50 method as described in this paragraph (b)(1). Under the 50/50 
method, one-half of the taxpayer's gross income will be considered 
income attributable to production activity and the source of that 
income will be determined under the rules of paragraph (c)(1) of this 
section. The remaining one-half of such gross income will be considered 
income attributable to sales activity and the source of that income 
will be determined under the rules of paragraph (c)(2) of this section. 
In lieu of the 50/50 method, the taxpayer may elect to determine the 
source of income from Section 863 Sales under the IFP method described 
in paragraph (b)(2) of this section or, with the consent of the 
District Director, the books and records method described in paragraph 
(b)(3) of this section.
    (ii) Example. The following example illustrates the rules of this 
paragraph (b)(1):

    Example. 50/50 method. (i) P, a U.S. corporation, produces 
widgets in the United States. P sells the widgets for $100 to D, an 
unrelated foreign distributor, in another country. P's cost of goods 
sold is $40. Thus, P's gross income is $60.
    (ii) Pursuant to the 50/50 method, one-half of P's gross income, 
or $30, is considered income attributable to production activity, 
and one-half of P's gross income, or $30, is considered income 
attributable to sales activity.

    (2) IFP method--(i) Establishing an IFP. A taxpayer may elect to 
allocate gross income earned from production activity and sales 
activity using the independent factory price (IFP) method described in 
this paragraph (b)(2) if an IFP is fairly established. An IFP is fairly 
established based on a sale by the taxpayer only if the taxpayer 
regularly sells part of its output to wholly independent distributors 
or other selling concerns in such a way as to reasonably reflect the 
income earned from production activity. A sale will not be considered 
to fairly establish an IFP if sales activity by the taxpayer with 
respect to that sale is significant in relation to all of the 
activities with respect to that product.
    (ii) Applying the IFP method. If the taxpayer elects to use the IFP 
method, the amount of the gross sales price equal to the IFP will be 
treated as attributable to production activity, and the excess of the 
gross sales price over the IFP will be treated as attributable to sales 
activity. If a taxpayer elects to use the IFP method, the IFP must be 
applied to all Section 863 Sales of inventory that are substantially 
similar in physical characteristics and function, and are sold at a 
similar level of distribution as the inventory sold in the sale fairly 
establishing an IFP. The IFP will only be applied to sales that are 
reasonably contemporaneous with the sale fairly establishing the IFP. 
An IFP cannot be applied to sales in other geographic markets if the 
markets are substantially different. The rules of this paragraph will 
also apply to determine the division of gross receipts between 
production activity and sales activity in a Section 863 Sale that 
itself fairly establishes an IFP. If the taxpayer elects to apply the 
IFP method, the IFP method must be applied to all sales for which an 
IFP may be fairly established for that taxable year and each subsequent 
taxable year. The taxpayer will apply either the 50/50 method described 
in paragraph (b)(1) of this section or the books and records method 
described in paragraph (b)(3) of this section to any other Section 863 
Sale for which an IFP cannot be established or applied for each taxable 
year.
    (iii) Determination of gross income. The amount of a taxpayer's 
gross income from production activity is determined by reducing the 
amount of gross receipts from production activity by the cost of goods 
sold properly attributable to production activity. The amount of a 
taxpayer's gross income from sales activity is determined by reducing 
the amount of gross receipts from sales activity by the cost of goods 
sold (if any) properly attributable to sales activity. The source of 
gross income from production activity is determined under the rules of 
paragraph (c)(1) of this section, and the source of gross income from 
sales activity will be determined under the rules of paragraph (c)(2) 
of this section.
    (iv) Examples. The following examples illustrate the rules of this 
paragraph (b)(2):

    Example 1. IFP method. (i) P, a U.S. producer, purchases cotton 
and produces cloth in the United States. P sells cloth in country X 
to D, a unrelated foreign clothing manufacturer, for $100. Cost of 
goods sold for cloth is $80, entirely attributable to production 
activity. P does not engage in significant sales activity in 
relation to its other activities in the sales to D. Under these 
facts, the sale to D fairly establishes an IFP of $100. Assume that 
P elects to use the IFP method. Accordingly, $100 of the gross sales 
price is treated as attributable to production activity, and no 
amount of income from this 

