Source of Income From Certain Space and Ocean Activities; Source of Communications Income, 77594-77612 [E6-22174]

Download as PDF 77594 Federal Register / Vol. 71, No. 248 / Wednesday, December 27, 2006 / Rules and Regulations Regulatory Policies and Procedures (44 FR 11034; February 26, 1979); and (3) does not warrant preparation of a regulatory evaluation as the anticipated impact is so minimal. For the same reason, the FAA certifies that this amendment will not have a significant economic impact on a substantial number of small entities under the criteria of the Regulatory Flexibility Act. List of Subjects in 14 CFR Part 97 Air Traffic Control, Airports, Incorporation by reference, and Navigation (Air). Issued in Washington, DC, on December 15, 2006. James J. Ballough, Director, Flight Standards Service. Adoption of the Amendment Accordingly, pursuant to the authority delegated to me, under title 14, Code of Federal Regulations, part 97 (14 CFR part 97) is amended by establishing, amending, suspending, or revoking Standard Instrument Approach Procedures and Weather Takeoff Minimums effective at 0901 UTC on the dates specified, as follows: I PART 97—STANDARD INSTRUMENT APPROACH PROCEDURES 1. The authority citation for part 97 continues to read as follows: I Authority: 49 U.S.C. 106(g), 40103, 40106, 40113, 40114, 40120, 44502, 44514, 44701, 44719, 44721–44722. 2. Part 97 is amended to read as follows: rwilkins on PROD1PC63 with RULES I Effective 18 January 2007 Eagle, CO, Eagle County Regional, LDA/DME RWY 25, Orig–B Wauchula, FL, Wauchula Muni, RNAV (GPS) RWY 18, Orig Wauchula, FL, Wauchula Muni, RNAV (GPS) RWY 36, Orig Wauchula, FL, Wauchula Muni, Takeoff Minimums and Textual DP, Amdt 1 Atlanta, GA, Hartsfield-Jackson Atlanta Intl, ILS PRM RWY 8L(Simultaneous Close Parallel) Orig Atlanta, GA, Hartsfield-Jackson Atlanta Intl, ILS PRM RWY 8R (Simultaneous Close Parallel) Orig Atlanta, GA, Hartsfield-Jackson Atlanta Intl, ILS PRM RWY 9L (Simultaneous Close Parallel) Orig Atlanta, GA, Hartsfield-Jackson Atlanta Intl, ILS PRM RWY 9R (Simultaneous Close Parallel) Orig Atlanta, GA, Hartsfield-Jackson Atlanta Intl, ILS PRM RWY 10 (Simultaneous Close Parallel) Orig Atlanta, GA, Hartsfield-Jackson Atlanta Intl, ILS PRM RWY 26L (Simultaneous Close Parallel) Orig Atlanta, GA, Hartsfield-Jackson Atlanta Intl, ILS PRM RWY 26R (Simultaneous Close Parallel) Orig VerDate Aug<31>2005 17:07 Dec 26, 2006 Jkt 211001 Atlanta, GA, Hartsfield-Jackson Atlanta Intl, ILS PRM RWY 27L (Simultaneous Close Parallel) Orig Atlanta, GA, Hartsfield-Jackson Atlanta Intl, ILS PRM RWY 27R (Simultaneous Close Parallel) Orig Atlanta, GA, Hartsfield-Jackson Atlanta Intl, ILS PRM RWY 28 (Simultaneous Close Parallel) Orig Indianapolis, IN, Indianapolis Intl, RNAV (GPS) RWY 14, Amdt 1 Indianapolis, IN, Indianapolis Intl, RNAV (GPS) RWY 32, Amdt 1 Indianapolis, IN, Indianapolis Intl, ILS OR LOC RWY 14, Amdt 5A Indianapolis, IN, Indianapolis Intl, ILS OR LOC RWY 32, Amdt 18 Indianapolis, IN, Indianapolis Intl, Takeoff Minimums & Textual DP’s, Orig Leonardtown, MD, St. Mary’s County Regional, Takeoff Minimums and Textual DP, Orig Monett, MO, Monett Muni, RNAV (GPS) RWY 18, Orig Monett, MO, Monett Muni, RNAV (GPS) RWY 36, Orig Monett, MO, Monett Muni, GPS RWY 18, Orig, CANCELLED Monett, MO, Monett Muni, GPS RWY 36, Amdt 1, CANCELLED Monett, MO, Monett Muni, Takeoff Minimums and Textual DP, Orig Ripley, MS, Ripley, VOR/DME–A, Amdt 2 Ripley, MS, Ripley, RNAV (GPS) RWY 3, Amdt 1 Ripley, MS, Ripley, RNAV (GPS) RWY 21, Amdt 1 Ripley, MS, Ripley, Takeoff Minimums and Textual DP, Orig Elizabeth City, NC, Elizabeth City CG Air Station/Regional, ILS OR LOC RWY 10, Orig Alliance, NE Alliance Muni, RNAV (GPS) RWY 12, Orig Alliance, NE Alliance Muni, RNAV (GPS) RWY 30, Orig Alliance, NE Alliance Muni, GPS RWY 30, Orig–A, CANCELLED Kimball, NE, Kimball Muni/Robert E. Arraj Field, RNAV (GPS) RWY 10, Orig Kimball, NE, Kimball Muni/Robert E. Arraj Field, RNAV (GPS) RWY 28, Orig Kimball, NE, Kimball Muni/Robert E. Arraj Field, NDB RWY 28, Amdt 2 Kimball, NE, Kimball Muni/Robert E. Arraj Field, GPS RWY 28, Orig–A, CANCELLED Kimball, NE, Kimball Muni/Robert E. Arraj Field, Takeoff Minimums and Textual DP, Orig Wellsville, NY, Wellsville Muni Arpt, Tarantine Fld, VOR–A, Amdt 6 Wellsville, NY, Wellsville Muni Arpt, Tarantine Fld, LOC/DME RWY 28, Amdt 4 Wellsville, NY, Wellsville Muni Arpt, Tarantine Fld, RNAV (GPS) RWY 10, Orig Wellsville, NY, Wellsville Muni Arpt, Tarantine Fld, RNAV (GPS) RWY 28, Orig Myerstown, PA, Deck, Takeoff Minimums and Textual DP, Orig Philadelphia, PA, Philadelphia Intl, ILS PRM RWY 26 (Simultaneous Close Parallel), Amdt 3 Philadelphia, PA, Philadelphia Intl, ILS PRM RWY 27L (Simultaneous Close Parallel), Amdt 3 The FAA published an Amendment in Docket No. 30525 Amdt No. 3196 to Part 97 PO 00000 Frm 00012 Fmt 4700 Sfmt 4700 of the Federal Aviation Regulations (Vol 71, FR No. 239, page 74764, dated December 13, 2006) Under Section 97.29 effective 18 January 2007, which is hereby rescinded: Homer, AK, Homer, RNAV (GPS) Y RWY 21, Orig Homer, AK, Homer, RNAV (GPS) Y RWY 3, Orig Homer, AK, Homer, GPS RWY 21, Orig–B, CANCELLED Homer, AK, Homer, GPS RWY 3, Orig–B, CANCELLED [FR Doc. E6–21956 Filed 12–26–06; 8:45 am] BILLING CODE 4910–13–P DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1 and 602 [TD 9305] RIN 1545–AW50 Source of Income From Certain Space and Ocean Activities; Source of Communications Income Internal Revenue Service (IRS), Treasury. ACTION: Final regulations. AGENCY: SUMMARY: This document contains final regulations under section 863(d) governing the source of income from certain space and ocean activities. It also contains final regulations under section 863(a), (d), and (e) governing the source of income from certain communications activities. In addition, this document contains final regulations under section 863(a) and (b), amending the regulations in § 1.863–3 to conform those regulations to these final regulations. The final regulations primarily affect 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). The final regulations also affect persons who derive income from transmission of communications. DATES: Effective Date: These regulations are effective December 27, 2006. Applicability Date: For dates of applicability, see § 1.863–8(h) and § 1.863–9(l). FOR FURTHER INFORMATION CONTACT: H. Michael Huynh, (202) 435–5161 (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 E:\FR\FM\27DER1.SGM 27DER1 Federal Register / Vol. 71, No. 248 / Wednesday, December 27, 2006 / Rules and Regulations rwilkins on PROD1PC63 with RULES 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 collections of information in these final regulations are in §§ 1.863– 8(g) and 1.863–9(k). This information is required by the IRS to monitor 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. The estimated annual burden per respondent is 5 hours. Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224, and to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503. 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, Pub. L. No. 99–514, 100 Stat. 2085. Section 863(d) governs the source of income derived from space or ocean activities. Section 863(e) governs the source of income derived from international communications activities. The Treasury Department and the IRS published a notice of proposed rulemaking (REG–106030–98) in the Federal Register on January 17, 2001 (66 FR 3903), which provided proposed regulations under section 863(a), (b), (d), and (e) (the 2001 proposed regulations). The Treasury Department and 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 (AJCA), Pub. L. No. 108– VerDate Aug<31>2005 17:07 Dec 26, 2006 Jkt 211001 357, 118 Stat. 1418, 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 rules. In light of the extensive written comments, industry evolution, and AJCA changes, the Treasury Department and the IRS felt that it was appropriate to repropose these regulations to reflect these changes and to provide another opportunity for comment. Consequently, the Treasury Department and the IRS published another notice of proposed rulemaking in the Federal Register on September 19, 2005 (70 FR 54859), which withdrew the 2001 proposed regulations and provided new proposed regulations under section 863(a), (b), (d), and (e) (the proposed regulations). The proposed regulations provided two sets of rules: one in § 1.863–8 for determining the source of income from space or ocean activities, the other in § 1.863–9 for determining the source of income from communications activities. A public hearing on the proposed regulations was scheduled for December 15, 2005, but was ultimately cancelled because no one requested to speak. A few written comments, however, were received. These comments uniformly praised the proposed regulations as an improvement over the 2001 proposed regulations and generally were supportive of much of the proposed regulations. However, commentators suggested a few additional changes. After consideration of these comments, the proposed regulations are adopted as final regulations, as amended by this Treasury decision. The revisions to regulations governing the source of income from space or ocean activities and the source of income from communications activities are discussed in section A and section B, respectively, of this preamble. Summary of Comments and Explanation of Revisions A. Space or Ocean Activity Under Section 863(d) Section 863(d) governs the source of income from certain space or ocean activities. In general, section 863(d)(1) provides that, except as provided in regulations, any income derived from a space or ocean activity (space and ocean income) is income from sources within the United States (U.S. source income) if derived by a United States person and is income from sources without the United States (foreign source income) if derived by a foreign person. Section 863(d)(2)(A)(i) defines space activity to include any activity conducted in space. PO 00000 Frm 00013 Fmt 4700 Sfmt 4700 77595 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 types of activities from the definition of space or ocean activity. Space or ocean activity does not include any activity giving rise to transportation income governed by section 863(c), international communications income governed by section 863(e), or income with respect to mines, oil and gas wells, or other natural deposits to the extent within the United States or any foreign country or possession of the United States (as defined in section 638). See Section 863(d)(2)(B). Section 1.863–8 of the proposed regulations generally provided rules for determining the source of income derived from space or ocean activity under section 863(d). Section 1.863– 8(b)(1) of the proposed regulations reflected the general source rule under section 863(d)(1) that a United States person’s space and ocean income is U.S. source income. Pursuant to the grant of regulatory authority under section 863(d)(1), however, the proposed regulations provided an exception to this general rule. Under that exception, a United States person’s space and ocean income is foreign source income (and therefore not sourced on the basis of citizenship or residency) 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. For a foreign person, proposed § 1.863–8(b)(2) reflected the general source rule under section 863(d)(1) that a foreign person’s space and ocean income is foreign source income. Pursuant to regulatory authority under section 863(d)(1), however, the proposed regulations contained two exceptions to this general rule, one for controlled foreign corporations (CFCs), the other for foreign persons engaged in a U.S. trade or business. The proposed regulations generally sourced space and ocean income derived by a CFC, like that of a United States person, as U.S. source income. However, also like the rule for a United States person, a CFC’s space and ocean income is foreign source income 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. For a foreign person, other than a CFC, engaged in a trade or business within the United E:\FR\FM\27DER1.SGM 27DER1 77596 Federal Register / Vol. 71, No. 248 / Wednesday, December 27, 2006 / Rules and Regulations rwilkins on PROD1PC63 with RULES States, space and ocean income is U.S. source income to the extent it is attributable to functions performed, resources employed, or risks assumed within the United States. In addition to the general source rules for United States and foreign persons, the proposed regulations provided special rules, applicable to both United States and foreign persons, for income from services, certain sales of property, and communications activities (other than international communications activities). These special rules, as well as modifications to the proposed regulations, are discussed below. 1. Activities performed outside space and international water Section 1.863–8 of the proposed regulations provided source rules only for income from space or ocean activity. Thus, in some cases, income derived from a transaction must be allocated between space and ocean income and other income. For example, § 1.863–8(b)(3)(ii)(C) of the proposed regulations provided that when property is produced both in space or international water and outside space and international water, gross income allocable to production activity is allocated to production occurring in space or international water and production occurring outside space and international water based on where functions are performed, resources are employed, or risks are assumed. The proposed regulations also provided a similar analysis of functions performed, resources employed, or risks assumed to allocate income in the case of performance of services. See Prop. Treas. Reg. § 1.863–8(d)(2). Under the proposed regulations, only the amount allocated to production or performance of a service occurring in space or international water is treated as space and ocean income (character rule). The source of gross income allocated to production or performance of a service occurring in space or international water is then determined under the rules of proposed § 1.863–8(b)(1) or (2), as applicable (source rule). Section 1.863–8(b)(1) of the proposed regulations reflected the general source rule that a United States person’s space and ocean income is U.S. source income. Proposed § 1.863–8(b)(2) reflected the general source rule that a foreign person’s space and ocean income is foreign source income. Both proposed § 1.863–8(b)(1) and (2), however, provided exceptions to their respective general source rules. As discussed above, under the exceptions, a United States person’s space and ocean income may be foreign source VerDate Aug<31>2005 17:07 Dec 26, 2006 Jkt 211001 income and a foreign person’s space and ocean income may be U.S. source income based on where functions are performed, resources are employed, or risks are assumed. One commentator noted that in some situations, the allocation of income derived from a transaction to determine space and ocean income based on functions performed, resources employed, or risks assumed presumably would remove the subsequent need to further analyze functions performed, resources employed, or risks assumed within a country to determine the source of the space and ocean income. In other words, the very act of determining the character of income seems to also determine the source of such income. The Treasury Department and the IRS agree with the commentator that use of the same standard to classify the transaction as space or ocean activity and to source the space and ocean income may be duplicative in some cases. However, there are other cases where a transaction with some landbased activity may be classified in its entirety as a space or ocean activity (for example, a lease of a satellite), but the income may be partially U.S. source and partially foreign source under the source rules of proposed § 1.863–8(b)(1) and (2) based on functions performed, resources employed, or risks assumed within the United States or a foreign country. Consequently, the character and source rules are not always duplicative. Thus, the extent to which the character rules overlap with the source rules is particular to the type of transaction involved. The Treasury Department and the IRS recognize that the overlap in the character and source rules may produce equivalent results. But, the overlap is necessary to provide taxpayers and the IRS with workable rules. As a result, the final regulations do not follow this comment as a general matter. Nonetheless, a conforming amendment has been made to the lease transaction in Example 1 in § 1.863–8(f) of the final regulations to more clearly illustrate how the rules work. That example illustrates that the transaction involved is first classified in its entirety as a space or ocean activity, and then the resulting space and ocean income is subjected to the source rules. The space and ocean income is sourced as foreign source income 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. PO 00000 Frm 00014 Fmt 4700 Sfmt 4700 2. Activities performed by another person Section 1.863–8(a) of the proposed regulations provided that a taxpayer will not be considered to derive income from space or ocean activity if such activity is performed by another person. The approach under § 1.863–8(a) of the proposed regulations, providing that a taxpayer derives income from a space or ocean activity only if it conducts such activity directly, is consistent with the approach adopted in the § 1.863–3 regulations governing the source of income from certain sales of inventory. See, e.g., Treas. Reg. § 1.863–3(c) (‘‘[T]he only production activities that are taken into account for purposes of §§ 1.863–1, 1.863–2, and this section are those conducted directly by the taxpayer.’’). Accordingly, commentators believed that this provision assured that a content provider that retains a satellite operator to transmit programming abroad would not derive space and ocean income based on attribution of the satellite operator’s activity. The Treasury Department and the IRS agree. One commentator noted, however, that Examples 2 and 4 in § 1.863–8(f) of the proposed regulations seem to indicate that this is not what was intended. In Example 2, the taxpayer, an Internet service provider, transmits information requested by its customer, in part using satellite capacity leased from a third party. Example 2 concludes that the service performed by the taxpayer is considered space activity to the extent the value of the service is attributable to functions performed, resources employed, and risks assumed in space. In Example 4, the taxpayer uses satellite capacity acquired from a third party to deliver programming services directly to its customers’ televisions sets. Example 4 concludes that the taxpayer’s delivery of programming and other services is considered space activity to the extent the value of the delivery transaction is attributable to performance in space. In the commentator’s view, the results reached in the examples conflict with the provision stating that activities performed by another person are not attributable to the taxpayer. The Treasury Department and the IRS do not believe that Examples 2 and 4 of § 1.863–8(f) of the proposed regulations produce the result that the commentator raised. In Examples 2 and 4, the taxpayer performed the transmission or delivery activities using satellite capacity leased or acquired from a third party. Both Examples 2 and 4 correctly conclude that the taxpayers derived space and ocean income from their own E:\FR\FM\27DER1.SGM 27DER1 Federal Register / Vol. 71, No. 248 / Wednesday, December 27, 2006 / Rules and Regulations rwilkins on PROD1PC63 with RULES activities rather than from activities of another person. Thus, the examples do not, in fact, conflict with the text of the proposed regulations. Nevertheless, the Treasury Department and the IRS are concerned that Examples 2 and 4 have been misinterpreted as suggesting that activities performed by another person may be attributable to the taxpayer in certain situations. This was not the intent of these examples. Consequently, Examples 2 and 4 in § 1.863–8(f) of the final regulations have been modified to make clear that the taxpayers in the examples directly engage in a space activity by performing the uplink (transmitting to the satellite) and downlink functions. These examples differ from cases in which the taxpayer is a mere content provider that derives income either from the creation of content or from the creation and delivery of content, but in either case contracts with another person to deliver the content via satellite. Pursuant to § 1.863–8(a) of the final regulations, content providers of this type would not derive space and ocean income because the delivery of the content via satellite is performed by another person. This would be the result even though the value of the customer contract includes a payment to the content provider for space or ocean activity. To clarify the distinction between these situations and Examples 2 and 4, a new Example 5 has been added to the final regulations. That example involves a content provider that does not derive space and ocean income because the taxpayer does not directly perform any space or ocean activity. another, as neither Example 3 in § 1.863–8(f) of the proposed regulations nor the text of the proposed regulations provides any guidance as to when activities performed in space or international water would be de minimis under a facts and circumstances approach. The Treasury Department and the IRS recognize that issues of interpretation may arise in any facts and circumstances approach. Nevertheless, the Treasury Department and the IRS generally have refrained from adopting the alternative approach, to wit, adopting precise definitions and quantitative measures for a de minimis standard. Moreover, the inclusion of a precise definition and quantitative measures for determining de minimis value could raise equal, if not greater, concerns in terms of the quantitative threshold and other issues. Thus, the final regulations retain the de minimis standard for determining whether a taxpayer has space and ocean income. If the value of the service attributable to space or ocean activity is de minimis based on the facts and circumstances, the taxpayer will not derive space and ocean income. Nevertheless, the Treasury Department and the IRS agree that more guidance could be provided as to the application of the retained de minimis rule. Accordingly, Examples 3 and 8 in § 1.863–8(f) of the final regulations (Example 7 in the proposed regulations) provide clearer illustrations of when activities performed in space or international water would be considered de minimis for this purpose and when those types of activities would not be considered de minimis. 3. Income Characterization Rules for Income from Services and the De Minimis Exception Under § 1.863–8(b)(4) of the proposed regulations, to the extent a service is characterized as space or ocean activity, the source of gross income derived from such transaction is determined under proposed § 1.863–8(b)(1) or (2), as applicable. Section 1.863–8(d)(2)(ii)(B) of the proposed regulations provided, however, that if the taxpayer can demonstrate, based on all the facts and circumstances, that the value of the service attributable to performance in space or international water is de minimis, such service will not be treated as space or ocean activity. The de minimis rule was adopted to address taxpayers’ concerns about potential confusion in qualifying for the ‘‘facilitation exception’’ under the 2001 proposed regulations. One commentator stated that the de minimis rule simply replaced one vague standard with 4. Source Rules for Income From Certain Sales of Property The proposed regulations provided special rules for income from certain sales of property, either when any production occurs in space or international water, or when the sale occurs in space or international water. In either case, section 863(d) and the proposed regulations applied to determine the source of income from the sales of property, and the rules of sections 861(a)(6), 862(a)(6), 863(a), 863(b), and 865 apply only to the extent provided in the proposed regulations. VerDate Aug<31>2005 17:07 Dec 26, 2006 Jkt 211001 a. Sales of Property Produced in the United States and Sold in Space or International Water Section 1.863–8(b)(3)(ii) of the proposed regulations provided that when the taxpayer both produces property and sells such property, onehalf of the taxpayer’s gross income will be considered income allocable to PO 00000 Frm 00015 Fmt 4700 Sfmt 4700 77597 production activity and one-half of such gross income will be considered income allocable to sales activity. Taxpayers generally must then apply the rules of section 863(d) and the proposed regulations to determine the source of income allocable to production activity and sales activity. For production activity, the source of gross income allocable to production occurring in space or international water is generally based on the citizenship or residence of the taxpayer, applying the rules of proposed § 1.863– 8(b)(1) or (2), as applicable. The source of gross income allocable to production occurring outside space and international water is determined under section 863(b) rather than section 863(d). See Prop. Treas. Reg. § 1.863– 8(b)(3)(ii)(B) (referencing Treas. Reg. § 1.863–3(c)(1)). As for sales activity, when property is sold in space or international water, the source of gross income allocable to sales activity is generally based on the citizenship or residence of the taxpayer, applying the rules of proposed § 1.863– 8(b)(1) or (2), as applicable. An exception to this general rule applied in cases when the property sold is inventory, within the meaning of section 1221(a)(1), and is sold in space or international water for use, consumption, or disposition outside space, international water, and the United States. In that case, the source of gross income allocable to sales activity is determined under Treas. Reg. § 1.861– 7(c) and § 1.863–3(c)(2). Treas. Reg. § 1.861–7(c) and § 1.863–3(c)(2) generally provide for foreign source income where the seller’s rights, title, and interest in the property are transferred to the buyer (the title passage rule) outside the United States and the property is not sold for use, consumption, or disposition in the United States. Treas. Reg. § 1.861–7(c) and § 1.863–3(c)(2) also applied to property sold outside space and international water. See Prop. Treas. Reg. § 1.863–8(b)(3)(ii)(D). One commentator believed that because certain U.S. manufacturers, such as U.S. satellite manufacturers, produce property that is sold in space or international water for use, consumption, or disposition in space or international water, they are at a disadvantage relative to U.S. manufacturers of other export property because the former may have U.S. source income with respect to income allocable to sales activity, while the latter may have foreign source income from sales activity. In response to comments on the 2001 proposed regulations, proposed § 1.863– E:\FR\FM\27DER1.SGM 27DER1 77598 Federal Register / Vol. 71, No. 248 / Wednesday, December 27, 2006 / Rules and Regulations rwilkins on PROD1PC63 with RULES 8(b)(1) was revised to provide that space and ocean income will be foreign source income to the extent the space and ocean income is attributable to functions performed, resources employed, or risks assumed in a foreign country or countries. The Treasury Department and the IRS believe that this change may in many cases mitigate concerns about U.S. manufacturers potentially deriving 100 percent U.S. source income in these cases. Moreover, the Treasury Department and the IRS believe that the rules under the proposed regulations for determining the source of income allocable to sales activity are consistent with legislative intent to assert primary tax jurisdiction over income earned by United States persons that is not subject to foreign tax. See S. REP. NO. 99–313, 1986–3 C.B. 357–358 (‘‘[T]he committee believes the United States should assert primary tax jurisdiction over income earned by its residents that is not within any foreign country’s taxing jurisdiction* * *. Moreover, when a U.S. taxpayer conducts activities in space or international waters, foreign countries generally do not tax the income. Thus, the foreign tax credit limitation is inflated by income that is not within any foreign country’s tax jurisdiction.’’). Based on the legislative history, 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 or international water for use, consumption, or disposition outside space, international water, and the United States—should be considered space or ocean activity and that the source of income from such sales activity should be determined under section 863(d). As a result, no changes were made in response to this comment. b. Purchased Versus Produced Property Sold for Use, Consumption, or Disposition in the United States One commentator questioned the appropriateness of differences in determining the source of sales income depending on whether the taxpayer produced or purchased the property sold. Under the proposed regulations, when property produced by the taxpayer is sold in space or international water, the source of gross income allocable to sales activity is generally based on the citizenship or residence of the taxpayer, applying the rules of proposed § 1.863–8(b)(1) or (2), as applicable (and not the title passage rule)—subject to the foregoing inventory exception for property that will be used, consumed, or disposed of outside space, international water, and the United VerDate Aug<31>2005 17:07 Dec 26, 2006 Jkt 211001 States. A slightly different rule applied to sales of property that had been purchased by the taxpayer. While the proposed regulations also provided that, for purchased property, the source of gross income allocable to sales activity is generally based on the citizenship or residence of the taxpayer, the inventory exception for purchased property only required that the property be used, consumed, or disposed of outside space and international water. The inventory exceptions for produced and purchased property were intended to produce different results when inventory property is used, consumed, or disposed of in the United States. In such case, the source of produced inventory property sales income is generally based on the citizenship or residence of the taxpayer, applying the rules of proposed § 1.863– 8(b)(1) or (2), because the inventory exception did not extend to produced property sold for use, consumption, or disposition in the United States. In contrast, the source of purchased inventory property sales income is generally based on title passage under Treas. Reg. § 1.861–7(c) because the inventory exception did extend to purchased property even if it was sold for use, consumption, or disposition in the United States. The Treasury Department and the IRS believe that this difference between the produced and purchased property rules in the space and ocean context is consistent with the difference in the rules for sales of produced and purchased property outside the space and ocean context. In particular, under section 863(a) and (b) and the regulations thereunder, if property is produced in the United States and sold for use, consumption, or disposition in the United States, the place of sale will be presumed to be the United States, and income attributable to the sales activity will be U.S. source income. See § 1.863–3(c)(2). There is, however, no comparable rule for purchased property under section 862(a)(6) or the regulations thereunder. Thus, the final regulations simply continue in the space and ocean context the varying treatment elsewhere for sales of purchased property and sales of produced property. In response to comments, however, the produced and purchased property rules have been modified to be similar in structure and style, to better reflect and highlight the differences between these two rules. 