Source of Compensation for Labor or Personal Services, 40663-40669 [05-13681]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 70, Number 134 (Thursday, July 14, 2005)]
[Rules and Regulations]
[Pages 40663-40669]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 05-13681]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9212]
RIN 1545-AO72


Source of Compensation for Labor or Personal Services

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulation.

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SUMMARY: This document contains final regulations that describe the 
proper basis for determining the source of compensation for labor or 
personal services performed partly within and partly without the United 
States. These final regulations will affect individuals who earn 
compensation for labor or personal services performed partly within and 
partly without the United States and are needed to provide appropriate 
guidance regarding the determination of the proper source of that 
compensation.

DATES: Effective Date: These regulations are effective July 14, 2005.
    Applicability Date: For dates of applicability, see Sec.  1.861-
4(d).

FOR FURTHER INFORMATION CONTACT: David Bergkuist, (202) 622-3850 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in these final regulations 
have been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
3507(d)) under control number 1545-1900.
    The collections of information in these final regulations are in 
Sec.  1.861-4(b)(2) (ii)(C)(1)(i), (b)(2)(ii)(D), and (b)(2)(ii)(D)(6). 
The information required in Sec.  1.861-4(b)(2) (ii)(C)(1)(i) will 
enable an individual, where appropriate, to use an alternative basis 
other than that described in Sec.  1.861-4(b)(2)(ii)(A) or (B) to 
determine the source of his or her compensation as an employee for 
labor or personal services performed partly within and partly without 
the United States. The information required in Sec.  1.861-
4(b)(2)(ii)(D) and (D)(6) will enable an employee to source certain 
fringe benefits on a geographical basis. The collections of information 
will, likewise, allow the IRS to verify these determinations.
    An agency may not conduct or sponsor, and a person is not required 
to

[[Page 40664]]

respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents might 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.

Background

    This document contains amendments to 26 CFR part 1. On August 6, 
2004, proposed revisions to the regulations (REG-208254-90) under 
section 861 of the Internal Revenue Code (Code) relating to the source 
of compensation for labor or personal services were published in the 
Federal Register (69 FR 47816). In the same document, a prior notice of 
proposed rulemaking (REG-208254-90), published in the Federal Register 
on January 21, 2000 (65 FR 3401), was withdrawn. A public hearing was 
held on January 13, 2005. Two written comments were received. After 
consideration of these comments, the August 6, 2004 proposed 
regulations are adopted as amended by this Treasury decision.

