Source of Income From Certain Sales of Personal Property, 79837-79853 [2020-21817]

Download as PDF Federal Register / Vol. 85, No. 239 / Friday, December 11, 2020 / Rules and Regulations ITAR provisions related to remote work. The notice and comment process will require additional time, including to allow DDTC to address any potential revisions through the interagency process. Pursuant to ITAR §§ 126.2 and 126.3, in the interest of the security and foreign policy of the United States and as warranted by the exceptional and undue hardships and risks to safety caused by the public health emergency related to the SARS–COV2 pandemic, notice is provided that the following temporary suspensions, modifications, and exceptions are being extended as follows: 1. As of March 13, 2020, a temporary suspension, modification, and exception to the requirement that a regular employee, for purposes of ITAR § 120.39(a)(2), work at the company’s facilities, to allow the individual to work at a remote work location, so long as the individual is not located in Russia or a country listed in ITAR § 126.1. This suspension, modification, and exception shall terminate on June 30, 2021, unless otherwise extended in writing. 2. As of March 13, 2020, a temporary suspension, modification, and exception to authorize regular employees of licensed entities who are working remotely in a country not currently authorized by a technical assistance agreement, manufacturing license agreement, or exemption to send, receive, or access any technical data authorized for export, reexport, or retransfer to their employer via a technical assistance agreement, manufacturing license agreement, or exemption so long as the regular employee is not located in Russia or a country listed in ITAR § 126.1. This suspension, modification, and exception shall terminate on June 30, 2021, unless otherwise extended in writing. This notification makes no other revision to the document published at 85 FR 25287, nor does it make any other temporary suspension, modification, or exception to the requirements of the ITAR. Authority: 22 CFR 126.2 and 126.3) Michael F. Miller, Deputy Assistant Secretary for Defense Trade Controls, U.S. Department of State. [FR Doc. 2020–27024 Filed 12–10–20; 8:45 am] jbell on DSKJLSW7X2PROD with RULES BILLING CODE 4710–25–P VerDate Sep<11>2014 22:08 Dec 10, 2020 Jkt 253001 DEPARTMENT OF THE TREASURY Internal Revenue Service 79837 of this Summary of Comments and Explanation of Revisions.’’ Crystal Pemberton, Senior Federal Register Liaison, Publications and Regulations Branch, Legal Processing Division, Associate Chief Counsel, (Procedure and Administration). 26 CFR Part 1 [TD 9902] [FR Doc. 2020–25374 Filed 12–10–20; 8:45 am] RIN 1545–BP15 BILLING CODE 4830–01–P Guidance Under Sections 951A and 954 Regarding Income Subject to a High Rate of Foreign Tax; Correction DEPARTMENT OF THE TREASURY Internal Revenue Service (IRS), Treasury. 26 CFR Part 1 AGENCY: ACTION: Final regulations; correction. Internal Revenue Service [TD 9921] RIN 1545–BP16 This document contains corrections to Treasury Decision 9902, which was published in the Federal Register on Thursday, July 23, 2020. Treasury Decision 9902 contained final regulations under the global intangible low-taxed income and subpart F income provisions of the Internal Revenue Code regarding the treatment of income that is subject to a high rate of foreign tax. SUMMARY: This correction is effective on December 11, 2020. DATES: FOR FURTHER INFORMATION CONTACT: Jorge M. Oben or Larry R. Pounders at (202) 317–6934 (not a toll-free number). SUPPLEMENTARY INFORMATION: Background The final regulations that are the subject of this correction are issued under section 951A of the Code. Need for Correction As published, the final regulations contain errors that need to be corrected. Correction of Publication Accordingly, the final regulations (TD 9902) that are the subject of FR Doc. 2020–15351, beginning on page 44620 in the issue of July 23, 2020, are corrected as follows: On page 44629, in the first column, the text of footnote 6 is corrected to read: ‘‘Under currently applicable § 1.951A–1(e)(2), a domestic partnership can be a controlling domestic shareholder—for example, for purposes of determining which party elects the GILTI high-tax exclusion under § 1.951A–2(c)(7)(viii)(A), including potentially for taxable years beginning after December 31, 2017, under § 1.951A–7(b), as discussed in part VIII PO 00000 Frm 00059 Fmt 4700 Sfmt 4700 Source of Income From Certain Sales of Personal Property Internal Revenue Service (IRS), Treasury. ACTION: Final regulations. AGENCY: This document contains final regulations modifying the rules for determining the source of income from sales of inventory produced within the United States and sold without the United States or vice versa. These final regulations also contain new rules for determining the source of income from sales of personal property (including inventory) by nonresidents that are attributable to an office or other fixed place of business that the nonresident maintains in the United States. Finally, these final regulations modify certain rules for determining whether foreign source income is effectively connected with the conduct of a trade or business within the United States. DATES: Effective Date: These final regulations are effective on December 11, 2020. Applicability Dates: For dates of applicability, see §§ 1.863–1(f), 1.863– 2(c), 1.863–3(g), 1.863–8(h), 1.864–5(e), 1.864–6(c)(4), and 1.865–3(g). FOR FURTHER INFORMATION CONTACT: Brad McCormack at (202) 317–6911 (not a toll free number). SUPPLEMENTARY INFORMATION: SUMMARY: Background The Tax Cuts and Jobs Act, Public Law 115–97, 131 Stat. 2054, 2208 (2017) (the ‘‘Act’’), enacted on December 22, 2017, amended section 863(b) of the Internal Revenue Code (‘‘Code’’). On December 30, 2019, the Department of the Treasury (‘‘Treasury Department’’) and the IRS published proposed regulations (REG–100956–19) under sections 863, 864, 865, 937, and 1502 in the Federal Register (84 FR 71836) (the E:\FR\FM\11DER1.SGM 11DER1 79838 Federal Register / Vol. 85, No. 239 / Friday, December 11, 2020 / Rules and Regulations ‘‘proposed regulations’’). A public hearing on the proposed regulations was held on June 3, 2020. All written comments received in response to the proposed regulations are available at https://www.regulations.gov or upon request. Terms used but not defined in this preamble have the meaning provided in these final regulations. Summary of Comments and Explanation of Revisions I. Overview The final regulations retain the overall approach of the proposed regulations, with certain revisions. This Summary of Comments and Explanation of Revisions section discusses those revisions as well as comments received in response to the solicitation of comments in the notice of proposed rulemaking. Comments outside the scope of this rulemaking are generally not addressed but may be considered in connection with future guidance projects. jbell on DSKJLSW7X2PROD with RULES II. Comments on and Revisions to Proposed § 1.863–1—Allocation of Gross Income Under Section 863(a) and Proposed § 1.863–3—Allocation and Apportionment of Income From Certain Sales of Inventory The Act amended section 863 of the Code, which provides special sourcing rules for determining the source of income, including income partly from within and partly from without the United States. Specifically, the Act amended section 863(b) to allocate or apportion income from the sale or exchange of inventory property produced (in whole or in part) by a taxpayer within the United States and sold or exchanged without the United States or produced (in whole or in part) by the taxpayer without the United States and sold or exchanged within the United States (collectively, ‘‘Section 863(b)(2) Sales’’) solely on the basis of production activities with respect to that inventory. Before the Act, section 863(b) provided that income from Section 863(b)(2) Sales would be treated as derived partly from sources within and partly from sources without the United States without providing the basis for such allocation or apportionment. Consistent with the Act’s changes to section 863(b), the proposed regulations amended § 1.863– 3 in order to properly allocate or apportion gross income from Section 863(b)(2) Sales based solely on production activity. Under § 1.863–3(c)(1)(ii)(A) (which has been redesignated in the final regulations as § 1.863–3(c)(2)(i)), where the taxpayer’s production assets are VerDate Sep<11>2014 22:08 Dec 10, 2020 Jkt 253001 located both within and without the United States, the amount of income from sources without the United States is determined by multiplying all the income attributable to the taxpayer’s production activities by a fraction, the numerator of which is the average adjusted basis of production assets that are located without the United States and the denominator of which is the average adjusted basis of all the production assets located within and without the United States. For purposes of applying this formula, the adjusted basis of production assets is determined under section 1011, which is adjusted under section 1016 for depreciation deductions allowed. The Act also amended section 168(k) to allow an additional first-year depreciation deduction of 100 percent of the basis of certain property placed in service after September 27, 2017, and before January 1, 2023. Therefore, certain new and used production assets placed in service and used predominantly within the United States during this period may have an adjusted basis of zero. However, production assets either placed in service or used predominantly without the United States, or both, do not qualify for this accelerated depreciation and must be depreciated using the straight-line method under the alternative depreciation system (‘‘ADS’’) of section 168(g)(2). In light of the Act’s change to section 168(k) to allow accelerated depreciation in some circumstances, the proposed regulations provided a new rule for computing the adjusted basis of production assets for purposes of applying the allocation formula in § 1.863–3. A. Income Attributable to Sales Activity Section 1.863–3, as in effect before this Treasury Decision, provided rules and corresponding methods for allocating or apportioning gross income from Section 863(b)(2) Sales between production activity and sales activity. To implement the changes to section 863(b) under the Act, the proposed regulations proposed removing § 1.863– 3(c)(2) which allocates and apportions income attributable to sales activity. One comment argued that removing § 1.863–3(c)(2) could lead to double taxation when a foreign jurisdiction imposes taxation on the sales activity. The Act amended section 863(b) to source income from the sale by a taxpayer of inventory produced by that taxpayer based only on production activity. Under the Code, sales activity is no longer a relevant factor for allocating and apportioning such income. Therefore, the final regulations PO 00000 Frm 00060 Fmt 4700 Sfmt 4700 remove § 1.863–3(c)(2). But see part V of this Summary of Comments and Explanation of Revisions section for a discussion of the interaction with income tax treaties. Another comment suggested that two aspects of § 1.863–3(c)(2) have continued relevance even after the Act’s changes to section 863(b)(2). First, § 1.863–3(c)(2) has a special rule modifying the rule in § 1.861–7(c) that generally sources income from the sale of personal property based on the place of sale. Under § 1.861–7(c), a sale is generally treated as consummated in the place where the rights, title, and interest of the seller in the property are transferred to the buyer. However, if a taxpayer wholly produces inventory in the United States and sells it for use, consumption, or disposition in the United States, § 1.863–3(c)(2) presumes that the place of sale is in the United States, even if title passes outside the United States. The comment recommended the final regulations include a similar rule and expand it to inventory wholly or partly produced in the United States that is acquired by a related party and resold for use, consumption, or disposition in the United States with title passing outside the United States. The comment observed that in the absence of such a rule, the sale by the related party would generate foreign source income, notwithstanding the fact that the inventory was produced wholly or partly in the United States and ultimately sold for use, consumption, or disposition in the United States. The final regulations do not adopt this comment. The place of sale rule of § 1.861–7(c) already contains a broad anti-abuse rule that would apply to any sales transactions ‘‘arranged in a particular manner for the primary purpose of tax avoidance,’’ which may cover certain related party arrangements about which the comment is concerned. Section 482 also applies to require that compensation paid between related parties is consistent with the arm’s length standard and will take into account the business functions and assets of, and risks assumed by, the related party intermediary. The Treasury Department and the IRS continue to study issues related to the distribution among related entities of the business functions, assets, and risks that generate business income, including sales income, and may address these issues in future guidance, particularly with respect to the sourcing of income from certain digital transactions. Second, the comment observed that § 1.863–3(c)(2) treats inventory as E:\FR\FM\11DER1.SGM 11DER1 Federal Register / Vol. 85, No. 239 / Friday, December 11, 2020 / Rules and Regulations jbell on DSKJLSW7X2PROD with RULES wholly produced in the United States for purposes of determining whether the place of sale is presumed to be in the United States if only minor assembly, packaging, repackaging, or labeling occurs outside the United States. The comment recommended including this rule as part of proposed § 1.863– 3(c)(1)(i). The final regulations adopt this comment in § 1.863–3(c)(1)(i) by incorporating the ‘‘principles of § 1.954– 3(a)(4)’’ (other than § 1.954–3(a)(4)(iv)). Section 1.954–3(a)(4) provides rules for determining when a corporation has manufactured, produced, or constructed personal property. Under § 1.954– 3(a)(4)(iii), packaging, repackaging, labeling, or minor assembly operations do not constitute the manufacture, production, or construction of property. Accordingly, under the final regulations, these principles apply for purposes of determining whether a taxpayer’s activities constitute production activity under § 1.863– 3(c)(1)(i) as well. See part II.B. of this Summary of Comments and Explanation of Revisions section. B. Definition of Production Activities Proposed § 1.863–1(b)(2) provided the rule for sourcing gross receipts from the sale of natural resources where the taxpayer performs production activities in addition to its ownership of a farm, mine, oil or gas well, other natural deposit, or uncut timber. Section 1.863– 1(b)(3)(ii) defines such ‘‘additional production activities’’ by reference to the ‘‘principles of § 1.954–3(a)(4).’’ Under section 951(a)(1)(A), a United States shareholder of a controlled foreign corporation (‘‘CFC’’) includes in gross income its pro rata share of the CFC’s subpart F income for the CFC’s taxable year which ends with or within the taxable year of the shareholder. Section 952(a)(2) defines the term subpart F income to include foreign base company income. Section 954(a)(2) defines foreign base company income to include foreign base company sales income (‘‘FBCSI’’) for the taxable year. Section 954(d)(1) defines FBCSI to mean income derived by a CFC in connection with certain related party transactions. Section 1.954–3(a)(4) provides an exception to FBCSI when a CFC manufactures property that it sells. One comment supported defining ‘‘additional production activities’’ by reference to ‘‘the principles of § 1.954– 3(a)(4),’’ as described in § 1.863– 1(b)(3)(ii), and requested that §§ 1.863– 3 and 1.865–3 include a similar cross reference. The final regulations adopt this recommendation, in part. Specifically, under the final regulations, §§ 1.863–3 VerDate Sep<11>2014 22:08 Dec 10, 2020 Jkt 253001 and 1.865–3 incorporate the principles of § 1.954–3(a)(4), with the exception of the rules regarding a ‘‘substantial contribution to the manufacturing of personal property’’ under § 1.954– 3(a)(4)(iv). See §§ 1.863–3(c)(1)(i) and 1.865–3(d)(2). The final regulations also modify § 1.863–1(b)(3)(ii) to incorporate the principles of § 1.954–3(a)(4), other than the ‘‘substantial contribution to the manufacturing of personal property’’ under § 1.954–3(a)(4)(iv). The substantial contribution rules were added to § 1.954–3(a)(4) in T.D. 9438 (December 29, 2008) after the adoption of § 1.863–1(b)(3)(ii) in T.D. 8687 (November 27, 1996). While the Treasury Department and the IRS agree with the comment that the principles of § 1.954–3(a)(4) may generally be helpful in determining the location of production activity for sourcing purposes, the substantial contribution rules of § 1.954–3(a)(4)(iv) are concerned with whether there is production activity and do not address the geographic location of that production activity, which is relevant for sourcing under sections 861, 863, and 865. Additionally, the substantial contribution rules are premised on treating a corporation as engaged in production activities even if it is not engaged in the direct use of production assets (other than oversight assets), while § 1.863–3 focuses on sourcing income based on the location of a corporation’s production assets that are used for production activities. See § 1.863–3(c)(1)(ii) (which has been redesignated in the final regulations as § 1.863–3(c)(2)). In this regard, there is not a clear metric for quantifying production arising from substantial contribution activities, even if such activities are properly identified, in order to assign production activities to a particular geographic location for purposes of determining the place of production under sections 861, 863, and 865. Therefore, the final regulations provide that the principles of § 1.954– 3(a)(4), other than the substantial contribution rules in § 1.954–3(a)(4)(iv), apply in determining whether production activities exist. C. Measuring Adjusted Basis of Production Assets For inventory produced both within and without the United States, the proposed regulations continued to allocate or apportion the gross income between U.S. and foreign sources based on the formula in § 1.863–3(c)(1)(ii)(A) (redesignated as proposed § 1.863– 3(c)(2)(i)). This formula determined the amount of foreign source income by multiplying the total gross income by a PO 00000 Frm 00061 Fmt 4700 Sfmt 4700 79839 fraction, the numerator of which is the average adjusted basis of production assets located outside the United States and the denominator of which is the average adjusted basis of all production assets within and without the United States. The remaining gross income is from U.S. sources. In light of the Act’s changes to section 168(k), proposed § 1.863–3(c)(2)(ii) measured the adjusted basis of the U.S. production assets for purposes of this formula based on the alternative depreciation system (‘‘ADS’’) of section 168(g)(2). The preamble to the proposed regulations observed that such rule allows the basis of both U.S. and nonU.S. production assets to be measured consistently on a straight-line method over the same recovery period, and requested comments on using ADS for this purpose or alternatives for measuring relative U.S. and non-U.S. production assets. One comment suggested that some taxpayers such as partnerships and S corporations would face administrative burdens if they had to maintain separate ADS books that they may not otherwise maintain if section 951A(d)(3) or 250(b)(2)(B) do not apply to them. The comment observed that the Act, in contrast to those other sections, does not mandate the use of ADS in the section 863(b) context. The comment requested that the final regulations maintain the existing rule of § 1.863–3(c)(1)(ii)(B) measuring the basis under section 1011 (as adjusted by section 1016), either as the principal rule or, alternatively, at the election of the taxpayer. The final regulations do not adopt this comment. The Treasury Department and the IRS have determined that the use of ADS for this purpose will prevent the Act’s modifications to section 168(k) (resulting in accelerated depreciation) from inappropriately skewing the apportionment formula under § 1.863– 3(c)(2)(i) in favor of foreign source income. While the Act does not mandate the use of ADS for this purpose, the Treasury Department and the IRS have authority to mandate the use of ADS under sections 863(a) and 7805 and have determined that the use of ADS is necessary to accurately measure the place of production using adjusted basis, as other basis measurements might inappropriately inflate foreign production activities. E:\FR\FM\11DER1.SGM 11DER1 jbell on DSKJLSW7X2PROD with RULES 79840 Federal Register / Vol. 85, No. 239 / Friday, December 11, 2020 / Rules and Regulations III. Comments on and Revisions to Proposed § 1.865–3—Source of Gross Income From Sales of Personal Property (Including Inventory Property) by a Nonresident Attributable to an Office or Other Fixed Place of Business in the United States Section 865 provides rules for sourcing income from sales of personal property. Section 865(e)(2) applies with respect to all sales of personal property (including inventory) by a nonresident, as that term is defined in section 865(g)(1)(B), attributable to an office or other fixed place of business in the United States. Section 865(e)(2)(A) generally provides that income from any sale of personal property attributable to such an office or other fixed place of business is sourced in the United States. An exception is provided in section 865(e)(2)(B) for a sale of inventory for use, disposition, or consumption outside the United States if a foreign office of the nonresident ‘‘materially participated’’ in the sale. Section 865(e)(3) provides that the ‘‘principles of section 864(c)(5) shall apply’’ to determine whether a nonresident has an office or other fixed place of business and whether a sale is attributable to such office or other fixed place of business. Where applicable, section 865(e)(2) applies ‘‘[n]otwithstanding any other provisions’’ of subchapter N, part I, including sections 863(b), 861(a)(6), and 862(a)(6). The proposed regulations under § 1.865–3 clarified the application of the principles of section 864(c)(5) in the context of section 865(e)(2) and provided that sales of inventory property produced outside the United States and sold through an office maintained by the nonresident in the United States must be sourced in the United States in part. Proposed § 1.865–3(e) also included a cross-reference to the rules for allocating and apportioning expenses to gross income effectively connected with the conduct of a trade or business in the United States in §§ 1.882–4 and 1.882– 5. Since those regulations apply only to foreign corporations, one comment requested that the final regulations also refer to § 1.873–1 to cover nonresident alien taxpayers subject to proposed § 1.865–3. In response to this comment, the final regulations broaden the crossreferences to include sections 882(c)(1) and 873(a) for purposes of allocating and apportioning expenses. See § 1.865– 3(e). The final regulations also reorder and revise parts of § 1.865–3 in a nonsubstantive manner solely for purposes of improving clarity and ease of application. The revision also helps to VerDate Sep<11>2014 22:08 Dec 10, 2020 Jkt 253001 clarify that § 1.865–3 applies only if a nonresident maintains an office or other fixed place of business in the United States to which a sale of personal property is attributable. Otherwise, the source of the income, gain, or loss from the sale will be determined under other applicable provisions of section 865, such as section 865(b) through (d). The final regulations also retain, with certain modifications, the rules for determining the portion of gross income from sales and production activities under § 1.865–3(d). Under the proposed regulations, the ‘‘50/50 method,’’ described in § 1.865–3(d)(2)(i), was the default method because it was ‘‘an appropriate and administrable way’’ to apply section 865(e)(2), but the proposed regulations also allowed nonresidents to elect a books and records method that would ‘‘more precisely’’ reflect their gross income from both sales and production activities, if any, in the United States, provided the nonresidents met certain requirements for maintaining their books of account under proposed § 1.865–3(d)(2)(ii)(B)(1) through (3). See 84 FR 71836, 71843. Under the final regulations, the 50/50 method continues to be the default method and taxpayers continue to be permitted to elect the books and records method. However, the Treasury Department and the IRS have determined that, where taxpayers have demonstrated the ability to use their books of account to determine their U.S. source gross income under the books and records method, a limitation is appropriate to prevent a nonresident from returning to the less precise 50/50 method solely to obtain a better tax result. In addition, the Treasury Department and the IRS have determined that revising the election to provide that it remains in effect until revoked would reduce the risk to taxpayers of inadvertently failing to include the election with their Federal income tax return. Accordingly, under the final regulations, an election to apply the books and records method continues until revoked and may not be revoked, without the consent of the Commissioner, for any taxable year beginning within 48 months of the end of the taxable year in which the election was made. The final regulations also revise § 1.864–5 to clarify the interaction with section 865(e)(2) and (3) and the promulgation of § 1.865–3. Gross income, gain, or loss from the sale of personal property treated as from sources within the United States under § 1.865–3 will generally be effectively connected with the conduct of a trade or business in the United States to the PO 00000 Frm 00062 Fmt 4700 Sfmt 4700 extent provided in section 864(c), other than section 864(c)(4) or (5). Gross income, gain, or loss from the sale of personal property treated as from sources without the United States under § 1.865–3 is not described in § 1.864– 5(b) and thus will generally not be effectively connected with the conduct of a trade or business in the United States. The rules of §§ 1.864–5, 1.864–6, and 1.864–7 continue to apply, however, in determining whether foreign source income of nonresident aliens and foreign corporations that does not arise from the sale of personal property described in § 1.865–3(c) is effectively connected with the conduct of a trade or business in the United States. The rules of §§ 1.864–5, 1.864–6, and 1.864– 7 also continue to apply in determining whether foreign source income from the sale of inventory by nonresident aliens, who would be residents under section 865(g)(1)(A), is effectively connected with the conduct of a trade or business in the United States. IV. Comments on the Rules for Determining the Location or Existence of Production Activity The proposed regulations did not modify the rules in § 1.863–3 for determining the location or existence of production activity for purposes of determining the sourcing of income derived from the sale of inventory. Section 1.863–3(c)(1)(i)(A) (which has been redesignated in the final regulations as § 1.863–3(c)(1)(i)) provides the rule for sourcing of income where production occurs only within the United States or only within foreign countries. That paragraph generally limits the scope of ‘‘production activities’’ to only ‘‘those conducted directly by the taxpayer.’’ Similarly, § 1.863–3(c)(1)(i)(B) (which has been redesignated in the final regulations as § 1.863–3(c)(1)(ii)) provides that production assets are those ‘‘owned directly by the taxpayer that are directly used by the taxpayer to produce inventory.’’ Section 1.863–3(c)(1)(ii) (which has been redesignated in the final regulations as § 1.863–3(c)(2)) provides the rule for the sourcing of income where production occurs both within and without the United States, and, as discussed in part II.C of this Summary of Comments and Explanation of Revisions section, allocates gross income based on the relative adjusted basis of production assets located within and without the United States, respectively. The final regulations clarify the determination of the adjusted basis of production assets under § 1.863– E:\FR\FM\11DER1.SGM 11DER1 jbell on DSKJLSW7X2PROD with RULES Federal Register / Vol. 85, No. 239 / Friday, December 11, 2020 / Rules and Regulations 3(c)(1)(ii)(B) (which has been redesignated in the final regulations as § 1.863–3(c)(2)(ii)(A)). Under the final regulations, the adjusted basis of production assets for a taxable year is determined by averaging the basis of the assets at the beginning and end of the year, except in the event that a change during the year would cause the average to ‘‘materially distort’’ the calculation for sourcing of income attributable to production activity under § 1.863– 3(c)(1)(ii)(A) (which has been redesignated in the final regulations as § 1.863–3(c)(2)(i)). This clarification uses certain concepts from § 1.861– 9(g)(2)(i)(A) to further explain when a change might ‘‘materially distort’’ the calculation. For example, the rule applies when an event such as a lateyear disposition of substantially all the U.S. production assets of a corporation would cause a material distortion in the corporation’s calculation of the split between U.S. and foreign production activities. One comment provided a range of suggestions to modify the rules of proposed §§ 1.863–3(c) and 1.865–3(d). This comment suggested that the rules of proposed §§ 1.863–3(c) and 1.865– 3(d) were adequate, in general, where a taxpayer independently manufactured its own inventory, but inadequate with respect to other business models that rely on limited risk contract manufacturers or where multiple members of a group each perform only limited manufacturing functions in various jurisdictions. The comment observed that apportionment of gross income using the relative adjusted basis of production assets may not reflect high value-adding core production and risk management functions and ownership of production assets by unrelated contract manufacturers. The comment suggested expanding the scope of covered production activities and ownership of production assets to include activities conducted and assets owned by related parties and unrelated agents of the taxpayer. The comment also recommended that these rules include any activities that constitute a ‘‘substantial contribution’’ within the meaning of § 1.954– 3(a)(4)(iv) to better conform to the rules under subpart F. See part II.B of this Summary of Comments and Explanation of Revisions section. In addition, the comment suggested that § 1.863–3 should not allocate and apportion gross income using only the relative adjusted basis of production assets located within and without the United States, and recommended allocation and apportionment based on other metrics, such as the location of personnel VerDate Sep<11>2014 22:08 Dec 10, 2020 Jkt 253001 involved in the production activities or personnel costs. The comment suggested that these modifications could, alternatively, be rebuttable presumptions that a taxpayer could overcome by showing that allocating and apportioning gross income based on adjusted basis or some other approach provides a more appropriate result under the taxpayer’s facts. Another comment suggested that the existing allocation and apportionment rules that rely on the relative adjusted basis of production assets encourage businesses to move (or locate additional) production assets outside the United States. Specifically, the comment expressed concern that treating income from the sale of inventory produced, in whole or in part, in the United States as U.S. source income might result in double taxation if the income is also subject to tax in a foreign jurisdiction, since the U.S. source income would be excluded from the numerator of the section 904 limitation, reducing the section 904 limitation, and potentially limiting the U.S. taxpayer’s ability to use its foreign tax credits. The comment requested replacing these rules with a more comprehensive formula, preferably one that minimizes the risk of double taxation. The comment did not suggest an alternative formula and observed that further legislation may be necessary in this regard. The Treasury Department and the IRS appreciate the various concerns presented by these comments and suggested revisions. The final regulations do not adopt these comments, but the Treasury Department and the IRS may consider these recommendations as part of a more comprehensive review of the sourcing rules for production activity (for purposes of both § 1.863–3 and § 1.865– 3) in a future notice of proposed rulemaking. Additionally, the anti-abuse rule in § 1.863–3(c)(1)(iii) (which has been redesignated in the final regulations as § 1.863–3(c)(3)) already applies to make appropriate adjustments where taxpayers enter into or structure certain transactions with a principal purpose of reducing U.S. tax liability under § 1.863–3, including by using production assets owned by a related party. To clarify the application of this rule, the final regulations provide that the anti-abuse rule applies to transactions inconsistent with the purpose of § 1.863–3(b) or (c), and adds as an example that the anti-abuse rule may cover acquisitions of domestic production assets by related partnerships (or subsidiaries thereof) with a principal purpose of reducing the PO 00000 Frm 00063 Fmt 4700 Sfmt 4700 79841 transferor’s U.S. tax liability by treating income from the sale of inventory property as subject to section 862(a)(6) rather than section 863(b). The Treasury Department and the IRS continue to request comments regarding potential approaches to determine the location or existence of production activity or other modifications to § 1.863–3 that may be appropriate. V. Comments on Income Tax Treaties The preamble to the proposed regulations included a statement about how proposed § 1.865–3 interacted with U.S. income tax treaties under which the business profits of foreign treaty residents may be taxable in the United States only if the profits are attributable to a permanent establishment in the United States. The preamble to the proposed regulations stated, ‘‘[w]ith respect to taxpayers entitled to the benefits of an income tax treaty, the amount of profits attributable to a U.S. permanent establishment will not be affected by these regulations.’’ See 84 FR 71836, 71844. One comment supported the preamble’s statement and requested that, consistent with the statement in the preamble, the final regulations not apply to Section 863(b)(2) Sales in a manner that results in double taxation to U.S. taxpayers engaged in business operations through a permanent establishment in a treaty jurisdiction, notwithstanding the Act’s change to section 863(b). The comment also requested that competent authority relief be provided in this regard. These regulations do not affect the ability of a taxpayer to rely on treaty provisions to mitigate or relieve double taxation, including treaty provisions that permit a taxpayer to make a request to the competent authority for assistance pursuant to a mutual agreement procedure article of an applicable income tax treaty. VI. Comment on Proposed Applicability Date The proposed regulations were proposed to apply to taxable years ending on or after December 23, 2019, although taxpayers and their related parties could generally apply the rules in their entirety for taxable years beginning after December 31, 2017, and ending before December 23, 2019. One comment requested that the final regulations apply to taxable years ending after December 31, 2019, because some taxpayers have consistently relied on the existing methods of § 1.863–3(b) for many years. The final regulations do not adopt this comment. Under section 7805(b)(1)(B), a final regulation can E:\FR\FM\11DER1.SGM 11DER1 79842 Federal Register / Vol. 85, No. 239 / Friday, December 11, 2020 / Rules and Regulations apply to any taxable period ending on or after the date on which the proposed regulation to which such final regulation relates was filed with the Federal Register, which for these final regulations was December 23, 2019. The final regulations implement the Act’s statutory change to section 863(b), which was effective for taxable years beginning after December 31, 2017. To provide certainty to taxpayers and avoid a multiplicity of different interpretations of the statute, the Treasury Department and the IRS have determined that it is appropriate for the final regulations to apply as closely as possible to the effective date of the statutory change. Applicability Date The final regulations generally apply to taxable years ending on or after December 23, 2019. Taxpayers may choose to apply the final regulations for any taxable year beginning after December 31, 2017, and ending before December 23, 2019, provided that the taxpayer and all persons that are related to the taxpayer (within the meaning of section 267 or 707) apply the final regulations in their entirety and, once applied, the taxpayer and all persons related to the taxpayer (within the meaning of section 267 or 707) continue to apply the final regulations in their entirety for all subsequent taxable years. See section 7805(b)(7). Alternatively, taxpayers may rely on the proposed regulations for any taxable year beginning after December 31, 2017, and ending on or before September 29, 2020, provided that the taxpayer and all persons that are related to the taxpayer (within the meaning of section 267 or 707) rely on the proposed regulations in their entirety and provided that the taxpayer and all persons that are related to the taxpayer (within the meaning of section 267 or 707) have not applied the final regulations to any preceding year. Special Analyses These regulations are not subject to review under section 6(b) of Executive Order 12866 pursuant to the Memorandum of Agreement (April 11, 2018) between the Treasury Department and the Office of Management and Budget regarding review of tax regulations. jbell on DSKJLSW7X2PROD with RULES I. Paperwork Reduction Act The Paperwork Reduction Act of 1995 (44 U.S.C. 3501–3520) (‘‘PRA’’) generally requires that a federal agency obtain the approval of OMB before collecting information from the public, whether such collection of information VerDate Sep<11>2014 22:08 Dec 10, 2020 Jkt 253001 is mandatory, voluntary, or required to obtain or retain a benefit. The final regulations include a collection of information in § 1.865– 3(d)(2)(ii)(B). Section 1.865– 3(d)(2)(ii)(B) allows a nonresident, as defined in section 865(g)(1)(B), whose inventory sales are described in § 1.865– 3(d)(2) (relating to inventory produced by the nonresident) to elect to allocate the profit from such sales to its U.S. office using a books and records method under § 1.865–3(d)(2)(ii), rather than using a default ‘‘50/50 method’’ under § 1.865–3(d)(2)(i). If the collection of information in § 1.865–3(d)(2)(ii)(B) applies to a nonresident, the nonresident must maintain detailed records of its receipts and expenditures attributable to its sales and production activities to support the allocation of its income, gain, or loss to its sales activities in the United States under the principles of section 482. See § 1.865– 3(d)(2)(ii)(B)(2). The nonresident must also prepare an explanation of how the allocation was determined. See § 1.865– 3(d)(2)(ii)(B)(3). The nonresident must make an election to apply the books and records method under § 1.865–3(d)(2)(ii) by attaching a statement to its original timely filed Federal income tax return (including extensions) that it elects to apply the books and records method under § 1.865–3(d)(2)(ii)(A) and has prepared the records described in § 1.865–3(d)(2)(ii)(B)(2) and (3). The nonresident must make available the explanation and records upon request of the Commissioner, within 30 days or some other time period as agreed between the Commissioner and the nonresident. See § 1.865– 3(d)(2)(ii)(B)(3). The reporting burdens associated with the collection of information in § 1.865– 3(d)(2)(ii)(B) will be reflected in the Form 14029, Paperwork Reduction Act Submission, that the Treasury Department and the IRS will submit to OMB for tax returns in the Forms 1120– F, U.S. Income Tax Return of a Foreign Corporation, and Forms 1040–NR, U.S. Nonresident Alien Income Tax Return. In particular, the reporting burden associated with the information collection in § 1.865–3(d)(2)(ii)(B) will be included in the burden estimate for OMB control numbers 1545–0123 and 1545–0074. OMB control number 1545– 0123 represents a total estimated burden time for all forms and schedules for corporations of 3.344 billion hours and total estimated monetized costs of $61.558 billion ($2019). OMB control number 1545–0074 represents a total estimated burden time, including all other related forms and schedules for individuals, of 1.717 billion hours and PO 00000 Frm 00064 Fmt 4700 Sfmt 4700 total estimated monetized costs of $33.267 billion ($2019). Table 1 summarizes the status of the PRA submissions of the Treasury Department and the IRS related to Forms 1120–F and 1040–NR. The overall burden estimate provided by the Treasury Department and the IRS to OMB in the PRA submissions for OMB control numbers 1545–0123 and 1545–0074 are aggregate amounts related to the U.S. Business Income Tax Return and the U.S. Individual Income Tax Return, along with any associated forms. The burden estimates in these PRA submissions, however, do not account for any burden imposed by § 1.865–3(d)(2)(ii)(B). The Treasury Department and the IRS have not identified the estimated burden for the collections of information in § 1.865– 3(d)(2)(ii)(B) because there are no burden estimates specific to § 1.865– 3(d)(2)(ii)(B) currently available. The burden estimates in the PRA submissions that the Treasury Department and the IRS will submit to OMB will in the future include, but not isolate, the estimated burden related to the collection of information in § 1.865– 3(d)(2)(ii)(B). The Treasury Department and the IRS have included the burdens related to the PRA submissions for OMB control numbers 1545–0123 and 1545–0074 in the PRA analysis for other regulations issued by the Treasury Department and the IRS related to the taxation of crossborder income. The Treasury Department and the IRS encourage users of this information to take measures to avoid overestimating the burden that the collection of information in § 1.865– 3(d)(2)(ii)(B), together with other international tax provisions, imposes. Moreover, the Treasury Department and the IRS also note that the Treasury Department and the IRS estimate PRA burdens on a taxpayer-type basis rather than a provision-specific basis because an estimate based on the taxpayer-type most accurately reflects taxpayers’ interactions with the forms. The Treasury Department and the IRS request comments on the forms that reflect the information collection burdens related to the final regulations, including estimates for how much time it would take to comply with the paperwork burden described above for each relevant form and ways for the IRS to minimize the paperwork burden. Proposed revisions (if any) to these forms that reflect the information collection contained in § 1.865– 3(d)(2)(ii)(B) will be made available for public comment at https://apps.irs.gov/ app/picklist/list/draftTaxForms.html and will not be finalized until after E:\FR\FM\11DER1.SGM 11DER1 Federal Register / Vol. 85, No. 239 / Friday, December 11, 2020 / Rules and Regulations 79843 these forms have been approved by OMB under the PRA. TABLE 1—SUMMARY OF INFORMATION COLLECTION REQUEST SUBMISSIONS RELATED TO FORMS 1120–F AND FORMS 1040–NR Form Type of filer OMB Nos. Form 1040–NR ...... Individual (NEW Model) ................ Status 1545–0074 Approved by OIRA 1/30/2020 until 1/31/2021. Link: https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201909-1545-021. Form 1120–F ......... Business (NEW Model) ................ 1545–0123 Approved by OIRA 1/30/2020 until 1/31/2021. Link: https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201907-1545-001. jbell on DSKJLSW7X2PROD with RULES II. Regulatory Flexibility Act Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it is hereby certified that these final regulations will not have a significant economic impact on a substantial number of small entities. Although data are not readily available to assess the number of small entities potentially affected, any economic impact of these regulations is unlikely to be significant. Specifically, the regulations in §§ 1.863–1 and 1.863– 3 (with conforming changes in crossreferencing regulations) implement the statutory change made to section 863(b) by the Act. This change affects sales of inventory property by any taxpayer where the taxpayer produces the inventory (in whole or in part) within the United States and sells that inventory without the United States, or vice versa. The change in sourcing for those entities is attributable to the change in section 863(b) made by the Act. Sections 1.863–1 and 1.863–3 merely implement the statutory change with limited additional guidance. The Treasury Department and the IRS do not anticipate that any differences between the changes in section 863(b) made by the Act and the changes in §§ 1.863–1 and 1.863–3 made by these regulations will have a significant economic impact on a substantial number of small entities. The other regulations in this publication (other than changes to ensure consistency with section 863(b)) are the final regulations in §§ 1.864–5, 1.864–6, and 1.865–3. These regulations solely affect non-U.S. taxpayers, which are not subject to the Regulatory Flexibility Act. Pursuant to section 7805(f) of the Code, the proposed regulations preceding these final regulations were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small businesses. No comments were received. VerDate Sep<11>2014 22:08 Dec 10, 2020 Jkt 253001 III. Unfunded Mandates Reform Act Section 202 of the Unfunded Mandates Reform Act of 1995 requires that agencies assess anticipated costs and benefits and take certain other actions before issuing a final rule that includes any Federal mandate that may result in expenditures in any one year by a state, local, or tribal government, in the aggregate, or by the private sector, of $100 million in 1995 dollars, updated annually for inflation. These regulations do not include any Federal mandate that may result in expenditures by state, local, or tribal governments, or by the private sector in excess of that threshold. IV. Executive Order 13132: Federalism Executive Order 13132 (entitled ‘‘Federalism’’) prohibits an agency from publishing any rule that has federalism implications if the rule either imposes substantial, direct compliance costs on state and local governments, and is not required by statute, or preempts state law, unless the agency meets the consultation and funding requirements of section 6 of the Executive Order. These regulations do not have federalism implications and do not impose substantial direct compliance costs on state and local governments or preempt state law within the meaning of the Executive Order. Drafting Information The principal author of the regulations is Brad McCormack of the Office of Associate Chief Counsel (International). However, other personnel from the Treasury Department and the IRS participated in the development of the regulations. List of Subjects in 26 CFR Part 1 Income taxes, Reporting and recordkeeping requirements. Adoption of Amendments to the Regulations Accordingly, 26 CFR part 1 is amended as follows: PO 00000 Frm 00065 Fmt 4700 Sfmt 4700 PART 1—INCOME TAXES Paragraph 1. The authority citation for part 1 is amended by adding an entry for § 1.865–3 in numerical order. The addition reads in part as follows: ■ Authority: 26 U.S.C. 7805 * * * * * * * * Section 1.865–3 also issued under 26 U.S.C. 865(j). * * * * * Par. 2. Section 1.863–0 is revised to read as follows: ■ § 1.863–0 Table of contents. This section lists captions contained in §§ 1.863–1 through 1.863–10. § 1.863–1 Allocation of gross income under section 863(a). (a) In general. (b) Natural resources. (1) In general. (2) Additional production activities. (3) Definitions. (i) Production activity. (ii) Additional production activities. (4) Determination of fair market value. (5) Determination of gross income. (6) Tax return disclosure. (7) Examples. (i) Example 1. No additional production, foreign source gross receipts. (ii) Example 2. No additional production, U.S. source gross receipts. (iii) Example 3. Production in United States, foreign