Source of Income From Sales of Inventory and Natural Resources Produced in One Jurisdiction and Sold in Another Jurisdiction

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[INTL-0003-95]

RIN 1545-AT92

Source of Income From Sales of Inventory and Natural Resources

Produced in One Jurisdiction and Sold in Another Jurisdiction

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations governing the

source of income from sales of natural resources or other inventory

produced in the United States and sold in a foreign country or produced

in a foreign country and sold in the United States. This document

affects persons who produce natural resources or other inventory in the

United States and sell in a foreign country, or produce natural

resources or other inventory in a foreign country and sell in the

United States. This document also provides notice of a public hearing

on these proposed regulations.

DATES: Written comments and outlines of oral comments to be presented

at the public hearing scheduled for April 10, 1996, at 10 a.m. must be

received by March 11, 1996.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (INTL-0003-95),

[[Page 63479]]

room 5228, Internal Revenue Service, POB 7604, Ben Franklin Station,

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

delivered between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R

(INTL-0003-95), Courier's Desk, Internal Revenue Service, 1111

Constitution Avenue NW., Washington, DC. The public hearing will be

held in the IRS Auditorium, Internal Revenue Building, 1111

Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Anne

Shelburne, (202) 622-3880; concerning submissions and the hearing, Ms.

Christina Vasquez, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed

rulemaking has been submitted to the Office of Management and Budget

(OMB) for review in accordance with the Paperwork Reduction Act of 1995

(44 U.S.C. 3507).

Comments on the collection of information should be sent to the

Office of Management and Budget, Attn: Desk Officer for the Department

of Treasury, Office of Information and Regulatory Affairs, Washington,

DC 20503, with copies to the Internal Revenue Service, Attn: IRS

Reports Clearance Officer, T:FP, Washington, DC 20224. Comments on the

collection of information should be received by February 9, 1996.

An agency may not conduct or sponsor, and a person is not required

to respond to, a collection of information unless the collection of

information displays a valid control number.

The collection of information requirements are in proposed

Secs. 1.863-1(b)(6) and 1.863-3(e)(2). This information is required by

the IRS to monitor compliance with the federal tax rules for

determining the source of income from the sale of natural resources or

other inventory produced in the United States and sold in a foreign

country or produced in a foreign country and sold in the United States.

The likely respondents are taxpayers who produce natural resources or

other inventory in the United States and sell in a foreign country, or

who produce natural resources or other inventory in a foreign country

and sell in the United States. Responses to this collection of

information are required to properly determine the source of a

taxpayer's income from such sales.

Books or records relating to a collection of information must be

retained as long as their contents may become material in the

administration of any internal revenue law. Generally, tax returns and

tax return information are confidential, as required by 26 U.S.C. 6103.

Estimated total annual reporting burden: 1125 hours. The estimated

annual burden per respondent varies from 1 hour to 5 hours, depending

on individual circumstances, with an estimated average of 2.6 hours.

Estimated number of respondents: 425.

Estimated annual frequency of responses: One time per year.

Background

These proposed regulations contain rules relating to the source of

income from the sale of certain natural resources and other inventory.

These regulations are proposed to be effective for taxable years

beginning 30 days after publication of final regulations. However,

taxpayers may elect to apply these regulations for taxable years

beginning after July 11, 1995.

Explanation of Provisions

I. Natural Resources

A. Current Regulations

Section 863 authorizes the Secretary to promulgate regulations

allocating or apportioning to sources within or without the United

States all items of gross income, expenses, losses, and deductions

other than those items specified in sections 861(a) and 862(a).

Section 1.863-1 of the existing regulations contains rules for

determining the source of income derived from the sale of certain

natural resources. Generally, under paragraph (b)(1) of those

regulations, income derived from the ownership or operation of any

farm, mine, oil or gas well, other natural deposit, or timber located

within the United States and from the sale by the producer of the

products within or without the United States ordinarily must be

included in gross income from sources within the United States.

However, if a taxpayer can show to the satisfaction of the District

Director that, due to peculiar conditions of production and sale or for

other reasons, not all of the gross income derived therefrom should be

allocated to sources within the United States, the source of the income

generally is determined under the 50/50 method described in Sec. 1.863-

3(b)(2) Example 2. The regulations do not define ``peculiar conditions

of production and sale.'' In addition, Sec. 1.863-1(b)(2) permits the

Commissioner to make an allocation or apportionment that more clearly

reflects the proper source of a taxpayer's income, if the Commissioner

determines that the application of paragraph (b)(1) does not result in

the proper allocation or apportionment of income. Similar rules apply

in the case of natural resources produced without the United States and

sold within the United States. See Sec. 1.863-6. Thus, income from the

sale of such products ordinarily will be allocated entirely to foreign

sources.

B. Issues Under Current Regulations

The IRS and Treasury have reexamined the existing regulations under

section 863 regarding natural resources and arrived at several

conclusions. First, certain ambiguities in existing Sec. 1.863-1 should

be clarified. For example, the regulation does not define the term

``peculiar conditions of production and sale,'' and there is virtually

no authoritative guidance as to the scope of that term. To the extent

that ``peculiar conditions of production and sale'' is defined

narrowly, the regulation may lead to inappropriate results when

determining the source of income from the sale of processed natural

resources. For example, if a U.S. corporation harvests timber to

manufacture furniture for export, all of its income may be from sources

within the United States. However, if another U.S. corporation

purchases cut timber to manufacture furniture for export from the

United States, one-half of that taxpayer's income may be from sources

without the United States under the 50/50 method.

Second, the interaction of the existing regulations and the

recently-issued consolidated return regulations may cause inappropriate

sourcing results. On July 11, 1995, the IRS and Treasury issued final

regulations under Sec. 1.1502-13 [TD 8597 (60 FR 36671)], treating

members of a U.S. consolidated group as a single entity for purposes of

determining the source of a taxpayer's income. The IRS and Treasury

understand that inappropriate results may occur when the current

section 863 regulations are applied to certain consolidated groups on a

single entity basis. For example, a U.S. corporation that is a member

of a consolidated group may extract oil abroad. The oil is then

transported to the United States where it is refined by another member

of the consolidated group. It is sold in the United States through

other members of the consolidated group. Under Sec. 1.1502-13 of the

consolidated return rules, the consolidated group is treated as a

single entity, and the source of income from the sale of oil must be

determined under

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section 863. Because the consolidated group refines the oil outside the

country of extraction, it may be that peculiar conditions of production

and sale exist, and the exclusive sourcing rules of paragraph (b)(1) do

not apply. Thus, the taxpayer would generally determine the source of

its income under the 50/50 method described in Sec. 1.863-3(b)(2)

Example 2. Under this method, 50 percent of the consolidated group's

income would be U.S. source income based on the place of sale. However,

this calculation may understate the appropriate amount of the

taxpayer's foreign source income because the value of the oil as

extracted may represent more than 50 percent of the total value of the

product that is finally sold in the United States. The preamble to the

regulations under Sec. 1.1502-13 indicated that the IRS and Treasury

would consider amending the regulations under section 863 to address

these concerns.

Accordingly, the IRS and Treasury are issuing proposed regulations

under section 863 to clarify ambiguities in the existing regulation and

to address concerns created by the new Sec. 1.1502-13 regulations.

C. Proposed Regulations

Section 1.863-1(b) provides special rules for determining the

source of income from the sale of products derived from the ownership

or operation of any farm, mine, oil or gas well, other natural deposit,

or timber, within the United States and the sale of these products

without the United States. The proposed regulations also provide

special rules for determining the source of income from the sale of

products derived from the ownership or operation of any farm, mine, oil

or gas well, other natural deposit, or timber, without the United

States and the sale of these products within the United States. The

export terminal rule of paragraph (b)(1) provides that the source of

gross receipts from the sale of such products equal to the fair market

value of the product immediately prior to export (referred to in the

proposed regulations as the export terminal) is determined according to

where the farm, mine, oil or gas well, other natural deposit or timber

is located. Separate rules are provided for determining the source of

any gross receipts in excess of the fair market value of the product at

the export terminal. Paragraph (b)(2) provides an exception to the

approach of paragraph (b)(1) where, prior to export, the taxpayer

engages in substantial production activities in addition to activities

related to the ownership or operation of a farm, mine, oil or gas well,

other natural deposit, or timber.

