Source of Income From Sales of Inventory Partly From Sources Within a Possession of the United States; Also, Source of Income Derived From Certain Purchases From a Corporation Electing Section 936

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-251985-96]

RIN 1545-AU79

Source of Income From Sales of Inventory Partly From Sources

Within a Possession of the United States; Also, Source of Income

Derived From Certain Purchases From a Corporation Electing Section 936

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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SUMMARY: This document contains proposed regulations under section 863

governing the source of income from sales of inventory produced in the

United States and sold in a possession of the United States or produced

in a possession of the United States and sold in the United States. It

also contains proposed regulations under section 863 governing the

source of income from sales of inventory purchased in a possession of

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

persons who produce (in whole or in part) inventory in the United

States and sell in a possession, or produce (in whole or in part)

inventory in a possession and sell in the United States, as well as

persons who purchase inventory in a possession and sell in the United

States. This document also contains proposed regulations under section

936 governing the source of income of a taxpayer from the sale in the

United States of property purchased from a corporation that has an

election under section 936 in effect. This document also provides

notice of a public hearing on these proposed regulations.

DATES: Comments and outlines of oral comments to be presented at the

public hearing scheduled for January 29, 1998, at 10 a.m. must be

received by January 8, 1998.

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

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

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

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

(REG-251985-96), Courier's Desk, Internal Revenue Service, 1111

Constitution Avenue NW., Washington, DC, or electronically, via the IRS

Internet site at: http://www.irs.ustreas.gov/prod/tax__regs/

comments.html. The public hearing will be held in room 2615, Internal

Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Anne

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

Evangelista Lee, (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed

rulemaking has been submitted to the Office of Management and Budget

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

(44 U.S.C. 3507(d)).

Comments on the collection of information should be sent to the

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

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

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

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

collection of information should be received by December 9, 1997.

Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the

proper performance of the functions of the IRS, including whether the

information will have practical utility;

The accuracy of the estimated burden associated with the proposed

collection of information (see below);

How the quality, utility, and clarity of the information to be

collected may be enhanced;

How the burden of complying with the proposed collection of

information may be minimized, including through the application of

automated collection techniques or other forms of information

technology; and

Estimates of capital or start-up costs and costs of operation,

maintenance, and purchase of services to provide information.

The collection of information requirements are in proposed

Sec. 1.863-3(f)(6). This information is required by the IRS to monitor

compliance with the federal tax rules for determining the source of

income from the sale of inventory produced in the United States and

sold in a possession of the United States or produced in a possession

of the United States and sold in the United States, or from the sale of

inventory purchased in a possession of the United States and sold in

the United States. The likely respondents are taxpayers who produce

inventory in the United States and sell in a possession, or who produce

inventory in a possession and sell in the United States, or who

purchase inventory in a possession and sell in the United States.

Responses to this collection of information are required to properly

determine the source of a taxpayer's income from such sales.

Books or records relating to a collection of information must be

retained as long as their contents may become material in the

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

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

Estimated total annual reporting burden: 500 hours. The estimated

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

on individual circumstances, with an estimated average of 2.5 hours.

Estimated number of respondents: 200.

Estimated annual frequency of responses: One time per year.

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 assigned by the Office of

Management and Budget.

Background

These proposed regulations contain rules under section 863 relating

to the source of income from cross-border sales of certain property.

These regulations also contain rules under

[[Page 52954]]

section 936 relating to the source of income of a taxpayer from the

sale in the United States of property purchased from a corporation that

has an election under section 936 in effect. These regulations are

proposed to be effective for taxable years beginning 30 days after

publication of final regulations.

Explanation of Provisions

I. Income Partly From Sources Within a Possession

A. Current Regulations

Section 863 authorizes the Secretary to promulgate regulations

allocating or apportioning to sources within or without the United

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

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

Guidance to determine the source of possession income is divided

into two types of transactions: transactions described in section

863(b)(2) for property produced in the United States and sold in a

possession (or vice versa), and transactions described in section

863(b)(3) for property purchased in a possession and sold in the United

States (collectively, Section 863 Possession Sales).