Summary of Comments and Explanation of Revisions

    These final regulations, as proposed in the notice of proposed 
rulemaking, retain the facts and circumstances basis as the general 
rule for determining the source of compensation for labor or personal 
services performed partly within and partly without the United States 
received by persons other than individuals and by individuals who are 
not employees. As proposed, the final regulations provide two general 
bases for determining the proper source of compensation that an 
individual receives as an employee for such labor or personal services. 
Under the first general basis of Sec.  1.861-4(b)(2)(ii)(A), an 
individual will source compensation, other than compensation in the 
form of certain fringe benefits, on a time basis, as defined in Sec.  
1.861-4(b)(2)(ii)(E).
    Under the second general basis of Sec.  1.861-4(b)(2)(ii)(B) and 
(D), an individual will source compensation in the form of fringe 
benefits, as described in Sec.  1.861-4(b)(2) (ii)(D)(1) through (6), 
on a geographical basis (e.g., at the employee's principal place of 
work, as defined in section 217 and Sec.  1.217-2(c)(3)). The fringe 
benefits to which this general basis applies are housing, education, 
local transportation, tax reimbursement, hazardous or hardship duty 
pay, and moving expense reimbursement fringe benefits. This general 
basis will apply only if the amount of the fringe benefit is reasonable 
and is substantiated by adequate contemporaneous records or sufficient 
evidence under rules similar to those set forth in Sec.  1.274-5T(c) or 
(h) or Sec.  1.132-5.
    Comments were received that proposed several changes with regard to 
the fringe benefits described in Sec.  1.861-4(b)(2)(ii)(D)(1) through 
(6). Under one suggestion, the specific definitions of the identified 
fringe benefits would be replaced with broad categories. The comment 
further suggested that the housing fringe benefit, education fringe 
benefit, and local transportation fringe benefit include employer-
provided allowances that are based on estimated, rather than actual, 
expenses. The comment also requested that the definition of education 
fringe benefit be expanded to include payments for the education of the 
employee's spouse for studies that relate to the foreign location of 
the employment, such as language courses and job training at the 
foreign location, and to include pre-school and post-secondary 
education, home schooling costs, and language courses of the employee's 
dependents. With respect to the transportation fringe benefit, the 
comment requested that automobile purchase assistance in the host 
country be included. The comment also requested that the amount of 
compensation qualifying for the hazardous or hardship duty pay fringe 
benefit not be limited to government-provided amounts. The comment 
suggested that the definition of moving expense reimbursement fringe 
benefit be expanded to include a list of specific expenses, such as 
moving allowances, home sale/purchase assistance, temporary living, car 
loss reimbursement, utility setup, appliance installation, auto 
registration, driver's license fees, power converters, and other 
related expenses. The comment also suggested three additional fringe 
benefits: home leave allowances, cost-of-living allowances, and 
exchange rate differential allowances.
    The Treasury Department and the IRS considered the various comments 
regarding the approach, scope, and detail of the identified fringe 
benefits under the proposed regulations. In response to the comments, 
the final regulations modify the definition of education fringe benefit 
to include education expenses of the type described in section 
530(b)(4)(A)(i) regardless of whether the education expenses are 
incurred in connection with enrollment or attendance at a school. The 
final regulations do not incorporate the suggestion for allowances 
based on estimated expenses because the Treasury Department and the IRS 
continue to believe that substantiation of relevant items is the more 
appropriate approach. Regarding the other proposed changes to the 
identified fringe benefits, the Treasury Department and the IRS believe 
that the regulations provide an appropriate scope of benefits, a 
reasonable manner of determining the appropriate amount of fringe 
benefit to be sourced geographically, and a reasonable limit to the 
amount of an individual's compensation that may be sourced under the 
exception to the general time basis rule of Sec.  1.861-4(b)(2)(ii)(E). 
As noted in the preamble to the proposed regulations, the Treasury 
Department and the IRS intend to keep the list and descriptions of 
identified fringe benefits current and continue to invite comments on 
whether the identified fringe benefits are appropriately defined and 
whether other fringe benefits should be identified and sourced on a 
specific geographic basis.
    Furthermore, the final regulations retain the proposed provision 
that permits an employee to use an alternative basis, based upon the 
facts and circumstances, to source such compensation if he or she 
establishes to the satisfaction of the Commissioner that such an 
alternative basis more properly determines the source of the 
compensation. An individual seeking to use an alternative basis need 
not obtain the satisfaction of the Commissioner prior to filing his or 
her return. To obtain the satisfaction of the Commissioner, an 
individual who uses an alternative basis must retain in his or her 
records documentation setting forth why the alternative basis more 
properly determines the source of the compensation than the basis for 
determining source of compensation described in Sec.  1.861-
4(b)(2)(ii)(A) or (B). One comment requested that substantiation by the 
individual's employer be accepted as substantiation by the employee, 
particularly where the alternative method is used by a group of 
employees. Whether an alternative basis more properly determines the 
source of an individual's compensation is based on the facts and 
circumstances of the individual's specific case. As a result, it is the 
individual employee, rather than the employer, who must demonstrate 
that the alternative basis more properly determines the source of the 
compensation than the basis for determining source of compensation 
described in Sec.  1.861-4(b)(2)(ii)(A) or (B). It is expected, 
however, that the

[[Page 40665]]

individual employee would use, among other documentation, documentation 
provided by the employer for such substantiation.
    Another comment requested relief from any penalties that might 
arise from inaccurate reporting or withholding if an alternative method 
is determined not to be acceptable or if the Commissioner determines 
that a method other than the two general methods determines the source 
of compensation in a more reasonable manner. The Treasury Department 
and the IRS believe that the existing standards of penalty 
administration, including applicable justifications, adequately address 
this matter.
    Section 1.861-4(b)(2)(ii)(C)(1)(i) of the proposed regulations 
provided that to assert an alternative basis the individual must comply 
with the requirements set forth in any administrative pronouncement 
issued by the Commissioner. The final regulations require that to 
assert an alternative basis, the individual must provide the 
information related to the alternative basis required by applicable 
Federal tax forms and accompanying instructions. It is expected that 
the applicable Federal tax forms and accompanying instructions will 
require individuals with $250,000 or more in compensation for the tax 
year that use an alternative basis to respond to questions on the tax 
form and to attach to their income tax returns a written statement that 
sets forth: (1) The specific compensation income, or the specific 
fringe benefit, for which an alternative method is used; (2) for each 
such item, the alternative method of allocation of source used; (3) for 
each such item, a computation showing how the alternative allocation 
was computed; and (4) a comparison of the dollar amount of the 
compensation sourced within and without the United States under both 
the individual's alternative basis and the basis for determining source 
of compensation described in Sec.  1.861-4(b)(2)(ii)(A) or (B).
    The proposed regulations at Sec.  1.861-4(b)(2)(ii)(C)(3) were 
reserved with respect to artists and athletes who are employees. 
Although requested, no comments were received on the definition of 
artists and athletes. The reservation is retained in these final 
regulations. As noted in the preamble to the proposed regulation, it is 
intended that the specific rules for artists and athletes who are 
employees, when issued, will require such individuals to determine the 
proper source of compensation for labor or personal services on the 
basis that most correctly reflects the proper source of that income 
under the facts and circumstances of the particular case, consistent 
with current law.
    Proposed Sec.  1.861-4(b)(2)(ii)(F) provided that the source of 
multi-year compensation of an employee is generally determined on a 
time basis over the applicable period to which the compensation is 
attributable. Determination of the applicable period to which the 
compensation is attributable (including whether the compensation 
relates to more than one taxable year) is based upon the facts and 
circumstances of the particular case. Comments requested additional 
guidance in the area of equity based compensation, particularly with 
respect to stock options, that relate to services performed over a 
period of more than one year. These comments requested guidance related 
to pre-grant sourcing, sourcing based upon exercise date, and non-
conventional equity compensation awards. Because under the regulations 
the applicable period is determined based on the facts and 
circumstances of the particular case, and a taxpayer may assert an 
alternative method to source such compensation income pursuant to Sec.  
1.861-4(b)(2)(ii)(C)(1)(i), the Treasury Department and the IRS 
concluded that Sec.  1.861-4(b)(2)(ii)(F), as proposed, was reasonable 
in its scope and the rules were not modified in the final regulations.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It is hereby 
certified that the collections of information contained in these 
regulations will not have a significant economic impact on a 
substantial number of small entities. Accordingly, a regulatory 
flexibility analysis is not required. This certification is based upon 
that fact that the Treasury Department and the IRS believe that a time 
basis generally is the most appropriate method for determining the 
source of an individual employee's compensation for labor or personal 
services performed partly within and partly without the United States. 
The information necessary to apply the time basis should be readily 
available to employers and employees. For example, Form 2555, ``Foreign 
Earned Income'', requires an individual who claims the foreign earned 
income exclusion to provide the IRS with information relating to the 
number of business days spent within the United States and any fringe 
benefits received. In addition, if an employee wishes to use an 
alternative method to source compensation, it is the employee that must 
document such alternative method. Pursuant to section 7805(f) of the 
Code, the notice of proposed rulemaking preceding these regulations was 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Drafting Information

