63478 Federal Register / Vol. 60, No. 237 / Monday, December 11, 1995 / Proposed Rules

12Under ‘‘recourse rates’’, pipelines would be free

to offer negotiated rates. Customers could choose

either negotiated rates or they could choose the

pipeline’s on-file, cost-of-service rates.

13See n. 13 supra.

OCSLA respecting rates for gas pipeline

services?

5. Does the OCSLA provide sufficient

remedial authority for the Commission

to ensure nondiscriminatory access by

prohibiting discriminatory or excessive

rates?

6. Does the OCSLA provide the

Commission with sufficient authority to

protect the interests of historical

customers of existing offshore interstate

pipelines if these pipelines were

declared to be gathering facilities?

7. Is it feasible, as a matter of law and

policy, to adopt a light-handed

regulatory approach that relies on

complaints about discriminatory access

or rates?

8. If such an approach is adopted, is

there a need to distinguish between new

and existing pipelines to determine how

much regulation is necessary? What

would be the legal and policy basis for

any such distinction?

9. What are the implications of a

change in OCS gathering policy on

existing OCS interstate pipelines that

may wish to retain their jurisdictional

status or on existing, interstate pipelineowned, OCS transmission facilities that

wish to retain a transmission

classification for those facilities?

10. How much, if any, OCS gas is

processed at locations other than

onshore or in shallow waters?

B. Should the Commission issue a

rule under the NGA declaring all

pipeline facilities on the OCS to be

nonjurisdicational gathering facilities

and simultaneously issue a rule under

the OCSLA imposing terms and

conditions on OCS facilities to protect

existing shippers on existing OCS

interstate pipelines or on existing OCS

transmission facilities?

1. What would be the practical effect

of these rules?

2. Does the Commission have

sufficient authority under the OCSLA to

prohibit, eliminate or alter rates that are

clearly discriminatory or rates that are

so high that they would have the effect

of denying access to shippers?

3. What would be the impact of the

Commission’s ceasing to regulate any

offshore pipeline rates under the ‘‘just

and reasonable’’ standard of sections 4

and 5 of the NGA?

4. Is here a legal basis under the

OCSLA for the Commission to regulate

generally the level of rates for services

performed by OCS pipelines?

5. What conditions could the

Commission require under the NGA

and/or the OCSLA to protect historical

customers of currently regulated OCS

pipelines if their facilities are declared

to be exempt gathering facilities?

6. Under this option, should the

Commission consider allowing all rate

regulation to end at any point that a

pipeline and a (non-affiliated) shipper

agree? (This option would be similar to

recent proposals for ‘‘recourse rates’’.12)

C. Should the Commission issue a

rule under the NGA declaring all

pipeline facilities on the OCS to be

jurisdictional transportation facilities,

but only regulate transportation rates for

historical customers on existing

interstate pipelines and for non-owner

shippers on new facilities?

1. What would be the practical effect

of such a rule?

2. Does a ‘‘regulatory gap’’ exist on the

OCS that would support the issuance of

such a rule?

3. What legal support is there for the

Commission’s regulating only those

pipelines that transport non-owner

shipper gas?

4. Is there any need to regulate the

rates charged new customers that have

not relied upon or have no expectation

of NGA regulation?

5. Would the provisions of the OSCLA

provide sufficient protection from

undue discrimination to both historical

and new customers of OCS pipelines?

6. Under this option, should the

Commission consider allowing all rate

regulation to end at any point that a

pipeline and a (non-affiliated) shipper

agree? (This option would be similar to

recent proposals for ‘‘recourse rates’’.13)

D. Should the Commission continue

the application of the ‘‘modified

primary function’’ test on a case-by-case

basis? What would be the effects of this

approach?

VI. Procedure for Comments

The Commission invites interested

persons to submit comments, data,

views, and other information

concerning the matters set out in this

notice.

To facilitate the Commission’s review

of the comments, commenters are

requested to provide an executive

summary of their position on the issues

raised in the NOI. Commenters are

requested to identify the specific

question posed by the NOI that their

discussion addresses and to use

appropriate headings. Additionally,

commenters should double space their

comments.

The original and 14 copies of such

comments must be received by the

Commission before 5:00 p.m., Friday,

January 12, 1996. Comments should be

submitted to the Office of the Secretary,

Federal Energy Regulatory Commission,

888 First Street, NE., Washington DC

20426 and should refer to Docket No.

RM96–5–000.

In addition, commenters are asked to

submit their written comments and

executive summaries on a 3 1/2-inch

diskette formatted for MS-DOS based

computers. In light of our ability to

translate MS-DOS based materials, the

text need only be submitted in the

format and version that it was generated

(i.e. MS WORD, WordPerfect, ASC III,

etc.) For Macintosh users, it would be

helpful to save the documents in word

processor format and then write them to

files on a diskette formatted for MS-DOS

machines.

By direction of the Commission.

Lois D. Cashell,

Secretary.

[FR Doc. 95–30062 Filed 12–8–95; 8:45 am]

BILLING CODE 6717–01–M

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[INTL–0003–95]

RIN 1545–AT92

Source of Income From Sales of

Inventory and Natural Resources

Produced in One Jurisdiction and Sold

in Another Jurisdiction

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Notice of proposed rulemaking

and notice of public hearing.

SUMMARY: This document contains

proposed regulations governing the

source of income from sales of natural

resources or other inventory produced

in the United States and sold in a

foreign country or produced in a foreign

country and sold in the United States.

This document affects persons who

produce natural resources or other

inventory in the United States and sell

in a foreign country, or produce natural

resources or other inventory in a foreign

country and sell in the United States.

This document also provides notice of

a public hearing on these proposed

regulations.

DATES: Written comments and outlines

of oral comments to be presented at the

public hearing scheduled for April 10,

1996, at 10 a.m. must be received by

March 11, 1996.

ADDRESSES: Send submissions to:

CC:DOM:CORP:R (INTL–0003–95),
Federal Register / Vol. 60, No. 237 / Monday, December 11, 1995 / Proposed Rules 63479

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 (INTL–

0003–95), Courier’s Desk, Internal

Revenue Service, 1111 Constitution

Avenue NW., Washington, DC. The

public hearing will be held in the IRS

Auditorium, 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.

Christina Vasquez, (202) 622–7180 (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).

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 February 9, 1996.

An agency may not conduct or

sponsor, and a person is not required to

respond to, a collection of information

unless the collection of information

displays a valid control number.

The collection of information

requirements are in proposed §§ 1.863–

1(b)(6) and 1.863–3(e)(2). 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 natural

resources or other inventory produced

in the United States and sold in a

foreign country or produced in a foreign

country and sold in the United States.

The likely respondents are taxpayers

who produce natural resources or other

inventory in the United States and sell

in a foreign country, or who produce

natural resources or other inventory in

a foreign country 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: 1125 hours. The estimated

annual burden per respondent varies

from 1 hour to 5 hours, depending on

individual circumstances, with an

estimated average of 2.6 hours.

Estimated number of respondents:

425.

Estimated annual frequency of

responses: One time per year.

Background

These proposed regulations contain

rules relating to the source of income

from the sale of certain natural

resources and other inventory. These

regulations are proposed to be effective

for taxable years beginning 30 days after

publication of final regulations.

However, taxpayers may elect to apply

these regulations for taxable years

beginning after July 11, 1995.

Explanation of Provisions

I. Natural Resources

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).