sales. (iv) Example 4. Production and sales in United States. (v) Example 5. Additional production. (c) Determination of taxable income. (d) Scholarships, fellowship grants, grants, prizes, and awards. (1) In general. (2) Source of income. (i) United States source income. (ii) Foreign source income. (iii) Certain activities conducted outside the United States. (3) Definitions. (4) Effective dates. (i) Scholarships and fellowship grants. (ii) Grants, prizes and awards. (e) Residual interest in a REMIC. (1) REMIC inducement fees. (2) Excess inclusion income and net losses. E:\FR\FM\11DER1.SGM 11DER1 jbell on DSKJLSW7X2PROD with RULES 79844 Federal Register / Vol. 85, No. 239 / Friday, December 11, 2020 / Rules and Regulations (f) Applicability date. § 1.863–2 Allocation and apportionment of taxable income. (a) Determination of taxable income. (b) Determination of source of taxable income. (c) Applicability date. § 1.863–3 Allocation and apportionment of income from certain sales of inventory. (a) In general. (1) Scope. (2) Cross references. (b) Sourcing based solely on production activities. (c) Determination of the source of gross income from production activity. (1) Production only within the United States or only within foreign countries. (i) Source of income. (ii) Definition of production assets. (iii) Location of production assets. (2) Production both within and without the United States. (i) Source of income. (ii) Adjusted basis of production assets. (A) In general. (B) Production assets used to produce other property. (3) Anti-abuse rule. (4) Examples. (i) Example1. Source of gross income. (ii) Example 2. Location of intangible property. (iii) Example 3. Anti-abuse rule. (d) Determination of source of taxable income. (e) Income partly from sources within a possession of the United States. (1) In general. (2) Allocation or apportionment for Possession Production Sales. (3) Allocation or apportionment for Possession Purchase Sales. (i) Determination of source of gross income from Possession Purchase Sales. (ii) Determination of source of gross income from business activity. (A) Source of gross income. (B) Business activity. (C) Location of business activity. (1) Sales activity. (2) Cost of goods sold. (3) Expenses. (4) Examples. (i) Example 1: Purchase of goods manufactured in possession. (ii) Example 2: Purchase of goods manufactured outside possession. (5) Special rules for partnerships. (f) Special rules for partnerships. (1) General rule. (2) Exceptions. (i) In general. (ii) Attribution of production assets to or from a partnership. (iii) Basis. (3) Examples. (i) Example 1. Distributive share of partnership income. (ii) Example 2. Distribution in kind. (g) Applicability dates. § 1.863–4 Certain transportation services. (a) General. (b) Gross income. (c) Allocation of costs or expenses. VerDate Sep<11>2014 22:08 Dec 10, 2020 Jkt 253001 (d) Items not included as costs or expenses. (1) Taxes and interest. (2) Other business activity and general expenses. (3) Personal exemptions and special deductions. (e) Property used while within the United States. (1) General. (2) Average property. (3) Current assets. (f) Taxable income. (1) General. (2) Interest and taxes. (3) General expenses. (4) Personal exemptions. (5) Special deductions. (g) Allocation based on books of account. § 1.863–6 Income from sources within a foreign country. § 1.863–7 Allocation of income attributable to certain notional principal contracts under section 863(a). (a) Scope. (1) Introduction. (2) Effective/applicability date. (b) Source of notional principal contract income. (1) General rule. (2) Qualified business unit exception. (3) Effectively connected notional principal contract income. (c) Election. (1) Eligibility and effect. (2) Time for making election. (3) Manner of making election. (d) Example. (e) Cross references. § 1.863–8 Source of income derived from space and ocean activity under section 863(d). (a) In general. (b) Source of gross income from space and ocean activity. (1) Space and ocean income derived by a United States person. (2) Space and ocean income derived by a foreign person. (i) In general. (ii) Space and ocean income derived by a controlled foreign corporation. (iii) Space and ocean income derived by foreign persons engaged in a trade or business within the United States. (3) Source rules for income from certain sales of property. (i) Sales of purchased property. (ii) Sales of property produced by the taxpayer. (A) General. (B) Production only in space or international water, or only outside space and international water. (C) Production both in space or international water and outside space and international water. (4) Special rule for determining the source of gross income from services. (5) Special rule for determining source of income from communications activity (other than income from international communications activity). (c) Taxable income. (d) Space and ocean activity. (1) Definition. PO 00000 Frm 00066 Fmt 4700 Sfmt 4700 (i) Space activity. (ii) Ocean activity. (2) Determining a space or ocean activity. (i) Production of property in space or international water. (ii) Special rule for performance of services. (A) General. (B) Exception to the general rule. (3) Exceptions to space or ocean activity. (e) Treatment of partnerships. (f) Examples. (1) Example 1. Space activity—activity occurring on land and in space. (2) Example 2. Space activity. (3) Example 3. Services as space activity— de minimis value attributable to performance occurring in space. (4) Example 4. Space activity. (5) Example 5. Space activity. (6) Example 6. Space activity—treatment of land activity. (7) Example 7. Use of intangible property in space. (8) Example 8. Performance of services. (9) Example 9. Separate transactions. (10) Example 10. Sale of property in international water. (11) Example 11. Sale of property in space. (12) Example 12. Sale of property in space. (13) Example 13. Source of income of a foreign person. (14) Example 14. Source of income of a foreign person. (g) Reporting and documentation requirements. (1) In general. (2) Required documentation. (3) Access to software. (4) Use of allocation methodology. (h) Applicability date. § 1.863–9 Source of income derived from communications activity under section 863(a), (d), and (e). (a) In general. (b) Source of international communications income. (1) International communications income derived by a United States person. (2) International communications income derived by foreign persons. (i) In general. (ii) International communications income derived by a controlled foreign corporation. (iii) International communications income derived by foreign persons with a fixed place of business in the United States. (iv) International communications income derived by foreign persons engaged in a trade or business within the United States. (c) Source of U.S. communications income. (d) Source of foreign communications income. (e) Source of space/ocean communications income. (f) Source of communications income when taxpayer cannot establish the two points between which the taxpayer is paid to transmit the communication. (g) Taxable income. (h) Communications activity and income derived from communications activity. (1) Communications activity. (i) General rule. (ii) Separate transaction. (2) Income derived from communications activity. E:\FR\FM\11DER1.SGM 11DER1 Federal Register / Vol. 85, No. 239 / Friday, December 11, 2020 / Rules and Regulations (3) Determining the type of communications activity. (i) In general. (ii) Income derived from international communications activity. (iii) Income derived from U.S. communications activity. (iv) Income derived from foreign communications activity. (v) Income derived from space/ocean communications activity. (i) Treatment of partnerships. (j) Examples. (k) Reporting and documentation requirements. (1) In general. (2) Required documentation. (3) Access to software. (4) Use of allocation methodology. (l) Effective date. § 1.863–10 Source of income from a qualified fails charge. (a) In general. (b) Qualified business unit exception. (c) Effectively connected income exception. (d) Qualified fails charge. (e) Designated security. (g) Effective/applicability date. Par. 3. Section 1.863–0A is added to read as follows: ■ § 1.863–0A Table of contents. This section lists captions contained in §§ 1.863–3A and 1.863–3AT. § 1.863–3A Income from the sale of personal property derived partly from within and partly from without the United States. (a) General. (1) Classes of income. (2) Definition. (b) Income partly from sources within a foreign country. (1) General. (2) Allocation or apportionment. (c) Income partly from sources within a possession of the United States. (1) General. (2) Allocation or apportionment. (3) Personal property produced and sold. (4) Personal property purchased and sold. § 1.863–3AT Income from the sale of personal property derived partly from within and partly from without the United States (temporary). (a) [Reserved]. (b) Income partly from sources within a foreign country. (1) [Reserved]. (2) Allocation or apportionment. (c)(1) through (4) [Reserved]. Par. 4. Section 1.863–1 is amended as follows: ■ a. In paragraph (a): ■ i. Revising the third sentence. ■ ii. Removing ‘‘§ 1.863–3(g)’’ and adding in its place ‘‘§ 1.863–3(f).’’ ■ b. Revising paragraph (b)(1). ■ c. In paragraph (b)(2): ■ i. Removing ‘‘prior to export terminal’’ from the heading and adding in its place ‘‘activities.’’ jbell on DSKJLSW7X2PROD with RULES ■ VerDate Sep<11>2014 22:08 Dec 10, 2020 Jkt 253001 ii. Removing ‘‘before the relevant product is shipped from the export terminal’’ from the first sentence. ■ iii. Adding ‘‘oil or gas’’ before ‘‘well’’ and ‘‘other natural’’ before ‘‘deposit’’ in the second sentence. ■ d. Removing ‘‘§§ 1.1502–13 or 1.863– 3(g)(2)’’ from paragraph (b)(3)(i) and adding in its place ‘‘§ 1.1502–13 or 1.863–3(f)(2).’’ ■ e. In paragraph (b)(3)(ii): ■ i. Adding ‘‘uncut’’ before ‘‘timber’’ in the first sentence. ■ ii. Adding ‘‘(except for § 1.954– 3(a)(4)(iv))’’ at the end of the second sentence. ■ iii. Removing ‘‘to or from the export terminal’’ from the third sentence. ■ f. Removing paragraph (b)(3)(iii). ■ g. In paragraph (b)(6), removing ‘‘this paragraph (b)’’ from the first sentence and adding in its place ‘‘paragraph (b)(2) of this section.’’ ■ h. Designating Examples 1, 2, 3, 4, and 5 of paragraph (b)(7) as paragraphs (b)(7)(i) through (v). ■ i. Revising newly designated paragraphs (b)(7)(i) through (v). ■ j. In paragraph (f): ■ i. Revising the heading. ■ ii. Adding three sentences at the start of the paragraph. The revisions and additions read as follows: ■ § 1.863–1 Allocation of gross income under section 863(a). (a) * * * See also section 865(b) for rules for sourcing income from the sale of inventory property, within the meaning of section 865(i)(1) (inventory), generally, and section 865(e)(2) and § 1.865–3 for sourcing income from the sale of personal property (including inventory) by a nonresident that is attributable to the nonresident’s office or other fixed place of business in the United States. * * * (b) Natural resources—(1) In general. Notwithstanding any other provision of this part, except to the extent provided in paragraph (b)(2) of this section or § 1.865–3, gross receipts from the sale outside the United States of products derived from the ownership or operation of any farm, mine, oil or gas well, other natural deposit, or uncut timber within the United States shall be treated as from sources within the United States, and gross receipts from the sale within the United States of products derived from the ownership or operation of any farm, mine, oil or gas well, other natural deposit, or uncut timber outside the United States shall be treated as from sources without the United States. * * * * * (7) * * * PO 00000 Frm 00067 Fmt 4700 Sfmt 4700 79845 (i) Example 1. No additional production, foreign source gross receipts. U.S. Mines, a domestic corporation, operates a copper mine and mill in Country X. U.S. Mines extracts copper-bearing rocks from the ground and transports the rocks to the mill where the rocks are ground and processed to produce copper-bearing concentrate. The concentrate is transported to a port where it is dried in preparation for export, stored, and then shipped to purchasers in the United States. Because, under the facts and circumstances, none of U.S. Mines’ activities constitute additional production activities, within the meaning of paragraph (b)(3)(ii) of this section, paragraph (b)(2) of this section does not apply, and under paragraph (b)(1) of this section, gross receipts from the sale of the concentrate will be treated as from sources without the United States. (ii) Example 2. No additional production, U.S. source gross receipts. U.S. Gas, a domestic corporation, extracts natural gas within the United States, and transports the natural gas to a Country X port where it is liquefied in preparation for shipment. The liquefied natural gas is then transported via freighter and sold without additional production activities in a foreign country. Under paragraph (b)(3)(ii) of this section, liquefaction of natural gas is not an additional production activity because liquefaction prepares the natural gas for transportation. Therefore, under paragraph (b)(1) of this section, gross receipts from the sale of the liquefied natural gas will be treated as from sources within the United States. (iii) Example 3. Production in United States, foreign sales. U.S. Gold, a domestic corporation, mines gold in Country X, produces gold jewelry using production assets located in the United States, and sells the jewelry in Country Y. Assume that the fair market value of the gold before the additional production activities in the United States is $40x and that U.S. Gold ultimately sells the gold jewelry in Country Y for $100x. Under paragraph (b)(2) of this section, $40x of U.S. Gold’s gross receipts will be treated as from sources without the United States, and the remaining $60x of gross receipts will be treated as from sources within the United States under § 1.863–3. (iv) Example 4. Production and sales in United States. U.S. Oil, a domestic corporation, extracts oil in Country X, transports the oil via a pipeline to the United States, refines the oil using production assets located in the United States, and sells the refined product in the United States to unrelated persons. E:\FR\FM\11DER1.SGM 11DER1 jbell on DSKJLSW7X2PROD with RULES 79846 Federal Register / Vol. 85, No. 239 / Friday, December 11, 2020 / Rules and Regulations Assume that the fair market value of the oil before refinement in the United States is $80x and U.S. Oil ultimately sells the refined product for $100x. Under paragraph (b)(2) of this section, $80x of gross receipts will be treated as from sources without the United States, and the remaining $20x of gross receipts will be treated as from sources within the United States under § 1.863–3. (v) Example 5. Additional production. The facts are the same as in paragraph (b)(7)(i) of this section (the facts in Example 1), except that U.S. Mines also operates a smelter in Country X. The concentrate output from the mill is transported to the smelter where it is transformed into smelted copper. The smelted copper is exported to purchasers in the United States. Under the facts and circumstances, all the processes applied to make copper concentrate are considered mining. Therefore, under paragraph (b)(2) of this section, gross receipts equal to the fair market value of the concentrate at the smelter will be treated as from sources without the United States. Under the facts and circumstances, the conversion of the concentrate into smelted copper is an additional production activity in a foreign country within the meaning of paragraph (b)(3)(ii) of this section. Therefore, the source of U.S. Mines’s excess gross receipts will be determined under § 1.863–3, pursuant to paragraph (b)(2) of this section. * * * * * (f) Applicability date. Paragraph (b) of this section applies to taxable years ending on or after December 23, 2019. However, a taxpayer may apply paragraph (b) of this section in its entirety for taxable years beginning after December 31, 2017, and ending before December 23, 2019, provided that the taxpayer and all persons related to the taxpayer (within the meaning of section 267 or 707) apply paragraph (b) of this section and §§ 1.863–2(b), 1.863–3, 1.863–8(b)(3)(ii), 1.864–5(a) and (b), 1.864–6(c)(2), and 1.865–3 in their entirety for the taxable year, and once applied, the taxpayer and all persons related to the taxpayer (within the meaning of section 267 or 707) continue to apply these regulations in their entirety for all subsequent taxable years. For regulations generally applicable to taxable years ending before December 23, 2019, see § 1.863–1 as contained in 26 CFR part 1 revised as of April 1, 2020. * * * ■ Par. 5. Section 1.863–2 is amended as follows: ■ a. In paragraph (a) introductory text: ■ i. Removing ‘‘(and that is treated as derived partly from sources within and VerDate Sep<11>2014 22:08 Dec 10, 2020 Jkt 253001 partly from sources without the United States)’’ from the third sentence. ■ ii. Adding a colon after the word ‘‘income’’ at the end of the paragraph. ■ b. Revising paragraph (b). ■ c. Revising paragraph (c). The revisions read as follows: § 1.863–2 Allocation and apportionment of taxable income. * * * * * (b) Determination of source of taxable income. Income treated as derived from sources partly within and partly without the United States under paragraph (a) of this section may be allocated or apportioned to sources within and without the United States pursuant to §§ 1.863–1, 1.863–3, 1.863–4, 1.863–8, and 1.863–9. To determine the source of certain types of income described in paragraph (a)(1) of this section, see § 1.863–4. To determine the source of gross income described in paragraph (a)(2) of this section, see § 1.863–1 for natural resources, § 1.863–3 for other sales of inventory property, and § 1.863– 8 for source of gross income from space and ocean activity. Section 1.865–3 may apply instead of the provisions in this section to source gross income from sales of personal property (including inventory property) by nonresidents attributable to an office or other fixed place of business in the United States. To determine the source of income partly from sources within a possession of the United States, including income described in paragraph (a)(3) of this section, see § 1.863–3(e). (c) Applicability date. Except as provided in this paragraph (c), this section applies to taxable years beginning after December 30, 1996. Paragraph (b) of this section applies to taxable years ending on or after December 23, 2019. However, a taxpayer may apply paragraph (b) of this section in its entirety for taxable years beginning after December 31, 2017, and ending before December 23, 2019, provided that the taxpayer and all persons related to the taxpayer (within the meaning of section 267 or 707) apply paragraph (b) of this section and §§ 1.863–1(b), 1.863–3, 1.863–8(b)(3)(ii), 1.864–5(a) and (b), 1.864–6(c)(2), and 1.865–3 in their entirety for the taxable year, and once applied, the taxpayer and all persons related to the taxpayer (within the meaning of section 267 or 707) continue to apply these regulations in their entirety for all subsequent taxable years. For regulations generally applicable to taxable years ending before December 23, 2019, see § 1.863– 2 as contained in 26 CFR part 1 revised as of April 1, 2020. PO 00000 Frm 00068 Fmt 4700 Sfmt 4700 Par. 6. Section 1.863–3 is revised as follows: ■ § 1.863–3 Allocation and apportionment of income from certain sales of inventory. (a) In general—(1) Scope. Subject to the rules of § 1.865–3, paragraphs (a) through (d) of this section apply to determine the source of income derived from the sale of inventory property (inventory) that a taxpayer produces (in whole or in part) within the United States and sells without the United States, or that a taxpayer produces (in whole or in part) without the United States and sells within the United States (collectively, Section 863(b)(2) Sales). See section 865(i)(1) for the definition of inventory. Paragraph (b) of this section provides that the source of gross income from Section 863(b)(2) Sales is based solely on the production activities with respect to the inventory. Paragraph (c) of this section describes how to determine source based on production activity, including when inventory is produced partly within the United States and partly without the United States. Paragraph (d) of this section determines taxable income from Section 863(b)(2) Sales. Paragraph (e) of this section applies to determine the source of certain income derived from a possession of the United States. Paragraph (f) of this section provides special rules for partnerships for all sales subject to §§ 1.863–1 through 1.863–3. Paragraph (g) of this section provides applicability dates for the rules in this section. (2) Cross references. To determine the source of income derived from the sale of personal property (including inventory) by a nonresident that is attributable to the nonresident’s office or other fixed place of business in the United States under section 865(e)(2) and § 1.865–3(c), the rules of § 1.865–3 apply, and the rules of this section do not apply except to the extent provided in § 1.865–3. 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, as defined in § 1.863–8(d)(1)(i), or international water, as defined in § 1.863–8(d)(1)(ii), 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. (b) Sourcing based solely on production activities. Subject to the rules of § 1.865–3, all income, gain, or loss derived from Section 863(b)(2) Sales is allocated and apportioned solely on the basis of the production activities with respect to the inventory. E:\FR\FM\11DER1.SGM 11DER1 jbell on DSKJLSW7X2PROD with RULES Federal Register / Vol. 85, No. 239 / Friday, December 11, 2020 / Rules and Regulations (c) Determination of the source of gross income from production activity— (1) Production only within the United States or only within foreign countries— (i) Source of income. For purposes of this section, production activity means an activity that creates, fabricates, manufactures, extracts, processes, cures, or ages inventory. See § 1.864–1. Whether a taxpayer’s activities constitute production activity is determined under the principles of § 1.954–3(a)(4) (except for § 1.954– 3(a)(4)(iv)). Subject to the provisions in § 1.1502–13 or paragraph (f)(2)(ii) of this section, the 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. Where the taxpayer’s production assets are located only within the United States or only outside the United States, gross income is sourced where the taxpayer’s production assets are located. For rules regarding the source of income when production assets are located both within the United States and without the United States, see paragraph (c)(2) of this section. 