[Federal Register Volume 62, Number 197 (Friday, October 10, 1997)]
[Proposed Rules]
[Pages 52953-52959]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-26857]


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 Proposed Rules
                                                 Federal Register
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 This section of the FEDERAL REGISTER contains notices to the public of 
 the proposed issuance of rules and regulations. The purpose of these 
 notices is to give interested persons an opportunity to participate in 
 the rule making prior to the adoption of the final rules.
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  Federal Register / Vol. 62, No. 197 / Friday, October 10, 1997 / 
Proposed Rules  

[[Page 52953]]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-251985-96]
RIN 1545-AU79


Source of Income From Sales of Inventory Partly From Sources 
Within a Possession of the United States; Also, Source of Income 
Derived From Certain Purchases From a Corporation Electing Section 936

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 under section 863 
governing the source of income from sales of inventory produced in the 
United States and sold in a possession of the United States or produced 
in a possession of the United States and sold in the United States. It 
also contains proposed regulations under section 863 governing the 
source of income from sales of inventory purchased in a possession of 
the United States and sold in the United States. This document affects 
persons who produce (in whole or in part) inventory in the United 
States and sell in a possession, or produce (in whole or in part) 
inventory in a possession and sell in the United States, as well as 
persons who purchase inventory in a possession and sell in the United 
States. This document also contains proposed regulations under section 
936 governing the source of income of a taxpayer from the sale in the 
United States of property purchased from a corporation that has an 
election under section 936 in effect. This document also provides 
notice of a public hearing on these proposed regulations.

DATES: Comments and outlines of oral comments to be presented at the 
public hearing scheduled for January 29, 1998, at 10 a.m. must be 
received by January 8, 1998.

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 
(REG-251985-96), Courier's Desk, Internal Revenue Service, 1111 
Constitution Avenue NW., Washington, DC, or electronically, via the IRS 
Internet site at: http://www.irs.ustreas.gov/prod/tax__regs/
comments.html. The public hearing will be held in room 2615, 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. 
Evangelista Lee, (202) 622-7190 (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(d)).
    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 December 9, 1997. 
Comments are specifically requested concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the IRS, including whether the 
information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collection of information requirements are in proposed 
Sec. 1.863-3(f)(6). 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 inventory produced in the United States and 
sold in a possession of the United States or produced in a possession 
of the United States and sold in the United States, or from the sale of 
inventory purchased in a possession of the United States and sold in 
the United States. The likely respondents are taxpayers who produce 
inventory in the United States and sell in a possession, or who produce 
inventory in a possession and sell in the United States, or who 
purchase inventory in a possession 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: 500 hours. The estimated 
annual burden per respondent varies from 1 hour to 5 hours, depending 
on individual circumstances, with an estimated average of 2.5 hours.
    Estimated number of respondents: 200.
    Estimated annual frequency of responses: One time per year.
    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 assigned by the Office of 
Management and Budget.

Background

    These proposed regulations contain rules under section 863 relating 
to the source of income from cross-border sales of certain property. 
These regulations also contain rules under

[[Page 52954]]

section 936 relating to the source of income of a taxpayer from the 
sale in the United States of property purchased from a corporation that 
has an election under section 936 in effect. These regulations are 
proposed to be effective for taxable years beginning 30 days after 
publication of final regulations.

Explanation of Provisions

I. Income Partly From Sources Within a Possession

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).
    Guidance to determine the source of possession income is divided 
into two types of transactions: transactions described in section 
863(b)(2) for property produced in the United States and sold in a 
possession (or vice versa), and transactions described in section 
863(b)(3) for property purchased in a possession and sold in the United 
States (collectively, Section 863 Possession Sales).
    Section 1.863-3 of the income tax regulations contains rules for 
determining the source of income derived from sales of certain 
property. These regulations were published in the Federal Register on 
November 29, 1996 (61 FR 60540), and the prior regulations were 
renumbered Secs. 1.863-3A and 1.863-3AT. The new regulations retain the 
prior rules for Section 863 Possession Sales by providing in paragraph 
Sec. 1.863-3(f) that taxpayers must apply the rules of Sec. 1.863-3A(c) 
in allocating and apportioning income derived from sources partly 
within the United States and partly within a possession of the United 
States. These proposed regulations would modify the existing rules for 
allocating and apportioning income between the United States and a 
possession.

