[Federal Register Volume 69, Number 151 (Friday, August 6, 2004)]
[Proposed Rules]
[Pages 47816-47822]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-17813]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-208254-90 and REG-136481-04]
RIN 1545-AO72 and RIN 1545-BD62


Source of Compensation for Labor or Personal Services

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Withdrawal of notice of proposed rulemaking and notice of 
proposed rulemaking.

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SUMMARY: This document contains new proposed rules that describe the 
proper basis for determining the source of compensation from labor or 
personal services performed partly within and partly without the United 
States. The new proposed rules will affect individuals that earn 
compensation from labor or personal services performed partly within 
and partly without the United States and are needed to provide 
appropriate guidance regarding the determination of the proper source 
of that compensation. This document also withdraws the notice of 
proposed rulemaking (REG-208254-90) published in the Federal Register 
on January 21, 2000 (65 FR 3401).

DATES: Written or electronic comments and requests for a public hearing 
must be received by November 4, 2004. The notice of proposed rulemaking 
published on January 21, 2000, is withdrawn as of August 6, 2004.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-208254-90), room 
5203, 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 4 p.m. to: CC:PA:LPD:PR (REG-
208254-90), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington DC or sent electronically, via the IRS Internet 
site at: http://www.irs.gov/regs or Federal eRulemaking Portal at 
http://www.regulations.gov (IRS and REG-208254-90).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
David Bergkuist, (202) 622-3850 (not a toll-free number); concerning 
the submissions of comments, Lanita Van Dyke (202) 622-7180 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in this notice of proposed 
rulemaking have been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collections of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP 
Washington, DC 20224. Comments on the collection of information should 
be received by October 5, 2004. Comments are specifically requested 
concerning:
    Whether the proposed collections of information are 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 
collections of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collections 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 collections of information in this proposed regulation are in 
Sec.  1.861-4(b)(2) (ii)(C)(1)(i), (b)(2)(ii)(D), and (b)(2)(ii)(D)(6). 
The information required in Sec.  1.861-4(b)(2) (ii)(C)(1)(i) will 
enable an individual, where appropriate, to use an alternative basis 
other than that described in Sec.  1.861-4(b)(2)(ii)(A) or (B) to 
determine the source of his or her compensation as an employee for 
labor or personal services performed partly within and partly without 
the United States. The information required in Sec.  1.861-
4(b)(2)(ii)(D) and (D)(6) will enable an employee to source certain 
fringe benefits on a geographical basis. The collections of information 
will, likewise, allow the IRS to verify these determinations.
    The collections of information and responses to these collections 
of information are required to obtain and maintain benefits. The likely 
respondents are individuals who perform labor or personal services 
partly within and partly without the United States, some of which may 
receive certain fringe benefit compensation for those services.
    Estimated total annual recordkeeping burden: 10,000 hours.
    The estimated annual burden per recordkeeper varies from 15 minutes 
to one hour, depending on the circumstances of the individual, with an 
estimated average of 30 minutes.
    Estimated number of recordkeepers: 20,000.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    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.

Background

    This document contains proposed amendments (the new proposed 
regulations) 26 CFR part 1 under section 861 of the Internal Revenue 
Code (Code). On January 21, 2000, a notice of proposed rulemaking was 
published in the Federal Register at 65 FR 3401 (REG-208254-90; 2000-1 
C.B. 577) (the previously proposed regulations). The previously 
proposed regulations would have modified the existing final regulations 
relating to the determination of the source of income from the

[[Page 47817]]

performance of labor or personal services performed partly within and 
partly without the United States. Written comments were received in 
response to the notice of proposed rulemaking. A public hearing was 
held on July 18, 2000. In response to these comments, and after further 
consideration of the issue, the previously proposed regulations are 
withdrawn and new regulations are proposed. This preamble discusses 
comments received on the previously proposed regulations and describes 
the differences between the new proposed regulations and the previously 
proposed regulations.