    The principal author of these final regulations is David Bergkuist 
of the Office of Associate Chief Counsel (International). However, 
other personnel from the IRS and the Treasury Department participated 
in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read, in 
part, as follows:

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


0
Par. 2. Section 1.861-4 is amended as follows:

0
1. The heading for paragraph (a) is revised.

0
2. A sentence is added at the beginning of paragraph (a)(1) 
introductory text.

0
3. Paragraph (b) is revised.

0
4. A sentence is added at the end of paragraph (d).
    The revisions and addition read as follows:


Sec.  1.861-4  Compensation for labor or personal services.

    (a) Compensation for labor or personal services performed wholly 
within the United States. (1) Generally, compensation for labor or 
personal services, including fees, commissions, fringe benefits, and 
similar items, performed wholly within the United States is gross 
income from sources within the United States. * * *
* * * * *
    (b) Compensation for labor or personal services performed partly 
within and partly without the United States--(1) Compensation for labor 
or

[[Page 40666]]

personal services performed by persons other than individuals--(i) In 
general. In the case of compensation for labor or personal services 
performed partly within and partly without the United States by a 
person other than an individual, the part of that compensation that is 
attributable to the labor or personal services performed within the 
United States, and that is therefore included in gross income as income 
from sources within the United States, is determined on the basis that 
most correctly reflects the proper source of the income under the facts 
and circumstances of the particular case. In many cases, the facts and 
circumstances will be such that an apportionment on the time basis, as 
defined in paragraph (b)(2)(ii)(E) of this section, will be acceptable.
    (ii) Example. The application of paragraph (b)(1)(i) is illustrated 
by the following example.

    Example. Corp X, a domestic corporation, receives compensation 
of $150,000 under a contract for services to be performed 
concurrently in the United States and in several foreign countries 
by numerous Corp X employees. Each Corp X employee performing 
services under this contract performs his or her services 
exclusively in one jurisdiction. Although the number of employees 
(and hours spent by employees) performing services under the 
contract within the United States equals the number of employees 
(and hours spent by employees) performing services under the 
contract without the United States, the compensation paid to 
employees performing services under the contract within the United 
States is higher because of the more sophisticated nature of the 
services performed by the employees within the United States. 
Accordingly, the payroll cost for employees performing services 
under the contract within the United States is $20,000 out of a 
total contract payroll cost of $30,000. Under these facts and 
circumstances, a determination based upon relative payroll costs 
would be the basis that most correctly reflects the proper source of 
the income received under the contract. Thus, of the $150,000 of 
compensation included in Corp X's gross income, $100,000 ($150,000 x 
$20,000/$30,000) is attributable to the labor or personal services 
performed within the United States and $50,000 ($150,000 x $10,000/
$30,000) is attributable to the labor or personal services performed 
without the United States.

