[Federal Register Volume 70, Number 180 (Monday, September 19, 2005)]
[Proposed Rules]
[Pages 54859-54878]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-18265]


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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; Source 
of Communications Income

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Withdrawal of notice of proposed rulemaking; 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 section 863(a), 
(d), and (e) governing the source of income from certain communications 
activities. This document also contains proposed regulations under 
section 863(a) and (b), amending the regulations in Sec.  1.863-3 to 
conform those regulations to these proposed regulations. This document 
affects persons who derive income from activities conducted in space, 
or on or under water not within the jurisdiction of a foreign country, 
possession of the United States, or the United States (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 and withdraws 
the notice of proposed rulemaking (66 FR 3903) published in the Federal 
Register on January 17, 2001.

DATES: Written or electronic comments must be received by November 23, 
2005. Outlines of topics to be discussed at the public hearing 
scheduled for December 15, 2005, at 10 a.m., must be received by 
November 23, 2005.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-106030-98), 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-
106030-98), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically, via either the IRS 
Internet site at http://www.irs.gov/regs or the Federal eRulemaking 
Portal at http://www.regulations.gov (IRS-REG-106030-98). The public 
hearing will be held in the Auditorium, Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Edward R. 
Barret, (202) 622-3880; concerning submissions of comments, the 
hearing, and/or to be placed on the building access list to attend the 
hearing, Cynthia Grigsby, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in this notice of proposed 
rulemaking have been reviewed and approved by the Office of Management 
and Budget (OMB) in accordance with the Paperwork Reduction Act of 1995 
(44 U.S.C. 3507(d)) under control number 1545-1718.
    The collection of information in these proposed regulations is in 
Sec. Sec.  1.863-8(g) and 1.863-9(g). This information is required by 
the IRS to monitor

[[Page 54860]]

compliance with the Federal tax rules for determining the source of 
income from space or ocean activities, or from transmission of 
communications.
    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.
    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

    Congress enacted section 863(d) and (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.
    On January 17, 2001, the Treasury Department and the IRS published 
a notice of proposed rulemaking (REG-106030-98) in the Federal Register 
(66 FR 3903) under section 863(a), (b), (d), and (e) (the 2001 proposed 
regulations). The 2001 proposed regulations provide two sets of rules, 
one in Sec.  1.863-8 for determining the source of income from space 
and ocean activities (space and ocean income), the other in Sec.  
1.863-9 for determining the source of income from communications 
activity (communications income).
    The IRS received numerous written comments on the 2001 proposed 
regulations and held a public hearing on May 23, 2001. Since that time, 
the aerospace, telecommunications, and related industries have 
experienced substantial technological evolution and significant 
business change and consolidation. In addition, the American Jobs 
Creation Act of 2004, Public Law 108-357, (AJCA) enacted a number of 
materially relevant statutory changes that affect the treatment of 
space and ocean income for purposes of the foreign tax credit and 
subpart F. In light of the extensive written comments, industry 
evolution, and AJCA changes, the Treasury Department and the IRS 
believe it is appropriate to repropose these regulations to provide a 
further opportunity for comment. Accordingly, this document withdraws 
the 2001 proposed regulations and provides new proposed regulations, 
which are referred to herein as the reproposed regulations.

Explanation of Provisions

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

1. Space and Ocean Income
    Section 863(d)(2)(A)(i) defines space activity to include any 
activity conducted in space. Section 863(d)(2)(A)(ii) defines ocean 
activity to include 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. Section 
863(d)(2)(B) excludes three specific types of activities from the 
definition of space or ocean activity. Section 863(d)(1) generally 
provides that, except as provided in regulations, any income derived 
from a space or ocean activity (space and ocean income) is U.S. source 
income if derived by a U.S. person and foreign source income if derived 
by a foreign person.
    Pursuant to the statute's grant of regulatory authority, the 
reproposed regulations provide that a U.S. person's space and ocean 
income will be sourced outside the United States to the extent the 
income, based on all the facts and circumstances, is attributable to 
functions performed, resources employed, or risks assumed in a foreign 
country or countries. This approach to allocation of space and ocean 
income between U.S. and foreign sources is pursuant to broad regulatory 
authority in section 863(d). The reproposed regulations also contain 
certain exceptions to the general foreign source rule for space and 
ocean income of foreign persons.
2. Space and Ocean Income of U.S.-Owned Foreign Corporation
    Section 1.863-8(b)(2) of the 2001 proposed regulations provides 
that if U.S. persons own 50 percent or more of a foreign corporation by 
vote or value (directly, indirectly, or constructively) and such 
corporation is not a controlled foreign corporation within the meaning 
of section 957 (CFC), all space and ocean income derived by the 
corporation (hereinafter a U.S.-owned foreign corporation) is U.S. 
source income.
    Several commentators requested that Sec.  1.863-8(b)(2) of the 2001 
proposed regulations be withdrawn. Commentators stated that the rule 
expanded the scope of U.S. taxing jurisdiction beyond the apparent 
intent of Congress by subjecting income not covered by subpart F to 
immediate U.S. taxation. Several commentators also stated that under 
the rule space and ocean income could in some cases be subject to 
multiple levels of taxation. In this regard, some commentators noted 
that the space and ocean income of a U.S.-owned foreign corporation 
could be subject to potential double taxation at the corporate level 
(by the United States and by the U.S.-owned foreign corporation's 
country of residence or the countries where such corporation does 
business) because Sec.  1.863-8(b)(2) of the 2001 proposed regulations 
makes such space and ocean income U.S. source. When the U.S.-owned 
foreign corporation's space and ocean income is distributed as a 
dividend, that income could be subject to an additional level of tax in 
the hands of its shareholders. Consequently, some commentators 
suggested that, if the rule were retained, the space and ocean income 
of U.S.-owned foreign corporations should be considered U.S. source 
solely for purposes of the U.S. shareholder's foreign tax credit 
limitation under section 904(a). Some commentators noted that although 
section 245 may partially ameliorate this situation by providing a 
dividends received deduction (DRD) to shareholders of foreign 
corporations in certain circumstances, the DRD would be limited to 80 
percent of qualifying dividends.
    Some commentators also noted potential withholding tax issues with 
the source rules for U.S.-owned foreign corporations. In such cases, 
U.S. source fixed or determinable annual or periodic income (FDAP) of a 
U.S.-owned foreign corporation would (in the absence of an applicable 
treaty) likely be subject to the 30-percent gross income tax imposed by 
section 881, which is typically collected through withholding by the 
payors of such income. Commentators stated that enforcement and 
administration of the 30-percent tax and withholding requirements could 
present multiple challenges (and potential multiple withholding tax 
obligations) for payments between foreign persons.
    Several commentators addressed the stock ownership test applicable 
to U.S.-owned foreign corporations. They stated that determining 
whether a foreign corporation is 50-percent U.S.-owned, especially 
without regard to the size of an owner's holding, presents potential 
difficulties (for example, when the foreign corporation is widely-
held). Some commentators stated that the indirect and constructive 
ownership rules are complex and would make it difficult for payors of 
space and ocean income to determine withholding tax obligations. Some 
commentators suggested that if the rule were retained, the 
determination whether a foreign corporation is 50-percent U.S.-owned

[[Page 54861]]

should be similar to the determination of CFC status, that is, only 
U.S. persons who own or are considered to own 10 percent or more of the 
total combined voting power of all classes of stock entitled to vote 
should be counted. Some commentators stated that the rule should not 
apply to publicly-traded foreign corporations.
    In light of the potential complexity in determining whether a 
foreign corporation is a U.S.-owned foreign corporation and the belief 
of the Treasury Department and the IRS that space and ocean income 
earned by foreign corporations should be sourced in accord with the 
rules for foreign persons, with the limited exception for certain CFCs 
discussed below, the reproposed regulations do not include a special 
source rule for space and ocean income earned by a U.S.-owned foreign 
corporation. Instead, the space and ocean income of foreign 
corporations (other than CFCs) is sourced under the applicable 
provisions of reproposed Sec.  1.863-8(b)(2)(i) or (iii). Under these 
provisions, space and ocean income of a foreign person is generally 
foreign source income. Space and ocean income of a foreign person 
(other than a CFC) that is engaged in trade or business within the 
United States is U.S. source income to the extent the income, based on 
all the facts and circumstances, is attributable to functions 
performed, resources employed, or risks assumed within the United 
States.
3. Space and Ocean Income of CFCs
    In enacting section 863(d), Congress ultimately did not adopt a 
provision included in early versions of the legislation that would have 
treated a CFC as a U.S. person for purposes of determining the source 
of a CFC's space and ocean income. The legislative history to the 1986 
Act indicates that Congress at that time viewed the provision as 
unnecessary because ``[t]he application of the separate foreign tax 
credit limitation for shipping income to any space or ocean income 
derived by a [CFC] provides adequate assurance, in the conferee's view, 
that high foreign taxes on unrelated income will not inappropriately 
offset U.S. taxes on this generally low-taxed income.'' H.R. Conf. Rep. 
No. 99-841, 99th Cong., 2d Sess., Vol. II, at II-600 (Sept. 18, 1986); 
see also Staff of Joint Comm. on Taxation, General Explanation of the 
Tax Reform Act of 1986, JCS-10-87, at 934 (May 4, 1987). Consequently, 
the 2001 proposed regulations also did not contain such a rule and only 
treated a U.S.-owned foreign corporation as a U.S. person for purposes 
of determining the source of space and ocean income.
    In 2004, AJCA enacted a number of significant statutory changes to 
subpart F and the foreign tax credit regimes as applicable to space and 
ocean income. These statutory changes have been taken into account in 
issuing the reproposed regulations.
    Section 415 of AJCA eliminated foreign base company shipping income 
from the definition of foreign base company income. This change is 
effective for taxable years of foreign corporations beginning after 
December 31, 2004, and for taxable years with or within which such 
taxable years of foreign corporations end. Prior to AJCA, foreign base 
company shipping income was defined by section 954(f) to include any 
income derived from a space or ocean activity as defined in section 
863(d)(2).
    In addition, section 404 of AJCA reduced the number of foreign tax 
credit limitation categories from nine to two (i.e., passive category 
income and general category income) in order to address Congressional 
concerns regarding the complexity of the foreign tax credit 
calculation. See H.R. Rep. No 108-548, 108th Cong., 2d Sess., at 190 
(June 16, 2004). This change is effective for taxable years beginning 
after December 31, 2006. Prior to AJCA, section 904(d) treated shipping 
income, defined as income ``which would be foreign base company 
shipping income (as defined in section 954(f)),'' as a separate 
category of income for foreign tax credit limitation purposes. For 
taxable years beginning after December 31, 2006, space and ocean income 
will generally fall into the general limitation category. See H.R. 
Conf. Rep. No. 108-755, 108th Cong., 2d Sess., at 383 (Oct. 7, 2004).
    The Treasury Department and the IRS believe that the changes made 
by AJCA with respect to the foreign tax credit reflect a decision to 
reduce the complexity in the foreign tax credit calculation caused by 
having nine foreign tax credit categories of income as well as a 
willingness to allow additional cross-crediting in order to minimize 
such complexity. However, the Treasury Department and the IRS also 
believe that for taxable years beginning after December 31, 2006, 
Congress's concern expressed in the 1986 Act that high foreign taxes on 
unrelated income may inappropriately offset U.S. taxes on space and 
ocean income, which is generally subject to low foreign taxes, is no 
longer addressed by the foreign tax credit rules because space and 
ocean income likely will be general limitation category income. In 
addition, Congress provided a broad grant of regulatory authority to 
the Treasury Department and the IRS in section 863(d) to issue guidance 
with respect to the source of space and ocean income.
    In light of AJCA, the reproposed regulations provide that if a 
foreign corporation is a CFC, its space and ocean income, like that of 
a U.S. person, is income from sources within the United States. 
However, a CFC's space and ocean income is sourced outside the United 
States to the extent the income, based on all the facts and 
circumstances, is attributable to functions performed, resources 
employed, or risks assumed in a foreign country or countries. This 
allocation approach is pursuant to broad regulatory authority under 
section 863(d).
    As noted above, several commentators stated that under the rule for 
U.S.-owned foreign corporations in the 2001 proposed regulations, space 
and ocean income could in some cases be subject to multiple levels of 
taxation. The Treasury Department and the IRS believe that the 
reproposed regulations mitigate such a possibility for CFCs because the 
reproposed regulations provide for foreign sourcing when a CFC's space 
and ocean income is attributable to functions performed, resources 
employed, or risks assumed in a foreign country or countries. The rule 
for CFCs in the reproposed regulations is thus a rule of limited 
application that, consistent with the legislative history of the 1986 
Act, provides U.S. source treatment only with respect to space and 
ocean income attributable to activities in space or international water 
that are not likely to be subject to tax in any foreign country. The 
rule for CFCs will permit a United States shareholder to establish as 
foreign source the amount of income attributable to the CFC's 
operations in a foreign country or countries.
    Several commentators submitted comments on potential withholding 
tax issues posed by the 2001 proposed regulations. The Treasury 
Department and the IRS recognize that certain provisions of the 
reproposed regulations (such as the source rule for the space and ocean 
income of CFCs in reproposed Sec.  1.863-8(b)(2)(ii)) may raise similar 
withholding tax issues. The Treasury Department and the IRS accordingly 
seek comments on these issues, in particular with regard to the 
following: (1) The extent to which Form W-8ECI, ``Certificate of 
Foreign Person's Claim for Exemption From Withholding on Income 
Effectively Connected With the Conduct of a Trade or Business in the 
United States'', may practically address these issues; (2) the nature 
of