[[Page 63488]]
sale is attributable to sales activity. After reducing the gross sales 
price by cost of goods sold, $20 of the gross income is treated as 
attributable to production activity ($100-$80).
    (ii) P also sells cloth in country X to A, a unrelated foreign 
retail outlet, for $110. Because P elected the IFP method and the 
cloth is substantially similar to the cloth sold to D, the IFP 
fairly established in the sales to D must be used to determine the 
amount attributable to production activity in the sale to A. 
Accordingly, $100 of the gross sales price is treated as 
attributable to production activity and $10 ($110-$100) is 
attributable to sales activity. After reducing the gross sales price 
by cost of goods sold, $20 of the gross income is treated as 
attributable to production activity ($100-$80) and $10 is 
attributable to sales activity.
    Example 2. Scope of IFP Method. (i) USCo manufactures three 
dissimilar products. USCo elects to apply the IFP method. In year 1, 
an IFP can be established for sales of product X, but not for 
products Y and Z. In year 2, an IFP cannot be established for any of 
USCo's products. In year 3, an IFP can be established for products X 
and Y, but not for product Z.
    (ii) In year 1, USCo must apply the IFP method to sales of 
product X. In year 2, although USCo's IFP election remains in 
effect, USCo is not required to apply the IFP election to any 
products. In year 3, USCo is required to apply the IFP method to 
sales of products X and Y.

    (3) Books and records method. A taxpayer may elect to determine the 
amount of its gross income from Section 863 Sales that is attributable 
to production and sales activities for the taxable year based upon its 
books of account if it has received in advance the permission of the 
District Director having audit responsibility over its tax return. The 
taxpayer must establish to the satisfaction of the District Director 
that the taxpayer, in good faith and unaffected by considerations of 
tax liability, will regularly employ in its books of account a detailed 
allocation of receipts and expenditures which clearly reflects the 
amount of the taxpayer's income from production and sales activities. 
If a taxpayer receives permission to apply the books and records 
method, but does not comply with a material condition set forth by the 
District Director, the District Director may, in its discretion, revoke 
permission to use the books and records method. The source of gross 
income treated as attributable to production activity under this method 
may be determined under the rules of paragraph (c)(1) of this section, 
and the source of gross income attributable to sales activity will be 
determined under the rules of paragraph (c)(2) of this section.
    (c) Determination of the source of gross income from production 
activity and sales activity--(1) Income attributable to production 
activity--(i) Production only within the United States or only within 
foreign countries--(A) Source of income. Where the taxpayer's 
production assets are located only within the United States or only 
within a foreign country, the income attributable to production 
activity is sourced where the taxpayer's production assets are located. 
For rules regarding the source of income when production assets are 
located both within the United States and within one or more foreign 
countries, see paragraph (c)(1)(ii) of this section. For purposes of 
this section, production activity means an activity that creates, 
fabricates, manufactures, extracts, processes, cures, or ages 
inventory. See Sec. 1.864-1.
    (B) Definition of production assets. For purposes of this section, 
production assets include only tangible and intangible assets owned by 
the taxpayer that are directly used by the taxpayer to produce 
inventory described in paragraph (a) of this section. Production assets 
do not include assets that are not directly used to produce inventory 
described in paragraph (a) of this section. Thus, production assets do 
not include such assets as accounts receivables, intangibles not 
related to production of inventory (e.g., marketing intangibles, 
including trademarks and customer lists), transportation assets, 
warehouses, the inventory itself, raw materials, or work-in-process. In 
addition, production assets do not include cash or other liquid assets 
(including working capital), investment assets, prepaid expenses, or 
stock of a subsidiary. A partner will be treated as owning its 
proportionate share of the partnership's production assets, determined 
by reference to the partner's distributive share of partnership income 
for the year attributable to such production assets.
    (C) Location of production assets. For purposes of this section, a 
tangible production asset will be considered located where the asset is 
physically located. An intangible production asset will be considered 
located where the tangible production assets owned by the taxpayer to 
which it relates are located.
    (ii) Production both within the United States and within foreign 
countries--(A) Source of income. Where the taxpayer's production assets 
are located both within the United States and within one or more 
foreign countries, income from sources without the United States will 
be determined by multiplying the income attributable to production 
activity by a fraction, the numerator of which is the average adjusted 
basis of production assets that are located in one or more foreign 
countries and the denominator of which is the average adjusted basis of 
all production assets in foreign countries and in the United States. 
The remaining income is treated as from sources within the United 
States.
    (B) Adjusted basis of production assets. For purposes of paragraph 
(c)(1)(ii)(A) of this section, the adjusted basis of an asset is 
determined under section 1011. The average adjusted basis is computed 
by averaging the adjusted basis of the asset at the beginning and end 
of the taxable year, unless by reason of material changes during the 
taxable year such average does not fairly represent the average for 
such year. In this event, the average adjusted basis will be determined 
upon a more appropriate basis. If production assets are used to produce 
inventory sold in Section 863 Sales and are also used to produce other 
property during the taxable year, the portion of its adjusted basis 
that is included in the fraction described in paragraph (c)(1)(ii)(A) 
of this section will be determined under any method that reasonably 
reflects the portion of the assets that produces inventory sold in 
Section 863 Sales. For example, the portion of such an asset that is 
included in the formula may be determined by multiplying the asset's 
average adjusted basis by a fraction, the numerator of which is the 
gross receipts from sales of inventory from Section 863 Sales produced 
by the asset, and the denominator of which is the gross receipts from 
all property produced by that asset. For purposes of this section, a 
taxpayer's basis in production assets held through a partnership shall 
be determined by reference to the partnership's adjusted basis in its 
assets (including a partner's special basis adjustment, if any, under 
section 743).
    (iii) Examples. The following examples illustrate the rules of this 
paragraph (c)(1):