    (2) Compensation for labor or personal services performed by an 
individual--(i) In general. Except as provided in paragraph (b)(2)(ii) 
of this section, in the case of compensation for labor or personal 
services performed partly within and partly without the United States 
by an individual, the part of such compensation that is attributable to 
the labor or personal services performed within the United States, and 
that is therefore included in gross income as income from sources 
within the United States, is determined on the basis that most 
correctly reflects the proper source of that income under the facts and 
circumstances of the particular case. In many cases, the facts and 
circumstances will be such that an apportionment on a time basis, as 
defined in paragraph (b)(2)(ii)(E) of this section, will be acceptable.
    (ii) Employee compensation--(A) In general. Except as provided in 
paragraph (b)(2)(ii)(B) or (C) of this section, in the case of 
compensation for labor or personal services performed partly within and 
partly without the United States by an individual as an employee, the 
part of such compensation that is attributable to the labor or personal 
services performed within the United States, and that is therefore 
included in gross income as income from sources within the United 
States, is determined on a time basis, as defined in paragraph 
(b)(2)(ii)(E) of this section.
    (B) Certain fringe benefits sourced on a geographical basis. Except 
as provided in paragraph (b)(2)(ii)(C) of this section, items of 
compensation of an individual as an employee for labor or personal 
services performed partly within and partly without the United States 
that are described in paragraphs (b)(2)(ii)(D)(1) through (6) of this 
section are sourced on a geographical basis in accordance with those 
paragraphs.
    (C) Exceptions and special rules--(1) Alternative basis--(i) 
Individual as an employee generally. An individual may determine the 
source of his or her compensation as an employee for labor or personal 
services performed partly within and partly without the United States 
under an alternative basis if the individual establishes to the 
satisfaction of the Commissioner that, under the facts and 
circumstances of the particular case, the alternative basis more 
properly determines the source of the compensation than a basis 
described in paragraph (b)(2)(ii)(A) or (B), whichever is applicable, 
of this section. An individual that uses an alternative basis must 
retain in his or her records documentation setting forth why the 
alternative basis more properly determines the source of the 
compensation. In addition, the individual must provide the information 
related to the alternative basis required by applicable Federal tax 
forms and accompanying instructions.
    (ii) Determination by Commissioner. The Commissioner may, under the 
facts and circumstances of the particular case, determine the source of 
compensation that is received by an individual as an employee for labor 
or personal services performed partly within and partly without the 
United States under an alternative basis other than a basis described 
in paragraph (b)(2)(ii)(A) or (B) of this section if such compensation 
either is not for a specific time period or constitutes in substance a 
fringe benefit described in paragraph (b)(2)(ii)(D) of this section 
notwithstanding a failure to meet any requirement of paragraph 
(b)(2)(ii)(D) of this section. The Commissioner may make this 
determination only if such alternative basis determines the source of 
compensation in a more reasonable manner than the basis used by the 
individual pursuant to paragraph (b)(2)(ii)(A) or (B) of this section.
    (2) Ruling or other administrative pronouncement with respect to 
groups of taxpayers. The Commissioner may, by ruling or other 
administrative pronouncement applying to similarly situated taxpayers 
generally, permit individuals to determine the source of their 
compensation as an employee for labor or personal services performed 
partly within and partly without the United States under an alternative 
basis. Any such individual shall be treated as having met the 
requirement to establish such alternative basis to the satisfaction of 
the Commissioner under the facts and circumstances of the particular 
case, provided that the individual meets the other requirements of 
paragraph (b)(2)(ii)(C)(1)(i) of this section. The Commissioner also 
may, by ruling or other administrative pronouncement, indicate the 
circumstances in which he will require individuals to determine the 
source of certain compensation as an employee for labor or personal 
services performed partly within and partly without the United States 
under an alternative basis pursuant to the authority under paragraph 
(b)(2)(ii)(C)(1)(ii) of this section.
    (3) Artists and athletes. [Reserved.]
    (D) Fringe benefits sourced on a geographical basis. Except as 
provided in paragraph (b)(2)(ii)(C) of this section, compensation of an 
individual as an employee for labor or personal services performed 
partly within and partly without the United States in the form of the 
following fringe benefits is sourced on a geographical basis as 
indicated in this paragraph (b)(2)(ii)(D). The amount of the 
compensation in the form of the fringe benefit must be reasonable, and 
the individual must substantiate such amounts by adequate records or by 
sufficient evidence under rules similar to those set forth in Sec.  
1.274-5T(c) or (h) or Sec.  1.132-5. For purposes of this paragraph 
(b)(2)(ii)(D), the term principal place of work has the same

