[Federal Register Volume 63, Number 41 (Tuesday, March 3, 1998)]
[Rules and Regulations]
[Pages 10305-10307]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-5128]


=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8764]
RIN 1545-AV91


Source and Grouping Rules for Foreign Sales Corporation Transfer 
Pricing

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

-----------------------------------------------------------------------

SUMMARY: This document contains temporary regulations that provide 
guidance to taxpayers who have made an election to be treated as a 
foreign sales corporation (FSC). The regulations provide rules that 
clarify the special sourcing rules under section 927(e)(1) and provide 
a deadline for the election to group transactions. The text of the 
temporary regulations also serves as the text of the proposed 
regulations on this subject in the Proposed Rules section of this issue 
of the Federal Register.

DATES: Effective date: These regulations are effective March 3, 1998.
    Applicability: For dates of applicability, see Secs. 1.925(a)-
1T(c)(8)(i) and 1.927(e)-1T(c).

FOR FURTHER INFORMATION CONTACT: Elizabeth Beck (202) 622-3880 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document contains amendments to the Income Tax Regulations (26 
CFR part 1) under sections 925 and 927 which were added by the Deficit 
Reduction Act of 1984, applicable for taxable years of foreign sales 
corporations beginning after December 31, 1984. Temporary regulations 
were published in the Federal Register (52 FR 6468) as a Treasury 
Decision (TD 8126) on March 3, 1987. Treasury and IRS believe that 
immediate guidance in the form of these temporary regulations is 
necessary for the reasons stated below.

Explanation of Provisions

    These regulations set a deadline for an election to group 
transactions for purposes of the foreign sales corporation (FSC) 
administrative pricing methods and clarify that the foreign source 
limit for a FSC's related supplier extends to all transactions giving 
rise to foreign trading gross receipts.

I. Grouping Election Deadline

A. Current Temporary Regulations
    Current Sec. 1.925(a)-1T(c)(8) and Sec. 1.925(b)-1T(b)(3) permit 
taxpayers annually to group transactions in applying the administrative 
pricing (including the marginal costing) rules to determine FSC 
benefits. Current Sec. 1.925(a)-1T(c)(8)(i) requires an election to 
group to be evidenced on the FSC income tax return for the taxable 
year. Current Sec. 1.925(a)-1T(e)(4) authorizes taxpayers to file 
amended returns subsequently (within the statute of limitations period) 
to redetermine FSC benefits based on a different grouping of 
transactions than that originally elected. Pursuant to this provision, 
taxpayers may change their grouping basis, or change from a grouping to 
a transaction-by-transaction basis. The IRS and the Treasury have 
become increasingly aware of taxpayers who, through the use of 
sophisticated computer programs, substantially revise their transaction 
groupings just prior to the expiration of the statute of limitations 
and many years after the original returns were filed. These revised 
groupings typically employ complex estimating techniques. The recent 
rise in this practice is placing a significant burden on the auditing 
process and is creating a potential for abuse.
B. Revised Temporary Regulations
    Under Sec. 1.925(a)-1T(c)(8)(i), the election to group must be made 
on Schedule P of the FSC's timely filed U.S. income tax return 
(including extensions thereof) for the taxable year. No untimely or 
amended returns will be allowed to elect to group, to change a grouping 
basis, or to change from a grouping basis to a transaction-by-
transaction basis for such year.
    Conforming changes and cross-references are reflected in 
Sec. 1.925(a)-1T(e)(4) and Sec. 1.925(b)-1T(b)(3).
    The regulations apply to taxable years beginning after December 31, 
1997. There is also a transition rule providing that the regulations 
also apply to taxable years beginning before January 1, 1998. For these 
taxable years, the transition rule allows taxpayers to redetermine 
their grouping of transactions with respect to such years provided such 
redetermination is made no later than the due date of the FSC's timely 
filed U.S. income tax return (including extensions thereof) for its 
first taxable year beginning after December 31, 1997.

