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 Parts 1 and 602

[TD 8687]

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: Final and temporary regulations.

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SUMMARY: This document contains regulations governing the source of

income from sales of natural resources or other inventory produced in

the United States and sold outside the United States or produced

outside the United States and sold in the United States. This document

affects persons who produce natural resources or other inventory in the

United States and sell outside the United States, or produce natural

resources or other inventory outside the United States and sell in the

United States.

DATES: Effective date: December 30, 1996.

Applicability: Taxpayers may apply these regulations for taxable

years beginning after July 11, 1995, and on or before December 30,

1996.

FOR FURTHER INFORMATION CONTACT: Anne Shelburne, (202) 622-3880 (not a

toll free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this final regulation

has been reviewed and approved by the Office of Management and Budget

in accordance with the requirements of the Paperwork Reduction Act (44

U.S.C. 3507) under control number 1545-1476. Responses to this

collection of information are mandatory.

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 estimated average annual burden per respondent is approximately

2.6 hours.

[[Page 60541]]

Comments concerning the accuracy of this burden estimate and

suggestions for reducing this burden should be sent to the Internal

Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington,

DC 20224, and the Office of Management and Budget, Attn: Desk Officer

for the Department of the Treasury, Office of Information and

Regulatory Affairs, Washington, DC, 20503.

Books or records relating to this 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.

Background

This document contains final regulations to be added to the Income

Tax Regulations (26 CFR part 1) under section 863 of the Internal

Revenue Code (Code). The final regulations provide rules for allocating

and apportioning income between U.S. and foreign sources from natural

resources and other inventory produced in the United States and sold

outside the United States, or produced outside the United States and

sold in the United States.

On December 11, 1995, proposed regulations [INTL-0003-95] were

published in the Federal Register (60 FR 63478). The IRS received

written comments on the proposed regulations and held a public hearing

on April 10, 1996. Having considered the comments and the statements

made at the hearing, the IRS and the Treasury Department adopt the

proposed regulations as modified by this Treasury decision. The

comments and revisions are discussed below.

Explanation of Provisions

I. Allocation of Gross Income From Sales of Natural Resources Under

Section 863(a)

Section 1.863-1(b) of the proposed regulations relate to the rules

governing natural resources. The proposed regulations provide three

methods for determining the amount of United States or foreign source

income from sales of natural resources. One method (derived from the

existing regulations) sources income in its entirety to the location of

the natural resources, and applies where the taxpayer does not engage

in substantial additional production beyond production of the natural

resources. The second method, the export terminal rule, splits sales

income at the export terminal, sourcing gross receipts equal to the

fair market value at the export terminal to the location of the natural

resources, and gross receipts in excess of that amount either to the

place of sale or according to the rules in Sec. 1.863-3, depending on

the circumstances. The third method requires taxpayers performing

additional production in the country where the natural resources are

located, to split gross receipts at the point of the additional

production, sourcing gross receipts equal to the fair market value

prior to that point to the location of the natural resources and gross

receipts in excess of that amount according to the rules in Sec. 1.863-

3.

1. Implications of the Tenth Circuit's Order in Phillips

Section 1.863-1(b)(1)(i) of the proposed regulations sources

certain income from natural resources in its entirety to the location

of the resources. The preamble to the proposed regulations states that

Treasury and the IRS would consider the Tenth Circuit's unpublished

opinion in its Order and Judgment in Phillips Petroleum v. Comm'r, 97

T.C. 30 (1991), 101 T.C. 78 (1993), aff'd. without published opinion,

70 F.3d 1282 (10th Cir., 1995), in finalizing the regulations. In

Phillips, the Tax Court ruled Sec. 1.863-1(b)'s natural resource

regulation, generally sourcing income from U.S. natural resources in

its entirety to the United States, invalid to the extent it conflicted

with the Court's interpretation of section 863(b)(2). That section

provides that gains, profits and income from the sale of inventory

property produced within and sold without the United States (or vice

versa) shall be treated as derived partly from sources within and

partly from sources without the United States. The Tenth Circuit

affirmed the Tax Court.

In view of Phillips, the final regulations modify the proposed

regulations to eliminate the 100 percent allocation rule, making the

determination of the source of income subject instead to the export

terminal rule. Thus, gross receipts equal to the fair market value of

the product at the export terminal are allocated to the location of the

farm, mine, well, deposit or uncut timber, with the source of gross

receipts from such sales in excess of the product's fair market value

at the export terminal allocated to the country of sale.

Several commentators requested that any change to the natural

resource rules made in light of Phillips be done in proposed form,

providing opportunity to comment on the regulations. However, because

the final regulations merely eliminate the rule which required a single

source of income for sales of natural resources, and because Treasury

and the IRS believe that there has been adequate opportunity to comment

on the proposed regulations' export terminal rule, the natural

resources rules are issued in final form.