[[Page 40667]]

meaning that it has for purposes of section 217 and Sec.  1.217-
2(c)(3).
    (1) Housing fringe benefit. The source of compensation in the form 
of a housing fringe benefit is determined based on the location of the 
individual's principal place of work. For purposes of this paragraph 
(b)(2)(ii)(D)(1), a housing fringe benefit includes payments to or on 
behalf of an individual (and the individual's family if the family 
resides with the individual) only for rent, utilities (other than 
telephone charges), real and personal property insurance, occupancy 
taxes not deductible under section 164 or 216(a), nonrefundable fees 
paid for securing a leasehold, rental of furniture and accessories, 
household repairs, residential parking, and the fair rental value of 
housing provided in kind by the individual's employer. A housing fringe 
benefit does not include payments for expenses or items set forth in 
Sec.  1.911-4(b)(2).
    (2) Education fringe benefit. The source of compensation in the 
form of an education fringe benefit for the education expenses of the 
individual's dependents is determined based on the location of the 
individual's principal place of work. For purposes of this paragraph 
(b)(2)(ii)(D)(2), an education fringe benefit includes payments only 
for qualified tuition and expenses of the type described in section 
530(b)(4)(A)(i) (regardless of whether incurred in connection with 
enrollment or attendance at a school) and expenditures for room and 
board and uniforms as described in section 530(b)(4)(A)(ii) with 
respect to education at an elementary or secondary educational 
institution.
    (3) Local transportation fringe benefit. The source of compensation 
in the form of a local transportation fringe benefit is determined 
based on the location of the individual's principal place of work. For 
purposes of this paragraph (b)(2)(ii)(D)(3), an individual's local 
transportation fringe benefit is the amount that the individual 
receives as compensation for local transportation of the individual or 
the individual's spouse or dependents at the location of the 
individual's principal place of work. The amount treated as a local 
transportation fringe benefit is limited to the actual expenses 
incurred for local transportation and the fair rental value of any 
vehicle provided by the employer and used predominantly by the 
individual or the individual's spouse or dependents for local 
transportation. For this purpose, actual expenses incurred for local 
transportation do not include the cost (including interest) of the 
purchase by the individual, or on behalf of the individual, of an 
automobile or other vehicle.
    (4) Tax reimbursement fringe benefit. The source of compensation in 
the form of a foreign tax reimbursement fringe benefit is determined 
based on the location of the jurisdiction that imposed the tax for 
which the individual is reimbursed.
    (5) Hazardous or hardship duty pay fringe benefit. The source of 
compensation in the form of a hazardous or hardship duty pay fringe 
benefit is determined based on the location of the hazardous or 
hardship duty zone for which the hazardous or hardship duty pay fringe 
benefit is paid. For purposes of this paragraph (b)(2)(ii)(D)(5), a 
hazardous or hardship duty zone is any place in a foreign country which 
is either designated by the Secretary of State as a place where living 
conditions are extraordinarily difficult, notably unhealthy, or where 
excessive physical hardships exist, and for which a post differential 
of 15 percent or more would be provided under section 5925(b) of Title 
5 of the U.S. Code to any officer or employee of the U.S. Government 
present at that place, or where a civil insurrection, civil war, 
terrorism, or wartime conditions threatens physical harm or imminent 
danger to the health and well-being of the individual. Compensation 
provided an employee during the period that the employee performs labor 
or personal services in a hazardous or hardship duty zone may be 
treated as a hazardous or hardship duty pay fringe benefit only if the 
employer provides the hazardous or hardship duty pay fringe benefit 
only to employees performing labor or personal services in a hazardous 
or hardship duty zone. The amount of compensation treated as a 
hazardous or hardship duty pay fringe benefit may not exceed the 
maximum amount that the U.S. government would allow its officers or 
employees present at that location.
    (6) Moving expense reimbursement fringe benefit. Except as 
otherwise provided in this paragraph (b)(2)(ii)(D)(6), the source of 
compensation in the form of a moving expense reimbursement is 
determined based on the location of the employee's new principal place 
of work. The source of such compensation is determined based on the 
location of the employee's former principal place of work, however, if 
the individual provides sufficient evidence that such determination of 
source is more appropriate under the facts and circumstances of the 
particular case. For purposes of this paragraph (b)(2)(ii)(D)(6), 
sufficient evidence generally requires an agreement, between the 
employer and the employee, or a written statement of company policy, 
which is reduced to writing before the move and which is entered into 
or established to induce the employee or employees to move to another 
country. Such written statement or agreement must state that the 
employer will reimburse the employee for moving expenses that the 
employee incurs to return to the employee's former principal place of 
work regardless of whether he or she continues to work for the employer 
after returning to that location. The writing may contain certain 
conditions upon which the right to reimbursement is determined as long 
as those conditions set forth standards that are definitely 
ascertainable and can only be fulfilled prior to, or through completion 
of, the employee's return move to the employee's former principal place 
of work.
    (E) Time basis. The amount of compensation for labor or personal 
services performed within the United States determined on a time basis 
is the amount that bears the same relation to the individual's total 
compensation as the number of days of performance of the labor or 
personal services by the individual within the United States bears to 
his or her total number of days of performance of labor or personal 
services. A unit of time less than a day may be appropriate for 
purposes of this calculation. The time period for which the 
compensation for labor or personal services is made is presumed to be 
the calendar year in which the labor or personal services are 
performed, unless the taxpayer establishes to the satisfaction of the 
Commissioner, or the Commissioner determines, that another distinct, 
separate, and continuous period of time is more appropriate. For 
example, a transfer during a year from a position in the United States 
to a foreign posting that lasted through the end of that year would 
generally establish two separate time periods within that taxable year. 
The first of these time periods would be the portion of the year 
preceding the start of the foreign posting, and the second of these 
time periods would be the portion of the year following the start of 
the foreign posting. However, in the case of a foreign posting that 
requires short-term returns to the United States to perform services 
for the employer, such short-term returns would not be sufficient to 
establish distinct, separate, and continuous time periods within the 
foreign posting time period but would be relevant to the allocation of 
compensation relating to the overall

