[Federal Register Volume 61, Number 92 (Friday, May 10, 1996)]
[Rules and Regulations]
[Pages 21366-21370]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-11639]



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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8669]
RIN 1545-AR18


Computation of Combined Taxable Income Under The Profit Split 
Method When the Possession Product is a Component Product or an End-
Product Form for Purposes of the Possessions Credit Under Section 936

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the 
computation of combined taxable income under the profit split method. 
These regulations amend the current regulations and provide revised 
rules for taxpayers to compute combined taxable income under the profit 
split method when the possession product chosen for purposes of section 
936(h)(5) of the Internal Revenue Code is a component product or an 
end-product form. These regulations are necessary to provide guidance 
to taxpayers electing the profit split method of computing taxable 
income under section 936(h)(5).

DATES: These regulations are effective May 10, 1996. See Supplementary 
Information for applicability dates.

FOR FURTHER INFORMATION CONTACT: Jacob Feldman, 202-622-3870 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    On January 12, 1994, the IRS published a notice of proposed 
rulemaking in the Federal Register (INTL-0068-92, 59 FR 1690, 1994-1 
C.B. 820) relating to the computation of combined taxable income under 
the profit split method under section 936(h)(5) (relating to the 
possessions credit for U.S. companies doing qualified business in 
Puerto Rico and certain U.S. possessions). A number of written public 
comments were received concerning the proposed regulations and a public 
hearing was held on July 11, 1994. After consideration of all the 
comments, the proposed regulations are adopted as revised by this 
Treasury decision. The revisions are discussed below.

Discussion

    The proposed regulations would amend Sec. 1.936-6(b)(1), Q&A 12. 
Under the proposed regulations, combined taxable income for a taxpayer 
that elects the profit split method for a possession product that is 
either a component product or an end-product form would be determined 
by multiplying the combined taxable income of the integrated product 
that includes the possession product by a production cost ratio. In the 
case of a component product, the combined taxable income of the 
integrated product would be multiplied by a ratio the numerator of 
which is the production costs of the component product and the 
denominator of which is the production costs of the integrated product. 
The combined taxable income of an end-product form would be determined 
in a similar manner using the production costs of the end-product form. 
The regulations were proposed to be effective for taxable years 
beginning after 1993.
    Taxpayers have argued that the regulations should not be adopted as 
proposed because they would violate the arm's length standard under 
section 482 and that a necessary consequence of the abandonment of the 
arm's length standard would be distortions in taxpayers' income. That 
is, income would be computed inconsistently for related versus 
unrelated party sales of the same product, under the same terms and in 
the same market.
    The proposed regulations did not apply the arm's length standard to 
component products and end-product forms under the profit-split method 
because application of section 482 in this context is inconsistent with 
the statutory framework. The effect of the profit split method when 
applied to possession products is to minimize disputes between 
taxpayers and the IRS because, unlike section 482 methods, there is no 
need to perform functional analyses to allocate income among the 
parties. Because Congress eliminated the section 482 analysis from the 
profit split method, the proposed regulations did not reinject this 
analysis into the area of intermediate products.
    In response to taxpayer comments, however, the IRS and Treasury are 
providing an election to taxpayers that sell the same possession 
product in both component form and integrated form if the transactions 
meet certain section 482 standards. This method is both simple to apply 
and produces consistent results with respect to related and unrelated 
party transactions. Under this method, the combined taxable income from 
covered sales of the component product shall be determined by using the 
same per unit combined taxable income as is derived from uncontrolled 
sales of the product as an integrated product. Taxpayers may elect to 
compute the combined taxable income for an end-product form in a 
similar manner if all excluded components are manufactured by a member 
of the affiliated group that includes the possession corporation and 
also sold by the group separately in uncontrolled transactions. In that 
case, the combined taxable income of the end-product form will be 
computed by reducing the combined taxable income of the integrated 
product that includes the end-product form by the combined taxable 
income of the excluded components determined under the rules of section 
936 as if the excluded components were possession products. In order to 
make the election, the uncontrolled sales must meet the comparability 
standards of the fourth sentence of Sec. 1.482-3(b)(2)(ii)(A), which 
requires that the uncontrolled and controlled transactions have no 
differences or minor differences for which adjustment can be made. 
However, under a no loss limitation, in no case can the taxpayer use as 
its per