Explanation of Provisions

    The existing final regulations, Sec.  1.861-4(b), provide that if a 
person performs labor or personal services partly within and partly 
without the United States, the amount to be included in gross income 
from United States sources shall be determined on the basis that most 
correctly reflects the proper source of income under the facts and 
circumstances of the particular case.
    The previously proposed regulations retained the facts and 
circumstances basis for determining the source of such income for 
persons other than individuals. For individuals, however, the 
previously proposed regulations provided that if an individual received 
compensation for a specific time period for labor or personal services 
that are performed partly within and partly without the United States, 
the amount of compensation for labor or personal services performed 
within the United States would have been determined solely on a time 
basis.
    Several comments questioned the rule in the previously proposed 
regulations that required individuals to determine the source of such 
income on a time basis. In response to those comments, and after 
further consideration of the issues presented, the previously proposed 
regulations are withdrawn and new regulations are proposed that take 
into account the concerns raised.
    Treasury and the IRS believe that a time basis generally is the 
most appropriate method for determining the source of an individual 
employee's compensation for labor and personal services performed 
partly within and partly without the United States. Compensation 
provided to an employee for a specific time period is generally 
considered to be earned by the employee ratably over that time period. 
Accordingly, it is appropriate generally to source such compensation on 
a ratable basis. In addition, Treasury and the IRS believe that this 
rule will provide certainty and simplification for both taxpayers and 
the IRS. The information necessary to apply the time basis should be 
readily available to employers and employees. For example, Form 2555, 
``Foreign Earned Income'', requires an individual who claims the 
foreign earned income exclusion to provide the IRS with information 
relating to the number of business days spent within the United States 
and any fringe benefits received. Sourcing on a time basis may be 
appropriate as well for individuals other than employees who receive 
compensation for labor or personal services and who may be viewed as 
earning such compensation ratably.
    Nonetheless, for entities other than individuals and for 
individuals who are not employees, the facts and circumstances in many 
cases may be such that an apportionment on a basis other than a time 
basis may be more appropriate. For example, a corporation could receive 
payments under a contract for services to be performed by numerous 
employees at various pay levels in a number of different geographic 
locations. In such a case, payroll costs under the contract for 
services, or another basis besides time, may more correctly reflect the 
proper source of the corporation's income.
    The new proposed regulations retain the facts and circumstances 
basis as the general rule for determining the source of compensation 
for labor and personal services performed partly within and partly 
without the United States received by persons other than individuals 
and by individuals who are not employees. However, the new proposed 
regulations provide two new general bases for determining the proper 
source of compensation that an individual receives as an employee for 
such labor or personal services. Under the first general basis of Sec.  
1.861-4(b)(2)(ii)(A), an individual who receives compensation, other 
than compensation in the form of certain fringe benefits, as an 
employee for labor or personal services performed partly within and 
partly without the United States is required to source such 
compensation on a time basis, as defined in Sec.  1.861-4(b)(2)(ii)(E).
    Under the second general basis of Sec.  1.861-4(b)(2)(ii)(B) and 
(D), an individual who receives compensation as an employee for labor 
or personal services performed partly within and partly without the 
United States in the form of fringe benefits, as described in Sec.  
1.861-4(b)(2)(ii)(D)(1) through (6), is required to source such 
compensation on a geographical basis (e.g., at the employee's principal 
place of work, as defined in section 217 and Sec.  1.217-2(c)(3)). The 
fringe benefits to which this general basis applies are: Housing, 
education, local transportation, tax reimbursement, hazardous or 
hardship duty pay, and moving expense reimbursement fringe benefits. 
This general basis will apply only if the amount of the fringe benefit 
is reasonable and is substantiated by adequate contemporaneous records 
or sufficient evidence under rules similar to those set forth in Sec.  
1.274-5T(c) or (h) or Sec.  1.132-5, and only if the fringe benefit 
meets the definition set forth in the new proposed regulations. 
Treasury and the IRS intend to keep the list and descriptions of 
identified fringe benefits current and invite comments regarding 
whether the identified fringe benefits are appropriately defined and 
whether other fringe benefits should be identified in the regulations 
and sourced on a specific geographic basis.
    Treasury and the IRS recognize that there are circumstances in 
which these two general bases may not be the most appropriate basis for 
determining the source of an employee's compensation for labor or 
personal services performed partly within and partly without the United 
States. Accordingly, the new proposed regulations at Sec.  1.861-
4(b)(2)(ii)(C)(1)(i) provide that an employee may use an alternative 
basis, based upon the facts and circumstances, to source such 
compensation if he or she establishes to the satisfaction of the 
Commissioner that such an alternative basis more properly determines 
the source of the compensation. For example, when an employee's 
compensation is tied to the performance of specific actions rather than 
earned ratably over a specific time period, an alternative basis may 
more properly determine the source of compensation than the bases for 
determining source of compensation described in Sec.  1.861-
4(b)(2)(ii)(A) and (B).
    In order to satisfy the Commissioner, an employee must retain in 
his or her records documentation setting forth why the alternative 
basis more properly determines the source of the compensation than the 
basis for determining source of compensation described in Sec.  1.861-
4(b)(2)(ii)(A) or (B). In addition, it is anticipated that the 
Commissioner, by ruling or other administrative pronouncement, will 
issue guidance as to what procedures an employee must follow in order 
to assert an alternative basis to determine the source of his or her 
compensation for labor or personal services performed partly within and 
partly without the United States. Such administrative

[[Page 47818]]