Section 1.863–1 of the existing

regulations contains rules for

determining the source of income

derived from the sale of certain natural

resources. Generally, under paragraph

(b)(1) of those regulations, income

derived from the ownership or

operation of any farm, mine, oil or gas

well, other natural deposit, or timber

located within the United States and

from the sale by the producer of the

products within or without the United

States ordinarily must be included in

gross income from sources within the

United States. However, if a taxpayer

can show to the satisfaction of the

District Director that, due to peculiar

conditions of production and sale or for

other reasons, not all of the gross

income derived therefrom should be

allocated to sources within the United

States, the source of the income

generally is determined under the 50/50

method described in § 1.863–3(b)(2)

Example 2. The regulations do not

define ‘‘peculiar conditions of

production and sale.’’ In addition,

§ 1.863–1(b)(2) permits the

Commissioner to make an allocation or

apportionment that more clearly reflects

the proper source of a taxpayer’s

income, if the Commissioner determines

that the application of paragraph (b)(1)

does not result in the proper allocation

or apportionment of income. Similar

rules apply in the case of natural

resources produced without the United

States and sold within the United

States. See § 1.863–6. Thus, income

from the sale of such products

ordinarily will be allocated entirely to

foreign sources.

B. Issues Under Current Regulations

The IRS and Treasury have

reexamined the existing regulations

under section 863 regarding natural

resources and arrived at several

conclusions. First, certain ambiguities

in existing § 1.863–1 should be clarified.

For example, the regulation does not

define the term ‘‘peculiar conditions of

production and sale,’’ and there is

virtually no authoritative guidance as to

the scope of that term. To the extent that

‘‘peculiar conditions of production and

sale’’ is defined narrowly, the regulation

may lead to inappropriate results when

determining the source of income from

the sale of processed natural resources.

For example, if a U.S. corporation

harvests timber to manufacture furniture

for export, all of its income may be from

sources within the United States.

However, if another U.S. corporation

purchases cut timber to manufacture

furniture for export from the United

States, one-half of that taxpayer’s

income may be from sources without

the United States under the 50/50

method.

Second, the interaction of the existing

regulations and the recently-issued

consolidated return regulations may

cause inappropriate sourcing results. On

July 11, 1995, the IRS and Treasury

issued final regulations under § 1.1502–

13 [TD 8597 (60 FR 36671)], treating

members of a U.S. consolidated group as

a single entity for purposes of

determining the source of a taxpayer’s

income. The IRS and Treasury

understand that inappropriate results

may occur when the current section 863

regulations are applied to certain

consolidated groups on a single entity

basis. For example, a U.S. corporation

that is a member of a consolidated group

may extract oil abroad. The oil is then

transported to the United States where

it is refined by another member of the

consolidated group. It is sold in the

United States through other members of

the consolidated group. Under § 1.1502–

13 of the consolidated return rules, the

consolidated group is treated as a single

entity, and the source of income from

the sale of oil must be determined under
63480 Federal Register / Vol. 60, No. 237 / Monday, December 11, 1995 / Proposed Rules

section 863. Because the consolidated

group refines the oil outside the country

of extraction, it may be that peculiar

conditions of production and sale exist,

and the exclusive sourcing rules of

paragraph (b)(1) do not apply. Thus, the

taxpayer would generally determine the

source of its income under the 50/50

method described in § 1.863–3(b)(2)

Example 2. Under this method, 50

percent of the consolidated group’s

income would be U.S. source income

based on the place of sale. However, this

calculation may understate the

appropriate amount of the taxpayer’s

foreign source income because the value

of the oil as extracted may represent

more than 50 percent of the total value

of the product that is finally sold in the

United States. The preamble to the

regulations under § 1.1502–13 indicated

that the IRS and Treasury would

consider amending the regulations

under section 863 to address these

concerns.

Accordingly, the IRS and Treasury are

issuing proposed regulations under

section 863 to clarify ambiguities in the

existing regulation and to address

concerns created by the new § 1.1502–

13 regulations.

C. Proposed Regulations

Section 1.863–1(b) provides special

rules for determining the source of

income from the sale of products

derived from the ownership or

operation of any farm, mine, oil or gas

well, other natural deposit, or timber,

within the United States and the sale of

these products without the United

States. The proposed regulations also

provide special rules for determining

the source of income from the sale of

products derived from the ownership or

operation of any farm, mine, oil or gas

well, other natural deposit, or timber,

without the United States and the sale

of these products within the United

States. The export terminal rule of

paragraph (b)(1) provides that the source

of gross receipts from the sale of such

products equal to the fair market value

of the product immediately prior to

export (referred to in the proposed

regulations as the export terminal) is

determined according to where the

farm, mine, oil or gas well, other natural

deposit or timber is located. Separate

rules are provided for determining the

source of any gross receipts in excess of

the fair market value of the product at

the export terminal. Paragraph (b)(2)

provides an exception to the approach

of paragraph (b)(1) where, prior to

export, the taxpayer engages in

substantial production activities in

addition to activities related to the

ownership or operation of a farm, mine,

oil or gas well, other natural deposit, or

timber.

1. Export Terminal Rule

Under the export terminal rule of

paragraph (b)(1), gross receipts derived

from the ownership or operation of any

farm, mine, oil or gas well, other natural

deposit, or timber, and sale of the

products derived therefrom, are

allocated between sources within and

without the United States based on the

fair market value of the product at the

export terminal. The export terminal is

the last point from which the product is

sent from the United States to a foreign

country or the last point from which

goods are sent from a foreign country to

the United States. For example, if a U.S.

corporation extracts oil in one foreign

country, sends the crude oil to a port in

a second foreign country via pipeline,

and delivers the oil to a U.S. refinery by

ship, the export terminal would be the

port in the second foreign country

where the crude oil was loaded onto the

ship.

Under the export terminal rule, the

source of gross receipts equal to the fair

market value of the product at the

export terminal is determined by the

location of the farm, mine, well, deposit,

or uncut timber. The source of gross

receipts in excess of the fair market

value of the product at the export

terminal (excess gross receipts) is

determined according to whether the

taxpayer engages in any additional

production activity following export. A

taxpayer will be treated as performing

production activities in addition to the

activities of owning or operating a farm,

mine, oil or gas well, other natural

deposit, or timber based on the

principles of § 1.954–3(a)(4). However,

activities that prepare the natural

resource itself for export, including

those that are designed to facilitate the

transportation of the natural resource to

or from the export terminal, will not be

considered additional production

activities. Thus, § 1.863–1 Example 2

illustrates that liquefaction of natural

gas would not constitute additional

production activities. In addition,

activities such as delimbing and

debarking trees, sorting grain, and

treating and stabilizing oil would

ordinarily not constitute additional

production activities. In contrast, the

transformation of timber into furniture

is not done to prepare the natural

resource itself for export, and would

constitute additional production

activity. Production activities are

defined in § 1.863–1(b)(3)(i).

If no additional production occurs

following export, paragraph (b)(1)(i)

requires that the source of the excess

gross receipts be determined according

to where the farm, mine, well, deposit,

or uncut timber is located.

However, under paragraph (b)(1)(ii), if

the taxpayer engages in additional

production activities after the export

terminal and outside the country of sale,

the source of excess gross receipts is

determined under the rules of § 1.863–

3. For example, if a U.S. corporation

extracts oil in a foreign country, refines

the oil in the United States, and sells the

refined product in another foreign

country, the source of gross receipts in

excess of the fair market value of the

product when it is exported from the

first foreign country must be determined

under one of the three methods

described in § 1.863–3 (i.e., the 50/50

method as described in § 1.863–3(b)(1),

the IFP method described in § 1.863–

3(b)(2), or, if permitted by the District

Director, the books and records method

as described in § 1.863–3(b)(3)).

In any case not described in either

paragraph (b)(1) (i) or (ii) of the

proposed regulations, the source of the

excess gross receipts is determined

according to the place of sale pursuant

to paragraph (b)(1)(iii). This rule would

apply, for example, in the case where

the taxpayer engages in additional

production activities in the country of

sale.

Paragraph (b)(1) addresses the

concerns of U.S. corporations involved

in the production of natural resources

abroad and the application of the new

§ 1.1502–13 consolidated return

regulations, by allowing them to treat

the value of the natural resources at the

point of export as income from sources

where the farm, mine, well, deposit, or

uncut timber is located. This rule has no

effect on the rules governing foreign oil

and gas extraction income under section

907(c)(1).

