Bulletin No. 2020–53

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Bulletin No. 2020–53

December 28, 2020

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.

ADMINISTRATIVE

REV. PROC. 2020-55, page 1811.

General Rules and Specifications for Substitute Forms and

Schedules

This procedure provides guidelines and general requirements for the development, printing, and approval of the

2020 substitute tax forms. This procedure will be reproduced as the next revision of Publication 1167. Rev. Proc.

2019-35 is superseded.

ADMINISTRATIVE, INCOME TAX

NOTICE 2020-88, page 1795.

Round 3 of Section 48A Phase III Program under the Qualifying Advanced Coal Project Program. This notice updates

and amplifies the procedures for the allocation of credits

under the qualifying advanced coal project program of §

48A of the Internal Revenue Code by announcing the immediate beginning of the 2020-2021 reallocation round

(“Round 3”) of the § 48A Phase III program.

REV. PROC. 2020-54, page 1806.

This revenue procedure will update Rev. Proc. 2019-42,

2019-49 I.R.B. 1298, and identifies circumstances under

which the disclosure on a taxpayer’s income tax return

with respect to an item or position is adequate for the

purpose of reducing the understatement of income tax under section 6662(d) of the Internal Revenue Code (relating

to the substantial understatement aspect of the accuracy-related penalty), and for the purpose of avoiding the

Finding Lists begin on page ii.

tax return preparer penalty under section 6694(a) (relating

to understatements due to unreasonable positions) with

respect to income tax returns.

This revenue procedure will apply to any income tax

return filed on 2020 tax forms for a taxable year beginning

in 2020, and to any income tax return filed in 2021 on

2020 tax forms for short taxable years beginning in 2021.

EMPLOYEE PLANS

NOTICE 2020-86, page 1786.

This notice provides guidance with respect to sections

102 and 103 of the Setting Every Community Up for Retirement Enhancement Act of 2019.

NOTICE 2020-87, page 1792.

This notice sets forth updates on the corporate bond

monthly yield curve, the corresponding spot segment

rates for December 2020 used under § 417(e)(3)(D), the

24-month average segment rates applicable for December 2020, and the 30-year Treasury rates, as reflected by

the application of § 430(h)(2)(C)(iv).

INCOME TAX

Notice 2020-78, page 1785.

The notice provides transition relief related to the work opportunity credit by giving employers additional time to submit

a certification request to a Designated Local Agency for the

targeted groups described in section 51(d)(5) and (7) of the

Internal Revenue Code.

T.D. 9921, page 1767.

These final regulations provide guidance on the sourcing of income from certain sales of personal property, including inventory, under section 863 of the Internal Revenue Code (“Code”),

which was amended by the Tax Cuts and Jobs Act, Pub. L.

No. 155-97 (2017) and also under section 865 of the Code.

The final regulations also modify certain rules for determining

whether foreign source income is effectively connected with

the conduct of a trade or business within the United States

under section 864 of the Code. The final regulations replace

previously issued proposed regulations and provide guidance

on determining the source of income from sales of inventory

produced within the United States and sold without the United

States or vice versa and new rules for determining the source

of income from sales of personal property by nonresidents

that are attributable to an office or other fixed place of business that the nonresident maintains in the United States. Finally, the final regulations provide rules, pursuant to section 1502

of the Code, for the determination of source of income from

sales of personal property in a consolidated group.

The IRS Mission

Provide America’s taxpayers top-quality service by helping

them understand and meet their tax responsibilities and enforce the law with integrity and fairness to all.

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.

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.

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.

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,

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.

Part II.—Treaties and Tax Legislation.

This part is divided into two subparts as follows: Subpart A,

Tax Conventions and Other Related Items, 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).

Part IV.—Items of General Interest.

This part includes notices of proposed rulemakings, disbarment and suspension lists, and announcements.

The last Bulletin for each month includes a cumulative index

for the matters published during the preceding months. These

monthly indexes are cumulated on a semiannual basis, and are

published in the last Bulletin of each semiannual period.

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.

December 28, 2020

Bulletin No. 2020–53

Part I

26 CFR 1.863-0, 1.863-0A, 1.863-1, 1.863-2, 1.8633, 1.863-8, 1.864-5, 1.864-6, 1.865-3, 1.937-2,

1.937-3, 1.1502-13

DEPARTMENT OF THE

TREASURY

Internal Revenue Service

26 CFR Part 1

Source of Income from

Certain Sales of Personal

Property

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final

regulations modifying the rules for determining the source of income from sales

of inventory produced within the United

States and sold without the United States or

vice versa. These final regulations also contain new rules for determining the source of

income from sales of personal property (including inventory) by nonresidents that are

attributable to an office or other fixed place

of business that the nonresident maintains

in the United States. Finally, these final

regulations modify certain rules for determining whether foreign source income is

effectively connected with the conduct of

a trade or business within the United States.

DATES: Effective Date: These final regulations are effective on December 11, 2020.

Applicability Dates: For dates of applicability, see §§1.863-1(f), 1.863-2(c), 1.8633(g), 1.863-8(h), 1.864-5(e), 1.864-6(c)

(4), and 1.865-3(g).

FOR FURTHER INFORMATION CONTACT: Brad McCormack at (202) 3176911 (not a toll free number).

SUPPLEMENTARY INFORMATION:

Background

The Tax Cuts and Jobs Act, Public Law

115-97, 131 Stat. 2054, 2208 (2017) (the

Bulletin No. 2020–53

“Act”), enacted on December 22, 2017,

amended section 863(b) of the Internal

Revenue Code (“Code”). On December

30, 2019, the Department of the Treasury

(“Treasury Department”) and the IRS

published proposed regulations (REG100956-19) under sections 863, 864, 865,

937, and 1502 in the Federal Register

(84 FR 71836) (the “proposed regulations”). A public hearing on the proposed

regulations was held on June 3, 2020. All

written comments received in response to

the proposed regulations are available at

https://www.regulations.gov or upon request. Terms used but not defined in this

preamble have the meaning provided in

these final regulations.

Summary of Comments and

Explanation of Revisions

I. Overview

The final regulations retain the overall approach of the proposed regulations,

with certain revisions. This Summary of

Comments and Explanation of Revisions

section discusses those revisions as well

as comments received in response to the

solicitation of comments in the notice of

proposed rulemaking. Comments outside

the scope of this rulemaking are generally not addressed but may be considered in

connection with future guidance projects.

II. Comments on and Revisions to

Proposed §1.863-1 — Allocation of

Gross Income Under Section 863(a) and

Proposed §1.863-3 — Allocation and

Apportionment of Income from Certain

Sales of Inventory

The Act amended section 863 of the

Code, which provides special sourcing rules for determining the source of

income, including income partly from

within and partly from without the United States. Specifically, the Act amended

section 863(b) to allocate or apportion

income from the sale or exchange of inventory property produced (in whole or

in part) by a taxpayer within the United

States and sold or exchanged without the

United States or produced (in whole or

in part) by the taxpayer without the Unit-

1767

ed States and sold or exchanged within

the United States (collectively, “Section

863(b)(2) Sales”) solely on the basis of

production activities with respect to that

inventory. Before the Act, section 863(b)

provided that income from Section 863(b)

(2) Sales would be treated as derived partly from sources within and partly from

sources without the United States without

providing the basis for such allocation or

apportionment. Consistent with the Act’s

changes to section 863(b), the proposed

regulations amended §1.863-3 in order to

properly allocate or apportion gross income from Section 863(b)(2) Sales based

solely on production activity.

Under §1.863-3(c)(1)(ii)(A) (which

has been redesignated in the final regulations as §1.863-3(c)(2)(i)), where the

taxpayer’s production assets are located

both within and without the United States,

the amount of income from sources without the United States is determined by

multiplying all the income attributable to

the taxpayer’s production activities by a

fraction, the numerator of which is the average adjusted basis of production assets

that are located without the United States

and the denominator of which is the average adjusted basis of all the production assets located within and without the United

States.

For purposes of applying this formula,

the adjusted basis of production assets is

determined under section 1011, which is

adjusted under section 1016 for depreciation deductions allowed. The Act also

amended section 168(k) to allow an additional first-year depreciation deduction of

100 percent of the basis of certain property placed in service after September 27,

2017, and before January 1, 2023. Therefore, certain new and used production assets placed in service and used predominantly within the United States during this

period may have an adjusted basis of zero.

However, production assets either placed

in service or used predominantly without

the United States, or both, do not qualify for this accelerated depreciation and

must be depreciated using the straight-line

method under the alternative depreciation

system (“ADS”) of section 168(g)(2). In

light of the Act’s change to section 168(k)

to allow accelerated depreciation in some

December 28, 2020

circumstances, the proposed regulations

provided a new rule for computing the adjusted basis of production assets for purposes of applying the allocation formula

in §1.863-3.

A. Income attributable to sales activity

Section 1.863-3, as in effect before this

Treasury Decision, provided rules and

corresponding methods for allocating or

apportioning gross income from Section

863(b)(2) Sales between production activity and sales activity. To implement the

changes to section 863(b) under the Act, the

proposed regulations proposed removing

§1.863-3(c)(2) which allocates and apportions income attributable to sales activity.

One comment argued that removing

§1.863-3(c)(2) could lead to double taxation when a foreign jurisdiction imposes taxation on the sales activity. The Act

amended section 863(b) to source income

from the sale by a taxpayer of inventory

produced by that taxpayer based only on

production activity. Under the Code, sales

activity is no longer a relevant factor for

allocating and apportioning such income.

Therefore, the final regulations remove

§1.863-3(c)(2). But see part V of this

Summary of Comments and Explanation

of Revisions section for a discussion of

the interaction with income tax treaties.

Another comment suggested that two

aspects of §1.863-3(c)(2) have continued

relevance even after the Act’s changes to

section 863(b)(2). First, §1.863-3(c)(2) has

a special rule modifying the rule in §1.8617(c) that generally sources income from

the sale of personal property based on the

place of sale. Under §1.861-7(c), a sale is

generally treated as consummated in the

place where the rights, title, and interest of

the seller in the property are transferred to

the buyer. However, if a taxpayer wholly

produces inventory in the United States

and sells it for use, consumption, or disposition in the United States, §1.863-3(c)

(2) presumes that the place of sale is in the

United States, even if title passes outside

the United States. The comment recommended the final regulations include a similar rule and expand it to inventory wholly

or partly produced in the United States that

is acquired by a related party and resold

for use, consumption, or disposition in the

United States with title passing outside the

December 28, 2020

United States. The comment observed that

in the absence of such a rule, the sale by

the related party would generate foreign

source income, notwithstanding the fact

that the inventory was produced wholly or

partly in the United States and ultimately

sold for use, consumption, or disposition in

the United States.

The final regulations do not adopt this

comment. The place of sale rule of §1.8617(c) already contains a broad anti-abuse

rule that would apply to any sales transactions “arranged in a particular manner

for the primary purpose of tax avoidance,”

which may cover certain related party arrangements about which the comment is

concerned. Section 482 also applies to

require that compensation paid between

related parties is consistent with the arm’s

length standard and will take into account

the business functions and assets of, and

risks assumed by, the related party intermediary. The Treasury Department and

the IRS continue to study issues related

to the distribution among related entities

of the business functions, assets, and risks

that generate business income, including

sales income, and may address these issues in future guidance, particularly with

respect to the sourcing of income from

certain digital transactions.

Second, the comment observed that

§1.863-3(c)(2) treats inventory as wholly produced in the United States for purposes of determining whether the place

of sale is presumed to be in the United

States if only minor assembly, packaging,

repackaging, or labeling occurs outside

the United States. The comment recommended including this rule as part of proposed §1.863-3(c)(1)(i). The final regulations adopt this comment in §1.863-3(c)

(1)(i) by incorporating the “principles of

§1.954-3(a)(4)” (other than §1.954-3(a)

(4)(iv)). Section 1.954-3(a)(4) provides

rules for determining when a corporation

has manufactured, produced, or constructed personal property. Under §1.954-3(a)

(4)(iii), packaging, repackaging, labeling, or minor assembly operations do not

constitute the manufacture, production, or

construction of property. Accordingly, under the final regulations, these principles

apply for purposes of determining whether a taxpayer’s activities constitute production activity under §1.863-3(c)(1)(i)

as well. See part II.B of this Summary of

1768

Comments and Explanation of Revisions

section.

B. Definition of production activities

Proposed §1.863-1(b)(2) provided the

rule for sourcing gross receipts from the

sale of natural resources where the taxpayer performs production activities in

addition to its ownership of a farm, mine,

oil or gas well, other natural deposit, or

uncut timber. Section 1.863-1(b)(3)(ii)

defines such “additional production activities” by reference to the “principles of

§1.954-3(a)(4).”

Under section 951(a)(1)(A), a United

States shareholder of a controlled foreign

corporation (“CFC”) includes in gross income its pro rata share of the CFC’s subpart

F income for the CFC’s taxable year which

ends with or within the taxable year of the

shareholder. Section 952(a)(2) defines the

term subpart F income to include foreign

base company income. Section 954(a)

(2) defines foreign base company income

to include foreign base company sales

income (“FBCSI”) for the taxable year.

Section 954(d)(1) defines FBCSI to mean

income derived by a CFC in connection

with certain related party transactions. Section 1.954-3(a)(4) provides an exception to

FBCSI when a CFC manufactures property that it sells. One comment supported

defining “additional production activities”

by reference to “the principles of §1.9543(a)(4),” as described in §1.863-1(b)(3)(ii),

and requested that §§1.863-3 and 1.865-3

include a similar cross reference.

The final regulations adopt this recommendation, in part. Specifically, under the

final regulations, §§1.863-3 and 1.865-3

incorporate the principles of §1.954-3(a)

(4), with the exception of the rules regarding a “substantial contribution to the

manufacturing of personal property” under §1.954-3(a)(4)(iv). See §§1.863-3(c)

(1)(i) and 1.865-3(d)(2). The final regulations also modify §1.863-1(b)(3)(ii) to

incorporate the principles of §1.954-3(a)

(4), other than the “substantial contribution to the manufacturing of personal

property” under §1.954-3(a)(4)(iv). The

substantial contribution rules were added

to §1.954-3(a)(4) in T.D. 9438 (December

29, 2008) after the adoption of §1.8631(b)(3)(ii) in T.D. 8687 (November 27,

1996). While the Treasury Department

Bulletin No. 2020–53

and the IRS agree with the comment

that the principles of §1.954-3(a)(4) may

generally be helpful in determining the

location of production activity for sourcing purposes, the substantial contribution

rules of §1.954-3(a)(4)(iv) are concerned

with whether there is production activity

and do not address the geographic location of that production activity, which is

relevant for sourcing under sections 861,

863, and 865. Additionally, the substantial

contribution rules are premised on treating

a corporation as engaged in production

activities even if it is not engaged in the

direct use of production assets (other than

oversight assets), while §1.863-3 focuses

on sourcing income based on the location

of a corporation’s production assets that

are used for production activities. See

§1.863-3(c)(1)(ii) (which has been redesignated in the final regulations as §1.8633(c)(2)). In this regard, there is not a clear

metric for quantifying production arising

from substantial contribution activities,

even if such activities are properly identified, in order to assign production activities to a particular geographic location for

purposes of determining the place of production under sections 861, 863, and 865.

Therefore, the final regulations provide

that the principles of §1.954-3(a)(4), other

than the substantial contribution rules in

§1.954-3(a)(4)(iv), apply in determining

whether production activities exist.

C. Measuring adjusted basis of

production assets

For inventory produced both within

and without the United States, the proposed regulations continued to allocate or

apportion the gross income between U.S.

and foreign sources based on the formula in §1.863-3(c)(1)(ii)(A) (redesignated

as proposed §1.863-3(c)(2)(i)). This formula determined the amount of foreign

source income by multiplying the total

gross income by a fraction, the numerator

of which is the average adjusted basis of

production assets 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 gross income is

from U.S. sources.