2. Availability of the 50/50 Method for Natural Resources

Several commentators wrote that there is no basis for treating

natural resources differently than other inventory. Therefore,

producers of natural resources should be permitted to determine the

source of their income under the 50/50 method described in Sec. 1.863-

3(b)(1). They point to legislation enacted in the Tax Reform Act of

1986, arguing that Congress, in enacting section 865 to govern personal

property sales, drew no distinction between sales of natural resources

and sales of other inventory. Commentators have also pointed to section

865(b), enacted in 1993, providing that income from sales of U.S.

softwood must be U.S. source in its entirety. They conclude that

Congress was aware of the Tax Court's decision in Phillips, overruling

Phillips only for softwood, but intending that all other natural

resources be sourced under the 50/50 method.

Treasury and the IRS do not believe that Congress in the 1986 Act

evidenced an intent to source all income from sales of natural

resources under the 50/50 method. Rather, Congress merely referred to

the 50/50 method to generally describe the methods for sourcing income

from certain types of inventory sales. In addition, the legislative

history to the 1993 Act, requiring income from softwood sales to be

allocated in its entirety to the United States, does not suggest that

Congress intended to overturn the longstanding regime governing sales

of other natural resources. Moreover, the Small Business Job Protection

Act of 1996, Public Law 104-188 (August 20, 1996) (the 1996 Act),

further clarifies that the Service is not required to apply the 50/50

method. Prior to the 1996 Act, section 865(b) provided that income from

inventory sales was to be sourced under sections 861(a)(6), 862(a)(6),

and 863(b). The 1996 Act, in section 1704(f)(4)(A), amended Code

section 865(b)(2) by striking 863(b) and inserting 863. The Act makes

this amendment effective as if included in amendments made by section

1211 of the Tax Reform Act of 1986 (Public Law 99-514). This technical

correction to the 1986 Act clarifies that Treasury has broad authority

to provide rules sourcing income from sales of inventory under

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section 863, and is not restricted to any particular method.

Treasury and the IRS also believe longstanding distinctions have

been made in the tax treatment of natural resources and other property,

both in our tax laws and in our tax treaties. Most treaties, for

example, grant primary or exclusive taxing jurisdiction to the country

where natural resources are located. Thus, income from sales of natural

resources is treated differently than income derived from sales of

other inventory, which is normally subject to the business profits

article of a treaty. See, e.g., Article 6 of the United States Model

Income Tax Convention (September 20, 1996), which provides that income

from real property, ``including income from agriculture and forestry''

may be taxed by the country where the resources are located.

The legislative history to section 863's predecessor, section

217(e) of the Revenue Act of 1921, also reflects an intention that

natural resources be treated differently from other property. The House

version of section 217 (H.R. 8245, 67th Cong., 1st Sess. (Aug.20,

1921)) included a provision sourcing income from natural resources in

its entirety to the location of the resources. However, based on

testimony raising the possibility of a case where such a single source

rule should not apply, the Senate struck the provision that allocated

all of the income from natural resources to a single country. (H.R.

8245 (67th Cong., 1st Sess. (November 4, 1921)); Hearings Before The

Committee on Finance, United States Senate, H.R. 8245, 67th Cong., 1st

Sess. (September 1 to October 1, 1921), at 309-310. A provision similar

to that considered by the House, but with flexibility available for

unusual cases, was then added to the regulations promulgated in 1922.

Thus, Treasury and the IRS believe that income from natural

resources should be sourced differently than income from other sales of

inventory.

3. Clarification of Language in Sec. 1.863-2

In response to a comment, the final regulations are modified to

clarify that the source of income from sales of natural resources must

be determined solely under the rules set forth in Sec. 1.863-1(b) of

the final regulations. Treasury and the IRS clarified this point in

corrections to the proposed regulations, published on August 27, 1996,

in the Federal Register (61 FR 44023).

4. Additional Production Activities

The proposed regulations define additional production activities in

Sec. 1.863-1(b)(3)(ii) as substantial production activities performed

by the taxpayer in addition to activities relating to the ownership or

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

timber. The proposed regulations provide that generally the principles

of Sec. 1.954-3(a)(4) apply in determining whether an activity

qualifies as such additional production. However, in no case will

activities that prepare the natural resource itself for export,

including those that are designed to facilitate transportation of the

natural resource to or from the export terminal, be considered

additional production. Thus, the proposed regulations in an example

indicate liquefaction of natural gas would not constitute additional

production activities.