1. Property Produced and Sold

    Currently, income derived from sales of inventory produced in the 
United States and sold in a possession of the United States or produced 
in a possession of the United States and sold in the United States 
(Possession Production Sales), is allocated or apportioned between the 
United States and a possession according to one of three methods. Such 
income is allocated under the independent factory price method, 
apportioned under an apportionment method, or, with permission of the 
District Director, allocated or apportioned on the basis of the 
taxpayer's books and records.
    Under the current regulations, if an independent factory or 
production price (IFP) exists for Possession Production Sales, 
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.
    If an IFP does not exist, the current possessions regulations 
provide that the taxable income from Possession Production Sales is 
first computed and then apportioned between the United States and the 
possession. One-half of the taxable income is apportioned on the basis 
of the taxpayer's property within the United States and within the 
possession. In applying the property fraction, the taxpayer's property 
includes property held or used to produce income derived from 
Possession Production Sales. The other half of the taxpayer's taxable 
income is apportioned between U.S. and possession sources on the basis 
of the business of the taxpayer within the United States and within the 
possession. Currently, business of the taxpayer is measured by the sum 
of certain expenses, including amounts paid for labor, and the purchase 
of certain supplies, plus receipts from Possession Production Sales. 
Finally, as a third method, the existing regulations allow a taxpayer 
to request permission from the District Director to use the taxpayer's 
books and records to allocate or apportion income to sources within or 
without the United States if those books reflect more clearly than the 
other methods the taxable income derived from sources within the United 
States.

2. Property Purchased and Sold

    The second type of possession transaction governed by the existing 
regulations is the sale of inventory purchased in a possession and sold 
in the United States (Possession Purchase Sales) as described in 
section 863(b)(3). Under the current regulations, the income from such 
sales is divided between the United States and possession sources under 
one of two methods. The income can be apportioned, or, with permission 
of the District Director, allocated or apportioned on the basis of the 
taxpayer's books and records.
    Under the apportionment method, taxable income is first determined, 
and then apportioned by a fraction, the numerator being the business of 
the taxpayer in the United States, the denominator being the total 
business of the taxpayer in the United States and in the possession. 
The fraction is computed in the same manner as the business fraction 
discussed previously, except that such expenses, purchases, and sales 
are limited to those attributable to Possession Purchase Sales.
B. Issues Under Current Regulations
    The IRS and Treasury believe the rules for allocating and 
apportioning income between the United States and the possessions of 
the United States should be amended to reflect certain changes made to 
the regulations under Sec. 1.863-3 governing cross-border sales of 
inventory involving the United States and a foreign country (other than 
those involving possessions). Thus, for example, under the 
apportionment method provided in the proposed regulations, the property 
and business activity fractions apportioning income between the United 
States and a possession are modified to apportion gross income 
attributable to an activity, rather than to apportion net income.
    The IRS and Treasury also believe certain ambiguities exist in the 
current regulations. The possessions rules were originally promulgated 
in 1926, and may not reflect current business practices. The current 
regulations use examples to illustrate methods for allocating or 
apportioning income between the United States and a possession, and 
should be modified to state rules.
    Further, although the apportionment method for allocating 
Possession Production Sales income under the existing possessions 
regulations treats half of the income as production income, the 
production formula is not necessarily limited to production assets. The 
current inclusion of sales assets in the formula apportioning 
production income results in excessive income being allocated to sales 
activities. The production income formula should only take into account 
assets directly involved in production of inventory. In addition, the 
IRS and Treasury have reexamined the business activity fraction, and 
have concluded it should be revised to more clearly reflect the 
taxpayer's business other than production. The current fraction, for 
example, omits certain investments or expenses, such as marketing and 
advertising expenses, although income attributable in part to such 
expenses or investments is then included in the income apportioned by 
the fraction. The current regulations also take into account production 
expenses in the business activity fraction apportioning income from 
Possession Production Sales. The Service and Treasury believe that this 
is inappropriate in the context