In light of the Act’s changes to section

168(k), proposed §1.863-3(c)(2)(ii) mea-

Bulletin No. 2020–53

sured the adjusted basis of the U.S. production assets for purposes of this formula

based on the alternative depreciation system (“ADS”) of section 168(g)(2). The preamble to the proposed regulations observed

that such rule allows the basis of both U.S.

and non-U.S. production assets to be measured consistently on a straight-line method

over the same recovery period, and requested comments on using ADS for this purpose

or alternatives for measuring relative U.S.

and non-U.S. production assets.

One comment suggested that some taxpayers such as partnerships and S corporations would face administrative burdens if

they had to maintain separate ADS books

that they may not otherwise maintain if

section 951A(d)(3) or 250(b)(2)(B) do

not apply to them. The comment observed

that the Act, in contrast to those other sections, does not mandate the use of ADS in

the section 863(b) context. The comment

requested that the final regulations maintain the existing rule of §1.863-3(c)(1)

(ii)(B) measuring the basis under section

1011 (as adjusted by section 1016), either

as the principal rule or, alternatively, at the

election of the taxpayer.

The final regulations do not adopt this

comment. The Treasury Department and

the IRS have determined that the use of

ADS for this purpose will prevent the Act’s

modifications to section 168(k) (resulting

in accelerated depreciation) from inappropriately skewing the apportionment formula under §1.863-3(c)(2)(i) in favor of foreign source income. While the Act does not

mandate the use of ADS for this purpose,

the Treasury Department and the IRS have

authority to mandate the use of ADS under

sections 863(a) and 7805 and have determined that the use of ADS is necessary to

accurately measure the place of production

using adjusted basis, as other basis measurements might inappropriately inflate

foreign production activities.

III. Comments on and Revisions to

Proposed §1.865-3 — Source of Gross

Income from Sales of Personal Property

(Including Inventory Property) by a

Nonresident Attributable to an Office

or Other Fixed Place of Business in the

United States

Section 865 provides rules for sourcing

income from sales of personal property.

1769

Section 865(e)(2) applies with respect to

all sales of personal property (including

inventory) by a nonresident, as that term

is defined in section 865(g)(1)(B), attributable to an office or other fixed place

of business in the United States. Section

865(e)(2)(A) generally provides that income from any sale of personal property

attributable to such an office or other fixed

place of business is sourced in the United

States. An exception is provided in section 865(e)(2)(B) for a sale of inventory

for use, disposition, or consumption outside the United States if a foreign office of

the nonresident ‘‘materially participated’’

in the sale. Section 865(e)(3) provides that

the ‘‘principles of section 864(c)(5) shall

apply’’ to determine whether a nonresident has an office or other fixed place of

business and whether a sale is attributable

to such office or other fixed place of business. Where applicable, section 865(e)(2)

applies ‘‘[n]otwithstanding any other provisions’’ of subchapter N, part I, including

sections 863(b), 861(a)(6), and 862(a)(6).

The proposed regulations under §1.865-3

clarified the application of the principles

of section 864(c)(5) in the context of section 865(e)(2) and provided that sales of

inventory property produced outside the

United States and sold through an office

maintained by the nonresident in the United States must be sourced in the United

States in part.

Proposed §1.865-3(e) also included a

cross-reference to the rules for allocating

and apportioning expenses to gross income effectively connected with the conduct of a trade or business in the United

States in §§1.882-4 and 1.882-5. Since

those regulations apply only to foreign

corporations, one comment requested that

the final regulations also refer to §1.873-1

to cover nonresident alien taxpayers subject to proposed §1.865-3. In response to

this comment, the final regulations broaden the cross-references to include sections

882(c)(1) and 873(a) for purposes of allocating and apportioning expenses. See

§1.865-3(e).

The final regulations also reorder and

revise parts of §1.865-3 in a non-substantive manner solely for purposes of improving clarity and ease of application. The revision also helps to clarify that §1.865-3

applies only if a nonresident maintains an

office or other fixed place of business in

December 28, 2020

the United States to which a sale of personal property is attributable. Otherwise,

the source of the income, gain, or loss

from the sale will be determined under

other applicable provisions of section 865,

such as section 865(b) through (d).

The final regulations also retain, with

certain modifications, the rules for determining the portion of gross income from

sales and production activities under

§1.865-3(d). Under the proposed regulations, the “50/50 method,” described in

§1.865-3(d)(2)(i), was the default method

because it was “an appropriate and administrable way” to apply section 865(e)(2),

but the proposed regulations also allowed

nonresidents to elect a books and records

method that would “more precisely” reflect their gross income from both sales

and production activities, if any, in the

United States, provided the nonresidents

met certain requirements for maintaining

their books of account under proposed

§1.865-3(d)(2)(ii)(B)(1) through (3). See

84 FR 71836, 71843. Under the final regulations, the 50/50 method continues to be

the default method and taxpayers continue to be permitted to elect the books and

records method. However, the Treasury

Department and the IRS have determined

that, where taxpayers have demonstrated

the ability to use their books of account

to determine their U.S. source gross income under the books and records method, a limitation is appropriate to prevent

a nonresident from returning to the less

precise 50/50 method solely to obtain a

better tax result. In addition, the Treasury

Department and the IRS have determined

that revising the election to provide that it

remains in effect until revoked would reduce the risk to taxpayers of inadvertently

failing to include the election with their

Federal income tax return. Accordingly,

under the final regulations, an election

to apply the books and records method

continues until revoked and may not be

revoked, without the consent of the Commissioner, for any taxable year beginning

within 48 months of the end of the taxable

year in which the election was made.

The final regulations also revise

§1.864-5 to clarify the interaction with

section 865(e)(2) and (3) and the promulgation of §1.865-3. Gross income, gain,

or loss from the sale of personal property

treated as from sources within the United

December 28, 2020

States under §1.865-3 will generally be

effectively connected with the conduct

of a trade or business in the United States

to the extent provided in section 864(c),

other than section 864(c)(4) or (5). Gross

income, gain, or loss from the sale of personal property treated as from sources

without the United States under §1.865-3

is not described in §1.864-5(b) and thus

will generally not be effectively connected with the conduct of a trade or business

in the United States.

The rules of §§1.864-5, 1.864-6, and

1.864-7 continue to apply, however, in determining whether foreign source income

of nonresident aliens and foreign corporations that does not arise from the sale of

personal property described in §1.8653(c) is effectively connected with the conduct of a trade or business in the United

States. The rules of §§1.864-5, 1.864-6,

and 1.864-7 also continue to apply in determining whether foreign source income

from the sale of inventory by nonresident

aliens, who would be residents under section 865(g)(1)(A), is effectively connected with the conduct of a trade or business

in the United States.

IV. Comments on the Rules for

Determining the Location or Existence of

Production Activity

The proposed regulations did not modify the rules in §1.863-3 for determining

the location or existence of production

activity for purposes of determining the

sourcing of income derived from the

sale of inventory. Section 1.863-3(c)(1)

(i)(A) (which has been redesignated in

the final regulations as §1.863-3(c)(1)(i))

provides the rule for sourcing of income

where production occurs only within

the United States or only within foreign

countries. That paragraph generally limits the scope of “production activities”

to only “those conducted directly by the

taxpayer.” Similarly, §1.863-3(c)(1)(i)(B)

(which has been redesignated in the final

regulations as §1.863-3(c)(1)(ii)) provides

that production assets are those “owned

directly by the taxpayer that are directly

used by the taxpayer to produce inventory.” Section 1.863-3(c)(1)(ii) (which has

been redesignated in the final regulations

as §1.863-3(c)(2)) provides the rule for

the sourcing of income where production

1770

occurs both within and without the United

States, and, as discussed in part II.C of this

Summary of Comments and Explanation

of Revisions section, allocates gross income based on the relative adjusted basis

of production assets located within and

without the United States, respectively.

The final regulations clarify the determination of the adjusted basis of production assets under §1.863-3(c)(1)(ii)

(B) (which has been redesignated in the

final regulations as §1.863-3(c)(2)(ii)(A)).

Under the final regulations, the adjusted

basis of production assets for a taxable

year is determined by averaging the basis

of the assets at the beginning and end of

the year, except in the event that a change

during the year would cause the average

to “materially distort” the calculation for

sourcing of income attributable to production activity under §1.863-3(c)(1)(ii)(A)

(which has been redesignated in the final

regulations as §1.863-3(c)(2)(i)). This

clarification uses certain concepts from

§1.861-9(g)(2)(i)(A) to further explain

when a change might “materially distort”

the calculation. For example, the rule applies when an event such as a late-year

disposition of substantially all the U.S.

production assets of a corporation would

cause a material distortion in the corporation’s calculation of the split between U.S.

and foreign production activities.

One comment provided a range of

suggestions to modify the rules of proposed §§1.863-3(c) and 1.865-3(d). This

comment suggested that the rules of proposed §§1.863-3(c) and 1.865-3(d) were

adequate, in general, where a taxpayer independently manufactured its own inventory, but inadequate with respect to other

business models that rely on limited risk

contract manufacturers or where multiple

members of a group each perform only

limited manufacturing functions in various jurisdictions. The comment observed

that apportionment of gross income using

the relative adjusted basis of production

assets may not reflect high value-adding

core production and risk management

functions and ownership of production assets by unrelated contract manufacturers.

The comment suggested expanding the

scope of covered production activities and

ownership of production assets to include

activities conducted and assets owned by

related parties and unrelated agents of the

Bulletin No. 2020–53

taxpayer. The comment also recommended that these rules include any activities

that constitute a “substantial contribution”

within the meaning of §1.954-3(a)(4)(iv)

to better conform to the rules under subpart F. See part II.B of this Summary of

Comments and Explanation of Revisions

section. In addition, the comment suggested that §1.863-3 should not allocate and

apportion gross income using only the

relative adjusted basis of production assets located within and without the United

States, and recommended allocation and

apportionment based on other metrics,

such as the location of personnel involved

in the production activities or personnel

costs. The comment suggested that these

modifications could, alternatively, be rebuttable presumptions that a taxpayer

could overcome by showing that allocating and apportioning gross income based

on adjusted basis or some other approach

provides a more appropriate result under

the taxpayer’s facts.

Another comment suggested that the

existing allocation and apportionment

rules that rely on the relative adjusted basis of production assets encourage businesses to move (or locate additional) production assets outside the United States.

Specifically, the comment expressed concern that treating income from the sale of

inventory produced, in whole or in part, in

the United States as U.S. source income

might result in double taxation if the income is also subject to tax in a foreign

jurisdiction, since the U.S. source income

would be excluded from the numerator of

the section 904 limitation, reducing the

section 904 limitation, and potentially

limiting the U.S. taxpayer’s ability to use

its foreign tax credits. The comment requested replacing these rules with a more

comprehensive formula, preferably one

that minimizes the risk of double taxation.

The comment did not suggest an alternative formula and observed that further legislation may be necessary in this regard.

The Treasury Department and the IRS

appreciate the various concerns presented

by these comments and suggested revisions. The final regulations do not adopt

these comments, but the Treasury Department and the IRS may consider these recommendations as part of a more comprehensive review of the sourcing rules for

production activity (for purposes of both

Bulletin No. 2020–53

§1.863-3 and §1.865-3) in a future notice

of proposed rulemaking. Additionally,

the anti-abuse rule in §1.863-3(c)(1)(iii)

(which has been redesignated in the final

regulations as §1.863-3(c)(3)) already

applies to make appropriate adjustments

where taxpayers enter into or structure

certain transactions with a principal purpose of reducing U.S. tax liability under

§1.863-3, including by using production

assets owned by a related party. To clarify

the application of this rule, the final regulations provide that the anti-abuse rule applies to transactions inconsistent with the

purpose of §1.863-3(b) or (c), and adds as

an example that the anti-abuse rule may

cover acquisitions of domestic production

assets by related partnerships (or subsidiaries thereof) with a principal purpose of

reducing the transferor’s U.S. tax liability

by treating income from the sale of inventory property as subject to section 862(a)

(6) rather than section 863(b). The Treasury Department and the IRS continue

to request comments regarding potential

approaches to determine the location or

existence of production activity or other

modifications to §1.863-3 that may be appropriate.

V. Comments on Income Tax Treaties

The preamble to the proposed regulations included a statement about how

proposed §1.865-3 interacted with U.S.

income tax treaties under which the business profits of foreign treaty residents

may be taxable in the United States only

if the profits are attributable to a permanent establishment in the United States.

The preamble to the proposed regulations

stated, “[w]ith respect to taxpayers entitled to the benefits of an income tax treaty, the amount of profits attributable to a

U.S. permanent establishment will not be

affected by these regulations.” See 84 FR

71836, 71844.

One comment supported the preamble’s statement and requested that, consistent with the statement in the preamble,

the final regulations not apply to Section

863(b)(2) Sales in a manner that results

in double taxation to U.S. taxpayers engaged in business operations through a

permanent establishment in a treaty jurisdiction, notwithstanding the Act’s change

to section 863(b). The comment also re-

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quested that competent authority relief be

provided in this regard. These regulations

do not affect the ability of a taxpayer to

rely on treaty provisions to mitigate or

relieve double taxation, including treaty

provisions that permit a taxpayer to make

a request to the competent authority for

assistance pursuant to a mutual agreement

procedure article of an applicable income

tax treaty.

VI. Comment on Proposed Applicability

Date

The proposed regulations were proposed to apply to taxable years ending

on or after December 23, 2019, although

taxpayers and their related parties could

generally apply the rules in their entirety

for taxable years beginning after December 31, 2017, and ending before December 23, 2019. One comment requested that

the final regulations apply to taxable years

ending after December 31, 2019, because

some taxpayers have consistently relied

on the existing methods of §1.863-3(b)

for many years. The final regulations do

not adopt this comment. Under section

7805(b)(1)(B), a final regulation can apply

to any taxable period ending on or after

the date on which the proposed regulation

to which such final regulation relates was

filed with the Federal Register, which for

these final regulations was December 23,

2019. The final regulations implement the

Act’s statutory change to section 863(b),

which was effective for taxable years

beginning after December 31, 2017. To

provide certainty to taxpayers and avoid a

multiplicity of different interpretations of

the statute, the Treasury Department and

the IRS have determined that it is appropriate for the final regulations to apply as

closely as possible to the effective date of

the statutory change.

Applicability Date

The final regulations generally apply to

taxable years ending on or after December

23, 2019. Taxpayers may choose to apply

the final regulations for any taxable year

beginning after December 31, 2017, and

ending before December 23, 2019, provided that the taxpayer and all persons

that are related to the taxpayer (within the

meaning of section 267 or 707) apply the

December 28, 2020

final regulations in their entirety and, once

applied, the taxpayer and all persons related to the taxpayer (within the meaning

of section 267 or 707) continue to apply

the final regulations in their entirety for

all subsequent taxable years. See section

7805(b)(7). Alternatively, taxpayers may

rely on the proposed regulations for any

taxable year beginning after December 31,

2017, and ending on or before September

29, 2020, provided that the taxpayer and

all persons that are related to the taxpayer

(within the meaning of section 267 or 707)

rely on the proposed regulations in their

entirety and provided that the taxpayer

and all persons that are related to the taxpayer (within the meaning of section 267

or 707) have not applied the final regulations to any preceding year.

Special Analyses

These regulations are not subject to review under section 6(b) of Executive Order 12866 pursuant to the Memorandum

of Agreement (April 11, 2018) between

the Treasury Department and the Office

of Management and Budget regarding review of tax regulations.

I. Paperwork Reduction Act

The Paperwork Reduction Act of 1995

(44 U.S.C. 3501-3520) (“PRA”) generally

requires that a federal agency obtain the

approval of OMB before collecting information from the public, whether such

collection of information is mandatory,

voluntary, or required to obtain or retain

a benefit.

The final regulations include a collection of information in §1.865-3(d)(2)

(ii)(B). Section 1.865-3(d)(2)(ii)(B) allows a nonresident, as defined in section

865(g)(1)(B), whose inventory sales are

described in §1.865-3(d)(2) (relating to

inventory produced by the nonresident)

to elect to allocate the profit from such

sales to its U.S. office using a books and

records method under §1.865-3(d)(2)(ii),

rather than using a default “50/50 method” under §1.865-3(d)(2)(i). If the collection of information in §1.865-3(d)(2)(ii)

(B) applies to a nonresident, the nonresident must maintain detailed records of

its receipts and expenditures attributable

December 28, 2020

to its sales and production activities to

support the allocation of its income, gain,

or loss to its sales activities in the United

States under the principles of section 482.