Liquefaction is the process of liquefying natural gas so that it

can be transported by tanker for sales abroad. Several commentators

urged us to reconsider our position, arguing that liquefaction is an

expensive, complex activity. Treasury and the IRS, however, continue to

believe that liquefaction is an activity preparing the natural resource

itself for export within the meaning of Sec. 1.863-1(b)(3)(ii) of the

final regulations, and that it is appropriate to exclude such

activities from the definition of additional production. Even though

liquefaction may be an expensive, complex process, liquefied natural

gas retains its character as a natural resource, so that liquefaction

should be treated no differently than other processes that prepare

natural resources for export.

Several commentators requested that the regulations more precisely

define the processes that constitute production of natural resources,

to better differentiate those activities described in Sec. 1.863-

1(b)(1) of the proposed regulations, as being from the ownership or

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

timber, from those that qualify as additional production activities

within the meaning of Sec. 1.863- 1(b)(3)(ii) of the proposed

regulations. In particular, a commentator requested that the final

regulations specifically address this issue in the case of mining. In

response to this comment, the final regulations include an example

describing certain mining processes that would not qualify as

additional production activities in the case of copper.

5. Treatment of Partnerships

The proposed regulations provide that, in applying the rules in

Sec. 1.863-3 of the proposed regulations, a partner would be treated as

engaged in the production activity of its partnership. However, that

provision was not extended to Sec. 1.863-1 of the proposed regulations,

which generally provides rules for determining the source of income

from sales of natural resources. The final regulations provide rules

for transactions involving partners and partnerships, which apply in

the same manner to sales of natural resources and to sales of other

inventory. See II. 3. of this preamble for a discussion of those rules.

6. Genetically-Engineered Agricultural Products

One commentator requested that final regulations state that natural

resources do not include products, such as certain seeds, where the

premium value of the product is derived from genetic traits produced by

biotechnology or traditional methods, and the seeds themselves are not

grown for consumption. The inherent nature of products as agricultural

products, however, does not change because they may be subject to

research and development. Because they remain natural resources,

Treasury and the IRS rejected this comment.

II. Allocation and Apportionment of Income From Sales of Inventory

Other Than Natural Resources

Section 1.863-3 of the proposed regulations provides rules for

allocating and apportioning income from inventory sales other than

natural resources where the taxpayer produces property in the United

States and sells outside the United States, or produces property

outside the United States and sells in the United States (Section 863

Sales). The proposed regulations provide three methods: the 50/50

method, the independent factory price method, and the books and records

method.

1. Sales in International Waters or in Space

Consistent with the existing regulations, the proposed regulations

limit the methods in Sec. 1.863-3 to sales within a foreign country.

The preamble, however, requests comments on whether the regulation

should be expanded to cover sales made in international waters or in

space. Although the statute refers to sales outside the United States,

Treasury and the IRS expressed concern in that preamble that expanding

the scope of the regulations to include all such sales could lead to

abuses where, for example, a taxpayer produced goods in the United

States, passed title to those

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goods outside the United States, and then sold the goods to U.S.

customers. In considering whether to expand the scope of the final

regulations to include such sales, Treasury and the IRS requested

comments on whether to include an exception to the title passage rule

for sales of goods produced in the United States and destined for the

U.S. market.

In response to comments and consistent with the preamble to the

proposed regulations, the final regulations expand the scope of the

existing and proposed regulations to include sales outside the United

States. Moreover, to prevent abuse from this expanded rule, the final

regulations provide that sales of goods wholly produced in the United

States and sold for use, consumption, or disposition in the United

States, will be considered to take place in the United States. Income

from such sales will be treated as from U.S. sources. The final

regulations rely on rules in Sec. 1.864-6(b)(3)(ii) (relating to the

determination of whether foreign source income is effectively connected

with a U.S. trade or business under section 864(c)(4)(iii)), for

determining the country of use, consumption, or disposition. Also,

property will be treated as wholly produced in the United States for

this purpose if it is subject to no more than packaging, repackaging,

labeling, or other minor assembly operations outside the United States.

See also Sec. 1.861-7(c) to determine the source of income in any case

in which the sales transaction is arranged in a particular manner for

the primary purpose of tax avoidance.

Treasury and the IRS are considering whether the rules of the final

regulations are appropriate where a product is produced in one country

but is destined for use either on the high seas or in space. Until

additional guidance is provided, taxpayers may rely upon the general

rules of the final regulations for these cases.

2. Segregation and Aggregation of Sales

Once a taxpayer selects a method under Sec. 1.863-3(b) for dividing

gross income derived from Section 863 Sales between production activity

and sales activity, Sec. 1.863-3(a) of the proposed regulations provide

that a taxpayer must separately apply that method to Section 863 Sales

in the United States and to Section 863 Sales outside the United

States. The proposed regulations also provide in Sec. 1.863-3(a) that

taxpayers must determine the source of gross income under paragraph (c)

and taxable income under paragraph (d) by aggregating all Section 863

Sales to which a method described in paragraph (b) applies.

