Source and Grouping Rules for Foreign Sales Corporation Transfer Pricing

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8764]

RIN 1545-AV91

Source and Grouping Rules for Foreign Sales Corporation Transfer

Pricing

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

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SUMMARY: This document contains temporary regulations that provide

guidance to taxpayers who have made an election to be treated as a

foreign sales corporation (FSC). The regulations provide rules that

clarify the special sourcing rules under section 927(e)(1) and provide

a deadline for the election to group transactions. The text of the

temporary regulations also serves as the text of the proposed

regulations on this subject in the Proposed Rules section of this issue

of the Federal Register.

DATES: Effective date: These regulations are effective March 3, 1998.

Applicability: For dates of applicability, see Secs. 1.925(a)-

1T(c)(8)(i) and 1.927(e)-1T(c).

FOR FURTHER INFORMATION CONTACT: Elizabeth Beck (202) 622-3880 (not a

toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains amendments to the Income Tax Regulations (26

CFR part 1) under sections 925 and 927 which were added by the Deficit

Reduction Act of 1984, applicable for taxable years of foreign sales

corporations beginning after December 31, 1984. Temporary regulations

were published in the Federal Register (52 FR 6468) as a Treasury

Decision (TD 8126) on March 3, 1987. Treasury and IRS believe that

immediate guidance in the form of these temporary regulations is

necessary for the reasons stated below.

Explanation of Provisions

These regulations set a deadline for an election to group

transactions for purposes of the foreign sales corporation (FSC)

administrative pricing methods and clarify that the foreign source

limit for a FSC's related supplier extends to all transactions giving

rise to foreign trading gross receipts.

I. Grouping Election Deadline

A. Current Temporary Regulations

Current Sec. 1.925(a)-1T(c)(8) and Sec. 1.925(b)-1T(b)(3) permit

taxpayers annually to group transactions in applying the administrative

pricing (including the marginal costing) rules to determine FSC

benefits. Current Sec. 1.925(a)-1T(c)(8)(i) requires an election to

group to be evidenced on the FSC income tax return for the taxable

year. Current Sec. 1.925(a)-1T(e)(4) authorizes taxpayers to file

amended returns subsequently (within the statute of limitations period)

to redetermine FSC benefits based on a different grouping of

transactions than that originally elected. Pursuant to this provision,

taxpayers may change their grouping basis, or change from a grouping to

a transaction-by-transaction basis. The IRS and the Treasury have

become increasingly aware of taxpayers who, through the use of

sophisticated computer programs, substantially revise their transaction

groupings just prior to the expiration of the statute of limitations

and many years after the original returns were filed. These revised

groupings typically employ complex estimating techniques. The recent

rise in this practice is placing a significant burden on the auditing

process and is creating a potential for abuse.

B. Revised Temporary Regulations

Under Sec. 1.925(a)-1T(c)(8)(i), the election to group must be made

on Schedule P of the FSC's timely filed U.S. income tax return

(including extensions thereof) for the taxable year. No untimely or

amended returns will be allowed to elect to group, to change a grouping

basis, or to change from a grouping basis to a transaction-by-

transaction basis for such year.

Conforming changes and cross-references are reflected in

Sec. 1.925(a)-1T(e)(4) and Sec. 1.925(b)-1T(b)(3).

The regulations apply to taxable years beginning after December 31,

1997. There is also a transition rule providing that the regulations

also apply to taxable years beginning before January 1, 1998. For these

taxable years, the transition rule allows taxpayers to redetermine

their grouping of transactions with respect to such years provided such

redetermination is made no later than the due date of the FSC's timely

filed U.S. income tax return (including extensions thereof) for its

first taxable year beginning after December 31, 1997.