See §1.865-3(d)(2)(ii)(B)(2). The nonresident must also prepare an explanation of

how the allocation was determined. See

§1.865-3(d)(2)(ii)(B)(3). The nonresident

must make an election to apply the books

and records method under §1.865-3(d)(2)

(ii) by attaching a statement to its original timely filed Federal income tax return

(including extensions) that it elects to apply the books and records method under

§1.865-3(d)(2)(ii)(A) and has prepared

the records described in §1.865-3(d)(2)

(ii)(B)(2) and (3). The nonresident must

make available the explanation and records upon request of the Commissioner,

within 30 days or some other time period

as agreed between the Commissioner and

the nonresident. See §1.865-3(d)(2)(ii)(B)

(3).

The reporting burdens associated with

the collection of information in §1.8653(d)(2)(ii)(B) will be reflected in the Form

14029, Paperwork Reduction Act Submission, that the Treasury Department

and the IRS will submit to OMB for tax

returns in the Forms 1120-F, U.S. Income

Tax Return of a Foreign Corporation, and

Forms 1040-NR, U.S. Nonresident Alien

Income Tax Return. In particular, the reporting burden associated with the information collection in §1.865-3(d)(2)(ii)(B)

will be included in the burden estimate

for OMB control numbers 1545-0123 and

1545-0074. OMB control number 15450123 represents a total estimated burden

time for all forms and schedules for corporations of 3.344 billion hours and total

estimated monetized costs of $61.558 billion ($2019). OMB control number 15450074 represents a total estimated burden

time, including all other related forms and

schedules for individuals, of 1.717 billion

hours and total estimated monetized costs

of $33.267 billion ($2019). Table 1 summarizes the status of the PRA submissions

of the Treasury Department and the IRS

related to Forms 1120-F and 1040-NR.

The overall burden estimate provided

by the Treasury Department and the IRS

to OMB in the PRA submissions for OMB

control numbers 1545-0123 and 15450074 are aggregate amounts related to

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the U.S. Business Income Tax Return and

the U.S. Individual Income Tax Return,

along with any associated forms. The burden estimates in these PRA submissions,

however, do not account for any burden

imposed by §1.865-3(d)(2)(ii)(B). The

Treasury Department and the IRS have

not identified the estimated burden for the

collections of information in §1.865-3(d)

(2)(ii)(B) because there are no burden estimates specific to §1.865-3(d)(2)(ii)(B)

currently available. The burden estimates

in the PRA submissions that the Treasury

Department and the IRS will submit to

OMB will in the future include, but not

isolate, the estimated burden related to the

collection of information in §1.865-3(d)

(2)(ii)(B).

The Treasury Department and the IRS

have included the burdens related to the

PRA submissions for OMB control numbers 1545-0123 and 1545-0074 in the

PRA analysis for other regulations issued

by the Treasury Department and the IRS

related to the taxation of cross-border income. The Treasury Department and the

IRS encourage users of this information to

take measures to avoid overestimating the

burden that the collection of information

in §1.865-3(d)(2)(ii)(B), together with

other international tax provisions, imposes. Moreover, the Treasury Department

and the IRS also note that the Treasury

Department and the IRS estimate PRA

burdens on a taxpayer-type basis rather

than a provision-specific basis because an

estimate based on the taxpayer-type most

accurately reflects taxpayers’ interactions

with the forms.

The Treasury Department and the IRS

request comments on the forms that reflect the information collection burdens

related to the final regulations, including

estimates for how much time it would

take to comply with the paperwork burden described above for each relevant

form and ways for the IRS to minimize

the paperwork burden. Proposed revisions (if any) to these forms that reflect

the information collection contained in

§1.865-3(d)(2)(ii)(B) will be made available for public comment at https://apps.

irs.gov/app/picklist/list/draftTaxForms.

html and will not be finalized until after

these forms have been approved by OMB

under the PRA.

Bulletin No. 2020–53

Table 1. Summary of Information Collection Request Submissions Related to Forms 1120-F and Forms 1040-NR.

Form

Type of Filer

OMB

Status

Number(s)

Individual (NEW Model)

1545-0074

Approved by OIRA 1/30/2020 until 1/31/2021.

Form 1040-NR

Link: https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201909-1545-021

Business (NEW Model)

1545-0123

Approved by OIRA 1/30/2020 until 1/31/2021.

Form 1120-F

Link: https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201907-1545-001

II. Regulatory Flexibility Act

Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it is hereby

certified that these final regulations will

not have a significant economic impact

on a substantial number of small entities.

Although data are not readily available

to assess the number of small entities potentially affected, any economic impact

of these regulations is unlikely to be significant. Specifically, the regulations in

§§1.863-1 and 1.863-3 (with conforming

changes in cross-referencing regulations)

implement the statutory change made to

section 863(b) by the Act. This change

affects sales of inventory property by any

taxpayer where the taxpayer produces

the inventory (in whole or in part) within

the United States and sells that inventory

without the United States, or vice versa.

The change in sourcing for those entities

is attributable to the change in section

863(b) made by the Act. Sections 1.8631 and 1.863-3 merely implement the

statutory change with limited additional

guidance. The Treasury Department and

the IRS do not anticipate that any differences between the changes in section

863(b) made by the Act and the changes

in §§1.863-1 and 1.863-3 made by these

regulations will have a significant economic impact on a substantial number of

small entities.

The other regulations in this publication (other than changes to ensure consistency with section 863(b)) are the final

regulations in §§1.864-5, 1.864-6, and

1.865-3. These regulations solely affect

non-U.S. taxpayers, which are not subject

to the Regulatory Flexibility Act.

Pursuant to section 7805(f) of the

Code, the proposed regulations preceding

these final regulations were submitted to

Bulletin No. 2020–53

the Chief Counsel for Advocacy of the

Small Business Administration for comment on their impact on small businesses.

No comments were received.

ciate Chief Counsel (International). However, other personnel from the Treasury

Department and the IRS participated in

the development of the regulations.

III. Unfunded Mandates Reform Act

List of Subjects in 26 CFR Part 1

Section 202 of the Unfunded Mandates

Reform Act of 1995 requires that agencies

assess anticipated costs and benefits and

take certain other actions before issuing a

final rule that includes any Federal mandate that may result in expenditures in any

one year by a state, local, or tribal government, in the aggregate, or by the private

sector, of $100 million in 1995 dollars, updated annually for inflation. These regulations do not include any Federal mandate

that may result in expenditures by state,

local, or tribal governments, or by the private sector in excess of that threshold.

Income taxes, Reporting and recordkeeping requirements.

IV. Executive Order 13132: Federalism

Executive Order 13132 (entitled

“Federalism”) prohibits an agency from

publishing any rule that has federalism

implications if the rule either imposes

substantial, direct compliance costs on

state and local governments, and is not

required by statute, or preempts state law,

unless the agency meets the consultation

and funding requirements of section 6 of

the Executive Order. These regulations do

not have federalism implications and do

not impose substantial direct compliance

costs on state and local governments or

preempt state law within the meaning of

the Executive Order.

Drafting Information

The principal author of the regulations

is Brad McCormack of the Office of Asso-

1773

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for

part 1 is amended by adding an entry for

§1.865-3 in numerical order.

The addition reads in part as follows:

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

*****

Section 1.865-3 also issued under 26

U.S.C. 865(j).

*****

Par. 2. Section 1.863-0 is revised to

read as follows:

§1.863-0 Table of contents.

This section lists captions contained in

§§1.863-1 through 1.863-10.

§1.863-1 Allocation of gross income

under section 863(a).

(a) In general.

(b) Natural resources.

(1) In general.

(2) Additional production activities.

(3) Definitions.

(i) Production activity.

December 28, 2020

(ii) Additional production activities.

(4) Determination of fair market value.

(5) Determination of gross income.

(6) Tax return disclosure.

(7) Examples.

(i) Example 1. No additional production, foreign source gross receipts.

(ii) Example 2. No additional production, U.S. source gross receipts.

(iii) Example 3. Production in United

States, foreign sales.

(iv) Example 4. Production and sales in

United States.

(v) Example 5. Additional production.

(d) Scholarships, fellowship grants,

grants, prizes, and awards.

(1) In general.

(2) Source of income.

(i) United States source income.

(ii) Foreign source income.

(iii) Certain activities conducted outside the United States.

(3) Definitions.

(4) Effective dates.

(i) Scholarships and fellowship grants.

(ii) Grants, prizes and awards.

(e) Residual interest in a REMIC.

(1) REMIC inducement fees.

(2) Excess inclusion income and net

losses.

(f) Applicability date.

§1.863-2 Allocation and apportionment

of taxable income.

(a) Determination of taxable income.

(b) Determination of source of taxable

income.

§1.863-3 Allocation and apportionment

of income from certain sales of inventory.

(a) In general.

(1) Scope.

(2) Cross references.

(b) Sourcing based solely on production activities.

gross income from production activity.

(1) Production only within the United

States or only within foreign countries.

(i) Source of income.

(ii) Definition of production assets.

(iii) Location of production assets.

December 28, 2020

(2) Production both within and without

the United States.

(i) Source of income.

(ii) Adjusted basis of production assets.

(A) In general.

(B) Production assets used to produce

other property.

(3) Anti-abuse rule.

(4) Examples.

(i) Example1. Source of gross income.

(ii) Example 2. Location of intangible

property.

(iii) Example 3. Anti-abuse rule.

(d) Determination of source of taxable

income.

(e) Income partly from sources within a

possession of the United States.

(1) In general.

(2) Allocation or apportionment for

Possession Production Sales.

(3) Allocation or apportionment for

Possession Purchase Sales.

(i) Determination of source of gross income from Possession Purchase Sales.

(ii) Determination of source of gross

income from business activity.

(A) Source of gross income.

(B) Business activity.

(1) Sales activity.

(2) Cost of goods sold.

(3) Expenses.

(4) Examples.

(i) Example 1: Purchase of goods manufactured in possession.

(ii) Example 2: Purchase of goods

manufactured outside possession.

(5) Special rules for partnerships.

(f) Special rules for partnerships.

(1) General rule.

(2) Exceptions.

(i) In general.

(ii) Attribution of production assets to

or from a partnership.

(iii) Basis.

(3) Examples.

(i) Example 1. Distributive share of

partnership income.

(ii) Example 2. Distribution in kind.

(g) Applicability dates.

§1.863-4 Certain transportation services.

(a) General.

(b) Gross income.

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(d) Items not included as costs or expenses.

(1) Taxes and interest.

(2) Other business activity and general

expenses.

(3) Personal exemptions and special

deductions.

(e) Property used while within the

United States.

(1) General.

(2) Average property.

(3) Current assets.

(f) Taxable income.

(1) General.

(2) Interest and taxes.

(3) General expenses.

(4) Personal exemptions.

(5) Special deductions.

(g) Allocation based on books of account.

§1.863-6 Income from sources within a

foreign country.

§1.863-7 Allocation of income

attributable to certain notional principal

contracts under section 863(a).

(a) Scope.

(1) Introduction.

(2) Effective/applicability date.

(b) Source of notional principal contract income.

(1) General rule.

(2) Qualified business unit exception.

(3) Effectively connected notional

principal contract income.

(1) Eligibility and effect.

(2) Time for making election.

(3) Manner of making election.

(d) Example.

(e) Cross references.

§1.863-8 Source of income derived from

space and ocean activity under section

863(d).

(a) In general.

(b) Source of gross income from space

and ocean activity.

(1) Space and ocean income derived by

a United States person.

(2) Space and ocean income derived by

a foreign person.

(i) In general.

Bulletin No. 2020–53

(ii) Space and ocean income derived by

a controlled foreign corporation.

(iii) Space and ocean income derived

by foreign persons engaged in a trade or

business within the United States.

(3) Source rules for income from certain sales of property.

(i) Sales of purchased property.

(ii) Sales of property produced by the

taxpayer.

(A) General.

(B) Production only in space or international water, or only outside space and

international water.

(4) Special rule for determining the

source of gross income from services.

(5) Special rule for determining source

of income from communications activity (other than income from international

communications activity).

(d) Space and ocean activity.

(1) Definition.

(i) Space activity.

(ii) Ocean activity.

(2) Determining a space or ocean activity.

(i) Production of property in space or

international water.

(ii) Special rule for performance of services.

(A) General.

(B) Exception to the general rule.

(3) Exceptions to space or ocean activity.

(e) Treatment of partnerships.

(f) Examples.

(1) Example 1. Space activity—activity occurring on land and in space.

(2) Example 2. Space activity.

(3) Example 3. Services as space activity—de minimis value attributable to performance occurring in space.

(4) Example 4. Space activity.

(5) Example 5. Space activity.

(6) Example 6. Space activity—treatment of land activity.

(7) Example 7. Use of intangible property in space.

(8) Example 8. Performance of services.

(9) Example 9. Separate transactions.

(10) Example 10. Sale of property in

international water.

Bulletin No. 2020–53

(11) Example 11. Sale of property in

space.

(12) Example 12. Sale of property in

space.

(13) Example 13. Source of income of

a foreign person.

(14) Example 14. Source of income of

a foreign person.

(g) Reporting and documentation requirements.

(1) In general.

(2) Required documentation.

(3) Access to software.

(4) Use of allocation methodology.

(h) Applicability date.

§1.863-9 Source of income derived from

communications activity under section

863(a), (d), and (e).

(a) In general.

(b) Source of international communications income.

(1) International communications income derived by a United States person.

(2) International communications income derived by foreign persons.

(i) In general.

(ii) International communications income derived by a controlled foreign corporation.

(iii) International communications income derived by foreign persons with

a fixed place of business in the United

States.

(iv) International communications income derived by foreign persons engaged in

a trade or business within the United States.

(d) Source of foreign communications

income.

(e) Source of space/ocean communications income.

(f) Source of communications income

when taxpayer cannot establish the two

points between which the taxpayer is paid

to transmit the communication.

(g) Taxable income.

(h) Communications activity and income derived from communications activity.

(1) Communications activity.

(i) General rule.

(ii) Separate transaction.

(2) Income derived from communications activity.

1775

(3) Determining the type of communications activity.

(i) In general.

(ii) Income derived from international

communications activity.

(iii) Income derived from U.S. communications activity.

(iv) Income derived from foreign communications activity.

(v) Income derived from space/ocean

communications activity.

(i) Treatment of partnerships.

(j) Examples.

(k) Reporting and documentation requirements.

(1) In general.

(2) Required documentation.

(3) Access to software.

(4) Use of allocation methodology.

(l) Effective date.

§1.863-10 Source of income from a

qualified fails charge.

(a) In general.

(b) Qualified business unit exception.

(d) Qualified fails charge.

(e) Designated security.

(g) Effective/applicability date.

Par. 3. Section 1.863-0A is added to

read as follows:

§1.863-0A Table of contents.

This section lists captions contained in

§§1.863-3A and 1.863-3AT.

§1.863-3A Income from the sale of

personal property derived partly from

within and partly from without the United

States.

(a) General.

(1) Classes of income.

(2) Definition.

(b) Income partly from sources within

a foreign country.

(1) General.

(2) Allocation or apportionment.

possession of the United States.

(1) General.

(2) Allocation or apportionment.

(3) Personal property produced and

sold.

December 28, 2020

(4) Personal property purchased and sold.

§1.863-3AT Income from the sale of

personal property derived partly from

within and partly from without the United

States (temporary).

(a) [Reserved].

(b) Income partly from sources within

a foreign country.

(1) [Reserved].

(2) Allocation or apportionment.

(c)(1) through (4) [Reserved].

