Source of Income From Certain Space and Ocean Activities; Source of Communications Income, 54859-54878 [05-18265]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 70, Number 180 (Monday, September 19, 2005)]
[Proposed Rules]
[Pages 54859-54878]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 05-18265]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-106030-98]
RIN 1545-AW50


Source of Income From Certain Space and Ocean Activities; Source 
of Communications Income

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Withdrawal of notice of proposed rulemaking; notice of proposed 
rulemaking; and notice of public hearing.

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SUMMARY: This document contains proposed regulations under section 
863(d) governing the source of income from certain space and ocean 
activities. It also contains proposed regulations under section 863(a), 
(d), and (e) governing the source of income from certain communications 
activities. This document also contains proposed regulations under 
section 863(a) and (b), amending the regulations in Sec.  1.863-3 to 
conform those regulations to these proposed regulations. This document 
affects persons who derive income from activities conducted in space, 
or on or under water not within the jurisdiction of a foreign country, 
possession of the United States, or the United States (in international 
water). This document also affects persons who derive income from 
transmission of communications. In addition, this document provides 
notice of a public hearing on these proposed regulations and withdraws 
the notice of proposed rulemaking (66 FR 3903) published in the Federal 
Register on January 17, 2001.

DATES: Written or electronic comments must be received by November 23, 
2005. Outlines of topics to be discussed at the public hearing 
scheduled for December 15, 2005, at 10 a.m., must be received by 
November 23, 2005.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-106030-98), room 
5203, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-
106030-98), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically, via either the IRS 
Internet site at https://www.irs.gov/regs or the Federal eRulemaking 
Portal at https://www.regulations.gov (IRS-REG-106030-98). The public 
hearing will be held in the Auditorium, Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Edward R. 
Barret, (202) 622-3880; concerning submissions of comments, the 
hearing, and/or to be placed on the building access list to attend the 
hearing, Cynthia Grigsby, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in this notice of proposed 
rulemaking have been reviewed and approved by the Office of Management 
and Budget (OMB) in accordance with the Paperwork Reduction Act of 1995 
(44 U.S.C. 3507(d)) under control number 1545-1718.
    The collection of information in these proposed regulations is in 
Sec. Sec.  1.863-8(g) and 1.863-9(g). This information is required by 
the IRS to monitor

[[Page 54860]]

compliance with the Federal tax rules for determining the source of 
income from space or ocean activities, or from transmission of 
communications.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number assigned by the Office of 
Management and Budget.
    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.

Background

    Congress enacted section 863(d) and (e) as part of the Tax Reform 
Act of 1986, Public Law 99-514 (100 Stat. 2085) (the 1986 Act). Section 
863(d) governs the source of income derived from certain space and 
ocean activities. Section 863(e) governs the source of income derived 
from international communications activity.
    On January 17, 2001, the Treasury Department and the IRS published 
a notice of proposed rulemaking (REG-106030-98) in the Federal Register 
(66 FR 3903) under section 863(a), (b), (d), and (e) (the 2001 proposed 
regulations). The 2001 proposed regulations provide two sets of rules, 
one in Sec.  1.863-8 for determining the source of income from space 
and ocean activities (space and ocean income), the other in Sec.  
1.863-9 for determining the source of income from communications 
activity (communications income).
    The IRS received numerous written comments on the 2001 proposed 
regulations and held a public hearing on May 23, 2001. Since that time, 
the aerospace, telecommunications, and related industries have 
experienced substantial technological evolution and significant 
business change and consolidation. In addition, the American Jobs 
Creation Act of 2004, Public Law 108-357, (AJCA) enacted a number of 
materially relevant statutory changes that affect the treatment of 
space and ocean income for purposes of the foreign tax credit and 
subpart F. In light of the extensive written comments, industry 
evolution, and AJCA changes, the Treasury Department and the IRS 
believe it is appropriate to repropose these regulations to provide a 
further opportunity for comment. Accordingly, this document withdraws 
the 2001 proposed regulations and provides new proposed regulations, 
which are referred to herein as the reproposed regulations.

Explanation of Provisions

A. Space and Ocean Activity Under Section 863(d)

1. Space and Ocean Income
    Section 863(d)(2)(A)(i) defines space activity to include any 
activity conducted in space. Section 863(d)(2)(A)(ii) defines ocean 
activity to include any activity conducted on or under water not within 
the jurisdiction (as recognized by the United States) of a foreign 
country, possession of the United States, or the United States. Section 
863(d)(2)(B) excludes three specific types of activities from the 
definition of space or ocean activity. Section 863(d)(1) generally 
provides that, except as provided in regulations, any income derived 
from a space or ocean activity (space and ocean income) is U.S. source 
income if derived by a U.S. person and foreign source income if derived 
by a foreign person.
    Pursuant to the statute's grant of regulatory authority, the 
reproposed regulations provide that a U.S. person's space and ocean 
income will be sourced outside the United States to the extent the 
income, based on all the facts and circumstances, is attributable to 
functions performed, resources employed, or risks assumed in a foreign 
country or countries. This approach to allocation of space and ocean 
income between U.S. and foreign sources is pursuant to broad regulatory 
authority in section 863(d). The reproposed regulations also contain 
certain exceptions to the general foreign source rule for space and 
ocean income of foreign persons.
2. Space and Ocean Income of U.S.-Owned Foreign Corporation
    Section 1.863-8(b)(2) of the 2001 proposed regulations provides 
that if U.S. persons own 50 percent or more of a foreign corporation by 
vote or value (directly, indirectly, or constructively) and such 
corporation is not a controlled foreign corporation within the meaning 
of section 957 (CFC), all space and ocean income derived by the 
corporation (hereinafter a U.S.-owned foreign corporation) is U.S. 
source income.
    Several commentators requested that Sec.  1.863-8(b)(2) of the 2001 
proposed regulations be withdrawn. Commentators stated that the rule 
expanded the scope of U.S. taxing jurisdiction beyond the apparent 
intent of Congress by subjecting income not covered by subpart F to 
immediate U.S. taxation. Several commentators also stated that under 
the rule space and ocean income could in some cases be subject to 
multiple levels of taxation. In this regard, some commentators noted 
that the space and ocean income of a U.S.-owned foreign corporation 
could be subject to potential double taxation at the corporate level 
(by the United States and by the U.S.-owned foreign corporation's 
country of residence or the countries where such corporation does 
business) because Sec.  1.863-8(b)(2) of the 2001 proposed regulations 
makes such space and ocean income U.S. source. When the U.S.-owned 
foreign corporation's space and ocean income is distributed as a 
dividend, that income could be subject to an additional level of tax in 
the hands of its shareholders. Consequently, some commentators 
suggested that, if the rule were retained, the space and ocean income 
of U.S.-owned foreign corporations should be considered U.S. source 
solely for purposes of the U.S. shareholder's foreign tax credit 
limitation under section 904(a). Some commentators noted that although 
section 245 may partially ameliorate this situation by providing a 
dividends received deduction (DRD) to shareholders of foreign 
corporations in certain circumstances, the DRD would be limited to 80 
percent of qualifying dividends.
    Some commentators also noted potential withholding tax issues with 
the source rules for U.S.-owned foreign corporations. In such cases, 
U.S. source fixed or determinable annual or periodic income (FDAP) of a 
U.S.-owned foreign corporation would (in the absence of an applicable 
treaty) likely be subject to the 30-percent gross income tax imposed by 
section 881, which is typically collected through withholding by the 
payors of such income. Commentators stated that enforcement and 
administration of the 30-percent tax and withholding requirements could 
present multiple challenges (and potential multiple withholding tax 
obligations) for payments between foreign persons.
    Several commentators addressed the stock ownership test applicable 
to U.S.-owned foreign corporations. They stated that determining 
whether a foreign corporation is 50-percent U.S.-owned, especially 
without regard to the size of an owner's holding, presents potential 
difficulties (for example, when the foreign corporation is widely-
held). Some commentators stated that the indirect and constructive 
ownership rules are complex and would make it difficult for payors of 
space and ocean income to determine withholding tax obligations. Some 
commentators suggested that if the rule were retained, the 
determination whether a foreign corporation is 50-percent U.S.-owned