pronouncement will likely require that an individual who has $250,000 
or more in compensation for the tax year must indicate in the manner 
prescribed that he or she is using an alternative basis to source his 
or her compensation. Such individual may be required to file a form, or 
retain the following in his or her records: (1) A written explanation 
of why the alternative basis more properly determines the source of the 
compensation than the basis for determining source of compensation 
described in Sec.  1.861-4(b)(2)(ii)(A) or (B) under the facts and 
circumstances, and (2) a written comparison of the dollar amount of the 
compensation sourced within and without the United States under both 
the individual's alternative basis and the basis for determining source 
of compensation described in Sec.  1.861-4(b)(2)(ii)(A) or (B).
    Section 1.861-4(b)(2)(ii)(C)(1)(ii) of the new proposed regulations 
also provides that the Commissioner may, under the facts and 
circumstances of the particular case, determine the source of 
compensation that is received by an individual as an employee for labor 
or personal services performed partly within and partly without the 
United States under an alternative basis other than a basis described 
in paragraph (b)(2)(ii)(A) or (B) if such compensation either (1) is 
not for a specific time period or (2) constitutes in substance a fringe 
benefit described in paragraph (b)(2)(ii)(D) notwithstanding a failure 
to meet any requirement of paragraph (b)(2)(ii)(D). The Commissioner 
may make this determination only if such alternative basis determines 
the source of compensation in a more reasonable manner than the basis 
used by the individual pursuant to paragraph (b)(2)(ii)(A) or (B).
    Section 1.861-4(b)(2)(ii)(C)(2) of the new proposed regulations 
provides that the Commissioner may, by ruling or other administrative 
pronouncement applying to similarly situated taxpayers generally, 
permit individuals to determine the source of their compensation as an 
employee for labor or personal services performed partly within and 
partly without the United States under an alternative basis. Any such 
individual shall be treated as having met the requirement to establish 
such alternative basis to the satisfaction of the Commissioner under 
the facts and circumstances of the particular case, provided that the 
individual meets the other requirements of paragraph 
(b)(2)(ii)(C)(1)(i). This paragraph also provides that the Commissioner 
may, by ruling or other administrative pronouncement, indicate the 
circumstances in which he will require individuals to determine the 
source of certain compensation as an employee for labor or personal 
services performed partly within and partly without the United States 
under an alternative basis pursuant to the authority under paragraph 
(b)(2)(ii)(C)(1)(ii) of this section.
    Section 1.861-4(b)(2)(ii)(C)(3) of the new proposed regulations is 
reserved with respect to artists and athletes who are employees. It is 
intended that the specific rules for artists and athletes who are 
employees will require such individuals to determine the proper source 
of compensation for labor or personal services on the basis that most 
correctly reflects the proper source of that income under the facts and 
circumstances of the particular case, consistent with current law. 
Comments are invited in this connection, including on the proper 
definition of an artist or athlete for this purpose.
    Examples illustrating these new rules with respect to compensation 
that an individual receives as an employee are included in Sec.  1.861-
4(b)(2)(ii)(G) of the new proposed regulations.
    Several of the comments to the previously proposed regulations 
requested specific rules for compensation arrangements that relate to 
services performed over a period of more than one year, such as 
employee stock option plans, transfers of restricted property, and 
other deferred compensation arrangements. The new proposed regulations 
provide at Sec.  1.861-4(b)(2)(ii)(F) that the source of multi-year 
compensation of an employee is generally determined on a time basis 
over the applicable period to which the compensation is attributable. 
Determination of the applicable period to which the compensation is 
attributable (including whether the compensation relates to more than 
one taxable year) is based upon the facts and circumstances of the 
particular case. Treasury and the IRS invite taxpayers to provide 
comments on whether alternative bases for determining the source of 
such multi-year compensation are appropriate.
    One comment questioned whether a day was the only time period upon 
which to apply the time basis of sourcing compensation. In response to 
this comment, the new proposed regulations provide at Sec.  1.861-
4(b)(2)(ii)(E) that, although the time basis is generally determined by 
comparing the number of days of performance of the labor or personal 
services by the individual within the United States to his or her total 
number of days of performance of labor or personal services, use of a 
unit of time less than a day may be appropriate for purposes of this 
calculation. For example, it may be more appropriate to source 
compensation paid to an airline flight crewmember based on a time unit 
of less than a day.

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 also has 
been determined that section 553(b) of 5 U.S.C. chapter 5 does not 
apply to these regulations, and because the regulation does not impose 
a collection of information on small entities, the Regulatory 
Flexibility Act, 5 U.S.C. chapter 6, does not apply. Pursuant to 
section 7805(f) of the Code, this notice of proposed rulemaking will be 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on their impact on small businesses.

Comments and Requests for a Public Hearing

    Before the new proposed regulations are adopted as final 
regulations, consideration will be given to any written comments (a 
signed original and 8 copies) or electronic comments that are submitted 
timely to the IRS. The IRS and Treasury request comments on the clarity 
of the proposed rules and how they may be made easier to understand. 
All comments will be made available for public inspection and copying. 
A public hearing will be scheduled if requested in writing by any 
person that timely submits written comments. If a public hearing is 
scheduled, notice of the date, time, and place for the public hearing 
will be published in the Federal Register.

Drafting Information

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

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Withdrawal of a Notice of Proposed Rulemaking

    Accordingly, under the authority of 26 U.S.C. 7805, the notice of 
proposed rulemaking published in the Federal Register on January 21, 
2000, (65 FR 3401), REG-208254-90 is withdrawn.

[[Page 47819]]

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 continues to read, 
in part, as follows:

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

    Par. 2. Section 1.861-4 is amended as follows:
    1. The heading for paragraph (a) is revised.
    2. A sentence is added at the beginning of paragraph (a)(1).
    3. Paragraph (b) is revised.
    4. A sentence is added at the end of paragraph (d).
    The revisions and addition read as follows:


Sec.  1.861-4  Compensation for labor or personal services.

