[Federal Register Volume 71, Number 248 (Wednesday, December 27, 2006)]
[Rules and Regulations]
[Pages 77594-77612]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E6-22174]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9305]
RIN 1545-AW50


Source of Income From Certain Space and Ocean Activities; Source 
of Communications Income

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations under section 863(d) 
governing the source of income from certain space and ocean activities. 
It also contains final regulations under section 863(a), (d), and (e) 
governing the source of income from certain communications activities. 
In addition, this document contains final regulations under section 
863(a) and (b), amending the regulations in Sec.  1.863-3 to conform 
those regulations to these final regulations. The final regulations 
primarily affect 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). The final regulations also affect persons who 
derive income from transmission of communications.

DATES: Effective Date: These regulations are effective December 27, 
2006.
    Applicability Date: For dates of applicability, see Sec.  1.863-
8(h) and Sec.  1.863-9(l).

FOR FURTHER INFORMATION CONTACT: H. Michael Huynh, (202) 435-5161 (not 
a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in these final regulations 
have been reviewed and approved by the

[[Page 77595]]

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 collections of information in these final regulations are in 
Sec. Sec.  1.863-8(g) and 1.863-9(k). This information is required by 
the IRS to monitor compliance with the Federal tax rules for 
determining the source of income from space or ocean activities, or 
from transmission of communications.
    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.
    The estimated annual burden per respondent is 5 hours.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, 
SE:W:CAR:MP:T:T:SP, Washington, DC 20224, and to the Office of 
Management and Budget, Attn: Desk Officer for the Department of the 
Treasury, Office of Information and Regulatory Affairs, Washington, DC 
20503.
    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, Pub. L. No. 99-514, 100 Stat. 2085. Section 863(d) governs 
the source of income derived from space or ocean activities. Section 
863(e) governs the source of income derived from international 
communications activities.
    The Treasury Department and the IRS published a notice of proposed 
rulemaking (REG-106030-98) in the Federal Register on January 17, 2001 
(66 FR 3903), which provided proposed regulations under section 863(a), 
(b), (d), and (e) (the 2001 proposed regulations). The Treasury 
Department and 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 (AJCA), Pub. L. No. 108-357, 118 Stat. 1418, 
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 rules.
    In light of the extensive written comments, industry evolution, and 
AJCA changes, the Treasury Department and the IRS felt that it was 
appropriate to repropose these regulations to reflect these changes and 
to provide another opportunity for comment. Consequently, the Treasury 
Department and the IRS published another notice of proposed rulemaking 
in the Federal Register on September 19, 2005 (70 FR 54859), which 
withdrew the 2001 proposed regulations and provided new proposed 
regulations under section 863(a), (b), (d), and (e) (the proposed 
regulations). The proposed regulations provided two sets of rules: one 
in Sec.  1.863-8 for determining the source of income from space or 
ocean activities, the other in Sec.  1.863-9 for determining the source 
of income from communications activities.
    A public hearing on the proposed regulations was scheduled for 
December 15, 2005, but was ultimately cancelled because no one 
requested to speak. A few written comments, however, were received. 
These comments uniformly praised the proposed regulations as an 
improvement over the 2001 proposed regulations and generally were 
supportive of much of the proposed regulations. However, commentators 
suggested a few additional changes. After consideration of these 
comments, the proposed regulations are adopted as final regulations, as 
amended by this Treasury decision. The revisions to regulations 
governing the source of income from space or ocean activities and the 
source of income from communications activities are discussed in 
section A and section B, respectively, of this preamble.

Summary of Comments and Explanation of Revisions

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

    Section 863(d) governs the source of income from certain space or 
ocean activities. In general, section 863(d)(1) provides that, except 
as provided in regulations, any income derived from a space or ocean 
activity (space and ocean income) is income from sources within the 
United States (U.S. source income) if derived by a United States person 
and is income from sources without the United States (foreign source 
income) if derived by a foreign person. 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 types 
of activities from the definition of space or ocean activity. Space or 
ocean activity does not include any activity giving rise to 
transportation income governed by section 863(c), international 
communications income governed by section 863(e), or income with 
respect to mines, oil and gas wells, or other natural deposits to the 
extent within the United States or any foreign country or possession of 
the United States (as defined in section 638). See Section 
863(d)(2)(B).
    Section 1.863-8 of the proposed regulations generally provided 
rules for determining the source of income derived from space or ocean 
activity under section 863(d). Section 1.863-8(b)(1) of the proposed 
regulations reflected the general source rule under section 863(d)(1) 
that a United States person's space and ocean income is U.S. source 
income. Pursuant to the grant of regulatory authority under section 
863(d)(1), however, the proposed regulations provided an exception to 
this general rule. Under that exception, a United States person's space 
and ocean income is foreign source income (and therefore not sourced on 
the basis of citizenship or residency) 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.
    For a foreign person, proposed Sec.  1.863-8(b)(2) reflected the 
general source rule under section 863(d)(1) that a foreign person's 
space and ocean income is foreign source income. Pursuant to regulatory 
authority under section 863(d)(1), however, the proposed regulations 
contained two exceptions to this general rule, one for controlled 
foreign corporations (CFCs), the other for foreign persons engaged in a 
U.S. trade or business. The proposed regulations generally sourced 
space and ocean income derived by a CFC, like that of a United States 
person, as U.S. source income. However, also like the rule for a United 
States person, a CFC's space and ocean income is foreign source income 
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. For a foreign person, other 
than a CFC, engaged in a trade or business within the United

[[Page 77596]]