Par. 4. Section 1.863-1 is amended as

follows:

a. In paragraph (a):

i. Revising the third sentence.

ii. Removing “§1.863-3(g)” and adding

in its place “§1.863-3(f)”.

b. Revising paragraph (b)(1).

c. In paragraph (b)(2):

i. Removing “prior to export terminal”

from the heading and adding in its place

“activities”.

ii. Removing “before the relevant product is shipped from the export terminal”

from the first sentence.

iii. Adding “oil or gas” before “well”

and “other natural” before “deposit” in the

second sentence.

d. Removing “§§1.1502-13 or 1.8633(g)(2)” from paragraph (b)(3)(i) and adding in its place “§1.1502-13 or 1.863-3(f)

(2)”.

e. In paragraph (b)(3)(ii):

i. Adding “uncut” before “timber” in

the first sentence.

ii. Adding “(except for §1.954-3(a)(4)

(iv))” at the end of the second sentence.

iii. Removing “to or from the export

terminal” from the third sentence.

f. Removing paragraph (b)(3)(iii).

g. In paragraph (b)(6), removing “this

paragraph (b)” from the first sentence and

adding in its place “paragraph (b)(2) of

this section”.

h. Designating Examples 1, 2, 3, 4, and

5 of paragraph (b)(7) as paragraphs (b)(7)

(i) through (v).

i. Revising newly designated paragraphs (b)(7)(i) through (v).

j. In paragraph (f):

i. Revising the heading.

ii. Adding three sentences at the start of

the paragraph.

The revisions and additions read as follows:

December 28, 2020

§1.863-1 Allocation of gross income

under section 863(a).

(a) * * * See also section 865(b) for

rules for sourcing income from the sale

of inventory property, within the meaning

of section 865(i)(1) (inventory), generally, and section 865(e)(2) and §1.865-3 for

sourcing income from the sale of personal

property (including inventory) by a nonresident that is attributable to the nonresident’s office or other fixed place of business in the United States. * * *

(b) Natural resources—(1) In general. Notwithstanding any other provision

of this part, except to the extent provided in paragraph (b)(2) of this section or

§1.865-3, 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 uncut timber

within the United States shall be treated

as from sources within the United States,

and 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 uncut timber outside the United States shall be treated as from sources

without the United States.

*****

(7) * * *

(i) Example 1. No additional production, foreign

source gross receipts. U.S. Mines, a domestic 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, under the facts and circumstances, none of U.S. Mines’ activities constitute additional production activities, within the meaning of

paragraph (b)(3)(ii) of this section, paragraph (b)(2)

of this section does not apply, and under paragraph

(b)(1) of this section, gross receipts from the sale of

the concentrate will be treated as from sources without the United States.

(ii) Example 2. No additional production, U.S.

source gross receipts. U.S. Gas, a domestic corporation, extracts natural gas within the United States,

and transports the natural gas to a Country X port

where it is liquefied in preparation for shipment. The

liquefied natural gas is then transported via freighter

and sold without additional production activities in

a foreign country. Under paragraph (b)(3)(ii) of this

section, liquefaction of natural gas is not an additional production activity because liquefaction prepares

the natural gas for transportation. Therefore, under

paragraph (b)(1) of this section, gross receipts from

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the sale of the liquefied natural gas will be treated as

from sources within the United States.

(iii) Example 3. Production in United States,

foreign sales. U.S. Gold, a domestic corporation,

mines gold in Country X, produces gold jewelry

using production assets located in the United States,

and sells the jewelry in Country Y. Assume that the

fair market value of the gold before the additional

production activities in the United States is $40x

and that U.S. Gold ultimately sells the gold jewelry in Country Y for $100x. Under paragraph (b)(2)

of this section, $40x of U.S. Gold’s gross receipts

will be treated as from sources without the United

States, and the remaining $60x of gross receipts will

be treated as from sources within the United States

under §1.863-3.

(iv) Example 4. Production and sales in United

States. U.S. Oil, a domestic corporation, extracts oil

in Country X, transports the oil via a pipeline to the

United States, refines the oil using production assets

located 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 before

refinement in the United States is $80x and U.S. Oil

ultimately sells the refined product for $100x. Under paragraph (b)(2) of this section, $80x of gross

receipts will be treated as from sources without

the United States, and the remaining $20x of gross

receipts will be treated as from sources within the

United States under §1.863-3.

(v) Example 5. Additional production. The facts

are the same as in paragraph (b)(7)(i) of this section

(the facts 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 the

processes applied to make copper concentrate are

considered mining. Therefore, under paragraph (b)

(2) of this section, gross receipts equal to the fair

market value of the concentrate at the smelter will

be treated as 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 paragraph (b)(3)(ii) of this section.

Therefore, the source of U.S. Mines’s excess gross

receipts will be determined under §1.863-3, pursuant

to paragraph (b)(2) of this section.

*****

(f) Applicability date. Paragraph (b) of

this section applies to taxable years ending

on or after December 23, 2019. However,

a taxpayer may apply paragraph (b) of this

section in its entirety for taxable years

beginning after December 31, 2017, and

ending before December 23, 2019, provided that the taxpayer and all persons related to the taxpayer (within the meaning

of section 267 or 707) apply paragraph (b)

of this section and §§1.863-2(b), 1.8633, 1.863-8(b)(3)(ii), 1.864-5(a) and (b),

1.864-6(c)(2), and 1.865-3 in their entirety for the taxable year, and once applied,

Bulletin No. 2020–53

the taxpayer and all persons related to the

taxpayer (within the meaning of section

267 or 707) continue to apply these regulations in their entirety for all subsequent

taxable years. For regulations generally

applicable to taxable years ending before

December 23, 2019, see §1.863-1 as contained in 26 CFR part 1 revised as of April

1, 2020. * * *

Par. 5. Section 1.863-2 is amended as

follows:

a. In paragraph (a) introductory text:

i. Removing “(and that is treated as

derived partly from sources within and

partly from sources without the United

States)” from the third sentence.

ii. Adding a colon after the word “income” at the end of the paragraph.

b. Revising paragraph (b).

c. Revising paragraph (c).

The revisions read as follows:

§1.863-2 Allocation and apportionment

of taxable income.

*****

(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 or apportioned to sources within and without

the United States pursuant to §§1.863-1,

1.863-3, 1.863-4, 1.863-8, and 1.863-9.

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, §1.863-3

for other sales of inventory property, and

§1.863-8 for source of gross income from

space and ocean activity. Section 1.865-3

may apply instead of the provisions in this

section to source gross income from sales

of personal property (including inventory property) by nonresidents attributable

to an office or other fixed place of business in the United States. 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(e).

applies to taxable years beginning after

December 30, 1996. Paragraph (b) of this

Bulletin No. 2020–53

section applies to taxable years ending on

or after December 23, 2019. However, a

taxpayer may apply paragraph (b) of this

section in its entirety for taxable years

beginning after December 31, 2017, and

ending before December 23, 2019, provided that the taxpayer and all persons related to the taxpayer (within the meaning

of section 267 or 707) apply paragraph (b)

of this section and §§1.863-1(b), 1.8633, 1.863-8(b)(3)(ii), 1.864-5(a) and (b),

1.864-6(c)(2), and 1.865-3 in their entirety for the taxable year, and once applied,

the taxpayer and all persons related to the

taxpayer (within the meaning of section

267 or 707) continue to apply these regulations in their entirety for all subsequent

taxable years. For regulations generally

applicable to taxable years ending before

December 23, 2019, see §1.863-2 as contained in 26 CFR part 1 revised as of April

1, 2020.

Par. 6. Section 1.863-3 is revised as

follows:

§1.863-3 Allocation and apportionment

of income from certain sales of

inventory.

(a) In general—(1) Scope. Subject

to the rules of §1.865-3, paragraphs (a)

through (d) of this section apply to determine the source of income derived from

the sale of inventory property (inventory) that a taxpayer produces (in whole

or in part) within the United States and

sells without the United States, or that a

taxpayer produces (in whole or in part)

without the United States and sells within the United States (collectively, Section

863(b)(2) Sales). See section 865(i)(1) for

the definition of inventory. Paragraph (b)

of this section provides that the source of

gross income from Section 863(b)(2) Sales

is based solely on the production activities

with respect to the inventory. Paragraph

partly within the United States and partly

without the United States. Paragraph (d)

of this section determines taxable income

from Section 863(b)(2) Sales. Paragraph

(e) of this section applies to determine the

source of certain income derived from a

possession of the United States. Paragraph

(f) of this section provides special rules

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for partnerships for all sales subject to

§§1.863-1 through 1.863-3. Paragraph (g)

of this section provides applicability dates

for the rules in this section.

(2) Cross references. To determine the

source of income derived from the sale

of personal property (including inventory) by a nonresident that is attributable

to the nonresident’s office or other fixed

place of business in the United States under section 865(e)(2) and §1.865-3(c), the

rules of §1.865-3 apply, and the rules of

this section do not apply except to the extent provided in §1.865-3. To determine

the source of income from sales of property produced by the taxpayer, when the

property is either produced in whole or in

part in space, as defined in §1.863-8(d)(1)

(i), or international water, as defined in

§1.863-8(d)(1)(ii), or is sold in space or

international water, the rules of §1.8638 apply, and the rules of this section do

not apply except to the extent provided in

§1.863-8.

(b) Sourcing based solely on production activities. Subject to the rules of

§1.865-3, all income, gain, or loss derived

from Section 863(b)(2) Sales is allocated

and apportioned solely on the basis of the

production activities with respect to the

inventory.

income from production activity—(1) Production only within the United States or

only within foreign countries—(i) 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. Whether a taxpayer’s activities constitute production activity is determined under the principles of §1.9543(a)(4) (except for §1.954-3(a)(4)(iv)).

Subject to the provisions in §1.1502-13

or paragraph (f)(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, gross income 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 para-

December 28, 2020

graph (c)(2) of this section. For rules regarding the source of income when production takes place, in whole or in part,

in space or international water, the rules

of §1.863-8 apply, and the rules of this

section do not apply except to the extent

provided in §1.863-8.

(ii) Definition of production assets.

Subject to the provisions of §1.1502-13

and paragraph (f)(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.

(iii) Location of production assets. For

purposes of this section, a tangible 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.

(2) Production both within and without

the United States—(i) 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 gross income 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.

(ii) Adjusted basis of production assets—(A) In general. For purposes of

paragraph (c)(2)(i) of this section, the adjusted basis of an asset is determined by

using the alternative depreciation system

December 28, 2020

under section 168(g)(2). The adjusted basis of all production assets for purposes of

paragraph (c)(2)(i) of this section is determined as though the production assets

were subject to the alternative depreciation system set forth in section 168(g)(2)

for the entire period that such property has

been in service. The adjusted basis of the

production assets is determined without

regard to the election to expense certain

depreciable assets under section 179 and

without regard to any additional firstyear depreciation provision (for example,

section 168(k), (l), and (m), and former

sections 1400L(b) and 1400N(d)). The

average adjusted basis of assets is computed by averaging the adjusted basis at

the beginning and end of the taxable year,

unless by reason of changes during the

taxable year, as might be the case in the

event of a major acquisition or disposition

of assets, the average would materially

distort the calculation in paragraph (c)(2)

(i) of this section. In this event, the average adjusted basis is determined upon a

more appropriate basis that is weighted to

reasonably reflect the period for which the

assets are held by the taxpayer during the

taxable year.

(B) Production assets used to produce

other property. If a production asset is

used to produce inventory sold in Section

863(b)(2) Sales and 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)(2)(i) of this section will be determined

under any method that reasonably reflects

the portion of the asset that produces inventory sold in Section 863(b)(2) 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(b)(2) Sales produced by the asset, and

the denominator of which is the gross receipts from all property produced by that

asset.

(3) Anti-abuse rule. The purpose of

paragraph (b) of this section and this

paragraph (c) is to attribute the source of

the taxpayer’s gross income from certain

sales of inventory property to the location of the taxpayer’s production activity. Therefore, if the taxpayer has entered

1778

into or structured one or more transactions

with a principal purpose of reducing its

U.S. tax liability in a manner inconsistent

with the purpose of paragraph (b) of this

section or this paragraph (c), the Commissioner may make appropriate adjustments

so that the source of the taxpayer’s gross

income more clearly reflects the location

of production activity. For example, a taxpayer may be subject to the rule in this

paragraph (c)(3) if domestic production

assets are acquired by a related partnership (or a subsidiary of a related partnership) with a principal purpose of reducing

its U.S. tax liability by claiming that the

taxpayer’s income from sales of inventory

is subject to section 862(a)(6) rather than

section 863(b).

(4) Examples. The following examples

illustrate the rules of this paragraph (c):

(i) Example 1. Source of gross income—(A)

Facts. 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, as determined using the alternative depreciation system under section 168(g)(2). 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.

(B) Analysis. A determines its gross income from

sources without the United States by multiplying A’s

$12 of gross income from sales of widgets in foreign

countries 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

× $25 gross receipts from export sales/$100 gross

receipts from all sales)). Therefore, A’s gross income

from sources without the United States is $4 ($12 ×

($25/$75)).

(ii) Example 2. Location of intangible property.

Assume the same facts as in paragraph (c)(4)(i)(A)

of this section (the facts in 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 gross income,

A’s patent, if it has an average adjusted basis, would

be located in the United States.

(iii) Example 3. Anti-abuse rule—(A) Facts.

Assume the same facts as in paragraph (c)(4)(i)(A)

of this section (the facts in 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

Bulletin No. 2020–53

by manipulating the property fraction. A then leases

these assets from B. After this transaction, under the

general rule of paragraph (c)(2) of this section, all of

A’s gross 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.

(B) Analysis. 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)(2)(i) of this section, A’s income

must be adjusted to more clearly reflect the source of

that income. In this case, the Commissioner may redetermine the source of A’s gross income by ignoring

the sale-leaseback transactions.

(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 its expenses, losses, and other deductions to its respective

amounts of gross income from sources

within and without the United States from

its Section 863(b)(2) Sales. See §§1.861-8

through 1.861-14T and 1.861-17.

(e) Income partly from sources within

a possession of the United States—(1) In

general. This paragraph (e) relates to certain sales that give rise to income, gain,

or loss that is treated as derived partly

from sources within the United States and

partly from sources within a possession of

the United States (Section 863 Possession

Sales). This paragraph (e) applies to determine the source of income derived from

the sale of inventory produced (in whole

or in part) by a taxpayer within the United States and sold within a possession of

the United States, or produced (in whole

or in part) by a taxpayer in a possession

of the United States and sold within the

United States (collectively, Possession

Production Sales). It also applies to determine the source of income derived from

the purchase of personal property within

a possession of the United States and its

sale within the United States (Possession

Purchase Sales). A taxpayer subject to this

paragraph (e) must apportion gross income from Section 863 Possession Sales

under paragraph (e)(2) of this section (in

the case of Possession Production Sales)

or under paragraph (e)(3) of this section

(in the case of Possession Purchase Sales).

The source of taxable income from Section 863 Possession Sales is determined

under paragraph (d) of this section.

(2) Allocation or apportionment for

Possession Production Sales. The source

Bulletin No. 2020–53

of gross income from Possession Production Sales is determined under the rules of

paragraph (c) of this section, except that

the term possession of the United States is

substituted for foreign country wherever it

appears.

(3) Allocation or apportionment for

Possession Purchase Sales—(i) Determination of source of gross income from

Possession Purchase Sales. Gross income from Possession Purchase Sales is

allocated in its entirety to the taxpayer’s

business activity, and is then apportioned

between sources within the United States

and sources within a possession of the

United States under paragraph (e)(3)(ii) of

this section.

(ii) Determination of source of gross income from business activity—(A) Source

of gross income. Gross income from the

taxpayer’s business activity is sourced in

the possession in the same proportion that

the amount of the taxpayer’s business activity for the taxable year within the possession bears to the amount of the taxpayer’s business activity for the taxable year

both within the possession and outside

the possession, with respect to Possession

Purchase Sales. The remaining income is

sourced in the United States.

(B) Business activity. For purposes of

this paragraph (e)(3)(ii), the taxpayer’s

business activity is equal to the sum of—

(1) The amounts for the taxable period

paid for wages, salaries, and other compensation of employees, and other expenses attributable to Possession Purchase

Sales (other than amounts that are nondeductible under section 263A, interest, and

research and development);

(2) Cost of goods sold attributable to

Possession Purchase Sales during the taxable period; and

(3) Possession Purchase Sales for the

taxable period.

purposes of determining the location of

the taxpayer’s business activity within a

possession, the following rules apply:

(1) Sales activity. Receipts from gross

sales will be attributed to a possession in

accordance with the principles of §1.8617(c).