On November 28, 1995, the Tenth

Circuit affirmed the Tax Court decision

in Phillips Petroleum v. Comm’r, 97 T.C.

30 (1991), which held existing § 1.863–

1(b)(1) invalid to the extent it allocates

income from the sale of U.S. natural

resources solely to sources within the

United States. Phillips Petroleum v.

Comm’r, No. 94–9021 (10th Cir. Nov.

28, 1995). The IRS and Treasury will

consider the implications of this

decision when finalizing these proposed

regulations.

2. Additional Production Prior to Export

Terminal

Paragraph (b)(2) provides a special

rule for determining the source of

income where a taxpayer performs

substantial additional production

activities before the product leaves the

export terminal. Under paragraph (b)(2),
Federal Register / Vol. 60, No. 237 / Monday, December 11, 1995 / Proposed Rules 63481

the source of gross receipts equal to the

fair market value of the product prior to

the additional production activities is

based on the location of the farm, mine,

well, deposit, or uncut timber. The

source of gross receipts in excess of the

fair market value of the products at the

beginning of the additional production

activities is determined under the rules

of § 1.863–3.

3. Other Rules

The proposed regulation contains

rules for determining the fair market

value of relevant products. For this

purpose, fair market value depends on

all of the facts and circumstances as

they exist relative to a party in any

particular case. Thus, these rules for

determining fair market value are

consistent with the foreign oil and gas

rules contained in § 1.907(c)–1(b)(6). In

addition, fair market value

determinations must be consistent with

prices charged in sales, if any, to related

parties in a transaction that is subject to

section 482. For example, if a member

of a U.S. consolidated group extracts

natural resources in a foreign country

and sells the natural resources to

another member of the same group at

the export terminal, the value of the

natural resources determined at the

export terminal should be the price

charged by the producing member to the

purchasing member for purposes of

section 482.

Under paragraph (b)(5), a taxpayer’s

gross income from sources within or

without the United States is determined

by reducing its gross receipts from

sources within or without the United

States by the cost of goods sold properly

attributable to such gross receipts.

Under paragraph (c), a taxpayer’s

taxable income from U.S. or foreign

sources must be determined under the

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

Under paragraph (b)(6), taxpayers

must fully explain the methodology

used, the facts describing substantial

additional production activities (if any),

and the determination of fair market

value in a statement attached to the

taxpayer’s return. In addition, taxpayers

must provide such other information as

is required by § 1.863–3(e)(2).

Taxpayers may elect to apply the

rules of these regulations for taxable

years beginning after July 11, 1995.

Otherwise, these regulations are

effective for taxable years beginning 30

days after the publication of this

regulation as a final regulation.

II. Inventory Other Than Natural

Resources

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 specified in

sections 861(a) and 862(a).

Section 1.863–3 of the current

regulations governs the source of

income from the sale of inventory

produced (in whole or in part) in the

United States and sold in a foreign

country, or produced (in whole or in

part) in a foreign country and sold in the

United States (Section 863 Sales).

Section 1.863–3 provides three

methods, set forth in the form of three

examples, to determine the source of

income from Section 863 Sales.

§ 1.861–3(b)(2) Example 1 of the

current regulations illustrates how an

independent factory or production price

(IFP) applies to determine the income

attributable to production (IFP method).

An IFP generally is established if a

taxpayer regularly sells part of its output

to wholly independent distributors in

such a way as to reasonably reflect the

income attributable to production

activity. If an IFP exists, 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.

See Phillips Petroleum v. Comm’r, 97

T.C. 30 (1991), aff’d, No. 94–9021 (10th

Cir. Nov. 28, 1995); Rev. Rul. 88–73

(1988–2 C.B. 173). Gross receipts in

excess of the IFP are attributable to sales

activity. Taxpayers can otherwise

establish an IFP by showing to the

satisfaction of the District Director that

an IFP exists. Notice 89–10 (1989–1 C.B.

631) contains additional rules regarding

the application of the IFP method.

Section 1.863–3(b)(2) Example 1 of the

current regulations does not provide

explicit guidance as to how to

determine the source of income

attributable to production activities

under the IFP method. However, the

source of income attributable to sales

activities is based generally on where

title to the inventory passes to the

purchaser as defined in § 1.861–7(c).

Section 1.863–3(b)(2) Example 2 of

the current regulations divides a

taxpayer’s income from Section 863

Sales equally between production

activity and sales activity (50/50

method). The source of income

attributable to production activity is

based on the location of the taxpayer’s

property. The portion of this production

income attributable to sources within

the United States is determined by a

fraction, the numerator of which is the

taxpayer’s property located within the

United States used to produce income

from Section 863 Sales, and the

denominator of which is the taxpayer’s

property both within the United States

and within a foreign country used to

produce income from Section 863 Sales.

The source of the taxpayer’s income

attributable to sales activity is based on

where title to the inventory passes to the

purchaser as defined in § 1.861–7(c).

Section 1.863–3(b)(2) Example 3 of

the current regulations allows a

taxpayer to request permission from the

District Director to use the taxpayer’s

books and records to allocate income to

sources within and without the United

States if those books reflect more clearly

than the other methods the taxable

income derived from sources within the

United States (books and records

method).

B. Issues Under Current Regulations

On July 12, 1995, the IRS and

Treasury issued regulations under

§ 1.1502–13, treating members of a

consolidated group as a single entity for

purposes of determining the source of a

taxpayer’s income. The IRS and

Treasury understand that the current

section 863 regulations may raise

questions when applied to certain

consolidated groups on a single entity

basis. The preamble to the regulations

under § 1.1502–13 indicated that the

IRS and Treasury would reevaluate part

of the regulations under section 863. As

part of this process, the IRS and

Treasury also have reexamined the

remainder of the existing section 863

regulations and have concluded that

several additional changes are

necessary.

First, the existing regulations were

drafted more than 70 years ago, and

have not been amended to reflect the

evolution of business practices. As a

result, the regulations have been the

source of controversies in recent years.

See Intel Corporation v. Comm’r, 100

T.C. 39 (1993), aff’d, No. 94–70105 (9th

Cir. Oct. 16, 1995); Phillips Petroleum v.

Comm’r, 97 T.C. 30 (1991), 101 T.C. 78,

104 (1993) (‘‘there have been no cases

interpreting [the 50/50 method] and no

administrative pronouncements

regarding its application since the

regulation was promulgated in 1922

except for necessary inferences to be

drawn from Intel * * *’’), aff’d, No. 94–

9021 (10th Cir. Nov. 28, 1995). In part,

these controversies may be due to the

structure of the current regulations,

which do not contain operative rules to

describe the methods of allocating and
63482 Federal Register / Vol. 60, No. 237 / Monday, December 11, 1995 / Proposed Rules

apportioning income, but instead rely

on examples.

Second, the existing regulations raise

important administrative concerns. For

example, the IFP method requires an

analysis of each of the taxpayer’s sales

transactions to identify an IFP. If one or

more IFPs are so identified, a second

analysis is required of each of the

taxpayer’s sales transactions to identify

which transactions are similar to the IFP

sale. In some cases, this process may

require a review of a multitude of

transactions. The IFP method may,

therefore, be difficult for both taxpayers

and the government to apply. The

existing 50/50 method also presents

administrative concerns. For example,

the 50/50 method may require the

taxpayer to determine the fair market

value of each of its assets at the end of

every tax year. Taxpayers have often

commented to the IRS about the

difficulties of determining the fair

market value of their assets.

