This section of the FEDERAL REGISTER

contains notices to the public of the proposed

issuance of rules and regulations. The

purpose of these notices is to give interested

persons an opportunity to participate in the

rule making prior to the adoption of the final

rules.

Proposed Rules Federal Register

52953

Vol. 62, No. 197

Friday, October 10, 1997

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG–251985–96]

RIN 1545–AU79

Source of Income From Sales of

Inventory Partly From Sources Within

a Possession of the United States;

Also, Source of Income Derived From

Certain Purchases From a Corporation

Electing Section 936

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Notice of proposed rulemaking

and notice of public hearing.

SUMMARY: This document contains

proposed regulations under section 863

governing the source of income from

sales of inventory produced in the

United States and sold in a possession

of the United States or produced in a

possession of the United States and sold

in the United States. It also contains

proposed regulations under section 863

governing the source of income from

sales of inventory purchased in a

possession of the United States and sold

in the United States. This document

affects persons who produce (in whole

or in part) inventory in the United

States and sell in a possession, or

produce (in whole or in part) inventory

in a possession and sell in the United

States, as well as persons who purchase

inventory in a possession and sell in the

United States. This document also

contains proposed regulations under

section 936 governing the source of

income of a taxpayer from the sale in

the United States of property purchased

from a corporation that has an election

under section 936 in effect. This

document also provides notice of a

public hearing on these proposed

regulations.

DATES: Comments and outlines of oral

comments to be presented at the public

hearing scheduled for January 29, 1998,

at 10 a.m. must be received by January

8, 1998.

ADDRESSES: Send submissions to:

CC:DOM:CORP:R (INTL–0003–95),

room 5228, Internal Revenue Service,

POB 7604, Ben Franklin Station,

Washington, DC 20044. In the

alternative, submissions may be hand

delivered between the hours of 8 a.m.

and 5 p.m. to: CC:DOM:CORP:R (REG–

251985–96), Courier’s Desk, Internal

Revenue Service, 1111 Constitution

Avenue NW., Washington, DC, or

electronically, via the IRS Internet site

at: http://www.irs.ustreas.gov/prod/

taxlregs/comments.html. The public

hearing will be held in room 2615,

Internal Revenue Building, 1111

Constitution Avenue, NW., Washington,

DC.

FOR FURTHER INFORMATION CONTACT:

Concerning the regulations, Anne

Shelburne, (202) 622–3880; concerning

submissions and the hearing, Ms.

Evangelista Lee, (202) 622–7190 (not

toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information

contained in this notice of proposed

rulemaking has been submitted to the

Office of Management and Budget

(OMB) for review in accordance with

the Paperwork Reduction Act of 1995

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

Comments on the collection of

information should be sent to the Office

of Management and Budget, Attn: Desk

Officer for the Department of Treasury,

Office of Information and Regulatory

Affairs, Washington, DC 20503, with

copies to the Internal Revenue Service,

Attn: IRS Reports Clearance Officer,

T:FP, Washington, DC 20224. Comments

on the collection of information should

be received by December 9, 1997.

Comments are specifically requested

concerning:

Whether the proposed collection of

information is necessary for the proper

performance of the functions of the IRS,

including whether the information will

have practical utility;

The accuracy of the estimated burden

associated with the proposed collection

of information (see below);

How the quality, utility, and clarity of

the information to be collected may be

enhanced;

How the burden of complying with

the proposed collection of information

may be minimized, including through

the application of automated collection

techniques or other forms of information

technology; and

Estimates of capital or start-up costs

and costs of operation, maintenance,

and purchase of services to provide

information.

The collection of information

requirements are in proposed § 1.863–

3(f)(6). This information is required by

the IRS to monitor compliance with the

federal tax rules for determining the

source of income from the sale of

inventory produced in the United States

and sold in a possession of the United

States or produced in a possession of

the United States and sold in the United

States, or from the sale of inventory

purchased in a possession of the United

States and sold in the United States. The

likely respondents are taxpayers who

produce inventory in the United States

and sell in a possession, or who produce

inventory in a possession and sell in the

United States, or who purchase

inventory in a possession and sell in the

United States. Responses to this

collection of information are required to

properly determine the source of a

taxpayer’s income from such sales.

Books or records relating to a

collection of information must be

retained as long as their contents may

become material in the administration

of any internal revenue law. Generally,

tax returns and tax return information

are confidential, as required by 26

U.S.C. 6103.

Estimated total annual reporting

burden: 500 hours. The estimated

annual burden per respondent varies

from 1 hour to 5 hours, depending on

individual circumstances, with an

estimated average of 2.5 hours.

Estimated number of respondents:

200.

Estimated annual frequency of

responses: One time per year.

An agency may not conduct or

sponsor, and a person is not required to

respond to, a collection of information

unless the collection of information

displays a valid control number

assigned by the Office of Management

and Budget.

Background

These proposed regulations contain

rules under section 863 relating to the

source of income from cross-border

sales of certain property. These

regulations also contain rules under
52954 Federal Register / Vol. 62, No. 197 / Friday, October 10, 1997 / Proposed Rules

section 936 relating to the source of

income of a taxpayer from the sale in

the United States of property purchased

from a corporation that has an election

under section 936 in effect. These

regulations are proposed to be effective

for taxable years beginning 30 days after

publication of final regulations.