(2) Cost of goods sold. Payments for

cost of goods sold will be properly attributable to gross receipts from sources

within the possession only to the extent

1779

that the property purchased was manufactured, produced, grown, or extracted in the

possession (within the meaning of section

954(d)(1)(A)).

(3) Expenses. Expenses will be attributed to a possession under the rules of

§§1.861-8 through 1.861-14T.

(4) Examples. The following examples

illustrate the rules of paragraph (e)(3)(ii)

of this section relating to the determination of source of gross income from business activity:

(i) Example 1. Purchase of goods manufactured

in possession—(A) Facts. U.S. Co. purchases in a

possession product X for $80 from A. A manufactures X in the possession. Without further production, U.S. Co. sells X in the United States for $100.

Assume U.S. Co. has sales and administrative expenses in the possession of $10.

(B) Analysis. To determine the source of U.S.

Co.’s gross income, the $100 gross income from

sales of X is allocated entirely to U.S. Co.’s business activity. Forty-seven dollars of U.S. Co.’s gross

income is sourced in the possession. [Possession

expenses ($10) plus possession purchases (i.e., cost

of goods sold) ($80) plus possessions sales ($0), divided by total expenses ($10) plus total purchases

($80) plus total sales ($100).] The remaining $53 is

sourced in the United States.

(ii) Example 2. Purchase of goods manufactured

outside possession—(A) Facts. Assume the same

facts as in paragraph (e)(4)(i)(A) of this section (the

facts in Example 1), except that A manufactures X

outside the possession.

(B) Analysis. To determine the source of U.S.

Co.’s gross income, the $100 gross income is allocated entirely to U.S. Co.’s business activity. Five dollars of U.S. Co.’s gross income is sourced in the possession. [Possession expenses ($10) plus possession

purchases ($0) plus possession sales ($0), divided by

total expenses ($10) plus total purchases ($80) plus

total sales ($100).] The $80 purchase is not included

in the numerator used to determine U.S. Co.’s business activity in the possession, since product X was

not manufactured in the possession. The remaining

$95 is sourced in the United States.

(5) Special rules for partnerships. In

applying the rules of this paragraph (e) to

transactions involving partners and partnerships, the rules of paragraph (f) of this

section apply.

(f) Special rules for partnerships—(1)

General rule. For purposes of §1.863-1

and this section, a taxpayer’s production

activity does not include production activities conducted by a partnership of which

the taxpayer is a partner either directly or

through one or more partnerships, except

as otherwise provided in paragraphs (c)(3)

or (f)(2) of this section.

(2) Exceptions—(i) In general. For

purposes of determining the source of the

partner’s distributive share of partnership

December 28, 2020

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 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 (f)(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)(2)(ii) 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.

(3) Examples. The following examples

illustrate the rules of this paragraph (f):

(i) 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

December 28, 2020

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.

(ii) Example 2. Distribution in kind. Assume the

same facts as in paragraph (f)(3)(i) of this section

(the facts 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 this section. In

applying paragraph (c) 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.

(g) Applicability dates. This section applies to taxable years ending on or after

December 23, 2019. However, a taxpayer

may apply this section in its entirety for

taxable years beginning after December

31, 2017, and ending before December

23, 2019, provided that the taxpayer and

all persons related to the taxpayer (within

the meaning of section 267 or 707) apply this section and §§1.863-1(b), 1.8632(b), 1.863-8(b)(3)(ii), 1.864-5(a) and (b),

1.864-6(c)(2), and 1.865-3 in their entirety for the taxable year, and once applied,

the taxpayer and all persons related to the

taxpayer (within the meaning of section

267 or 707) continue to apply these regulations in their entirety for all subsequent

taxable years. For regulations generally

applicable to taxable years ending before

December 23, 2019, see §1.863-3 as contained in 26 CFR part 1 revised as of April

1, 2020.

Par. 7. Section 1.863-8 is amended as

follows:

a. Revising paragraph (b)(3)(ii)(A).

b. In paragraph (b)(3)(ii)(B):

i. Removing “income allocable to production activity” wherever it appears and

adding in its place “gross income”.

ii. Removing “§1.863-3(c)(1)” from

the second sentence and adding in its

place “§1.863-3(c)”.

c. In paragraph (b)(3)(ii)(C):

1780

i. Removing “allocable to production

activity” wherever it appears.

ii. Removing “allocated to production

activity” from the fifth sentence.

iii. Removing “§1.863-3(c)(1)” from

the fifth sentence and adding in its place

“§1.863-3(c)”.

d. Removing paragraph (b)(3)(ii)(D).

e. In paragraph (c), removing “(b)(3)

(ii)(C)” from the first sentence and adding

in its place “(b)(3)(ii)”.

f. Designating Examples 1 through

14 of paragraph (f) as paragraphs (f)(1)

through (14).

g. In newly designated paragraphs (f)

(1) through (14), removing the period

between the second and third level paragraph headings and adding an em-dash in

its place.

h. Removing “this Example 4” from

newly designated paragraph (f)(4)(i)

wherever it appears and adding in its place

“paragraph (f)(4)(i) (Example 4)”.

i. Removing “Example 4” from newly

designated paragraph (f)(5)(i) and adding

in its place “paragraph (f)(4)(i) of this section (the facts in Example 4)”.

j. Revising newly designated paragraph

(f)(6)(ii).

k. Removing “Example 8” from newly

designated paragraph (f)(9)(i) and adding

in its place “in paragraph (f)(8)(i) of this

section (the facts in Example 8)”.

l. Removing “Example 8” from newly

designated paragraph (f)(9)(ii) and adding

in its place “paragraph (f)(8)(ii) of this

section (the analysis in Example 8)”.

m. Revising newly designated paragraph (f)(11)(ii).

n. In paragraph (g)(1), removing “(b)

(3)(ii)(C)” from the first sentence and adding in its place “(b)(3)(ii)”.

o. In paragraph (g)(4) introductory

text, removing “(b)(3)(ii)(C)” from the

first sentence and adding in its place “(b)

(3)(ii)”.

p. In paragraph (h), adding three sentences at the end of the paragraph.

The revisions and additions read as follows:

§1.863-8 Source of income derived

from space and ocean activity under

section 863(d).

*****

(b) * * *

Bulletin No. 2020–53

(3) * * *

(ii) Sales of property produced by the

taxpayer—(A) General. If the taxpayer both produces property and sells such

property and either the production (in

whole or in part) or the sale takes place

in space or international water, the taxpayer must allocate and apportion all income, gain, or loss derived from sales of

such property solely on the basis of the

production activities with respect to such

property, and the source of that income

will be determined under paragraph (b)(3)

(ii)(B) or (C) of this section. To determine

the source of income derived from the sale

of personal property (including inventory)

by a nonresident that is attributable to the

nonresident’s office or other fixed place of

business in the United States under section 865(e)(2), the rules of §1.865-3 apply,

and the rules of this section do not apply.

*****

(f) * * *

(6) * * *

(ii) Analysis. The collection of data and

creation of images in space is characterized as the creation of property in space.

Because S both produces and sells the

data, the source of the gross income from

the sale of the data is determined under

paragraph (b)(3)(ii) of this section solely

on the basis of the production activities.

The source of S’s gross income is determined under paragraph (b)(3)(ii)(C) of

this section because production activities

occur both in space and on land.

*****

(11) * * *

(ii) Analysis. Because S’s rights, title,

and interest in the satellite pass to the

customer in space, the sale takes place

in space under §1.861-7(c), and the sale

transaction is space activity under paragraph (d)(1)(i) of this section. The source

of income derived from the sale of the satellite manufactured in the United States

and sold in space is determined under

paragraph (b)(3)(ii) of this section solely

on the basis of the production activities

with respect to the satellite.

*****

(h) * * * Paragraph (b)(3)(ii) of this

section applies to taxable years ending on

or after December 23, 2019. However, a

taxpayer may apply paragraph (b)(3)(ii)

of this section in its entirety for taxable

years beginning after December 31, 2017,

Bulletin No. 2020–53

and ending before December 23, 2019,

provided that the taxpayer and all persons

related to the taxpayer (within the meaning of section 267 or 707) apply paragraph

(b)(3)(ii) of this section and §§1.863-1(b),

1.863-2(b), 1.863-3, 1.864-5(a) and (b),

1.864-6(c)(2), and 1.865-3 in their entirety for the taxable year, and once applied,

the taxpayer and all persons related to the

taxpayer (within the meaning of section

267 or 707) continue to apply these regulations in their entirety for all subsequent

taxable years. For regulations generally

applicable to taxable years ending before

December 23, 2019, see §1.863-8 as contained in 26 CFR part 1 revised as of April

1, 2020.

Par. 8. Section 1.864-5 is amended as

follows:

a. Adding a sentence to the end of paragraph (a);

b. Revising the first sentence of paragraph (b) introductory text; and

c. Adding paragraph (e).

The additions read as follows:

§1.864-5 Foreign source income

effectively connected with U.S.

business.

(a) * * * To determine the source of

income, gain or loss from the sale of personal property (including inventory property) attributable to an office or other fixed

place of business in the United States by

nonresidents, as defined in section 865(g)

(1)(B), see §1.865-3.

(b) * * * Income, gain, or loss from

sources without the United States other

than income described in paragraph (c)

of this section or income from section

865(e)(2) sales, as defined in §1.865-3(c),

shall be taken into account pursuant to

paragraph (a) of this section in applying

§§1.864-6 and 1.864-7 only if it consists

of—

*****

(e) Applicability dates. Paragraphs (a)

and (b) of this section apply to taxable

years ending on or after December 23,

2019. However, a taxpayer may apply

paragraphs (a) and (b) of this section in

their entirety for taxable years beginning

after December 31, 2017, and ending before December 23, 2019, provided that the

taxpayer and all persons related to the taxpayer (within the meaning of section 267

1781

or 707) apply paragraphs (a) and (b) of

this section and §§1.863-1(b), 1.863-2(b),

1.863-3, 1.863-8(b)(3)(ii), 1.864-6(c)(2),

and 1.865-3 in their entirety for the taxable year, and once applied, the taxpayer

and all persons related to the taxpayer

(within the meaning of section 267 or 707)

continue to apply these regulations in their

entirety for all subsequent taxable years.

For regulations generally applicable to

taxable years ending before December

23, 2019, see §1.864-5 as contained in 26

CFR part 1 revised as of April 1, 2020.

Par. 9. Section 1.864-6 is amended as

follows:

a. Revising paragraph (c)(2).

b. Revising paragraph (c)(3).

c. Adding paragraph (c)(4).

The revisions and additions read as follows:

§1.864-6 Income, gain, or loss

attributable to an office or other fixed

place of business in the United States.

*****

(2) Special limitation in case of sales

of goods or merchandise through U.S. office. Notwithstanding paragraph (c)(1) of

this section, the special rules described in

this paragraph (c)(2) apply with respect to

a sale of goods or merchandise specified

in §1.864-5(b)(3), to which paragraph (b)

(3)(i) of this section does not apply. In the

case of a nonresident alien with a tax home

within the United States, as defined in section 911(d)(3), the amount of income from

the sale of goods or merchandise that is

properly allocable to the individual’s U.S.

office is determined under §1.865-3(d).

(3) Examples. The application of this

paragraph (c) may be illustrated by the

following examples—

(i) Example 1. Sales of produced inventory

through a U.S. sales office. Individual A, who is a

nonresident alien within the meaning of section

7701(b)(1)(B) and has a tax home in the United

States, manufactures machinery in a foreign country and sells the machinery outside the United States

through A’s sales office in the United States for use

in foreign countries. A is not a nonresident within the meaning of section 865(g)(1)(B). Therefore,

§1.865-3 does not apply to A’s sale of the machinery,

except to the extent provided in paragraph (c)(2) of

this section. Title to the property sold is transferred

to the foreign purchaser outside the United States,

but no office or other fixed place of business of A

in a foreign country materially participates in the

sale made through A’s U.S. office. By reason of its

December 28, 2020

sales activities in the United States, A is engaged in

business in the United States during the taxable year.

During the taxable year, A derives a total income of

$250,000x from these sales. Under paragraph (c)(2)

of this section, the amount of income that is allocable

to A’s U.S. office is determined under §1.865-3(d)

(2). The taxpayer does not allocate income from the

sale under the books and records method described

in §1.865-3(d)(2)(ii). Thus, 50 percent of A’s foreign

source income of $250,000x, plus any additional

income allocable based on the location of production activities under §§1.865-3(d)(2)(i) and 1.863-3

(in this case, $0x), is effectively connected for the

taxable year with the conduct of A’s U.S. trade or

business, or $125,000x.

(ii) Example 2. Sales of inventory purchased and

resold through a U.S. sales office by a nonresident

alien with a tax home in the United States. Individual B, who is a nonresident alien within the meaning

of section 7701(b)(1)(B) and has a tax home in the

United States, has an office in a foreign country that

purchases merchandise and sells it through B’s sales

office in the United States for use in various foreign

countries, with title to the property passing outside

the United States. B is not a nonresident within the

meaning of section 865(g)(1)(B). Therefore, §1.8653 does not apply to B’s sale of the merchandise, except to the extent provided in paragraph (c)(2) of this

section. No other office of B materially participates

in these sales made through its U.S. office. By reason

of its sales activities in the United States, B is engaged in business in the United States during the taxable year. During the taxable year, B derives income

of $300,000x from these sales made through its U.S.

sales office. All of B’s income from these sales is

foreign source as B purchases the merchandise outside the United States and title to the merchandise

also passes outside the United States. The amount of

income properly allocable to B’s U.S. office determined under §1.865-3(d)(3) is $300,000x, and thus

$300,000x is effectively connected for the taxable

year with the conduct of B’s U.S. trade or business.

(iii) Example 3. Foreign sales office also materially participates in sale. The facts are the same as in

paragraph (c)(3)(ii) of this section (the facts in Example 2), except that B also has an office in a foreign

country that is a material factor in the realization of

income from the sales made through B’s U.S. office.

No income from the sale of merchandise is allocable

to B’s U.S. sales office for the taxable year, by reason of paragraph (b)(3)(i) of this section, and thus

none of the $300,000x is effectively connected for

the taxable year with the conduct of B’s U.S. trade

or business.

(iv) Example 4. Sales of inventory purchased and

resold through a U.S. sales office by a foreign corporation. The facts are the same as in paragraph (c)

(3)(ii) of this section (the facts in Example 2), except

that B is a foreign corporation. B is a nonresident

within the meaning of section 865(g)(1)(B). The income from such sales will be sourced in accordance

with §1.865-3(a) and (d)(3).

(4) Applicability date. Paragraph (c)

(2) of this section applies to taxable years

ending on or after December 23, 2019.

However, a taxpayer may apply paragraph

(c)(2) of this section in its entirety for tax-

December 28, 2020

able years beginning after December 31,

2017, and ending before December 23,

2019, provided that the taxpayer and all

persons related to the taxpayer (within

the meaning of section 267 or 707) apply paragraph (c)(2) of this section and

§§1.863-1(b), 1.863-2(b), 1.863-3, 1.8638(b)(3)(ii), 1.864-5(a) and (b), and 1.8653 in their entirety for the taxable year, and

once applied, the taxpayer and all persons

related to the taxpayer (within the meaning of section 267 or 707) continue to apply these regulations in their entirety for

all subsequent taxable years. For regulations generally applicable to taxable years

ending before December 23, 2019, see

§1.864-6 as contained in 26 CFR part 1

revised as of April 1, 2020.

Par. 10. Section 1.865-3 is added to

read as follows:

§1.865-3 Source of gross income from

sales of personal property (including

inventory property) by a nonresident

attributable to an office or other fixed

place of business in the United States.

(a) In general. Notwithstanding any

provision of section 861 through 865 or

other regulations in this part, this section

provides the sole sourcing rules for gross

income, gain, or loss from section 865(e)

(2) sales. Gross income, gain, or loss from

a section 865(e)(2) sale is U.S. source income to the extent that the gross income,

gain, or loss is properly allocable to an office or other fixed place of business in the

United States under paragraph (d) of this

section.

