# Bulletin No. 1996–52

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- **Document type:** Agency decision

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Bulletin No. 1996–52
December 23, 1996

HIGHLIGHTS
OF THIS ISSUE
These synopses are intended only as aids to the reader in
identifying the subject matter covered. They may not be relied
upon as authoritative interpretations.

INCOME TAX
Rev. Rul. 96–61, page 24.
Interest rates; underpayments and overpayments.
The rate of interest determined under section 6621 of
the Code for the calendar quarter beginning January 1,
1997, will be 8 percent for overpayments, 9 percent for
underpayments, and 11 percent for large corporate
underpayments. The rate of interest paid on the portion
of a corporate overpayment exceeding $10,000 is 6.5
percent.
T.D. 8687, page 4.
Final regulations under section 863 of the Code governs
the source of income from sales of natural resources or
other inventory produced in and sold outside the United
States.
Notice 96–68, page 30.
Definitions relating to application of exclusion under
section 127. This notice provides guidance regarding
the definitions of the terms “graduate level course” and
“courses beginning.”

EXEMPT ORGANIZATIONS
Announcement 96–131, page 32.
A list is given of organizations now classified as private
foundations.

ESTATE TAX
T.D. 8686, page 14.
Final regulations provide guidance relating to the additional requirements necessary to ensure the collection

Finding Lists begin on page 36.
Announcement of Disbarments and Suspensions begins on page 34.

of estate taxes imposed under section 2056A of the
Code with respect to taxable events involving qualified
domestic trusts (QDOTs).

EXCISE TAX
Announcement 96–130, page 32.
Effective after December 31, 1996, the tax rates for
aviation gasoline and aviation fuel taxes have changed.
The rate and base amount imposed on luxury passenger
vehicles have also changed. Ozone-depleting chemical
rates for 1997 are included in this announcement. Also,
excise taxes on transportation expire December 31,
1996.

ADMINISTRATIVE
Notice 96–65, page 28.
This notice provides guidance for certain provisions of
the Small Business Job Protection Act of 1996 (the
“Act”) dealing with the status of a trust as domestic or
foreign under sections 7701(a)(30) and 7701(a)(31) of
the Code. This notice grants taxpayers additional time to
comply with the new domestic trust criteria contained in
the Act and announces the time and manner for making
an election to apply the new trust criteria retroactively.
Also, guidance regarding the application of sections
1491 through 1494 of the Code is provided if the status
of a trust changes from domestic to foreign.
Announcement 96–132, page 33.
Orthopaedic Development Foundation, Hilton Head, SC,
no longer qualifies as an organization to which contributions are deductible under section 170 of the Code.

Mission of the Service
The purpose of the Internal Revenue Service is to
collect the proper amount of tax revenue at the least
cost; serve the public by continually improving the

quality of our products and services; and perform in a
manner warranting the highest degree of public
confidence in our integrity, efficiency and fairness.

Statement of Principles
of Internal Revenue
Tax Administration
The Service also has the responsibility of applying
and administering the law in a reasonable,
practical manner. Issues should only be raised by
examining of ficers when they have merit, never
arbitrarily or for trading purposes. At the same
time, the examining officer should never hesitate
to raise a meritorious issue. It is also important
that care be exercised not to raise an issue or to
ask a court to adopt a position inconsistent with
an established Service position.

The function of the Internal Revenue Service is to
administer the Internal Revenue Code. Tax policy
for raising revenue is determined by Congress.
With this in mind, it is the duty of the Service to
carry out that policy by correctly applying the laws
enacted by Congress; to determine the reasonable
meaning of various Code provisions in light of the
Congressional purpose in enacting them; and to
perform this work in a fair and impartial manner,
with neither a government nor a taxpayer point of view.

Administration should be both reasonable and
vigorous. It should be conducted with as little
delay as possible and with great cour tesy and
considerateness. It should never try to overreach,
and should be reasonable within the bounds of law
and sound administration. It should, however, be
vigorous in requiring compliance with law and it
should be relentless in its attack on unreal tax
devices and fraud.

At the heart of administration is interpretation of the
Code. It is the responsibility of each person in the
Service, charged with the duty of interpreting the
law, to try to find the true meaning of the statutory
provision and not to adopt a strained construction in
the belief that he or she is ‘‘protecting the revenue.’’
The revenue is properly protected only when we ascertain and apply the true meaning of the statute.

2

Introduction
The Internal Revenue Bulletin is the authoritative instrument of the Commissioner of Internal Revenue for
announcing official rulings and procedures of the Internal Revenue Service and for publishing Treasury Decisions, Executive Orders, Tax Conventions, legislation,
court decisions, and other items of general interest. It is
published weekly and may be obtained from the Superintendent of Documents on a subscription basis. Bulletin
contents of a permanent nature are consolidated semiannually into Cumulative Bulletins, which are sold on a
single-copy basis.

court decisions, rulings, and procedures must be considered, and Service personnel and others concerned are
cautioned against reaching the same conclusions in
other cases unless the facts and circumstances are
substantially the same.
The Bulletin is divided into four parts as follows:
Part I.—1986 Code.
This part includes rulings and decisions based on
provisions of the Internal Revenue Code of 1986.

It is the policy of the Service to publish in the Bulletin all
substantive rulings necessary to promote a uniform
application of the tax laws, including all rulings that
supersede, revoke, modify, or amend any of those
previously published in the Bulletin. All published rulings
apply retroactively unless otherwise indicated. Procedures relating solely to matters of internal management
are not published; however, statements of internal
practices and procedures that affect the rights and
duties of taxpayers are published.

Part II.—Treaties and Tax Legislation.
This part is divided into two subparts as follows:
Subpart A, Tax Conventions, and Subpart B, Legislation
and Related Committee Reports.
Part III.—Administrative, Procedural, and Miscellaneous.
To the extent practicable, pertinent cross references to
these subjects are contained in the other Parts and
Subparts. Also included in this part are Bank Secrecy
Act Administrative Rulings. Bank Secrecy Act Administrative Rulings are issued by the Department of the
Treasury’s Office of the Assistant Secretary (Enforcement).

Revenue rulings represent the conclusions of the Service on the application of the law to the pivotal facts
stated in the revenue ruling. In those based on positions
taken in rulings to taxpayers or technical advice to
Service field offices, identifying details and information
of a confidential nature are deleted to prevent unwarranted invasions of privacy and to comply with statutory
requirements.

Part IV.—Items of General Interest.
With the exception of the Notice of Proposed Rulemaking and the disbarment and suspension list included in
this part, none of these announcements are consolidated in the Cumulative Bulletins.

Rulings and procedures reported in the Bulletin do not
have the force and effect of Treasury Department
Regulations, but they may be used as precedents.
Unpublished rulings will not be relied on, used, or cited
as precedents by Service personnel in the disposition of
other cases. In applying published rulings and procedures, the effect of subsequent legislation, regulations,

The first Bulletin for each month includes an index for
the matters published during the preceding month.
These monthly indexes are cumulated on a quarterly and
semiannual basis, and are published in the first Bulletin
of the succeeding quarterly and semi-annual period,
respectively.

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.
For sale by the Superintendent of Documents U.S. Government Printing Office, Washington, D.C. 20402.

3

Part I. Rulings and Decisions Under the Internal Revenue Code of 1986
Section 863.—Special Rules for
Determining Source
26 CFR 1.863–3: Allocation and apportionment of
income from certain sales of inventory.

T.D. 8687
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
Source of Income From Sales of
Inventory and Natural Resources
Produced in One Jurisdiction and
Sold in Another Jurisdiction
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final and temporary regulations.
SUMMARY: This document contains
regulations governing the source of income from sales of natural resources or
other inventory produced in the United
States and sold outside the United States
or produced outside the United States
and sold in the United States. This
document affects persons who produce
natural resources or other inventory in
the United States and sell outside the
United States, or produce natural resources or other inventory outside the
United States and sell in the United
States.
EFFECTIVE DATE: December 30,
1996.
Applicability: Taxpayers may apply
these regulations for taxable years beginning after July 11, 1995, and on or
before December 30, 1996.
FOR FURTHER INFORMATION CONTACT: Anne Shelburne, (202) 622–3880
(not a toll free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained in this final regulation has been
reviewed and approved by the Office of
Management and Budget in accordance
with the requirements of the Paperwork
Reduction Act (44 U.S.C. 3507) under
control number 1545–1476. Responses
to this collection of information are
mandatory.
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.
The estimated average annual burden
per respondent is approximately 2.6
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, T:FP,
Washington, DC 20224, and 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 this collection of information must be retained
as long as their contents may become
material in the administration of any
internal revenue law. Generally, tax returns and tax return information are
confidential, as required by 26 U.S.C.
6103.
Background
This document contains final regulations to be added to the Income Tax
Regulations (26 CFR part 1) under
section 863 of the Internal Revenue
Code (Code). The final regulations provide rules for allocating and apportioning income between U.S. and foreign
sources from natural resources and other
inventory produced in the United States
and sold outside the United States, or
produced outside the United States and
sold in the United States.
On December 11, 1995, proposed
regulations [INTL–0003–95 (1996–1
C.B. 831)] were published in the Federal Register (60 FR 63478). The IRS
received written comments on the proposed regulations and held a public
hearing on April 10, 1996. Having considered the comments and the statements
made at the hearing, the IRS and the
Treasury Department adopt the proposed
regulations as modified by this Treasury
decision. The comments and revisions
are discussed below.
Explanation of Provisions
I. Allocation of gross income from sales
of natural resources under section 863(a)
Section 1.863–1(b) of the proposed
regulations relate to the rules governing
natural resources. The proposed regulations provide three methods for determining the amount of United States or
foreign source income from sales of

4

natural resources. One method (derived
from the existing regulations) sources
income in its entirety to the location of
the natural resources, and applies where
the taxpayer does not engage in substantial additional production beyond production of the natural resources. The
second method, the export terminal rule,
splits sales income at the export terminal, sourcing gross receipts equal to the
fair market value at the export terminal
to the location of the natural resources,
and gross receipts in excess of that
amount either to the place of sale or
according to the rules in § 1.863–3,
depending on the circumstances. The
third method requires taxpayers performing additional production in the
country where the natural resources are
located, to split gross receipts at the
point of the additional production,
sourcing gross receipts equal to the fair
market value prior to that point to the
location of the natural resources and
gross receipts in excess of that amount
according to the rules in § 1.863–3.
1. Implications of the Tenth Circuit’s
Order in Phillips
Section 1.863–1(b)(1)(i) of the proposed regulations sources certain income
from natural resources in its entirety to
the location of the resources. The preamble to the proposed regulations states
that Treasury and the IRS would consider the Tenth Circuit’s unpublished
opinion in its Order and Judgment in
Phillips Petroleum v. Comm’r, 97 T.C.
30 (1991), 101 T.C. 78 (1993), aff’d.
without published opinion, 70 F.3d 1282
(10th Cir., 1995), in finalizing the regulations. In Phillips, the Tax Court ruled
§ 1.863–1(b)’s natural resource regulation, generally sourcing income from
U.S. natural resources in its entirety to
the United States, invalid to the extent it
conflicted with the Court’s interpretation
of section 863(b)(2). That section provides that gains, profits and income
from the sale of inventory property
produced within and sold without the
United States (or vice versa) shall be
treated as derived partly from sources
within and partly from sources without
the United States. The Tenth Circuit
affirmed the Tax Court.
In view of Phillips, the final regulations modify the proposed regulations to
eliminate the 100 percent allocation rule,
making the determination of the source
of income subject instead to the export
terminal rule. Thus, gross receipts equal

to the fair market value of the product
at the export terminal are allocated to
the location of the farm, mine, well,
deposit or uncut timber, with the source
of gross receipts from such sales in
excess of the product’s fair market value
at the export terminal allocated to the
country of sale.
Several commentators requested that
any change to the natural resource rules
made in light of Phillips be done in
proposed form, providing opportunity to
comment on the regulations. However,
because the final regulations merely
eliminate the rule which required a
single source of income for sales of
natural resources, and because Treasury
and the IRS believe that there has been
adequate opportunity to comment on the
proposed regulations’ export terminal
rule, the natural resources rules are
issued in final form.
2. Availability of the 50/50 method for
natural resources
Several commentators wrote that there
is no basis for treating natural resources
differently than other inventory. Therefore, producers of natural resources
should be permitted to determine the
source of their income under the 50/50
method described in § 1.863–3(b)(1).
They point to legislation enacted in the
Tax Reform Act of 1986, arguing that
Congress, in enacting section 865 to
govern personal property sales, drew no
distinction between sales of natural resources and sales of other inventory.
Commentators have also pointed to section 865(b), enacted in 1993, providing
that income from sales of U.S. softwood
must be U.S. source in its entirety. They
conclude that Congress was aware of
the Tax Court’s decision in Phillips,
overruling Phillips only for softwood,
but intending that all other natural resources be sourced under the 50/50
method.
Treasury and the IRS do not believe
that Congress in the 1986 Act evidenced
an intent to source all income from sales
of natural resources under the 50/50
method. Rather, Congress merely referred to the 50/50 method to generally
describe the methods for sourcing income from certain types of inventory
sales. In addition, the legislative history
to the 1993 Act, requiring income from
softwood sales to be allocated in its
entirety to the United States, does not
suggest that Congress intended to overturn the longstanding regime governing
sales of other natural resources. Moreover, the Small Business Job Protection