[[Page 54862]]

situations in which withholding tax issues will arise (for example, how 
particular businesses involving space, ocean, or communications 
activities are conducted, whether payors of income potentially subject 
to withholding under the reproposed regulations are typically related 
or unrelated parties, etc.); and (3) suggestions to address these 
issues in the cases in which they arise.
4. Space and Ocean Income of a Foreign Person Engaged in a Trade or 
Business Within the United States
    Section 1.863-3(b)(3) of the 2001 proposed regulations provides 
that if a foreign person is engaged in a trade or business within the 
United States, the foreign person's income derived from a space or 
ocean activity is presumed to be U.S. source income. The rule reflects 
the general view of the Treasury Department and the IRS that Congress 
intended that a foreign person engaged in a substantial business within 
the United States be subject to U.S. tax on related space or ocean 
income. However, the Treasury Department and the IRS recognize that the 
presumption may be over-inclusive in certain cases. Therefore, the 2001 
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 sources without the 
United States, space, and international water, to the satisfaction of 
the Commissioner, based on all the facts and circumstances, income 
allocated to sources without the United States, space, and 
international water will be treated as foreign source income.
    Several commentators stated that the presumption is overbroad, 
given that it applies to all space and ocean income regardless of any 
nexus with the foreign corporation's U.S. trade or business. Several 
commentators suggested that if the presumption were retained, objective 
standards consistent with existing rules for effectively connected 
income should be included to ensure that the space and ocean income has 
a meaningful connection with the foreign corporation's U.S. trade or 
business. In the absence of objective standards, commentators stated 
that taxpayers should be permitted to apply a reasonable allocation 
method on a consistent basis to all of their space and ocean income. In 
addition, as with Sec.  1.863-8(b)(2) of the 2001 proposed regulations, 
several commentators stated that under Sec.  1.863-8(b)(3) of the 2001 
proposed regulations space and ocean income could in some cases be 
subject to multiple levels of taxation.
    In response to these comments, the reproposed regulations provide 
that if a foreign person, other than a CFC, is engaged in a trade or 
business within the United States, its space or ocean income is from 
sources within the United States to the extent the income, based on all 
the facts and circumstances, is attributable to functions performed, 
resources employed, or risks assumed within the United States.
    The Treasury Department and the IRS believe that the revision in 
reproposed Sec.  1.863-8(b)(2)(iii) providing that space or ocean 
income will be U.S. source income to the extent the space or ocean 
income is attributable to functions performed, resources employed, or 
risks assumed in the United States should mitigate commentators' 
concerns about potential multiple levels of taxation.
    Examples 12 and 13 in Sec.  1.863-8(f) of the 2001 proposed 
regulations illustrate the application of Sec.  1.863-8(b)(3) of those 
regulations to foreign persons that conduct certain activities in the 
United States. One commentator noted that these examples appear to 
state that engaging in certain activities would constitute the conduct 
of a trade or business in the United States. In response to this 
comment, Examples 12 and 13 have been clarified in the reproposed 
regulations to state that they assume, on the facts of the example, 
that the activities constitute the conduct of a trade or business 
within the United States within the meaning of section 864(b). The 
Treasury Department and the IRS intend that the determination whether a 
foreign person is engaged in a trade or business in the United States 
continue to be made under general section 864(b) principles.
5. Source Rules for Sales of Property in Space or International Water
    The 2001 proposed regulations provide generally that taxpayers must 
apply the rules of section 863(d) and the 2001 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 international water, or when the sale occurs in space 
or international water. Under the 2001 proposed regulations, income 
from sales of inventory property (within the meaning of section 
1221(a)(1)) on international water is sourced under Sec.  1.863-
3(c)(2). Section 1.863-3(c)(2), as amended by the 2001 proposed 
regulations, provides that the place of sale will be presumed to be the 
United States when property is produced in the United States and the 
property is sold to a U.S. resident for use in space or international 
water; in such cases, the property will be treated as sold for use, 
consumption, or disposition in the United States.
    Section 1.863-8(d)(1)(i) of the 2001 proposed regulations defines 
space activity to include the sale of property in space. Section 1.863-
8(d)(1)(ii) of the 2001 proposed regulations defines ocean activity to 
include the sale of property in international water, but not the sale 
of inventory property on international water. Under Sec.  1.863-
8(d)(2)(iii) of the 2001 proposed regulations, a sale occurs in space 
or international water if the property is located in space or 
international water at the time the rights, title, and interest of the 
seller in the property are transferred to the purchaser, or if the 
property is sold for use in space or international water.
    For sales in space or international water of property produced by 
the taxpayer, Sec.  1.863-8(b)(4)(ii)(A) of the 2001 proposed 
regulations generally provides that the source of income attributable 
to sales activity is determined under Sec.  1.863-8(b)(1), (2), or (3) 
of the 2001 proposed regulations. If, however, the taxpayer sells such 
property outside space and international water, the source of income 
attributable to sales activity is determined under Sec.  1.863-3(c)(2).
    Commentators stated that the inclusion of sales of inventory 
property in space or international water in the definitions of space 
and ocean activity is inconsistent with the legislative history of the 
1986 Act, which indicates that the Senate Committee on Finance did not 
intend sales of inventory property on the high seas to be considered 
space or ocean activity. See S. Rep. No. 99-313, at 359.
    In response to comments, the reproposed regulations provide that 
sales of inventory property in space or international water will be 
considered space or ocean activity only if the inventory property is 
sold for use, consumption, or disposition in space or international 
water. In such cases, the source of income will be determined under the 
source rules provided for space and ocean income by the reproposed 
regulations. The source of income from sales in space or international 
water of inventory property when the inventory property is sold for 
use, consumption, or disposition outside space and international water 
will be determined under Sec. Sec.  1.861-7(c) and 1.863-3(c)(2). The 
Treasury Department and the IRS believe that sales of property in space 
or international water--with the exception of sales of inventory 
property in space

[[Page 54863]]

or international water for use, consumption, or disposition outside 
space or international water--should be considered space or ocean 
activity, and that the source of income from such sales should be 
determined under section 863(d). The Treasury Department and the IRS 
believe that this result is consistent with both the statute and the 
legislative history. The statute provides that space or ocean activity 
includes any activity in space or international water. However, the 
Senate Report states that the Senate Committee on Finance did not 
intend to override the general source rule in Sec.  1.861-7(c) for 
sales of property on the high seas. See S. Rep. No. 99-313, at 359. 
Thus, sales of inventory property in transit between the United States 
and a foreign country will continue to be sourced under sections 861 
through 865, and not section 863(d).
    The reproposed regulations do not contain the presumption in Sec.  
1.863-3(c)(2) of the 2001 proposed regulations regarding sales of 
property produced by the taxpayer in the United States to U.S. 
residents for use in space or international water. Under the reproposed 
regulations, if such sales occur in space or international water, the 
source of income attributable to sales activity will be determined 
under reproposed Sec.  1.863-8(b)(3)(ii)(D).
6. Special Rule for Determining the Source of Income From Services
    Section 1.863-8(b)(5) of the 2001 proposed regulations provides 
that income derived from the performance of services in space or 
international water is sourced under Sec.  1.863-8(b)(1), (2), or (3) 
of the 2001 proposed regulations, as applicable. Section 1.863-
8(d)(2)(ii)(A) of the 2001 proposed regulations contains a general rule 
providing that the performance of a service is a space or ocean 
activity in its entirety when a part of the service, even if de 
minimis, is performed in space or international water.
    The Treasury Department and the IRS recognized that this rule could 
be over-inclusive in certain cases. Therefore, Sec.  1.863-
8(d)(2)(ii)(A) of the 2001 proposed regulations provides a facilitation 
exception, under which a service will not be treated as either space or 
ocean activity if the taxpayer's only activity in space or 
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 the service would not otherwise be a space or ocean 
activity. Section 1.863-8(b)(5) of the 2001 proposed regulations also 
provides that if the taxpayer can allocate, to the satisfaction of the 
Commissioner, gross income from the services transaction between 
performance occurring outside space and international water, and 
performance occurring in space or international water, the source of 
income allocated to performance occurring outside space and 
international water will be determined under sections 861, 862, 863, 
and 865.
    Several commentators commented unfavorably on a rule that 
characterizes an entire services transaction as space or ocean activity 
when only de minimis performance occurs in space or international 
water. Several commentators noted that even though Sec.  1.863-8(b)(5) 
of the 2001 proposed regulations permits a taxpayer to source services 
income to sources outside space or international water, the entire 
transaction continues to be characterized as space or ocean activity, 
and all income derived from the services transaction is thus included 
in the separate subpart F and foreign tax credit limitation category 
for shipping income. Some commentators stated that under the 2001 
proposed regulations significant consequences result from 
characterization as a services transaction, even though the 
characterization rules are themselves unclear. Some commentators also 
stated that the facilitation exception to space or ocean activity 
characterization is confusing, and that the example intended to 
illustrate the application of the facilitation exception (Example 4 in 
Sec.  1.863-8(f) of the 2001 proposed regulations) is itself unclear.
    As noted above, subsequent to the publication of the 2001 proposed 
regulations, AJCA amended the subpart F rules relating to space and 
ocean income by eliminating shipping income as a category of subpart F 
income and reduced the number of foreign tax credit limitation 
categories from nine to two (with space and ocean income generally 
falling into the general limitation category) for taxable years 
beginning after December 31, 2006. The Treasury Department and the IRS 
believe that these statutory changes should allay commentators' 
concerns regarding the characterization of a services transaction as 
space or ocean activity. In addition, as discussed below, the 
reproposed regulations provide that if the taxpayer can demonstrate the 
value of the service attributable to performance in space or 
international water and the value of the service attributable to 
performance outside space and international water, then the service 
will be treated as a space or ocean activity only to the extent of the 
activity performed in space or international water. The value of the 
service is attributable to performance occurring in space or 
international water to the extent the performance of services, based on 
all the facts and circumstances, is attributable to functions 
performed, resources employed, or risks assumed in space or 
international water.
    Based on the comments, the reproposed regulations eliminate the 
facilitation exception. Under reproposed Sec.  1.863-8(d)(2)(ii), to 
the extent, based on all the facts and circumstances, the value of the 
service attributable to functions performed, resources employed, or 
risks assumed in space or international water is de minimis, such 
service is not treated as space or ocean activity. The adoption of the 
de minimis rule is intended to address taxpayer concerns about 
potential confusion in qualifying for the facilitation exception. 
Example 4 of reproposed Sec.  1.863-8(f) has been revised accordingly.
    The rule for determining the source of income from performance of 
services that occur in part in space or international water and in part 
outside space and international water has been adapted to conform to 
the changes made to reproposed Sec.  1.863-8(d)(2)(ii). To the extent a 
service is characterized as space or ocean activity under reproposed 
Sec.  1.863-8(d)(2)(ii), the source of gross income derived from such 
transaction is determined under reproposed Sec.  1.863-8(b)(1) or (2), 
as applicable, as provided by reproposed Sec.  1.863-8(b)(4). 
Accordingly, to the extent the value of the service, based on all the 
facts and circumstances, is attributable to functions performed, 
resources employed, or risks assumed outside space and international 
water, the service will not constitute space or ocean activity, and, to 
that extent, the source of income from the service will be determined 
under section 861, 862, or 863, as applicable.
7. Definition of Space and Ocean Activity
a. Foreign Communications Activity as Space or Ocean Activity
    Section 1.863-8(b)(6) of the 2001 proposed regulations provides 
that space and ocean activity include communications activity (but not 
international communications activity) occurring in space or 
international water. Foreign communications activity is thus 
characterized under the 2001 proposed regulations as space or ocean 
activity when, for example, part of the transmission is via satellite 
or via underwater cable located in international water.