(b) Exception for certain inventory

sales for use, disposition or consumption

outside the United States. A section 865(e)

(2) sale does not include any sale of inventory property that is sold for use, disposition, or consumption outside the United

States if an office or other fixed place of

business of the nonresident in a foreign

country materially participates in the sale.

See §1.864-6(b)(3) to determine whether

a foreign office materially participates in

the sale and whether the property was destined for foreign use.

sale” is a sale of personal property by a

nonresident, including inventory property,

other than a sale described in paragraph

1782

(b) of this section, that is attributable to

an office or other fixed place of business

in the United States under the principles

of section 864(c)(5)(B) as prescribed in

§1.864-6(b)(1) and (2). In determining

whether a nonresident maintains an office or other fixed place of business in the

United States, the principles of section

864(c)(5)(A) as prescribed in §1.864-7

apply, including the rules of paragraph (d)

of that section regarding the office or other fixed place of business of a dependent

agent of the nonresident. For purposes of

this section, “inventory property” has the

meaning provided in section 865(i)(1),

and “nonresident” has the meaning provided in section 865(g)(1)(B).

(d) Amount of gross income, gain, or

loss on sale of personal property properly allocable to a U.S. office—(1) In

general. Except as otherwise provided in

paragraphs (d)(2) through (4) of this section, the amount of gross income, gain,

or loss from a section 865(e)(2) sale that

is properly allocable to an office or other fixed place of business in the United

States is determined under the principles

of §1.864-6(c)(1).

(2) Produced inventory property. Gross

income, gain, or loss from a section 865(e)

(2) sale of inventory property that is produced by the nonresident seller is properly

allocable to an office or other fixed place

of business in the United States or to production activities in accordance with the

“50/50 method” described in paragraph

(d)(2)(i) of this section. However, in lieu

of the 50/50 method, the nonresident seller may elect to allocate the gross income,

gain, or loss under the “books and records

method” described in paragraph (d)(2)

(ii)(A) of this section, provided that the

nonresident satisfies all of the requirements described in paragraph (d)(2)(ii)

(B) of this section to the satisfaction of the

Commissioner. Gross income allocable

to production activities under this paragraph (d)(2) is sourced in accordance with

§1.863-3. For purposes of this paragraph

(d)(2), the term “produced” includes created, fabricated, manufactured, extracted,

processed, cured, and aged, as determined

under the principles of §1.954-3(a)(4) (except for §1.954-3(a)(4)(iv)). See section

864(a) and §1.864-1.

(i) The 50/50 method. Fifty percent of

the gross income, gain, or loss from a sec-

Bulletin No. 2020–53

tion 865(e)(2) sale of inventory property

that is produced by the nonresident seller

is properly allocable to an office or other fixed place of business in the United

States, and the remaining 50 percent of

the gross income, gain, or loss is properly allocable to production activities (the

“50/50 method”).

(ii) Books and records method—(A)

Method. Subject to paragraph (d)(2)(ii)(B)

of this section, a nonresident may elect to

determine the amount of its gross income,

gain, or loss from the sale of inventory

property produced by the nonresident seller that is properly allocable to production

activities and sales activities for the taxable year based upon its books of account

(the “books and records method”). The

gross income, gain, or loss allocable to

sales activities under this method is treated as properly allocable to an office or

other fixed place of business in the United

States and the remaining gross income,

gain, or loss is treated as properly allocable to production activities.

(B) Election and reporting rules—(1)

In general. A nonresident may not make

the election described in paragraph (d)

(2)(ii)(A) of this section unless the requirements of paragraphs (d)(2)(ii)(B)(2)

through (4) of this section are satisfied.

Once the election is made, the nonresident

must continue to satisfy the requirements

of paragraphs (d)(2)(ii)(B)(2) through

(4) of this section until the election is

revoked. If the nonresident fails to satisfy the requirements in paragraphs (d)(2)

(ii)(B)(2) through (4) of this section to

the satisfaction of the Commissioner, the

Commissioner may, in its sole discretion,

apply the 50/50 method described in paragraph (d)(2)(i) of this section.

(2) Books of account. The nonresident

must establish that it, in good faith and

unaffected by considerations of tax liability, regularly employs in its books of

account a detailed allocation of receipts

and expenditures that, under the principles of section 482, clearly reflects both

the amount of the nonresident’s gross

income, gain, or loss from its inventory

sales that are attributable to its sales activities, and the amount of its gross income,

gain, or loss from its inventory sales that

are attributable to its production activities.

For purposes of this paragraph (d)(2)(ii)

(B)(2), section 482 principles apply as if

Bulletin No. 2020–53

the office or other fixed place of business

in the United States were a separate organization, trade, or business (and, thus,

a separate controlled taxpayer) from the

nonresident (whether or not payments are

made between the United States office or

other fixed place of business and the nonresident’s other offices, and whether or

not the nonresident itself would otherwise

constitute an organization, trade, or business).

(3) Required records. The nonresident must prepare and maintain the records described in paragraph (d)(2)(ii)

(B)(2) of this section, which must be in

existence when its return is filed. The

nonresident must also prepare an explanation of how the allocation clearly

reflects the nonresident’s gross income,

gain, or loss from production and sales

activities under the principles of section

482. The nonresident must make available the explanation and records of the

nonresident (including for the office or

other fixed place of business in the United States and the offices or branches that

perform the production activities) upon

request of the Commissioner, within 30

days, unless some other period is agreed

upon between the Commissioner and the

nonresident.

(4) Making and revoking the books

and records method election; disclosure

of election. Except as otherwise provided in publications, forms, instructions, or

other guidance, a nonresident makes or revokes the election to apply the books and

records method by attaching a statement

to its original timely filed Federal income

tax return (including extensions) providing that it elects, or revokes the election,

to apply the books and records method

described in paragraph (d)(2)(ii)(A) of

this section. For nonresidents making the

election, the statement must provide that

the nonresident has prepared the records

described in paragraph (d)(2)(ii)(B)(2)

and (3) of this section.

(5) Limitation on revoking the books

and records method election. Once made,

the books and records method election

continues until revoked. An election cannot be revoked, without the consent of the

Commissioner, for any taxable year beginning within 48 months of the last day

of the taxable year for which the election

was made.

1783

(3) Purchased inventory property. All

gross income, gain, or loss from a section

865(e)(2) sale of inventory property that

is both purchased and sold by a nonresident is properly allocable to an office or

other fixed place of business in the United

States.

(4) Depreciable personal property.

Gain from a section 865(e)(2) sale of depreciable personal property (as defined in

section 865(c)(4)) is allocated under paragraphs (d)(4)(i) and (ii) of this section.

(i) The gain not in excess of the depreciation adjustments, if any, is properly allocable to an office or other fixed place of

business in the United States to the same

extent that the gain would be allocated to

sources within the United States under the

rules of section 865(c)(1). The remaining

gain not in excess of the depreciation adjustments, if any, is allocated to sources

without the United States in accordance

with section 865(c)(1). However, notwithstanding the preceding sentences, if

the property was predominantly used in

the United States, within the meaning of

section 865(c)(3)(B)(i), for a particular

taxable year, all of the gain not in excess

of depreciation for that year is properly allocable to the office or other fixed place of

business in the United States.

(ii) The gain in excess of the depreciation adjustments, if any, is treated as if

such gain was from the sale of inventory and the amount allocable to an office

or fixed place of business in the United

States is determined under paragraph (d)

(2) or (3) of this section, as applicable.

(e) Determination of source of taxable

income. For rules allocating and apportioning expenses to gross income effectively connected with the conduct of a

trade or business of a foreign corporation

in the United States (including gross income, gain, or loss sourced under this

section), see section 882(c)(1). For rules

allocating and apportioning expenses to

gross income, gain, or loss effectively

connected with the conduct of a trade or

business of a nonresident alien in the United States (including gross income, gain, or

loss sourced under this section), see section 873(a).

(f) Export trade corporations. This

section does not apply for purposes of defining an export trade corporation under

section 971(a).

December 28, 2020

(g) Applicability date. This section applies to taxable years ending on or after

December 23, 2019. However, a nonresident may apply this section in its entirety

for taxable years beginning after December 31, 2017, and ending before December

23, 2019, provided that the nonresident

and all persons related to the nonresident (within the meaning of section 267

or 707) apply this section and §§1.8631(b), 1.863-2(b), 1.863-3, 1.863-8(b)(3)

(ii), 1.864-5(a) and (b), and 1.864-6(c)(2)

in their entirety for the taxable year, and

once applied, the nonresident and all persons related to the nonresident (within the

meaning of section 267 or 707) continue

to apply these regulations in their entirety

for all subsequent taxable years.

§1.937-2 [Amended]

Par. 11. In §1.937-2 amend paragraph

(d) by removing “§1.863-3(f)” and adding

in its place “§1.863-3(e)”.

§1.937-3 [Amended]

Par. 12. In §1.937-3 amend paragraph

(d) by removing “§1.863-3(f)” and adding

in its place “§1.863-3(e)”.

Par. 13. Section 1.1502-13 is amended

by revising paragraph (c)(7)(ii)(N) to read

as follows:

§1.1502-13 Intercompany transactions.

*****

(7) * * *

December 28, 2020

(ii) * * *

(N) Example (14): Source of income under section 863—(1) Intercompany sale—(i) Facts. S manufactures inventory property solely in the United

States and recognizes $75x of income on sales to B

in Year 1. B conducts further production activity on

the inventory property solely in Country Y and then

sells the inventory property to X in Country Y and

recognizes $25x of income on the sale to X, also in

Year 1. Title passes from S to B, and from B to X, in

Country Y. Assume that applying §1.863-3 on a single entity basis, including the formula for apportionment of multi-country production activities by reference to the basis of production assets, $10x would

be treated as foreign source income and $90x would

be treated as U.S. source income (that is, 10 percent

of the production occurred outside the United States

and 90 percent occurred within the United States, as

measured by the basis of assets used in production

activities with respect to the property). Assume further that, on a separate entity basis, S would have $0x

of foreign source income and $75x of U.S. source

income and all of B’s $25x of income would be foreign source income.

(ii) Analysis. Under the matching rule, both S’s

$75x intercompany item and B’s $25x corresponding

item are taken into account in Year 1. In determining

the source of S and B’s income from the inventory property sales, the attributes of S’s intercompany

item and B’s corresponding item are redetermined to

the extent necessary to produce the same effect on

consolidated taxable income (and consolidated tax

liability) as if S and B were divisions of a single corporation. See paragraph (c)(1)(i) of this section. On

a single entity basis, S and B would have $10x that

would be treated as foreign source income and $90x

that would be treated as U.S. source income, but

without application of this section (that is, on a separate entity basis), S would have $75x of U.S. source

income and B would have $25x of foreign source

income. Under paragraph (c)(4)(ii) of this section, a

redetermined attribute must be allocated between S

and B using a reasonable method. On a separate entity basis B would have only foreign source income

and S would have only U.S. source income. Accordingly, under paragraph (c)(1)(i) of this section, $15x

1784

of B’s $25x sales income that would be treated as

foreign source income on a separate entity basis is

redetermined to be U.S. source income.

(2) Sale of property reflecting intercompany

services or intangibles—(i) Facts. S earns $10x of

income performing services in the United States for

B. B capitalizes S’s fees into the basis of inventory

property that it manufactures in the United States

and sells to an unrelated person in Year 1 at a $90x

profit, with title passing in Country Y. Assume that

on a single entity basis, $100x is treated as U.S.

source income and $0x is treated as foreign source

income. Further assume that on a separate entity basis, S would have $10x of U.S. source income, and B

would have $90x of U.S. source income, with neither

having any foreign source income.

(ii) Analysis. Under the matching rule, S’s $10x

income and B’s $90x income are taken into account

in Year 1. In determining the source of S and B’s

income, the attributes of S’s intercompany item and

B’s corresponding item are redetermined to the extent necessary to produce the same effect on consolidated taxable income (and consolidated tax liability)

as if S and B were divisions of a single corporation.

Because the results are the same on a single entity basis and a separate entity basis ($100x of U.S.

source income and $0x of foreign source income),

the attributes are not redetermined under paragraph

(c)(1)(i) of this section.

Sunita Lough,

Deputy Commissioner for Services

and Enforcement.

Approved: September 21, 2020

David J. Kautter,

Assistant Secretary of the Treasury

(Tax Policy).

(Filed by the Office of the Federal Register on

December 10, 2020, 8:45 a.m., and published in the

issue of the Federal Register for December 11, 2020,

85 F.R. 79837)

Bulletin No. 2020–53

Part III

Work Opportunity Tax

Credit (WOTC) Transition

Relief under Internal

Revenue Code § 51

Notice 2020-78

I. PURPOSE

This notice provides transition relief

for certain employers claiming the Work

Opportunity Tax Credit (WOTC) under

§ 51 of the Internal Revenue Code (Code).

Specifically, this notice provides transition

relief by extending the 28-day deadline for

employers described in section IV of this

notice to request certification from a designated local agency (DLA)1 that an individual hired on or after January 1, 2018,

and before January 1, 2021, is a member

of the designated community resident targeted group or the qualified summer youth

employee targeted group.

II. BACKGROUND

Section 51(a) of the Code provides the

WOTC to employers based on a percentage of qualified wages paid during the taxable year. Section 51(b) defines “qualified

wages” as wages paid or incurred by an

employer during the taxable year to an individual who is certified as a member of a

targeted group. Section 51(d)(1) lists the

targeted groups, which include designated

community residents defined in § 51(d)(5)

and qualified summer youth employees

defined in § 51(d)(7).

Pursuant to § 51(d)(13)(A), an individual is not treated as a member of a targeted group unless (1) on or before the day

the individual begins work, the employer

obtains certification from the DLA that

the individual is a member of a targeted

group, or (2) the employer completes a

pre-screening notice on or before the day

the individual is offered employment and

submits such notice to the DLA to request

certification not later than 28 days after

the individual begins work. The Form

8850 (Pre-Screening Notice and Certification Request for the Work Opportunity

Credit) is the pre-screening notice that

must be submitted to the DLA to request

certification.

Among the requirements for an individual to be certified as a member of

a targeted group described in § 51(d)(5)

or (7), the individual must be certified by

the DLA as having a principal place of

residence within an empowerment zone2

where the individual continuously resides.

Any wages paid to or incurred on behalf

of the individual for services rendered

while the individual is not living at a residence within an empowerment zone do

not qualify for the WOTC.

III. TAXPAYER CERTAINTY AND

DISASTER TAX RELIEF ACT

AMENDMENTS

The WOTC has been subject to several

legislative extensions and modifications

since its enactment by § 1201 of the Small

Business Job Protection Act of 1996, Pub.

L. 104-188, 110 Stat. 1755 (August 20,

1996). Most recently, the Taxpayer Certainty and Disaster Tax Relief Act (Act),

enacted as Division Q of the Further Consolidated Appropriations Act, 2020, Pub.

L. 116-94, 133 Stat. 2534, 3226 (December 19, 2019), amended § 51 of the Code

to extend the WOTC through December

31, 2020.

Specifically, § 143 of the Act amended § 51(c)(4) of the Code to extend the

WOTC for an employer that hires individuals who are members of a targeted group

with respect to wages paid or incurred to

such individuals who begin work for the

employer after December 31, 2019, but

not after December 31, 2020.

In addition, § 118(a) of the Act amended § 1391(d)(1) of the Code to provide

that any designation of an empowerment

zone ends on the earliest of (1) December

31, 2020, (2) the termination date desig-

nated by the State and local governments

as provided for in their nomination, or (3)

the date the appropriate Secretary3 revokes

the designation. Section 118(b) of the Act

provides that where a nomination of an

empowerment zone included a termination date of December 31, 2017, § 1391(d)

(1)(B) of the Code will not apply with respect to such designation if, after the date

of the enactment of the Act, the entity that

made such nomination amends the nomination, in such manner as the Secretary of

the Treasury may provide, to provide for

a new termination date. The amendment

made by § 118(a) of the Act applies to taxable years beginning after December 31,

2017.

