Computation of Combined Taxable Income Under the Profit Split Method When the Possession Product Is a Component Product or an End- Product Form

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[INTL-0068-92]

RIN 1545-AR18

Computation of Combined Taxable Income Under the Profit Split

Method When the Possession Product Is a Component Product or an End-

Product Form

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

-----------------------------------------------------------------------

SUMMARY: This document contains proposed Income Tax Regulations

relating to the determination of combined taxable income under the

profit split method. These regulations would amend the current

regulations and provide revised rules in order for taxpayers to compute

the combined taxable income under profit split when the possession

product chosen for purposes of section 936(h)(5) of the Internal

Revenue Code is a component product or an end-product form. These

regulations are necessary to provide guidance to taxpayers electing the

profit split method of computing taxable income under section

936(h)(5).

DATES: Written comments and requests for a public hearing must be

received by March 14, 1994.

ADDRESSES: Send submissions to: Internal Revenue Service, P.O. Box

7604, Ben Franklin Station, Attention: CC:CORP:T:R (INTL-0068-92), room

5228, Washington, DC 20044. In the alternative, submissions may be hand

delivered to: CC:DOM:CORP:T:R (INTL-0068-92), Internal Revenue Service,

room 5228, 1111 Constitution Avenue, NW., Washington, DC 20224.

FOR FURTHER INFORMATION CONTACT: Jacob Feldman or Mary Gillmarten of

the Office of Associate Chief Counsel (International), Internal Revenue

Service, at 202-622-3870 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains proposed amendments to the Income Tax

Regulations (26 CFR part 1) under section 936 of the Internal Revenue

Code of 1986. These amendments to the regulations are proposed to

provide simplified rules for computing combined taxable income under

the profit split method for a taxpayer that has chosen a component

product or an end-product form as its possession product.

Explanation of Provisions

The proposed regulations would amend Sec. 1.936-6(b)(1), Q & A. 12,

with conforming changes made to Q & A. 10, A. 11, and A. 13. Under the

proposed revision, where the possession product is a component product

or an end-product form, the combined taxable income attributable to the

possession product will be determined by multiplying the combined

taxable income of the possession corporation and affiliated groups

derived from covered sales of integrated products (which includes the

possession product) by a production cost ratio. In the case of a

component product, the combined taxable income of the integrated

product would be multiplied by a ratio, the numerator of which equals

the production costs of the component product and the denominator of

which equals the production costs of the integrated product. The

combined taxable income of an end-product form is determined in a

similar manner using the production costs of the end-product form.

The proposed change is intended to simplify the computation of

combined taxable income under Q & A. 12 and to eliminate the need to

apply section 482 in cases in which a possession product is a component

product or an end-product form. No inference is intended as to the

interpretation or scope of current regulations by the revisions

proposed herein.

The example under Sec. 1.936-6(b)(1), Q & A. 12 is modified to

reflect the revised rule.

Proposed Effective Date

The changes made in this document are proposed to be effective for

taxable years beginning after December 31, 1993.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in Executive Order

12866. It also has been determined that section 553(b) of the

Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory

Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations

and, therefore, a Regulatory Flexibility Analysis is not required.

Pursuant to section 7805(f) of the Internal Revenue Code, a copy of

this notice of proposed rulemaking will be submitted to the Chief

Counsel for Advocacy of the Small Business Administration for comment

on its impact on small business.

Comments and Request for Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments that are submitted

timely (preferably a signed original and eight copies) to the IRS. All

comments will be available for public inspection and copying. A public

hearing may be scheduled if requested in writing by a person that

timely submits written comments. If a public hearing is scheduled,

notice of the date, time, and place for the hearing will be published

in the Federal Register.

Drafting Information

The principal author of these proposed regulations is Mary

Gillmarten of the Office of Associate Chief Counsel (International),

Internal Revenue Service. Other personnel from the Internal Revenue

Service and Treasury Department participated in developing the

regulations.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in

part as follows:

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

Par. 2. The heading of Sec. 1.936-6 is amended by removing the

colon after the word ``make'' and by adding in its place a semicolon.

Par. 3. Section 1.936-6, paragraph (b)(1) is amended by:

1. Revising Q & A. 10.

2. Designating the first sentence of A. 11 as paragraph (i) and

revising it.

3. Designating the flush text and example following newly

designated A. 11 (i) as paragraph (ii).

