[Federal Register Volume 66, Number 11 (Wednesday, January 17, 2001)]
[Proposed Rules]
[Pages 3903-3916]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-7]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-106030-98]
RIN 1545-AW50


Source of Income from Certain Space and Ocean Activities; Also, 
Source of Communications Income

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(d) governing the source of income from certain space and ocean 
activities. It also contains proposed regulations under sections 
863(a), (d), and (e) governing the source of income from certain 
communications activity. This document also contains proposed 
regulations under sections 863(a) and (b), amending the regulations in 
Sec. 1.863-3 to conform those regulations with these proposed 
regulations. This document affects persons who conduct activities in 
space, or on or under water not within the jurisdiction of a foreign 
country, possession of the United States, or the United States 
(collectively, in international water). This document also affects 
persons who derive income from transmission of communications. In 
addition, this document 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 March 28, 2001, at 10 a.m. must be 
received by March 7, 2001.

ADDRESSES: Send submissions to: CC:M&SP:RU (Reg-106030-98), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered Monday through Friday 
between the hours of 8 a.m. and 5 p.m. to: CC:M&SP:RU (REG-106030-98), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW., 
Washington, DC. Alternatively, taxpayers may submit comments 
electronically via the Internet by selecting the ``Tax Regs'' option on 
the IRS Home Page, or by submitting comments directly to the IRS 
Internet site at: http://www.irs.ustreas.gov/tax__regs/regslist.html. 
The public hearing will be held in the auditorium, seventh floor, 
Internal Revenue Building, 1111 Constitution Avenue, NW., Washington, 
DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Anne 
Shelburne, (202) 874-1490; concerning submissions and the hearing, and/
or to be placed on the building access list to attend the hearing, La 
Nita Van Dyke, (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(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, W:CAR:MP:FP:S:O, Washington, DC 20224. 
Comments on the collection of information should be received by March 
19, 2001. 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);

[[Page 3904]]

    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. 1.863-8(g) and in Sec. 1.863-9(g). This information is required by 
the IRS to monitor compliance with the federal tax rules for 
determining the source of income from space or ocean activities, or 
from transmission of communications. The likely respondents are 
taxpayers who conduct space or ocean activities, or who derive 
communications income. Responses to this collection of information are 
required to properly determine the source of a taxpayer's income from 
such transactions.
    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/recordkeeping burden: 1,200 hours. 
The estimated annual burden per respondent varies from 3 hours to 7 
hours, depending on individual circumstances, with an estimated average 
of 5 hours.
    Estimated number of respondents: 250.
    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

    This document contains proposed regulations relating to the Income 
Tax Regulations (CFR part 1) under sections 863(a), (b), (d), and (e) 
of the Internal Revenue Code (Code). Congress enacted section 863(d) 
and section 863(e) as part of the Tax Reform Act of 1986 (Public Law 
99-514, 100 Stat. 2085) (the 1986 Act). Section 863(d) governs the 
source of income derived from certain space and ocean activities. 
Section 863(e) governs the source of income derived from international 
communications activity.

Explanation of Provisions

    These proposed regulations provide two sets of rules, one in 
Sec. 1.863-8 for determining the source of income from space and ocean 
activities, the other in Sec. 1.863-9 for determining the source of 
income from communications activity. Section 1.863-9 provides rules for 
both international communications income (ICI) and other communications 
income. The IRS and Treasury believe it is appropriate to provide 
source rules for both ICI and other communications income in a single 
regulation.
    The IRS and Treasury are fully aware of the rapid technological 
evolution in the space and communications industries since Congress 
enacted sections 863(d) and (e) in 1986, and have attempted to take 
into account these changes as well as changes in the space and 
communications industries and business practices and business models. 
The IRS and Treasury recognize that these regulations address important 
issues for many different industries and have worked closely with the 
industries in drafting these rules. The IRS and Treasury are interested 
in receiving comments from these industries on how to accommodate 
issues arising from the use of new technologies, consistent with the 
language and purpose of the statutory provisions.

A. Space and Ocean Activity Under Section 863(d)

1. Scope of Sec. 1.863-8 of the Proposed Regulations
    Section 1.863-8 of the proposed regulations provides rules for 
sourcing income derived from space and ocean activity, notwithstanding 
other sections. Proposed regulations Sec. 1.863-8(a) provides that a 
taxpayer derives income from a space or ocean activity only if the 
taxpayer conducts such activity directly. This is consistent with the 
approach that IRS and Treasury adopted in the Sec. 1.863-3 regulations 
sourcing income from inventory sales.
2. Source of Gross Income From Space or Ocean Activity
    a. General. Section 863(d)(1) states that, except as provided in 
regulations, any income derived from space or ocean activity by a U.S. 
person will be U.S. source income, and if derived by a foreign person, 
foreign source income. Proposed regulations Sec. 1.863-8(b)(1) provides 
that a U.S. person's space or ocean income is U.S. source. Proposed 
regulations Sec. 1.863-8(b)(1) also states the general rule that income 
derived by a foreign person from a space or ocean activity is foreign 
source income. However, the proposed regulations contain several 
exceptions to that general rule.
    Proposed regulations Sec. 1.863-8(b)(2) provides that if a foreign 
corporation is 50 percent or more owned by vote or value (directly, 
indirectly, or constructively) by U.S. persons and is not a controlled 
foreign corporation within the meaning of section 957 (CFC), all income 
derived by the corporation from space or ocean activity is U.S. source 
income. This rule reflects IRS and Treasury's concern that U.S. persons 
may use a foreign corporation (for example, by incorporating a 50/50 
joint venture with a foreign person, thereby avoiding CFC status) to 
obtain results that are inconsistent with the purposes of this section. 
The IRS and Treasury believe Congress granted Treasury broad regulatory 
authority in section 863(d) to prevent taxpayers from circumventing the 
purposes of this section.
    Proposed regulations Sec. 1.863-8(b)(3) provides that if a foreign 
person is engaged in a U.S. trade or business, the foreign person's 
income derived from a space or ocean activity is presumed to be U.S. 
source income. The rule reflects IRS and Treasury's concern that a 
foreign person could engage in significant economic activities in the 
United States and avoid U.S. taxation of space or ocean income derived 
from such activities. For example, a foreign satellite company 
established in a no-tax jurisdiction could engage in substantial 
activity in the United States through launch facilities, yet pay no 
U.S. or foreign tax on income arising from leasing the satellites it 
launches. The IRS and Treasury believe Congress intended that a foreign 
person engaged in substantial U.S. business in the United States be 
subject to U.S. tax on related space or ocean activity.
    The IRS and Treasury recognize that the presumption may be over-
inclusive in certain cases. Therefore, the proposed regulations provide 
that if the foreign person can allocate gross space or ocean income 
between income from sources within the United States, space, or 
international water, and outside the United States and space and 
international water, to the satisfaction of the Commissioner, based on 
the facts and circumstances, which may include functions performed, 
resources employed, risks assumed, or other contributions to value, 
income from outside the United States and space and international water 
will be treated as foreign source income. When a foreign person is 
entitled to the benefits of a tax

[[Page 3905]]