States, space and ocean income is U.S. source income to the extent it 
is attributable to functions performed, resources employed, or risks 
assumed within the United States.
    In addition to the general source rules for United States and 
foreign persons, the proposed regulations provided special rules, 
applicable to both United States and foreign persons, for income from 
services, certain sales of property, and communications activities 
(other than international communications activities). These special 
rules, as well as modifications to the proposed regulations, are 
discussed below.
1. Activities performed outside space and international water
    Section 1.863-8 of the proposed regulations provided source rules 
only for income from space or ocean activity. Thus, in some cases, 
income derived from a transaction must be allocated between space and 
ocean income and other income.
    For example, Sec.  1.863-8(b)(3)(ii)(C) of the proposed regulations 
provided that when property is produced both in space or international 
water and outside space and international water, gross income allocable 
to production activity is allocated to production occurring in space or 
international water and production occurring outside space and 
international water based on where functions are performed, resources 
are employed, or risks are assumed. The proposed regulations also 
provided a similar analysis of functions performed, resources employed, 
or risks assumed to allocate income in the case of performance of 
services. See Prop. Treas. Reg. Sec.  1.863-8(d)(2). Under the proposed 
regulations, only the amount allocated to production or performance of 
a service occurring in space or international water is treated as space 
and ocean income (character rule). The source of gross income allocated 
to production or performance of a service occurring in space or 
international water is then determined under the rules of proposed 
Sec.  1.863-8(b)(1) or (2), as applicable (source rule).
    Section 1.863-8(b)(1) of the proposed regulations reflected the 
general source rule that a United States person's space and ocean 
income is U.S. source income. Proposed Sec.  1.863-8(b)(2) reflected 
the general source rule that a foreign person's space and ocean income 
is foreign source income. Both proposed Sec.  1.863-8(b)(1) and (2), 
however, provided exceptions to their respective general source rules. 
As discussed above, under the exceptions, a United States person's 
space and ocean income may be foreign source income and a foreign 
person's space and ocean income may be U.S. source income based on 
where functions are performed, resources are employed, or risks are 
assumed.
    One commentator noted that in some situations, the allocation of 
income derived from a transaction to determine space and ocean income 
based on functions performed, resources employed, or risks assumed 
presumably would remove the subsequent need to further analyze 
functions performed, resources employed, or risks assumed within a 
country to determine the source of the space and ocean income. In other 
words, the very act of determining the character of income seems to 
also determine the source of such income.
    The Treasury Department and the IRS agree with the commentator that 
use of the same standard to classify the transaction as space or ocean 
activity and to source the space and ocean income may be duplicative in 
some cases. However, there are other cases where a transaction with 
some land-based activity may be classified in its entirety as a space 
or ocean activity (for example, a lease of a satellite), but the income 
may be partially U.S. source and partially foreign source under the 
source rules of proposed Sec.  1.863-8(b)(1) and (2) based on functions 
performed, resources employed, or risks assumed within the United 
States or a foreign country. Consequently, the character and source 
rules are not always duplicative.
    Thus, the extent to which the character rules overlap with the 
source rules is particular to the type of transaction involved. The 
Treasury Department and the IRS recognize that the overlap in the 
character and source rules may produce equivalent results. But, the 
overlap is necessary to provide taxpayers and the IRS with workable 
rules. As a result, the final regulations do not follow this comment as 
a general matter.
    Nonetheless, a conforming amendment has been made to the lease 
transaction in Example 1 in Sec.  1.863-8(f) of the final regulations 
to more clearly illustrate how the rules work. That example illustrates 
that the transaction involved is first classified in its entirety as a 
space or ocean activity, and then the resulting space and ocean income 
is subjected to the source rules. The space and ocean income is sourced 
as foreign source income 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. Activities performed by another person
    Section 1.863-8(a) of the proposed regulations provided that a 
taxpayer will not be considered to derive income from space or ocean 
activity if such activity is performed by another person. The approach 
under Sec.  1.863-8(a) of the proposed regulations, providing that a 
taxpayer derives income from a space or ocean activity only if it 
conducts such activity directly, is consistent with the approach 
adopted in the Sec.  1.863-3 regulations governing the source of income 
from certain sales of inventory. See, e.g., Treas. Reg. Sec.  1.863-
3(c) (``[T]he only production activities that are taken into account 
for purposes of Sec. Sec.  1.863-1, 1.863-2, and this section are those 
conducted directly by the taxpayer.'').
    Accordingly, commentators believed that this provision assured that 
a content provider that retains a satellite operator to transmit 
programming abroad would not derive space and ocean income based on 
attribution of the satellite operator's activity. The Treasury 
Department and the IRS agree.
    One commentator noted, however, that Examples 2 and 4 in Sec.  
1.863-8(f) of the proposed regulations seem to indicate that this is 
not what was intended. In Example 2, the taxpayer, an Internet service 
provider, transmits information requested by its customer, in part 
using satellite capacity leased from a third party. Example 2 concludes 
that the service performed by the taxpayer is considered space activity 
to the extent the value of the service is attributable to functions 
performed, resources employed, and risks assumed in space. In Example 
4, the taxpayer uses satellite capacity acquired from a third party to 
deliver programming services directly to its customers' televisions 
sets. Example 4 concludes that the taxpayer's delivery of programming 
and other services is considered space activity to the extent the value 
of the delivery transaction is attributable to performance in space. In 
the commentator's view, the results reached in the examples conflict 
with the provision stating that activities performed by another person 
are not attributable to the taxpayer.
    The Treasury Department and the IRS do not believe that Examples 2 
and 4 of Sec.  1.863-8(f) of the proposed regulations produce the 
result that the commentator raised. In Examples 2 and 4, the taxpayer 
performed the transmission or delivery activities using satellite 
capacity leased or acquired from a third party. Both Examples 2 and 4 
correctly conclude that the taxpayers derived space and ocean income 
from their own

[[Page 77597]]