[[Page 54861]]

should be similar to the determination of CFC status, that is, only 
U.S. persons who own or are considered to own 10 percent or more of the 
total combined voting power of all classes of stock entitled to vote 
should be counted. Some commentators stated that the rule should not 
apply to publicly-traded foreign corporations.
    In light of the potential complexity in determining whether a 
foreign corporation is a U.S.-owned foreign corporation and the belief 
of the Treasury Department and the IRS that space and ocean income 
earned by foreign corporations should be sourced in accord with the 
rules for foreign persons, with the limited exception for certain CFCs 
discussed below, the reproposed regulations do not include a special 
source rule for space and ocean income earned by a U.S.-owned foreign 
corporation. Instead, the space and ocean income of foreign 
corporations (other than CFCs) is sourced under the applicable 
provisions of reproposed Sec.  1.863-8(b)(2)(i) or (iii). Under these 
provisions, space and ocean income of a foreign person is generally 
foreign source income. Space and ocean income of a foreign person 
(other than a CFC) that is engaged in trade or business within the 
United States is U.S. source income to the extent the income, based on 
all the facts and circumstances, is attributable to functions 
performed, resources employed, or risks assumed within the United 
States.
3. Space and Ocean Income of CFCs
    In enacting section 863(d), Congress ultimately did not adopt a 
provision included in early versions of the legislation that would have 
treated a CFC as a U.S. person for purposes of determining the source 
of a CFC's space and ocean income. The legislative history to the 1986 
Act indicates that Congress at that time viewed the provision as 
unnecessary because ``[t]he application of the separate foreign tax 
credit limitation for shipping income to any space or ocean income 
derived by a [CFC] provides adequate assurance, in the conferee's view, 
that high foreign taxes on unrelated income will not inappropriately 
offset U.S. taxes on this generally low-taxed income.'' H.R. Conf. Rep. 
No. 99-841, 99th Cong., 2d Sess., Vol. II, at II-600 (Sept. 18, 1986); 
see also Staff of Joint Comm. on Taxation, General Explanation of the 
Tax Reform Act of 1986, JCS-10-87, at 934 (May 4, 1987). Consequently, 
the 2001 proposed regulations also did not contain such a rule and only 
treated a U.S.-owned foreign corporation as a U.S. person for purposes 
of determining the source of space and ocean income.
    In 2004, AJCA enacted a number of significant statutory changes to 
subpart F and the foreign tax credit regimes as applicable to space and 
ocean income. These statutory changes have been taken into account in 
issuing the reproposed regulations.
    Section 415 of AJCA eliminated foreign base company shipping income 
from the definition of foreign base company income. This change is 
effective for taxable years of foreign corporations beginning after 
December 31, 2004, and for taxable years with or within which such 
taxable years of foreign corporations end. Prior to AJCA, foreign base 
company shipping income was defined by section 954(f) to include any 
income derived from a space or ocean activity as defined in section 
863(d)(2).
    In addition, section 404 of AJCA reduced the number of foreign tax 
credit limitation categories from nine to two (i.e., passive category 
income and general category income) in order to address Congressional 
concerns regarding the complexity of the foreign tax credit 
calculation. See H.R. Rep. No 108-548, 108th Cong., 2d Sess., at 190 
(June 16, 2004). This change is effective for taxable years beginning 
after December 31, 2006. Prior to AJCA, section 904(d) treated shipping 
income, defined as income ``which would be foreign base company 
shipping income (as defined in section 954(f)),'' as a separate 
category of income for foreign tax credit limitation purposes. For 
taxable years beginning after December 31, 2006, space and ocean income 
will generally fall into the general limitation category. See H.R. 
Conf. Rep. No. 108-755, 108th Cong., 2d Sess., at 383 (Oct. 7, 2004).
    The Treasury Department and the IRS believe that the changes made 
by AJCA with respect to the foreign tax credit reflect a decision to 
reduce the complexity in the foreign tax credit calculation caused by 
having nine foreign tax credit categories of income as well as a 
willingness to allow additional cross-crediting in order to minimize 
such complexity. However, the Treasury Department and the IRS also 
believe that for taxable years beginning after December 31, 2006, 
Congress's concern expressed in the 1986 Act that high foreign taxes on 
unrelated income may inappropriately offset U.S. taxes on space and 
ocean income, which is generally subject to low foreign taxes, is no 
longer addressed by the foreign tax credit rules because space and 
ocean income likely will be general limitation category income. In 
addition, Congress provided a broad grant of regulatory authority to 
the Treasury Department and the IRS in section 863(d) to issue guidance 
with respect to the source of space and ocean income.
    In light of AJCA, the reproposed regulations provide that if a 
foreign corporation is a CFC, its space and ocean income, like that of 
a U.S. person, is income from sources within the United States. 
However, a CFC's space and ocean income is sourced outside the United 
States to the extent the income, based on all the facts and 
circumstances, is attributable to functions performed, resources 
employed, or risks assumed in a foreign country or countries. This 
allocation approach is pursuant to broad regulatory authority under 
section 863(d).
    As noted above, several commentators stated that under the rule for 
U.S.-owned foreign corporations in the 2001 proposed regulations, space 
and ocean income could in some cases be subject to multiple levels of 
taxation. The Treasury Department and the IRS believe that the 
reproposed regulations mitigate such a possibility for CFCs because the 
reproposed regulations provide for foreign sourcing when a CFC's space 
and ocean income is attributable to functions performed, resources 
employed, or risks assumed in a foreign country or countries. The rule 
for CFCs in the reproposed regulations is thus a rule of limited 
application that, consistent with the legislative history of the 1986 
Act, provides U.S. source treatment only with respect to space and 
ocean income attributable to activities in space or international water 
that are not likely to be subject to tax in any foreign country. The 
rule for CFCs will permit a United States shareholder to establish as 
foreign source the amount of income attributable to the CFC's 
operations in a foreign country or countries.
    Several commentators submitted comments on potential withholding 
tax issues posed by the 2001 proposed regulations. The Treasury 
Department and the IRS recognize that certain provisions of the 
reproposed regulations (such as the source rule for the space and ocean 
income of CFCs in reproposed Sec.  1.863-8(b)(2)(ii)) may raise similar 
withholding tax issues. The Treasury Department and the IRS accordingly 
seek comments on these issues, in particular with regard to the 
following: (1) The extent to which Form W-8ECI, ``Certificate of 
Foreign Person's Claim for Exemption From Withholding on Income 
Effectively Connected With the Conduct of a Trade or Business in the 
United States'', may practically address these issues; (2) the nature 
of

