Title 26—Internal Revenue--Volume 1
PART 1—INCOME TAXES
§ 1.861-19   Classification of cloud transactions.
(a) In general. This section provides rules for classifying cloud transactions (as defined in paragraph (b) of this section). The rules of this section apply for purposes of Internal Revenue Code sections 59A, 245A, 250, 267A, 367, 404A, 482, 679, and 1059A; subchapter N of chapter 1; chapters 3 and 4; and sections 842 and 845 (to the extent involving a foreign person), and apply with respect to transfers to foreign trusts not covered by section 679.
(b) Cloud transaction defined. A cloud transaction is a transaction through which a person obtains on-demand network access to computer hardware, digital content (as defined in § 1.861-18(a)(2)), or other similar resources. A cloud transaction does not include network access to download digital content for storage and use on a person's computer or other electronic device.
(c) Classification of cloud transactions —(1) In general. A cloud transaction is classified as the provision of services.
(2) Transaction with multiple elements. Taking into account the overall transaction and the surrounding facts and circumstances, a transaction that has multiple elements, one or more of which would be a cloud transaction if considered separately, is classified in its entirety as a cloud transaction if the predominant character of the transaction as determined under § 1.861-18(b)(3) is a cloud transaction.
(d) Examples. The examples in this paragraph (d) illustrate the provisions of this section. Unless otherwise specified, assume that Corp A is a domestic corporation, no rights described in § 1.861-18(c)(2) (copyright rights) are transferred as part of the transactions described, and all facts in each example occur as part of a single transaction.
(1) Example 1: Computing capacity —(i) Facts. Corp A operates data centers on its premises in various locations. Corp A provides Corp B computing capacity on Corp A's servers in exchange for a monthly fee based on the amount of computing power made available to Corp B. Corp B provides its own software to run on Corp A's servers.
(ii) Analysis. The provision of on-demand network computing capacity by Corp A to Corp B is a cloud transaction with one element. Therefore, the transaction is treated solely as a cloud transaction under paragraph (b) of this section and is classified as the provision of services under paragraph (c)(1) of this section.
(2) Example 2: Computing capacity on dedicated on-premises servers —(i) Facts. The facts are the same as in paragraph (d)(1)(i) of this section (the facts in Example 1 ), except that, in order to offer more security to Corp B, Corp A provides Corp B computing capacity exclusively through designated servers, which are owned and operated by Corp A and located at Corp B's facilities. Corp A agrees not to use the designated server for any other customer for the duration of its arrangement with Corp B. Although the server is located at Corp B's facilities, Corp B accesses the server through Corp A's network and the monthly fee is based on the amount of computing power made available to Corp B.
(ii) Analysis. As in paragraph (d)(1) of this section ( Example 1 ), the transaction between Corp A and Corp B is the provision of on-demand network computing capacity and is therefore a cloud transaction with one element. Therefore, the transaction is treated solely as a cloud transaction under paragraph (b) of this section and is classified as the provision of services under paragraph (c)(1) of this section. If the transaction between Corp A and Corp B involved only the provision of a server by Corp A for use by Corp B, and not on-demand network access to computing capacity, the transaction would not be a cloud transaction and this section would not apply.
(3) Example 3: Access to software development platform and website hosting —(i) Facts. Corp A provides Corp B a software platform that Corp B uses to develop and deploy websites with a range of features, including blogs, message boards, and other collaborative knowledge bases. The software development platform consists of an operating system, web server software, scripting languages, libraries, tools, and back-end relational database software and allows Corp B to use in its websites certain visual elements subject to copyrights held by Corp A. The software development platform is hosted on servers owned by Corp A and located at Corp A's facilities. Corp B's finished websites are also hosted on Corp A's servers. Corp B accesses the software development platform via a standard web browser. Corp B has no ability to alter the software code. A small amount of copyrighted scripting code is downloaded onto Corp B's computers to facilitate secure logins and access to the software development platform. All other functions of the software development platform execute on Corp A's servers, and no portion of the core software code is ever downloaded by Corp B or Corp B's customers. Corp A has ascertained that the primary benefit or value to Corp B from the transaction is the right to use the software development platform. Corp B pays Corp A a monthly fee for the platform and website hosting.
(ii) Analysis. (A) There is one transaction with multiple elements between Corp A and Corp B. One element is Corp A's provision to Corp B of on-demand network access to the software platform, which would be a cloud transaction described in paragraph (b) of this section if considered separately. Another element is Corp A's hosting of Corp B's finished websites, which would be a cloud transaction described in paragraph (b) of this section if considered separately. A third element is the grant by Corp A to Corp B of the right to use in Corp B's websites certain visual elements subject to copyrights held by Corp A, which would be a transfer of copyright rights under § 1.861-18(b)(1)(i) if considered separately. A fourth element is the download of scripting code by Corp B, which would be a transfer of a copyrighted article under § 1.861-18(b)(1)(ii) if considered separately.
(B) Because the transaction has multiple elements, one or more of which would be a cloud transaction if considered separately, paragraph (c)(2) of this section provides that the transaction is classified as a cloud transaction if its predominant character is a cloud transaction. Pursuant to § 1.861-18(b)(3), the predominant character of the transaction is based on the primary benefit or value of the transaction to the customer, if it is reasonably ascertainable. The predominant character of this transaction is therefore a cloud transaction because the primary benefit or value received by Corp B is the right to use the software development platform. Accordingly, this transaction is classified solely as a cloud transaction described in paragraph (b) of this section and is classified as the provision of services under paragraph (c)(1) of this section.
(4) Example 4: Access to online software via an application —(i) Facts. Corp A provides Corp B word processing, spreadsheet, and presentation software and allows employees of Corp B to access the software over the internet through a web browser or an application (“app”) that can be downloaded from Corp A's servers onto a computer or mobile device. Corp B's employees usually download Corp A's app onto their mobile devices. To access the full functionality of the app, the device must be connected to the internet. Only a limited number of features on the app are available without an internet connection. Corp B has no ability to alter the software code. The software is hosted on servers owned by Corp A and located at Corp A's facilities and is used concurrently by other Corp A customers in addition to Corp B. Corp B pays a monthly fee based on the number of employees with access to the software. Users have the option to save files either online using the storage provided by Corp B, or offline on their own hard drives. Corp B's employees can also download updates to the app as part of the monthly fee arrangement. Upon termination of the arrangement, Corp A activates an electronic lock preventing Corp B's employees from further utilizing the app, and Corp B's employees are no longer able to access the software via a web browser. Corp A has ascertained that the primary benefit or value to Corp B from the transaction is the right to access Corp A's software over the internet, whether via web browser or after downloading the app.
(ii) Analysis. (A) There is one transaction with multiple elements between Corp A and Corp B. One element is Corp A's provision to Corp B of on-demand network access to Corp A's computer hardware and software resources for the purpose of fully utilizing Corp A's software, which would be a cloud transaction described in paragraph (b) of this section if considered separately. Another element is the download of Corp A's app by Corp B employees, which would be a transfer of a copyrighted article under § 1.861-18(b)(1)(ii) if considered separately.
(B) Because the transaction has multiple elements, one or more of which would be a cloud transaction if considered separately, paragraph (c)(2) of this section provides that the transaction is classified as a cloud transaction if its predominant character is a cloud transaction. Pursuant to § 1.861-18(b)(3), the predominant character of the transaction is based on the primary benefit or value of the transaction to the customer, if it is reasonably ascertainable. The predominant character of this transaction is therefore a cloud transaction because the primary benefit or value received by Corp B is the right to access Corp A's software over the internet. Accordingly, this transaction is classified solely as a cloud transaction described in paragraph (b) of this section and is classified as the provision of services under paragraph (c)(1) of this section.
(5) Example 5: Access to offline software with limited online functions —(i) Facts. Corp A provides Corp B word processing, spreadsheet, and presentation software that is functionally similar to the software in paragraph (d)(4) of this section ( Example 4 ). The software is made available for access over the internet but only to download the software from servers owned by Corp A onto a computer or mobile device in the form of an app. The downloaded software contains all the core functions of the software. Employees of Corp B can use the software on their computers or mobile devices regardless of whether their computer or mobile device is online. When online, the software provides a few ancillary functions that are not available offline, such as access to document templates and data collection for diagnosing problems with the software. Whether working online or offline, Corp B employees can store their files only on their own computer or mobile device, and not on Corp A's data storage servers. Corp B's employees can also download updates to the software as part of the monthly fee arrangement. Upon termination of the arrangement, an electronic lock is activated so that the software can no longer be accessed. Corp A has ascertained that the primary benefit or value to Corp B from the transaction is the right to download and use Corp A's software offline.
(ii) Analysis. (A) The transaction between Corp A and Corp B contains multiple elements. One element is the transfer of a copy of Corp A's software via download, which would be a transfer of a copyrighted article described under § 1.861-18(b)(1)(ii) if considered separately. Another element is the provision of online ancillary functionality of the software, which would be a cloud transaction described in paragraph (b) of this section if considered separately.
(B) Because the transaction has multiple elements, one or more of which would be a cloud transaction if considered separately, paragraph (c)(2) of this section provides that the transaction is classified as a cloud transaction if its predominant character is a cloud transaction. Pursuant to § 1.861-18(b)(3), the predominant character of the transaction is based on the primary benefit or value of the transaction to the customer, if it is reasonably ascertainable. The predominant character of this transaction is therefore the transfer of a copyrighted article because the primary benefit or value received by Corp B is the right to download and use Corp A's software offline. Accordingly, this transaction is classified solely as a transfer of a copyrighted article described in § 1.861-18(b)(1)(ii). The provision of the software constitutes a lease of a copyrighted article under § 1.861-18 because access to the app is terminated when the monthly fee is no longer paid, even though Corp B employees retain the locked files on their devices. See § 1.861-18(h)(4).
(6) Example 6: Data storage, separate from access to offline software —(i) Facts. The facts are the same as in paragraph (d)(5)(i) of this section (the facts in Example 5 ), except that Corp A also provides on-demand network data storage to Corp B on Corp A's servers in exchange for a monthly fee based on the amount of data storage used by Corp B. Under the data storage terms, Corp B employees may store files created by Corp B employees using Corp A's software or other software. Although Corp A's word processing software is compatible with Corp A's data storage systems, the core functionality of Corp A's software is not dependent on Corp B's purchase of the storage plan. Corp A's provision of software and data storage capacity constitute separate transactions.
(ii) Analysis. (A) As explained in paragraph (d)(5)(ii) of this section, Corp B's download of fully functional software, along with on-demand network access to certain limited online features, does not constitute a cloud transaction, but rather constitutes a lease of a copyrighted article under § 1.861-18.
(B) The provision of on-demand network data storage by Corp A to Corp B is a cloud transaction with one element. Therefore, the transaction is treated solely as a cloud transaction under paragraph (b) of this section and is classified as the provision of services under paragraph (c)(1) of this section.
(7) Example 7: Streaming and temporary download of digital content using third-party servers —(i) Facts. Corp A offers via stream or temporary download digital content in the form of videos and music to customers from servers located in data centers owned and operated by Data Center Operator. Each customer uses a computer or other electronic device to access unlimited streaming or temporary downloads of video and music in exchange for payment of a flat monthly fee to Corp A. The customer may select from among the available content the particular video or song to be streamed or downloaded. Corp A continually updates its content catalog, replacing content with higher quality versions and adding new content at no additional charge to the customer. It also provides additional functionality such as various methods of filtering and sorting the library, a watchlist, and recommendations based on a customer's preferences. Content that is streamed to the customer is not stored locally on the customer's computer or other electronic device and therefore can be played only while the customer's computer or other electronic device is connected to the internet. Content that is temporarily downloaded is stored on the customer's computer or other electronic device for 1 week and therefore can be played while the customer's computer or other electronic device is not connected to the internet. Corp A cannot reasonably ascertain the primary benefit or value that its specific customers derive from accessing Corp A's catalog of digital content. Data collected by Corp A indicates that the vast majority of customers stream digital content rather than temporarily download the content. Corp A pays Data Center Operator a fee based on the amount of data storage used and computing power made available in connection with Corp A's content offerings.
(ii) Analysis. (A) The provision of data storage and computing power by Data Center Operator to Corp A is a cloud transaction with one element. Therefore, the transaction is treated solely as a cloud transaction under paragraph (b) of this section, and is classified as the provision of services under paragraph (c)(1) of this section.
(B) A transaction between Corp A and a customer has two elements. One element is streaming access to a curated and routinely updated library of digital content, which would be a cloud transaction described in paragraph (b) of this section if considered separately. Another element is the transfer of a copy of digital content via temporary download, which would be a transfer of a copyrighted article under § 1.861-18(b)(1)(ii) if considered separately.
(C) Because the transaction has multiple elements, one or more of which would be a cloud transaction if considered separately, paragraph (c)(2) of this section provides that the transaction is classified as a cloud transaction if its predominant character is a cloud transaction. Pursuant to § 1.861-18(b)(3), the predominant character of the transaction is based on the primary benefit or value of the transaction to the customer if it is reasonably ascertainable. However, Corp A cannot reasonably ascertain the primary benefit or value derived by a specific customer from Corp A's offering. In such situations, § 1.861-18(b)(3)(ii) provides that the predominant character of a transaction may be determined based on the primary benefit or value to a typical customer of a substantially similar transaction. This primary benefit or value to a typical customer can be identified through actual data about use or access pursuant to § 1.861-18(b)(3)(ii)(A), or if that data is not available, by using other evidence indicative of the primary benefit or value to a typical customer pursuant to § 1.861-18(b)(3)(ii)(B). Because Corp A has data that shows the typical customer streams digital content rather than temporarily downloading it, the primary benefit or value received by a typical customer is streaming access to digital content. Therefore, the predominant character of the transaction is a cloud transaction. Under paragraph (c)(1) of this section, the cloud transaction is classified as the provision of services.
(8) Example 8: Access to online database —(i) Facts. Corp A offers an online database of industry-specific materials. Customers access the materials through Corp A's website, which aggregates and organizes information topically and hosts a proprietary search engine. Corp A hosts the website and database on its own servers and provides multiple customers access to the website and database concurrently. Most materials in Corp A's database are publicly available by other means, but Corp A's website offers an efficient way to locate and obtain the information on demand. Certain materials in Corp A's database constitute digital content within the meaning of § 1.861-18(a)(2), and Corp A pays the copyright owners a license fee for using them. Each customer may download any of the materials to its own computer and keep such materials without further payment. The customer pays Corp A a fee based on the number of searches or the amount of time spent on the website, and such fee is not dependent on the amount of materials the customer downloads. The fee that the customer pays is substantially higher than the stand-alone charge for accessing the same digital content outside of Corp A's system. Corp A cannot reasonably ascertain the primary benefit or value that a specific customer derives from accessing Corp A's database. Corp A does not have data indicating whether the typical customer downloads materials from the database. Corp A markets its website and online database as user-friendly and an efficient way to find relevant materials because of its proprietary search engine. Developing the proprietary search engine was the largest cost Corp A incurred in creating its website and online database.
(ii) Analysis. (A) The transaction between Corp A and a customer has multiple elements. One element is Corp A's provision to a customer of access to Corp A's website and online database, which is a cloud transaction described in paragraph (b) of this section if considered separately. Another element is the transfer of digital content via download, which is the transfer of a copyrighted article under § 1.861-18 if considered separately.
(B) Because the transaction has multiple elements, one or more of which would be a cloud transaction if considered separately, paragraph (c)(2) of this section provides that the transaction is classified as a cloud transaction if its predominant character is a cloud transaction. Pursuant to § 1.861-18(b)(3), the predominant character of the transaction is based on the primary benefit or value of the transaction to the customer, if it is reasonably ascertainable. However, Corp A cannot reasonably ascertain the primary benefit or value derived by a specific customer from access to Corp A's database. In such situations, § 1.861-18(b)(3)(ii) provides that the predominant character of a transaction may be determined based on the primary benefit or value to a typical customer of a substantially similar transaction. This primary benefit or value to a typical customer can be identified through actual data about use or access pursuant to § 1.861-18(b)(3)(ii)(A), or if that data is not available, by using other evidence indicative of the primary benefit or value to a typical customer pursuant to § 1.861-18(b)(3)(ii)(B). That Corp A focuses on its proprietary search engine when marketing its website and database, as well as the facts that the search engine was the most expensive cost incurred by Corp A in creating its website and database, and that customers pay a substantially higher fee to access Corp A's system than they would otherwise pay to access the content outside of Corp A's system, indicates that the primary benefit or value received by a typical customer is the right to use the search engine. Therefore, under paragraph (c)(2) of this section, the predominant character of the transaction between Corp A and a customer is a cloud transaction. Under paragraph (c)(1) of this section the cloud transaction is classified as the provision of services.
(9) Example 9: Temporary or perpetual access to a single movie via stream or download —(i) Facts. Corp A hosts movies on its website and allows customers to view a single movie for a limited period or perpetually for a one-time fee, with perpetual viewing rights costing a higher fee. Corp A does not charge customers a separate fee for access to the website. In addition, Corp A's website provides recommendations for movies based on a customer's search for a particular title and/or the customer's purchase history. Customers have no ability to alter the servers, website, or movies available on the website. The movies in Corp A's database constitute digital content within the meaning of § 1.861-18(a)(2), and Corp A pays the copyright owners a license fee for using them. Corp A allows customers to view the movies by either streaming the movies from Corp A's servers, or by downloading the movies onto the customer's computer or other electronic device. The file size of movies offered by Corp A is generally large and so customers may be expected to download movies only in certain situations such as when traveling without internet access. Upon the expiration of the rental period, customers will no longer have access to stream the movies, and any movie that was downloaded onto a customer's computer or other electronic device will auto-delete from the customer's computer or other electronic device. Whether a customer chooses to view the movie via stream or download, Corp A charges the same one-time fee. Corp A cannot reasonably ascertain the primary benefit or value that a specific customer derives from accessing Corp A's website. Corp A maintains aggregate data on whether a given movie is viewed via stream or download, and this data shows that most movies are viewed by streaming, even in the case where a customer pays for the right to view a movie in perpetuity.
(ii) Analysis. (A) A transaction between Corp A and a customer contains multiple elements. One element is Corp A's provision to a customer of access to Corp A's website in order to view a movie via stream, which is a cloud transaction described in paragraph (b) of this section if considered separately. Another element is Corp A's provision to a customer of access to Corp A's website in order to download a movie, which is the transfer of a copyrighted article under § 1.861-18 if considered separately.
(B) Because the transaction has multiple elements, one or more of which would be a cloud transaction if considered separately, paragraph (c)(2) of this section provides that the transaction is classified as a cloud transaction if its predominant character is a cloud transaction. Pursuant to § 1.861-18(b)(3), the predominant character of the transaction is based on the primary benefit or value of the transaction to the customer, if it is reasonably ascertainable. However, Corp A cannot reasonably ascertain the primary benefit or value derived by a specific customer from access to Corp A's database. In such situations, § 1.861-18(b)(3)(ii) provides that the predominant character of a transaction may be determined based on the primary benefit or value to a typical customer of a substantially similar transaction. This primary benefit or value to a typical customer can be identified through actual data about use or access pursuant to § 1.861-18(b)(3)(ii)(A), or if that data is not available, by using other evidence indicative of the primary benefit or value to a typical customer pursuant to § 1.861-18(b)(3)(ii)(B). Corp A has data that shows that the typical customer views movies by streaming rather than download. Accordingly, under paragraph (c)(2) of this section, the predominant character of the transaction is a cloud transaction because the primary benefit or value a typical customer receives is access to stream movies on Corp A's website. Under paragraph (c)(1) of this section, the cloud transaction is classified as the provision of services.