[[Page 40668]]

time period. In each case, the source of the compensation on a time 
basis is based upon the number of days (or unit of time less than a 
day, if appropriate) in that separate time period.
    (F) Multi-year compensation arrangements. The source of multi-year 
compensation is determined generally on a time basis, as defined in 
paragraph (b)(2)(ii)(E) of this section, over the period to which such 
compensation is attributable. For purposes of this paragraph 
(b)(2)(ii)(F), multi-year compensation means compensation that is 
included in the income of an individual in one taxable year but that is 
attributable to a period that includes two or more taxable years. The 
determination of the period to which such compensation is attributable, 
for purposes of determining its source, is based upon the facts and 
circumstances of the particular case. For example, an amount of 
compensation that specifically relates to a period of time that 
includes several calendar years is attributable to the entirety of that 
multi-year period. The amount of such compensation that is treated as 
from sources within the United States is the amount that bears the same 
relationship to the total multi-year compensation as the number of days 
(or unit of time less than a day, if appropriate) that labor or 
personal services were performed within the United States in connection 
with the project bears to the total number of days (or unit of time 
less than a day, if appropriate) that labor or personal services were 
performed in connection with the project. In the case of stock options, 
the facts and circumstances generally will be such that the applicable 
period to which the compensation is attributable is the period between 
the grant of an option and the date on which all employment-related 
conditions for its exercise have been satisfied (the vesting of the 
option).
    (G) Examples. The following examples illustrate the application of 
this paragraph (b)(2)(ii):