    (a) Compensation for labor or personal services performed wholly 
within the United States--(1) Generally, compensation for labor or 
personal services, including fees, commissions, fringe benefits, and 
similar items, performed wholly within the United States is gross 
income from sources within the United States. * * *
* * * * *
    (b) Compensation for labor or personal services performed partly 
within and partly without the United States--(1) Compensation for labor 
or personal services performed by persons other than individuals--(i) 
In general. In the case of compensation for labor or personal services 
performed partly within and partly without the United States by a 
person other than an individual, the part of that compensation that is 
attributable to the labor or personal services performed within the 
United States, and that is therefore included in gross income as income 
from sources within the United States, is determined on the basis that 
most correctly reflects the proper source of the income under the facts 
and circumstances of the particular case. In many cases, the facts and 
circumstances will be such that an apportionment on the time basis, as 
defined in paragraph (b)(2)(ii)(E) of this section, will be acceptable.

    (ii) Example. Corp X, a domestic corporation, receives 
compensation of $150,000 under a contract for services to be 
performed concurrently in the United States and in several foreign 
countries by numerous Corp X employees. Each Corp X employee 
performing services under this contract performs his or her services 
exclusively in one jurisdiction. Although the number of employees 
(and hours spent by employees) performing services under the 
contract within the United States equals the number of employees 
(and hours spent by employees) performing services under the 
contract without the United States, the compensation paid to 
employees performing services under the contract within the United 
States is higher because of the more sophisticated nature of the 
services performed by the employees within the United States. 
Accordingly, the payroll cost for employees performing services 
under the contract within the United States is $20,000 out of a 
total contract payroll cost of $30,000. Under these facts and 
circumstances, a determination based upon relative payroll costs 
would be the basis that most correctly reflects the proper source of 
the income received under the contract. Thus, of the $150,000 of 
compensation included in Corp X's gross income, $100,000 ($150,000 x 
$20,000/$30,000) is attributable to the labor or personal services 
performed within the United States and $50,000 ($150,000 x $10,000/
$30,000) is attributable to the labor or personal services performed 
without the United States.

    (2) Compensation for labor or personal services performed by an 
individual--(i) In general. Except as provided in paragraph (b)(2)(ii) 
of this section, in the case of compensation for labor or personal 
services performed partly within and partly without the United States 
by an individual, the part of such compensation that is attributable to 
the labor or personal services performed within the United States, and 
that is therefore included in gross income as income from sources 
within the United States, is determined on the basis that most 
correctly reflects the proper source of that income under the facts and 
circumstances of the particular case. In many cases, the facts and 
circumstances will be such that an apportionment on a time basis, as 
defined in paragraph (b)(2)(ii)(E) of this section, will be acceptable.
    (ii) Employee compensation--(A) In general. Except as provided in 
paragraph (b)(2)(ii)(B) or (C) of this section, in the case of 
compensation for labor or personal services performed partly within and 
partly without the United States by an individual as an employee, the 
part of such compensation that is attributable to the labor or personal 
services performed within the United States, and that is therefore 
included in gross income as income from sources within the United 
States, is determined on a time basis, as defined in paragraph 
(b)(2)(ii)(E) of this section.
    (B) Certain fringe benefits sourced on a geographical basis. Except 
as provided in paragraph (b)(2)(ii)(C) of this section, items of 
compensation of an individual as an employee for labor or personal 
services performed partly within and partly without the United States 
that are described in paragraph (b)(2)(ii)(D)(1) through (6) of this 
section are sourced on a geographical basis in accordance with those 
paragraphs.
    (C) Exceptions and special rules--(1) Alternative basis--(i) 
Individual as an employee generally. An individual may determine the 
source of his or her compensation as an employee for labor or personal 
services performed partly within and partly without the United States 
under an alternative basis if the individual establishes to the 
satisfaction of the Commissioner that, under the facts and 
circumstances of the particular case, the alternative basis more 
properly determines the source of the compensation than a basis 
described in paragraph (b)(2)(ii)(A) or (B), whichever is applicable, 
of this section. An individual that uses an alternative basis must 
retain in his or her records documentation setting forth why the 
alternative basis more properly determines the source of the 
compensation. In addition, the individual must comply with the 
requirements set forth in any applicable administrative pronouncement 
issued by the Commissioner.
    (ii) Determination by Commissioner. The Commissioner may, under the 
facts and circumstances of the particular case, determine the source of 
compensation that is received by an individual as an employee for labor 
or personal services performed partly within and partly without the 
United States under an alternative basis other than a basis described 
in paragraph (b)(2)(ii)(A) or (B) of this section if such compensation 
either is not for a specific time period or constitutes in substance a 
fringe benefit described in paragraph (b)(2)(ii)(D) of this section 
notwithstanding a failure to meet any requirement of paragraph 
(b)(2)(ii)(D) of this section. The Commissioner may make this 
determination only if such alternative basis determines the source of 
compensation in a more reasonable manner than the basis used by the 
individual pursuant to paragraph (b)(2)(ii)(A) or (B) of this section.
    (2) Ruling or other administrative pronouncement with respect to 
groups of taxpayers. The Commissioner may, by ruling or other 
administrative pronouncement applying to similarly situated taxpayers 
generally, permit individuals to determine the source of their 
compensation as an employee for labor or personal services performed 
partly within and partly without the United States under an alternative 
basis. Any such individual shall be treated as having met the 
requirement to establish