Act of 1996, Public Law 104–188 (August 20, 1996) (the 1996 Act), further
clarifies that the Service is not required
to apply the 50/50 method. Prior to the
1996 Act, section 865(b) provided that
income from inventory sales was to be
sourced under sections 861(a)(6),
862(a)(6), and 863(b). The 1996 Act, in
section 1704(f)(4)(A), amended Code
section 865(b)(2) by striking 863(b) and
inserting 863. The Act makes this
amendment effective as if included in
amendments made by section 1211 of
the Tax Reform Act of 1986 (Public
Law 99–514). This technical correction
to the 1986 Act clarifies that Treasury
has broad authority to provide rules
sourcing income from sales of inventory
under section 863, and is not restricted
to any particular method.
Treasury and the IRS also believe
longstanding distinctions have been
made in the tax treatment of natural
resources and other property, both in our
tax laws and in our tax treaties. Most
treaties, for example, grant primary or
exclusive taxing jurisdiction to the country where natural resources are located.
Thus, income from sales of natural
resources is treated differently than income derived from sales of other inventory, which is normally subject to the
business profits article of a treaty. See,
e.g., Article 6 of the United States
Model Income Tax Convention (September 20, 1996), which provides that income from real property, ‘‘including
income from agriculture and forestry’’
may be taxed by the country where the
resources are located.
The legislative history to section
863’s predecessor, section 217(e) of the
Revenue Act of 1921, also reflects an
intention that natural resources be
treated differently from other property.
The House version of section 217 (H.R.
8245, 67th Cong., 1st Sess. (Aug.20,
1921)) included a provision sourcing
income from natural resources in its
entirety to the location of the resources.
However, based on testimony raising the
possibility of a case where such a single
source rule should not apply, the Senate
struck the provision that allocated all of
the income from natural resources to a
single country. (H.R. 8245 (67th Cong.,
1st Sess. (November 4, 1921)); Hearings
Before The Committee on Finance,
United States Senate, H.R. 8245, 67th
Cong., 1st Sess. (September 1 to October 1, 1921), at 309–310. A provision
similar to that considered by the House,
but with flexibility available for unusual

5

cases, was then added to the regulations
promulgated in 1922.
Thus, Treasury and the IRS believe
that income from natural resources
should be sourced differently than income from other sales of inventory.
3. Clarification
§ 1.863–2

of

language

in

In response to a comment, the final
regulations are modified to clarify that
the source of income from sales of
natural resources must be determined
solely under the rules set forth in
§ 1.863–1(b) of the final regulations.
Treasury and the IRS clarified this point
in corrections to the proposed regulations, published on August 27, 1996, in
the Federal Register (61 FR 44023).
4. Additional production activities
The proposed regulations define additional production activities in § 1.863–
1(b)(3)(ii) as substantial production activities performed by the taxpayer in
addition to activities relating to the
ownership or operation of any farm,
mine, oil or gas well, other natural
deposit, or timber. The proposed regulations provide that generally the principles of § 1.954–3(a)(4) apply in determining whether an activity qualifies as
such additional production. However, in
no case will activities that prepare the
natural resource itself for export, including those that are designed to facilitate
transportation of the natural resource to
or from the export terminal, be considered additional production. Thus, the
proposed regulations in an example indicate liquefaction of natural gas would
not constitute additional production activities.
Liquefaction is the process of liquefying natural gas so that it can be transported by tanker for sales abroad. Several commentators urged us to
reconsider our position, arguing that
liquefaction is an expensive, complex
activity. Treasury and the IRS, however,
continue to believe that liquefaction is
an activity preparing the natural resource itself for export within the meaning of § 1.863–1(b)(3)(ii) of the final
regulations, and that it is appropriate to
exclude such activities from the definition of additional production. Even
though liquefaction may be an expensive, complex process, liquefied natural
gas retains its character as a natural
resource, so that liquefaction should be
treated no differently than other processes that prepare natural resources for
export.

Several commentators requested that
the regulations more precisely define the
processes that constitute production of
natural resources, to better differentiate
those activities described in § 1.863–
1(b)(1) of the proposed regulations, as
being from the ownership or operation
of any farm, mine, oil or gas well, other
natural deposit, or timber, from those
that qualify as additional production
activities within the meaning of
§ 1.863–1(b)(3)(ii) of the proposed
regulations. In particular, a commentator
requested that the final regulations specifically address this issue in the case of
mining. In response to this comment,
the final regulations include an example
describing certain mining processes that
would not qualify as additional production activities in the case of copper.
5. Treatment of partnerships
The proposed regulations provide that,
in applying the rules in § 1.863–3 of
the proposed regulations, a partner
would be treated as engaged in the
production activity of its partnership.
However, that provision was not extended to § 1.863–1 of the proposed
regulations, which generally provides
rules for determining the source of income from sales of natural resources.
The final regulations provide rules for
transactions involving partners and partnerships, which apply in the same manner to sales of natural resources and to
sales of other inventory. See II. 3. of
this preamble for a discussion of those
rules.
6. Genetically-engineered agricultural
products
One commentator requested that final
regulations state that natural resources
do not include products, such as certain
seeds, where the premium value of the
product is derived from genetic traits
produced by biotechnology or traditional
methods, and the seeds themselves are
not grown for consumption. The inherent nature of products as agricultural
products, however, does not change because they may be subject to research
and development. Because they remain
natural resources, Treasury and the IRS
rejected this comment.
II. Allocation and apportionment of
income from sales of inventory other
than natural resources
Section 1.863–3 of the proposed regulations provides rules for allocating and
apportioning income from inventory

sales other than natural resources where
the taxpayer produces property in the
United States and sells outside the
United States, or produces property outside the United States and sells in the
United States (Section 863 Sales). The
proposed regulations provide three
methods: the 50/50 method, the independent factory price method, and the
books and records method.
1. Sales in international waters or in
space
Consistent with the existing regulations, the proposed regulations limit the
methods in § 1.863–3 to sales within a
foreign country. The preamble, however,
requests comments on whether the regulation should be expanded to cover sales
made in international waters or in space.
Although the statute refers to sales outside the United States, Treasury and the
IRS expressed concern in that preamble
that expanding the scope of the regulations to include all such sales could lead
to abuses where, for example, a taxpayer produced goods in the United
States, passed title to those goods outside the United States, and then sold the
goods to U.S. customers. In considering
whether to expand the scope of the final
regulations to include such sales, Treasury and the IRS requested comments
on whether to include an exception to
the title passage rule for sales of goods
produced in the United States and destined for the U.S. market.
In response to comments and consistent with the preamble to the proposed
regulations, the final regulations expand
the scope of the existing and proposed
regulations to include sales outside the
United States. Moreover, to prevent
abuse from this expanded rule, the final
regulations provide that sales of goods
wholly produced in the United States
and sold for use, consumption, or disposition in the United States, will be
considered to take place in the United
States. Income from such sales will be
treated as from U.S. sources. The final
regulations rely on rules in § 1.864–
6(b)(3)(ii) (relating to the determination
of whether foreign source income is
effectively connected with a U.S. trade
or business under section 864(c)(4)(iii)),
for determining the country of use,
consumption, or disposition. Also, property will be treated as wholly produced
in the United States for this purpose if it
is subject to no more than packaging,
repackaging, labeling, or other minor
assembly operations outside the United
States. See also § 1.861–7(c) to deter-

6

mine the source of income in any case
in which the sales transaction is arranged in a particular manner for the
primary purpose of tax avoidance.
Treasury and the IRS are considering
whether the rules of the final regulations
are appropriate where a product is produced in one country but is destined for
use either on the high seas or in space.
Until additional guidance is provided,
taxpayers may rely upon the general
rules of the final regulations for these
cases.
2. Segregation and aggregation of sales
Once a taxpayer selects a method
under § 1.863–3(b) for dividing gross
income derived from Section 863 Sales
between production activity and sales
activity, § 1.863–3(a) of the proposed
regulations provide that a taxpayer must
separately apply that method to Section
863 Sales in the United States and to
Section 863 Sales outside the United
States. The proposed regulations also
provide in § 1.863–3(a) that taxpayers
must determine the source of gross
income under paragraph (c) and taxable
income under paragraph (d) by aggregating all Section 863 Sales to which a
method described in paragraph (b) applies.
The final regulations clarify that the
rules of paragraphs (c) and (d) apply
separately to Section 863 Sales in the
United States and to Section 863 Sales
outside the United States, so that taxpayers are required to aggregate all
Section 863 Sales under paragraphs (c)
and (d) after the taxpayer has first
separately applied the method under
paragraph (b) to Section 863 Sales in
the United States and to Section 863
Sales outside the United States.
3. Transactions with partnerships
The proposed regulations provide in
§ 1.863–3(a) that a taxpayer’s production activity includes production activities conducted through a partnership of
which the taxpayer is a partner either
directly or through one or more partnerships. One commentator recommended
that final regulations extend the partnership rules to natural resources. However,
the commentator suggested that an aggregate approach to partnerships should
apply only in cases where the partnership, instead of selling the property and
distributing the proceeds to the partner,
distributes the property to a partner. In
response to the comments, the final
regulations modify the proposed regulations. Under the final regulations, the

aggregate approach applies to a partnership’s production or sales activity only
for two purposes. First, the aggregate
approach applies for purposes of determining the source of a partner’s distributive share of partnership income.
Thus, if a partnership engages in the
production of inventory property in the
United States and sells such property
outside the United States, a partner will
be considered to have produced and sold
that inventory property in the same
manner as the partnership when determining the source of its distributive
share of such sales income. Second, the
aggregate approach applies for purposes
of sourcing income from the sale of
inventory property that is transferred in
kind from or to a partnership. Thus, for
example, where the partnership makes
an in kind distribution of inventory
property to its partners, the source of the
partner’s income from the sale of such
property is determined based on both its
own activity and on the partnership’s
activity. Similarly, the aggregate approach applies in cases where a partner
contributes inventory produced by it to
its partnership, if the partnership then
sells the inventory (e.g., as a distributor
or after further processing).
The entity approach applies for all
other purposes. For example, where a
partnership manufactures inventory
property and sells the property to one of
its partners, the source of that partner’s
income from the resale of the property
is determined without regard to the
partnership’s manufacturing activity.
Consistent with this modification, the
final regulations also specify that assets
owned by a partnership (or a partner)
are not deemed owned by the partner
(or the partnership) unless the aggregate
approach applies to the transaction at
issue.
4. Taxable income method
In response to comments, § 1.863–
2(b) of the proposed regulations is clarified to provide that taxpayers may elect
the principles of § 1.863–3(b)(1) and (c)
to determine the source of taxable income (rather than gross income) from
sales of inventory property.
5. Independent factory price (IFP)
method
One commentator requested clarification that the sale establishing an IFP
must be sourced under the IFP method
only if a taxpayer elects the IFP method.
The proposed and final regulations intend this result. The IFP method applies

to either the sale establishing the IFP or
to a sale applying the IFP only if the
taxpayer elects the IFP method.
The proposed regulations eliminated
the provision in existing regulations permitting taxpayers to establish an IFP by
methods other than by sales to independent distributors. The preamble, however, requested comments on the continued utility of such a provision. Two
commentators recommended that the
provision be retained and expanded to
permit taxpayers to establish an IFP by
any method that is appropriate under
section 482. The commentators stated
that any evidence acceptable for proving
an arm’s length price under section 482
should be acceptable as an IFP. The
commentators also stated that taxpayers
who cannot use the IFP method must
use the 50/50 method, and that the
50/50 method may not produce an equitable result for nonresidents importing
goods into the United States.
After further consideration, Treasury
and the IRS have decided to finalize the
regulations on this point as proposed.
No convincing evidence has been presented for the need of a broad-based
rule permitting taxpayers to establish an
IFP by any method that would otherwise
be appropriate under section 482 when
they can use books and records to
demonstrate a more appropriate sourcing
result. In view of the absence of a
clearly identified benefit for taxpayers
and the availability of the books and
records method, Treasury and the IRS
believe that expansion of the IFP rule is
not justified.
6. Books and records
Under both the existing and proposed
regulations, taxpayers can request permission from the District Director to use
a taxpayer’s books and records to allocate or apportion income between U.S.
and foreign sources if this method more
clearly reflects the taxpayer’s income.
The preamble to the proposed regulations requests comments on retaining the
books and records method. Two commentators asked for retention of this
method because instances may arise
where a taxpayer does not have third
party sales, thereby making the IFP
method unavailable. In such cases, a
taxpayer may find it advantageous to
determine the source of its income on
the basis of its books and records. These
comments were accepted. The final
regulations retain the books and records