Section 1.863-3 of the income tax regulations contains rules for

determining the source of income derived from sales of certain

property. These regulations were published in the Federal Register on

November 29, 1996 (61 FR 60540), and the prior regulations were

renumbered Secs. 1.863-3A and 1.863-3AT. The new regulations retain the

prior rules for Section 863 Possession Sales by providing in paragraph

Sec. 1.863-3(f) that taxpayers must apply the rules of Sec. 1.863-3A(c)

in allocating and apportioning income derived from sources partly

within the United States and partly within a possession of the United

States. These proposed regulations would modify the existing rules for

allocating and apportioning income between the United States and a

possession.

1. Property Produced and Sold

Currently, income derived from sales of inventory produced in the

United States and sold in a possession of the United States or produced

in a possession of the United States and sold in the United States

(Possession Production Sales), is allocated or apportioned between the

United States and a possession according to one of three methods. Such

income is allocated under the independent factory price method,

apportioned under an apportionment method, or, with permission of the

District Director, allocated or apportioned on the basis of the

taxpayer's books and records.

Under the current regulations, if an independent factory or

production price (IFP) exists for Possession Production Sales,

taxpayers must use the IFP method to determine the income attributable

to production activities in both the sale establishing the IFP and in

sales of similar products.

If an IFP does not exist, the current possessions regulations

provide that the taxable income from Possession Production Sales is

first computed and then apportioned between the United States and the

possession. One-half of the taxable income is apportioned on the basis

of the taxpayer's property within the United States and within the

possession. In applying the property fraction, the taxpayer's property

includes property held or used to produce income derived from

Possession Production Sales. The other half of the taxpayer's taxable

income is apportioned between U.S. and possession sources on the basis

of the business of the taxpayer within the United States and within the

possession. Currently, business of the taxpayer is measured by the sum

of certain expenses, including amounts paid for labor, and the purchase

of certain supplies, plus receipts from Possession Production Sales.

Finally, as a third method, the existing regulations allow a taxpayer

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

books and records to allocate or apportion income to sources within or

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

other methods the taxable income derived from sources within the United

States.

2. Property Purchased and Sold

The second type of possession transaction governed by the existing

regulations is the sale of inventory purchased in a possession and sold

in the United States (Possession Purchase Sales) as described in

section 863(b)(3). Under the current regulations, the income from such

sales is divided between the United States and possession sources under

one of two methods. The income can be apportioned, or, with permission

of the District Director, allocated or apportioned on the basis of the

taxpayer's books and records.

Under the apportionment method, taxable income is first determined,

and then apportioned by a fraction, the numerator being the business of

the taxpayer in the United States, the denominator being the total

business of the taxpayer in the United States and in the possession.

The fraction is computed in the same manner as the business fraction

discussed previously, except that such expenses, purchases, and sales

are limited to those attributable to Possession Purchase Sales.

B. Issues Under Current Regulations

The IRS and Treasury believe the rules for allocating and

apportioning income between the United States and the possessions of

the United States should be amended to reflect certain changes made to

the regulations under Sec. 1.863-3 governing cross-border sales of

inventory involving the United States and a foreign country (other than

those involving possessions). Thus, for example, under the

apportionment method provided in the proposed regulations, the property

and business activity fractions apportioning income between the United

States and a possession are modified to apportion gross income

attributable to an activity, rather than to apportion net income.

The IRS and Treasury also believe certain ambiguities exist in the

current regulations. The possessions rules were originally promulgated

in 1926, and may not reflect current business practices. The current

regulations use examples to illustrate methods for allocating or

apportioning income between the United States and a possession, and

should be modified to state rules.