II. Scope of Related Supplier Foreign Source Limit

A. Current Temporary Regulations and TRA 97
    Section 927(e)(1) provides that ``[u]nder regulations, the income 
of a person described in section 482 from a transaction giving rise to 
foreign trading gross receipts of a FSC which is treated as from 
sources outside the United States shall not exceed the amount which 
would be treated as foreign source income earned by such person if the 
pricing rule under section 994 which corresponds to the rule used under 
section 925 with respect to such transaction applied to such 
transaction.'' Transactions giving rise to foreign trading gross 
receipts include qualifying sales, leases, licenses and services. 
Current Sec. 1.927(e)-1T restates the section 927(e)(1) rule as 
applicable on ``the sale of export property.'' While the statute is not 
limited to export sale transactions in that it applies to any 
transaction giving rise to foreign trading gross receipts of a FSC, the 
current regulation might be interpreted to apply the special foreign 
sourcing limit only to sales of export property.
    Section 1171 of the Taxpayer Relief Act of 1997 (TRA 97) amended 
section 927(a)(2)(B) (without any inference intended regarding prior 
law) to provide that computer software licensed for reproduction abroad 
is included within

[[Page 10306]]

the definition of export property for purposes of the FSC provisions. 
The amendment applies to gross receipts from computer software licenses 
attributable to periods after December 31, 1997, in tax years ending 
after such date.
    In light of TRA 97, it is important to clarify the scope of the 
related supplier's foreign source limit under the regulations. This 
clarification needs to be implemented immediately in order to provide 
clear guidance to taxpayers, including those utilizing the TRA 97 
amendment to section 927(a)(2)(B).
B. Revised Temporary Regulations
    Under Sec. 1.927(e)-1T(a)(1), the related supplier's foreign source 
limit applies to any transaction, including but not limited to any 
sale, lease, license or service, giving rise to foreign trading gross 
receipts of a FSC. No inference is intended regarding the scope of 
application of the prior regulation.
    Conforming changes are reflected in Sec. 1.927(e)-1T(a)(2) and (3). 
Special rules are added in Sec. 1.927(e)-1T(a)(3)(ii) to clarify how 
the corresponding DISC transfer pricing rules are to be applied for 
purposes of the foreign source limit. Three examples set forth in 
Sec. 1.927(e)-1T(b) illustrate how the limit is applied under different 
transfer pricing methods and for different types of transactions.
    The regulations apply to taxable years beginning after December 31, 
1997.

Special Analyses

    It has been determined that this Treasury Decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has also been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations, and because the 
regulation does not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Internal Revenue Code, these 
temporary regulations will be submitted to the Chief Counsel for 
Advocacy of the Small Business Administration for comment on their 
impact on small business.
    Drafting Information: The principal author of these regulations is 
Elizabeth Beck of the Office of the Associate Chief Counsel 
(International). Other personnel from the IRS and Treasury Department 
also participated in the development of these regulations.

List of Subjects 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirement.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by 
revising the entries for sections 1.925(a)-1T and 1.925(b)-1T to read 
as follows:

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

    Section 1.925(a)-1T is also issued under 26 U.S.C. 925(b)(1) and 
(2) and 927(d)(2)(B).
    Section 1.925(b)-1T is also issued under 26 U.S.C. 925(b)(1) and 
(2) and 927(d)(2)(B) * * *
    Par. 2. Section 1.925(a)-1T is amended by:
    1. Removing the last sentence of paragraph (c)(8)(i) and adding 
five sentences in its place.
    2. Paragraph (e)(4) is amended by:
    a. Removing the language ``or grouping of transactions'' from the 
fourth sentence.
    b. Adding a sentence to the end of the paragraph.
    The additions read as follows:


Sec. 1.925(a)-1T  Temporary Regulations; Transfer pricing rules for 
FSCs.