[[Page 54864]]

    Commentators requested that the regulations characterize income 
from foreign-to-foreign communications as international communications 
income, which is specifically excluded from the definition of space and 
ocean activity by section 863(d)(2)(B) and Sec.  1.863-8(d)(3) of the 
2001 proposed regulations, but retain the 100 percent foreign source 
rule otherwise provided for foreign communications income by Sec.  
1.863-9(b)(4) of the 2001 proposed regulations. International 
communications income is defined by section 863(e)(2) as income derived 
from the transmission of communications between the United States and a 
foreign country (or possession of the United States) and is discussed 
in greater detail below.
    Commentators noted that this rule puts telecommunications companies 
using satellite or underwater cable methods of transmission at a 
competitive disadvantage vis-[aacute]-vis competitors in foreign 
marketplaces that use solely land-based facilities. For example, if a 
CFC were paid to transmit a telephone call between two foreign 
countries and used a land line connecting the two countries to transmit 
the call, the CFC's income from the transmission would be included in 
the general limitation category for foreign tax credit purposes. If the 
communication were transmitted using fiber optic cable located in 
international water or a satellite, the CFC's income from the 
transmission would be foreign source space or ocean income included in 
the separate subpart F and foreign tax credit limitation category for 
shipping income.
    The reproposed regulations do not characterize income from foreign-
to-foreign communications as international communications income as 
suggested by commentators. Section 863(d)(2)(A) broadly defines space 
and ocean activity as any activity conducted in space or international 
water. The statutory exception to space and ocean activity in section 
863(d)(2)(B) removes only activities giving rise to international 
communications income from the scope of space and ocean activity. In 
addition, if foreign-to-foreign communications income were 
characterized as international communications income, U.S. persons with 
such income would be subject to the statutory source rule in section 
863(e)(1)(A), which provides for the split-sourcing of a U.S. person's 
international communications income. The Treasury Department and the 
IRS thus consider the language of the statute to preclude the approach 
suggested by commentators with respect to the characterization and 
sourcing of income from foreign-to-foreign communications. The 
legislative history of the 1986 Act also indicates that Congress 
intended income from foreign-to-foreign communications to be foreign 
source income. See S. Rep. No. 99-313, at 359, ``Finally, if the 
communication is between two foreign locations, the committee intends 
income attributable thereto to be foreign source.''. This would not be 
the result, however, if foreign-to-foreign communications income were 
included in the definition of international communications income and 
thus subject to the statute's 50/50 source rule for U.S. persons.
    In addition, as noted above, AJCA made significant changes to 
subpart F and the foreign tax credit regime as applicable to space and 
ocean income. The Treasury Department and the IRS believe that these 
statutory changes should allay commentators' concerns regarding the 
characterization of foreign-to-foreign communications as space or ocean 
activity.
    The Treasury Department and the IRS believe that the modifications 
in the reproposed regulations with respect to the characterization of 
services involving space or ocean activities address some of the 
commentators' concerns regarding the characterization of foreign-to-
foreign communications activities involving services performed both in 
space or international water and in foreign countries. Reproposed Sec.  
1.863-8(d)(2)(ii) provides that a transaction characterized as the 
performance of a service will be treated as a space or ocean activity 
only to the extent the value of the service, based on all the facts and 
circumstances, is attributable to functions performed, resources 
employed, or risks assumed in space or international water.
b. Definition of Space
    Section 1.863-8(d)(1)(i) of the 2001 proposed regulations 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. Under the 2001 
proposed regulations, space comprises the entire area outside the 
jurisdiction of any country or U.S. possession, extending from just 
above the surface of international water (and Antarctica) through, and 
beyond, the earth's atmosphere. Space thus includes international 
airspace.
    Several commentators stated that the definition of space should be 
limited to the area beyond the earth's atmosphere. One commentator 
proposed a definition of space that conforms to a definition used for 
non-tax purposes (for example, beyond the maximum altitude at which 
powered flight by aircraft equipped with air-breathing engines is 
possible). Another commentator stated that the definition of space 
could be read to include cyberspace, the electronic medium in which 
online communication takes place, and suggested that cyberspace be 
specifically excluded from the definition of space. One commentator 
noted language in the legislative history stating that space activities 
had not been very prevalent at the time of the 1986 Act (see, for 
example, S. Rep. No. 99-313, at 358) and argued that Congress did not 
intend to include international airspace in space.
    No changes were made to the reproposed regulations in response to 
these comments. The Treasury Department and the IRS believe a broad 
definition of space that includes international airspace is consistent 
with legislative intent to assert primary tax jurisdiction over income 
earned by U.S. residents that is not within any foreign country's 
taxing jurisdiction. See, e.g., S. Rep. No. 99-313, at 357. The 
Treasury Department and the IRS also believe that providing guidance 
with respect to the place of performance of activities involving online 
communications is beyond the scope of the present regulations, and that 
taxpayers should rely on generally applicable principles to determine 
where functions are performed, resources are employed, or risks are 
assumed in a specific online transaction.
c. Transportation Income
    Certain activities occurring in space or international water are 
not considered either space or ocean activity. Section 1.863-8(d)(3)(i) 
of the 2001 proposed regulations, consistent with section 863(d), 
provides that space or ocean activity does not include any activity 
that gives rise to transportation income as defined in section 863(c).
    One commentator stated that a portion of a bareboat charter--the 
return of an empty vessel that has unloaded its cargo (backhaul)--may 
potentially be considered ocean activity under the 2001 proposed 
regulations. Another commentator stated that income from container 
leasing by a party other than the ship operator could constitute space 
or ocean income, and could be subject to withholding tax. One 
commentator also suggested that the regulations should state that they 
do not apply to the income of foreign corporations derived from the 
international operation of ships, or to container leasing.
    The reproposed regulations do not adopt changes to reflect these

[[Page 54865]]

comments. The reproposed regulations reflect the broad statutory 
definition of ocean activity in section 863(d)(2) as ``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.'' The Treasury Department and the IRS do 
not consider it appropriate to construe the definition of section 
863(c) transportation income in the context of these regulations. The 
Treasury Department and the IRS will consider addressing the definition 
of section 863(c) transportation income in separate guidance.
8. Treatment of Partnerships
    Section 1.863-8(e) of the 2001 proposed regulations generally 
provides that section 863(d) and the regulations thereunder will be 
applied to domestic partnerships at the partnership level and to 
foreign partnerships at the partner level. Commentators suggested that 
the source rules of Sec.  1.863-8 of the 2001 proposed regulations be 
applied to all partnerships either at the entity level or at the 
partner level.
    The Treasury Department and the IRS believe that section 863(d) 
should be applied to domestic and foreign partnerships in the same 
manner. Accordingly, the reproposed regulations do not provide a 
different rule for foreign partnerships and domestic partnerships. 
Section 1.863-8(e) of the reproposed regulations provides that section 
863(d) and the regulations thereunder will be applied to domestic 
partnerships at the partner level. In order to conform the treatment of 
domestic and foreign partnerships, no change was made with respect to 
the rule in the 2001 proposed regulations that section 863(d) and the 
regulations thereunder will be applied to foreign partnerships at the 
partner level.
9. Allocations
    When a taxpayer must allocate gross income to the satisfaction of 
the Commissioner, based on all the facts and circumstances, under the 
provisions of the 2001 proposed regulations, the Treasury Department 
and the IRS believe such allocations generally should be based on 
section 482 principles.
    Several commentators stated that allocation of gross income based 
on section 482 principles will be burdensome and expensive and will 
create uncertainty. Commentators also noted that the 2001 proposed 
regulations provide no guidance on allocating income other than a facts 
and circumstances approach.
    The Treasury Department and the IRS consider the allocation of 
gross income based on the general guidance of section 482 to be an 
approach that is well-suited to application in the wide variety of 
factual contexts within the scope of the reproposed regulations. The 
Treasury Department and the IRS solicit comments on alternative methods 
of allocation for particular industries and criteria that could be used 
to evaluate the reasonableness of such methods.
10. Reporting and Documentation Requirements
    In order to satisfy the Commissioner with respect to a taxpayer's 
allocation of gross income under Sec.  1.863-8(b)(3), (b)(4)(ii)(C), or 
(b)(5) of the 2001 proposed regulations, the taxpayer must make the 
allocation on a timely filed original return (including extensions). An 
amended return does not qualify for this purpose, and section 9100 
relief will not be available. In all cases, a taxpayer must also 
maintain contemporaneous documentation regarding the allocation of 
gross income, allocation and apportionment of expenses, losses, and 
other deductions, the methodologies used, and the circumstances 
justifying use of those methodologies. The taxpayer must produce such 
documentation within 30 days upon request.
    Commentators stated that neither the statute nor the legislative 
history provides a basis for the reporting, recordkeeping, and 
contemporaneous documentation requirements in the 2001 proposed 
regulations. Commentators also noted that the Code and regulations do 
not contain similar requirements with respect to certain other expense 
allocation provisions.
    The reproposed regulations generally retain the recordkeeping and 
documentation requirements. The Treasury Department and the IRS believe 
that it is appropriate to require taxpayers to keep proper records, and 
additionally note the potentially considerable difficulties the IRS 
would face in performing the allocations required by the reproposed 
regulations without appropriate taxpayer records.
    The Treasury Department and the IRS recognize, however, that 
taxpayers may not have all the information necessary to make 
allocations at the time a return is originally filed. The reproposed 
regulations therefore provide that a taxpayer may make changes to 
allocations made on the taxpayer's original return with respect to any 
taxable year for which the statute of limitations has not closed, 
subject to certain conditions. Nonetheless, changes to such allocations 
that are not made until an audit of the taxable year to which the 
allocations relate has commenced, or a taxpayer's failure timely to 
provide documentation and other information supporting the allocations, 
create administrative difficulties for the IRS. Accordingly, reproposed 
Sec.  1.863-8(g)(4) sets forth the actions required of taxpayers and 
the procedures the IRS will follow in the case of taxpayers that change 
their allocations.
    The reproposed regulations also require taxpayers, upon request, to 
provide access to the software programs and other systems used by the 
taxpayer to make allocations under these regulations. For this purpose, 
software has the meaning provided in section 7612(d). The Treasury 
Department and the IRS believe that the IRS could face significant 
administrative and other difficulties in the examination of allocations 
made under these regulations without access to such software.
11. Examples
    Certain examples in Sec.  1.863-8(f) of the 2001 proposed 
regulations contain statements regarding the characterization of 
certain activities (as, for example, the lease of equipment or the 
performance of services). One commentator suggested that the examples 
clarify that the character of the transactions at issue is only assumed 
for purposes of the specific example. In response to this comment, the 
examples in reproposed Sec.  1.863-8(f) have been revised to make clear 
that the characterization of certain transactions is assumed based on 
the facts of the specific example. The Treasury Department and the IRS 
did not consider it necessary to modify certain other examples (for 
example, Example 1 of reproposed Sec.  1.863-8(f)) in which the 
character of the transaction at issue should be clear under the facts 
presented.
    In addition, Examples 2, 3, 4, and 7 of reproposed Sec.  1.863-
8(f), have been revised to reflect substantive changes made to 
reproposed Sec.  1.863-8(b)(4) and (d)(2)(ii) with respect to services 
that involve activities performed in space or international water.

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

1. International Communications Income
    International communications income is defined by section 863(e)(2) 
as income derived from the transmission of communications between the 
United States and a foreign country (or

[[Page 54866]]