Further, although the apportionment method for allocating

Possession Production Sales income under the existing possessions

regulations treats half of the income as production income, the

production formula is not necessarily limited to production assets. The

current inclusion of sales assets in the formula apportioning

production income results in excessive income being allocated to sales

activities. The production income formula should only take into account

assets directly involved in production of inventory. In addition, the

IRS and Treasury have reexamined the business activity fraction, and

have concluded it should be revised to more clearly reflect the

taxpayer's business other than production. The current fraction, for

example, omits certain investments or expenses, such as marketing and

advertising expenses, although income attributable in part to such

expenses or investments is then included in the income apportioned by

the fraction. The current regulations also take into account production

expenses in the business activity fraction apportioning income from

Possession Production Sales. The Service and Treasury believe that this

is inappropriate in the context

[[Page 52955]]

of Possession Production Sales because the business activity fraction

is not intended to determine the source of income attributable to

production activity. In the proposed regulations, the fraction

apportioning Possession Production Sales is renamed the business sales

activity fraction and excludes factors reflecting production activity.

The current regulations also do not address issues in attributing

to the United States or to the possession, the activities reflected in

the business activity fraction. For example, the current regulations

provide no guidance on whether a particular expense should be

represented in the fraction as attributable to the United States or to

a possession.

Accordingly, the IRS and Treasury are issuing proposed regulations

under section 863 to make the possessions rules more consistent with

the other regulations governing the source of income from cross-border

sales of inventory, and to address certain ambiguities and problems in

the existing regulations.

C. Proposed Regulations

Section 1.863-3(f) generally retains the methods of the current

regulations for dividing income between the United States and a

possession of the United States, with several modifications.

1. Methods to Allocate Gross Income to Activities of the Taxpayer

a. Property Produced and Sold

i. The Possession 50/50 Method

Consistent with the final regulations under Sec. 1.863-3, paragraph

(f)(2)(i)(A) of the proposed regulations makes the 50/50 method the

general rule to allocate gross income from Possession Production Sales

between production and business sales activity, so that the income from

each type of activity can then be apportioned between U. S. and foreign

sources. The taxpayer, however, may elect to apply the IFP method

(described in paragraph (f)(2)(i)(B)), or, with the consent of the

District Director, the books and records method (described in paragraph

(f)(2)(i)(C)).

Under the possession 50/50 method, the proposed regulations

allocate half of the taxpayer's gross income from Possession Production

Sales to production activity and half to business sales activity. The

income is then apportioned between U.S. and possession sources based on

a property fraction and a business sales activity fraction. As

described below, the proposed regulations make certain changes to the

existing property fraction and to the existing business activity

fraction.

The proposed regulations apply the property fraction in Sec. 1.863-

3(c) to apportion the half of a taxpayer's income allocated to

production activity. Thus, income is apportioned to the United States

or to a possession based on the location of the taxpayer's production

assets. In a change from the current regulations, and consistent with

the changes made to the regulations under Sec. 1.863-3(c), production

assets are defined as tangible and intangible assets owned directly by

the taxpayer that are directly used by the taxpayer to produce

inventory sold in Possession Production Sales, instead of all its

assets that produce income from Possession Production Sales. Production

assets are included in the fraction at their adjusted tax basis.

The other half of the taxpayer's gross income is apportioned

according to a business sales activity fraction. The portion of this

income that is possession source income is determined by multiplying

the income by a fraction, the numerator being the business sales

activity of the taxpayer in the possession, and the denominator being

the business sales activity of the taxpayer within the possession and

outside the possession. The remaining income is sourced in the United

States. Although some of the business sales activity factors not

incurred in a possession may be incurred in a foreign country, Treasury

and the Internal Revenue Service believe that the business sales

activity fraction is only intended to source the business sales

activity portion of Possession Production Sales outside the United

States to the extent of business sales activity located in a

possession.

The proposed regulations make some modifications to the factors in

the fraction representing the business sales activity of the taxpayer.

Business sales activity is measured by the sum of certain expenses,

including amounts paid for labor, materials, advertising, and marketing

(but excluding any expenses or other amounts that are nondeductible

under section 263A, interest, and research and development), plus

receipts for the sale of goods. This formula is intended to reflect

better the business sales activity producing the income by including

more of the factors responsible for producing that income. Cost of

goods sold is also excluded from the business sales activity fraction

apportioning income from Possession Production Sales, because such

costs generally reflect production activity. Production activity is

already represented in the formula by the one-half of the taxpayer's

income apportioned according to the location of production assets.