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of Possession Production Sales because the business activity fraction 
is not intended to determine the source of income attributable to 
production activity. In the proposed regulations, the fraction 
apportioning Possession Production Sales is renamed the business sales 
activity fraction and excludes factors reflecting production activity.
    The current regulations also do not address issues in attributing 
to the United States or to the possession, the activities reflected in 
the business activity fraction. For example, the current regulations 
provide no guidance on whether a particular expense should be 
represented in the fraction as attributable to the United States or to 
a possession.
    Accordingly, the IRS and Treasury are issuing proposed regulations 
under section 863 to make the possessions rules more consistent with 
the other regulations governing the source of income from cross-border 
sales of inventory, and to address certain ambiguities and problems in 
the existing regulations.
C. Proposed Regulations
    Section 1.863-3(f) generally retains the methods of the current 
regulations for dividing income between the United States and a 
possession of the United States, with several modifications.

1. Methods to Allocate Gross Income to Activities of the Taxpayer

a. Property Produced and Sold

i. The Possession 50/50 Method
    Consistent with the final regulations under Sec. 1.863-3, paragraph 
(f)(2)(i)(A) of the proposed regulations makes the 50/50 method the 
general rule to allocate gross income from Possession Production Sales 
between production and business sales activity, so that the income from 
each type of activity can then be apportioned between U. S. and foreign 
sources. The taxpayer, however, may elect to apply the IFP method 
(described in paragraph (f)(2)(i)(B)), or, with the consent of the 
District Director, the books and records method (described in paragraph 
(f)(2)(i)(C)).
    Under the possession 50/50 method, the proposed regulations 
allocate half of the taxpayer's gross income from Possession Production 
Sales to production activity and half to business sales activity. The 
income is then apportioned between U.S. and possession sources based on 
a property fraction and a business sales activity fraction. As 
described below, the proposed regulations make certain changes to the 
existing property fraction and to the existing business activity 
fraction.
    The proposed regulations apply the property fraction in Sec. 1.863-
3(c) to apportion the half of a taxpayer's income allocated to 
production activity. Thus, income is apportioned to the United States 
or to a possession based on the location of the taxpayer's production 
assets. In a change from the current regulations, and consistent with 
the changes made to the regulations under Sec. 1.863-3(c), production 
assets are defined as tangible and intangible assets owned directly by 
the taxpayer that are directly used by the taxpayer to produce 
inventory sold in Possession Production Sales, instead of all its 
assets that produce income from Possession Production Sales. Production 
assets are included in the fraction at their adjusted tax basis.
    The other half of the taxpayer's gross income is apportioned 
according to a business sales activity fraction. The portion of this 
income that is possession source income is determined by multiplying 
the income by a fraction, the numerator being the business sales 
activity of the taxpayer in the possession, and the denominator being 
the business sales activity of the taxpayer within the possession and 
outside the possession. The remaining income is sourced in the United 
States. Although some of the business sales activity factors not 
incurred in a possession may be incurred in a foreign country, Treasury 
and the Internal Revenue Service believe that the business sales 
activity fraction is only intended to source the business sales 
activity portion of Possession Production Sales outside the United 
States to the extent of business sales activity located in a 
possession.
    The proposed regulations make some modifications to the factors in 
the fraction representing the business sales activity of the taxpayer. 
Business sales activity is measured by the sum of certain expenses, 
including amounts paid for labor, materials, advertising, and marketing 
(but excluding any expenses or other amounts that are nondeductible 
under section 263A, interest, and research and development), plus 
receipts for the sale of goods. This formula is intended to reflect 
better the business sales activity producing the income by including 
more of the factors responsible for producing that income. Cost of 
goods sold is also excluded from the business sales activity fraction 
apportioning income from Possession Production Sales, because such 
costs generally reflect production activity. Production activity is 
already represented in the formula by the one-half of the taxpayer's 
income apportioned according to the location of production assets.
    Finally, the proposed regulations provide more explicit guidance 
for attributing business sales activity between the United States and a 
possession. Expenses are allocated and apportioned between the United 
States and a possession based on the rules in Secs. 1.861-8 through 
1.861-14T. Gross sales are allocated to the United States or a 
possession based on the place of sale.
ii. The IFP Method
    The proposed regulations make the IFP method elective, and thus 
eliminate any bias against taxpayers choosing to export through 
independent distributors. The regulations rely upon the revised 
regulations under Sec. 1.863-3 for rules in applying the IFP method.
iii. 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 
source of their income. The proposed regulations refer to revised 
Sec. 1.863-3(b)(3) in applying the method to Possession Production 
Sales.