Third, the existing regulations result

in disparate treatment of similarly

situated taxpayers. Although an IFP

must be used under current rules if one

exists, the mandate applies only to

taxpayers selling inventory to certain

independent distributors. Taxpayers

selling exclusively to related parties are

not required to use the IFP method since

the IRS may not establish an IFP based

on such sales. Instead, these taxpayers

use the 50/50 method to source their

income from export sales. Thus,

taxpayers selling inventory exclusively

to related parties may be deemed to

generate far more foreign source income

than taxpayers selling a portion of their

inventory to independent distributors,

even though the two taxpayers may

perform the same functions. The IRS

and Treasury believe that this differing

treatment of similarly situated taxpayers

is not justified.

Fourth, the existing 50/50 method can

result in apportionment of income that

is inconsistent with the common

understanding of that method. The 50/

50 method is generally characterized as

a method that would source export sales

income one-half in the United States

and one-half in a foreign country. For

example, in 1984 the Treasury

Department stated: ‘‘Generally, [income

derived from manufacture and sale of

property] is allocated one-half on the

basis of the place of manufacture and

half on the basis of the place of sale

* * *’’ Treasury Department, Tax

Reform for Fairness, Simplicity, and

Economic Growth, Nov. 1984 at 364. In

addition, Congress understands the 50/

50 method to operate in this fashion. In

1986, the House, Senate and Conference

Committees each stated: ‘‘[Under the

existing 50/50 method], half of such

income generally is sourced in the

country of manufacture, and half of the

income is sourced on the basis of the

place of sale’’. House Rep. No. 426, 99th

Cong. 1st Sess. 359 (1985); S. Rep. No.

313, 99th Cong. 2d Sess. 329 (1986);

H.R. Conf. Rep. No. 841, 99th Cong. 2d

Sess. II–595 (1986). The staff of the Joint

Committee on Taxation has referred to

the 50/50 method as the ‘‘production/

marketing split’’ and stated that under

this method ‘‘50 percent of such income

generally is attributed to the place of

production * * *’’ Staff of the Joint

Comm. on Taxation, Factors Affecting

International Competitiveness of the

United States 148 (1991).

The existing regulations may,

however, allow taxpayers to use the 50/

50 method to obtain results that are

inconsistent with this common

understanding. Under the existing

regulations, 50 percent of the income is

treated as sales income and sourced on

the basis of title passage. The remaining

50 percent is treated as production

income and sourced based on the

location of assets. This half of the

formula is not necessarily, however,

limited to production assets. For

example, goodwill and accounts

receivables are counted as assets in

allocating production income. The

inclusion of sales assets in the formula

allocating production income results in

additional income being allocated to

sales activities. The contribution of the

sales assets to sales income should be

reflected only in the 50 percent of the

income that is allocated to sales and

sourced under title passage. Thus, the

production income formula should only

take into account assets directly

involved in the production of inventory.

B. Proposed Regulations

1. Overview

Section 1.863–3 provides rules for

allocating and apportioning income

from Section 863 Sales. Generally,

§ 1.863–3(b) provides three methods for

determining the amount of gross income

attributable to production activity and

the amount of gross income attributable

to sales activity. The source of gross

income attributable to each activity is

then determined under the rules of

paragraph (c). Paragraph (d) provides

rules to determine the source of taxable

income. Reporting and election rules are

set forth under paragraph (e) of the

proposed regulations. The proposed

regulations reserve on paragraph (f)

(prior paragraph (c)), dealing with

income partly from sources within a

possession of the United States. The IRS

and Treasury solicit comments from

taxpayers regarding changes that should

be made to new paragraph (f) (if any) to

conform to the other changes

in § 1.863–3.

The proposed regulations generally

apply an aggregate approach in taking

into account a taxpayer’s interest in a

partnership. The IRS and Treasury

solicit comments on the appropriate

treatment of partnerships, including

whether there should be special rules

for limited partnerships, de minimis

interests in partnerships, and tiered

partnerships.

2. Methods To Determine Gross Income

Attributable to Production Activity and

Sales Activity

Section 1.863–3 generally retains the

three methods of the current regulations

for splitting income between production

and sales activity, with several

modifications.

a. 50/50 Method

The proposed regulations do not

change the allocation of half of the

taxpayer’s income from Section 863

Sales to production activity and half to

sales activity. As described below, the

proposed regulations modify and clarify

the determination of the location of

assets. In addition, paragraph (b)(1) of

the proposed regulations makes

the 50/50 method the general rule to

determine the amount of income

attributable to production and sales

activities. The taxpayer, however, may

elect to apply the IFP method, described

in paragraph (b)(2), or, with the consent

of the District Director, the books and

records method, described in paragraph

(b)(3).

b. IFP Method

By making the IFP method elective,

the proposed regulations significantly

reduce administrative burdens related to

its application and eliminate any bias

against taxpayers choosing to export

through independent distributors.

Under the proposed regulations, the

taxpayer may elect to apply the IFP

method if it is able to establish an IFP.

As in the current regulations, an IFP is

fairly established by actual sales of the

taxpayer if the taxpayer regularly sells

part of its output to wholly independent

distributors or other selling concerns in

such a way as to reasonably reflect the

income attributable to production

activity. Once the IFP is established, it

can be used to determine the amount of

income attributable to production

activity in other Section 863 Sales if the

inventory sold in the other sales is

substantially similar in physical

characteristics and function, and is sold

at a similar level of distribution as the
Federal Register / Vol. 60, No. 237 / Monday, December 11, 1995 / Proposed Rules 63483

inventory sold in a sale establishing an

IFP. A sale will not be considered to

establish an IFP if sales activity for the

relevant product is significant in

relation to all of the activities for that

product. The IRS and Treasury intend to

supersede Notice 89–10 upon

publication of final regulations.

The proposed regulations would also

eliminate the existing rule permitting

taxpayers to otherwise establish an IFP

by showing to the satisfaction of the

District Director that a sale reasonably

reflecting the income attributable to

production exists. This ‘‘otherwise

established’’ IFP is rarely, if ever, used.

American Law Institute, International

Aspects of United States Income

Taxation 31 (1987). The IRS and

Treasury solicit comments from

taxpayers on the continued utility of the

otherwise established IFP.

The proposed regulations omit the

reference in the existing regulation to a

sales branch. A taxpayer may elect to

use the IFP method even if it does not

maintain a sales branch in a foreign

country.

c. 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 income

attributable to production and sales

activities. The District Director will

consider a taxpayer’s request if the

taxpayer maintains a detailed allocation

of receipts and expenditures, clearly

reflecting the amount of income from

production and sales activities.

The books and records method is

rarely, if ever, used. American Law

Institute, International Aspects of

United States Income Taxation, 31

(1987). The IRS and Treasury solicit

comments from taxpayers on the

continued utility of the books and

records method, or whether the books

and records method should be replaced

by another method of economic

sourcing.

3. 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 sales activity

only for purposes of the 50/50 method,

the proposed regulations adopt rules

applicable to each of the three methods.

Under the proposed regulations, once

gross income attributable to production

activity and sales activity has been

determined under one of the methods

described in paragraph (b), the source of

the income is determined separately for

each type of income under paragraph

(c). The source of gross income

attributable to production activity is

determined under paragraph (c)(1),

based on the location of production

assets, and the source of gross income

attributable to sales activity is

determined under paragraph (c)(2)

based on the location of the sale.

a. Source of Gross Income Attributable

to Production Activity

The proposed regulations generally

adopt the approach set forth in the

current regulations under the 50/50

method, but with modifications and

clarifications.

Under § 1.863–3(c)(1), the source of

income attributable to production

activity is determined based on the

location of the taxpayer’s production

assets. Thus, if a taxpayer manufactures

inventory exclusively in the United

States, all of its income attributable to

production activity will be considered

from sources within the United States.

The rules described below are intended

to apply only to taxpayers that produce

inventory both within and without the

United States.