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. (ii) Definition of production assets. Subject to the provisions of § 1.1502–13 and paragraph (f)(2)(ii) of this section, production assets include only tangible and intangible assets owned directly by the taxpayer that are directly used by the taxpayer to produce inventory described in paragraph (a) of this section. Production assets do not include assets that are not directly used to produce inventory described in paragraph (a) of this section. Thus, production assets do not include such assets as accounts receivables, intangibles not related to production of inventory (e.g., marketing intangibles, including trademarks and customer lists), transportation assets, warehouses, the inventory itself, raw materials, or work-in-process. In addition, production assets do not include cash or other liquid assets (including working capital), investment assets, prepaid expenses, or stock of a subsidiary. (iii) Location of production assets. For purposes of this section, a tangible production asset will be considered located where the asset is physically located. An intangible production asset will be considered located where the tangible production assets owned by the taxpayer to which it relates are located. VerDate Sep<11>2014 22:08 Dec 10, 2020 Jkt 253001 (2) Production both within and without the United States—(i) Source of income. Where the taxpayer’s production assets are located both within and without the United States, income from sources without the United States will be determined by multiplying the gross income by a fraction, the numerator of which is the average adjusted basis of production assets that are located outside the United States and the denominator of which is the average adjusted basis of all production assets within and without the United States. The remaining income is treated as from sources within the United States. (ii) Adjusted basis of production assets—(A) In general. For purposes of paragraph (c)(2)(i) of this section, the adjusted basis of an asset is determined by using the alternative depreciation system under section 168(g)(2). The adjusted basis of all production assets for purposes of paragraph (c)(2)(i) of this section is determined as though the production assets were subject to the alternative depreciation system set forth in section 168(g)(2) for the entire period that such property has been in service. The adjusted basis of the production assets is determined without regard to the election to expense certain depreciable assets under section 179 and without regard to any additional first-year depreciation provision (for example, section 168(k), (l), and (m), and former sections 1400L(b) and 1400N(d)). The average adjusted basis of assets is computed by averaging the adjusted basis at the beginning and end of the taxable year, unless by reason of changes during the taxable year, as might be the case in the event of a major acquisition or disposition of assets, the average would materially distort the calculation in paragraph (c)(2)(i) of this section. In this event, the average adjusted basis is determined upon a more appropriate basis that is weighted to reasonably reflect the period for which the assets are held by the taxpayer during the taxable year. (B) Production assets used to produce other property. If a production asset is used to produce inventory sold in Section 863(b)(2) Sales and also used to produce other property during the taxable year, the portion of its adjusted basis that is included in the fraction described in paragraph (c)(2)(i) of this section will be determined under any method that reasonably reflects the portion of the asset that produces inventory sold in Section 863(b)(2) Sales. For example, the portion of such an asset that is included in the formula may be determined by multiplying the asset’s average adjusted basis by a PO 00000 Frm 00069 Fmt 4700 Sfmt 4700 79847 fraction, the numerator of which is the gross receipts from sales of inventory from Section 863(b)(2) Sales produced by the asset, and the denominator of which is the gross receipts from all property produced by that asset. (3) Anti-abuse rule. The purpose of paragraph (b) of this section and this paragraph (c) is to attribute the source of the taxpayer’s gross income from certain sales of inventory property to the location of the taxpayer’s production activity. Therefore, if the taxpayer has entered into or structured one or more transactions with a principal purpose of reducing its U.S. tax liability in a manner inconsistent with the purpose of paragraph (b) of this section or this paragraph (c), the Commissioner may make appropriate adjustments so that the source of the taxpayer’s gross income more clearly reflects the location of production activity. For example, a taxpayer may be subject to the rule in this paragraph (c)(3) if domestic production assets are acquired by a related partnership (or a subsidiary of a related partnership) with a principal purpose of reducing its U.S. tax liability by claiming that the taxpayer’s income from sales of inventory is subject to section 862(a)(6) rather than section 863(b). (4) Examples. The following examples illustrate the rules of this paragraph (c): (i) Example 1. Source of gross income—(A) Facts. A, a U.S. corporation, produces widgets that are sold both within the United States and within a foreign country. The initial manufacture of all widgets occurs in the United States. The second stage of production of widgets that are sold within a foreign country is completed within the country of sale. A’s U.S. plant and machinery which is involved in the initial manufacture of the widgets has an average adjusted basis of $200, as determined using the alternative depreciation system under section 168(g)(2). A also owns warehouses used to store work-in-process. A owns foreign equipment with an average adjusted basis of $25. A’s gross receipts from all sales of widgets is $100, and its gross receipts from export sales of widgets is $25. Assume that apportioning average adjusted basis using gross receipts is reasonable. Assume A’s cost of goods sold from the sale of widgets in the foreign countries is $13 and thus, its gross income from widgets sold in foreign countries is $12. (B) Analysis. A determines its gross income from sources without the United States by multiplying A’s $12 of gross income from sales of widgets in foreign countries by a fraction, the numerator of which is all relevant foreign production E:\FR\FM\11DER1.SGM 11DER1 jbell on DSKJLSW7X2PROD with RULES 79848 Federal Register / Vol. 85, No. 239 / Friday, December 11, 2020 / Rules and Regulations assets, or $25, and the denominator of which is all relevant production assets, or $75 ($25 foreign assets + ($200 U.S. assets × $25 gross receipts from export sales/$100 gross receipts from all sales)). Therefore, A’s gross income from sources without the United States is $4 ($12 × ($25/$75)). (ii) Example 2. Location of intangible property. Assume the same facts as in paragraph (c)(4)(i)(A) of this section (the facts in Example 1), except that A employs a patented process that applies only to the initial production of widgets. In computing the formula used to determine the source of gross income, A’s patent, if it has an average adjusted basis, would be located in the United States. (iii) Example 3. Anti-abuse rule—(A) Facts. Assume the same facts as in paragraph (c)(4)(i)(A) of this section (the facts in Example 1). A sells its U.S. assets to B, an unrelated U.S. corporation, with a principal purpose of reducing its U.S. tax liability by manipulating the property fraction. A then leases these assets from B. After this transaction, under the general rule of paragraph (c)(2) of this section, all of A’s gross income would be considered from sources without the United States, because all of A’s relevant production assets are located within a foreign country. Since the leased property is not owned by the taxpayer, it is not included in the fraction. (B) Analysis. Because A has entered into a transaction with a principal purpose of reducing its U.S. tax liability by manipulating the formula described in paragraph (c)(2)(i) of this section, A’s income must be adjusted to more clearly reflect the source of that income. In this case, the Commissioner may redetermine the source of A’s gross income by ignoring the sale-leaseback transactions. (d) Determination of source of taxable income. Once the source of gross income has been determined under paragraph (c) of this section, the taxpayer must properly allocate and apportion its expenses, losses, and other deductions to its respective amounts of gross income from sources within and without the United States from its Section 863(b)(2) Sales. See §§ 1.861–8 through 1.861–14T and 1.861–17. (e) Income partly from sources within a possession of the United States—(1) In general. This paragraph (e) relates to certain sales that give rise to income, gain, or loss that is treated as derived partly from sources within the United States and partly from sources within a possession of the United States (Section 863 Possession Sales). This paragraph (e) applies to determine the source of VerDate Sep<11>2014 22:08 Dec 10, 2020 Jkt 253001 income derived from the sale of inventory produced (in whole or in part) by a taxpayer within the United States and sold within a possession of the United States, or produced (in whole or in part) by a taxpayer in a possession of the United States and sold within the United States (collectively, Possession Production Sales). It also applies to determine the source of income derived from the purchase of personal property within a possession of the United States and its sale within the United States (Possession Purchase Sales). A taxpayer subject to this paragraph (e) must apportion gross income from Section 863 Possession Sales under paragraph (e)(2) of this section (in the case of Possession Production Sales) or under paragraph (e)(3) of this section (in the case of Possession Purchase Sales). The source of taxable income from Section 863 Possession Sales is determined under paragraph (d) of this section. (2) Allocation or apportionment for Possession Production Sales. The source of gross income from Possession Production Sales is determined under the rules of paragraph (c) of this section, except that the term possession of the United States is substituted for foreign country wherever it appears. (3) Allocation or apportionment for Possession Purchase Sales—(i) Determination of source of gross income from Possession Purchase Sales. Gross income from Possession Purchase Sales is allocated in its entirety to the taxpayer’s business activity, and is then apportioned between sources within the United States and sources within a possession of the United States under paragraph (e)(3)(ii) of this section. (ii) Determination of source of gross income from business activity—(A) Source of gross income. Gross income from the taxpayer’s business activity is sourced in the possession in the same proportion that the amount of the taxpayer’s business activity for the taxable year within the possession bears to the amount of the taxpayer’s business activity for the taxable year both within the possession and outside the possession, with respect to Possession Purchase Sales. The remaining income is sourced in the United States. (B) Business activity. For purposes of this paragraph (e)(3)(ii), the taxpayer’s business activity is equal to the sum of— (1) The amounts for the taxable period paid for wages, salaries, and other compensation of employees, and other expenses attributable to Possession Purchase Sales (other than amounts that are nondeductible under section 263A, interest, and research and development); PO 00000 Frm 00070 Fmt 4700 Sfmt 4700 (2) Cost of goods sold attributable to Possession Purchase Sales during the taxable period; and (3) Possession Purchase Sales for the taxable period. (C) Location of business activity. For purposes of determining the location of the taxpayer’s business activity within a possession, the following rules apply: (1) Sales activity. Receipts from gross sales will be attributed to a possession in accordance with the principles of § 1.861–7(c). (2) Cost of goods sold. Payments for cost of goods sold will be properly attributable to gross receipts from sources within the possession only to the extent that the property purchased was manufactured, produced, grown, or extracted in the possession (within the meaning of section 954(d)(1)(A)). (3) Expenses. Expenses will be attributed to a possession under the rules of §§ 1.861–8 through 1.861–14T. (4) Examples. The following examples illustrate the rules of paragraph (e)(3)(ii) of this section relating to the determination of source of gross income from business activity: (i) Example 1. Purchase of goods manufactured in possession—(A) Facts. U.S. Co. purchases in a possession product X for $80 from A. A manufactures X in the possession. Without further production, U.S. Co. sells X in the United States for $100. Assume U.S. Co. has sales and administrative expenses in the possession of $10. (B) Analysis. To determine the source of U.S. Co.’s gross income, the $100 gross income from sales of X is allocated entirely to U.S. Co.’s business activity. Forty-seven dollars of U.S. Co.’s gross income is sourced in the possession. [Possession expenses ($10) plus possession purchases (i.e., cost of goods sold) ($80) plus possessions sales ($0), divided by total expenses ($10) plus total purchases ($80) plus total sales ($100).] The remaining $53 is sourced in the United States. (ii) Example 2. Purchase of goods manufactured outside possession—(A) Facts. Assume the same facts as in paragraph (e)(4)(i)(A) of this section (the facts in Example 1), except that A manufactures X outside the possession. (B) Analysis. To determine the source of U.S. Co.’s gross income, the $100 gross income is allocated entirely to U.S. Co.’s business activity. Five dollars of U.S. Co.’s gross income is sourced in the possession. [Possession expenses ($10) plus possession purchases ($0) plus possession sales ($0), divided by total expenses ($10) plus total purchases ($80) plus total sales ($100).] The $80 purchase is not included in the E:\FR\FM\11DER1.SGM 11DER1 jbell on DSKJLSW7X2PROD with RULES Federal Register / Vol. 85, No. 239 / Friday, December 11, 2020 / Rules and Regulations numerator used to determine U.S. Co.’s business activity in the possession, since product X was not manufactured in the possession. The remaining $95 is sourced in the United States. (5) Special rules for partnerships. In applying the rules of this paragraph (e) to transactions involving partners and partnerships, the rules of paragraph (f) of this section apply. (f) Special rules for partnerships—(1) General rule. For purposes of § 1.863–1 and this section, a taxpayer’s production activity does not include production activities conducted by a partnership of which the taxpayer is a partner either directly or through one or more partnerships, except as otherwise provided in paragraphs (c)(3) or (f)(2) of this section. (2) Exceptions—(i) In general. For purposes of determining the source of the partner’s distributive share of partnership income or determining the source of the partner’s income from the sale of inventory property which the partnership distributes to the partner in kind, the partner’s production activity includes an activity conducted by the partnership. In addition, the production activity of a partnership includes the production activity of a taxpayer that is a partner either directly or through one or more partnerships, to the extent that the partner’s production activity is related to inventory that the partner contributes to the partnership in a transaction described under section 721. (ii) Attribution of production assets to or from a partnership. A partner will be treated as owning its proportionate share of the partnership’s production assets only to the extent that, under paragraph (f)(2)(i) of this section, the partner’s activity includes production activity conducted through a partnership. A partner’s share of partnership assets will be determined by reference to the partner’s distributive share of partnership income for the year attributable to such production assets. Similarly, to the extent a partnership’s activities include the production activities of a partner, the partnership will be treated as owning the partner’s production assets related to the inventory that is contributed in kind to the partnership. See paragraph (c)(2)(ii) of this section for rules apportioning the basis of assets to Section 863 Sales. (iii) Basis. For purposes of this section, in those cases where the partner is treated as owning its proportionate share of the partnership’s production assets, the partner’s basis in production assets held through a partnership shall be determined by reference to the partnership’s adjusted basis in its assets (including a partner’s special basis VerDate Sep<11>2014 22:08 Dec 10, 2020 Jkt 253001 adjustment, if any, under section 743). Similarly, a partnership’s basis in a partner’s production assets is determined with reference to the partner’s adjusted basis in its assets. (3) Examples. The following examples illustrate the rules of this paragraph (f): (i) Example 1. Distributive share of partnership income. A, a U.S. corporation, forms a partnership in the United States with B, a country X corporation. A and B each have a 50 percent interest in the income, gains, losses, deductions and credits of the partnership. The partnership is engaged in the manufacture and sale of widgets. The widgets are manufactured in the partnership’s plant located in the United States and are sold by the partnership outside the United States. The partnership owns the manufacturing facility and all other production assets used to produce the widgets. A’s distributive share of partnership income includes 50 percent of the sales income from these sales. In applying the rules of section 863 to determine the source of its distributive share of partnership income from the export sales of widgets, A is treated as carrying on the activity of the partnership related to production of these widgets and as owning a proportionate share of the partnership’s assets related to production of the widgets, based upon its distributive share of partnership income. (ii) Example 2. Distribution in kind. Assume the same facts as in paragraph (f)(3)(i) of this section (the facts in Example 1) except that the partnership, instead of selling the widgets, distributes the widgets to A and B. A then further processes the widgets and then sells them outside the United States. In determining the source of the income earned by A on the sales outside the United States, A is treated as conducting the activities of the partnership related to production of the distributed widgets. Thus, the source of gross income on the sale of the widgets is determined under section 863 and this section. In applying paragraph (c) of this section, A is treated as owning its proportionate share of the partnership’s production assets based upon its distributive share of partnership income. (g) Applicability dates. This section applies to taxable years ending on or after December 23, 2019. However, a taxpayer may apply this section in its entirety for taxable years beginning after December 31, 2017, and ending before December 23, 2019, provided that the taxpayer and all persons related to the taxpayer (within the meaning of section 267 or 707) apply this section and PO 00000 Frm 00071 Fmt 4700 Sfmt 4700 79849 §§ 1.863–1(b), 1.863–2(b), 1.863– 8(b)(3)(ii), 1.864–5(a) and (b), 1.864– 6(c)(2), and 1.865–3 in their entirety for the taxable year, and once applied, the taxpayer and all persons related to the taxpayer (within the meaning of section 267 or 707) continue to apply these regulations in their entirety for all subsequent taxable years. For regulations generally applicable to taxable years ending before December 23, 2019, see § 1.863–3 as contained in 26 CFR part 1 revised as of April 1, 2020. ■ Par. 7. Section 1.863–8 is amended as follows: ■ a. Revising paragraph (b)(3)(ii)(A). ■ b. In paragraph (b)(3)(ii)(B): ■ i. Removing ‘‘income allocable to production activity’’ wherever it appears and adding in its place ‘‘gross income’’. ■ ii. Removing ‘‘§ 1.863–3(c)(1)’’ from the second sentence and adding in its place ‘‘§ 1.863–3(c)’’. ■ c. In paragraph (b)(3)(ii)(C): ■ i. Removing ‘‘allocable to production activity’’ wherever it appears. ■ ii. Removing ‘‘allocated to production activity’’ from the fifth sentence. ■ iii. Removing ‘‘§ 1.863–3(c)(1)’’ from the fifth sentence and adding in its place ‘‘§ 1.863–3(c)’’. ■ d. Removing paragraph (b)(3)(ii)(D). ■ e. In paragraph (c), removing ‘‘(b)(3)(ii)(C)’’ from the first sentence and adding in its place ‘‘(b)(3)(ii)’’. ■ f. Designating Examples 1 through 14 of paragraph (f) as paragraphs (f)(1) through (14). ■ g. In newly designated paragraphs (f)(1) through (14), removing the period between the second and third level paragraph headings and adding an emdash in its place. ■ h. Removing ‘‘this Example 4’’ from newly designated paragraph (f)(4)(i) wherever it appears and adding in its place ‘‘paragraph (f)(4)(i) (Example 4)’’. ■ i. Removing ‘‘Example 4’’ from newly designated paragraph (f)(5)(i) and adding in its place ‘‘paragraph (f)(4)(i) of this section (the facts in Example 4)’’. ■ j. Revising newly designated paragraph (f)(6)(ii). ■ k. Removing ‘‘Example 8’’ from newly designated paragraph (f)(9)(i) and adding in its place ‘‘in paragraph (f)(8)(i) of this section (the facts in Example 8)’’. ■ l. Removing ‘‘Example 8’’ from newly designated paragraph (f)(9)(ii) and adding in its place ‘‘paragraph (f)(8)(ii) of this section (the analysis in Example 8)’’. ■ m. Revising newly designated paragraph (f)(11)(ii). ■ n. In paragraph (g)(1), removing ‘‘(b)(3)(ii)(C)’’ from the first sentence and adding in its place ‘‘(b)(3)(ii)’’. E:\FR\FM\11DER1.SGM 11DER1 79850 Federal Register / Vol. 85, No. 239 / Friday, December 11, 2020 / Rules and Regulations o. In paragraph (g)(4) introductory text, removing ‘‘(b)(3)(ii)(C)’’ from the first sentence and adding in its place ‘‘(b)(3)(ii)’’. ■ p. In paragraph (h), adding three sentences at the end of the paragraph. The revisions and additions read as follows: ■ § 1.863–8 Source of income derived from space and ocean activity under section 863(d). jbell on DSKJLSW7X2PROD with RULES * * * * * (b) * * * (3) * * * (ii) Sales of property produced by the taxpayer—(A) General. If the taxpayer both produces property and sells such property and either the production (in whole or in part) or the sale takes place in space or international water, the taxpayer must allocate and apportion all income, gain, or loss derived from sales of such property solely on the basis of the production activities with respect to such property, and the source of that income will be determined under paragraph (b)(3)(ii)(B) or (C) of this section. To determine the source of income derived from the sale of personal property (including inventory) by a nonresident that is attributable to the nonresident’s office or other fixed place of business in the United States under section 865(e)(2), the rules of § 1.865–3 apply, and the rules of this section do not apply. * * * * * (f) * * * (6) * * * (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, the source of the gross income from the sale of the data is determined under paragraph (b)(3)(ii) of this section solely on the basis of the production activities. The source of S’s gross income is determined under paragraph (b)(3)(ii)(C) of this section because production activities occur both in space and on land. * * * * * (11) * * * (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 manufactured in the United States and sold in space is determined under paragraph (b)(3)(ii) of this section solely on the basis of the production activities with respect to the satellite. * * * * * VerDate Sep<11>2014 22:08 Dec 10, 2020 Jkt 253001 (h) * * * Paragraph (b)(3)(ii) of this section applies to taxable years ending on or after December 23, 2019. However, a taxpayer may apply paragraph (b)(3)(ii) of this section in its entirety for taxable years beginning after December 31, 2017, and ending before December 23, 2019, provided that the taxpayer and all persons related to the taxpayer (within the meaning of section 267 or 707) apply paragraph (b)(3)(ii) of this section and §§ 1.863–1(b), 1.863–2(b), 1.863–3, 1.864–5(a) and (b), 1.864– 6(c)(2), and 1.865–3 in their entirety for the taxable year, and once applied, the taxpayer and all persons related to the taxpayer (within the meaning of section 267 or 707) continue to apply these regulations in their entirety for all subsequent taxable years. For regulations generally applicable to taxable years ending before December 23, 2019, see § 1.863–8 as contained in 26 CFR part 1 revised as of April 1, 2020. ■ Par. 8. Section 1.864–5 is amended as follows: ■ a. Adding a sentence to the end of paragraph (a); ■ b. Revising the first sentence of paragraph (b) introductory text; and ■ c. Adding paragraph (e). The additions read as follows: § 1.864–5 Foreign source income effectively connected with U.S. business. (a) * * * To determine the source of income, gain or loss from the sale of personal property (including inventory property) attributable to an office or other fixed place of business in the United States by nonresidents, as defined in section 865(g)(1)(B), see § 1.865–3. (b) * * * Income, gain, or loss from sources without the United States other than income described in paragraph (c) of this section or income from section 865(e)(2) sales, as defined in § 1.865– 3(c), shall be taken into account pursuant to paragraph (a) of this section in applying §§ 1.864–6 and 1.864–7 only if it consists of— * * * * * (e) Applicability dates. Paragraphs (a) and (b) of this section apply to taxable years ending on or after December 23, 2019. However, a taxpayer may apply paragraphs (a) and (b) of this section in their entirety for taxable years beginning