Computation of Combined Taxable Income Under The Profit Split Method When the Possession Product is a Component Product or an End- Product Form for Purposes of the Possessions Credit Under Section 936

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8669]

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 for Purposes of the Possessions Credit Under Section 936

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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

SUMMARY: This document contains final regulations relating to the

computation of combined taxable income under the profit split method.

These regulations amend the current regulations and provide revised

rules for taxpayers to compute combined taxable income under the profit

split method 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: These regulations are effective May 10, 1996. See Supplementary

Information for applicability dates.

FOR FURTHER INFORMATION CONTACT: Jacob Feldman, 202-622-3870 (not a

toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On January 12, 1994, the IRS published a notice of proposed

rulemaking in the Federal Register (INTL-0068-92, 59 FR 1690, 1994-1

C.B. 820) relating to the computation of combined taxable income under

the profit split method under section 936(h)(5) (relating to the

possessions credit for U.S. companies doing qualified business in

Puerto Rico and certain U.S. possessions). A number of written public

comments were received concerning the proposed regulations and a public

hearing was held on July 11, 1994. After consideration of all the

comments, the proposed regulations are adopted as revised by this

Treasury decision. The revisions are discussed below.

Discussion

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

Under the proposed regulations, combined taxable income for a taxpayer

that elects the profit split method for a possession product that is

either a component product or an end-product form would be determined

by multiplying the combined taxable income of the integrated product

that 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 is the production costs of the component product and the

denominator of which is the production costs of the integrated product.

The combined taxable income of an end-product form would be determined

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

The regulations were proposed to be effective for taxable years

beginning after 1993.

Taxpayers have argued that the regulations should not be adopted as

proposed because they would violate the arm's length standard under

section 482 and that a necessary consequence of the abandonment of the

arm's length standard would be distortions in taxpayers' income. That

is, income would be computed inconsistently for related versus

unrelated party sales of the same product, under the same terms and in

the same market.

The proposed regulations did not apply the arm's length standard to

component products and end-product forms under the profit-split method

because application of section 482 in this context is inconsistent with

the statutory framework. The effect of the profit split method when

applied to possession products is to minimize disputes between

taxpayers and the IRS because, unlike section 482 methods, there is no

need to perform functional analyses to allocate income among the

parties. Because Congress eliminated the section 482 analysis from the

profit split method, the proposed regulations did not reinject this

analysis into the area of intermediate products.

In response to taxpayer comments, however, the IRS and Treasury are

providing an election to taxpayers that sell the same possession

product in both component form and integrated form if the transactions

meet certain section 482 standards. This method is both simple to apply

and produces consistent results with respect to related and unrelated

party transactions. Under this method, the combined taxable income from

covered sales of the component product shall be determined by using the

same per unit combined taxable income as is derived from uncontrolled

sales of the product as an integrated product. Taxpayers may elect to

compute the combined taxable income for an end-product form in a

similar manner if all excluded components are manufactured by a member

of the affiliated group that includes the possession corporation and

also sold by the group separately in uncontrolled transactions. In that

case, the combined taxable income of the end-product form will be

computed by reducing the combined taxable income of the integrated

product that includes the end-product form by the combined taxable

income of the excluded components determined under the rules of section

936 as if the excluded components were possession products. In order to

make the election, the uncontrolled sales must meet the comparability

standards of the fourth sentence of Sec. 1.482-3(b)(2)(ii)(A), which

requires that the uncontrolled and controlled transactions have no

differences or minor differences for which adjustment can be made.

However, under a no loss limitation, in no case can the taxpayer use as

its per

[[Page 21367]]

unit combined taxable income for a component product or an end-product

form an amount that exceeds the per unit combined taxable income of the

integrated product that includes the component product or end-product

form.

In 1993, Congress adopted limitations on the amount of the section

936 credit; the taxpayer may be subject to an activity based limitation

or may elect a percentage limitation. The election for the percentage

limitation had to be made for the first taxable year beginning after

December 31, 1993. Taxpayers commented that the proposed regulations

created uncertainty with respect to the consequences of making the

percentage limitation election and, therefore, the period for making

the election should be extended until after the regulations are

finalized. This comment is adopted. Taxpayers that have not elected the

percentage limitation under section 936(a)(1) for the first taxable

year beginning after December 31, 1993, may so elect if the taxpayer

has elected the profit split method and the computation of combined

taxable income is affected by Sec. 1.936-6(b)(1) Q&A 12.