    Example 1. B, a nonresident alien individual, was employed by 
Corp M, a domestic corporation, from March 1 to December 25 of the 
taxable year, a total of 300 days, for which B received compensation 
in the amount of $80,000. Under B's employment contract with Corp M, 
B was subject to call at all times by Corp M and was in a payment 
status on a 7-day week basis. Pursuant to that contract, B performed 
services (or was available to perform services) within the United 
States for 180 days and performed services (or was available to 
perform services) without the United States for 120 days. None of 
B's $80,000 compensation was for fringe benefits as identified in 
paragraph (b)(2)(ii)(D) of this section. B determined the amount of 
compensation that is attributable to his labor or personal services 
performed within the United States on a time basis under paragraph 
(b)(2)(ii)(A) and (E) of this section. B did not assert, pursuant to 
paragraph (b)(2)(ii)(C)(1)(i) of this section, that, under the 
particular facts and circumstances, an alternative basis more 
properly determines the source of that compensation than the time 
basis. Therefore, B must include in income from sources within the 
United States $48,000 ($80,000 x 180/300) of his compensation from 
Corporation M.
    Example 2. (i) Same facts as in Example 1 except that Corp M had 
a company-wide arrangement with its employees, including B, that 
they would receive an education fringe benefit, as described in 
paragraph (b)(2)(ii)(D)(2) of this section, while working in the 
United States. During the taxable year, B incurred education 
expenses for his dependent daughter that qualified for the education 
fringe benefit in the amount of $10,000, for which B received a 
reimbursement from Corp M. B did not maintain adequate records or 
sufficient evidence of this fringe benefit as required by paragraph 
(b)(2)(ii)(D) of this section. When B filed his Federal income tax 
return for the taxable year, B did not apply paragraphs 
(b)(2)(ii)(B) and (D)(2) of this section to treat the compensation 
in the form of the education fringe benefit as income from sources 
within the United States, the location of his principal place of 
work during the 300-day period. Rather, B combined the $10,000 
reimbursement with his base compensation of $80,000 and applied the 
time basis of paragraph (b)(2)(ii)(A) of this section to determine 
the source of his gross income.
    (ii) On audit, B argues that because he failed to substantiate 
the education fringe benefit in accordance with paragraph 
(b)(2)(ii)(D) of this section, his entire employment compensation 
from Corp M is sourced on a time basis pursuant to paragraph 
(b)(2)(ii)(A) of this section. The Commissioner, after reviewing 
Corp M's fringe benefit arrangement, determines, pursuant to 
paragraph (b)(2)(ii)(C)(1)(ii) of this section, that the $10,000 
educational expense reimbursement constitutes in substance a fringe 
benefit described in paragraph (b)(2)(ii)(D)(2) of this section, 
notwithstanding a failure to meet all of the requirements of 
paragraph (b)(2)(ii)(D) of this section, and that an alternative 
geographic source basis, under the facts and circumstances of this 
particular case, is a more reasonable manner to determine the source 
of the compensation than the time basis used by B.
    Example 3. (i) A, a United States citizen, is employed by Corp 
N, a domestic corporation. A's principal place of work is in the 
United States. A earns an annual salary of $100,000. During the 
first quarter of the calendar year (which is also A's taxable year), 
A performed services entirely within the United States. At the 
beginning of the second quarter of the calendar year, A was 
transferred to Country X for the remainder of the year and received, 
in addition to her annual salary, $30,000 in fringe benefits that 
are attributable to her new principal place of work in Country X. 
Corp N paid these fringe benefits separately from A's annual salary. 
Corp N supplied A with a statement detailing that $25,000 of the 
fringe benefit was paid for housing, as defined in paragraph 
(b)(2)(ii)(D)(1) of this section, and $5,000 of the fringe benefit 
was paid for local transportation, as defined in paragraph 
(b)(2)(ii)(D)(3) of this section. None of the local transportation 
fringe benefit is excluded from the employee's gross income as a 
qualified transportation fringe benefit under section 132(a)(5). 
Under A's employment contract, A was required to work on a 5-day 
week basis, Monday through Friday. During the last three quarters of 
the year, A performed services 30 days in the United States and 150 
days in Country X and other foreign countries.
    (ii) A determined the source of all of her compensation from 
Corp N pursuant to paragraphs (b)(2)(ii)(A), (B), and (D)(1) and (3) 
of this section. A did not assert, pursuant to paragraph 
(b)(2)(ii)(C)(1)(i) of this section, that, under the particular 
facts and circumstances, an alternative basis more properly 
determines the source of that compensation than the bases set forth 
in paragraphs (b)(2)(ii)(A), (B), and (D)(1) and (3) of this 
section. However, in applying the time basis set forth in paragraph 
(b)(2)(ii)(E) of this section, A establishes to the satisfaction of 
the Commissioner that the first quarter of the calendar year and the 
last three quarters of the calendar year are two separate, distinct, 
and continuous periods of time. Accordingly, $25,000 of A's annual 
salary is attributable to the first quarter of the year (25 percent 
of $100,000). This amount is entirely compensation that was 
attributable to the labor or personal services performed within the 
United States and is, therefore, included in gross income as income 
from sources within the United States. The balance of A's 
compensation as an employee of Corp N, $105,000 (which includes the 
$30,000 in fringe benefits that are attributable to the location of 
A's principal place of work in Country X), is compensation 
attributable to the final three quarters of her taxable year. During 
those three quarters, A's periodic performance of services in the 
United States does not result in distinct, separate, and continuous 
periods of time. Of the $75,000 paid for annual salary, $12,500 (30/
180 x $75,000) is compensation that was attributable to the labor or 
personal services performed within the United States and $62,500 
(150/180 x $75,000) is compensation that was attributable to the 
labor or personal services performed outside the United States. 
Pursuant to paragraphs (b)(2)(ii)(B) and (D)(1) and (3) of this 
section, A sourced the $25,000 received for the housing fringe 
benefit and the $5,000 received for the local transportation fringe 
benefit based on the location of her principal place of work, 
Country X. Accordingly, A included the $30,000 in fringe benefits in 
her gross income as income from sources without the United States.
    Example 4. Same facts as in Example 3. Of the 150 days during 
which A performed services in Country X and in other foreign 
countries (during the final three quarters of A's taxable year), she 
performed 30 days of those services in Country Y. Country Y is a

[[Page 40669]]