1. Export Terminal Rule

Under the export terminal rule of paragraph (b)(1), gross receipts

derived from the ownership or operation of any farm, mine, oil or gas

well, other natural deposit, or timber, and sale of the products

derived therefrom, are allocated between sources within and without the

United States based on the fair market value of the product at the

export terminal. The export terminal is the last point from which the

product is sent from the United States to a foreign country or the last

point from which goods are sent from a foreign country to the United

States. For example, if a U.S. corporation extracts oil in one foreign

country, sends the crude oil to a port in a second foreign country via

pipeline, and delivers the oil to a U.S. refinery by ship, the export

terminal would be the port in the second foreign country where the

crude oil was loaded onto the ship.

Under the export terminal rule, the source of gross receipts equal

to the fair market value of the product at the export terminal is

determined by the location of the farm, mine, well, deposit, or uncut

timber. The source of gross receipts in excess of the fair market value

of the product at the export terminal (excess gross receipts) is

determined according to whether the taxpayer engages in any additional

production activity following export. A taxpayer will be treated as

performing production activities in addition to the activities of

owning or operating a farm, mine, oil or gas well, other natural

deposit, or timber based on the principles of Sec. 1.954-3(a)(4).

However, activities that prepare the natural resource itself for

export, including those that are designed to facilitate the

transportation of the natural resource to or from the export terminal,

will not be considered additional production activities. Thus,

Sec. 1.863-1 Example 2 illustrates that liquefaction of natural gas

would not constitute additional production activities. In addition,

activities such as delimbing and debarking trees, sorting grain, and

treating and stabilizing oil would ordinarily not constitute additional

production activities. In contrast, the transformation of timber into

furniture is not done to prepare the natural resource itself for

export, and would constitute additional production activity. Production

activities are defined in Sec. 1.863-1(b)(3)(i).

If no additional production occurs following export, paragraph

(b)(1)(i) requires that the source of the excess gross receipts be

determined according to where the farm, mine, well, deposit, or uncut

timber is located.

However, under paragraph (b)(1)(ii), if the taxpayer engages in

additional production activities after the export terminal and outside

the country of sale, the source of excess gross receipts is determined

under the rules of Sec. 1.863-3. For example, if a U.S. corporation

extracts oil in a foreign country, refines the oil in the United

States, and sells the refined product in another foreign country, the

source of gross receipts in excess of the fair market value of the

product when it is exported from the first foreign country must be

determined under one of the three methods described in Sec. 1.863-3

(i.e., the 50/50 method as described in Sec. 1.863-3(b)(1), the IFP

method described in Sec. 1.863-3(b)(2), or, if permitted by the

District Director, the books and records method as described in

Sec. 1.863-3(b)(3)).

In any case not described in either paragraph (b)(1) (i) or (ii) of

the proposed regulations, the source of the excess gross receipts is

determined according to the place of sale pursuant to paragraph

(b)(1)(iii). This rule would apply, for example, in the case where the

taxpayer engages in additional production activities in the country of

sale.

Paragraph (b)(1) addresses the concerns of U.S. corporations

involved in the production of natural resources abroad and the

application of the new Sec. 1.1502-13 consolidated return regulations,

by allowing them to treat the value of the natural resources at the

point of export as income from sources where the farm, mine, well,

deposit, or uncut timber is located. This rule has no effect on the

rules governing foreign oil and gas extraction income under section

907(c)(1).

On November 28, 1995, the Tenth Circuit affirmed the Tax Court

decision in Phillips Petroleum v. Comm'r, 97 T.C. 30 (1991), which held

existing Sec. 1.863-1(b)(1) invalid to the extent it allocates income

from the sale of U.S. natural resources solely to sources within the

United States. Phillips Petroleum v. Comm'r, No. 94-9021 (10th Cir.

Nov. 28, 1995). The IRS and Treasury will consider the implications of

this decision when finalizing these proposed regulations.

2. Additional Production Prior to Export Terminal

Paragraph (b)(2) provides a special rule for determining the source

of income where a taxpayer performs substantial additional production

activities before the product leaves the export terminal. Under

paragraph (b)(2),

[[Page 63481]]

the source of gross receipts equal to the fair market value of the

product prior to the additional production activities is based on the

location of the farm, mine, well, deposit, or uncut timber. The source

of gross receipts in excess of the fair market value of the products at

the beginning of the additional production activities is determined

under the rules of Sec. 1.863-3.

3. Other Rules

The proposed regulation contains rules for determining the fair

market value of relevant products. For this purpose, fair market value

depends on all of the facts and circumstances as they exist relative to

a party in any particular case. Thus, these rules for determining fair

market value are consistent with the foreign oil and gas rules

contained in Sec. 1.907(c)-1(b)(6). In addition, fair market value

determinations must be consistent with prices charged in sales, if any,

to related parties in a transaction that is subject to section 482. For

example, if a member of a U.S. consolidated group extracts natural

resources in a foreign country and sells the natural resources to

another member of the same group at the export terminal, the value of

the natural resources determined at the export terminal should be the

price charged by the producing member to the purchasing member for

purposes of section 482.

Under paragraph (b)(5), a taxpayer's gross income from sources

within or without the United States is determined by reducing its gross

receipts from sources within or without the United States by the cost

of goods sold properly attributable to such gross receipts. Under

paragraph (c), a taxpayer's taxable income from U.S. or foreign sources

must be determined under the rules of Secs. 1.861-8 through 1.861-14T.

Under paragraph (b)(6), taxpayers must fully explain the

methodology used, the facts describing substantial additional

production activities (if any), and the determination of fair market

value in a statement attached to the taxpayer's return. In addition,

taxpayers must provide such other information as is required by

Sec. 1.863-3(e)(2).

Taxpayers may elect to apply the rules of these regulations for

taxable years beginning after July 11, 1995. Otherwise, these

regulations are effective for taxable years beginning 30 days after the

publication of this regulation as a final regulation.

II. Inventory Other Than Natural Resources

A. Current Regulations

Section 863 authorizes the Secretary to promulgate regulations

allocating or apportioning to sources within or without the United

States all items of gross income, expenses, losses, and deductions

other than those specified in sections 861(a) and 862(a).

Section 1.863-3 of the current regulations governs the source of

income from the sale of inventory produced (in whole or in part) in the

United States and sold in a foreign country, or produced (in whole or

in part) in a foreign country and sold in the United States (Section

863 Sales). Section 1.863-3 provides three methods, set forth in the

form of three examples, to determine the source of income from Section

863 Sales.

Sec. 1.861-3(b)(2) Example 1 of the current regulations illustrates

how an independent factory or production price (IFP) applies to

determine the income attributable to production (IFP method). An IFP

generally is established if a taxpayer regularly sells part of its

output to wholly independent distributors in such a way as to

reasonably reflect the income attributable to production activity. If

an IFP exists, taxpayers must use the IFP method to determine the

income attributable to production activities in both the sale

establishing the IFP and in sales of similar products. See Phillips

Petroleum v. Comm'r, 97 T.C. 30 (1991), aff'd, No. 94-9021 (10th Cir.

Nov. 28, 1995); Rev. Rul. 88-73 (1988-2 C.B. 173). Gross receipts in

excess of the IFP are attributable to sales activity. Taxpayers can

otherwise establish an IFP by showing to the satisfaction of the

District Director that an IFP exists. Notice 89-10 (1989-1 C.B. 631)

contains additional rules regarding the application of the IFP method.