5. Allocations Taxpayers must allocate gross income under paragraphs (b)(1) and (b)(2) of proposed § 1.863–8 among U.S., foreign, PO 00000 Frm 00016 Fmt 4700 Sfmt 4700 and space or ocean activities. Under proposed § 1.863–8(b)(3)(ii)(C), allocations are also made between production activity occurring in space or international water and that occurring outside space and international water. Finally, allocations are also made under proposed § 1.863– 8(b)(4) between services performed in space or international water and services performed outside space and international water. In performing these allocations, the proposed regulations generally provided that taxpayers should consider the relative value of functions performed, resources employed, or risks assumed in different locations. Moreover, the preamble to the proposed regulations provided that allocations should be based generally on section 482 principles. Commentators noted that little guidance is given as to the mechanics of allocation other than the statement that the principles of section 482 should be used. Commentators stated that allocation of gross income based on section 482 principles will result in added expense, uncertainty, and extra burden on multinational taxpayers who are already required to undertake and update functional analyses and satisfy substantial documentation requirements. While the final regulations were not changed in response to these comments, the Treasury Department and the IRS believe that some clarification is warranted. In suggesting the use of section 482 principles as a guide, the Treasury Department and the IRS intend for taxpayers to adopt a reasonable approach to the allocations required in this area. Taxpayers know their businesses and will generally be in the best position to fashion a reasonable method that most reliably reflects the relative value of functions performed, resources employed, and risks assumed in different locations. In the preamble to the proposed regulations, the Treasury Department and the IRS solicited comments on alternative methods of allocation for particular industries and criteria that could be used to evaluate the reasonableness of such methods. No such comments were received. One commentator noted, however, that the proposed regulations perhaps reflected what taxpayers in these industries have already been doing in order to determine the character and source of their space and ocean income. Consequently, the Treasury Department and the IRS believe that allocations of gross income based on functions performed, resources employed, and E:\FR\FM\27DER1.SGM 27DER1 Federal Register / Vol. 71, No. 248 / Wednesday, December 27, 2006 / Rules and Regulations risks assumed are appropriate in these circumstances. rwilkins on PROD1PC63 with RULES 6. Separation of a Single Transaction and Aggregation of Multiple Transactions Paragraphs (d)(1)(i) and (d)(1)(ii) of § 1.863–8 of the proposed regulations provided that for purposes of determining space or ocean activity, the Commissioner may separate parts of a single transaction or combine separate transactions into a single transaction. One commentator stated that this is a ‘‘one-way’’ street, as only the Commissioner has the authority to separate or combine transactions for purposes of the proposed regulations. The final regulations do not change this rule. The Treasury Department and the IRS believe taxpayers are not inappropriately disadvantaged by this rule because taxpayers generally have the ability to structure their transactions in line with the economic prospects of their businesses. In addition, the Commissioner’s ability to separate or combine transactions is not unfettered. Rather, the Commissioner may only separate or combine transactions to better reflect the value of functions performed, resources employed, or risks assumed. A taxpayer can always protect itself against recharacterization by adopting an arrangement that appropriately reflects the economic realities of a transaction or series of transactions. The taxpayer is clearly in the best position at the outset to structure its arrangements in this manner. In addition, taxpayers traditionally are not permitted to restructure retroactively the form of their completed transactions. Thus, the Treasury Department and the IRS believe that the limited ‘‘one-way’’ rule is appropriate in this case. 7. Income Derived From the Leasing of Shipping Cargo Containers One commentator requested that the Treasury Department and the IRS make clear that the final regulations under section 863(d) do not apply to income derived from the leasing of shipping cargo containers and that such income should be treated as rental income, sourced under sections 861 and 862. This commentator noted that valid arguments also exist for treating income derived from the leasing of shipping cargo containers as transportation income; however, in the commentator’s view, the most appropriate treatment is rental income treatment, sourced under sections 861 and 862. The treatment of income derived from the leasing of shipping cargo containers is not covered by these final regulations. VerDate Aug<31>2005 17:07 Dec 26, 2006 Jkt 211001 Instead, the Treasury Department and the IRS intend to address the treatment of such income explicitly in separate guidance. That guidance may apply section 863(c), section 863(d), or other provisions to source income derived from the leasing of shipping cargo containers. Any such guidance will be prospective in nature. Until such time, the treatment of such income will be determined under existing law. B. Communications Activity Under Section 863(a), (d), and (e) Section 863(e) governs the source of income from international communications activities (international communications income). International communications income is defined in section 863(e)(2) as income derived from the transmission of communications or data between the United States and a foreign country (or possession of the United States). Section 863(e)(1)(A) provides that any international communications income of a United States person is sourced 50 percent in the United States and 50 percent outside the United States (50/50 source rule). Section 863(e)(1)(A) does not provide for any statutory or regulatory exceptions to this 50/50 source rule. In contrast, section 863(e)(1)(B)(i) provides that any international communications income of a foreign person is sourced outside the United States, except as provided in regulations or in section 863(e)(1)(B)(ii). The exception under section 863(e)(1)(B)(ii) provides that if a foreign person maintains an office or other fixed place of business in the United States, any international communications income attributable to such office or other fixed place of business is U.S. source income. Section 1.863–9 of the proposed regulations generally provided rules for determining the source of international communications income under section 863(e) and other communications income under section 863(a) and (d). Proposed § 1.863–9(b)(1) reflected the rule under section 863(e)(1)(A) that a United States person’s international communications income is 50 percent U.S. source income and 50 percent foreign source income. Proposed § 1.863–9(b)(2) reflected the general rule under section 863(e)(1)(B) that a foreign person’s international communications income is foreign source income. Consistent with the statutory exception under section 863(e)(1)(B)(ii), proposed § 1.863–9(b)(2)(iii) provided that any international communications income derived by a foreign person, other than a CFC, that is attributable to an office or other fixed place of business PO 00000 Frm 00017 Fmt 4700 Sfmt 4700 77599 of the foreign person in the United States is U.S. source income. International communications income is attributable to an office or other fixed place of business to the extent of functions performed, resources employed, or risks assumed by the office or other fixed place of business. In addition to the statutory exception under section 863(e)(1)(B)(ii), section 863(e)(1)(B) provides general regulatory authority to depart from the general 100 percent foreign source rule for foreign persons. Thus, pursuant to this regulatory authority, the proposed regulations contained additional exceptions to the general rule applicable to foreign persons. In particular, the proposed regulations provided that international communications income derived by a CFC is 50 percent U.S. source income and 50 percent foreign source income (the same as for United States persons). The proposed regulations also provided that international communications income derived by a foreign person, other than a CFC, engaged in a trade or business within the United States is income 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. In addition to the general source rules for international communications income of United States and foreign persons, the proposed regulations also provided rules, applicable to both United States and foreign persons, for income from U.S. communications, foreign communications, space/ocean communications, and communications where endpoints are indeterminate. These rules, as well as modifications to the proposed regulations, are discussed below. 1. Income Characterization Rules for Communications Income Section 1.863–9(h)(3) of the proposed regulations provided that the type of communications activity (and thus the applicable source rule) is determined by identifying the two points between which the taxpayer is paid to transmit the communication. For United States and foreign persons, U.S. communications income is entirely U.S. source income. A taxpayer derives U.S. communications income when the taxpayer is paid to transmit between two points in the United States or between the United States and a point in space or international water. In contrast, foreign communications income is entirely foreign source income for United States and foreign E:\FR\FM\27DER1.SGM 27DER1 rwilkins on PROD1PC63 with RULES 77600 Federal Register / Vol. 71, No. 248 / Wednesday, December 27, 2006 / Rules and Regulations persons. A taxpayer derives foreign communications income when the taxpayer is paid to transmit between two points in a foreign country or countries (or a possession or possessions of the United States), between a foreign country and a possession of the United States, or between a foreign country (or a possession of the United States) and a point in space or international water. Finally, the proposed regulations provided different source rules for international communications income of United States and foreign persons. See section B.3 of this preamble for further discussion. A taxpayer derives international communications income when the taxpayer is paid to transmit between a point in the United States and a point in a foreign country (or a possession of the United States). When a taxpayer cannot establish the two points between which the taxpayer is paid to transmit the communication, § 1.863–9(f) of the proposed regulation provided a default source rule under which all the income derived by the taxpayer from such communications activity is U.S. source income. Commentators stated that the treatment of communications income as U.S. source income when the endpoints are indeterminate is overbroad and harsh, particularly as it relates to foreign taxpayers. Commentators also stated that taxpayers would have to commit significant resources to develop the technology necessary to identify the endpoints of communications. One commentator stated that it is unclear that a reliable system can be created at any expense to establish the endpoints of the transmission under all circumstances. Commentators suggested instead the use of any reasonable method to establish the endpoints between which a taxpayer is paid to transmit the communications. One commentator suggested that the Treasury Department and the IRS consider employing the Industry Issue Resolution Program or Prefiling Agreement Program as aids in the administration of a reasonable method rule. The Treasury Department and the IRS solicited comments on the challenges to identifying the endpoints of communications in specific industries or situations, as well as suggestions for rules that are responsive to these particular challenges. The Treasury Department and the IRS also solicited comments on methods to establish the endpoints of a communication that may be reasonable for particular industries, as well as criteria that may be appropriate to evaluate the VerDate Aug<31>2005 17:07 Dec 26, 2006 Jkt 211001 reasonableness of such methods. In response, one commentator submitted examples of reasonable methods to establish the endpoints between which a taxpayer is paid to transmit the communications. The examples relied on statistical reports of data such as minutes used, areas of transmission, port locations, and transport charges. This commentator noted that current federal regulations already require telecommunications companies to submit some of these reports to certain governmental agencies, for example, the Federal Communications Commission. In light of the potential complexity in identifying the type of communications activity and in response to comments, the final regulations provide that a taxpayer may satisfy the requirement that the taxpayer establish the two points between which the taxpayer is paid to transmit, and bears the risk of transmitting, the communication by using any consistently applied reasonable method to establish one or both endpoints. In doing so, the taxpayer carries the burden of proof and must establish that the method used is reasonable (taking into account all of the facts and circumstances) and is consistently applied. In satisfying its burden of proof, a taxpayer will need to maintain reasonable records of communications activities. Depending on the facts and circumstances, methods based on, for example, records of port or transport charges, customer billing records, a satellite footprint, or records of termination fees made pursuant to an international settlement agreement may be reasonable. In addition, practices used by taxpayers to classify or categorize certain communications activity in connection with preparation of statements and analyses for the use of management, creditors, minority shareholders, joint ventures, or other parties or governmental agencies in interest may be reliable indicators of the reasonableness of the method chosen, but need not be accorded conclusive weight by the Commissioner. Furthermore, in evaluating the reasonableness of the method chosen, consideration will be given to all the facts and circumstances, including whether the endpoints would otherwise be identifiable absent this reasonable method provision. Along with resultant changes made to the text of the final regulations, several examples have been added to § 1.863– 9(j) of the final regulations that illustrate instances where the taxpayer may be able to use reasonable methods to determine the endpoints between which the taxpayer is paid to transmit the communications. PO 00000 Frm 00018 Fmt 4700 Sfmt 4700 2. The Paid-to-do Rule With Respect to Foreign-Originating Communications Under the proposed regulations, a taxpayer derives income from a certain type of communications activity (for example, foreign communications or international communications) only if the taxpayer is paid to transmit, and bears the risk of transmitting (the paidto-do rule), the communications of such type. See Prop. Treas. Reg. § 1.863– 9(h)(2) and (3). This is the case even if the taxpayer contracts out the transmission function. Commentators stated that application of the paid-to-do rule in all instances would give rise to results that are inconsistent with Congressional intent and may result in excessive amounts of U.S. source income. One commentator noted that in some cases, while it is clear that a communication originated in a foreign country and that a U.S. telecommunications company is paid to terminate the foreign-originating traffic in the United States, it is unclear exactly where the U.S. telecommunications company picked up the communication. This lack of clarity often may be due to legal restrictions in certain foreign countries on ownership of capacity and carriage of transmissions by nonnationals. It can also be due to the fact that the international settlement agreements under which major international telecommunications carriers operate often do not specify where the traffic is picked up or handed off, and in some cases the hand-off point is specified by reference to a mid-point convention, even though the transmission signal, from a technical standpoint, travels from end-to-end with no real points in-between. The commentator further stated that at the time section 863(e) was enacted, U.S. carriers were generally not allowed to own and operate facilities in foreign countries; specifically, no U.S. carrier could carry a foreign-to-U.S. or U.S.-toforeign transmission end-to-end. Thus, concluded the commentator, Congress focused on the endpoints of the communications rather than where the activities constituting the transmission of communications take place. The commentator suggested a rule that would provide that when a taxpayer is paid to transmit foreign-originating communications from a point outside the United States to a point in the United States, the taxpayer should be deemed to have been paid to transmit the communications from a point in the foreign country in which the communication originated. Upon further consideration, the Treasury Department and the IRS E:\FR\FM\27DER1.SGM 27DER1 Federal Register / Vol. 71, No. 248 / Wednesday, December 27, 2006 / Rules and Regulations rwilkins on PROD1PC63 with RULES believe that the paid-to-do rule may be over-inclusive in certain cases. Accordingly, the final regulations provide that international communications income also includes income derived from communications activity when the taxpayer is paid to transmit foreign-originating communications (communications with a beginning point in a foreign country or a possession of the United States) from a point in space or international water to a point in the United States. Also, a new example has been added to § 1.863–9(j) of the final regulations to illustrate the changes made in the final regulations with respect to foreignoriginating communications. The changes made in the final regulations only affect communications that originate in a foreign country (or a possession of the United States) and does not affect communications that originate in space, international water, or the United States. The Treasury Department and the IRS continue to believe that communications activity is most appropriately characterized based on the two points between which the taxpayer is paid to transmit, and bears the risk of transmitting, the communication. 3. Determining the Source of Communications Income Based on Functions Performed, Resources Employed, or Risks Assumed in a Foreign Country or Countries As discussed above, the proposed regulations provided that the source of communications income is largely dependant on the type of communications activity and the citizenship or residence of the taxpayer. However, the proposed regulations provided for two instances where (in addition to the type of communications activity and the citizenship or residence of the taxpayer) the source of communications income may depend on functions performed, resources employed, or risks assumed. First, the proposed regulations provided that international communications income derived by a foreign person, other than a CFC, that is attributable to an office or other fixed place of business of the foreign person in the United States is U.S. source income. The proposed regulations provided that international communications income is attributable to an office or other fixed place of business to the extent of functions performed, resources employed, or risks assumed by the office or other fixed place of business. Second, the proposed regulations provided that international communications income derived by a foreign person, other than a CFC, VerDate Aug<31>2005 17:07 Dec 26, 2006 Jkt 211001 engaged in a trade or business within the United States is income 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. Commentators suggested that the final regulations also provide for similar rules that would source communications income as foreign source income based on functions performed, resources employed, or risks assumed in a foreign country or countries. For example, one commentator suggested that the source of international and U.S. communications income derived by any United States or foreign person (including branches, partnerships, and disregarded entities) engaged in a trade or business in a foreign country or countries is income from sources without 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 such foreign country or countries. While the Treasury Department and the IRS recognize that commentators’ suggestion to provide for a source rule based on functions performed, resources employed, or risks assumed in a foreign country or countries is reasonable, as explained below, the Treasury Department and the IRS believe that the statute and legislative history preclude such an option. a. International Communications Income Consistent with section 863(e)(1)(A), proposed § 1.863–9(b)(1) provided that international communications income of a United States person is 50 percent U.S. source income and 50 percent foreign source income. One commentator suggested that it may be appropriate, in certain situations, to depart from the 50/50 source rule to provide special rules for foreign activities. According to the commentator, as a result of local regulatory requirements, U.S.-based international telecommunications providers often need to conduct portions of their international business through locally formed entities, and such entities are fully subject to foreign tax on their income. The commentator therefore concluded that a source rule for international communications income based on functions performed, resources employed, or risks assumed in a foreign country or countries is not only equitable but also consistent with treatment accorded to foreign persons PO 00000 Frm 00019 Fmt 4700 Sfmt 4700 77601 having a U.S. fixed placed of business or engaged in a U.S. trade or business. The Treasury Department and the IRS recognize that a source rule based on functions performed, resources employed, or risks assumed may be a reasonable alternative to the 50/50 source rule. Nonetheless, they continue to believe that the 50/50 source rule is the method that must be used to determine the source of a United States person’s international communications income. This is because section 863(e)(1)(A) provides for an explicit 50/50 source rule for those persons without exception. In contrast, section 863(e)(1)(B) provides that a foreign person’s international communications income is generally sourced outside the United States, except as provided in regulations. The Treasury Department and the IRS believe that the express grant of regulatory authority in the case of foreign persons and the omission of any such authority in the case of United States persons indicate that Congress intended the 50/50 sourcing rule be applied to United States persons without regulatory modification. There is nothing in the statute or legislative history that clearly demonstrates a different intention. In contrast, section 863(e)(1)(B)(ii) provides for a special source rule with respect to foreign persons with an office or other fixed place of business in the United States. A similar rule is not provided with respect to a United States person’s foreign activities. Thus, Congress chose a rule that sourced international communications income of foreign persons in certain instances based on the place of their activities, but expressly chose the 50/50 method to source international communications income of United States persons, regardless of the place of their activities. The Treasury Department and the IRS recognize that the statute does not require strict application of the 50/50 source rule for CFCs. Section 863(e)(1)(B) only provides that the international communications income of a foreign person is foreign source income, except as provided in regulations. Consistent with and in light of this regulatory authority, however, the Treasury Department and the IRS believe that the 50/50 source rule is the most appropriate method to determine the source of a CFC’s international communications income. This approach addresses the concern of the Treasury Department and the IRS that United States persons may use CFCs to obtain benefits that are inconsistent with the purposes of section 863(e). Consequently, the rules for determining the source of international E:\FR\FM\27DER1.SGM 27DER1 77602 Federal Register / Vol. 71, No. 248 / Wednesday, December 27, 2006 / Rules and Regulations communications income derived by a CFC should be the same as the rules for determining the source of such income if it is derived by a United States person. In addition, the Treasury Department and the IRS believe that the 50/50 source rule for CFCs, as opposed to the 100 percent U.S. source rule that was originally proposed as part of the 2001 proposed regulations, should limit the potential for multiple levels of taxation that commentators raised with respect to those prior proposed regulations. rwilkins on PROD1PC63 with RULES b. U.S. Communications Income Section 1.863–9(c) of the proposed regulations provided that income derived by a United States or foreign person from U.S. communications activity is entirely from sources within the United States. One commentator noted that a foreign person deriving income from the transmission of communications between a point in the United States and another point in the United States or between a point in the United States and a point in space or international water has 100 percent U.S. source income, even if much or all of the activity involved is outside the United States. In contrast, under the space and ocean rules, a foreign person has U.S. source income only to the extent the income is attributable to functions performed, resources employed, or risks assumed within the United States. Commentators therefore suggested modification of the 100 percent U.S. source rule for U.S. communications income derived by United States and foreign persons to take into account foreign activities. The Treasury Department and the IRS recognize that a source rule based on functions performed, resources employed, or risks assumed may be a reasonable alternative to the 100 percent U.S. source rule for U.S. communications. Nonetheless, the Treasury Department and the IRS believe that Congress did not intend such an option. The legislative history indicates that if a communication is between two points within the United States, the ‘‘income attributable thereto is to be sourced entirely as U.S. source income.’’ S. Rep. No. 99–313, 1986–3 C.B. 359 (emphasis added). Congress intended such a result ‘‘even if the communication is routed through a satellite located in space, regardless of the satellite’s location.’’ Id. Thus, the legislative history clearly provides that Congress intended that U.S. communications income be sourced entirely as U.S. source income. VerDate Aug<31>2005 17:07 Dec 26, 2006 Jkt 211001 4. International Communications Income Derived by a Foreign Person (Other Than a CFC) Proposed § 1.863–9(b)(2) reflected the general rule under section 863(e)(1)(B) that a foreign person’s international communications income is foreign source income. Consistent with the statutory exception under section 863(e)(1)(B)(ii), proposed § 1.863– 9(b)(2)(iii) provided that any international communications income derived by a foreign person, other than a CFC, that is attributable to an office or other fixed place of business of the foreign person in the United States is U.S. source income. International communications income is attributable to an office or other fixed place of business to the extent of functions performed, resources employed, or risks assumed by the office or other fixed place of business. Pursuant to the grant of regulatory authority under section 863(e)(1)(B), the proposed regulations provided other exceptions to the general rule for foreign persons. The first exception is the 50/50 source rule for CFCs under § 1.863–9(b)(2)(ii) of the proposed regulations, as discussed above. The second exception was provided in § 1.863–9(b)(2)(iv) of the proposed regulations and applied to foreign persons other than CFCs. Section 1.863–9(b)(2)(iv) of the proposed regulations provided that international communications income derived by a foreign person, other than a CFC, engaged in a trade or business within the United States, that is attributable to functions performed, resources employed, or risks assumed within the United States is U.S. source income. One commentator noted that it is unclear why a separate rule is needed for a fixed place of business in the United States and a U.S. trade or business because international communications income attributable to a fixed place of business in the United States should also be attributable to functions performed, resources employed and risks assumed within the United States. As indicated, the office or other fixed place of business rule under § 1.863– 9(b)(2)(iii) of the proposed regulations was derived from the statutory language of section 863(e), while the trade or business rule under § 1.863–9(b)(2)(iv) of the proposed regulations was derived from the express grant of regulatory authority to source international communications income of foreign persons as other than foreign source. The Treasury Department and the IRS recognize that in most situations, the latter trade or business rule would PO 00000 Frm 00020 Fmt 4700 Sfmt 4700 indeed subsume the former fixed place of business rule, but still believe that the later rule serves an important function. The trade or business rule addresses 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. 5. Allocations Section 1.863–9(h)(1)(ii) of the proposed regulations provided that to the extent that a taxpayer’s transaction consists in part of non-de minimis communications activity and in part of non-de minimis non-communications activity, each part of the transaction must be treated as a separate transaction. Gross income is then allocated to each communications activity transaction and each noncommunications activity transaction to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in each such activity. Moreover, the Treasury Department and the IRS suggested in the preamble to the proposed regulations that allocations of gross income should be based generally on section 482 principles. One commentator stated that the complexities inherent in allocating income, based on section 482 principles, between the separated transactions are significant. While the final regulations were not changed in response to this comment, as in the case of allocations for space and ocean income, the Treasury Department and the IRS believe that some clarification is warranted. In suggesting the use of section 482 principles as a guide, the Treasury Department and the IRS intend for taxpayers to adopt a reasonable approach to the allocations required in this area. Taxpayers know their businesses and will generally be in the best position to fashion a reasonable method that most reliably reflects the relative value of functions performed, resources employed, and risks assumed in different locations. In the preamble to the proposed regulations, the Treasury Department and the IRS solicited comments on alternative methods of allocation for particular industries and criteria that could be used to evaluate the reasonableness of such methods. No such comments were received. One commentator noted, however, that the proposed regulations perhaps reflected E:\FR\FM\27DER1.SGM 27DER1 Federal Register / Vol. 71, No. 248 / Wednesday, December 27, 2006 / Rules and Regulations what taxpayers in these industries have already been doing in order to determine the character and source of their communications income. Consequently, as in the case of space and ocean income, the Treasury Department and the IRS believe that allocations of gross income based on functions performed, resources employed, and risks assumed are appropriate in these circumstances. 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 pursuant to that Order is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it is hereby certified that the collection of information in these regulations will not have a significant economic impact on a substantial number of small entities. This certification is based on the fact that the rules provided in these regulations principally affect large multinational corporations that pay foreign taxes on income derived from substantial foreign operations and that use these and any other applicable source rules in determining their foreign tax credit. Accordingly, a Regulatory Flexibility Act assessment is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the NPRM preceding these regulations were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business. Drafting Information The principal author of these regulations is H. Michael Huynh of the Office of the Associate Chief Counsel (International). However, other personnel from the Treasury Department and the IRS participated in their development. List of Subjects 26 CFR Part 1 Income taxes, Reporting and recordkeeping requirements. 26 CFR Part 602 rwilkins on PROD1PC63 with RULES Reporting and recordkeeping requirements. Adoption of Amendments to the Regulations Accordingly, 26 CFR parts 1 and 602 are amended as follows: I VerDate Aug<31>2005 17:07 Dec 26, 2006 Jkt 211001 PART 1—INCOME TAXES Paragraph 1. The authority citation for part 1 is amended by adding entries in numerical order to read, in part, as follows: I Authority: 26 U.S.C. 7805 * * *. Section 1.863–8 also issued under 26 U.S.C. 863(a), (b) and (d). * * * Section 1.863–9 also issued under 26 U.S.C. 863(a), (d) and (e). * * * I Par. 2. Section 1.863–3 is amended by: I 1. Adding a sentence after the first sentence in paragraph (a)(1). I 2. Adding a sentence at the end of paragraph (c)(1)(i)(A). I 3. Adding a sentence after the first sentence in paragraph (c)(2). The additions read as follows: § 1.863–3 Allocation and apportionment of income from certain sales of inventory. (a) * * * (1) * * * To determine the source of income from sales of property produced by the taxpayer, when the property is either produced in whole or in part in space or 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 (in international water), or is sold in space or international water, the rules of § 1.863–8 apply, and the rules of this section do not apply except to the extent provided in § 1.863–8. * * * (c) * * * (1) * * * (i) * * * (A) * * * For rules regarding the source of income when production takes place, in whole or in part, in space or international water, the rules of § 1.863– 8 apply, and the rules of this section do not apply except to the extent provided in § 1.863–8. * * * * * (2) * * * Notwithstanding any other provision, for rules regarding the source of income when a sale takes place in space or international water, the rules of § 1.863–8 apply, and the rules of this section do not apply except to the extent provided in § 1.863–8. * * * * * * * * I Par. 3. Sections 1.863–8 and 1.863–9 are added to read as follows: § 1.863–8 Source of income derived from space and ocean activity under section 863(d). (a) In general. Income of a United States or a foreign person derived from space and ocean activity (space and ocean income) is sourced under the rules of this section, notwithstanding any other provision, including sections PO 00000 Frm 00021 Fmt 4700 Sfmt 4700 77603 861, 862, 863, and 865. A taxpayer will not be considered to derive income from space or ocean activity, as defined in paragraph (d) of this section, if such activity is performed by another person, subject to the rules for the treatment of consolidated groups in § 1.1502–13. (b) Source of gross income from space and ocean activity—(1) Space and ocean income derived by a United States person. Space and ocean income derived by a United States person is income from sources within the United States. However, space and ocean income derived by a United States person is income from sources without 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. (2) Space and ocean income derived by a foreign person—(i) In general. Space and ocean income derived by a person other than a United States person is income from sources without the United States, except as otherwise provided in this paragraph (b)(2). (ii) Space and ocean income derived by a controlled foreign corporation. Space and ocean income derived by a controlled foreign corporation within the meaning of section 957 (CFC) is income from sources within the United States. However, space and ocean income derived by a CFC is income from sources without 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. (iii) Space and ocean income derived by foreign persons engaged in a trade or business within the United States. Space and ocean income derived by a foreign person (other than a CFC) engaged in a trade or business within the United States is income 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. (3) Source rules for income from certain sales of property—(i) Sales of purchased property. When a taxpayer sells purchased property in space or international water, the source of gross income from the sale generally will be determined under paragraph (b)(1) or (2) of this section, as applicable. However, if such property is inventory property within the meaning of section 1221(a)(1) (inventory property) and is sold for use, consumption, or disposition outside space and international water, the E:\FR\FM\27DER1.SGM 27DER1 rwilkins on PROD1PC63 with RULES 77604 Federal Register / Vol. 71, No. 248 / Wednesday, December 27, 2006 / Rules and Regulations source of income from the sale will be determined under § 1.861–7(c). (ii) Sales of property produced by the taxpayer—(A) General. If the taxpayer both produces property and sells such property, the taxpayer must allocate gross income from such sales between production activity and sales activity under the 50/50 method. Under the 50/ 50 method, one-half of the taxpayer’s gross income will be considered income allocable to production activity, and the source of that income will be determined under paragraph (b)(3)(ii)(B) or (C) of this section. The remaining one-half of such gross income will be considered income allocable to sales activity, and the source of that income will be determined under paragraph (b)(3)(ii)(D) of this section. (B) Production only in space or international water, or only outside space and international water. When production occurs only in space or international water, income allocable to production activity is sourced under paragraph (b)(1) or (2) of this section, as applicable. When production occurs only outside space and international water, income allocable to production activity is sourced under § 1.863–3(c)(1). (C) Production both in space or international water and outside space and international water. When property is produced both in space or international water and outside space and international water, gross income allocable to production activity must be allocated to production occurring in space or international water and production occurring outside space and international water. Such gross income is allocated to production activity occurring in space or international water to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in space or international water. The balance of such gross income is allocated to production activity occurring outside space and international water. The source of gross income allocable to production activity in space or international water is determined under paragraph (b)(1) or (2) of this section, as applicable. The source of gross income allocated to production activity occurring outside space and international water is determined under § 1.863–3(c)(1). (D) Source of income allocable to sales activity. When property produced by the taxpayer is sold outside space and international water, the source of gross income allocable to sales activity will be determined under §§ 1.861–7(c) and 1.863–3(c)(2). When property produced by the taxpayer is sold in VerDate Aug<31>2005 17:07 Dec 26, 2006 Jkt 211001 space or international water, the source of gross income allocable to sales activity generally will be determined under paragraph (b)(1) or (2) of this section, as applicable. However, if such property is inventory property within the meaning of section 1221(a)(1) and is sold in space or international water for use, consumption, or disposition outside space, international water, and the United States, the source of gross income allocable to sales activity will be determined under §§ 1.861–7(c) and 1.863–3(c)(2). (4) Special rule for determining the source of gross income from services. To the extent a transaction characterized as the performance of a service constitutes a space or ocean activity, as determined under paragraph (d)(2)(ii) of this section, the source of gross income derived from such transaction is determined under paragraph (b)(1) or (2) of this section. (5) Special rule for determining source of income from communications activity (other than income from international communications activity). Space and ocean activity, as defined in paragraph (d) of this section, includes activity that occurs in space or international water that is characterized as a communications activity as defined in § 1.863–9(h)(1) (other than international communications activity). The source of space and ocean income that is also communications income as defined in § 1.863–9(h)(2) (but not space/ocean communications income as defined in § 1.863–9(h)(3)(v)) is determined under the rules of § 1.863–9(c), (d), and (f), as applicable, rather than under paragraph (b) of this section. The source of space and ocean income that is also space/ ocean communications income as defined in § 1.863–9(h)(3)(v) is determined under the rules of paragraph (b) of this section. See § 1.863–9(e). (c) Taxable income. When a taxpayer allocates gross income under paragraph (b)(1), (b)(2), (b)(3)(ii)(C), or (b)(4) of this section, the taxpayer must allocate expenses, losses, and other deductions as prescribed in §§ 1.861–8 through 1.861–14T to the class or classes of gross income that include the income so allocated in each case. A taxpayer must then apply the rules of §§ 1.861–8 through 1.861–14T to apportion properly amounts of expenses, losses, and other deductions so allocated to such gross income between gross income from sources within the United States and gross income from sources without the United States. (d) Space and ocean activity—(1) Definition—(i) Space activity. In general, space activity is any activity conducted in space. For purposes of this PO 00000 Frm 00022 Fmt 4700 Sfmt 4700 section, space means 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. For purposes of determining space activity, the Commissioner may separate parts of a single transaction into separate transactions or combine separate transactions as part of a single transaction. Paragraph (d)(3) of this section lists specific exceptions to the general definition of space activity. Activities that constitute space activity include but are not limited to— (A) Performance and provision of services in space, as defined in paragraph (d)(2)(ii) of this section; (B) Leasing of equipment located in space, including spacecraft (for example, satellites) or transponders located in space; (C) Licensing of technology or other intangibles for use in space; (D) Production, processing, or creation of property in space, as defined in paragraph (d)(2)(i) of this section; (E) Activity occurring in space that is characterized as communications activity (other than international communications activity) under § 1.863–9(h)(1); (F) Underwriting income from the insurance of risks on activities that produce space income; and (G) Sales of property in space (see § 1.861–7(c)). (ii) Ocean activity. In general, ocean activity is 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 (collectively, in international water). For purposes of determining ocean activity, the Commissioner may separate parts of a single transaction into separate transactions or combine separate transactions as part of a single transaction. Paragraph (d)(3) of this section lists specific exceptions to the general definition of ocean activity. Activities that constitute ocean activity include but are not limited to— (A) Performance and provision of services in international water, as defined in paragraph (d)(2)(ii) of this section; (B) Leasing of equipment located in international water, including underwater cables; (C) Licensing of technology or other intangibles for use in international water; (D) Production, processing, or creation of property in international water, as defined in paragraph (d)(2)(i) of this section; E:\FR\FM\27DER1.SGM 27DER1 rwilkins on PROD1PC63 with RULES Federal Register / Vol. 71, No. 248 / Wednesday, December 27, 2006 / Rules and Regulations (E) Activity occurring in international water that is characterized as communications activity (other than international communications activity) under § 1.863–9(h)(1); (F) Underwriting income from the insurance of risks on activities that produce ocean income; (G) Sales of property in international water (see § 1.861–7(c)); (H) Any activity performed in Antarctica; (I) The leasing of a vessel that does not transport cargo or persons for hire between ports-of-call (for example, the leasing of a vessel to engage in research activities in international water); and (J) The leasing of drilling rigs, extraction of minerals, and performance and provision of services related thereto, except as provided in paragraph (d)(3)(ii) of this section. (2) Determining a space or ocean activity—(i) Production of property in space or international water. For purposes of this section, production activity means an activity that creates, fabricates, manufactures, extracts, processes, cures, or ages property within the meaning of section 864(a) and § 1.864–1. (ii) Special rule for performance of services—(A) General. Except as provided in paragraph (d)(2)(ii)(B) of this section, if a transaction is characterized as the performance of a service, then such service will be treated as a space or ocean activity in its entirety when any part of the service is performed in space or international water. Services are performed in space or international water if functions are performed, resources are employed, or risks are assumed in space or international water, regardless of whether performed by personnel, equipment, or otherwise. (B) Exception to the general rule. If the taxpayer can demonstrate the value of the service attributable to performance occurring in space or international water, and the value of the service attributable to performance occurring outside space and international water, then such service will be treated as 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 the service, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in space or international water. In addition, if the VerDate Aug<31>2005 17:56 Dec 26, 2006 Jkt 211001 taxpayer can demonstrate, based on all the facts and circumstances, that the value of the service attributable to performance in space and international water is de minimis, such service will not be treated as space or ocean activity. (3) Exceptions to space or ocean activity. Space or ocean activity does not include the following types of activities: (i) Any activity giving rise to transportation income as defined in section 863(c). (ii) Any activity with respect to mines, oil and gas wells, or other natural deposits, to the extent the mines, wells, or natural deposits are located within the jurisdiction (as recognized by the United States) of any country, including the United States and its possessions. (iii) Any activity giving rise to international communications income as defined in § 1.863–9(h)(3)(ii). (e) Treatment of partnerships. This section is applied at the partner level. (f) Examples. The following examples illustrate the rules of this section: Example 1. Space activity—activity occurring on land and in space—(i) Facts. S, a United States person, owns satellites in orbit. S leases one of its satellites to A. S, as lessor, will not operate the satellite. Part of S’s performance as lessor in this transaction occurs on land. Assume that the combination of S’s activities is characterized as the lease of equipment. (ii) Analysis. Because the leased equipment is located in space, the transaction is defined in its entirety as space activity under paragraph (d)(1)(i) of this section. Income derived from the lease will be sourced under paragraph (b)(1) of this section. Under paragraph (b)(1) of this section, S’s space 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. Example 2. Space activity—(i) Facts. X is an Internet service provider. X offers a service that permits a customer (C) to connect to the Internet via a telephone call, initiated by the modem of C’s personal computer, to a control center. X transmits information requested by C to C’s personal computer, in part using satellite capacity leased by X from S. X performs the uplink and downlink functions. X charges its customers a flat monthly fee. Assume that neither X nor S derive international communications income within the meaning of § 1.863–9(h)(3)(ii). In addition, assume that X is able to demonstrate, pursuant to paragraph (d)(2)(ii)(B) of this section, the extent to which the value of the service is attributable to functions performed, resources employed, and risks assumed in space. (ii) Analysis. Under paragraph (d)(2)(ii) of this section, the service performed by X PO 00000 Frm 00023 Fmt 4700 Sfmt 4700 77605 constitutes space activity to the extent the value of the service is attributable to functions performed, resources employed, and risks assumed in space. To the extent the service performed by X constitutes space activity, the source of X’s income from the service transaction is determined under paragraph (b) of this section. To the extent the service performed by X does not constitute space or ocean activity, the source of X’s income from the service is determined under sections 861, 862, and 863, as applicable. To the extent that X derives space and ocean income that is also communications income within the meaning of § 1.863–9(h)(2), the source of X’s income is determined under paragraph (b) of this section and § 1.863–9(c), (d), and (f), as applicable, as provided in paragraph (b)(5) of this section. S derives space and ocean income that is also communications income within the meaning of § 1.863–9(h)(2), and the source of S’s income is therefore determined under paragraph (b) of this section and § 1.863–9(c), (d), and (f), as applicable, as provided in paragraph (b)(5) of this section. Example 3. Services as space activity—de minimis value attributable to performance occurring in space—(i) Facts. R owns a retail outlet in the United States. R engages S to provide a security system for R’s premises. S operates its security system by transmitting images from R’s premises directly to a satellite, and from the satellite to a group of S employees located in Country B, who monitor the premises by viewing the transmitted images. The satellite is used as a medium of delivery and not as a method of surveillance. O provides S with transponder capacity on O’s satellite, which S uses to transmit those images. Assume that S’s transaction with R is characterized as the performance of a service. Assume that O’s provision of transponder capacity is also viewed as the provision of a service. Assume also that S is able to demonstrate, pursuant to § 1.863–9(h)(1), that the value of the transaction with R attributable to communications activities is de minimis. (ii) Analysis. S derives income from providing monitoring services. S can demonstrate, pursuant to paragraph (d)(2)(ii) of this section, that based on all the facts and circumstances, the value of S’s service transaction attributable to performance in space is de minimis. Thus, S is not treated as engaged in a space activity, and none of S’s income from the service transaction is space income. In addition, because S demonstrates that the value of the transaction with R attributable to communications activities is de minimis, S is not required under § 1.863–9(h)(1)(ii) to treat the transaction as separate communications and non-communications transactions, and none of S’s gross income from the transaction is treated as communications income within the meaning of § 1.863–9(h)(2). O’s provision of transponder capacity is viewed as the provision of a service. Based on all