II. Scope of Related Supplier Foreign Source Limit

A. Current Temporary Regulations and TRA 97

Section 927(e)(1) provides that ``[u]nder regulations, the income

of a person described in section 482 from a transaction giving rise to

foreign trading gross receipts of a FSC which is treated as from

sources outside the United States shall not exceed the amount which

would be treated as foreign source income earned by such person if the

pricing rule under section 994 which corresponds to the rule used under

section 925 with respect to such transaction applied to such

transaction.'' Transactions giving rise to foreign trading gross

receipts include qualifying sales, leases, licenses and services.

Current Sec. 1.927(e)-1T restates the section 927(e)(1) rule as

applicable on ``the sale of export property.'' While the statute is not

limited to export sale transactions in that it applies to any

transaction giving rise to foreign trading gross receipts of a FSC, the

current regulation might be interpreted to apply the special foreign

sourcing limit only to sales of export property.

Section 1171 of the Taxpayer Relief Act of 1997 (TRA 97) amended

section 927(a)(2)(B) (without any inference intended regarding prior

law) to provide that computer software licensed for reproduction abroad

is included within

[[Page 10306]]

the definition of export property for purposes of the FSC provisions.

The amendment applies to gross receipts from computer software licenses

attributable to periods after December 31, 1997, in tax years ending

after such date.

In light of TRA 97, it is important to clarify the scope of the

related supplier's foreign source limit under the regulations. This

clarification needs to be implemented immediately in order to provide

clear guidance to taxpayers, including those utilizing the TRA 97

amendment to section 927(a)(2)(B).

B. Revised Temporary Regulations

Under Sec. 1.927(e)-1T(a)(1), the related supplier's foreign source

limit applies to any transaction, including but not limited to any

sale, lease, license or service, giving rise to foreign trading gross

receipts of a FSC. No inference is intended regarding the scope of

application of the prior regulation.

Conforming changes are reflected in Sec. 1.927(e)-1T(a)(2) and (3).

Special rules are added in Sec. 1.927(e)-1T(a)(3)(ii) to clarify how

the corresponding DISC transfer pricing rules are to be applied for

purposes of the foreign source limit. Three examples set forth in

Sec. 1.927(e)-1T(b) illustrate how the limit is applied under different

transfer pricing methods and for different types of transactions.

The regulations apply to taxable years beginning after December 31,

1997.

Special Analyses

It has been determined that this Treasury Decision is not a

significant regulatory action as defined in Executive Order 12866.

Therefore, a regulatory assessment is not required. It has also been

determined that section 553(b) of the Administrative Procedure Act (5

U.S.C. chapter 5) does not apply to these regulations, and because the

regulation does not impose a collection of information on small

entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not

apply. Pursuant to section 7805(f) of the Internal Revenue Code, these

temporary regulations will be submitted to the Chief Counsel for

Advocacy of the Small Business Administration for comment on their

impact on small business.

Drafting Information: The principal author of these regulations is

Elizabeth Beck of the Office of the Associate Chief Counsel

(International). Other personnel from the IRS and Treasury Department

also participated in the development of these regulations.

List of Subjects 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirement.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

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

revising the entries for sections 1.925(a)-1T and 1.925(b)-1T to read

as follows:

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

Section 1.925(a)-1T is also issued under 26 U.S.C. 925(b)(1) and

(2) and 927(d)(2)(B).

Section 1.925(b)-1T is also issued under 26 U.S.C. 925(b)(1) and

(2) and 927(d)(2)(B) * * *

Par. 2. Section 1.925(a)-1T is amended by:

1. Removing the last sentence of paragraph (c)(8)(i) and adding

five sentences in its place.

2. Paragraph (e)(4) is amended by:

a. Removing the language ``or grouping of transactions'' from the

fourth sentence.

b. Adding a sentence to the end of the paragraph.

The additions read as follows:

Sec. 1.925(a)-1T Temporary Regulations; Transfer pricing rules for

FSCs.