[[Page 47820]]

such alternative basis to the satisfaction of the Commissioner under 
the facts and circumstances of the particular case, provided that the 
individual meets the other requirements of paragraph 
(b)(2)(ii)(C)(1)(i) of this section. The Commissioner also may, by 
ruling or other administrative pronouncement, indicate the 
circumstances in which he will require individuals to determine the 
source of certain compensation as an employee for labor or personal 
services performed partly within and partly without the United States 
under an alternative basis pursuant to the authority under paragraph 
(b)(2)(ii)(C)(1)(ii) of this section.
    (3) Artists and athletes. [Reserved]
    (D) Fringe benefits sourced on a geographical basis. Except as 
provided in paragraph (b)(2)(ii)(C) of this section, compensation of an 
individual as an employee for labor or personal services performed 
partly within and partly without the United States in the form of the 
following fringe benefits is sourced on a geographical basis as 
indicated in this paragraph (b)(2)(ii)(D). The amount of the 
compensation in the form of the fringe benefit must be reasonable, and 
the individual must substantiate such amounts by adequate records or by 
sufficient evidence under rules similar to those set forth in Sec.  
1.274-5T(c) or (h) or Sec.  1.132-5. For purposes of this paragraph 
(b)(2)(ii)(D), the term principal place of work has the same meaning 
that it has for purposes of section 217 and Sec.  1.217-2(c)(3).
    (1) Housing fringe benefit. The source of compensation in the form 
of a housing fringe benefit is determined based on the location of the 
individual's principal place of work. For purposes of this paragraph 
(b)(2)(ii)(D)(1), a housing fringe benefit includes payments to or on 
behalf of an individual (and the individual's family if the family 
resides with the individual) only for rent, utilities (other than 
telephone charges), real and personal property insurance, occupancy 
taxes not deductible under section 164 or 216(a), nonrefundable fees 
paid for securing a leasehold, rental of furniture and accessories, 
household repairs, residential parking, and the fair rental value of 
housing provided in kind by the individual's employer. A housing fringe 
benefit does not include payments for expenses or items set forth in 
Sec.  1.911-4(b)(2).
    (2) Education fringe benefit. The source of compensation in the 
form of an education fringe benefit for the education expenses of the 
individual's dependents is determined based on the location of the 
individual's principal place of work. For purposes of this paragraph 
(b)(2)(ii)(D)(2), an education fringe benefit includes payments only 
for qualified tuition and related expenses of the type described in 
section 530(b)(4)(A)(i) and expenditures for room and board and 
uniforms as described in section 530(b)(4)(A)(ii) with respect to 
education at an elementary or secondary educational institution.
    (3) Local transportation fringe benefit. The source of compensation 
in the form of a local transportation fringe benefit is determined 
based on the location of the individual's principal place of work. For 
purposes of this paragraph (b)(2)(ii)(D)(3), an individual's local 
transportation fringe benefit is the amount that the individual 
receives as compensation for local transportation of the individual or 
the individual's spouse or dependents at the location of the 
individual's principal place of work. The amount treated as a local 
transportation fringe benefit is limited to the actual expenses 
incurred for local transportation and the fair rental value of any 
vehicle provided by the employer and used predominantly by the 
individual or the individual's spouse or dependents for local 
transportation. For this purpose, actual expenses incurred for local 
transportation do not include the cost (including interest) of the 
purchase by the individual, or on behalf of the individual, of an 
automobile or other vehicle.
    (4) Tax reimbursement fringe benefit. The source of compensation in 
the form of a foreign tax reimbursement fringe benefit is determined 
based on the location of the jurisdiction that imposed the tax for 
which the individual is reimbursed.
    (5) Hazardous or hardship duty pay fringe benefit. The source of 
compensation in the form of a hazardous or hardship duty pay fringe 
benefit is determined based on the location of the hazardous or 
hardship duty zone for which the hazardous or hardship duty pay fringe 
benefit is paid. For purposes of this paragraph (b)(2)(ii)(D)(5), a 
hazardous or hardship duty zone is any place in a foreign country which 
is either designated by the Secretary of State as a place where living 
conditions are extraordinarily difficult, notably unhealthy, or where 
excessive physical hardships exist, and for which a post differential 
of 15 percent or more would be provided under section 5925(b) of Title 
5 of the U.S. Code to any officer or employee of the U.S. Government 
present at that place, or where a civil insurrection, civil war, 
terrorism, or wartime conditions threatens physical harm or imminent 
danger to the health and well-being of the individual. Compensation 
provided an employee during the period that the employee performs labor 
or personal services in a hazardous or hardship duty zone may be 
treated as a hazardous or hardship duty pay fringe benefit only if the 
employer provides the hazardous or hardship duty pay fringe benefit 
only to employees performing labor or personal services in a hazardous 
or hardship duty zone. The amount of compensation treated as a 
hazardous or hardship duty pay fringe benefit may not exceed the 
maximum amount that the U.S. government would allow its officers or 
employees present at that location.
    (6) Moving expense reimbursement fringe benefit. Except as 
otherwise provided in this paragraph (b)(2)(ii)(D)(6), the source of 
compensation in the form of a moving expense reimbursement is 
determined based on the location of the employee's new principal place 
of work. The source of such compensation is determined based on the 
location of the employee's former principal place of work, however, if 
the individual provides sufficient evidence that such determination of 
source is more appropriate under the facts and circumstances of the 
particular case. For purposes of this paragraph (b)(2)(ii)(D)(6), 
sufficient evidence generally requires an agreement, between the 
employer and the employee, or a written statement of company policy, 
which is reduced to writing before the move and which is entered into 
or established to induce the employee or employees to move to another 
country. The writing must state that the employer will reimburse the 
employee for moving expenses that the employee incurs to return to the 
employee's former principal place of work regardless of whether he or 
she continues to work for the employer after returning to that 
location. The writing may contain certain conditions upon which the 
right to reimbursement is determined as long as those conditions set 
forth standards that are definitely ascertainable and can only be 
fulfilled prior to, or through completion of, the employee's return 
move to the employee's former principal place of work.
    (E) Time basis. The amount of compensation for labor or personal 
services performed within the United States determined on a time basis 
is the amount that bears the same relation to the individual's total 
compensation as the number of days of performance of the labor or 
personal services by the individual within the United States bears to 
his or her total number of days of performance of labor or personal 
services. A unit of time less than a day