b. Property Purchased and Sold

i. The Business Activity Method
    Paragraph (f)(3)(i)(A) makes the business activity method the 
general rule to apportion income from Possession Purchase Sales between 
the United States and a possession. The taxpayer may, however, elect to 
apply, with consent of the District Director, the books and records 
method.
    The proposed regulations retain the structure of the existing 
regulations by apportioning the taxpayer's income from Possession 
Purchase Sales on the basis of a business activity fraction. The 
portion of this income that is possession source income is determined 
by multiplying the income by a fraction, the numerator being the 
business of the taxpayer in the possession, and the denominator being 
the business of the taxpayer within the possession and outside the 
possession. The remaining income is sourced in the United States.
    The business activity fraction is similar to that discussed 
previously, used to apportion the taxpayer's income in Possession 
Production Sales, except that the fraction applies only to expenses, 
cost of goods sold, and sales attributable to Possession Purchase 
Sales. In addition, the business activity

[[Page 52956]]

fraction apportioning Possession Purchase Sales includes amounts paid 
for cost of goods sold. Such costs are attributed to the possession, 
however, only to the extent the property purchased is manufactured, 
produced, grown, or extracted in the possession. Treasury and the 
Internal Revenue Service anticipate that if a taxpayer acts in the 
reasonable belief that the products were manufactured in the 
possession, the taxpayer could act on that basis in preparing its tax 
return. As modified, the business activity fraction reflects the view 
of Treasury and the Internal Revenue Service that section 863(b)(3)'s 
purchase rule was intended to apply only to purchase and resale 
transactions, where the goods purchased are created or derived from the 
possession.
ii. 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 
source of their income. The proposed regulations refer to revised 
Sec. 1.863-3(b)(3) in applying the method to Possession Purchase Sales.

2. 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 business activity only for purposes of the 50/50 method, the 
proposed regulations adopt rules applicable to each of the methods. 
Under the proposed regulations, once gross income attributable to 
production activity, business activity, or sales activity has been 
determined under one of the prescribed methods, the source of the gross 
income is determined separately for each type of income. The source of 
gross income attributable to production activity (when applying the 
possession 50/50 method) is determined under paragraph (c)(1), based on 
the location of production assets. The source of gross income 
attributable to sales activity (when applying the IFP method or the 
books and records method) is determined under paragraph (c)(2), based 
generally on the location of the sale. The source of gross income 
attributable to business sales activity (when applying the possession 
50/50 method) is determined under paragraph (f)(2)(ii)(B), based on 
expenses, and gross sales attributable to Possession Production Sales. 
The source of gross income attributable to business activity (when 
applying the business activity method) is determined under paragraph 
(f)(3)(ii), based on expenses, cost of goods sold, and gross sales 
attributable to Possession Purchase Sales.

3. Determination of Source of Taxable Income

    Once the source of gross income is determined under paragraph 
(f)(2) or (3), taxpayers then determine the source of taxable income. 
Under proposed paragraph (f)(4), taxpayers must allocate or apportion 
under Secs. 1.861-8 through 1.861-14T the amounts of expenses, losses 
and other deductions to gross income determined under each of the 
prescribed methods. 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 the 
United States and within a possession. For expenses, losses and other 
deductions allocated or apportioned to gross income determined under 
the possessions 50/50 method, taxpayers must apportion expenses and 
other deductions pro rata based on the relative amounts of U.S. and 
possession source gross income. The research and experimental (R&E) 
expense allocation rules in Sec. 1.861-17 apply to taxpayers using the 
50/50 method, so that the R&E set aside (described in Sec. 1.861-17) 
remains available to such taxpayers.