Explanation of Provisions

I. Income Partly From Sources Within a

Possession

A. Current Regulations

Section 863 authorizes the Secretary

to promulgate regulations allocating or

apportioning to sources within or

without the United States all items of

gross income, expenses, losses, and

deductions other than those items

specified in sections 861(a) and 862(a).

Guidance to determine the source of

possession income is divided into two

types of transactions: transactions

described in section 863(b)(2) for

property produced in the United States

and sold in a possession (or vice versa),

and transactions described in section

863(b)(3) for property purchased in a

possession and sold in the United States

(collectively, Section 863 Possession

Sales).

Section 1.863–3 of the income tax

regulations contains rules for

determining the source of income

derived from sales of certain property.

These regulations were published in the

Federal Register on November 29, 1996

(61 FR 60540), and the prior regulations

were renumbered §§ 1.863–3A and

1.863–3AT. The new regulations retain

the prior rules for Section 863

Possession Sales by providing in

paragraph § 1.863–3(f) that taxpayers

must apply the rules of § 1.863–3A(c) in

allocating and apportioning income

derived from sources partly within the

United States and partly within a

possession of the United States. These

proposed regulations would modify the

existing rules for allocating and

apportioning income between the

United States and a possession.

1. Property Produced and Sold

Currently, income derived from sales

of inventory produced in the United

States and sold in a possession of the

United States or produced in a

possession of the United States and sold

in the United States (Possession

Production Sales), is allocated or

apportioned between the United States

and a possession according to one of

three methods. Such income is allocated

under the independent factory price

method, apportioned under an

apportionment method, or, with

permission of the District Director,

allocated or apportioned on the basis of

the taxpayer’s books and records.

Under the current regulations, if an

independent factory or production price

(IFP) exists for Possession Production

Sales, taxpayers must use the IFP

method to determine the income

attributable to production activities in

both the sale establishing the IFP and in

sales of similar products.

If an IFP does not exist, the current

possessions regulations provide that the

taxable income from Possession

Production Sales is first computed and

then apportioned between the United

States and the possession. One-half of

the taxable income is apportioned on

the basis of the taxpayer’s property

within the United States and within the

possession. In applying the property

fraction, the taxpayer’s property

includes property held or used to

produce income derived from

Possession Production Sales. The other

half of the taxpayer’s taxable income is

apportioned between U.S. and

possession sources on the basis of the

business of the taxpayer within the

United States and within the

possession. Currently, business of the

taxpayer is measured by the sum of

certain expenses, including amounts

paid for labor, and the purchase of

certain supplies, plus receipts from

Possession Production Sales. Finally, as

a third method, the existing regulations

allow a taxpayer to request permission

from the District Director to use the

taxpayer’s books and records to allocate

or apportion income to sources within

or without the United States if those

books reflect more clearly than the other

methods the taxable income derived

from sources within the United States.

2. Property Purchased and Sold

The second type of possession

transaction governed by the existing

regulations is the sale of inventory

purchased in a possession and sold in

the United States (Possession Purchase

Sales) as described in section 863(b)(3).

Under the current regulations, the

income from such sales is divided

between the United States and

possession sources under one of two

methods. The income can be

apportioned, or, with permission of the

District Director, allocated or

apportioned on the basis of the

taxpayer’s books and records.

Under the apportionment method,

taxable income is first determined, and

then apportioned by a fraction, the

numerator being the business of the

taxpayer in the United States, the

denominator being the total business of

the taxpayer in the United States and in

the possession. The fraction is

computed in the same manner as the

business fraction discussed previously,

except that such expenses, purchases,

and sales are limited to those

attributable to Possession Purchase

Sales.

B. Issues Under Current Regulations

The IRS and Treasury believe the

rules for allocating and apportioning

income between the United States and

the possessions of the United States

should be amended to reflect certain

changes made to the regulations under

§ 1.863–3 governing cross-border sales

of inventory involving the United States

and a foreign country (other than those

involving possessions). Thus, for

example, under the apportionment

method provided in the proposed

regulations, the property and business

activity fractions apportioning income

between the United States and a

possession are modified to apportion

gross income attributable to an activity,

rather than to apportion net income.

The IRS and Treasury also believe

certain ambiguities exist in the current

regulations. The possessions rules were

originally promulgated in 1926, and

may not reflect current business

practices. The current regulations use

examples to illustrate methods for

allocating or apportioning income

between the United States and a

possession, and should be modified to

state rules.

Further, although the apportionment

method for allocating Possession

Production Sales income under the

existing possessions regulations treats

half of the income as production

income, the production formula is not

necessarily limited to production assets.