activities rather than from activities of another person. Thus, the 
examples do not, in fact, conflict with the text of the proposed 
regulations. Nevertheless, the Treasury Department and the IRS are 
concerned that Examples 2 and 4 have been misinterpreted as suggesting 
that activities performed by another person may be attributable to the 
taxpayer in certain situations. This was not the intent of these 
examples. Consequently, Examples 2 and 4 in Sec.  1.863-8(f) of the 
final regulations have been modified to make clear that the taxpayers 
in the examples directly engage in a space activity by performing the 
uplink (transmitting to the satellite) and downlink functions.
    These examples differ from cases in which the taxpayer is a mere 
content provider that derives income either from the creation of 
content or from the creation and delivery of content, but in either 
case contracts with another person to deliver the content via 
satellite. Pursuant to Sec.  1.863-8(a) of the final regulations, 
content providers of this type would not derive space and ocean income 
because the delivery of the content via satellite is performed by 
another person. This would be the result even though the value of the 
customer contract includes a payment to the content provider for space 
or ocean activity. To clarify the distinction between these situations 
and Examples 2 and 4, a new Example 5 has been added to the final 
regulations. That example involves a content provider that does not 
derive space and ocean income because the taxpayer does not directly 
perform any space or ocean activity.
3. Income Characterization Rules for Income from Services and the De 
Minimis Exception
    Under Sec.  1.863-8(b)(4) of the proposed regulations, to the 
extent a service is characterized as space or ocean activity, the 
source of gross income derived from such transaction is determined 
under proposed Sec.  1.863-8(b)(1) or (2), as applicable. Section 
1.863-8(d)(2)(ii)(B) of the proposed regulations provided, however, 
that 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. The de minimis rule was 
adopted to address taxpayers' concerns about potential confusion in 
qualifying for the ``facilitation exception'' under the 2001 proposed 
regulations. One commentator stated that the de minimis rule simply 
replaced one vague standard with another, as neither Example 3 in Sec.  
1.863-8(f) of the proposed regulations nor the text of the proposed 
regulations provides any guidance as to when activities performed in 
space or international water would be de minimis under a facts and 
circumstances approach.
    The Treasury Department and the IRS recognize that issues of 
interpretation may arise in any facts and circumstances approach. 
Nevertheless, the Treasury Department and the IRS generally have 
refrained from adopting the alternative approach, to wit, adopting 
precise definitions and quantitative measures for a de minimis 
standard. Moreover, the inclusion of a precise definition and 
quantitative measures for determining de minimis value could raise 
equal, if not greater, concerns in terms of the quantitative threshold 
and other issues. Thus, the final regulations retain the de minimis 
standard for determining whether a taxpayer has space and ocean income. 
If the value of the service attributable to space or ocean activity is 
de minimis based on the facts and circumstances, the taxpayer will not 
derive space and ocean income. Nevertheless, the Treasury Department 
and the IRS agree that more guidance could be provided as to the 
application of the retained de minimis rule. Accordingly, Examples 3 
and 8 in Sec.  1.863-8(f) of the final regulations (Example 7 in the 
proposed regulations) provide clearer illustrations of when activities 
performed in space or international water would be considered de 
minimis for this purpose and when those types of activities would not 
be considered de minimis.
4. Source Rules for Income From Certain Sales of Property
    The proposed regulations provided special rules for income from 
certain sales of property, either when any production occurs in space 
or international water, or when the sale occurs in space or 
international water. In either case, section 863(d) and the proposed 
regulations applied to determine the source of income from the sales of 
property, and the rules of sections 861(a)(6), 862(a)(6), 863(a), 
863(b), and 865 apply only to the extent provided in the proposed 
regulations.
a. Sales of Property Produced in the United States and Sold in Space or 
International Water
    Section 1.863-8(b)(3)(ii) of the proposed regulations provided that 
when the taxpayer both produces property and sells such property, one-
half of the taxpayer's gross income will be considered income allocable 
to production activity and one-half of such gross income will be 
considered income allocable to sales activity. Taxpayers generally must 
then apply the rules of section 863(d) and the proposed regulations to 
determine the source of income allocable to production activity and 
sales activity.
    For production activity, the source of gross income allocable to 
production occurring in space or international water is generally based 
on the citizenship or residence of the taxpayer, applying the rules of 
proposed Sec.  1.863-8(b)(1) or (2), as applicable. The source of gross 
income allocable to production occurring outside space and 
international water is determined under section 863(b) rather than 
section 863(d). See Prop. Treas. Reg. Sec.  1.863-8(b)(3)(ii)(B) 
(referencing Treas. Reg. Sec.  1.863-3(c)(1)).
    As for sales activity, when property is sold in space or 
international water, the source of gross income allocable to sales 
activity is generally based on the citizenship or residence of the 
taxpayer, applying the rules of proposed Sec.  1.863-8(b)(1) or (2), as 
applicable. An exception to this general rule applied in cases when the 
property sold is inventory, 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, and the United States. 
In that case, the source of gross income allocable to sales activity is 
determined under Treas. Reg. Sec.  1.861-7(c) and Sec.  1.863-3(c)(2). 
Treas. Reg. Sec.  1.861-7(c) and Sec.  1.863-3(c)(2) generally provide 
for foreign source income where the seller's rights, title, and 
interest in the property are transferred to the buyer (the title 
passage rule) outside the United States and the property is not sold 
for use, consumption, or disposition in the United States. Treas. Reg. 
Sec.  1.861-7(c) and Sec.  1.863-3(c)(2) also applied to property sold 
outside space and international water. See Prop. Treas. Reg. Sec.  
1.863-8(b)(3)(ii)(D).
    One commentator believed that because certain U.S. manufacturers, 
such as U.S. satellite manufacturers, produce property that is sold in 
space or international water for use, consumption, or disposition in 
space or international water, they are at a disadvantage relative to 
U.S. manufacturers of other export property because the former may have 
U.S. source income with respect to income allocable to sales activity, 
while the latter may have foreign source income from sales activity.
    In response to comments on the 2001 proposed regulations, proposed 
Sec.  1.863-

[[Page 77598]]

8(b)(1) was revised to provide that space and ocean income will be 
foreign source income to the extent the space and ocean income is 
attributable to functions performed, resources employed, or risks 
assumed in a foreign country or countries. The Treasury Department and 
the IRS believe that this change may in many cases mitigate concerns 
about U.S. manufacturers potentially deriving 100 percent U.S. source 
income in these cases. Moreover, the Treasury Department and the IRS 
believe that the rules under the proposed regulations for determining 
the source of income allocable to sales activity are consistent with 
legislative intent to assert primary tax jurisdiction over income 
earned by United States persons that is not subject to foreign tax. See 
S. REP. NO. 99-313, 1986-3 C.B. 357-358 (``[T]he committee believes the 
United States should assert primary tax jurisdiction over income earned 
by its residents that is not within any foreign country's taxing 
jurisdiction* * *. Moreover, when a U.S. taxpayer conducts activities 
in space or international waters, foreign countries generally do not 
tax the income. Thus, the foreign tax credit limitation is inflated by 
income that is not within any foreign country's tax jurisdiction.''). 
Based on the legislative history, 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 or international 
water for use, consumption, or disposition outside space, international 
water, and the United States--should be considered space or ocean 
activity and that the source of income from such sales activity should 
be determined under section 863(d). As a result, no changes were made 
in response to this comment.
b. Purchased Versus Produced Property Sold for Use, Consumption, or 
Disposition in the United States
    One commentator questioned the appropriateness of differences in 
determining the source of sales income depending on whether the 
taxpayer produced or purchased the property sold. Under the proposed 
regulations, when property produced by the taxpayer is sold in space or 
international water, the source of gross income allocable to sales 
activity is generally based on the citizenship or residence of the 
taxpayer, applying the rules of proposed Sec.  1.863-8(b)(1) or (2), as 
applicable (and not the title passage rule)--subject to the foregoing 
inventory exception for property that will be used, consumed, or 
disposed of outside space, international water, and the United States. 
A slightly different rule applied to sales of property that had been 
purchased by the taxpayer. While the proposed regulations also provided 
that, for purchased property, the source of gross income allocable to 
sales activity is generally based on the citizenship or residence of 
the taxpayer, the inventory exception for purchased property only 
required that the property be used, consumed, or disposed of outside 
space and international water.
    The inventory exceptions for produced and purchased property were 
intended to produce different results when inventory property is used, 
consumed, or disposed of in the United States. In such case, the source 
of produced inventory property sales income is generally based on the 
citizenship or residence of the taxpayer, applying the rules of 
proposed Sec.  1.863-8(b)(1) or (2), because the inventory exception 
did not extend to produced property sold for use, consumption, or 
disposition in the United States. In contrast, the source of purchased 
inventory property sales income is generally based on title passage 
under Treas. Reg. Sec.  1.861-7(c) because the inventory exception did 
extend to purchased property even if it was sold for use, consumption, 
or disposition in the United States. The Treasury Department and the 
IRS believe that this difference between the produced and purchased 
property rules in the space and ocean context is consistent with the 
difference in the rules for sales of produced and purchased property 
outside the space and ocean context. In particular, under section 
863(a) and (b) and the regulations thereunder, if property is produced 
in the United States and sold for use, consumption, or disposition in 
the United States, the place of sale will be presumed to be the United 
States, and income attributable to the sales activity will be U.S. 
source income. See Sec.  1.863-3(c)(2). There is, however, no 
comparable rule for purchased property under section 862(a)(6) or the 
regulations thereunder. Thus, the final regulations simply continue in 
the space and ocean context the varying treatment elsewhere for sales 
of purchased property and sales of produced property.
    In response to comments, however, the produced and purchased 
property rules have been modified to be similar in structure and style, 
to better reflect and highlight the differences between these two 
rules.
5. Allocations
    Taxpayers must allocate gross income under paragraphs (b)(1) and 
(b)(2) of proposed Sec.  1.863-8 among U.S., foreign, and space or 
ocean activities. Under proposed Sec.  1.863-8(b)(3)(ii)(C), 
allocations are also made between production activity occurring in 
space or international water and that occurring outside space and 
international water. Finally, allocations are also made under proposed 
Sec.  1.863-8(b)(4) between services performed in space or 
international water and services performed outside space and 
international water. In performing these allocations, the proposed 
regulations generally provided that taxpayers should consider the 
relative value of functions performed, resources employed, or risks 
assumed in different locations. Moreover, the preamble to the proposed 
regulations provided that allocations should be based generally on 
section 482 principles. Commentators noted that little guidance is 
given as to the mechanics of allocation other than the statement that 
the principles of section 482 should be used. Commentators stated that 
allocation of gross income based on section 482 principles will result 
in added expense, uncertainty, and extra burden on multinational 
taxpayers who are already required to undertake and update functional 
analyses and satisfy substantial documentation requirements.
    While the final regulations were not changed in response to these 
comments, the Treasury Department and the IRS believe that some 
clarification is warranted. In suggesting the use of section 482 
principles as a guide, the Treasury Department and the IRS intend for 
taxpayers to adopt a reasonable approach to the allocations required in 
this area. Taxpayers know their businesses and will generally be in the 
best position to fashion a reasonable method that most reliably 
reflects the relative value of functions performed, resources employed, 
and risks assumed in different locations. In the preamble to the 
proposed regulations, the Treasury Department and the IRS solicited 
comments on alternative methods of allocation for particular industries 
and criteria that could be used to evaluate the reasonableness of such 
methods. No such comments were received. One commentator noted, 
however, that the proposed regulations perhaps reflected what taxpayers 
in these industries have already been doing in order to determine the 
character and source of their space and ocean income. Consequently, the 
Treasury Department and the IRS believe that allocations of gross 
income based on functions performed, resources employed, and