the facts and circumstances, the value of O’s service transaction attributable to performance E:\FR\FM\27DER1.SGM 27DER1 rwilkins on PROD1PC63 with RULES 77606 Federal Register / Vol. 71, No. 248 / Wednesday, December 27, 2006 / Rules and Regulations in space is not de minimis. Thus, O’s activity will be considered space activity, pursuant to paragraph (d)(2)(ii) of this section, to the extent the value of the services transaction is attributable to performance in space (unless O’s activity in space is international communications activity). To the extent that O derives communications income, the source of such income is determined under paragraph (b) of this section and § 1.863–9(b), (c), (d), and (f), as applicable, as provided in paragraph (b)(5) of this section. R does not derive any income from space activity. Example 4. Space activity—(i) Facts. L, a domestic corporation, offers programming and certain other services to customers located both in the United States and in foreign countries. Assume that L’s provision of programming and other services in this Example 4 is characterized as the provision of a service, and that no part of the service transaction occurs in space or international water. Assume that the delivery of the programming constitutes a separate transaction also characterized as the performance of a service. L uses satellite capacity acquired from S to deliver the programming service directly to customers’ television sets. L performs the uplink and downlink functions, so that part of the value of the delivery transaction derives from functions performed and resources employed in space. Assume that these contributions to the value of the delivery transaction occurring in space are not considered de minimis under paragraph (d)(2)(ii)(B) of this section. Customer C pays L to provide and deliver programming to C’s residence in the United States. Assume S’s provision of satellite capacity in this Example 4 is viewed as the provision of a service, and also that S does not derive international communications income within the meaning of § 1.863–9(h)(3)(ii). (ii) Analysis. S’s activity will be considered space activity. To the extent that S derives space and ocean income that is also communications income under § 1.863– 9(h)(2), the source of S’s income is determined under paragraph (b) of this section and § 1.863–9(c), (d), and (f), as applicable, as provided in paragraph (b)(5) of this section. On these facts, L’s activities are treated as two separate service transactions: the provision of programming (and other services), and the delivery of programming. L’s income derived from provision of programming and other services is not income derived from space activity. L’s delivery of programming and other services is considered space activity, pursuant to paragraph (d)(2)(ii) of this section, to the extent the value of the delivery transaction is attributable to performance in space. To the extent that the delivery of programming is treated as a space activity, the source of L’s income derived from the delivery transaction is determined under paragraph (b)(1) of this section, as provided in paragraph (b)(4) of this section. To the extent that L derives space and ocean income that is also communications income within the meaning of § 1.863–9(h)(2), the source of such income is determined under paragraph (b) of this section and § 1.863–9(b), (c), (d), (e), and (f), as applicable, as provided in paragraph (b)(5) of this section. VerDate Aug<31>2005 17:56 Dec 26, 2006 Jkt 211001 Example 5. Space activity—(i) Facts. The facts are the same as in Example 4, except that L does not deliver the programming service directly but instead engages R, a domestic corporation specializing in content delivery, to deliver by transmission its programming. For all portions of a transmission which require satellite capacity, R, in turn, contracts out such functions to S. S performs the uplink and downlink functions, so that part of the value of the delivery transaction derives from functions performed and resources employed in space. (ii) Analysis. L’s activity will not be considered space activity because none of L’s activity occurs in space. Thus, L does not derive any space and ocean income. L does, however, derive communications income within the meaning of § 1.863–9(h)(2). This is the case even though L does not perform the transmission function because L is paid by Customer C to transmit, and bears the risk of transmitting, the communications or data. To the extent that L’s activity consists in part of non-de minimis communications and non-de minimis non-communications activity, each part of the transaction must be treated as a separate transaction and gross income is allocated accordingly under § 1.863– 9(h)(1)(ii). In addition, L must also allocate expenses, losses, and other deductions, for example, payments to R, to the class or classes of gross income that include the income so allocated. R’s activity will not be considered space activity. Since R contracts out all of the functions involving satellite capacity to S, no part of R’s activity occurs in space. Thus, R does not derive any space and ocean income. R does, however, derive communications income within the meaning of § 1.863–9(h)(2). This is the case even though R does not perform the transmission function because R is paid by L to transmit, and bears the risk of transmitting, the communications or data. S’s activity will be considered space activity. To the extent that S derives space and ocean income that is also communications income within the meaning of § 1.863–9(h)(2), the source of such income is determined under paragraph (b) of this section and § 1.863–9(b), (c), (d), (e), and (f), as applicable, as provided in paragraph (b)(5) of this section. Example 6. Space activity—treatment of land activity—(i) Facts. S, a United States person, offers remote imaging products and services to its customers. In year 1, S uses its satellite’s remote sensors to gather data on certain geographical terrain. In year 3, C, a construction development company, contracts with S to obtain a satellite image of an area for site development work. S pulls data from its archives and transfers to C the images gathered in year 1, in a transaction that is characterized as a sale of the data. S’s rights, title, and interest in the data pass to C in the United States. Before transferring the images to C, S uses computer software in its land-based office to enhance the images so that the images can be used. (ii) Analysis. The collection of data and creation of images in space is characterized as the creation of property in space. Because S both produces and sells the data, S must allocate gross income from the sale of the data between production activity and sales PO 00000 Frm 00024 Fmt 4700 Sfmt 4700 activity under the 50/50 method of paragraph (b)(3)(ii)(A). The source of S’s income allocable to production activity is determined under paragraph (b)(3)(ii)(C) of this section because production activities occur both in space and on land. The source of S’s income attributable to sales activity is determined under paragraph (b)(3)(ii)(D) of this section (by reference to § 1.863–3(c)(2)) as U.S. source income because S’s rights, title, and interest in the data pass to C in the United States. Example 7. Use of intangible property in space—(i) Facts. X acquires a license to use a particular satellite slot or orbit, which X sublicenses to C. C pays X a royalty. (ii) Analysis. Because the royalty is paid for the right to use intangible property in space, the source of the royalty paid by C to X is determined under paragraph (b) of this section. Example 8. Performance of services—(i) Facts. E, a domestic corporation, operates satellites with sensing equipment that can determine how much heat and light particular plants emit and reflect. Based on the data, E will provide F, a U.S. farmer, a report analyzing the data, which F will use in growing crops. E analyzes the data from offices located in the United States. Assume that E’s combined activities are characterized as the performance of services. (ii) Analysis. Based on all the facts and circumstances, the value of E’s service transaction attributable to performance in space is not de minimis. Thus, E’s activities will be considered space activities, pursuant to paragraph (d)(2)(ii) of this section, to the extent the value of E’s service transaction is attributable to performance in space. To the extent E’s service transaction constitutes a space activity, the source of E’s income derived from the service transaction will be determined under paragraph (b)(4) of this section, by reference to paragraph (b)(1) of this section. To the extent that E’s service transaction does not constitute a space or ocean activity, the source of E’s income derived from the service transaction is determined under sections 861, 862, and 863, as applicable. Example 9. Separate transactions—(i) Facts. The same facts as Example 8, except that E provides the raw data to F in a transaction characterized as a sale of a copyrighted article. In addition, E provides an analysis in the form of a report to F. The price F pays E for the raw data is separately stated. (ii) Analysis. To the extent that the provision of raw data and the analysis of the data are each treated as separate transactions, the source of income from the production and sale of data is determined under paragraph (b)(3)(ii) of this section. The provision of services would be analyzed in the same manner as in Example 8. Example 10. Sale of property in international water—(i) Facts. T purchased and owns transatlantic cable that lies in international water. T sells the cable to B, with T’s rights, title, and interest in the cable E:\FR\FM\27DER1.SGM 27DER1 rwilkins on PROD1PC63 with RULES Federal Register / Vol. 71, No. 248 / Wednesday, December 27, 2006 / Rules and Regulations passing to B in international water. Assume that the transatlantic cable is not inventory property within the meaning of section 1221(a)(1). (ii) Analysis. Because T’s rights, title, and interest in the property pass to B in international water, the sale takes place in international water under § 1.861–7(c), and the sale transaction is ocean activity under paragraph (d)(1)(ii) of this section. The source of T’s sales income is determined under paragraph (b)(3)(i) of this section, by reference to paragraph (b)(1) or (2) of this section. Example 11. Sale of property in space—(i) Facts. S, a United States person, manufactures a satellite in the United States and sells it to a customer who is not a United States person. S’s rights, title, and interest in the satellite pass to the customer in space. (ii) Analysis. Because S’s rights, title, and interest in the satellite pass to the customer in space, the sale takes place in space under § 1.861–7(c), and the sale transaction is space activity under paragraph (d)(1)(i) of this section. The source of income derived from the sale of the satellite in space is determined under paragraph (b)(3)(ii) of this section, with the source of income allocable to production activity determined under paragraphs (b)(3)(ii)(A) and (B) of this section, and the source of income allocable to sales activity determined under paragraphs (b)(3)(ii)(A) and (D) of this section. Under paragraph (b)(1) of this section, S’s space 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. Example 12. Sale of property in space—(i) Facts. S has a right to operate from a particular position (satellite slot or orbit) in space. S sells the right to operate from that position to P. Assume that the sale of the satellite slot is characterized as a sale of property and that S’s rights, title, and interest in the satellite slot pass to P in space. (ii) Analysis. The sale of the satellite slot takes place in space under § 1.861–7(c) because S’s rights, title, and interest in the satellite slot pass to P in space. The sale of the satellite slot is space activity under paragraph (d)(1)(i) of this section, and income or gain from the sale is sourced under paragraph (b)(3)(i) of this section, by reference to paragraph (b)(1) or (2) of this section. Example 13. Source of income of a foreign person—(i) Facts. FP, a foreign corporation that is not a CFC, derives income from the operation of satellites. FP operates ground stations in the United States and in foreign Country FC. Assume that FP is considered engaged in a trade or business within the United States based on FP’s operation of the ground station in the United States. (ii) Analysis. Under paragraph (b)(2)(iii) of this section, FP’s space income is sourced in 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. Example 14. Source of income of a foreign person—(i) Facts. FP, a foreign corporation VerDate Aug<31>2005 17:07 Dec 26, 2006 Jkt 211001 that is not a CFC, operates remote sensing satellites in space to collect data and images for its customers. FP uses an independent agent, A, in the United States who provides marketing, order-taking, and other customer service functions. Assume that FP is considered engaged in a trade or business within the United States based on A’s activities on FP’s behalf in the United States. (ii) Analysis. Under paragraph (b)(2)(iii) of this section, FP’s space income is sourced in 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. 77607 does so by making the allocation on a timely filed original return (including extensions). However, a taxpayer will be permitted to make changes to such allocations made on its original return with respect to any taxable year for which the statute of limitations has not closed as follows: (i) In the case of a taxpayer that has made a change to such allocations prior to the opening conference for the audit of the taxable year to which the allocation relates or who makes such a change within 90 days of such opening conference, if the IRS issues a written (g) Reporting and documentation information document request asking requirements—(1) In general. A taxpayer the taxpayer to provide the documents making an allocation of gross income and such other information described in under paragraph (b)(1), (b)(2), paragraphs (g)(2) and (3) of this section (b)(3)(ii)(C), or (b)(4) of this section must with respect to the changed allocations satisfy the requirements in paragraphs and the taxpayer complies with such (g)(2), (3), and (4) of this section. request within 30 days of the request, (2) Required documentation. In all then the IRS will complete its cases, a taxpayer must prepare and examination, if any, with respect to the maintain documentation in existence allocations for that year as part of the when its return is filed regarding the current examination cycle. If the allocation of gross income and taxpayer does not provide the allocation and apportionment of documents and information described expenses, losses, and other deductions, in paragraphs (g)(2) and (3) of this the methodologies used, and the section within 30 days of the request, circumstances justifying use of those then the procedures described in methodologies. The taxpayer must make paragraph (g)(4)(ii) of this section shall available such documentation within 30 apply. days upon request. (ii) If the taxpayer changes such (3) Access to software. If the taxpayer allocations more than 90 days after the or any third party used any computer opening conference for the audit of the software, within the meaning of section taxable year to which the allocations 7612(d), to allocate gross income, or to relate or the taxpayer does not provide allocate or apportion expenses, losses, the documents and information with and other deductions, the taxpayer must respect to the changed allocations as make available upon request— requested in accordance with (i) Any computer software executable paragraphs (g)(2) and (3) of this section, code, within the meaning of section then the IRS will, in a separate cycle, 7612(d), used for such purposes, determine whether an examination of including an executable copy of the the taxpayer’s allocations is warranted version of the software used in the and complete any such examination. preparation of the taxpayer’s return The separate cycle will be worked as (including any plug-ins, supplements, resources are available and may not etc.) and a copy of all related electronic have the same estimated completion data files. Thus, if software date as the other issues under subsequently is upgraded or examination for the taxable year. The supplemented, a separate executable IRS may ask the taxpayer to extend the copy of the version used in preparing statute of limitations on assessment and the taxpayer’s return must be retained; collection for the taxable year to permit (ii) Any related computer software examination of the taxpayer’s method of source code, within the meaning of allocation, including an extension section 7612(d), acquired or developed limited, where appropriate, to the by the taxpayer or a related person, or taxpayer’s method of allocation. primarily for internal use by the (h) Effective date. This section applies taxpayer or such person rather than for to taxable years beginning on or after commercial distribution; and December 27, 2006. (iii) In the case of any spreadsheet software or similar software, any § 1.863–9 Source of income derived from communications activity under section formulae or links to supporting 863(a), (d), and (e). worksheets. (4) Use of allocation methodology. In (a) In general. Income of a United general, when a taxpayer allocates gross States or a foreign person derived from income under paragraph (b)(1), (b)(2), each type of communications activity, (b)(3)(ii)(C), or (b)(4) of this section, it as defined in paragraph (h)(3) of this PO 00000 Frm 00025 Fmt 4700 Sfmt 4700 E:\FR\FM\27DER1.SGM 27DER1 rwilkins on PROD1PC63 with RULES 77608 Federal Register / Vol. 71, No. 248 / Wednesday, December 27, 2006 / Rules and Regulations section, is sourced under the rules of this section, notwithstanding any other provision including sections 861, 862, 863, and 865. Notwithstanding that a communications activity would qualify as space or ocean activity under section 863(d) and the regulations thereunder, the source of income derived from such communications activity is determined under this section, and not under section 863(d) and the regulations thereunder, except to the extent provided in § 1.863–8(b)(5). (b) Source of international communications income—(1) International communications income derived by a United States person. Income derived from international communications activity (international communications income) by a United States person is one-half from sources within the United States and one-half from sources without the United States. (2) International communications income derived by foreign persons—(i) In general. International communications income derived by a person other than a United States person is, except as otherwise provided in this paragraph (b)(2), wholly from sources without the United States. (ii) International communications income derived by a controlled foreign corporation. International communications income derived by a controlled foreign corporation within the meaning of section 957 (CFC) is onehalf from sources within the United States and one-half from sources without the United States. (iii) International communications income derived by foreign persons with a fixed place of business in the United States. International communications income derived by a foreign person, other than a CFC, that is attributable to an office or other fixed place of business of the foreign person in the United States is from sources within the United States. The principles of section 864(c)(5) apply in determining whether a foreign person has an office or fixed place of business in the United States. See § 1.864–7. International communications income is attributable to an office or other fixed place of business to the extent of functions performed, resources employed, or risks assumed by the office or other fixed place of business. (iv) International communications income derived by foreign persons engaged in a trade or business within the United States. International communications income derived by a foreign person (other than a CFC) engaged in a trade or business within the United States is income from sources within the United States to the VerDate Aug<31>2005 17:56 Dec 26, 2006 Jkt 211001 extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed within the United States. (c) Source of U.S. communications income. Income derived by a United States or foreign person from U.S. communications activity is from sources within the United States. (d) Source of foreign communications income. Income derived by a United States or foreign person from foreign communications activity is from sources without the United States. (e) Source of space/ocean communications income. The source of income derived by a United States or foreign person from space/ocean communications activity is determined under section 863(d) and the regulations thereunder. (f) Source of communications income when taxpayer cannot establish the two points between which the taxpayer is paid to transmit the communication. Income derived by a United States or foreign person from communications activity, when the taxpayer cannot establish the two points between which the taxpayer is paid to transmit the communication as required in paragraph (h)(3)(i) of this section, is from sources within the United States. (g) Taxable income. When a taxpayer allocates gross income under paragraph (b)(2)(iii), (b)(2)(iv), or (h)(1)(ii) of this section, the taxpayer must allocate expenses, losses, and other deductions as prescribed in §§ 1.861–8 through 1.861–14T to the class or classes of gross income that include the income so allocated in each case. A taxpayer must then apply the rules of §§ 1.861–8 through 1.861–14T properly to apportion amounts of expenses, losses, and other deductions so allocated to such gross income between gross income from sources within the United States and gross income from sources without the United States. For amounts of expenses, losses, and other deductions allocated to gross income derived from international communications activity, when the source of income is determined under the 50/50 method of paragraph (b)(1) or (b)(2)(ii) of this section, taxpayers generally must apportion expenses, losses, and other deductions between sources within the United States and sources without the United States pro rata based on the relative amounts of gross income from sources within the United States and gross income from sources without the United States. However, the preceding sentence shall not apply to research and experimental expenditures qualifying under § 1.861– PO 00000 Frm 00026 Fmt 4700 Sfmt 4700 17, which are to be allocated and apportioned under the rules of that section. (h) Communications activity and income derived from communications activity—(1) Communications activity— (i) General rule. For purposes of this part, communications activity consists solely of the delivery by transmission of communications or data (communications). Delivery of communications other than by transmission (for example, by delivery of physical packages and letters) is not communications activity within the meaning of this section. Communications activity also includes the provision of capacity to transmit communications. Provision of content or any other additional service provided along with, or in connection with, a non-de minimis communications activity must be treated as a separate non-communications activity unless de minimis. Communications activity or non-communications activity will be treated as de minimis to the extent, based on the facts and circumstances, the value attributable to such activity is de minimis. (ii) Separate transaction. To the extent that a taxpayer’s transaction consists in part of non-de minimis communications activity and in part of non-de minimis non-communications activity, each such part of the transaction must be treated as a separate transaction. Gross income is allocated to each such communications activity transaction and non-communications activity transaction to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in each such activity. (2) Income derived from communications activity. Income derived from communications activity (communications income) is income derived from the delivery by transmission of communications, including income derived from the provision of capacity to transmit communications. Income may be considered derived from a communications activity even if the taxpayer itself does not perform the transmission function, but in all cases, the taxpayer derives communications income only if the taxpayer is paid to transmit, and bears the risk of transmitting, the communications. (3) Determining the type of communications activity—(i) In general. Whether income is derived from international communications activity, U.S. communications activity, foreign communications activity, or space/ E:\FR\FM\27DER1.SGM 27DER1 rwilkins on PROD1PC63 with RULES Federal Register / Vol. 71, No. 248 / Wednesday, December 27, 2006 / Rules and Regulations ocean communications activity is determined by identifying the two points between which the taxpayer is paid to transmit the communication. The taxpayer must establish the two points between which the taxpayer is paid to transmit, and bears the risk of transmitting, the communication. Whether the taxpayer contracts out part or all of the transmission function is not relevant. A taxpayer may satisfy the requirement that the taxpayer establish the two points between which the taxpayer is paid to transmit, and bears the risk of transmitting, the communication by using any consistently applied reasonable method to establish one or both endpoints. In evaluating the reasonableness of such method, consideration will be given to all the facts and circumstances, including whether the endpoints would otherwise be identifiable absent this reasonable method provision and the reliability of the data. Depending on the facts and circumstances, methods based on, for example, records of port or transport charges, customer billing records, a satellite footprint, or records of termination fees made pursuant to an international settlement agreement may be reasonable. In addition, practices used by taxpayers to classify or categorize certain communications activity in connection with preparation of statements and analyses for the use of management, creditors, minority shareholders, joint ventures, or other parties or governmental agencies in interest may be reliable indicators of the reasonableness of the method chosen, but need not be accorded conclusive weight by the Commissioner. In all cases, the method chosen to establish the two points between which the taxpayer is paid to transmit, and bears the risk of transmitting, the communication must be supported by sufficient documentation to permit verification by the Commissioner. (ii) Income derived from international communications activity. Income derived by a taxpayer from international communications activity (international communications income) is income derived from communications activity, as defined in paragraph (h)(2) of this section, when the taxpayer is paid to transmit— (A) Between a point in the United States and a point in a foreign country (or a possession of the United States); or (B) Foreign-originating communications (communications with a beginning point in a foreign country or a possession of the United States) VerDate Aug<31>2005 17:56 Dec 26, 2006 Jkt 211001 from a point in space or international water to a point in the United States. (iii) Income derived from U.S. communications activity. Income derived by a taxpayer from U.S. communications activity (U.S. communications income) is income derived from communications activity, as defined in paragraph (h)(2) of this section, when the taxpayer is paid to transmit— (A) Between two points in the United States; or (B) Between the United States and a point in space or international water, except as provided in paragraph (h)(3)(ii)(B) of this section. (iv) Income derived from foreign communications activity. Income derived by a taxpayer from foreign communications activity (foreign communications income) is income derived from communications activity, as defined in paragraph (h)(2) of this section, when the taxpayer is paid to transmit— (A) Between two points in a foreign country or countries (or a possession or possessions of the United States); (B) Between a foreign country and a possession of the United States; or (C) Between a foreign country (or a possession of the United States) and a point in space or international water. (v) Income derived from space/ocean communications activity. Income derived by a taxpayer from space/ocean communications activity (space/ocean communications income) is income derived from communications activity, as defined in paragraph (h)(2) of this section, when the taxpayer is paid to transmit between a point in space or international water and another point in space or international water. (i) Treatment of partnerships. This section is applied at the partner level. (j) Examples. The following examples illustrate the rules of this section: Example 1. Income derived from noncommunications activity—remote data base access—(i) Facts. D provides its customers in various foreign countries with access to its data base, which contains information on certain individuals’ health care insurance coverage. Customer C obtains access to D’s data base by placing a call to D’s telephone number. Assume that C’s telephone service, used to access D’s data base, is provided by a third party, and that D assumes no responsibility for the transmission of the information via telephone. (ii) Analysis. D is not paid to transmit communications and does not derive income from communications activity within the meaning of paragraph (h)(2) of this section. Rather, D derives income from provision of content or provision of services to its PO 00000 Frm 00027 Fmt 4700 Sfmt 4700 77609 customers. Therefore, the rules of this section do not apply to determine the source of D’s income. Example 2. Income derived from U.S. communications activity—U.S. portion of international communication—(i) Facts. TC, a local telephone company, receives an access fee from an international carrier for picking up a call from a local telephone customer and delivering the call to a U.S. point of presence (POP) of the international carrier. The international carrier picks up the call from its U.S. POP and delivers the call to a foreign country. (ii) Analysis. TC is not paid to carry the transmission between the United States and a foreign country. TC is paid to transmit a communication between two points in the United States. TC derives U.S. communications income as defined in paragraph (h)(3)(iii) of this section, which is sourced under paragraph (c) of this section as U.S. source income. Example 3. Income derived from international communications activity— underwater cable—(i) Facts. TC, a domestic corporation, owns an underwater fiber optic cable. Pursuant to contracts, TC makes available to its customers capacity to transmit communications via the cable. TC’s customers then solicit telephone customers and arrange to transmit the telephone customers’ calls. The cable runs in part through U.S. waters, in part through international waters, and in part through foreign country waters. (ii) Analysis. TC derives international communications income as defined in paragraph (h)(3)(ii) of this section because TC is paid to make available capacity to transmit communications between the United States and a foreign country. Because TC is a United States person, TC’s international communications income is sourced under paragraph (b)(1) of this section as one-half from sources within the United States and one-half from sources without the United States. Example 4. Income derived from international communications activity— satellite—(i) Facts. S, a United States person, owns satellites in orbit and uplink facilities in Country X, a foreign country. B, a resident of Country X, pays S to deliver B’s programming from S’s uplink facility, located in Country X, to a downlink facility in the United States owned by C, a customer of B. (ii) Analysis. S derives international communications income under paragraph (h)(3)(ii) of this section because S is paid to transmit the communications between a beginning point in a foreign country and an endpoint in the United States. Because S is a United States person, the source of S’s international communications income is determined under paragraph (b)(1) of this section as one-half from sources within the United States and one-half from sources without the United States. Example 5. The paid-to-do rule—foreign communications via domestic route—(i) E:\FR\FM\27DER1.SGM 27DER1 rwilkins on PROD1PC63 with RULES 77610 Federal Register / Vol. 71, No. 248 / Wednesday, December 27, 2006 / Rules and Regulations Facts. TC is paid to transmit communications from Toronto, Canada, to Paris, France. TC transmits the communications from Toronto to New York. TC pays another communications company, IC, to transmit the communications from New York to Paris. (ii) Analysis. Under the paid-to-do rule of paragraph (h)(3)(i) of this section, TC derives foreign communications income under paragraph (h)(3)(iv) of this section because TC is paid to transmit communications between two points in foreign countries, Toronto and Paris. Under paragraph (h)(3)(i) of this section, the character of TC’s communications activity is determined without regard to the fact that TC pays IC to transmit the communications for some portion of the delivery path. IC has international communications income under paragraph (h)(3)(ii) of this section because IC is paid to transmit the communications between a point in the United States and a point in a foreign country. Example 6. The paid-to-do rule—domestic communication via foreign route—(i) Facts. TC is paid to transmit a call between two points in the United States, but routes the call through Canada. (ii) Analysis. Under paragraph (h)(3)(i) of this section, the character of income derived from communications activity is determined by the two points between which the taxpayer is paid to transmit, and bears the risk of transmitting, the communications, without regard to the path of the transmission between those two points. Thus, under paragraph (h)(3)(iii) of this section, TC derives income from U.S. communications activity because it is paid to transmit the communications between two U.S. points. Example 7. The paid-to-do rule—foreignoriginating communications—(i) Facts. Under an international settlement agreement, G, a Country X international carrier, pays T to receive all calls originating in Country X that are bound for the United States and to terminate such calls in the United States. Due to Country X legal restrictions, the international settlement agreement specifies that G carries the transmission to a point outside the territory of Country X and that T carries the foreign-originating transmission from such point to the destined point in the United States. T, in turn, contracts out with another communications company, S, to transmit the U.S. portion of the communications. Tracing and identifying the endpoints of each transmission is not possible or practical. T does, however, keep records of termination fees received from G for terminating the foreign-originating calls. (ii) Analysis. T derives communications income as defined in paragraph (h)(2) of this section. Based on all the facts and circumstances, T can establish that T is paid to transmit, and bears the risk of transmitting, foreign-originating calls from a point in space or international water to a point in the United States using a reasonable method to establish the endpoints, assuming that this method is consistently applied. In this case, T can reasonably establish that T is paid to receive foreign-originating calls and terminate such calls in the United States based on the records of termination fees VerDate Aug<31>2005 17:56 Dec 26, 2006 Jkt 211001 pursuant to an international settlement agreement. Under paragraph (h)(3)(ii)(B) of this section, a taxpayer derives income from international communications activity when the taxpayer is paid to transmit foreignoriginating communications from space or international water to the United States. Thus, under paragraph (h)(3)(ii)(B) of this section, T derives income from international communications. If, based on all the facts and circumstances, T could reasonably trace and identify the endpoints, then T would have to directly establish that each call originated in a foreign country. Assuming T is able to do so, the rest of the analysis in this Example 7 remains the same. Under paragraph (h)(3)(iii) of this section, S derives income from U.S. communications activity because S is paid to transmit the communications between two U.S. points. Example 8. Indeterminate endpoints— prepaid telephone calling cards—(i) Facts. S purchases capacity from TC to transmit telephone calls. S sells prepaid telephone calling cards that give customers access to TC’s telephone lines for a certain number of minutes. Assume that S cannot establish the endpoints of its customers’ telephone calls, even under the reasonable method rule of paragraph (h)(3) of this section. (ii) Analysis. S derives communications income as defined in paragraph (h)(2) of this section because S makes capacity to transmit communications available to its customers. In this case, S cannot establish the two points between which the communications are transmitted. Therefore, S’s communications income is U.S. source income, as provided by paragraph (f) of this section. Example 9. Reasonable methods—minutes of use data on long distance calling plans— (i)Facts. B provides both domestic and international long distance services in a calling plan for a limited number of minutes for a set amount each month. Tracing and identifying the endpoints of each transmission is not possible or practical. B is, however, able to establish that the calling plan generated $10,000 of revenue for 25,000 minutes based on reports derived from customer billing records. Based on minutes of use data in these reports, B is able to establish that of the total 25,000 minutes, 60 percent or 15,000 minutes were for U.S. long distance calls and 40 percent or 10,000 minutes were for international calls. (ii) Analysis. B derives communications income as defined in paragraph (h)(2) of this section. Based on all the facts and circumstances, B can establish the two points between which B is paid to transmit, and bears the risk of transmitting, the communications using a reasonable method to establish the endpoints, assuming that this method is consistently applied. In this case, B can reasonably establish that 60 percent of the income derived from the long distance calling plan is U.S. communications income and 40 percent is international communications income based on the minutes of use data derived from customer billing records to establish the endpoints of the communications. If, based on all the facts and circumstances, B could reasonably trace and identify the endpoints, then B would have to directly identify the endpoints PO 00000 Frm 00028 Fmt 4700 Sfmt 4700 between which B is paid to transmit the communications. Example 10. Reasonable methods—system design—(i) Facts. D operates satellites which are designed to transmit signals through two separate ranges of signal frequencies (bands). Due to technological limitations, requirements, and practicalities, one band is designed to only transmit signals within the United States. The other band is designed to transmit signals between foreign countries and the United States. D cannot trace and identify the endpoints of each individual transmission. D does, however, track the total transmission through each band and the total income derived from transmitting signals through each band. (ii) Analysis. D derives communications income as defined in paragraph (h)(2) of this section. Based on all the facts and circumstances, D can establish the two points between which D is paid to transmit, and bears the risk of transmitting, the communications using a reasonable method to establish endpoints, assuming that this method is consistently applied. In this case, D can reasonably establish that income derived from transmissions through the first band is U.S. communications income and income derived from transmissions through the second band is international communications income based on the design of the bands to establish the endpoints of the communications. Example 11. Reasonable methods—port locations—(i) Facts. X provides its customer, C, with a virtual private network (VPN) so that C’s U.S. headquarter office canconnect and communicate with offices in the United States, Country X, Country Y, and Country Z. Assume that the VPN is only for communications with the U.S. headquarter office. X cannot trace and identify the endpoints of each transmission. C pays X a set amount each month for the entire service, regardless of the magnitude of the usage or the geographic points between which C uses the service. (ii) Analysis. X derives communications income as defined in paragraph (h)(2) of this section. Based on the facts and circumstances, X can establish the two points between which X is paid to transmit, and bears the risk of transmitting, the communications using a reasonable method to establish endpoints, assuming that this method is consistently applied. In this case, X can reasonably establish that one-fourth of the income derived from the VPN service is U.S. communications income and threefourths is international communications income based on the location of the VPN ports to establish the endpoints of the communications. Example 12. Indeterminate endpoints— Internet access—(i) Facts. B, a domestic corporation, is an Internet service provider. B charges its customer, C, a monthly lump sum for Internet access. C accesses the Internet via a telephone call, initiated by the modem of C’s personal computer, to one of B’s control centers, which serves as C’s portal to the Internet. B transmits data sent by C from B’s control center in France to a recipient in England, over the Internet. B does not maintain records as to the beginning and endpoints of the transmission. E:\FR\FM\27DER1.SGM 27DER1 rwilkins on PROD1PC63 with RULES Federal Register / Vol. 71, No. 248 / Wednesday, December 27, 2006 / Rules and Regulations (ii) Analysis. B derives communications income as defined in paragraph (h)(2) of this section. The source of B’s communications income is determined under paragraph (f) of this section as income from sources within the United States because B cannot establish the two points between which it is paid to transmit the communications. Example 13. De minimis noncommunications activity—(i) Facts. The same facts as in Example 12. Assume in addition that B replicates frequently requested sites on B’s own servers, solely to speed up response time. Assume that B’s replication of frequently requested sites would be considered a de minimis noncommunications activity under this section. (ii) Analysis. On these facts, because B’s replication of frequently requested sites would be considered a de minimis noncommunications activity, B is not required to treat the replication activity as a separate non-communications activity transaction under paragraph (h)(1) of this section. B derives communications income under paragraph (h)(2) of this section. The character and source of B’s communications income are determined by demonstrating the points between which B is paid to transmit the communications, under paragraph (h)(3)(i) of this section. Example 14. Income derived from communications and non-communications activity—bundled services—(i) Facts. A, a domestic corporation, offers customers local and long distance phone service, video, and Internet services. Customers pay a flat monthly fee plus 10 cents a minute for all long-distance calls, including international calls. (ii) Analysis. Under paragraph (h)(1)(ii) of this section, to the extent that A’s transaction with its customer consists in part of non-de minimis communications activity and in part of non-de minimis non-communications activity, each such part of the transaction must be treated as a separate transaction. A’s gross income from the transaction is allocated to each such communications activity transaction and non-communications activity transaction in accordance with paragraph (h)(1)(ii) of this section. To the extent A can establish that it derives international communications income as defined in paragraph (h)(3)(ii) of this section, A would determine the source of such income under paragraph (b)(1) of this section. If A cannot establish the points between which it is paid to transmit communications, as required by paragraph (h)(3)(i) of this section, A’s communications income is from sources within the United States, as provided by paragraph (f) of this section. Example 15. Income derived from communications and non-communications activity—(i) Facts. B, a domestic corporation, is paid by D, a cable system operator in Foreign Country, to provide television programs and to transmit the television programs to Foreign Country. Using its own satellite transponder, B transmits the television programs from the United States to downlink facilities owned by D in Foreign Country. D receives the transmission, unscrambles the signals, and distributes the broadcast to D’s customers in Foreign VerDate Aug<31>2005 19:21 Dec 26, 2006 Jkt 211001 Country. Assume that B’s provision of television programs is a non-de minimis noncommunications activity, and that B’s transmission of television programs is a nonde minimis communications activity. (ii) Analysis. Under paragraph (h)(1)(ii) of this section, B must treat its communications and non-communications activities as separate transactions. B’s gross income is allocated to each such separate communications and non-communications activity transaction in accordance with paragraph (h)(1)(ii) of this section. Income derived by B from the transmission of television programs to D’s Foreign Country downlink facility is international communications income as defined in paragraph (h)(3)(ii) of this section because B is paid to transmit communications from the United States to a foreign country. Example 16. Income derived from foreign communications activity—(i) Facts. STS provides satellite capacity to B, a broadcaster located in Australia. B beams programming from Australia to the satellite. S’s satellite picks the communications up in space and beams the programming over a footprint covering Southeast Asia. (ii) Analysis. S derives communications income as defined in paragraph (h)(2) of this section. S’s income is characterized as foreign communications income under paragraph (h)(3)(iv) of this section because S picks up the communication in space, and beams it to a footprint entirely covering a foreign area. Under paragraph (d) of this section, S’s foreign communications income is from sources without the United States. If S were beaming the programming over a satellite footprint that covered area both in the United States and outside the United States, S would be required to allocate the income derived from the different types of communications activity. 77611 including an executable copy of the version of the software used in the preparation of the taxpayer’s return (including any plug-ins, supplements, etc.) and a copy of all related electronic data files. Thus, if software subsequently is upgraded or supplemented, a separate executable copy of the version used in preparing the taxpayer’s return must be retained; (ii) Any related computer software source code, within the meaning of section 7612(d), acquired or developed by the taxpayer or a related person, or primarily for internal use by the taxpayer or such person rather than for commercial distribution; and (iii) In the case of any spreadsheet software or similar software, any formulae or links to supporting worksheets. (4) Use of allocation methodology. In general, when a taxpayer allocates gross income under paragraph (b)(2)(iii), (b)(2)(iv), or (h)(1)(ii) of this section, it does so by making the allocation on a timely filed original return (including extensions). However, a taxpayer will be permitted to make changes to such allocations made on its original return with respect to any taxable year for which the statute of limitations has not closed as follows: (i) In the case of a taxpayer that has made a change to such allocations prior to the opening conference for the audit of the taxable year to which the allocation relates or who makes such a change within 90 days of such opening conference, if the IRS issues a written information document request asking (k) Reporting and documentation requirements—(1) In general. A taxpayer the taxpayer to provide the documents and such other information described in making an allocation of gross income paragraphs (k)(2) and (3) of this section under paragraph (b)(2)(iii), (b)(2)(iv), or with respect to the changed allocations (h)(1)(ii) of this section must satisfy the and the taxpayer complies with such requirements in paragraphs (k)(2), (3), request within 30 days of the request, and (4) of this section. then the IRS will complete its (2) Required documentation. In all examination, if any, with respect to the cases, a taxpayer must prepare and allocations for that year as part of the maintain documentation in existence current examination cycle. If the when its return is filed regarding the taxpayer does not provide the allocation of gross income, and documents and information described allocation and apportionment of in paragraphs (k)(2) and (3) of this expenses, losses, and other deductions, section within 30 days of the request, the methodologies used, and the then the procedures described in circumstances justifying use of those methodologies. The taxpayer must make paragraph (k)(4)(ii) of this section shall available such documentation within 30 apply. (ii) If the taxpayer changes such days upon request. allocations more than 90 days after the (3) Access to software. If the taxpayer opening conference for the audit of the or any third party used any computer taxable year to which the allocations software, within the meaning of section relate or the taxpayer does not provide 7612(d), to allocate gross income, or to the documents and information with allocate or apportion expenses, losses, and other deductions, the taxpayer must respect to the changed allocations as requested in accordance with make available upon request— (i) Any computer software executable paragraphs (k)(2) and (3) of this section, then the IRS will, in a separate cycle, code, within the meaning of section determine whether an examination of 7612(d), used for such purposes, PO 00000 Frm 00029 Fmt 4700 Sfmt 4700 E:\FR\FM\27DER1.SGM 27DER1 77612 Federal Register / Vol. 71, No. 248 / Wednesday, December 27, 2006 / Rules and Regulations the taxpayer’s allocations is warranted and complete any such examination. The separate cycle will be worked as resources are available and may not have the same estimated completion date as the other issues under examination for the taxable year. The IRS may ask the taxpayer to extend the statute of limitations on assessment and collection for the taxable year to permit examination of the taxpayer’s method of allocation, including an extension limited, where appropriate, to the taxpayer’s method of allocation. (l) Effective date. This section applies to taxable years beginning on or after December 27, 2006. PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT I Par. 4. The authority citation for part 602 continues to read as follows: Authority: 26 U.S.C. 7805. Par. 5. In § 602.101 paragraph (b) is amended by adding an entry to the table in numerical order, §§ 1.863–8 and 1.863–9, to read as follows: I § 602.101 * * CFR part or section where identified and described Background The final regulations that are the subject of these corrections are under sections 3401 and 3402 of the Internal Revenue Code. Need for Corrections As published, final regulations (TD 9276) contain errors that may prove to be misleading and are in need of clarification. * Current OMB control No. 1545–1718. 1545–1718. Kevin M. Brown, Acting Deputy Commissioner for Services and Enforcement. Approved: December 21, 2006. Eric Solomon, Assistant Secretary of the Treasury (Tax Policy). [FR Doc. E6–22174 Filed 12–26–06; 8:45 am] BILLING CODE 4830–01–P DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 31 [TD 9276] rwilkins on PROD1PC63 with RULES Internal Revenue Service (IRS), Treasury. ACTION: Correcting amendment. VerDate Aug<31>2005 17:07 Dec 26, 2006 Jkt 211001 * * * * * * * * (vi) * * * If U elects to withhold income tax at the flat rate provided under paragraph (a)(7)(iii)(F) of this section, withholding on the $50,000 of sick pay would be calculated at 25 percent of the $50,000 payment and would be $12,500. * * * * * * * * LaNita Van Dyke, Chief, Publications and Regulations Branch, Legal Processing Division, Associate Chief Counsel (Procedure and Administration). [FR Doc. E6–22022 Filed 12–26–06; 8:45 am] BILLING CODE 4830–01–P Correction of Publication [CGD05–06–119] RIN 1625–AA–09 PART 31—EMPLOYMENT TAXES AND COLLECTION OF INCOME TAX AT SOURCE Paragraph 1. The authority citation for part 31 continues to read, in part, as follows: I Authority: 26 U.S.C. 7805 * * * I Par. 2. Section 31.3402(g)-1(a)(8) is amended by revising the fifth sentence of Example 1 paragraph (iii), the fifth sentence of Example 3 paragraph (i), the last sentence of Example 3 paragraph (iv) and the third sentence of Example 3 paragraph (vi). The revisions read as follows: Supplemental wage (a) * * * (8) * * * Flat Rate Supplemental Wage Withholding; Correction SUMMARY: This document contains corrections to final regulations (TD * (iv) * * * If R elects to use optional flat rate withholding provided under paragraph (a)(7)(iii)(f) of this section, withholding would be calculated at 25 percent of the $1,000,000 portion of the payment and would be $250,000. DEPARTMENT OF HOMELAND SECURITY § 31.3402(g)–1 payments. RIN 1545–BD96 AGENCY: * List of Subjects in 26 CFR Part 31 Employment taxes, Income taxes, Penalties, Pensions, Railroad retirement, Reporting and recordkeeping requirements, Social security, Unemployment compensation. I 1.863–8 ..................... 1.863–9 ..................... Example 3. (i) * * * Unrelated company U pays D sick pay as an agent of the employer R and such sick pay is supplemental wages pursuant to § 31.3401(a)-1(b)(8)(i)(b)(2). * * * Accordingly, 26 CFR part 31 is corrected by making the following correcting amendments: OMB Control numbers. * * (b) * * * 9276) that were published in the Federal Register on Tuesday, July 25, 2006 (71 FR 42049), amending the regulations that provide for determining the amount of income tax withholding on supplemental wages. These regulations apply to all employers and others making supplemental wage payments to employees. DATES: The correction will be effective January 1, 2007. FOR FURTHER INFORMATION CONTACT: A.G. Kelley, (202) 622–6040 (not a toll-free number). SUPPLEMENTARY INFORMATION: Example 1. * * * (iii) * * * If Y elected to withhold income tax using paragraph (a)(7) of this section, Y would withhold on the $400,000 component at 25 percent (pursuant to paragraph (a)(7)(iii)(F) of this section), which would result in $100,000 tax withheld. * * * * PO 00000 * * Frm 00030 * Fmt 4700 * Sfmt 4700 Coast Guard 33 CFR Part 117 Drawbridge Operation Regulations; Potomac River, Alexandria, VA and Oxon Hill, MD Coast Guard, DHS. Notice of temporary deviation from regulations. AGENCY: ACTION: SUMMARY: The Commander, Fifth Coast Guard District, has issued a temporary deviation from the regulation governing the operation of the new Woodrow Wilson Memorial (I–95) Bridge, mile 103.8, across Potomac River between Alexandria, Virginia and Oxon Hill, Maryland. This deviation allows the new drawbridge to remain closed to navigation each day from 10 a.m. to 2 p.m. beginning on December 25, 2006 until and including February 22, 2007, to facilitate completion of the Outer Loop portion for the new Woodrow Wilson Bridge construction project. DATES: This deviation is effective from 10 a.m. on December 25, 2006, until 2 p.m. on February 22, 2007. ADDRESSES: Materials referred to in this document are available for inspection or copying at Commander (dpb), Fifth Coast Guard District, Federal Building, 1st Floor, 431 Crawford Street, E:\FR\FM\27DER1.SGM 27DER1