[[Page 54862]]

situations in which withholding tax issues will arise (for example, how 
particular businesses involving space, ocean, or communications 
activities are conducted, whether payors of income potentially subject 
to withholding under the reproposed regulations are typically related 
or unrelated parties, etc.); and (3) suggestions to address these 
issues in the cases in which they arise.
4. Space and Ocean Income of a Foreign Person Engaged in a Trade or 
Business Within the United States
    Section 1.863-3(b)(3) of the 2001 proposed regulations provides 
that if a foreign person is engaged in a trade or business within the 
United States, the foreign person's income derived from a space or 
ocean activity is presumed to be U.S. source income. The rule reflects 
the general view of the Treasury Department and the IRS that Congress 
intended that a foreign person engaged in a substantial business within 
the United States be subject to U.S. tax on related space or ocean 
income. However, the Treasury Department and the IRS recognize that the 
presumption may be over-inclusive in certain cases. Therefore, the 2001 
proposed regulations provide that if the foreign person can allocate 
gross space or ocean income between income from sources within the 
United States, space, or international water, and sources without the 
United States, space, and international water, to the satisfaction of 
the Commissioner, based on all the facts and circumstances, income 
allocated to sources without the United States, space, and 
international water will be treated as foreign source income.
    Several commentators stated that the presumption is overbroad, 
given that it applies to all space and ocean income regardless of any 
nexus with the foreign corporation's U.S. trade or business. Several 
commentators suggested that if the presumption were retained, objective 
standards consistent with existing rules for effectively connected 
income should be included to ensure that the space and ocean income has 
a meaningful connection with the foreign corporation's U.S. trade or 
business. In the absence of objective standards, commentators stated 
that taxpayers should be permitted to apply a reasonable allocation 
method on a consistent basis to all of their space and ocean income. In 
addition, as with Sec.  1.863-8(b)(2) of the 2001 proposed regulations, 
several commentators stated that under Sec.  1.863-8(b)(3) of the 2001 
proposed regulations space and ocean income could in some cases be 
subject to multiple levels of taxation.
    In response to these comments, the reproposed regulations provide 
that if a foreign person, other than a CFC, is engaged in a trade or 
business within the United States, its space or ocean income is from 
sources within the United States to the extent the income, based on all 
the facts and circumstances, is attributable to functions performed, 
resources employed, or risks assumed within the United States.
    The Treasury Department and the IRS believe that the revision in 
reproposed Sec.  1.863-8(b)(2)(iii) providing that space or ocean 
income will be U.S. source income to the extent the space or ocean 
income is attributable to functions performed, resources employed, or 
risks assumed in the United States should mitigate commentators' 
concerns about potential multiple levels of taxation.
    Examples 12 and 13 in Sec.  1.863-8(f) of the 2001 proposed 
regulations illustrate the application of Sec.  1.863-8(b)(3) of those 
regulations to foreign persons that conduct certain activities in the 
United States. One commentator noted that these examples appear to 
state that engaging in certain activities would constitute the conduct 
of a trade or business in the United States. In response to this 
comment, Examples 12 and 13 have been clarified in the reproposed 
regulations to state that they assume, on the facts of the example, 
that the activities constitute the conduct of a trade or business 
within the United States within the meaning of section 864(b). The 
Treasury Department and the IRS intend that the determination whether a 
foreign person is engaged in a trade or business in the United States 
continue to be made under general section 864(b) principles.
5. Source Rules for Sales of Property in Space or International Water
    The 2001 proposed regulations provide generally that taxpayers must 
apply the rules of section 863(d) and the 2001 proposed regulations to 
determine the source of income from sales of property purchased or 
produced by the taxpayer, either when production occurs in whole or in 
part in space or international water, or when the sale occurs in space 
or international water. Under the 2001 proposed regulations, income 
from sales of inventory property (within the meaning of section 
1221(a)(1)) on international water is sourced under Sec.  1.863-
3(c)(2). Section 1.863-3(c)(2), as amended by the 2001 proposed 
regulations, provides that the place of sale will be presumed to be the 
United States when property is produced in the United States and the 
property is sold to a U.S. resident for use in space or international 
water; in such cases, the property will be treated as sold for use, 
consumption, or disposition in the United States.
    Section 1.863-8(d)(1)(i) of the 2001 proposed regulations defines 
space activity to include the sale of property in space. Section 1.863-
8(d)(1)(ii) of the 2001 proposed regulations defines ocean activity to 
include the sale of property in international water, but not the sale 
of inventory property on international water. Under Sec.  1.863-
8(d)(2)(iii) of the 2001 proposed regulations, a sale occurs in space 
or international water if the property is located in space or 
international water at the time the rights, title, and interest of the 
seller in the property are transferred to the purchaser, or if the 
property is sold for use in space or international water.
    For sales in space or international water of property produced by 
the taxpayer, Sec.  1.863-8(b)(4)(ii)(A) of the 2001 proposed 
regulations generally provides that the source of income attributable 
to sales activity is determined under Sec.  1.863-8(b)(1), (2), or (3) 
of the 2001 proposed regulations. If, however, the taxpayer sells such 
property outside space and international water, the source of income 
attributable to sales activity is determined under Sec.  1.863-3(c)(2).
    Commentators stated that the inclusion of sales of inventory 
property in space or international water in the definitions of space 
and ocean activity is inconsistent with the legislative history of the 
1986 Act, which indicates that the Senate Committee on Finance did not 
intend sales of inventory property on the high seas to be considered 
space or ocean activity. See S. Rep. No. 99-313, at 359.
    In response to comments, the reproposed regulations provide that 
sales of inventory property in space or international water will be 
considered space or ocean activity only if the inventory property is 
sold for use, consumption, or disposition in space or international 
water. In such cases, the source of income will be determined under the 
source rules provided for space and ocean income by the reproposed 
regulations. The source of income from sales in space or international 
water of inventory property when the inventory property is sold for 
use, consumption, or disposition outside space and international water 
will be determined under Sec. Sec.  1.861-7(c) and 1.863-3(c)(2). The 
Treasury Department and the IRS believe that sales of property in space 
or international water--with the exception of sales of inventory 
property in space