possession of the United States). Section 863(e)(1)(A) provides that in 
the case of any U.S. person, 50 percent of any international 
communications income will be sourced in the United States and 50 
percent of such income will be sourced outside the United States. 
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). Section 1.863-
9(b)(2)(ii)(A) of the 2001 proposed regulations states the general rule 
that international communications income of a foreign person is foreign 
source income. However, the 2001 proposed regulations contain certain 
exceptions to the general rule.
2. International Communications Income of 50-Percent or More U.S.-Owned 
Foreign Corporations
    The first exception, in Sec.  1.863-9(b)(2)(ii)(B) of the 2001 
proposed regulations, provides that if U.S. persons own 50 percent or 
more of a foreign corporation by vote or value (directly, indirectly, 
or constructively), including a CFC within the meaning of section 957, 
international communications income derived by that corporation is 
entirely U.S. source income.
    As with the similar rule provided for the space and ocean income of 
U.S.-owned foreign corporations in Sec.  1.863-8(b)(2) of the 2001 
proposed regulations, several commentators requested that the rule be 
withdrawn because it expands the scope of U.S. taxing jurisdiction 
beyond the apparent intent of Congress. Commentators stated that the 
rule is punitive in nature because it is less favorable than the 50/50 
source rule applied to international communications income earned 
directly by U.S. persons. As with Sec.  1.863-8(b)(2) and (3) of the 
2001 proposed regulations, commentators also stated that under the rule 
the international communications income of certain foreign corporations 
may be subject to multiple levels of taxation.
    Commentators noted that in certain circumstances international 
communications income could be subject to the 30-percent gross income 
tax imposed by section 881, which is typically collected through 
withholding by the payors of such income. Commentators stated that 
although most tax treaties should prevent the imposition of the 30-
percent tax (international communications income would likely be 
characterized as business profits under most treaties and would 
accordingly be exempt from U.S. taxation unless attributable to a 
permanent establishment in the United States), the rule in the 2001 
proposed regulations would result in disparate treatment for 
corporations from treaty countries vis-[agrave]-vis corporations from 
non-treaty countries. The requirement to withhold the 30-percent tax 
could also create numerous administrative and enforcement difficulties. 
In addition, given the extent of resale of capacity between 
telecommunications providers, commentators noted that payments relating 
to the same transmission could be subject to multiple withholding. 
Finally, as with the similar rule provided for the space and ocean 
income of U.S.-owned foreign corporations in Sec.  1.863-8(b)(2) of the 
2001 proposed regulations, commentators raised the issue of potential 
difficulties in determining whether a foreign corporation is 50-percent 
or more U.S.-owned.
    As noted above, several commentators addressed the stock ownership 
test applicable to U.S.-owned foreign corporations. They stated that 
determining whether a foreign corporation is 50-percent U.S. owned, 
especially without regard to the size of an owner's holding, presents 
potential difficulties (for example, when the foreign corporation is 
widely-held).
    In light of the potential complexity in determining whether a 
foreign corporation is a U.S.-owned foreign corporation and the belief 
of the Treasury Department and the IRS that international 
communications income earned by foreign corporations should be sourced 
in accord with the rules for foreign persons, with the limited 
exception for CFCs discussed below, the reproposed regulations do not 
include a special source rule for international communications income 
earned by a 50 percent or more U.S.-owned foreign corporation. Instead, 
the international communications income of foreign corporations (other 
than CFCs) is sourced under the applicable provisions of reproposed 
Sec.  1.863-9(b)(2)(i), (iii), and (iv).
3. International Communications Income of CFCs
    In light of the comments with respect to CFCs described above, the 
reproposed regulations provide that in the case of a CFC, 50 percent of 
any international communications income will be sourced in the United 
States and 50 percent of such income will be sourced outside the United 
States. The 100-percent U.S. source rule is eliminated. Consequently, 
the source rule for international communications income in the hands of 
a CFC is the same rule that applies to U.S. persons. In both cases, the 
source rules take into account that international communications 
activities must have both a U.S. and a foreign connection (i.e., one 
endpoint in the United States and the other in a foreign country or 
possession of the United States). The Treasury Department and the IRS 
believe that the revision of the source rule for CFCs deriving 
international communications income should mitigate commentators' 
concerns about potential multiple levels of taxation because 50 percent 
of this income is foreign source.
    The Treasury Department and the IRS recognize that this and other 
provisions of reproposed Sec.  1.863-9 may raise withholding tax issues 
similar to those discussed above in connection with the source rule for 
the space and ocean income of CFCs (in reproposed Sec.  1.863-
8(b)(2)(ii)). As noted above, the Treasury Department and the IRS seek 
comments on these issues and practical suggestions to address them in 
the specific factual contexts in which they may arise.
4. International Communications Income Derived by a Foreign Person With 
an Office or Fixed Place of Business in the United States
    Section 863(e)(1)(B)(ii) and Sec.  1.863-9(b)(2)(ii)(C) of the 2001 
proposed regulations provide that international communications income 
derived by a foreign person that is attributable to an office or other 
fixed place of business in the United States is from sources within the 
United States. Section 864 and the regulations thereunder provide 
guidance in determining ``income * * * attributable to an office or 
other fixed place of business'' in specific contexts. However, the 
Treasury Department and the IRS believe that, for purposes of section 
863(e), international communications income should be attributed to an 
office or fixed place on business based on functions performed, 
resources employed, and risks assumed. Therefore, pursuant to the 
regulatory authority in section 863(e)(1)(B)(i), the reproposed 
regulations provide that, for purposes of this section, income is 
attributable to an office or other fixed place of business in the 
United States to the extent of functions performed, resources employed, 
or risks assumed by the office or other fixed place of business.
5. International Communications Income of a Foreign Person Engaged in a 
Trade or Business Within the United States
    The second exception to Sec.  1.863-9(b)(2)(ii)(A) of the 2001 
proposed regulations is contained in Sec.  1.863-

[[Page 54867]]

9(b)(2)(ii)(D), which provides that if a foreign person (other than a 
50 percent or more U.S.-owned foreign corporation described in Sec.  
1.863-9(b)(2)(ii)(B) of the 2001 proposed regulations) is engaged in a 
trade or business within the United States, the foreign person's 
international communications income is presumed to be U.S. source 
income. However, if the foreign person can allocate its international 
communications income between sources within the United States, space, 
and international water and sources outside the United States, space, 
and international water to the satisfaction of the Commissioner, based 
on all the facts and circumstances, which may include functions 
performed, resources employed, or risks assumed, then the income 
allocated to sources outside the United States, space, and 
international water will be foreign source income.
    Several commentators stated that the presumption is overbroad 
because it applies to all international communications income 
regardless of any nexus with the foreign corporation's U.S. trade or 
business. These commentators claimed that the presumption is 
inconsistent with U.S. tax policy and international norms that require 
a connection between the income and the foreign person's activities in 
the United States before U.S. taxing jurisdiction is exercised.
    In response to comments, the reproposed regulations provide that if 
a foreign person, other than a CFC, is engaged in a trade or business 
within the United States, gross income derived by that person from 
international communications activity is from sources within the United 
States to the extent the income, based on all the facts and 
circumstances, is attributable to functions performed, resources 
employed, or risks assumed within the United States. This rule is 
similar to the rule in the reproposed regulations under section 863(d) 
for foreign persons engaged in a trade or business within the United 
States. There is no longer a presumption of U.S. source income.
    The Treasury Department and the IRS believe that the provision in 
the reproposed regulations that such a foreign person's international 
communications income is U.S. source only to the extent attributable to 
functions performed, resources employed, or risks assumed in the United 
States addresses taxpayers' concerns regarding a nexus between the 
foreign person's international communications income and its business 
activities in the United States.
    Several commentators objected to the rule that international 
communications income could be foreign source income only to the extent 
that the foreign person could allocate international communications 
income to activity occurring in a foreign country. Because the 
reproposed regulations provide for U.S. sourcing only to the extent 
that the foreign person's international communications income is 
attributable to functions performed, resources employed, or risks 
assumed in the United States, this concern should be mitigated.
    Several commentators stated that section 863(e) makes international 
communications income that is attributable to a U.S. office U.S. source 
income, and that the regulations should not adopt a broader U.S. trade 
or business rule. Section 863(e)(1)(B)(ii) provides that if a foreign 
person has a fixed place of business in the United States, 
international communications income attributable to such fixed place of 
business is U.S. source income. The Treasury Department and the IRS 
have not made changes to the reproposed regulations in response to 
these comments. Section 863(e)(1)(B)(i) by its terms gives the 
Secretary broad authority to source international communications income 
of a foreign person as U.S. source income. The Treasury Department and 
the IRS believe that it is appropriate to exercise that authority in 
this case. The trade or business rule reflects the concern of the 
Treasury Department and the IRS 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 
Treasury Department and the IRS believe that Congress intended that a 
foreign person engaged in substantial business in the United States be 
subject to U.S. tax on that communications activity.
6. Income Derived From Communications Activity--The Paid-To-Do Rule
    Income derived from communications activity is defined in Sec.  
1.863-9(d)(2) of the 2001 proposed regulations 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 recipient of communications income perform the 
transmission function itself. This rule reflects the understanding of 
the Treasury Department and the IRS that providers of 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.
    Section 1.863-9(d)(3) of the 2001 proposed regulations 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 (the 
paid-to-do rule). 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 if the taxpayer contracts out part of the transmission 
to another party. This rule reflects the recognition by the Treasury 
Department and the IRS, as noted above, that providers of 
communications services often use capacity owned or operated by others.
    When the taxpayer cannot establish the two points between which the 
taxpayer is paid to transmit the communication, Sec.  1.863-9(b)(6) of 
the 2001 proposed regulations provides a default source rule, under 
which all income from the communications activity, whether derived by a 
U.S. person or a foreign person, is deemed to be from sources within 
the United States. Thus, for example, when a provider of communications 
services provides both local and international long distance services 
in one-price bundles for a set amount each month and tracing each 
transmission is not possible or practical, the income derived from the 
communications activity is U.S. source income. The Treasury Department 
and the IRS understand that many taxpayers in the communications 
industry may consider it impractical or impossible to prove the 
endpoints of the communications they transmit. The Treasury Department 
and the IRS accordingly solicited comments as to proposals for those 
situations when taxpayers cannot establish the points between which the 
taxpayer is paid to transmit the communication.
    One commentator stated that the phrase ``bears the risk of 
transmitting,'' contained in Sec.  1.863-9(d)(2) and (d)(3)(i) of the 
2001 proposed regulations, is ambiguous and does not meaningfully 
improve the determination of when income is derived from communications 
activity. This commentator noted that the nature of the risk a taxpayer 
must bear to be treated as deriving

[[Page 54868]]

communications income was unclear, and that the determination of risk 
would pose administrative difficulties given the complexity of business 
models and structures. No change was made to the reproposed regulations 
in response to this comment. The Treasury Department and the IRS 
believe that, in determining whether a taxpayer derives communications 
income, risk is more important than the mere fact of payment. The 
Treasury Department and the IRS thus believe that a taxpayer should not 
be considered to derive communications income unless the taxpayer bears 
the economic risk of nonpayment with respect to the transmission of 
communications or the provision of capacity to transmit communications.
    Commentators stated that the paid-to-do rule is overbroad because 
it asserts primary U.S. taxing jurisdiction over certain communications 
income regardless of any nexus between the income and the United 
States. Commentators also noted that when certain taxpayers cannot 
establish the two points between which they are paid to transmit a 
communication, the income from such communications activity may be 
subject to potential double taxation at the corporate level (for 
example, a foreign corporation could be subject to tax on such 
communications income in both the United States and in the foreign 
corporation's country of residence or incorporation or countries where 
it does business).
    Commentators stated that the paid-to-do rule places undue burdens 
on taxpayers who want to obtain the benefit of foreign source income 
characterization. Commentators noted that, in many cases, it may be 
impractical or technologically impossible to track the origination and 
termination points of an individual transmission, and that development 
of the required technology, software, and other systems would require 
significant capital investments. Maintenance of the records needed to 
substantiate proper income sourcing could also be onerous for those 
taxpayers who perform extremely large numbers of transmissions. 
Commentators thus requested that the regulations provide assurance that 
reasonable methods of proof, consistent with industry practice and 
consistently applied, would be accepted in establishing the points of 
origin and/or destination of a communication.
    Commentators submitted suggested modifications to the paid-to-do 
rule. One commentator suggested that the paid-to-do rule be modified to 
characterize all income from a communication based on the two endpoints 
between which the transmission is made. Under this commentator's 
suggested rule, whether a particular taxpayer itself carried out all, 
or only a portion, of the transmission would be irrelevant, and the 
characterization of the communication would be the same for all 
taxpayers involved in the transmission. One commentator suggested that 
the paid-to-do rule be applied on a single entity basis for United 
States corporations that join in the filing of a consolidated U.S. 
income tax return.
    Commentators also suggested reasonable method approaches to 
determine the endpoints between which a taxpayer is paid to transmit 
communications (for example, based on technical characteristics of the 
communication or contractual terms, or on a per transaction, per 
customer, or aggregate basis). One commentator suggested factors that 
could be taken into account in determining whether a particular method 
is reasonable, including the reliability of the method chosen, the 
degree to which the method is in line with generally accepted industry 
practices and norms, and the extent to which the method takes into 
account all the information available to the taxpayer.
    Commentators suggested that the U.S. source default rule for income 
from communications for which the endpoints of transmission cannot be 
identified should only apply to foreign taxpayers that directly own or 
operate communications facilities, or otherwise directly hold rights to 
communications capacity, in the United States; when a foreign taxpayer 
does not own or otherwise have rights to telecommunications capacity in 
the United States, income from such communications would thus be 
foreign source. Other commentators suggested that income from 
communications for which the endpoints of transmission cannot be 
identified be treated in the same manner as international 
communications income, with a 100-percent U.S. source exception 
provided for telecommunications service providers who are paid to 
transmit communications that are substantially all between multiple 
points located within the United States.
    The Treasury Department and the IRS continue to believe that 
communications activity is most appropriately characterized based on 
the two points between which the taxpayer is paid to transmit, and 
bears the risk of transmitting, the communication. The Treasury 
Department and the IRS consider the endpoint-based source rule in the 
reproposed regulations to be an approach that best matches the source 
of communications income to the location where functions are performed, 
resources are employed, or risks are assumed in a taxpayer's 
communications transaction. Moreover, although commentators noted 
potential difficulties in identifying the endpoints of a communication, 
the industry-specific comments received in response to the 2001 
proposed regulations generally focused on recordkeeping burdens. 
Taxpayers have much better access to the relevant information regarding 
the facts and circumstances of their communications transactions than 
the IRS. The Treasury Department and the IRS accordingly solicit 
comments on the challenges to identifying the endpoints of 
communications in specific industries or situations, as well as 
suggestions for rules that are responsive to these particular 
challenges. The Treasury Department and the IRS also again solicit 
comments on methods to identify the endpoints of a communication that 
may be reasonable for particular industries, as well as criteria that 
may be appropriate to evaluate the reasonableness of such methods.
7. Treatment of a Content Provider's Communications Activity
    Section 1.863-9(d)(1)(ii) of the 2001 proposed regulations provides 
that, to the extent a taxpayer's transaction consists in part of non-de 
minimis communications activities and in part of non-de minimis non-
communications activities, such parts of the transaction must be 
treated as separate transactions. Section 1.863-9(d)(1)(ii) of the 2001 
proposed regulations then provides that gross income derived from the 
activities must be allocated to each separate transaction, to the 
satisfaction of the Commissioner, based on all the facts and 
circumstances, which may include functions performed, resources 
employed, or risks assumed in the respective transactions.
    One commentator suggested that the regulations be clarified to 
provide that a content company (for example, the creator of a 
television or radio program) that does not possess or operate 
communications equipment or itself perform any communications function 
is not engaged in communications activities. This commentator did not 
believe that communication activities should be attributed to a content 
provider and stated that delivery of a content provider's programming 
by a