(10) Example 10: Reseller of software as a service —(i) Facts. Corp A owns the copyright to software (Program S). Corp A hosts Program S on its servers. Customers access Program S only through an internet connection. Corp A grants Corp B, a foreign corporation wholly owned by Corp A, the right to sell access to Program S to Corp B's customers that are located in Corp B's country. Corp B is responsible for managing the purchase/sale interaction with Corp B's customers, including invoicing and collections. Corp A is responsible for providing customers with access to Program S. Corp B does not perform any functions to provide access to Program S.
(ii) Analysis. (A) The transaction between Corp A and Corp B is treated as Corp A providing on-demand access to Program S to Corp B even though Corp B resells that access. This transaction is a cloud transaction with one element. Under paragraph (c)(1) of this section, the cloud transaction is classified as the provision of services. The transaction does not involve the transfer of any copyright rights described in § 1.861-18(c)(2), and therefore is governed solely by this section.
(B) The transaction between Corp B and its customers is the provision of on-demand access to Program S by Corp B, which is a cloud transaction with one element. Under paragraph (c)(1) of this section, the cloud transaction is classified as the provision of services. The transaction does not involve the transfer of any copyright rights described in § 1.861-18(c)(2), and therefore is governed solely by this section.
(11) Example 11: Computer game with online functionality and in-game purchases —(i) Facts. Corp A owns the copyright to a computer game (Game X). Customers can purchase Game X for a one-time fee and download it onto their computers. A customer may play certain aspects of Game X while not connected to the internet, but most of the core functionality of Game X is available only when the customer is connected to the internet, including the ability to play with other customers. In order to access the additional online functionality specific to Game X, customers must pay a monthly fee to Corp A. The additional functionality of Game X is hosted on servers owned by Corp A. Customers may also pay a one-time fee to access an in-game item that can be utilized only when playing Game X online.
(ii) Analysis. (A) There are three transactions between Corp A and a customer. The first transaction is the transfer of a copy of Game X, which is a digital content transaction with one element because a customer receives from Corp A access only to offline content in exchange for purchasing a copy of the game. Therefore, this transaction is treated solely as a transfer of a copyrighted article under § 1.861-18.
(B) The second transaction between Corp A and a customer is the payment of a monthly fee to play Game X online on Corp A's servers, which is a cloud transaction with one element. Therefore, this transaction is treated solely as a cloud transaction, and is classified as the provision of services under paragraph (c)(1) of this section.
(C) The third transaction between Corp A and a customer is the payment of a one-time fee in exchange for an in-game item. Because a customer can utilize the item only when playing Game X through an internet connection, the transaction is a cloud transaction with one element. Therefore, this transaction is treated solely as a cloud transaction, and is classified as the provision of services under paragraph (c)(1) of this section.
(e) Applicability date —(1) In general. This section applies to taxable years beginning on or after January 14, 2025.
(2) Early application. A taxpayer can apply this section to taxable years beginning on or after August 14, 2019 and all subsequent taxable years not described in paragraph (e)(1) (early application years) if—
(i) The taxpayer also applies § 1.861-18 to the early application years;
(ii) This section and § 1.861-18 are applied to the early application years by all persons related to the taxpayer (within the meaning of sections 267(b) and 707(b));
(iii) The period of limitations on assessment for each early application year of the taxpayer and all related parties (within the meaning of sections 267(b) and 707(b)) is open under section 6501; and
(iv) The taxpayer would not be required under this section to change its method of accounting as a result of such election.
(f) Change in method of accounting required by this section. In order to comply with this section, a taxpayer may be required to change its method of accounting. If so required, the taxpayer must secure the consent of the Commissioner in accordance with the requirements of § 1.446-1(e) and the applicable administrative procedures for obtaining the Commissioner's consent under section 446(e) for voluntary changes in methods of accounting.
§ 1.861-20   Allocation and apportionment of foreign income taxes.
(a) Scope. This section provides rules for the allocation and apportionment of foreign income taxes, including allocating and apportioning foreign income taxes to separate categories for purposes of the foreign tax credit. The rules of this section apply except as modified under the rules for an operative section (as described in § 1.861-8(f)(1)). See, for example, §§ 1.704-1(b)(4)(viii)( d )( 1 ), 1.904-6, 1.960-1(d)(3)(ii), and 1.965-5(b)(2). Paragraph (b) of this section provides definitions for the purposes of this section. Paragraph (c) of this section provides the general rule for allocation and apportionment of foreign income taxes. Paragraph (d) of this section provides rules for assigning foreign gross income to statutory and residual groupings. Paragraph (e) of this section provides rules for allocating and apportioning foreign law deductions to foreign gross income in the statutory and residual groupings. Paragraph (f) of this section provides rules for apportioning foreign income taxes among statutory and residual groupings. Paragraph (g) of this section provides examples that illustrate the application of this section. Paragraph (h) of this section provides the applicability date for this section.
(b) Definitions. The following definitions apply for purposes of this section.
(1) Corporation. The term corporation has the same meaning as set forth in § 301.7701-2(b) of this chapter, and so includes a reverse hybrid.
(2) Corresponding U.S. item. The term corresponding U.S. item means the item of U.S. gross income or U.S. loss, if any, that arises from the same transaction or other realization event from which an item of foreign gross income also arises. An item of U.S. gross income or U.S. loss is a corresponding U.S. item even if the item of foreign gross income that arises from the same transaction or realization event differs in amount from the item of U.S. gross income or U.S. loss. A corresponding U.S. item does not include an item of gross income that is exempt, excluded, or eliminated from U.S. gross income, nor does it include an item of U.S. gross income or U.S. loss that is not realized, recognized or taken into account by the taxpayer in the U.S. taxable year in which the taxpayer paid or accrued the foreign income tax, except as provided in the next sentence. If a taxpayer pays or accrues a foreign income tax that is imposed on foreign taxable income that includes an item of foreign gross income by reason of a transaction or other realization event that also gave rise to an item of U.S. gross income or U.S. loss, but the U.S. and foreign taxable years end on different dates and the event occurred in the last U.S. taxable year that ends before the end of the foreign taxable year, then the item of U.S. gross income or U.S. loss is a corresponding U.S. item.
(3) Disregarded entity. The term disregarded entity means an entity described in § 301.7701-2(c)(2) of this chapter that is disregarded as an entity separate from its owner for Federal income tax purposes.
(4) Foreign capital gain amount. The term foreign capital gain amount means the portion of a distribution that under foreign law gives rise to gross income of a type described in section 301(c)(3)(A) or section 731(a).
(5) Foreign dividend amount. The term foreign dividend amount means the portion of a distribution that is taxable as a dividend under foreign law.
(6) Foreign gross income. The term foreign gross income means the items of gross income included in the base upon which a foreign income tax is imposed. This includes all items of foreign gross income included in the foreign tax base, even if the foreign taxable year begins in the U.S. taxable year that precedes the U.S. taxable year in which the taxpayer pays or accrues the foreign income tax.
(7) Foreign income tax. The term foreign income tax has the meaning provided in § 1.901-2(a).
(8) Foreign law CFC. The term foreign law CFC means an entity that is a body corporate under foreign law, certain of the earnings of which are taxable to its shareholder under a foreign law inclusion regime.
(9) Foreign law disposition. The term foreign law disposition means an event that foreign law treats as a taxable disposition or deemed disposition of property but that Federal income tax law does not treat as a disposition causing the recognition of gain or loss (for example, marking property to market under foreign law).
(10) Foreign law distribution. The term foreign law distribution means an event that foreign law treats as a taxable distribution (other than by reason of a foreign law inclusion regime) but that Federal income tax law does not treat as a distribution of property within the meaning of section 317(a) (for example, a stock dividend described in section 305 or a foreign law consent dividend).
(11) Foreign law inclusion regime. A foreign law inclusion regime is a foreign law tax regime similar to the subpart F or GILTI regime described in sections 951 through 959, or the PFIC regime described in sections 1293 through 1295 (relating to qualified electing funds), that imposes a tax on a shareholder of an entity based on an inclusion in the shareholder's taxable income of certain of the entity's current earnings, whether or not the foreign law deems the entity's earnings to be distributed.
(12) Foreign law inclusion regime income. The term foreign law inclusion regime income means the items of foreign gross income included by a taxpayer with respect to a foreign law CFC by reason of a foreign law inclusion regime.
(13) Foreign law pass-through income. The term foreign law pass-through income means the items of a reverse hybrid, computed under foreign law, that give rise to an inclusion in a taxpayer's foreign gross income under the laws of a foreign country imposing tax by reason of the taxpayer's ownership of the reverse hybrid.
(14) Foreign taxable income. The term foreign taxable income means foreign gross income reduced by the deductions that are allowed under foreign law.
(15) Foreign taxable year. The term foreign taxable year has the meaning set forth in section 7701(a)(23), applied by substituting “under foreign law” for the phrase “under subtitle A.”
(16) Partnership. The term partnership has the same meaning as set forth in § 301.7701-2(c)(1) of this chapter.
(17) Previously taxed earnings and profits. The term previously taxed earnings and profits has the meaning provided in § 1.960-1(b).
(18) Reverse hybrid. The term reverse hybrid means a corporation that is a fiscally transparent entity (under the principles of § 1.894-1(d)(3)) or a branch under the laws of a foreign country imposing tax on the income of the entity.
(19) Taxpayer. The term taxpayer has the meaning described in § 1.901-2(f)(1).
(20) U.S. capital gain amount. The term U.S. capital gain amount means gain recognized by a taxpayer on the sale, exchange, or other disposition of stock or an interest in a partnership or, in the case of a distribution with respect to stock or a partnership interest, the portion of the distribution to which section 301(c)(3)(A) or 731(a)(1), respectively, applies. A U.S. capital gain amount includes gain that is subject to section 751 and § 1.751-1, but does not include the portion of any gain recognized by a taxpayer that is included in gross income as a dividend under section 964(e) or 1248.
(21) U.S. dividend amount. The term U.S. dividend amount means the portion of a distribution that is made out of earnings and profits under Federal income tax law, including distributions out of previously taxed earnings and profits described in section 959(a) or (b). It also includes amounts included in gross income as a dividend by reason of section 1248 or section 964(e).
(22) U.S. equity hybrid instrument. The term U.S. equity hybrid instrument means an instrument that is treated as stock or a partnership interest for Federal income tax purposes but for foreign income tax purposes is treated as indebtedness or otherwise gives rise to the accrual of income to the holder with respect to such instrument that is not characterized as a dividend or distributive share of partnership income for foreign tax law purposes.
(23) U.S. gross income. The term U.S. gross income means the items of gross income that a taxpayer recognizes and includes in taxable income under Federal income tax law for its U.S. taxable year.
(24) U.S. loss. The term U.S. loss means the item of loss that a taxpayer recognizes and includes in taxable income under Federal income tax law for its U.S. taxable year.
(25) U.S. return of capital amount. The term U.S. return of capital amount means, in the case of the sale, exchange, or other disposition of stock, the taxpayer's adjusted basis of the stock, or in the case of a distribution with respect to stock, the portion of the distribution to which section 301(c)(2) applies.
(26) U.S. taxable year. The term U.S. taxable year has the same meaning as that of the term taxable year set forth in section 7701(a)(23).
(c) General rule. A foreign income tax (other than certain in lieu of taxes described in paragraph (h) of this section) is allocated and apportioned to the statutory and residual groupings that include the items of foreign gross income included in the base on which the tax is imposed. Each such foreign income tax (that is, each separate levy) is allocated and apportioned separately under the rules in paragraphs (c) through (f) of this section. A foreign income tax is allocated and apportioned to or among the statutory and residual groupings under the following steps:
(1) First, by assigning the items of foreign gross income to the groupings under the rules of paragraph (d) of this section;
(2) Second, by allocating and apportioning the deductions that are allowed under foreign law to the foreign gross income in the groupings under the rules of paragraph (e) of this section; and
(3) Third, by allocating and apportioning the foreign income tax by reference to the foreign taxable income in the groupings under the rules of paragraph (f) of this section.
(d) Assigning items of foreign gross income to the statutory and residual groupings —(1) In general. Each item of foreign gross income is assigned to a statutory or residual grouping. The amount of the item is determined under foreign law. However, Federal income tax law applies to characterize the item and the transaction or other realization event from which the item arose, and to assign it to a grouping. Except as provided in paragraph (d)(3) of this section, if a taxpayer pays or accrues a foreign income tax that is imposed on foreign taxable income that includes an item of foreign gross income with respect to which the taxpayer also realizes, recognizes, or takes into account a corresponding U.S. item, then the item of foreign gross income is assigned to the grouping to which the corresponding U.S. item is assigned. See paragraph (g)(2) of this section ( Example 1 ). If the corresponding U.S. item is a U.S. loss (or zero), the foreign gross income is assigned to the grouping to which a gain would be assigned had the transaction or other realization event given rise to a gain, rather than a U.S. loss (or zero), for Federal income tax purposes, and not (if different) to the grouping to which the U.S. loss is allocated and apportioned in computing U.S. taxable income. Paragraph (d)(3) of this section provides special rules regarding the assignment of the item of foreign gross income in particular circumstances.
(2) Items of foreign gross income with no corresponding U.S. item —(i) In general. The rules in paragraphs (d)(2)(ii) and (iii) of this section apply for purposes of characterizing an item of foreign gross income and assigning it to a grouping if the taxpayer does not realize, recognize, or take into account a corresponding U.S. item. But see paragraphs (d)(3)(i)(C) and (d)(3)(iii) of this section for special rules with respect to items of foreign gross income attributable to foreign law pass-through income and foreign law inclusion regime income.
(ii) Foreign gross income from U.S. nonrecognition event, or U.S. recognition event that falls in a different U.S. taxable year —(A) In general. If a taxpayer recognizes an item of foreign gross income arising from a transaction or other foreign realization event that does not result in the recognition of gross income or loss under Federal income tax law in the same U.S. taxable year in which the foreign income tax is paid or accrued or (in the circumstance described in the last sentence of paragraph (b)(2) of this section) in the immediately preceding U.S. taxable year, then the item of foreign gross income is characterized and assigned to the grouping to which the corresponding U.S. item (or the items described in paragraph (d)(3) of this section that are used to assign certain items of foreign gross income to the statutory and residual groupings) would be assigned if the event giving rise to the foreign gross income resulted in the recognition of gross income or loss under Federal income tax law in the U.S. taxable year in which the foreign income tax is paid or accrued.
(B) Foreign law distributions. An item of foreign gross income that a taxpayer includes as a result of a foreign law distribution with respect to either stock or a partnership interest is assigned to the same statutory or residual groupings to which the foreign gross income would be assigned if a distribution of property in the amount of the taxable distribution under foreign law were made for Federal income tax purposes on the date on which the foreign law distribution occurred. See paragraph (g)(6) of this section ( Example 5 ). See paragraph (d)(3)(i)(B) of this section for rules regarding the assignment of foreign gross income arising from a distribution with respect to stock. For purposes of applying paragraph (d)(3)(i)(B) of this section to a foreign law distribution, the U.S. dividend amount, U.S. capital gain amount, and U.S. return of capital amount are computed as if the distribution occurred on the date the distribution occurs for foreign law purposes. See § 1.960-1(d)(3)(ii) for rules for assigning foreign gross income arising from a foreign law distribution to income groups or PTEP groups for purposes of section 960 as the operative section, and paragraph (d)(3)(ii)(B) of this section for rules regarding the assignment of foreign gross income arising from a distribution by a partnership.
(C) Foreign law dispositions. A foreign gross income item of gain that a taxpayer includes as a result of a foreign law disposition of property is assigned to the grouping to which a corresponding U.S. item of gain or loss would be assigned on a taxable disposition of the property under Federal income tax law in exchange for an amount equal to the gross receipts or other value used under foreign law to determine the amount of the items of foreign gross income arising from the foreign law disposition in the U.S. taxable year in which the taxpayer paid or accrued the foreign income tax. For example, an item of foreign gross income that results from a deemed disposition of stock under a foreign law mark-to-market regime is assigned under the rules of this paragraph (d)(2)(ii)(C) as though a taxable disposition of the stock occurred under Federal income tax law for an amount equal to the fair market value determined under foreign law for purposes of marking the stock to market. See paragraph (g)(3) of this section ( Example 2 ).
(D) Foreign law transfers between taxable units. This paragraph (d)(2)(ii) applies to an item of foreign gross income arising from an event that foreign law treats as a transfer of property, or as giving rise to an item of accrued income, gain, deduction, or loss with respect to a transaction, between taxable units (as defined in paragraph (d)(3)(v)(E) of this section) of the same taxpayer, and that would be treated as a disregarded payment (as defined in paragraph (d)(3)(v)(E) of this section) if the transfer of property occurred, or the item accrued, for Federal income tax purposes in the same U.S. taxable year in which the foreign income tax is paid or accrued. An item of foreign gross income to which this paragraph (d)(2)(ii) applies is characterized and assigned to the grouping to which a disregarded payment in the amount of the item of foreign gross income (or the gross receipts giving rise to the item of foreign gross income) would be assigned under the rules of paragraph (d)(3)(v) of this section if the event giving rise to the foreign gross income resulted in a disregarded payment in the U.S. taxable year in which the foreign income tax is paid or accrued. For example, an item of foreign gross income that a taxpayer recognizes by reason of a foreign law distribution (such as a stock dividend or a consent dividend) from a disregarded entity is assigned to the same statutory or residual groupings to which the foreign gross income would be assigned if a distribution of property in the amount of the taxable distribution under foreign law were made for Federal income tax purposes on the date on which the foreign law distribution occurred.
(iii) Foreign gross income of a type that is recognized but excluded from U.S. gross income —(A) In general. If a taxpayer recognizes an item of foreign gross income that is a type of recognized gross income that Federal income tax law excludes from U.S. gross income, then the item of foreign gross income is assigned to the grouping to which the item of gross income would be assigned if it were included in U.S. gross income. See paragraph (g)(4) of this section ( Example 3 ). Notwithstanding the first sentence of this paragraph (d)(2)(iii)(A), foreign gross income that is attributable to a base difference is assigned under paragraph (d)(2)(iii)(B) of this section.
(B) Base differences. If a taxpayer recognizes an item of foreign gross income that is attributable to a base difference, then the item of foreign gross income is assigned to the residual grouping. But see § 1.904-6(b)(1) (assigning foreign gross income attributable to a base difference to foreign source income in the separate category described in section 904(d)(2)(H)(i)) for purposes of applying section 904 as the operative section). An item of foreign gross income is attributable to a base difference under this paragraph (d)(2)(iii)(B) only if the item results from the receipt of one of the following items:
( 1 ) Death benefits described in section 101;
( 2 ) Gifts and inheritances described in section 102;
( 3 ) Contributions to capital described in section 118;
( 4 ) Money or other property in exchange for stock described in section 1032 (including by reason of a transfer described in section 351(a)); or
( 5 ) Money or other property in exchange for a partnership interest described in section 721.
(3) Special rules for assigning certain items of foreign gross income to a statutory or residual grouping —(i) Items of foreign gross income that a taxpayer includes by reason of its ownership of an interest in a corporation —(A) Scope. The rules of this paragraph (d)(3)(i) apply to characterize and assign to a statutory or residual grouping an item of foreign gross income that a taxpayer includes in foreign taxable income as a result of its ownership of an interest in a corporation with respect to which there is a distribution under both foreign law and Federal income tax law, an inclusion of foreign law pass-through income, or a disposition under both foreign law and Federal income tax law.