[[Page 54863]]

or international water for use, consumption, or disposition outside 
space or international water--should be considered space or ocean 
activity, and that the source of income from such sales should be 
determined under section 863(d). The Treasury Department and the IRS 
believe that this result is consistent with both the statute and the 
legislative history. The statute provides that space or ocean activity 
includes any activity in space or international water. However, the 
Senate Report states that the Senate Committee on Finance did not 
intend to override the general source rule in Sec.  1.861-7(c) for 
sales of property on the high seas. See S. Rep. No. 99-313, at 359. 
Thus, sales of inventory property in transit between the United States 
and a foreign country will continue to be sourced under sections 861 
through 865, and not section 863(d).
    The reproposed regulations do not contain the presumption in Sec.  
1.863-3(c)(2) of the 2001 proposed regulations regarding sales of 
property produced by the taxpayer in the United States to U.S. 
residents for use in space or international water. Under the reproposed 
regulations, if such sales occur in space or international water, the 
source of income attributable to sales activity will be determined 
under reproposed Sec.  1.863-8(b)(3)(ii)(D).
6. Special Rule for Determining the Source of Income From Services
    Section 1.863-8(b)(5) of the 2001 proposed regulations provides 
that income derived from the performance of services in space or 
international water is sourced under Sec.  1.863-8(b)(1), (2), or (3) 
of the 2001 proposed regulations, as applicable. Section 1.863-
8(d)(2)(ii)(A) of the 2001 proposed regulations contains a general rule 
providing that the performance of a service is a space or ocean 
activity in its entirety when a part of the service, even if de 
minimis, is performed in space or international water.
    The Treasury Department and the IRS recognized that this rule could 
be over-inclusive in certain cases. Therefore, Sec.  1.863-
8(d)(2)(ii)(A) of the 2001 proposed regulations provides a facilitation 
exception, under which a service will not be treated as either space or 
ocean activity if the taxpayer's only activity in space or 
international water is to facilitate the taxpayer's own communications 
as part of the provision or delivery of a service provided by the 
taxpayer, and the service would not otherwise be a space or ocean 
activity. Section 1.863-8(b)(5) of the 2001 proposed regulations also 
provides that if the taxpayer can allocate, to the satisfaction of the 
Commissioner, gross income from the services transaction between 
performance occurring outside space and international water, and 
performance occurring in space or international water, the source of 
income allocated to performance occurring outside space and 
international water will be determined under sections 861, 862, 863, 
and 865.
    Several commentators commented unfavorably on a rule that 
characterizes an entire services transaction as space or ocean activity 
when only de minimis performance occurs in space or international 
water. Several commentators noted that even though Sec.  1.863-8(b)(5) 
of the 2001 proposed regulations permits a taxpayer to source services 
income to sources outside space or international water, the entire 
transaction continues to be characterized as space or ocean activity, 
and all income derived from the services transaction is thus included 
in the separate subpart F and foreign tax credit limitation category 
for shipping income. Some commentators stated that under the 2001 
proposed regulations significant consequences result from 
characterization as a services transaction, even though the 
characterization rules are themselves unclear. Some commentators also 
stated that the facilitation exception to space or ocean activity 
characterization is confusing, and that the example intended to 
illustrate the application of the facilitation exception (Example 4 in 
Sec.  1.863-8(f) of the 2001 proposed regulations) is itself unclear.
    As noted above, subsequent to the publication of the 2001 proposed 
regulations, AJCA amended the subpart F rules relating to space and 
ocean income by eliminating shipping income as a category of subpart F 
income and reduced the number of foreign tax credit limitation 
categories from nine to two (with space and ocean income generally 
falling into the general limitation category) for taxable years 
beginning after December 31, 2006. The Treasury Department and the IRS 
believe that these statutory changes should allay commentators' 
concerns regarding the characterization of a services transaction as 
space or ocean activity. In addition, as discussed below, the 
reproposed regulations provide that if the taxpayer can demonstrate the 
value of the service attributable to performance in space or 
international water and the value of the service attributable to 
performance outside space and international water, then the service 
will be treated as a space or ocean activity only to the extent of the 
activity performed in space or international water. The value of the 
service is attributable to performance occurring in space or 
international water to the extent the performance of services, based on 
all the facts and circumstances, is attributable to functions 
performed, resources employed, or risks assumed in space or 
international water.
    Based on the comments, the reproposed regulations eliminate the 
facilitation exception. Under reproposed Sec.  1.863-8(d)(2)(ii), to 
the extent, based on all the facts and circumstances, the value of the 
service attributable to functions performed, resources employed, or 
risks assumed in space or international water is de minimis, such 
service is not treated as space or ocean activity. The adoption of the 
de minimis rule is intended to address taxpayer concerns about 
potential confusion in qualifying for the facilitation exception. 
Example 4 of reproposed Sec.  1.863-8(f) has been revised accordingly.
    The rule for determining the source of income from performance of 
services that occur in part in space or international water and in part 
outside space and international water has been adapted to conform to 
the changes made to reproposed Sec.  1.863-8(d)(2)(ii). To the extent a 
service is characterized as space or ocean activity under reproposed 
Sec.  1.863-8(d)(2)(ii), the source of gross income derived from such 
transaction is determined under reproposed Sec.  1.863-8(b)(1) or (2), 
as applicable, as provided by reproposed Sec.  1.863-8(b)(4). 
Accordingly, to the extent the value of the service, based on all the 
facts and circumstances, is attributable to functions performed, 
resources employed, or risks assumed outside space and international 
water, the service will not constitute space or ocean activity, and, to 
that extent, the source of income from the service will be determined 
under section 861, 862, or 863, as applicable.
7. Definition of Space and Ocean Activity
a. Foreign Communications Activity as Space or Ocean Activity
    Section 1.863-8(b)(6) of the 2001 proposed regulations provides 
that space and ocean activity include communications activity (but not 
international communications activity) occurring in space or 
international water. Foreign communications activity is thus 
characterized under the 2001 proposed regulations as space or ocean 
activity when, for example, part of the transmission is via satellite 
or via underwater cable located in international water.