* * * * *
    (c) * * *
    (8) * * *
    (i) * * * The election to group transactions shall be evidenced on 
Schedule P of the FSC's timely filed U.S. income tax return (including 
extensions thereof) for the taxable year. No untimely or amended 
returns will be allowed to elect to group, to change a grouping basis, 
or to change from a grouping basis to a transaction-by-transaction 
basis. The rules of the previous two sentences of this paragraph 
(c)(8)(i) are applicable to taxable years beginning after December 31, 
1997. For any taxable year beginning before January 1, 1998, for which 
a redetermination is otherwise permissible under paragraph (e)(4) of 
this section as in effect for taxable years beginning before January 1, 
1998, a redetermination of grouping of transactions cannot be made 
later than the due date of the FSC's timely filed U.S. income tax 
return (including extensions thereof) for the FSC's first taxable year 
beginning after December 31, 1997. The language ``or grouping of 
transactions'' is removed from the fourth sentence of paragraph (e)(4) 
of this section, applicable to taxable years beginning after December 
31, 1997.
* * * * *
    (e) * * *
    (4) * * * For the election to group transactions for purposes of 
applying the administrative pricing methods, see paragraph (c)(8)(i) of 
this section.
* * * * *
    Par. 3. In Sec. 1.925(b)-1T, paragraph (b)(3)(i) is amended by 
adding at the end of the paragraph the following sentence:


Sec. 1.925(b)-1T  Temporary regulations; marginal costing rules.

* * * * *
    (b) * * *
    (3) * * * (i) * * * For the election to group transactions for 
purposes of applying the administrative pricing methods, see 
Sec. 1.925(a)-1T(c)(8)(i).
* * * * *
    Par. 4. Section 1.927(e)-1T is revised to read as follows:


Sec. 1.927(e)-1T  Temporary regulations; special sourcing rule.

    (a) Source rules for related persons--(1) In general. The income of 
a person described in section 482 from a transaction giving rise to 
foreign trading gross receipts of a FSC which is treated as from 
sources outside the United States shall not exceed the amount which 
would be treated as foreign source income earned by such person if the 
pricing rule under section 994 which corresponds to the rule used under 
section 925 with respect to such transaction applied to such 
transaction. This section applies to any transaction, including but not 
limited to any sale, lease, license or service, giving rise to foreign 
trading gross receipts of a FSC. This special sourcing rule also 
applies if the FSC is acting as a commission agent for the related 
supplier with respect to the transaction described above which gives 
rise to foreign trading gross receipts and the transfer pricing rules 
of section 925 are used to determine the commission payable to the FSC. 
No limitation results under this section with respect to a transaction 
to which the section 482 pricing rule under section 925(a)(3) applies.
    (2) Grouping of transactions. If, for purposes of determining the 
FSC's profits under the administrative pricing rules of sections 
925(a)(1) and (2), grouping of transactions under Sec. 1.925(a)-
1T(c)(8) was elected, the same grouping shall be used for making the 
determinations under this special sourcing rule.
    (3) Corresponding DISC pricing rules--(i) In general. For purposes 
of this section----

[[Page 10307]]