The current inclusion of sales assets in

the formula apportioning production

income results in excessive income

being allocated to sales activities. The

production income formula should only

take into account assets directly

involved in production of inventory. In

addition, the IRS and Treasury have

reexamined the business activity

fraction, and have concluded it should

be revised to more clearly reflect the

taxpayer’s business other than

production. The current fraction, for

example, omits certain investments or

expenses, such as marketing and

advertising expenses, although income

attributable in part to such expenses or

investments is then included in the

income apportioned by the fraction. The

current regulations also take into

account production expenses in the

business activity fraction apportioning

income from Possession Production

Sales. The Service and Treasury believe

that this is inappropriate in the context
Federal Register / Vol. 62, No. 197 / Friday, October 10, 1997 / Proposed Rules 52955

of Possession Production Sales because

the business activity fraction is not

intended to determine the source of

income attributable to production

activity. In the proposed regulations, the

fraction apportioning Possession

Production Sales is renamed the

business sales activity fraction and

excludes factors reflecting production

activity.

The current regulations also do not

address issues in attributing to the

United States or to the possession, the

activities reflected in the business

activity fraction. For example, the

current regulations provide no guidance

on whether a particular expense should

be represented in the fraction as

attributable to the United States or to a

possession.

Accordingly, the IRS and Treasury are

issuing proposed regulations under

section 863 to make the possessions

rules more consistent with the other

regulations governing the source of

income from cross-border sales of

inventory, and to address certain

ambiguities and problems in the

existing regulations.

C. Proposed Regulations

Section 1.863–3(f) generally retains

the methods of the current regulations

for dividing income between the United

States and a possession of the United

States, with several modifications.

1. Methods to Allocate Gross Income to

Activities of the Taxpayer

a. Property Produced and Sold

i. The Possession 50/50 Method

Consistent with the final regulations

under § 1.863–3, paragraph (f)(2)(i)(A) of

the proposed regulations makes the 50/

50 method the general rule to allocate

gross income from Possession

Production Sales between production

and business sales activity, so that the

income from each type of activity can

then be apportioned between U. S. and

foreign sources. The taxpayer, however,

may elect to apply the IFP method

(described in paragraph (f)(2)(i)(B)), or,

with the consent of the District Director,

the books and records method

(described in paragraph (f)(2)(i)(C)).

Under the possession 50/50 method,

the proposed regulations allocate half of

the taxpayer’s gross income from

Possession Production Sales to

production activity and half to business

sales activity. The income is then

apportioned between U.S. and

possession sources based on a property

fraction and a business sales activity

fraction. As described below, the

proposed regulations make certain

changes to the existing property fraction

and to the existing business activity

fraction.

The proposed regulations apply the

property fraction in § 1.863–3(c) to

apportion the half of a taxpayer’s

income allocated to production activity.

Thus, income is apportioned to the

United States or to a possession based

on the location of the taxpayer’s

production assets. In a change from the

current regulations, and consistent with

the changes made to the regulations

under § 1.863–3(c), production assets

are defined as tangible and intangible

assets owned directly by the taxpayer

that are directly used by the taxpayer to

produce inventory sold in Possession

Production Sales, instead of all its assets

that produce income from Possession

Production Sales. Production assets are

included in the fraction at their adjusted

tax basis.

The other half of the taxpayer’s gross

income is apportioned according to a

business sales activity fraction. The

portion of this income that is possession

source income is determined by

multiplying the income by a fraction,

the numerator being the business sales

activity of the taxpayer in the

possession, and the denominator being

the business sales activity of the

taxpayer within the possession and

outside the possession. The remaining

income is sourced in the United States.

Although some of the business sales

activity factors not incurred in a

possession may be incurred in a foreign

country, Treasury and the Internal

Revenue Service believe that the

business sales activity fraction is only

intended to source the business sales

activity portion of Possession

Production Sales outside the United

States to the extent of business sales

activity located in a possession.

The proposed regulations make some

modifications to the factors in the

fraction representing the business sales

activity of the taxpayer. Business sales

activity is measured by the sum of

certain expenses, including amounts

paid for labor, materials, advertising,

and marketing (but excluding any

expenses or other amounts that are

nondeductible under section 263A,

interest, and research and

development), plus receipts for the sale

of goods. This formula is intended to

reflect better the business sales activity

producing the income by including

more of the factors responsible for

producing that income. Cost of goods

sold is also excluded from the business

sales activity fraction apportioning

income from Possession Production

Sales, because such costs generally

reflect production activity. Production

activity is already represented in the

formula by the one-half of the taxpayer’s

income apportioned according to the

location of production assets.

Finally, the proposed regulations

provide more explicit guidance for

attributing business sales activity

between the United States and a

possession. Expenses are allocated and

apportioned between the United States

and a possession based on the rules in

§§ 1.861–8 through 1.861–14T. Gross

sales are allocated to the United States

or a possession based on the place of

sale.

ii. The IFP Method

The proposed regulations make the

IFP method elective, and thus eliminate

any bias against taxpayers choosing to

export through independent

distributors. The regulations rely upon

the revised regulations under § 1.863–3

for rules in applying the IFP method.

iii. Books and Records Method

The proposed regulations retain the

books and records method of the

existing regulations, permitting

taxpayers to request permission from

the District Director to use their books

and records to determine the source of

their income. The proposed regulations

refer to revised § 1.863–3(b)(3) in

applying the method to Possession

Production Sales.

b. Property Purchased and Sold

i. The Business Activity Method

Paragraph (f)(3)(i)(A) makes the

business activity method the general

rule to apportion income from

Possession Purchase Sales between the

United States and a possession. The

taxpayer may, however, elect to apply,

with consent of the District Director, the

books and records method.