7

method, subject to an election and prior
approval of the method by the District
Director.
7. Determination of source of gross income from production activities
a. Definition of production assets
i. Contract manufacturing
Under the proposed regulations, production assets are limited to those
owned directly by the taxpayer that are
directly used by the taxpayer to produce
the relevant inventory. These rules are
intended to insure that taxpayers do not
attribute the assets or activities of related or unrelated parties manufacturing
under contract with the taxpayer. One
commentator asked that the definition of
production assets be expanded to include production assets owned by related or unrelated contract manufacturers. The commentator contends that by
limiting production assets to those
owned by the taxpayer, the regulations
source income differently depending
upon the form in which the taxpayer
conducts business. Treasury and the
IRS, however, believe it is appropriate
to limit production assets in the apportionment formula to assets owned by the
taxpayer and used by the taxpayer to
produce the inventory. In addition, taxpayers generally do not know the contract manufacturer’s basis in its production assets. Further, it would be very
difficult to draw a clear line between
contract manufacturers and other suppliers. Thus, Treasury and the IRS do not
believe the source of a taxpayer’s income should take into account activities
of others or assets owned by others with
whom the taxpayer has manufacturing
arrangements. The final regulations
clarify, however, that this rule does not
override the single entity rules set forth
under § 1.1502–13 (dealing with members of an affiliated group filing on a
consolidated basis), or the rules under
§ 1.863–3(g) dealing with partnerships.
ii. Accounts receivable
One commentator also asserted that
accounts receivable should be included
as a production asset. This comment
was rejected. The production formula is
intended to approximate the location of
the taxpayer’s production activity. Thus,
assets not directly involved in production should not be included.
b. Anti-abuse rule
The preamble to the proposed regulations indicated that the purpose of the
property fraction is to attribute the
source of production income to the

location of production activity. Treasury
and the IRS, however, were concerned
that taxpayers would attempt to artificially affect the location of assets to
manipulate the rules, and so solicited
comments on whether an anti-abuse rule
was needed. No comments were received that objected to such anti-abuse
rule. After further considering the issue,
Treasury and the IRS have included an
anti-abuse rule in the final regulations to
prevent taxpayers from manipulating the
property formula to achieve inappropriate results. Therefore, the anti-abuse rule
provides that if a taxpayer has entered
into or structured one or more transactions with a principal purpose of reducing its U.S. tax liability by affecting the
formula in a manner inconsistent with
the purpose of the regulation, the District Director may make appropriate adjustments so that the source of the
taxpayer’s income from production activity more clearly reflects the source of
that income. An example in the regulations demonstrates circumstances where
the anti-abuse rule may apply. In that
example, with a principal purpose of
reducing its U.S. tax liability, the taxpayer leases all of its U.S. property so
that it owns only property located in a
foreign country. The example concludes
that the District Director may ignore a
sale-leaseback transaction to more
clearly reflect the source of the taxpayer’s production income.

a statement attached to the tax return,
explaining the methodology used, the
circumstances justifying that use, the
aggregation of sales, and the amount of
income allocated. Treasury and the IRS
believe the reporting requirements in
§ 1.863–3(e) of the proposed regulations are reasonable, and serve legitimate administrative purposes.
Special Analyses
It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866.
Therefore, a regulatory assessment is not
required. It is hereby certified that these
regulations will not have a significant
economic impact on a substantial number of small entities. This certification is
based on the fact that the rules of this
section principally impact large multinationals who pay foreign taxes on substantial foreign operations and therefore
the rules will impact very few small
entities. Moreover, in those few instances where the rules of this section
impact small entities, the economic impact on such entities is not likely to be
significant. Accordingly, a regulatory
flexibility analysis is not required. Pursuant to section 7805(f) of the Internal
Revenue Code, the notice of proposed
rulemaking preceding these regulations
was submitted to the Small Business
Administration for comment on its impact on small business.

8. Determination of taxable income
One commentator requested that the
calculation of taxable income, when applying the 50/50 method along with the
research and experimental (R&E) expense allocation rules in § 1.861–17, be
clarified. The commentator suggests that
the last sentence of § 1.863–3(d) of the
proposed regulations can be read to
conflict with the R&E set aside in
§ 1.861–17. The final regulations clarify
that the R&E set aside remains available
to taxpayers using the 50/50 method.
9. Reporting requirements
The proposed regulations, in § 1.863–
3(e), require a taxpayer to fully explain
the methodology used to determine the
source of income, the circumstances
justifying use of that method, the extent
that sales are aggregated, and the
amount of income so allocated. One
commentator wrote that the reporting
requirements in § 1.863–3(e) of the proposed regulations are unnecessary and
excessively burdensome. The regulations
clarify that the requirement is limited to

Section 1.863–4 also issued under 26
U.S.C. 863.
Section 1.863–6 also issued under 26
U.S.C. 863. * * *
Par. 2. Sections 1.863–3 and
1.863–3T are redesignated as §§ 1.863–
3A and 1.863–3AT, respectively, and an
undesignated center heading is added
preceding the redesignated sections to
read as follows:

Drafting Information
The principal author of these regulations is Anne Shelburne, Office of Associate Chief Counsel (International).
However, other personnel from the IRS
and Treasury Department participated in
their development.
*

*

*

*

*

Adoption of Amendments to the
Regulations
Accordingly, 26 CFR parts 1 and 602
are amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 is amended by adding entries in
numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.863–2 also issued under 26
U.S.C. 863.
Section 1.863–3 also issued under 26
U.S.C. 863.

8

Regulations Applicable to Taxable
Years Prior to December 30, 1996
Par. 3. Section 1.863–0 is added to
read as follows:
§ 1.863–0 Table of contents.
This section lists captions contained
in §§ 1.863–1, 1.863–2, and 1.863–3.
§ 1.863–1 Allocation of gross income.
(a) In general.
(b) Natural resources.
(1) In general.
(2) Additional production prior to export terminal.
(3) Definitions.
(i) Production activity.
(ii) Additional production activities.
(iii) Export terminal.
(4) Determination of fair market
value.
(5) Determination of gross income.
(6) Tax return disclosure.
(7) Examples.
(c) Determination of taxable income.
(e) Effective dates.
§ 1.863–2 Allocation and apportionment
of taxable income.
(a) Determination of taxable income.
(b) Determination of source of taxable income.
(c) Effective dates.
§ 1.863–3 Allocation and apportionment
of income from certain sales of inventory.
(a) In general.
(1) Scope
(2) Special rules
(b) Methods to determine income attributable to production activity and
sales activity.
(1) 50/50 method.
(i) Determination of gross income.
(ii) Example.
(2) IFP method.
(i) Establishing an IFP.
(ii) Applying the IFP method.
(iii) Determination of gross income.
(iv) Examples.

(3) Books and records method.
(c) Determination of the source of
gross income from production activity
and sales activity.
(1) Income attributable to production
activity.
(i) Production only within the United
States or only within foreign countries.
(A) Source of income.
(B) Definition of production assets.
(C) Location of production assets.
(ii) Production both within the United
States and within foreign countries.
(A) Source of income.
(B) Adjusted basis of production assets.
(iii) Anti-abuse rule.
(iv) Examples.
(2) Income attributable to sales activity.
(d) Determination of source of taxable income.
(e) Election and reporting rules.
(1) Elections under paragraph (b) of
this section.
(2) Disclosure on tax return.
(f) Income partly from sources within
a possession of the United States.
(g) Special rules for partnerships.
(h) Effective dates.
Par. 4. In § 1.863–1, paragraphs (a),
(b) and (c) are revised and paragraph (e)
is added to read as follows:
§ 1.863–1 Allocation of gross income.
(a) In general. Items of gross income
other than those specified in section
861(a) and section 862(a) will generally
be separately allocated to sources within
or without the United States. See
§ 1.863–2 for alternate methods to determine the income from sources within
or without the United States in the case
of items specified in § 1.863–2(a). See
also sections 865(b) and (e)(2). In the
case of sales of property involving partners and partnerships, the rules of
§ 1.863–3(g) apply.
(b) Natural resources—(1) In general. Notwithstanding any other provision, except to the extent provided in
paragraph (b)(2) of this section, gross
receipts from the sale outside the United
States of products derived from the
ownership or operation of any farm,
mine, oil or gas well, other natural
deposit, or timber within the United
States, must be allocated between
sources within and without the United
States based on the fair market value of
the product at the export terminal (as
defined in paragraph (b)(3)(iii) of this
section). Notwithstanding any other pro-

vision, except to the extent provided in
paragraph (b)(2) of this section, gross
receipts from the sale within the United
States of products derived from the
ownership or operation of any farm,
mine, oil or gas well, other natural
deposit, or timber outside the United
States must be allocated between
sources within and without the United
States based on the fair market value of
the product at the export terminal. For
place of sale, see §§ 1.861–7(c) and
1.863–3(c)(2). The source of gross receipts equal to the fair market value of
the product at the export terminal will
be from sources where the farm, mine,
well, deposit, or uncut timber is located.
The source of gross receipts from the
sale of the product in excess of its fair
market value at the export terminal
(excess gross receipts) will be determined as follows—
(i) If the taxpayer engages in additional production activities subsequent to
shipment from the export terminal and
outside the country of sale, the source of
excess gross receipts must be determined under § 1.863–3. For purposes of
applying § 1.863–3, only production assets used in additional production activity subsequent to the export terminal are
taken into account.
(ii) In all other cases, excess gross
receipts will be from sources within the
country of sale. This paragraph (b)(1)(ii)
applies to a taxpayer that engages in
additional production activities in the
country of sale, as well as to a taxpayer
that does not engage in additional production activities at all.
(2) Additional production prior to export terminal. Notwithstanding any other
provision of this section, gross receipts
from the sale of products derived by a
taxpayer who performs additional production activities as defined in paragraph (b)(3)(ii) of this section before the
relevant product is shipped from the
export terminal are allocated between
sources within and without the United
States based on the fair market value of
the product immediately prior to the
additional production activities. The
source of gross receipts equal to the fair
market value of the product immediately
prior to the additional production activities will be from sources where the
farm, mine, well, deposit, or uncut timber is located. The source of gross
receipts from the sale of the product in
excess of the fair market value immediately prior to the additional production
activities must be determined under
§ 1.863–3. For purposes of applying