Section 1.863-3(b)(2) Example 1 of the current regulations does not

provide explicit guidance as to how to determine the source of income

attributable to production activities under the IFP method. However,

the source of income attributable to sales activities is based

generally on where title to the inventory passes to the purchaser as

defined in Sec. 1.861-7(c).

Section 1.863-3(b)(2) Example 2 of the current regulations divides

a taxpayer's income from Section 863 Sales equally between production

activity and sales activity (50/50 method). The source of income

attributable to production activity is based on the location of the

taxpayer's property. The portion of this production income attributable

to sources within the United States is determined by a fraction, the

numerator of which is the taxpayer's property located within the United

States used to produce income from Section 863 Sales, and the

denominator of which is the taxpayer's property both within the United

States and within a foreign country used to produce income from Section

863 Sales. The source of the taxpayer's income attributable to sales

activity is based on where title to the inventory passes to the

purchaser as defined in Sec. 1.861-7(c).

Section 1.863-3(b)(2) Example 3 of the current regulations allows a

taxpayer to request permission from the District Director to use the

taxpayer's books and records to allocate income to sources within and

without the United States if those books reflect more clearly than the

other methods the taxable income derived from sources within the United

States (books and records method).

B. Issues Under Current Regulations

On July 12, 1995, the IRS and Treasury issued regulations under

Sec. 1.1502-13, treating members of a consolidated group as a single

entity for purposes of determining the source of a taxpayer's income.

The IRS and Treasury understand that the current section 863

regulations may raise questions when applied to certain consolidated

groups on a single entity basis. The preamble to the regulations under

Sec. 1.1502-13 indicated that the IRS and Treasury would reevaluate

part of the regulations under section 863. As part of this process, the

IRS and Treasury also have reexamined the remainder of the existing

section 863 regulations and have concluded that several additional

changes are necessary.

First, the existing regulations were drafted more than 70 years

ago, and have not been amended to reflect the evolution of business

practices. As a result, the regulations have been the source of

controversies in recent years. See Intel Corporation v. Comm'r, 100

T.C. 39 (1993), aff'd, No. 94-70105 (9th Cir. Oct. 16, 1995); Phillips

Petroleum v. Comm'r, 97 T.C. 30 (1991), 101 T.C. 78, 104 (1993)

(``there have been no cases interpreting [the 50/50 method] and no

administrative pronouncements regarding its application since the

regulation was promulgated in 1922 except for necessary inferences to

be drawn from Intel * * *''), aff'd, No. 94-9021 (10th Cir. Nov. 28,

1995). In part, these controversies may be due to the structure of the

current regulations, which do not contain operative rules to describe

the methods of allocating and

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apportioning income, but instead rely on examples.

Second, the existing regulations raise important administrative

concerns. For example, the IFP method requires an analysis of each of

the taxpayer's sales transactions to identify an IFP. If one or more

IFPs are so identified, a second analysis is required of each of the

taxpayer's sales transactions to identify which transactions are

similar to the IFP sale. In some cases, this process may require a

review of a multitude of transactions. The IFP method may, therefore,

be difficult for both taxpayers and the government to apply. The

existing 50/50 method also presents administrative concerns. For

example, the 50/50 method may require the taxpayer to determine the

fair market value of each of its assets at the end of every tax year.

Taxpayers have often commented to the IRS about the difficulties of

determining the fair market value of their assets.

Third, the existing regulations result in disparate treatment of

similarly situated taxpayers. Although an IFP must be used under

current rules if one exists, the mandate applies only to taxpayers

selling inventory to certain independent distributors. Taxpayers

selling exclusively to related parties are not required to use the IFP

method since the IRS may not establish an IFP based on such sales.

Instead, these taxpayers use the 50/50 method to source their income

from export sales. Thus, taxpayers selling inventory exclusively to

related parties may be deemed to generate far more foreign source

income than taxpayers selling a portion of their inventory to

independent distributors, even though the two taxpayers may perform the

same functions. The IRS and Treasury believe that this differing

treatment of similarly situated taxpayers is not justified.

Fourth, the existing 50/50 method can result in apportionment of

income that is inconsistent with the common understanding of that

method. The 50/50 method is generally characterized as a method that

would source export sales income one-half in the United States and one-

half in a foreign country. For example, in 1984 the Treasury Department

stated: ``Generally, [income derived from manufacture and sale of

property] is allocated one-half on the basis of the place of

manufacture and half on the basis of the place of sale * * *'' Treasury

Department, Tax Reform for Fairness, Simplicity, and Economic Growth,

Nov. 1984 at 364. In addition, Congress understands the 50/50 method to

operate in this fashion. In 1986, the House, Senate and Conference

Committees each stated: ``[Under the existing 50/50 method], half of

such income generally is sourced in the country of manufacture, and

half of the income is sourced on the basis of the place of sale''.

House Rep. No. 426, 99th Cong. 1st Sess. 359 (1985); S. Rep. No. 313,

99th Cong. 2d Sess. 329 (1986); H.R. Conf. Rep. No. 841, 99th Cong. 2d

Sess. II-595 (1986). The staff of the Joint Committee on Taxation has

referred to the 50/50 method as the ``production/marketing split'' and

stated that under this method ``50 percent of such income generally is

attributed to the place of production * * *'' Staff of the Joint Comm.

on Taxation, Factors Affecting International Competitiveness of the

United States 148 (1991).

The existing regulations may, however, allow taxpayers to use the

50/50 method to obtain results that are inconsistent with this common

understanding. Under the existing regulations, 50 percent of the income

is treated as sales income and sourced on the basis of title passage.

The remaining 50 percent is treated as production income and sourced

based on the location of assets. This half of the formula is not

necessarily, however, limited to production assets. For example,

goodwill and accounts receivables are counted as assets in allocating

production income. The inclusion of sales assets in the formula

allocating production income results in additional income being

allocated to sales activities. The contribution of the sales assets to

sales income should be reflected only in the 50 percent of the income

that is allocated to sales and sourced under title passage. Thus, the

production income formula should only take into account assets directly

involved in the production of inventory.

B. Proposed Regulations

1. Overview

Section 1.863-3 provides rules for allocating and apportioning

income from Section 863 Sales. Generally, Sec. 1.863-3(b) provides

three methods for determining the amount of gross income attributable

to production activity and the amount of gross income attributable to

sales activity. The source of gross income attributable to each

activity is then determined under the rules of paragraph (c). Paragraph

(d) provides rules to determine the source of taxable income. Reporting

and election rules are set forth under paragraph (e) of the proposed

regulations. The proposed regulations reserve on paragraph (f) (prior

paragraph (c)), dealing with income partly from sources within a

possession of the United States. The IRS and Treasury solicit comments

from taxpayers regarding changes that should be made to new paragraph

(f) (if any) to conform to the other changes in Sec. 1.863-3.

The proposed regulations generally apply an aggregate approach in

taking into account a taxpayer's interest in a partnership. The IRS and

Treasury solicit comments on the appropriate treatment of partnerships,

including whether there should be special rules for limited

partnerships, de minimis interests in partnerships, and tiered

partnerships.

2. Methods To Determine Gross Income Attributable to Production

Activity and Sales Activity

Section 1.863-3 generally retains the three methods of the current

regulations for splitting income between production and sales activity,

with several modifications.

a. 50/50 Method

The proposed regulations do not change the allocation of half of

the taxpayer's income from Section 863 Sales to production activity and

half to sales activity. As described below, the proposed regulations

modify and clarify the determination of the location of assets. In

addition, paragraph (b)(1) of the proposed regulations makes the 50/50

method the general rule to determine the amount of income attributable

to production and sales activities. The taxpayer, however, may elect to

apply the IFP method, described in paragraph (b)(2), or, with the

consent of the District Director, the books and records method,

described in paragraph (b)(3).

b. IFP Method

By making the IFP method elective, the proposed regulations

significantly reduce administrative burdens related to its application

and eliminate any bias against taxpayers choosing to export through

independent distributors.