[[Page 54864]]

    Commentators requested that the regulations characterize income 
from foreign-to-foreign communications as international communications 
income, which is specifically excluded from the definition of space and 
ocean activity by section 863(d)(2)(B) and Sec.  1.863-8(d)(3) of the 
2001 proposed regulations, but retain the 100 percent foreign source 
rule otherwise provided for foreign communications income by Sec.  
1.863-9(b)(4) of the 2001 proposed regulations. International 
communications income is defined by section 863(e)(2) as income derived 
from the transmission of communications between the United States and a 
foreign country (or possession of the United States) and is discussed 
in greater detail below.
    Commentators noted that this rule puts telecommunications companies 
using satellite or underwater cable methods of transmission at a 
competitive disadvantage vis-[aacute]-vis competitors in foreign 
marketplaces that use solely land-based facilities. For example, if a 
CFC were paid to transmit a telephone call between two foreign 
countries and used a land line connecting the two countries to transmit 
the call, the CFC's income from the transmission would be included in 
the general limitation category for foreign tax credit purposes. If the 
communication were transmitted using fiber optic cable located in 
international water or a satellite, the CFC's income from the 
transmission would be foreign source space or ocean income included in 
the separate subpart F and foreign tax credit limitation category for 
shipping income.
    The reproposed regulations do not characterize income from foreign-
to-foreign communications as international communications income as 
suggested by commentators. Section 863(d)(2)(A) broadly defines space 
and ocean activity as any activity conducted in space or international 
water. The statutory exception to space and ocean activity in section 
863(d)(2)(B) removes only activities giving rise to international 
communications income from the scope of space and ocean activity. In 
addition, if foreign-to-foreign communications income were 
characterized as international communications income, U.S. persons with 
such income would be subject to the statutory source rule in section 
863(e)(1)(A), which provides for the split-sourcing of a U.S. person's 
international communications income. The Treasury Department and the 
IRS thus consider the language of the statute to preclude the approach 
suggested by commentators with respect to the characterization and 
sourcing of income from foreign-to-foreign communications. The 
legislative history of the 1986 Act also indicates that Congress 
intended income from foreign-to-foreign communications to be foreign 
source income. See S. Rep. No. 99-313, at 359, ``Finally, if the 
communication is between two foreign locations, the committee intends 
income attributable thereto to be foreign source.''. This would not be 
the result, however, if foreign-to-foreign communications income were 
included in the definition of international communications income and 
thus subject to the statute's 50/50 source rule for U.S. persons.
    In addition, as noted above, AJCA made significant changes to 
subpart F and the foreign tax credit regime as applicable to space and 
ocean income. The Treasury Department and the IRS believe that these 
statutory changes should allay commentators' concerns regarding the 
characterization of foreign-to-foreign communications as space or ocean 
activity.
    The Treasury Department and the IRS believe that the modifications 
in the reproposed regulations with respect to the characterization of 
services involving space or ocean activities address some of the 
commentators' concerns regarding the characterization of foreign-to-
foreign communications activities involving services performed both in 
space or international water and in foreign countries. Reproposed Sec.  
1.863-8(d)(2)(ii) provides that a transaction characterized as the 
performance of a service will be treated as a space or ocean activity 
only to the extent the value of the service, based on all the facts and 
circumstances, is attributable to functions performed, resources 
employed, or risks assumed in space or international water.
b. Definition of Space
    Section 1.863-8(d)(1)(i) of the 2001 proposed regulations defines 
space as any area not within the jurisdiction (as recognized by the 
United States) of a foreign country, possession of the United States, 
or the United States, and not in international water. Under the 2001 
proposed regulations, space comprises the entire area outside the 
jurisdiction of any country or U.S. possession, extending from just 
above the surface of international water (and Antarctica) through, and 
beyond, the earth's atmosphere. Space thus includes international 
airspace.
    Several commentators stated that the definition of space should be 
limited to the area beyond the earth's atmosphere. One commentator 
proposed a definition of space that conforms to a definition used for 
non-tax purposes (for example, beyond the maximum altitude at which 
powered flight by aircraft equipped with air-breathing engines is 
possible). Another commentator stated that the definition of space 
could be read to include cyberspace, the electronic medium in which 
online communication takes place, and suggested that cyberspace be 
specifically excluded from the definition of space. One commentator 
noted language in the legislative history stating that space activities 
had not been very prevalent at the time of the 1986 Act (see, for 
example, S. Rep. No. 99-313, at 358) and argued that Congress did not 
intend to include international airspace in space.
    No changes were made to the reproposed regulations in response to 
these comments. The Treasury Department and the IRS believe a broad 
definition of space that includes international airspace is consistent 
with legislative intent to assert primary tax jurisdiction over income 
earned by U.S. residents that is not within any foreign country's 
taxing jurisdiction. See, e.g., S. Rep. No. 99-313, at 357. The 
Treasury Department and the IRS also believe that providing guidance 
with respect to the place of performance of activities involving online 
communications is beyond the scope of the present regulations, and that 
taxpayers should rely on generally applicable principles to determine 
where functions are performed, resources are employed, or risks are 
assumed in a specific online transaction.
c. Transportation Income
    Certain activities occurring in space or international water are 
not considered either space or ocean activity. Section 1.863-8(d)(3)(i) 
of the 2001 proposed regulations, consistent with section 863(d), 
provides that space or ocean activity does not include any activity 
that gives rise to transportation income as defined in section 863(c).
    One commentator stated that a portion of a bareboat charter--the 
return of an empty vessel that has unloaded its cargo (backhaul)--may 
potentially be considered ocean activity under the 2001 proposed 
regulations. Another commentator stated that income from container 
leasing by a party other than the ship operator could constitute space 
or ocean income, and could be subject to withholding tax. One 
commentator also suggested that the regulations should state that they 
do not apply to the income of foreign corporations derived from the 
international operation of ships, or to container leasing.
    The reproposed regulations do not adopt changes to reflect these