[[Page 54869]]

third party should not change the character of the content provider's 
income to communications income.
    No changes were made to the reproposed regulations in response to 
this comment. The Treasury Department and the IRS believe that the 
transmission of any communications, including content, is appropriately 
considered a communications activity. The Treasury Department and the 
IRS also believe that when a content provider is paid to transmit, and 
bears the risk of transmitting, content to a customer, the content 
provider should be considered to derive communications income. Under 
reproposed Sec.  1.863-9(h)(1)(ii), as under the 2001 proposed 
regulations, the content provider will derive communications income 
only to the extent of the gross income allocated to the separate 
transaction involving the communications activity. The Treasury 
Department and the IRS believe that it is appropriate for a content 
provider to derive communications income when communications activities 
make more than a de minimis contribution to the value of the content 
provider's overall transaction with its customer.
8. Treatment of Partnerships
    Section 1.863-9(e)(1) of the 2001 proposed regulations generally 
provides that section 863(e) and the regulations thereunder will be 
applied to domestic partnerships at the partnership level. Section 
1.863-9(e)(1) of the 2001 proposed regulations also provides that 
section 863(e) and the regulations thereunder will be applied at the 
partner level to foreign partnerships. Section 1.863-9(e)(2) of the 
2001 proposed regulations similarly provides that section 863(e) and 
the regulations thereunder will be applied at the partner level to 
domestic partnerships in which 50 percent or more of the partnership 
interests are owned by foreign persons.
    One commentator stated that Sec.  1.863-9(e)(2) of the 2001 
proposed regulations conflicts with sections 863(e)(1)(A) (which 
provides that the international communications income of any United 
States person shall be 50-percent U.S. source and 50-percent foreign 
source) and 7701(a)(3) (which defines United States person to include a 
domestic partnership). According to this commentator, the rule 
potentially discriminates against foreign partners in a domestic 
partnership owned 50 percent or more by foreign partners vis-[aacute]-
vis the U.S. partners in such a partnership. For example, the 
international communications income of a foreign partner could be 100-
percent U.S. source under Sec.  1.863-9(b)(2)(ii)(B) or (C) of the 2001 
proposed regulations, whereas the international communications income 
of a U.S. partner would be 50-percent U.S. source and 50-percent 
foreign source, creating the potential for double taxation of the 
foreign partner. Another commentator stated that Sec.  1.863-9(e)(1) of 
the 2001 proposed regulations could result in the double taxation of 
the U.S. partners of foreign partnerships. This commentator noted that 
the international communications income of a foreign partnership could 
be subject to tax in the country in which the foreign partnership is 
organized. Under Sec.  1.863-9(e) of the 2001 proposed regulations, a 
U.S. partner's share of such international communications income would 
be subject to the 50/50 source rule in Sec.  1.863-9(b)(2)(i) of the 
2001 proposed regulations. As a result, the U.S. partner may be unable 
to credit its proportionate share of tax paid in the foreign country. 
Commentators suggested that the source rules of Sec.  1.863-9 of the 
2001 proposed regulations be applied to all partnerships at the entity 
level.
    As is the case for reproposed Sec.  1.863-8(e) with respect to 
section 863(d), the Treasury Department and the IRS believe that 
section 863(e) should be applied to domestic and foreign partnerships 
in the same manner. Accordingly, the reproposed regulations do not 
provide a different rule for foreign partnerships and domestic 
partnerships. Section 1.863-9(i) of the reproposed regulations provides 
that the regulations will be applied at the partner level for all 
partnerships.
9. Allocations
    When a taxpayer must allocate gross income to the satisfaction of 
the Commissioner, based on all the facts and circumstances, under Sec.  
1.863-9(b)(2)(ii)(D) or (d)(1)(ii) of the 2001 proposed regulations, 
the Treasury Department and the IRS believe that such allocations 
should be based generally on section 482 principles. As with Sec.  
1.863-8 of the 2001 proposed regulations, commentators stated that 
allocation of income based on section 482 principles would be 
burdensome and expensive and would create uncertainty.
    The Treasury Department and the IRS consider the allocation of 
gross income based on the general guidance of section 482 to be an 
approach that is well-suited to application in the wide variety of 
factual contexts within the scope of the reproposed regulations. The 
Treasury Department and the IRS solicit comments on alternative methods 
of allocation for particular industries and criteria that could be used 
to evaluate the reasonableness of such methods.
10. Issues With Uplink Functions
    Examples 5, 10, and 12 of Sec.  1.863-9(f) of the 2001 proposed 
regulations involve communications activities that include the 
performance of satellite uplink and downlink functions. One commentator 
stated that these examples do not provide clear guidance as to whether 
the satellite operator must itself perform the uplink function in order 
for its income to qualify as international communications income, and 
could be read to treat a satellite operator that contracts with another 
party to transmit signals as not engaged in international 
communications activity because the uplink function is performed by 
that other party.
    No changes were made to the reproposed regulations in response to 
this comment. Reproposed Sec.  1.863-9(h)(2) provides that income may 
be considered derived from a communications activity even if the 
taxpayer does not perform the transmission function, but, in all cases, 
a taxpayer derives communications income only if the taxpayer is paid 
to transmit, and bears the risk of transmitting, the communications. 
The Treasury Department and the IRS believe that whether a satellite 
operator should be considered to derive international 
telecommunications income from a transaction is appropriately 
determined by applying reproposed Sec.  1.863-9(h)(2), as well as the 
other substantive provisions of the reproposed regulations, to the 
specific facts of the taxpayer's transaction.
11. Characterization of Income
    One commentator stated that the regulations should be clarified to 
provide that they do not purport to establish general rules for the 
characterization of income and that the characterization of income 
items for purposes of the application of section 863(d) and (e) is to 
be made under general principles of tax law. This commentator stated 
that some examples in the 2001 proposed regulations could suggest 
conflicting characterizations of income from what appear to be the same 
activities. In response to this comment, the examples in the reproposed 
regulations have been clarified to state that the characterization of 
the transactions at issue is assumed for purposes of the specific 
example. In addition, certain examples have been reconciled to the 
extent they could suggest different characterizations of the same 
activities.

[[Page 54870]]

12. Reporting and Documentation Requirements
    In order to satisfy the Commissioner with respect to a taxpayer's 
allocation of gross income under Sec.  1.863-9(b)(2)(ii)(D) or 
(d)(1)(ii) of the 2001 proposed regulations, the taxpayer must make the 
allocation on a timely filed original return (including extensions). An 
amended return does not qualify for this purpose, and section 9100 
relief will not be available. In all cases, a taxpayer must also 
maintain contemporaneous documentation regarding the allocation of 
gross income, allocation and apportionment of expenses, losses and 
other deductions, the methodologies used, and the circumstances 
justifying use of those methodologies. The taxpayer must produce such 
documentation within 30 days upon request.
    As with the similar requirements under Sec.  1.863-8 of the 2001 
proposed regulations, commentators stated that there is no basis in the 
statute or the legislative history for the reporting, recordkeeping, 
and contemporaneous documentation requirements in the 2001 proposed 
regulations. Commentators also noted that the Code and regulations do 
not contain similar requirements with respect to other expense 
allocation provisions.
    The reproposed regulations generally retain the recordkeeping and 
documentation requirements. The Treasury Department and the IRS believe 
that it is appropriate to require taxpayers to keep proper records, and 
additionally note the potentially considerable difficulties the IRS 
would face in performing the allocations required by the reproposed 
regulations without appropriate taxpayer records.
    The Treasury Department and the IRS recognize, however, that 
taxpayers may not have all the information necessary to make 
allocations at the time a return is originally filed. The reproposed 
regulations therefore provide that a taxpayer may make changes to 
allocations made on the taxpayer's original return with respect to any 
taxable year for which the statute of limitations has not closed, 
subject to certain conditions. Nonetheless, changes to such allocations 
that are not made until an audit of the taxable year to which the 
allocations relate has commenced, or a taxpayer's failure timely to 
provide documentation and other information supporting the allocations, 
create administrative difficulties for the IRS. Accordingly, reproposed 
Sec.  1.863-9(k)(4) sets forth the actions required of taxpayers and 
the procedures the IRS will follow in the case of taxpayers changing 
their allocations.
    The reproposed regulations also require taxpayers, upon request, to 
provide access to the software programs and other systems used by the 
taxpayer to make allocations under these regulations. For this purpose, 
software has the meaning provided in section 7612(d). The Treasury 
Department and the IRS believe that the IRS could face significant 
administrative and other difficulties in the examination of income 
allocations made under these regulations without access to such 
software.

Proposed Effective Date

    These regulations are proposed to apply for taxable years beginning 
on or 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 pursuant to that Order is not 
required. It has also been determined that section 553(b) of the 
Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to 
these regulations. Pursuant to the Regulatory Flexibility Act (5 U.S.C. 
chapter 6), it is hereby certified that the collection of information 
in 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 provided in these regulations principally 
affect large multinational corporations that pay foreign taxes on 
income derived from substantial foreign operations and that use these 
and any other applicable source rules in determining their foreign tax 
credit. Accordingly, a Regulatory Flexibility Act assessment is not 
required. Pursuant to section 7805(f) of the Internal Revenue Code, 
this notice of proposed rulemaking has been submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) or electronic comments that are submitted timely 
to the IRS. The Treasury Department and the IRS 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 December 15, 2005, at 10 
a.m., in the IRS Auditorium, Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC. Due to building security 
procedures, visitors must enter at the Constitution Avenue entrance. 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 30 minutes before the 
hearing starts. For information on 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 written or 
electronic comments and an outline of the topics to be discussed and 
the time to be devoted to each topic (a signed original and eight (8) 
copies) by November 23, 2005. A period of 10 minutes will be allotted 
to each person for making comments. An agenda showing the scheduling of 
the speakers will be prepared after the deadline for receiving outlines 
has passed. Copies of the agenda will be available free of charge at 
the hearing.

Drafting Information

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

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Withdrawal of Previous Notice of Proposed Rulemaking

    Accordingly, under the authority of 26 U.S.C. 7805, the notice of 
proposed rulemaking (REG-106030-98) that was published in the Federal 
Register on January 17, 2001 (66 FR 3903), is withdrawn as of September 
19, 2005.

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, in part, as follows:


[[Page 54871]]


    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 a sentence after the first sentence in 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 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 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.
* * * * *
    (2) * * * Notwithstanding any other provision, for rules regarding 
the source of income when a sale takes place in space or 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. * * *
* * * * *
    Par. 3. Sections 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 United States or a foreign person 
derived from space and ocean activity (space and 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 Sec.  1.1502-13.
    (b) Source of gross income from space and ocean activity--(1) Space 
and ocean income derived by a U.S. person. Space and ocean income 
derived by a U.S. person is income from sources within the United 
States. However, space and ocean income derived by a U.S. person is 
income from sources without the United States to the extent the income, 
based on all the facts and circumstances, is attributable to functions 
performed, resources employed, or risks assumed in a foreign country or 
countries.
    (2) Space and ocean income derived by a foreign person--(i) In 
general. Space and ocean income derived by a person other than a U.S. 
person is income from sources without the United States, except as 
otherwise provided in this paragraph (b)(2).
    (ii) Space and ocean income derived by a controlled foreign 
corporation. Space and ocean income derived by a controlled foreign 
corporation within the meaning of section 957 (CFC) is income from 
sources within the United States. However, space and ocean income 
derived by a CFC is income from sources without the United States to 
the extent the income, based on all the facts and circumstances, is 
attributable to functions performed, resources employed, or risks 
assumed in a foreign country or countries.
    (iii) Space and ocean income derived by foreign persons engaged in 
a trade or business within the United States. Space and ocean income 
derived by a foreign person (other than a CFC) engaged in a trade or 
business within the United States is income from sources within the 
United States to the extent the income, based on all the facts and 
circumstances, is attributable to functions performed, resources 
employed, or risks assumed within the United States.
    (3) Source rules for income from certain sales of property--(i) 
Sales of purchased property. When a taxpayer sells purchased property 
in space or international water, the source of gross income from the 
sale generally will be determined under paragraph (b)(1) or (2) of this 
section, as applicable. However, if such property is inventory property 
within the meaning of section 1221(a)(1) (inventory property) and is 
not sold for use, consumption, or disposition in space or international 
water, the source of income from the sale will be determined under 
Sec.  1.861-7(c).
    (ii) Sales of property produced by the taxpayer--(A) General. If 
the taxpayer both produces property and sells such property, the 
taxpayer must allocate gross income from such sales between production 
activity and sales activity under the 50/50 method. Under the 50/50 
method, one-half of the taxpayer's gross income will be considered 
income allocable to production activity, and the source of that income 
will be determined under paragraph (b)(3)(ii)(B) or (C) of this 
section. The remaining one-half of such gross income will be considered 
income allocable to sales activity, and the source of that income will 
be determined under paragraph (b)(3)(ii)(D) of this section.
    (B) Production only in space or international water, or only 
outside space and international water. When production occurs only in 
space or international water, income allocable to production activity 
is sourced under paragraph (b)(1) or (2) of this section, as 
applicable. When production occurs only outside space and international 
water, income allocable to production activity is sourced under Sec.  
1.863-3(c)(1).
    (C) Production both in space or international water and outside 
space and international water. When property is produced both in space 
or international water and outside space and international water, gross 
income allocable to production activity must be allocated to production 
occurring in space or international water and production occurring 
outside space and international water. Such gross income is allocated 
to production activity occurring in space or international water to the 
extent the income, based on all the facts and circumstances, is 
attributable to functions performed, resources employed, or risks 
assumed in space or international water. The balance of such gross 
income is allocated to production activity occurring outside space and 
international water. The source of gross income allocable to production 
activity in space or international water is determined under paragraph 
(b)(1) or (2) of this section, as applicable. The source of gross 
income allocated to production activity occurring outside space and 
international water is determined under Sec.  1.863-3(c)(1).
    (D) Source of income allocable to sales activity. When property 
produced by the taxpayer is sold outside space and international water, 
the source of gross income allocable to sales activity will be 
determined under Sec. Sec.  1.861-7(c) and 1.863-3(c)(2). When property 
produced by the taxpayer is sold in space or international water, the 
source of gross income allocable to sales activity generally will be 
determined under paragraph (b)(1) or (2) of this section, as 
applicable. However, if such property is inventory property within the 
meaning of section 1221(a)(1) and is sold in space or international 
water for use, consumption, or disposition outside space, international 
water, or