The final regulations clarify that the rules of paragraphs (c) and

(d) apply separately to Section 863 Sales in the United States and to

Section 863 Sales outside the United States, so that taxpayers are

required to aggregate all Section 863 Sales under paragraphs (c) and

(d) after the taxpayer has first separately applied the method under

paragraph (b) to Section 863 Sales in the United States and to Section

863 Sales outside the United States.

3. Transactions With Partnerships

The proposed regulations provide in Sec. 1.863-3(a) that a

taxpayer's production activity includes production activities conducted

through a partnership of which the taxpayer is a partner either

directly or through one or more partnerships. One commentator

recommended that final regulations extend the partnership rules to

natural resources. However, the commentator suggested that an aggregate

approach to partnerships should apply only in cases where the

partnership, instead of selling the property and distributing the

proceeds to the partner, distributes the property to a partner. In

response to the comments, the final regulations modify the proposed

regulations. Under the final regulations, the aggregate approach

applies to a partnership's production or sales activity only for two

purposes. First, the aggregate approach applies for purposes of

determining the source of a partner's distributive share of partnership

income. Thus, if a partnership engages in the production of inventory

property in the United States and sells such property outside the

United States, a partner will be considered to have produced and sold

that inventory property in the same manner as the partnership when

determining the source of its distributive share of such sales income.

Second, the aggregate approach applies for purposes of sourcing income

from the sale of inventory property that is transferred in kind from or

to a partnership. Thus, for example, where the partnership makes an in

kind distribution of inventory property to its partners, the source of

the partner's income from the sale of such property is determined based

on both its own activity and on the partnership's activity. Similarly,

the aggregate approach applies in cases where a partner contributes

inventory produced by it to its partnership, if the partnership then

sells the inventory (e.g., as a distributor or after further

processing).

The entity approach applies for all other purposes. For example,

where a partnership manufactures inventory property and sells the

property to one of its partners, the source of that partner's income

from the resale of the property is determined without regard to the

partnership's manufacturing activity. Consistent with this

modification, the final regulations also specify that assets owned by a

partnership (or a partner) are not deemed owned by the partner (or the

partnership) unless the aggregate approach applies to the transaction

at issue.

4. Taxable Income Method

In response to comments, Sec. 1.863-2(b) of the proposed

regulations is clarified to provide that taxpayers may elect the

principles of Sec. 1.863-3 (b)(1) and (c) to determine the source of

taxable income (rather than gross income) from sales of inventory

property.

5. Independent Factory Price (IFP) Method

One commentator requested clarification that the sale establishing

an IFP must be sourced under the IFP method only if a taxpayer elects

the IFP method. The proposed and final regulations intend this result.

The IFP method applies to either the sale establishing the IFP or to a

sale applying the IFP only if the taxpayer elects the IFP method.

The proposed regulations eliminated the provision in existing

regulations permitting taxpayers to establish an IFP by methods other

than by sales to independent distributors. The preamble, however,

requested comments on the continued utility of such a provision. Two

commentators recommended that the provision be retained and expanded to

permit taxpayers to establish an IFP by any method that is appropriate

under section 482. The commentators stated that any evidence acceptable

for proving an arm's length price under section 482 should be

acceptable as an IFP. The commentators also stated that taxpayers who

cannot use the IFP method must use the 50/50 method, and that the 50/50

method may not produce an equitable result for nonresidents importing

goods into the United States.

After further consideration, Treasury and the IRS have decided to

finalize the regulations on this point as proposed. No convincing

evidence has been presented for the need of a broad-based rule

permitting taxpayers to establish an IFP by any method that would

otherwise be appropriate under section 482 when they can use books and

records to demonstrate a more appropriate sourcing result. In view of

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the absence of a clearly identified benefit for taxpayers and the

availability of the books and records method, Treasury and the IRS

believe that expansion of the IFP rule is not justified.

6. Books and Records

Under both the existing and proposed regulations, taxpayers can

request permission from the District Director to use a taxpayer's books

and records to allocate or apportion income between U.S. and foreign

sources if this method more clearly reflects the taxpayer's income. The

preamble to the proposed regulations requests comments on retaining the

books and records method. Two commentators asked for retention of this

method because instances may arise where a taxpayer does not have third

party sales, thereby making the IFP method unavailable. In such cases,

a taxpayer may find it advantageous to determine the source of its

income on the basis of its books and records. These comments were

accepted. The final regulations retain the books and records method,

subject to an election and prior approval of the method by the District

Director.