treaty with the United States, such person may elect to be taxed under 
the rules of that treaty, so that, for example, the United States would 
tax only income attributable to a permanent establishment of that 
foreign person, regardless of the amount of income considered 
effectively connected with a U.S. trade or business.
    b. Source Rules for Sales of Certain Property. Taxpayers must apply 
the rules of section 863(d) and these proposed regulations to determine 
the source of income from sales of property purchased or produced by 
the taxpayer, either when production occurs in whole or in part in 
space or in international water, or when the sale occurs in space or in 
international water. The rules of sections 861, 862, 863(a) and (b), 
and 865, and the regulations thereunder apply only to the extent 
provided in proposed regulations Sec. 1.863-8(b)(4).
    Proposed regulations Sec. 1.863-8(b)(4)(i) provides that income 
derived from the sale of purchased property in space or international 
water is sourced under paragraph (b)(1), (2), or (3) of this section. 
Proposed regulations Sec. 1.863-8(d)(2)(iii) provides that a sale 
occurs in space or international water if either property is located in 
space or international water at the time the rights, title, and 
interests pass to the purchaser, or the property sold is for use in 
space or international water. This rule for determining if a sale takes 
place in space or in international water modifies for space and ocean 
activity the rule in Sec. 1.861-7(c) for otherwise determining where a 
sale takes place. The IRS and Treasury believe this rule for 
determining the place of sale in the case of space or ocean activity is 
consistent with the legislative history of section 863(d), indicating 
Congress intended that space and ocean activity be broadly defined. See 
S. Rept. No. 313, 99th Cong., 2d Sess. 357 (1986) (Senate Report). It 
is also consistent with the language of the Senate Report stating that 
the committee did not intend to override the title passage rule for 
sales of property on the high seas. Consistent with this language, 
proposed regulations Sec. 1.863-8(d)(1)(ii) excludes from the 
definition of ocean activity the sale of inventory on international 
water, and the source of income from such sales continues to be 
determined under Sec. 1.861-7(c).
    Proposed regulations Sec. 1.863-8(b)(4)(ii) provides rules for 
income derived from the sale of property produced by the taxpayer. To 
determine the source of income derived from the sale of property 
produced by the taxpayer, proposed regulations Sec. 1.863-
8(b)(4)(ii)(A) provides that the taxpayer must divide gross income from 
such sale equally between production activity and sales activity. Thus, 
one-half of the taxpayer's gross income is attributed to production 
activity, and the other one-half of such gross income is attributed to 
sales activity.
    Proposed regulations Sec. 1.863-8(b)(4)(ii)(A) provides that income 
attributable to sales activity is sourced applying the rules applicable 
to the sale of purchased property. If the taxpayer sells such property 
in space or international water, the source of income attributable to 
sales activity is determined under paragraph (b)(1), (2), or (3). If 
the taxpayer sells such property outside space and outside 
international water, the source of income attributable to sales 
activity is determined under Sec. 1.863-3(c)(2). Proposed regulations 
Sec. 1.863-8(b)(4)(ii)(B) provides that income attributable to 
production activity, when production occurs only in space or in 
international water, is sourced under paragraphs (b)(1), (2), or (3). 
When production occurs only outside space and international water, 
income attributable to production activity is sourced under Sec. 1.863-
3(c)(1). When production activity occurs both in space or in 
international water and outside space and international water, proposed 
regulations Sec. 1.863-8(b)(4)(ii)(C) splits the income attributed to 
production activity between production activities occurring in space or 
in international water, and production activities occurring outside 
space and international water. Gross income must be allocated to the 
satisfaction of the Commissioner, based on all relevant facts and 
circumstances, which may include functions performed, resources 
employed, risks assumed, and any other contributions to the value of 
the property. The source of gross income attributable to production 
activities in space or in international water is sourced under 
paragraphs (b)(1), (2), or (3). The source of gross income attributable 
to production activities outside space and international water is 
determined under Sec. 1.863-3(c)(1).
    c. Special Rule for Determining the Source of Income from Services. 
Proposed regulations Sec. 1.863-8(b)(5) provides that income derived 
from the performance of services in space or in international water is 
sourced under paragraph (b)(1), (2), or (3). Proposed regulations 
Sec. 1.863-8(d)(2)(ii)(A) provides that a performance of a service is a 
space or ocean activity when a part of the service, even if de minimis, 
is performed in space or in international water. The IRS and Treasury 
believe that Congress intended a broad range of activities be treated 
as space or ocean activities.
    The IRS and Treasury recognize that this rule may be over-inclusive 
in certain cases. Therefore, proposed regulations Sec. 1.863-8(b)(5) 
provides that the taxpayer can allocate gross income derived from the 
performance of the service between activities that occur in space or 
international water and activities that occur outside space and 
international water, to the satisfaction of the Commissioner, based on 
facts and circumstances, which may include functions performed, 
resources employed, risks assumed, or other contributions to value. 
Gross income allocated to activities occurring outside space and 
international water will be sourced under sections 861, 862, 863, and 
865 of the Code.
    d. Special Rule for Determining the Source of Communications 
Income. A communications activity, as defined in proposed regulations 
Sec. 1.863-9(d), also can be a space or ocean activity. Pursuant to the 
authority granted in section 863(d)(1), proposed regulations 
Sec. 1.863-8(b)(6) provides that income from communications activity 
that is also a space or ocean activity is sourced under proposed 
regulations Sec. 1.863-9(b).
3. Taxable Income
    When a taxpayer allocates gross income under paragraph (b)(3) 
(allocation for certain foreign persons), paragraph (b)(4)(ii)(C) 
(allocation between production occurring in space or international 
water and production occurring outside), or paragraph (b)(5) 
(allocation between services occurring in space or international water 
and those occurring outside) of this section, the taxpayer must 
allocate or apportion expenses, losses, and other deductions under 
Secs. 1.861-8 through 1.861-14T of the regulations to the class of 
gross income, which must include the total income so allocated in each 
case. A taxpayer must then apply the rules of Secs. 1.861-8 through 
1.861-14T to properly allocate or apportion amounts of expenses, 
losses, and other deductions allocated or apportioned to such class of 
gross income between gross income from sources within the United States 
and without the United States.
    When a taxpayer must allocate gross income to the satisfaction of 
the Commissioner based on the facts and circumstances, IRS and Treasury 
believe that such allocations would be based generally on section 482 
principles. However, IRS and Treasury solicit comments on this 
approach, including specific comments and examples on

[[Page 3906]]

alternative methods that could be used to make these allocations.
4. Definition of Space and Ocean Activity
    a. General Rules. Section 863(d)(2) provides that space or ocean 
activity means any activity conducted in space, and any activity 
conducted in or under water not within the jurisdiction of the United 
States or a foreign country. Proposed regulations Sec. 1.863-8(d)(1)(i) 
defines space as any area not within the jurisdiction (as recognized by 
the United States) of a foreign country, possession of the United 
States, or the United States, and not in international water.
    Proposed regulations Sec. 1.863-8(d)(1)(i) provides that space 
activity is any activity conducted in space, with certain exceptions. 
Space activity includes performance and provision of services in space, 
leasing of equipment or other property, including spacecraft (e.g., 
satellites) or transponders, located in space, licensing of technology 
or other intangibles for use in space, and the production, processing, 
or creation of property in space. Space activity includes the sale of 
property in space. Space activity also includes underwriting income 
from the insurance of risks on activities that produce income derived 
from space activity. The inclusion of such underwriting income is 
consistent with language in the Senate Report. See Senate Report at 
357.
    Proposed regulations Sec. 1.863-8(d)(1)(ii) provides that ocean 
activity is any activity conducted in international water, with certain 
exceptions. Ocean activity includes performance and provision of 
services in international water, leasing of equipment or other property 
located in international water, licensing of technology or other 
intangibles for use in international water, and the production, 
processing, or creation of property in international water. Ocean 
activity includes the sale of property in international water, and the 
sale of inventory under international water, but does not include the 
selling of inventory if the sale takes place on international water. 
Thus, if property sold on international water is inventory property, 
income attributable to sales activity is sourced under Sec. 1.861-7(c).
    Ocean activity also includes underwriting income from the insurance 
of risks on activities that produce income derived from ocean activity. 
The inclusion of such underwriting income is consistent with language 
in the Senate Report. See Senate Report at 357.
    Ocean activity also includes any activity performed in Antarctica. 
Ocean activity further includes the leasing of a vessel if such vessel 
does not transport cargo or persons for hire between ports-of-call. 
Thus, for example, income earned by a lessor of a vessel that is to 
engage only in research activities in international water is ocean 
income. Ocean activity also includes the leasing of drilling rigs, 
extraction of minerals, and performance and provision of services 
related thereto, to the extent the mines, oil and gas wells, or other 
natural deposits are not within the jurisdiction of the United States, 
U.S. possessions, or any foreign country (as defined in section 638).
    Based on legislative history, the IRS and Treasury believe space 
and ocean activity should be broadly defined based on legislative 
history. The legislative history clearly indicates that Congress 
intended to characterize certain land based activity as space or ocean 
activity. See Senate Report at 357. Consistent with that determination, 
the proposed regulations provide that when activities occur both in 
space or in international water and outside space and international 
water, and constitute parts of a single transaction described in 
Sec. 1.863-8(d)(1), the transaction will be characterized as space or 
ocean activity. Thus, for example, income from the lease of equipment 
located in space will be sourced in its entirety under section 863(d), 
even though certain functions associated with the transaction may be 
performed outside space and international water. The rules of this 
section for defining space or ocean activity by combining activities 
occurring both in space or in international water and outside space and 
international water simply reflect existing principles for 
characterizing a transaction, and are fully consistent with rules for 
characterizing income for purposes of other source rules. Taxpayers 
enjoy flexibility in structuring their transactions that will be 
characterized under existing principles. To ensure the statutory 
purpose is not circumvented, the Commissioner may treat parts of a 
transaction as separate transactions, or combine separate transactions 
as a single transaction.
    Certain activities occurring in space or international water are 
not considered either space or ocean activity. Proposed regulations 
Sec. 1.863-8(d)(3)(i) provides that space or ocean activity does not 
include any activity giving rise to transportation income as defined in 
section 863(c). Proposed regulations Sec. 1.863-8(d)(3)(ii) provides 
that space or ocean activity also does not include any activity with 
respect to mines, oil and gas wells, or other natural deposits to the 
extent the mines or wells are located within the jurisdiction (as 
recognized by the United States) of any country, including the United 
States and its possessions (as defined in section 638). Proposed 
regulations Sec. 1.863-8(d)(3)(iii) provides that space or ocean 
activity does not include any activity giving rise to international 
communications income as defined in proposed regulations Sec. 1.863-
9(d)(3)(ii). These exceptions are consistent with section 863(d)(2)(B) 
of the Code.
    b. Special Rules in Determining Space or Ocean Activity. Proposed 
regulations Sec. 1.863-8(d)(2)(ii)(A) provides that services are 
performed in space or in international water if functions are 
performed, resources employed, risks assumed, or other contributions to 
the value of the transaction occur in space or international water, 
whether such contributions are performed by personnel, or equipment, or 
otherwise. The IRS and Treasury believe that all contributions to a 
transaction's value, whether contributed by personnel, equipment, or 
otherwise, should be considered in determining whether services are 
performed in space or international water.
    Proposed regulations Sec. 1.863-8(d)(2)(ii)(A) provides that the 
performance of a service is treated as a space or ocean activity if a 
part of the service is performed in space or international water. The 
IRS and Treasury recognize that this rule may be over-inclusive in 
certain cases. Therefore, proposed regulations Sec. 1.863-
8(d)(2)(ii)(B) provides that the performance of a service will not be a 
space or ocean activity if the only activity of the taxpayer in space 
or in international water is to facilitate the taxpayer's own 
communications, as part of provision or delivery of a service by the 
taxpayer, and that service would not otherwise be in whole or in part a 
space or ocean activity. Several examples in the regulations illustrate 
this facilitation exception. The IRS and Treasury recognize that 
taxpayers may use communications services in conducting a business, and 
the fact that such communications may be routed through space or 
international water instead of by way of land should not produce 
differences in the source of the taxpayer's income derived from such 
service.
5. Treatment of Partnerships
    Proposed regulations Sec. 1.863-8(e) provides that for U.S. 
partnerships, section 863(d) and the regulations thereunder will be 
applied at the partnership level. The IRS and Treasury believe this 
rule is consistent with

[[Page 3907]]

section 7701(a)(30)(B), which defines a U.S. person as a domestic 
partnership. For foreign partnerships, section 863(d) and the 
regulations thereunder will be applied at the partner level. The 
proposed regulations provide a different rule for foreign partnerships 
because IRS and Treasury are concerned that U.S. persons may use a 
foreign partnership to circumvent the purposes of this section. For 
example, two U.S. persons by the simple expediency of forming a foreign 
partnership can change significantly the U.S. tax consequences under 
section 863(d).
6. Reporting and Documentation Requirements
    When a taxpayer allocates gross income to the satisfaction of the 
Commissioner under Sec. 1.863-8(b)(3) (income of certain foreign 
persons), Sec. 1.863-8(b)(4)(ii)(C) (certain production activity), or 
under Sec. 1.863-8(b)(5) (services) of the proposed regulations, the 
taxpayer must do so by making the allocation on a timely filed original 
return (including extensions). An amended return does not qualify, and 
section 9100 relief will not be available. In all cases, a taxpayer 
must maintain contemporaneous documentation regarding the allocation of 
gross income, and allocation of expenses, losses, and other deductions, 
the methodology used, and the circumstances justifying use of that 
methodology. The taxpayer must produce such documentation within 30 
days upon request.