[[Page 21367]]

unit combined taxable income for a component product or an end-product 
form an amount that exceeds the per unit combined taxable income of the 
integrated product that includes the component product or end-product 
form.
    In 1993, Congress adopted limitations on the amount of the section 
936 credit; the taxpayer may be subject to an activity based limitation 
or may elect a percentage limitation. The election for the percentage 
limitation had to be made for the first taxable year beginning after 
December 31, 1993. Taxpayers commented that the proposed regulations 
created uncertainty with respect to the consequences of making the 
percentage limitation election and, therefore, the period for making 
the election should be extended until after the regulations are 
finalized. This comment is adopted. Taxpayers that have not elected the 
percentage limitation under section 936(a)(1) for the first taxable 
year beginning after December 31, 1993, may so elect if the taxpayer 
has elected the profit split method and the computation of combined 
taxable income is affected by Sec. 1.936-6(b)(1) Q&A 12.
    With respect to the proposed effective date, taxpayers commented 
that the regulations should not be applied retroactively. One of the 
justifications for the proposed rule was that it would simplify the 
computation of combined taxable income and applying the regulation 
retroactively would not simplify the computation because it would 
require filing amended returns. This comment is adopted in part. The 
regulation is effective for taxable years ending 30 days after May 10, 
1996. If however, the election under paragraph (v) of A. 12 of 
Sec. 1.936-6(b)(1) is made, this election must be made for the 
taxpayer's first taxable year beginning after December 31, 1993, and if 
not made effective for that year, the election cannot be made for any 
later taxable year.
    The last sentence of paragraph (vi) of A. 13 of Sec. 1.936-6(b)(1) 
in the proposed regulations provided that, for purposes of determining 
the estimated tax liability of an affiliate of the possessions 
corporation with respect to income allocated to it from the possessions 
corporation, the income would be deemed received on the last day of the 
taxable year of each such affiliate in which or with which the taxable 
year of the possessions corporation ended. This rule is limited to 
taxable years beginning prior to January 1, 1995. For taxable years 
beginning after December 31, 1994, quarterly estimated tax payments 
will be required as provided under section 711 of the Uruguay Round 
Agreements, Public Law 103-465 (1994), page 230, and any administrative 
guidance issued by the IRS thereunder. See Rev. Proc. 95-23 (1995-1 
C.B. 693).
    Accordingly, the proposed regulations are finalized as proposed 
except with respect to the changes discussed above and the necessary 
conforming changes.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in EO 12866. Therefore, a 
regulatory assessment is not required. It has also been determined that 
this regulation does not have a significant impact on a substantial 
number of small entities. Thus, the Regulatory Flexibility Act (5 
U.S.C. chapter 6) does not apply to these regulations, and therefore, a 
Regulatory Flexibility Analysis is not required. Pursuant to section 
7805(f) of the Internal Revenue Code, the notice of proposed rulemaking 
preceding these regulations was submitted to the Small Business 
Administration for comment on its impact on small business.

Drafting Information

    The principal authors of these regulations are Jacob Feldman and 
Mary Gillmarten of the Office of Associate Chief Counsel 
(International), IRS. 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.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *
    Par. 2. In Sec. 1.936-6, paragraph (b)(1) is amended by:
    1. Revising Q. 10.
    2. Amending A. 10 by:
    a. Redesignating the text of A. 10 as paragraph A. 10(i).
    b. Removing the last two sentences of newly designated A.
    10(i).
    c. Adding paragraphs A. 10 (ii) through (v).
    3. Revising the first sentence of A. 11.
    4. Revising Q&A. 12.
    5. Revising A. 13.
    The revisions and addition read as follows:


Sec. 1.936-6   Intangible property income when an election out is made; 
cost sharing and profit split options; covered intangibles.