(B) Foreign gross income items arising from a distribution with respect to a corporation —( 1 ) In general. If there is a distribution by a corporation that is treated as a distribution of property for both foreign law and Federal income tax purposes, a taxpayer first applies the rules of paragraph (d)(3)(i)(B)( 2 ) of this section, and then (if necessary) applies the rules of paragraph (d)(3)(i)(B)( 3 ) of this section to characterize and assign to the statutory and residual groupings the items of foreign gross income that constitute the foreign dividend amount and the foreign capital gain amount, if any, that arise from the distribution. See paragraph (g)(5) of this section ( Example 4 ). For purposes of this paragraph (d)(3)(i)(B), the U.S. dividend amount, U.S. capital gain amount, and U.S. return of capital amount that result from a distribution (including a distribution that occurs on the same date, but in different taxable years, for foreign law purposes and Federal income tax purposes) are computed on the date the distribution occurred for Federal income tax purposes. See paragraph (d)(2)(ii)(B) of this section for rules for assigning foreign gross income arising from any portion of a distribution that is a foreign law distribution. See § 1.960-1(d)(3)(ii) for rules for assigning foreign gross income arising from a distribution described in this paragraph (d)(3)(i)(B) to income groups or PTEP groups for purposes of section 960 as the operative section.
( 2 ) Foreign dividend amounts. The foreign dividend amount is, to the extent of the U.S. dividend amount, assigned to the same statutory and residual grouping (or ratably to the groupings) to which a distribution of the U.S. dividend amount is assigned under Federal income tax law. If the foreign dividend amount exceeds the U.S. dividend amount, the excess foreign dividend amount is an item of foreign gross income that is, to the extent of the U.S. return of capital amount, assigned to the same statutory and residual grouping (or ratably to the groupings) to which earnings of the distributing corporation would be assigned if they were recognized for Federal income tax purposes in the U.S. taxable year in which the distribution is made. These earnings are deemed to arise in the statutory and residual groupings in the same proportions as the proportions in which the tax book value of the stock of the distributing corporation is (or would be if the taxpayer were a United States person) assigned to the groupings under the asset method in § 1.861-9 in the U.S. taxable year in which the distribution is made. Any additional excess of the foreign dividend amount over the sum of the U.S. dividend amount and the U.S. return of capital amount is an item of foreign gross income that is assigned to the statutory or residual grouping (or ratably to the groupings) to which the U.S. capital gain amount is assigned.
( 3 ) Foreign capital gain amounts. The foreign capital gain amount is, to the extent of the U.S. capital gain amount, assigned to the statutory and residual groupings to which the U.S. capital gain amount is assigned under Federal income tax law. If the foreign capital gain amount exceeds the U.S. capital gain amount, the excess is, to the extent of the U.S. return of capital amount, assigned to the statutory and residual groupings to which earnings equal to the U.S. return of capital amount would be assigned if they were recognized in the U.S. taxable year in which the distribution is made. These earnings are deemed to arise in the statutory and residual groupings in the same proportions as the proportions in which the tax book value of the stock of the distributing corporation is (or would be if the taxpayer were a United States person) assigned under the asset method in § 1.861-9 in the U.S. taxable year in which the distribution is made. Any excess of the foreign capital gain amount over the sum of the U.S. capital gain amount and the U.S. return of capital amount is assigned ratably to the statutory and residual groupings to which the U.S. dividend amount is assigned.
(C) Foreign law pass-through income from a reverse hybrid. An item of foreign law pass-through income that a taxpayer includes in its foreign taxable income as a result of its direct or indirect ownership of a reverse hybrid is assigned to a statutory or residual grouping by treating the taxpayer's items of foreign law pass-through income as the foreign gross income of the reverse hybrid, and applying the rules in this paragraph (d) by treating the reverse hybrid as the taxpayer in the reverse hybrid's U.S. taxable year with or within which its foreign taxable year (under the law of the foreign jurisdiction imposing the owner-level tax) ends. See § 1.904-6(f) for special rules that apply for purposes of section 904 with respect to items of foreign gross income that under this paragraph (d)(3)(iii) would be assigned to a separate category that includes income that gives rise to inclusions under section 951A.
(D) Foreign gross income items arising from a disposition of stock. An item of foreign gross income that arises from a transaction that is treated as a sale, exchange, or other disposition for both foreign law and Federal income tax purposes of an interest that is stock in a corporation for Federal income tax purposes is assigned first, to the extent of any U.S. dividend amount that results from the disposition, to the same statutory or residual grouping (or ratably to the groupings) to which the U.S. dividend amount is assigned under Federal income tax law. If the foreign gross income item exceeds the U.S. dividend amount, the foreign gross income item is next assigned, to the extent of the U.S. capital gain amount, to the statutory or residual grouping (or ratably to the groupings) to which the U.S. capital gain amount is assigned under Federal income tax law. Any excess of the foreign gross income item over the sum of the U.S. dividend amount and the U.S. capital gain amount is assigned to the same statutory or residual grouping (or ratably to the groupings) to which earnings equal to such excess amount would be assigned if they were recognized for Federal income tax purposes in the U.S. taxable year in which the disposition occurred. These earnings are deemed to arise in the statutory and residual groupings in the same proportions as the proportions in which the tax book value of the stock is (or would be if the taxpayer were a United States person) assigned to the groupings under the asset method in § 1.861-9 in the U.S. taxable year in which the disposition occurs. See paragraph (g)(10) of this section ( Example 9 ).
(ii) Items of foreign gross income included by a taxpayer by reason of its ownership of an interest in a partnership —(A) Scope. The rules of this paragraph (d)(3)(ii) apply to assign to a statutory or residual grouping certain items of foreign gross income that a taxpayer includes in foreign taxable income by reason of its ownership of an interest in a partnership. See paragraphs (d)(1) and (2) of this section for rules that apply in characterizing items of foreign gross income that are attributable to a partner's distributive share of income of a partnership. See paragraph (d)(3)(iii) of this section for rules that apply in characterizing items of foreign gross income that are attributable to an inclusion under a foreign law inclusion regime.
(B) Foreign gross income items arising from a distribution with respect to an interest in a partnership. If a partnership makes a distribution that is treated as a distribution of property for both foreign law and Federal income tax purposes, any foreign gross income item arising from the distribution (including foreign gross income attributable to a distribution from a partnership that foreign law classifies as a dividend from a corporation) is, to the extent of the U.S. capital gain amount arising from the distribution, assigned to the statutory and residual groupings to which the U.S. capital gain amount is assigned under Federal income tax law. If the foreign gross income item arising from the distribution exceeds the U.S. capital gain amount, such excess amount is assigned to the statutory and residual groupings to which a distributive share of income of the partnership in the amount of such excess would be assigned if such income were recognized for Federal income tax purposes in the U.S. taxable year in which the distribution is made. The items constituting this distributive share of income are deemed to arise in the statutory and residual groupings in the same proportions as the proportions in which the tax book value of the partnership interest or the partner's pro rata share of the partnership assets, as applicable, is assigned (or would be assigned if the partner were a United States person) for purposes of apportioning the partner's interest expense under § 1.861-9(e) in the U.S. taxable year in which the distribution is made.
(C) Foreign gross income items arising from the disposition of an interest in a partnership. An item of foreign gross income arising from a transaction that is treated as a sale, exchange, or other disposition for both foreign law and Federal income tax purposes of an interest that is an interest in a partnership for Federal income tax purposes is assigned first, to the extent of the U.S. capital gain amount arising from the disposition, to the statutory or residual grouping (or ratably to the groupings) to which the U.S. capital gain amount is assigned. If the foreign gross income item arising from the disposition exceeds the U.S. capital gain amount, such excess amount is assigned to the statutory and residual grouping (or ratably to the groupings) to which a distributive share of income of the partnership in the amount of such excess would be assigned if such income were recognized for Federal income tax purposes in the U.S. taxable year in which the disposition occurred. The items constituting this distributive share of income are deemed to arise in the statutory and residual groupings in the same proportions as the proportions in which the tax book value of the partnership interest, or the partner's pro rata share of the partnership assets, as applicable, is assigned (or would be assigned if the partner were a United States person) for purposes of apportioning the partner's interest expense under § 1.861-9(e) in the U.S. taxable year in which the disposition occurred.
(iii) Foreign law inclusion regime income. A gross item of foreign law inclusion regime income that a taxpayer includes in its capacity as a shareholder under foreign law of a foreign law CFC under a foreign law inclusion regime is assigned to the same statutory and residual groupings as the item of foreign gross income of the foreign law CFC that gives rise to the item of foreign law inclusion regime income of the taxpayer. The assignment is made by treating the gross items of foreign law inclusion regime income of the taxpayer as the items of foreign gross income of the foreign law CFC and applying the rules in this paragraph (d) by treating the foreign law CFC as the taxpayer in its U.S. taxable year with or within which its foreign taxable year (under the law of the foreign jurisdiction imposing the shareholder-level tax) ends. See paragraphs (g)(7) and (8) of this section ( Examples 6 and 7 ). See § 1.904-6(f) for special rules with respect to items of foreign gross income relating to items of the foreign law CFC that give rise to inclusions under section 951A for purposes of applying section 904 as the operative section.
(iv) Gain on sale of disregarded entity. An item of foreign gross income arising from gain recognized on the sale, exchange, or other disposition of a disregarded entity that is characterized as a disposition of assets for Federal income tax purposes is assigned to statutory and residual groupings in the same proportion as the gain that would be treated as foreign gross income in each grouping if the transaction were treated as a disposition of assets for foreign tax law purposes. See paragraph (g)(9) of this section ( Example 8 ).
(v) Disregarded payments —(A) In general. This paragraph (d)(3)(v) applies to assign to a statutory or residual grouping a foreign gross income item that a taxpayer includes by reason of the receipt of a disregarded payment. In the case of a taxpayer that is an individual or a domestic corporation, this paragraph (d)(3)(v) applies to a disregarded payment made between a taxable unit that is a foreign branch, a foreign branch owner, or a non-branch taxable unit, and another such taxable unit of the same taxpayer. In the case of a taxpayer that is a foreign corporation, this paragraph (d)(3)(v) applies to a disregarded payment made between taxable units that are tested units of the same taxpayer. For purposes of this paragraph (d)(3)(v), an individual or corporation is treated as the taxpayer with respect to its distributive share of foreign income taxes paid or accrued by a partnership, estate, trust or other pass-through entity. The rules of paragraph (d)(3)(v)(B) of this section apply to attribute U.S. gross income comprising the portion of a disregarded payment that is a reattribution payment to a taxable unit, and to associate the foreign gross income item arising from the receipt of the reattribution payment with the statutory and residual groupings to which that U.S. gross income is assigned. The rules of paragraph (d)(3)(v)(C) of this section apply to assign to statutory and residual groupings items of foreign gross income arising from the receipt of the portion of a disregarded payment that is a remittance or a contribution. The rules of paragraph (d)(3)(v)(D) of this section apply to assign to statutory and residual groupings items of foreign gross income arising from disregarded payments, other than the portions of disregarded payments that are reattribution payments, in connection with disregarded sales or exchanges of property. Paragraph (d)(3)(v)(E) of this section provides definitions that apply for purposes of this paragraph (d)(3)(v) and paragraph (g) of this section.
(B) Reattribution payments —( 1 ) In general. This paragraph (d)(3)(v)(B) assigns to a statutory or residual grouping a foreign gross income item that a taxpayer includes by reason of the receipt by a taxable unit of the portion of a disregarded payment that is a reattribution payment. The foreign gross income item is assigned to the statutory or residual groupings to which one or more reattribution amounts that constitute the reattribution payment are assigned upon receipt by the taxable unit. If a reattribution payment comprises multiple reattribution amounts and the amount of the foreign gross income item that is attributable to the reattribution payment differs from the amount of the reattribution payment, foreign gross income is apportioned among the statutory and residual groupings in proportion to the reattribution amounts in each statutory and residual grouping. The statutory or residual grouping of a reattribution amount received by a taxable unit is the grouping that includes the U.S. gross income attributed to the taxable unit by reason of its receipt of the gross reattribution amount, regardless of whether, after taking into account disregarded payments made by the taxable unit, the taxable unit has an attribution item as a result of its receipt of the reattribution amount. See paragraph (g)(13) of this section ( Example 12 ).
( 2 ) Attribution of U.S. gross income to a taxable unit. This paragraph (d)(3)(v)(B)( 2 ) provides attribution rules to determine the reattribution amounts received by a taxable unit in the statutory and residual groupings in order to apply paragraph (d)(3)(v)(B)( 1 ) of this section to assign foreign gross income items arising from a reattribution payment to the groupings. In the case of a taxpayer that is an individual or a domestic corporation, the attribution rules in § 1.904-4(f)(2) apply to determine the reattribution amounts received by a taxable unit in the separate categories (as defined in § 1.904-5(a)(4)(v)) in order to apply paragraph (d)(3)(v)(B)( 1 ) of this section for purposes of § 1.904-6(b)(2)(i). In the case of a taxpayer that is a foreign corporation, the attribution rules in § 1.951A-2(c)(7)(ii)(B) apply to determine the reattribution amounts received by a taxable unit in the statutory and residual groupings in order to apply paragraph (d)(3)(v)(B)( 1 ) of this section for purposes of §§ 1.951A-2(c)(3), 1.951A-2(c)(7), and 1.960-1(d)(3)(ii). For purposes of other operative sections (as described in § 1.861-8(f)(1)), the principles of § 1.904-4(f)(2)(vi) or § 1.951A-2(c)(7)(ii)(B), as applicable, apply to determine the reattribution amounts received by a taxable unit in the statutory and residual groupings. The rules and principles of § 1.904-4(f)(2)(vi) or § 1.951A-2(c)(7)(ii)(B), as applicable, apply to determine the extent to which a disregarded payment made by the taxable unit is a reattribution payment and the reattribution amounts that constitute a reattribution payment, and to adjust the U.S. gross income initially attributed to each taxable unit to reflect the reattribution payments that the taxable unit makes and receives. The rules in this paragraph (d)(3)(v)(B)( 2 ) limit the amount of a disregarded payment that is a reattribution payment to the U.S. gross income of the payor taxable unit that is recognized in the U.S. taxable year in which the disregarded payment is made.
( 3 ) Effect of reattribution payment on foreign gross income items of payor taxable unit. The statutory or residual grouping to which an item of foreign gross income of a taxable unit is assigned is determined without regard to reattribution payments made by the taxable unit, and without regard to whether the taxable unit has one or more attribution items after taking into account such reattribution payments. No portion of the foreign gross income of the payor taxable unit is treated as foreign gross income of the payee taxable unit by reason of the reattribution payment, notwithstanding that U.S. gross income of the payor taxable unit that is used to assign foreign gross income of the payor taxable unit to statutory and residual groupings is reattributed to the payee taxable unit under paragraph (d)(3)(v)(B)( 1 ) of this section by reason of the reattribution payment. See paragraph (e) of this section for rules reducing the amount of a foreign gross income item of a taxable unit by deductions allowed under foreign law, including deductions by reason of disregarded payments made by a taxable unit that are included in the foreign gross income of the payee taxable unit.
(C) Remittances and contributions —( 1 ) Remittances —( i ) In general. An item of foreign gross income that a taxpayer includes by reason of the receipt of a remittance by a taxable unit is assigned to the statutory or residual groupings of the recipient taxable unit that correspond to the groupings out of which the payor taxable unit made the remittance under the rules of this paragraph (d)(3)(v)(C)( 1 )( i ). A remittance paid by a taxable unit is considered to be made ratably out of all of the accumulated after-tax income of the taxable unit. The accumulated after-tax income of the taxable unit that pays the remittance is deemed to have arisen in the statutory and residual groupings in the same proportions as the proportions in which the tax book value of the assets of the taxable unit are (or would be if the owner of the taxable unit were a United States person) assigned for purposes of apportioning interest expense under the asset method in § 1.861-9 in the taxable year in which the remittance is made. See paragraph (g)(11) and (12) of this section ( Examples 10 and 11 ). If the payor taxable unit is determined to have no assets under paragraph (d)(3)(v)(C)( 1 )( ii ) of this section, then the foreign gross income that is included by reason of the receipt of the remittance is assigned to the residual grouping.
( ii ) Assets of a taxable unit. The assets of a taxable unit are determined in accordance with § 1.987-6(b), except that for purposes of applying § 1.987-6(b)(2) under this paragraph (d)(3)(v)(C)( 1 )( ii ), a taxable unit is deemed to be a section 987 QBU (within the meaning of § 1.987-1(b)(2)) and assets of the taxable unit include stock held by the taxable unit, the portion of the tax book value of a reattribution asset that is assigned to the taxable unit, and the taxable unit's pro rata share of the assets of another taxable unit (other than a corporation or a partnership), including the portion of any reattribution assets assigned to the other taxable unit, in which it owns an interest. If a taxable unit owns an interest in a taxable unit that is a partnership, the assets of the taxable unit that is the owner include its interest in the partnership or its pro rata share of the partnership assets, as applicable, determined under the principles of § 1.861-9(e). The portion of the tax book value of a reattribution asset that is assigned to a taxable unit is an amount that bears the same ratio to the total tax book value of the reattribution asset as the sum of the attribution items of that taxable unit arising from gross income produced by the reattribution asset bears to the total gross income produced by the reattribution asset. The portion of a reattribution asset that is assigned to a taxable unit under this paragraph (d)(3)(v)(C)( 1 )( ii ) is not treated as an asset of the taxable unit making the reattribution payment for purposes of applying paragraph (d)(3)(v)(C)( 1 )( i ) of this section.
( 2 ) Contributions. An item of foreign gross income that a taxpayer includes by reason of the receipt of a contribution by a taxable unit is assigned to the residual grouping. See, however, § 1.904-6(b)(2)(ii) (assigning certain items of foreign gross income to the foreign branch category for purposes of applying section 904 as the operative section).
( 3 ) Disregarded payment that comprises both a reattribution payment and a remittance or contribution. If both a reattribution payment and either a remittance or a contribution result from a single disregarded payment, the foreign gross income is first attributed to the portion of the disregarded payment that is a reattribution payment to the extent of the amount of the reattribution payment, and any excess of the foreign gross income item over the amount of the reattribution payment is then to attributed to the portion of the disregarded payment that is a remittance or contribution.
(D) Disregarded payments in connection with disregarded sales or exchanges of property. An item of foreign gross income that is attributable to gain recognized under foreign law by reason of a disregarded payment, other than the portion of the disregarded payment that is a reattribution payment, received in exchange for property is characterized and assigned under the rules of paragraph (d)(2) of this section. See paragraph (d)(3)(v)(B) of this section for rules for assigning an item of foreign gross income attributable to the portion of a disregarded payment that is a reattribution payment, including a reattribution payment received in exchange for property.
(E) Definitions. The following definitions apply for purposes of this paragraph (d)(3)(v) and paragraph (g) of this section.
( 1 ) Attribution item. The term attribution item means the portion of an item of gross income, computed under Federal income tax law, that is attributed to a taxable unit after taking into account all reattribution payments made and received by the taxable unit.
( 2 ) Contribution. The term contribution means the excess amount of a disregarded payment, other than a disregarded payment received in exchange for property, made by a taxable unit to another taxable unit that the first taxable unit owns over the portion of the disregarded payment, if any, that is a reattribution payment.