B. Communications Activity Under Sections 863(a), (d), and (e)

1. Scope
    Section 1.863-9 of the proposed regulations provides rules for 
sourcing income derived from communications activity, notwithstanding 
any other section. Pursuant to proposed regulations Sec. 1.863-8, these 
source rules apply to communications activity that is also space or 
ocean activity.
2. Source of Gross Income Derived From Communications Activity
    a. International Communications Income. Section 863(e)(1)(A) states 
that any international communications income of a U.S. person will be 
sourced 50 percent to the United States and 50 percent to foreign 
sources. Proposed regulations Sec. 1.863-9(b)(2)(i) provides that 
international communications income of a U.S. person will be sourced 50 
percent to the United States and 50 percent to foreign sources.
    Section 863(e)(1)(B)(i) provides that any international 
communications income of a foreign person will be foreign source income 
except as provided in regulations or in section 863(e)(1)(B)(ii). 
Proposed regulations Sec. 1.863-9(b)(2)(ii)(A) states the general rule 
that international communications income of a foreign person is foreign 
source income. However, the proposed regulations contain several 
exceptions to the general rule.
    Proposed regulations Sec. 1.863-9(b)(2)(ii)(B) states that if a 
foreign corporation is 50 percent or more owned by vote or value 
(directly, indirectly, or constructively) by U.S. persons, or is a 
controlled foreign corporation within the meaning of section 957, all 
international communications income is U.S. source income. This rule 
reflects IRS and Treasury's concern that U.S. persons may use a foreign 
corporation to obtain benefits that are inconsistent with the purposes 
of this section.
    Section 863(e)(1)(B)(ii) provides that if a foreign person has a 
U.S. fixed place of business, international communications income 
attributable to the fixed place of business is U.S. source income. 
Consistent with section 863(e)(1)(B)(ii), proposed regulations 
Sec. 1.863-9(b)(2)(ii)(C) states that if a foreign person, other than a 
foreign person described in paragraph (b)(2)(ii)(A), maintains an 
office or other fixed place of business in the United States, any 
international communications income attributable to the office or other 
fixed place of business is U.S. source income. The principles of 
section 864(c)(5) will apply to determine whether a foreign person has 
an office or fixed place of business in the United States. This rule 
does not apply if the foreign person is engaged in a U.S. trade or 
business.
    Proposed regulations Sec. 1.863-9(b)(2)(ii)(D) provides that if a 
foreign person is engaged in a U.S. trade or business, the foreign 
person's international communications income is presumed to be U.S. 
source income. The rule reflects IRS and Treasury's concern that a 
foreign person could avoid a U.S. fixed place of business under section 
863(e)(1)(B)(ii), yet engage in significant communications activity in 
the United States.
    The IRS and Treasury believe Congress intended that a foreign 
person engaged in substantial U.S. business in the United States be 
subject to U.S. tax on that communications activity.
    The IRS and Treasury recognize that this rule may be over-inclusive 
in certain cases. Therefore, the proposed regulations provide that if 
the foreign person can allocate income to international communications 
activity outside the United States and space and international water, 
to the satisfaction of the Commissioner, based on the facts and 
circumstances, which may include functions performed, resources 
employed, risks assumed, or other contributions to value, then the 
income allocated to such communications activity outside the United 
States and space and international water will be foreign source income. 
When a foreign person is entitled to the benefits of a tax treaty with 
the United States, such person may elect to be taxed under the rules of 
that treaty, so that, for example, the United States would tax only 
income attributable to a permanent establishment of that foreign 
person, regardless of the amount of income considered effectively 
connected with a U.S. trade or business.
    b. Other Communications Income. The proposed regulations also 
provide rules, for both U.S. and foreign persons, for determining the 
source of income from communications activity that does not qualify as 
international communications activity. The IRS and Treasury believe 
rules that address income from other communications activities are 
necessary based on the legislative history. See Senate Report at 357.
    Proposed regulations Sec. 1.863-9(b)(3) states that the source of 
income derived by either a U.S. or foreign person from U.S. 
communications activity is U.S. source income. Proposed regulations 
Sec. 1.863-9(b)(4) states that the source of income derived by either a 
U.S. or foreign person from foreign communications activity is foreign 
source income. Proposed regulations Sec. 1.863-9(b)(5) states that the 
source of income derived from space/ocean communications activity is 
determined under section 863(d) and the regulations thereunder.
3. Taxable Income
    When a taxpayer allocates gross income under paragraph 
(b)(2)(ii)(D) (certain foreign persons), or (d)(1)(ii) (determining a 
communications activity), the taxpayer must allocate or apportion 
expenses, losses, and other deductions as prescribed in Secs. 1.861-8 
through 1.861-14T of the regulations to the class of gross income, 
which must include the total income so allocated in each case. A 
taxpayer must then apply the rules of Secs. 1.861-8 through 1.861-14T 
of the regulations to properly allocate or apportion amounts of 
expenses, losses, and other deductions allocated or apportioned to such 
gross income between gross income from sources within the United States 
and without the United States. For amounts of expenses, losses, and 
other

[[Page 3908]]

deductions allocated or apportioned to gross income derived from 
international communications activity, when the source of income is 
determined under the 50/50 method of paragraph (b)(2)(i), taxpayers 
must apportion expenses and other deductions between U.S. and foreign 
sources pro rata based on the relative amounts of U.S. and foreign 
source gross income. Research and experimental expenditures qualifying 
under Sec. 1.861-17 are allocated under that section.
    When a taxpayer must allocate gross income to the satisfaction of 
the Commissioner based on the facts and circumstances, IRS and Treasury 
believe that such allocations would be based generally on section 482 
principles. However, IRS and Treasury solicit comments on this 
approach, including specific comments and examples on alternative 
methods that could be used to make these allocations.
4. Definition of Communications Activity and Income Derived From 
Communications Activity
    a. Communications Activity. Proposed regulations Sec. 1.863-9(d)(1) 
defines a communications activity as an activity consisting solely in 
the delivery by transmission of communications or data 
(communications). The definition of a communications activity is 
limited to the function of transmitting a particular communication from 
point A to point B. The delivery of communications by means other than 
transmission, for example, delivery of a letter is not a communications 
activity. The IRS and Treasury believe that this narrow definition of 
communications activity is consistent with the legislative history of 
section 863(e). See Senate Report at 357.
    The provision of capacity to transmit communications or data is 
considered to be a communications activity. For example, the provision 
of satellite transponder capacity can qualify as a communications 
activity.
    The provision of content or any other additional service will not 
be treated as a communications activity unless de minimis. For example, 
changes in the form of a voice communication when switching from analog 
technology to digital data for Internet telephony would be disregarded 
in determining whether there has been a transmission of communications 
within the meaning of proposed regulations Sec. 1.863-9(d). However, 
payment for information from a data base sent electronically, or for 
income attributable to an entertainment event transmitted 
electronically, would not be income derived from a communications 
activity.
    When the provision of content or any other services is de minimis, 
such content or services are ignored, and the transaction will be 
treated solely as the transmission of communications within the meaning 
of proposed regulations Sec. 1.863-9(d)(1). The determination of 
whether the provision of content or other services is de minimis should 
be based on all the facts and circumstances. The IRS and Treasury 
believe the exclusion of content and other services is consistent with 
the legislative history of section 863(e). No evidence exists in the 
Congressional testimony or in the legislative history that content 
provided by transmission was to be considered a communications 
activity.
    Proposed regulations Sec. 1.863-9(d)(1)(ii) requires that a 
transaction encompassing non-de minimis communications activities and 
non-de minimis non-communications activities must be broken into parts 
and each part treated as a separate transaction. Proposed regulations 
Sec. 1.863-9(d)(1)(ii) states that gross income derived from the 
activities must be allocated to each separate transaction, to the 
satisfaction of the Commissioner, based on all relevant facts and 
circumstances, which may include functions performed, resources 
employed, risks assumed, and any other contributions to the value of 
the respective transactions. For example, a payment by an advertiser to 
a TV broadcast station may be in part a payment for transmission of the 
advertisement, but could also be a payment for other property or 
services, for example the transmitter's ability to reach a particular 
market or audience. Such activities, if not de minimis, must be treated 
as non-communications activities under Sec. 1.863-9(d)(1)(ii) of the 
proposed regulations.
    To ensure the statutory purposes are not circumvented, the 
Commissioner may treat parts of a transaction as separate transactions, 
or construe separate transactions as a single transaction.
    b. Income Derived from Communications Activity. Income derived from 
communications activity is defined in proposed regulations Sec. 1.863-
9(d)(2) as income derived from the transmission of communications, 
including income derived from the provision of capacity to transmit 
communications. There is no requirement that the income recipient 
perform the transmission function. This rule reflects IRS and 
Treasury's understanding that those providing communications services 
often use capacity owned or operated by others. However, income is 
derived from communications activity only if the taxpayer is paid to 
transmit, and bears the risk of transmitting, the communications.
    c. Character of Communications Activity. Proposed regulations 
Sec. 1.863-9(d)(3) provides rules for characterizing income derived 
from a communications activity for purposes of sourcing the income 
derived from such activity. The character of income derived from 
communications activity is determined by establishing the two points 
between which the taxpayer is paid to transmit, and bears the risk of 
transmitting, the communication. Under the paid-to-do rule, the path 
the communication takes between the two points is not relevant in 
determining the character of the transmission. If a taxpayer is paid to 
take a communication from one point to another point, income derived 
from the transmission is characterized based on the transmission 
between those two points, even though the taxpayer contracts out part 
of the transmission to another. This rule reflects IRS and Treasury's 
recognition that those providing communications often use the network 
owned or operated by others. Several examples in the proposed 
regulations illustrate the paid-to-do rule.
    Proposed regulations Sec. 1.863-9(d)(3)(ii) defines income derived 
from international communications activity as the transmission from a 
point in the United States and a point in a foreign country (or a 
possession of the United States). Proposed regulations Sec. 1.863-
9(d)(3)(iii) defines income derived from U.S. communications activity 
as the transmission between two points in the United States or a point 
in the United States and a point in space or international water.
    Proposed regulations Sec. 1.863-9(d)(3)(iv) defines income derived 
from foreign communications activity as the transmission between two 
points either in a foreign country or in foreign countries or a point 
in a foreign country and a point in space or international water. 
Proposed regulations Sec. 1.863-9(d)(3)(v) defines income derived from 
space/ocean communications activity as the transmission between a point 
in space or international water and another point in space or 
international water. The IRS and Treasury believe these rules are 
consistent with the legislative history. See Senate Report at 357.
    When the taxpayer cannot establish the two points between which the 
taxpayer is paid to transmit, the source of income derived from such 
activity, for either a U.S. or foreign person, is U.S. source income. 
Thus, for example, when a provider of communications services provides 
both local and