[[Page 47821]]

may be appropriate for purposes of this calculation. The time period 
for which the compensation for labor or personal services is made is 
presumed to be the calendar year in which the labor or personal 
services are performed, unless the taxpayer establishes to the 
satisfaction of the Commissioner, or the Commissioner determines, that 
another distinct, separate, and continuous period of time is more 
appropriate. For example, a transfer during a year from a position in 
the United States to a foreign posting that lasted through the end of 
that year would generally establish two separate time periods within 
that taxable year. The first of these time periods would be the portion 
of the year preceding the start of the foreign posting, and the second 
of these time periods would be the portion of the year following the 
start of the foreign posting. However, in the case of a foreign posting 
that requires short-term returns to the United States to perform 
services for the employer, such short-term returns would not be 
sufficient to establish distinct, separate, and continuous time periods 
within the foreign posting time period but would be relevant to the 
allocation of compensation relating to the overall time period. In each 
case, the source of the compensation on a time basis is based upon the 
number of days (or unit of time less than a day, if appropriate) in 
that separate time period.
    (F) Multi-year compensation arrangements. The source of multi-year 
compensation is determined generally on a time basis, as defined in 
paragraph (b)(2)(ii)(E) of this section, over the period to which such 
compensation is attributable. For purposes of this paragraph 
(b)(2)(ii)(F), multi-year compensation means compensation that is 
included in the income of an individual in one taxable year but that is 
attributable to a period that includes two or more taxable years. The 
determination of the period to which such compensation is attributable, 
for purposes of determining its source, is based upon the facts and 
circumstances of the particular case. For example, an amount of 
compensation that specifically relates to a period of time that 
includes several calendar years is attributable to the entirety of that 
multi-year period. The amount of such compensation that is treated as 
from sources within the United States is the amount that bears the same 
relationship to the total multi-year compensation as the number of days 
(or unit of time less than a day, if appropriate) that labor or 
personal services were performed within the United States in connection 
with the project bears to the total number of days (or unit of time 
less than a day, if appropriate) that labor or personal services were 
performed in connection with the project. In the case of stock options, 
the facts and circumstances generally will be such that the applicable 
period to which the compensation is attributable is the period between 
the grant of an option and the date on which all employment-related 
conditions for its exercise have been satisfied (the vesting of the 
option).
    (G) Examples. The following examples illustrate the application of 
this paragraph (b)(2)(ii):