[[Page 54872]]

the United States, the source of gross income allocable to sales 
activity will be determined under Sec. Sec.  1.861-7(c) and 1.863-
3(c)(2).
    (4) Special rule for determining the source of gross income from 
services. To the extent a transaction characterized as the performance 
of a service constitutes a space or ocean activity, as determined under 
paragraph (d)(2)(ii) of this section, the source of gross income 
derived from such transaction is determined under paragraph (b)(1) or 
(2) of this section.
    (5) Special rule for determining source of income from 
communications activity (other than income from international 
communications activity). Space and ocean activity, as defined in 
paragraph (d) of this section, includes activity that occurs in space 
or international water that is characterized as a communications 
activity as defined in Sec.  1.863-9(h)(1) (other than international 
communications activity). The source of space and ocean income that is 
also communications income as defined in Sec.  1.863-9(h)(2) (but not 
space/ocean communications income as defined in Sec.  1.863-9(h)(3)(v)) 
is determined under the rules of Sec.  1.863-9(c), (d), and (f), as 
applicable, rather than under paragraph (b) of this section. The source 
of space and ocean income that is also space/ocean communications 
income as defined in Sec.  1.863-9(h)(3)(v) is determined under the 
rules of paragraph (b) of this section. See Sec.  1.863-9(e).
    (c) Taxable income. When a taxpayer allocates gross income under 
paragraph (b)(1), (b)(2), (b)(3)(ii)(C), or (b)(4) of this section, the 
taxpayer must allocate expenses, losses, and other deductions as 
prescribed in Sec. Sec.  1.861-8 through 1.861-14T to the class or 
classes of gross income that include the income so allocated in each 
case. A taxpayer must then apply the rules of Sec. Sec.  1.861-8 
through 1.861-14T to apportion properly amounts of expenses, losses, 
and other deductions so allocated to such gross income between gross 
income from sources within the United States and gross income from 
sources without the United States.
    (d) Space and ocean activity--(1) Definition--(i) Space activity. 
In general, space activity is any activity conducted in space. 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 part of a single 
transaction. Paragraph (d)(3) of this section lists specific exceptions 
to the general definition of space activity. Activities that constitute 
space activity include but are not limited to--
    (A) Performance and provision of services in space, as defined in 
paragraph (d)(2)(ii) of this section;
    (B) Leasing of equipment located in space, including spacecraft 
(for example, satellites) or transponders located in space;
    (C) Licensing of technology or other intangibles for use in space;
    (D) Production, processing, or creation of property in space, as 
defined in paragraph (d)(2)(i) of this section;
    (E) Activity occurring in space that is characterized as 
communications activity (other than international communications 
activity) under Sec.  1.863-9(h)(1);
    (F) Underwriting income from the insurance of risks on activities 
that produce space income; and
    (G) Sales of property in space (see Sec.  1.861-7(c)), but not 
sales of inventory property for use, consumption, or disposition 
outside space or international water.
    (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). 
For purposes of determining ocean activity, the Commissioner may 
separate parts of a single transaction into separate transactions or 
combine separate transactions as part of a single transaction. 
Paragraph (d)(3) of this section lists specific exceptions to the 
general definition of ocean activity. Activities that constitute ocean 
activity include but are not limited to--
    (A) Performance and provision of services in international water, 
as defined in paragraph (d)(2)(ii) of this section;
    (B) Leasing of equipment located in international water, including 
underwater cables;
    (C) Licensing of technology or other intangibles for use in 
international water;
    (D) Production, processing, or creation of property in 
international water, as defined in paragraph (d)(2)(i) of this section;
    (E) Activity occurring in international water that is characterized 
as communications activity (other than international communications 
activity) under Sec.  1.863-9(h)(1);
    (F) Underwriting income from the insurance of risks on activities 
that produce ocean income;
    (G) Sales of property in international water (see Sec.  1.861-
7(c)), but not sales of inventory property for use, consumption, or 
disposition outside space or international water;
    (H) Any activity performed in Antarctica;
    (I) The leasing of a vessel that does not transport cargo or 
persons for hire between ports-of-call (for example, the leasing of a 
vessel to engage in research activities in international water); and
    (J) The leasing of drilling rigs, extraction of minerals, and 
performance and provision of services related thereto, except as 
provided in paragraph (d)(3)(ii) of this section.
    (2) Determining a space or ocean activity--(i) Production of 
property in space or 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 section 864(a) and Sec.  1.864-1.
    (ii) Special rule for performance of services--(A) General. Except 
as provided in paragraph (d)(2)(ii)(B) of this section, if a 
transaction is characterized as the performance of a service, then such 
service will be treated as a space or ocean activity in its entirety 
when any part of the service is performed in space or international 
water. Services are performed in space or international water if 
functions are performed, resources are employed, or risks are assumed 
in space or international water, regardless of whether performed by 
personnel, equipment, or otherwise.
    (B) Exception to the general rule. If the taxpayer can demonstrate 
the value of the service attributable to performance occurring in space 
or international water, and the value of the service attributable to 
performance occurring outside space and international water, then such 
service will be treated as space or ocean activity only to the extent 
of the activity performed in space or international water. The value of 
the service is attributable to performance occurring in space or 
international water to the extent the performance of the service, based 
on all the facts and circumstances, is attributable to functions 
performed, resources employed, or risks assumed in space or 
international water. In addition, if the taxpayer can demonstrate, 
based on all the facts and circumstances, that the value of the service 
attributable to performance in space or international water is de 
minimis, such service will not be treated as space or ocean activity.

[[Page 54873]]

    (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).
    (ii) Any activity with respect to mines, oil and gas wells, or 
other natural deposits, to the extent the mines, wells, or natural 
deposits are located within the jurisdiction (as recognized by the 
United States) of any country, including the United States and its 
possessions.
    (iii) Any activity giving rise to international communications 
income as defined in Sec.  1.863-9(h)(3)(ii).
    (e) Treatment of partnerships. This section is 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, a U.S. person, owns satellites in orbit. S 
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. Assume that the combination of S's activities is 
characterized as the lease of equipment.
    (ii) Analysis. Because the leased 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)(1) of this section. 
Under paragraph (b)(1) of this section, S's space income is sourced 
outside the United States to the extent the income, based on all the 
facts and circumstances, is attributable to functions performed, 
resources employed, or risks assumed in a foreign country or 
countries.
    Example 2. Space activity--(i) Facts. X is an Internet service 
provider. X offers a service that permits a customer (C) to connect 
to the Internet via a telephone call, initiated by the modem of C's 
personal computer, to a control center. X transmits information 
requested by C to C's personal computer, in part using satellite 
capacity leased by X from S. X charges its customers a flat monthly 
fee. Assume that neither X nor S derive international communications 
income within the meaning of Sec.  1.863-9(h)(3)(ii). In addition, 
assume that X is able to demonstrate, pursuant to paragraph 
(d)(2)(ii)(B) of this section, the extent to which the value of the 
service is attributable to functions performed, resources employed, 
and risks assumed in space.
    (ii) Analysis. Under paragraph (d)(2)(ii) of this section, the 
service performed by X constitutes space activity to the extent the 
value of the service is attributable to functions performed, 
resources employed, and risks assumed in space. To the extent the 
service performed by X constitutes space activity, the source of X's 
income from the service transaction is determined under paragraph 
(b) of this section. To the extent the service performed by X does 
not constitute space or ocean activity, the source of X's income 
from the service is determined under sections 861, 862, and 863, as 
applicable. To the extent that X derives space and ocean income that 
is also communications income within the meaning of Sec.  1.863-
9(h)(2), the source of X's income is determined under paragraph (b) 
of this section and Sec.  1.863-9(c), (d), and (f), as applicable, 
as provided in paragraph (b)(5) of this section. S derives space and 
ocean income that is also communications income within the meaning 
of Sec.  1.863-9(h)(2), and the source of S's income is therefore 
determined under paragraph (b) of this section and Sec.  1.863-9(c), 
(d), and (f), as applicable, as provided in paragraph (b)(5) of this 
section.
    Example 3. Services as space activity--de minimis value 
attributable to performance occurring in space--(i) Facts. R owns a 
retail outlet in the United States. R engages S to provide a 
security system for R's premises. S operates its security system by 
transmitting images from R's premises directly to a satellite, and 
from the satellite to a group of S employees located in Country B, 
who 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. Assume that S's transaction with R is 
characterized as the performance of a service. Assume that O's 
provision of transponder capacity is also viewed as the provision of 
a service and that the value of O's service transaction attributable 
to performance in space is not de minimis. In addition, assume that 
S is able to demonstrate, pursuant to paragraph (d)(2)(ii) of this 
section, that a de minimis portion of the value of S's service 
transaction with R is attributable to performance in space. Assume 
also that S is able to demonstrate, pursuant to Sec.  1.863-9(h)(1), 
that the value of the transaction with R attributable to 
communications activities is de minimis.
    (ii) Analysis. S derives income from providing monitoring 
services. Because S demonstrates that the value of S's service 
transaction attributable to performance in space is de minimis, S is 
not treated as engaged in a space activity, and none of S's income 
from the service transaction is space income. In addition, because S 
demonstrates that the value of the transaction with R attributable 
to communications activities is de minimis, S is not required under 
Sec.  1.863-9(h)(1)(ii) to treat the transaction as separate 
communications and non-communications transactions, and none of S's 
gross income from the transaction is treated as communications 
income within the meaning of Sec.  1.863-9(h)(2). Because O's 
provision of transponder capacity is viewed as the provision of a 
service and the value of O's service transaction attributable to 
performance in space is not de minimis, O's activity will be 
considered space activity, pursuant to paragraph (d)(2)(ii) of this 
section, to the extent the value of the services transaction is 
attributable to performance in space (unless O's activity in space 
is international communications activity). To the extent that O 
derives communications income, the source of such income is 
determined under paragraph (b) of this section and Sec.  1.863-9(b), 
(c), (d), and (f), as applicable, as provided in paragraph (b)(5) of 
this section. R does not derive any income from space activity.
    Example 4. Space activity--(i) Facts. L, a domestic corporation, 
offers programming and certain other services to customers located 
both in the United States and in foreign countries. Assume that L's 
provision of programming and other services in this Example 4 is 
characterized as the provision of a service, and that no part of the 
service transaction occurs in space or international water. Assume 
that the delivery of the programming constitutes a separate 
transaction also characterized as the performance of a service. L 
uses satellite capacity acquired from S to deliver the programming 
service directly to customers' television sets, so that part of the 
value of the delivery transaction derives from functions performed 
and resources employed in space. Assume that these contributions to 
the value of the delivery transaction occurring in space are not 
considered de minimis under paragraph (d)(2)(ii)(B) of this section. 
Customer C pays L to provide and deliver programming to C's 
residence in the United States. Assume S's provision of satellite 
capacity in this Example 4 is 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(h)(3)(ii).
    (ii) Analysis. S's activity will be considered space activity. 
To the extent that S derives space and ocean income that is also 
communications income under Sec.  1.863-9(h)(2), the source of S's 
income is determined under paragraph (b) of this section and Sec.  
1.863-9(c), (d), and (f), as applicable, as provided in paragraph 
(b)(5) of this section. On these facts, L's activities are treated 
as two separate service transactions: the provision of programming 
(and other services), and the delivery of programming. L's income 
derived from provision of programming and other services is not 
income derived from space activity. L's delivery of programming and 
other services is considered space activity, pursuant to paragraph 
(d)(2)(ii) of this section, to the extent the value of the delivery 
transaction is attributable to performance in space. To the extent 
that the delivery of programming is treated as a space activity, the 
source of L's income derived from the delivery transaction is 
determined under paragraph (b)(1) of this section, as provided in 
paragraph (b)(4) of this section. To the extent that L derives space 
and ocean income that is also communications income within the 
meaning of Sec.  1.863-9(h)(2), the source of such income is 
determined under paragraph (b) of this section and Sec.  1.863-9(b), 
(c), (d), (e), and (f), as applicable, as provided in paragraph 
(b)(5) 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