Finally, the proposed regulations provide more explicit guidance

for attributing business sales activity between the United States and a

possession. Expenses are allocated and apportioned between the United

States and a possession based on the rules in Secs. 1.861-8 through

1.861-14T. Gross sales are allocated to the United States or a

possession based on the place of sale.

ii. The IFP Method

The proposed regulations make the IFP method elective, and thus

eliminate any bias against taxpayers choosing to export through

independent distributors. The regulations rely upon the revised

regulations under Sec. 1.863-3 for rules in applying the IFP method.

iii. Books and Records Method

The proposed regulations retain the books and records method of the

existing regulations, permitting taxpayers to request permission from

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

source of their income. The proposed regulations refer to revised

Sec. 1.863-3(b)(3) in applying the method to Possession Production

Sales.

b. Property Purchased and Sold

i. The Business Activity Method

Paragraph (f)(3)(i)(A) makes the business activity method the

general rule to apportion income from Possession Purchase Sales between

the United States and a possession. The taxpayer may, however, elect to

apply, with consent of the District Director, the books and records

method.

The proposed regulations retain the structure of the existing

regulations by apportioning the taxpayer's income from Possession

Purchase Sales on the basis of a business activity fraction. The

portion of this income that is possession source income is determined

by multiplying the income by a fraction, the numerator being the

business of the taxpayer in the possession, and the denominator being

the business of the taxpayer within the possession and outside the

possession. The remaining income is sourced in the United States.

The business activity fraction is similar to that discussed

previously, used to apportion the taxpayer's income in Possession

Production Sales, except that the fraction applies only to expenses,

cost of goods sold, and sales attributable to Possession Purchase

Sales. In addition, the business activity

[[Page 52956]]

fraction apportioning Possession Purchase Sales includes amounts paid

for cost of goods sold. Such costs are attributed to the possession,

however, only to the extent the property purchased is manufactured,

produced, grown, or extracted in the possession. Treasury and the

Internal Revenue Service anticipate that if a taxpayer acts in the

reasonable belief that the products were manufactured in the

possession, the taxpayer could act on that basis in preparing its tax

return. As modified, the business activity fraction reflects the view

of Treasury and the Internal Revenue Service that section 863(b)(3)'s

purchase rule was intended to apply only to purchase and resale

transactions, where the goods purchased are created or derived from the

possession.

ii. Books and Records Method

The proposed regulations retain the books and records method of the

existing regulations, permitting taxpayers to request permission from

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

source of their income. The proposed regulations refer to revised

Sec. 1.863-3(b)(3) in applying the method to Possession Purchase Sales.

2. Determination of Source of Gross Income

Unlike the current regulations which provide specific rules for

determining the source of income attributable to production activity

and business activity only for purposes of the 50/50 method, the

proposed regulations adopt rules applicable to each of the methods.

Under the proposed regulations, once gross income attributable to

production activity, business activity, or sales activity has been

determined under one of the prescribed methods, the source of the gross

income is determined separately for each type of income. The source of

gross income attributable to production activity (when applying the

possession 50/50 method) is determined under paragraph (c)(1), based on

the location of production assets. The source of gross income

attributable to sales activity (when applying the IFP method or the

books and records method) is determined under paragraph (c)(2), based

generally on the location of the sale. The source of gross income

attributable to business sales activity (when applying the possession

50/50 method) is determined under paragraph (f)(2)(ii)(B), based on

expenses, and gross sales attributable to Possession Production Sales.

The source of gross income attributable to business activity (when

applying the business activity method) is determined under paragraph

(f)(3)(ii), based on expenses, cost of goods sold, and gross sales

attributable to Possession Purchase Sales.

3. Determination of Source of Taxable Income

Once the source of gross income is determined under paragraph

(f)(2) or (3), taxpayers then determine the source of taxable income.