* * * * *

(c) * * *

(8) * * *

(i) * * * The election to group transactions shall be evidenced on

Schedule P of the FSC's timely filed U.S. income tax return (including

extensions thereof) for the taxable year. No untimely or amended

returns will be allowed to elect to group, to change a grouping basis,

or to change from a grouping basis to a transaction-by-transaction

basis. The rules of the previous two sentences of this paragraph

(c)(8)(i) are applicable to taxable years beginning after December 31,

1997. For any taxable year beginning before January 1, 1998, for which

a redetermination is otherwise permissible under paragraph (e)(4) of

this section as in effect for taxable years beginning before January 1,

1998, a redetermination of grouping of transactions cannot be made

later than the due date of the FSC's timely filed U.S. income tax

return (including extensions thereof) for the FSC's first taxable year

beginning after December 31, 1997. The language ``or grouping of

transactions'' is removed from the fourth sentence of paragraph (e)(4)

of this section, applicable to taxable years beginning after December

31, 1997.

* * * * *

(e) * * *

(4) * * * For the election to group transactions for purposes of

applying the administrative pricing methods, see paragraph (c)(8)(i) of

this section.

* * * * *

Par. 3. In Sec. 1.925(b)-1T, paragraph (b)(3)(i) is amended by

adding at the end of the paragraph the following sentence:

Sec. 1.925(b)-1T Temporary regulations; marginal costing rules.

* * * * *

(b) * * *

(3) * * * (i) * * * For the election to group transactions for

purposes of applying the administrative pricing methods, see

Sec. 1.925(a)-1T(c)(8)(i).

* * * * *

Par. 4. Section 1.927(e)-1T is revised to read as follows:

Sec. 1.927(e)-1T Temporary regulations; special sourcing rule.

(a) Source rules for related persons--(1) In general. The income of

a person described in section 482 from a transaction giving rise to

foreign trading gross receipts of a FSC which is treated as from

sources outside the United States shall not exceed the amount which

would be treated as foreign source income earned by such person if the

pricing rule under section 994 which corresponds to the rule used under

section 925 with respect to such transaction applied to such

transaction. This section applies to any transaction, including but not

limited to any sale, lease, license or service, giving rise to foreign

trading gross receipts of a FSC. This special sourcing rule also

applies if the FSC is acting as a commission agent for the related

supplier with respect to the transaction described above which gives

rise to foreign trading gross receipts and the transfer pricing rules

of section 925 are used to determine the commission payable to the FSC.

No limitation results under this section with respect to a transaction

to which the section 482 pricing rule under section 925(a)(3) applies.

(2) Grouping of transactions. If, for purposes of determining the

FSC's profits under the administrative pricing rules of sections

925(a)(1) and (2), grouping of transactions under Sec. 1.925(a)-

1T(c)(8) was elected, the same grouping shall be used for making the

determinations under this special sourcing rule.

(3) Corresponding DISC pricing rules--(i) In general. For purposes

of this section----

[[Page 10307]]

(A) The DISC gross receipts pricing rule of section 994(a)(1)

corresponds to the gross receipts pricing rule of section 925(a)(1);

(B) The DISC combined taxable income pricing rule of section

994(a)(2) corresponds to the combined taxable income pricing rule of

section 925(a)(2); and

(C) The DISC section 482 pricing rule of section 994(a)(3)

corresponds to the section 482 pricing rule of section 925(a)(3).

(ii) Special rules. For purposes of this section--

(A) The DISC pricing rules of section 994(a)(1) and (2) shall be

determined without regard to export promotion expenses;

(B) Qualified export receipts under section 994(a)(1) and (2) shall

be deemed to be an amount equal to the foreign trading gross receipts

arising from the transaction; and

(C) Combined taxable income for purposes of section 994(a)(2) shall

be deemed to be an amount equal to the combined taxable income for

purposes of section 925(a)(2) arising from the transaction.

(b) Examples. The provisions of this section may be illustrated by

the following examples:

Example 1. (i) R and F are calendar year taxpayers. R, a

domestic manufacturing company, owns all the stock of F, which is a

FSC acting as a commission agent for R. For the taxable year, R and

F used the combined taxable income pricing rule of section

925(a)(2). For the taxable year, the combined taxable income of R

and F is $100 from the sale of export property, as defined in

section 927(a), manufactured by R using production assets located in

the United States. Title to the export property passed outside of

the United States.