9

§ 1.863–3, only production assets used
in the additional production activities
are taken into account.
(3) Definitions—(i) Production activity. For purposes of this section, production activity means an activity that creates, fabricates, manufactures, extracts,
processes, cures, or ages inventory. See
§ 1.864–1. Except as otherwise provided in §§ 1.1502–13 or 1.863–(g)(2),
only production activities conducted directly by the taxpayer are taken into
account.
(ii) Additional production activities.
For purposes of this section, additional
production activities are substantial production activities performed directly by
the taxpayer in addition to activities
from the ownership or operation of any
farm, mine, oil or gas well, other natural
deposit, or timber. Whether a taxpayer’s
activities constitute additional production activities will be determined under
the principles of § 1.954–3(a)(4). However, in no case will activities that
prepare the natural resource itself for
export, including those that are designed
to facilitate the transportation of the
natural resource to or from the export
terminal, be considered additional production activities for purposes of this
section.
(iii) Export terminal. Where the farm,
mine, well, deposit, or uncut timber is
located without the United States, the
export terminal will be the final point in
a foreign country from which goods are
shipped to the United States. If there is
no such final point in a foreign country
(e.g., the property is extracted and produced on the high seas), the export
terminal will be the place of production.
Where the farm, mine, well, deposit, or
uncut timber is located within the
United States, the export terminal will
be the final point in the United States
from which goods are shipped from the
United States to a foreign country. The
location of the export terminal is determined without regard to any contractual
terms agreed to by the taxpayer and
without regard to whether there is an
actual sale of the products at the export
terminal.
(4) Determination of fair market
value. For purposes of this section, fair
market value depends on all of the facts
and circumstances as they exist relative
to a party in any particular case. Where
the products are sold to a related party
in a transaction subject to section 482,
the determination of fair market value

under this section must be consistent
with the arm’s length price determined
under section 482.
(5) Determination of gross income.
To determine the amount of a taxpayer’s
gross income from sources within or
without the United States, the taxpayer’s
gross receipts from sources within or
without the United States determined
under this paragraph (b) must be reduced by the cost of goods sold properly attributable to gross receipts from
sources within or without the United
States.
(6) Tax return disclosure. A taxpayer
that determines the source of its income
under this paragraph (b) shall attach a
statement to its return explaining the
methodology used to determine fair
market value under paragraph (b)(4) of
this section, and explaining any additional production activities (as defined
in paragraph (b)(3)(ii) of this section)
performed by the taxpayer. In addition,
the taxpayer must provide such other
information as is required by § 1.863–3.
(7) Examples. The following examples illustrate the rules of this paragraph (b):
Example 1. No additional production. U.S.
Mines, a U.S. corporation, operates a copper mine
and mill in country X. U.S. Mines extracts
copper-bearing rocks from the ground and transports the rocks to the mill where the rocks are
ground and processed to produce copper-bearing
concentrate. The concentrate is transported to a
port where it is dried in preparation for export,
stored and then shipped to purchasers in the
United States. Because title to the property is
passed in the United States and, under the facts
and circumstances, none of U.S. Mine’s activities
constitutes additional production prior to the export terminal within the meaning of § 1.863–
1(b)(3)(ii), under § 1.863–1(b)(1) and (b)(1)(ii),
gross receipts equal to the fair market value of the
concentrate at the export terminal will be from
sources without the United States, and excess
gross receipts will be from sources within the
United States.
Example 2. No additional production. US Gas, a
U.S. corporation, extracts natural gas within the
United States, and transports the natural gas to a
U.S. port where it is liquified in preparation for
shipment. The liquified natural gas is then transported via freighter and sold without additional
production activities in a foreign country. Liquefaction of natural gas is not an additional production activity because liquefaction prepares the
natural gas for transportation from the export
terminal. Therefore, under § 1.863–1(b)(1) and
(b)(1)(ii), gross receipts equal to the fair market
value of the liquefied natural gas at the export
terminal will be from sources within the United
States, and excess gross receipts will be from
sources without the United States.
Example 3. Sale in third country. US Gold, a
U.S. corporation, mines gold in country X, produces gold jewelry in the United States, and sells
the jewelry in country Y. Assume that the fair
market value of the gold at the export terminal in

country X is $40, and that US Gold ultimately
sells the gold jewelry in country Y for $100.
Under § 1.863–1(b), $40 of US Gold’s gross
receipts will be allocated to sources without the
United States. Under § 1.863–1(b)(1)(i), the
source of the remaining $60 of gross receipts will
be determined under § 1.863–3. If US Gold
applies the 50/50 method described in § 1.863–3,
$20 of cost of goods sold is properly attributable
to activities subsequent to the export terminal, and
all of US Gold’s production assets subsequent to
the export terminal are located in the United
States, then $20 of gross income will be allocated
to sources within the United States and $20 of
gross income will be allocated to sources without
the United States.
Example 4. Production in country of sale. US
Oil, a U.S. corporation, extracts oil in country X,
transports the oil via pipeline to the export
terminal in country Y, refines the oil in the United
States, and sells the refined product in the United
States to unrelated persons. Assume that the fair
market value of the oil at the export terminal in
country Y is $80, and that US Oil ultimately sells
the refined product for $100. Under § 1.863–
1(b)(1), $80 of US Oil’s gross receipts will be
allocated to sources without the United States, and
under § 1.863–1(b)(1)(ii) the remaining $20 of
gross receipts will be allocated to sources within
the United States.
Example 5. Additional production prior to export. The facts are the same as in Example 1,
except that U.S. Mines also operates a smelter in
country X. The concentrate output from the mill is
transported to the smelter where it is transformed
into smelted copper. The smelted copper is exported to purchasers in the United States. Under
the facts and circumstances, all of the processes
applied to make copper concentrate are considered
mining. Therefore, under § 1.863–1(b)(2), gross
receipts equal to the fair market value of the
concentrate at the smelter will be from sources
without the United States. Under the facts and
circumstances, the conversion of the concentrate
into smelted copper is an additional production
activity in a foreign country within the meaning of
§ 1.863–1(b)(3)(ii). Therefore, the source of U.S.
Mine’s excess gross receipts will be determined
pursuant to § 1.863–1(b)(2).

(c) Determination of taxable income.
The taxpayer’s taxable income from
sources within or without the United
States will be determined under the
rules of §§ 1.861–8 through 1.861–14T
for determining taxable income from
sources within the United States.
*

*

*

*

*

(e) Effective dates. The rules of paragraphs (a), (b) and (c) of this section
will apply to taxable years beginning
December 30, 1996. However, taxpayers
may apply the rules of this section for
taxable years beginning after July 11,
1995, and before December 30, 1996.
For years beginning before December
30, 1996, see § 1.863–1 (as contained
in 26 CFR part 1 revised as of April 1,
1996).
Par. 5. Section 1.863–2 is revised to
read as follows:

10

§ 1.863–2 Allocation and apportionment
of taxable income.
(a) Determination of taxable income.
Section 863(b) provides an alternate
method for determining taxable income
from sources within the United States in
the case of gross income derived from
sources partly within and partly without
the United States. Under this method,
taxable income is determined by deducting from such gross income the expenses, losses, or other deductions properly apportioned or allocated thereto and
a ratable part of any other expenses,
losses, or deductions that cannot definitely be allocated to some item or class
of gross income. The income to which
this section applies (and that is treated
as derived partly from sources within
and partly from sources without the
United States) will consist of gains,
profits, and income
(1) From certain transportation or
other services rendered partly within and
partly without the United States to the
extent not within the scope of section
863(c) or other specific provisions of
this title;
(2) From the sale of inventory property (within the meaning of section
865(i)) produced (in whole or in part)
by the taxpayer in the United States and
sold outside the United States or produced (in whole or in part) by the
taxpayer outside the United States and
sold in the United States; or
(3) Derived from the purchase of personal property within a possession of
the United States and its sale within the
United States, to the extent not excluded
from the scope of these regulations
under § 1.936–6(a)(5), Q&A 7.
(b) Determination of source of taxable income. Income treated as derived
from sources partly within and partly
without the United States under paragraph (a) of this section may be allocated to sources within and without the
United States pursuant to § 1.863–1 or
apportioned to such sources in accordance with the methods described in
other regulations under section 863. To
determine the source of certain types of
income described in paragraph (a)(1) of
this section, see § 1.863–4. To determine the source of gross income described in paragraph (a)(2) of this section, see § 1.863–1 for natural resources
and see § 1.863–3 for other inventory.
Taxpayers, at their election, may apply
the principles of § 1.863–3(b)(1) and (c)
to determine the source of taxable income (rather than gross income) from

sales of inventory property (other than
natural resources). To determine the
source of income partly from sources
within a possession of the United States,
including income described in paragraph
(a)(3) of this section, see § 1.863–3(f).
(c) Effective dates. This section will
apply to taxable years beginning December 30, 1996. However, taxpayers
may apply the rules of this section for
taxable years beginning after July 11,
1995, and before December 30, 1996.
For years beginning before December
30, 1996, see § 1.863–2 (as contained
in 26 CFR part 1 revised as of April 1,
1996).
Par. 6. Section 1.863–3 is added to
read as follows:
§ 1.863–3 Allocation and apportionment
of income from certain sales of inventory.
(a) In general—(1) Scope. Paragraphs (a) through (e) of this section
apply to determine the source of income
derived from the sale of inventory property (inventory), which a taxpayer produces (in whole or in part) within the
United States and sells outside the
United States, or which a taxpayer produces (in whole or in part) outside the
United States and sells within the
United States (Section 863 Sales). A
taxpayer must divide gross income from
Section 863 Sales between production
activity and sales activity using one of
the methods described in paragraph (b)
of this section. The source of gross
income from production activity and
from sales activity must then be determined under paragraph (c) of this section. Taxable income from Section 863
Sales is determined under paragraph (d)
of this section. Paragraph (e) of this
section describes the rules for electing
the methods described in paragraph (b)
of this section and the information that a
taxpayer must disclose on a tax return.
Paragraph (f) of this section applies to
determine the source of certain income
derived from a possession of the United
States. Paragraph (g) of this section
provides special rules for partnerships
for all sales subject to §§ 1.863–1
through 1.863–3. Paragraph (h) of this
section provides effective dates for the
rules in this section.
(2) Rules of application for Section
863 Sales. Once a taxpayer has elected a
method described in paragraph (b) of
this section, the taxpayer must separately apply that method to Section 863
Sales in the United States and to Section

863 Sales outside the United States. In
addition, the taxpayer must apply the
rules of paragraphs (c) and (d) of this
section by aggregating all Section 863
Sales to which a method described in
paragraph (b) of this section applies,
after separately applying that method to
Section 863 Sales in the United States
and to Section 863 Sales outside the
United States. See section 865(i)(1) for
the definition of inventory property. See
also section 865(e)(2). See § 1.861–7(c)
and paragraph (c)(2) of this section for
the time and place of sale.
(b) Methods to determine income attributable to production activity and
sales activity—(1) 50/50 method—
(i) Determination of gross income. Generally, gross income from Section 863
Sales will be apportioned between production activity and sales activity under
the 50/50 method as described in this
paragraph (b)(1). Under the 50/50
method, one-half of the taxpayer’s gross
income will be considered income attributable to production activity and the
source of that income will be determined under the rules of paragraph
(c)(1) of this section. The remaining
one-half of such gross income will be
considered income attributable to sales
activity and the source of that income
will be determined under the rules of
paragraph (c)(2) of this section. In lieu
of the 50/50 method, the taxpayer may
elect to determine the source of income
from Section 863 Sales under the IFP
method described in paragraph (b)(2) of
this section or, with the consent of the
District Director, the books and records
method described in paragraph (b)(3) of
this section.
(ii) Example. The following example
illustrates the rules of this paragraph
(b)(1):
Example. 50/50 method. (i) P, a U.S. corporation, produces widgets in the United States. P sells
the widgets for $100 to D, an unrelated foreign
distributor, in another country. P’s cost of goods
sold is $40. Thus, P’s gross income is $60.
(ii) Pursuant to the 50/50 method, one-half of
P’s gross income, or $30, is considered income
attributable to production activity, and one-half of
P’s gross income, or $30, is considered income
attributable to sales activity.