Agencies

[Federal Register Volume 71, Number 248 (Wednesday, December 27, 2006)]
[Rules and Regulations]
[Pages 77594-77612]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E6-22174]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9305]
RIN 1545-AW50


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

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations under section 863(d) 
governing the source of income from certain space and ocean activities. 
It also contains final regulations under section 863(a), (d), and (e) 
governing the source of income from certain communications activities. 
In addition, this document contains final regulations under section 
863(a) and (b), amending the regulations in Sec.  1.863-3 to conform 
those regulations to these final regulations. The final regulations 
primarily affect 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). The final regulations also affect persons who 
derive income from transmission of communications.

DATES: Effective Date: These regulations are effective December 27, 
2006.
    Applicability Date: For dates of applicability, see Sec.  1.863-
8(h) and Sec.  1.863-9(l).

FOR FURTHER INFORMATION CONTACT: H. Michael Huynh, (202) 435-5161 (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

[[Page 77595]]

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 collections of information in these final regulations are in 
Sec. Sec.  1.863-8(g) and 1.863-9(k). This information is required by 
the IRS to monitor 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.
    The estimated annual burden per respondent is 5 hours.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, 
SE:W:CAR:MP:T:T:SP, Washington, DC 20224, and to the Office of 
Management and Budget, Attn: Desk Officer for the Department of the 
Treasury, Office of Information and Regulatory Affairs, Washington, DC 
20503.
    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, Pub. L. No. 99-514, 100 Stat. 2085. Section 863(d) governs 
the source of income derived from space or ocean activities. Section 
863(e) governs the source of income derived from international 
communications activities.
    The Treasury Department and the IRS published a notice of proposed 
rulemaking (REG-106030-98) in the Federal Register on January 17, 2001 
(66 FR 3903), which provided proposed regulations under section 863(a), 
(b), (d), and (e) (the 2001 proposed regulations). The Treasury 
Department and 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 (AJCA), Pub. L. No. 108-357, 118 Stat. 1418, 
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 rules.
    In light of the extensive written comments, industry evolution, and 
AJCA changes, the Treasury Department and the IRS felt that it was 
appropriate to repropose these regulations to reflect these changes and 
to provide another opportunity for comment. Consequently, the Treasury 
Department and the IRS published another notice of proposed rulemaking 
in the Federal Register on September 19, 2005 (70 FR 54859), which 
withdrew the 2001 proposed regulations and provided new proposed 
regulations under section 863(a), (b), (d), and (e) (the proposed 
regulations). The proposed regulations provided two sets of rules: one 
in Sec.  1.863-8 for determining the source of income from space or 
ocean activities, the other in Sec.  1.863-9 for determining the source 
of income from communications activities.
    A public hearing on the proposed regulations was scheduled for 
December 15, 2005, but was ultimately cancelled because no one 
requested to speak. A few written comments, however, were received. 
These comments uniformly praised the proposed regulations as an 
improvement over the 2001 proposed regulations and generally were 
supportive of much of the proposed regulations. However, commentators 
suggested a few additional changes. After consideration of these 
comments, the proposed regulations are adopted as final regulations, as 
amended by this Treasury decision. The revisions to regulations 
governing the source of income from space or ocean activities and the 
source of income from communications activities are discussed in 
section A and section B, respectively, of this preamble.

Summary of Comments and Explanation of Revisions

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

    Section 863(d) governs the source of income from certain space or 
ocean activities. In general, section 863(d)(1) provides that, except 
as provided in regulations, any income derived from a space or ocean 
activity (space and ocean income) is income from sources within the 
United States (U.S. source income) if derived by a United States person 
and is income from sources without the United States (foreign source 
income) if derived by a foreign person. 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 types 
of activities from the definition of space or ocean activity. Space or 
ocean activity does not include any activity giving rise to 
transportation income governed by section 863(c), international 
communications income governed by section 863(e), or income with 
respect to mines, oil and gas wells, or other natural deposits to the 
extent within the United States or any foreign country or possession of 
the United States (as defined in section 638). See Section 
863(d)(2)(B).
    Section 1.863-8 of the proposed regulations generally provided 
rules for determining the source of income derived from space or ocean 
activity under section 863(d). Section 1.863-8(b)(1) of the proposed 
regulations reflected the general source rule under section 863(d)(1) 
that a United States person's space and ocean income is U.S. source 
income. Pursuant to the grant of regulatory authority under section 
863(d)(1), however, the proposed regulations provided an exception to 
this general rule. Under that exception, a United States person's space 
and ocean income is foreign source income (and therefore not sourced on 
the basis of citizenship or residency) 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.
    For a foreign person, proposed Sec.  1.863-8(b)(2) reflected the 
general source rule under section 863(d)(1) that a foreign person's 
space and ocean income is foreign source income. Pursuant to regulatory 
authority under section 863(d)(1), however, the proposed regulations 
contained two exceptions to this general rule, one for controlled 
foreign corporations (CFCs), the other for foreign persons engaged in a 
U.S. trade or business. The proposed regulations generally sourced 
space and ocean income derived by a CFC, like that of a United States 
person, as U.S. source income. However, also like the rule for a United 
States person, a CFC's space and ocean income is foreign source income 
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. For a foreign person, other 
than a CFC, engaged in a trade or business within the United

[[Page 77596]]