Under proposed paragraph (f)(4), taxpayers must allocate or apportion

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

and other deductions to gross income determined under each of the

prescribed methods. In the case of amounts of expenses, losses and

other deductions allocated or apportioned to gross income determined

under the IFP method or the books and records method, the taxpayer must

apply the rules of Secs. 1.861-8 through 1.861-14T to allocate or

apportion these amounts between gross income from sources within the

United States and within a possession. For expenses, losses and other

deductions allocated or apportioned to gross income determined under

the possessions 50/50 method, taxpayers must apportion expenses and

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

possession source gross income. The research and experimental (R&E)

expense allocation rules in Sec. 1.861-17 apply to taxpayers using the

50/50 method, so that the R&E set aside (described in Sec. 1.861-17)

remains available to such taxpayers.

4. Treatment of Gross Income Derived From Certain Purchases From a

Corporation That Has an Election in Effect Under Section 936

The proposed regulations clarify that section 863 does not apply to

determine the source of a taxpayer's gross income derived from a

purchase of inventory from a corporation that has an election in effect

under section 936, if the taxpayer's income from sales of that

inventory is taken into account to determine benefits under section

936(h)(5)(C) for the section 936 corporation.

5. Treatment of Partners and Partnerships

The proposed regulations rely on the rules in Sec. 1.863-3(g) for

determining the appropriate treatment in transactions involving

partnerships. Under those rules, the aggregate approach applies to a

partnership's production and sales activity for two purposes only.

First, the aggregate approach applies in determining the character of a

partner's distributive share of partnership income. Second, the

aggregate approach applies in sourcing income from sales of inventory

property that is transferred in-kind from or to a partnership.

6. Election and Reporting Rules

Under paragraph (f)(6)(i) of the proposed regulations, a taxpayer

must use the 50/50 method to determine the source of income from

Possession Production Sales unless the taxpayer elects to use the IFP

method, or elects the books and records method. For Possession Purchase

Sales, a taxpayer must use the business activity method, unless the

taxpayer elects the books and records method. The taxpayer makes an

election by using the method on its timely filed original tax return.

That method must be used in later taxable years unless the Commissioner

or his delegate consents to a change. Permission to change methods in

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

substantial distortion of the source of income.

A taxpayer must fully explain the methodology used in applying

either paragraph (f)(2) or (3), and the amount of income allocated or

apportioned to U.S. and foreign sources, in a statement attached to its

tax return.

II. Income Derived From Certain Purchases From a Corporation That Has

an Election in Effect Under Section 936

These proposed regulations clarify that where a taxpayer purchases

a product from a corporation that has an election in effect under

section 936, the source of the taxpayer's gross income derived from

sales of that product (in whatever form sold) in the United States is

U.S. source, if the taxpayer's income from sales of that product is

taken into account to determine benefits under section 936(h)(5)(C)(i)

for the section 936 corporation. The taxpayer's income is U.S. source

without regard to whether a possession product is a component, end-

product form, or integrated product. No inference should be drawn from

the proposed effective date concerning the treatment of transactions

involving sales of property purchased from a section 936 corporation

entered into before the regulations are applicable.

Proposed Effective Dates

These regulations are proposed to be effective for taxable years

beginning on or after the date that is 30 days after the date of

publication of final regulations.

Special Analyses

It has been determined that this notice of proposed rulemaking is

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

a regulatory assessment is not required. It is hereby

[[Page 52957]]

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,

this notice of proposed rulemaking will be submitted to the Chief

Counsel for Advocacy of the Small Business Administration for comment

on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any comments that are submitted timely

(in the manner described under the ADDRESSES caption) to the IRS. All

comments will be available for public inspection and copying.

A public hearing has been scheduled for January 29, 1998, at 10

a.m., in room 2615, Internal Revenue Building, 1111 Constitution

Avenue, NW., Washington, DC. Because of access restrictions, visitors

will not be admitted beyond the Internal Revenue Building lobby more

than 15 minutes before the hearing starts.

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

Persons that wish to present oral comments at the hearing must

submit comments and an outline of topics to be discussed and the time

to be devoted to each topic (in the manner described under the

ADDRESSES caption of this preamble) by January 8, 1998.

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

comments.