* * * * *
    (b) * * *
    (1) * * *
    Q. 10: If the possessions corporation is entitled to use the profit 
split method in the situation described in Q. 9 (leasing units of the 
possession product or use of such units in the taxpayer's own trade or 
business), how should it compute combined taxable income with respect 
to such units?
    A. 10: (i) * * *
    (ii) If the possession product is a component product or an end-
product form, the combined taxable income with respect to the 
possession product shall be determined under Q&A. 12 of this paragraph 
(b)(1).
    (iii) For purposes of determining the basis of a component product 
or an end-product form, the deemed sales price of such product must be 
determined. The deemed sales price of the component product shall be 
determined by multiplying the deemed sales price of the integrated 
product that includes the component product by a ratio, the numerator 
of which is the production costs of the component product and the 
denominator of which is the production costs of the integrated product 
that includes the component product. The deemed sales price of an end-
product form shall be determined by multiplying the deemed sales price 
of the integrated product that includes the end-product form by a 
ratio, the numerator of which is the production costs of the end-
product form and the denominator of which is the production costs of 
the integrated product that includes the end-product form. For the 
definition of production costs, see Q&A. 12 of this paragraph (b)(1).
    (iv)(A) If combined taxable income is determined under paragraph 
(v) of A. 12 of this paragraph (b)(1), in the case of a component 
product, the deemed sales price shall be determined by using the actual 
sales price of that product when sold as an integrated product (as 
adjusted under the rules of the fourth sentence of Sec. 1.482-
3(b)(2)(ii)(A)).
    (B) If combined taxable income is determined under paragraph (v) of 
A. 12 of this paragraph (b)(1), in the case of an end-product form, the 
deemed sales price shall be determined by subtracting from the deemed 
sales price of the integrated product that includes the end-product 
form (e.g., the leased property) the actual sales price of the excluded 
component when sold as an

[[Page 21368]]

integrated product to an unrelated person (as adjusted under the rules 
of the fourth sentence of Sec. 1.482-3(b)(2)(ii)(A)).
    (v) The full amount of income received under the lease shall be 
treated as income of (and be taxed to) the U.S. affiliate and not the 
possessions corporation.
* * * * *
    A. 11: The U.S. affiliate shall be treated, for purposes of 
computing its basis in such units, as if it had repurchased such units 
immediately following the deemed sale and at the deemed sales price as 
provided in Q&A. 10 of this paragraph (b)(1). * * *
    Q. 12: If the possession product is a component product or an end-
product form, how is the combined taxable income for such product to be 
determined?
    A. 12: (i) Except as provided in paragraph (v) of this A. 12, 
combined taxable income for a component product or an end-product form 
is computed under the production cost ratio (PCR) method.
    (ii) Under the PCR method, the combined taxable income for a 
component product will be the same proportion of the combined taxable 
income for the integrated product that includes the component product 
that the production costs attributable to the component product bear to 
the total production costs (including costs incurred by the U.S. 
affiliates) for the integrated product that includes the component 
product. Production costs will be the sum of the direct and indirect 
production costs as defined under Sec. 1.936-5(b)(4) except that the 
costs will not include any costs of materials. If the possession 
product is a component product that is transformed into an integrated 
product in whole or in part by a contract manufacturer outside of the 
possession, within the meaning of Sec. 1.936-5(c), the denominator of 
the PCR shall be computed by including the same amount paid to the 
contract manufacturer, less the costs of materials of the contract 
manufacturer, as is taken into account for purposes of the significant 
business presence test under Sec. 1.936-5(c) Q&A. 5.
    (iii) Under the PCR method the combined taxable income for an end-
product form will be the same proportion of the combined taxable income 
for the integrated product that includes the end-product form that the 
production costs attributable to the end-product form bear to the total 
production costs (including costs incurred by the U.S. affiliates) for 
the integrated product that includes the end-product form. Production 
costs will be the sum of the direct and indirect production costs as 
defined under Sec. 1.936-5(b)(4) except that the costs will not include 
any costs of materials. If the possession product is an end-product 
form and an excluded component is contract manufactured outside of the 
possession, within the meaning of Sec. 1.936-5(c), the denominator 
shall be computed by including the same amount paid to the contract 
manufacturer, less cost of materials of the contract manufacturer, as 
is also taken into account for purposes of the significant business 
presence test under Sec. 1.936-5(c) Q&A. 5.
    (iv) This paragraph (iv) of A. 12 illustrates the computation of 
combined taxable income for a component product or end-product form 
under the PCR method. S, a possessions corporation, is engaged in the 
manufacture of microprocessors. S obtains a component from a U.S. 
affiliate, O. S sells its production to another U.S. affiliate, P, 
which incorporates the microprocessors into central processing units 
(CPUs). P transfers the CPUs to a U.S. affiliate, Q, which incorporates 
the CPUs into computers for sale to unrelated persons. S chooses to 
define the possession product as the CPUs. The combined taxable income 
for the sale of the possession product on the basis of the given 
production, sales, and cost data is computed as follows:

Production costs (excluding costs of materials):                        
    1. O's costs for the component.........................          100
    2. S's costs for the microprocessors...................          500
    3. P's costs for the CPU's (the possession                          
     product)..............................................          200
    4. Q's costs for the computers.........................          400
    5. Total production costs for the computer (Add lines 1             
     through 4)............................................        1,200
    6. Combined production costs for the CPU (the                       
     possession product) (Add lines 1 through                           
     3)....................................................          800
    7. Ratio of production costs for the CPUs (the                      
     possession product) to the production costs for the                
     computer..............................................        0.667
Determination of combined taxable income for computers:                 
  Sales:                                                                
    8. Total possession sales of computers to unrelated                 
     customers and foreign affiliates......................        7,500
  Total costs of O, S, P, and Q incurred in production of a             
   computer:                                                            
    9. Production costs (enter from line                                
     5)....................................................        1,200
    10. Material costs ....................................          100
    11. Total costs (line 9 plus line 10)..................        1,300
    12. Combined gross income from sale of computers (line              
     8 minus line 11)......................................        6,200
  Expenses of the affiliated group (other than foreign                  
   affiliates) allocable and apportionable to the computers             
   or any component thereof under the rules of Secs.  1.861-            
   8 through 1.861-14T and 1.936-6 (b)(1), Q&A. 1:                      
    13. Expenses (other than research expenses)............          980
  Research expenses of the affiliated group allocable and               
   apportionable to the computers:                                      
    14. Total sales in the 3-digit SIC Code................       12,500
    15. Possession sales of the computers (enter from line              
     8)....................................................        7,500
    16. Cost sharing fraction (divide line 15 by line                   
     14)...................................................          0.6
    17. Research expenses incurred by the affiliated group              
     in 3-digit SIC Code multiplied by 120                              
     percent...............................................          700
    18. Cost sharing amount (multiply line 16 by line                   
     17)...................................................          420
    19. Research of the affiliated group (other than                    
     foreign affiliates) allocable and apportionable under              
     Secs.  1.861-17 and 1.861-14T(e)(2) to the                         
     computers.............................................          300
    20. Enter the greater of line 18 or line 19............          420
Computation of combined taxable income of the computer and              
 the CPU:                                                               
    21. Combined taxable income attributable to the                     
     computer (line 12 minus line 13 and line                           
     20)...................................................        4,800
    22. Combined taxable income attributable to CPUs                    
     (multiply line 21 by line 7) (production cost                      
     ratio)................................................        3,200
    23. Share of combined taxable income apportioned to S               
     (50 percent of line 22)...............................        1,600
Share of combined taxable income apportioned to U.S.                    
 affiliate(s) of S:                                                     
    24. Adjustments for research expenses (line 18 minus                
     line 19 multiplied by line 7).........................           80
    25. Adjusted combined taxable income (line 22 plus line             
     24)...................................................        3,280
    26. Share of combined taxable income apportioned to                 
     affiliates of S (line 25 minus line 23)...............        1,680
                                                                        


[[Page 21369]]