[[Page 54874]]

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. S's rights, title, and 
interest in the data pass to C in the United States. Before 
transferring the images to C, S uses computer software in its land-
based office 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. Because 
S both produces and sells the data, S must allocate gross income 
from the sale of the data between production activity and sales 
activity under the 50/50 method of paragraph (b)(3)(ii)(A). The 
source of S's income allocable to production activity is determined 
under paragraph (b)(3)(ii)(C) of this section because production 
activities occur both in space and on land. The source of S's income 
attributable to sales activity is determined under paragraph 
(b)(3)(ii)(D) of this section (by reference to Sec.  1.863-3(c)(2)) 
as U.S. source income because S's rights, title, and interest in the 
data pass to C in the United States.
    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. Because the royalty is paid for the right to use 
intangible property in space, the source of the royalty paid by C to 
X is determined under paragraph (b) of this section.
    Example 7. Performance of services--(i) Facts. E, a domestic 
corporation, 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 offices located in the United States. Assume 
that E's combined activities are characterized as the performance of 
services.
    (ii) Analysis. E's activities will be considered space 
activities, pursuant to paragraph (d)(2)(ii) of this section, to the 
extent the value of E's service transaction is attributable to 
performance in space. To the extent E's service transaction 
constitutes a space activity, the source of E's income derived from 
the service transaction will be determined under paragraph (b)(4) of 
this section, by reference to paragraph (b)(1) of this section. To 
the extent that E's service transaction does not constitute a space 
or ocean activity, the source of E's income derived from the service 
transaction is determined under sections 861, 862, and 863, as 
applicable.
    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. In addition, E 
provides an analysis in the form of a report to F. The price F pays 
E for the raw data is separately stated.
    (ii) Analysis. To the extent that 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)(3)(ii) of this section. The provision 
of services would be analyzed in the same manner as in Example 7.
    Example 9. Sale of property in international water--(i) Facts. T 
purchased and owns transatlantic cable that lies in international 
water. T sells the cable to B, with T's rights, title, and interest 
in the cable passing to B in international water. Assume that the 
transatlantic cable is not inventory property within the meaning of 
section 1221(a)(1).
    (ii) Analysis. Because T's rights, title, and interest in the 
property pass to B in international water, the sale takes place in 
international water under Sec.  1.861-7(c), and the sale transaction 
is ocean activity under paragraph (d)(1)(ii) of this section. The 
source of T's sales income is determined under paragraph (b)(3)(i) 
of this section, by reference to paragraph (b)(1) or (2) of this 
section.
    Example 10. Sale of property in space--(i) Facts. S, a U.S. 
person, manufactures a satellite in the United States and sells it 
to a customer who is not a U.S. person. S's rights, title, and 
interest in the satellite pass to the customer in space.
    (ii) Analysis. Because S's rights, title, and interest in the 
satellite pass to the customer in space, the sale takes place in 
space under Sec.  1.861-7(c), and the sale transaction is space 
activity under paragraph (d)(1)(i) of this section. The source of 
income derived from the sale of the satellite in space is determined 
under paragraph (b)(3)(ii) of this section, with the source of 
income allocable to production activity determined under paragraphs 
(b)(3)(ii)(A) and (B) of this section, and the source of income 
allocable to sales activity determined under paragraphs 
(b)(3)(ii)(A) and (D) of this section. Under paragraph (b)(1) of 
this section, S's space income is sourced outside the United States 
to the extent the income, based on all the facts and circumstances, 
is attributable to functions performed, resources employed, or risks 
assumed in a foreign country or countries.
    Example 11. Sale of property in space--(i) Facts. S has a right 
to operate from a particular position (satellite slot or orbit) in 
space. S sells the right to operate from that position to P. Assume 
that the sale of the satellite slot is characterized as a sale of 
property and that S's rights, title, and interest in the satellite 
slot pass to P in space.
    (ii) Analysis. The sale of the satellite slot takes place in 
space under Sec.  1.861-7(c) because S's rights, title, and interest 
in the satellite slot pass to P in space. The sale of the satellite 
slot is space activity under paragraph (d)(1)(i) of this section, 
and income or gain from the sale is sourced under paragraph 
(b)(3)(i) of this section, by reference to paragraph (b)(1) or (2) 
of this section.
    Example 12. Source of income of a foreign person--(i) Facts. FP, 
a foreign corporation that is not a CFC, derives income from the 
operation of satellites. FP operates ground stations in the United 
States and in foreign country FC. Assume that FP is considered 
engaged in a trade or business within the United States based on 
FP's operation of the ground station in the United States.
    (ii) Analysis. Under paragraph (b)(2)(iii) of this section, FP's 
space income is sourced in the United States to the extent the 
income, based on all the facts and circumstances, is attributable to 
functions performed, resources employed, or risks assumed within the 
United States.
    Example 13. Source of income of a foreign person--(i) Facts. FP, 
a foreign corporation that is not a CFC, operates remote sensing 
satellites in space to collect data and images for its customers. FP 
uses an independent agent, A, in the United States who provides 
marketing, order-taking, and other customer service functions. 
Assume that FP is considered engaged in a trade or business within 
the United States based on A's activities on FP's behalf in the 
United States.
    (ii) Analysis. Under paragraph (b)(2)(iii) of this section, FP's 
space income is sourced in the United States to the extent the 
income, based on all the facts and circumstances, is attributable to 
functions performed, resources employed, or risks assumed within the 
United States.

    (g) Reporting and documentation requirements--(1) General. A 
taxpayer making an allocation of gross income under paragraph (b)(1), 
(b)(2), (b)(3)(ii)(C), or (b)(4) of this section must satisfy the 
requirements in paragraphs (g)(2), (3), and (4) of this section.
    (2) Required documentation. In all cases, a taxpayer must prepare 
and maintain documentation in existence when its return is filed 
regarding the allocation of gross income and allocation and 
apportionment of expenses, losses, and other deductions, the 
methodologies used, and the circumstances justifying use of those 
methodologies. The taxpayer must make available such documentation 
within 30 days upon request.
    (3) Access to software. If the taxpayer or any third party used any 
computer software, within the meaning of section 7612(d), to allocate 
gross income, or to allocate or apportion expenses, losses, and other 
deductions, the taxpayer must make available upon request--
    (i) Any computer software executable code, within the meaning of 
section 7612(d), used for such purposes, including an executable copy 
of the version of the software used in the preparation of the 
taxpayer's return (including any plug-ins, supplements, etc.) and a 
copy of all related electronic data files. Thus, if software 
subsequently is upgraded or supplemented, a separate executable copy of 
the version used in preparing the taxpayer's return must be retained;
    (ii) Any related computer software source code, within the meaning 
of section 7612(d), acquired or developed by the taxpayer or a related 
person, or primarily for internal use by the taxpayer or such person 
rather than for commercial distribution; and

[[Page 54875]]

    (iii) In the case of any spreadsheet software or similar software, 
any formulae or links to supporting worksheets.
    (4) Use of allocation methodology. In general, when a taxpayer 
allocates gross income under paragraph (b)(1), (b)(2), (b)(3)(ii)(C), 
or (b)(4) of this section, it does so by making the allocation on a 
timely filed original return (including extensions). However, a 
taxpayer will be permitted to make changes to such allocations made on 
its original return with respect to any taxable year for which the 
statute of limitations has not closed as follows:
    (i) In the case of a taxpayer that has made a change to such 
allocations prior to the opening conference for the audit of the 
taxable year to which the allocation relates or who makes such a change 
within 90 days of such opening conference, if the IRS issues a written 
information document request asking the taxpayer to provide the 
documents and such other information described in paragraphs (g)(2) and 
(3) of this section with respect to the changed allocations and the 
taxpayer complies with such request within 30 days of the request, then 
the IRS will complete its examination, if any, with respect to the 
allocations for that year as part of the current examination cycle. If 
the taxpayer does not provide the documents and information described 
in paragraphs (g)(2) and (3) of this section within 30 days of the 
request, then the procedures described in paragraph (g)(4)(ii) of this 
section shall apply.
    (ii) If the taxpayer changes such allocations more than 90 days 
after the opening conference for the audit of the taxable year to which 
the allocations relate or the taxpayer does not provide the documents 
and information with respect to the changed allocations as requested in 
accordance with paragraphs (g)(2) and (3) of this section, then the IRS 
will, in a separate cycle, determine whether an examination of the 
taxpayer's allocations is warranted and complete any such examination. 
The separate cycle will be worked as resources are available and may 
not have the same estimated completion date as the other issues under 
examination for the taxable year. The IRS may ask the taxpayer to 
extend the statute of limitations on assessment and collection for the 
taxable year to permit examination of the taxpayer's method of 
allocation, including an extension limited, where appropriate, to the 
taxpayer's method of allocation.
    (h) Effective date. This section applies to taxable years beginning 
on or 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 United States or a foreign person 
derived from each type of communications activity, as defined in 
paragraph (h)(3) of this section, is sourced under the rules of this 
section, notwithstanding any other provision including sections 861, 
862, 863, and 865. Notwithstanding that 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, except to the extent 
provided in Sec.  1.863-8(b)(5).
    (b) Source of international communications income--(1) 
International communications income derived by a U.S. person. Income 
derived from international communications activity (international 
communications income) by a U.S. person is one-half from sources within 
the United States and one-half from sources without the United States.
    (2) International communications income derived by foreign 
persons--(i) In general. International communications income derived by 
a person other than a U.S. person is, except as otherwise provided in 
this paragraph (b)(2), wholly from sources without the United States.
    (ii) International communications income derived by a controlled 
foreign corporation. International communications income derived by a 
controlled foreign corporation within the meaning of section 957 (CFC) 
is one-half from sources within the United States and one-half from 
sources without the United States.
    (iii) International communications income derived by foreign 
persons with a fixed place of business in the United States. 
International communications income derived by a foreign person, other 
than a CFC, that is attributable to an office or other fixed place of 
business of the foreign person in the United States 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.  1.864-7. International 
communications income is attributable to an office or other fixed place 
of business to the extent of functions performed, resources employed, 
or risks assumed by the office or other fixed place of business.
    (iv) International communications income derived by foreign persons 
engaged in a trade or business within the United States. International 
communications income derived by a foreign person (other than a CFC) 
engaged in a trade or business within the United States is income from 
sources within the United States to the extent the income, based on all 
the facts and circumstances, is attributable to functions performed, 
resources employed, or risks assumed within the United States.
    (c) Source of U.S. communications income. Income derived by a 
United States or foreign person from U.S. communications activity is 
from sources within the United States.
    (d) Source of foreign communications income. Income derived by a 
United States or foreign person from foreign communications activity is 
from sources without the United States.
    (e) Source of space/ocean communications income. Income derived by 
a United States or foreign person from space/ocean communications 
activity is determined under section 863(d) and the regulations 
thereunder.
    (f) Source of communications income when taxpayer cannot establish 
the two points between which the taxpayer is paid to transmit the 
communication. Income derived by a United States 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 (h)(3)(i) of this section, is from sources 
within the United States.
    (g) Taxable income. When a taxpayer allocates gross income under 
paragraph (b)(2)(iii), (b)(2)(iv), or (h)(1)(ii) of this section, the 
taxpayer must allocate expenses, losses, and other deductions as 
prescribed in Sec. Sec.  1.861-8 through 1.861-14T to the class or 
classes of gross income that include the income so allocated in each 
case. A taxpayer must then apply the rules of Sec. Sec.  1.861-8 
through 1.861-14T properly to apportion amounts of expenses, losses, 
and other deductions so allocated to such gross income between gross 
income from sources within the United States and gross income from 
sources without the United States. For amounts of expenses, losses, and 
other deductions allocated to gross income derived from international 
communications activity, when the source of income is determined under 
the 50/50 method of paragraph (b)(1) or (b)(2)(ii) of this section, 
taxpayers