An agenda showing the scheduling of the speakers will be prepared

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

agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these regulations is Anne Shelburne, Office

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

from the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

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

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by

revising the entry for ``Section 1.863-3'', removing the entry for

``Sections 1.936-4 through 1.936-7'', and adding entries in numerical

order to read as follows:

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

Section 1.863-3 also issued under 26 U.S.C. 863(a) and (b), and

26 U.S.C. 936(h).* * *

Section 1.936-4 also issued under 26 U.S.C. 936(h).

Section 1.936-5 also issued under 26 U.S.C. 936(h).

Section 1.936-6 also issued under 26 U.S.C. 863(a) and (b), and

26 U.S.C. 936(h).

Section 1.936-7 also issued under 26 U.S.C. 936(h).* * *

Par. 2. Section 1.863-3 is amended as follows:

1. Paragraph (f) is revised.

2. Paragraph (h) is amended by adding a sentence at the end of the

paragraph.

The revision and addition read as follows:

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

of inventory.

* * * * *

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

States--(1) In general. This paragraph (f) relates to gains, profits,

and income, which are treated as derived partly from sources within the

United States and partly from sources within a possession of the United

States (Section 863 Possession Sales). This paragraph (f) applies to

determine the source of income derived from the sale of inventory

produced (in whole or in part) by the taxpayer within the United States

and sold within a possession, or produced (in whole or in part) by a

taxpayer in a possession and sold within the United States (Possession

Production Sales). It also applies to determine the source of income

derived from the purchase of personal property within a possession of

the United States and its sale within the United States (Possession

Purchase Sales). A taxpayer subject to this paragraph (f) must divide

gross income from Section 863 Possession Sales using one of the methods

described in either paragraph (f)(2)(i) of this section (in the case of

Possession Production Sales) or paragraph (f)(3)(i) of this section (in

the case of Possession Purchase Sales). Once a taxpayer has elected a

method, the taxpayer must separately apply that method to the

applicable category of Section 863 Possession Sales in the United

States and to those in a possession. The source of gross income from

each type of activity must then be determined under either paragraph

(f)(2)(ii) or (3)(ii) of this section, as appropriate. The source of

taxable income from Section 863 Possession Sales is determined under

paragraph (f)(4) of this section. The taxpayer must apply the rules for

computing gross and taxable income by aggregating all Section 863

Possession Sales to which a method in this section applies after

separately applying that method to Section 863 Possession Sales in the

United States and to Section 863 Possession Sales in a possession. This

section does not apply to determine the source of a taxpayer's gross

income derived from a sale of inventory purchased from a corporation

that has an election in effect under section 936, if the taxpayer's

income from sales of that inventory is taken into account to determine

benefits under section 936 for the section 936 corporation. For rules

to be applied to determine the source of such income, see Sec. 1.936-

6(a)(5) Q&A 7a and (b)(1) Q&A 13.

(2) Allocation or apportionment for Possession Production Sales--

(i) Methods for determining the source of gross income for Possession

Production Sales--(A) Possession 50/50 method. Under the possession 50/

50 method, gross income from Possession Production Sales is allocated

between production activity and business sales activity as described in

this paragraph (f)(2)(i)(A). Under the possession 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 (f)(2)(ii)(A) of this

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

income attributable to business sales activity and the source of that

income will be determined under the rules of paragraph (f)(2)(ii)(B) of

this section.

(B) IFP method. In lieu of the possession 50/50 method, a taxpayer

may elect the independent factory price (IFP) method. Under the IFP

method, gross income from Possession Production Sales is allocated to

production activity or sales activity using the IFP method, as

described in paragraph (b)(2) of this section, if an IFP is fairly

established under the rules of paragraph (b)(2) of this section. See

paragraphs (f)(2)(ii) (A) and (C) of this section for rules for

determining the source of gross income attributable to production

activity and sales activity.

[[Page 52958]]

(C) Books and Records method. A taxpayer may elect to allocate

gross income using the books and records method described in paragraph

(b)(3) of this section, if it has received in advance the permission of

the District Director having audit responsibility over its return. See

paragraph (f)(2)(ii) of this section for rules for determining the

source of gross income.