( 3 ) Disregarded entity. The term disregarded entity means an entity described in § 301.7701-2(c)(2) of this chapter that is disregarded as an entity separate from its owner for Federal income tax purposes.
( 4 ) Disregarded payment. The term disregarded payment means an amount of property (within the meaning of section 317(a)) that is transferred to or from a taxable unit, including a transfer of property that would be a contribution to capital described in section 118 or a transfer described in section 351 if the taxable unit were a corporation under Federal income tax law, a transfer of property that would be a distribution by a corporation to a shareholder with respect to its stock if the taxable unit were a corporation under Federal income tax law, or a payment in exchange for property or in satisfaction of an account payable, in connection with a transaction that is disregarded for Federal income tax purposes and that is reflected on the separate set of books and records of the taxable unit. A disregarded payment also includes any other amount that is reflected on the separate set of books and records of a taxable unit in connection with a transaction that is disregarded for Federal income tax purposes and that would constitute an item of accrued income, gain, deduction, or loss of the taxable unit if the transaction to which the amount is attributable were regarded for Federal income tax purposes.
( 5 ) Reattribution amount. The term reattribution amount means an amount of gross income, computed under Federal income tax law, that is initially assigned to a single statutory or residual grouping that includes gross income of a taxable unit but that is, by reason of a disregarded payment made by that taxable unit, attributed to another taxable unit under paragraph (d)(3)(v)(B)( 2 ) of this section.
( 6 ) Reattribution asset. The term reattribution asset means an asset that produces one or more items of gross income, computed under Federal income tax law, to which a disregarded payment is allocated under the rules of paragraph (d)(3)(v)(B)( 2 ) of this section.
( 7 ) Reattribution payment. The term reattribution payment means the portion of a disregarded payment equal to the sum of all reattribution amounts that are attributed to the recipient of the disregarded payment.
( 8 ) Remittance. The term remittance means the excess amount, other than an amount that is treated as a contribution under paragraph (d)(3)(v)(E)( 2 ) of this section, of a disregarded payment, other than a disregarded payment received in exchange for property, made by a taxable unit to a second taxable unit (including a second taxable unit that shares the same owner as the payor taxable unit) over the portion of the disregarded payment, if any, that is a reattribution payment.
( 9 ) Taxable unit. In the case of a taxpayer that is an individual or a domestic corporation, the term taxable unit means a foreign branch, a foreign branch owner, or a non-branch taxable unit, as defined in § 1.904-6(b)(2)(i)(B). In the case of a taxpayer that is a foreign corporation, the term taxable unit means a tested unit, as defined in § 1.951A-2(c)(7)(iv)(A).
(vi) Foreign gross income included by reason of U.S. equity hybrid instrument ownership —(A) Foreign gross income included by reason of an accrual. Foreign gross income included by reason of an accrual under foreign law with respect to a U.S. equity hybrid instrument is considered to arise from the same transaction or realization event as a distribution of property described in paragraph (d)(3)(i) or (ii) of this section and is assigned to the statutory and residual groupings by treating each amount accrued as a foreign law distribution made on the date of the accrual under foreign law.
(B) Foreign gross income included by reason of a payment. Foreign gross income included by reason of a payment of interest under foreign law with respect to a U.S. equity hybrid instrument is considered to arise from the same transaction or realization event as a distribution of property described in paragraph (d)(3)(i) or (ii) of this section and is assigned to the statutory and residual groupings by treating each payment as a distribution made on the date of the payment.
(e) Allocating and apportioning deductions (allowed under foreign law) to foreign gross income in a grouping —(1) Application of foreign law expense allocation rules. In order to determine foreign taxable income in each statutory grouping, or the residual grouping, foreign gross income in each grouping is reduced by deducting any expenses, losses, or other amounts that are deductible under foreign law that are specifically allocable to the items of foreign gross income in the grouping under the laws of that foreign country. If expenses are not specifically allocated under foreign law, then the expenses are allocated and apportioned among the groupings under the principles of foreign law. Thus, for example, if foreign law provides that expenses will be apportioned on a gross income basis, the foreign law deductions are apportioned on the basis of the relative amounts of foreign gross income assigned to each grouping.
(2) Application of U.S. expense allocation rules in the absence of foreign law rules. If foreign law does not provide rules for the allocation or apportionment of expenses, losses or other deductions to particular items of foreign gross income, then the principles of the section 861 regulations (as defined in § 1.861-8(a)(1)) apply in allocating and apportioning such expenses, losses, or other deductions to foreign gross income. For example, in the absence of foreign law expense allocation rules, the principles of the section 861 regulations apply to allocate definitely related expenses to particular categories of foreign gross income and provide the methods for apportioning foreign law expenses that are definitely related to more than one statutory grouping or that are not definitely related to any statutory grouping. For purposes of this paragraph (e)(2), the apportionment of expenses required to be made under the principles of the section 861 regulations need not be made on other than a separate company basis. If the taxpayer applies the principles of the section 861 regulations for purposes of allocating foreign law deductions under this paragraph (e), the taxpayer must apply the principles in the same manner as the taxpayer applies such principles in determining the income or earnings and profits for Federal income tax purposes of the taxpayer (or of the foreign branch, controlled foreign corporation, or other entity that paid or accrued the foreign taxes, as the case may be). For example, a taxpayer must use the modified gross income method under § 1.861-9T when applying the principles of that section for purposes of this paragraph (e) to determine the amount of foreign taxable income in each grouping if the taxpayer applies the modified gross income method in determining the income and earnings and profits of a controlled foreign corporation for Federal income tax purposes.
(f) Allocation and apportionment of foreign income tax. Foreign income tax is allocated to the statutory or residual grouping or groupings to which the items of foreign gross income are assigned under the rules of paragraph (d) of this section. If foreign gross income is assigned to more than one grouping, then the foreign income tax is apportioned among the statutory and residual groupings by multiplying the foreign income tax by a fraction, the numerator of which is the foreign taxable income in a grouping and the denominator of which is all foreign taxable income on which the foreign income tax is imposed. If foreign law, including by reason of an income tax convention, exempts certain types of income from tax, or if foreign taxable income is reduced to or below zero by foreign law deductions, then no foreign income tax is allocated and apportioned to that income. A withholding tax (as defined in section 901(k)(1)(B)) is allocated and apportioned to the foreign gross income from which it is withheld. If foreign law, including by reason of an income tax convention, provides for a specific rate of tax with respect to certain types of income (for example, capital gains), or allows credits only against tax on particular items or types of income (for example, credit for foreign withholding taxes), then such provisions are taken into account in determining the amount of foreign tax imposed on such foreign taxable income.
(g) Examples. The following examples illustrate the application of this section and § 1.904-6.
(1) Presumed facts. Except as otherwise provided in this paragraph (g), the following facts are assumed for purposes of the examples in paragraphs (g)(2) through (9) of this section:
(i) USP and US2 are domestic corporations, which are unrelated;
(ii) USP elects to claim a foreign tax credit under section 901;
(iii) CFC, CFC1, and CFC2 are controlled foreign corporations organized in Country A, and are not reverse hybrids;
(iv) All parties have a U.S. dollar functional currency and a U.S. taxable year and foreign taxable year that correspond to the calendar year;
(v) No party has expenses for Country A tax purposes or expenses for U.S. tax purposes (other than foreign income tax expense); and
(vi) Section 904 is the operative section, and terms have the meaning provided in this section or §§ 1.904-4 and 1.904-5.
(2) Example 1: Corresponding U.S. item —(i) Facts. USP conducts business in Country A that gives rise to a foreign branch (as defined in § 1.904-4(f)(3)). In Year 1, in a transaction that is a sale for purposes of the laws of Country A and Federal income tax law, the foreign branch transfers Asset X to US2 for $1,000x. For Country A tax purposes, USP earns $600x of gross income from the sale of Asset X and incurs foreign income tax of $80x. For Federal income tax purposes, USP earns $800x of foreign branch category income from the sale of Asset X.
(ii) Analysis. For purposes of allocating and apportioning the $80x of Country A foreign income tax, the $600x of Country A gross income from the sale of Asset X is first assigned to separate categories. The $800x of foreign branch category income from the sale of Asset X is the corresponding U.S. item to the Country A item of gross income. Under paragraph (d)(1) of this section, because USP recognizes a corresponding U.S. item with respect to the Country A item of gross income in the same U.S. taxable year, the $600x of Country A gross income is assigned to the same separate category as the corresponding U.S. item. This is the case even though the amount of gross income recognized for Federal income tax purposes differs from the amount recognized for Country A tax purposes. Accordingly, the $600x of Country A gross income is assigned to the foreign branch category. Additionally, because all of the Country A taxable income is assigned to a single separate category, the $80x of Country A tax is also allocated to the foreign branch category. No apportionment of the $80x is necessary because the class of gross income to which the tax is allocated consists entirely of a single statutory grouping, foreign branch category income.
(3) Example 2: Foreign law disposition —(i) Facts. USP owns all of the outstanding stock of CFC, which conducts business in Country A. CFC sells Asset X for $1,000x. For Country A tax purposes, CFC's basis in Asset X is $600x, the sale of Asset X occurs in Year 1, and CFC recognizes $400x of foreign gross income and incurs $80x of foreign income tax. For Federal income tax purposes, CFC's basis in Asset X is $500x, the sale of Asset X occurs in Year 2, and CFC recognizes $500x of general category income.
(ii) Analysis. For purposes of allocating and apportioning the $80x of Country A foreign income tax in Year 1, the $400x of Country A gross income from the sale of Asset X is first assigned to separate categories. There is no corresponding U.S. item because the sale occurs on a different date and in a different U.S. taxable year for U.S. and foreign tax purposes. Under paragraph (d)(2)(ii)(C) of this section, the item of foreign gross income (the $400x from the sale of Asset X) is characterized and assigned to the groupings to which the corresponding U.S. item would be assigned if for Federal income tax purposes Asset X were sold for $1,000x in Year 1, the same U.S. taxable year in which the foreign income tax accrued. This is the case even though the amount of gross income that would be recognized for Federal income tax purposes differs from the amount recognized for Country A tax purposes. Accordingly, the $400x of Country A gross income is assigned to the general category. Additionally, because all of the Country A taxable income is assigned to a single separate category, the $80x of Country A tax is also allocated to the general category. No apportionment of the $80x is necessary because the class of gross income to which the deduction is allocated consists entirely of a single statutory grouping, general category income.
(4) Example 3: Foreign gross income excluded from U.S. gross income —(i) Facts. USP conducts business in Country A. In Year 1, USP earns $200x of interest income on a State or local bond. For Country A tax purposes, the $200x of income is included in gross income and incurs $10x of foreign income tax. For Federal income tax purposes, the $200x is excluded from gross income under section 103.
(ii) Analysis. For purposes of allocating and apportioning the $10x of Country A foreign income tax, the $200x of Country A gross income is first assigned to separate categories. There is no corresponding U.S. item because the interest income is excluded from U.S. gross income. Thus, the rules of paragraph (d)(2) of this section apply to characterize and assign the foreign gross income to the groupings to which a corresponding U.S. item would be assigned if it were recognized under Federal income tax law in that U.S. taxable year. The interest income is excluded from U.S. gross income but is otherwise described or identified by section 103. Accordingly, under paragraph (d)(2)(iii)(A) of this section, the $200x of Country A gross income is assigned to the separate category to which the interest income would be assigned under Federal income tax law if the income were included in gross income. Under section 904(d)(2)(B)(i), the interest income would be passive category income. Accordingly, the $200x of Country A gross income is assigned to the passive category. Additionally, because all of the Country A taxable income is assigned to a single separate category, the $10x of Country A tax is also allocated to the passive category (subject to the rules in § 1.904-4(c)). No apportionment of the $10x is necessary because the class of gross income to which the deduction is allocated consists entirely of a single statutory grouping, passive category income.
(5) Example 4: Actual distribution —(1) Facts. USP owns all of the outstanding stock of CFC1, which in turn owns all of the outstanding stock of CFC2. CFC1 and CFC2 conduct business in Country A. In Year 1, CFC2 distributes $300x to CFC1. For Country A tax purposes, $100x of the distribution is the foreign dividend amount, $160x is treated as a nontaxable return of capital, and the remaining $40x is the foreign capital gain amount. CFC1 incurs $20x of foreign income tax with respect to the foreign dividend amount and $4x of foreign income tax with respect to the foreign capital gain amount. The $20x and $4x of foreign income tax are each a separate levy within the meaning of § 1.901-2(d). For Federal income tax purposes, $150x of the distribution is the U.S. dividend amount, $100x is the U.S. return of capital amount, and the remaining $50x is the U.S. capital gain amount. Under section 904(d)(3)(D) and §§ 1.904-4(d) and 1.904-5(c)(4), the $150x of U.S. dividend amount consists solely of general category income in the hands of CFC1. Under section 904(d)(2)(B)(i) and § 1.904-4(b)(2)(i)(A), the $50x of U.S. capital gain amount is passive category income to CFC1.
(ii) Analysis —(A) In general. Because the $20x of Country A foreign income tax and the $4x of Country A foreign income tax are separate levies, the taxes are allocated and apportioned separately. For purposes of allocating and apportioning each foreign income tax, the relevant item of Country A gross income (the foreign dividend amount or foreign capital gain amount) is first assigned to separate categories. The U.S. dividend amount and U.S. capital gain amount are corresponding U.S. items. However, paragraph (d)(3)(i)(B) of this section (and not paragraph (d)(1) of this section) applies to assign the items of foreign gross income arising from the distribution.
(B) Foreign dividend amount. Under paragraph (d)(3)(i)(B)( 2 ) of this section, the foreign dividend amount ($100x) is, to the extent of the U.S. dividend amount ($150x), assigned to the same separate category from which the distribution of the U.S. dividend amount is made under Federal income tax law. Thus, $100x of foreign gross income that is the foreign dividend amount is assigned to the general category. Additionally, because all of the Country A taxable income included in the base on which the $20x of foreign income tax is imposed is assigned to a single separate category, the $20x of Country A tax on the foreign dividend amount is also allocated to the general category. No apportionment of the $20x is necessary because the class of gross income to which the deduction for foreign income tax is allocated consists entirely of a single statutory grouping, general category income. See also section 245A(d) for rules that may apply to disallow a credit or deduction for certain foreign taxes.
(C) Foreign capital gain amount. Under paragraph (d)(3)(i)(B)( 3 ) of this section, the foreign capital gain amount ($40x) is, to the extent of the U.S. capital gain amount ($50x), assigned to the same separate category to which the U.S. capital gain is assigned under Federal income tax law. Thus, the $40x of foreign gross income that is the foreign capital gain amount is assigned to the passive category. Additionally, because all of the Country A taxable income in the base on which the $4x of foreign income tax is imposed is assigned to a single separate category, the $4x of Country A tax on the foreign dividend amount is also allocated to the passive category. No apportionment of the $4x is necessary because the class of gross income to which the deduction is allocated consists entirely of a single statutory grouping, passive category income.
(6) Example 5: Foreign law distribution —(i) Facts. USP owns all of the outstanding stock of CFC. In Year 1, for Country A tax purposes, CFC distributes $1,000x of its stock that is treated entirely as a dividend to USP, and Country A imposes a withholding tax on USP of $150x with respect to the $1,000x of foreign gross income. For Federal income tax purposes, the distribution is treated as a stock dividend described in section 305(a) and USP recognizes no U.S. gross income. At the time of the distribution, CFC has $800x of section 965(a) PTEP (as defined in § 1.960-3(c)(2)(vi)) in a single annual PTEP account (as defined in § 1.960-3(c)(1)), and $500x of earnings and profits described in section 959(c)(3). Section 965(g) is the operative section for purposes of this paragraph (g)(6). See § 1.965-5(b)(2). Section 904 is also a relevant operative section, but is not addressed in this paragraph (g)(6).
(ii) Analysis. For purposes of allocating and apportioning the $150x of Country A foreign income tax, the $1,000x of Country A gross income is first assigned to the relevant statutory and residual groupings for purposes of applying section 965(g) as the operative section. Under § 1.965-5(b)(2), the statutory grouping is the portion of the distribution that is attributable to section 965(a) previously taxed earnings and profits and the residual grouping is the portion of the distribution attributable to other earnings and profits. There is no corresponding U.S. item because under section 305(a) USP recognizes no U.S. gross income with respect to the distribution. Under paragraph (d)(2)(ii)(B) of this section, the item of foreign gross income (the $1,000x distribution) is assigned under the rules of paragraph (d)(3)(i)(B) of this section to the same statutory or residual groupings to which the foreign gross income would be assigned if a distribution of the same amount were made for Federal income tax purposes in Year 1 on the date the distribution occurs for foreign law purposes. If recognized for Federal income tax purposes, a $1,000x distribution in Year 1 would result in a U.S. dividend amount of $1,000x. Under paragraph (d)(3)(i)(B)( 2 ) of this section, the foreign dividend amount ($1,000x) is, to the extent of the U.S. dividend amount ($1,000x), assigned to the same statutory or residual groupings from which a distribution of the U.S. dividend amount would be made under Federal income tax law. Thus, $800x of foreign gross income related to the foreign dividend amount is assigned to the statutory grouping for the portion of the distribution attributable to section 965(a) previously taxed earnings and profits and $200x of foreign gross income is assigned to the residual grouping. Under paragraph (f) of this section, $120x ($150x × $800x/$1,000x) of the Country A foreign income tax is apportioned to the statutory grouping and $30x ($150x × $200x/$1,000x) of the Country A foreign income tax is apportioned to the residual grouping. See section 965(g)(2) and § 1.965-5(b) for application of the applicable percentage (as defined in § 1.965-5(d)) to the foreign income tax allocated and apportioned to the statutory grouping.
(7) Example 6: Foreign law inclusion regime, CFC shareholder —(i) Facts. USP owns all of the outstanding stock of CFC1, which in turn owns all of the outstanding stock of CFC2. CFC2 is organized and conducts business in Country B. Country A has a foreign law inclusion regime that imposes a tax on CFC1 for certain earnings of CFC2, a foreign law CFC. In Year 1, CFC2 earns $400x of interest income and $200x of royalty income. CFC2 incurs no foreign income tax. For Country A tax purposes, the $400x of interest income and $200x of royalty income are each an item of foreign law inclusion regime income of CFC2 that are included in the gross income of CFC1. CFC1 incurs $150x of Country A foreign income tax with respect to the foreign law inclusion regime income. For Federal income tax purposes, with respect to CFC2, the $400x of interest income is passive category income under section 904(d)(2)(B)(i) and the $200x of royalty income is general category income under § 1.904-4(b)(2)(iii).
(ii) Analysis. For purposes of allocating and apportioning CFC1's $150x of Country A foreign income tax, the $600x of Country A gross income is first assigned to separate categories. The $600x of foreign gross income is not included in the U.S. gross income of CFC1, and thus, there is no corresponding U.S. item. Under paragraph (d)(3)(iii) of this section, each item of foreign law inclusion regime income that is included in CFC1's foreign gross income is assigned to the same separate category as the items of foreign gross income of CFC2 that give rise to the foreign law inclusion regime income of CFC1. With respect to CFC2, the $400x of interest income and the $200x of royalty income would be corresponding U.S. items if CFC2 were the taxpayer. Accordingly, $400x of CFC1's foreign gross income is assigned to the passive category and $200x of CFC1's foreign gross income is assigned to the general category. Under paragraph (f) of this section, $100x ($150x × $400x/$600x) of the Country A foreign income tax is apportioned to the passive category and $50x ($150x × $200x/$600x) of the Country A foreign income tax is apportioned to the general category.