7. Determination of Source of Gross Income From Production Activities

a. Definition of Production Assets

i. Contract manufacturing. Under the proposed regulations,

production assets are limited to those owned directly by the taxpayer

that are directly used by the taxpayer to produce the relevant

inventory. These rules are intended to insure that taxpayers do not

attribute the assets or activities of related or unrelated parties

manufacturing under contract with the taxpayer. One commentator asked

that the definition of production assets be expanded to include

production assets owned by related or unrelated contract manufacturers.

The commentator contends that by limiting production assets to those

owned by the taxpayer, the regulations source income differently

depending upon the form in which the taxpayer conducts business.

Treasury and the IRS, however, believe it is appropriate to limit

production assets in the apportionment formula to assets owned by the

taxpayer and used by the taxpayer to produce the inventory. In

addition, taxpayers generally do not know the contract manufacturer's

basis in its production assets. Further, it would be very difficult to

draw a clear line between contract manufacturers and other suppliers.

Thus, Treasury and the IRS do not believe the source of a taxpayer's

income should take into account activities of others or assets owned by

others with whom the taxpayer has manufacturing arrangements. The final

regulations clarify, however, that this rule does not override the

single entity rules set forth under Sec. 1.1502-13 (dealing with

members of an affiliated group filing on a consolidated basis), or the

rules under Sec. 1.863-3(g) dealing with partnerships.

ii. Accounts receivable. One commentator also asserted that

accounts receivable should be included as a production asset. This

comment was rejected. The production formula is intended to approximate

the location of the taxpayer's production activity. Thus, assets not

directly involved in production should not be included.

b. Anti-Abuse Rule

The preamble to the proposed regulations indicated that the purpose

of the property fraction is to attribute the source of production

income to the location of production activity. Treasury and the IRS,

however, were concerned that taxpayers would attempt to artificially

affect the location of assets to manipulate the rules, and so solicited

comments on whether an anti-abuse rule was needed. No comments were

received that objected to such anti-abuse rule. After further

considering the issue, Treasury and the IRS have included an anti-abuse

rule in the final regulations to prevent taxpayers from manipulating

the property formula to achieve inappropriate results. Therefore, the

anti-abuse rule provides that if a taxpayer has entered into or

structured one or more transactions with a principal purpose of

reducing its U.S. tax liability by affecting the formula in a manner

inconsistent with the purpose of the regulation, the District Director

may make appropriate adjustments so that the source of the taxpayer's

income from production activity more clearly reflects the source of

that income. An example in the regulations demonstrates circumstances

where the anti-abuse rule may apply. In that example, with a principal

purpose of reducing its U.S. tax liability, the taxpayer leases all of

its U.S. property so that it owns only property located in a foreign

country. The example concludes that the District Director may ignore a

sale-leaseback transaction to more clearly reflect the source of the

taxpayer's production income.

8. Determination of Taxable Income

One commentator requested that the calculation of taxable income,

when applying the 50/50 method along with the research and experimental

(R&E) expense allocation rules in Sec. 1.861-17, be clarified. The

commentator suggests that the last sentence of Sec. 1.863-3(d) of the

proposed regulations can be read to conflict with the R&E set aside in

Sec. 1.861-17. The final regulations clarify that the R&E set aside

remains available to taxpayers using the 50/50 method.

9. Reporting Requirements

The proposed regulations, in Sec. 1.863-3(e), require a taxpayer to

fully explain the methodology used to determine the source of income,

the circumstances justifying use of that method, the extent that sales

are aggregated, and the amount of income so allocated. One commentator

wrote that the reporting requirements in Sec. 1.863-3(e) of the

proposed regulations are unnecessary and excessively burdensome. The

regulations clarify that the requirement is limited to a statement

attached to the tax return, explaining the methodology used, the

circumstances justifying that use, the aggregation of sales, and the

amount of income allocated. Treasury and the IRS believe the reporting

requirements in Sec. 1.863-3(e) of the proposed regulations are

reasonable, and serve legitimate administrative purposes.

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 is hereby certified that

these regulations will not have a significant economic impact on a

substantial number of small entities. This certification is based on

the fact that the rules of this section principally impact large

multinationals who pay foreign taxes on substantial foreign operations

and therefore the rules will impact very few small entities. Moreover,

in those few instances where the rules of this section impact small

entities, the economic impact on such entities is not likely to be

significant. Accordingly, 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 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.

[[Page 60545]]

List of Subjects

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are 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 1.863-2 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 1.863-3 and 1.863-3T are redesignated as

Secs. 1.863-3A and 1.863-3AT, respectively, and an undesignated center

heading is added preceding the redesignated sections to read as

follows:

Regulations Applicable to Taxable Years Prior to December 30, 1996

Par. 3. Section 1.863-0 is added to read as follows:

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.

(e) 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.

(1) Scope.

(2) Special rules.

(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) Anti-abuse rule.