[[Page 3909]]

international long distance along with cable services in one-price 
bundles for a set amount each month, tracing each transmission may not 
be possible or practical. In such cases, the source of income derived 
from communications activity is U.S. source income. The IRS and 
Treasury understand that many in the communications industry may not 
consider it practical or possible to prove the end points of the 
communications the taxpayer transmits. The IRS and Treasury solicit 
comments as to proposals for those situations when taxpayers cannot 
establish the points between which the taxpayer is paid to transmit the 
communications.
5. Treatment of Partnerships
    Proposed regulations Sec. 1.863-9(e) provides, in general, that for 
U.S. partnerships, section 863(e) and the regulations thereunder will 
be applied at the partnership level. The IRS and Treasury believe this 
rule is consistent with section 7701(a)(30)(B), which defines a U.S. 
person as a domestic partnership. For foreign partnerships, and in the 
case of a U.S. partnership in which 50 percent or more of the 
partnership interests are owned by foreign persons, section 863(e) and 
the regulations thereunder will be applied at the partner level. The 
proposed regulations provide a different rule for foreign partnerships 
and for U.S. partnerships with substantial foreign ownership because 
the IRS and Treasury are concerned that U.S. persons may use such 
partnerships to circumvent the purposes of this section.
6. Reporting Rules and Documentation Requirements
    When a taxpayer allocates gross income to the satisfaction of the 
Commissioner under proposed regulations Sec. 1.863-9(b)(2)(ii)(D) 
(certain foreign persons) or -(d)(1)(ii) (determining a communications 
activity), it does so by making the allocation on a timely filed 
original return (including extensions). An amended return does not 
qualify, and section 9100 relief will not be available. In all cases, a 
taxpayer must maintain contemporaneous documentation regarding the 
allocation of gross income, and allocation of expenses, losses and 
other deductions, the methodology used, and the circumstances 
justifying use of that methodology. The taxpayer must produce such 
documentation within 30 days upon request.

C. Amendment to the Sec. 1.863-3 Regulations

    These proposed regulations amend the regulations under Sec. 1.863-3 
for determining the source of income in certain inventory sales.
    The regulations provide that in determining the source of income 
from sales of property when the property is either (i) produced in 
whole or in part in space or in international water, or (ii) sold in 
space or in international water, the rules of Sec. 1.863-8 of the 
proposed regulations apply. The rules of sections 863 (a) and (b), and 
the regulations under those sections, do not apply to determine the 
source of income in such cases, except to the extent provided in 
Sec. 1.863-8 of the proposed regulations. The proposed regulations in 
Sec. 1.863-8(b)(4)(ii)(A) provide, however, that the source of income 
from sales of inventory on international water continues to be sourced 
under Sec. 1.863-3(c)(2). The regulations in Sec. 1.863-3(a)(1) and -
3(c)(1)(i)(A) are amended to reflect these provisions.
    The proposed regulations also amend Sec. 1.863-3(c)(2) to provide 
that the place of sale will be presumed to be the United States, for 
purposes of that section, when property is produced in the United 
States and the property is sold to a U.S. resident for use, 
consumption, or disposition in space. See Sec. 1.864-6(b)(3) for 
determining whether property is used in space and whether the sale is 
to a U.S. resident.
    These rules reflect the views of Treasury and the IRS that sales of 
satellites or transponders by a U.S. resident in space should produce 
U.S. source income. These rules also reflect the view that sales of 
such property by a U.S. resident to a U.S. purchaser should produce 
U.S. source income. Treasury and the IRS believe that these provisions 
are consistent with Congress' intent in enacting section 863(d) to tax 
U.S. persons on a residency basis on income that is not likely to be 
subject to foreign tax by a foreign country. It is also consistent with 
the tax policy of the foreign tax credit that income not likely to be 
subject to foreign tax should not be treated as foreign source income, 
which would inappropriately allow taxpayers with excess foreign tax 
credits to shelter this income from U.S. tax.

Proposed Effective Dates

    These regulations are proposed to apply for taxable years beginning 
on or after the date that is 30 days after the date of publication of 
final regulations in the Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
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. 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. The 
IRS and Treasury specifically request comments on the clarity of the 
proposed regulations and how they may be made easier to understand. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for March 28, 2001, at 10 a.m., 
in the auditorium, seventh floor, Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC. Due to building security 
procedures, visitors must enter at the 10th Street entrance, located 
between Constitution and Pennsylvania Avenues, NW. In addition, all 
visitors must present photo identification to enter the building. 
Because of access restrictions, visitors will not be admitted beyond 
the immediate entrance area more than 15 minutes before the hearing 
starts. For information about having your name placed on the building 
access list to attend the hearing, see the FOR FURTHER INFORMATION 
CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
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 March 7, 2001.
    A period of 10 minutes will be allotted to each person for making 
comments.

[[Page 3910]]

    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 1.863-8 also issued under 26 U.S.C. 863(a), (b) and (d).
    Section 1.863-9 also issued under 26 U.S.C. 863(a), (d) and (e). * 
* *

    Par. 2 Section 1.863-3 is amended by:
    1. Adding a sentence after the first sentence in paragraph (a)(1).
    2. Adding a sentence at the end of paragraph (c)(1)(i)(A).
    3. Adding three sentences, one after the current first sentence of 
paragraph (c)(2), and the other two sentences after the current second 
sentence of paragraph (c)(2).
    The additions read as follows:


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

    (a) * * * (1) * * *To determine the source of income from sales of 
property produced by the taxpayer, when the property is either produced 
in whole or in part in space or on or under water not within the 
jurisdiction (as recognized by the United States) of a foreign country, 
possession of the United States, or the United States (in international 
water), or is sold in space or in international water, the rules of 
Sec. 1.863-8 apply, and the rules of this section do not apply, except 
to the extent provided in Sec. 1.863-8. * * *
* * * * *
    (c) * * * (1) * * * (i) * * * (A) * * * For rules regarding the 
source of income when production takes place, in whole or in part, in 
space or in international water, the rules of Sec. 1.863-8 apply, and 
the rules of this section do not apply except to the extent provided in 
Sec. 1.863-8.
* * * * *
    (c)(2) * * * Notwithstanding any other provision, for rules 
regarding the source of income when a sale takes place in space or in 
international water, the rules of Sec. 1.863-8 apply, and the rules of 
this section do not apply except to the extent provided in Sec. 1.863-
8. * * * The place of sale will be presumed to be the United States 
under this rule when property is produced in the United States and the 
property is sold to a U.S. resident, who uses the property in space or 
in international water. In such cases, the property will be treated as 
sold for use, consumption, or disposition in the United States.
* * * * *
    Par. 3 Section 1.863-8 and 1.863-9 are added to read as follows:


Sec. 1.863-8  Source of income from space and ocean activity under 
section 863(d).