(ii) Under section 925(a)(2), 23 percent of the $100 combined

taxable income of R and F, that is $23, is allocated to F and the

remaining $77 is allocated to R. Absent the special sourcing rule,

under section 863(b) the $77 income allocated to R would be sourced

$38.50 U.S. source and $38.50 foreign source. Under the special

sourcing rule, the amount of foreign source income earned by a

related supplier of a FSC shall not exceed the amount that would

result if the corresponding DISC pricing rule applied. The DISC

combined taxable income pricing rule of section 994(a)(2)

corresponds to the combined taxable income pricing rule of section

925(a)(2). Under section 994(a)(2), $50 of the combined taxable

income ($100 x .50) would be allocated to the DISC and the

remaining $50 would be allocated to the related supplier. Under

section 863(b), the $50 income allocated to the DISC's related

supplier would be sourced $25 U.S. source and $25 foreign source.

Accordingly, under the special sourcing rule, the foreign source

income of R shall not exceed $25.

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

the combined taxable income arises from the licensing of the

copyright rights in computer software for use outside of the United

States and that R developed the computer software in the United

States.

(ii) Under section 925(a)(2), 23 percent of the $100 combined

taxable income of R and F, that is $23, is allocated to F and the

remaining $77 is allocated to R. Absent the special sourcing rule,

under section 862(a)(4) the $77 income allocated to R would be

sourced $77 foreign source in its entirety. Under the special

sourcing rule, the amount of foreign source income earned by a

related supplier of a FSC shall not exceed the amount that would

result if the corresponding DISC pricing rule applied. The DISC

combined taxable income pricing rule of section 994(a)(2)

corresponds to the combined taxable income pricing rule of section

925(a)(2). Under section 994(a)(2), $50 of the combined taxable

income ($100 x .50) would be allocated to the DISC and the remaining

$50 would be allocated to the related supplier. Under section

862(a)(4), the $50 income allocated to the DISC's related supplier

would be sourced $50 foreign source in its entirety. Accordingly,

under the special sourcing rule, the foreign source income of R

shall not exceed $50.

Example 3. (i) Assume the same facts as in Example 1 except that

R and F used the gross receipts pricing rule of section 925(a)(1).

In addition, for the taxable year foreign trading gross receipts

derived from the sale of the export property are $2,000.

(ii) Under section 925(a)(1), 1.83 percent of the $2,000 foreign

trading gross receipts, that is $36.60, is allocated to F and the

$63.40 remaining combined taxable income ($100--$36.60) is allocated

to R. Absent the special sourcing rule, under section 863(b) the

$63.40 income allocated to R would be sourced $31.70 U.S. source and

$31.70 foreign source. Under the special sourcing rule, the amount

of foreign source income earned by a related supplier of a FSC shall

not exceed the amount that would result if the corresponding DISC

pricing rule applied. The DISC gross receipts pricing rule of

section 994(a)(1) corresponds to the gross receipts pricing rule of

section 925(a)(1). Under section 994(a)(1), $80 ($2,000 x .04) would

be allocated to the DISC and the $20 remaining combined taxable

income would be allocated to the related supplier. Under section

863(b), the $20 income allocated to the DISC's related supplier

would be sourced $10 U.S. source and $10 foreign source.

Accordingly, under the special sourcing rule, the foreign source

income of R shall not exceed $10.

(c) Effective Date. The rules of this section are applicable to

taxable years beginning after December 31, 1997.

Michael P. Dolan,

Deputy Commissioner of Internal Revenue.

Approved: February 20, 1998.

Donald C. Lubick,

Acting Assistant Secretary of the Treasury.

[FR Doc. 98-5128 Filed 3-2-98; 8:45 am]

BILLING CODE 4830-01-U