(ii) Determination of source of gross income from production,

business sales, and sales activity--(A) Gross income attributable to

production activity. The source of gross income from production

activity is determined under the rules of paragraph (c)(1) of this

section, except that the term possession is substituted for foreign

country wherever it appears.

(B) Gross income attributable to business sales activity--(1)

Source of gross income. Gross income from the taxpayer's business sales

activity is sourced in the possession in the same proportion that the

amount of the taxpayer's business sales activity for the taxable year

within the possession bears to the amount of the taxpayer's business

sales activity for the taxable year both within the possession and

outside the possession, with respect to Possession Production Sales.

The remaining income is sourced in the United States.

(2) Business sales activity. For purposes of this paragraph

(f)(2)(ii)(B), the taxpayer's business sales activity is equal to the

sum of--

(i) The amounts for the taxable period paid for wages, salaries,

and other compensation of employees, and other expenses attributable to

Possession Production Sales (other than amounts that are nondeductible

under section 263A, interest, and research and development); and

(ii) Possession Production Sales for the taxable period.

(3) Location of business sales activity. For purposes of

determining the location of the taxpayer's business activity within a

possession, the following rules apply:

(i) Sales. Receipts from gross sales will be attributed to a

possession under the provisions of paragraph (c)(2) of this section.

(ii) Expenses. Expenses will be attributed to a possession under

the rules of Secs. 1.861-8 through 1.861-14T.

(C) Gross income attributable to sales activity. The source of the

taxpayer's income that is attributable to sales activity, as determined

under the IFP method or the books and records method, will be

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

(3) Allocation or apportionment for Possession Purchase Sales--(i)

Methods for determining the source of gross income for Possession

Purchase Sales--(A) Business activity method. Gross income from

Possession Purchase Sales is allocated in its entirety to the

taxpayer's business activity, and is then apportioned between U.S. and

possession sources under paragraph (f)(3)(ii) of this section.

(B) Books and records method. A taxpayer may elect to allocate

gross income using the books and records method described in paragraph

(b)(3) of this section, subject to the conditions set forth in

paragraph (b)(3) of this section. See paragraph (f)(2)(ii) of this

section for rules for determining the source of gross income.

(ii) Determination of source of gross income from business

activity--(A) Source of gross income. Gross income from the taxpayer's

business activity is sourced in the possession in the same proportion

that the amount of the taxpayer's business activity for the taxable

year within the possession bears to the amount of the taxpayer's

business activity for the taxable year both within the possession and

outside the possession, with respect to Possession Purchase Sales. The

remaining income is sourced in the United States.

(B) Business activity. For purposes of this paragraph (f)(3)(ii),

the taxpayer's business activity is equal to the sum of--

(1) The amounts for the taxable period paid for wages, salaries,

and other compensation of employees, and other expenses attributable to

Possession Purchase Sales (other than amounts that are nondeductible

under section 263A, interest, and research and development);

(2) Cost of goods sold attributable to Possession Purchase Sales

during the taxable period; and

(3) Possession Purchase Sales for the taxable period.

(C) Location of business activity. For purposes of determining the

location of the taxpayer's business activity within a possession, the

following rules apply:

(1) Sales. Receipts from gross sales will be attributed to a

possession under the provisions of paragraph (c)(2) of this section.

(2) Cost of goods sold. Payments for cost of goods sold will be

properly attributable to gross receipts from sources within the

possession only to the extent that the property purchased was

manufactured, produced, grown, or extracted in the possession (within

the meaning of section 954(d)(1)(A)).

(3) Expenses. Expenses will be attributed to a possession under the

rules of Secs. 1.861-8 through 1.861-14T.

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

paragraph (f)(3)(ii) relating to the determination of source of gross

income from business activity:

Example 1. (i) U.S. Co. purchases in a possession product X for

$80 from A. A manufactures X in the possession. Without further

production, U.S. Co. sells X in the United States for $100. Assume

U.S. Co. has sales and administrative expenses in the possession of

$10.

