# Bulletin No. 2020–53

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## Record

- **Collection:** Agency decision
- **Document type:** Agency decision

## Text

HIGHLIGHTS
OF THIS ISSUE




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2019-35 is superseded.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

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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-

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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.
(c) Determination of taxable income.
(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.
(c) Applicability date.
§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.
(c) Determination of the source of
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.
(C) Location of 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.
(c) Allocation of costs or expenses.

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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.
(c) Election.
(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.
(C) Production both in space or international water and 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).
(c) Taxable income.
(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.
(c) Source of U.S. communications income.
(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.

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(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.
(c) Effectively connected income 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.
(c) Income partly from sources within a
possession of the United States.
(1) General.
(2) Allocation or apportionment.
(3) Personal property produced and
sold.

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(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).
(c) Applicability date. Except as provided in this paragraph (c), this section
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
(c) of this section describes how to determine source based on production activity, including when inventory is produced
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.
(c) Determination of the source of gross
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

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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.
(C) Location of business activity. For
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

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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):

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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.
*****
(c) * * *
(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.
(c) Section 865(e)(2) sales. For purposes of this section, a “section 865(e)(2)
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.
*****
(c) * * *
(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

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Airs%3A45017dc97f2481c7. Public record. Not legal advice.