Under the proposed regulations, the taxpayer may elect to apply the

IFP method if it is able to establish an IFP. As in the current

regulations, an IFP is fairly established by actual sales of the

taxpayer if the taxpayer regularly sells part of its output to wholly

independent distributors or other selling concerns in such a way as to

reasonably reflect the income attributable to production activity. Once

the IFP is established, it can be used to determine the amount of

income attributable to production activity in other Section 863 Sales

if the inventory sold in the other sales is substantially similar in

physical characteristics and function, and is sold at a similar level

of distribution as the

[[Page 63483]]

inventory sold in a sale establishing an IFP. A sale will not be

considered to establish an IFP if sales activity for the relevant

product is significant in relation to all of the activities for that

product. The IRS and Treasury intend to supersede Notice 89-10 upon

publication of final regulations.

The proposed regulations would also eliminate the existing rule

permitting taxpayers to otherwise establish an IFP by showing to the

satisfaction of the District Director that a sale reasonably reflecting

the income attributable to production exists. This ``otherwise

established'' IFP is rarely, if ever, used. American Law Institute,

International Aspects of United States Income Taxation 31 (1987). The

IRS and Treasury solicit comments from taxpayers on the continued

utility of the otherwise established IFP.

The proposed regulations omit the reference in the existing

regulation to a sales branch. A taxpayer may elect to use the IFP

method even if it does not maintain a sales branch in a foreign

country.

c. Books and Records Method

The proposed regulations retain the books and records method of the

existing regulations, permitting taxpayers to request permission from

the District Director to use their books and records to determine the

income attributable to production and sales activities. The District

Director will consider a taxpayer's request if the taxpayer maintains a

detailed allocation of receipts and expenditures, clearly reflecting

the amount of income from production and sales activities.

The books and records method is rarely, if ever, used. American Law

Institute, International Aspects of United States Income Taxation, 31

(1987). The IRS and Treasury solicit comments from taxpayers on the

continued utility of the books and records method, or whether the books

and records method should be replaced by another method of economic

sourcing.

3. Determination of Source of Gross Income

Unlike the current regulations which provide specific rules for

determining the source of income attributable to production activity

and sales activity only for purposes of the 50/50 method, the proposed

regulations adopt rules applicable to each of the three methods. Under

the proposed regulations, once gross income attributable to production

activity and sales activity has been determined under one of the

methods described in paragraph (b), the source of the income is

determined separately for each type of income under paragraph (c). The

source of gross income attributable to production activity is

determined under paragraph (c)(1), based on the location of production

assets, and the source of gross income attributable to sales activity

is determined under paragraph (c)(2) based on the location of the sale.

a. Source of Gross Income Attributable to Production Activity

The proposed regulations generally adopt the approach set forth in

the current regulations under the 50/50 method, but with modifications

and clarifications.

Under Sec. 1.863-3(c)(1), the source of income attributable to

production activity is determined based on the location of the

taxpayer's production assets. Thus, if a taxpayer manufactures

inventory exclusively in the United States, all of its income

attributable to production activity will be considered from sources

within the United States. The rules described below are intended to

apply only to taxpayers that produce inventory both within and without

the United States.

Under the proposed regulations, the source of a taxpayer's income

from production activities is determined by reference to the taxpayer's

production assets, instead of all of its assets that produce income

from Section 863 Sales. The IRS and Treasury believe that this change

is appropriate to ensure that the source of production income

corresponds to the location of production activity. Production assets

are defined to include tangible and intangible property owned by the

taxpayer that are used to produce inventory sold in Section 863 Sales.

Any property not directly used to produce inventory is excluded. Thus,

accounts receivable and marketing intangibles are excluded because they

are sales assets and not production assets. Other assets excluded

because they do not directly produce inventory are transportation

assets, warehouses, inventory, work-in-process, raw materials, cash,

investment assets, and stock of a subsidiary. Working capital is

excluded to avoid uncertainty arising from determinations of the

appropriate amount of working capital. In addition, working capital

would generally be apportioned pro rata in accordance with a taxpayer's

production assets. As under the current regulations, leased assets are

excluded; only assets owned by the taxpayer are included.

The proposed regulations also provide specific rules for

determining where a production asset is located. Tangible assets are

located where the assets are used by the taxpayer. Intangible Assets

are located where the tangible production assets to which they relate

are located.

Where production takes place both within the United States and

within a foreign country, the regulations apply a property fraction to

apportion production income between U.S. and foreign sources. The

taxpayer's foreign source gross production income is determined by

multiplying its gross production income by a fraction, the numerator of

which is the taxpayer's production assets located within a foreign

country, and the denominator of which is the taxpayer's production

assets located both within the united States and within a foreign

country.

The current regulations generally include assets in the property

formula at fair market value. The proposed regulations modify this rule

to provide that an asset must be included in the property formula at

its average adjusted basis (see section 1011). The IRS and Treasury

believe that this change to adjusted basis will significantly simplify

the application of this formula for both taxpayers and the IRS.

The proposed regulations also contain more detailed guidance than

the current regulations for determining the amounts to be included in

the property fraction. For example, the proposed regulations would

require that if the asset is used to produce inventory sold in Section

863 Sales and is also used to produce other property, the basis of the

asset must be prorated to account for such other uses.

The purpose of the property formula is to attribute the source of

the taxpayer's production income to the location of its production

activity. The IRS and Treasury are concerned that taxpayers may be able

to affect the location of assets without changing the sit us of

economic activity. Accordingly, comments are solicited about whether

there should be rules to prevent manipulation of this formula in a

manner inconsistent with the purpose of the regulation.

b. Source of Gross Income Attributable to Sales Activity

The source of gross income that is attributable to sales activity

is determined under paragraph (c)(2). As under the current regulations,

the source of this income is generally based on where a sale takes

place. See Sec. 1.861-7(c). Accordingly, if a U.S. producer sells its

goods in a foreign country, the income attributable to sales activity

is generally foreign source income.

[[Page 63484]]

The proposed regulation would retain the language of the existing

regulation, which only applies to sales that occur within a foreign

country. The IRS and Treasury solicit comments as to whether the

regulations should be expanded to apply to sales made in international

waters or in space. The IRS and Treasury are concerned, however, that

if such a change were made, a U.S. seller may try to use the 50/50

method by selling inventory in international waters to U.S. purchasers,

even when the goods were destined for the United States. In view of

these concerns, the IRS and Treasury also solicit comments as to

whether the regulations should provide an exception to the title

passage rule in the case of sales of goods produced in the United

States and destined for use in the United States.

4. Determination of Source of Taxable Income

Once the amount and source of gross income are determined under

paragraph (c), taxpayers then determine the source of their taxable

income. Under proposed paragraph (d), taxpayers must allocate or

apportion under Secs. 1.861-8 through 1.861-14T the amounts of

expenses, losses and other deductions to its gross income determined

under each method described in paragraph (b). In the case of amounts of

expenses, losses and other deductions allocated or apportioned to gross

income determined under the IFP method or the books and records method,

the taxpayer must apply the rules of Secs. 1.861-8 through 1.861-14T to

allocate or apportion these amounts between gross income from sources

within and without the United States. For amounts of expenses, losses

and other deductions allocated or apportioned to gross income

determined under the 50/50 method, taxpayers must apportion expenses

and other deductions prorata based on the relative amounts of U.S. and

foreign source gross income. These rules are consistent with existing

regulations.

5. Election and Reporting Rules

Under paragraph (e) of the proposed regulations, a taxpayer must

use the 50/50 method unless the taxpayer elects to use the IFP method,

or elects the Books and Records method. The taxpayer makes the election

by using the method on its tax return. Once The tax return is filed,

the election is not revokable for that year. In addition, that method

must be used in later taxable years unless the Commissioner or her

delegate consents to a change. Permission to change methods in later

years will not be withheld unless the change would result in a

substantial distortion of the source of income.