after December 31, 2017, and ending before December 23, 2019, provided that the taxpayer and all persons related to the taxpayer (within the meaning of section 267 or 707) apply paragraphs (a) and (b) of this section and §§ 1.863–1(b), 1.863–2(b), 1.863–3, 1.863–8(b)(3)(ii), 1.864–6(c)(2), and 1.865–3 in their entirety for the taxable year, and once PO 00000 Frm 00072 Fmt 4700 Sfmt 4700 applied, the taxpayer and all persons related to the taxpayer (within the meaning of section 267 or 707) continue to apply these regulations in their entirety for all subsequent taxable years. For regulations generally applicable to taxable years ending before December 23, 2019, see § 1.864–5 as contained in 26 CFR part 1 revised as of April 1, 2020. ■ Par. 9. Section 1.864–6 is amended as follows: ■ a. Revising paragraph (c)(2). ■ b. Revising paragraph (c)(3). ■ c. Adding paragraph (c)(4). The revisions and additions read as follows: § 1.864–6 Income, gain, or loss attributable to an office or other fixed place of business in the United States. * * * * * (c) * * * (2) Special limitation in case of sales of goods or merchandise through U.S. office. Notwithstanding paragraph (c)(1) of this section, the special rules described in this paragraph (c)(2) apply with respect to a sale of goods or merchandise specified in § 1.864– 5(b)(3), to which paragraph (b)(3)(i) of this section does not apply. In the case of a nonresident alien with a tax home within the United States, as defined in section 911(d)(3), the amount of income from the sale of goods or merchandise that is properly allocable to the individual’s U.S. office is determined under § 1.865–3(d). (3) Examples. The application of this paragraph (c) may be illustrated by the following examples— (i) Example 1. Sales of produced inventory through a U.S. sales office. Individual A, who is a nonresident alien within the meaning of section 7701(b)(1)(B) and has a tax home in the United States, manufactures machinery in a foreign country and sells the machinery outside the United States through A’s sales office in the United States for use in foreign countries. A is not a nonresident within the meaning of section 865(g)(1)(B). Therefore, § 1.865– 3 does not apply to A’s sale of the machinery, except to the extent provided in paragraph (c)(2) of this section. Title to the property sold is transferred to the foreign purchaser outside the United States, but no office or other fixed place of business of A in a foreign country materially participates in the sale made through A’s U.S. office. By reason of its sales activities in the United States, A is engaged in business in the United States during the taxable year. During the taxable year, A derives a total income of $250,000x from these sales. Under paragraph (c)(2) of this E:\FR\FM\11DER1.SGM 11DER1 jbell on DSKJLSW7X2PROD with RULES Federal Register / Vol. 85, No. 239 / Friday, December 11, 2020 / Rules and Regulations section, the amount of income that is allocable to A’s U.S. office is determined under § 1.865–3(d)(2). The taxpayer does not allocate income from the sale under the books and records method described in § 1.865–3(d)(2)(ii). Thus, 50 percent of A’s foreign source income of $250,000x, plus any additional income allocable based on the location of production activities under §§ 1.865–3(d)(2)(i) and 1.863–3 (in this case, $0x), is effectively connected for the taxable year with the conduct of A’s U.S. trade or business, or $125,000x. (ii) Example 2. Sales of inventory purchased and resold through a U.S. sales office by a nonresident alien with a tax home in the United States. Individual B, who is a nonresident alien within the meaning of section 7701(b)(1)(B) and has a tax home in the United States, has an office in a foreign country that purchases merchandise and sells it through B’s sales office in the United States for use in various foreign countries, with title to the property passing outside the United States. B is not a nonresident within the meaning of section 865(g)(1)(B). Therefore, § 1.865– 3 does not apply to B’s sale of the merchandise, except to the extent provided in paragraph (c)(2) of this section. No other office of B materially participates in these sales made through its U.S. office. By reason of its sales activities in the United States, B is engaged in business in the United States during the taxable year. During the taxable year, B derives income of $300,000x from these sales made through its U.S. sales office. All of B’s income from these sales is foreign source as B purchases the merchandise outside the United States and title to the merchandise also passes outside the United States. The amount of income properly allocable to B’s U.S. office determined under § 1.865–3(d)(3) is $300,000x, and thus $300,000x is effectively connected for the taxable year with the conduct of B’s U.S. trade or business. (iii) Example 3. Foreign sales office also materially participates in sale. The facts are the same as in paragraph (c)(3)(ii) of this section (the facts in Example 2), except that B also has an office in a foreign country that is a material factor in the realization of income from the sales made through B’s U.S. office. No income from the sale of merchandise is allocable to B’s U.S. sales office for the taxable year, by reason of paragraph (b)(3)(i) of this section, and thus none of the $300,000x is effectively connected for the taxable year with the conduct of B’s U.S. trade or business. VerDate Sep<11>2014 22:08 Dec 10, 2020 Jkt 253001 (iv) Example 4. Sales of inventory purchased and resold through a U.S. sales office by a foreign corporation. The facts are the same as in paragraph (c)(3)(ii) of this section (the facts in Example 2), except that B is a foreign corporation. B is a nonresident within the meaning of section 865(g)(1)(B). The income from such sales will be sourced in accordance with § 1.865–3(a) and (d)(3). (4) Applicability date. Paragraph (c)(2) of this section applies to taxable years ending on or after December 23, 2019. However, a taxpayer may apply paragraph (c)(2) of this section in its entirety for taxable years beginning after December 31, 2017, and ending before December 23, 2019, provided that the taxpayer and all persons related to the taxpayer (within the meaning of section 267 or 707) apply paragraph (c)(2) of this section and §§ 1.863–1(b), 1.863– 2(b), 1.863–3, 1.863–8(b)(3)(ii), 1.864– 5(a) and (b), and 1.865–3 in their entirety for the taxable year, and once applied, the taxpayer and all persons related to the taxpayer (within the meaning of section 267 or 707) continue to apply these regulations in their entirety for all subsequent taxable years. For regulations generally applicable to taxable years ending before December 23, 2019, see § 1.864–6 as contained in 26 CFR part 1 revised as of April 1, 2020. ■ Par. 10. Section 1.865–3 is added to read as follows: § 1.865–3 Source of gross income from sales of personal property (including inventory property) by a nonresident attributable to an office or other fixed place of business in the United States. (a) In general. Notwithstanding any provision of section 861 through 865 or other regulations in this part, this section provides the sole sourcing rules for gross income, gain, or loss from section 865(e)(2) sales. Gross income, gain, or loss from a section 865(e)(2) sale is U.S. source income to the extent that the gross income, gain, or loss is properly allocable to an office or other fixed place of business in the United States under paragraph (d) of this section. (b) Exception for certain inventory sales for use, disposition or consumption outside the United States. A section 865(e)(2) sale does not include any sale of inventory property that is sold for use, disposition, or consumption outside the United States if an office or other fixed place of business of the nonresident in a foreign country materially participates in the sale. See § 1.864–6(b)(3) to determine whether a foreign office materially PO 00000 Frm 00073 Fmt 4700 Sfmt 4700 79851 participates in the sale and whether the property was destined for foreign use. (c) Section 865(e)(2) sales. For purposes of this section, a ‘‘section 865(e)(2) sale’’ is a sale of personal property by a nonresident, including inventory property, other than a sale described in paragraph (b) of this section, that is attributable to an office or other fixed place of business in the United States under the principles of section 864(c)(5)(B) as prescribed in § 1.864–6(b)(1) and (2). In determining whether a nonresident maintains an office or other fixed place of business in the United States, the principles of section 864(c)(5)(A) as prescribed in § 1.864–7 apply, including the rules of paragraph (d) of that section regarding the office or other fixed place of business of a dependent agent of the nonresident. For purposes of this section, ‘‘inventory property’’ has the meaning provided in section 865(i)(1), and ‘‘nonresident’’ has the meaning provided in section 865(g)(1)(B). (d) Amount of gross income, gain, or loss on sale of personal property properly allocable to a U.S. office—(1) In general. Except as otherwise provided in paragraphs (d)(2) through (4) of this section, the amount of gross income, gain, or loss from a section 865(e)(2) sale that is properly allocable to an office or other fixed place of business in the United States is determined under the principles of § 1.864–6(c)(1). (2) Produced inventory property. Gross income, gain, or loss from a section 865(e)(2) sale of inventory property that is produced by the nonresident seller is properly allocable to an office or other fixed place of business in the United States or to production activities in accordance with the ‘‘50/50 method’’ described in paragraph (d)(2)(i) of this section. However, in lieu of the 50/50 method, the nonresident seller may elect to allocate the gross income, gain, or loss under the ‘‘books and records method’’ described in paragraph (d)(2)(ii)(A) of this section, provided that the nonresident satisfies all of the requirements described in paragraph (d)(2)(ii)(B) of this section to the satisfaction of the Commissioner. Gross income allocable to production activities under this paragraph (d)(2) is sourced in accordance with § 1.863–3. For purposes of this paragraph (d)(2), the term ‘‘produced’’ includes created, fabricated, manufactured, extracted, processed, cured, and aged, as determined under the principles of § 1.954–3(a)(4) (except for § 1.954– 3(a)(4)(iv)). See section 864(a) and § 1.864–1. E:\FR\FM\11DER1.SGM 11DER1 jbell on DSKJLSW7X2PROD with RULES 79852 Federal Register / Vol. 85, No. 239 / Friday, December 11, 2020 / Rules and Regulations (i) The 50/50 method. Fifty percent of the gross income, gain, or loss from a section 865(e)(2) sale of inventory property that is produced by the nonresident seller is properly allocable to an office or other fixed place of business in the United States, and the remaining 50 percent of the gross income, gain, or loss is properly allocable to production activities (the ‘‘50/50 method’’). (ii) Books and records method—(A) Method. Subject to paragraph (d)(2)(ii)(B) of this section, a nonresident may elect to determine the amount of its gross income, gain, or loss from the sale of inventory property produced by the nonresident seller that is properly allocable to production activities and sales activities for the taxable year based upon its books of account (the ‘‘books and records method’’). The gross income, gain, or loss allocable to sales activities under this method is treated as properly allocable to an office or other fixed place of business in the United States and the remaining gross income, gain, or loss is treated as properly allocable to production activities. (B) Election and reporting rules—(1) In general. A nonresident may not make the election described in paragraph (d)(2)(ii)(A) of this section unless the requirements of paragraphs (d)(2)(ii)(B)(2) through (4) of this section are satisfied. Once the election is made, the nonresident must continue to satisfy the requirements of paragraphs (d)(2)(ii)(B)(2) through (4) of this section until the election is revoked. If the nonresident fails to satisfy the requirements in paragraphs (d)(2)(ii)(B)(2) through (4) of this section to the satisfaction of the Commissioner, the Commissioner may, in its sole discretion, apply the 50/50 method described in paragraph (d)(2)(i) of this section. (2) Books of account. The nonresident must establish that it, in good faith and unaffected by considerations of tax liability, regularly employs in its books of account a detailed allocation of receipts and expenditures that, under the principles of section 482, clearly reflects both the amount of the nonresident’s gross income, gain, or loss from its inventory sales that are attributable to its sales activities, and the amount of its gross income, gain, or loss from its inventory sales that are attributable to its production activities. For purposes of this paragraph (d)(2)(ii)(B)(2), section 482 principles apply as if the office or other fixed place of business in the United States were a separate organization, trade, or business (and, thus, a separate controlled VerDate Sep<11>2014 22:08 Dec 10, 2020 Jkt 253001 taxpayer) from the nonresident (whether or not payments are made between the United States office or other fixed place of business and the nonresident’s other offices, and whether or not the nonresident itself would otherwise constitute an organization, trade, or business). (3) Required records. The nonresident must prepare and maintain the records described in paragraph (d)(2)(ii)(B)(2) of this section, which must be in existence when its return is filed. The nonresident must also prepare an explanation of how the allocation clearly reflects the nonresident’s gross income, gain, or loss from production and sales activities under the principles of section 482. The nonresident must make available the explanation and records of the nonresident (including for the office or other fixed place of business in the United States and the offices or branches that perform the production activities) upon request of the Commissioner, within 30 days, unless some other period is agreed upon between the Commissioner and the nonresident. (4) Making and revoking the books and records method election; disclosure of election. Except as otherwise provided in publications, forms, instructions, or other guidance, a nonresident makes or revokes the election to apply the books and records method by attaching a statement to its original timely filed Federal income tax return (including extensions) providing that it elects, or revokes the election, to apply the books and records method described in paragraph (d)(2)(ii)(A) of this section. For nonresidents making the election, the statement must provide that the nonresident has prepared the records described in paragraph (d)(2)(ii)(B)(2) and (3) of this section. (5) Limitation on revoking the books and records method election. Once made, the books and records method election continues until revoked. An election cannot be revoked, without the consent of the Commissioner, for any taxable year beginning within 48 months of the last day of the taxable year for which the election was made. (3) Purchased inventory property. All gross income, gain, or loss from a section 865(e)(2) sale of inventory property that is both purchased and sold by a nonresident is properly allocable to an office or other fixed place of business in the United States. (4) Depreciable personal property. Gain from a section 865(e)(2) sale of depreciable personal property (as defined in section 865(c)(4)) is allocated under paragraphs (d)(4)(i) and (ii) of this section. PO 00000 Frm 00074 Fmt 4700 Sfmt 4700 (i) The gain not in excess of the depreciation adjustments, if any, is properly allocable to an office or other fixed place of business in the United States to the same extent that the gain would be allocated to sources within the United States under the rules of section 865(c)(1). The remaining gain not in excess of the depreciation adjustments, if any, is allocated to sources without the United States in accordance with section 865(c)(1). However, notwithstanding the preceding sentences, if the property was predominantly used in the United States, within the meaning of section 865(c)(3)(B)(i), for a particular taxable year, all of the gain not in excess of depreciation for that year is properly allocable to the office or other fixed place of business in the United States. (ii) The gain in excess of the depreciation adjustments, if any, is treated as if such gain was from the sale of inventory and the amount allocable to an office or fixed place of business in the United States is determined under paragraph (d)(2) or (3) of this section, as applicable. (e) Determination of source of taxable income. For rules allocating and apportioning expenses to gross income effectively connected with the conduct of a trade or business of a foreign corporation in the United States (including gross income, gain, or loss sourced under this section), see section 882(c)(1). For rules allocating and apportioning expenses to gross income, gain, or loss effectively connected with the conduct of a trade or business of a nonresident alien in the United States (including gross income, gain, or loss sourced under this section), see section 873(a). (f) Export trade corporations. This section does not apply for purposes of defining an export trade corporation under section 971(a). (g) Applicability date. This section applies to taxable years ending on or after December 23, 2019. However, a nonresident may apply this section in its entirety for taxable years beginning after December 31, 2017, and ending before December 23, 2019, provided that the nonresident and all persons related to the nonresident (within the meaning of section 267 or 707) apply this section and §§ 1.863–1(b), 1.863–2(b), 1.863–3, 1.863–8(b)(3)(ii), 1.864–5(a) and (b), and 1.864–6(c)(2) in their entirety for the taxable year, and once applied, the nonresident and all persons related to the nonresident (within the meaning of section 267 or 707) continue to apply these regulations in their entirety for all subsequent taxable years. E:\FR\FM\11DER1.SGM 11DER1 Federal Register / Vol. 85, No. 239 / Friday, December 11, 2020 / Rules and Regulations § 1.937–2 [Amended] Par. 11. In § 1.937–2 amend paragraph (d) by removing ‘‘§ 1.863–3(f)’’ and adding in its place ‘‘§ 1.863–3(e)’’. ■ § 1.937–3 [Amended] Par. 12. In § 1.937–3 amend paragraph (d) by removing ‘‘§ 1.863–3(f)’’ and adding in its place ‘‘§ 1.863–3(e)’’. ■ Par. 13. Section 1.1502–13 is amended by revising paragraph (c)(7)(ii)(N) to read as follows: ■ § 1.1502–13 Intercompany transactions. jbell on DSKJLSW7X2PROD with RULES * * * * * (c) * * * (7) * * * (ii) * * * (N) Example (14): Source of income under section 863—(1) Intercompany sale—(i) Facts. S manufactures inventory property solely in the United States and recognizes $75x of income on sales to B in Year 1. B conducts further production activity on the inventory property solely in Country Y and then sells the inventory property to X in Country Y and recognizes $25x of income on the sale to X, also in Year 1. Title passes from S to B, and from B to X, in Country Y. Assume that applying § 1.863–3 on a single entity basis, including the formula for apportionment of multi-country production activities by reference to the basis of production assets, $10x would be treated as foreign source income and $90x would be treated as U.S. source income (that is, 10 percent of the production occurred outside the United States and 90 percent occurred within the United States, as measured by the basis of assets used in production activities with respect to the property). Assume further that, on a separate entity basis, S would have $0x of foreign source income and $75x of U.S. source income and all of B’s $25x of income would be foreign source income. (ii) Analysis. Under the matching rule, both S’s $75x intercompany item and B’s $25x corresponding item are taken into account in Year 1. In determining the source of S and B’s income from the inventory property sales, the attributes of S’s intercompany item and B’s corresponding item are redetermined to the extent necessary to produce the same effect on consolidated taxable income (and consolidated tax liability) as if S and B were divisions of a single corporation. See paragraph (c)(1)(i) of this section. On a single entity basis, S and B would have $10x that would be treated as foreign source income and $90x that would be treated as U.S. source income, but without application of this section (that is, on a separate VerDate Sep<11>2014 22:08 Dec 10, 2020 Jkt 253001 entity basis), S would have $75x of U.S. source income and B would have $25x of foreign source income. Under paragraph (c)(4)(ii) of this section, a redetermined attribute must be allocated between S and B using a reasonable method. On a separate entity basis B would have only foreign source income and S would have only U.S. source income. Accordingly, under paragraph (c)(1)(i) of this section, $15x of B’s $25x sales income that would be treated as foreign source income on a separate entity basis is redetermined to be U.S. source income. (2) Sale of property reflecting intercompany services or intangibles— (i) Facts. S earns $10x of income performing services in the United States for B. B capitalizes S’s fees into the basis of inventory property that it manufactures in the United States and sells to an unrelated person in Year 1 at a $90x profit, with title passing in Country Y. Assume that on a single entity basis, $100x is treated as U.S. source income and $0x is treated as foreign source income. Further assume that on a separate entity basis, S would have $10x of U.S. source income, and B would have $90x of U.S. source income, with neither having any foreign source income. (ii) Analysis. Under the matching rule, S’s $10x income and B’s $90x income are taken into account in Year 1. In determining the source of S and B’s income, the attributes of S’s intercompany item and B’s corresponding item are redetermined to the extent necessary to produce the same effect on consolidated taxable income (and consolidated tax liability) as if S and B were divisions of a single corporation. Because the results are the same on a single entity basis and a separate entity basis ($100x of U.S. source income and $0x of foreign source income), the attributes are not redetermined under paragraph (c)(1)(i) of this section. Sunita Lough, Deputy Commissioner for Services and Enforcement. Approved: September 21, 2020. David J. Kautter, Assistant Secretary of the Treasury (Tax Policy). [FR Doc. 2020–21817 Filed 12–10–20; 8:45 am] BILLING CODE 4830–01–P PO 00000 Frm 00075 Fmt 4700 Sfmt 4700 79853 DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1 [TD 9902] RIN 1545–BP15 Guidance Under Sections 951A and 954 Regarding Income Subject to a High Rate of Foreign Tax; Correcting Amendment Internal Revenue Service (IRS), Treasury. ACTION: Correcting amendments. AGENCY: This document contains corrections to Treasury Decision 9902, which was published in the Federal Register on Thursday, July 23, 2020. Treasury Decision 9902 contained final regulations under the global intangible low-taxed income and subpart F income provisions of the Internal Revenue Code regarding the treatment of income that is subject to a high rate of foreign tax. DATES: This correction is effective on December 11, 2020. FOR FURTHER INFORMATION CONTACT: Jorge M. Oben or Larry R. Pounders at (202) 317–6934 (not a toll-free number). SUPPLEMENTARY INFORMATION: SUMMARY: Background The final regulations (TD 9902) that are the subject of this correction are issued under section 951A of the Code. Need for Correction As published on July 23, 2020 (85 FR 44620) the final regulations (TD 9902) contain errors that need to be corrected. List of Subjects in 26 CFR Part 1 Income taxes, Reporting and recordkeeping requirements. Correction of Publication Accordingly, 26 CFR part 1 is corrected by making the following correcting amendments: PART 1—INCOME TAXES Paragraph 1. The authority citation for part 1 continues to read in part as follows: ■ Authority: 26 U.S.C. 7805. * * * * * Par. 2. Section 1.951A–2 is amended by: ■ a. Revising the third sentence of paragraph (c)(3)(ii)(B). ■ b. Revising paragraphs (c)(7)(iii)(B)(2) and (c)(7)(viii)(A)(2)(ii). ■ c. Revising the first sentence of paragraph (c)(7)(viii)(A)(4) introductory text. ■ E:\FR\FM\11DER1.SGM 11DER1