    Example 1. B, a nonresident alien individual, was employed by 
Corp M, a domestic corporation, from March 1 to December 25 of the 
taxable year, a total of 300 days, for which B received compensation 
in the amount of $80,000. Under B's employment contract with Corp M, 
B was subject to call at all times by Corp M and was in a payment 
status on a 7-day week basis. Pursuant to that contract, B performed 
services (or was available to perform services) within the United 
States for 180 days and performed services (or was available to 
perform services) without the United States for 120 days. None of 
B's $80,000 compensation was for fringe benefits as identified in 
paragraph (b)(2)(ii)(D) of this section. B determined the amount of 
compensation that is attributable to his labor or personal services 
performed within the United States on a time basis under paragraph 
(b)(2)(ii)(A) and (E) of this section. B did not assert, pursuant to 
paragraph (b)(2)(ii)(C)(1)(i) of this section, that, under the 
particular facts and circumstances, an alternative basis more 
properly determines the source of that compensation than the time 
basis. Therefore, B must include in income from sources within the 
United States $48,000 ($80,000 x 180/300) of his compensation from 
Corporation M.
    Example 2. (i) Same facts as in Example 1 except that Corp M had 
a company-wide arrangement with its employees, including B, that 
they would receive an education fringe benefit, as described in 
paragraph (b)(2)(ii)(D)(2) of this section, while working in the 
United States. During the taxable year, B incurred education 
expenses for his dependent daughter that qualified for the education 
fringe benefit in the amount of $10,000, for which B received a 
reimbursement from Corp M. B did not maintain adequate records or 
sufficient evidence of this fringe benefit as required by paragraph 
(b)(2)(ii)(D) of this section. When B filed his Federal income tax 
return for the taxable year, B did not apply paragraphs 
(b)(2)(ii)(B) and (D)(2) of this section to treat the compensation 
in the form of the education fringe benefit as income from sources 
within the United States, the location of his principal place of 
work during the 300-day period. Rather, B combined the $10,000 
reimbursement with his base compensation of $80,000 and applied the 
time basis of paragraph (b)(2)(ii)(A) of this section to determine 
the source of his gross income.
    (ii) On audit, B argues that because he failed to substantiate 
the education fringe benefit in accordance with paragraph 
(b)(2)(ii)(D) of this section, his entire employment compensation 
from Corp M is sourced on a time basis pursuant to paragraph 
(b)(2)(ii)(A) of this section. The Commissioner, after reviewing 
Corp M's fringe benefit arrangement, determines, pursuant to 
paragraph (b)(2)(ii)(C)(1)(ii) of this section, that the $10,000 
educational expense reimbursement constitutes in substance a fringe 
benefit described in paragraph (b)(2)(ii)(D)(2) of this section, 
notwithstanding a failure to meet all of the requirements of 
paragraph (b)(2)(ii)(D) of this section, and that an alternative 
geographic source basis, under the facts and circumstances of this 
particular case, is a more reasonable manner to determine the source 
of the compensation than the time basis used by B.
    Example 3. (i) A, a United States citizen, is employed by Corp 
N, a domestic corporation. A's principal place of work is in the 
United States. A earns an annual salary of $100,000. During the 
first quarter of the calendar year (which is also A's taxable year), 
A performed services entirely within the United States. At the 
beginning of the second quarter of the calendar year, A was 
transferred to Country X for the remainder of the year and received, 
in addition to her annual salary, $30,000 in fringe benefits that 
are attributable to her new principal place of work in Country X. 
Corp N paid these fringe benefits separately from A's annual salary. 
Corp N supplied A with a statement detailing that $25,000 of the 
fringe benefit was paid for housing, as defined in paragraph 
(b)(2)(ii)(D)(1) of this section, and $5,000 of the fringe benefit 
was paid for local transportation, as defined in paragraph 
(b)(2)(ii)(D)(3) of this section. None of the local transportation 
fringe benefit is excluded from the employee's gross income as a 
qualified transportation fringe benefit under section 132(a)(5). 
Under A's employment contract, A was required to work on a 5-day 
week basis, Monday through Friday. During the last three quarters of 
the year, A performed services 30 days in the United States and 150 
days in Country X and other foreign countries.
    (ii) A determined the source of all of her compensation from 
Corp N pursuant to paragraph (b)(2)(ii)(A), (B), and (D)(1) and (3) 
of this section. A did not assert, pursuant to paragraph 
(b)(2)(ii)(C)(1)(i) of this section, that, under the particular 
facts and circumstances, an alternative basis more properly 
determines the source of that compensation than the bases set forth 
in paragraphs (b)(2)(ii)(A), (B), and (D)(1) and (3) of this 
section. However, in applying the time basis set forth in paragraph 
(b)(2)(ii)(E) of this section, A establishes to the satisfaction of 
the Commissioner that the first quarter of the calendar year and the 
last three quarters of the calendar year are two separate, distinct, 
and continuous periods of time. Accordingly, $25,000 of A's annual 
salary is attributable to the first quarter of the year (25 percent 
of $100,000). This amount is entirely compensation that was 
attributable to the labor or personal services performed

[[Page 47822]]