States, space and ocean income is U.S. source income to the extent it 
is attributable to functions performed, resources employed, or risks 
assumed within the United States.
    In addition to the general source rules for United States and 
foreign persons, the proposed regulations provided special rules, 
applicable to both United States and foreign persons, for income from 
services, certain sales of property, and communications activities 
(other than international communications activities). These special 
rules, as well as modifications to the proposed regulations, are 
discussed below.
1. Activities performed outside space and international water
    Section 1.863-8 of the proposed regulations provided source rules 
only for income from space or ocean activity. Thus, in some cases, 
income derived from a transaction must be allocated between space and 
ocean income and other income.
    For example, Sec.  1.863-8(b)(3)(ii)(C) of the proposed regulations 
provided that when property is produced both in space or international 
water and outside space and international water, gross income allocable 
to production activity is allocated to production occurring in space or 
international water and production occurring outside space and 
international water based on where functions are performed, resources 
are employed, or risks are assumed. The proposed regulations also 
provided a similar analysis of functions performed, resources employed, 
or risks assumed to allocate income in the case of performance of 
services. See Prop. Treas. Reg. Sec.  1.863-8(d)(2). Under the proposed 
regulations, only the amount allocated to production or performance of 
a service occurring in space or international water is treated as space 
and ocean income (character rule). The source of gross income allocated 
to production or performance of a service occurring in space or 
international water is then determined under the rules of proposed 
Sec.  1.863-8(b)(1) or (2), as applicable (source rule).
    Section 1.863-8(b)(1) of the proposed regulations reflected the 
general source rule that a United States person's space and ocean 
income is U.S. source income. Proposed Sec.  1.863-8(b)(2) reflected 
the general source rule that a foreign person's space and ocean income 
is foreign source income. Both proposed Sec.  1.863-8(b)(1) and (2), 
however, provided exceptions to their respective general source rules. 
As discussed above, under the exceptions, a United States person's 
space and ocean income may be foreign source income and a foreign 
person's space and ocean income may be U.S. source income based on 
where functions are performed, resources are employed, or risks are 
assumed.
    One commentator noted that in some situations, the allocation of 
income derived from a transaction to determine space and ocean income 
based on functions performed, resources employed, or risks assumed 
presumably would remove the subsequent need to further analyze 
functions performed, resources employed, or risks assumed within a 
country to determine the source of the space and ocean income. In other 
words, the very act of determining the character of income seems to 
also determine the source of such income.
    The Treasury Department and the IRS agree with the commentator that 
use of the same standard to classify the transaction as space or ocean 
activity and to source the space and ocean income may be duplicative in 
some cases. However, there are other cases where a transaction with 
some land-based activity may be classified in its entirety as a space 
or ocean activity (for example, a lease of a satellite), but the income 
may be partially U.S. source and partially foreign source under the 
source rules of proposed Sec.  1.863-8(b)(1) and (2) based on functions 
performed, resources employed, or risks assumed within the United 
States or a foreign country. Consequently, the character and source 
rules are not always duplicative.
    Thus, the extent to which the character rules overlap with the 
source rules is particular to the type of transaction involved. The 
Treasury Department and the IRS recognize that the overlap in the 
character and source rules may produce equivalent results. But, the 
overlap is necessary to provide taxpayers and the IRS with workable 
rules. As a result, the final regulations do not follow this comment as 
a general matter.
    Nonetheless, a conforming amendment has been made to the lease 
transaction in Example 1 in Sec.  1.863-8(f) of the final regulations 
to more clearly illustrate how the rules work. That example illustrates 
that the transaction involved is first classified in its entirety as a 
space or ocean activity, and then the resulting space and ocean income 
is subjected to the source rules. The space and ocean income is sourced 
as foreign source income 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.
2. Activities performed by another person
    Section 1.863-8(a) of the proposed regulations provided that a 
taxpayer will not be considered to derive income from space or ocean 
activity if such activity is performed by another person. The approach 
under Sec.  1.863-8(a) of the proposed regulations, providing that a 
taxpayer derives income from a space or ocean activity only if it 
conducts such activity directly, is consistent with the approach 
adopted in the Sec.  1.863-3 regulations governing the source of income 
from certain sales of inventory. See, e.g., Treas. Reg. Sec.  1.863-
3(c) (``[T]he only production activities that are taken into account 
for purposes of Sec. Sec.  1.863-1, 1.863-2, and this section are those 
conducted directly by the taxpayer.'').
    Accordingly, commentators believed that this provision assured that 
a content provider that retains a satellite operator to transmit 
programming abroad would not derive space and ocean income based on 
attribution of the satellite operator's activity. The Treasury 
Department and the IRS agree.
    One commentator noted, however, that Examples 2 and 4 in Sec.  
1.863-8(f) of the proposed regulations seem to indicate that this is 
not what was intended. In Example 2, the taxpayer, an Internet service 
provider, transmits information requested by its customer, in part 
using satellite capacity leased from a third party. Example 2 concludes 
that the service performed by the taxpayer is considered space activity 
to the extent the value of the service is attributable to functions 
performed, resources employed, and risks assumed in space. In Example 
4, the taxpayer uses satellite capacity acquired from a third party to 
deliver programming services directly to its customers' televisions 
sets. Example 4 concludes that the taxpayer's delivery of programming 
and other services is considered space activity to the extent the value 
of the delivery transaction is attributable to performance in space. In 
the commentator's view, the results reached in the examples conflict 
with the provision stating that activities performed by another person 
are not attributable to the taxpayer.
    The Treasury Department and the IRS do not believe that Examples 2 
and 4 of Sec.  1.863-8(f) of the proposed regulations produce the 
result that the commentator raised. In Examples 2 and 4, the taxpayer 
performed the transmission or delivery activities using satellite 
capacity leased or acquired from a third party. Both Examples 2 and 4 
correctly conclude that the taxpayers derived space and ocean income 
from their own

[[Page 77597]]

activities rather than from activities of another person. Thus, the 
examples do not, in fact, conflict with the text of the proposed 
regulations. Nevertheless, the Treasury Department and the IRS are 
concerned that Examples 2 and 4 have been misinterpreted as suggesting 
that activities performed by another person may be attributable to the 
taxpayer in certain situations. This was not the intent of these 
examples. Consequently, Examples 2 and 4 in Sec.  1.863-8(f) of the 
final regulations have been modified to make clear that the taxpayers 
in the examples directly engage in a space activity by performing the 
uplink (transmitting to the satellite) and downlink functions.
    These examples differ from cases in which the taxpayer is a mere 
content provider that derives income either from the creation of 
content or from the creation and delivery of content, but in either 
case contracts with another person to deliver the content via 
satellite. Pursuant to Sec.  1.863-8(a) of the final regulations, 
content providers of this type would not derive space and ocean income 
because the delivery of the content via satellite is performed by 
another person. This would be the result even though the value of the 
customer contract includes a payment to the content provider for space 
or ocean activity. To clarify the distinction between these situations 
and Examples 2 and 4, a new Example 5 has been added to the final 
regulations. That example involves a content provider that does not 
derive space and ocean income because the taxpayer does not directly 
perform any space or ocean activity.
3. Income Characterization Rules for Income from Services and the De 
Minimis Exception
    Under Sec.  1.863-8(b)(4) of the proposed regulations, to the 
extent a service is characterized as space or ocean activity, the 
source of gross income derived from such transaction is determined 
under proposed Sec.  1.863-8(b)(1) or (2), as applicable. Section 
1.863-8(d)(2)(ii)(B) of the proposed regulations provided, however, 
that if the taxpayer can demonstrate, based on all the facts and 
circumstances, that the value of the service attributable to 
performance in space or international water is de minimis, such service 
will not be treated as space or ocean activity. The de minimis rule was 
adopted to address taxpayers' concerns about potential confusion in 
qualifying for the ``facilitation exception'' under the 2001 proposed 
regulations. One commentator stated that the de minimis rule simply 
replaced one vague standard with another, as neither Example 3 in Sec.  
1.863-8(f) of the proposed regulations nor the text of the proposed 
regulations provides any guidance as to when activities performed in 
space or international water would be de minimis under a facts and 
circumstances approach.
    The Treasury Department and the IRS recognize that issues of 
interpretation may arise in any facts and circumstances approach. 
Nevertheless, the Treasury Department and the IRS generally have 
refrained from adopting the alternative approach, to wit, adopting 
precise definitions and quantitative measures for a de minimis 
standard. Moreover, the inclusion of a precise definition and 
quantitative measures for determining de minimis value could raise 
equal, if not greater, concerns in terms of the quantitative threshold 
and other issues. Thus, the final regulations retain the de minimis 
standard for determining whether a taxpayer has space and ocean income. 
If the value of the service attributable to space or ocean activity is 
de minimis based on the facts and circumstances, the taxpayer will not 
derive space and ocean income. Nevertheless, the Treasury Department 
and the IRS agree that more guidance could be provided as to the 
application of the retained de minimis rule. Accordingly, Examples 3 
and 8 in Sec.  1.863-8(f) of the final regulations (Example 7 in the 
proposed regulations) provide clearer illustrations of when activities 
performed in space or international water would be considered de 
minimis for this purpose and when those types of activities would not 
be considered de minimis.
4. Source Rules for Income From Certain Sales of Property
    The proposed regulations provided special rules for income from 
certain sales of property, either when any production occurs in space 
or international water, or when the sale occurs in space or 
international water. In either case, section 863(d) and the proposed 
regulations applied to determine the source of income from the sales of 
property, and the rules of sections 861(a)(6), 862(a)(6), 863(a), 
863(b), and 865 apply only to the extent provided in the proposed 
regulations.
a. Sales of Property Produced in the United States and Sold in Space or 
International Water
    Section 1.863-8(b)(3)(ii) of the proposed regulations provided that 
when the taxpayer both produces property and sells such property, one-
half of the taxpayer's gross income will be considered income allocable 
to production activity and one-half of such gross income will be 
considered income allocable to sales activity. Taxpayers generally must 
then apply the rules of section 863(d) and the proposed regulations to 
determine the source of income allocable to production activity and 
sales activity.
    For production activity, the source of gross income allocable to 
production occurring in space or international water is generally based 
on the citizenship or residence of the taxpayer, applying the rules of 
proposed Sec.  1.863-8(b)(1) or (2), as applicable. The source of gross 
income allocable to production occurring outside space and 
international water is determined under section 863(b) rather than 
section 863(d). See Prop. Treas. Reg. Sec.  1.863-8(b)(3)(ii)(B) 
(referencing Treas. Reg. Sec.  1.863-3(c)(1)).
    As for sales activity, when property is sold in space or 
international water, the source of gross income allocable to sales 
activity is generally based on the citizenship or residence of the 
taxpayer, applying the rules of proposed Sec.  1.863-8(b)(1) or (2), as 
applicable. An exception to this general rule applied in cases when the 
property sold is inventory, within the meaning of section 1221(a)(1), 
and is sold in space or international water for use, consumption, or 
disposition outside space, international water, and the United States. 
In that case, the source of gross income allocable to sales activity is 
determined under Treas. Reg. Sec.  1.861-7(c) and Sec.  1.863-3(c)(2). 
Treas. Reg. Sec.  1.861-7(c) and Sec.  1.863-3(c)(2) generally provide 
for foreign source income where the seller's rights, title, and 
interest in the property are transferred to the buyer (the title 
passage rule) outside the United States and the property is not sold 
for use, consumption, or disposition in the United States. Treas. Reg. 
Sec.  1.861-7(c) and Sec.  1.863-3(c)(2) also applied to property sold 
outside space and international water. See Prop. Treas. Reg. Sec.  
1.863-8(b)(3)(ii)(D).
    One commentator believed that because certain U.S. manufacturers, 
such as U.S. satellite manufacturers, produce property that is sold in 
space or international water for use, consumption, or disposition in 
space or international water, they are at a disadvantage relative to 
U.S. manufacturers of other export property because the former may have 
U.S. source income with respect to income allocable to sales activity, 
while the latter may have foreign source income from sales activity.
    In response to comments on the 2001 proposed regulations, proposed 
Sec.  1.863-

[[Page 77598]]

8(b)(1) was revised to provide that space and ocean income will be 
foreign source income to the extent the space and ocean income is 
attributable to functions performed, resources employed, or risks 
assumed in a foreign country or countries. The Treasury Department and 
the IRS believe that this change may in many cases mitigate concerns 
about U.S. manufacturers potentially deriving 100 percent U.S. source 
income in these cases. Moreover, the Treasury Department and the IRS 
believe that the rules under the proposed regulations for determining 
the source of income allocable to sales activity are consistent with 
legislative intent to assert primary tax jurisdiction over income 
earned by United States persons that is not subject to foreign tax. See 
S. REP. NO. 99-313, 1986-3 C.B. 357-358 (``[T]he committee believes the 
United States should assert primary tax jurisdiction over income earned 
by its residents that is not within any foreign country's taxing 
jurisdiction* * *. Moreover, when a U.S. taxpayer conducts activities 
in space or international waters, foreign countries generally do not 
tax the income. Thus, the foreign tax credit limitation is inflated by 
income that is not within any foreign country's tax jurisdiction.''). 
Based on the legislative history, 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 or international 
water for use, consumption, or disposition outside space, international 
water, and the United States--should be considered space or ocean 
activity and that the source of income from such sales activity should 
be determined under section 863(d). As a result, no changes were made 
in response to this comment.
b. Purchased Versus Produced Property Sold for Use, Consumption, or 
Disposition in the United States
    One commentator questioned the appropriateness of differences in 
determining the source of sales income depending on whether the 
taxpayer produced or purchased the property sold. Under the proposed 
regulations, when property produced by the taxpayer is sold in space or 
international water, the source of gross income allocable to sales 
activity is generally based on the citizenship or residence of the 
taxpayer, applying the rules of proposed Sec.  1.863-8(b)(1) or (2), as 
applicable (and not the title passage rule)--subject to the foregoing 
inventory exception for property that will be used, consumed, or 
disposed of outside space, international water, and the United States. 
A slightly different rule applied to sales of property that had been 
purchased by the taxpayer. While the proposed regulations also provided 
that, for purchased property, the source of gross income allocable to 
sales activity is generally based on the citizenship or residence of 
the taxpayer, the inventory exception for purchased property only 
required that the property be used, consumed, or disposed of outside 
space and international water.
    The inventory exceptions for produced and purchased property were 
intended to produce different results when inventory property is used, 
consumed, or disposed of in the United States. In such case, the source 
of produced inventory property sales income is generally based on the 
citizenship or residence of the taxpayer, applying the rules of 
proposed Sec.  1.863-8(b)(1) or (2), because the inventory exception 
did not extend to produced property sold for use, consumption, or 
disposition in the United States. In contrast, the source of purchased 
inventory property sales income is generally based on title passage 
under Treas. Reg. Sec.  1.861-7(c) because the inventory exception did 
extend to purchased property even if it was sold for use, consumption, 
or disposition in the United States. The Treasury Department and the 
IRS believe that this difference between the produced and purchased 
property rules in the space and ocean context is consistent with the 
difference in the rules for sales of produced and purchased property 
outside the space and ocean context. In particular, under section 
863(a) and (b) and the regulations thereunder, if property is produced 
in the United States and sold for use, consumption, or disposition in 
the United States, the place of sale will be presumed to be the United 
States, and income attributable to the sales activity will be U.S. 
source income. See Sec.  1.863-3(c)(2). There is, however, no 
comparable rule for purchased property under section 862(a)(6) or the 
regulations thereunder. Thus, the final regulations simply continue in 
the space and ocean context the varying treatment elsewhere for sales 
of purchased property and sales of produced property.
    In response to comments, however, the produced and purchased 
property rules have been modified to be similar in structure and style, 
to better reflect and highlight the differences between these two 
rules.
5. Allocations
    Taxpayers must allocate gross income under paragraphs (b)(1) and 
(b)(2) of proposed Sec.  1.863-8 among U.S., foreign, and space or 
ocean activities. Under proposed Sec.  1.863-8(b)(3)(ii)(C), 
allocations are also made between production activity occurring in 
space or international water and that occurring outside space and 
international water. Finally, allocations are also made under proposed 
Sec.  1.863-8(b)(4) between services performed in space or 
international water and services performed outside space and 
international water. In performing these allocations, the proposed 
regulations generally provided that taxpayers should consider the 
relative value of functions performed, resources employed, or risks 
assumed in different locations. Moreover, the preamble to the proposed 
regulations provided that allocations should be based generally on 
section 482 principles. Commentators noted that little guidance is 
given as to the mechanics of allocation other than the statement that 
the principles of section 482 should be used. Commentators stated that 
allocation of gross income based on section 482 principles will result 
in added expense, uncertainty, and extra burden on multinational 
taxpayers who are already required to undertake and update functional 
analyses and satisfy substantial documentation requirements.
    While the final regulations were not changed in response to these 
comments, the Treasury Department and the IRS believe that some 
clarification is warranted. In suggesting the use of section 482 
principles as a guide, the Treasury Department and the IRS intend for 
taxpayers to adopt a reasonable approach to the allocations required in 
this area. Taxpayers know their businesses and will generally be in the 
best position to fashion a reasonable method that most reliably 
reflects the relative value of functions performed, resources employed, 
and risks assumed in different locations. In the preamble to the 
proposed regulations, the Treasury Department and the IRS solicited 
comments on alternative methods of allocation for particular industries 
and criteria that could be used to evaluate the reasonableness of such 
methods. No such comments were received. One commentator noted, 
however, that the proposed regulations perhaps reflected what taxpayers 
in these industries have already been doing in order to determine the 
character and source of their space and ocean income. Consequently, the 
Treasury Department and the IRS believe that allocations of gross 
income based on functions performed, resources employed, and

[[Page 77599]]

risks assumed are appropriate in these circumstances.
6. Separation of a Single Transaction and Aggregation of Multiple 
Transactions
    Paragraphs (d)(1)(i) and (d)(1)(ii) of Sec.  1.863-8 of the 
proposed regulations provided that for purposes of determining space or 
ocean activity, the Commissioner may separate parts of a single 
transaction or combine separate transactions into a single transaction. 
One commentator stated that this is a ``one-way'' street, as only the 
Commissioner has the authority to separate or combine transactions for 
purposes of the proposed regulations.
    The final regulations do not change this rule. The Treasury 
Department and the IRS believe taxpayers are not inappropriately 
disadvantaged by this rule because taxpayers generally have the ability 
to structure their transactions in line with the economic prospects of 
their businesses. In addition, the Commissioner's ability to separate 
or combine transactions is not unfettered. Rather, the Commissioner may 
only separate or combine transactions to better reflect the value of 
functions performed, resources employed, or risks assumed. A taxpayer 
can always protect itself against recharacterization by adopting an 
arrangement that appropriately reflects the economic realities of a 
transaction or series of transactions. The taxpayer is clearly in the 
best position at the outset to structure its arrangements in this 
manner. In addition, taxpayers traditionally are not permitted to 
restructure retroactively the form of their completed transactions. 
Thus, the Treasury Department and the IRS believe that the limited 
``one-way'' rule is appropriate in this case.
7. Income Derived From the Leasing of Shipping Cargo Containers
    One commentator requested that the Treasury Department and the IRS 
make clear that the final regulations under section 863(d) do not apply 
to income derived from the leasing of shipping cargo containers and 
that such income should be treated as rental income, sourced under 
sections 861 and 862. This commentator noted that valid arguments also 
exist for treating income derived from the leasing of shipping cargo 
containers as transportation income; however, in the commentator's 
view, the most appropriate treatment is rental income treatment, 
sourced under sections 861 and 862.
    The treatment of income derived from the leasing of shipping cargo 
containers is not covered by these final regulations. Instead, the 
Treasury Department and the IRS intend to address the treatment of such 
income explicitly in separate guidance. That guidance may apply section 
863(c), section 863(d), or other provisions to source income derived 
from the leasing of shipping cargo containers. Any such guidance will 
be prospective in nature. Until such time, the treatment of such income 
will be determined under existing law.