[[Page 77599]]

risks assumed are appropriate in these circumstances.
6. Separation of a Single Transaction and Aggregation of Multiple 
Transactions
    Paragraphs (d)(1)(i) and (d)(1)(ii) of Sec.  1.863-8 of the 
proposed regulations provided that for purposes of determining space or 
ocean activity, the Commissioner may separate parts of a single 
transaction or combine separate transactions into a single transaction. 
One commentator stated that this is a ``one-way'' street, as only the 
Commissioner has the authority to separate or combine transactions for 
purposes of the proposed regulations.
    The final regulations do not change this rule. The Treasury 
Department and the IRS believe taxpayers are not inappropriately 
disadvantaged by this rule because taxpayers generally have the ability 
to structure their transactions in line with the economic prospects of 
their businesses. In addition, the Commissioner's ability to separate 
or combine transactions is not unfettered. Rather, the Commissioner may 
only separate or combine transactions to better reflect the value of 
functions performed, resources employed, or risks assumed. A taxpayer 
can always protect itself against recharacterization by adopting an 
arrangement that appropriately reflects the economic realities of a 
transaction or series of transactions. The taxpayer is clearly in the 
best position at the outset to structure its arrangements in this 
manner. In addition, taxpayers traditionally are not permitted to 
restructure retroactively the form of their completed transactions. 
Thus, the Treasury Department and the IRS believe that the limited 
``one-way'' rule is appropriate in this case.
7. Income Derived From the Leasing of Shipping Cargo Containers
    One commentator requested that the Treasury Department and the IRS 
make clear that the final regulations under section 863(d) do not apply 
to income derived from the leasing of shipping cargo containers and 
that such income should be treated as rental income, sourced under 
sections 861 and 862. This commentator noted that valid arguments also 
exist for treating income derived from the leasing of shipping cargo 
containers as transportation income; however, in the commentator's 
view, the most appropriate treatment is rental income treatment, 
sourced under sections 861 and 862.
    The treatment of income derived from the leasing of shipping cargo 
containers is not covered by these final regulations. Instead, the 
Treasury Department and the IRS intend to address the treatment of such 
income explicitly in separate guidance. That guidance may apply section 
863(c), section 863(d), or other provisions to source income derived 
from the leasing of shipping cargo containers. Any such guidance will 
be prospective in nature. Until such time, the treatment of such income 
will be determined under existing law.

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

    Section 863(e) governs the source of income from international 
communications activities (international communications income). 
International communications income is defined in section 863(e)(2) as 
income derived from the transmission of communications or data between 
the United States and a foreign country (or possession of the United 
States). Section 863(e)(1)(A) provides that any international 
communications income of a United States person is sourced 50 percent 
in the United States and 50 percent outside the United States (50/50 
source rule). Section 863(e)(1)(A) does not provide for any statutory 
or regulatory exceptions to this 50/50 source rule. In contrast, 
section 863(e)(1)(B)(i) provides that any international communications 
income of a foreign person is sourced outside the United States, except 
as provided in regulations or in section 863(e)(1)(B)(ii). The 
exception under section 863(e)(1)(B)(ii) provides that if a foreign 
person maintains an office or other fixed place of business in the 
United States, any international communications income attributable to 
such office or other fixed place of business is U.S. source income.
    Section 1.863-9 of the proposed regulations generally provided 
rules for determining the source of international communications income 
under section 863(e) and other communications income under section 
863(a) and (d). Proposed Sec.  1.863-9(b)(1) reflected the rule under 
section 863(e)(1)(A) that a United States person's international 
communications income is 50 percent U.S. source income and 50 percent 
foreign source income. Proposed Sec.  1.863-9(b)(2) reflected the 
general rule under section 863(e)(1)(B) that a foreign person's 
international communications income is foreign source income.
    Consistent with the statutory exception under section 
863(e)(1)(B)(ii), proposed Sec.  1.863-9(b)(2)(iii) provided that any 
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 U.S. source 
income. 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. In addition to the statutory exception under 
section 863(e)(1)(B)(ii), section 863(e)(1)(B) provides general 
regulatory authority to depart from the general 100 percent foreign 
source rule for foreign persons. Thus, pursuant to this regulatory 
authority, the proposed regulations contained additional exceptions to 
the general rule applicable to foreign persons. In particular, the 
proposed regulations provided that international communications income 
derived by a CFC is 50 percent U.S. source income and 50 percent 
foreign source income (the same as for United States persons). The 
proposed regulations also provided that 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.
    In addition to the general source rules for international 
communications income of United States and foreign persons, the 
proposed regulations also provided rules, applicable to both United 
States and foreign persons, for income from U.S. communications, 
foreign communications, space/ocean communications, and communications 
where endpoints are indeterminate. These rules, as well as 
modifications to the proposed regulations, are discussed below.
1. Income Characterization Rules for Communications Income
    Section 1.863-9(h)(3) of the proposed regulations provided that the 
type of communications activity (and thus the applicable source rule) 
is determined by identifying the two points between which the taxpayer 
is paid to transmit the communication. For United States and foreign 
persons, U.S. communications income is entirely U.S. source income. A 
taxpayer derives U.S. communications income when the taxpayer is paid 
to transmit between two points in the United States or between the 
United States and a point in space or international water. In contrast, 
foreign communications income is entirely foreign source income for 
United States and foreign