(2) IFP method—(i) Establishing an
IFP. A taxpayer may elect to allocate
gross income earned from production
activity and sales activity using the
independent factory price (IFP) method
described in this paragraph (b)(2) if an
IFP is fairly established. An IFP is fairly
established based on a sale by the
taxpayer only if the taxpayer regularly
sells part of its output to wholly inde-

11

pendent distributors or other selling concerns in such a way as to reasonably
reflect the income earned from production activity. A sale will not be considered to fairly establish an IFP if sales
activity by the taxpayer with respect to
that sale is significant in relation to all
of the activities with respect to that
product.
(ii) Applying the IFP method. If the
taxpayer elects to use the IFP method,
the amount of the gross sales price
equal to the IFP will be treated as
attributable to production activity, and
the excess of the gross sales price over
the IFP will be treated as attributable to
sales activity. If a taxpayer elects to use
the IFP method, the IFP must be applied
to all Section 863 Sales of inventory
that are substantially similar in physical
characteristics and function, and are sold
at a similar level of distribution as the
inventory sold in the sale fairly establishing an IFP. The IFP will only be
applied to sales that are reasonably
contemporaneous with the sale fairly
establishing the IFP. An IFP cannot be
applied to sales in other geographic
markets if the markets are substantially
different. If the taxpayer elects the IFP
method, the rules of this paragraph will
also apply to determine the division of
gross receipts between production activity and sales activity in a Section 863
Sale that itself fairly establishes an IFP.
If the taxpayer elects to apply the IFP
method, the IFP method must be applied
to all sales for which an IFP may be
fairly established and applied for that
taxable year and each subsequent taxable year. The taxpayer will apply either
the 50/50 method described in paragraph
(b)(1) of this section or the books and
records method described in paragraph
(b)(3) of this section to any other Section 863 Sale for which an IFP cannot
be established or applied for each taxable year.
(iii) Determination of gross income.
The amount of a taxpayer’s gross income from production activity is determined by reducing the amount of gross
receipts from production activity by the
cost of goods sold properly attributable
to production activity. The amount of a
taxpayer’s gross income from sales activity is determined by reducing the
amount of gross receipts from sales
activity by the cost of goods sold (if
any) properly attributable to sales activity. The source of gross income from
production activity is determined under
the rules of paragraph (c)(1) of this
section, and the source of gross income

from sales activity will be determined
under the rules of paragraph (c)(2) of
this section.
(iv) Examples. The following examples illustrate the rules of this paragraph (b)(2):
Example 1. IFP method. (i) P, a U.S. producer,
purchases cotton and produces cloth in the United
States. P sells cloth in country X to D, an
unrelated foreign clothing manufacturer, for $100.
Cost of goods sold for cloth is $80, entirely
attributable to production activity. P does not
engage in significant sales activity in relation to its
other activities in the sales to D. Under these
facts, the sale to D fairly establishes an IFP of
$100. Assume that P elects to use the IFP method.
Accordingly, $100 of the gross sales price is
treated as attributable to production activity, and
no amount of income from this sale is attributable
to sales activity. After reducing the gross sales
price by cost of goods sold, $20 of the gross
income is treated as attributable to production
activity ($100–$80).
(ii) P also sells cloth in country X to A, a
unrelated foreign retail outlet, for $110. Because P
elected the IFP method and the cloth is substantially similar to the cloth sold to D, the IFP fairly
established in the sales to D must be used to
determine the amount attributable to production
activity in the sale to A. Accordingly, $100 of the
gross sales price is treated as attributable to
production activity and $10 ($110–$100) is attributable to sales activity. After reducing the gross
sales price by cost of goods sold, $20 of the gross
income is treated as attributable to production
activity ($100–$80) and $10 is attributable to sales
activity.
Example 2. Scope of IFP Method. (i) USCo
manufactures three dissimilar products. USCo
elects to apply the IFP method. In year 1, an IFP
can be established for sales of product X, but not
for products Y and Z. In year 2, an IFP cannot be
established for any of USCo’s products. In year 3,
an IFP can be established for products X and Y,
but not for product Z.
(ii) In year 1, USCo must apply the IFP method
to sales of product X. In year 2, although USCo’s
IFP election remains in effect, USCo is not
required to apply the IFP election to any products.
In year 3, USCo is required to apply the IFP
method to sales of products X and Y.

(3) Books and records method. A taxpayer may elect to determine the
amount of its gross income from Section
863 Sales that is attributable to production and sales activities for the taxable
year based upon its books of account if
it has received in advance the permission of the District Director having audit
responsibility over its tax return. The
taxpayer must establish to the satisfaction of the District Director that the
taxpayer, in good faith and unaffected
by considerations of tax liability, will
regularly employ in its books of account
a detailed allocation of receipts and
expenditures which clearly reflects the
amount of the taxpayer’s income from
production and sales activities. If a
taxpayer receives permission to apply
the books and records method, but does
not comply with a material condition set

forth by the District Director, the District Director may, in its discretion,
revoke permission to use the books and
records method. The source of gross
income treated as attributable to production activity under this method may be
determined under the rules of paragraph
(c)(1) of this section, and the source of
gross income attributable to sales activity will be determined under the rules of
paragraph (c)(2) of this section.
(c) Determination of the source of
gross income from production activity
and sales activity—(1) Income attributable to production activity—(i) Production only within the United States or
only within foreign countries—
(A) Source of income. For purposes of
this section, production activity means
an activity that creates, fabricates,
manufactures, extracts, processes, cures,
or ages inventory. See § 1.864–1. Subject to the provisions in § 1.1502–13 or
paragraph (g)(2)(ii) of this section, the
only production activities that are taken
into account for purposes of §§ 1.863–
1, 1.863–2, and this section are those
conducted directly by the taxpayer.
Where the taxpayer’s production assets
are located only within the United States
or only outside the United States, the
income attributable to production activity is sourced where the taxpayer’s
production assets are located. For rules
regarding the source of income when
production assets are located both within
the United States and without the United
States, see paragraph (c)(1)(ii) of this
section.
(B) Definition of production assets.
Subject to the provisions of § 1.1502–13
and paragraph (g)(2)(ii) of this section,
production assets include only tangible
and intangible assets owned directly by
the taxpayer that are directly used by the
taxpayer to produce inventory described
in paragraph (a) of this section. Production assets do not include assets that are
not directly used to produce inventory
described in paragraph (a) of this section. Thus, production assets do not
include such assets as accounts receivables, intangibles not related to production of inventory (e.g., marketing intangibles, including trademarks and
customer lists), transportation assets,
warehouses, the inventory itself, raw
materials, or work-in-process. In addition, production assets do not include
cash or other liquid assets (including
working capital), investment assets, prepaid expenses, or stock of a subsidiary.
(C) Location of production assets.
For purposes of this section, a tangible

12

production asset will be considered located where the asset is physically located. An intangible production asset
will be considered located where the
tangible production assets owned by the
taxpayer to which it relates are located.
(ii) Production both within the United
States and within foreign countries—
(A) Source of income. Where the taxpayer’s production assets are located
both within and without the United
States, income from sources without the
United States will be determined by
multiplying the income attributable to
the taxpayer’s production activity by a
fraction, the numerator of which is the
average adjusted basis of production
assets that are located outside the United
States and the denominator of which is
the average adjusted basis of all production assets within and without the
United States. The remaining income is
treated as from sources within the
United States.
(B) Adjusted basis of production assets. For purposes of paragraph
(c)(1)(ii)(A) of this section, the adjusted
basis of an asset is determined under
section 1011. The average adjusted basis
is computed by averaging the adjusted
basis of the asset at the beginning and
end of the taxable year, unless by reason
of material changes during the taxable
year such average does not fairly represent the average for such year. In this
event, the average adjusted basis will be
determined upon a more appropriate
basis. If production assets are used to
produce inventory sold in Section 863
Sales and are also used to produce other
property during the taxable year, the
portion of its adjusted basis that is
included in the fraction described in
paragraph (c)(1)(ii)(A) of this section
will be determined under any method
that reasonably reflects the portion of
the assets that produces inventory sold
in Section 863 Sales. For example, the
portion of such an asset that is included
in the formula may be determined by
multiplying the asset’s average adjusted
basis by a fraction, the numerator of
which is the gross receipts from sales of
inventory from Section 863 Sales produced by the asset, and the denominator
of which is the gross receipts from all
property produced by that asset.
(iii) Anti-abuse rule. The purpose of
this paragraph (c)(1) is to attribute the
source of the taxpayer’s production income to the location of the taxpayer’s
production activity. Therefore, if the
taxpayer has entered into or structured
one or more transactions with a princi-

pal purpose of reducing its U.S. tax
liability by manipulating the formula
described in paragraph (c)(1)(ii)(A) of
this section in a manner inconsistent
with the purpose of this paragraph
(c)(1), the District Director may make
appropriate adjustments so that the
source of the taxpayer’s income from
production activity more clearly reflects
the source of that income.
(iv) Examples. The following examples illustrate the rules of this paragraph (c)(1):
Example 1. Source of production income. (i) A,
a U.S. corporation, produces widgets that are sold
both within the United States and within a foreign
country. The initial manufacture of all widgets
occurs in the United States. The second stage of
production of widgets that are sold within a
foreign country is completed within the country of
sale. A’s U.S. plant and machinery which is
involved in the initial manufacture of the widgets
has an average adjusted basis of $200. A also
owns warehouses used to store work-in-process. A
owns foreign equipment with an average adjusted
basis of $25. A’s gross receipts from all sales of
widgets is $100, and its gross receipts from export
sales of widgets is $25. Assume that apportioning
average adjusted basis using gross receipts is
reasonable. Assume A’s cost of goods sold from
the sale of widgets in the foreign countries is $13
and thus, its gross income from widgets sold in
foreign countries is $12. A uses the 50/50 method
to divide its gross income between production
activity and sales activity.
(ii) A determines its production gross income
from sources without the United States by multiplying one-half of A’s $12 of gross income from
sales of widgets in foreign countries, or $6, by a
fraction, the numerator of which is all relevant
foreign production assets, or $25, and the denominator of which is all relevant production assets, or
$75 ($25 foreign assets + ($200 U.S. assets X $25
gross receipts from export sales/$100 gross receipts from all sales)). Therefore, A’s gross production income from sources without the United
States is $2 ($6 X ($25/$75)).
Example 2. Location of intangible property.
Assume the same facts as Example 1, except that
A employs a patented process that applies only to
the initial production of widgets. In computing the
formula used to determine the source of income
from production activity, A’s patent, if it has an
average adjusted basis, would be located in the
United States.
Example 3. Anti-abuse rule. (i) Assume the
same facts as Example 1. A sells its U.S. assets to
B, an unrelated U.S. corporation, with a principal
purpose of reducing its U.S. tax liability by
manipulating the property fraction. A then leases
these assets from B. After this transaction, under
the general rule of paragraph (c)(1)(ii) of this
section, all of A’s production income would be
considered from sources without the United States,
because all of A’s relevant production assets are
located within a foreign country. Since the leased
property is not owned by the taxpayer, it is not
included in the fraction.
(ii) Because A has entered into a transaction
with a principal purpose of reducing its U.S. tax
liability by manipulating the formula described in
paragraph (c)(1)(ii)(A) of this section, A’s income
must be adjusted to more clearly reflect the source
of that income. In this case, the District Director

may redetermine the source of A’s production
income by ignoring the sale-leaseback transactions.