country designated by the Secretary of State as a place where living 
conditions are extremely difficult, notably unhealthy, or where 
excessive physical hardships exist and for which a post differential 
of 15 percent or more would be provided under section 5925(b) of 
Title 5 of the U.S. Code to any officer or employee of the U.S. 
government present at that place. Corp N has a policy of paying its 
employees a $65 premium per day for each day worked in countries so 
designated. The $65 premium per day does not exceed the maximum 
amount that the U. S. government would pay its officers or employees 
stationed in Country Y. Because A performed services in Country Y 
for 30 days, she earned additional compensation of $1,950. The 
$1,950 is considered a hazardous duty or hardship pay fringe benefit 
and is sourced under paragraphs (b)(2)(ii)(B) and (D)(5) of this 
section based on the location of the hazardous or hardship duty 
zone, Country Y. Accordingly, A included the amount of the hazardous 
duty or hardship pay fringe benefit ($1,950) in her gross income as 
income from sources without the United States.
    Example 5. (i) During 2006 and 2007, Corp P, a domestic 
corporation, employed four United States citizens, E, F, G, and H to 
work in its manufacturing plant in Country V. As part of his or her 
compensation package, each employee arranged for local 
transportation unrelated to Corp P's business needs. None of the 
local transportation fringe benefit is excluded from the employee's 
gross income as a qualified transportation fringe benefit under 
section 132(a)(5) and (f).
    (ii) Under the terms of the compensation package that E 
negotiated with Corp P, Corp P permitted E to use an automobile 
owned by Corp P. In addition, Corp P agreed to reimburse E for all 
expenses incurred by E in maintaining and operating the automobile, 
including gas and parking. Provided that the local transportation 
fringe benefit meets the requirements of paragraph (b)(2)(ii)(D)(3) 
of this section, E's compensation with respect to the fair rental 
value of the automobile and reimbursement for the expenses E 
incurred is sourced under paragraphs (b)(2)(ii)(B) and (D)(3) of 
this section based on E's principal place of work in Country V. 
Thus, the local transportation fringe benefit will be included in 
E's gross income as income from sources without the United States.
    (iii) Under the terms of the compensation package that F 
negotiated with Corp P, Corp P let F use an automobile owned by Corp 
P. However, Corp P did not agree to reimburse F for any expenses 
incurred by F in maintaining and operating the automobile. Provided 
that the local transportation fringe benefit meets the requirements 
of paragraph (b)(2)(ii)(D)(3) of this section, F's compensation with 
respect to the fair rental value of the automobile is sourced under 
paragraphs (b)(2)(ii)(B) and (D)(3) of this section based on F's 
principal place of work in Country V. Thus, the local transportation 
fringe benefit will be included in F's gross income as income from 
sources without the United States.
    (iv) Under the terms of the compensation package that G 
negotiated with Corp P, Corp P agreed to reimburse G for the 
purchase price of an automobile that G purchased in Country V. Corp 
P did not agree to reimburse G for any expenses incurred by G in 
maintaining and operating the automobile. Because the cost to 
purchase an automobile is not a local transportation fringe benefit 
as defined in paragraph (b)(2)(ii)(D)(3) of this section, the source 
of the compensation to G will be determined pursuant to paragraph 
(b)(2)(ii)(A) or (C) of this section.
    (v) Under the terms of the compensation package that H 
negotiated with Corp P, Corp P agreed to reimburse H for the 
expenses that H incurred in maintaining and operating an automobile, 
including gas and parking, which H purchased in Country V. Provided 
that the local transportation fringe benefit meets the requirements 
of paragraph (b)(2)(ii)(D)(3) of this section, H's compensation with 
respect to the reimbursement for the expenses H incurred is sourced 
under paragraphs (b)(2)(ii)(B) and (D)(3) of this section based on 
H's principal place of work in Country V. Thus, the local 
transportation fringe benefit will be included in H's gross income 
as income from sources without the United States.
    Example 6. (i) On January 1, 2006, Company Q compensates 
employee J with a grant of options to which section 421 does not 
apply that do not have a readily ascertainable fair market value 
when granted. The stock options permit J to purchase 100 shares of 
Company Q stock for $5 per share. The stock options do not become 
exercisable unless and until J performs services for Company Q (or a 
related company) for 5 years. J works for Company Q for the 5 years 
required by the stock option grant. In years 2006-08, J performs all 
of his services for Company Q within the United States. In 2009, J 
performs \1/2\ of his services for Company Q within the United 
States and \1/2\ of his services for Company Q without the United 
States. In year 2010, J performs his services entirely without the 
United States. On December 31, 2012, J exercises the options when 
the stock is worth $10 per share. J recognizes $500 in taxable 
compensation (($10-$5) x 100) in 2012.
    (ii) Under the facts and circumstances, the applicable period is 
the 5-year period between the date of grant (January 1, 2006) and 
the date the stock options become exercisable (December 31, 2010). 
On the date the stock options become exercisable, J performs all 
services necessary to obtain the compensation from Company Q. 
Accordingly, the services performed after the date the stock options 
become exercisable are not taken into account in sourcing the 
compensation from the stock options. Therefore, pursuant to 
paragraph (b)(2)(ii)(A), since J performs 3\1/2\ years of services 
for Company Q within the United States and 1\1/2\ years of services 
for Company Q without the United States during the 5-year period, 7/
10 of the $500 of compensation (or $350) recognized in 2012 is 
income from sources within the United States and the remaining 3/10 
of the compensation (or $150) is income from sources without the 
United States.
* * * * *
    (d) Effective date. * * * Paragraph (b) and the first sentence of 
paragraph (a)(1) of this section apply to taxable years beginning on or 
after July 14, 2005.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

0
Par. 3. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

0
Par. 4. In Sec.  602.101, paragraph (b) is amended by adding an entry 
for Sec.  1.861-4 in numerical order to the table to read as follows:


Sec.  602.101  OMB Control numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
                                                             Current OMB
    CFR part or section  where Identified and described      control No.
------------------------------------------------------------------------
 
                                * * * * *
1.861-4....................................................    1545-1900
 
                                * * * * *
------------------------------------------------------------------------


Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
    Approved: July 5, 2005.
Eric Solomon,
Acting Deputy Assistant Secretary for Tax Policy.
[FR Doc. 05-13681 Filed 7-13-05; 8:45 am]
BILLING CODE 4830-01-P