[[Page 77600]]

persons. A taxpayer derives foreign communications income when the 
taxpayer is paid to transmit between two points in a foreign country or 
countries (or a possession or possessions of the United States), 
between a foreign country and a possession of the United States, or 
between a foreign country (or a possession of the United States) and a 
point in space or international water. Finally, the proposed 
regulations provided different source rules for international 
communications income of United States and foreign persons. See section 
B.3 of this preamble for further discussion. A taxpayer derives 
international communications income 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). When a taxpayer cannot 
establish the two points between which the taxpayer is paid to transmit 
the communication, Sec.  1.863-9(f) of the proposed regulation provided 
a default source rule under which all the income derived by the 
taxpayer from such communications activity is U.S. source income.
    Commentators stated that the treatment of communications income as 
U.S. source income when the endpoints are indeterminate is overbroad 
and harsh, particularly as it relates to foreign taxpayers. 
Commentators also stated that taxpayers would have to commit 
significant resources to develop the technology necessary to identify 
the endpoints of communications. One commentator stated that it is 
unclear that a reliable system can be created at any expense to 
establish the endpoints of the transmission under all circumstances. 
Commentators suggested instead the use of any reasonable method to 
establish the endpoints between which a taxpayer is paid to transmit 
the communications. One commentator suggested that the Treasury 
Department and the IRS consider employing the Industry Issue Resolution 
Program or Prefiling Agreement Program as aids in the administration of 
a reasonable method rule.
    The Treasury Department and the IRS solicited 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 solicited comments on methods to establish 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. In response, one commentator submitted examples of 
reasonable methods to establish the endpoints between which a taxpayer 
is paid to transmit the communications. The examples relied on 
statistical reports of data such as minutes used, areas of 
transmission, port locations, and transport charges. This commentator 
noted that current federal regulations already require 
telecommunications companies to submit some of these reports to certain 
governmental agencies, for example, the Federal Communications 
Commission.
    In light of the potential complexity in identifying the type of 
communications activity and in response to comments, the final 
regulations provide that a taxpayer may satisfy the requirement that 
the taxpayer establish the two points between which the taxpayer is 
paid to transmit, and bears the risk of transmitting, the communication 
by using any consistently applied reasonable method to establish one or 
both endpoints. In doing so, the taxpayer carries the burden of proof 
and must establish that the method used is reasonable (taking into 
account all of the facts and circumstances) and is consistently 
applied. In satisfying its burden of proof, a taxpayer will need to 
maintain reasonable records of communications activities. Depending on 
the facts and circumstances, methods based on, for example, records of 
port or transport charges, customer billing records, a satellite 
footprint, or records of termination fees made pursuant to an 
international settlement agreement may be reasonable. In addition, 
practices used by taxpayers to classify or categorize certain 
communications activity in connection with preparation of statements 
and analyses for the use of management, creditors, minority 
shareholders, joint ventures, or other parties or governmental agencies 
in interest may be reliable indicators of the reasonableness of the 
method chosen, but need not be accorded conclusive weight by the 
Commissioner. Furthermore, in evaluating the reasonableness of the 
method chosen, consideration will be given to all the facts and 
circumstances, including whether the endpoints would otherwise be 
identifiable absent this reasonable method provision.
    Along with resultant changes made to the text of the final 
regulations, several examples have been added to Sec.  1.863-9(j) of 
the final regulations that illustrate instances where the taxpayer may 
be able to use reasonable methods to determine the endpoints between 
which the taxpayer is paid to transmit the communications.
2. The Paid-to-do Rule With Respect to Foreign-Originating 
Communications
    Under the proposed regulations, a taxpayer derives income from a 
certain type of communications activity (for example, foreign 
communications or international communications) only if the taxpayer is 
paid to transmit, and bears the risk of transmitting (the paid-to-do 
rule), the communications of such type. See Prop. Treas. Reg. Sec.  
1.863-9(h)(2) and (3). This is the case even if the taxpayer contracts 
out the transmission function.
    Commentators stated that application of the paid-to-do rule in all 
instances would give rise to results that are inconsistent with 
Congressional intent and may result in excessive amounts of U.S. source 
income. One commentator noted that in some cases, while it is clear 
that a communication originated in a foreign country and that a U.S. 
telecommunications company is paid to terminate the foreign-originating 
traffic in the United States, it is unclear exactly where the U.S. 
telecommunications company picked up the communication. This lack of 
clarity often may be due to legal restrictions in certain foreign 
countries on ownership of capacity and carriage of transmissions by 
non-nationals. It can also be due to the fact that the international 
settlement agreements under which major international 
telecommunications carriers operate often do not specify where the 
traffic is picked up or handed off, and in some cases the hand-off 
point is specified by reference to a mid-point convention, even though 
the transmission signal, from a technical standpoint, travels from end-
to-end with no real points in-between. The commentator further stated 
that at the time section 863(e) was enacted, U.S. carriers were 
generally not allowed to own and operate facilities in foreign 
countries; specifically, no U.S. carrier could carry a foreign-to-U.S. 
or U.S.-to-foreign transmission end-to-end. Thus, concluded the 
commentator, Congress focused on the endpoints of the communications 
rather than where the activities constituting the transmission of 
communications take place. The commentator suggested a rule that would 
provide that when a taxpayer is paid to transmit foreign-originating 
communications from a point outside the United States to a point in the 
United States, the taxpayer should be deemed to have been paid to 
transmit the communications from a point in the foreign country in 
which the communication originated.
    Upon further consideration, the Treasury Department and the IRS

[[Page 77601]]