(8) Example 7: Foreign law inclusion regime, U.S. shareholder —(i) Facts. The facts are the same as in paragraph (g)(7)(i) of this section (the facts in Example 6 ), except that both CFC1 and CFC2 are organized and conduct business in Country B, all of the outstanding stock of CFC1 is owned by Individual X, a U.S. citizen resident in Country A, and Country A imposes tax of $150x on foreign gross income of $600x under its foreign law inclusion regime on Individual X, rather than on CFC1. For Federal income tax purposes, in the hands of CFC2, the $400x of interest income is passive category subpart F income and the $200x of royalty income is general category tested income (as defined in § 1.951A-2(b)(1)). CFC2's $400x of interest income gives rise to a passive category subpart F inclusion under section 951(a)(1)(A), and its $200x of tested income gives rise to a GILTI inclusion amount (as defined in § 1.951A-1(c)(1)) of $200x, with respect to Individual X.
(ii) Analysis. The analysis is the same as in paragraph (g)(7)(ii) of this section (the analysis in Example 6 ) except that under § 1.904-6(f), because $50x of the Country A foreign income tax is allocated and apportioned under paragraph (d)(3)(iii) of this section to CFC2's general category tested income group to which Individual X's inclusion under section 951A is attributable, the $50x of Country A foreign income tax is allocated and apportioned in the hands of Individual X to the section 951A category.
(9) Example 8: Sale of disregarded entity —(i) Facts. USP sells FDE, a disregarded entity that is organized and operates a trade or business in Country A, for $500x. FDE owns Asset X and Asset Y in Country A, each having a fair market value of $250x. For Country A tax purposes, FDE has a basis in Asset X of $100x and a basis in Asset Y of $200x, USP's basis in FDE is $100x, and the sale is treated as a sale of stock. Country A imposes foreign income tax of $40x on USP on the Country A gross income of $400x resulting from the sale of FDE, based on its rules for taxing capital gains of nonresidents selling stock of companies operating a trade or business in Country A. For Federal income tax purposes, USP has a basis of $150x in each of Assets X and Y, and so the sale of FDE results in $100x of passive category income with respect to the sale of Asset X and $100x of general category income with respect to the sale of Asset Y.
(ii) Analysis. For purposes of allocating and apportioning USP's $40x of Country A foreign income tax, the $400x of Country A gross income resulting from the sale of FDE is first assigned to separate categories. Under paragraph (d)(3)(iv) of this section, USP's $400x of Country A gross income is assigned among the statutory groupings in the same percentages as the foreign gross income in each grouping that would have resulted if the sale of FDE were treated as an asset sale for Country A tax purposes. Because for Country A tax purposes Asset X had a built-in gain of $150x and Asset Y had a built-in gain of $50x, $300x ($400x × $150x/$200x) of the Country A gross income is assigned to the passive category and $100x ($400x × $50x/$200x) is assigned to the general category. Under paragraph (f) of this section, $30x ($40x × $300x/$400x) of the Country A foreign income tax is apportioned to the passive category, and $10x ($40x × $100x/$400x) of the Country A foreign income tax is apportioned to the general category.
(10) Example 9: Gain on disposition of stock —(i) Facts. USP owns all of the outstanding stock of CFC, which conducts business in Country A. In Year 1, USP sells all of the stock of CFC to US2 for $1,000x. For Country A tax purposes, USP's basis in the stock of CFC is $200x. Accordingly, USP recognizes $800x of gain on which Country A imposes $80x of foreign income tax based on its rules for taxing capital gains of nonresidents, which satisfy the requirement in § 1.901-2(b)(5)(i)(C). For Federal income tax purposes, USP's basis in the stock of CFC is $400x. Accordingly, USP recognizes $600x of gain on the sale of the stock of CFC, of which $150x is included in the gross income of USP as a dividend under section 1248(a) that, as provided in section 1248(j), is treated as a dividend eligible for the deduction under section 245A(a). Under paragraphs (b)(20) and (21) of this section, respectively, the sale of CFC stock by USP gives rise to a $450x U.S. capital gain amount and a $150x U.S. dividend amount. Under §§ 1.904-4(d) and 1.904-5(c)(4), the $150x U.S. dividend amount is general category section 245A subgroup income, and the $450x U.S. capital gain amount is passive category income to USP. For purposes of allocating and apportioning its interest expense under §§ 1.861-9(g)(2)(i)(B) and 1.861-13, USP's stock in CFC is characterized as general category stock in the section 245A subgroup.
(ii) Analysis. For purposes of allocating and apportioning the $80x of Country A foreign income tax, the $800x of Country A gross income from the sale of the stock of CFC is first assigned to separate categories. Under paragraph (d)(3)(i)(D) of this section, the $800x of Country A gross income is first assigned to the separate category to which the $150x U.S. dividend amount is assigned, to the extent thereof, and is next assigned to the separate category to which the $450x U.S. capital gain amount is assigned, to the extent thereof. Accordingly, $150x of Country A gross income is assigned to the general category in the section 245A subgroup, and $450x of Country A gross income is assigned to the passive category. Under paragraph (d)(3)(i)(D) of this section, the remaining $200x of Country A gross income is assigned to the statutory and residual groupings to which earnings of CFC in that amount would be assigned if they were recognized for Federal income tax purposes in the U.S. taxable year in which the disposition occurred. These earnings are all deemed to arise in the section 245A subgroup of the general category, based on USP's characterization of its stock in CFC. Thus, under paragraph (d)(3)(i)(D) of this section the $800x of foreign gross income, and therefore the foreign taxable income, is characterized as $350x ($150x + $200x) of income in the general category section 245A subgroup and $450x of income in the passive category. This is the result even though for Country A tax purposes all $800x of Country A gross income is characterized as gain from the sale of stock, which would be passive category income under section 904(d)(2)(B)(i), because the income is assigned to a separate category based on the characterization of the gain under Federal income tax law. Under paragraph (f) of this section, the $80x of Country A tax is ratably apportioned between the general category section 245A subgroup and the passive category based on the relative amounts of foreign taxable income in each grouping. Accordingly, $35x ($80x × $350x/$800x) of the Country A tax is apportioned to the general category section 245A subgroup, and $45x ($80x × $450x/$800x) of the Country A tax is apportioned to the passive category. See also § 1.245A(d)-1 for rules that may disallow a credit or deduction for the $35x of Country A tax apportioned to the general category section 245A subgroup.
(11) Example 10: Disregarded transfer of built-in gain property —(i) Facts. USP owns FDE, a disregarded entity that is treated for Federal income tax purposes as a foreign branch operating in Country A. FDE transfers Asset F, equipment used in FDE's trade or business in Country A, for no consideration to USP in a transaction that is a remittance described in paragraph (d)(3)(v)(E) of this section for Federal income tax purposes but is treated as a distribution of Asset F from a corporation to its shareholder, USP, for Country A tax purposes. At the time of the transfer, Asset F has a fair market value of $250x and an adjusted basis of $100x for both Federal and Country A income tax purposes. Country A imposes $30x of tax on FDE with respect to the $150x of built-in gain on a deemed sale of Asset F, which is recognized for Country A tax purposes by reason of the transfer to USP. If FDE had sold Asset F for $250x in a transaction that was regarded for Federal income tax purposes, FDE would also have recognized gain of $150x for Federal income tax purposes, and that gain would have been characterized as foreign branch category income under § 1.904-4(f). Country A also imposes $25x of withholding tax, a separate levy, on USP by reason of the distribution of Asset F to USP.
(ii) Analysis —(A) Net income tax on built-in gain. For purposes of allocating and apportioning the $30x of Country A foreign income tax imposed on FDE by reason of the transfer of Asset F to USP for Country A tax purposes, under paragraph (c)(1) of this section the $150x of Country A gross income is first assigned to a separate category. Because the transfer does not result in a deemed sale for Federal income tax purposes, there is no corresponding U.S. item. However, FDE would have recognized gain of $150x, which would have been the corresponding U.S. item, if the deemed sale had been recognized for Federal income tax purposes. Therefore, under paragraph (d)(2)(ii) of this section, the $150x item of foreign gross income is characterized and assigned to the grouping to which such corresponding U.S. item would have been assigned if the deemed sale were recognized under Federal income tax law. Because the sale of Asset F in a regarded transaction would have resulted in foreign branch category income, the foreign gross income is characterized as foreign branch category income. Under paragraph (f) of this section, the $30x of Country A tax is also allocated to the foreign branch category, the statutory grouping to which the $150x of Country A gross income is assigned. No apportionment of the $30x of Country A tax is necessary because the class of gross income to which the foreign gross income is allocated consists entirely of a single statutory grouping.
(B) Withholding tax on distribution. For purposes of allocating and apportioning the $25x of Country A withholding tax imposed on USP by reason of the transfer of Asset F, under paragraph (c)(1) of this section the $250x of Country A gross income arising from the transfer of Asset F is first assigned to a separate category. For Federal income tax purposes, the transfer of Asset F is a remittance from FDE to USP, and thus there is no corresponding U.S. item. Under paragraph (d)(3)(v)(C)( 1 )( i ) of this section, the item of foreign gross income is assigned to the groupings to which the income out of which the payment is made is assigned; the payment is considered to be made ratably out of all of the accumulated after-tax income of FDE, as computed for Federal income tax purposes; and the accumulated after-tax income of FDE is deemed to have arisen in the statutory and residual groupings in the same proportions as those in which the tax book value of FDE's assets in the groupings, determined in accordance with paragraph (d)(3)(v)(C)( 1 )( ii ) of this section, are assigned for purposes of apportioning USP's interest expense. Because all of FDE's assets produce foreign branch category income, under paragraph (d)(3)(v)(C)( 1 ) of this section the foreign gross income is characterized as foreign branch category income. Under paragraph (f) of this section, the $25x of Country A withholding tax is also allocated entirely to the foreign branch category, the statutory grouping to which the $250x of Country A gross income is assigned. No apportionment of the $25x is necessary because the class of gross income to which the foreign gross income is allocated consists entirely of a single statutory grouping.
(12) Example 11: Disregarded payment that is a remittance —(i) Facts. USP wholly owns CFC1, which is a tested unit within the meaning of § 1.951A-2(c)(7)(iv)(A) (the “CFC1 tested unit”). CFC1 wholly owns FDE, a disregarded entity that is organized in Country B, which is a tested unit within the meaning of § 1.951A-2(c)(7)(iv)(A) (the “FDE tested unit”). The sole assets of FDE (determined in accordance with paragraph (d)(3)(v)(C)( 1 )( ii ) of this section) are all the outstanding stock of CFC3, a controlled foreign corporation organized in Country B. In Year 1, CFC3 pays a $400x dividend to FDE that is excluded from CFC1's foreign personal holding company income (“FPHCI”) by reason of section 954(c)(6). FDE makes no payments to CFC1 and pays no Country B tax in Year 1. In Year 2, FDE makes a $400x remittance to CFC1 as defined in paragraph (d)(3)(v)(E) of this section. Under the laws of Country B, the remittance gives rise to a $400x dividend. Country B imposes a 5% ($20x) withholding tax (which is an eligible current year tax as defined in § 1.960-1(b)) on CFC1 on the dividend. In Year 2, CFC3 pays no dividends to FDE, and FDE earns no income. For Federal income tax purposes, the $400x payment from FDE to CFC1 is a disregarded payment and results in no income to CFC1. For purposes of this paragraph (g)(12) ( Example 11 ), section 960(a) is the operative section and the income groups described in § 1.960-1(d)(2) are the statutory and residual groupings. See § 1.960-1(d)(3)(ii)(A) (applying § 1.960-1 to allocate and apportion current year taxes to income groups). For Federal income tax purposes, in Year 2 the stock of CFC3 owned by FDE has a tax book value of $1,000x, $750x of which is assigned under the asset method in § 1.861-9 (as applied by treating CFC1 as a United States person) to the general category tested income group described in § 1.960-1(d)(2)(ii)(C), and $250x of which is assigned to a passive category FPHCI group described in § 1.960-1(d)(2)(ii)(B)( 2 )( i ).
(ii) Analysis. (A) The $20x Country B withholding tax on the Year 2 remittance from FDE is imposed on a $400x item of foreign gross income that CFC1 includes in foreign gross income by reason of its receipt of a disregarded payment. In order to allocate and apportion the $20x of Country B withholding tax under paragraph (c) of this section for purposes of § 1.960-1(d)(3)(ii)(A), paragraph (d)(3)(v) of this section applies to assign the $400x item of foreign gross dividend income to a statutory or residual grouping. Under paragraph (d)(3)(v)(C)( 1 ) of this section, the $400x item of foreign gross income is assigned to the statutory or residual groupings of the CFC1 tested unit that correspond to the statutory and residual groupings out of which FDE made the remittance.
(B) Under paragraph (d)(3)(v)(C)( 1 )( i ) of this section, FDE is considered to have made the remittance ratably out of all of its accumulated after-tax income, which is deemed to have arisen in the statutory and residual groupings in the same proportions as the proportions in which the tax book value of FDE's assets would be assigned (if CFC1 were a United States person) for purposes of apportioning interest expense under the asset method in Year 2, the taxable year in which FDE made the remittance. Accordingly, $300x ($400x × $750x/$1,000x) of the remittance is deemed made out of the general category tested income of the FDE tested unit, and $100x ($400x × $250x/$1,000x) of the remittance is deemed made out of the passive category FPHCI of the FDE tested unit.
(C) Under paragraph (d)(3)(v)(C)( 1 )( i ) of this section, $300x of the $400x item of foreign gross income from the remittance, and therefore an equal amount of foreign taxable income, is assigned to the income group that includes general category tested income attributable to the CFC1 tested unit, and $100x of this foreign gross income item, and therefore an equal amount of foreign taxable income, is assigned to the income group that includes passive category FPHCI attributable to the CFC1 tested unit. Under paragraph (f) of this section, the $20x of Country B withholding tax is ratably apportioned between the income groups based on the relative amounts of foreign taxable income in each grouping. Accordingly, $15x ($20x × $300x/$400x) of the Country B withholding tax is apportioned to the CFC1 tested unit's general category tested income group, and $5x ($20x × $100x/$400x) of the Country B withholding tax is apportioned to the CFC1 tested unit's passive category FPHCI income group. See § 1.960-2 for rules on determining the amount of such taxes that may be deemed paid under section 960(a) and (d).
(13) Example 12: Disregarded payment that is a reattribution payment —(i) Facts. (A) USP wholly owns CFC1, a tested unit within the meaning of § 1.951A-2(c)(7)(iv)(A)( 1 ) (the “CFC1 tested unit”). CFC1 wholly owns FDE1, a disregarded entity organized in Country B, that is a tested unit within the meaning of § 1.951A-2(c)(7)(iv)(A)( 2 ) (the “FDE1 tested unit”). Country B imposes a 20 percent net income tax on its residents. CFC1 also wholly owns FDE2, a disregarded entity organized in Country C, that is a tested unit within the meaning of § 1.951A-2(c)(7)(iv)(A)( 2 ) (the “FDE2 tested unit”). Country C imposes a 15 percent net income tax on its residents. The net income tax imposed by each of Country B and Country C on their tax residents is a foreign income tax within the meaning of § 1.901-2(a) and a separate levy within the meaning of § 1.901-2(d). For purposes of this paragraph (g)(13) ( Example 12 ), the operative section is the high-tax exclusion of section 951A(c)(2)(A)(i)(III) and § 1.951A-2(c)(7), and the statutory groupings are the tested income groups of each tested unit, as defined in § 1.951A-2(c)(7)(iv)(A).
(B) FDE2 owns Asset A, which is intangible property with a tax book value of $12,000x that is properly reflected on the separate set of books and records of FDE2. In Year 1, pursuant to a license agreement between FDE1 and FDE2 for the use of Asset A, FDE1 makes a disregarded royalty payment to FDE2 of $1,000x that would be deductible if regarded for Federal income tax purposes. Because it is disregarded for Federal income tax purposes, the $1,000x disregarded royalty payment by FDE1 to FDE2 results in no income to CFC1 for Federal income tax purposes. Also, in Year 1, pursuant to a sub-license agreement between FDE1 and an unrelated third party for the use of Asset A, FDE1 earns $1,200x of royalty income for Federal income tax purposes (the “U.S. gross royalty”) for the use of Asset A. The $1,200 of royalty income received by FDE1 from the unrelated third party is excluded from CFC1's foreign personal holding company income by reason of the active business exception in section 954(c)(2) because CFC1 satisfies the requirements of § 1.954-2(d)(1). As a result, the $1,200x of royalty income that FDE1 earns from the sub-license agreement is gross tested income (as defined in § 1.951A-2(c)(1)), which is properly reflected on the separate set of books and records of FDE1.
(C) Under the laws of Country B, the transaction that gives rise to the $1,200x item of U.S. gross royalty income causes FDE1 to include a $1,200x item of gross royalty income in its Country B taxable income (the “Country B gross royalty”). In addition, FDE1 deducts its $1,000x disregarded royalty payment to FDE2 for Country B tax purposes. For Country B tax purposes, FDE1 therefore has $200x ($1,200x−$1,000x) of taxable income on which Country B imposes $40x (20% × $200x) of net income tax.
(D) Under the laws of Country C, the $1,000x disregarded royalty payment from FDE1 to FDE2 causes FDE2 to include a $1,000x item of gross royalty income in its Country C taxable income (the “Country C gross royalty”). FDE2 therefore has $1,000x of taxable income for Country C tax purposes, on which Country C imposes $150x (15% × $1,000x) of net income tax.
(ii) Analysis —(A) Country B net income tax. ( 1 ) The Country B net income tax is imposed on foreign taxable income of FDE1 that consists of a $1,200x item of Country B gross royalty income and a $1,000x item of royalty expense. For Federal income tax purposes, the FDE1 tested unit has a $1,200x item of U.S. gross royalty income that is initially attributable to it under paragraph (d)(3)(v)(B)( 2 ) of this section and § 1.951A-2(c)(7)(ii)(B). The transaction that produced the $1,200x item of U.S. gross royalty income also produced the $1,200x item of Country B gross royalty income. Under paragraph (b)(2) of this section, the $1,200x item of U.S. gross royalty income is therefore the corresponding U.S. item for the $1,200x item of Country B gross royalty income of FDE1.
( 2 ) The $1,000x disregarded royalty payment from FDE1 to FDE2 is allocated under paragraph (d)(3)(v)(B)( 2 ) of this section and § 1.951A-2(c)(7)(ii)(B) to the $1,200x of U.S. gross income of the FDE1 tested unit to the extent of that gross income. As a result, the $1,000x disregarded royalty payment causes $1,000x of the $1,200x item of U.S. gross royalty income to be reattributed from the FDE1 tested unit to the FDE2 tested unit, and results in a $1,000x reattribution amount that is also a reattribution payment.
( 3 ) The $1,200x Country B gross royalty item that is included in the Country B taxable income of FDE1 is assigned under paragraph (d)(1) of this section to the statutory or residual grouping to which the $1,200x corresponding U.S. item is initially assigned under § 1.951A-2(c)(7)(ii), namely, the FDE1 income group. This assignment is made without regard to the $1,000x reattribution payment from the FDE1 tested unit to the FDE2 tested unit; none of the FDE1 tested unit's $1,200x Country B gross royalty income is reattributed to the FDE2 tested unit for this purpose. See paragraph (d)(3)(v)(B)( 3 ) of this section. Under paragraph (f) of this section, all of the $40x of Country B net income tax on the $200x of Country B taxable income is allocated to the FDE1 income group, the statutory grouping to which the $1,200x item of Country B gross royalty income of FDE1 is assigned. No apportionment of the $40x is necessary because the class of gross income to which the foreign gross income is allocated consists entirely of a single statutory grouping.