With respect to the proposed effective date, taxpayers commented

that the regulations should not be applied retroactively. One of the

justifications for the proposed rule was that it would simplify the

computation of combined taxable income and applying the regulation

retroactively would not simplify the computation because it would

require filing amended returns. This comment is adopted in part. The

regulation is effective for taxable years ending 30 days after May 10,

1996. If however, the election under paragraph (v) of A. 12 of

Sec. 1.936-6(b)(1) is made, this election must be made for the

taxpayer's first taxable year beginning after December 31, 1993, and if

not made effective for that year, the election cannot be made for any

later taxable year.

The last sentence of paragraph (vi) of A. 13 of Sec. 1.936-6(b)(1)

in the proposed regulations provided that, for purposes of determining

the estimated tax liability of an affiliate of the possessions

corporation with respect to income allocated to it from the possessions

corporation, the income would be deemed 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 ended. This rule is limited to

taxable years beginning prior to January 1, 1995. For taxable years

beginning after December 31, 1994, quarterly estimated tax payments

will be required as provided under section 711 of the Uruguay Round

Agreements, Public Law 103-465 (1994), page 230, and any administrative

guidance issued by the IRS thereunder. See Rev. Proc. 95-23 (1995-1

C.B. 693).

Accordingly, the proposed regulations are finalized as proposed

except with respect to the changes discussed above and the necessary

conforming changes.

Special Analyses

It has been determined that this Treasury decision is not a

significant regulatory action as defined in EO 12866. Therefore, a

regulatory assessment is not required. It has also been determined that

this regulation does not have a significant impact on a substantial

number of small entities. Thus, the Regulatory Flexibility Act (5

U.S.C. chapter 6) does not apply to these regulations, and therefore, a

Regulatory Flexibility Analysis is not required. Pursuant to section

7805(f) of the Internal Revenue Code, the notice of proposed rulemaking

preceding these regulations was submitted to the Small Business

Administration for comment on its impact on small business.

Drafting Information

The principal authors of these regulations are Jacob Feldman and

Mary Gillmarten of the Office of Associate Chief Counsel

(International), IRS. 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.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

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

part as follows:

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

Par. 2. In Sec. 1.936-6, paragraph (b)(1) is amended by:

1. Revising Q. 10.

2. Amending A. 10 by:

a. Redesignating the text of A. 10 as paragraph A. 10(i).

b. Removing the last two sentences of newly designated A.

10(i).

c. Adding paragraphs A. 10 (ii) through (v).

3. Revising the first sentence of A. 11.

4. Revising Q&A. 12.

5. Revising A. 13.

The revisions and addition 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: (i) * * *

(ii) If the possession product is a component product or an end-

product form, the combined taxable income with respect to the

possession product shall be determined under Q&A. 12 of this paragraph

(b)(1).

(iii) 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 that includes the component 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

that includes the component product. The deemed sales price of an end-

product form shall be determined by multiplying the deemed sales price

of the integrated product that includes the end-product form 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 that includes the end-product form. For the

definition of production costs, see Q&A. 12 of this paragraph (b)(1).

(iv)(A) If combined taxable income is determined under paragraph

(v) of A. 12 of this paragraph (b)(1), in the case of a component

product, the deemed sales price shall be determined by using the actual

sales price of that product when sold as an integrated product (as

adjusted under the rules of the fourth sentence of Sec. 1.482-

3(b)(2)(ii)(A)).

(B) If combined taxable income is determined under paragraph (v) of

A. 12 of this paragraph (b)(1), in the case of an end-product form, the

deemed sales price shall be determined by subtracting from the deemed

sales price of the integrated product that includes the end-product

form (e.g., the leased property) the actual sales price of the excluded

component when sold as an

[[Page 21368]]

integrated product to an unrelated person (as adjusted under the rules

of the fourth sentence of Sec. 1.482-3(b)(2)(ii)(A)).