within the United States and is, therefore, included in gross income 
as income from sources within the United States. The balance of A's 
compensation as an employee of Corp N, $105,000 (which includes the 
$30,000 in fringe benefits that are attributable to the location of 
A's principal place of work in Country X), is compensation 
attributable to the final three quarters of her taxable year. During 
those three quarters, A's periodic performance of services in the 
United States does not result in distinct, separate, and continuous 
periods of time. Of the $75,000 paid for annual salary, $12,500 (30/
180 x $75,000) is compensation that was attributable to the labor or 
personal services performed within the United States and $62,500 
(150/180 x $75,000) is compensation that was attributable to the 
labor or personal services performed outside the United States. 
Pursuant to paragraphs (b)(2)(ii)(B) and (D)(1) and (3) of this 
section, A sourced the $25,000 received for the housing fringe 
benefit and the $5,000 received for the local transportation fringe 
benefit based on the location of her principal place of work, 
Country X. Accordingly, A included the $30,000 in fringe benefits in 
her gross income as income from sources without the United States.
    Example 4. Same facts as in Example 3. Of the 150 days during 
which A performed services in Country X and in other foreign 
countries (during the final three quarters of A's taxable year), she 
performed 30 days of those services in Country Y. Country Y is a 
country designated by the Secretary of State as a place where living 
conditions are extremely difficult, notably unhealthy, or where 
excessive physical hardships exist and for which a post differential 
of 15 percent or more would be provided under section 5925(b) of 
Title 5 of the U.S. Code to any officer or employee of the U.S. 
government present at that place. Corp N has a policy of paying its 
employees a $65 premium per day for each day worked in countries so 
designated. The $65 premium per day does not exceed the maximum 
amount that the U.S. government would pay its officers or employees 
stationed in Country Y. Because A performed services in Country Y 
for 30 days, she earned additional compensation of $1,950. The 
$1,950 is considered a hazardous duty or hardship pay fringe benefit 
and is sourced under paragraphs (b)(2)(ii)(B) and (D)(5) of this 
section based on the location of the hazardous or hardship duty 
zone, Country Y. Accordingly, A included the amount of the hazardous 
duty or hardship pay fringe benefit ($1,950) in her gross income as 
income from sources without the United States.
    Example 5. (i) During 2006 and 2007, Corp P, a domestic 
corporation, employed four United States citizens, E, F, G, and H to 
work in its manufacturing plant in Country V. As part of his or her 
compensation package, each employee arranged for local 
transportation unrelated to Corp P's business needs. None of the 
local transportation fringe benefit is excluded from the employee's 
gross income as a qualified transportation fringe benefit under 
section 132(a)(5) and (f).
    (ii) Under the terms of the compensation package that E 
negotiated with Corp P, Corp P permitted E to use an automobile 
owned by Corp P. In addition, Corp P agreed to reimburse E for all 
expenses incurred by E in maintaining and operating the automobile, 
including gas and parking. Provided that the local transportation 
fringe benefit meets the requirements of paragraph (b)(2)(ii)(D)(3) 
of this section, E's compensation with respect to the fair rental 
value of the automobile and reimbursement for the expenses E 
incurred is sourced under paragraphs (b)(2)(ii)(B) and (D)(3) of 
this section based on E's principal place of work in Country V. 
Thus, the local transportation fringe benefit will be included in 
E's gross income as income from sources without the United States.
    (iii) Under the terms of the compensation package that F 
negotiated with Corp P, Corp P let F use an automobile owned by Corp 
P. However, Corp P did not agree to reimburse F for any expenses 
incurred by F in maintaining and operating the automobile. Provided 
that the local transportation fringe benefit meets the requirements 
of paragraph (b)(2)(ii)(D)(3) of this section, F's compensation with 
respect to the fair rental value of the automobile is sourced under 
paragraphs (b)(2)(ii)(B) and (D)(3) of this section based on F's 
principal place of work in Country V. Thus, the local transportation 
fringe benefit will be included in F's gross income as income from 
sources without the United States.
    (iv) Under the terms of the compensation package that G 
negotiated with Corp P, Corp P agreed to reimburse G for the 
purchase price of an automobile that G purchased in Country V. Corp 
P did not agree to reimburse G for any expenses incurred by G in 
maintaining and operating the automobile. Because the cost to 
purchase an automobile is not a local transportation fringe benefit 
as defined in paragraph (b)(2)(ii)(D)(3) of this section, the source 
of the compensation to G will be determined pursuant to paragraph 
(b)(2)(ii)(A) or (C) of this section.
    (v) Under the terms of the compensation package that H 
negotiated with Corp P, Corp P agreed to reimburse H for the 
expenses that H incurred in maintaining and operating an automobile, 
including gas and parking, which H purchased in Country V. Provided 
that the local transportation fringe benefit meets the requirements 
of paragraph (b)(2)(ii)(D)(3) of this section, H's compensation with 
respect to the reimbursement for the expenses H incurred is sourced 
under paragraphs (b)(2)(ii)(B) and (D)(3) of this section based on 
H's principal place of work in Country V. Thus, the local 
transportation fringe benefit will be included in H's gross income 
as income from sources without the United States.
    Example 6. (i) On January 1, 2006, Company Q compensates 
employee J with a grant of options to which section 421 does not 
apply that do not have a readily ascertainable fair market value 
when granted. The stock options permit J to purchase 100 shares of 
Company Q stock for $5 per share. The stock options do not become 
exercisable unless and until J performs services for Company Q (or a 
related company) for 5 years. J works for Company Q for the 5 years 
required by the stock option grant. In years 2006-08, J performs all 
of his services for Company Q within the United States. In 2009, J 
performs \1/2\ of his services for Company Q within the United 
States and \1/2\ of his services for Company Q without the United 
States. In year 2010, J performs his services entirely without the 
United States. On December 31, 2012, J exercises the options when 
the stock is worth $10 per share. J recognizes $500 in taxable 
compensation (($10-$5) X 100) in 2012.
    (ii) Under the facts and circumstances, the applicable period is 
the 5-year period between the date of grant (January 1, 2006) and 
the date the stock options become exercisable (December 31, 2010). 
On the date the stock options become exercisable, J performs all 
services necessary to obtain the compensation from Company Q. 
Accordingly, the services performed after the date the stock options 
become exercisable are not taken into account in sourcing the 
compensation from the stock options. Therefore, pursuant to 
paragraph (b)(2)(ii)(A), since J performs 3\1/2\ years of services 
for Company Q within the United States and 1\1/2\ years of services 
for Company Q without the United States during the 5-year period, 7/
10 of the $500 of compensation (or $350) recognized in 2012 is 
income from sources within the United States and the remaining 3/10 
of the compensation (or $150) is income from sources without the 
United States.
* * * * *
    (d) Effective date. * * * The first sentence of Sec.  1.861-4(a)(1) 
and Sec.  1.861-4(b) apply to taxable years beginning on or after 
publication of the Treasury Decision adopting these rules as final 
regulations in the Federal Register.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 04-17813 Filed 8-5-04; 8:45 am]
BILLING CODE 4830-01-P