(B) Country C net income tax. The Country C net income tax is imposed on foreign taxable income of FDE2 that consists of a $1,000x item of Country C gross royalty income. For Federal income tax purposes, under paragraph (d)(3)(v)(B)( 2 ) of this section and § 1.951A-2(c)(7)(ii)(B), the FDE2 tested unit has a reattribution amount of $1,000x of U.S. gross royalty income by reason of its receipt of the $1,000x reattribution payment from FDE1. The $1,000x item of U.S. gross royalty income that is included in the taxable income of the FDE2 tested unit by reason of the $1,000x reattribution payment is assigned under paragraph (d)(3)(v)(B)( 1 ) of this section to the statutory or residual grouping to which the $1,000x reattribution amount of U.S. gross royalty income that constitutes the reattribution payment is assigned upon receipt by the FDE2 tested unit under § 1.951A-2(c)(7)(ii), namely, the FDE2 income group. Under paragraph (d)(3)(v)(B)( 1 ) of this section, the $1,000x item of Country C gross royalty income is assigned to the statutory grouping to which the $1,000x corresponding U.S. item is assigned. Accordingly, under paragraph (f) of this section, all of the $150x of Country C net income tax is allocated to the FDE2 income group, the statutory grouping to which the $1,000x item of Country C gross royalty income of FDE2 is assigned. No apportionment of the $150x is necessary because the class of gross income to which the foreign gross income is allocated consists entirely of a single statutory grouping.
(14) Example 13: Assets of a taxable unit that owns an interest in a lower-tier taxable unit —(i) Facts. USP wholly owns CFC1, a tested unit within the meaning of § 1.951A-2(c)(7)(iv)(A) (the “CFC1 tested unit”). CFC1 wholly owns FDE1, a disregarded entity that is organized in Country A, and FDE2, a disregarded entity that is organized in Country B. CFC1's interests in FDE1 and FDE2 are each tested units within the meaning of § 1.951A-2(c)(7)(iv)(A) (the “FDE1 tested unit” and “FDE2 tested unit,” respectively). The FDE1 tested unit and FDE2 tested unit each own 50% of the interests in FDE3, a disregarded entity that is organized in Country C. CFC1's indirect interests in FDE3 are also a tested unit within the meaning of § 1.951A-2(c)(7)(iv)(A) (the “FDE3 tested unit”). The FDE2 tested unit owns Asset A with a tax book value of $10,000x, and makes a reattribution payment to FDE3 that causes $5,000x of the tax book value of Asset A to be assigned to FDE3 under paragraph (d)(3)(v)(C)( 1 )( ii ) of this section. FDE3 owns Asset B, which has a tax book value of $5,000x.
(ii) Analysis —(A) Assets of the FDE3 tested unit. The assets of the FDE3 tested unit consist of the portion of Asset A that is assigned to it under paragraph (d)(3)(v)(C)( 1 )( ii ) of this section and any other assets determined in accordance with § 1.987-6(b). The assets of the FDE3 tested unit thus consist of $5,000x of the tax book value of Asset A and all $5,000x of the tax book value of Asset B.
(B) Assets of the FDE2 tested unit. The assets of the FDE2 tested unit consist of the tax book value of any assets that it owns directly plus its pro rata share of the assets of the FDE3 tested unit, including the portion of reattribution assets assigned to the FDE3 tested unit. Asset A is a reattribution asset under paragraphs (d)(3)(v)(C)( 1 )( ii ) and (d)(3)(v)(E) of this section. The assets of the FDE2 tested unit therefore consist of the portion of Asset A that it owns directly and that was not assigned to the FDE3 tested unit (or $5,000x) plus its pro rata share of the portion of Asset A that was assigned to the FDE3 tested unit, or $2,500x (50% of $5,000x). In addition, the assets of the FDE2 tested unit include its pro rata share of the tax book value of Asset B, or $2,500x (50% of $5,000x).
(C) Assets of the FDE1 tested unit. The assets of the FDE1 tested unit consist of its pro rata share of the assets of the FDE3 tested unit, including the portion of reattribution assets assigned to the FDE3 tested unit. Asset A is a reattribution asset under paragraphs (d)(3)(v)(C)( 1 )( ii ) and (d)(3)(v)(E) of this section. The assets of the FDE1 tested unit therefore consist of its pro rata share of the portion of Asset A that was reattributed to the FDE3 tested unit, or $2,500x (50% of $5,000x), plus its pro rata share of the tax book value of Asset B, or $2,500x (50% of $5,000x).
(h) Allocation and apportionment of certain foreign in lieu of taxes described in section 903. A tax that is a foreign income tax by reason of § 1.903-1(c)(1) is allocated and apportioned to statutory and residual groupings in the same proportions as the foreign taxable income that comprises the excluded income (as defined in § 1.903-1(c)(1)). See paragraph (f) of this section for rules on allocating and apportioning certain withholding taxes described in § 1.903-1(c)(2).
(i) Applicability dates. Except as provided in this paragraph (i), this section applies to taxable years beginning after December 31, 2019. Paragraphs (b)(19) and (23) and (d)(3)(i), (ii), and (v) of this section apply to taxable years that begin after December 31, 2019, and end on or after November 2, 2020. Paragraph (h) of this section applies to taxable years beginning after December 28, 2021.
§ 1.862-1   Income specifically from sources without the United States.
(a) Gross income. (1) The following items of gross income shall be treated as income from sources without the United States:
(i) Interest other than that specified in section 861(a)(1) and § 1.861-2 as being derived from sources within the United States;
(ii) Dividends other than those derived from sources within the United States as provided in section 861(a)(2) and § 1.861-3;
(iii) Compensation for labor or personal services performed without the United States;
(iv) Rentals or royalties from property located without the United States or from any interest in such property, including rentals or royalties for the use of, or for the privilege of using, without the United States, patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises, and other like property;
(v) Gains, profits, and income from the sale of real property located without the United States; and
(vi) Gains, profits, and income derived from the purchase of personal property within the United States and its sale without the United States.
(2) In applying subparagraph (1)(iv) of this paragraph for taxable years beginning after December 31, 1966, gains described in section 871(a)(1)(D) and section 881(a)(4) from the sale or exchange after October 4, 1966, of patents, copyrights, and other like property shall be treated, as provided in section 871(e)(2), as rentals or royalties for the use of, or privilege of using, property or an interest in property. See paragraph (e) of § 1.871-11.
(3) For determining the time and place of sale of personal property for purposes of subparagraph (1)(vi) of this paragraph, see paragraph (c) of § 1.861-7.
(4) Income derived from the purchase of personal property within the United States and its sale within a possession of the United States shall be treated as derived entirely from within that possession.
(5) If interest is paid on an obligation of a nonresident of the United States by a resident of the United States acting in the resident's capacity as a guarantor of the obligation of the nonresident, the interest will be treated as income from sources without the United States.
(6) For rules treating certain interest as income from sources without the United States, see paragraph (b) of § 1.861-2.
(7) For the treatment of compensation for labor or personal services performed partly within the United States and partly without the United States, see paragraph (b) of § 1.861-4.
(b) Taxable income. The taxable income from sources without the United States, in the case of the items of gross income specified in paragraph (a) of this section, shall be determined on the same basis as that used in § 1.861-8 for determining the taxable income from sources within the United States.
(c) Income from certain property. For provisions permitting a taxpayer to elect to treat amounts of gross income attributable to certain aircraft or vessels first leased on or before December 28, 1980, as income from sources within the United States which would otherwise be treated as income from sources without the United States under paragraph (a) of this section, see § 1.861-9. For provisions requiring amounts of gross income attributable to certain aircraft, vessels, or spacecraft first leased by the taxpayer after December 28, 1980, to be treated as income from sources within the United States which would otherwise be treated as income from sources without the United States under paragraph (a) of this section, see § 1.861-9A.
§ 1.863-0   Table of contents.
This section lists captions contained in §§ 1.863-1 through 1.863-10.
(a) In general.
(b) Natural resources.
(1) In general.
(2) Additional production activities.
(3) Definitions.
(i) Production activity.
(ii) Additional production activities.
(4) Determination of fair market value.
(5) Determination of gross income.
(6) Tax return disclosure.
(7) Examples.
(i) Example 1. No additional production, foreign source gross receipts.
(ii) Example 2. No additional production, U.S. source gross receipts.
(iii) Example 3. Production in United States, foreign sales.
(iv) Example 4. Production and sales in United States.
(v) Example 5. Additional production.
(c) Determination of taxable income.
(d) Scholarships, fellowship grants, grants, prizes, and awards.
(1) In general.
(2) Source of income.
(i) United States source income.
(ii) Foreign source income.
(iii) Certain activities conducted outside the United States.
(3) Definitions.
(4) Effective dates.
(i) Scholarships and fellowship grants.
(ii) Grants, prizes and awards.
(e) Residual interest in a REMIC.
(1) REMIC inducement fees.
(2) Excess inclusion income and net losses.
(f) Applicability date.
(a) Determination of taxable income.
(b) Determination of source of taxable income.
(c) Applicability date.
(a) In general.
(1) Scope.
(2) Cross references.
(b) Sourcing based solely on production activities.
(c) Determination of the source of gross income from production activity.
(1) Production only within the United States or only within foreign countries.
(i) Source of income.
(ii) Definition of production assets.
(iii) Location of production assets.
(2) Production both within and without the United States.
(i) Source of income.
(ii) Adjusted basis of production assets.
(A) In general.
(B) Production assets used to produce other property.
(3) Anti-abuse rule.
(4) Examples.
(i) Example1. Source of gross income.
(ii) Example 2. Location of intangible property.
(iii) Example 3. Anti-abuse rule.
(d) Determination of source of taxable income.
(e) Income partly from sources within a possession of the United States.
(1) In general.
(2) Allocation or apportionment for Possession Production Sales.
(3) Allocation or apportionment for Possession Purchase Sales.
(i) Determination of source of gross income from Possession Purchase Sales.
(ii) Determination of source of gross income from business activity.
(A) Source of gross income.
(B) Business activity.
(C) Location of business activity.
( 1 ) Sales activity.
( 2 ) Cost of goods sold.
( 3 ) Expenses.
(4) Examples.
(i) Example 1: Purchase of goods manufactured in possession.
(ii) Example 2: Purchase of goods manufactured outside possession.
(5) Special rules for partnerships.
(f) Special rules for partnerships.
(1) General rule.
(2) Exceptions.
(i) In general.
(ii) Attribution of production assets to or from a partnership.
(iii) Basis.
(3) Examples.
(i) Example 1. Distributive share of partnership income.
(ii) Example 2. Distribution in kind.
(g) Applicability dates.
(a) General.
(b) Gross income.
(c) Allocation of costs or expenses.
(d) Items not included as costs or expenses.
(1) Taxes and interest.
(2) Other business activity and general expenses.
(3) Personal exemptions and special deductions.
(e) Property used while within the United States.
(1) General.
(2) Average property.
(3) Current assets.
(f) Taxable income.
(1) General.
(2) Interest and taxes.
(3) General expenses.
(4) Personal exemptions.
(5) Special deductions.
(g) Allocation based on books of account.
(a) Scope.
(1) Introduction.
(2) Effective/applicability date.
(b) Source of notional principal contract income.
(1) General rule.
(2) Qualified business unit exception.
(3) Effectively connected notional principal contract income.
(c) Election.
(1) Eligibility and effect.
(2) Time for making election.
(3) Manner of making election.
(d) Example.
(e) Cross references.
(a) In general.
(b) Source of gross income from space and ocean activity.
(1) Space and ocean income derived by a United States person.
(2) Space and ocean income derived by a foreign person.
(i) In general.
(ii) Space and ocean income derived by a controlled foreign corporation.
(iii) Space and ocean income derived by foreign persons engaged in a trade or business within the United States.
(3) Source rules for income from certain sales of property.
(i) Sales of purchased property.
(ii) Sales of property produced by the taxpayer.
(A) General.
(B) Production only in space or international water, or only outside space and international water.
(C) Production both in space or international water and outside space and international water.
(4) Special rule for determining the source of gross income from services.
(5) Special rule for determining source of income from communications activity (other than income from international communications activity).
(c) Taxable income.
(d) Space and ocean activity.
(1) Definition.
(i) Space activity.
(ii) Ocean activity.
(2) Determining a space or ocean activity.
(i) Production of property in space or international water.
(ii) Special rule for performance of services.
(A) General.
(B) Exception to the general rule.
(3) Exceptions to space or ocean activity.
(e) Treatment of partnerships.
(f) Examples.
(1) Example 1. Space activity—activity occurring on land and in space.
(2) Example 2. Space activity.
(3) Example 3. Services as space activity—de minimis value attributable to performance occurring in space.
(4) Example 4. Space activity.
(5) Example 5. Space activity.
(6) Example 6. Space activity—treatment of land activity.
(7) Example 7. Use of intangible property in space.
(8) Example 8. Performance of services.
(9) Example 9. Separate transactions.
(10) Example 10. Sale of property in international water.
(11) Example 11. Sale of property in space.
(12) Example 12. Sale of property in space.
(13) Example 13. Source of income of a foreign person.
(14) Example 14. Source of income of a foreign person.
(g) Reporting and documentation requirements.
(1) In general.
(2) Required documentation.
(3) Access to software.
(4) Use of allocation methodology.
(h) Applicability date.
(a) In general.
(b) Source of international communications income.
(1) International communications income derived by a United States person.
(2) International communications income derived by foreign persons.
(i) In general.
(ii) International communications income derived by a controlled foreign corporation.
(iii) International communications income derived by foreign persons with a fixed place of business in the United States.
(iv) International communications income derived by foreign persons engaged in a trade or business within the United States.
(c) Source of U.S. communications income.
(d) Source of foreign communications income.
(e) Source of space/ocean communications income.
(f) Source of communications income when taxpayer cannot establish the two points between which the taxpayer is paid to transmit the communication.
(g) Taxable income.
(h) Communications activity and income derived from communications activity.
(1) Communications activity.
(i) General rule.
(ii) Separate transaction.
(2) Income derived from communications activity.
(3) Determining the type of communications activity.
(i) In general.
(ii) Income derived from international communications activity.
(iii) Income derived from U.S. communications activity.
(iv) Income derived from foreign communications activity.
(v) Income derived from space/ocean communications activity.
(i) Treatment of partnerships.
(j) Examples.
(k) Reporting and documentation requirements.
(1) In general.
(2) Required documentation.
(3) Access to software.
(4) Use of allocation methodology.
(l) Effective date.
(a) In general.
(b) Qualified business unit exception.
(c) Effectively connected income exception.
(d) Qualified fails charge.
(e) Designated security.
(g) Effective/applicability date.
§ 1.863-0A   Table of contents.
This section lists captions contained in §§ 1.863-3A and 1.863-3AT.
(a) General.
(1) Classes of income.
(2) Definition.
(b) Income partly from sources within a foreign country.
(1) General.
(2) Allocation or apportionment.
(c) Income partly from sources within a possession of the United States.
(1) General.
(2) Allocation or apportionment.
(3) Personal property produced and sold.
(4) Personal property purchased and sold.
(a) [Reserved].
(b) Income partly from sources within a foreign country.
(1) [Reserved].
(2) Allocation or apportionment.
(c)(1) through (4) [Reserved].
§ 1.863-1   Allocation of gross income under section 863(a).
(a) In general. Items of gross income other than those specified in section 861(a) and section 862(a) will generally be separately allocated to sources within or without the United States. See § 1.863-2 for alternate methods to determine the income from sources within or without the United States in the case of items specified in § 1.863-2(a). See also section 865(b) for rules for sourcing income from the sale of inventory property, within the meaning of section 865(i)(1) (inventory), generally, and section 865(e)(2) and § 1.865-3 for sourcing income from the sale of personal property (including inventory) by a nonresident that is attributable to the nonresident's office or other fixed place of business in the United States. In the case of sales of property involving partners and partnerships, the rules of § 1.863-3(f) apply.
(b) Natural resources —(1) In general. Notwithstanding any other provision of this part, except to the extent provided in paragraph (b)(2) of this section or § 1.865-3, gross receipts from the sale outside the United States of products derived from the ownership or operation of any farm, mine, oil or gas well, other natural deposit, or uncut timber within the United States shall be treated as from sources within the United States, and gross receipts from the sale within the United States of products derived from the ownership or operation of any farm, mine, oil or gas well, other natural deposit, or uncut timber outside the United States shall be treated as from sources without the United States.
(2) Additional production activities. Notwithstanding any other provision of this section, gross receipts from the sale of products derived by a taxpayer who performs additional production activities as defined in paragraph (b)(3)(ii) of this section are allocated between sources within and without the United States based on the fair market value of the product immediately prior to the additional production activities. The source of gross receipts equal to the fair market value of the product immediately prior to the additional production activities will be from sources where the farm, mine, oil or gas well, other natural deposit, or uncut timber is located. The source of gross receipts from the sale of the product in excess of the fair market value immediately prior to the additional production activities must be determined under § 1.863-3. For purposes of applying § 1.863-3, only production assets used in the additional production activities are taken into account.
(3) Definitions —(i) Production activity. For purposes of this section, production activity means an activity that creates, fabricates, manufactures, extracts, processes, cures, or ages inventory. See § 1.864-1. Except as otherwise provided in § 1.1502-13 or 1.863-3(f)(2), only production activities conducted directly by the taxpayer are taken into account.
(ii) Additional production activities. For purposes of this section, additional production activities are substantial production activities performed directly by the taxpayer in addition to activities from the ownership or operation of any farm, mine, oil or gas well, other natural deposit, or uncut timber. Whether a taxpayer's activities constitute additional production activities will be determined under the principles of § 1.954-3(a)(4) (except for § 1.954-3(a)(4)(iv)). However, in no case will activities that prepare the natural resource itself for export, including those that are designed to facilitate the transportation of the natural resource, be considered additional production activities for purposes of this section.
(4) Determination of fair market value. For purposes of this section, fair market value depends on all of the facts and circumstances as they exist relative to a party in any particular case. Where the products are sold to a related party in a transaction subject to section 482, the determination of fair market value under this section must be consistent with the arm's length price determined under section 482.
(5) Determination of gross income. To determine the amount of a taxpayer's gross income from sources within or without the United States, the taxpayer's gross receipts from sources within or without the United States determined under this paragraph (b) must be reduced by the cost of goods sold properly attributable to gross receipts from sources within or without the United States.
(6) Tax return disclosure. A taxpayer that determines the source of its income under paragraph (b)(2) of this section shall attach a statement to its return explaining the methodology used to determine fair market value under paragraph (b)(4) of this section, and explaining any additional production activities (as defined in paragraph (b)(3)(ii) of this section) performed by the taxpayer. In addition, the taxpayer must provide such other information as is required by § 1.863-3.