On June 11, 2020, the Department

of the Treasury (Treasury Department)

and the Internal Revenue Service (IRS)

issued Revenue Procedure 2020-16,

2020-27 IRB 10, to explain how a State

or local government is deemed to extend the termination date designated in

an empowerment zone nomination until

December 31, 2020. Revenue Procedure

2020-16 provides that if a State or local

government did not submit a written declination to the IRS by August 10, 2020,

and if the appropriate Secretary did not

revoke the empowerment zone designation, then the termination date provided

in that empowerment zone nomination is

automatically extended to December 31,

2020.

IV. GRANT OF RELIEF

Because the Act extended the WOTC

through December 31, 2020, and retroactively extended the period for which an

empowerment zone designation is in effect under § 1391(d)(1) from December

31, 2017, to December 31, 2020, employers need additional time to comply with

the DLA certification requirements of

§ 51(d)(13)(A)(ii).

The Treasury Department and the IRS

understand that, due to the expiration of

empowerment zone designations at the

Section 51(d)(12) provides that a “DLA” is a State employment security agency (sometimes referred to as a State Workforce Agency) established in accordance with 29 U.S.C. §§ 49-49n.

Section 1393(b) provides that for purposes of the Code, the term “empowerment zone” means an area designated as such under § 1391.

Section 1393(a)(1) of the Code defines the term “appropriate Secretary” as the Secretary of Housing and Urban Development (in the case of any nominated area designated under § 1391

that is located in an urban area as defined in § 1393(a)(3)) or the Secretary of Agriculture (in the case of any nominated area designated under § 1391 that is located in a rural area as defined

in § 1393(a)(2)).

Bulletin No. 2020–53

1785

December 28, 2020

end of 2017 and the uncertainty of whether empowerment zone designations would

be extended, some employers that hired

members of targeted groups described in

§ 51(d)(5) and (7) may not have submitted

Form 8850 to the DLA within 28 days of

the individual beginning work. To be eligible for the relief provided by this notice, an employer that did not submit Form

8850 to the DLA within 28 days of an individual beginning work must submit the

completed Form 8850 to the DLA by the

date set forth in section IV.A of this notice.

In addition, the Treasury Department and

the IRS are aware that some employers that

hired members of targeted groups described

in § 51(d)(5) and (7) may have submitted

Form 8850 to the DLA within 28 days of

an individual beginning work, regardless

of the expiration of the empowerment zone

designations. To be eligible for the relief

provided by this notice, an employer that

submitted Form 8850 to the DLA and subsequently received a denial letter from the

DLA by reason of the expiration of the empowerment zone designations must re-submit the completed Form 8850 by the date

set forth in section IV.A of this notice. In

the event that an employer submitted Form

8850 to the DLA and was not issued a denial letter by the DLA, the employer does not

need to re-submit Form 8850 to be eligible

for the relief provided in this notice.

For these reasons, the Treasury Department and the IRS are providing employers

with additional time to submit Form 8850

with the DLAs in accordance with the following timeframe.

A. Additional time for employers that

hired or hire designated community

residents or qualified summer youth

employees between January 1, 2018,

and December 31, 2020, to submit a

completed Form 8850 to the DLA.

An employer that hired an individual

who is a designated community resident

described in § 51(d)(5), or a qualified summer youth employee described in § 51(d)

(7), and who began work for that employer on or after January 1, 2018, and before

January 1, 2021, will be considered to

have satisfied the requirements of § 51(d)

(13)(A)(ii), whether or not the employer

submitted the completed Form 8850 to the

DLA within 28 days of the individual beginning work for the employer, if the employer submits the completed Form 8850

to the DLA to request certification no later

than January 28, 2021. In the event that

an employer submitted Form 8850 to the

DLA and was not issued a denial notification by the DLA, the employer does not

need to re-submit Form 8850.

B. Application of 28-day requirement

to individuals hired on or after

January 1, 2021.

An employer that hires a member of a

targeted group described in § 51(d)(5) or

(7), who begins work for the employer on

or after January 1, 2021, is not eligible for

the transition relief described in this notice with respect to that new employee.

V. EFFECTIVE DATE

The effective date of this notice is December 11, 2020.

VI. DRAFTING INFORMATION

The principal author of this notice is

Christopher Dellana of the Office of Associate Chief Counsel (Employee Benefits,

Exempt Organizations, and Employment

Taxes). For further information regarding

the WOTC, contact Mr. Dellana at (202)

317-5500 (not a toll-free number).

Guidance on Sections 102

and 103 of the SECURE

Act With Respect to Safe

Harbor Plans

Notice 2020-86

I. PURPOSE

This notice provides guidance in the

form of questions and answers with re-

spect to §§ 102 and 103 of Division O of

the Further Consolidated Appropriations

Act, 2020, Pub. L. 116-94, 133 Stat. 2534

(2019), known as the Setting Every Community Up for Retirement Enhancement

Act of 2019 (SECURE Act).1 Section

102 of the SECURE Act increases the 10

percent cap for automatic enrollment safe

harbor plans. Section 103 of the Secure

Act eliminates certain safe harbor notice

requirements for plans that provide for

safe harbor nonelective contributions and

adds new provisions for the retroactive

adoption of safe harbor status for those

plans. This notice is not intended to provide comprehensive guidance as to § 102

or 103 of the SECURE Act, but rather is

intended to assist taxpayers by providing

guidance on particular issues while the

Treasury Department and the IRS develop

regulations to fully implement these sections of the SECURE Act. The Treasury

Department and the IRS invite comments

on the guidance in this notice and any other aspect of § 102 or 103 of the SECURE

Act.

II. BACKGROUND

A. Exemptions from Actual Deferral

Percentage (ADP) and Actual

Contribution Percentage (ACP) Testing

for Safe Harbor Plans

Under § 401(a)(4) of the Internal Revenue Code (Code) and § 1.401(a)(4)‑1(b)

(2), contributions or benefits provided under a qualified retirement plan must not be

discriminatory in amount in favor of highly compensated employees (HCEs), as defined in § 414(q). Under § 401(k)(3) and

§ 1.401(k)-1(a)(4)(iv)(A) and (b)(1)(ii)

(A), a § 401(k) plan satisfies this requirement if elective contributions made on behalf of eligible employees for a year satisfy the ADP test described in § 1.401(k)-2.

Under § 401(m)(2) and § 1.401(m)‑1(a)

(1)(i) and (b)(1)(i), a similar test, the ACP

test, applies to matching contributions and

employee contributions.

As an alternative to satisfying the annual ADP test, a plan may satisfy the ADP

safe harbor provisions of § 401(k)(12) (a

On September 2, 2020, the Department of the Treasury (Treasury Department) and the Internal Revenue Service (IRS) released Notice 2020-68, 2020‑38 IRB 567, which provides guidance

with respect to §§ 105, 107, 112, 113, 116, and 601 of the SECURE Act (and § 104 of Division M of the Further Consolidated Appropriations Act, 2020, known as the Bipartisan American

Miners Act of 2019).

December 28, 2020

1786

Bulletin No. 2020–53

traditional safe harbor § 401(k) plan) or

401(k)(13) (a qualified automatic contribution arrangement (QACA) safe harbor

§ 401(k) plan). Similarly, as an alternative to satisfying the annual ACP test with

respect to matching contributions, a plan

may satisfy the ACP safe harbor provisions of § 401(m)(11) (a traditional safe

harbor § 401(m) plan) or 401(m)(12) (a

QACA safe harbor § 401(m) plan).

B. Safe Harbor Contributions

Under § 1.401(k)-3(a)(1), a traditional safe harbor § 401(k) plan is required

to satisfy the safe harbor contribution

requirements of either § 1.401(k)-3(b)

(safe harbor nonelective contributions)

or 1.401(k)-3(c) (safe harbor matching

contributions) for the plan year. Under

§ 1.401(k)-3(b) and (c), contributions

must be made on behalf of each eligible

employee who is not an HCE (NHCE).

Similarly, under § 1.401(m)-3(a)(1), a

traditional safe harbor § 401(m) plan is

required to satisfy the safe harbor contribution requirements of either § 1.401(m)3(b), which cross-references the safe harbor nonelective contribution requirements

of § 1.401(k)-3(b), or 1.401(m)-3(c),

which cross‑references the safe harbor

matching contribution requirements of

§ 1.401(k)-3(c), for the plan year.

Under § 1.401(k)-3(a)(2), a QACA

safe harbor § 401(k) plan is required to

satisfy the safe harbor contribution requirements of § 1.401(k)-3(k) for the plan

year. Under § 1.401(k)-3(k)(1), a QACA

safe harbor § 401(k) plan must satisfy either the safe harbor nonelective contribution requirements of § 1.401(k)-3(b) or the

safe harbor matching contribution requirements of § 1.401(k)-3(c), as modified by

§ 1.401(k)‑3(k)(2) and (3). Similarly, under § 1.401(m)-3(a)(2), a QACA safe harbor § 401(m) plan is required to satisfy the

safe harbor requirements of § 1.401(k)-3,

including the safe harbor contribution requirements of § 1.401(k)‑3(k).

Subject to certain requirements, a plan

that provides for safe harbor contributions

also may provide for contributions that are

not safe harbor contributions. For example, a traditional safe harbor § 401(k) plan

that provides for safe harbor nonelective

contributions may also provide for either

(1) a discretionary matching contribution

Bulletin No. 2020–53

of four percent of safe harbor compensation that would not need to satisfy the ACP

test because the contribution satisfies the

requirements of § 1.401(m)-3(d) (including the limits on matching rate increases,

matching contributions, and matching

rates on behalf of HCEs as compared to

matching rates on behalf of NHCEs), or

(2) a discretionary matching contribution

in excess of four percent of safe harbor

compensation that would need to satisfy the ACP test because the contribution

does not satisfy the limit on discretionary

matching contributions under § 1.401(m)3(d)(3)(ii). Under § 1.401(k)‑3(a)(3), neither of these types of additional matching

contributions are referred to as safe harbor

contributions.

C. Safe Harbor Notices

Section 401(k)(12)(D) generally requires a traditional safe harbor § 401(k)

plan to provide a safe harbor notice to

each eligible employee “within a reasonable period before any year.” Section

1.401(k)-3(d)(3)(i) clarifies that a safe

harbor notice must be “provided within a

reasonable period before the beginning of

the plan year (or, in the year an employee

becomes eligible, within a reasonable period before the employee becomes eligible).” Section 401(m)(11)(A)(ii) requires

a traditional safe harbor § 401(m) plan to

satisfy the safe harbor notice requirements

of § 401(k)(12)(D).

Section 401(k)(13)(E)(i) similarly requires a QACA safe harbor § 401(k) plan to

provide a safe harbor notice to each eligible employee “within a reasonable period

before each plan year,” and § 1.401(k)‑3(a)

(2) requires a QACA safe harbor § 401(k)

plan to satisfy the safe harbor notice requirements of § 1.401(k)‑3(d), as modified by § 1.401(k)‑3(k)(4). Section 401(m)

(12)(A) requires a QACA safe harbor

§ 401(m) plan to satisfy the requirements

for a QACA safe harbor § 401(k) plan.

D. Mid-Year Changes to Safe Harbor

Plans and Notices

Section 1.401(k)-3(e)(1) provides that,

in general, a plan will fail to satisfy the

requirements of § 401(k)(12) and (13)

and § 1.401(k)-3 unless plan provisions

that satisfy the safe harbor plan rules of

1787

§ 1.401(k)-3 are adopted before the first

day of the plan year and remain in effect

for an entire 12-month plan year. In addition, § 1.401(k)‑3(e)(1) provides that,

except as provided in § 1.401(k)-3(g) or

in guidance of general applicability published in the Internal Revenue Bulletin, a

plan that includes provisions that satisfy

the safe harbor plan rules of § 1.401(k)-3

will not satisfy the nondiscrimination requirements for § 401(k) plans for a plan

year if the plan is amended to change

those provisions during the plan year. Section 1.401(m)-3(f) includes similar rules

for safe harbor § 401(m) plans.

Under § 1.401(k)-3(g), a plan that provides for safe harbor contributions for a

plan year may be amended during the plan

year to reduce or suspend future safe harbor matching contributions or safe harbor

nonelective contributions if the plan is

also amended to provide that the ADP test

will be satisfied for the entire plan year in

which the reduction or suspension occurs

(using the current year testing method)

and if certain other requirements are satisfied. Section 1.401(k)-3(g)(1)(i) sets forth

the requirements for a mid-year reduction

or suspension of safe harbor matching

contributions, and § 1.401(k)-3(g)(1)(ii)

sets forth the requirements for a mid-year

reduction or suspension of safe harbor

nonelective contributions.

Under § 1.401(k)-3(g)(1)(i)(A) and (ii)

(A), the employer must either (1) be operating at an economic loss (as described

in § 412(c)(2)(A)) for the plan year, or

(2) have included in the plan’s safe harbor

notice (as described in § 1.401(k)-3(d))

for the plan year a statement that the plan

may be amended during the plan year to

reduce or suspend safe harbor contributions and that the reduction or suspension

will not apply earlier than 30 days after

all eligible employees are provided notice of the reduction or suspension. Under

§ 1.401(k)‑3(g)(1)(i)(C) and (ii)(C), the

reduction or suspension of safe harbor

contributions may be effective no earlier

than the later of the date the amendment is

adopted or 30 days after eligible employees are provided the supplemental notice

described in § 1.401(k)-3(g)(2). Under

§ 1.401(k)-3(g)(1)(i)(D) and (ii)(D), eligible employees must be given a reasonable

opportunity (including a reasonable period

after receipt of the supplemental notice)

December 28, 2020

prior to the reduction or suspension of safe

harbor contributions to change their cash

or deferred elections and, if applicable,

their employee contribution elections.

Section 1.401(m)-3(h) provides rules

similar to those of § 1.401(k)-3(g) for a

reduction or suspension of future safe harbor matching contributions or safe harbor

nonelective contributions in a safe harbor

§ 401(m) plan.

Notice 2016-16, 2016-7 IRB 318, provides guidance on mid-year changes to

safe harbor plans to the extent that conditions for those mid-year changes are

not addressed in the Code or regulations

(including conditions for reducing or

suspending safe harbor contributions under §§ 1.401(k)-3(g) and 1.401(m)-3(h)).

Section III.B of Notice 2016‑16 provides

that a change made to a safe harbor plan

or to a plan’s required safe harbor notice

content does not fail to satisfy the requirements of §§ 1.401(k)-3 and 1.401(m)-3

merely because the change is a mid-year

change, provided that: (1) if it is a midyear change to a plan’s required safe harbor notice content, the notice and election

opportunity conditions in section III.C of

Notice 2016‑16 are satisfied; and (2) the

mid‑year change is not described in a list

of prohibited mid‑year changes in section

III.D of Notice 2016-16. Section III.A of

Notice 2016-16 defines required safe harbor notice content as the information that

is required by the safe harbor plan regulations to be provided in a plan’s safe harbor

notice. For example, a plan’s safe harbor

notice must describe any other contributions under the plan or matching contributions to another plan on account of elective

contributions or employee contributions

under the plan (including the potential for

discretionary matching contributions) and

the conditions under which such contributions are made. See § 1.401(k)‑3(d)(2)(ii)

(B).

E. Section 102 of the SECURE Act

For a QACA safe harbor § 401(k) plan,

§ 401(k)(13)(C) generally requires that

each employee eligible to participate be

treated as having elected to have the employer make elective contributions in an

amount equal to a qualified percentage of

compensation (subject to certain exceptions for employees who have made or

make affirmative participation elections).

The qualified percentage of compensation

may be any percentage determined under

the plan if such percentage is applied uniformly, does not exceed the maximum percentage specified in § 401(k)(13)(C)(iii),

and satisfies certain minimum percentage

requirements specified in § 401(k)(13)

(C)(iii)(I) – (IV). For example, § 401(k)

(13)(C)(iii)(I) provides that the qualified

percentage must be at least three percent

during the initial period ending on the last

day of the first plan year that begins after

the date on which the first automatic elective contribution is made with respect to

an employee. Prior to the enactment of the

SECURE Act, § 401(k)(13)(C)(iii) of the

Code provided that the qualified percentage could not exceed 10 percent.