(ii) To determine the source of U.S. Co.'s gross income, the

$100 gross income from sales of X is allocated entirely to U.S.

Co.'s business activity. Forty-seven dollars of U.S. Co.'s gross

income is sourced in the possession. [Possession expenses ($10) plus

possession purchases ($80) plus possessions sales ($0), divided by

total expenses ($10) plus total purchases ($80) plus total sales

($100).] The remaining $53 is sourced in the United States.

Example 2. (i) Assume the same facts as in Example 1, except

that A manufactures X outside the possession.

(ii) To determine the source of U.S. Co.'s gross income, the

$100 gross income is allocated entirely to U.S. Co.'s business

activity. Five dollars of U.S. Co.'s gross income is sourced in the

possession. [Possession expenses ($10) plus possession purchases

($0) plus possession sales ($0), divided by total expenses ($10)

plus total purchases ($80) plus total sales ($100).] The $80

purchase is not included in the numerator used to determine U.S.

Co.'s business activity in the possession, since product X was not

manufactured in the possession. The remaining $95 is sourced in the

United States.

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

gross income has been determined under paragraph (f)(2) or (3) 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 Possession Sales determined separately under each

method described in paragraph (f)(2) or (3) 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 Possession

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 Possession Sales determined under

the IFP method or books and records method, a taxpayer must apply the

rules of Secs. 1.861-8 through 1.861-14T to properly allocate or

apportion amounts of expenses,

[[Page 52959]]

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 Possession Production Sales

determined under the possessions 50/50 method or gross income from

Possession Purchase Sales computed under the business activity 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 those methods.

(5) Special rules for partnerships. In applying the rules of this

paragraph (f) to transactions involving partners and partnerships, the

rules of paragraph (g) of this section apply.

(6) Election and reporting rules--(i) Elections under paragraph

(f)(2) or (3) of this section. If a taxpayer does not elect one of the

methods specified in paragraph (f)(2) or (3) of this section, the

taxpayer must apply the possession 50/50 method in the case of

Possession Production Sales or the business activity method in the case

of Possession Purchase Sales. The taxpayer may elect to apply a method

specified in either paragraph (f)(2) or (3) of this section by using

the method on a timely filed original return (including extensions).

Once a method has been used, that method must be used in later taxable

years unless the Commissioner consents to a change. Permission to

change methods from one year to another year will be granted unless the

change would result in a substantial distortion of the source of the

taxpayer's income.

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

methods described in paragraph (f)(2) or (3) of this section must fully

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

the circumstances justifying use of that methodology, the extent that

sales are aggregated, and the amount of income so allocated.

* * * * *

(h) Effective dates. * * * However, the rules of paragraph (f) of

this section apply to taxable years beginning on or after the date that

is 30 days after the date of publication of final regulations.

Par. 3. In Sec. 1.936-6, paragraph (a)(5) Q&A 7a is added to read

as follows:

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

Cost sharing and profit split options; covered intangibles.

* * * * *

(a) * * *

(5) * * *

Q.7a: What is the source of the taxpayer's gross income derived

from a sale in the United States of a possession product purchased by

the taxpayer (or an affiliate) from a corporation that has an election

in effect under section 936, if the income from such sale is taken into

account to determine benefits under cost sharing for the section 936

corporation? Is the result different if the taxpayer (or an affiliate)

derives gross income from a sale in the United States of an integrated

product incorporating a possession product purchased by the taxpayer

(or an affiliate) from the section 936 corporation, if the taxpayer (or

an affiliate) processes the possession product or an excluded component

in the United States?

A.7a: Under either scenario, the income is U.S. source, without

regard to whether the possession product is a component, end-product,

or integrated product. Section 863 does not apply in determining the

source of the taxpayer's income. This Q&A 7a is applicable for taxable

years beginning on or after the date that is 30 days after the date of

publication of final regulations.

* * * * *

Michael P. Dolan,

Acting Commissioner of Internal Revenue.

[FR Doc. 97-26857 Filed 10-9-97; 8:45 am]

BILLING CODE 4830-01-P