4. Revising Q & A. 12.

5. Revising A. 13.

6. The revisions read as follows:

Sec. 1.936-6 Intangible property income when an election out is made;

cost sharing and profit split options; covered intangibles.

* * * * *

(b) * * * (1) * * *

Q. 10: If the possessions corporation is entitled to use the profit

split method in the situation described in Q. 9 (leasing units of the

possession product or use of such units in the taxpayer's own trade or

business), how should it compute combined taxable income with respect

to such units?

A. 10: In the case of an integrated product, combined taxable

income shall be computed as if the U.S. affiliate had sold the units to

an unrelated person (or to a foreign affiliate) at the time the units

were first leased or otherwise placed in service by the U.S. affiliate.

The sales price shall be equal to the sales price from comparable

uncontrolled transactions determined in accordance with Sec. 1.482-

2(e)(2). If a sales price from comparable uncontrolled transactions

cannot be determined in accordance with Sec. 1.482-2(e)(2), then the

taxpayer shall not be treated as having possession sales with respect

to such leasing transaction. If the possession product is a component

product or an end-product form, and there is a comparable uncontrolled

price for the integrated product which includes the possession product,

the combined taxable income with respect to the possession product

shall be determined under Q & A. 12 of this paragraph (b)(1). For

purposes of determining the basis of a component product or an end-

product form, the deemed sales price of such product must be

determined. The deemed sales price of the component product shall be

determined by multiplying the deemed sales price of the integrated

product by a ratio, the numerator of which is the production costs of

the component product and the denominator of which is the production

costs of the integrated product. The deemed sales price of an end-

product form shall be determined by multiplying the deemed sales price

of the integrated product by a ratio, the numerator of which is the

production costs of the end-product form and the denominator of which

is the production costs of the integrated product. The definition of

production costs with respect to the component product or end-product

form shall be determined under the rules of Q & A. 12 of this paragraph

(b)(1). The full amount of income received under the lease shall be

treated as income of (and taxed to) the U.S. affiliate and not the

possessions corporation.

* * * * *

A. 11: (i) The U.S. affiliate shall be treated, for purposes of

computing its basis in such units, as if it had repurchased such units

immediately following the deemed sale and at the deemed sales price as

provided in Q & A. 10 of this paragraph (b)(1).

(ii) * * *

Q. 12: If the possession product is a component product or an end-

product form, how is the combined taxable income for such product to be

determined?

A. 12: (i) Combined taxable income for a component product or an

end-product form is computed under the production cost ratio (PCR)

method.

(ii) Under the PCR method, the combined taxable income for a

component product will be the same proportion of the combined taxable

income for the integrated product which the production costs

attributable to the component product bear to the total production

costs for the integrated product. Production costs will be the sum of

the direct and indirect production costs as defined for inventory

accounting purposes under Sec. 1.471-11 (b), (c) or (d), except that

the costs will not include the costs of materials.

(iii) Under the PCR method the combined taxable income for an end-

product form will be the same proportion of the combined taxable income

for the integrated product which the production costs attributable to

the end-product form bear to the total production costs for the

integrated product. Production costs will be the sum of the direct and

indirect production costs as defined for inventory accounting purposes

under Sec. 1.471-11 (b), (c) or (d), except that the costs will not

include the costs of materials.

(iv) Example. The following example illustrates a possessions

corporation, S, engaged in the manufacture of microprocessors. S

obtains a component from a U.S. affiliate, O. S sells its production

to another U.S. affiliate, P, which incorporates the microprocessors

into central processing units (CPUs). P transfers the CPUs to a U.S.

affiliate, Q, which incorporates the CPUs into computers for sale to

unrelated persons. S chooses to define the possession product as the

CPUs. The combined taxable income for the sale of the possession

product on the basis of the given production, sales, and cost data

is computed below:

Production costs (excluding costs of materials):

1. O's costs for the component.............................. 100

2. S's costs for the microprocessors........................ 500

3. P's costs for the CPU's (the possession product)......... 200

4. Q's costs for the computers.............................. 400

5. Total production costs for the computer (Add lines 1

through 4)................................................. 1,200

6. Combined production costs for the CPU (the possession

product) (Add lines 1 through 3)........................... 800

7. Ratio of production costs for the CPUs (the possession

product) to the production costs for the computer (the

integrated product)........................................ 0.667

Determination of combined taxable income for computers--Sales:

8. Total possession sales of computers to unrelated

customers and foreign affiliates........................... 7,500

Total costs of O, S, P, and Q incurred in production of a

computer:

9. Production costs (enter from line 5)..................... 1,200

10. Material costs.......................................... 100

11. Total costs (line 9 plus line 10)....................... 1,300

12. Combined gross income from sale of computers (line 8

minus line 11)............................................. 6,200

Expenses of the affiliated group (other than foreign

affiliates) allocable and apportionable to the computers or

any component thereof under the rules of Secs. 1.861-8

through 1.861-14T and 1.936-6(b)(1), Question and Answer 1:

13. Expenses (other than research expenses)................. 980

Research expenses of the affiliated group allocable and

apportionable to the computers:

14. Total sales in the 3-digit SIC Code..................... 12,500

15. Possession sales (enter from line 8).................... 7,500

16. Cost sharing fraction (divide line 15 by line 14)....... 0.6

17. Research expenses incurred by the affiliated group in 3-

digit SIC Code multiplied by 120 percent................... 700

18. Cost sharing amount (multiply line 16 by line 17)....... 420

19. Research of the affiliated group (other than foreign

affiliates) allocable and apportionable under Secs. 1.861-

8(e)(3) and 1.861-14T(e)(2) to the computers (the

integrated product)........................................ 300

20. Enter the greater of line 18 or line 19................. 420

Computation of combined taxable income of the computer and the

CPU:

21. Combined taxable income attributable to the computer

(line 12 minus line 13 and line 20)........................ 4,800

22. Combined taxable income attributable to CPUs (multiply

line 21 by line 7) (production cost ratio)................. 3,200

23. Share of combined taxable income apportioned to S (50

percent of line 22)........................................ 1,600

Share of combined taxable income apportioned to U.S.

affiliate(s) of S:

24. Adjustments for research expenses (line 18 minus line 19

multiplied by line 7)...................................... 80

25. Adjusted combined taxable income (line 22 plus line 24). 3,280

26. Share of combined taxable income apportioned to

affiliates of S (line 25 minus line 23).................... 1,680

* * * * *

A. 13: (i) The income shall be allocated to U.S. affiliates as

follows--

(A) First, to U.S. affiliates (other than tax-exempt affiliates)

within the group (as determined under section 482) which derive income

with respect to the product produced in whole or in part in the

possession;

(B) Second, to U.S. affiliates (other than tax-exempt affiliates)

which derive income from the active conduct of a trade or business in

the same product area as the possession product;

(C) Third, to other U.S. affiliates (other than tax-exempt

affiliates);

(D) Fourth, to foreign affiliates which derive income from the

active conduct of a U.S. trade or business in the same product area as

the possession product (or, if the foreign members are resident in a

country with which the U.S. has an income tax convention, then to those

foreign members that have a permanent establishment in the United

States which derives income in the same product area as the possession

product); and

(E) Fifth, to all other affiliates.

(ii) The allocations made under paragraph (i)(A) of this A. 13

shall be made on the basis of the relative gross income derived by each

such affiliate with respect to the product produced in whole or in part

in the possession. Where the product is a component product, the

relative gross income with respect to the component product shall be

determined by multiplying the relative gross income of the integrated

product by a ratio, the numerator of which is the production costs of

the component product and the denominator of which is the production

costs of the integrated product. Where the product is an end-product

form, the relative gross income of an end-product form shall be

determined by multiplying the gross income of the integrated product by

a ratio, the numerator of which is the production costs of the end-

product form and the denominator of which is the production costs of

the integrated product.

(iii) The allocations made under paragraphs (i)(B) and (i)(D) of

this A. 13 shall be made on the basis of the relative gross income

derived by each such affiliate from the active conduct of the trade or

business in the same product area.

(iv) The allocations made under paragraphs (i)(C) and (i)(E) of

this A. 13 shall be made on the basis of the relative total gross

income of each such affiliate before allocating income under this

section.

(v) Income allocated to affiliates shall be treated as U.S. source

and section 863(b) does not apply for this purpose. For purposes of

determining an affiliate's estimated tax liability with respect to

income thus allocated, the income shall be deemed to be received on the

last day of the taxable year of each such affiliate in which or with

which the taxable year of the possessions corporation ends.

* * * * *

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 94-668 Filed 1-11-94; 8:45 am]

BILLING CODE 4830-01-U