    (v)(A) If a possession product is sold by a taxpayer or its 
affiliate to unrelated persons in covered sales both as an integrated 
product and as a component product and the conditions of paragraph 
(v)(C) of this A. 12 are satisfied, the taxpayer may elect to determine 
the combined taxable income derived from covered sales of the component 
product under this paragraph (v). In that case, the combined taxable 
income derived from covered sales of the component product shall be 
determined by using the same per unit combined taxable income as is 
derived from covered sales of the product as an integrated product, but 
subject to the limitation of paragraph (v)(D) of this A. 12.
    (B) In the case of a possession product that is an end-product 
form, if all of the excluded components are also separately sold by the 
taxpayer or its affiliate to unrelated persons in uncontrolled 
transactions and the conditions of paragraph (v)(C) of this A. 12 are 
satisfied, the taxpayer may elect to determine the combined taxable 
income of such end-product form under this paragraph (v). In that case, 
the combined taxable income derived from covered sales of the end-
product form shall be determined by reducing the per unit combined 
taxable income from the integrated product that includes the end-
product form by the per unit combined taxable income for excluded 
components determined under the rules of this paragraph (v), but 
subject to the limitation of paragraph (v)(D) of this A. 12. For this 
purpose, combined taxable income of the excluded components must be 
determined under section 936 as if the excluded components were 
possession products.
    (C) In the case of component products, this paragraph (v) applies 
only if the sales price of the possession product sold in covered sales 
as an integrated product (i.e., in uncontrolled transactions) would be 
the most direct and reliable measure of an arm's length price within 
the meaning of the fourth sentence of Sec. 1.482-3(b)(2)(ii)(A) for the 
component product. For purposes of applying the fourth sentence of 
Sec. 1.482-3(b)(2)(ii)(A), the sale of the integrated product that 
includes the component product is treated as being immediately preceded 
by a sale of the component (i.e. without further processing) in a 
controlled transaction. In the case of end-product forms, this 
paragraph (v) applies only if the sales price of excluded components 
separately sold in uncontrolled transactions would be the most direct 
and reliable measure of an arm's length price within the meaning of the 
fourth sentence of Sec. 1.482-3(b)(2)(ii)(A) for all excluded 
components of an integrated product that includes an end-product form. 
For purposes of applying the fourth sentence of Sec. 1.482-
3(b)(2)(ii)(A), the sale of the integrated product that includes 
excluded components is treated as being immediately preceded by a sale 
of the excluded components (i.e. without further processing) in a 
controlled transaction. Under the fourth sentence of Sec. 1.482-
3(b)(2)(ii)(A), the uncontrolled transactions referred to in this 
paragraph (v)(C) must have no differences with the controlled 
transactions that would affect price, or have only minor differences 
that have a definite and reasonably ascertainable effect on price and 
for which appropriate adjustments are made (resulting in appropriate 
adjustments to the computation of combined taxable income). If such 
adjustments cannot be made, or if there are more than minor differences 
between the controlled and uncontrolled transactions, the method 
provided by this paragraph (v)(C) cannot be used. Thus, for example, 
these uncontrolled transactions must involve substantially identical 
property in the same or a substantially identical geographic market, 
and must be substantially identical to the controlled transaction in 
terms of their volumes, contractual terms, and market level. See 
Sec. 1.482-3(b)(2)(ii)(B).
    (D) In no case can the per unit combined taxable income as 
determined under paragraph (v)(A) or (B) of this A. 12 be greater than 
the per unit combined taxable income of the integrated product that 
includes the component product or end-product form.
    (E) The provisions of this paragraph (v) are illustrated by the 
following example. Taxpayer manufactures product A in a U.S. 
possession. Some portion of product A is sold to unrelated persons as 
an integrated product and the remainder is sold to related persons for 
transformation into product AB. The combined taxable income of 
integrated product A is $400 per unit and the combined taxable income 
of product AB is $300 per unit. The production cost ratio with respect 
to product A when sold as a component of product AB, is 2/3. Unless the 
taxpayer elects and satisfies the conditions of this paragraph (v), the 
combined taxable income with respect to A will be $200 per unit 
(combined taxable income for AB of $300  x  the production cost ratio 
of 2/3). If, however, the comparability standards of paragraph (v)(C) 
of this A. 12 are met, the taxpayer may elect to determine combined 
taxable income of product A when sold as a component of product AB 
using the same per unit combined taxable income as product A when sold 
as an integrated product. However, the per unit combined taxable income 
from sales of product A as a component product may not exceed the per 
unit combined taxable income on the sale of product AB. Therefore, the 
combined taxable income of component product A may not exceed $300 per 
unit.
    (vi) Taxpayers that have not elected the percentage limitation 
under section 936(a)(1) for the first taxable year beginning after 
December 31, 1993, may do so if the taxpayer has elected the profit 
split method and computation of combined taxable income is affected by 
Q&A.12 of this paragraph (b)(1).
    (vii) The rules of Q&A. 12 of this paragraph (b)(1) apply for 
taxable years ending 30 days after May 10, 1996. If, however, the 
election under paragraph (v) of A. 12 of Sec. 1.936-6(b)(1) is made, 
this election must be made for the taxpayer's first taxable year 
beginning after December 31, 1993, and if not made effective for that 
year, the election cannot be made for any later taxable year. A 
successor corporation that makes the same or substantially similar 
products as its predecessor corporation cannot make an election under 
paragraph (v) of A.12 of Sec. 1.936-6(b)(1) unless the election was 
made by its predecessor corporation for its first taxable year 
beginning after December 31, 1993.
* * * * *
    A. 13: (i) The income shall be allocated to affiliates in the 
following order, but no allocations will be made to affiliates 
described in a later category if there are any affiliates in a prior 
category--
    (A) First, to U.S. affiliates (other than tax exempt affiliates) 
within the group (as determined under section 482) that derive income 
with respect to the product produced in whole or in part in the 
possession;
    (B) Second, to U.S. affiliates (other than tax exempt affiliates) 
that derive income from the active conduct of a trade or business in 
the same product area as the possession product;
    (C) Third, to other U.S. affiliates (other than tax-exempt 
affiliates);
    (D) Fourth, to foreign affiliates that derive income from the 
active conduct of a U.S. trade or business in the same product area as 
the possession product (or, if the foreign members are resident in a 
country with which the U.S. has an income tax convention, then to those 
foreign members that have a permanent establishment in the United 
States that derives income in the same product area as the possession 
product); and
    (E) Fifth, to all other affiliates.
    (ii) The allocations made under paragraph (i)(A) of this A. 13 
shall be