Agencies

[Federal Register Volume 85, Number 239 (Friday, December 11, 2020)]
[Rules and Regulations]
[Pages 79837-79853]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-21817]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9921]
RIN 1545-BP16


Source of Income From Certain Sales of Personal Property

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations modifying the rules 
for determining the source of income from sales of inventory produced 
within the United States and sold without the United States or vice 
versa. These final regulations also contain new rules for determining 
the source of income from sales of personal property (including 
inventory) by nonresidents that are attributable to an office or other 
fixed place of business that the nonresident maintains in the United 
States. Finally, these final regulations modify certain rules for 
determining whether foreign source income is effectively connected with 
the conduct of a trade or business within the United States.

DATES: 
    Effective Date: These final regulations are effective on December 
11, 2020.
    Applicability Dates: For dates of applicability, see Sec. Sec.  
1.863-1(f), 1.863-2(c), 1.863-3(g), 1.863-8(h), 1.864-5(e), 1.864-
6(c)(4), and 1.865-3(g).

FOR FURTHER INFORMATION CONTACT: Brad McCormack at (202) 317-6911 (not 
a toll free number).

SUPPLEMENTARY INFORMATION: 

Background

    The Tax Cuts and Jobs Act, Public Law 115-97, 131 Stat. 2054, 2208 
(2017) (the ``Act''), enacted on December 22, 2017, amended section 
863(b) of the Internal Revenue Code (``Code''). On December 30, 2019, 
the Department of the Treasury (``Treasury Department'') and the IRS 
published proposed regulations (REG-100956-19) under sections 863, 864, 
865, 937, and 1502 in the Federal Register (84 FR 71836) (the

[[Page 79838]]

``proposed regulations''). A public hearing on the proposed regulations 
was held on June 3, 2020. All written comments received in response to 
the proposed regulations are available at https://www.regulations.gov 
or upon request. Terms used but not defined in this preamble have the 
meaning provided in these final regulations.

Summary of Comments and Explanation of Revisions

I. Overview

    The final regulations retain the overall approach of the proposed 
regulations, with certain revisions. This Summary of Comments and 
Explanation of Revisions section discusses those revisions as well as 
comments received in response to the solicitation of comments in the 
notice of proposed rulemaking. Comments outside the scope of this 
rulemaking are generally not addressed but may be considered in 
connection with future guidance projects.

II. Comments on and Revisions to Proposed Sec.  1.863-1--Allocation of 
Gross Income Under Section 863(a) and Proposed Sec.  1.863-3--
Allocation and Apportionment of Income From Certain Sales of Inventory

    The Act amended section 863 of the Code, which provides special 
sourcing rules for determining the source of income, including income 
partly from within and partly from without the United States. 
Specifically, the Act amended section 863(b) to allocate or apportion 
income from the sale or exchange of inventory property produced (in 
whole or in part) by a taxpayer within the United States and sold or 
exchanged without the United States or produced (in whole or in part) 
by the taxpayer without the United States and sold or exchanged within 
the United States (collectively, ``Section 863(b)(2) Sales'') solely on 
the basis of production activities with respect to that inventory. 
Before the Act, section 863(b) provided that income from Section 
863(b)(2) Sales would be treated as derived partly from sources within 
and partly from sources without the United States without providing the 
basis for such allocation or apportionment. Consistent with the Act's 
changes to section 863(b), the proposed regulations amended Sec.  
1.863-3 in order to properly allocate or apportion gross income from 
Section 863(b)(2) Sales based solely on production activity.
    Under Sec.  1.863-3(c)(1)(ii)(A) (which has been redesignated in 
the final regulations as Sec.  1.863-3(c)(2)(i)), where the taxpayer's 
production assets are located both within and without the United 
States, the amount of income from sources without the United States is 
determined by multiplying all the income attributable to the taxpayer's 
production activities by a fraction, the numerator of which is the 
average adjusted basis of production assets that are located without 
the United States and the denominator of which is the average adjusted 
basis of all the production assets located within and without the 
United States.
    For purposes of applying this formula, the adjusted basis of 
production assets is determined under section 1011, which is adjusted 
under section 1016 for depreciation deductions allowed. The Act also 
amended section 168(k) to allow an additional first-year depreciation 
deduction of 100 percent of the basis of certain property placed in 
service after September 27, 2017, and before January 1, 2023. 
Therefore, certain new and used production assets placed in service and 
used predominantly within the United States during this period may have 
an adjusted basis of zero. However, production assets either placed in 
service or used predominantly without the United States, or both, do 
not qualify for this accelerated depreciation and must be depreciated 
using the straight-line method under the alternative depreciation 
system (``ADS'') of section 168(g)(2). In light of the Act's change to 
section 168(k) to allow accelerated depreciation in some circumstances, 
the proposed regulations provided a new rule for computing the adjusted 
basis of production assets for purposes of applying the allocation 
formula in Sec.  1.863-3.
A. Income Attributable to Sales Activity
    Section 1.863-3, as in effect before this Treasury Decision, 
provided rules and corresponding methods for allocating or apportioning 
gross income from Section 863(b)(2) Sales between production activity 
and sales activity. To implement the changes to section 863(b) under 
the Act, the proposed regulations proposed removing Sec.  1.863-3(c)(2) 
which allocates and apportions income attributable to sales activity.
    One comment argued that removing Sec.  1.863-3(c)(2) could lead to 
double taxation when a foreign jurisdiction imposes taxation on the 
sales activity. The Act amended section 863(b) to source income from 
the sale by a taxpayer of inventory produced by that taxpayer based 
only on production activity. Under the Code, sales activity is no 
longer a relevant factor for allocating and apportioning such income. 
Therefore, the final regulations remove Sec.  1.863-3(c)(2). But see 
part V of this Summary of Comments and Explanation of Revisions section 
for a discussion of the interaction with income tax treaties.
    Another comment suggested that two aspects of Sec.  1.863-3(c)(2) 
have continued relevance even after the Act's changes to section 
863(b)(2). First, Sec.  1.863-3(c)(2) has a special rule modifying the 
rule in Sec.  1.861-7(c) that generally sources income from the sale of 
personal property based on the place of sale. Under Sec.  1.861-7(c), a 
sale is generally treated as consummated in the place where the rights, 
title, and interest of the seller in the property are transferred to 
the buyer. However, if a taxpayer wholly produces inventory in the 
United States and sells it for use, consumption, or disposition in the 
United States, Sec.  1.863-3(c)(2) presumes that the place of sale is 
in the United States, even if title passes outside the United States. 
The comment recommended the final regulations include a similar rule 
and expand it to inventory wholly or partly produced in the United 
States that is acquired by a related party and resold for use, 
consumption, or disposition in the United States with title passing 
outside the United States. The comment observed that in the absence of 
such a rule, the sale by the related party would generate foreign 
source income, notwithstanding the fact that the inventory was produced 
wholly or partly in the United States and ultimately sold for use, 
consumption, or disposition in the United States.
    The final regulations do not adopt this comment. The place of sale 
rule of Sec.  1.861-7(c) already contains a broad anti-abuse rule that 
would apply to any sales transactions ``arranged in a particular manner 
for the primary purpose of tax avoidance,'' which may cover certain 
related party arrangements about which the comment is concerned. 
Section 482 also applies to require that compensation paid between 
related parties is consistent with the arm's length standard and will 
take into account the business functions and assets of, and risks 
assumed by, the related party intermediary. The Treasury Department and 
the IRS continue to study issues related to the distribution among 
related entities of the business functions, assets, and risks that 
generate business income, including sales income, and may address these 
issues in future guidance, particularly with respect to the sourcing of 
income from certain digital transactions.
    Second, the comment observed that Sec.  1.863-3(c)(2) treats 
inventory as

[[Page 79839]]

wholly produced in the United States for purposes of determining 
whether the place of sale is presumed to be in the United States if 
only minor assembly, packaging, repackaging, or labeling occurs outside 
the United States. The comment recommended including this rule as part 
of proposed Sec.  1.863-3(c)(1)(i). The final regulations adopt this 
comment in Sec.  1.863-3(c)(1)(i) by incorporating the ``principles of 
Sec.  1.954-3(a)(4)'' (other than Sec.  1.954-3(a)(4)(iv)). Section 
1.954-3(a)(4) provides rules for determining when a corporation has 
manufactured, produced, or constructed personal property. Under Sec.  
1.954-3(a)(4)(iii), packaging, repackaging, labeling, or minor assembly 
operations do not constitute the manufacture, production, or 
construction of property. Accordingly, under the final regulations, 
these principles apply for purposes of determining whether a taxpayer's 
activities constitute production activity under Sec.  1.863-3(c)(1)(i) 
as well. See part II.B. of this Summary of Comments and Explanation of 
Revisions section.
B. Definition of Production Activities
    Proposed Sec.  1.863-1(b)(2) provided the rule for sourcing gross 
receipts from the sale of natural resources where the taxpayer performs 
production activities in addition to its ownership of a farm, mine, oil 
or gas well, other natural deposit, or uncut timber. Section 1.863-
1(b)(3)(ii) defines such ``additional production activities'' by 
reference to the ``principles of Sec.  1.954-3(a)(4).''
    Under section 951(a)(1)(A), a United States shareholder of a 
controlled foreign corporation (``CFC'') includes in gross income its 
pro rata share of the CFC's subpart F income for the CFC's taxable year 
which ends with or within the taxable year of the shareholder. Section 
952(a)(2) defines the term subpart F income to include foreign base 
company income. Section 954(a)(2) defines foreign base company income 
to include foreign base company sales income (``FBCSI'') for the 
taxable year. Section 954(d)(1) defines FBCSI to mean income derived by 
a CFC in connection with certain related party transactions. Section 
1.954-3(a)(4) provides an exception to FBCSI when a CFC manufactures 
property that it sells. One comment supported defining ``additional 
production activities'' by reference to ``the principles of Sec.  
1.954-3(a)(4),'' as described in Sec.  1.863-1(b)(3)(ii), and requested 
that Sec. Sec.  1.863-3 and 1.865-3 include a similar cross reference.
    The final regulations adopt this recommendation, in part. 
Specifically, under the final regulations, Sec. Sec.  1.863-3 and 
1.865-3 incorporate the principles of Sec.  1.954-3(a)(4), with the 
exception of the rules regarding a ``substantial contribution to the 
manufacturing of personal property'' under Sec.  1.954-3(a)(4)(iv). See 
Sec. Sec.  1.863-3(c)(1)(i) and 1.865-3(d)(2). The final regulations 
also modify Sec.  1.863-1(b)(3)(ii) to incorporate the principles of 
Sec.  1.954-3(a)(4), other than the ``substantial contribution to the 
manufacturing of personal property'' under Sec.  1.954-3(a)(4)(iv). The 
substantial contribution rules were added to Sec.  1.954-3(a)(4) in 
T.D. 9438 (December 29, 2008) after the adoption of Sec.  1.863-
1(b)(3)(ii) in T.D. 8687 (November 27, 1996). While the Treasury 
Department and the IRS agree with the comment that the principles of 
Sec.  1.954-3(a)(4) may generally be helpful in determining the 
location of production activity for sourcing purposes, the substantial 
contribution rules of Sec.  1.954-3(a)(4)(iv) are concerned with 
whether there is production activity and do not address the geographic 
location of that production activity, which is relevant for sourcing 
under sections 861, 863, and 865. Additionally, the substantial 
contribution rules are premised on treating a corporation as engaged in 
production activities even if it is not engaged in the direct use of 
production assets (other than oversight assets), while Sec.  1.863-3 
focuses on sourcing income based on the location of a corporation's 
production assets that are used for production activities. See Sec.  
1.863-3(c)(1)(ii) (which has been redesignated in the final regulations 
as Sec.  1.863-3(c)(2)). In this regard, there is not a clear metric 
for quantifying production arising from substantial contribution 
activities, even if such activities are properly identified, in order 
to assign production activities to a particular geographic location for 
purposes of determining the place of production under sections 861, 
863, and 865. Therefore, the final regulations provide that the 
principles of Sec.  1.954-3(a)(4), other than the substantial 
contribution rules in Sec.  1.954-3(a)(4)(iv), apply in determining 
whether production activities exist.
C. Measuring Adjusted Basis of Production Assets
    For inventory produced both within and without the United States, 
the proposed regulations continued to allocate or apportion the gross 
income between U.S. and foreign sources based on the formula in Sec.  
1.863-3(c)(1)(ii)(A) (redesignated as proposed Sec.  1.863-3(c)(2)(i)). 
This formula determined the amount of foreign source income by 
multiplying the total gross income by a fraction, the numerator of 
which is the average adjusted basis of production assets located 
outside the United States and the denominator of which is the average 
adjusted basis of all production assets within and without the United 
States. The remaining gross income is from U.S. sources.
    In light of the Act's changes to section 168(k), proposed Sec.  
1.863-3(c)(2)(ii) measured the adjusted basis of the U.S. production 
assets for purposes of this formula based on the alternative 
depreciation system (``ADS'') of section 168(g)(2). The preamble to the 
proposed regulations observed that such rule allows the basis of both 
U.S. and non-U.S. production assets to be measured consistently on a 
straight-line method over the same recovery period, and requested 
comments on using ADS for this purpose or alternatives for measuring 
relative U.S. and non-U.S. production assets.
    One comment suggested that some taxpayers such as partnerships and 
S corporations would face administrative burdens if they had to 
maintain separate ADS books that they may not otherwise maintain if 
section 951A(d)(3) or 250(b)(2)(B) do not apply to them. The comment 
observed that the Act, in contrast to those other sections, does not 
mandate the use of ADS in the section 863(b) context. The comment 
requested that the final regulations maintain the existing rule of 
Sec.  1.863-3(c)(1)(ii)(B) measuring the basis under section 1011 (as 
adjusted by section 1016), either as the principal rule or, 
alternatively, at the election of the taxpayer.
    The final regulations do not adopt this comment. The Treasury 
Department and the IRS have determined that the use of ADS for this 
purpose will prevent the Act's modifications to section 168(k) 
(resulting in accelerated depreciation) from inappropriately skewing 
the apportionment formula under Sec.  1.863-3(c)(2)(i) in favor of 
foreign source income. While the Act does not mandate the use of ADS 
for this purpose, the Treasury Department and the IRS have authority to 
mandate the use of ADS under sections 863(a) and 7805 and have 
determined that the use of ADS is necessary to accurately measure the 
place of production using adjusted basis, as other basis measurements 
might inappropriately inflate foreign production activities.