(iv) 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.

(g) Special rules for partnerships.

(h) Effective dates.

Par. 4. In Sec. 1.863-1, paragraphs (a), (b) and (c) are revised

and paragraph (e) is added 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 (e)(2). In the case of

sales of property involving partners and partnerships, the rules of

Sec. 1.863-3(g) apply.

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

provision, 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,

must be allocated between sources within and 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). Notwithstanding

any other provision, 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 must be allocated between sources within and without the United

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

terminal. For place of sale, see Secs. 1.861-7(c) and 1.863-3(c)(2).

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 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.

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

within the country of sale. This paragraph (b)(1)(ii) applies to a

taxpayer that engages in additional production activities in the

country of sale, as well as to a taxpayer that does not engage in

additional production activities at all.

(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.

[[Page 60546]]

(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. Except as otherwise provided in

Secs. 1.1502-13 or 1.863-3(g)(2), only production activities conducted

directly by the taxpayer are taken into account.

(ii) Additional production activities. For purposes of this

section, additional production activities are substantial production

activities performed directly 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's activities

constitute 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 to the United States. If there is no such final point in a

foreign country (e.g., the property is extracted and produced on the

high seas), the export terminal will be the place of production. 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 location of 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.

(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. U.S. Mines, a U.S.

corporation, operates a copper mine and mill in country X. U.S.

Mines extracts copper-bearing rocks from the ground and transports

the rocks to the mill where the rocks are ground and processed to

produce copper-bearing concentrate. The concentrate is transported

to a port where it is dried in preparation for export, stored and

then shipped to purchasers in the United States. Because title to

the property is passed in the United States and, under the facts and

circumstances, none of U.S. Mine's activities constitutes additional

production prior to the export terminal within the meaning of

paragraph (b)(3)(ii) of this section, under paragraph (b)(1) and

(b)(1)(ii) of this section, gross receipts equal to the fair market

value of the concentrate at the export terminal will be from sources

without the United States, and excess gross receipts will be from

sources within the United States.

Example 2. No 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

paragraph (b)(1) and (b)(1)(ii) of this section, gross receipts

equal to the fair market value of the liquefied natural gas at the

export terminal will be from sources within the United States, and

excess gross receipts will be from sources without 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 paragraph

(b)(1)(i) of this section, 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 paragraph (b)(1) of this

section, $80 of US Oil's gross receipts will be allocated to sources

without the United States, and under paragraph (b)(1)(ii) of this

section the remaining $20 of gross receipts will be allocated to

sources within the United States.

Example 5. Additional production prior to export. The facts are

the same as in Example 1, except that U.S. Mines also operates a

smelter in country X. The concentrate output from the mill is

transported to the smelter where it is transformed into smelted

copper. The smelted copper is exported to purchasers in the United

States. Under the facts and circumstances, all of the processes

applied to make copper concentrate are considered mining. Therefore,

under paragraph (b)(2) of this section, gross receipts equal to the

fair market value of the concentrate at the smelter will be from

sources without the United States. Under the facts and

circumstances, the conversion of the concentrate into smelted copper

is an additional production activity in a foreign country within the

meaning of paragraph (b)(3)(ii) of this section. Therefore, the

source of U.S. Mine's excess gross receipts will be determined

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

(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.

* * * * *

(e) Effective dates. The rules of paragraphs (a), (b) and (c) of

this section will apply to taxable years beginning December 30, 1996.

However, taxpayers may apply the rules of this section for taxable

years beginning after July 11, 1995, and before December 30, 1996. For

years beginning before December 30, 1996, see Sec. 1.863-1 (as

contained in 26 CFR part 1 revised as of April 1, 1996).

Par. 5. Section 1.863-2 is revised to read as follows:

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

[[Page 60547]]

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 outside the United States or produced (in whole

or in part) by the taxpayer outside the United States 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. 1.863-1 for natural

resources and see Sec. 1.863-3 for other inventory. Taxpayers, at their

election, may apply the principles of Sec. 1.863-3 (b)(1) and (c) to

determine the source of taxable income (rather than gross income) from

sales of inventory property (other than natural resources). To

determine the source of income partly from sources within a possession

of the United States, including income described in paragraph (a)(3) of

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

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

beginning December 30, 1996. However, taxpayers may apply the rules of

this section for taxable years beginning after July 11, 1995, and

before December 30, 1996. For years beginning before December 30, 1996,

see Sec. 1.863-2 (as contained in 26 CFR part 1 revised as of April 1,

1996).

Par. 6. Section 1.863-3 is added to read as follows:

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

of inventory.