The proposed regulations retain the

structure of the existing regulations by

apportioning the taxpayer’s income

from Possession Purchase Sales on the

basis of a business activity fraction. The

portion of this income that is possession

source income is determined by

multiplying the income by a fraction,

the numerator being the business of the

taxpayer in the possession, and the

denominator being the business of the

taxpayer within the possession and

outside the possession. The remaining

income is sourced in the United States.

The business activity fraction is

similar to that discussed previously,

used to apportion the taxpayer’s income

in Possession Production Sales, except

that the fraction applies only to

expenses, cost of goods sold, and sales

attributable to Possession Purchase

Sales. In addition, the business activity
52956 Federal Register / Vol. 62, No. 197 / Friday, October 10, 1997 / Proposed Rules

fraction apportioning Possession

Purchase Sales includes amounts paid

for cost of goods sold. Such costs are

attributed to the possession, however,

only to the extent the property

purchased is manufactured, produced,

grown, or extracted in the possession.

Treasury and the Internal Revenue

Service anticipate that if a taxpayer acts

in the reasonable belief that the

products were manufactured in the

possession, the taxpayer could act on

that basis in preparing its tax return. As

modified, the business activity fraction

reflects the view of Treasury and the

Internal Revenue Service that section

863(b)(3)’s purchase rule was intended

to apply only to purchase and resale

transactions, where the goods purchased

are created or derived from the

possession.

ii. Books and Records Method

The proposed regulations retain the

books and records method of the

existing regulations, permitting

taxpayers to request permission from

the District Director to use their books

and records to determine the source of

their income. The proposed regulations

refer to revised § 1.863–3(b)(3) in

applying the method to Possession

Purchase Sales.

2. Determination of Source of Gross

Income

Unlike the current regulations which

provide specific rules for determining

the source of income attributable to

production activity and business

activity only for purposes of the 50/50

method, the proposed regulations adopt

rules applicable to each of the methods.

Under the proposed regulations, once

gross income attributable to production

activity, business activity, or sales

activity has been determined under one

of the prescribed methods, the source of

the gross income is determined

separately for each type of income. The

source of gross income attributable to

production activity (when applying the

possession 50/50 method) is determined

under paragraph (c)(1), based on the

location of production assets. The

source of gross income attributable to

sales activity (when applying the IFP

method or the books and records

method) is determined under paragraph

(c)(2), based generally on the location of

the sale. The source of gross income

attributable to business sales activity

(when applying the possession 50/50

method) is determined under paragraph

(f)(2)(ii)(B), based on expenses, and

gross sales attributable to Possession

Production Sales. The source of gross

income attributable to business activity

(when applying the business activity

method) is determined under paragraph

(f)(3)(ii), based on expenses, cost of

goods sold, and gross sales attributable

to Possession Purchase Sales.

3. Determination of Source of Taxable

Income

Once the source of gross income is

determined under paragraph (f)(2) or (3),

taxpayers then determine the source of

taxable income. Under proposed

paragraph (f)(4), taxpayers must allocate

or apportion under §§ 1.861–8 through

1.861–14T the amounts of expenses,

losses and other deductions to gross

income determined under each of the

prescribed methods. In the case of

amounts of expenses, losses and other

deductions allocated or apportioned to

gross income determined under the IFP

method or the books and records

method, the taxpayer must apply the

rules of §§ 1.861–8 through 1.861–14T

to allocate or apportion these amounts

between gross income from sources

within the United States and within a

possession. For expenses, losses and

other deductions allocated or

apportioned to gross income determined

under the possessions 50/50 method,

taxpayers must apportion expenses and

other deductions pro rata based on the

relative amounts of U.S. and possession

source gross income. The research and

experimental (R&E) expense allocation

rules in § 1.861–17 apply to taxpayers

using the 50/50 method, so that the R&E

set aside (described in § 1.861–17)

remains available to such taxpayers.

4. Treatment of Gross Income Derived

From Certain Purchases From a

Corporation That Has an Election in

Effect Under Section 936

The proposed regulations clarify that

section 863 does not apply to determine

the source of a taxpayer’s gross income

derived from a purchase of inventory

from a corporation that has an election

in effect under section 936, if the

taxpayer’s income from sales of that

inventory is taken into account to

determine benefits under section

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

corporation.

5. Treatment of Partners and

Partnerships

The proposed regulations rely on the

rules in § 1.863–3(g) for determining the

appropriate treatment in transactions

involving partnerships. Under those

rules, the aggregate approach applies to

a partnership’s production and sales

activity for two purposes only. First, the

aggregate approach applies in

determining the character of a partner’s

distributive share of partnership

income. Second, the aggregate approach

applies in sourcing income from sales of

inventory property that is transferred inkind from or to a partnership.