A taxpayer must fully explain the methodology used in paragraph

(b), and the amount of income allocated or apportioned to U.S. and

foreign sources in a statement attached to its tax return.

6. Conforming Changes

The proposed regulations make conforming changes to Sec. 1.863-2 of

the regulations. Under Sec. 1.863-2, the taxpayer may elect to apply

the 50/50 method to its net taxable income, instead of its gross income

as specified in Sec. 1.863-3. The proposed regulations clarify that

income derived from the purchase of personal property within a

possession of the United States and its sale within the United States

is subject to these regulations only to the extent it is not excluded

by Sec. 1.936-6(a)(5), Q&A 7. Other changes to Sec. 1.863-2 were

intended to conform the language of the regulation to the changes in

Sec. 1.863-3.

Finally, the IRS and Treasury will reconsider the existing

regulations issued under section 863 regarding transportation services

and cable and telegraph services in light of the Tax Reform Act of

1986. Accordingly, the transportation rules contained in Sec. 1.863-4

will only apply to services that are not described in section 863(c)

and the telegraph and cable rules contained in Sec. 1.863-5 are

deleted. No inference is intended as to whether portions of the

existing regulations continued to apply after the Tax Reform Act of

1986.

7. Proposed Effective Dates

These regulations are effective for taxable years beginning 30 days

after publication of final regulations. However, taxpayers may apply

these regulations for taxable years beginning after July 11, 1995, and

before 30 days after publication of these regulations as final

regulations.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It is hereby certified that

these regulations will not have a significant economic impact on a

substantial number of small entities. Accordingly, a regulatory

flexibility analysis is not required. Pursuant to section 7805(f) of

the Internal Revenue Code, 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 Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (a signed original

and eight (8) copies) that are submitted timely to the IRS. All

comments will be available for public inspection and copying.

A public hearing has been scheduled for April 10, 1996, at 10 a.m.

in the IRS Auditorium. Because of access restrictions, visitors will

not be admitted beyond the Internal Revenue Building lobby more than 15

minutes before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons that wish to present oral comments at the hearing must

submit written comments and an outline of topics to be discussed and

the time to be devoted to each topic (signed original and eight (8)

copies) by March 11, 1996.

A period of 10 minutes will be allotted to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these regulations is Anne Shelburne, Office

of Associate Chief Counsel (International). However, other personnel

from the IRS and Treasury Department participated in their development.

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 is amended by adding

entries in numerical order to read as follows:

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

Section 1.863-1 also issued under 26 U.S.C. 863.

Section 1.863-2 also issued under 26 U.S.C. 863.

Section 1.863-3 also issued under 26 U.S.C. 863.

Section 1.863-4 also issued under 26 U.S.C. 863.

Section 1.863-6 also issued under 26 U.S.C. 863. * * *

Par. 2. Sections 1.863-0 is added to read as follows:

[[Page 63485]]

Sec. 1.863-0 Table of contents.

This section lists captions contained in Secs. 1.863-1, 1.863-2,

and 1.863-3.

Sec. 1.863-1 Allocation of Gross Income.

(a) In general.

(b) Natural resources.

(1) In general.

(2) Additional production prior to export terminal.

(3) Definitions.

(i) Production activity.

(ii) Additional production activities.

(iii) Export terminal.

(4) Determination of fair market value.

(5) Determination of gross income.

(6) Tax return disclosure.

(7) Examples.

(c) Determination of taxable income.

(d) Effective dates.

Sec. 1.863-2 Allocation and Apportionment of Taxable Income.

(a) Determination of taxable income.

(b) Determination of source of taxable income.

(c) Effective dates.

Sec. 1.863-3 Allocation and Apportionment of Income from Certain

Sales of Inventory.

(a) In general.

(b) Methods to determine income attributable to production activity

and sales activity.

(1) 50/50 method.

(i) Determination of gross income.

(ii) Example.

(2) IFP method.

(i) Establishing an IFP.

(ii) Applying the IFP method.

(iii) Determination of gross income.

(iv) Examples.

(3) Books and records method.

(c) Determination of the source of gross income from production

activity and sales activity.

(1) Income attributable to production activity.

(i) Production only within the United States or only within foreign

countries.

(A) Source of income.

(B) Definition of production assets.

(C) Location of production assets.

(ii) Production both within the United States and within foreign

countries.

(A) Source of income.

(B) Adjusted basis of production assets.

(iii)Examples.

(2) Income attributable to sales activity.

(d) Determination of source of taxable income.

(e) Election and reporting rules.

(1) Elections under paragraph (b) of this section.

(2) Disclosure on tax return.

(f) Income partly from sources within a possession of the United

States. [Reserved]

(g) Effective dates.

Par. 3. Sections 1.863-1, 1.863-2, and 1.863-3 are revised to read

as follows:

Sec. 1.863-1 Allocation of gross income.

(a) In general. Items of gross income other than those specified in

section 861(a) and section 862(a) will generally be separately

allocated to sources within or without the United States. See

Sec. 1.863-2 for alternate methods to determine the income from sources

within or without the United States in the case of items specified in

Sec. 1.863-2(a). See also sections 865(b) and 865(e)(2).

(b) Natural resources--(1) In general. Except to the extent

provided in paragraph (b)(2) of this section, gross receipts from the

sale outside the United States of products derived from the ownership

or operation of any farm, mine, oil or gas well, other natural deposit,

or timber within the United States, are allocated between sources

within or without the United States based on the fair market value of

the product at the export terminal (as defined in paragraph (b)(3)(iii)

of this section). Except to the extent provided in paragraph (b)(2) of

this section, gross receipts from the sale within the United States of

products derived from the ownership or operation of any farm, mine, oil

or gas well, other natural deposit, or timber outside the United States

are also allocated between sources within or without the United States

based on the fair market value of the product at the export terminal.

The source of gross receipts equal to the fair market value of the

product at the export terminal will be from sources where the farm,

mine, well, deposit, or uncut timber is located. The source of gross

receipts from the sale of the product in excess of its fair market

value at the export terminal (excess gross receipts) will be determined

as follows--

(i) If the taxpayer does not engage in additional production

activities (as defined in paragraph (b)(3)(ii) of this section), excess

gross receipts will be from sources where the farm, mine, well,

deposit, or uncut timber is located;

(ii) If the taxpayer engages in additional production activities

subsequent to shipment from the export terminal and outside the country

of sale, the source of excess gross receipts must be determined under

Sec. 1.863-3. For purposes of applying Sec. 1.863-3, only production

assets used in additional production activity subsequent to the export

terminal are taken into account; or

(iii) In all other cases, excess gross receipts will be from

sources within the country of sale, as described in Sec. 1.861-7(c).

This paragraph (b)(1)(iii) applies, for example, to a taxpayer that

engages in additional production activities in the country of sale.

(2) Additional production prior to export terminal. Notwithstanding

any other provision of this section, gross receipts from the sale of

products derived by a taxpayer who performs additional production

activities as defined in paragraph (b)(3)(ii) of this section before

the relevant product is shipped from the export terminal are allocated

between sources within and without the United States based on the fair

market value of the product immediately prior to the additional

production activities. The source of gross receipts equal to the fair

market value of the product immediately prior to the additional

production activities will be from sources where the farm, mine, well,

deposit, or uncut timber is located. The source of gross receipts from

the sale of the product in excess of the fair market value immediately

prior to the additional production activities must be determined under

Sec. 1.863-3. For purposes of applying Sec. 1.863-3, only production

assets used in the additional production activities are taken into

account.

(3) Definitions--(i) Production activity. For purposes of this

section, production activity means an activity that creates,

fabricates, manufactures, extracts, processes, cures, or ages

inventory. See Sec. 1.864-1.

(ii) Additional production activities. For purposes of this

section, additional production activities are substantial production

activities performed by the taxpayer in addition to activities from the

ownership or operation of any farm, mine, oil or gas well, other

natural deposit, or timber. Whether a taxpayer performs such additional

production activities will be determined under the principles of

Sec. 1.954-3(a)(4). However, in no case will activities that prepare

the natural resource itself for export, including those that are

designed to facilitate the transportation of the natural resource to or

from the export terminal, be considered additional production

activities for purposes of this section.