    (a) In general. Income of a U.S. or a foreign person derived from 
space or ocean activity (space or ocean income) is sourced under the 
rules of this section, notwithstanding any other provision, including 
sections 861, 862, 863, and 865. A taxpayer will not be considered to 
derive income from space or ocean activity, as defined in paragraph (d) 
of this section, if such activity is performed by another person, 
subject to the rules for the treatment of consolidated groups in 
section Sec. 1.1502-13.
    (b) Source of gross income from space or ocean activity--(1) In 
general. Income derived by a U.S. person from space or ocean activity 
is income from sources within the United States, except as otherwise 
provided in this paragraph (b). Income derived by a person other than a 
United States person from space or ocean activity is income from 
sources without the United States, except as otherwise provided in this 
paragraph (b).
    (2) Income derived by certain foreign corporations. If a U.S. 
person or U.S. persons own 50 percent or more of the vote or value of 
the stock of a foreign corporation (directly, indirectly or 
constructively) that is not a controlled foreign corporation within the 
meaning of section 957, all income derived by that foreign corporation 
from space or ocean activity is U.S. source income.
    (3) Income derived by foreign persons engaged in a U.S. trade or 
business. If a foreign person, other than a controlled foreign 
corporation within the meaning of section 957 or a foreign person 
described in paragraph (b)(2) of this section, is engaged in a U.S. 
trade or business, all income derived by that person from space or 
ocean activity is presumed to be U.S. source income. However, if the 
foreign person can allocate income between sources within the United 
States, or space, or international water, and sources outside the 
United States and space and international water, to the satisfaction of 
the Commissioner, based on the facts and circumstances, which may 
include functions performed, resources employed, risks assumed, or 
other contributions to value, then space or ocean income allocated to 
sources outside the United States and space and international water 
shall be treated as from sources outside the United States.
    (4) Source rules for income from certain sales of property--(i) 
Sales of purchased property. When a taxpayer sells property in space or 
in international water, the source of gross income shall be determined 
under paragraph (b)(1), (2), or (3) of this section as applicable. 
However, if inventory, within the meaning of section 1221(1), is sold 
on international water, the source of income shall be determined under 
Sec. 1.863-3(c)(2).
    (ii) Sales of property produced by the taxpayer--(A) General. If 
the taxpayer both produces property and also sells such property, the 
taxpayer must divide gross income from such sales between production 
activity and sales activity under the 50/50 method as described in this 
paragraph (b)(4)(ii)(A). 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 paragraphs (b)(4)(ii)(B) or (C) 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 
paragraph (b)(4)(i) of this section. However, if the taxpayer sells 
such property outside space and outside international water, the source 
of gross income attributable to sales activity will be determined under 
Sec. 1.863-3(c)(2).
    (B) Production only in space or in international water, or only 
outside space and international water. When production occurs only in 
space or in international water, income attributable to production 
activity is sourced under paragraph (b)(1), (2), or (3) of this section 
as space or ocean income. When production occurs only outside space and 
international water, income attributable to production activity is 
sourced under Sec. 1.863-3(c)(1).
    (C) Production both in space or in international water and outside 
space and international water. When property is produced in space or in 
international

[[Page 3911]]

water and outside space and international water, gross income must be 
allocated to production occurring in space or in international water 
and production occurring outside space and international water, to the 
satisfaction of the Commissioner, based on all the facts and 
circumstances, which may include functions performed, resources 
employed, risks assumed, and any other contributions to value. The 
source of gross income allocated to space or international water is 
determined under paragraph (b)(1), (2), or (3) of this section. The 
source of gross income allocated outside space and international water 
is determined under Sec. 1.863-3(c)(1).
    (5) Special rule for determining the source of gross income from 
services. If a transaction characterized as the performance of services 
constitutes a space or ocean activity by reason of the performance of 
part of the service in space or in international water, as determined 
under paragraph (d)(2)(ii)(A) of this section, the source of all gross 
income derived from such transaction of which such performance is a 
part is determined under paragraph (b)(1), (2), or (3) of this section. 
However, if the taxpayer can allocate gross income between performance 
occurring outside space and international water, and performance 
occurring in space or international water, to the satisfaction of the 
Commissioner, based on the facts and circumstances, including functions 
performed, resources employed, risks assumed, or other contributions to 
value, then the source of income allocated to performance occurring 
outside space and international water shall be determined under 
sections 861, 862, 863, and 865.
    (6) Special rule for determining source of income from 
communications activity (other than income from international 
communications activity). Space and ocean activity, as defined in 
paragraphs (d)(1) and (2) of this section, includes activity occurring 
in space or in international water that is characterized as a 
communications activity as defined in Sec. 1.863-9(d). The source of 
gross income from space or ocean activity that is also a communications 
activity as defined in Sec. 1.863-9(d) is determined under the rules of 
Sec. 1.863-9(b), rather than under paragraph (b) of this section.
    (c) Taxable income. When a taxpayer allocates gross income under 
paragraph (b)(3), (b)(4)(ii)(C), or (b)(5) of this section, to the 
satisfaction of the Commissioner, based on all the facts and 
circumstances, the taxpayer must allocate or apportion expenses, 
losses, and other deductions as prescribed in Secs. 1.861-8 through 
1.861-14T to the class of gross income, which must include the total 
income so allocated in each case. A taxpayer must then apply the rules 
of Secs. 1.861-8 through 1.861-14T to properly allocate or apportion 
amounts of expenses, losses, and other deductions allocated or 
apportioned to such gross income between gross income from sources 
within the United States and without the United States.
    (d) Space and Ocean activity--(1) Definition--(i) Space activity. 
In general, space activity is any activity conducted in space. Space 
activity includes performance and provision of services in space, as 
defined in paragraph (d)(2)(ii)(A) of this section, leasing of 
equipment located in space, including spacecraft (e.g., satellites) or 
transponders located in space, licensing of technology or other 
intangibles for use in space, and the production, processing, or 
creation of property in space, as defined in paragraph (d)(2)(i) of 
this section. Space activity includes activity occurring in space that 
is characterized as communications activity (other than international 
communications activity) under Sec. 1.863-9(d). Space activity also 
includes underwriting income from the insurance of risks on activities 
that produce space income. Space activity includes the sale in space of 
property, as defined in paragraph (d)(2)(iii) of this section. For 
purposes of this section, space means any area not within the 
jurisdiction (as recognized by the United States) of a foreign country, 
possession of the United States, or the United States, and not in 
international water. For purposes of determining space activity, the 
Commissioner may separate parts of a single transaction into separate 
transactions or combine separate transactions as parts of a single 
transaction. Paragraph (d)(3) of this section lists exceptions to the 
general rule.
    (ii) Ocean activity. In general, ocean activity is any activity 
conducted on or under water not within the jurisdiction (as recognized 
by the United States) of a foreign country, possession of the United 
States, or the United States (collectively, in international water). 
Ocean activity includes performance and provision of services in 
international water, as defined in paragraph (d)(2)(ii)(A) of this 
section, leasing of equipment located in international water, including 
underwater cables, licensing of technology or other intangibles for use 
in international water, and the production, processing, or creation of 
property in international water, as defined in paragraph (d)(2)(i) of 
this section. Ocean activity includes sales of property in 
international water, as defined in paragraph (d)(2)(iii) of this 
section, but ocean activity does not include the selling of inventory 
as defined in section 1221(1) on international water. Ocean activity 
includes activity occurring in international water that is 
characterized as communications activity (other than international 
communications activity) under Sec. 1.863-9(d). Ocean activity also 
includes underwriting income from the insurance of risks on activities 
that produce ocean income. Ocean activity also includes any activity 
performed in Antarctica. Ocean activity further includes the leasing of 
a vessel if such vessel does not transport cargo or persons for hire 
between ports-of-call. Thus, for example, the leasing of a vessel that 
is to engage only in research activities in international water is an 
ocean activity. Except as provided in paragraph (d)(3)(ii) of this 
section, ocean activity also includes the leasing of drilling rigs, 
extraction of minerals, and performance and provision of services 
related thereto. For purposes of determining ocean activity, the 
Commissioner may separate parts of a single transaction into separate 
transactions or combine separate transactions as parts of a single 
transaction. Paragraph (d)(3) of this section lists exceptions to the 
general rule.
    (2) Determining a space or ocean activity--(i) Production of 
property in space or in international water. For purposes of this 
section, production activity means an activity that creates, 
fabricates, manufactures, extracts, processes, cures, or ages property 
within the meaning of sections 864(a) and Sec. 1.864-1.
    (ii) Special rule for performance of services--(A) General. If a 
transaction is characterized as the performance of a service, then such 
service will be treated as a space or ocean activity when a part of the 
service, even if de minimis, is performed in space or in international 
water. Services are performed in space or in international water if 
functions are performed, resources employed, risks assumed, or other 
contributions to value occur in space or in international water, 
regardless of whether performed by personnel, or equipment, or 
otherwise.
    (B) Exception to the general rule--facilitating the taxpayer's own 
communications. If a taxpayer's only activity in space or in 
international water is to facilitate the taxpayer's own communications 
as part of the provision or delivery of a service provided by the 
taxpayer, and that service would not otherwise be in whole or in part a 
space

[[Page 3912]]