believe that the paid-to-do rule may be over-inclusive in certain 
cases. Accordingly, the final regulations provide that international 
communications income also includes income derived from communications 
activity when the taxpayer is paid to transmit foreign-originating 
communications (communications with a beginning point in a foreign 
country or a possession of the United States) from a point in space or 
international water to a point in the United States. Also, a new 
example has been added to Sec.  1.863-9(j) of the final regulations to 
illustrate the changes made in the final regulations with respect to 
foreign-originating communications.
    The changes made in the final regulations only affect 
communications that originate in a foreign country (or a possession of 
the United States) and does not affect communications that originate in 
space, international water, or 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.
3. Determining the Source of Communications Income Based on Functions 
Performed, Resources Employed, or Risks Assumed in a Foreign Country or 
Countries
    As discussed above, the proposed regulations provided that the 
source of communications income is largely dependant on the type of 
communications activity and the citizenship or residence of the 
taxpayer. However, the proposed regulations provided for two instances 
where (in addition to the type of communications activity and the 
citizenship or residence of the taxpayer) the source of communications 
income may depend on functions performed, resources employed, or risks 
assumed. First, the proposed regulations provided that 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 U.S. source income. The 
proposed regulations provided that 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. Second, the proposed 
regulations provided that 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.
    Commentators suggested that the final regulations also provide for 
similar rules that would source communications income as foreign source 
income based on functions performed, resources employed, or risks 
assumed in a foreign country or countries. For example, one commentator 
suggested that the source of international and U.S. communications 
income derived by any United States or foreign person (including 
branches, partnerships, and disregarded entities) engaged in a trade or 
business in a foreign country or countries 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 such foreign country or 
countries.
    While the Treasury Department and the IRS recognize that 
commentators' suggestion to provide for a source rule based on 
functions performed, resources employed, or risks assumed in a foreign 
country or countries is reasonable, as explained below, the Treasury 
Department and the IRS believe that the statute and legislative history 
preclude such an option.
a. International Communications Income
    Consistent with section 863(e)(1)(A), proposed Sec.  1.863-9(b)(1) 
provided that international communications income of a United States 
person is 50 percent U.S. source income and 50 percent foreign source 
income. One commentator suggested that it may be appropriate, in 
certain situations, to depart from the 50/50 source rule to provide 
special rules for foreign activities. According to the commentator, as 
a result of local regulatory requirements, U.S.-based international 
telecommunications providers often need to conduct portions of their 
international business through locally formed entities, and such 
entities are fully subject to foreign tax on their income. The 
commentator therefore concluded that a source rule for international 
communications income based on functions performed, resources employed, 
or risks assumed in a foreign country or countries is not only 
equitable but also consistent with treatment accorded to foreign 
persons having a U.S. fixed placed of business or engaged in a U.S. 
trade or business.
    The Treasury Department and the IRS recognize that a source rule 
based on functions performed, resources employed, or risks assumed may 
be a reasonable alternative to the 50/50 source rule. Nonetheless, they 
continue to believe that the 50/50 source rule is the method that must 
be used to determine the source of a United States person's 
international communications income. This is because section 
863(e)(1)(A) provides for an explicit 50/50 source rule for those 
persons without exception. In contrast, section 863(e)(1)(B) provides 
that a foreign person's international communications income is 
generally sourced outside the United States, except as provided in 
regulations. The Treasury Department and the IRS believe that the 
express grant of regulatory authority in the case of foreign persons 
and the omission of any such authority in the case of United States 
persons indicate that Congress intended the 50/50 sourcing rule be 
applied to United States persons without regulatory modification. There 
is nothing in the statute or legislative history that clearly 
demonstrates a different intention. In contrast, section 
863(e)(1)(B)(ii) provides for a special source rule with respect to 
foreign persons with an office or other fixed place of business in the 
United States. A similar rule is not provided with respect to a United 
States person's foreign activities. Thus, Congress chose a rule that 
sourced international communications income of foreign persons in 
certain instances based on the place of their activities, but expressly 
chose the 50/50 method to source international communications income of 
United States persons, regardless of the place of their activities.
    The Treasury Department and the IRS recognize that the statute does 
not require strict application of the 50/50 source rule for CFCs. 
Section 863(e)(1)(B) only provides that the international 
communications income of a foreign person is foreign source income, 
except as provided in regulations. Consistent with and in light of this 
regulatory authority, however, the Treasury Department and the IRS 
believe that the 50/50 source rule is the most appropriate method to 
determine the source of a CFC's international communications income. 
This approach addresses the concern of the Treasury Department and the 
IRS that United States persons may use CFCs to obtain benefits that are 
inconsistent with the purposes of section 863(e). Consequently, the 
rules for determining the source of international

[[Page 77602]]

communications income derived by a CFC should be the same as the rules 
for determining the source of such income if it is derived by a United 
States person. In addition, the Treasury Department and the IRS believe 
that the 50/50 source rule for CFCs, as opposed to the 100 percent U.S. 
source rule that was originally proposed as part of the 2001 proposed 
regulations, should limit the potential for multiple levels of taxation 
that commentators raised with respect to those prior proposed 
regulations.
b. U.S. Communications Income
    Section 1.863-9(c) of the proposed regulations provided that income 
derived by a United States or foreign person from U.S. communications 
activity is entirely from sources within the United States. One 
commentator noted that a foreign person deriving income from the 
transmission of communications between a point in the United States and 
another point in the United States or between a point in the United 
States and a point in space or international water has 100 percent U.S. 
source income, even if much or all of the activity involved is outside 
the United States. In contrast, under the space and ocean rules, a 
foreign person has U.S. source income only to the extent the income is 
attributable to functions performed, resources employed, or risks 
assumed within the United States. Commentators therefore suggested 
modification of the 100 percent U.S. source rule for U.S. 
communications income derived by United States and foreign persons to 
take into account foreign activities.
    The Treasury Department and the IRS recognize that a source rule 
based on functions performed, resources employed, or risks assumed may 
be a reasonable alternative to the 100 percent U.S. source rule for 
U.S. communications. Nonetheless, the Treasury Department and the IRS 
believe that Congress did not intend such an option. The legislative 
history indicates that if a communication is between two points within 
the United States, the ``income attributable thereto is to be sourced 
entirely as U.S. source income.'' S. Rep. No. 99-313, 1986-3 C.B. 359 
(emphasis added). Congress intended such a result ``even if the 
communication is routed through a satellite located in space, 
regardless of the satellite's location.'' Id. Thus, the legislative 
history clearly provides that Congress intended that U.S. 
communications income be sourced entirely as U.S. source income.
4. International Communications Income Derived by a Foreign Person 
(Other Than a CFC)
    Proposed Sec.  1.863-9(b)(2) reflected the general rule under 
section 863(e)(1)(B) that a foreign person's international 
communications income is foreign source income. Consistent with the 
statutory exception under section 863(e)(1)(B)(ii), proposed Sec.  
1.863-9(b)(2)(iii) provided that any 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 U.S. source income. 
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. Pursuant to the grant of regulatory authority under 
section 863(e)(1)(B), the proposed regulations provided other 
exceptions to the general rule for foreign persons. The first exception 
is the 50/50 source rule for CFCs under Sec.  1.863-9(b)(2)(ii) of the 
proposed regulations, as discussed above. The second exception was 
provided in Sec.  1.863-9(b)(2)(iv) of the proposed regulations and 
applied to foreign persons other than CFCs. Section 1.863-9(b)(2)(iv) 
of the proposed regulations provided that international communications 
income derived by a foreign person, other than a CFC, engaged in a 
trade or business within the United States, that is attributable to 
functions performed, resources employed, or risks assumed within the 
United States is U.S. source income. One commentator noted that it is 
unclear why a separate rule is needed for a fixed place of business in 
the United States and a U.S. trade or business because international 
communications income attributable to a fixed place of business in the 
United States should also be attributable to functions performed, 
resources employed and risks assumed within the United States.
    As indicated, the office or other fixed place of business rule 
under Sec.  1.863-9(b)(2)(iii) of the proposed regulations was derived 
from the statutory language of section 863(e), while the trade or 
business rule under Sec.  1.863-9(b)(2)(iv) of the proposed regulations 
was derived from the express grant of regulatory authority to source 
international communications income of foreign persons as other than 
foreign source. The Treasury Department and the IRS recognize that in 
most situations, the latter trade or business rule would indeed subsume 
the former fixed place of business rule, but still believe that the 
later rule serves an important function. The trade or business rule 
addresses 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.
5. Allocations
    Section 1.863-9(h)(1)(ii) of the proposed regulations provided that 
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 part of the transaction must be treated 
as a separate transaction. Gross income is then allocated to each 
communications activity transaction and each 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. Moreover, the 
Treasury Department and the IRS suggested in the preamble to the 
proposed regulations that allocations of gross income should be based 
generally on section 482 principles. One commentator stated that the 
complexities inherent in allocating income, based on section 482 
principles, between the separated transactions are significant.
    While the final regulations were not changed in response to this 
comment, as in the case of allocations for space and ocean income, the 
Treasury Department and the IRS believe that some clarification is 
warranted. In suggesting the use of section 482 principles as a guide, 
the Treasury Department and the IRS intend for taxpayers to adopt a 
reasonable approach to the allocations required in this area. Taxpayers 
know their businesses and will generally be in the best position to 
fashion a reasonable method that most reliably reflects the relative 
value of functions performed, resources employed, and risks assumed in 
different locations. In the preamble to the proposed regulations, the 
Treasury Department and the IRS solicited comments on alternative 
methods of allocation for particular industries and criteria that could 
be used to evaluate the reasonableness of such methods. No such 
comments were received. One commentator noted, however, that the 
proposed regulations perhaps reflected