Section 102(a) of the SECURE Act

amended § 401(k)(13)(C)(iii) of the Code

to provide that the qualified percentage

may not exceed 15 percent (or 10 percent

during the initial period of automatic elective contributions described in § 401(k)

(13)(C)(iii)(I)).

Section 102(b) of the SECURE Act

provides that the amendments made by

§ 102 of the SECURE Act apply to plan

years beginning after December 31, 2019.

F. Section 103 of the SECURE Act

Prior to the enactment of the SECURE

Act, § 401(k)(12) required all traditional safe harbor § 401(k) plans to satisfy

the safe harbor notice requirements of

§ 401(k)(12)(D), and § 401(k)(13) required all QACA safe harbor § 401(k)

plans to satisfy the safe harbor notice requirements of § 401(k)(13)(E). In addition, § 401(k)(12) and (13) did not explicitly permit retroactive adoption of the safe

harbor nonelective contribution requirements of § 401(k)(12)(C) (traditional) or

401(k)(13)(D)(i)(II) (QACA) for a plan

year.2

Section 103(a) of the SECURE Act

amended § 401(k)(12)(A) of the Code to

eliminate the safe harbor notice requirements of § 401(k)(12)(D) for a traditional safe harbor § 401(k) plan that satisfies

the safe harbor nonelective contribution

requirements of § 401(k)(12)(C). Section

103(a) of the SECURE Act also amended

§ 401(k)(13)(B) of the Code to eliminate

the safe harbor notice requirements of

§ 401(k)(13)(E) for a QACA safe harbor

§ 401(k) plan that satisfies the safe harbor

nonelective contribution requirements of

§ 401(k)(13)(D)(i)(II).

Section 103(a) of the SECURE Act did

not amend § 401(m)(11) or 401(m)(12) of

the Code. Thus, § 401(m)(11)(A)(ii) continues to require all traditional safe harbor

§ 401(m) plans to satisfy the safe harbor

notice requirements of § 401(k)(12)(D).

Section 401(m)(12)(A) also continues to

require all QACA safe harbor § 401(m)

plans to satisfy the requirements for a

QACA safe harbor § 401(k) plan. However, § 103(a) of the SECURE Act eliminated the safe harbor notice requirements of

§ 401(k)(13)(E) of the Code for a QACA

safe harbor § 401(k) plan that satisfies the

safe harbor nonelective contribution requirements of § 401(k)(13)(D)(i)(II).

Section 103(b) of the SECURE Act

added new § 401(k)(12)(F) of the Code

to permit a plan to be amended after the

beginning of a plan year to provide that

the safe harbor nonelective contribution

requirements of § 401(k)(12)(C) will apply for the plan year, provided that: (1) the

amendment is adopted before the 30th day

before the close of the plan year (or before

the last day under § 401(k)(8)(A) for distributing excess contributions for the plan

year if the safe harbor nonelective contribution for the plan year is at least four percent of each employee’s compensation);

and (2) the plan did not provide, at any

time during the plan year, for safe harbor

matching contributions under § 401(k)

(12)(B) (traditional) or 401(k)(13)(D)(i)

(I) (QACA) for the plan year.

Section 103(c) of the SECURE Act

likewise amended the QACA safe harbor

§ 401(k) plan rules of § 401(k)(13) of the

Although § 401(k)(12) and (13) did not explicitly permit retroactive adoption of safe harbor nonelective contribution requirements, §§ 1.401(k)-3(f) and 1.401(m)-3(g) permit a plan that

provides for the use of the current year testing method to be retroactively amended to adopt a safe harbor design for the plan year, using safe harbor nonelective contributions, if certain

additional requirements are met (including contingent and follow-up notice requirements).

December 28, 2020

1788

Bulletin No. 2020–53

Code to add new § 401(k)(13)(F), which

provides rules similar to those of § 401(k)

(12)(F).

Section 103(d) of the SECURE Act

provides that the amendments made by

§ 103 of the SECURE Act apply to plan

years beginning after December 31, 2019.

III. GUIDANCE REGARDING

SECTION 102 OF THE SECURE ACT

(INCREASE IN 10 PERCENT CAP

FOR AUTO-ENROLLMENT SAFE

HARBOR)

Q-1. In order to maintain its status as

a QACA safe harbor § 401(k) plan, is a

QACA safe harbor § 401(k) plan required,

pursuant to § 102(a) of the SECURE Act,

to increase the maximum qualified percentage of compensation used to determine automatic elective contributions?

A-1. No. The qualified percentage under a QACA safe harbor § 401(k) plan

may be any percentage of compensation

determined under the plan, as long as the

percentage is applied uniformly, does not

exceed the maximum percentage specified

in § 401(k)(13)(C)(iii) (15 percent, or 10

percent during the initial period of automatic elective contributions described in

§ 401(k)(13)(C)(iii)(I)), and satisfies certain minimum percentage requirements

specified in § 401(k)(13)(C)(iii)(I) – (IV).

Q-2. If a plan incorporates the maximum qualified percentage of § 401(k)(13)

(C)(iii) by reference, will the plan fail to

operate in accordance with its terms merely because the plan continues to apply the

maximum qualified percentage of 10 percent that applied under § 401(k)(13)(C)

(iii) of the Code before that section was

amended by § 102(a) of the SECURE Act?

A-2. No. However, the plan would

need to be amended on or before the plan

amendment deadline determined under

§ 601(b) of the SECURE Act,3 as described in Q&A G-1 of Notice 2020-68,

to provide explicitly that the plan’s maximum qualified percentage is 10 percent,

retroactive to the first day of the first plan

year beginning after December 31, 2019.

If a plan incorporates the maximum qualified percentage of § 401(k)(13)(C)(iii)

of the Code by reference and the plan is

not amended on or before the plan amendment deadline determined under § 601(b)

of the SECURE Act to provide a specific

maximum qualified percentage, then the

plan will be treated as providing for the

maximum qualified percentage specified

in § 401(k)(13)(C)(iii) of the Code, as

amended by § 102(a) of the SECURE Act,

effective as of the first day of the first plan

year beginning after December 31, 2019.

In this case, the plan will have failed to

operate in accordance with its terms by

applying the maximum qualified percentage of 10 percent that applied under

§ 401(k)(13)(C)(iii) of the Code before

that section was amended by § 102(a) of

the SECURE Act.

Q-3. What plan amendment timing

rules apply to a plan amendment that increases the maximum qualified percentage

of compensation used to determine automatic elective contributions to a percentage greater than 10 percent (but no greater

than 15 percent) after the initial period of

automatic elective contributions described

in § 401(k)(13)(C)(iii)(I)?

A-3. In general, the plan amendment

timing provisions of § 601 of the SECURE Act, as described in Q&A G-1 of

Notice 2020-68, apply to a plan amendment adopted under § 102 of the SECURE

Act. In addition, a plan may be amended

to reflect § 102 of the SECURE Act after

the applicable plan amendment deadline

under § 601 of the SECURE Act, in accordance with the general discretionary

amendment deadlines set forth in Rev.

Proc. 2016‑37, 2016‑29 IRB 136, as most

recently modified by Rev. Proc. 2020-40,

2020-38 IRB 575.

IV. GUIDANCE REGARDING

SECTION 103 OF THE SECURE

ACT (SAFE HARBOR NOTICE

REQUIREMENTS AND

RETROACTIVE SAFE HARBOR

STATUS FOR PLANS THAT PROVIDE

SAFE HARBOR NONELECTIVE

CONTRIBUTIONS)

Q-4. How does § 103(a) of the SECURE Act affect the safe harbor notice

requirements for a traditional safe harbor

§ 401(k) plan or a traditional safe harbor

§ 401(m) plan?

A-4. Section 103(a) of the SECURE

Act amended the requirements for a traditional safe harbor § 401(k) plan that

satisfies the safe harbor nonelective contribution requirements of § 401(k)(12)

harbor notice requirements of § 401(k)

(12)(D) (including the requirement under

§ 1.401(k)‑3(d)(3)(i) to provide a safe harbor notice within a reasonable period before an employee becomes eligible). However, § 103(a) of the SECURE Act did not

eliminate the safe harbor notice requirements of § 401(m)(11)(A) of the Code for

a traditional safe harbor § 401(m) plan

that satisfies the safe harbor nonelective

contribution requirements of § 401(k)(12)

(C).

Thus, for example, if a traditional safe

harbor § 401(k) plan satisfies the safe harbor nonelective contribution requirements

of § 401(k)(12)(C), but also provides

non‑safe harbor matching contributions

that are structured to satisfy the requirements of § 1.401(m)-3(d) (and, therefore,

are not required to satisfy the ACP test),

then the plan still must satisfy the safe harbor notice requirements of § 401(m)(11)

(A). On the other hand, if a traditional safe

harbor § 401(k) plan that satisfies the safe

harbor nonelective contribution requirements of § 401(k)(12)(C) also provides

non‑safe harbor matching contributions

that are not intended to satisfy the requirements of § 1.401(m)‑3(d) (and, therefore,

are required to satisfy the ACP test), then

the plan need not satisfy the safe harbor

notice requirements of either § 401(k)(12)

(D) or 401(m)(11)(A).

Q-5. How does § 103(a) of the SECURE Act affect the safe harbor notice requirements for a QACA safe harbor § 401(k) plan or QACA safe harbor

§ 401(m) plan?

A-5. Section 103(a) of the SECURE

Act amended the requirements for a

QACA safe harbor § 401(k) plan that satisfies the safe harbor nonelective contribution requirements of § 401(k)(13)(D)

(i)(II) of the Code by eliminating the safe

In general, for a qualified retirement plan that is not a governmental plan within the meaning of § 414(d) of the Code, or an applicable collectively bargained plan, the plan amendment

deadline determined under § 601 of the SECURE Act is the last day of the first plan year beginning on or after January 1, 2022. The plan amendment deadline for a qualified governmental

plan, as defined in § 414(d) of the Code, or for an applicable collectively bargained plan is the last day of the first plan year beginning on or after January 1, 2024.

Bulletin No. 2020–53

1789

December 28, 2020

harbor notice requirements of § 401(k)

(13)(E) (including the requirement under

§ 1.401(k)-3(d)(3)(i) to provide a notice

within a reasonable period before an employee becomes eligible). The amendments made by § 103(a) of the SECURE

Act also result in the elimination of any

safe harbor notice requirement under

§ 401(m)(12) of the Code for a QACA

safe harbor § 401(m) plan that satisfies the

safe harbor nonelective contribution requirements of § 401(k)(13)(D)(i)(II). The

result is different for a traditional safe harbor § 401(m) plan, as described in Q&A-4

of this notice, than for a QACA safe harbor § 401(m) plan because § 401(m)(11)

specifically requires a traditional safe harbor § 401(m) plan to satisfy the safe harbor notice requirements of § 401(k)(12)

(D), but § 401(m)(12)(A) merely requires

a QACA safe harbor § 401(m) plan to satisfy the requirements for a QACA safe

harbor § 401(k) plan.

Q-6. Does § 103(a) of the SECURE

Act change any other requirements?

A-6. No. Section 103(a) of the SECURE Act does not change any other requirements that may apply to a plan that

satisfies the safe harbor nonelective contribution requirements applicable to a traditional or QACA safe harbor § 401(k) plan

under § 401(k)(12)(C) or 401(k)(13)(D)

(i)(II) of the Code. For example, § 103(a)

of the SECURE Act did not change the

notice requirements under § 414(w)(4) of

the Code for a plan that permits, pursuant

to the eligible automatic contribution arrangement rules of § 414(w), an employee to elect to withdraw automatic elective

contributions (and earnings) no later than

90 days after the date of the first elective

contribution with respect to the employee

under the eligible automatic contribution

arrangement. Accordingly, the § 414(w)

(4) notice requirements continue to apply

even if the plan satisfies the safe harbor

nonelective contribution requirements of

§ 401(k)(12)(C) or 401(k)(13)(D)(i)(II).

As another example, § 103(a) of the

SECURE Act did not change the requirement under § 1.401(k)‑1(e)(2)(ii) that a

cash or deferred arrangement (including

an arrangement in a plan that satisfies the

safe harbor nonelective contribution requirements of § 401(k)(12)(C) or 401(k)

(13)(D)(i)(II) of the Code) provide an

employee with an effective opportunity,

determined based on all the relevant facts

and circumstances, including the adequacy of notice of the availability of a cash

or deferred election, to make (or change)

a cash or deferred election at least once

during each plan year.

Q-7. If a plan does not provide a safe

harbor notice for a plan year beginning

after December 31, 2019 (because, pursuant to § 103(a) of the SECURE Act

and Q&A‑4 or Q&A-5 of this notice,

safe harbor notice requirements no longer apply to the plan), but the employer

nevertheless provides a notice that includes a statement that the plan may be

amended mid-year to reduce or suspend

safe harbor nonelective contributions, as

described in §§ 1.401(k)‑3(g)(1)(ii)(A)(2)

and 1.401(m)‑3(h)(1)(ii)(A)(2), and that

otherwise satisfies the requirements for a

safe harbor notice, will the plan fail to satisfy the condition in § 1.401(k)‑3(g)(1)(ii)

(A)(2) or 1.401(m)‑3(h)(1)(ii)(A)(2) that

the statement regarding the possible midyear reduction or suspension of safe harbor nonelective contributions be included

in a safe harbor notice?

A-7. No. The plan will not fail to

satisfy § 1.401(k)‑3(g)(1)(ii)(A)(2) or

1.401(m)‑3(h)(1)(ii)(A)(2) merely because the employer included the statement

described in §§ 1.401(k)‑3(g)(1)(ii)(A)

(2) and 1.401(m)-3(h)(1)(ii)(A)(2) in a

notice that otherwise satisfies the requirements for a safe harbor notice (rather than

in an actual safe harbor notice).4 Further,

solely with respect to the first plan year

beginning after December 31, 2020, a

notice will be treated as satisfying the requirement under §§ 1.401(k)-3(d)(3) and

1.401(m)-3(e) that the notice be provided within a reasonable period before the

beginning of the plan year if the notice

is given to each eligible employee by the

later of (1) 30 days before the beginning

of the plan year, or (2) January 31, 2021.

However, except as provided in Q&A-8 of

this notice, the plan must satisfy all other

requirements set forth in § 1.401(k)‑3(g)

(1)(ii) or 1.401(m)‑3(h)(1)(ii), as applicable, in order to reduce or suspend safe

harbor nonelective contributions during

the plan year.

Q-8. If an employer amends a traditional or QACA safe harbor § 401(k) plan

(or a traditional or QACA safe harbor

§ 401(m) plan) to reduce or suspend the

plan’s safe harbor nonelective contributions during a plan year, but later amends

the plan to readopt the safe harbor nonelective contributions in accordance with

§ 401(k)(12)(F) or 401(k)(13)(F) for the

entirety of the plan year, will the plan be

required to satisfy the ADP or ACP test (as

applicable) for the plan year or be subject

to the top‑heavy rules under § 416 for the

plan year?

A-8. No. The retroactive plan amendment provisions of §§ 401(k)(12)(F) and

401(k)(13)(F) of the Code, as amended by

§ 103 of the SECURE Act, are not conditioned on whether a prior plan amendment

reduced or suspended safe harbor nonelective contributions during the plan year.

Accordingly, the plan will not be required

to satisfy either § 1.401(k)‑3(g)(1)(ii)(E)

(ADP testing) or 1.401(m)‑3(h)(1)(ii)(E)

(ACP testing) for the plan year and, pursuant to § 416(g)(4)(H) of the Code, the

plan will not be subject to the top‑heavy

rules under § 416 for the plan year.5

Q-9. If a plan is amended pursuant

to § 401(k)(12)(F)(i)(II) (traditional) or

401(k)(13)(F)(i)(II) (QACA) to adopt

safe harbor nonelective contributions of at

least four percent of compensation for a

plan year, and the safe harbor nonelective

contributions are contributed to the plan

after the tax filing deadline for the prior

taxable year (including extensions) but

before the last day under § 401(k)(8)(A)

for distributing excess contributions for

the plan year, are the safe harbor nonelective contributions deductible for the prior

taxable year?

A-9. No. Section 404(a)(6) provides

that a taxpayer will be deemed to have

made a payment on the last day of the

prio

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