(iii) Export terminal. Where the farm, mine, well, deposit, or

uncut timber is located without the United States, the export terminal

will be the final point in a foreign country from which goods are

shipped from a foreign country to the United States. Where the farm,

mine, well, deposit, or uncut timber is located within the United

States, the export terminal will be the final point in the United

States from which goods are shipped from the United States to a foreign

country. The export terminal is determined without regard to any

contractual terms agreed to by the taxpayer and without regard to

whether there is an actual sale of the products at the export terminal.

[[Page 63486]]

(4) Determination of fair market value. For purposes of this

section, fair market value depends on all of the facts and

circumstances as they exist relative to a party in any particular case.

Where the products are sold to a related party in a transaction subject

to section 482, the determination of fair market value under this

section must be consistent with the arm's length price determined under

section 482.

(5) Determination of gross income. To determine the amount of a

taxpayer's gross income from sources within or without the United

States, the taxpayer's gross receipts from sources within or without

the United States determined under this paragraph (b) must be reduced

by the cost of goods sold properly attributable to gross receipts from

sources within or without the United States.

(6) Tax return disclosure. A taxpayer that determines the source of

its income under this paragraph (b) shall attach a statement to its

return explaining the methodology used to determine fair market value

under paragraph (b)(4) of this section, and explaining any additional

production activities (as defined in paragraph (b)(3)(ii) of this

section) performed by the taxpayer. In addition, the taxpayer must

provide such other information as is required by Sec. 1.863-3.

(7) Examples. The following examples illustrate the rules of this

paragraph (b):

Example 1. No additional production. US Mines, a U.S.

corporation, extracts coal in the United States and, without

substantial additional production, sells the coal in a foreign

country. Under Sec. 1.863-1(b) and (b)(1)(i), all of US Mines'

income will be from sources within the United States.

Example 2. Scope of additional production. US Gas, a U.S.

corporation, extracts natural gas within the United States, and

transports the natural gas to a U.S. port where it is liquified in

preparation for shipment. The liquified natural gas is then

transported via freighter and sold without additional production

activities in a foreign country. Liquefaction of natural gas is not

an additional production activity because liquefaction prepares the

natural gas for transportation from the export terminal. Therefore,

under Sec. 1.863-1(b) and (b)(1)(i), all of US Gas' income will be

from sources within the United States.

Example 3. Sale in third country. US Gold, a U.S. corporation,

mines gold in country X, produces gold jewelry in the United States,

and sells the jewelry in country Y. Assume that the fair market

value of the gold at the export terminal in country X is $40, and

that US Gold ultimately sells the gold jewelry in country Y for

$100. Under Sec. 1.863-1(b), $40 of US Gold's gross receipts will be

allocated to sources without the United States. Under Sec. 1.863-

1(b)(1)(ii), the source of the remaining $60 of gross receipts will

be determined under Sec. 1.863-3. If US Gold applies the 50/50

method described in Sec. 1.863-3, $20 of cost of goods sold is

properly attributable to activities subsequent to the export

terminal, and all of US Gold's production assets subsequent to the

export terminal are located in the United States, then $20 of gross

income will be allocated to sources within the United States and $20

of gross income will be allocated to sources without the United

States.

Example 4. Production in country of sale. US Oil, a U.S.

corporation, extracts oil in country X, transports the oil via

pipeline to the export terminal in country Y, refines the oil in the

United States, and sells the refined product in the United States to

unrelated persons. Assume that the fair market value of the oil at

the export terminal in country Y is $80, and that US Oil ultimately

sells the refined product for $100. Under Sec. 1.863-1(b)(1), $80 of

US Oil's gross receipts will be allocated to sources without the

United States, and under Sec. 1.863-1(b)(1)(iii) the remaining $20

of gross receipts will be allocated to sources within the United

States.

Example 5. Additional production prior to export. US Furniture,

a U.S. corporation, cuts trees in the United States, converts the

trees into lumber, uses the lumber to manufacture furniture in the

United States, and sells the furniture in another country. Assume

that the fair market value of the trees when the conversion into

lumber begins is $40, and that US Furniture ultimately sells the

furniture for $100. Because the conversion of the trees into lumber

is an additional production activity within the United States within

the meaning of Sec. 1.863-1(b)(3)(ii), the source of US Furniture's

income will be determined under Sec. 1.863-1(b)(2). Thus, $40 of US

Furniture's gross receipts will be allocated to sources within the

United States. The source of the remaining $60 of gross receipts

will be determined under Sec. 1.863-3. If US Furniture applies the

50/50 method described in Sec. 1.863-3(b)(1), $20 of cost of goods

sold is properly attributable to the additional production activity,

and all of US Furniture's production assets used in the additional

production activity are located in the United States, then $20 of

gross income will be allocated to sources within the United States

and $20 of gross income will be allocated to sources without the

United States.

(c) Determination of taxable income. The taxpayer's taxable income

from sources within or without the United States will be determined

under the rules of Secs. 1.861-8 through 1.861-14T for determining

taxable income from sources within the United States.

(d) Effective dates. The rules of this section will apply to

taxable years beginning 30 days after publication of these regulations

as final regulations. However, taxpayers may apply the rules of this

section for taxable years beginning after July 11, 1995, and before 30

days after publication of these regulations as final regulations. For

years beginning before 30 days after publication of these regulations

as final regulations, see Sec. 1.863-1 (as contained in 26 CFR part 1

revised as of April 1, 1995).

Sec. 1.863-2 Allocation and apportionment of taxable income.

(a) Determination of taxable income. Section 863(b) provides an

alternate method for determining taxable income from sources within the

United States in the case of gross income derived from sources partly

within and partly without the United States. Under this method, taxable

income is determined by deducting from such gross income the expenses,

losses, or other deductions properly apportioned or allocated thereto

and a ratable part of any other expenses, losses, or deductions that

cannot definitely be allocated to some item or class of gross income.

The income to which this section applies (and that is treated as

derived partly from sources within and partly from sources without the

United States) will consist of gains, profits, and income--

(1) From certain transportation or other services rendered partly

within and partly without the United States to the extent not within

the scope of section 863(c) or other specific provisions of this title;

(2) From the sale of inventory property (within the meaning of

section 865(i)) produced (in whole or in part) by the taxpayer in the

United States and sold in a foreign country or produced (in whole or in

part) by the taxpayer in a foreign country and sold in the United

States; or

(3) Derived from the purchase of personal property within a

possession of the United States and its sale within the United States,

to the extent not excluded from the scope of these regulations under

Sec. 1.936-6(a)(5), Q&A 7.

(b) Determination of source of taxable income. Income treated as

derived from sources partly within and partly without the United States

under paragraph (a) of this section may be allocated to sources within

and without the United States pursuant to Sec. 1.863-1 or apportioned

to such sources in accordance with the methods described in other

regulations under section 863. To determine the source of certain types

of income described in paragraph (a)(1) of this section, see

Sec. 1.863-4. To determine the source of gross income described in

paragraph (a)(2) of this section, see Sec. 1.863-3. However, the

principles of Sec. 1.863-3 (b)(1) and (c) may be applied to determine

the source of taxable income from sales of inventory property. To

determine the source of income described in paragraph (a)(3) of this

section, see Sec. 1.863-3(f).

[[Page 63487]]

(c) Effective dates. This section will apply to taxable years

beginning 30 days after publication of these regulations as final

regulations. However, taxpayers may apply the rules of this section for

taxable years beginning after July 11, 1995, and before 30 days after

publication of these regulations as final regulations. For years

beginning before 30 days after publication of these regulations as

final regulations, see Sec. 1.863-2 (as contained in 26 CFR part 1

revised as of April 1, 1995).

Sec. 1.863-3 Allocation and apportionment of income from certain sales

of inventory.