Under the proposed regulations, the

source of a taxpayer’s income from

production activities is determined by

reference to the taxpayer’s production

assets, instead of all of its assets that

produce income from Section 863 Sales.

The IRS and Treasury believe that this

change is appropriate to ensure that the

source of production income

corresponds to the location of

production activity. Production assets

are defined to include tangible and

intangible property owned by the

taxpayer that are used to produce

inventory sold in Section 863 Sales.

Any property not directly used to

produce inventory is excluded. Thus,

accounts receivable and marketing

intangibles are excluded because they

are sales assets and not production

assets. Other assets excluded because

they do not directly produce inventory

are transportation assets, warehouses,

inventory, work-in-process, raw

materials, cash, investment assets, and

stock of a subsidiary. Working capital is

excluded to avoid uncertainty arising

from determinations of the appropriate

amount of working capital. In addition,

working capital would generally be

apportioned pro rata in accordance with

a taxpayer’s production assets. As under

the current regulations, leased assets are

excluded; only assets owned by the

taxpayer are included.

The proposed regulations also provide

specific rules for determining where a

production asset is located. Tangible

assets are located where the assets are

used by the taxpayer. Intangible Assets

are located where the tangible

production assets to which they relate

are located.

Where production takes place both

within the United States and within a

foreign country, the regulations apply a

property fraction to apportion

production income between U.S. and

foreign sources. The taxpayer’s foreign

source gross production income is

determined by multiplying its gross

production income by a fraction, the

numerator of which is the taxpayer’s

production assets located within a

foreign country, and the denominator of

which is the taxpayer’s production

assets located both within the united

States and within a foreign country.

The current regulations generally

include assets in the property formula at

fair market value. The proposed

regulations modify this rule to provide

that an asset must be included in the

property formula at its average adjusted

basis (see section 1011). The IRS and

Treasury believe that this change to

adjusted basis will significantly simplify

the application of this formula for both

taxpayers and the IRS.

The proposed regulations also contain

more detailed guidance than the current

regulations for determining the amounts

to be included in the property fraction.

For example, the proposed regulations

would require that if the asset is used

to produce inventory sold in Section

863 Sales and is also used to produce

other property, the basis of the asset

must be prorated to account for such

other uses.

The purpose of the property formula

is to attribute the source of the

taxpayer’s production income to the

location of its production activity. The

IRS and Treasury are concerned that

taxpayers may be able to affect the

location of assets without changing the

sit us of economic activity. Accordingly,

comments are solicited about whether

there should be rules to prevent

manipulation of this formula in a

manner inconsistent with the purpose of

the regulation.

b. Source of Gross Income Attributable

to Sales Activity

The source of gross income that is

attributable to sales activity is

determined under paragraph (c)(2). As

under the current regulations, the

source of this income is generally based

on where a sale takes place. See § 1.861–

7(c). Accordingly, if a U.S. producer

sells its goods in a foreign country, the

income attributable to sales activity is

generally foreign source income.
63484 Federal Register / Vol. 60, No. 237 / Monday, December 11, 1995 / Proposed Rules

The proposed regulation would retain

the language of the existing regulation,

which only applies to sales that occur

within a foreign country. The IRS and

Treasury solicit comments as to whether

the regulations should be expanded to

apply to sales made in international

waters or in space. The IRS and

Treasury are concerned, however, that if

such a change were made, a U.S. seller

may try to use the 50/50 method by

selling inventory in international waters

to U.S. purchasers, even when the goods

were destined for the United States. In

view of these concerns, the IRS and

Treasury also solicit comments as to

whether the regulations should provide

an exception to the title passage rule in

the case of sales of goods produced in

the United States and destined for use

in the United States.

4. Determination of Source of Taxable

Income

Once the amount and source of gross

income are determined under paragraph

(c), taxpayers then determine the source

of their taxable income. Under proposed

paragraph (d), taxpayers must allocate

or apportion under §§ 1.861–8 through

1.861–14T the amounts of expenses,

losses and other deductions to its gross

income determined under each method

described in paragraph (b). 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 and without the United States.

For amounts of expenses, losses and

other deductions allocated or

apportioned to gross income determined

under the 50/50 method, taxpayers must

apportion expenses and other

deductions prorata based on the relative

amounts of U.S. and foreign source

gross income. These rules are consistent

with existing regulations.

5. Election and Reporting Rules

Under paragraph (e) of the proposed

regulations, a taxpayer must use the 50/

50 method unless the taxpayer elects to

use the IFP method, or elects the Books

and Records method. The taxpayer

makes the election by using the method

on its tax return. Once The tax return is

filed, the election is not revokable for

that year. In addition, that method must

be used in later taxable years unless the

Commissioner or her 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 paragraph (b), and

the amount of income allocated or

apportioned to U.S. and foreign sources

in a statement attached to its tax return.

6. Conforming Changes

The proposed regulations make

conforming changes to § 1.863–2 of the

regulations. Under § 1.863–2, the

taxpayer may elect to apply the 50/50

method to its net taxable income,

instead of its gross income as specified

in § 1.863–3. The proposed regulations

clarify that income derived from the

purchase of personal property within a

possession of the United States and its

sale within the United States is subject

to these regulations only to the extent it

is not excluded by § 1.936–6(a)(5), Q&A

7. Other changes to § 1.863–2 were

intended to conform the language of the

regulation to the changes in § 1.863–3.

Finally, the IRS and Treasury will

reconsider the existing regulations

issued under section 863 regarding

transportation services and cable and

telegraph services in light of the Tax

Reform Act of 1986. Accordingly, the

transportation rules contained in

§ 1.863–4 will only apply to services

that are not described in section 863(c)

and the telegraph and cable rules

contained in § 1.863–5 are deleted. No

inference is intended as to whether

portions of the existing regulations

continued to apply after the Tax Reform

Act of 1986.

7. Proposed Effective Dates

These regulations are effective for

taxable years beginning 30 days after

publication of final regulations.

However, taxpayers may apply these

regulations for taxable years beginning

after July 11, 1995, and before 30 days

after publication of these regulations as

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

certified that these regulations will not

have a significant economic impact on

a substantial number of small entities.

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

written comments (a signed original and

eight (8) copies) that are submitted

timely to the IRS. All comments will be

available for public inspection and

copying.

A public hearing has been scheduled

for April 10, 1996, at 10 a.m. in the IRS

Auditorium. 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

written comments and an outline of

topics to be discussed and the time to

be devoted to each topic (signed original

and eight (8) copies) by March 11, 1996.

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 adding entries

in numerical order to read as follows:

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

Section 1.863–1 also issued under 26

U.S.C. 863.

Section 1.863–2 also issued under 26

U.S.C. 863.

Section 1.863–3 also issued under 26

U.S.C. 863.

Section 1.863–4 also issued under 26

U.S.C. 863.

Section 1.863–6 also issued under 26

U.S.C. 863. * * *

Par. 2. Sections 1.863–0 is added to

read as follows:
Federal Register / Vol. 60, No. 237 / Monday, December 11, 1995 / Proposed Rules 63485

§ 1.863–0 Table of contents.

This section lists captions contained

in §§ 1.863–1, 1.863–2, and 1.863–3.

§ 1.863–1 Allocation of Gross Income.

(a) In general.

(b) Natural resources.

(1) In general.

(2) Additional production prior to export

terminal.

(3) Definitions.

(i) Production activity.

(ii) Additional production activities.

(iii) Export terminal.

(4) Determination of fair market value.

(5) Determination of gross income.

(6) Tax return disclosure.

(7) Examples.

(c) Determination of taxable income.

(d) Effective dates.

§ 1.863–2 Allocation and Apportionment of

Taxable Income.

(a) Determination of taxable income.

(b) Determination of source of taxable

income.

(c) Effective dates.

§ 1.863–3 Allocation and Apportionment of

Income from Certain Sales of Inventory.

(a) In general.