(v) The full amount of income received under the lease shall be

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

possessions corporation.

* * * * *

A. 11: 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). * * *

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) Except as provided in paragraph (v) of this A. 12,

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 that includes the component product

that the production costs attributable to the component product bear to

the total production costs (including costs incurred by the U.S.

affiliates) for the integrated product that includes the component

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

production costs as defined under Sec. 1.936-5(b)(4) except that the

costs will not include any costs of materials. If the possession

product is a component product that is transformed into an integrated

product in whole or in part by a contract manufacturer outside of the

possession, within the meaning of Sec. 1.936-5(c), the denominator of

the PCR shall be computed by including the same amount paid to the

contract manufacturer, less the costs of materials of the contract

manufacturer, as is taken into account for purposes of the significant

business presence test under Sec. 1.936-5(c) Q&A. 5.

(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 that includes the end-product form that the

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

production costs (including costs incurred by the U.S. affiliates) for

the integrated product that includes the end-product form. Production

costs will be the sum of the direct and indirect production costs as

defined under Sec. 1.936-5(b)(4) except that the costs will not include

any costs of materials. If the possession product is an end-product

form and an excluded component is contract manufactured outside of the

possession, within the meaning of Sec. 1.936-5(c), the denominator

shall be computed by including the same amount paid to the contract

manufacturer, less cost of materials of the contract manufacturer, as

is also taken into account for purposes of the significant business

presence test under Sec. 1.936-5(c) Q&A. 5.

(iv) This paragraph (iv) of A. 12 illustrates the computation of

combined taxable income for a component product or end-product form

under the PCR method. S, a possessions corporation, is 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 as follows:

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.............................................. 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), Q&A. 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 of the computers (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. 1.861-17 and 1.861-14T(e)(2) to the

computers............................................. 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

[[Page 21369]]

(v)(A) If a possession product is sold by a taxpayer or its

affiliate to unrelated persons in covered sales both as an integrated

product and as a component product and the conditions of paragraph

(v)(C) of this A. 12 are satisfied, the taxpayer may elect to determine

the combined taxable income derived from covered sales of the component

product under this paragraph (v). In that case, the combined taxable

income derived from covered sales of the component product shall be

determined by using the same per unit combined taxable income as is

derived from covered sales of the product as an integrated product, but

subject to the limitation of paragraph (v)(D) of this A. 12.

(B) In the case of a possession product that is an end-product

form, if all of the excluded components are also separately sold by the

taxpayer or its affiliate to unrelated persons in uncontrolled

transactions and the conditions of paragraph (v)(C) of this A. 12 are

satisfied, the taxpayer may elect to determine the combined taxable

income of such end-product form under this paragraph (v). In that case,

the combined taxable income derived from covered sales of the end-

product form shall be determined by reducing the per unit combined

taxable income from the integrated product that includes the end-

product form by the per unit combined taxable income for excluded

components determined under the rules of this paragraph (v), but

subject to the limitation of paragraph (v)(D) of this A. 12. For this

purpose, combined taxable income of the excluded components must be

determined under section 936 as if the excluded components were

possession products.

(C) In the case of component products, this paragraph (v) applies

only if the sales price of the possession product sold in covered sales

as an integrated product (i.e., in uncontrolled transactions) would be

the most direct and reliable measure of an arm's length price within

the meaning of the fourth sentence of Sec. 1.482-3(b)(2)(ii)(A) for the

component product. For purposes of applying the fourth sentence of

Sec. 1.482-3(b)(2)(ii)(A), the sale of the integrated product that

includes the component product is treated as being immediately preceded

by a sale of the component (i.e. without further processing) in a

controlled transaction. In the case of end-product forms, this

paragraph (v) applies only if the sales price of excluded components

separately sold in uncontrolled transactions would be the most direct

and reliable measure of an arm's length price within the meaning of the

fourth sentence of Sec. 1.482-3(b)(2)(ii)(A) for all excluded

components of an integrated product that includes an end-product form.