4. Treatment of Gross Income Derived From Certain Purchases From a 
Corporation That Has an Election in Effect Under Section 936

    The proposed regulations clarify that section 863 does not apply to 
determine the source of a taxpayer's gross income derived from a 
purchase of inventory from a corporation that has an election in effect 
under section 936, if the taxpayer's income from sales of that 
inventory is taken into account to determine benefits under section 
936(h)(5)(C) for the section 936 corporation.

5. Treatment of Partners and Partnerships

    The proposed regulations rely on the rules in Sec. 1.863-3(g) for 
determining the appropriate treatment in transactions involving 
partnerships. Under those rules, the aggregate approach applies to a 
partnership's production and sales activity for two purposes only. 
First, the aggregate approach applies in determining the character of a 
partner's distributive share of partnership income. Second, the 
aggregate approach applies in sourcing income from sales of inventory 
property that is transferred in-kind from or to a partnership.

6. Election and Reporting Rules

    Under paragraph (f)(6)(i) of the proposed regulations, a taxpayer 
must use the 50/50 method to determine the source of income from 
Possession Production Sales unless the taxpayer elects to use the IFP 
method, or elects the books and records method. For Possession Purchase 
Sales, a taxpayer must use the business activity method, unless the 
taxpayer elects the books and records method. The taxpayer makes an 
election by using the method on its timely filed original tax return. 
That method must be used in later taxable years unless the Commissioner 
or his 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 applying 
either paragraph (f)(2) or (3), and the amount of income allocated or 
apportioned to U.S. and foreign sources, in a statement attached to its 
tax return.

II. Income Derived From Certain Purchases From a Corporation That Has 
an Election in Effect Under Section 936

    These proposed regulations clarify that where a taxpayer purchases 
a product from a corporation that has an election in effect under 
section 936, the source of the taxpayer's gross income derived from 
sales of that product (in whatever form sold) in the United States is 
U.S. source, if the taxpayer's income from sales of that product is 
taken into account to determine benefits under section 936(h)(5)(C)(i) 
for the section 936 corporation. The taxpayer's income is U.S. source 
without regard to whether a possession product is a component, end-
product form, or integrated product. No inference should be drawn from 
the proposed effective date concerning the treatment of transactions 
involving sales of property purchased from a section 936 corporation 
entered into before the regulations are applicable.

Proposed Effective Dates

    These regulations are proposed to be effective for taxable years 
beginning on or after the date that is 30 days after the date of 
publication of 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

[[Page 52957]]

certified that these regulations will not have a significant economic 
impact on a substantial number of small entities. This certification is 
based on the fact that the rules of this section principally impact 
large multinationals who pay foreign taxes on substantial foreign 
operations and therefore the rules will impact very few small entities. 
Moreover, in those few instances where the rules of this section impact 
small entities, the economic impact on such entities is not likely to 
be significant. Accordingly, a regulatory flexibility analysis is not 
required. Pursuant to section 7805(f) of the Internal Revenue Code, 
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 comments that are submitted timely 
(in the manner described under the ADDRESSES caption) to the IRS. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for January 29, 1998, at 10 
a.m., in room 2615, Internal Revenue Building, 1111 Constitution 
Avenue, NW., Washington, DC. 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 comments and an outline of topics to be discussed and the time 
to be devoted to each topic (in the manner described under the 
ADDRESSES caption of this preamble) by January 8, 1998.
    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 
revising the entry for ``Section 1.863-3'', removing the entry for 
``Sections 1.936-4 through 1.936-7'', and adding entries in numerical 
order to read as follows:

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

    Section 1.863-3 also issued under 26 U.S.C. 863(a) and (b), and 
26 U.S.C. 936(h).* * *
    Section 1.936-4 also issued under 26 U.S.C. 936(h).
    Section 1.936-5 also issued under 26 U.S.C. 936(h).
    Section 1.936-6 also issued under 26 U.S.C. 863(a) and (b), and 
26 U.S.C. 936(h).
    Section 1.936-7 also issued under 26 U.S.C. 936(h).* * *