[[Page 54865]]

comments. The reproposed regulations reflect the broad statutory 
definition of ocean activity in section 863(d)(2) as ``any activity 
conducted on or under water not within the jurisdiction (as recognized 
by the United States) of a foreign country, possession of the United 
States, or the United States.'' The Treasury Department and the IRS do 
not consider it appropriate to construe the definition of section 
863(c) transportation income in the context of these regulations. The 
Treasury Department and the IRS will consider addressing the definition 
of section 863(c) transportation income in separate guidance.
8. Treatment of Partnerships
    Section 1.863-8(e) of the 2001 proposed regulations generally 
provides that section 863(d) and the regulations thereunder will be 
applied to domestic partnerships at the partnership level and to 
foreign partnerships at the partner level. Commentators suggested that 
the source rules of Sec.  1.863-8 of the 2001 proposed regulations be 
applied to all partnerships either at the entity level or at the 
partner level.
    The Treasury Department and the IRS believe that section 863(d) 
should be applied to domestic and foreign partnerships in the same 
manner. Accordingly, the reproposed regulations do not provide a 
different rule for foreign partnerships and domestic partnerships. 
Section 1.863-8(e) of the reproposed regulations provides that section 
863(d) and the regulations thereunder will be applied to domestic 
partnerships at the partner level. In order to conform the treatment of 
domestic and foreign partnerships, no change was made with respect to 
the rule in the 2001 proposed regulations that section 863(d) and the 
regulations thereunder will be applied to foreign partnerships at the 
partner level.
9. Allocations
    When a taxpayer must allocate gross income to the satisfaction of 
the Commissioner, based on all the facts and circumstances, under the 
provisions of the 2001 proposed regulations, the Treasury Department 
and the IRS believe such allocations generally should be based on 
section 482 principles.
    Several commentators stated that allocation of gross income based 
on section 482 principles will be burdensome and expensive and will 
create uncertainty. Commentators also noted that the 2001 proposed 
regulations provide no guidance on allocating income other than a facts 
and circumstances approach.
    The Treasury Department and the IRS consider the allocation of 
gross income based on the general guidance of section 482 to be an 
approach that is well-suited to application in the wide variety of 
factual contexts within the scope of the reproposed regulations. The 
Treasury Department and the IRS solicit comments on alternative methods 
of allocation for particular industries and criteria that could be used 
to evaluate the reasonableness of such methods.
10. Reporting and Documentation Requirements
    In order to satisfy the Commissioner with respect to a taxpayer's 
allocation of gross income under Sec.  1.863-8(b)(3), (b)(4)(ii)(C), or 
(b)(5) of the 2001 proposed regulations, the taxpayer must make the 
allocation on a timely filed original return (including extensions). An 
amended return does not qualify for this purpose, and section 9100 
relief will not be available. In all cases, a taxpayer must also 
maintain contemporaneous documentation regarding the allocation of 
gross income, allocation and apportionment of expenses, losses, and 
other deductions, the methodologies used, and the circumstances 
justifying use of those methodologies. The taxpayer must produce such 
documentation within 30 days upon request.
    Commentators stated that neither the statute nor the legislative 
history provides a basis for the reporting, recordkeeping, and 
contemporaneous documentation requirements in the 2001 proposed 
regulations. Commentators also noted that the Code and regulations do 
not contain similar requirements with respect to certain other expense 
allocation provisions.
    The reproposed regulations generally retain the recordkeeping and 
documentation requirements. The Treasury Department and the IRS believe 
that it is appropriate to require taxpayers to keep proper records, and 
additionally note the potentially considerable difficulties the IRS 
would face in performing the allocations required by the reproposed 
regulations without appropriate taxpayer records.
    The Treasury Department and the IRS recognize, however, that 
taxpayers may not have all the information necessary to make 
allocations at the time a return is originally filed. The reproposed 
regulations therefore provide that a taxpayer may make changes to 
allocations made on the taxpayer's original return with respect to any 
taxable year for which the statute of limitations has not closed, 
subject to certain conditions. Nonetheless, changes to such allocations 
that are not made until an audit of the taxable year to which the 
allocations relate has commenced, or a taxpayer's failure timely to 
provide documentation and other information supporting the allocations, 
create administrative difficulties for the IRS. Accordingly, reproposed 
Sec.  1.863-8(g)(4) sets forth the actions required of taxpayers and 
the procedures the IRS will follow in the case of taxpayers that change 
their allocations.
    The reproposed regulations also require taxpayers, upon request, to 
provide access to the software programs and other systems used by the 
taxpayer to make allocations under these regulations. For this purpose, 
software has the meaning provided in section 7612(d). The Treasury 
Department and the IRS believe that the IRS could face significant 
administrative and other difficulties in the examination of allocations 
made under these regulations without access to such software.
11. Examples
    Certain examples in Sec.  1.863-8(f) of the 2001 proposed 
regulations contain statements regarding the characterization of 
certain activities (as, for example, the lease of equipment or the 
performance of services). One commentator suggested that the examples 
clarify that the character of the transactions at issue is only assumed 
for purposes of the specific example. In response to this comment, the 
examples in reproposed Sec.  1.863-8(f) have been revised to make clear 
that the characterization of certain transactions is assumed based on 
the facts of the specific example. The Treasury Department and the IRS 
did not consider it necessary to modify certain other examples (for 
example, Example 1 of reproposed Sec.  1.863-8(f)) in which the 
character of the transaction at issue should be clear under the facts 
presented.
    In addition, Examples 2, 3, 4, and 7 of reproposed Sec.  1.863-
8(f), have been revised to reflect substantive changes made to 
reproposed Sec.  1.863-8(b)(4) and (d)(2)(ii) with respect to services 
that involve activities performed in space or international water.