(b) Methods to determine income

attributable to production activity and

sales activity.

(1) 50/50 method.

(i) Determination of gross income.

(ii) Example.

(2) IFP method.

(i) Establishing an IFP.

(ii) Applying the IFP method.

(iii) Determination of gross income.

(iv) Examples.

(3) Books and records method.

(c) Determination of the source of gross

income from production activity and

sales activity.

(1) Income attributable to production

activity.

(i) Production only within the United States

or only within foreign countries.

(A) Source of income.

(B) Definition of production assets.

(C) Location of production assets.

(ii) Production both within the United States

and within foreign countries.

(A) Source of income.

(B) Adjusted basis of production assets.

(iii)Examples.

(2) Income attributable to sales activity.

(d) Determination of source of taxable

income.

(e) Election and reporting rules.

(1) Elections under paragraph (b) of this

section.

(2) Disclosure on tax return.

(f) Income partly from sources within a

possession of the United States.

[Reserved]

(g) Effective dates.

Par. 3. Sections 1.863–1, 1.863–2, and

1.863–3 are revised to read as follows:

§ 1.863–1 Allocation of gross income.

(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 sections 865(b) and

865(e)(2).

(b) Natural resources—(1) In general.

Except to the extent provided in

paragraph (b)(2) of this section, 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 timber within the United

States, are allocated between sources

within or without the United States

based on the fair market value of the

product at the export terminal (as

defined in paragraph (b)(3)(iii) of this

section). Except to the extent provided

in paragraph (b)(2) of this section, 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 timber outside the United

States are also allocated between

sources within or without the United

States based on the fair market value of

the product at the export terminal. The

source of gross receipts equal to the fair

market value of the product at the

export terminal will be from sources

where the farm, mine, well, deposit, or

uncut timber is located. The source of

gross receipts from the sale of the

product in excess of its fair market value

at the export terminal (excess gross

receipts) will be determined as

follows—

(i) If the taxpayer does not engage in

additional production activities (as

defined in paragraph (b)(3)(ii) of this

section), excess gross receipts will be

from sources where the farm, mine,

well, deposit, or uncut timber is located;

(ii) If the taxpayer engages in

additional production activities

subsequent to shipment from the export

terminal and outside the country of sale,

the source of excess gross receipts must

be determined under § 1.863–3. For

purposes of applying § 1.863–3, only

production assets used in additional

production activity subsequent to the

export terminal are taken into account;

or

(iii) In all other cases, excess gross

receipts will be from sources within the

country of sale, as described in § 1.861–

7(c). This paragraph (b)(1)(iii) applies,

for example, to a taxpayer that engages

in additional production activities in

the country of sale.

(2) Additional production prior to

export terminal. 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 before the relevant product is

shipped from the export terminal 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, well, 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.

(ii) Additional production activities.

For purposes of this section, additional

production activities are substantial

production activities performed by the

taxpayer in addition to activities from

the ownership or operation of any farm,

mine, oil or gas well, other natural

deposit, or timber. Whether a taxpayer

performs such additional production

activities will be determined under the

principles of § 1.954–3(a)(4). 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 to or from the export

terminal, be considered additional

production activities for purposes of

this section.

(iii) Export terminal. Where the farm,

mine, well, deposit, or uncut timber is

located without the United States, the

export terminal will be the final point

in a foreign country from which goods

are shipped from a foreign country to

the United States. Where the farm,

mine, well, deposit, or uncut timber is

located within the United States, the

export terminal will be the final point

in the United States from which goods

are shipped from the United States to a

foreign country. The export terminal is

determined without regard to any

contractual terms agreed to by the

taxpayer and without regard to whether

there is an actual sale of the products at

the export terminal.
63486 Federal Register / Vol. 60, No. 237 / Monday, December 11, 1995 / Proposed Rules

(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 this paragraph (b) 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):

Example 1. No additional production. US

Mines, a U.S. corporation, extracts coal in the

United States and, without substantial

additional production, sells the coal in a

foreign country. Under § 1.863–1(b) and

(b)(1)(i), all of US Mines’ income will be from

sources within the United States.

Example 2. Scope of additional

production. US Gas, a U.S. corporation,

extracts natural gas within the United States,

and transports the natural gas to a U.S. port

where it is liquified in preparation for

shipment. The liquified natural gas is then

transported via freighter and sold without

additional production activities in a foreign

country. Liquefaction of natural gas is not an

additional production activity because

liquefaction prepares the natural gas for

transportation from the export terminal.

Therefore, under § 1.863–1(b) and (b)(1)(i), all

of US Gas’ income will be from sources

within the United States.

Example 3. Sale in third country. US Gold,

a U.S. corporation, mines gold in country X,

produces gold jewelry in the United States,

and sells the jewelry in country Y. Assume

that the fair market value of the gold at the

export terminal in country X is $40, and that

US Gold ultimately sells the gold jewelry in

country Y for $100. Under § 1.863–1(b), $40

of US Gold’s gross receipts will be allocated

to sources without the United States. Under

§ 1.863–1(b)(1)(ii), the source of the

remaining $60 of gross receipts will be

determined under § 1.863–3. If US Gold

applies the 50/50 method described in

§ 1.863–3, $20 of cost of goods sold is

properly attributable to activities subsequent

to the export terminal, and all of US Gold’s

production assets subsequent to the export

terminal are located in the United States,

then $20 of gross income will be allocated to

sources within the United States and $20 of

gross income will be allocated to sources

without the United States.

Example 4. Production in country of sale.

US Oil, a U.S. corporation, extracts oil in

country X, transports the oil via pipeline to

the export terminal in country Y, refines the

oil 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 at the export terminal in country Y is

$80, and that US Oil ultimately sells the

refined product for $100. Under § 1.863–

1(b)(1), $80 of US Oil’s gross receipts will be

allocated to sources without the United

States, and under § 1.863–1(b)(1)(iii) the

remaining $20 of gross receipts will be

allocated to sources within the United States.

Example 5. Additional production prior to

export. US Furniture, a U.S. corporation, cuts

trees in the United States, converts the trees

into lumber, uses the lumber to manufacture

furniture in the United States, and sells the

furniture in another country. Assume that the

fair market value of the trees when the

conversion into lumber begins is $40, and

that US Furniture ultimately sells the

furniture for $100. Because the conversion of

the trees into lumber is an additional

production activity within the United States

within the meaning of § 1.863–1(b)(3)(ii), the

source of US Furniture’s income will be

determined under § 1.863–1(b)(2). Thus, $40

of US Furniture’s gross receipts will be

allocated to sources within the United States.

The source of the remaining $60 of gross

receipts will be determined under § 1.863–3.

If US Furniture applies the 50/50 method

described in § 1.863–3(b)(1), $20 of cost of

goods sold is properly attributable to the

additional production activity, and all of US

Furniture’s production assets used in the

additional production activity are located in

the United States, then $20 of gross income

will be allocated to sources within the United

States and $20 of gross income will be

allocated to sources without the United

States.

(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) Effective dates. The rules of this

section will apply to taxable years

beginning 30 days after publication of

these regulations as final regulations.

However, taxpayers may apply the rules

of this section for taxable years

beginning after July 11, 1995, and before

30 days after publication of these

regulations as final regulations. For

years beginning before 30 days after

publication of these regulations as final

regulations, see § 1.863–1 (as contained

in 26 CFR part 1 revised as of April 1,

1995).