    Par. 2. Section 1.863-3 is amended as follows:
    1. Paragraph (f) is revised.
    2. Paragraph (h) is amended by adding a sentence at the end of the 
paragraph.
    The revision and addition read as follows:


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

* * * * *
    (f) Income partly from sources within a possession of the United 
States--(1) In general. This paragraph (f) relates to gains, profits, 
and income, which are treated as derived partly from sources within the 
United States and partly from sources within a possession of the United 
States (Section 863 Possession Sales). This paragraph (f) applies to 
determine the source of income derived from the sale of inventory 
produced (in whole or in part) by the taxpayer within the United States 
and sold within a possession, or produced (in whole or in part) by a 
taxpayer in a possession and sold within the United States (Possession 
Production Sales). It also applies to determine the source of income 
derived from the purchase of personal property within a possession of 
the United States and its sale within the United States (Possession 
Purchase Sales). A taxpayer subject to this paragraph (f) must divide 
gross income from Section 863 Possession Sales using one of the methods 
described in either paragraph (f)(2)(i) of this section (in the case of 
Possession Production Sales) or paragraph (f)(3)(i) of this section (in 
the case of Possession Purchase Sales). Once a taxpayer has elected a 
method, the taxpayer must separately apply that method to the 
applicable category of Section 863 Possession Sales in the United 
States and to those in a possession. The source of gross income from 
each type of activity must then be determined under either paragraph 
(f)(2)(ii) or (3)(ii) of this section, as appropriate. The source of 
taxable income from Section 863 Possession Sales is determined under 
paragraph (f)(4) of this section. The taxpayer must apply the rules for 
computing gross and taxable income by aggregating all Section 863 
Possession Sales to which a method in this section applies after 
separately applying that method to Section 863 Possession Sales in the 
United States and to Section 863 Possession Sales in a possession. This 
section does not apply to determine the source of a taxpayer's gross 
income derived from a sale of inventory purchased from a corporation 
that has an election in effect under section 936, if the taxpayer's 
income from sales of that inventory is taken into account to determine 
benefits under section 936 for the section 936 corporation. For rules 
to be applied to determine the source of such income, see Sec. 1.936-
6(a)(5) Q&A 7a and (b)(1) Q&A 13.
    (2) Allocation or apportionment for Possession Production Sales--
(i) Methods for determining the source of gross income for Possession 
Production Sales--(A) Possession 50/50 method. Under the possession 50/
50 method, gross income from Possession Production Sales is allocated 
between production activity and business sales activity as described in 
this paragraph (f)(2)(i)(A). Under the possession 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 (f)(2)(ii)(A) of this 
section. The remaining one-half of such gross income will be considered 
income attributable to business sales activity and the source of that 
income will be determined under the rules of paragraph (f)(2)(ii)(B) of 
this section.
    (B) IFP method. In lieu of the possession 50/50 method, a taxpayer 
may elect the independent factory price (IFP) method. Under the IFP 
method, gross income from Possession Production Sales is allocated to 
production activity or sales activity using the IFP method, as 
described in paragraph (b)(2) of this section, if an IFP is fairly 
established under the rules of paragraph (b)(2) of this section. See 
paragraphs (f)(2)(ii) (A) and (C) of this section for rules for 
determining the source of gross income attributable to production 
activity and sales activity.

[[Page 52958]]