or ocean activity, such service will not be treated as either space or 
ocean activity because of such facilitation.
    (iii) Sale in space or in international water. In applying 
Sec. 1.861-7(c) to determine where a sale takes place, property will be 
sold in space or in international water if the property is located in 
space or in international water when rights, title and interest pass to 
the buyer (or when bare legal title is retained, at the time and place 
of passage of beneficial ownership and risk of loss), or if property is 
sold for use in space or in international water.
    (3) Exceptions to space or ocean activity. Space or ocean activity 
does not include the following types of activities--
    (i) Any activity giving rise to transportation income as defined in 
section 863(c); or
    (ii) Any activity with respect to mines, oil and gas wells, or 
other natural deposits to the extent the mines or wells are located 
within the jurisdiction (as recognized by the United States) of any 
country, including the United States and its possessions; or
    (iii) Any activity giving rise to international communications 
income as defined in Sec. 1.863-9(d)(3)(ii).
    (e) Treatment of partnerships. In the case of a U.S. partnership, 
this section will be applied at the partnership level. In the case of a 
foreign partnership, this section will be applied at the partner level.
    (f) Examples. The following examples illustrate the rules of this 
section:
    Example 1. Space activity--activity occurring on land and in 
space. (i) Facts. S owns satellites, and leases one of its 
satellites to A. S, as lessor, will not operate the satellite. Part 
of S's performance as lessor in this transaction occurs on land.
    (ii) Analysis. The combination of S's activities is 
characterized as the lease of equipment. Since the equipment is 
located in space, the transaction is defined as space activity under 
paragraph (d)(1)(i) of this section. Income derived from the lease 
will be sourced in its entirety under paragraph (b) of this section.
    Example 2. Space activity. (i) Facts. X is an Internet service 
provider, offering a service to personal computer users accessing 
the Internet. This service permits a customer, C, to make a call, 
initiated by a modem, routed to a control center, for connection to 
the World Wide Web. X transmits the requested information over its 
satellite capacity leased from S to C's personal computer. X charges 
its customers a flat monthly fee. Assume neither X nor S derive 
international communications income within the meaning of 
Sec. 1.863-9(d)(3)(ii).
    (ii) Analysis. In this case, X performs a service, and X's 
activity in space is not simply facilitation within the meaning of 
paragraph (d)(2)(ii)(B) of this section, because X's activity is not 
simply the facilitation of X's own communications and because X's 
activity is not just part of another service provided by X. Thus, 
X's activity constitutes space activity in its entirety under 
paragraph (d)(2)(ii)(A) of this section, and the source of X's 
income is determined under paragraph (b) of this section. To the 
extent X derives income from communications activity, within the 
meaning of Sec. 1.863-9(d), the source of X's income is determined 
under Sec. 1.863-9(b), as provided in paragraph (b)(6) of this 
section. S derives communications income within the meaning of 
Sec. 1.863-9(d), and therefore the source of S's income is 
determined under Sec. 1.863-9(b), as provided in paragraph (b)(6) of 
this section.
    Example 3. Services as space activity--facilitation of 
communications. (i) Facts. R owns a retail outlet in the United 
States. R employs S to provide a security system for R's premises. S 
operates its security system by transmitting images from R's 
premises to a satellite, and from there to a group of S employees 
located in Country B, who then monitor the premises by viewing the 
transmitted images. O provides S with transponder capacity on O's 
satellite, which S uses to transmit those images.
    (ii) Analysis. S derives income for providing monitoring 
services. Because, in this case, S uses O's satellite transponder to 
transmit images to facilitate S's own communications in space as 
part of its provision of a security service, S's activity in space 
is limited to facilitating communications as described in paragraph 
(d)(2)(ii)(B) of this section. Thus, S is not engaged in a space 
activity, and none of S's income is space income. Assuming O's 
provision of capacity is viewed as the provision of a service, O's 
activity in space is not simply the facilitation of communications 
as provided in paragraph (d)(2)(ii)(B) of this section, because O is 
not just facilitating its own communications. Thus, O's activity is 
characterized as space activity in its entirety under paragraph 
(d)(2)(ii)(A) of this section (unless O's activity in space 
qualifies as international communications activity). To the extent O 
derives income from communications activity, within the meaning of 
Sec. 1.863-9(d), the source of O's income is determined under 
Sec. 1863-9(b), as provided in paragraph (b)(6) of this section. On 
these facts, R does not derive any income from space activity.
    Example 4. Space activity. (i) Facts. L, a U.S. company, offers 
programming and also certain services to customers located both in 
the United States and in foreign countries. Assume L's provision of 
programming and services in this case was viewed as the provision of 
a service, with no part of that service occurring in space. L uses 
satellite capacity acquired from S to deliver the service directly 
to customers' television sets, so that the delivery of the service 
occurs in space. Assume the delivery in this case is not considered 
de minimis. L also acquires programming from H, and L pays H a 
royalty for use of copyrighted material in the United States and in 
foreign countries. Customer, C, pays L for delivery of the service 
to C's residence in the United States. Assume S's provision of 
capacity in this case was viewed as the provision of a service, and 
also that S does not derive international communications income 
within the meaning of Sec. 1.863-9(d)(3)(ii).
    (ii) Analysis. On these facts, S's activity in space is not just 
the facilitation of its own communications within the meaning of 
paragraph (d)(2)(ii)(B) of this section, because S is facilitating 
the communications of others. To the extent S derives income from a 
space activity that is also a communications activity under 
Sec. 1.863-9(d), the source of S's income is determined under 
Sec. 1.863-9(b), as provided in paragraph (b)(6) of this section. On 
these facts, L is treated as providing a service and is paid to 
deliver that service to its customers, and each transaction, i.e., 
the provision of the service and the delivery of the service, 
constitutes a separate transaction. L's income derived from 
provision of the service is not income derived from space activity. 
L's income derived from delivery of the service is space activity. 
L's delivery of the service is not just the facilitation of L's own 
communications within the meaning of paragraph (d)(2)(ii)(B) of this 
section, because it is not just a part of the provision of a 
service, but instead the entire service. Since L derives 
communications income within the meaning of Sec. 1.863-9(d), the 
source of L's income is determined under Sec. 1.863-9(b), as 
provided in paragraph (b)(6) of this section. If on other facts, L 
provides a service and delivers that service, and L treats the 
provision of the service and the delivery of the service as one 
separate transaction, then L performs services in space under 
paragraph (d)(2)(ii)(A) of this section, because the delivery of the 
service occurs in space. However, L's activity in space would be 
limited to facilitating its own communications within the meaning of 
paragraph (d)(2)(ii)(B) of this section, because it is part of 
another service that would not otherwise be a space activity. As a 
result, L's provision of the service would not be a space activity 
under paragraph (d)(2)(ii)(A) of this section.
    Example 5. Space activity--treatment of land activity. (i) 
Facts. S, a U.S. person, offers remote imaging products and services 
to its customers. In year 1, S uses its satellite's remote sensors 
to gather data on certain geographical terrain. In year 3, C, a 
construction development company, contracts with S to obtain a 
satellite image of an area for site development work. S pulls data 
from its archives and transfers to C the images gathered in year 1, 
in a transaction that is characterized as a sale of the data. Title 
to the data passes to C in the United States. Before transferring 
the images to C, S uses computer software to enhance the images so 
that the images can be used.
    (ii) Analysis. The collection of data and creation of images in 
space is characterized as the creation of property in space. S's 
income is derived from production of property in part in space, and 
is, therefore, derived in part from space activity. The source of 
S's income from production and sale of property is, therefore, 
determined under paragraph (b)(4) of this section. Since production 
activity occurs both in space and on land, the source of S's 
production income is determined under paragraphs (b)(4)(ii)(A) and 
(C) of this section. The source of S's

[[Page 3913]]

income attributable to sales activity is determined under paragraph 
(b)(4)(ii)(A) of this section and Sec. 1.863-3(c)(2) as U.S. source 
income.
    Example 6. Use of intangible property in space. (i) Facts. X 
acquires a license to use a particular satellite slot or orbit, 
which X sublicenses to C. C pays X a royalty.
    (ii) Analysis. Since the royalty is paid for the right to use 
intangible property in space, the source of X's royalty is 
determined under paragraph (b) of this section.
    Example 7. Performance of services.
    (i) Facts. E, a U.S. company, operates satellites with sensing 
equipment that can determine how much heat and light particular 
plants emit and reflect. Based on the data, E will provide F, a U.S. 
farmer, a report analyzing the data, which F will use in growing 
crops. E analyzes the data from U.S. offices.
    (ii) Analysis. Assume E's combined activities are characterized 
as the performance of services. Because part of the service is 
performed in space, all income E derives from the transaction will 
be treated as derived from space activity under paragraph 
(d)(2)(ii)(A) of this section. The source of such income will be 
determined under paragraph (b)(5) of this section. If, however, E 
can allocate gross income, to the satisfaction of the Commissioner, 
as prescribed in paragraph (b)(5) of this section, then the source 
of gross income attributable to services performed outside space may 
be determined as provided in paragraph (b)(5) of this section.
    Example 8. Separate transactions.
    (i) Facts. The same facts as Example 7, except that E provides 
the raw data to F in a transaction characterized as a sale of a 
copyrighted article, and in addition also provides an analysis in 
the form of a report to F, a U.S. farmer who uses the information in 
growing crops. The price F pays E for the raw data is separately 
stated.
    (ii) Analysis. To the extent the provision of raw data and the 
analysis of the data are each treated as separate transactions, the 
source of income from the production and sale of data is determined 
under paragraph (b)(4) of this section. The provision of services 
would be analyzed in the same manner as in Example 7.
    Example 9. Sale of property under international water.
    (i) Facts. T owns transatlantic cable lying under the ocean, 
which it purchased. T sells the cable to B.
    (ii) Analysis. Because the property is sold under international 
water as provided in paragraph (d)(2)(iii) of this section, the 
transaction is ocean activity under paragraph (d)(1)(ii) of this 
section, and the source of income is determined under paragraph 
(b)(4)(i) of this section, by reference to paragraph (b)(1), (2), or 
(3) of this section.
    Example 10. Sales of property in space.
    (i) Facts. S manufactures a satellite in the United States and 
sells it to a U.S. customer, with the rights, title, and interest 
passing to the customer when the satellite is located in space.
    (ii) Analysis. The source of income derived from the sale of the 
satellite in space is determined under paragraph (b)(4) of this 
section, with the source of income attributable to production 
activity determined under paragraphs (b)(4)(ii)(A) and (B) of this 
section, and the source of income attributable to sales activity 
determined under paragraphs (b)(4)(ii)(A) and (b)(4)(i) of this 
section, by reference to paragraph (b)(1), (2), or (3) of this 
section.
    Example 11. Sale of property located in space.
    (i) Facts. S has a right to operate from a particular position 
in space. S sells the right to operate from that satellite slot or 
orbit to P.
    (ii) Analysis. Because the sale takes place in space, as 
provided in paragraph (d)(2)(iii) of this section, gain on the sale 
of the satellite slot or orbit is income derived from space activity 
under paragraph (d)(1)(i) of this section, and income from the sale 
is sourced under paragraph (b)(4)(i) of this section, by reference 
to paragraph (b)(1), (2), or (3) of this section.
    Example 12. Source of income of a foreign person.
    (1) Facts. FP, a foreign company, not a controlled foreign 
corporation within the meaning of section 957, derives income from 
the operation of satellites. FP operates a ground station in the 
United States and in foreign country, FC.
    (ii) Analysis. In this case, FP is engaged in a U.S. trade or 
business of operating the ground station. Thus, under paragraph 
(b)(3) of this section, all FP's income derived from space activity 
is presumed to be U.S. source income. However, if FP can allocate 
space income to contributions occurring outside the United States, 
space, and international water, as provided in paragraph (b)(3) of 
this section, for example, to the ground station located in FC, then 
such space income so allocated will be from sources outside the 
United States.
    Example 13. Source of income of a foreign person.
    (i) Facts. FP, a foreign company, not a controlled foreign 
corporation within the meaning of Section 957, operates remote 
sensing satellites, collecting data and images in space for its 
customers. FP uses an independent agent, A, in the United States who 
provides marketing, order taking, and other customer service 
functions.
    (ii) Analysis. In this case, FP is engaged in a U.S. trade or 
business on the basis of A's activities on its behalf in the United 
States. Therefore, under paragraph (b)(3) of this section, all of 
FP's income derived from space activity is presumed to be space 
income. However, if FP can allocate income to contributions 
occurring outside the United States, space, and international water, 
as provided in paragraph (b)(3) of this section, then such income so 
allocated will be from sources outside the United States.