[[Page 21370]]

made on the basis of the relative gross income derived by each such 
affiliate with respect to the product produced in whole or in part in 
the possession. For this purpose, gross income must be determined 
consistently for each affiliate and consistently from year to year.
    (iii) The allocations made under paragraphs (i)(B) and (i)(D) of 
this A. 13 shall be made on the basis of the relative gross income 
derived by each such affiliate from the active conduct of the trade or 
business in the same product area.
    (iv) The allocations made under paragraphs (i)(C) and (i)(E) of 
this A. 13 shall be made on the basis of the relative total gross 
income of each such affiliate before allocating income under this 
section.
    (v) Income allocated to affiliates shall be treated as U.S. source 
and section 863(b) does not apply for this purpose.
    (vi) For purposes of determining an affiliate's estimated tax 
liability for income thus allocated for taxable years beginning prior 
to January 1, 1995, the income shall be deemed to be received on the 
last day of the taxable year of each such affiliate in which or with 
which the taxable year of the possessions corporation ends. For taxable 
years beginning after December 31, 1994, quarterly estimated tax 
payments will be required as provided under section 711 of the Uruguay 
Round Agreements, Public Law 103-465 (1994), page 230, and any 
administrative guidance issued by the Internal Revenue Service 
thereunder.
* * * * *
Margaret Milner Richardson,
Commissioner of Internal Revenue.
    Approved: April 4, 1996.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 96-11639 Filed 5-9-96; 8:45 am]
BILLING CODE 4830-01-U