B. Communications Activity Under Section 863(a), (d), and (e)

1. International Communications Income
    International communications income is defined by section 863(e)(2) 
as income derived from the transmission of communications between the 
United States and a foreign country (or

[[Page 54866]]

possession of the United States). Section 863(e)(1)(A) provides that in 
the case of any U.S. person, 50 percent of any international 
communications income will be sourced in the United States and 50 
percent of such income will be sourced outside the United States. 
Section 863(e)(1)(B)(i) provides that any international communications 
income of a foreign person will be foreign source income except as 
provided in regulations or in section 863(e)(1)(B)(ii). Section 1.863-
9(b)(2)(ii)(A) of the 2001 proposed regulations states the general rule 
that international communications income of a foreign person is foreign 
source income. However, the 2001 proposed regulations contain certain 
exceptions to the general rule.
2. International Communications Income of 50-Percent or More U.S.-Owned 
Foreign Corporations
    The first exception, in Sec.  1.863-9(b)(2)(ii)(B) of the 2001 
proposed regulations, provides that if U.S. persons own 50 percent or 
more of a foreign corporation by vote or value (directly, indirectly, 
or constructively), including a CFC within the meaning of section 957, 
international communications income derived by that corporation is 
entirely U.S. source income.
    As with the similar rule provided for the space and ocean income of 
U.S.-owned foreign corporations in Sec.  1.863-8(b)(2) of the 2001 
proposed regulations, several commentators requested that the rule be 
withdrawn because it expands the scope of U.S. taxing jurisdiction 
beyond the apparent intent of Congress. Commentators stated that the 
rule is punitive in nature because it is less favorable than the 50/50 
source rule applied to international communications income earned 
directly by U.S. persons. As with Sec.  1.863-8(b)(2) and (3) of the 
2001 proposed regulations, commentators also stated that under the rule 
the international communications income of certain foreign corporations 
may be subject to multiple levels of taxation.
    Commentators noted that in certain circumstances international 
communications income could be subject to the 30-percent gross income 
tax imposed by section 881, which is typically collected through 
withholding by the payors of such income. Commentators stated that 
although most tax treaties should prevent the imposition of the 30-
percent tax (international communications income would likely be 
characterized as business profits under most treaties and would 
accordingly be exempt from U.S. taxation unless attributable to a 
permanent establishment in the United States), the rule in the 2001 
proposed regulations would result in disparate treatment for 
corporations from treaty countries vis-[agrave]-vis corporations from 
non-treaty countries. The requirement to withhold the 30-percent tax 
could also create numerous administrative and enforcement difficulties. 
In addition, given the extent of resale of capacity between 
telecommunications providers, commentators noted that payments relating 
to the same transmission could be subject to multiple withholding. 
Finally, as with the similar rule provided for the space and ocean 
income of U.S.-owned foreign corporations in Sec.  1.863-8(b)(2) of the 
2001 proposed regulations, commentators raised the issue of potential 
difficulties in determining whether a foreign corporation is 50-percent 
or more U.S.-owned.
    As noted above, several commentators addressed the stock ownership 
test applicable to U.S.-owned foreign corporations. They stated that 
determining whether a foreign corporation is 50-percent U.S. owned, 
especially without regard to the size of an owner's holding, presents 
potential difficulties (for example, when the foreign corporation is 
widely-held).
    In light of the potential complexity in determining whether a 
foreign corporation is a U.S.-owned foreign corporation and the belief 
of the Treasury Department and the IRS that international 
communications income earned by foreign corporations should be sourced 
in accord with the rules for foreign persons, with the limited 
exception for CFCs discussed below, the reproposed regulations do not 
include a special source rule for international communications income 
earned by a 50 percent or more U.S.-owned foreign corporation. Instead, 
the international communications income of foreign corporations (other 
than CFCs) is sourced under the applicable provisions of reproposed 
Sec.  1.863-9(b)(2)(i), (iii), and (iv).
3. International Communications Income of CFCs
    In light of the comments with respect to CFCs described above, the 
reproposed regulations provide that in the case of a CFC, 50 percent of 
any international communications income will be sourced in the United 
States and 50 percent of such income will be sourced outside the United 
States. The 100-percent U.S. source rule is eliminated. Consequently, 
the source rule for international communications income in the hands of 
a CFC is the same rule that applies to U.S. persons. In both cases, the 
source rules take into account that international communications 
activities must have both a U.S. and a foreign connection (i.e., one 
endpoint in the United States and the other in a foreign country or 
possession of the United States). The Treasury Department and the IRS 
believe that the revision of the source rule for CFCs deriving 
international communications income should mitigate commentators' 
concerns about potential multiple levels of taxation because 50 percent 
of this income is foreign source.
    The Treasury Department and the IRS recognize that this and other 
provisions of reproposed Sec.  1.863-9 may raise withholding tax issues 
similar to those discussed above in connection with the source rule for 
the space and ocean income of CFCs (in reproposed Sec.  1.863-
8(b)(2)(ii)). As noted above, the Treasury Department and the IRS seek 
comments on these issues and practical suggestions to address them in 
the specific factual contexts in which they may arise.
4. International Communications Income Derived by a Foreign Person With 
an Office or Fixed Place of Business in the United States
    Section 863(e)(1)(B)(ii) and Sec.  1.863-9(b)(2)(ii)(C) of the 2001 
proposed regulations provide that international communications income 
derived by a foreign person that is attributable to an office or other 
fixed place of business in the United States is from sources within the 
United States. Section 864 and the regulations thereunder provide 
guidance in determining ``income * * * attributable to an office or 
other fixed place of business'' in specific contexts. However, the 
Treasury Department and the IRS believe that, for purposes of section 
863(e), international communications income should be attributed to an 
office or fixed place on business based on functions performed, 
resources employed, and risks assumed. Therefore, pursuant to the 
regulatory authority in section 863(e)(1)(B)(i), the reproposed 
regulations provide that, for purposes of this section, income is 
attributable to an office or other fixed place of business in the 
United States to the extent of functions performed, resources employed, 
or risks assumed by the office or other fixed place of business.
5. International Communications Income of a Foreign Person Engaged in a 
Trade or Business Within the United States
    The second exception to Sec.  1.863-9(b)(2)(ii)(A) of the 2001 
proposed regulations is contained in Sec.  1.863-

[[Page 54867]]