§ 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

(and that is treated as derived partly

from sources within and partly from

sources without the United States) 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 in a foreign country or produced

(in whole or in part) by the taxpayer in

a foreign country 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 to sources

within and without the United States

pursuant to § 1.863–1 or apportioned to

such sources in accordance with the

methods described in other regulations

under section 863. 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

§ 1.863–3. However, the principles of

§ 1.863–3 (b)(1) and (c) may be applied

to determine the source of taxable

income from sales of inventory

property. To determine the source of

income described in paragraph (a)(3) of

this section, see § 1.863–3(f).
Federal Register / Vol. 60, No. 237 / Monday, December 11, 1995 / Proposed Rules 63487

(c) Effective dates. This section will

apply to taxable years beginning 30 days

after publication of these regulations as

final regulations. However, taxpayers

may apply the rules of this section for

taxable years beginning after July 11,

1995, and before 30 days after

publication of these regulations as final

regulations. For years beginning before

30 days after publication of these

regulations as final regulations, see

§ 1.863–2 (as contained in 26 CFR part

1 revised as of April 1, 1995).

§ 1.863–3 Allocation and apportionment of

income from certain sales of inventory.

(a) In general. This section applies to

determine the source of income derived

from the sale of inventory property

(inventory) produced (in whole or in

part) by a taxpayer within the United

States and sold within a foreign country,

or produced (in whole or in part) by a

taxpayer in one or more foreign

countries and sold within the United

States (Section 863 Sales). For purposes

of this section, a taxpayer’s production

activity includes production activities

conducted by members of the same

affiliated group as defined under section

1504(a). A taxpayer’s production

activity also includes production

activities conducted through a

partnership of which the taxpayer is a

partner either directly or through one or

more partnerships. A taxpayer subject to

this section must divide gross income

from Section 863 Sales between

production activity and sales activity

using one of the methods described in

paragraph (b) of this section. The source

of gross income from production

activity and from sales activity must

then be determined under paragraph (c)

of this section. Taxable income from

Section 863 Sales is determined under

paragraph (d) of this section. Paragraph

(e) of this section describes the rules for

electing the methods described in

paragraph (b) of this section and the

information that a taxpayer must

disclose on a tax return. Paragraph (f) of

this section applies to determine the

source of certain income derived from a

possession of the United States.

Paragraph (g) of this section provides

effective dates for the rules in this

section. Once a taxpayer has elected a

method described in paragraph (b) of

this section, the taxpayer must

separately apply that method to Section

863 Sales in the United States and to

Section 863 Sales in foreign countries.

In addition, the taxpayer must apply the

rules of paragraphs (c) and (d) of this

section by aggregating all Section 863

Sales to which a method described in

paragraph (b) of this section applies. See

section 865(i)(1) for the definition of

inventory property; § 1.861–7(c) for the

time and place of sale. See also section

865(e)(2).

(b) Methods to determine income

attributable to production activity and

sales activity—(1) 50/50 method—(i)

Determination of gross income.

Generally, gross income from Section

863 Sales will be apportioned between

production activity and sales activity

under the 50/50 method as described in

this paragraph (b)(1). Under the 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

(c)(1) of this section. The remaining onehalf of such gross income will be

considered income attributable to sales

activity and the source of that income

will be determined under the rules of

paragraph (c)(2) of this section. In lieu

of the 50/50 method, the taxpayer may

elect to determine the source of income

from Section 863 Sales under the IFP

method described in paragraph (b)(2) of

this section or, with the consent of the

District Director, the books and records

method described in paragraph (b)(3) of

this section.

(ii) Example. The following example

illustrates the rules of this paragraph

(b)(1):

Example. 50/50 method. (i) P, a U.S.

corporation, produces widgets in the United

States. P sells the widgets for $100 to D, an

unrelated foreign distributor, in another

country. P’s cost of goods sold is $40. Thus,

P’s gross income is $60.

(ii) Pursuant to the 50/50 method, one-half

of P’s gross income, or $30, is considered

income attributable to production activity,

and one-half of P’s gross income, or $30, is

considered income attributable to sales

activity.

(2) IFP method—(i) Establishing an

IFP. A taxpayer may elect to allocate

gross income earned from production

activity and sales activity using the

independent factory price (IFP) method

described in this paragraph (b)(2) if an

IFP is fairly established. An IFP is fairly

established based on a sale by the

taxpayer only if the taxpayer regularly

sells part of its output to wholly

independent distributors or other selling

concerns in such a way as to reasonably

reflect the income earned from

production activity. A sale will not be

considered to fairly establish an IFP if

sales activity by the taxpayer with

respect to that sale is significant in

relation to all of the activities with

respect to that product.

(ii) Applying the IFP method. If the

taxpayer elects to use the IFP method,

the amount of the gross sales price equal

to the IFP will be treated as attributable

to production activity, and the excess of

the gross sales price over the IFP will be

treated as attributable to sales activity.

If a taxpayer elects to use the IFP

method, the IFP must be applied to all

Section 863 Sales of inventory that are

substantially similar in physical

characteristics and function, and are

sold at a similar level of distribution as

the inventory sold in the sale fairly

establishing an IFP. The IFP will only be

applied to sales that are reasonably

contemporaneous with the sale fairly

establishing the IFP. An IFP cannot be

applied to sales in other geographic

markets if the markets are substantially

different. The rules of this paragraph

will also apply to determine the

division of gross receipts between

production activity and sales activity in

a Section 863 Sale that itself fairly

establishes an IFP. If the taxpayer elects

to apply the IFP method, the IFP

method must be applied to all sales for

which an IFP may be fairly established

for that taxable year and each

subsequent taxable year. The taxpayer

will apply either the 50/50 method

described in paragraph (b)(1) of this

section or the books and records method

described in paragraph (b)(3) of this

section to any other Section 863 Sale for

which an IFP cannot be established or

applied for each taxable year.

(iii) Determination of gross income.

The amount of a taxpayer’s gross

income from production activity is

determined by reducing the amount of

gross receipts from production activity

by the cost of goods sold properly

attributable to production activity. The

amount of a taxpayer’s gross income

from sales activity is determined by

reducing the amount of gross receipts

from sales activity by the cost of goods

sold (if any) properly attributable to

sales activity. The source of gross

income from production activity is

determined under the rules of paragraph

(c)(1) of this section, and the source of

gross income from sales activity will be

determined under the rules of paragraph

(c)(2) of this section.

(iv) Examples. The following

examples illustrate the rules of this

paragraph (b)(2):

Example 1. IFP method. (i) P, a U.S.

producer, purchases cotton and produces

cloth in the United States. P sells cloth in

country X to D, a unrelated foreign clothing

manufacturer, for $100. Cost of goods sold for

cloth is $80, entirely attributable to

production activity. P does not engage in

significant sales activity in relation to its

other activities in the sales to D. Under these

facts, the sale to D fairly establishes an IFP

of $100. Assume that P elects to use the IFP

method. Accordingly, $100 of the gross sales

price is treated as attributable to production

activity, and no amount of income from this
63488 Federal Register / Vol. 60, No. 237 / Monday, December 11, 1995 / Proposed Rules

sale is attributable to sales activity. After

reducing the gross sales price by cost of

goods sold, $20 of the gross income is treated

as attributable to production activity ($100–

$80).

(ii) P also sells cloth in country X to A, a

unrelated foreign retail outlet, for $110.

Because P elected the IFP method and the

cloth is substantially similar to the cloth sold

to D, the IFP fairly established in the sales

to D must be used to determine the amount

attributable to production activity in the sale

to A. Accordingly, $100 of the gross sales

price is treated as attributable to production

activity and $10 ($110–$100) is attributable

to sales activity. After reducing the gross

sales price by cost of goods sold, $20 of the

gross income is treated as attributable to

production activity ($100¥$80) and $10 is

attributable to sales activity.

Example 2. Scope of IFP Method. (i) USCo

manufactures three dissimilar products.

USCo elects to apply the IFP method. In year

1, an IFP can be established for sales of

product X, but not for products Y and Z. In

year 2, an IFP cannot be established for any

of USCo’s products. In year 3, an IFP can be

established for products X and Y, but not for

product Z.