6. Election and Reporting Rules

Under paragraph (f)(6)(i) of the

proposed regulations, a taxpayer must

use the 50/50 method to determine the

source of income from Possession

Production Sales unless the taxpayer

elects to use the IFP method, or elects

the books and records method. For

Possession Purchase Sales, a taxpayer

must use the business activity method,

unless the taxpayer elects the books and

records method. The taxpayer makes an

election by using the method on its

timely filed original tax return. That

method must be used in later taxable

years unless the Commissioner or his

delegate consents to a change.

Permission to change methods in later

years will not be withheld unless the

change would result in a substantial

distortion of the source of income.

A taxpayer must fully explain the

methodology used in applying either

paragraph (f)(2) or (3), and the amount

of income allocated or apportioned to

U.S. and foreign sources, in a statement

attached to its tax return.

II. Income Derived From Certain

Purchases From a Corporation That Has

an Election in Effect Under Section 936

These proposed regulations clarify

that where a taxpayer purchases a

product from a corporation that has an

election in effect under section 936, the

source of the taxpayer’s gross income

derived from sales of that product (in

whatever form sold) in the United States

is U.S. source, if the taxpayer’s income

from sales of that product is taken into

account to determine benefits under

section 936(h)(5)(C)(i) for the section

936 corporation. The taxpayer’s income

is U.S. source without regard to whether

a possession product is a component,

end-product form, or integrated product.

No inference should be drawn from the

proposed effective date concerning the

treatment of transactions involving sales

of property purchased from a section

936 corporation entered into before the

regulations are applicable.

Proposed Effective Dates

These regulations are proposed to be

effective for taxable years beginning on

or after the date that is 30 days after the

date of publication of final regulations.

Special Analyses

It has been determined that this notice

of proposed rulemaking is not a

significant regulatory action as defined

in EO 12866. Therefore, a regulatory

assessment is not required. It is hereby
Federal Register / Vol. 62, No. 197 / Friday, October 10, 1997 / Proposed Rules 52957

certified that these regulations will not

have a significant economic impact on

a substantial number of small entities.

This certification is based on the fact

that the rules of this section principally

impact large multinationals who pay

foreign taxes on substantial foreign

operations and therefore the rules will

impact very few small entities.

Moreover, in those few instances where

the rules of this section impact small

entities, the economic impact on such

entities is not likely to be significant.

Accordingly, a regulatory flexibility

analysis is not required. Pursuant to

section 7805(f) of the Internal Revenue

Code, this notice of proposed

rulemaking will be submitted to the

Chief Counsel for Advocacy of the Small

Business Administration for comment

on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are

adopted as final regulations,

consideration will be given to any

comments that are submitted timely (in

the manner described under the

ADDRESSES caption) to the IRS. All

comments will be available for public

inspection and copying.

A public hearing has been scheduled

for January 29, 1998, at 10 a.m., in room

2615, Internal Revenue Building, 1111

Constitution Avenue, NW., Washington,

DC. Because of access restrictions,

visitors will not be admitted beyond the

Internal Revenue Building lobby more

than 15 minutes before the hearing

starts.

The rules of 26 CFR 601.601(a)(3)

apply to the hearing.

Persons that wish to present oral

comments at the hearing must submit

comments and an outline of topics to be

discussed and the time to be devoted to

each topic (in the manner described

under the ADDRESSES caption of this

preamble) by January 8, 1998.

A period of 10 minutes will be

allotted to each person for making

comments.

An agenda showing the scheduling of

the speakers will be prepared after the

deadline for receiving outlines has

passed. Copies of the agenda will be

available free of charge at the hearing.

Drafting Information

The principal author of these

regulations is Anne Shelburne, Office of

Associate Chief Counsel (International).

However, other personnel from the IRS

and Treasury Department participated

in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and

recordkeeping requirements.

Proposed Amendments to the

Regulations

Accordingly, 26 CFR part 1 is

proposed to be amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation

for part 1 is amended by revising the

entry for ‘‘Section 1.863–3’’, removing

the entry for ‘‘Sections 1.936–4 through

1.936–7’’, and adding entries in

numerical order to read as follows:

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

Section 1.863–3 also issued under 26

U.S.C. 863(a) and (b), and 26 U.S.C.

936(h).* * *

Section 1.936–4 also issued under 26

U.S.C. 936(h).

Section 1.936–5 also issued under 26

U.S.C. 936(h).

Section 1.936–6 also issued under 26

U.S.C. 863(a) and (b), and 26 U.S.C. 936(h).

Section 1.936–7 also issued under 26

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

Par. 2. Section 1.863–3 is amended as

follows:

1. Paragraph (f) is revised.

2. Paragraph (h) is amended by adding

a sentence at the end of the paragraph.

The revision and addition read as

follows:

§ 1.863–3 Allocation and apportionment of

income from certain sales of inventory.

* * * * *

(f) Income partly from sources within

a possession of the United States—(1) In

general. This paragraph (f) relates to

gains, profits, and income, which are

treated as derived partly from sources

within the United States and partly from

sources within a possession of the

United States (Section 863 Possession

Sales). This paragraph (f) applies to

determine the source of income derived

from the sale of inventory produced (in

whole or in part) by the taxpayer within

the United States and sold within a

possession, or produced (in whole or in

part) by a taxpayer in a possession and

sold within the United States

(Possession Production Sales). It also

applies to determine the source of

income derived from the purchase of

personal property within a possession of

the United States and its sale within the

United States (Possession Purchase

Sales). A taxpayer subject to this

paragraph (f) must divide gross income

from Section 863 Possession Sales using

one of the methods described in either

paragraph (f)(2)(i) of this section (in the

case of Possession Production Sales) or

paragraph (f)(3)(i) of this section (in the

case of Possession Purchase Sales).