(7) Examples. The following examples illustrate the rules of this paragraph (b):
(i) Example 1. No additional production, foreign source gross receipts. U.S. Mines, a domestic corporation, operates a copper mine and mill in Country X. U.S. Mines extracts copper-bearing rocks from the ground and transports the rocks to the mill where the rocks are ground and processed to produce copper-bearing concentrate. The concentrate is transported to a port where it is dried in preparation for export, stored, and then shipped to purchasers in the United States. Because, under the facts and circumstances, none of U.S. Mines' activities constitute additional production activities, within the meaning of paragraph (b)(3)(ii) of this section, paragraph (b)(2) of this section does not apply, and under paragraph (b)(1) of this section, gross receipts from the sale of the concentrate will be treated as from sources without the United States.
(ii) Example 2. No additional production, U.S. source gross receipts. U.S. Gas, a domestic corporation, extracts natural gas within the United States, and transports the natural gas to a Country X port where it is liquefied in preparation for shipment. The liquefied natural gas is then transported via freighter and sold without additional production activities in a foreign country. Under paragraph (b)(3)(ii) of this section, liquefaction of natural gas is not an additional production activity because liquefaction prepares the natural gas for transportation. Therefore, under paragraph (b)(1) of this section, gross receipts from the sale of the liquefied natural gas will be treated as from sources within the United States.
(iii) Example 3. Production in United States, foreign sales. U.S. Gold, a domestic corporation, mines gold in Country X, produces gold jewelry using production assets located in the United States, and sells the jewelry in Country Y. Assume that the fair market value of the gold before the additional production activities in the United States is $40x and that U.S. Gold ultimately sells the gold jewelry in Country Y for $100x. Under paragraph (b)(2) of this section, $40x of U.S. Gold's gross receipts will be treated as from sources without the United States, and the remaining $60x of gross receipts will be treated as from sources within the United States under § 1.863-3.
(iv) Example 4. Production and sales in United States. U.S. Oil, a domestic corporation, extracts oil in Country X, transports the oil via a pipeline to the United States, refines the oil using production assets located in the United States, and sells the refined product in the United States to unrelated persons. Assume that the fair market value of the oil before refinement in the United States is $80x and U.S. Oil ultimately sells the refined product for $100x. Under paragraph (b)(2) of this section, $80x of gross receipts will be treated as from sources without the United States, and the remaining $20x of gross receipts will be treated as from sources within the United States under § 1.863-3.
(v) Example 5. Additional production. The facts are the same as in paragraph (b)(7)(i) of this section (the facts in Example 1 ), except that U.S. Mines also operates a smelter in Country X. The concentrate output from the mill is transported to the smelter where it is transformed into smelted copper. The smelted copper is exported to purchasers in the United States. Under the facts and circumstances, all the processes applied to make copper concentrate are considered mining. Therefore, under paragraph (b)(2) of this section, gross receipts equal to the fair market value of the concentrate at the smelter will be treated as from sources without the United States. Under the facts and circumstances, the conversion of the concentrate into smelted copper is an additional production activity in a foreign country within the meaning of paragraph (b)(3)(ii) of this section. Therefore, the source of U.S. Mines's excess gross receipts will be determined under § 1.863-3, pursuant to paragraph (b)(2) of this section.
(c) Determination of taxable income. The taxpayer's taxable income from sources within or without the United States will be determined under the rules of §§ 1.861-8 through 1.861-14T for determining taxable income from sources within the United States.
(d) Scholarships, fellowship grants, grants, prizes and awards —(1) In general. This paragraph (d) applies to scholarships, fellowship grants, grants, prizes and awards. The provisions of this paragraph (d) do not apply to amounts paid as salary or other compensation for services.
(2) Source of income. The source of income from scholarships, fellowship grants, grants, prizes and awards is determined as follows:
(i) United States source income. Except as provided in paragraph (d)(2)(iii) of this section, scholarships, fellowship grants, grants, prizes and awards made by a U.S. citizen or resident, a domestic partnership, a domestic corporation, an estate or trust (other than a foreign estate or trust within the meaning of section 7701(a)(31)), the United States (or an instrumentality or agency thereof), a State (or any political subdivision thereof), or the District of Columbia shall be treated as income from sources within the United States.
(ii) Foreign source income. Scholarships, fellowship grants, grants, prizes and awards made by a foreign government (or an instrumentality, agency, or any political subdivision thereof), an international organization (as defined in section 7701(a)(18)), or a person other than a U.S. person (as defined in section 7701(a)(30)) shall be treated as income from sources without the United States.
(iii) Certain activities conducted outside the United States. Scholarships, fellowship grants, targeted grants, and achievement awards received by a person other than a U.S. person (as defined in section 7701(a)(30)) with respect to activities previously conducted (in the case of achievement awards) or to be conducted (in the case of scholarships, fellowships grants, and targeted grants) outside the United States shall be treated as income from sources without the United States.
(3) Definitions. The following definitions apply for purposes of this paragraph (d):
(i) Scholarships are defined in section 117 and the regulations thereunder.
(ii) Fellowship grants are defined in section 117 and the regulations thereunder.
(iii) Prizes and awards are defined in section 74 and the regulations thereunder.
(iv) Grants are amounts described in subparagraph (3) of section 4945(g) and the regulations thereunder, and are not amounts otherwise described in paragraphs (d)(3) (i), (ii), or (iii) of this section. For purposes of this paragraph (d), the reference to section 4945(g)(3) is applied without regard to the identity of the payor or recipient and without the application of the objective and nondiscriminatory basis test and the requirement of a procedure approved in advance.
(v) Targeted grants are grants—
(A) Issued by an organization described in section 501(c)(3), the United States (or an instrumentality or agency thereof), a State (or any political subdivision thereof), or the District of Columbia; and
(B) For an activity undertaken in the public interest and not primarily for the private financial benefit of a specific person or persons or organization.
(vi) Achievement awards are awards—
(A) Issued by an organization described in section 501(c)(3), the United States (or an instrumentality or agency thereof), a State (or political subdivision thereof), or the District of Columbia; and
(B) For a past activity undertaken in the public interest and not primarily for the private financial benefit of a specific person or persons or organization.
(4) Effective dates. The following are the effective dates concerning this paragraph (d):
(i) Scholarships and fellowship grants. This paragraph (d) is effective for scholarship and fellowship grant payments made after December 31, 1986. However, for scholarship and fellowship grant payments made after May 14, 1989, and before June 16, 1993, the residence of the payor rule of paragraph (d)(2) (i) and (ii) of this section may be applied without applying paragraph (d)(2)(iii) of this section.
(ii) Grants, prizes and awards. This paragraph (d) is effective for payments made for grants, prizes and awards, targeted grants, and achievement awards after September 25, 1995. However, the taxpayer may elect to apply the provisions of this paragraph (d) to payments made for grants, prizes and awards, targeted grants, and achievement awards after December 31, 1986, and before September 26, 1995.
(e) Residual interest in a REMIC —(1) REMIC inducement fees. An inducement fee (as defined in § 1.446-6(b)(2)) shall be treated as income from sources within the United States.
(2) Excess inclusion income and net losses. An excess inclusion (as defined in section 860E(c)) shall be treated as income from sources within the United States. To the extent of excess inclusion income previously taken into account with respect to a residual interest (reduced by net losses previously taken into account under this paragraph), a net loss (described in section 860C(b)(2)) with respect to the residual interest shall be allocated to the class of gross income and apportioned to the statutory grouping(s) or residual grouping of gross income to which the excess inclusion income was assigned.
(f) Applicability date. Paragraph (b) of this section applies to taxable years ending on or after December 23, 2019. However, a taxpayer may apply paragraph (b) of this section in its entirety for taxable years beginning after December 31, 2017, and ending before December 23, 2019, provided that the taxpayer and all persons related to the taxpayer (within the meaning of section 267 or 707) apply paragraph (b) of this section and §§ 1.863-2(b), 1.863-3, 1.863-8(b)(3)(ii), 1.864-5(a) and (b), 1.864-6(c)(2), and 1.865-3 in their entirety for the taxable year, and once applied, the taxpayer and all persons related to the taxpayer (within the meaning of section 267 or 707) continue to apply these regulations in their entirety for all subsequent taxable years. For regulations generally applicable to taxable years ending before December 23, 2019, see § 1.863-1 as contained in 26 CFR part 1 revised as of April 1, 2020. Paragraph (e)(2) of this section applies for taxable years ending after August 1, 2006.
§ 1.863-2   Allocation and apportionment of taxable income.
(a) Determination of taxable income. Section 863(b) provides an alternate method for determining taxable income from sources within the United States in the case of gross income derived from sources partly within and partly without the United States. Under this method, taxable income is determined by deducting from such gross income the expenses, losses, or other deductions properly apportioned or allocated thereto and a ratable part of any other expenses, losses, or deductions that cannot definitely be allocated to some item or class of gross income. The income to which this section applies will consist of gains, profits, and income:
(1) From certain transportation or other services rendered partly within and partly without the United States to the extent not within the scope of section 863(c) or other specific provisions of this title;
(2) From the sale of inventory property (within the meaning of section 865(i)) produced (in whole or in part) by the taxpayer in the United States and sold outside the United States or produced (in whole or in part) by the taxpayer outside the United States and sold in the United States; or
(3) Derived from the purchase of personal property within a possession of the United States and its sale within the United States, to the extent not excluded from the scope of these regulations under § 1.936-6(a)(5), Q&A 7.
(b) Determination of source of taxable income. Income treated as derived from sources partly within and partly without the United States under paragraph (a) of this section may be allocated or apportioned to sources within and without the United States pursuant to §§ 1.863-1, 1.863-3, 1.863-4, 1.863-8, and 1.863-9. To determine the source of certain types of income described in paragraph (a)(1) of this section, see § 1.863-4. To determine the source of gross income described in paragraph (a)(2) of this section, see § 1.863-1 for natural resources, § 1.863-3 for other sales of inventory property, and § 1.863-8 for source of gross income from space and ocean activity. Section 1.865-3 may apply instead of the provisions in this section to source gross income from sales of personal property (including inventory property) by nonresidents attributable to an office or other fixed place of business in the United States. To determine the source of income partly from sources within a possession of the United States, including income described in paragraph (a)(3) of this section, see § 1.863-3(e).
(c) Applicability date. Except as provided in this paragraph (c), this section applies to taxable years beginning after December 30, 1996. Paragraph (b) of this section applies to taxable years ending on or after December 23, 2019. However, a taxpayer may apply paragraph (b) of this section in its entirety for taxable years beginning after December 31, 2017, and ending before December 23, 2019, provided that the taxpayer and all persons related to the taxpayer (within the meaning of section 267 or 707) apply paragraph (b) of this section and §§ 1.863-1(b), 1.863-3, 1.863-8(b)(3)(ii), 1.864-5(a) and (b), 1.864-6(c)(2), and 1.865-3 in their entirety for the taxable year, and once applied, the taxpayer and all persons related to the taxpayer (within the meaning of section 267 or 707) continue to apply these regulations in their entirety for all subsequent taxable years. For regulations generally applicable to taxable years ending before December 23, 2019, see § 1.863-2 as contained in 26 CFR part 1 revised as of April 1, 2020.
§ 1.863-3   Allocation and apportionment of income from certain sales of inventory.
(a) In general —(1) Scope. Subject to the rules of § 1.865-3, paragraphs (a) through (d) of this section apply to determine the source of income derived from the sale of inventory property (inventory) that a taxpayer produces (in whole or in part) within the United States and sells without the United States, or that a taxpayer produces (in whole or in part) without the United States and sells within the United States (collectively, Section 863(b)(2) Sales). See section 865(i)(1) for the definition of inventory. Paragraph (b) of this section provides that the source of gross income from Section 863(b)(2) Sales is based solely on the production activities with respect to the inventory. Paragraph (c) of this section describes how to determine source based on production activity, including when inventory is produced partly within the United States and partly without the United States. Paragraph (d) of this section determines taxable income from Section 863(b)(2) Sales. Paragraph (e) of this section applies to determine the source of certain income derived from a possession of the United States. Paragraph (f) of this section provides special rules for partnerships for all sales subject to §§ 1.863-1 through 1.863-3. Paragraph (g) of this section provides applicability dates for the rules in this section.
(2) Cross references. To determine the source of income derived from the sale of personal property (including inventory) by a nonresident that is attributable to the nonresident's office or other fixed place of business in the United States under section 865(e)(2) and § 1.865-3(c), the rules of § 1.865-3 apply, and the rules of this section do not apply except to the extent provided in § 1.865-3. To determine the source of income from sales of property produced by the taxpayer, when the property is either produced in whole or in part in space, as defined in § 1.863-8(d)(1)(i), or international water, as defined in § 1.863-8(d)(1)(ii), or is sold in space or international water, the rules of § 1.863-8 apply, and the rules of this section do not apply except to the extent provided in § 1.863-8.
(b) Sourcing based solely on production activities. Subject to the rules of § 1.865-3, all income, gain, or loss derived from Section 863(b)(2) Sales is allocated and apportioned solely on the basis of the production activities with respect to the inventory.
(c) Determination of the source of gross income from production activity —(1) Production only within the United States or only within foreign countries —(i) Source of income. For purposes of this section, production activity means an activity that creates, fabricates, manufactures, extracts, processes, cures, or ages inventory. See § 1.864-1. Whether a taxpayer's activities constitute production activity is determined under the principles of § 1.954-3(a)(4) (except for § 1.954-3(a)(4)(iv)). Subject to the provisions in § 1.1502-13 or paragraph (f)(2)(ii) of this section, the only production activities that are taken into account for purposes of §§ 1.863-1, 1.863-2, and this section are those conducted directly by the taxpayer. Where the taxpayer's production assets are located only within the United States or only outside the United States, gross income is sourced where the taxpayer's production assets are located. For rules regarding the source of income when production assets are located both within the United States and without the United States, see paragraph (c)(2) of this section. For rules regarding the source of income when production takes place, in whole or in part, in space or international water, the rules of § 1.863-8 apply, and the rules of this section do not apply except to the extent provided in § 1.863-8.
(ii) Definition of production assets. Subject to the provisions of § 1.1502-13 and paragraph (f)(2)(ii) of this section, production assets include only tangible and intangible assets owned directly by the taxpayer that are directly used by the taxpayer to produce inventory described in paragraph (a) of this section. Production assets do not include assets that are not directly used to produce inventory described in paragraph (a) of this section. Thus, production assets do not include such assets as accounts receivables, intangibles not related to production of inventory ( e.g., marketing intangibles, including trademarks and customer lists), transportation assets, warehouses, the inventory itself, raw materials, or work-in-process. In addition, production assets do not include cash or other liquid assets (including working capital), investment assets, prepaid expenses, or stock of a subsidiary.
(iii) Location of production assets. For purposes of this section, a tangible production asset will be considered located where the asset is physically located. An intangible production asset will be considered located where the tangible production assets owned by the taxpayer to which it relates are located.
(2) Production both within and without the United States —(i) Source of income. Where the taxpayer's production assets are located both within and without the United States, income from sources without the United States will be determined by multiplying the gross income by a fraction, the numerator of which is the average adjusted basis of production assets that are located outside the United States and the denominator of which is the average adjusted basis of all production assets within and without the United States. The remaining income is treated as from sources within the United States.
(ii) Adjusted basis of production assets —(A) In general. For purposes of paragraph (c)(2)(i) of this section, the adjusted basis of an asset is determined by using the alternative depreciation system under section 168(g)(2). The adjusted basis of all production assets for purposes of paragraph (c)(2)(i) of this section is determined as though the production assets were subject to the alternative depreciation system set forth in section 168(g)(2) for the entire period that such property has been in service. The adjusted basis of the production assets is determined without regard to the election to expense certain depreciable assets under section 179 and without regard to any additional first-year depreciation provision (for example, section 168(k), (l), and (m), and former sections 1400L(b) and 1400N(d)). The average adjusted basis of assets is computed by averaging the adjusted basis at the beginning and end of the taxable year, unless by reason of changes during the taxable year, as might be the case in the event of a major acquisition or disposition of assets, the average would materially distort the calculation in paragraph (c)(2)(i) of this section. In this event, the average adjusted basis is determined upon a more appropriate basis that is weighted to reasonably reflect the period for which the assets are held by the taxpayer during the taxable year.
(B) Production assets used to produce other property. If a production asset is used to produce inventory sold in Section 863(b)(2) Sales and also used to produce other property during the taxable year, the portion of its adjusted basis that is included in the fraction described in paragraph (c)(2)(i) of this section will be determined under any method that reasonably reflects the portion of the asset that produces inventory sold in Section 863(b)(2) Sales. For example, the portion of such an asset that is included in the formula may be determined by multiplying the asset's average adjusted basis by a fraction, the numerator of which is the gross receipts from sales of inventory from Section 863(b)(2) Sales produced by the asset, and the denominator of which is the gross receipts from all property produced by that asset.
(3) Anti-abuse rule. The purpose of paragraph (b) of this section and this paragraph (c) is to attribute the source of the taxpayer's gross income from certain sales of inventory property to the location of the taxpayer's production activity. Therefore, if the taxpayer has entered into or structured one or more transactions with a principal purpose of reducing its U.S. tax liability in a manner inconsistent with the purpose of paragraph (b) of this section or this paragraph (c), the Commissioner may make appropriate adjustments so that the source of the taxpayer's gross income more clearly reflects the location of production activity. For example, a taxpayer may be subject to the rule in this paragraph (c)(3) if domestic production assets are acquired by a related partnership (or a subsidiary of a related partnership) with a principal purpose of reducing its U.S. tax liability by claiming that the taxpayer's income from sales of inventory is subject to section 862(a)(6) rather than section 863(b).
(4) Examples. The following examples illustrate the rules of this paragraph (c):
(i) Example 1. Source of gross income —(A) Facts. A, a U.S. corporation, produces widgets that are sold both within the United States and within a foreign country. The initial manufacture of all widgets occurs in the United States. The second stage of production of widgets that are sold within a foreign country is completed within the country of sale. A's U.S. plant and machinery which is involved in the initial manufacture of the widgets has an average adjusted basis of $200, as determined using the alternative depreciation system under section 168(g)(2). A also owns warehouses used to store work-in-process. A owns foreign equipment with an average adjusted basis of $25. A's gross receipts from all sales of widgets is $100, and its gross receipts from export sales of widgets is $25. Assume that apportioning average adjusted basis using gross receipts is reasonable. Assume A's cost of goods sold from the sale of widgets in the foreign countries is $13 and thus, its gross income from widgets sold in foreign countries is $12.
(B) Analysis. A determines its gross income from sources without the United States by multiplying A's $12 of gross income from sales of widgets in foreign countries by a fraction, the numerator of which is all relevant foreign production assets, or $25, and the denominator of which is all relevant production assets, or $75 ($25 foreign assets + ($200 U.S. assets × $25 gross receipts from export sales/$100 gross receipts from all sales)). Therefore, A's gross income from sources without the United States is $4 ($12 × ($25/$75)).
(ii) Example 2. Location of intangible property. Assume the same facts as in paragraph (c)(4)(i)(A) of this section (the facts in Example 1 ), except that A employs a patented process that applies only to the initial production of widgets. In computing the formula used to determine the source of gross income, A's patent, if it has an average adjusted basis, would be located in the United States.
(iii) Example 3. Anti-abuse rule —(A) Facts. Assume the same facts as in paragraph (c)(4)(i)(A) of this section (the facts in Example 1 ). A sells its U.S. assets to B, an unrelated U.S. corporation, with a principal purpose of reducing its U.S. tax liability by manipulating the property fraction. A then leases these assets from B. After this transaction, under the general rule of paragraph (c)(2) of this section, all of A's gross income would be considered from sources without the United States, because all of A's relevant production assets are located within a foreign country. Since the leased property is not owned by the taxpayer, it is not included in the fraction.