(ii) In year 1, USCo must apply the IFP

method to sales of product X. In year 2,

although USCo’s IFP election remains in

effect, USCo is not required to apply the IFP

election to any products. In year 3, USCo is

required to apply the IFP method to sales of

products X and Y.

(3) Books and records method. A

taxpayer may elect to determine the

amount of its gross income from Section

863 Sales that is attributable to

production and sales activities for the

taxable year based upon its books of

account if it has received in advance the

permission of the District Director

having audit responsibility over its tax

return. The taxpayer must establish to

the satisfaction of the District Director

that the taxpayer, in good faith and

unaffected by considerations of tax

liability, will regularly employ in its

books of account a detailed allocation of

receipts and expenditures which clearly

reflects the amount of the taxpayer’s

income from production and sales

activities. If a taxpayer receives

permission to apply the books and

records method, but does not comply

with a material condition set forth by

the District Director, the District

Director may, in its discretion, revoke

permission to use the books and records

method. The source of gross income

treated as attributable to production

activity under this method may be

determined under the rules of paragraph

(c)(1) of this section, and the source of

gross income attributable to sales

activity will be determined under the

rules of paragraph (c)(2) of this section.

(c) Determination of the source of

gross income from production activity

and sales activity—(1) Income

attributable to production activity—(i)

Production only within the United

States or only within foreign countries—

(A) Source of income. Where the

taxpayer’s production assets are located

only within the United States or only

within a foreign country, the income

attributable to production activity 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 within one

or more foreign countries, see paragraph

(c)(1)(ii) of this section. For purposes of

this section, production activity means

an activity that creates, fabricates,

manufactures, extracts, processes, cures,

or ages inventory. See § 1.864–1.

(B) Definition of production assets.

For purposes of this section, production

assets include only tangible and

intangible assets owned 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. A partner will be treated as

owning its proportionate share of the

partnership’s production assets,

determined by reference to the partner’s

distributive share of partnership income

for the year attributable to such

production assets.

(C) 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.

(ii) Production both within the United

States and within foreign countries—(A)

Source of income. Where the taxpayer’s

production assets are located both

within the United States and within one

or more foreign countries, income from

sources without the United States will

be determined by multiplying the

income attributable to production

activity by a fraction, the numerator of

which is the average adjusted basis of

production assets that are located in one

or more foreign countries and the

denominator of which is the average

adjusted basis of all production assets in

foreign countries and in the United

States. The remaining income is treated

as from sources within the United

States.

(B) Adjusted basis of production

assets. For purposes of paragraph

(c)(1)(ii)(A) of this section, the adjusted

basis of an asset is determined under

section 1011. The average adjusted basis

is computed by averaging the adjusted

basis of the asset at the beginning and

end of the taxable year, unless by reason

of material changes during the taxable

year such average does not fairly

represent the average for such year. In

this event, the average adjusted basis

will be determined upon a more

appropriate basis. If production assets

are used to produce inventory sold in

Section 863 Sales and are 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)(1)(ii)(A) of

this section will be determined under

any method that reasonably reflects the

portion of the assets that produces

inventory sold in Section 863 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

Sales produced by the asset, and the

denominator of which is the gross

receipts from all property produced by

that asset. For purposes of this section,

a taxpayer’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).

(iii) Examples. The following

examples illustrate the rules of this

paragraph (c)(1):

Example 1. Source of production income.

(i) 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. 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
Federal Register / Vol. 60, No. 237 / Monday, December 11, 1995 / Proposed Rules 63489

income from widgets sold in foreign

countries is $12. A uses the 50/50 method to

divide its gross income between production

activity and sales activity.

(ii) A determines its production gross

income from sources without the United

States by multiplying one-half of A’s $12 of

gross income from sales of widgets in foreign

countries, or $6, 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

production income from sources without the

United States is $2 ($6 × ($25/$75)).

Example 2. Location of intangible property.

Assume the same facts as 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 income from

production activity, A’s patent, if it has an

average adjusted basis, would be located in

the United States.

(2) Income attributable to sales

activity. The source of the taxpayer’s

income that is attributable to sales

activity will be determined under the

provisions of § 1.861–7(c).

(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 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 Sales

determined separately under each

method described in paragraph (b) 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

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 Sales determined

under the IFP method or the books and

records method, the rules of §§ 1.861–8

through 1.861–14T must apply to

properly allocate or apportion amounts

of expenses, losses and other deductions

allocated and apportioned to such gross

income between gross income from

sources within and without the United

States. In the case of gross income from

Section 863 Sales determined under the

50/50 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 the 50/50 method.

(e) Election and reporting rules—(1)

Elections under paragraph (b) of this

section. If a taxpayer does not elect a

method specified in paragraph (b)(2) or

(3) of this section, the taxpayer must

apply the method specified in paragraph

(b)(1) of this section. The taxpayer may

elect to apply the method specified in

paragraph (b)(2) of this section by using

the method on a timely filed original

return (including extensions). A

taxpayer may elect to apply the method

specified in paragraph (b)(3) of this

section by using the method on a timely

filed original return (including

extensions), but only if the taxpayer has

received permission from the District

Director to apply that method. Once a

method under paragraph (b) of this

section has been used, that method must

be used in later taxable years unless the

Commissioner consents to a change. See

e.g., paragraph (b)(2)(ii) Example 2 of

this section. However, if a taxpayer

elects to change to or from the method

specified in paragraph (b)(3) of this

section, the taxpayer must obtain

permission from the District Director

instead of the Commissioner.

Permission to change methods from one

year to another year will not be

withheld unless the change would

result in a substantial distortion of the

source of the taxpayer’s income.

(2) Disclosure on tax return. A

taxpayer who uses one of the methods

described in paragraph (b) of this

section must fully explain the

methodology used, the circumstances

justifying use of that method, the extent

that sales are aggregated, and the

amount of income so allocated.

(f) Income partly from sources within

a possession of the United States.

[Reserved]

(g) Effective dates. The rules of

paragraphs (a) through (e) of this section

will apply to taxable years beginning 30

days after publication of final

regulations. However, taxpayers may

apply these regulations for taxable years

beginning after July 11, 1995, and before

30 days after publication of these

regulations as final regulations. For

years beginning before 30 days after the

publication of these regulations as final

regulations, see § 1.863–3 (as contained

in 26 CFR part 1 revised as of April 1,

1995).

Par. 4. Section 1.863–4 is amended by

revising the section heading and

paragraph (a) to read as follows:

§ 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.

* * * * *

§ 1.863–5 [Removed]

Par. 6. Section 1.863–5 is removed.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 95–30087 Filed 12–7–95; 2:00 pm]

BILLING CODE 4830–01–U

DEPARTMENT OF TRANSPORTATION

Office of the Secretary

33 CFR Part 52

[OST Docket No. OST–95–878; Notice 95–

14]

RIN 2105–AC31

Coast Guard Board for Correction of

Military Records; Procedural

Regulation

AGENCY: Office of the Secretary, DOT.

ACTION: Notice of proposed rulemaking.

SUMMARY: The Department proposes to

amend its regulations with respect to

reconsideration of final decisions of the

Board for Correction of Military Records

of the Coast Guard (Board). This action

is taken on the Department’s initiative

in order to streamline processing of

these cases and to clarify the

circumstances under which final

decisions can be reconsidered. The

proposed amendment will make it

possible for the Board to expedite

reconsideration and will increase the

resources available to meet the

requirement that all cases be decided

within 10 months of the receipt of a

completed application.

DATES: Comments must be submitted on

or before February 9, 1996. Late-filed

comments will be considered to the

extent practicable.

ADDRESSES: Comments should be

mailed, preferably in duplicate, to

Docket No. OST–95–878, Documentary

Services Division, C–55, PL–401, U.S.

Department of Transportation; 400

Seventh Street SW, Washington, D.C.

20590. Comments will be available for

review by the public at this address

from 9 a.m. through 5 p.m., Monday