9(b)(2)(ii)(D), which provides that if a foreign person (other than a 
50 percent or more U.S.-owned foreign corporation described in Sec.  
1.863-9(b)(2)(ii)(B) of the 2001 proposed regulations) is engaged in a 
trade or business within the United States, the foreign person's 
international communications income is presumed to be U.S. source 
income. However, if the foreign person can allocate its international 
communications income between sources within the United States, space, 
and international water and sources outside the United States, space, 
and international water to the satisfaction of the Commissioner, based 
on all the facts and circumstances, which may include functions 
performed, resources employed, or risks assumed, then the income 
allocated to sources outside the United States, space, and 
international water will be foreign source income.
    Several commentators stated that the presumption is overbroad 
because it applies to all international communications income 
regardless of any nexus with the foreign corporation's U.S. trade or 
business. These commentators claimed that the presumption is 
inconsistent with U.S. tax policy and international norms that require 
a connection between the income and the foreign person's activities in 
the United States before U.S. taxing jurisdiction is exercised.
    In response to comments, the reproposed regulations provide that if 
a foreign person, other than a CFC, is engaged in a trade or business 
within the United States, gross income derived by that person from 
international communications activity is from sources within the United 
States to the extent the income, based on all the facts and 
circumstances, is attributable to functions performed, resources 
employed, or risks assumed within the United States. This rule is 
similar to the rule in the reproposed regulations under section 863(d) 
for foreign persons engaged in a trade or business within the United 
States. There is no longer a presumption of U.S. source income.
    The Treasury Department and the IRS believe that the provision in 
the reproposed regulations that such a foreign person's international 
communications income is U.S. source only to the extent attributable to 
functions performed, resources employed, or risks assumed in the United 
States addresses taxpayers' concerns regarding a nexus between the 
foreign person's international communications income and its business 
activities in the United States.
    Several commentators objected to the rule that international 
communications income could be foreign source income only to the extent 
that the foreign person could allocate international communications 
income to activity occurring in a foreign country. Because the 
reproposed regulations provide for U.S. sourcing only to the extent 
that the foreign person's international communications income is 
attributable to functions performed, resources employed, or risks 
assumed in the United States, this concern should be mitigated.
    Several commentators stated that section 863(e) makes international 
communications income that is attributable to a U.S. office U.S. source 
income, and that the regulations should not adopt a broader U.S. trade 
or business rule. Section 863(e)(1)(B)(ii) provides that if a foreign 
person has a fixed place of business in the United States, 
international communications income attributable to such fixed place of 
business is U.S. source income. The Treasury Department and the IRS 
have not made changes to the reproposed regulations in response to 
these comments. Section 863(e)(1)(B)(i) by its terms gives the 
Secretary broad authority to source international communications income 
of a foreign person as U.S. source income. The Treasury Department and 
the IRS believe that it is appropriate to exercise that authority in 
this case. The trade or business rule reflects the concern of the 
Treasury Department and the IRS that a foreign person could avoid a 
U.S. fixed place of business under section 863(e)(1)(B)(ii), yet engage 
in significant communications activity in the United States. The 
Treasury Department and the IRS believe that Congress intended that a 
foreign person engaged in substantial business in the United States be 
subject to U.S. tax on that communications activity.
6. Income Derived From Communications Activity--The Paid-To-Do Rule
    Income derived from communications activity is defined in Sec.  
1.863-9(d)(2) of the 2001 proposed regulations as income derived from 
the transmission of communications, including income derived from the 
provision of capacity to transmit communications. There is no 
requirement that the recipient of communications income perform the 
transmission function itself. This rule reflects the understanding of 
the Treasury Department and the IRS that providers of communications 
services often use capacity owned or operated by others. However, 
income is derived from communications activity only if the taxpayer is 
paid to transmit, and bears the risk of transmitting, the 
communications.
    Section 1.863-9(d)(3) of the 2001 proposed regulations provides 
rules for characterizing income derived from a communications activity 
for purposes of sourcing the income derived from such activity. The 
character of income derived from communications activity is determined 
by establishing the two points between which the taxpayer is paid to 
transmit, and bears the risk of transmitting, the communication (the 
paid-to-do rule). Under the paid-to-do rule, the path the communication 
takes between the two points is not relevant in determining the 
character of the transmission. If a taxpayer is paid to take a 
communication from one point to another point, income derived from the 
transmission is characterized based on the transmission between those 
two points, even if the taxpayer contracts out part of the transmission 
to another party. This rule reflects the recognition by the Treasury 
Department and the IRS, as noted above, that providers of 
communications services often use capacity owned or operated by others.
    When the taxpayer cannot establish the two points between which the 
taxpayer is paid to transmit the communication, Sec.  1.863-9(b)(6) of 
the 2001 proposed regulations provides a default source rule, under 
which all income from the communications activity, whether derived by a 
U.S. person or a foreign person, is deemed to be from sources within 
the United States. Thus, for example, when a provider of communications 
services provides both local and international long distance services 
in one-price bundles for a set amount each month and tracing each 
transmission is not possible or practical, the income derived from the 
communications activity is U.S. source income. The Treasury Department 
and the IRS understand that many taxpayers in the communications 
industry may consider it impractical or impossible to prove the 
endpoints of the communications they transmit. The Treasury Department 
and the IRS accordingly solicited comments as to proposals for those 
situations when taxpayers cannot establish the points between which the 
taxpayer is paid to transmit the communication.
    One commentator stated that the phrase ``bears the risk of 
transmitting,'' contained in Sec.  1.863-9(d)(2) and (d)(3)(i) of the 
2001 proposed regulations, is ambiguous and does not meaningfully 
improve the determination of when income is derived from communications 
activity. This commentator noted that the nature of the risk a taxpayer 
must bear to be treated as deriving

[[Page 54868]]

communications income was unclear, and that the determination of risk 
would pose administrative difficulties given the complexity of business 
models and structures. No change was made to the reproposed regulations 
in response to this comment. The Treasury Department and the IRS 
believe that, in determining whether a taxpayer derives communications 
income, risk is more important than the mere fact of payment. The 
Treasury Department and the IRS thus believe that a taxpayer should not 
be considered to derive communications income unless the taxpayer bears 
the economic risk of nonpayment with respect to the transmission of 
communications or the provision of capacity to transmit communications.
    Commentators stated that the paid-to-do rule is overbroad because 
it asserts primary U.S. taxing jurisdiction over certain communications 
income regardless of any nexus between the income and the United 
States. Commentators also noted that when certain taxpayers cannot 
establish the two points between which they are paid to transmit a 
communication, the income from such communications activity may be 
subject to potential double taxation at the corporate level (for 
example, a foreign corporation could be subject to tax on such