(B) Analysis. Because A has entered into a transaction with a principal purpose of reducing its U.S. tax liability by manipulating the formula described in paragraph (c)(2)(i) of this section, A's income must be adjusted to more clearly reflect the source of that income. In this case, the Commissioner may redetermine the source of A's gross income by ignoring the sale-leaseback transactions.
(d) Determination of source of taxable income. Once the source of gross income has been determined under paragraph (c) of this section, the taxpayer must properly allocate and apportion its expenses, losses, and other deductions to its respective amounts of gross income from sources within and without the United States from its Section 863(b)(2) Sales. See §§ 1.861-8 through 1.861-14T and 1.861-17.
(e) Income partly from sources within a possession of the United States —(1) In general. This paragraph (e) relates to certain sales that give rise to income, gain, or loss that is 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 (e) applies to determine the source of income derived from the sale of inventory produced (in whole or in part) by a taxpayer within the United States and sold within a possession of the United States, or produced (in whole or in part) by a taxpayer in a possession of the United States and sold within the United States (collectively, 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 (e) must apportion gross income from Section 863 Possession Sales under paragraph (e)(2) of this section (in the case of Possession Production Sales) or under paragraph (e)(3) of this section (in the case of Possession Purchase Sales). The source of taxable income from Section 863 Possession Sales is determined under paragraph (d) of this section.
(2) Allocation or apportionment for Possession Production Sales. The source of gross income from Possession Production Sales is determined under the rules of paragraph (c) of this section, except that the term possession of the United States is substituted for foreign country wherever it appears.
(3) Allocation or apportionment for Possession Purchase Sales —(i) Determination of source of gross income from Possession Purchase Sales. Gross income from Possession Purchase Sales is allocated in its entirety to the taxpayer's business activity, and is then apportioned between sources within the United States and sources within a possession of the United States under paragraph (e)(3)(ii) of this section.
(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 (e)(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 activity. Receipts from gross sales will be attributed to a possession in accordance with the principles of § 1.861-7(c).
( 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 §§ 1.861-8 through 1.861-14T.
( 4 ) Examples. The following examples illustrate the rules of paragraph (e)(3)(ii) of this section relating to the determination of source of gross income from business activity:
(i) Example 1. Purchase of goods manufactured in possession —(A) Facts. 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.
(B) Analysis. 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.
(ii) Example 2. Purchase of goods manufactured outside possession —(A) Facts. Assume the same facts as in paragraph (e)(4)(i)(A) of this section (the facts in Example 1 ), except that A manufactures X outside the possession.
(B) Analysis. 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.
(5) Special rules for partnerships. In applying the rules of this paragraph (e) to transactions involving partners and partnerships, the rules of paragraph (f) of this section apply.
(f) Special rules for partnerships —(1) General rule. For purposes of § 1.863-1 and this section, a taxpayer's production activity does not include production activities conducted by a partnership of which the taxpayer is a partner either directly or through one or more partnerships, except as otherwise provided in paragraphs (c)(3) or (f)(2) of this section.
(2) Exceptions —(i) In general. For purposes of determining the source of the partner's distributive share of partnership income or determining the source of the partner's income from the sale of inventory property which the partnership distributes to the partner in kind, the partner's production activity includes an activity conducted by the partnership. In addition, the production activity of a partnership includes the production activity of a taxpayer that is a partner either directly or through one or more partnerships, to the extent that the partner's production activity is related to inventory that the partner contributes to the partnership in a transaction described under section 721.
(ii) Attribution of production assets to or from a partnership. A partner will be treated as owning its proportionate share of the partnership's production assets only to the extent that, under paragraph (f)(2)(i) of this section, the partner's activity includes production activity conducted through a partnership. A partner's share of partnership assets will be determined by reference to the partner's distributive share of partnership income for the year attributable to such production assets. Similarly, to the extent a partnership's activities include the production activities of a partner, the partnership will be treated as owning the partner's production assets related to the inventory that is contributed in kind to the partnership. See paragraph (c)(2)(ii) of this section for rules apportioning the basis of assets to Section 863 Sales.
(iii) Basis. For purposes of this section, in those cases where the partner is treated as owning its proportionate share of the partnership's production assets, the partner's basis in production assets held through a partnership shall be determined by reference to the partnership's adjusted basis in its assets (including a partner's special basis adjustment, if any, under section 743). Similarly, a partnership's basis in a partner's production assets is determined with reference to the partner's adjusted basis in its assets.
(3) Examples. The following examples illustrate the rules of this paragraph (f):
(i) Example 1. Distributive share of partnership income. A, a U.S. corporation, forms a partnership in the United States with B, a country X corporation. A and B each have a 50 percent interest in the income, gains, losses, deductions and credits of the partnership. The partnership is engaged in the manufacture and sale of widgets. The widgets are manufactured in the partnership's plant located in the United States and are sold by the partnership outside the United States. The partnership owns the manufacturing facility and all other production assets used to produce the widgets. A's distributive share of partnership income includes 50 percent of the sales income from these sales. In applying the rules of section 863 to determine the source of its distributive share of partnership income from the export sales of widgets, A is treated as carrying on the activity of the partnership related to production of these widgets and as owning a proportionate share of the partnership's assets related to production of the widgets, based upon its distributive share of partnership income.
(ii) Example 2. Distribution in kind. Assume the same facts as in paragraph (f)(3)(i) of this section (the facts in Example 1 ) except that the partnership, instead of selling the widgets, distributes the widgets to A and B. A then further processes the widgets and then sells them outside the United States. In determining the source of the income earned by A on the sales outside the United States, A is treated as conducting the activities of the partnership related to production of the distributed widgets. Thus, the source of gross income on the sale of the widgets is determined under section 863 and this section. In applying paragraph (c) of this section, A is treated as owning its proportionate share of the partnership's production assets based upon its distributive share of partnership income.
(g) Applicability dates. This section applies to taxable years ending on or after December 23, 2019. However, a taxpayer may apply this section in its entirety for taxable years beginning after December 31, 2017, and ending before December 23, 2019, provided that the taxpayer and all persons related to the taxpayer (within the meaning of section 267 or 707) apply this section and §§ 1.863-1(b), 1.863-2(b), 1.863-8(b)(3)(ii), 1.864-5(a) and (b), 1.864-6(c)(2), and 1.865-3 in their entirety for the taxable year, and once applied, the taxpayer and all persons related to the taxpayer (within the meaning of section 267 or 707) continue to apply these regulations in their entirety for all subsequent taxable years. For regulations generally applicable to taxable years ending before December 23, 2019, see § 1.863-3 as contained in 26 CFR part 1 revised as of April 1, 2020.
§ 1.863-3A   Income from the sale of personal property derived partly from within and partly from without the United States.
(a) General —(1) Classes of income. Income from the sale of property to which paragraph (b)(2) and (3) of § 1.863-2 applies is divided into two classes for purposes of this section, namely, income which is treated as derived partly from sources within the United States and partly from sources within a foreign country, and income which is treated as derived partly from sources within the United States and partly from sources within a possession of the United States.
(2) Definition. For purposes of this section, the word “produced” includes created, fabricated, manufactured, extracted, processed, cured, or aged. For determining the time and place of sale of personal property for purposes of this section, see paragraph (c) of § 1.861-7.
(b) Income partly from sources within a foreign country —(1) General. This paragraph relates to gains, profits, and income derived from the sale of personal property produced (in whole or in part) by the taxpayer within the United States and sold within a foreign country, or produced (in whole or in part) by the taxpayer within a foreign country and sold within the United States. Pursuant to section 863(b) such items shall be treated as derived partly from sources within the United States and partly from sources within a foreign country.
(2) Allocation or apportionment. The taxable income from sources within the United States, in the case of the items to which this paragraph applies, shall be determined according to the examples set forth in this subparagraph. For such purposes, the deductions for the personal exemptions shall not be taken into account, but the special deductions described in paragraph (c) of § 1.861-8 shall be taken into account.
(iii) The term “gross sales”, as used in this example, refers only to the sales of personal property produced (in whole or in part) by the taxpayer within the United States and sold within a foreign country or produced (in whole or in part) by the taxpayer within a foreign country and sold within the United States.
(iv) The term “property”, as used in this example, includes only the property held or used to produce income which is derived from such sales. Such property should be taken at its actual value, which in the case of property valued or appraised for purposes of inventory, depreciation, depletion, or other purposes of taxation shall be the highest amount at which so valued or appraised, and which in other cases shall be deemed to be its book value in the absence of affirmative evidence showing such value to be greater or less than the actual value. The average value during the taxable year or period shall be employed. The average value of property as above prescribed at the beginning and end of the taxable year or period ordinarily may be used, unless by reason of material changes during the taxable year or period such average does not fairly represent the average for such year or period, in which event the average shall be determined upon a monthly or daily basis.
(v) Bills and accounts receivable shall (unless satisfactory reason for a different treatment is shown) be assigned or allocated to the United States when the debtor resides in the United States, unless the taxpayer has no office, branch, or agent in the United States.
(c) Income partly from sources within a possession of the United States —(1) General. This paragraph relates to gains, profits, and income which, pursuant to section 863(b), are treated as derived partly from sources within the United States and partly from sources within a possession of the United States. The items so treated are described in subparagraphs (3) and (4) of this paragraph.
(2) Allocation or apportionment. The taxable income from sources within the United States, in the case of the items to which this paragraph applies, shall be determined according to the examples set forth in subparagraphs (3) and (4) of this paragraph. For such purposes, the deductions for the personal exemptions shall not be taken into account, but the special deductions described in paragraph (c) of § 1.861-8 shall be taken into account.
(3) Personal property produced and sold. This subparagraph relates to gross income derived from the sale of personal property produced (in whole or in part) by the taxpayer within the United States and sold within a possession of the United States, or produced (in whole or in part) by the taxpayer within a possession of the United States and sold within the United States.
(ii) Of the amount of taxable income so determined, one-half shall be apportioned in accordance with the value of the taxpayer's property within the United States and within the possession of the United States, the portion attributable to sources within the United States being determined by multiplying such one-half by a fraction the numerator of which consists of the value of the taxpayer's property within the United States, and the denominator of which consists of the value of the taxpayer's property both within the United States and within the possession of the United States. The remaining one-half of such taxable income shall be apportioned in accordance with the total business of the taxpayer within the United States and within the possession of the United States, the portion attributable to sources within the United States being determined by multiplying such one-half by a fraction the numerator of which consists of the amount of the taxpayer's business for the taxable year or period within the United States, and the denominator of which consists of the amount of the taxpayer's business for the taxable year or period both within the United States and within the possession of the United States.
(iii) “The business of the taxpayer”, as used in this example, shall be measured by the amounts which the taxpayer paid out during the taxable year or period for wages, salaries, and other compensation of employees and for the purchase of goods, materials, and supplies consumed in the regular course of business, plus the amounts received during the taxable year or period from gross sales, such expenses, purchases, and gross sales being limited to those attributable to the production (in whole or in part) of personal property within the United States and its sale within a possession of the United States or to the production (in whole or in part) of personal property within a possession of the United States and its sale within the United States. The term “property”, as used in this example, includes only the property held or used to produce income which is derived from such sales.
(4) Personal property purchased and sold. This subparagraph relates to gross income derived from the purchase of personal property within a possession of the United States and its sale within the United States.
(ii) The amount of taxable income so determined shall be apportioned in accordance with the total business of the taxpayer within the United States and within the possession of the United States, the portion attributable to sources within the United States being that percentage of such taxable income which the amount of the taxpayer's business for the taxable year or period within the United States bears to the amount of the taxpayer's business for the taxable year or period both within the United States and within the possession of the United States.
(iii) The “business of the taxpayer”, as that term is used in this example, shall be measured by the amounts which the taxpayer paid out during the taxable year or period for wages, salaries, and other compensation of employees and for the purchase of goods, materials, and supplies sold or consumed in the regular course of business, plus the amount received during the taxable year or period from gross sales, such expenses, purchases, and gross sales being limited to those attributable to the purchase of personal property within a possession of the United States and its sale within the United States.
§ 1.863-3AT   Income from the sale of personal property derived partly from within and partly from without the United States (temporary regulations).
(a) [Reserved]
(b) Income partly from sources within a foreign country. (1) [Reserved]
(2) Allocation or apportionment.
(ii) Of this gross amount, one-half shall be apportioned in accordance with the value of the taxpayer's property within the United States and within the foreign country, the portion attributable to sources within the United States being determined by multiplying such one-half by a fraction, the numerator of which consists of the value of the taxpayer's property within the United States and the denominator of which consists of the value of the taxpayer's property both within the United States and within the foreign country. The remaining one-half of such gross income shall be apportioned in accordance with the gross sales of the taxpayer within the United States and within the foreign country, the portion attributable to sources within the United States being determined by multiplying such one-half by a fraction the numerator of which consists of the taxpayer's gross sales for the taxable year or period within the United States, and the denominator of which consists of the taxpayer's gross sales for the taxable year or period both within the United States and within the foreign country. Deductions from gross income that are allocable and apportionable to gross income described in paragraph (i) of this Example 2 shall be apportioned between the United States and foreign source portions of such income, as determined under this paragraph (ii), on a pro rata basis, without regard to whether the deduction relates primarily or exclusively to the production of property or to the sale of property.
(b)(2) Example (2)(iii) through (c)(4) [Reserved]
§ 1.863-4   Certain transportation services.
(a) General. A taxpayer carrying on the business of transportation service (other than an activity giving rise to transportation income described in section 863(c) or to income subject to other specific provisions of this title) between points in the United States and points outside the United States derives income partly from sources within and partly from sources without the United States.
(b) Gross income. The gross income from sources within the United States derived from such services shall be determined by taking such a portion of the total gross revenues therefrom as (1) the sum of the costs or expenses of such transportation business carried on by the taxpayer within the United States and a reasonable return upon the property used in its transportation business while within the United States bears to (2) the sum of the total costs or expenses of such transportation business carried on by the taxpayer and a reasonable return upon the total property used in such transportation business. Revenues from operations incidental to transportation services, such as the sale of money orders, shall be apportioned on the same basis as direct revenues from transportation services.
(c) Allocation of costs or expenses. In allocating the total costs or expenses incurred in such transportation business, costs or expenses incurred in connection with that part of the services which was wholly rendered in the United States shall be assigned to the cost of transportation business within the United States. For example, expenses of loading and unloading in the United States, rentals, office expenses, salaries, and wages wholly incurred for services rendered to the taxpayer in the United States belong to this class. Costs and expenses incurred in connection with services rendered partly within and partly without the United States may be prorated on a reasonable basis between such services. For example, ship wages, charter money, insurance, and supplies chargeable to voyage expenses shall ordinarily be prorated for each voyage on the basis of the proportion which the number of days the ship was within the territorial limits of the United States bears to the total number of days on the voyage; and fuel consumed on each voyage may be prorated on the basis of the proportion which the number of miles sailed within the territorial limits of the United States bears to the total number of miles sailed on the voyage. For other expenses entering into the cost of services, only such expenses as are allowable deductions under the internal revenue laws shall be taken into account.
(d) Items not included as costs or expenses —(1) Taxes and interest. Income, war profits, and excess profits taxes shall not be regarded as costs or expenses for the purpose of determining the proportion of gross income from sources within the United States; and, for such purpose, interest and other expenses for the use of borrowed capital shall not be taken into the cost of services rendered, for the reason that the return upon the property used measures the extent to which such borrowed capital is the source of the income. See paragraph (f)(2) of this section.
(2) Other business activity and general expenses. If a taxpayer subject to this section is also engaged in a business other than that of providing transportation service between points in the United States and points outside the United States, the costs and expenses, including taxes, properly apportioned or allocated to such other business shall be excluded both from the deductions and from the apportionment process prescribed in paragraph (c) of this section; but, for the purpose of determining taxable income, a ratable part of any general expenses, losses, or deductions, which cannot definitely be allocated to some item or class of gross income, may be deducted from the gross income from sources within the United States after the amount of such gross income has been determined. Such ratable part shall ordinarily be based upon the ratio of gross income from sources within the United States to the total gross income. See paragraph (f)(3) of this section.
(3) Personal exemptions and special deductions. The deductions for the personal exemptions, and the special deductions described in paragraph (c) of § 1.861-8, shall not be taken into account for purposes of paragraph (c) of this section.
(e) Property used while within the United States —(1) General. The value of the property used shall be determined upon the basis of cost less depreciation. Eight percent may ordinarily be taken as a reasonable rate of return to apply to such property. The property taken shall be the average property employed in the transportation service between points in the United States and points outside the United States during the taxable year.
(2) Average property. For ships, the average shall be determined upon a daily basis for each ship, and the amount to be apportioned for each ship as assets employed within the United States shall be computed upon the proportion which the number of days the ship was within the territorial limits of the United States bears to the total number of days the ship was in service during the taxable period. For other assets employed in the transportation business, the average of the assets at the beginning and end of the taxable period ordinarily may be taken, but if the average so obtained does not, by reason of material changes during the taxable year, fairly represent the average for such year either for the assets employed in the transportation business in the United States or in total, the average must be determined upon a monthly or daily basis.
(3) Current assets. Current assets shall be decreased by current liabilities and allocated to services between the United States and foreign countries and to other services. The part allocated to services between the United States and foreign countries shall be based on the proportion which the gross receipts from such services bear to the gross receipts from all services. The amount so allocated to services between the United States and foreign countries shall be further allocated to services rendered within the United States and to services rendered without the United States. The portion allocable to services rendered within the United States shall be based on the proportion which the expenses incurred within the territorial limits of the United States bear to the total expenses incurred in services between the United States and foreign countries.
(f) Taxable income —(1) General. In computing taxable income from sources within the United States there shall be allowed as deductions from the gross income from such sources, determined in accordance with paragraph (b) of this section, (i) the expenses of the transportation business carried on within the United States (as determined under paragraphs (c) and (d) of this section) and (ii) the expenses and deductions determined in accordance with this paragraph.
(2) Interest and taxes. Interest and income, war-profits, and excess profits taxes shall be excluded from the apportionment process, as indicated in paragraph (d) of this section; but, for the purpose of computing taxable income there may be deducted from the gross income from sources within the United States, after the amount of such gross income has been determined, a ratable part of all interest deductible under section 163 and of all income, war-profits, and excess profits taxes deductible under section 164, paid or accrued in respect of the business of transportation service between points in the United States and points outside the United States. The ratable part shall ordinarily be based upon the ratio of gross income from sources within the United States to the total gross income, from such transportation service.
(3) General expenses. General expenses, losses, or deductions shall be deducted under this paragraph to the extent indicated in paragraph (d)(2) of this section.
(4) Personal exemptions. The deductions for the personal exemptions shall be allowed under this paragraph to the same extent as provided by paragraph (b) of § 1.861-8.
(5) Special deductions. The special deductions allowed in the case of a corporation by sections 241, 922, and 941 shall be allowed under this paragraph to the same extent as provided by paragraph (c) of § 1.861-8.
(g) Allocation based on books of account. Application for permission to base the return upon the taxpayer's books of account will be considered by the district director (or, if applicable, the Director of International Operations) in the case of any taxpayer subject to this section, who, in good faith and unaffected by considerations of tax liability, regularly employs in his books of account a detailed allocation of receipts and expenditures which more clearly reflects the income derived from sources within the United States than does the process prescribed by paragraphs (b) to (f), inclusive, of this section.