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

    Section 863(e) governs the source of income from international 
communications activities (international communications income). 
International communications income is defined in section 863(e)(2) as 
income derived from the transmission of communications or data between 
the United States and a foreign country (or possession of the United 
States). Section 863(e)(1)(A) provides that any international 
communications income of a United States person is sourced 50 percent 
in the United States and 50 percent outside the United States (50/50 
source rule). Section 863(e)(1)(A) does not provide for any statutory 
or regulatory exceptions to this 50/50 source rule. In contrast, 
section 863(e)(1)(B)(i) provides that any international communications 
income of a foreign person is sourced outside the United States, except 
as provided in regulations or in section 863(e)(1)(B)(ii). The 
exception under section 863(e)(1)(B)(ii) provides that if a foreign 
person maintains an office or other fixed place of business in the 
United States, any international communications income attributable to 
such office or other fixed place of business is U.S. source income.
    Section 1.863-9 of the proposed regulations generally provided 
rules for determining the source of international communications income 
under section 863(e) and other communications income under section 
863(a) and (d). Proposed Sec.  1.863-9(b)(1) reflected the rule under 
section 863(e)(1)(A) that a United States person's international 
communications income is 50 percent U.S. source income and 50 percent 
foreign source income. Proposed Sec.  1.863-9(b)(2) reflected the 
general rule under section 863(e)(1)(B) that a foreign person's 
international communications income is foreign source income.
    Consistent with the statutory exception under section 
863(e)(1)(B)(ii), proposed Sec.  1.863-9(b)(2)(iii) provided that any 
international communications income derived by a foreign person, other 
than a CFC, that is attributable to an office or other fixed place of 
business of the foreign person in the United States is U.S. source 
income. International communications income is attributable to an 
office or other fixed place of business to the extent of functions 
performed, resources employed, or risks assumed by the office or other 
fixed place of business. In addition to the statutory exception under 
section 863(e)(1)(B)(ii), section 863(e)(1)(B) provides general 
regulatory authority to depart from the general 100 percent foreign 
source rule for foreign persons. Thus, pursuant to this regulatory 
authority, the proposed regulations contained additional exceptions to 
the general rule applicable to foreign persons. In particular, the 
proposed regulations provided that international communications income 
derived by a CFC is 50 percent U.S. source income and 50 percent 
foreign source income (the same as for United States persons). The 
proposed regulations also provided that international communications 
income derived by a foreign person, other than a CFC, engaged in a 
trade or business within the United States is income 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.
    In addition to the general source rules for international 
communications income of United States and foreign persons, the 
proposed regulations also provided rules, applicable to both United 
States and foreign persons, for income from U.S. communications, 
foreign communications, space/ocean communications, and communications 
where endpoints are indeterminate. These rules, as well as 
modifications to the proposed regulations, are discussed below.
1. Income Characterization Rules for Communications Income
    Section 1.863-9(h)(3) of the proposed regulations provided that the 
type of communications activity (and thus the applicable source rule) 
is determined by identifying the two points between which the taxpayer 
is paid to transmit the communication. For United States and foreign 
persons, U.S. communications income is entirely U.S. source income. A 
taxpayer derives U.S. communications income when the taxpayer is paid 
to transmit between two points in the United States or between the 
United States and a point in space or international water. In contrast, 
foreign communications income is entirely foreign source income for 
United States and foreign

[[Page 77600]]

persons. A taxpayer derives foreign communications income when the 
taxpayer is paid to transmit between two points in a foreign country or 
countries (or a possession or possessions of the United States), 
between a foreign country and a possession of the United States, or 
between a foreign country (or a possession of the United States) and a 
point in space or international water. Finally, the proposed 
regulations provided different source rules for international 
communications income of United States and foreign persons. See section 
B.3 of this preamble for further discussion. A taxpayer derives 
international communications income when the taxpayer is paid to 
transmit between a point in the United States and a point in a foreign 
country (or a possession of the United States). When a taxpayer cannot 
establish the two points between which the taxpayer is paid to transmit 
the communication, Sec.  1.863-9(f) of the proposed regulation provided 
a default source rule under which all the income derived by the 
taxpayer from such communications activity is U.S. source income.
    Commentators stated that the treatment of communications income as 
U.S. source income when the endpoints are indeterminate is overbroad 
and harsh, particularly as it relates to foreign taxpayers. 
Commentators also stated that taxpayers would have to commit 
significant resources to develop the technology necessary to identify 
the endpoints of communications. One commentator stated that it is 
unclear that a reliable system can be created at any expense to 
establish the endpoints of the transmission under all circumstances. 
Commentators suggested instead the use of any reasonable method to 
establish the endpoints between which a taxpayer is paid to transmit 
the communications. One commentator suggested that the Treasury 
Department and the IRS consider employing the Industry Issue Resolution 
Program or Prefiling Agreement Program as aids in the administration of 
a reasonable method rule.
    The Treasury Department and the IRS solicited comments on the 
challenges to identifying the endpoints of communications in specific 
industries or situations, as well as suggestions for rules that are 
responsive to these particular challenges. The Treasury Department and 
the IRS also solicited comments on methods to establish the endpoints 
of a communication that may be reasonable for particular industries, as 
well as criteria that may be appropriate to evaluate the reasonableness 
of such methods. In response, one commentator submitted examples of 
reasonable methods to establish the endpoints between which a taxpayer 
is paid to transmit the communications. The examples relied on 
statistical reports of data such as minutes used, areas of 
transmission, port locations, and transport charges. This commentator 
noted that current federal regulations already require 
telecommunications companies to submit some of these reports to certain 
governmental agencies, for example, the Federal Communications 
Commission.
    In light of the potential complexity in identifying the type of 
communications activity and in response to comments, the final 
regulations provide that a taxpayer may satisfy the requirement that 
the taxpayer establish the two points between which the taxpayer is 
paid to transmit, and bears the risk of transmitting, the communication 
by using any consistently applied reasonable method to establish one or 
both endpoints. In doing so, the taxpayer carries the burden of proof 
and must establish that the method used is reasonable (taking into 
account all of the facts and circumstances) and is consistently 
applied. In satisfying its burden of proof, a taxpayer will need to 
maintain reasonable records of communications activities. Depending on 
the facts and circumstances, methods based on, for example, records of 
port or transport charges, customer billing records, a satellite 
footprint, or records of termination fees made pursuant to an 
international settlement agreement may be reasonable. In addition, 
practices used by taxpayers to classify or categorize certain 
communications activity in connection with preparation of statements 
and analyses for the use of management, creditors, minority 
shareholders, joint ventures, or other parties or governmental agencies 
in interest may be reliable indicators of the reasonableness of the 
method chosen, but need not be accorded conclusive weight by the 
Commissioner. Furthermore, in evaluating the reasonableness of the 
method chosen, consideration will be given to all the facts and 
circumstances, including whether the endpoints would otherwise be 
identifiable absent this reasonable method provision.
    Along with resultant changes made to the text of the final 
regulations, several examples have been added to Sec.  1.863-9(j) of 
the final regulations that illustrate instances where the taxpayer may 
be able to use reasonable methods to determine the endpoints between 
which the taxpayer is paid to transmit the communications.
2. The Paid-to-do Rule With Respect to Foreign-Originating 
Communications
    Under the proposed regulations, a taxpayer derives income from a 
certain type of communications activity (for example, foreign 
communications or international communications) only if the taxpayer is 
paid to transmit, and bears the risk of transmitting (the paid-to-do 
rule), the communications of such type. See Prop. Treas. Reg. Sec.  
1.863-9(h)(2) and (3). This is the case even if the taxpayer contracts 
out the transmission function.
    Commentators stated that application of the paid-to-do rule in all 
instances would give rise to results that are inconsistent with 
Congressional intent and may result in excessive amounts of U.S. source 
income. One commentator noted that in some cases, while it is clear 
that a communication originated in a foreign country and that a U.S. 
telecommunications company is paid to terminate the foreign-originating 
traffic in the United States, it is unclear exactly where the U.S. 
telecommunications company picked up the communication. This lack of 
clarity often may be due to legal restrictions in certain foreign 
countries on ownership of capacity and carriage of transmissions by 
non-nationals. It can also be due to the fact that the international 
settlement agreements under which major international 
telecommunications carriers operate often do not specify where the 
traffic is picked up or handed off, and in some cases the hand-off 
point is specified by reference to a mid-point convention, even though 
the transmission signal, from a technical standpoint, travels from end-
to-end with no real points in-between. The commentator further stated 
that at the time section 863(e) was enacted, U.S. carriers were 
generally not allowed to own and operate facilities in foreign 
countries; specifically, no U.S. carrier could carry a foreign-to-U.S. 
or U.S.-to-foreign transmission end-to-end. Thus, concluded the 
commentator, Congress focused on the endpoints of the communications 
rather than where the activities constituting the transmission of 
communications take place. The commentator suggested a rule that would 
provide that when a taxpayer is paid to transmit foreign-originating 
communications from a point outside the United States to a point in the 
United States, the taxpayer should be deemed to have been paid to 
transmit the communications from a point in the foreign country in 
which the communication originated.
    Upon further consideration, the Treasury Department and the IRS

[[Page 77601]]

believe that the paid-to-do rule may be over-inclusive in certain 
cases. Accordingly, the final regulations provide that international 
communications income also includes income derived from communications 
activity when the taxpayer is paid to transmit foreign-originating 
communications (communications with a beginning point in a foreign 
country or a possession of the United States) from a point in space or 
international water to a point in the United States. Also, a new 
example has been added to Sec.  1.863-9(j) of the final regulations to 
illustrate the changes made in the final regulations with respect to 
foreign-originating communications.
    The changes made in the final regulations only affect 
communications that originate in a foreign country (or a possession of 
the United States) and does not affect communications that originate in 
space, international water, or the United States. The Treasury 
Department and the IRS continue to believe that communications activity 
is most appropriately characterized based on the two points between 
which the taxpayer is paid to transmit, and bears the risk of 
transmitting, the communication.
3. Determining the Source of Communications Income Based on Functions 
Performed, Resources Employed, or Risks Assumed in a Foreign Country or 
Countries
    As discussed above, the proposed regulations provided that the 
source of communications income is largely dependant on the type of 
communications activity and the citizenship or residence of the 
taxpayer. However, the proposed regulations provided for two instances 
where (in addition to the type of communications activity and the 
citizenship or residence of the taxpayer) the source of communications 
income may depend on functions performed, resources employed, or risks 
assumed. First, the proposed regulations provided that international 
communications income derived by a foreign person, other than a CFC, 
that is attributable to an office or other fixed place of business of 
the foreign person in the United States is U.S. source income. The 
proposed regulations provided that international communications income 
is attributable to an office or other fixed place of business to the 
extent of functions performed, resources employed, or risks assumed by 
the office or other fixed place of business. Second, the proposed 
regulations provided that international communications income derived 
by a foreign person, other than a CFC, engaged in a trade or business 
within the United States is income 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.
    Commentators suggested that the final regulations also provide for 
similar rules that would source communications income as foreign source 
income based on functions performed, resources employed, or risks 
assumed in a foreign country or countries. For example, one commentator 
suggested that the source of international and U.S. communications 
income derived by any United States or foreign person (including 
branches, partnerships, and disregarded entities) engaged in a trade or 
business in a foreign country or countries is income from sources 
without 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 such foreign country or 
countries.
    While the Treasury Department and the IRS recognize that 
commentators' suggestion to provide for a source rule based on 
functions performed, resources employed, or risks assumed in a foreign 
country or countries is reasonable, as explained below, the Treasury 
Department and the IRS believe that the statute and legislative history 
preclude such an option.
a. International Communications Income
    Consistent with section 863(e)(1)(A), proposed Sec.  1.863-9(b)(1) 
provided that international communications income of a United States 
person is 50 percent U.S. source income and 50 percent foreign source 
income. One commentator suggested that it may be appropriate, in 
certain situations, to depart from the 50/50 source rule to provide 
special rules for foreign activities. According to the commentator, as 
a result of local regulatory requirements, U.S.-based international 
telecommunications providers often need to conduct portions of their 
international business through locally formed entities, and such 
entities are fully subject to foreign tax on their income. The 
commentator therefore concluded that a source rule for international 
communications income based on functions performed, resources employed, 
or risks assumed in a foreign country or countries is not only 
equitable but also consistent with treatment accorded to foreign 
persons having a U.S. fixed placed of business or engaged in a U.S. 
trade or business.
    The Treasury Department and the IRS recognize that a source rule 
based on functions performed, resources employed, or risks assumed may 
be a reasonable alternative to the 50/50 source rule. Nonetheless, they 
continue to believe that the 50/50 source rule is the method that must 
be used to determine the source of a United States person's 
international communications income. This is because section 
863(e)(1)(A) provides for an explicit 50/50 source rule for those 
persons without exception. In contrast, section 863(e)(1)(B) provides 
that a foreign person's international communications income is 
generally sourced outside the United States, except as provided in 
regulations. The Treasury Department and the IRS believe that the 
express grant of regulatory authority in the case of foreign persons 
and the omission of any such authority in the case of United States 
persons indicate that Congress intended the 50/50 sourcing rule be 
applied to United States persons without regulatory modification. There 
is nothing in the statute or legislative history that clearly 
demonstrates a different intention. In contrast, section 
863(e)(1)(B)(ii) provides for a special source rule with respect to 
foreign persons with an office or other fixed place of business in the 
United States. A similar rule is not provided with respect to a United 
States person's foreign activities. Thus, Congress chose a rule that 
sourced international communications income of foreign persons in 
certain instances based on the place of their activities, but expressly 
chose the 50/50 method to source international communications income of 
United States persons, regardless of the place of their activities.
    The Treasury Department and the IRS recognize that the statute does 
not require strict application of the 50/50 source rule for CFCs. 
Section 863(e)(1)(B) only provides that the international 
communications income of a foreign person is foreign source income, 
except as provided in regulations. Consistent with and in light of this 
regulatory authority, however, the Treasury Department and the IRS 
believe that the 50/50 source rule is the most appropriate method to 
determine the source of a CFC's international communications income. 
This approach addresses the concern of the Treasury Department and the 
IRS that United States persons may use CFCs to obtain benefits that are 
inconsistent with the purposes of section 863(e). Consequently, the 
rules for determining the source of international

[[Page 77602]]

communications income derived by a CFC should be the same as the rules 
for determining the source of such income if it is derived by a United 
States person. In addition, the Treasury Department and the IRS believe 
that the 50/50 source rule for CFCs, as opposed to the 100 percent U.S. 
source rule that was originally proposed as part of the 2001 proposed 
regulations, should limit the potential for multiple levels of taxation 
that commentators raised with respect to those prior proposed 
regulations.
b. U.S. Communications Income
    Section 1.863-9(c) of the proposed regulations provided that income 
derived by a United States or foreign person from U.S. communications 
activity is entirely from sources within the United States. One 
commentator noted that a foreign person deriving income from the 
transmission of communications between a point in the United States and 
another point in the United States or between a point in the United 
States and a point in space or international water has 100 percent U.S. 
source income, even if much or all of the activity involved is outside 
the United States. In contrast, under the space and ocean rules, a 
foreign person has U.S. source income only to the extent the income is 
attributable to functions performed, resources employed, or risks 
assumed within the United States. Commentators therefore suggested 
modification of the 100 percent U.S. source rule for U.S. 
communications income derived by United States and foreign persons to 
take into account foreign activities.
    The Treasury Department and the IRS recognize that a source rule 
based on functions performed, resources employed, or risks assumed may 
be a reasonable alternative to the 100 percent U.S. source rule for 
U.S. communications. Nonetheless, the Treasury Department and the IRS 
believe that Congress did not intend such an option. The legislative 
history indicates that if a communication is between two points within 
the United States, the ``income attributable thereto is to be sourced 
entirely as U.S. source income.'' S. Rep. No. 99-313, 1986-3 C.B. 359 
(emphasis added). Congress intended such a result ``even if the 
communication is routed through a satellite located in space, 
regardless of the satellite's location.'' Id. Thus, the legislative 
history clearly provides that Congress intended that U.S. 
communications income be sourced entirely as U.S. source income.
4. International Communications Income Derived by a Foreign Person 
(Other Than a CFC)
    Proposed Sec.  1.863-9(b)(2) reflected the general rule under 
section 863(e)(1)(B) that a foreign person's international 
communications income is foreign source income. Consistent with the 
statutory exception under section 863(e)(1)(B)(ii), proposed Sec.  
1.863-9(b)(2)(iii) provided that any international communications 
income derived by a foreign person, other than a CFC, that is 
attributable to an office or other fixed place of business of the 
foreign person in the United States is U.S. source income. 
International communications income is attributable to an office or 
other fixed place of business to the extent of functions performed, 
resources employed, or risks assumed by the office or other fixed place 
of business. Pursuant to the grant of regulatory authority under 
section 863(e)(1)(B), the proposed regulations provided other 
exceptions to the general rule for foreign persons. The first exception 
is the 50/50 source rule for CFCs under Sec.  1.863-9(b)(2)(ii) of the 
proposed regulations, as discussed above. The second exception was 
provided in Sec.  1.863-9(b)(2)(iv) of the proposed regulations and 
applied to foreign persons other than CFCs. Section 1.863-9(b)(2)(iv) 
of the proposed regulations provided that international communications 
income derived by a foreign person, other than a CFC, engaged in a 
trade or business within the United States, that is attributable to 
functions performed, resources employed, or risks assumed within the 
United States is U.S. source income. One commentator noted that it is 
unclear why a separate rule is needed for a fixed place of business in 
the United States and a U.S. trade or business because international 
communications income attributable to a fixed place of business in the 
United States should also be attributable to functions performed, 
resources employed and risks assumed within the United States.
    As indicated, the office or other fixed place of business rule 
under Sec.  1.863-9(b)(2)(iii) of the proposed regulations was derived 
from the statutory language of section 863(e), while the trade or 
business rule under Sec.  1.863-9(b)(2)(iv) of the proposed regulations 
was derived from the express grant of regulatory authority to source 
international communications income of foreign persons as other than 
foreign source. The Treasury Department and the IRS recognize that in 
most situations, the latter trade or business rule would indeed subsume 
the former fixed place of business rule, but still believe that the 
later rule serves an important function. The trade or business rule 
addresses 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.
5. Allocations
    Section 1.863-9(h)(1)(ii) of the proposed regulations provided that 
to the extent that a taxpayer's transaction consists in part of non-de 
minimis communications activity and in part of non-de minimis non-
communications activity, each part of the transaction must be treated 
as a separate transaction. Gross income is then allocated to each 
communications activity transaction and each non-communications 
activity transaction to the extent the income, based on all the facts 
and circumstances, is attributable to functions performed, resources 
employed, or risks assumed in each such activity. Moreover, the 
Treasury Department and the IRS suggested in the preamble to the 
proposed regulations that allocations of gross income should be based 
generally on section 482 principles. One commentator stated that the 
complexities inherent in allocating income, based on section 482 
principles, between the separated transactions are significant.
    While the final regulations were not changed in response to this 
comment, as in the case of allocations for space and ocean income, the 
Treasury Department and the IRS believe that some clarification is 
warranted. In suggesting the use of section 482 principles as a guide, 
the Treasury Department and the IRS intend for taxpayers to adopt a 
reasonable approach to the allocations required in this area. Taxpayers 
know their businesses and will generally be in the best position to 
fashion a reasonable method that most reliably reflects the relative 
value of functions performed, resources employed, and risks assumed in 
different locations. In the preamble to the proposed regulations, the 
Treasury Department and the IRS solicited comments on alternative 
methods of allocation for particular industries and criteria that could 
be used to evaluate the reasonableness of such methods. No such 
comments were received. One commentator noted, however, that the 
proposed regulations perhaps reflected

[[Page 77603]]

what taxpayers in these industries have already been doing in order to 
determine the character and source of their communications income. 
Consequently, as in the case of space and ocean income, the Treasury 
Department and the IRS believe that allocations of gross income based 
on functions performed, resources employed, and risks assumed are 
appropriate in these circumstances.

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 pursuant to that Order is not 
required. It has also been determined that section 553(b) of the 
Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to 
these regulations. Pursuant to the Regulatory Flexibility Act (5 U.S.C. 
chapter 6), it is hereby certified that the collection of information 
in these regulations will not have a significant economic impact on a 
substantial number of small entities. This certification is based on 
the fact that the rules provided in these regulations principally 
affect large multinational corporations that pay foreign taxes on 
income derived from substantial foreign operations and that use these 
and any other applicable source rules in determining their foreign tax 
credit. Accordingly, a Regulatory Flexibility Act assessment is not 
required. Pursuant to section 7805(f) of the Internal Revenue Code, the 
NPRM preceding these regulations were submitted to the Chief Counsel 
for Advocacy of the Small Business Administration for comment on their 
impact on small business.

Drafting Information

    The principal author of these regulations is H. Michael Huynh of 
the Office of the Associate Chief Counsel (International). However, 
other personnel from the Treasury Department and the IRS 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 is amended by adding 
entries in numerical order to read, in part, as follows:

    Authority: 26 U.S.C. 7805 * * *.
    Section 1.863-8 also issued under 26 U.S.C. 863(a), (b) and (d). 
* * *
    Section 1.863-9 also issued under 26 U.S.C. 863(a), (d) and (e). 
* * *

0
Par. 2. Section 1.863-3 is amended by:
0
1. Adding a sentence after the first sentence in paragraph (a)(1).
0
2. Adding a sentence at the end of paragraph (c)(1)(i)(A).
0
3. Adding a sentence after the first sentence in