Once a taxpayer has elected a method,

the taxpayer must separately apply that

method to the applicable category of

Section 863 Possession Sales in the

United States and to those in a

possession. The source of gross income

from each type of activity must then be

determined under either paragraph

(f)(2)(ii) or (3)(ii) of this section, as

appropriate. The source of taxable

income from Section 863 Possession

Sales is determined under paragraph

(f)(4) of this section. The taxpayer must

apply the rules for computing gross and

taxable income by aggregating all

Section 863 Possession Sales to which

a method in this section applies after

separately applying that method to

Section 863 Possession Sales in the

United States and to Section 863

Possession Sales in a possession. This

section does not apply to determine the

source of a taxpayer’s gross income

derived from a sale of inventory

purchased from a corporation that has

an election in effect under section 936,

if the taxpayer’s income from sales of

that inventory is taken into account to

determine benefits under section 936 for

the section 936 corporation. For rules to

be applied to determine the source of

such income, see § 1.936–6(a)(5) Q&A 7a

and (b)(1) Q&A 13.

(2) Allocation or apportionment for

Possession Production Sales—(i)

Methods for determining the source of

gross income for Possession Production

Sales—(A) Possession 50/50 method.

Under the possession 50/50 method,

gross income from Possession

Production Sales is allocated between

production activity and business sales

activity as described in this paragraph

(f)(2)(i)(A). Under the possession 50/50

method, one-half of the taxpayer’s gross

income will be considered income

attributable to production activity and

the source of that income will be

determined under the rules of paragraph

(f)(2)(ii)(A) of this section. The

remaining one-half of such gross income

will be considered income attributable

to business sales activity and the source

of that income will be determined under

the rules of paragraph (f)(2)(ii)(B) of this

section.

(B) IFP method. In lieu of the

possession 50/50 method, a taxpayer

may elect the independent factory price

(IFP) method. Under the IFP method,

gross income from Possession

Production Sales is allocated to

production activity or sales activity

using the IFP method, as described in

paragraph (b)(2) of this section, if an IFP

is fairly established under the rules of

paragraph (b)(2) of this section. See

paragraphs (f)(2)(ii) (A) and (C) of this

section for rules for determining the

source of gross income attributable to

production activity and sales activity.
52958 Federal Register / Vol. 62, No. 197 / Friday, October 10, 1997 / Proposed Rules

(C) Books and Records method. A

taxpayer may elect to allocate gross

income using the books and records

method described in paragraph (b)(3) of

this section, if it has received in

advance the permission of the District

Director having audit responsibility over

its return. See paragraph (f)(2)(ii) of this

section for rules for determining the

source of gross income.

(ii) Determination of source of gross

income from production, business sales,

and sales activity—(A) Gross income

attributable to production activity. The

source of gross income from production

activity is determined under the rules of

paragraph (c)(1) of this section, except

that the term possession is substituted

for foreign country wherever it appears.

(B) Gross income attributable to

business sales activity—(1) Source of

gross income. Gross income from the

taxpayer’s business sales activity is

sourced in the possession in the same

proportion that the amount of the

taxpayer’s business sales activity for the

taxable year within the possession bears

to the amount of the taxpayer’s business

sales activity for the taxable year both

within the possession and outside the

possession, with respect to Possession

Production Sales. The remaining

income is sourced in the United States.

(2) Business sales activity. For

purposes of this paragraph (f)(2)(ii)(B),

the taxpayer’s business sales activity is

equal to the sum of—

(i) The amounts for the taxable period

paid for wages, salaries, and other

compensation of employees, and other

expenses attributable to Possession

Production Sales (other than amounts

that are nondeductible under section

263A, interest, and research and

development); and

(ii) Possession Production Sales for

the taxable period.

(3) Location of business sales activity.

For purposes of determining the

location of the taxpayer’s business

activity within a possession, the

following rules apply:

(i) Sales. Receipts from gross sales

will be attributed to a possession under

the provisions of paragraph (c)(2) of this

section.

(ii) Expenses. Expenses will be

attributed to a possession under the

rules of §§ 1.861–8 through 1.861–14T.

(C) Gross income attributable to sales

activity. The source of the taxpayer’s

income that is attributable to sales

activity, as determined under the IFP

method or the books and records

method, will be determined under the

provisions of paragraph (c)(2) of this

section.

(3) Allocation or apportionment for

Possession Purchase Sales—(i) Methods

for determining the source of gross

income for Possession Purchase Sales—

(A) Business activity method. Gross

income from Possession Purchase Sales

is allocated in its entirety to the

taxpayer’s business activity, and is then

apportioned between U.S. and

possession sources under paragraph

(f)(3)(ii) of this section.

