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 Parts 1 and 602

[TD 8786]

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: Final regulations.

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SUMMARY: This document contains final 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;

final 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; and final 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 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, and

also persons who sell in the United States property purchased from a

corporation that has a section 936 election in effect.

DATES: Effective Date: These regulations are effective November 13,

1998.

Applicability Date: These regulations apply to taxable years

beginning on or after November 13, 1998.

FOR FURTHER INFORMATION CONTACT: Anne Shelburne, (202) 874-1305 (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 of

1995 (44 U.S.C. 3507(d)) under control number 1545-1556. 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

2.5 hours.

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, OP:FS:FP,

Washington, DC 20224, and the Office of Management and Budget, Attn:

Desk Officer for the Department of Treasury, Office of Information and

Regulatory Affairs, Washington, DC 20503.

Books or records relating to a collection of information must be

[[Page 55021]]

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 under section 863 of the

Internal Revenue Code (Code), providing rules to source income from

cross-border sales of certain property, where the property is

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

United States, or vice versa, or purchased in a possession and sold in

the United States. These regulations also contain rules under section

936 to source 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.

On October 10, 1997, proposed regulations (REG-251985-96) were

published in the Federal Register (62 FR 52953). Having considered the

comments, the IRS and the Treasury Department adopt the proposed

regulations without significant change in this Treasury decision.

Explanation of Provisions

I. Income Partly From Sources Within a Possession

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 in these regulations to determine the source of possession

income under section 863 concerns 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).

1. Methods for Allocating or Apportioning Gross Income From Section 863

Possession Sales

a. Property produced and sold. Under the final regulations, income

from sales of inventory produced in the United States and sold in a

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

the United States (collectively, Possession Production Sales), is

allocated or apportioned according to one of three methods.

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

the general rule to allocate gross income from Possession Production

Sales between production activity 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

independent factory price (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 final 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.

The final 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 or to other foreign sources based on the location of

the taxpayer's production assets. 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. Production assets are included in the fraction at

their adjusted tax basis, consistent with the changes made to the

regulations under Sec. 1.863-3(c).

The other half of the taxpayer's gross income, allocated to

business sales activity, 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 IRS 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.

Under the final regulations, as opposed to the current regulations,

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. Also, cost

of goods sold is now 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.

The final regulations provide explicit guidance for attributing

business sales activity between the United States and a possession. In

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.

The final regulations make the IFP method elective, and thus

eliminate any bias against taxpayers choosing to export through

independent distributors. The regulations rely upon the regulations

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

The final regulations permit taxpayers to request permission from

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

source of their income. The final regulations refer to Sec. 1.863-

3(b)(3) in applying the method to Possession Production Sales.

b. Property purchased and sold. Paragraph (f)(3)(i)(A) makes the

business activity method the general rule to apportion income between

the United States and a possession, from sales of property purchased in

a possession and sold in the United States (Possession Purchase Sales).

The taxpayer may, however, elect to apply, with consent of the District

Director, the books and records method.

The final regulations apportion 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.

[[Page 55022]]

The remaining income is sourced in the United States.

The business activity fraction is similar to the business sales

activity fraction 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 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. The business activity fraction reflects the view of Treasury

and the IRS that the purchase rule of section 863(b)(3) was intended to

apply only to purchase and resale transactions where the goods

purchased are created or derived from the possession.

The final regulations permit 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 Sec. 1.863-

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

2. Determination of Source of Gross Income

Under the final 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 paragraph (f)(4), taxpayers must allocate and 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 and 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 and

apportion these amounts between gross income from sources within the

United States and within a possession. However, for expenses, losses

and other deductions allocated and apportioned to gross income

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

Possession Purchase Sales determined under the business activity

method, taxpayers must apportion expenses and other deductions pro rata

based on the relative amounts of U.S. and possession source gross

income. Nevertheless, 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 final 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 final 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 final 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 be granted 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 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

concerning the treatment of transactions involving sales of property

purchased from a section 936 corporation entered into before the

regulations are applicable.

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

[[Page 55023]]

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 Chief Counsel for Advocacy of 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.

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

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 1.936-6(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.

(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.

[[Page 55024]]

(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) of this section 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 (i.e., cost of goods sold) ($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. 1.861-17, 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. 1.861-17. Thus, 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, losses and other deductions, allocated and

apportioned to such gross income, between gross income from sources

within and without the United States. However, 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, except that the rules regarding the allocation and

apportionment of research and experimental expenditures in Sec. 1.861-

17 shall apply to such expenditures of taxpayers using the 50/50

method.

(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

[[Page 55025]]

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 November 13,

1998.

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 November 13, 1998.

* * * * *

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

Par. 4. The authority citation for part 602 continues to read as

follows:

Authority: 26 U.S.C. 7805.

Par. 5. In Sec. 602.101, paragraph (c) is amended in the table by

revising the entry for 1.863-3 to read as follows:

Sec. 602.101 OMB Control numbers.

* * * * *

(c) * * *

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

Current OMB

identified

CFR part or section where and

described

control No.

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

* * * * *

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

1545-1556

* * * * *

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

Michael P. Dolan,

Deputy Commissioner of Internal Revenue.

Approved: September 18, 1998.

Donald C. Lubick,

Assistant Secretary of the Treasury for Tax Policy.

[FR Doc. 98-27395 Filed 10-13-98; 8:45 am]

BILLING CODE 4830-01-U