[[Page 54876]]

generally must apportion expenses, losses, and other deductions between 
sources within the United States and sources without the United States 
pro rata based on the relative amounts of gross income from sources 
within the United States and gross income from sources without the 
United States. However, the preceding sentence shall not apply to 
research and experimental expenditures qualifying under Sec.  1.861-17, 
which are to be allocated and apportioned under the rules of that 
section.
    (h) 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. Communications 
activity or non-communications activity will be treated as de minimis 
to the extent, based on the facts and circumstances, the value 
attributable to such activity is de minimis.
    (ii) Separate transaction. To the extent that a taxpayer's 
transaction consists in part of non-de minimis communications activity 
and in part of non-de minimis non-communications activity, each such 
part of the transaction must be treated as a separate transaction. 
Gross income is allocated to each such communications activity 
transaction and non-communications activity transaction to the extent 
the income, based on all the facts and circumstances, is attributable 
to functions performed, resources employed, or risks assumed in each 
such activity.
    (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 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 (h)(2) of this 
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 (h)(2) 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 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 (h)(2) of this section, when the taxpayer is 
paid to transmit--
    (A) Between two points in a foreign country or countries (or a 
possession or possessions of the United States);
    (B) Between a foreign country and a possession of the United 
States; or
    (C) Between a foreign country (or a possession of the United 
States) and a point in space or 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 communications 
activity, as defined in paragraph (h)(2) of this section, when the 
taxpayer is paid to transmit between a point in space or international 
water and another point in space or international water.
    (i) Treatment of partnerships. This section is applied at the 
partner level.
    (j) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Income derived from non-communications activity--
remote data base access--(i) Facts. D provides its customers in 
various foreign countries with access to its data base, which 
contains information on certain individuals' health care insurance 
coverage. Customer C obtains access to D's data base by placing a 
call to D's telephone number. Assume that C's telephone service, 
used to access D's data base, is provided by a third party, and that 
D assumes no responsibility for the transmission of the information 
via telephone.
    (ii) Analysis. D is not paid to transmit communications and does 
not derive income from communications activity within the meaning of 
paragraph (h)(2) of this section. Rather, D derives income from 
provision of content or provision of services to its customers. 
Therefore, the rules of this section do not apply to determine the 
source of D's income.
    Example 2. Income derived from U.S. communications activity--
U.S. portion of international communication--(i) Facts. TC, a local 
telephone company, receives an access fee from an international 
carrier for picking up a call 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. TC is paid to transmit a 
communication between two points in the United States. TC derives 
U.S. communications income as defined in paragraph (h)(3)(iii) of 
this section, which is sourced under paragraph (c) of this section 
as U.S. source income.
    Example 3. Income derived from international communications 
activity--underwater cable--(i) Facts. TC, a domestic corporation, 
owns an underwater fiber optic cable. Pursuant to contracts, TC 
makes available to its customers capacity to transmit communications 
via the cable. TC's customers then solicit telephone customers and 
arrange to transmit the telephone customers' calls. The cable runs 
in part through U.S. waters, in part through international waters, 
and in part through foreign country waters.
    (ii) Analysis. TC derives international communications income as 
defined in paragraph (h)(3)(ii) of this section because TC is paid 
to make available capacity to transmit communications between the 
United States and a foreign country. Because TC is a U.S. person, 
TC's international communications income is sourced under paragraph 
(b)(1) of this section as one-half from sources within the United 
States and one-half from sources without the United States.

[[Page 54877]]

    Example 4. Income derived from international communications 
activity--satellite--(i) Facts. S, a U.S. person, owns satellites in 
orbit and uplink facilities in Country X, a foreign country. B, a 
resident of Country X, pays S to deliver B's programming from S's 
uplink facility, located in Country X, to a downlink facility in the 
United States owned by C, a customer of B.
    (ii) Analysis. S derives international communications income 
under paragraph (h)(3)(ii) of this section because S is paid to 
transmit the communications between a beginning point in a foreign 
country and an endpoint in the United States. Because S is a U.S. 
person, the source of S's international communications income is 
determined under paragraph (b)(1) of this section as one-half from 
sources within the United States and one-half from sources without 
the United States.
    Example 5. The paid-to-do rule--foreign communications via 
domestic route--(i) Facts. TC is paid to transmit communications 
from Toronto, Canada, to Paris, France. TC transmits the 
communications from Toronto 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 (h)(3)(i) 
of this section, TC derives foreign communications income under 
paragraph (h)(3)(iv) of this section because TC is paid to transmit 
communications between two points in foreign countries, Toronto and 
Paris. Under paragraph (h)(3)(i) of this section, the character of 
TC's communications activity is determined without regard to the 
fact that TC pays IC to transmit the communications for some portion 
of the delivery path. IC has international communications income 
under paragraph (h)(3)(ii) of this section because IC is paid to 
transmit the communications between a point in the United States and 
a point in a foreign country.
    Example 6. The paid-to-do rule--domestic communication via 
foreign route--(i) Facts. TC is paid to transmit a call between two 
points in the United States, but routes the call through Canada.
    (ii) Analysis. Under paragraph (h)(3)(i) of this section, the 
character of 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 (h)(3)(iii) of this section, TC 
derives income from U.S. communications activity because it is paid 
to transmit the communications between two U.S. points.
    Example 7. Indeterminate endpoints--prepaid telephone calling 
cards--(i) Facts. S purchases capacity from TC to transmit telephone 
calls. S sells prepaid telephone calling cards that give customers 
access to TC's telephone lines for a certain number of minutes. 
Assume that S cannot establish the endpoints of its customers' 
telephone calls.
    (ii) Analysis. S derives communications income as defined in 
paragraph (h)(2) of this section because S makes capacity to 
transmit communications available to its customers. In this case, S 
cannot establish the two points between which the communications are 
transmitted. Therefore, S's communications income is U.S. source 
income, as provided by paragraph (f) of this section.
    Example 8. Indeterminate endpoints--Internet access--(i) Facts. 
B, a domestic corporation, is an Internet service provider. B 
charges its customer, C, a monthly lump sum for Internet access. C 
accesses the Internet via a telephone call, initiated by the modem 
of C's personal computer, to one of B's control centers, which 
serves as C's portal to the Internet. B transmits data sent by C 
from B's control center in France to a recipient in England, over 
the Internet. B does not maintain records as to the beginning and 
endpoints of the transmission.
    (ii) Analysis. B derives communications income as defined in 
paragraph (h)(2) of this section. The source of B's communications 
income is determined under paragraph (f) of this section as income 
from sources within the United States because B cannot establish the 
two points between which it is paid to transmit the communications.
    Example 9. De minimis non-communications activity--(i) Facts. 
The same facts as in Example 8. Assume in addition that B replicates 
frequently requested sites on B's own servers, solely to speed up 
response time. Assume that B's replication of frequently requested 
sites would be considered a de minimis non-communications activity 
under this section.
    (ii) Analysis. On these facts, because B's replication of 
frequently requested sites would be considered a de minimis non-
communications activity, B is not required to treat the replication 
activity as a separate non-communications activity transaction under 
paragraph (h)(1) of this section. B derives communications income 
under paragraph (h)(2) of this section. The character and source of 
B's communications income are determined by demonstrating the points 
between which B is paid to transmit the communications, under 
paragraph (h)(3)(i) of this section.
    Example 10. Income derived from communications and non-
communications activity--bundled services--(i) Facts. A, a domestic 
corporation, offers customers local and long distance phone service, 
video, and Internet services. Customers pay a flat monthly fee plus 
10 cents a minute for all long-distance calls, including 
international calls.
    (ii) Analysis. Under paragraph (h)(1)(ii) of this section, to 
the extent that A's transaction with its customer consists in part 
of non-de minimis communications activity and in part of non-de 
minimis non-communications activity, each such part of the 
transaction must be treated as a separate transaction. A's gross 
income from the transaction is allocated to each such communications 
activity transaction and non-communications activity transaction in 
accordance with paragraph (h)(1)(ii) of this section. To the extent 
A can establish that it derives international communications income 
as defined in paragraph (h)(3)(ii) of this section, A would 
determine the source of such income under paragraph (b)(1) of this 
section. If A cannot establish the points between which it is paid 
to transmit communications, as required by paragraph (h)(3)(i) of 
this section, A's communications income is from sources within the 
United States, as provided by paragraph (f) of this section.
    Example 11. Income derived from communications and non-
communications activity--(i) Facts. B, a domestic corporation, is 
paid by D, a cable system operator in Foreign Country, to provide 
television programs and to transmit the television programs to 
Foreign Country. Using its own satellite transponder, B transmits 
the television programs from the United States to downlink 
facilities owned by D in Foreign Country. D receives the 
transmission, unscrambles the signals, and distributes the broadcast 
to D's customers in Foreign Country. Assume that B's provision of 
television programs is a non-de minimis non-communications activity, 
and that B's transmission of television programs is a non-de minimis 
communications activity.

    (ii) Analysis. Under paragraph (h)(1)(ii) of this section, B must 
treat its communications and non-communications activities as separate 
transactions. B's gross income is allocated to each such separate 
communications and non-communications activity transaction in 
accordance with paragraph (h)(1)(ii) of this section. Income derived by 
B from the transmission of television programs to D's Foreign Country 
downlink facility is international communications income as defined in 
paragraph (h)(3)(ii) of this section because B is paid to transmit 
communications from the United States to a foreign country.

    Example 12. Income derived from foreign communications 
activity--(i) Facts. S provides satellite capacity to B, a 
broadcaster located in Australia. B beams programming from Australia 
to the satellite. S's satellite picks the communications up in space 
and beams the programming over a footprint covering Southeast Asia.
    (ii) Analysis. S derives communications income as defined in 
paragraph (h)(2) of this section. S's income is characterized as 
foreign communications income under paragraph (h)(3)(iv) of this 
section because S picks up the communication in space, and beams it 
to a footprint entirely covering a foreign area. Under paragraph (d) 
of this section, S's foreign communications income is 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.

    (k) Reporting and documentation requirements--(1) In general. A 
taxpayer making an allocation of gross income under paragraph 
(b)(2)(iii), (b)(2)(iv), or (h)(1)(ii) of this section must satisfy the 
requirements in paragraphs (k)(2) and (3) of this section.
    (2) Required documentation. In all cases, a taxpayer must prepare 
and

[[Page 54878]]

maintain documentation in existence when its return is filed regarding 
the allocation of gross income, and allocation and apportionment of 
expenses, losses, and other deductions, the methodologies used, and the 
circumstances justifying use of those methodologies. The taxpayer must 
make available such documentation within 30 days upon request.
    (3) Access to software. If the taxpayer or any third party used any 
computer software, within the meaning of section 7612(d), to allocate 
gross income, or to allocate or apportion expenses, losses, and other 
deductions, the taxpayer must make available upon request--
    (i) Any computer software executable code, within the meaning of 
section 7612(d), used for such purposes, including an executable copy 
of the version of the software used in the preparation of the 
taxpayer's return (including any plug-ins, supplements, etc.) and a 
copy of all related electronic data files. Thus, if software 
subsequently is upgraded or supplemented, a separate executable copy of 
the version used in preparing the taxpayer's return must be retained;
    (ii) Any related computer software source code, within the meaning 
of section 7612(d), acquired or developed by the taxpayer or a related 
person, or primarily for internal use by the taxpayer or such person 
rather than for commercial distribution; and
    (iii) In the case of any spreadsheet software or similar software, 
any formulae or links to supporting worksheets.
    (4) Use of allocation methodology. In general, when a taxpayer 
allocates gross income under paragraph (b)(2)(iii), (b)(2)(iv), or 
(h)(1)(ii) of this section, it does so by making the allocation on a 
timely filed original return (including extensions). However, a 
taxpayer will be permitted to make changes to such allocations made on 
its original return with respect to any taxable year for which the 
statute of limitations has not closed as follows:
    (i) In the case of a taxpayer that has made a change to such 
allocations prior to the opening conference for the audit of the 
taxable year to which the allocation relates or who makes such a change 
within 90 days of such opening conference, if the IRS issues a written 
information document request asking the taxpayer to provide the 
documents and such other information described in paragraphs (k)(2) and 
(3) of this section with respect to the changed allocations and the 
taxpayer complies with such request within 30 days of the request, then 
the IRS will complete its examination, if any, with respect to the 
allocations for that year as part of the current examination cycle. If 
the taxpayer does not provide the documents and information described 
in paragraphs (k)(2) and (3) of this section within 30 days of the 
request, then the procedures described in paragraph (k)(4)(ii) of this 
section shall apply.
    (ii) If the taxpayer changes such allocations more than 90 days 
after the opening conference for the audit of the taxable year to which 
the allocations relate or the taxpayer does not provide the documents 
and information with respect to the changed allocations as requested in 
accordance with paragraphs (k)(2) and (3) of this section, then the IRS 
will, in a separate cycle, determine whether an examination of the 
taxpayer's allocations is warranted and complete any such examination. 
The separate cycle will be worked as resources are available and may 
not have the same estimated completion date as the other issues under 
examination for the taxable year. The IRS may ask the taxpayer to 
extend the statute of limitations on assessment and collection for the 
taxable year to permit examination of the taxpayer's method of 
allocation, including an extension limited, where appropriate, to the 
taxpayer's method of allocation.
    (l) Effective date. This section applies to taxable years beginning 
on or after the date of publication of final regulations in the Federal 
Register.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 05-18265 Filed 9-16-05; 8:45 am]
BILLING CODE 4830-01-P