(2) Income attributable to sales activity. The source of the taxpayer’s income
that is attributable to sales activity will
be determined under the provisions of
§ 1.861–7(c). However, notwithstanding
any other provision, for purposes of
section 863, the place of sale will be
presumed to be the United States if
personal property is wholly produced in
the United States and the property is
sold for use, consumption, or disposition
in the United States. See § 1.864–
6(b)(3)(ii) to determine the country of
use, consumption, or disposition. Also,
in applying this paragraph, property will
be treated as wholly produced in the
United States if it is subject to no more
than packaging, repackaging, labeling,
or other minor assembly operations outside the United States, within the meaning of § 1.954–3(a)(4)(iii)(property
manufactured or produced by a controlled foreign corporation).
(d) Determination of source of taxable income. Once the source of gross
income has been determined under paragraph (c) of this section, the taxpayer
must properly allocate and apportion
separately under §§ 1.861–8 through
1.861–14T the amounts of its expenses,
losses, and other deductions to its respective amounts of gross income from
Section 863 Sales determined separately
under each method described in paragraph (b) of this section. In addition, if
the taxpayer deducts expenses for research and development under section
174 that may be attributed to its Section
863 Sales under § 1.861–8(e)(3), the
taxpayer must separately allocate or apportion expenses, losses, and other deductions to its respective amounts of
gross income from each relevant product
category that the taxpayer uses in applying the rules of § 1.861–8(e)(3)(i)(A).
In the case of gross income from Section 863 Sales determined under the IFP
method or the books and records
method, the rules of §§ 1.861–8 through
1.861–14T must apply to properly allocate or apportion amounts of expenses,
losses and other deductions allocated
and apportioned to such gross income
between gross income from sources
within and without the United States. In
the case of gross income from Section
863 Sales determined under the 50/50
method, the amounts of expenses,
losses, and other deductions allocated
and apportioned to such gross income
must be apportioned between sources

13

within and without the United States pro
rata based on the relative amounts of
gross income from sources within and
without the United States determined
under the 50/50 method. Research and
experimental expenditures qualifying under § 1.861–17 are allocated under that
section, and are not allocated and apportioned pro rata under the 50/50 method.
(e) Election and reporting rules—
(1) Elections under paragraph (b) of
this section. If a taxpayer does not elect
a method specified in paragraph (b)(2)
or (3) of this section, the taxpayer must
apply the method specified in paragraph
(b)(1) of this section. The taxpayer may
elect to apply the method specified in
paragraph (b)(2) of this section by using
the method on a timely filed original
return (including extensions). A taxpayer
may elect to apply the method specified
in paragraph (b)(3) of this section by
using the method on a timely filed
original return (including extensions),
but only if the taxpayer has received
permission from the District Director to
apply that method. Once a method under
paragraph (b) of this section has been
used, that method must be used in later
taxable years unless the Commissioner
consents to a change. However, if a
taxpayer elects to change to or from the
method specified in paragraph (b)(3) of
this section, the taxpayer must obtain
permission from the District Director
instead of the Commissioner. Permission
to change methods from one year to
another year will not be withheld unless
the change would result in a substantial
distortion of the source of the taxpayer’s
income.
(2) Disclosure on tax return. A taxpayer who uses one of the methods
described in paragraph (b) of this section must fully explain in a statement
attached to the return the methodology
used, the circumstances justifying use of
that methodology, the extent that sales
are aggregated, and the amount of income so allocated.
(f) Income partly from sources within
a possession of the United States. Taxpayers with income partly from sources
within a possession of the United States
must apply the rules of § 1.863–3A(c).
(g) Special rules for partnerships—
(1) General rule. For purposes of
§ 1.863–1 and this section, a taxpayer’s
production or sales activity does not
include production and sales activities
conducted by a partnership of which the
taxpayer is a partner either directly or
through one or more partnerships, ex-

cept as otherwise provided in paragraph
(g)(2) of this section.
(2) Exceptions—(i) In general. For
purposes of determining the source of
the partner’s distributive share of partnership income or determining the
source of the partner’s income from the
sale of inventory property which the
partnership distributes to the partner in
kind, the partner’s production or sales
activity includes an activity conducted
by the partnership. In addition, the production activity of a partnership includes
the production activity of a taxpayer that
is a partner either directly or through
one or more partnerships, to the extent
that the partner’s production activity is
related to inventory that the partner
contributes to the partnership in a transaction described under section 721.
(ii) Attribution of production assets to
or from a partnership. A partner will be
treated as owning its proportionate share
of the partnership’s production assets
only to the extent that, under paragraph
(g)(2)(i) of this section, the partner’s
activity includes production activity conducted through a partnership. A partner’s
share of partnership assets will be determined by reference to the partner’s
distributive share of partnership income
for the year attributable to such production assets. Similarly, to the extent a
partnership’s activities include the production activities of a partner, the partnership will be treated as owning the
partner’s production assets related to the
inventory that is contributed in kind to
the partnership. See paragraph
(c)(1)(ii)(B) of this section for rules
apportioning the basis of assets to Section 863 Sales.
(iii) Basis. For purposes of this section, in those cases where the partner is
treated as owning its proportionate share
of the partnership’s production assets,
the partner’s basis in production assets
held through a partnership shall be determined by reference to the partnership’s adjusted basis in its assets (including a partner’s special basis
adjustment, if any, under section 743).
Similarly, a partnership’s basis in a
partner’s production assets is determined
with reference to the partner’s adjusted
basis in its assets.
(iv) Separate application of methods.
If, under paragraph (g)(2) of this section, a partner is treated as conducting
the activity of a partnership, and is
treated as owning its proportionate share
of a partnership’s production assets, a
partner must apply the method it has
elected under paragraph (b) of this sec-

tion separately to Section 863 Sales
described in this paragraph (g) and all
other Section 863 Sales.
(3) Examples. The following examples illustrate the rules of this paragraph (g):
Example 1. Distributive share of partnership
income. A, a U.S. corporation, forms a partnership
in the United States with B, a country X corporation. A and B each have a 50 percent interest in
the income, gains, losses, deductions and credits
of the partnership. The partnership is engaged in
the manufacture and sale of widgets. The widgets
are manufactured in the partnership’s plant located
in the United States and are sold by the partnership outside the United States. The partnership
owns the manufacturing facility and all other
production assets used to produce the widgets. A’s
distributive share of partnership income includes
50 percent of the sales income from these sales. In
applying the rules of section 863 to determine the
source of its distributive share of partnership
income from the export sales of widgets, A is
treated as carrying on the activity of the partnership related to production of these widgets and as
owning a proportionate share of the partnership’s
assets related to production of the widgets, based
upon its distributive share of partnership income.
Example 2. Distribution in kind. Assume the
same facts as in Example 1 except that the
partnership, instead of selling the widgets, distributes the widgets to A and B. A then further
processes the widgets and then sells them outside
the United States. In determining the source of the
income earned by A on the sales outside the
United States, A is treated as conducting the
activities of the partnership related to production
of the distributed widgets. Thus, the source of
gross income on the sale of the widgets is
determined under section 863 and these regulations. A applies the 50/50 method described in
paragraph (b)(1) of this section to determine the
source of income from the sales. In applying
paragraph (c)(1) of this section, A is treated as
owning its proportionate share of the partnership’s
production assets based upon its distributive share
of partnership income.

(h) Effective dates. The rules of this
section apply to taxable years beginning
December 30, 1996. However, taxpayers
may apply these regulations for taxable
years beginning after July 11, 1995, and
before December 30, 1996. For years
beginning before December 30, 1996,
see §§ 1.863–3A and 1.863–3AT.
Par. 7. Section 1.863–4 is amended by
revising the section heading and paragraph (a) to read as follows:

*

*

*

*

*

§ 1.863–5 [Removed]
Par. 8. Section 1.863–5 is removed.
PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK
REDUCTION ACT
Par. 9. The authority citation for part
602 continues to read as follows:
Authority: 26 U.S.C. 7805.
Par. 10. In § 602.101, paragraph (c)
is amended by adding entries for
1.863–1 and 1.863–3A, and revising the
entry for 1.863–3 to read as follows:
§ 602.101 OMB Control numbers.
*

*

*

*

*

(c) * * *
CFR part or section
where identified and
described

Current OMB
control No.

*
*
*
*
*
1.863–1 . . . . . . . . . . . . . . 1545–1476
1.863–3 . . . . . . . . . . . . . . 1545–1476
*
*
*
*
*
1.863–3A. . . . . . . . . . . . . 1545–0126
*
*
*
*
*
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved November 25, 1996.
Donald C. Lubick,
Acting Assistant Secretary
of Tax Policy.
(Filed by the Office of the Federal Register on
November 27, 1996, 8:45 a.m., and published in
the issue of the Federal Register for November 29,
1996, 61 F.R. 60540)

Section 1491.—Imposition of Tax
If the status of a trust changes from domestic to
foreign, what are the consequences for purposes of
the section 1491 excise tax? See Notice 96–65,
page 28.

Section 2056A.—Qualified
Domestic Trust

§ 1.863–4 Certain transportation services.

26 CFR 20.2056A–2: Requirements for qualified
domestic trusts.

(a) General. A taxpayer carrying on
the business of transportation service
(other than an activity giving rise to
transportation income described in section 863(c) or to income subject to other
specific provisions of this title) between
points in the United States and points
outside the United States derives income
partly from sources within and partly
from sources without the United States.

T.D. 8686

14

DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 20 and 602
Requirements to Ensure Collection
of Section 2056A Estate Tax
AGENCY: Internal Revenue Service
(IRS), Treasury.

ACTION: Final regulations.

Background

SUMMARY: This document contains
final regulations that provide guidance
relating to the additional requirements
necessary to ensure the collection of the
estate tax imposed under section
2056A(b) with respect to taxable events
involving qualified domestic trusts
(QDOTs) described in section 2056A(a).
DATES: These regulations are effective
November 29, 1996.
For dates of applicability, see
§ 20.2056A–2(d).

A notice of proposed rulemaking was
published in the Federal Register on
January 5, 1993 (58 FR 305), reflecting
amendments to the Internal Revenue
Code by the Technical and Miscellaneous Revenue Act of 1988 (Public Law
100–647), the Revenue Reconciliation
Act of 1989 (Public Law 101–239), and
the Revenue Reconciliation Act of 1990
(Public Law 101–508). The amendments
generally relate to sections 2056 and
2523, and affect the availability of the
estate and gift tax marital deduction
when the surviving spouse or the donee
spouse is not a United States citizen.
Part of the NPRM was published in the
Federal Register as final regulations, in
TD 8612, on August 22, 1995 (60 FR
43531 [1995–2 C.B. 192]). That part of
the NPRM that addressed the regulatory
requirements to ensure the collection of
the estate tax imposed by section
2056A(b)(1)(A) and (B) was published
in the Federal Register on August 22,
1995, in the form of temporary and
proposed regulations, (60 FR 43554 and
60 FR 43575, respectively) in order to
afford the public a further opportunity to
comment on these security arrangements.
On January 16, 1996, the IRS held a
hearing on the temporary and proposed
regulations. These final regulations reflect the comments received in response
to the temporary and proposed regulations.

FOR FURTHER INFORMATION CONTACT: Susan Hurwitz (202) 622–3090
(not a toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained in these final regulations has been
reviewed and approved by the Office of
Management and Budget in accordance
with the Paperwork Reduction Act (44
U.S.C. 3507) under control number
1545–1443. Responses to this collection
of information are required in order for
an estate to be eligible for the estate tax
marital deduction in cases where the
surviving spouse is not a United States
citizen.
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.
The estimated annual burden per respondent varies from 30 minutes to 3
hours, depending on individual circumstances, with an estimated average of
1.39 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 T:FP,
Washington, DC 20224, and to the Office of Management and Budget, Attention: Desk Officer for the Department
of the Treasury, Office of Information
and Regulatory Affairs, Washington, DC
20503.
Books or records relating to this 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.