    (g) Reporting and documentation requirements. When a taxpayer 
allocates gross income, to the satisfaction of the Commissioner, under 
paragraph (b)(3), (b)(4)(ii)(C), or (b)(5) of this section, it does so 
by making the allocation on a timely filed original return (including 
extensions). An amended return does not qualify for this purpose, nor 
shall the provisions of Sec. 301.9100-1 of this chapter and any 
guidance promulgated thereunder apply. In all cases, a taxpayer must 
maintain contemporaneous documentation in existence when such return is 
filed regarding the allocation of gross income and allocation or 
apportionment of expenses, losses and other deductions, the methodology 
used, and the circumstances justifying use of that methodology. The 
taxpayer must produce such documentation within 30 days upon request.
    (h) Effective date. This section applies to taxable years beginning 
on or after the date that is 30 days after the date of publication of 
final regulations in the Federal Register.


Sec. 1.863-9  Source of income derived from communications activity 
under sections 863(a), (d), and (e).

    (a) In general. Income of a U.S. or foreign person derived from 
communications activity is sourced under the rules of this section, 
notwithstanding any other provision including sections 861, 862, 863, 
and 865.
    (b) Source of gross income derived from communications activity--
(1) In general. The source of gross income derived from each type of 
communications activity, as defined in paragraph (d)(3) of this 
section, is determined under this paragraph (b). If a communications 
activity would qualify as space or ocean activity under section 863(d) 
and the regulations thereunder, the source of income derived from such 
communications activity is determined under this section, and not under 
section 863(d) and the regulations thereunder. See Sec. 1.863-8(b)(6).
    (2) Source of international communications income--(i) Income 
derived by a U.S. person. Under the 50/50 method of this paragraph 
(b)(2)(i), income derived by a U.S. person from international 
communications activity is one-half from sources within the United 
States and one-half from sources without the United States.
    (ii) Income derived by foreign persons--(A) General rule. Income 
derived by a person other than a U.S. person from international 
communications activity is, except as otherwise provided in this 
paragraph (b), wholly from sources without the United States.
    (B) Income derived by certain foreign corporations. If a foreign 
corporation, including a controlled foreign corporation within the 
meaning of section 957, is 50 percent or more owned by vote or value 
(directly,

[[Page 3914]]

indirectly, or constructively) by U.S. persons, all income derived by 
that corporation from international communications activity is from 
sources within the United States.
    (C) Income derived by foreign persons with a U.S. fixed place of 
business. If a foreign person (other than a foreign person described in 
paragraph (b)(2)(ii)(B) of this section) maintains an office or other 
fixed place of business in the United States, the foreign person's 
international communications income, as determined to the satisfaction 
of the Commissioner, attributable to the office or other fixed place of 
business is from sources within the United States. The principles of 
section 864(c)(5) apply in determining whether a foreign person has an 
office or fixed place of business in the United States. See Sec. 1.864-
6 and -7. This paragraph does not apply if the foreign person is 
engaged in a U.S. trade or business.
    (D) Income derived by foreign persons engaged in a U.S. trade or 
business. If a foreign person (other than a foreign person described in 
paragraph (b)(2)(ii)(B) of this section) is engaged in a U.S. trade or 
business, all of the foreign person's international communications 
income is presumed to be from sources within the United States. 
However, if the foreign person can allocate income between sources 
within the United States, or space, or international water and sources 
outside the United States and space and international water, to the 
satisfaction of the Commissioner, based on the facts and circumstances, 
which may include functions performed, resources employed, risks 
assumed, or other contributions to value, then the income allocated to 
sources outside the United States and space and international water 
shall be treated as from sources without the United States.
    (3) Source of U.S. communications income. The source of income 
derived by a U.S. or a foreign person from U.S. communications activity 
is from sources within the United States.
    (4) Source of foreign communications income. The source of income 
derived by a U.S. or a foreign person from foreign communications 
activity is from sources without the United States.
    (5) Source of space/ocean communications income. The source of 
income derived by a U.S. or a foreign person from space/ocean 
communications activity is determined under section 863(d) and the 
regulations thereunder, without regard to Sec. 1.863-8(b)(6).
    (6) Source of communications income when taxpayer cannot establish 
the two points between which the taxpayer is paid to transmit the 
communication. The income derived by a U.S. person or foreign person 
from communications activity, when the taxpayer cannot establish the 
two points between which the taxpayer is paid to transmit the 
communication as required in paragraph (d)(3)(i) of this section, is 
from sources within the United States.
    (c) Taxable income. When a taxpayer allocates gross income under 
paragraph (b)(2)(ii)(D) or (d)(1)(ii) of this section, to the 
satisfaction of the Commissioner, based on all the facts and 
circumstances, the taxpayer must allocate or apportion expenses, 
losses, and other deductions as prescribed in Secs. 1.861-8 through 
1.861-14T to the class of gross income, which must include the total 
income so allocated in each case. A taxpayer must then apply the rules 
of Secs. 1.861-8 through 1.861-14T to properly allocate or apportion 
amounts of expenses, losses, and other deductions allocated or 
apportioned to such gross income between gross income from sources 
within the United States and without the United States. For amounts of 
expenses, losses, and other deductions allocated or apportioned to 
gross income derived from international communications activity, when 
the source of income is determined under the 50/50 method of paragraph 
(b)(2)(i) of this section, taxpayers must apportion expenses, losses, 
and other deductions between sources within and sources without pro 
rata based on the relative amounts of gross income from sources within 
the United States and without the United States. Research and 
experimental expenditures qualifying under Sec. 1.861-17 are allocated 
under that section, and are not allocated and apportioned pro rata 
under the method of paragraph (b)(2)(i) of this section.
    (d) Communications activity and income derived from communications 
activity--(1) Communications activity--(i) General rule. For purposes 
of this part, communications activity consists solely of the delivery 
by transmission of communications or data (communications). Delivery of 
communications other than by transmission, for example, by delivery of 
physical packages and letters, is not communications activity within 
the meaning of this section. Communications activity also includes the 
provision of capacity to transmit communications. Provision of content 
or any other additional service provided along with, or in connection 
with, a non-de minimis communications activity must be treated as a 
separate non-communications activity unless de minimis.
    (ii) Separate transaction. To the extent a taxpayer's transaction 
consists in part of non-de minimis communications activity and in part 
of non-de minimis non-communications activity, such parts of the 
transaction must be treated as separate transactions. Gross income must 
be allocated to each such transaction involving the communications 
activity and the non-communications activity to the satisfaction of the 
Commissioner, based on all relevant facts and circumstances, which may 
include functions performed, resources employed, risks assumed, and any 
other contributions to the value of the respective transactions. For 
purposes of determining whether income is derived from communications 
activity, the Commissioner may treat communications activity and non-
communications activity, treated as a single transaction, as separate 
transactions, or combine separate communications activity and non-
communications activity transactions into a single transaction.
    (2) Income derived from communications activity. Income derived 
from communications activity (communications income) is income derived 
from the delivery by transmission of communications, including income 
derived from the provision of capacity to transmit communications. 
Income may be considered derived from a communications activity even if 
the taxpayer itself does not perform the transmission function, but in 
all cases, the taxpayer derives communications income only if the 
taxpayer is paid to transmit, and bears the risk of transmitting, the 
communications.
    (3) Determining the type of communications activity--(i) In 
general. Whether income is derived from international communications 
activity, U.S. communications activity, foreign communications 
activity, or space/ocean communications activity is determined by 
identifying the two points between which the taxpayer is paid to 
transmit the communication. The taxpayer must establish to the 
satisfaction of the Commissioner the two points between which the 
taxpayer is paid to transmit, and bears the risk of transmitting, the 
communication. Whether the taxpayer contracts out part or all of the 
transmission function is not relevant.
    (ii) Income derived from international communications activity. 
Income derived by a taxpayer from international communications activity 
(international communications income) is income derived from 
communications activity, as defined in paragraph (d)(1) of this