    Example 1. Source of production income. (i) A, a U.S. 
corporation, produces widgets that are sold both within the United 
States and within a foreign country. The initial manufacture of all 
widgets occurs in the United States. The second stage of production 
of widgets that are sold within a foreign country is completed 
within the country of sale. A's U.S. plant and machinery which is 
involved in the initial manufacture of the widgets has an average 
adjusted basis of $200. A also owns warehouses used to store work-
in-process. A owns foreign equipment with an average adjusted basis 
of $25. A's gross receipts from all sales of widgets is $100, and 
its gross receipts from export sales of widgets is $25. Assume that 
apportioning average adjusted basis using gross receipts is 
reasonable. Assume A's cost of goods sold from the sale of widgets 
in the foreign countries is $13 and thus, its gross 

[[Page 63489]]
income from widgets sold in foreign countries is $12. A uses the 50/50 
method to divide its gross income between production activity and 
sales activity.
    (ii) A determines its production gross income from sources 
without the United States by multiplying one-half of A's $12 of 
gross income from sales of widgets in foreign countries, or $6, by a 
fraction, the numerator of which is all relevant foreign production 
assets, or $25, and the denominator of which is all relevant 
production assets, or $75 ($25 foreign assets + ($200 U.S. assets 
x  $25 gross receipts from export sales/$100 gross receipts from all 
sales)). Therefore, A's gross production income from sources without 
the United States is $2 ($6  x  ($25/$75)).
    Example 2. Location of intangible property. Assume the same 
facts as Example 1, except that A employs a patented process that 
applies only to the initial production of widgets. In computing the 
formula used to determine the source of income from production 
activity, A's patent, if it has an average adjusted basis, would be 
located in the United States.