(B) Books and records method. A

taxpayer may elect to allocate gross

income using the books and records

method described in paragraph (b)(3) of

this section, subject to the conditions set

forth in paragraph (b)(3) of this section.

See paragraph (f)(2)(ii) of this section for

rules for determining the source of gross

income.

(ii) Determination of source of gross

income from business activity—(A)

Source of gross income. Gross income

from the taxpayer’s business activity is

sourced in the possession in the same

proportion that the amount of the

taxpayer’s business activity for the

taxable year within the possession bears

to the amount of the taxpayer’s business

activity for the taxable year both within

the possession and outside the

possession, with respect to Possession

Purchase Sales. The remaining income

is sourced in the United States.

(B) Business activity. For purposes of

this paragraph (f)(3)(ii), the taxpayer’s

business activity is equal to the sum

of—

(1) The amounts for the taxable period

paid for wages, salaries, and other

compensation of employees, and other

expenses attributable to Possession

Purchase Sales (other than amounts that

are nondeductible under section 263A,

interest, and research and

development);

(2) Cost of goods sold attributable to

Possession Purchase Sales during the

taxable period; and

(3) Possession Purchase Sales for the

taxable period.

(C) Location of business activity. For

purposes of determining the location of

the taxpayer’s business activity within a

possession, the following rules apply:

(1) Sales. Receipts from gross sales

will be attributed to a possession under

the provisions of paragraph (c)(2) of this

section.

(2) Cost of goods sold. Payments for

cost of goods sold will be properly

attributable to gross receipts from

sources within the possession only to

the extent that the property purchased

was manufactured, produced, grown, or

extracted in the possession (within the

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

(3) Expenses. Expenses will be

attributed to a possession under the

rules of §§ 1.861–8 through 1.861–14T.

(iii) Examples. The following

examples illustrate the rules of

paragraph (f)(3)(ii) relating to the

determination of source of gross income

from business activity:

Example 1. (i) U.S. Co. purchases in a

possession product X for $80 from A. A

manufactures X in the possession. Without

further production, U.S. Co. sells X in the

United States for $100. Assume U.S. Co. has

sales and administrative expenses in the

possession of $10.

(ii) To determine the source of U.S. Co.’s

gross income, the $100 gross income from

sales of X is allocated entirely to U.S. Co.’s

business activity. Forty-seven dollars of U.S.

Co.’s gross income is sourced in the

possession. [Possession expenses ($10) plus

possession purchases ($80) plus possessions

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

plus total purchases ($80) plus total sales

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

United States.

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

Example 1, except that A manufactures X

outside the possession.

(ii) To determine the source of U.S. Co.’s

gross income, the $100 gross income is

allocated entirely to U.S. Co.’s business

activity. Five dollars of U.S. Co.’s gross

income is sourced in the possession.

[Possession expenses ($10) plus possession

purchases ($0) plus possession sales ($0),

divided by total expenses ($10) plus total

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

$80 purchase is not included in the

numerator used to determine U.S. Co.’s

business activity in the possession, since

product X was not manufactured in the

possession. The remaining $95 is sourced in

the United States.

(4) Determination of source of taxable

income. Once the source of gross

income has been determined under

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

taxpayer must properly allocate and

apportion separately under §§ 1.861–8

through 1.861–14T the amounts of its

expenses, losses, and other deductions

to its respective amounts of gross

income from Section 863 Possession

Sales determined separately under each

method described in paragraph (f)(2) or

(3) of this section. In addition, if the

taxpayer deducts expenses for research

and development under section 174 that

may be attributed to its Section 863

Possession Sales under § 1.861–8(e)(3),

the taxpayer must separately allocate or

apportion expenses, losses, and other

deductions to its respective amounts of

gross income from each relevant

product category that the taxpayer uses

in applying the rules of § 1.861–

8(e)(3)(i)(A). In the case of gross income

from Section 863 Possession Sales

determined under the IFP method or

books and records method, a taxpayer

must apply the rules of §§ 1.861–8

through 1.861–14T to properly allocate

or apportion amounts of expenses,
Federal Register / Vol. 62, No. 197 / Friday, October 10, 1997 / Proposed Rules 52959

losses and other deductions, allocated

and apportioned to such gross income,

between gross income from sources

within and without the United States. In

the case of gross income from

Possession Production Sales determined

under the possessions 50/50 method or

gross income from Possession Purchase

Sales computed under the business

activity method, the amounts of

expenses, losses, and other deductions

allocated and apportioned to such gross

income must be apportioned between

sources within and without the United

States pro rata based on the relative

amounts of gross income from sources

within and without the United States

determined under those methods.

(5) Special rules for partnerships. In

applying the rules of this paragraph (f)

to transactions involving partners and

partnerships, the rules of paragraph (g)

of this section apply.

(6) Election and reporting rules—(i)

Elections under paragraph (f)(2) or (3) of

this section. If a taxpayer does not elect

one of the methods specified in

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

taxpayer must apply the possession 50/

50 method in the case of Possession

Production Sales or the business activity

method in the case of Possession

Purchase Sales. The taxpayer may elect

to apply a method specified in either

paragraph (f)(2) or (3) of this section by

using the method on a timely filed

original return (including extensions).