(a) In general. This section applies to determine the source of

income derived from the sale of inventory property (inventory) produced

(in whole or in part) by a taxpayer within the United States and sold

within a foreign country, or produced (in whole or in part) by a

taxpayer in one or more foreign countries and sold within the United

States (Section 863 Sales). For purposes of this section, a taxpayer's

production activity includes production activities conducted by members

of the same affiliated group as defined under section 1504(a). A

taxpayer's production activity also includes production activities

conducted through a partnership of which the taxpayer is a partner

either directly or through one or more partnerships. A taxpayer subject

to this section must divide gross income from Section 863 Sales between

production activity and sales activity using one of the methods

described in paragraph (b) of this section. The source of gross income

from production activity and from sales activity must then be

determined under paragraph (c) of this section. Taxable income from

Section 863 Sales is determined under paragraph (d) of this section.

Paragraph (e) of this section describes the rules for electing the

methods described in paragraph (b) of this section and the information

that a taxpayer must disclose on a tax return. Paragraph (f) of this

section applies to determine the source of certain income derived from

a possession of the United States. Paragraph (g) of this section

provides effective dates for the rules in this section. Once a taxpayer

has elected a method described in paragraph (b) of this section, the

taxpayer must separately apply that method to Section 863 Sales in the

United States and to Section 863 Sales in foreign countries. In

addition, the taxpayer must apply the rules of paragraphs (c) and (d)

of this section by aggregating all Section 863 Sales to which a method

described in paragraph (b) of this section applies. See section

865(i)(1) for the definition of inventory property; Sec. 1.861-7(c) for

the time and place of sale. See also section 865(e)(2).

(b) Methods to determine income attributable to production activity

and sales activity--(1) 50/50 method--(i) Determination of gross

income. Generally, gross income from Section 863 Sales will be

apportioned between production activity and sales activity under the

50/50 method as described in this paragraph (b)(1). Under the 50/50

method, one-half of the taxpayer's gross income will be considered

income attributable to production activity and the source of that

income will be determined under the rules of paragraph (c)(1) of this

section. The remaining one-half of such gross income will be considered

income attributable to sales activity and the source of that income

will be determined under the rules of paragraph (c)(2) of this section.

In lieu of the 50/50 method, the taxpayer may elect to determine the

source of income from Section 863 Sales under the IFP method described

in paragraph (b)(2) of this section or, with the consent of the

District Director, the books and records method described in paragraph

(b)(3) of this section.

(ii) Example. The following example illustrates the rules of this

paragraph (b)(1):

Example. 50/50 method. (i) P, a U.S. corporation, produces

widgets in the United States. P sells the widgets for $100 to D, an

unrelated foreign distributor, in another country. P's cost of goods

sold is $40. Thus, P's gross income is $60.

(ii) Pursuant to the 50/50 method, one-half of P's gross income,

or $30, is considered income attributable to production activity,

and one-half of P's gross income, or $30, is considered income

attributable to sales activity.

(2) IFP method--(i) Establishing an IFP. A taxpayer may elect to

allocate gross income earned from production activity and sales

activity using the independent factory price (IFP) method described in

this paragraph (b)(2) if an IFP is fairly established. An IFP is fairly

established based on a sale by the taxpayer only if the taxpayer

regularly sells part of its output to wholly independent distributors

or other selling concerns in such a way as to reasonably reflect the

income earned from production activity. A sale will not be considered

to fairly establish an IFP if sales activity by the taxpayer with

respect to that sale is significant in relation to all of the

activities with respect to that product.

(ii) Applying the IFP method. If the taxpayer elects to use the IFP

method, the amount of the gross sales price equal to the IFP will be

treated as attributable to production activity, and the excess of the

gross sales price over the IFP will be treated as attributable to sales

activity. If a taxpayer elects to use the IFP method, the IFP must be

applied to all Section 863 Sales of inventory that are substantially

similar in physical characteristics and function, and are sold at a

similar level of distribution as the inventory sold in the sale fairly

establishing an IFP. The IFP will only be applied to sales that are

reasonably contemporaneous with the sale fairly establishing the IFP.

An IFP cannot be applied to sales in other geographic markets if the

markets are substantially different. The rules of this paragraph will

also apply to determine the division of gross receipts between

production activity and sales activity in a Section 863 Sale that

itself fairly establishes an IFP. If the taxpayer elects to apply the

IFP method, the IFP method must be applied to all sales for which an

IFP may be fairly established for that taxable year and each subsequent

taxable year. The taxpayer will apply either the 50/50 method described

in paragraph (b)(1) of this section or the books and records method

described in paragraph (b)(3) of this section to any other Section 863

Sale for which an IFP cannot be established or applied for each taxable

year.

(iii) Determination of gross income. The amount of a taxpayer's

gross income from production activity is determined by reducing the

amount of gross receipts from production activity by the cost of goods

sold properly attributable to production activity. The amount of a

taxpayer's gross income from sales activity is determined by reducing

the amount of gross receipts from sales activity by the cost of goods

sold (if any) properly attributable to sales activity. The source of

gross income from production activity is determined under the rules of

paragraph (c)(1) of this section, and the source of gross income from

sales activity will be determined under the rules of paragraph (c)(2)

of this section.

(iv) Examples. The following examples illustrate the rules of this

paragraph (b)(2):

Example 1. IFP method. (i) P, a U.S. producer, purchases cotton

and produces cloth in the United States. P sells cloth in country X

to D, a unrelated foreign clothing manufacturer, for $100. Cost of

goods sold for cloth is $80, entirely attributable to production

activity. P does not engage in significant sales activity in

relation to its other activities in the sales to D. Under these

facts, the sale to D fairly establishes an IFP of $100. Assume that

P elects to use the IFP method. Accordingly, $100 of the gross sales

price is treated as attributable to production activity, and no

amount of income from this

[[Page 63488]]

sale is attributable to sales activity. After reducing the gross sales

price by cost of goods sold, $20 of the gross income is treated as

attributable to production activity ($100-$80).

(ii) P also sells cloth in country X to A, a unrelated foreign

retail outlet, for $110. Because P elected the IFP method and the

cloth is substantially similar to the cloth sold to D, the IFP

fairly established in the sales to D must be used to determine the

amount attributable to production activity in the sale to A.

Accordingly, $100 of the gross sales price is treated as

attributable to production activity and $10 ($110-$100) is

attributable to sales activity. After reducing the gross sales price

by cost of goods sold, $20 of the gross income is treated as

attributable to production activity ($100-$80) and $10 is

attributable to sales activity.

Example 2. Scope of IFP Method. (i) USCo manufactures three

dissimilar products. USCo elects to apply the IFP method. In year 1,

an IFP can be established for sales of product X, but not for

products Y and Z. In year 2, an IFP cannot be established for any of

USCo's products. In year 3, an IFP can be established for products X

and Y, but not for product Z.

(ii) In year 1, USCo must apply the IFP method to sales of

product X. In year 2, although USCo's IFP election remains in

effect, USCo is not required to apply the IFP election to any

products. In year 3, USCo is required to apply the IFP method to

sales of products X and Y.

(3) Books and records method. A taxpayer may elect to determine the

amount of its gross income from Section 863 Sales that is attributable

to production and sales activities for the taxable year based upon its

books of account if it has received in advance the permission of the

District Director having audit responsibility over its tax return. The

taxpayer must establish to the satisfaction of the District Director

that the taxpayer, in good faith and unaffected by considerations of

tax liability, will regularly employ in its books of account a detailed

allocation of receipts and expenditures which clearly reflects the

amount of the taxpayer's income from production and sales activities.

If a taxpayer receives permission to apply the books and records

method, but does not comply with a material condition set forth by the

District Director, the District Director may, in its discretion, revoke

permission to use the books and records method. The source of gross

income treated as attributable to production activity under this method

may be determined under the rules of paragraph (c)(1) of this section,

and the source of gross income attributable to sales activity will be

determined under the rules of paragraph (c)(2) of this section.