[[Page 79840]]

III. Comments on and Revisions to Proposed Sec.  1.865-3--Source of 
Gross Income From Sales of Personal Property (Including Inventory 
Property) by a Nonresident Attributable to an Office or Other Fixed 
Place of Business in the United States

    Section 865 provides rules for sourcing income from sales of 
personal property. Section 865(e)(2) applies with respect to all sales 
of personal property (including inventory) by a nonresident, as that 
term is defined in section 865(g)(1)(B), attributable to an office or 
other fixed place of business in the United States. Section 
865(e)(2)(A) generally provides that income from any sale of personal 
property attributable to such an office or other fixed place of 
business is sourced in the United States. An exception is provided in 
section 865(e)(2)(B) for a sale of inventory for use, disposition, or 
consumption outside the United States if a foreign office of the 
nonresident ``materially participated'' in the sale. Section 865(e)(3) 
provides that the ``principles of section 864(c)(5) shall apply'' to 
determine whether a nonresident has an office or other fixed place of 
business and whether a sale is attributable to such office or other 
fixed place of business. Where applicable, section 865(e)(2) applies 
``[n]otwithstanding any other provisions'' of subchapter N, part I, 
including sections 863(b), 861(a)(6), and 862(a)(6). The proposed 
regulations under Sec.  1.865-3 clarified the application of the 
principles of section 864(c)(5) in the context of section 865(e)(2) and 
provided that sales of inventory property produced outside the United 
States and sold through an office maintained by the nonresident in the 
United States must be sourced in the United States in part.
    Proposed Sec.  1.865-3(e) also included a cross-reference to the 
rules for allocating and apportioning expenses to gross income 
effectively connected with the conduct of a trade or business in the 
United States in Sec. Sec.  1.882-4 and 1.882-5. Since those 
regulations apply only to foreign corporations, one comment requested 
that the final regulations also refer to Sec.  1.873-1 to cover 
nonresident alien taxpayers subject to proposed Sec.  1.865-3. In 
response to this comment, the final regulations broaden the cross-
references to include sections 882(c)(1) and 873(a) for purposes of 
allocating and apportioning expenses. See Sec.  1.865-3(e).
    The final regulations also reorder and revise parts of Sec.  1.865-
3 in a non-substantive manner solely for purposes of improving clarity 
and ease of application. The revision also helps to clarify that Sec.  
1.865-3 applies only if a nonresident maintains an office or other 
fixed place of business in the United States to which a sale of 
personal property is attributable. Otherwise, the source of the income, 
gain, or loss from the sale will be determined under other applicable 
provisions of section 865, such as section 865(b) through (d).
    The final regulations also retain, with certain modifications, the 
rules for determining the portion of gross income from sales and 
production activities under Sec.  1.865-3(d). Under the proposed 
regulations, the ``50/50 method,'' described in Sec.  1.865-3(d)(2)(i), 
was the default method because it was ``an appropriate and 
administrable way'' to apply section 865(e)(2), but the proposed 
regulations also allowed nonresidents to elect a books and records 
method that would ``more precisely'' reflect their gross income from 
both sales and production activities, if any, in the United States, 
provided the nonresidents met certain requirements for maintaining 
their books of account under proposed Sec.  1.865-3(d)(2)(ii)(B)(1) 
through (3). See 84 FR 71836, 71843. Under the final regulations, the 
50/50 method continues to be the default method and taxpayers continue 
to be permitted to elect the books and records method. However, the 
Treasury Department and the IRS have determined that, where taxpayers 
have demonstrated the ability to use their books of account to 
determine their U.S. source gross income under the books and records 
method, a limitation is appropriate to prevent a nonresident from 
returning to the less precise 50/50 method solely to obtain a better 
tax result. In addition, the Treasury Department and the IRS have 
determined that revising the election to provide that it remains in 
effect until revoked would reduce the risk to taxpayers of 
inadvertently failing to include the election with their Federal income 
tax return. Accordingly, under the final regulations, an election to 
apply the books and records method continues until revoked and may not 
be revoked, without the consent of the Commissioner, for any taxable 
year beginning within 48 months of the end of the taxable year in which 
the election was made.
    The final regulations also revise Sec.  1.864-5 to clarify the 
interaction with section 865(e)(2) and (3) and the promulgation of 
Sec.  1.865-3. Gross income, gain, or loss from the sale of personal 
property treated as from sources within the United States under Sec.  
1.865-3 will generally be effectively connected with the conduct of a 
trade or business in the United States to the extent provided in 
section 864(c), other than section 864(c)(4) or (5). Gross income, 
gain, or loss from the sale of personal property treated as from 
sources without the United States under Sec.  1.865-3 is not described 
in Sec.  1.864-5(b) and thus will generally not be effectively 
connected with the conduct of a trade or business in the United States.
    The rules of Sec. Sec.  1.864-5, 1.864-6, and 1.864-7 continue to 
apply, however, in determining whether foreign source income of 
nonresident aliens and foreign corporations that does not arise from 
the sale of personal property described in Sec.  1.865-3(c) is 
effectively connected with the conduct of a trade or business in the 
United States. The rules of Sec. Sec.  1.864-5, 1.864-6, and 1.864-7 
also continue to apply in determining whether foreign source income 
from the sale of inventory by nonresident aliens, who would be 
residents under section 865(g)(1)(A), is effectively connected with the 
conduct of a trade or business in the United States.

IV. Comments on the Rules for Determining the Location or Existence of 
Production Activity

    The proposed regulations did not modify the rules in Sec.  1.863-3 
for determining the location or existence of production activity for 
purposes of determining the sourcing of income derived from the sale of 
inventory. Section 1.863-3(c)(1)(i)(A) (which has been redesignated in 
the final regulations as Sec.  1.863-3(c)(1)(i)) provides the rule for 
sourcing of income where production occurs only within the United 
States or only within foreign countries. That paragraph generally 
limits the scope of ``production activities'' to only ``those conducted 
directly by the taxpayer.'' Similarly, Sec.  1.863-3(c)(1)(i)(B) (which 
has been redesignated in the final regulations as Sec.  1.863-
3(c)(1)(ii)) provides that production assets are those ``owned directly 
by the taxpayer that are directly used by the taxpayer to produce 
inventory.'' Section 1.863-3(c)(1)(ii) (which has been redesignated in 
the final regulations as Sec.  1.863-3(c)(2)) provides the rule for the 
sourcing of income where production occurs both within and without the 
United States, and, as discussed in part II.C of this Summary of 
Comments and Explanation of Revisions section, allocates gross income 
based on the relative adjusted basis of production assets located 
within and without the United States, respectively.
    The final regulations clarify the determination of the adjusted 
basis of production assets under Sec.  1.863-

[[Page 79841]]

3(c)(1)(ii)(B) (which has been redesignated in the final regulations as 
Sec.  1.863-3(c)(2)(ii)(A)). Under the final regulations, the adjusted 
basis of production assets for a taxable year is determined by 
averaging the basis of the assets at the beginning and end of the year, 
except in the event that a change during the year would cause the 
average to ``materially distort'' the calculation for sourcing of 
income attributable to production activity under Sec.  1.863-
3(c)(1)(ii)(A) (which has been redesignated in the final regulations as 
Sec.  1.863-3(c)(2)(i)). This clarification uses certain concepts from 
Sec.  1.861-9(g)(2)(i)(A) to further explain when a change might 
``materially distort'' the calculation. For example, the rule applies 
when an event such as a late-year disposition of substantially all the 
U.S. production assets of a corporation would cause a material 
distortion in the corporation's calculation of the split between U.S. 
and foreign production activities.
    One comment provided a range of suggestions to modify the rules of 
proposed Sec. Sec.  1.863-3(c) and 1.865-3(d). This comment suggested 
that the rules of proposed Sec. Sec.  1.863-3(c) and 1.865-3(d) were 
adequate, in general, where a taxpayer independently manufactured its 
own inventory, but inadequate with respect to other business models 
that rely on limited risk contract manufacturers or where multiple 
members of a group each perform only limited manufacturing functions in 
various jurisdictions. The comment observed that apportionment of gross 
income using the relative adjusted basis of production assets may not 
reflect high value-adding core production and risk management functions 
and ownership of production assets by unrelated contract manufacturers.
    The comment suggested expanding the scope of covered production 
activities and ownership of production assets to include activities 
conducted and assets owned by related parties and unrelated agents of 
the taxpayer. The comment also recommended that these rules include any 
activities that constitute a ``substantial contribution'' within the 
meaning of Sec.  1.954-3(a)(4)(iv) to better conform to the rules under 
subpart F. See part II.B of this Summary of Comments and Explanation of 
Revisions section. In addition, the comment suggested that Sec.  1.863-
3 should not allocate and apportion gross income using only the 
relative adjusted basis of production assets located within and without 
the United States, and recommended allocation and apportionment based 
on other metrics, such as the location of personnel involved in the 
production activities or personnel costs. The comment suggested that 
these modifications could, alternatively, be rebuttable presumptions 
that a taxpayer could overcome by showing that allocating and 
apportioning gross income based on adjusted basis or some other 
approach provides a more appropriate result under the taxpayer's facts.
    Another comment suggested that the existing allocation and 
apportionment rules that rely on the relative adjusted basis of 
production assets encourage businesses to move (or locate additional) 
production assets outside the United States. Specifically, the comment 
expressed concern that treating income from the sale of inventory 
produced, in whole or in part, in the United States as U.S. source 
income might result in double taxation if the income is also subject to 
tax in a foreign jurisdiction, since the U.S. source income would be 
excluded from the numerator of the section 904 limitation, reducing the 
section 904 limitation, and potentially limiting the U.S. taxpayer's 
ability to use its foreign tax credits. The comment requested replacing 
these rules with a more comprehensive formula, preferably one that 
minimizes the risk of double taxation. The comment did not suggest an 
alternative formula and observed that further legislation may be 
necessary in this regard.
    The Treasury Department and the IRS appreciate the various concerns 
presented by these comments and suggested revisions. The final 
regulations do not adopt these comments, but the Treasury Department 
and the IRS may consider these recommendations as part of a more 
comprehensive review of the sourcing rules for production activity (for 
purposes of both Sec.  1.863-3 and Sec.  1.865-3) in a future notice of 
proposed rulemaking. Additionally, the anti-abuse rule in Sec.  1.863-
3(c)(1)(iii) (which has been redesignated in the final regulations as 
Sec.  1.863-3(c)(3)) already applies to make appropriate adjustments 
where taxpayers enter into or structure certain transactions with a 
principal purpose of reducing U.S. tax liability under Sec.  1.863-3, 
including by using production assets owned by a related party. To 
clarify the application of this rule, the final regulations provide 
that the anti-abuse rule applies to transactions inconsistent with the 
purpose of Sec.  1.863-3(b) or (c), and adds as an example that the 
anti-abuse rule may cover acquisitions of domestic production assets by 
related partnerships (or subsidiaries thereof) with a principal purpose 
of reducing the transferor's U.S. tax liability by treating income from 
the sale of inventory property as subject to section 862(a)(6) rather 
than section 863(b). The Treasury Department and the IRS continue to 
request comments regarding potential approaches to determine the 
location or existence of production activity or other modifications to 
Sec.  1.863-3 that may be appropriate.

V. Comments on Income Tax Treaties

    The preamble to the proposed regulations included a statement about 
how proposed Sec.  1.865-3 interacted with U.S. income tax treaties 
under which the business profits of foreign treaty residents may be 
taxable in the United States only if the profits are attributable to a 
permanent establishment in the United States. The preamble to the 
proposed regulations stated, ``[w]ith respect to taxpayers entitled to 
the benefits of an income tax treaty, the amount of profits 
attributable to a U.S. permanent establishment will not be affected by 
these regulations.'' See 84 FR 71836, 71844.
    One comment supported the preamble's statement and requested that, 
consistent with the statement in the preamble, the final regulations 
not apply to Section 863(b)(2) Sales in a manner that results in double 
taxation to U.S. taxpayers engaged in business operations through a 
permanent establishment in a treaty jurisdiction, notwithstanding the 
Act's change to section 863(b). The comment also requested that 
competent authority relief be provided in this regard. These 
regulations do not affect the ability of a taxpayer to rely on treaty 
provisions to mitigate or relieve double taxation, including treaty 
provisions that permit a taxpayer to make a request to the competent 
authority for assistance pursuant to a mutual agreement procedure 
article of an applicable income tax treaty.

VI. Comment on Proposed Applicability Date

    The proposed regulations were proposed to apply to taxable years 
ending on or after December 23, 2019, although taxpayers and their 
related parties could generally apply the rules in their entirety for 
taxable years beginning after December 31, 2017, and ending before 
December 23, 2019. One comment requested that the final regulations 
apply to taxable years ending after December 31, 2019, because some 
taxpayers have consistently relied on the existing methods of Sec.  
1.863-3(b) for many years. The final regulations do not adopt this 
comment. Under section 7805(b)(1)(B), a final regulation can

[[Page 79842]]

apply to any taxable period ending on or after the date on which the 
proposed regulation to which such final regulation relates was filed 
with the Federal Register, which for these final regulations was 
December 23, 2019. The final regulations implement the Act's statutory 
change to section 863(b), which was effective for taxable years 
beginning after December 31, 2017. To provide certainty to taxpayers 
and avoid a multiplicity of different interpretations of the statute, 
the Treasury Department and the IRS have determined that it is 
appropriate for the final regulations to apply as closely as possible 
to the effective date of the statutory change.

Applicability Date

    The final regulations generally apply to taxable years ending on or 
after December 23, 2019. Taxpayers may choose to apply the final 
regulations for any taxable year beginning after December 31, 2017, and 
ending before December 23, 2019, provided that the taxpayer and all 
persons that are related to the taxpayer (within the meaning of section 
267 or 707) apply the final regulations in their entirety and, once 
applied, the taxpayer and all persons related to the taxpayer (within 
the meaning of section 267 or 707) continue to apply the final 
regulations in their entirety for all subsequent taxable years. See 
section 7805(b)(7). Alternatively, taxpayers may rely on the proposed 
regulations for any taxable year beginning after December 31, 2017, and 
ending on or before September 29, 2020, provided that the taxpayer and 
all persons that are related to the taxpayer (within the meaning of 
section 267 or 707) rely on the proposed regulations in their entirety 
and provided that the taxpayer and all persons that are related to the 
taxpayer (within the meaning of section 267 or 707) have not applied 
the final regulations to any preceding year.

Special Analyses

    These regulations are not subject to review under section 6(b) of 
Executive Order 12866 pursuant to the Memorandum of Agreement (April 
11, 2018) between the Treasury Department and the Office of Management 
and Budget regarding review of tax regulations.

I. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 (44 U.S.C. 3501-3520) (``PRA'') 
generally requires that a federal agency obtain the approval of OMB 
before collecting information from the public, whether such collection 
of information is mandatory, voluntary, or required to obtain or retain 
a benefit.
    The final regulations include a collection of information in Sec.  
1.865-3(d)(2)(ii)(B). Section 1.865-3(d)(2)(ii)(B) allows a 
nonresident, as defined in section 865(g)(1)(B), whose inventory sales 
are described in Sec.  1.865-3(d)(2) (relating to inventory produced by 
the nonresident) to elect to allocate the profit from such sales to its 
U.S. office using a books and records method under Sec.  1.865-
3(d)(2)(ii), rather than using a default ``50/50 method'' under Sec.  
1.865-3(d)(2)(i). If the collection of information in Sec.  1.865-
3(d)(2)(ii)(B) applies to a nonresident, the nonresident must maintain 
detailed records of its receipts and expenditures attributable to its 
sales and production activities to support the allocation of its 
income, gain, or loss to its sales activities in the United States 
under the principles of section 482. See Sec.  1.865-3(d)(2)(ii)(B)(2). 
The nonresident must also prepare an explanation of how the allocation 
was determined. See Sec.  1.865-3(d)(2)(ii)(B)(3). The nonresident must 
make an election to apply the books and records method under Sec.  
1.865-3(d)(2)(ii) by attaching a statement to its original timely filed 
Federal income tax return (including extensions) that it elects to 
apply the books and records method under Sec.  1.865-3(d)(2)(ii)(A) and 
has prepared the records described in Sec.  1.865-3(d)(2)(ii)(B)(2) and 
(3). The nonresident must make available the explanation and records 
upon request of the Commissioner, within 30 days or some other time 
period as agreed between the Commissioner and the nonresident. See 
Sec.  1.865-3(d)(2)(ii)(B)(3).
    The reporting burdens associated with the collection of information 
in Sec.  1.865-3(d)(2)(ii)(B) will be reflected in the Form 14029, 
Paperwork Reduction Act Submission, that the Treasury Department and 
the IRS will submit to OMB for tax returns in the Forms 1120-F, U.S. 
Income Tax Return of a Foreign Corporation, and Forms 1040-NR, U.S. 
Nonresident Alien Income Tax Return. In particular, the reporting 
burden associated with the information collection in Sec.  1.865-
3(d)(2)(ii)(B) will be included in the burden estimate for OMB control 
numbers 1545-0123 and 1545-0074. OMB control number 1545-0123 
represents a total estimated burden time for all forms and schedules 
for corporations of 3.344 billion hours and total estimated monetized 
costs of $61.558 billion ($2019). OMB control number 1545-0074 
represents a total estimated burden time, including all other related 
forms and schedules for individuals, of 1.717 billion hours and total 
estimated monetized costs of $33.267 billion ($2019). Table 1 
summarizes the status of the PRA submissions of the Treasury Department 
and the IRS related to Forms 1120-F and 1040-NR.
    The overall burden estimate provided by the Treasury Department and 
the IRS to OMB in the PRA submissions for OMB control numbers 1545-0123 
and 1545-0074 are aggregate amounts related to the U.S. Business Income 
Tax Return and the U.S. Individual Income Tax Return, along with any 
associated forms. The burden estimates in these PRA submissions, 
however, do not account for any burden imposed by Sec.  1.865-
3(d)(2)(ii)(B). The Treasury Department and the IRS have not identified 
the estimated burden for the collections of information in Sec.  1.865-
3(d)(2)(ii)(B) because there are no burden estimates specific to Sec.  
1.865-3(d)(2)(ii)(B) currently available. The burden estimates in the 
PRA submissions that the Treasury Department and the IRS will submit to 
OMB will in the future include, but not isolate, the estimated burden 
related to the collection of information in Sec.  1.865-3(d)(2)(ii)(B).
    The Treasury Department and the IRS have included the burdens 
related to the PRA submissions for OMB control numbers 1545-0123 and 
1545-0074 in the PRA analysis for other regulations issued by the 
Treasury Department and the IRS related to the taxation of cross-border 
income. The Treasury Department and the IRS encourage users of this 
information to take measures to avoid overestimating the burden that 
the collection of information in Sec.  1.865-3(d)(2)(ii)(B), together 
with other international tax provisions, imposes. Moreover, the 
Treasury Department and the IRS also note that the Treasury Department 
and the IRS estimate PRA burdens on a taxpayer-type basis rather than a 
provision-specific basis because an estimate based on the taxpayer-type 
most accurately reflects taxpayers' interactions with the forms.
    The Treasury Department and the IRS request comments on the forms 
that reflect the information collection burdens related to the final 
regulations, including estimates for how much time it would take to 
comply with the paperwork burden described above for each relevant form 
and ways for the IRS to minimize the paperwork burden. Proposed 
revisions (if any) to these forms that reflect the information 
collection contained in Sec.  1.865-3(d)(2)(ii)(B) will be made 
available for public comment at https://apps.irs.gov/app/picklist/list/draftTaxForms.html and will not be finalized until after

[[Page 79843]]

these forms have been approved by OMB under the PRA.

    Table 1--Summary of Information Collection Request Submissions Related to Forms 1120-F and Forms 1040-NR
----------------------------------------------------------------------------------------------------------------
                Form                        Type of filer           OMB Nos.                  Status
----------------------------------------------------------------------------------------------------------------
Form 1040-NR.......................  Individual (NEW Model)....       1545-0074  Approved by OIRA 1/30/2020
                                                                                  until 1/31/2021.
                                    ----------------------------------------------------------------------------
                                     Link: https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201909-1545-021.
----------------------------------------------------------------------------------------------------------------
Form 1120-F........................  Business (NEW Model)......       1545-0123  Approved by OIRA 1/30/2020
                                                                                  until 1/31/2021.
----------------------------------------------------------------------------------------------------------------
                                     Link: https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201907-1545-001.
----------------------------------------------------------------------------------------------------------------

II. Regulatory Flexibility Act

    Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it 
is hereby certified that these final regulations will not have a 
significant economic impact on a substantial number of small entities. 
Although data are not readily available to assess the number of small 
entities potentially affected, any economic impact of these regulations 
is unlikely to be significant. Specifically, the regulations in 
Sec. Sec.  1.863-1 and 1.863-3 (with conforming changes in cross-
referencing regulations) implement the statutory change made to section 
863(b) by the Act. This change affects sales of inventory property by 
any taxpayer where the taxpayer produces the inventory (in whole or in 
part) within the United States and sells that inventory without the 
United States, or vice versa. The change in sourcing for those entities 
is attributable to the change in section 863(b) made by the Act. 
Sections 1.863-1 and 1.863-3 merely implement the statutory change with 
limited additional guidance. The Treasury Department and the IRS do not 
anticipate that any differences between the changes in section 863(b) 
made by the Act and the changes in Sec. Sec.  1.863-1 and 1.863-3 made 
by these regulations will have a significant economic impact on a 
substantial number of small entities.
    The other regulations in this publication (other than changes to 
ensure consistency with section 863(b)) are the final regulations in 
Sec. Sec.  1.864-5, 1.864-6, and 1.865-3. These regulations solely 
affect non-U.S. taxpayers, which are not subject to the Regulatory 
Flexibility Act.
    Pursuant to section 7805(f) of the Code, the proposed regulations 
preceding these final regulations were submitted to the Chief Counsel 
for Advocacy of the Small Business Administration for comment on their 
impact on small businesses. No comments were received.

III. Unfunded Mandates Reform Act

    Section 202 of the Unfunded Mandates Reform Act of 1995 requires 
that agencies assess anticipated costs and benefits and take certain 
other actions before issuing a final rule that includes any Federal 
mandate that may result in expenditures in any one year by a state, 
local, or tribal government, in the aggregate, or by the private 
sector, of $100 million in 1995 dollars, updated annually for 
inflation. These regulations do not include any Federal mandate that 
may result in expenditures by state, local, or tribal governments, or 
by the private sector in excess of that threshold.