Explanation of Provisions
The following is a summary of the
significant comments received and the
reasons for accepting or rejecting those
comments in the final regulations.
Under the temporary regulations, a
qualified domestic trust (QDOT) that
has assets in excess of $2 million, may
alternate among the three security arrangements provided in the regulations
(U.S. bank trustee, bond or letter of
credit), provided that at all times, at
least one of the three arrangements is in
effect. A QDOT with assets of $2
million or less need not satisfy these
requirements, if, in general, the trust
holdings of foreign situs real property
are limited to 35 percent of the fair
market value of the trust corpus.
Comments were received that trusts in
actual compliance with these regulatory
requirements, but which do not explicitly include the required language, will
not qualify as a QDOT. In addition,
comments suggested that the imposition
of numerous governing instrument re-

15

quirements will increase the difficulty of
drafting a QDOT and result in a trust
document that will have to include detailed provisions, many of which are not
likely to be applicable. A suggestion was
made that if the governing instrument
requirement is retained in the regulations, then the required security provisions should be permitted to be incorporated by reference in a trust document.
This suggestion was adopted. However,
in order to assist taxpayers who may
wish to specify the required provisions
in the governing instrument, the IRS has
published guidance in the Internal Revenue Bulletin (see § 602.101(d)(2) of
this chapter) providing sample language
that may be used in a QDOT instrument
to satisfy the additional security requirements contained in the final regulations.
In response to comments, the language of the regulations has been modified to clarify that the QDOT may
alternate among the three arrangements
provided in the regulations as long as, at
any given time, one of the three arrangements is required to be operative.
Comments suggested that the temporary regulations may be viewed as requiring that a QDOT that initially employs the bank trustee security
alternative must, irrespective of whether
the QDOT has switched to another
security option, continue to have at least
one U.S. Bank acting as a trustee. In
response to this comment, the final
regulations clarify that, if the QDOT
changes to a different security arrangement, a U.S. bank need not continue to
act as trustee.
Under the temporary regulations, in
determining whether the value of the
assets passing to a QDOT are in excess
of, or less than, $2 million, indebtedness
with respect to the assets is not taken
into account to reduce value. Similarly,
under the temporary regulations, the
amount of the bond or letter of credit
that is furnished to the IRS must be
equal to 65 percent of the fair market
value of the trust assets determined
‘‘without regard to any indebtedness
thereon.’’ Comments suggested that indebtedness should be taken into account
in determining whether the $2 million
dollar threshold has been exceeded and
the amount of the bond or letter of
credit required. This change has not
been made. The IRS and Treasury believe that the retention of the rule that
indebtedness on the property is not
taken into account to reduce value most
effectively ensures collection of the estate tax imposed under section

2056A(b). For the limited purpose under
this section (i.e., to determine whether
the $2 million threshold is exceeded and
the amount of the bond or letter of
credit to be furnished to the IRS) the
complexity that would be involved in
drafting rules to determine which debts
qualify to be taken into account and
which do not is not warranted.
Under the temporary regulations, with
regard to the bond and letter of credit
security options, if the fair market value
of the trust assets, is ‘‘finally determined’’ to be in excess of the value of
the trust assets as originally reported,
the trustee has a reasonable period of
time (not exceeding sixty days from the
date of the final determination) to adjust
the amount of the bond or letter of
credit. The temporary regulations also
use the term ‘‘finally determined’’ in
addressing substantial undervaluations of
property passing to a QDOT and the
grace period provided to meet the security requirements when a QDOT is
determined to contain assets in excess of
$2 million. Comments were received
suggesting that the regulations provide a
definition of ‘‘finally determined’’.
Accordingly, the final regulations provide that the value of the assets will be
finally determined on the earliest to
occur of—
1. The entry of a decision, judgment,
decree, or other order by any court of
competent jurisdiction that has become
final;
2. The execution of a closing agreement made under section 7121;
3. Any final disposition by the IRS of
a claim for refund;
4. The issuance of an estate tax closing letter (if no claim for refund is
filed); or
5. The expiration of the statute of
limitations for assessment with respect
to the decedent’s estate tax liability.
In response to comments, the regulation addressing the required duration of
the bond or letter of credit has been
clarified to provide that the security
arrangement must remain in effect until
the trust ceases to function as a QDOT.
Comments have been received regarding the amount of the bond or letter of
credit that must be furnished to the IRS.
One commentator stated that, since the
purpose of the bond or letter of credit
requirement is to provide a source of
funds for the payment of the section
2056A(b) estate tax, the amount of the
required bond or letter of credit should
be based on either the maximum federal
estate tax rate, or the amount of estate

tax deferred, rather than 65% of the
value of the QDOT, as provided in the
regulations. This suggestion has not
been adopted. Generally, the regulation
requires a bond of 65 percent of the
initial fair market value of the trust
assets to ensure that the potential estate
tax liability is adequately secured if the
trust property appreciates in value.
The temporary regulations providing
that notice of failure to renew a bond or
letter of credit must be ‘‘received by the
IRS at least 60 days prior to the end of
the term of the bond or letter of credit’’
has been changed to reference the date
the notice is ‘‘mailed to’’ the IRS.
Further, under the final regulations, the
notice must also be mailed to the U.S.
Trustee of the QDOT.
Under the regulations, in the case of a
QDOT of less than $2 million, if on the
last day of a taxable year of the QDOT,
the value of foreign real property owned
by the QDOT exceeds 35 percent of the
QDOT assets because of distributions of
principal during that year, or because of
fluctuations in the value of the foreign
currency in the jurisdiction where the
real property is located, a grace period
of one year is provided to allow the
trustee to comply with the 35 percent
limit. Comments suggested that changes
in the relative value of the trust assets
would also cause the trust to fail to
satisfy the 35 percent limit, and failure
to comply due to such changes that are
beyond the control of the trustee should
also be eligible for the grace period.
Accordingly, under the final regulations,
the trustee will also be accorded the
grace period to satisfy the 35 percent
limit if, as a result of changes in the
relative values of the trust assets, more
than 35 percent of the value of the trust
consists of foreign real estate.
Under the temporary regulations, for
purposes of determining whether the $2
million threshold has been exceeded,
and for purposes of determining the
amount of the bond or letter of credit,
the executor of the decedent’s estate
may exclude up to $600,000 in value
attributable to real property wherever
situated (and related furnishings) owned
directly by the QDOT that is used by
the surviving spouse as the spouse’s
principal residence. Comments were received that the regulations should be
expanded to allow the exclusion of all
residential real property that is actually
used by the surviving spouse. Thus, a
vacation home or second home would
qualify for the exclusion. It was also
suggested that all personally used resi-

16

dential real property, regardless of value,
should be eligible for the exclusion. The
final regulations do not change the monetary limit of $600,000 for the exclusion. The $600,000 limit for the exclusion facilitates the reduction of the costs
associated with providing security while
adequately ensuring the collection of the
section 2056A(b) tax. This is especially
the case in situations where the residential real property is situated outside the
United States so that a significant collection risk is presented. However, under
the final regulations the exclusion has
been redesignated as a ‘‘personal residence’’ exclusion. The exclusion is now
available for the principal residence of
the surviving spouse and one additional
residence, to the extent the combined
value excluded does not exceed
$600,000. The second residence will be
eligible for the exclusion only if the
residence is used by the surviving
spouse as a personal residence and not
subject to any rental arrangement with
any person.
Under the temporary regulations, the
residence exclusion election is made by
attaching a written statement to the
estate tax return on which the QDOT
election is made. Commentators suggested that the final regulations allow
the election to be made at any time
during the term of the QDOT, and not
necessarily at the time of filing of the
decedent’s estate tax return. For example, if the bank trustee alternative is
selected by the trustee of the QDOT, but
at some future date the trustee desires to
change to the bond or letter of credit
security arrangement, the trustee should
be given the opportunity to make a
delayed election of the exclusion. In
response to these comments, the final
regulations provide that the election may
be made at any time during the term of
the QDOT. In addition, the final regulation provides for the cancellation of a
prior election.
Under the temporary regulations, the
U.S. Trustee of a QDOT is required to
file an annual statement with the IRS
containing specified items of information (including a list of all assets held
by the QDOT together with the fair
market value of each asset determined
as of the last day of the taxable year) if
the residence exclusion applies during
the taxable year. Comments were received suggesting that the cost of compliance with this annual reporting requirement will limit the utility of the
residence exclusion. In response to these
comments, annual reporting is no longer

required solely because the personal
residence exclusion was elected. However, the regulations retain the annual
reporting requirement where the residence previously subject to the exclusion is sold, or where the residence
ceases to be used as a personal residence during the taxable or calendar
year.
Under the temporary regulations, if a
residence that is subject to the exclusion
is sold during the term of the QDOT,
the exclusion will continue to apply if,
within 12 months of the date of sale, the
amount of the adjusted sales price (as
defined in section 1034(d)(1)) is used to
purchase a new residence for the spouse.
In response to comments, this provision
has been amended to provide that if a
residence ceases to be used as the
personal residence of the spouse, or if
the residence is sold during the term of
the QDOT, the exclusion may be applied to another residence that is held in
either the same QDOT or in another
QDOT, if the other residence is used as
a personal residence of the spouse. The
amount of exclusion that may be applied
to the new personal residence under
these circumstances can be up to
$600,000 (less that amount previously
allocated to a residence that continues to
qualify for the exclusion) even if the
entire $600,000 exclusion was not previously used for the initial personal residence(s).
Also, under the temporary regulations,
on the sale of a residence, if less than
the entire adjusted sales price is reinvested in a new residence, then the
amount of the exclusion initially
claimed by the QDOT is reduced proportionately. For example, if a residence
is sold for an adjusted sales price of
$1,000,000 and a new residence is acquired for $800,000, then, the original
exclusion would be reduced by
$120,000 to $480,000: $200,000 (adjusted sales price not reinvested)/
$1,000,000 (adjusted sales price) x
$600,000. Comments were received suggesting that this rule be changed to
provide that the amount of the exclusion
as adjusted not be reduced below the
amount actually reinvested (up to
$600,000). This suggestion was adopted
in the final regulations, reflecting that
two residences can now qualify for the
$600,000 exclusion.
Special Analyses
It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not

apply to these regulations, and because
the notice of proposed rulemaking preceding the regulations was issued prior
to March 29, 1996, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not
apply.
Drafting Information
The principal author of these regulations is Susan Hurwitz, Office of Assistant Chief Counsel (Passthroughs and
Special Industries). However, other personnel from the IRS and Treasury Department participated in their development.
*

*

*

*

*

Adoption of Amendments to the Regulations
Accordingly, 26 CFR parts 20 and
602 are amended as follows:
PART 20—ESTATE TAX; ESTATES
OF DECEDENTS DYING AFTER AUGUST 16, 1954
Paragraph 1. The authority citation for
part 20 continues to read in part as
follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. In § 20.2056A–0, the table of
contents is amended by revising the
entry for § 20.2056A–2(d) to read as
follows:
§ 20.2056A–0 Table of contents.
*

*

*

*

*

§ 20.2056A–2 Requirements for qualified domestic trust.
*

*

*

*

*

(d) Additional requirements to ensure
collection of the section 2056A estate
tax.
(1) Security and other arrangements
for payment of estate tax imposed under
section 2056A(b)(1).
(2) Individual trustees.
(3) Annual reporting requirements.
(4) Request for alternate arrangement
or waiver.
(5) Adjustment of dollar threshold
and exclusion.
(6) Effective date and special rules.
*

*

*

*

*

Par. 3. In § 20.2056A–2, paragraph
(d) is added to read as follows:
§ 20.2056A–2 Requirements for qualified domestic trust.
*

*

*

*

*

(d) Additional requirements to ensure
collection of the section 2056A estate
tax—(1) Security and other arrange-