Once a method has been used, that

method must be used in later taxable

years unless the Commissioner consents

to a change. Permission to change

methods from one year to another year

will be granted unless the change would

result in a substantial distortion of the

source of the taxpayer’s income.

(ii) Disclosure on tax return. A

taxpayer who uses one of the methods

described in paragraph (f)(2) or (3) of

this section must fully explain in a

statement attached to the tax return the

methodology used, the circumstances

justifying use of that methodology, the

extent that sales are aggregated, and the

amount of income so allocated.

* * * * *

(h) Effective dates. * * * However,

the rules of paragraph (f) of this section

apply to taxable years beginning on or

after the date that is 30 days after the

date of publication of final regulations.

Par. 3. In § 1.936–6, paragraph (a)(5)

Q&A 7a is added to read as follows:

§ 1.936–6 Intangible property income when

an election out is made: Cost sharing and

profit split options; covered intangibles.

* * * * *

(a) * * *

(5) * * *

Q.7a: What is the source of the

taxpayer’s gross income derived from a

sale in the United States of a possession

product purchased by the taxpayer (or

an affiliate) from a corporation that has

an election in effect under section 936,

if the income from such sale is taken

into account to determine benefits

under cost sharing for the section 936

corporation? Is the result different if the

taxpayer (or an affiliate) derives gross

income from a sale in the United States

of an integrated product incorporating a

possession product purchased by the

taxpayer (or an affiliate) from the

section 936 corporation, if the taxpayer

(or an affiliate) processes the possession

product or an excluded component in

the United States?

A.7a: Under either scenario, the

income is U.S. source, without regard to

whether the possession product is a

component, end-product, or integrated

product. Section 863 does not apply in

determining the source of the taxpayer’s

income. This Q&A 7a is applicable for

taxable years beginning on or after the

date that is 30 days after the date of

publication of final regulations.

* * * * *

Michael P. Dolan,

Acting Commissioner of Internal Revenue.

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

BILLING CODE 4830–01–P

ENVIRONMENTAL PROTECTION

AGENCY

40 CFR Part 52

[CA 198–0056; FRL–5907–3]

Approval and Promulgation of

Implementation Plans; California State

Implementation Plan Revision, San

Diego County Air Pollution Control

District

AGENCY: Environmental Protection

Agency (EPA).

ACTION: Proposed rule.

SUMMARY: EPA is proposing to approve

revisions to the California State

Implementation Plan (SIP) which

concern the control of volatile organic

compound (VOC) emissions from kelp

processing and bio-polymer

manufacturing operations.

The intended effect of proposing

approval of this rule is to regulate

emissions of VOCs in accordance with

the requirements of the Clean Air Act,

as amended in 1990 (CAA or the Act).

EPA’s final action will incorporate this

rule into the federally approved SIP. In

addition, final action on this rule will

serve as a final determination that

deficiencies in the rule (identified by

EPA in a limited approval/limited

disapproval action on February 14,

1996) have been corrected and that any

sanctions or Federal Implementation

Plan (FIP) obligations are permanently

stopped. An Interim Final

Determination published in today’s

Federal Register will defer the

imposition of sanctions until EPA takes

final action. EPA has evaluated the rule

and is proposing to approve the rule

under provisions of the CAA regarding

EPA action on SIP submittals, SIPs for

national primary and secondary ambient

air quality standards, and plan

requirements for nonattainment areas.

DATES: Comments must be received on

or before November 10, 1997.

ADDRESSES: Comments may be mailed

to: Andrew Steckel, Rulemaking Office

(AIR–4), Air Division, U.S.

Environmental Protection Agency,

Region IX, 75 Hawthorne Street, San

Francisco, CA 94105–3901.

Copies of the rule and EPA’s

evaluation report of the rule are

available for public inspection at EPA’s

Region 9 office during normal business

hours. Copies of the submitted rule are

also available for inspection at the

following locations:

San Diego County Air Pollution Control

District, 9150 Chesapeake Drive, San

Diego, CA 92123–1096

California Air Resources Board,

Stationary Source Division, Rule

Evaluation Section, 2020 ‘‘L’’ Street,

Sacramento, CA 95814.

FOR FURTHER INFORMATION CONTACT:

Patricia A. Bowlin, Rulemaking Office

(AIR–4), Air Division, U.S.

Environmental Protection Agency,

Region IX, 75 Hawthorne Street, San

Francisco, CA 94105–3901, (415) 744–

1188.

SUPPLEMENTARY INFORMATION:

I. Applicability

The rule being proposed for approval

into the California SIP is San Diego

County Air Pollution Control District

(SDCAPCD) Rule 67.10, Kelp Processing

and Bio-Polymer Manufacturing

Operations. This rule was submitted by

the California Air Resources Board

(CARB) to EPA on August 1, 1997.

II. Background

On March 3, 1978, EPA promulgated

a list of ozone nonattainment areas

under the provisions of the Clean Air

Act, as amended in 1977 (1977 CAA or

pre-amended Act), that included the

San Diego Area. 43 FR 8964; 40 CFR

81.305. On May 26, 1988, EPA notified

the Governor of California, pursuant to

section 110(a)(2)(H) of the pre-amended