[[Page 77603]]

what taxpayers in these industries have already been doing in order to 
determine the character and source of their communications income. 
Consequently, as in the case of space and ocean income, the Treasury 
Department and the IRS believe that allocations of gross income based 
on functions performed, resources employed, and risks assumed are 
appropriate in these circumstances.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment 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, the 
NPRM preceding these regulations were submitted to the Chief Counsel 
for Advocacy of the Small Business Administration for comment on their 
impact on small business.

Drafting Information

    The principal author of these regulations is H. Michael Huynh 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

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order to read, in part, as follows:

    Authority: 26 U.S.C. 7805 * * *.
    Section 1.863-8 also issued under 26 U.S.C. 863(a), (b) and (d). 
* * *
    Section 1.863-9 also issued under 26 U.S.C. 863(a), (d) and (e). 
* * *

0
Par. 2. Section 1.863-3 is amended by:
0
1. Adding a sentence after the first sentence in paragraph (a)(1).
0
2. Adding a sentence at the end of paragraph (c)(1)(i)(A).
0
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. * * *
* * * * *

0
Par. 3. Sections 1.863-8 and 1.863-9 are added to read as follows:


Sec.  1.863-8  Source of income derived 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 United States person. Space and ocean 
income derived by a United States person is income from sources within 
the United States. However, space and ocean income derived by a United 
States 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 United 
States 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 
sold for use, consumption, or disposition outside space and 
international water, the

[[Page 77604]]

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, and 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)).
    (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;

[[Page 77605]]

    (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));
    (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 and international water is de 
minimis, such service will not be treated as space or ocean activity.
    (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 United States 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 in its entirety as space activity under 
paragraph (d)(1)(i) of this section. Income derived from the lease 
will be sourced 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 performs the uplink and downlink 
functions. 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. The 
satellite is used as a medium of delivery and not as a method of 
surveillance. 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. 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. S can demonstrate, pursuant to paragraph (d)(2)(ii) of 
this section, that based on all the facts and circumstances, the 
value of S's service transaction attributable to performance in 
space is de minimis. Thus, 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). O's provision of transponder capacity is viewed as the 
provision of a service. Based on all the facts and circumstances, 
the value of O's service transaction attributable to performance

[[Page 77606]]

in space is not de minimis. Thus, 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. L performs the 
uplink and downlink functions, 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--(i) Facts. The facts are the same as 
in Example 4, except that L does not deliver the programming service 
directly but instead engages R, a domestic corporation specializing 
in content delivery, to deliver by transmission its programming. For 
all portions of a transmission which require satellite capacity, R, 
in turn, contracts out such functions to S. S performs the uplink 
and downlink functions, so that part of the value of the delivery 
transaction derives from functions performed and resources employed 
in space.
    (ii) Analysis. L's activity will not be considered space 
activity because none of L's activity occurs in space. Thus, L does 
not derive any space and ocean income. L does, however, derive 
communications income within the meaning of Sec.  1.863-9(h)(2). 
This is the case even though L does not perform the transmission 
function because L is paid by Customer C to transmit, and bears the 
risk of transmitting, the communications or data. To the extent that 
L's activity consists in part of non-de minimis communications and 
non-de minimis non-communications activity, each part of the 
transaction must be treated as a separate transaction and gross 
income is allocated accordingly under Sec.  1.863-9(h)(1)(ii). In 
addition, L must also allocate expenses, losses, and other 
deductions, for example, payments to R, to the class or classes of 
gross income that include the income so allocated. R's activity will 
not be considered space activity. Since R contracts out all of the 
functions involving satellite capacity to S, no part of R's activity 
occurs in space. Thus, R does not derive any space and ocean income. 
R does, however, derive communications income within the meaning of 
Sec.  1.863-9(h)(2). This is the case even though R does not perform 
the transmission function because R is paid by L to transmit, and 
bears the risk of transmitting, the communications or data. S's 
activity will be considered space activity. To the extent that S 
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 6. Space activity--treatment of land activity--(i) 
Facts. S, a United States person, offers remote imaging products and 
services to its customers. In year 1, S uses its satellite's remote 
sensors to gather data on certain geographical terrain. In year 3, 
C, a construction development company, contracts with S to obtain a 
satellite image of an area for site development work. S pulls data 
from its archives and transfers to C the images gathered in year 1, 
in a transaction that is characterized as a sale of the data. 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 7. 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 8. 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. Based on all the facts and circumstances, the 
value of E's service transaction attributable to performance in 
space is not de minimis. Thus, 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 9. Separate transactions--(i) Facts. The same facts as 
Example 8, 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 8.
    Example 10. 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

[[Page 77607]]

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 11. Sale of property in space--(i) Facts. S, a United 
States person, manufactures a satellite in the United States and 
sells it to a customer who is not a United States 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 12. 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 13. 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 14. 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) In 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
    (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 December 27, 2006.