(a) In general--(1) Scope. Paragraphs (a) through (e) of this

section apply to determine the source of income derived from the sale

of inventory property (inventory), which a taxpayer produces (in whole

or in part) within the United States and sells outside the United

States, or which a taxpayer produces (in whole or in part) outside the

United States and sells within the United States (Section 863 Sales). A

taxpayer 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 special rules for partnerships for all sales subject to

Secs. 1.863-1 through 1.863-3. Paragraph (h) of this section provides

effective dates for the rules in this section.

(2) Rules of application for Section 863 Sales. 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 outside the United States. 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, after separately

applying that method to Section 863 Sales in the United States and to

Section 863 Sales outside the United States. See section 865(i)(1) for

the definition of inventory property. See also section 865(e)(2). See

Sec. 1.861-7(c) and paragraph (c)(2) of this section for the time and

place of sale.

(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

[[Page 60548]]

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. If the taxpayer elects the

IFP method, 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 and

applied 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, an 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 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, an 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. 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. Subject to the provisions in Sec. 1.1502-13 or paragraph

(g)(2)(ii) of this section, the only production activities that are

taken into account for purposes of Secs. 1.863-1, 1.863-2, and this

section are those conducted directly by the taxpayer. Where the

taxpayer's production assets are located only within the United States

or only outside the United States, 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 without the United

States, see paragraph (c)(1)(ii) of this section.

(B) Definition of production assets. Subject to the provisions of

Sec. 1.1502-13 and paragraph (g)(2)(ii) of this section, production

assets include only tangible and intangible assets owned directly by

the taxpayer that are directly used by the taxpayer to produce

inventory described in paragraph (a) of this section. Production assets

do not include assets that are not directly used to produce inventory

described in paragraph (a) of this section. Thus, production assets do

not include such assets as accounts receivables, intangibles not

related to production of inventory (e.g., marketing intangibles,

including trademarks and customer lists), transportation assets,

warehouses, the inventory itself, raw materials, or work-in-process. In

addition, production assets do not include cash or other liquid assets

(including working capital), investment assets, prepaid expenses, or

stock of a subsidiary.

(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 and without the

United States, income from sources without the United States will be

determined by multiplying the income attributable to the taxpayer's

production activity by a fraction, the numerator of which is the

average adjusted basis of production assets that are located outside

the United States and the denominator of which is the average adjusted

basis of all production assets within and without the United States.

The

[[Page 60549]]

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.

(iii) Anti-abuse rule. The purpose of this paragraph (c)(1) is to

attribute the source of the taxpayer's production income to the

location of the taxpayer's production activity. Therefore, if the

taxpayer has entered into or structured one or more transactions with a

principal purpose of reducing its U.S. tax liability by manipulating

the formula described in paragraph (c)(1)(ii)(A) of this section in a

manner inconsistent with the purpose of this paragraph (c)(1), the

District Director may make appropriate adjustments so that the source

of the taxpayer's income from production activity more clearly reflects

the source of that income.

(iv) 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 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.

Example 3. Anti-abuse rule. (i) Assume the same facts as Example

1. A sells its U.S. assets to B, an unrelated U.S. corporation, with

a principal purpose of reducing its U.S. tax liability by

manipulating the property fraction. A then leases these assets from

B. After this transaction, under the general rule of paragraph

(c)(1)(ii) of this section, all of A's production income would be

considered from sources without the United States, because all of

A's relevant production assets are located within a foreign country.

Since the leased property is not owned by the taxpayer, it is not

included in the fraction.

(ii) Because A has entered into a transaction with a principal

purpose of reducing its U.S. tax liability by manipulating the

formula described in paragraph (c)(1)(ii)(A) of this section, A's

income must be adjusted to more clearly reflect the source of that

income. In this case, the District Director may redetermine the

source of A's production income by ignoring the sale-leaseback

transactions.

(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). However,

notwithstanding any other provision, for purposes of section 863, the

place of sale will be presumed to be the United States if personal

property is wholly produced in the United States and the property is

sold for use, consumption, or disposition in the United States. See

Sec. 1.864-6(b)(3)(ii) to determine the country of use, consumption, or

disposition. Also, in applying this paragraph, property will be treated

as wholly produced in the United States if it is subject to no more

than packaging, repackaging, labeling, or other minor assembly

operations outside the United States, within the meaning of Sec. 1.954-

3(a)(4)(iii) (property manufactured or produced by a controlled foreign

corporation).

(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. Research and

experimental expenditures qualifying under Sec. 1.861-17 are allocated

under that section, and are not allocated and apportioned pro rata

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

[[Page 60550]]

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. 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

in a statement attached to the return the methodology used, the

circumstances justifying use of that methodology, 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. Taxpayers with income partly from sources within a possession

of the United States must apply the rules of Sec. 1.863-3A(c).