    (2) Income attributable to sales activity. The source of the 
taxpayer's income that is attributable to sales activity will be 
determined under the provisions of Sec. 1.861-7(c).
    (d) Determination of source of taxable income. Once the source of 
gross income has been determined under paragraph (c) of this section, 
the taxpayer must properly allocate and apportion separately under 
Secs. 1.861-8 through 1.861-14T the amounts of its expenses, losses, 
and other deductions to its respective amounts of gross income from 
Section 863 Sales determined separately under each method described in 
paragraph (b) of this section. In addition, if the taxpayer deducts 
expenses for research and development under section 174 that may be 
attributed to its Section 863 Sales under Sec. 1.861-8(e)(3), the 
taxpayer must separately allocate or apportion expenses, losses, and 
other deductions to its respective amounts of gross income from each 
relevant product category that the taxpayer uses in applying the rules 
of Sec. 1.861-8(e)(3)(i)(A). In the case of gross income from Section 
863 Sales determined under the IFP method or the books and records 
method, the rules of Secs. 1.861-8 through 1.861-14T must apply to 
properly allocate or apportion amounts of expenses, losses and other 
deductions allocated and apportioned to such gross income between gross 
income from sources within and without the United States. In the case 
of gross income from Section 863 Sales determined under the 50/50 
method, the amounts of expenses, losses, and other deductions allocated 
and apportioned to such gross income must be apportioned between 
sources within and without the United States pro rata based on the 
relative amounts of gross income from sources within and without the 
United States determined under the 50/50 method.
    (e) Election and reporting rules--(1) Elections under paragraph (b) 
of this section. If a taxpayer does not elect a method specified in 
paragraph (b)(2) or (3) of this section, the taxpayer must apply the 
method specified in paragraph (b)(1) of this section. The taxpayer may 
elect to apply the method specified in paragraph (b)(2) of this section 
by using the method on a timely filed original return (including 
extensions). A taxpayer may elect to apply the method specified in 
paragraph (b)(3) of this section by using the method on a timely filed 
original return (including extensions), but only if the taxpayer has 
received permission from the District Director to apply that method. 
Once a method under paragraph (b) of this section has been used, that 
method must be used in later taxable years unless the Commissioner 
consents to a change. See e.g., paragraph (b)(2)(ii) Example 2 of this 
section. However, if a taxpayer elects to change to or from the method 
specified in paragraph (b)(3) of this section, the taxpayer must obtain 
permission from the District Director instead of the Commissioner. 
Permission to change methods from one year to another year will not be 
withheld unless the change would result in a substantial distortion of 
the source of the taxpayer's income.
    (2) Disclosure on tax return. A taxpayer who uses one of the 
methods described in paragraph (b) of this section must fully explain 
the methodology used, the circumstances justifying use of that method, 
the extent that sales are aggregated, and the amount of income so 
allocated.
    (f) Income partly from sources within a possession of the United 
States. [Reserved]
    (g) Effective dates. The rules of paragraphs (a) through (e) of 
this section will apply to taxable years beginning 30 days after 
publication of final regulations. However, taxpayers may apply these 
regulations for taxable years beginning after July 11, 1995, and before 
30 days after publication of these regulations as final regulations. 
For years beginning before 30 days after the publication of these 
regulations as final regulations, see Sec. 1.863-3 (as contained in 26 
CFR part 1 revised as of April 1, 1995).
    Par. 4. Section 1.863-4 is amended by revising the section heading 
and paragraph (a) to read as follows:


Sec. 1.863-4  Certain transportation services.

    (a) General. A taxpayer carrying on the business of transportation 
service (other than an activity giving rise to transportation income 
described in section 863(c) or to income subject to other specific 
provisions of this title) between points in the United States and 
points outside the United States derives income partly from sources 
within and partly from sources without the United States.
* * * * *


Sec. 1.863-5  [Removed]

    Par. 6. Section 1.863-5 is removed.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 95-30087 Filed 12-7-95; 2:00 pm]
BILLING CODE 4830-01-U