For purposes of applying the fourth sentence of Sec. 1.482-

3(b)(2)(ii)(A), the sale of the integrated product that includes

excluded components is treated as being immediately preceded by a sale

of the excluded components (i.e. without further processing) in a

controlled transaction. Under the fourth sentence of Sec. 1.482-

3(b)(2)(ii)(A), the uncontrolled transactions referred to in this

paragraph (v)(C) must have no differences with the controlled

transactions that would affect price, or have only minor differences

that have a definite and reasonably ascertainable effect on price and

for which appropriate adjustments are made (resulting in appropriate

adjustments to the computation of combined taxable income). If such

adjustments cannot be made, or if there are more than minor differences

between the controlled and uncontrolled transactions, the method

provided by this paragraph (v)(C) cannot be used. Thus, for example,

these uncontrolled transactions must involve substantially identical

property in the same or a substantially identical geographic market,

and must be substantially identical to the controlled transaction in

terms of their volumes, contractual terms, and market level. See

Sec. 1.482-3(b)(2)(ii)(B).

(D) In no case can the per unit combined taxable income as

determined under paragraph (v)(A) or (B) of this A. 12 be greater than

the per unit combined taxable income of the integrated product that

includes the component product or end-product form.

(E) The provisions of this paragraph (v) are illustrated by the

following example. Taxpayer manufactures product A in a U.S.

possession. Some portion of product A is sold to unrelated persons as

an integrated product and the remainder is sold to related persons for

transformation into product AB. The combined taxable income of

integrated product A is $400 per unit and the combined taxable income

of product AB is $300 per unit. The production cost ratio with respect

to product A when sold as a component of product AB, is 2/3. Unless the

taxpayer elects and satisfies the conditions of this paragraph (v), the

combined taxable income with respect to A will be $200 per unit

(combined taxable income for AB of $300 x the production cost ratio

of 2/3). If, however, the comparability standards of paragraph (v)(C)

of this A. 12 are met, the taxpayer may elect to determine combined

taxable income of product A when sold as a component of product AB

using the same per unit combined taxable income as product A when sold

as an integrated product. However, the per unit combined taxable income

from sales of product A as a component product may not exceed the per

unit combined taxable income on the sale of product AB. Therefore, the

combined taxable income of component product A may not exceed $300 per

unit.

(vi) Taxpayers that have not elected the percentage limitation

under section 936(a)(1) for the first taxable year beginning after

December 31, 1993, may do so if the taxpayer has elected the profit

split method and computation of combined taxable income is affected by

Q&A.12 of this paragraph (b)(1).

(vii) The rules of Q&A. 12 of this paragraph (b)(1) apply for

taxable years ending 30 days after May 10, 1996. If, however, the

election under paragraph (v) of A. 12 of Sec. 1.936-6(b)(1) is made,

this election must be made for the taxpayer's first taxable year

beginning after December 31, 1993, and if not made effective for that

year, the election cannot be made for any later taxable year. A

successor corporation that makes the same or substantially similar

products as its predecessor corporation cannot make an election under

paragraph (v) of A.12 of Sec. 1.936-6(b)(1) unless the election was

made by its predecessor corporation for its first taxable year

beginning after December 31, 1993.

* * * * *

A. 13: (i) The income shall be allocated to affiliates in the

following order, but no allocations will be made to affiliates

described in a later category if there are any affiliates in a prior

category--

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

within the group (as determined under section 482) that 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)

that 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 that 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 that 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

[[Page 21370]]

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. For this purpose, gross income must be determined

consistently for each affiliate and consistently from year to year.

(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.

(vi) For purposes of determining an affiliate's estimated tax

liability for income thus allocated for taxable years beginning prior

to January 1, 1995, 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. For taxable

years beginning after December 31, 1994, quarterly estimated tax

payments will be required as provided under section 711 of the Uruguay

Round Agreements, Public Law 103-465 (1994), page 230, and any

administrative guidance issued by the Internal Revenue Service

thereunder.

* * * * *

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: April 4, 1996.

Leslie Samuels,

Assistant Secretary of the Treasury.

[FR Doc. 96-11639 Filed 5-9-96; 8:45 am]

BILLING CODE 4830-01-U