(c) Determination of the source of gross income from production

activity and sales activity--(1) Income attributable to production

activity--(i) Production only within the United States or only within

foreign countries--(A) Source of income. Where the taxpayer's

production assets are located only within the United States or only

within a foreign country, the income attributable to production

activity is sourced where the taxpayer's production assets are located.

For rules regarding the source of income when production assets are

located both within the United States and within one or more foreign

countries, see paragraph (c)(1)(ii) of this section. For purposes of

this section, production activity means an activity that creates,

fabricates, manufactures, extracts, processes, cures, or ages

inventory. See Sec. 1.864-1.

(B) Definition of production assets. For purposes of this section,

production assets include only tangible and intangible assets owned 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. A partner will be treated as owning its

proportionate share of the partnership's production assets, determined

by reference to the partner's distributive share of partnership income

for the year attributable to such production assets.

(C) 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.

(ii) Production both within the United States and within foreign

countries--(A) Source of income. Where the taxpayer's production assets

are located both within the United States and within one or more

foreign countries, income from sources without the United States will

be determined by multiplying the income attributable to production

activity by a fraction, the numerator of which is the average adjusted

basis of production assets that are located in one or more foreign

countries and the denominator of which is the average adjusted basis of

all production assets in foreign countries and in the United States.

The remaining income is treated as from sources within the United

States.

(B) Adjusted basis of production assets. For purposes of paragraph

(c)(1)(ii)(A) of this section, the adjusted basis of an asset is

determined under section 1011. The average adjusted basis is computed

by averaging the adjusted basis of the asset at the beginning and end

of the taxable year, unless by reason of material changes during the

taxable year such average does not fairly represent the average for

such year. In this event, the average adjusted basis will be determined

upon a more appropriate basis. If production assets are used to produce

inventory sold in Section 863 Sales and are also used to produce other

property during the taxable year, the portion of its adjusted basis

that is included in the fraction described in paragraph (c)(1)(ii)(A)

of this section will be determined under any method that reasonably

reflects the portion of the assets that produces inventory sold in

Section 863 Sales. For example, the portion of such an asset that is

included in the formula may be determined by multiplying the asset's

average adjusted basis by a fraction, the numerator of which is the

gross receipts from sales of inventory from Section 863 Sales produced

by the asset, and the denominator of which is the gross receipts from

all property produced by that asset. For purposes of this section, a

taxpayer'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).

(iii) Examples. The following examples illustrate the rules of this

paragraph (c)(1):

Example 1. Source of production income. (i) A, a U.S.

corporation, produces widgets that are sold both within the United

States and within a foreign country. The initial manufacture of all

widgets occurs in the United States. The second stage of production

of widgets that are sold within a foreign country is completed

within the country of sale. A's U.S. plant and machinery which is

involved in the initial manufacture of the widgets has an average

adjusted basis of $200. A also owns warehouses used to store work-

in-process. A owns foreign equipment with an average adjusted basis

of $25. A's gross receipts from all sales of widgets is $100, and

its gross receipts from export sales of widgets is $25. Assume that

apportioning average adjusted basis using gross receipts is

reasonable. Assume A's cost of goods sold from the sale of widgets

in the foreign countries is $13 and thus, its gross

[[Page 63489]]

income from widgets sold in foreign countries is $12. A uses the 50/50

method to divide its gross income between production activity and

sales activity.

(ii) A determines its production gross income from sources

without the United States by multiplying one-half of A's $12 of

gross income from sales of widgets in foreign countries, or $6, by a

fraction, the numerator of which is all relevant foreign production

assets, or $25, and the denominator of which is all relevant

production assets, or $75 ($25 foreign assets + ($200 U.S. assets

x $25 gross receipts from export sales/$100 gross receipts from all

sales)). Therefore, A's gross production income from sources without

the United States is $2 ($6 x ($25/$75)).

Example 2. Location of intangible property. Assume the same

facts as Example 1, except that A employs a patented process that

applies only to the initial production of widgets. In computing the

formula used to determine the source of income from production

activity, A's patent, if it has an average adjusted basis, would be

located in the United States.

(2) Income attributable to sales activity. The source of the

taxpayer's income that is attributable to sales activity will be

determined under the provisions of Sec. 1.861-7(c).

(d) Determination of source of taxable income. Once the source of

gross income has been determined under paragraph (c) of this section,

the taxpayer must properly allocate and apportion separately under

Secs. 1.861-8 through 1.861-14T the amounts of its expenses, losses,

and other deductions to its respective amounts of gross income from

Section 863 Sales determined separately under each method described in

paragraph (b) of this section. In addition, if the taxpayer deducts

expenses for research and development under section 174 that may be

attributed to its Section 863 Sales under Sec. 1.861-8(e)(3), the

taxpayer must separately allocate or apportion expenses, losses, and

other deductions to its respective amounts of gross income from each

relevant product category that the taxpayer uses in applying the rules

of Sec. 1.861-8(e)(3)(i)(A). In the case of gross income from Section

863 Sales determined under the IFP method or the books and records

method, the rules of Secs. 1.861-8 through 1.861-14T must apply to

properly allocate or apportion amounts of expenses, losses and other

deductions allocated and apportioned to such gross income between gross

income from sources within and without the United States. In the case

of gross income from Section 863 Sales determined under the 50/50

method, the amounts of expenses, losses, and other deductions allocated

and apportioned to such gross income must be apportioned between

sources within and without the United States pro rata based on the

relative amounts of gross income from sources within and without the

United States determined under the 50/50 method.

(e) Election and reporting rules--(1) Elections under paragraph (b)

of this section. If a taxpayer does not elect a method specified in

paragraph (b)(2) or (3) of this section, the taxpayer must apply the

method specified in paragraph (b)(1) of this section. The taxpayer may

elect to apply the method specified in paragraph (b)(2) of this section

by using the method on a timely filed original return (including

extensions). A taxpayer may elect to apply the method specified in

paragraph (b)(3) of this section by using the method on a timely filed

original return (including extensions), but only if the taxpayer has

received permission from the District Director to apply that method.

Once a method under paragraph (b) of this section has been used, that

method must be used in later taxable years unless the Commissioner

consents to a change. See e.g., paragraph (b)(2)(ii) Example 2 of this

section. However, if a taxpayer elects to change to or from the method

specified in paragraph (b)(3) of this section, the taxpayer must obtain

permission from the District Director instead of the Commissioner.

Permission to change methods from one year to another year will not be

withheld unless the change would result in a substantial distortion of

the source of the taxpayer's income.

(2) Disclosure on tax return. A taxpayer who uses one of the

methods described in paragraph (b) of this section must fully explain

the methodology used, the circumstances justifying use of that method,

the extent that sales are aggregated, and the amount of income so

allocated.

(f) Income partly from sources within a possession of the United

States. [Reserved]

(g) Effective dates. The rules of paragraphs (a) through (e) of

this section will apply to taxable years beginning 30 days after

publication of final regulations. However, taxpayers may apply these

regulations for taxable years beginning after July 11, 1995, and before

30 days after publication of these regulations as final regulations.

For years beginning before 30 days after the publication of these

regulations as final regulations, see Sec. 1.863-3 (as contained in 26

CFR part 1 revised as of April 1, 1995).

Par. 4. Section 1.863-4 is amended by revising the section heading

and paragraph (a) to read as follows:

Sec. 1.863-4 Certain transportation services.

(a) General. A taxpayer carrying on the business of transportation

service (other than an activity giving rise to transportation income

described in section 863(c) or to income subject to other specific

provisions of this title) between points in the United States and

points outside the United States derives income partly from sources

within and partly from sources without the United States.

* * * * *

Sec. 1.863-5 [Removed]

Par. 6. Section 1.863-5 is removed.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 95-30087 Filed 12-7-95; 2:00 pm]

BILLING CODE 4830-01-U