Sec.  1.863-9  Source of income derived from communications activity 
under section 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

[[Page 77608]]

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 United States person. 
Income derived from international communications activity 
(international communications income) by a United States 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 United States 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. The source of 
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 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/

[[Page 77609]]

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. A taxpayer may satisfy the 
requirement that the taxpayer establish the two points between which 
the taxpayer is paid to transmit, and bears the risk of transmitting, 
the communication by using any consistently applied reasonable method 
to establish one or both endpoints. In evaluating the reasonableness of 
such method, consideration will be given to all the facts and 
circumstances, including whether the endpoints would otherwise be 
identifiable absent this reasonable method provision and the 
reliability of the data. Depending on the facts and circumstances, 
methods based on, for example, records of port or transport charges, 
customer billing records, a satellite footprint, or records of 
termination fees made pursuant to an international settlement agreement 
may be reasonable. In addition, practices used by taxpayers to classify 
or categorize certain communications activity in connection with 
preparation of statements and analyses for the use of management, 
creditors, minority shareholders, joint ventures, or other parties or 
governmental agencies in interest may be reliable indicators of the 
reasonableness of the method chosen, but need not be accorded 
conclusive weight by the Commissioner. In all cases, the method chosen 
to establish the two points between which the taxpayer is paid to 
transmit, and bears the risk of transmitting, the communication must be 
supported by sufficient documentation to permit verification by the 
Commissioner.
    (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--
    (A) Between a point in the United States and a point in a foreign 
country (or a possession of the United States); or
    (B) Foreign-originating communications (communications with a 
beginning point in a foreign country or a possession of the United 
States) from a point in space or international water to a point in 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, except as provided in paragraph (h)(3)(ii)(B) of this section.
    (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 United States 
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.
    Example 4. Income derived from international communications 
activity--satellite--(i) Facts. S, a United States 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 United 
States 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)

[[Page 77610]]

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. The paid-to-do rule--foreign-originating 
communications--(i) Facts. Under an international settlement 
agreement, G, a Country X international carrier, pays T to receive 
all calls originating in Country X that are bound for the United 
States and to terminate such calls in the United States. Due to 
Country X legal restrictions, the international settlement agreement 
specifies that G carries the transmission to a point outside the 
territory of Country X and that T carries the foreign-originating 
transmission from such point to the destined point in the United 
States. T, in turn, contracts out with another communications 
company, S, to transmit the U.S. portion of the communications. 
Tracing and identifying the endpoints of each transmission is not 
possible or practical. T does, however, keep records of termination 
fees received from G for terminating the foreign-originating calls.
    (ii) Analysis. T derives communications income as defined in 
paragraph (h)(2) of this section. Based on all the facts and 
circumstances, T can establish that T is paid to transmit, and bears 
the risk of transmitting, foreign-originating calls from a point in 
space or international water to a point in the United States using a 
reasonable method to establish the endpoints, assuming that this 
method is consistently applied. In this case, T can reasonably 
establish that T is paid to receive foreign-originating calls and 
terminate such calls in the United States based on the records of 
termination fees pursuant to an international settlement agreement. 
Under paragraph (h)(3)(ii)(B) of this section, a taxpayer derives 
income from international communications activity when the taxpayer 
is paid to transmit foreign-originating communications from space or 
international water to the United States. Thus, under paragraph 
(h)(3)(ii)(B) of this section, T derives income from international 
communications. If, based on all the facts and circumstances, T 
could reasonably trace and identify the endpoints, then T would have 
to directly establish that each call originated in a foreign 
country. Assuming T is able to do so, the rest of the analysis in 
this Example 7 remains the same. Under paragraph (h)(3)(iii) of this 
section, S derives income from U.S. communications activity because 
S is paid to transmit the communications between two U.S. points.
    Example 8. 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, even under the reasonable method rule of paragraph 
(h)(3) of this section.
    (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 9. Reasonable methods--minutes of use data on long 
distance calling plans--(i)Facts. B provides both domestic and 
international long distance services in a calling plan for a limited 
number of minutes for a set amount each month. Tracing and 
identifying the endpoints of each transmission is not possible or 
practical. B is, however, able to establish that the calling plan 
generated $10,000 of revenue for 25,000 minutes based on reports 
derived from customer billing records. Based on minutes of use data 
in these reports, B is able to establish that of the total 25,000 
minutes, 60 percent or 15,000 minutes were for U.S. long distance 
calls and 40 percent or 10,000 minutes were for international calls.
    (ii) Analysis. B derives communications income as defined in 
paragraph (h)(2) of this section. Based on all the facts and 
circumstances, B can establish the two points between which B is 
paid to transmit, and bears the risk of transmitting, the 
communications using a reasonable method to establish the endpoints, 
assuming that this method is consistently applied. In this case, B 
can reasonably establish that 60 percent of the income derived from 
the long distance calling plan is U.S. communications income and 40 
percent is international communications income based on the minutes 
of use data derived from customer billing records to establish the 
endpoints of the communications. If, based on all the facts and 
circumstances, B could reasonably trace and identify the endpoints, 
then B would have to directly identify the endpoints between which B 
is paid to transmit the communications.
    Example 10. Reasonable methods--system design--(i) Facts. D 
operates satellites which are designed to transmit signals through 
two separate ranges of signal frequencies (bands). Due to 
technological limitations, requirements, and practicalities, one 
band is designed to only transmit signals within the United States. 
The other band is designed to transmit signals between foreign 
countries and the United States. D cannot trace and identify the 
endpoints of each individual transmission. D does, however, track 
the total transmission through each band and the total income 
derived from transmitting signals through each band.
    (ii) Analysis. D derives communications income as defined in 
paragraph (h)(2) of this section. Based on all the facts and 
circumstances, D can establish the two points between which D is 
paid to transmit, and bears the risk of transmitting, the 
communications using a reasonable method to establish endpoints, 
assuming that this method is consistently applied. In this case, D 
can reasonably establish that income derived from transmissions 
through the first band is U.S. communications income and income 
derived from transmissions through the second band is international 
communications income based on the design of the bands to establish 
the endpoints of the communications.
    Example 11. Reasonable methods--port locations--(i) Facts. X 
provides its customer, C, with a virtual private network (VPN) so 
that C's U.S. headquarter office canconnect and communicate with 
offices in the United States, Country X, Country Y, and Country Z. 
Assume that the VPN is only for communications with the U.S. 
headquarter office. X cannot trace and identify the endpoints of 
each transmission. C pays X a set amount each month for the entire 
service, regardless of the magnitude of the usage or the geographic 
points between which C uses the service.
    (ii) Analysis. X derives communications income as defined in 
paragraph (h)(2) of this section. Based on the facts and 
circumstances, X can establish the two points between which X is 
paid to transmit, and bears the risk of transmitting, the 
communications using a reasonable method to establish endpoints, 
assuming that this method is consistently applied. In this case, X 
can reasonably establish that one-fourth of the income derived from 
the VPN service is U.S. communications income and three-fourths is 
international communications income based on the location of the VPN 
ports to establish the endpoints of the communications.
    Example 12. 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.

[[Page 77611]]

    (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 13. De minimis non-communications activity--(i) Facts. 
The same facts as in Example 12. 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 14. 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 15. 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 16. Income derived from foreign communications 
activity--(i) Facts. STS 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), (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
    (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

[[Page 77612]]

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 December 27, 2006.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

0
Par. 4. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

0
Par. 5. In Sec.  602.101 paragraph (b) is amended by adding an entry to 
the table in numerical order, Sec. Sec.  1.863-8 and 1.863-9, to read 
as follows:


Sec.  602.101  OMB Control numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
 CFR part or section where identified and
                 described                     Current OMB control No.
------------------------------------------------------------------------
1.863-8...................................  1545-1718.
1.863-9...................................  1545-1718.
------------------------------------------------------------------------


 Kevin M. Brown,
Acting Deputy Commissioner for Services and Enforcement.
    Approved: December 21, 2006.
Eric Solomon,
Assistant Secretary of the Treasury (Tax Policy).
 [FR Doc. E6-22174 Filed 12-26-06; 8:45 am]
BILLING CODE 4830-01-P