[[Page 3915]]

section, when the taxpayer is paid to transmit between a point in the 
United States and a point in a foreign country (or a possession of the 
United States).
    (iii) Income derived from U.S. communications activity. Income 
derived by a taxpayer from U.S. communications activity (U.S. 
communications income) is income derived from communications activity, 
as defined in paragraph (d)(1) of this section, when the taxpayer is 
paid to transmit--
    (A) Between two points in the United States; or
    (B) Between the United States and a point in space or in 
international water.
    (iv) Income derived from foreign communications activity. Income 
derived by a taxpayer from foreign communications activity (foreign 
communications income) is income derived from communications activity, 
as defined in paragraph (d)(1) of this section, when the taxpayer is 
paid to transmit--
    (A) Between two points in a foreign country or countries (or 
possession or possessions of the United States); or
    (B) Between a foreign country (or a possession of the United 
States) and a point in space or in international water.
    (v) Income derived from space/ocean communications activity. Income 
derived by a taxpayer from space/ocean communications activity (space/
ocean communications income) is income derived from a communications 
activity, as defined in paragraph (d)(1) of this section, when the 
taxpayer is paid to transmit between a point in space or in 
international water and another point in space or in international 
water.
    (e) Treatment of partnerships--(1) General. In the case of a U.S. 
partnership, this section will be applied at the partnership level. In 
the case of a foreign partnership, this section will be applied at the 
partner level.
    (2) Exception. In the case of a U.S. partnership in which 50 
percent or more of the partnership interests are owned by foreign 
persons, this section will be applied at the partner level.
    (f) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Income derived from communications activity. (i) 
Facts. D provides its customers in various foreign countries with 
access to its data base. A customer, C, places a toll call to D's 
telephone number, and can then access D's data base to obtain 
certain information, such as C's customers' health care coverage.
    (ii) Analysis. D is not paid to transmit communications and does 
not derive income solely from transmission of communications within 
the meaning of paragraph (d) of this section. D instead derives 
income from provision of content or provision of services to its 
customers.
    Example 2. Income derived from U.S. communications activity. (i) 
Facts. Local telephone company (TC) receives access fees from an 
international carrier for picking up calls from a local telephone 
customer and delivering the call to a U.S. point of presence (POP) 
of the international carrier. The international carrier picks up the 
call from its U.S. POP and delivers the call to a foreign country.
    (ii) Analysis. TC is not paid to carry the transmission between 
the United States and a foreign country. It is paid to transmit 
communications between two points in the United States. TC derives 
income from U.S. communications activity as defined in paragraph 
(d)(3)(iii) of this section, which is sourced under paragraph (b)(3) 
of this section as U.S. source income.
    Example 3. Income derived from international communications 
activity. (i) Facts. TC, a U.S. company, owns an underwater fiber 
optic cable. Pursuant to three year contracts, TC makes capacity to 
transmit communications via the cable available to its customers. 
Such customers then solicit telephone customers and arrange for 
transmitting their calls. The cable runs in part through U.S. 
waters, through international waters, and in part through foreign 
country waters.
    (ii) Analysis. TC derives income from communications activity 
under paragraph (d)(2) of this section. The income is derived from 
international communications activity as provided in paragraph 
(d)(3)(ii) of this section, since TC is paid to make available 
capacity to transmit between the United States and a foreign 
country, and vice versa. Since TC is a U.S. person, TC's 
international communications income is sourced under paragraph 
(b)(2)(i) of this section as one-half from sources within the United 
States and one-half from sources without the United States.
    Example 4. Character of communications activity: the paid-to-do 
rule. (i) Facts. TC is paid to transmit communications from Toronto, 
Canada, to Paris, France. TC transmits the communication to New 
York. TC pays another communications company, IC, to transmit the 
communications from New York to Paris.
    (ii) Analysis. Under the paid-to-do rule of paragraph (d)(3)(i) 
of this section, TC derives income from foreign communications 
activity under paragraph (d)(3)(iv) of this section, since it is 
paid to transmit communications between two foreign points, Toronto 
and Paris. Under paragraph (d)(3)(i) of this section, the character 
of TC's activity is determined without regard to the fact that TC 
pays IC to transmit the communication for some portion of the 
delivery path. IC has international communications income under 
paragraph (d)(3)(ii) of this section, because it is paid to transmit 
the communication between a point in the United States and a point 
in a foreign country.
    Example 5. Income derived from international communications 
activity. (i) Facts. S, a U.S. satellite operator, owns satellites 
and the uplink facilities in Country X, a foreign country. B, a 
resident of Country X, pays S to deliver its programming from 
Country X to its downlink facility in the United States, owned by C, 
a customer of B.
    (ii) Analysis. S derives communications income under paragraph 
(d) of this section. S's income is characterized as international 
communications income under paragraph (d)(3)(ii) of this section, 
because S is paid to transmit the communication between the 
beginning point in a foreign country to an end point in the United 
States. The source of S's international communications income is 
determined under paragraph (b)(2)(i) of this section as one-half 
from sources within the United States and one-half from sources 
without the United States.
    Example 6. Character of income derived from communications 
activity: the paid-to-do rule. (i) Facts. TC is paid to take a call 
from North Carolina to Iowa, two points in the United States, but 
routes the call through Canada.
    (ii) Analysis. Under paragraph (d)(3)(i) of this section, the 
character of the income derived from communications activity is 
determined by the two points between which the taxpayer is paid to 
transmit, and bears the risk of transmitting, the communications, 
without regard to the path of the transmission between those two 
points. Thus, under paragraph (d)(3)(iii) of this section, TC 
derives income from U.S. communications activity because it is paid 
to transmit between two U.S. points.
    Example 7. Source of income derived from communications 
activity. (i) Facts. A, a U.S. company, is an Internet access 
provider. A charges C a lump sum, paid monthly, for Internet access. 
A transmits a call made by C in France to a recipient in England, 
over the public Internet. A does not maintain records as to the 
beginning and end points of the transmission.
    (ii) Analysis. Although A derives income from communications 
activity as defined in paragraph (d)(1) of this section, the source 
of income is determined under paragraph (b)(6) of this section as 
income from sources within the United States, because A cannot 
establish the two points between which it is paid to transmit the 
communications.
    Example 8. Income derived from communications and non-
communications activity. (i) Facts. A, a U.S. company, offers 
customers local and long distance phone service, video, and Internet 
services. Customers pay one monthly fee, and in addition 10 cents a 
minute for all long-distance calls, including international calls.
    (ii) Analysis. To the extent A derives income from 
communications activity, A must allocate income to its 
communications activity as provided in paragraph (d)(1)(ii) of this 
section. To the extent A can establish that it derives international 
communications income as defined in paragraph (d)(3)(ii) of this 
section, A would determine the source of such income under paragraph 
(b)(2)(i) of this section. If A cannot establish the points between 
which it is paid to transmit communications, as required in 
paragraph (d)(3)(i) of this section, the source of A's income must 
be determined under paragraph (b)(6) of this section as from within 
the United States.
    Example 9. Income derived from communications activity. (i) 
Facts. T

[[Page 3916]]

purchases capacity from TC to transmit telephone calls. T sells 
prepaid telephone calling cards, giving customers access to TC's 
lines, for a certain number of minutes.
    (ii) Analysis. T derives income from communications activity, 
under paragraph (d)(2) of this section, because T makes capacity to 
transmit available to its customers. In this case, T cannot 
establish the points between which communications are transmitted. 
Therefore, the source of its income must be determined under 
paragraph (b)(6) of this section as U.S. source income.
    Example 10. Income derived from communications and non-
communications activity. (i) Facts. B, a U.S. company, transmits 
television programs using its satellite transponder, from the United 
States to downlink facilities in foreign country Y, owned by D, a 
cable system operator in Country Y. D receives the transmission, 
unscrambles the signals, and distributes the broadcast to customers 
in Country Y.
    (ii) Analysis. B derives income both from communications 
activity as defined under paragraph (d)(1)(i) of this section, and 
from non-communications activity. Gross income must be allocated to 
the communications activity as required in paragraph (d)(1)(ii) of 
this section. Income derived by B for transmission to D is 
international communications income within paragraph (d)(3)(ii) of 
this section, because B is paid to transmit communications from the 
United States to a foreign country.
    Example 11. Income derived from communications activity. (i) 
Facts. TC is paid for Internet access. TC replicates frequently 
requested sites on its servers, solely to speed up response time.
    (ii) Analysis. On these facts, the replication service would be 
treated as de minimis under paragraph (d)(1)(i) of this section, so 
that TC derives income from communications activity. The type and 
source of TC's communications income depends on demonstrating the 
points between which TC is paid by its customer to transmit the 
communications, under paragraph (d)(3)(i) of this section.
    Example 12. Income derived from foreign communications activity. 
(i) Facts. S leases capacity to B, a broadcaster located in 
Australia. B beams programming to the satellite, and S's satellite 
picks the communications up in space, and beams the programming over 
Southeast Asia.
    (ii) Analysis. S derives income from communications activity 
under paragraph (d)(2) of this section. S's income is characterized 
as income derived from foreign communications activity under 
paragraph (d)(3)(iv) of this section, because S picks up the 
communication in space, and beams it to a footprint entirely 
covering a foreign area. The source of S's income is determined 
under paragraph (b)(4) of this section as from sources without the 
United States. If S were beaming the programming over a satellite 
footprint that covered area both in the United States and outside 
the United States, S would be required to allocate the income 
derived from the different types of communications activity.

    (g) Reporting rules and disclosure on tax return. When a taxpayer 
allocates gross income to the satisfaction of the Commissioner under 
paragraph (b)(2)(ii)(D) or (d)(1)(ii) of this section, it does so by 
making the allocation on a timely filed original return (including 
extensions). An amended return does not qualify for this purpose, nor 
shall the provisions of Sec. 301.9100-1 of this chapter and any 
guidance promulgated thereunder apply. In all cases, a taxpayer must 
maintain contemporaneous documentation in existence when such return is 
filed regarding the allocation of gross income, and allocation and 
apportionment of expenses, losses, and other deductions, the 
methodology used, and the circumstances justifying use of that 
methodology. The taxpayer must produce such documentation within 30 
days of a request.
    (h) Effective date. This section applies to taxable years beginning 
on or after the date that is 30 days after the date of publication of 
final regulations in the Federal Register.

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 01-7 Filed 1-16-01; 8:45 am]
BILLING CODE 4830-01-U