17

ments for payment of estate tax imposed
under section 2056A(b)(1)—(i) QDOTs
with assets in excess of $2 million. If
the fair market value of the assets
passing, treated, or deemed to have
passed to the QDOT (or in the form of
a QDOT), determined without reduction
for any indebtedness with respect to the
assets, as finally determined for federal
estate tax purposes, exceeds $2 million
as of the date of the decedent’s death or,
if applicable, the alternate valuation date
(adjusted as provided in paragraph
(d)(1)(iii) of this section), the trust instrument must meet the requirements of
either paragraph (d)(1)(i)(A), (B), or (C)
of this section at all times during the
term of the QDOT. The QDOT may
alternate between any of the arrangements provided in paragraphs (d)(1)(i)(A), (B), and (C) of this section provided that, at any given time, one of the
arrangements must be operative. See
paragraph (d)(1)(iii) of this section for
the definition of finally determined. The
QDOT may provide that the trustee has
the discretion to use any one of the
security arrangements or may provide
that the trustee is limited to using only
one or two of the arrangements specified in the trust instrument. A trust
instrument that specifically states that
the trust must be administered in compliance with paragraph (d)(1)(i)(A), (B),
or (C) of this section is treated as
meeting the requirements of paragraphs
(d)(1)(i)(A), (B), or (C) for purposes of
paragraphs (d)(1)(i) and, if applicable,
(d)(1)(ii) of this section.
(A) Bank Trustee. Except as otherwise provided in paragraph (d)(6)(ii) or
(iii) of this section, the trust instrument
must provide that whenever the Bank
Trustee security alternative is used for
the QDOT, at least one U.S. Trustee
must be a bank as defined in section
581. Alternatively, except as otherwise
provided in paragraph (d)(6)(ii) or (iii)
of this section, at least one trustee must
be a United States branch of a foreign
bank, provided that, in such cases, during the entire term of the QDOT a U.S.
Trustee must act as a trustee with the
foreign bank trustee.
(B) Bond. Except as otherwise provided in paragraph (d)(6)(ii) or (iii) of
this section, the trust instrument must
provide that whenever the bond security
arrangement alternative is used for the
QDOT, the U.S. Trustee must furnish a
bond in favor of the Internal Revenue
Service in an amount equal to 65 percent of the fair market value of the trust
assets (determined without regard to any

indebtedness with respect to the assets)
as of the date of the decedent’s death
(or alternate valuation date, if applicable), as finally determined for federal
estate tax purposes (and as further adjusted as provided in paragraph
(d)(1)(iv) of this section). If, after examination of the estate tax return, the
fair market value of the trust assets, as
originally reported on the estate tax
return, is adjusted (pursuant to a judicial
proceeding or otherwise) resulting in a
final determination of the value of the
assets as reported on the return, the U.S.
Trustee has a reasonable period of time
(not exceeding sixty days after the conclusion of the proceeding or other action
resulting in a final determination of the
value of the assets) to adjust the amount
of the bond accordingly. But see, paragraph (d)(1)(i)(D) of this section for a
special rule in the case of a substantial
undervaluation of QDOT assets. Unless
an alternate arrangement under paragraph (d)(1)(i)(A), (B), or (C) of this
section, or an arrangement prescribed
under paragraph (d)(4) of this section, is
provided, or the trust is otherwise no
longer subject to the requirements of
section 2056A pursuant to section
2056A(b)(12), the bond must remain in
effect until the trust ceases to function
as a QDOT and any tax liability finally
determined to be due under section
2056A(b) is paid, or is finally determined to be zero.
(1) Requirements for the bond. The
bond must be with a satisfactory surety,
as prescribed under section 7101 and
§ 301.7101–1 of this chapter (Regulations on Procedure and Administration),
and is subject to Internal Revenue Service review as may be prescribed by the
Commissioner. The bond may not be
cancelled. The bond must be for a term
of at least one year and must be automatically renewable at the end of that
term, on an annual basis thereafter,
unless notice of failure to renew is
mailed to the U.S. Trustee and the
Internal Revenue Service at least 60
days prior to the end of the term,
including periods of automatic extensions. Any notice of failure to renew
required to be sent to the Internal Revenue Service must be sent to the Estate
and Gift Tax Group in the District
Office of the Internal Revenue Service
that has examination jurisdiction over
the decedent’s estate (Internal Revenue
Service, District Director, [specify location] District Office, Estate and Gift Tax
Examination Group, [specify Street Address, City, State, Zip Code]) (or in the

case of noncitizen decedents and United
States citizens who die domiciled outside the United States, Estate Tax
Group, Assistant Commissioner (International), 950 L’Enfant Plaza, CP:IN:D:C:EX:HQ:1114, Washington, DC 20024).
The Internal Revenue Service will not
draw on the bond if, within 30 days of
receipt of the notice of failure to renew,
the U.S. Trustee notifies the Internal
Revenue Service (at the same address to
which notice of failure to renew is to be
sent) that an alternate arrangement under
paragraph (d)(1)(i)(A), (B), or (C) or
(d)(4) of this section, has been secured
and that the arrangement will take effect
immediately prior to or upon expiration
of the bond.
(2) Form of bond. The bond must be
in the following form (or in a form that
is the same as the following form in all
material respects), or in such alternative
form as the Commissioner may prescribe by guidance published in the
Internal Revenue Bulletin (see
§ 601.601(d)(2) of this chapter):
Bond in Favor of the Internal Revenue Service To Secure Payment of
Section 2056A Estate Tax Imposed Under Section 2056A(b) of the Internal
Revenue Code.
KNOW ALL PERSONS BY
THESE PRESENTS, That the under, the SURETY,
signed,
, the PRINCIPAL,
and
are irrevocably held and firmly bound to
pay the Internal Revenue Service upon
written demand that amount of any tax
up to $[amount determined under paragraph (d)(1)(i)(B) of this section], imposed under section 2056A(b)(1) of the
Internal Revenue Code (including penalties and interest on said tax) determined
by the Internal Revenue Service to be
payable with respect to the principal as
trustee for: [Identify trust and governing
instrument, name and address of
trustee], a qualified domestic trust as
defined in section 2056A(a) of the Internal Revenue Code, for the payment of
which the said Principal and said Surety,
bind themselves, their heirs, executors,
administrators, successors and assigns,
jointly and severally, firmly by these
presents.
WHEREAS, The Internal Revenue
Service may demand payment under this
bond at any time if the Internal Revenue
Service in its sole discretion determines
that a taxable event with respect to the
trust has occurred; the trust no longer
qualifies as a qualified domestic trust as
described in section 2056A(a) of the

18

Internal Revenue Code and the regulations promulgated thereunder, or a distribution subject to the tax imposed
under section 2056A(b)(1) has been
made. Demand by the Internal Revenue
Service for payment may be made
whether or not the tax and tax return
(Form 706–QDT) with respect to the
taxable event is due at the time of such
demand, or an assessment has been
made by the Internal Revenue Service
with respect to the tax.
NOW THEREFORE, The condition
of this obligation is such that it must not
be cancelled and, if payment of all tax
liability finally determined to be imposed under section 2056A(b) is made,
then this obligation is null and void;
otherwise, this obligation is to remain in
full force and effect for one year from
its effective date and is to be automatically renewable on an annual basis
unless, at least 60 days prior to the
expiration date, including periods of
automatic renewals, the surety mails to
the U.S. Trustee and the Internal Revenue Service by Registered or Certified
Mail, return receipt requested, notice of
the failure to renew. Receipt of this
notice of failure to renew by the Internal
Revenue Service may be considered a
taxable event. The Internal Revenue Service will not draw upon the bond if,
within 30 days of receipt of the notice
of failure to renew, the trustee notifies
the Internal Revenue Service that an
alternate security arrangement has been
secured and that the arrangement will
take effect immediately prior to or upon
expiration of the bond. The surety remains liable for all taxable events occurring prior to the date of expiration.
All notices required to be sent to the
Internal Revenue Service under this
instrument should be sent to District
Director, [specify location] District Office, Estate and Gift Tax Examination
Group, Street Address, City, State, Zip
Code. (In the case of nonresident noncitizen decedents and United States citizens who die domiciled outside the
United States, all notices should be sent
to Estate Tax Group, Assistant Commissioner (International), 950 L’Enfant
Plaza, CP:IN:D:C:EX:HQ:1114, Washington, DC 20024).
This bond shall be effective as of
. Principal
Date
Surety
Date
(3) Additional governing instrument
requirements. The trust instrument must
provide that in the event the Internal
Revenue Service draws on the bond, in

accordance with its terms, neither the
U.S. Trustee nor any other person will
seek a return of any part of the remittance until after April 15th of the calendar year following the year in which the
bond is drawn upon. After that date, any
such remittance will be treated as a
deposit and returned (without interest)
upon request of the U.S. Trustee, unless
it is determined that assessment or collection of the tax imposed by section
2056A(b)(1) is in jeopardy, within the
meaning of section 6861. If an assessment under section 6861 is made, the
remittance will first be credited to any
tax liability reported on the Form 706–
QDT, then to any unpaid balance of a
section 2056A(b)(1)(A) tax liability
(plus interest and penalties) for any
prior taxable years, and any balance will
then be returned to the U.S. Trustee.
(4) Procedure. The bond is to be
filed with the decedent’s federal estate
tax return, Form 706 or 706NA (unless
an extension for filing the bond is
granted under § 301.9100 of this chapter). The U.S. Trustee must provide a
written statement with the bond that
provides a list of the assets that will be
used to fund the QDOT and the respective values of the assets. The written
statement must also indicate whether
any exclusions under paragraph
(d)(1)(iv) of this section are claimed.
(C) Letter of credit. Except as otherwise provided in paragraph (d)(6)(ii) or
(iii) of this section, the trust instrument
must provide that whenever the letter of
credit security arrangement is used for
the QDOT, the U.S. Trustee must furnish an irrevocable letter of credit issued
by a bank as defined in section 581, a
United States branch of a foreign bank,
or a foreign bank with a confirmation
by a bank as defined in section 581. The
letter of credit must be for an amount
equal to 65 percent of the fair market
value of the trust assets (determined
without regard to any indebtedness with
respect to the assets) as of the date of
the decedent’s death (or alternate valuation date, if applicable), as finally determined for federal estate tax purposes
(and as further adjusted as provided in
paragraph (d)(1)(iv) of this section). If,
after examination of the estate tax return, the fair market value of the trust
assets, as originally reported on the
estate tax return, is adjusted (pursuant to
a judicial proceeding or otherwise) resulting in a final determination of the
value of the assets as reported on the
return, the U.S. Trustee has a reasonable
period of time (not exceeding 60 days

after the conclusion of the proceeding or
other action resulting in a final determination of the value of the assets) to
adjust the amount of the letter of credit
accordingly. But see, paragraph
(d)(1)(i)(D) of this section for a special
rule in the case of a substantial undervaluation of QDOT assets. Unless an
alternate arrangement under paragraph
(d)(1)(i)(A), (B), or (C) of this section,
or an arrangement prescribed under
paragraph (d)(4) of this section, is provided, or the trust is otherwise no longer
subject to the requirements of section
2056A
pursuant
to
section
2056A(b)(12), the letter of credit must
remain in effect until the trust ceases to
function as a QDOT and any tax liability finally determined to be due under
section 2056A(b) is paid or is finally
determined to be zero.
(1) Requirements for the letter of
credit. The letter of credit must be
irrevocable and provide for sight payment. The letter of credit must have a
term of at least one year and must be
automatically renewable at the end of
the term, at least on an annual basis,
unless notice of failure to renew is
mailed to the U.S. Trustee and the
Internal Revenue Service at least sixty
days prior to the end of the term,
including periods of automatic renewals.
If the letter of credit is issued by the
U.S. branch of a foreign bank and the
U.S. branch is closing, the branch (or
foreign bank) must notify the U.S.
Trustee and the Internal Revenue Service
of the closure and the notice of closure
must be mailed at least 60 days prior to
the date of closure. Any notice of failure
to renew or closure of a U.S. branch of
a foreign bank required to be sent to the
Internal Revenue Service must be sent to
the Estate and Gift Tax Group in the
District Office of the Internal Revenue
Service that has examination jurisdiction
over the decedent’s estate (Internal Revenue Service, District Director, [specify
location] District Office, Estate and Gift
Tax Examination Group, [Street Address,
City State, Zip Code]) (or in the case of
noncitizen decedents and United States
citizens who die domiciled outside the
United States, Estate Tax, Assistant
Commissioner (International), 950
L’Enfant Plaza, CP:IN:D:C:EX:HQ:1114,
Washington, DC 20024). The Internal
Revenue Service will not draw on the
letter of credit if, within 30 days of
receipt of the notice of failure to renew
or closure of the U.S. branch of a
foreign bank, the U.S. Trustee notifies
the Internal Revenue Service (at the

19

same address to which notice is to be
sent) that an alternate arrangement under
paragraph (d)(1)(i)(A), (B), or (C), or
(d)(4) of this section, has been secured
and that the arrangement will take effect
immediately prior to or upon expiration
of the letter of credit or closure of the
U.S. branch of the foreign bank.
(2) Form of letter of credit. The letter
of credit must be made in the following
form (or in a form that is the same as
the following

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Airs%3A0b0173a370762064. Public record. Not legal advice.