    (C) Books and Records method. A taxpayer may elect to allocate 
gross income using the books and records method described in paragraph 
(b)(3) of this section, if it has received in advance the permission of 
the District Director having audit responsibility over its return. See 
paragraph (f)(2)(ii) of this section for rules for determining the 
source of gross income.
    (ii) Determination of source of gross income from production, 
business sales, and sales activity--(A) Gross income attributable to 
production activity. The source of gross income from production 
activity is determined under the rules of paragraph (c)(1) of this 
section, except that the term possession is substituted for foreign 
country wherever it appears.
    (B) Gross income attributable to business sales activity--(1) 
Source of gross income. Gross income from the taxpayer's business sales 
activity is sourced in the possession in the same proportion that the 
amount of the taxpayer's business sales activity for the taxable year 
within the possession bears to the amount of the taxpayer's business 
sales activity for the taxable year both within the possession and 
outside the possession, with respect to Possession Production Sales. 
The remaining income is sourced in the United States.
    (2) Business sales activity. For purposes of this paragraph 
(f)(2)(ii)(B), the taxpayer's business sales activity is equal to the 
sum of--
    (i) The amounts for the taxable period paid for wages, salaries, 
and other compensation of employees, and other expenses attributable to 
Possession Production Sales (other than amounts that are nondeductible 
under section 263A, interest, and research and development); and
    (ii) Possession Production Sales for the taxable period.
    (3) Location of business sales activity. For purposes of 
determining the location of the taxpayer's business activity within a 
possession, the following rules apply:
    (i) Sales. Receipts from gross sales will be attributed to a 
possession under the provisions of paragraph (c)(2) of this section.
    (ii) Expenses. Expenses will be attributed to a possession under 
the rules of Secs. 1.861-8 through 1.861-14T.
    (C) Gross income attributable to sales activity. The source of the 
taxpayer's income that is attributable to sales activity, as determined 
under the IFP method or the books and records method, will be 
determined under the provisions of paragraph (c)(2) of this section.
    (3) Allocation or apportionment for Possession Purchase Sales--(i) 
Methods for determining the source of gross income for Possession 
Purchase Sales--(A) Business activity method. Gross income from 
Possession Purchase Sales is allocated in its entirety to the 
taxpayer's business activity, and is then apportioned between U.S. and 
possession sources under paragraph (f)(3)(ii) of this section.
    (B) Books and records method. A taxpayer may elect to allocate 
gross income using the books and records method described in paragraph 
(b)(3) of this section, subject to the conditions set forth in 
paragraph (b)(3) of this section. See paragraph (f)(2)(ii) of this 
section for rules for determining the source of gross income.
    (ii) Determination of source of gross income from business 
activity--(A) Source of gross income. Gross income from the taxpayer's 
business activity is sourced in the possession in the same proportion 
that the amount of the taxpayer's business activity for the taxable 
year within the possession bears to the amount of the taxpayer's 
business activity for the taxable year both within the possession and 
outside the possession, with respect to Possession Purchase Sales. The 
remaining income is sourced in the United States.
    (B) Business activity. For purposes of this paragraph (f)(3)(ii), 
the taxpayer's business activity is equal to the sum of--
    (1) The amounts for the taxable period paid for wages, salaries, 
and other compensation of employees, and other expenses attributable to 
Possession Purchase Sales (other than amounts that are nondeductible 
under section 263A, interest, and research and development);
    (2) Cost of goods sold attributable to Possession Purchase Sales 
during the taxable period; and
    (3) Possession Purchase Sales for the taxable period.
    (C) Location of business activity. For purposes of determining the 
location of the taxpayer's business activity within a possession, the 
following rules apply:
    (1) Sales. Receipts from gross sales will be attributed to a 
possession under the provisions of paragraph (c)(2) of this section.
    (2) Cost of goods sold. Payments for cost of goods sold will be 
properly attributable to gross receipts from sources within the 
possession only to the extent that the property purchased was 
manufactured, produced, grown, or extracted in the possession (within 
the meaning of section 954(d)(1)(A)).
    (3) Expenses. Expenses will be attributed to a possession under the 
rules of Secs. 1.861-8 through 1.861-14T.
    (iii) Examples. The following examples illustrate the rules of 
paragraph (f)(3)(ii) relating to the determination of source of gross 
income from business activity:

    Example 1. (i) U.S. Co. purchases in a possession product X for 
$80 from A. A manufactures X in the possession. Without further 
production, U.S. Co. sells X in the United States for $100. Assume 
U.S. Co. has sales and administrative expenses in the possession of 
$10.
    (ii) To determine the source of U.S. Co.'s gross income, the 
$100 gross income from sales of X is allocated entirely to U.S. 
Co.'s business activity. Forty-seven dollars of U.S. Co.'s gross 
income is sourced in the possession. [Possession expenses ($10) plus 
possession purchases ($80) plus possessions sales ($0), divided by 
total expenses ($10) plus total purchases ($80) plus total sales 
($100).] The remaining $53 is sourced in the United States.
    Example 2. (i) Assume the same facts as in Example 1, except 
that A manufactures X outside the possession.
    (ii) To determine the source of U.S. Co.'s gross income, the 
$100 gross income is allocated entirely to U.S. Co.'s business 
activity. Five dollars of U.S. Co.'s gross income is sourced in the 
possession. [Possession expenses ($10) plus possession purchases 
($0) plus possession sales ($0), divided by total expenses ($10) 
plus total purchases ($80) plus total sales ($100).] The $80 
purchase is not included in the numerator used to determine U.S. 
Co.'s business activity in the possession, since product X was not 
manufactured in the possession. The remaining $95 is sourced in the 
United States.

    (4) Determination of source of taxable income. Once the source of 
gross income has been determined under paragraph (f)(2) or (3) 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 Possession Sales determined separately under each 
method described in paragraph (f)(2) or (3) 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 Possession 
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 Possession Sales determined under 
the IFP method or books and records method, a taxpayer must apply the 
rules of Secs. 1.861-8 through 1.861-14T to properly allocate or 
apportion amounts of expenses,

[[Page 52959]]

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 Possession Production Sales 
determined under the possessions 50/50 method or gross income from 
Possession Purchase Sales computed under the business activity 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 those methods.
    (5) Special rules for partnerships. In applying the rules of this 
paragraph (f) to transactions involving partners and partnerships, the 
rules of paragraph (g) of this section apply.
    (6) Election and reporting rules--(i) Elections under paragraph 
(f)(2) or (3) of this section. If a taxpayer does not elect one of the 
methods specified in paragraph (f)(2) or (3) of this section, the 
taxpayer must apply the possession 50/50 method in the case of 
Possession Production Sales or the business activity method in the case 
of Possession Purchase Sales. The taxpayer may elect to apply a method 
specified in either paragraph (f)(2) or (3) of this section by using 
the method on a timely filed original return (including extensions). 
Once a method has been used, that method must be used in later taxable 
years unless the Commissioner consents to a change. Permission to 
change methods from one year to another year will be granted unless the 
change would result in a substantial distortion of the source of the 
taxpayer's income.
    (ii) Disclosure on tax return. A taxpayer who uses one of the 
methods described in paragraph (f)(2) or (3) of this section must fully 
explain in a statement attached to the tax return the methodology used, 
the circumstances justifying use of that methodology, the extent that 
sales are aggregated, and the amount of income so allocated.
* * * * *
    (h) Effective dates. * * * However, the rules of paragraph (f) of 
this section apply to taxable years beginning on or after the date that 
is 30 days after the date of publication of final regulations.
    Par. 3. In Sec. 1.936-6, paragraph (a)(5) Q&A 7a is added to read 
as follows:


Sec. 1.936-6  Intangible property income when an election out is made: 
Cost sharing and profit split options; covered intangibles.

* * * * *
    (a) * * *
    (5) * * *
    Q.7a: What is the source of the taxpayer's gross income derived 
from a sale in the United States of a possession product purchased by 
the taxpayer (or an affiliate) from a corporation that has an election 
in effect under section 936, if the income from such sale is taken into 
account to determine benefits under cost sharing for the section 936 
corporation? Is the result different if the taxpayer (or an affiliate) 
derives gross income from a sale in the United States of an integrated 
product incorporating a possession product purchased by the taxpayer 
(or an affiliate) from the section 936 corporation, if the taxpayer (or 
an affiliate) processes the possession product or an excluded component 
in the United States?
    A.7a: Under either scenario, the income is U.S. source, without 
regard to whether the possession product is a component, end-product, 
or integrated product. Section 863 does not apply in determining the 
source of the taxpayer's income. This Q&A 7a is applicable for taxable 
years beginning on or after the date that is 30 days after the date of 
publication of final regulations.
* * * * *
Michael P. Dolan,
Acting Commissioner of Internal Revenue.
[FR Doc. 97-26857 Filed 10-9-97; 8:45 am]
BILLING CODE 4830-01-P