    (A) The DISC gross receipts pricing rule of section 994(a)(1) 
corresponds to the gross receipts pricing rule of section 925(a)(1);
    (B) The DISC combined taxable income pricing rule of section 
994(a)(2) corresponds to the combined taxable income pricing rule of 
section 925(a)(2); and
    (C) The DISC section 482 pricing rule of section 994(a)(3) 
corresponds to the section 482 pricing rule of section 925(a)(3).
    (ii) Special rules. For purposes of this section--
    (A) The DISC pricing rules of section 994(a)(1) and (2) shall be 
determined without regard to export promotion expenses;
    (B) Qualified export receipts under section 994(a)(1) and (2) shall 
be deemed to be an amount equal to the foreign trading gross receipts 
arising from the transaction; and
    (C) Combined taxable income for purposes of section 994(a)(2) shall 
be deemed to be an amount equal to the combined taxable income for 
purposes of section 925(a)(2) arising from the transaction.
    (b) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. (i) R and F are calendar year taxpayers. R, a 
domestic manufacturing company, owns all the stock of F, which is a 
FSC acting as a commission agent for R. For the taxable year, R and 
F used the combined taxable income pricing rule of section 
925(a)(2). For the taxable year, the combined taxable income of R 
and F is $100 from the sale of export property, as defined in 
section 927(a), manufactured by R using production assets located in 
the United States. Title to the export property passed outside of 
the United States.
    (ii) Under section 925(a)(2), 23 percent of the $100 combined 
taxable income of R and F, that is $23, is allocated to F and the 
remaining $77 is allocated to R. Absent the special sourcing rule, 
under section 863(b) the $77 income allocated to R would be sourced 
$38.50 U.S. source and $38.50 foreign source. Under the special 
sourcing rule, the amount of foreign source income earned by a 
related supplier of a FSC shall not exceed the amount that would 
result if the corresponding DISC pricing rule applied. The DISC 
combined taxable income pricing rule of section 994(a)(2) 
corresponds to the combined taxable income pricing rule of section 
925(a)(2). Under section 994(a)(2), $50 of the combined taxable 
income ($100  x  .50) would be allocated to the DISC and the 
remaining $50 would be allocated to the related supplier. Under 
section 863(b), the $50 income allocated to the DISC's related 
supplier would be sourced $25 U.S. source and $25 foreign source. 
Accordingly, under the special sourcing rule, the foreign source 
income of R shall not exceed $25.
    Example 2. (i) Assume the same facts as in Example 1 except that 
the combined taxable income arises from the licensing of the 
copyright rights in computer software for use outside of the United 
States and that R developed the computer software in the United 
States.
    (ii) Under section 925(a)(2), 23 percent of the $100 combined 
taxable income of R and F, that is $23, is allocated to F and the 
remaining $77 is allocated to R. Absent the special sourcing rule, 
under section 862(a)(4) the $77 income allocated to R would be 
sourced $77 foreign source in its entirety. Under the special 
sourcing rule, the amount of foreign source income earned by a 
related supplier of a FSC shall not exceed the amount that would 
result if the corresponding DISC pricing rule applied. The DISC 
combined taxable income pricing rule of section 994(a)(2) 
corresponds to the combined taxable income pricing rule of section 
925(a)(2). Under section 994(a)(2), $50 of the combined taxable 
income ($100 x .50) would be allocated to the DISC and the remaining 
$50 would be allocated to the related supplier. Under section 
862(a)(4), the $50 income allocated to the DISC's related supplier 
would be sourced $50 foreign source in its entirety. Accordingly, 
under the special sourcing rule, the foreign source income of R 
shall not exceed $50.
    Example 3. (i) Assume the same facts as in Example 1 except that 
R and F used the gross receipts pricing rule of section 925(a)(1). 
In addition, for the taxable year foreign trading gross receipts 
derived from the sale of the export property are $2,000.
    (ii) Under section 925(a)(1), 1.83 percent of the $2,000 foreign 
trading gross receipts, that is $36.60, is allocated to F and the 
$63.40 remaining combined taxable income ($100--$36.60) is allocated 
to R. Absent the special sourcing rule, under section 863(b) the 
$63.40 income allocated to R would be sourced $31.70 U.S. source and 
$31.70 foreign source. Under the special sourcing rule, the amount 
of foreign source income earned by a related supplier of a FSC shall 
not exceed the amount that would result if the corresponding DISC 
pricing rule applied. The DISC gross receipts pricing rule of 
section 994(a)(1) corresponds to the gross receipts pricing rule of 
section 925(a)(1). Under section 994(a)(1), $80 ($2,000 x .04) would 
be allocated to the DISC and the $20 remaining combined taxable 
income would be allocated to the related supplier. Under section 
863(b), the $20 income allocated to the DISC's related supplier 
would be sourced $10 U.S. source and $10 foreign source. 
Accordingly, under the special sourcing rule, the foreign source 
income of R shall not exceed $10.

    (c) Effective Date. The rules of this section are applicable to 
taxable years beginning after December 31, 1997.
Michael P. Dolan,
Deputy Commissioner of Internal Revenue.

    Approved: February 20, 1998.
Donald C. Lubick,
Acting Assistant Secretary of the Treasury.
[FR Doc. 98-5128 Filed 3-2-98; 8:45 am]
BILLING CODE 4830-01-U