(g) Special rules for partnerships--(1) General rule. For purposes

of Sec. 1.863-1 and this section, a taxpayer's production or sales

activity does not include production and sales activities conducted by

a partnership of which the taxpayer is a partner either directly or

through one or more partnerships, except as otherwise provided in

paragraph (g)(2) of this section.

(2) Exceptions--(i) In general. For purposes of determining the

source of the partner's distributive share of partnership income or

determining the source of the partner's income from the sale of

inventory property which the partnership distributes to the partner in

kind, the partner's production or sales activity includes an activity

conducted by the partnership. In addition, the production activity of a

partnership includes the production activity of a taxpayer that is a

partner either directly or through one or more partnerships, to the

extent that the partner's production activity is related to inventory

that the partner contributes to the partnership in a transaction

described under section 721.

(ii) Attribution of production assets to or from a partnership. A

partner will be treated as owning its proportionate share of the

partnership's production assets only to the extent that, under

paragraph (g)(2)(i) of this section, the partner's activity includes

production activity conducted through a partnership. A partner's share

of partnership assets will be determined by reference to the partner's

distributive share of partnership income for the year attributable to

such production assets. Similarly, to the extent a partnership's

activities include the production activities of a partner, the

partnership will be treated as owning the partner's production assets

related to the inventory that is contributed in kind to the

partnership. See paragraph (c)(1)(ii)(B) of this section for rules

apportioning the basis of assets to Section 863 Sales.

(iii) Basis. For purposes of this section, in those cases where the

partner is treated as owning its proportionate share of the

partnership's production assets, the partner's basis in production

assets held through a partnership shall be determined by reference to

the partnership's adjusted basis in its assets (including a partner's

special basis adjustment, if any, under section 743). Similarly, a

partnership's basis in a partner's production assets is determined with

reference to the partner's adjusted basis in its assets.

(iv) Separate application of methods. If, under paragraph (g)(2) of

this section, a partner is treated as conducting the activity of a

partnership, and is treated as owning its proportionate share of a

partnership's production assets, a partner must apply the method it has

elected under paragraph (b) of this section separately to Section 863

Sales described in this paragraph (g) and all other Section 863 Sales.

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

paragraph (g):

Example 1. Distributive share of partnership income. A, a U.S.

corporation, forms a partnership in the United States with B, a

country X corporation. A and B each have a 50 percent interest in

the income, gains, losses, deductions and credits of the

partnership. The partnership is engaged in the manufacture and sale

of widgets. The widgets are manufactured in the partnership's plant

located in the United States and are sold by the partnership outside

the United States. The partnership owns the manufacturing facility

and all other production assets used to produce the widgets. A's

distributive share of partnership income includes 50 percent of the

sales income from these sales. In applying the rules of section 863

to determine the source of its distributive share of partnership

income from the export sales of widgets, A is treated as carrying on

the activity of the partnership related to production of these

widgets and as owning a proportionate share of the partnership's

assets related to production of the widgets, based upon its

distributive share of partnership income.

Example 2. Distribution in kind. Assume the same facts as in

Example 1 except that the partnership, instead of selling the

widgets, distributes the widgets to A and B. A then further

processes the widgets and then sells them outside the United States.

In determining the source of the income earned by A on the sales

outside the United States, A is treated as conducting the activities

of the partnership related to production of the distributed widgets.

Thus, the source of gross income on the sale of the widgets is

determined under section 863 and these regulations. A applies the

50/50 method described in paragraph (b)(1) of this section to

determine the source of income from the sales. In applying paragraph

(c)(1) of this section, A is treated as owning its proportionate

share of the partnership's production assets based upon its

distributive share of partnership income.

(h) Effective dates. The rules of this section apply to taxable

years beginning December 30, 1996. However, taxpayers may apply these

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

December 30, 1996. For years beginning before December 30, 1996, see

Secs. 1.863-3A and 1.863-3AT.

Par. 7. 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. 8. Section 1.863-5 is removed.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 9. The authority citation for part 602 continues to read as

follows:

Authority: 26 U.S.C. 7805.

Par. 10. In Sec. 602.101, paragraph (c) is amended by adding

entries for 1.863-1 and 1.863-3A, and revising the entry for 1.863-3 to

read as follows:

Sec. 602.101 OMB Control numbers.

* * * * *

(c) * * *

[[Page 60551]]

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

Current OMB

CFR part or section where identified and described control No.

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

* * * * *

1.863-1.................................................... 1545-1476

1.863-3.................................................... 1545-1476

* * * * *

1.863-3A................................................... 1545-0126

* * * * *

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

Approved: November 25, 1996.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Donald C. Lubick,

Acting Assistant Secretary of Tax Policy.

[FR Doc. 96-30617 Filed 11-27-96; 8:45 am]

BILLING CODE 4830-01-U