IV. Executive Order 13132: Federalism

    Executive Order 13132 (entitled ``Federalism'') prohibits an agency 
from publishing any rule that has federalism implications if the rule 
either imposes substantial, direct compliance costs on state and local 
governments, and is not required by statute, or preempts state law, 
unless the agency meets the consultation and funding requirements of 
section 6 of the Executive Order. These regulations do not have 
federalism implications and do not impose substantial direct compliance 
costs on state and local governments or preempt state law within the 
meaning of the Executive Order.

Drafting Information

    The principal author of the regulations is Brad McCormack of the 
Office of Associate Chief Counsel (International). However, other 
personnel from the Treasury Department and the IRS participated in the 
development of the regulations.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding an 
entry for Sec.  1.865-3 in numerical order.
    The addition reads in part as follows:

    Authority:  26 U.S.C. 7805 * * *
* * * * *
    Section 1.865-3 also issued under 26 U.S.C. 865(j).
* * * * *

0
Par. 2. Section 1.863-0 is revised to read as follows:


Sec.  1.863-0   Table of contents.

    This section lists captions contained in Sec. Sec.  1.863-1 through 
1.863-10.

Sec.  1.863-1 Allocation of gross income under section 863(a).

    (a) In general.
    (b) Natural resources.
    (1) In general.
    (2) Additional production activities.
    (3) Definitions.
    (i) Production activity.
    (ii) Additional production activities.
    (4) Determination of fair market value.
    (5) Determination of gross income.
    (6) Tax return disclosure.
    (7) Examples.
    (i) Example 1. No additional production, foreign source gross 
receipts.
    (ii) Example 2. No additional production, U.S. source gross 
receipts.
    (iii) Example 3. Production in United States, foreign sales.
    (iv) Example 4. Production and sales in United States.
    (v) Example 5. Additional production.
    (c) Determination of taxable income.
    (d) Scholarships, fellowship grants, grants, prizes, and awards.
    (1) In general.
    (2) Source of income.
    (i) United States source income.
    (ii) Foreign source income.
    (iii) Certain activities conducted outside the United States.
    (3) Definitions.
    (4) Effective dates.
    (i) Scholarships and fellowship grants.
    (ii) Grants, prizes and awards.
    (e) Residual interest in a REMIC.
    (1) REMIC inducement fees.
    (2) Excess inclusion income and net losses.

[[Page 79844]]

    (f) Applicability date.

Sec.  1.863-2 Allocation and apportionment of taxable income.

    (a) Determination of taxable income.
    (b) Determination of source of taxable income.
    (c) Applicability date.

Sec.  1.863-3 Allocation and apportionment of income from certain 
sales of inventory.

    (a) In general.
    (1) Scope.
    (2) Cross references.
    (b) Sourcing based solely on production activities.
    (c) Determination of the source of gross income from production 
activity.
    (1) Production only within the United States or only within 
foreign countries.
    (i) Source of income.
    (ii) Definition of production assets.
    (iii) Location of production assets.
    (2) Production both within and without the United States.
    (i) Source of income.
    (ii) Adjusted basis of production assets.
    (A) In general.
    (B) Production assets used to produce other property.
    (3) Anti-abuse rule.
    (4) Examples.
    (i) Example1. Source of gross income.
    (ii) Example 2. Location of intangible property.
    (iii) Example 3. Anti-abuse rule.
    (d) Determination of source of taxable income.
    (e) Income partly from sources within a possession of the United 
States.
    (1) In general.
    (2) Allocation or apportionment for Possession Production Sales.
    (3) Allocation or apportionment for Possession Purchase Sales.
    (i) Determination of source of gross income from Possession 
Purchase Sales.
    (ii) Determination of source of gross income from business 
activity.
    (A) Source of gross income.
    (B) Business activity.
    (C) Location of business activity.
    (1) Sales activity.
    (2) Cost of goods sold.
    (3) Expenses.
    (4) Examples.
    (i) Example 1: Purchase of goods manufactured in possession.
    (ii) Example 2: Purchase of goods manufactured outside 
possession.
    (5) Special rules for partnerships.
    (f) Special rules for partnerships.
    (1) General rule.
    (2) Exceptions.
    (i) In general.
    (ii) Attribution of production assets to or from a partnership.
    (iii) Basis.
    (3) Examples.
    (i) Example 1. Distributive share of partnership income.
    (ii) Example 2. Distribution in kind.
    (g) Applicability dates.

Sec.  1.863-4 Certain transportation services.

    (a) General.
    (b) Gross income.
    (c) Allocation of costs or expenses.
    (d) Items not included as costs or expenses.
    (1) Taxes and interest.
    (2) Other business activity and general expenses.
    (3) Personal exemptions and special deductions.
    (e) Property used while within the United States.
    (1) General.
    (2) Average property.
    (3) Current assets.
    (f) Taxable income.
    (1) General.
    (2) Interest and taxes.
    (3) General expenses.
    (4) Personal exemptions.
    (5) Special deductions.
    (g) Allocation based on books of account.

Sec.  1.863-6 Income from sources within a foreign country.

Sec.  1.863-7 Allocation of income attributable to certain notional 
principal contracts under section 863(a).

    (a) Scope.
    (1) Introduction.
    (2) Effective/applicability date.
    (b) Source of notional principal contract income.
    (1) General rule.
    (2) Qualified business unit exception.
    (3) Effectively connected notional principal contract income.
    (c) Election.
    (1) Eligibility and effect.
    (2) Time for making election.
    (3) Manner of making election.
    (d) Example.
    (e) Cross references.

Sec.  1.863-8 Source of income derived from space and ocean activity 
under section 863(d).

    (a) In general.
    (b) Source of gross income from space and ocean activity.
    (1) Space and ocean income derived by a United States person.
    (2) Space and ocean income derived by a foreign person.
    (i) In general.
    (ii) Space and ocean income derived by a controlled foreign 
corporation.
    (iii) Space and ocean income derived by foreign persons engaged 
in a trade or business within the United States.
    (3) Source rules for income from certain sales of property.
    (i) Sales of purchased property.
    (ii) Sales of property produced by the taxpayer.
    (A) General.
    (B) Production only in space or international water, or only 
outside space and international water.
    (C) Production both in space or international water and outside 
space and international water.
    (4) Special rule for determining the source of gross income from 
services.
    (5) Special rule for determining source of income from 
communications activity (other than income from international 
communications activity).
    (c) Taxable income.
    (d) Space and ocean activity.
    (1) Definition.
    (i) Space activity.
    (ii) Ocean activity.
    (2) Determining a space or ocean activity.
    (i) Production of property in space or international water.
    (ii) Special rule for performance of services.
    (A) General.
    (B) Exception to the general rule.
    (3) Exceptions to space or ocean activity.
    (e) Treatment of partnerships.
    (f) Examples.
    (1) Example 1. Space activity--activity occurring on land and in 
space.
    (2) Example 2. Space activity.
    (3) Example 3. Services as space activity--de minimis value 
attributable to performance occurring in space.
    (4) Example 4. Space activity.
    (5) Example 5. Space activity.
    (6) Example 6. Space activity--treatment of land activity.
    (7) Example 7. Use of intangible property in space.
    (8) Example 8. Performance of services.
    (9) Example 9. Separate transactions.
    (10) Example 10. Sale of property in international water.
    (11) Example 11. Sale of property in space.
    (12) Example 12. Sale of property in space.
    (13) Example 13. Source of income of a foreign person.
    (14) Example 14. Source of income of a foreign person.
    (g) Reporting and documentation requirements.
    (1) In general.
    (2) Required documentation.
    (3) Access to software.
    (4) Use of allocation methodology.
    (h) Applicability date.

Sec.  1.863-9 Source of income derived from communications activity 
under section 863(a), (d), and (e).

    (a) In general.
    (b) Source of international communications income.
    (1) International communications income derived by a United 
States person.
    (2) International communications income derived by foreign 
persons.
    (i) In general.
    (ii) International communications income derived by a controlled 
foreign corporation.
    (iii) International communications income derived by foreign 
persons with a fixed place of business in the United States.
    (iv) International communications income derived by foreign 
persons engaged in a trade or business within the United States.
    (c) Source of U.S. communications income.
    (d) Source of foreign communications income.
    (e) Source of space/ocean communications income.
    (f) Source of communications income when taxpayer cannot 
establish the two points between which the taxpayer is paid to 
transmit the communication.
    (g) Taxable income.
    (h) Communications activity and income derived from 
communications activity.
    (1) Communications activity.
    (i) General rule.
    (ii) Separate transaction.
    (2) Income derived from communications activity.

[[Page 79845]]

    (3) Determining the type of communications activity.
    (i) In general.
    (ii) Income derived from international communications activity.
    (iii) Income derived from U.S. communications activity.
    (iv) Income derived from foreign communications activity.
    (v) Income derived from space/ocean communications activity.
    (i) Treatment of partnerships.
    (j) Examples.
    (k) Reporting and documentation requirements.
    (1) In general.
    (2) Required documentation.
    (3) Access to software.
    (4) Use of allocation methodology.
    (l) Effective date.

Sec.  1.863-10 Source of income from a qualified fails charge.

    (a) In general.
    (b) Qualified business unit exception.
    (c) Effectively connected income exception.
    (d) Qualified fails charge.
    (e) Designated security.
    (g) Effective/applicability date.


0
Par. 3. Section 1.863-0A is added to read as follows:


Sec.  1.863-0A   Table of contents.

    This section lists captions contained in Sec. Sec.  1.863-3A and 
1.863-3AT.

Sec.  1.863-3A Income from the sale of personal property derived 
partly from within and partly from without the United States.

    (a) General.
    (1) Classes of income.
    (2) Definition.
    (b) Income partly from sources within a foreign country.
    (1) General.
    (2) Allocation or apportionment.
    (c) Income partly from sources within a possession of the United 
States.
    (1) General.
    (2) Allocation or apportionment.
    (3) Personal property produced and sold.
    (4) Personal property purchased and sold.

Sec.  1.863-3AT Income from the sale of personal property derived 
partly from within and partly from without the United States 
(temporary).

    (a) [Reserved].
    (b) Income partly from sources within a foreign country.
    (1) [Reserved].
    (2) Allocation or apportionment.
    (c)(1) through (4) [Reserved].


0
Par. 4. Section 1.863-1 is amended as follows:
0
a. In paragraph (a):
0
i. Revising the third sentence.
0
ii. Removing ``Sec.  1.863-3(g)'' and adding in its place ``Sec.  
1.863-3(f).''
0
b. Revising paragraph (b)(1).
0
c. In paragraph (b)(2):
0
i. Removing ``prior to export terminal'' from the heading and adding in 
its place ``activities.''
0
ii. Removing ``before the relevant product is shipped from the export 
terminal'' from the first sentence.
0
iii. Adding ``oil or gas'' before ``well'' and ``other natural'' before 
``deposit'' in the second sentence.
0
d. Removing ``Sec. Sec.  1.1502-13 or 1.863-3(g)(2)'' from paragraph 
(b)(3)(i) and adding in its place ``Sec.  1.1502-13 or 1.863-3(f)(2).''
0
e. In paragraph (b)(3)(ii):
0
i. Adding ``uncut'' before ``timber'' in the first sentence.
0
ii. Adding ``(except for Sec.  1.954-3(a)(4)(iv))'' at the end of the 
second sentence.
0
iii. Removing ``to or from the export terminal'' from the third 
sentence.
0
f. Removing paragraph (b)(3)(iii).
0
g. In paragraph (b)(6), removing ``this paragraph (b)'' from the first 
sentence and adding in its place ``paragraph (b)(2) of this section.''
0
h. Designating Examples 1, 2, 3, 4, and 5 of paragraph (b)(7) as 
paragraphs (b)(7)(i) through (v).
0
i. Revising newly designated paragraphs (b)(7)(i) through (v).
0
j. In paragraph (f):
0
i. Revising the heading.
0
ii. Adding three sentences at the start of the paragraph.
    The revisions and additions read as follows:


Sec.  1.863-1   Allocation of gross income under section 863(a).

    (a) * * * See also section 865(b) for rules for sourcing income 
from the sale of inventory property, within the meaning of section 
865(i)(1) (inventory), generally, and section 865(e)(2) and Sec.  
1.865-3 for sourcing income from the sale of personal property 
(including inventory) by a nonresident that is attributable to the 
nonresident's office or other fixed place of business in the United 
States. * * *
    (b) Natural resources--(1) In general. Notwithstanding any other 
provision of this part, except to the extent provided in paragraph 
(b)(2) of this section or Sec.  1.865-3, gross receipts from the sale 
outside the United States of products derived from the ownership or 
operation of any farm, mine, oil or gas well, other natural deposit, or 
uncut timber within the United States shall be treated as from sources 
within the United States, and gross receipts from the sale within the 
United States of products derived from the ownership or operation of 
any farm, mine, oil or gas well, other natural deposit, or uncut timber 
outside the United States shall be treated as from sources without the 
United States.
* * * * *
    (7) * * *
    (i) Example 1. No additional production, foreign source gross 
receipts. U.S. Mines, a domestic corporation, operates a copper mine 
and mill in Country X. U.S. Mines extracts copper-bearing rocks from 
the ground and transports the rocks to the mill where the rocks are 
ground and processed to produce copper-bearing concentrate. The 
concentrate is transported to a port where it is dried in preparation 
for export, stored, and then shipped to purchasers in the United 
States. Because, under the facts and circumstances, none of U.S. Mines' 
activities constitute additional production activities, within the 
meaning of paragraph (b)(3)(ii) of this section, paragraph (b)(2) of 
this section does not apply, and under paragraph (b)(1) of this 
section, gross receipts from the sale of the concentrate will be 
treated as from sources without the United States.
    (ii) Example 2. No additional production, U.S. source gross 
receipts. U.S. Gas, a domestic corporation, extracts natural gas within 
the United States, and transports the natural gas to a Country X port 
where it is liquefied in preparation for shipment. The liquefied 
natural gas is then transported via freighter and sold without 
additional production activities in a foreign country. Under paragraph 
(b)(3)(ii) of this section, liquefaction of natural gas is not an 
additional production activity because liquefaction prepares the 
natural gas for transportation. Therefore, under paragraph (b)(1) of 
this section, gross receipts from the sale of the liquefied natural gas 
will be treated as from sources within the United States.
    (iii) Example 3. Production in United States, foreign sales. U.S. 
Gold, a domestic corporation, mines gold in Country X, produces gold 
jewelry using production assets located in the United States, and sells 
the jewelry in Country Y. Assume that the fair market value of the gold 
before the additional production activities in the United States is 
$40x and that U.S. Gold ultimately sells the gold jewelry in Country Y 
for $100x. Under paragraph (b)(2) of this section, $40x of U.S. Gold's 
gross receipts will be treated as from sources without the United 
States, and the remaining $60x of gross receipts will be treated as 
from sources within the United States under Sec.  1.863-3.
    (iv) Example 4. Production and sales in United States. U.S. Oil, a 
domestic corporation, extracts oil in Country X, transports the oil via 
a pipeline to the United States, refines the oil using production 
assets located in the United States, and sells the refined product in 
the United States to unrelated persons.

[[Page 79846]]

Assume that the fair market value of the oil before refinement in the 
United States is $80x and U.S. Oil ultimately sells the refined product 
for $100x. Under paragraph (b)(2) of this section, $80x of gross 
receipts will be treated as from sources without the United States, and 
the remaining $20x of gross receipts will be treated as from sources 
within the United States under Sec.  1.863-3.
    (v) Example 5. Additional production. The facts are the same as in 
paragraph (b)(7)(i) of this section (the facts in Example 1), except 
that U.S. Mines also operates a smelter in Country X. The concentrate 
output from the mill is transported to the smelter where it is 
transformed into smelted copper. The smelted copper is exported to 
purchasers in the United States. Under the facts and circumstances, all 
the processes applied to make copper concentrate are considered mining. 
Therefore, under paragraph (b)(2) of this section, gross receipts equal 
to the fair market value of the concentrate at the smelter will be 
treated as from sources without the United States. Under the facts and 
circumstances, the conversion of the concentrate into smelted copper is 
an additional production activity in a foreign country within the 
meaning of paragraph (b)(3)(ii) of this section. Therefore, the source 
of U.S. Mines's excess gross receipts will be determined under Sec.  
1.863-3, pursuant to paragraph (b)(2) of this section.
* * * * *
    (f) Applicability date. Paragraph (b) of this section applies to 
taxable years ending on or after December 23, 2019. However, a taxpayer 
may apply paragraph (b) of this section in its entirety for taxable 
years beginning after December 31, 2017, and ending before December 23, 
2019, provided that the taxpayer and all persons related to the 
taxpayer (within the meaning of section 267 or 707) apply paragraph (b) 
of this section and Sec. Sec.  1.863-2(b), 1.863-3, 1.863-8(b)(3)(ii), 
1.864-5(a) and (b), 1.864-6(c)(2), and 1.865-3 in their entirety for 
the taxable year, and once applied, the taxpayer and all persons 
related to the taxpayer (within the meaning of section 267 or 707) 
continue to apply these regulations in their entirety for all 
subsequent taxable years. For regulations generally applicable to 
taxable years ending before December 23, 2019, see Sec.  1.863-1 as 
contained in 26 CFR part 1 revised as of April 1, 2020. * * *

0
Par. 5. Section 1.863-2 is amended as follows:
0
a. In paragraph (a) introductory text:
0
i. Removing ``(and that is treated as derived partly from sources 
within and partly from sources without the United States)'' from the 
third sentence.
0
ii. Adding a colon after the word ``income'' at the end of the 
paragraph.
0
b. Revising paragraph (b).
0
c. Revising paragraph (c).
    The revisions read as follows:


Sec.  1.863-2   Allocation and apportionment of taxable income.

* * * * *
    (b) Determination of source of taxable income. Income treated as 
derived from sources partly within and partly without the United States 
under paragraph (a) of this section may be allocated or apportioned to 
sources within and without the United States pursuant to Sec. Sec.  
1.863-1, 1.863-3, 1.863-4, 1.863-8, and 1.863-9. To determine the 
source of certain types of income described in paragraph (a)(1) of this 
section, see Sec.  1.863-4. To determine the source of gross income 
described in paragraph (a)(2) of this section, see Sec.  1.863-1 for 
natural resources, Sec.  1.863-3 for other sales of inventory property, 
and Sec.  1.863-8 for source of gross income from space and ocean 
activity. Section 1.865-3 may apply instead of the provisions in this 
section to source gross income from sales of personal property 
(including inventory property) by nonresidents attributable to an 
office or other fixed place of business in the United States. To 
determine the source of income partly from sources within a possession 
of the United States, including income described in paragraph (a)(3) of 
this section, see Sec.  1.863-3(e).
    (c) Applicability date. Except as provided in this paragraph (c), 
this section applies to taxable years beginning after December 30, 
1996. Paragraph (b) of this section applies to taxable years ending on 
or after December 23, 2019. However, a taxpayer may apply paragraph (b) 
of this section in its entirety for taxable years beginning after 
December 31, 2017, and ending before December 23, 2019, provided that 
the taxpayer and all persons related to the taxpayer (within the 
meaning of section 267 or 707) apply paragraph (b) of this section and 
Sec. Sec.  1.863-1(b), 1.863-3, 1.863-8(b)(3)(ii), 1.864-5(a) and (b), 
1.864-6(c)(2), and 1.865-3 in their entirety for the taxable year, and 
once applied, the taxpayer and all persons related to the taxpayer 
(within the meaning of section 267 or 707) continue to apply these 
regulations in their entirety for all subsequent taxable years. For 
regulations generally applicable to taxable years ending before 
December 23, 2019, see Sec.  1.863-2 as contained in 26 CFR part 1 
revised as of April 1, 2020.

0
Par. 6. Section 1.863-3 is revised as follows:


Sec.  1.863-3   Allocation and apportionment of income from certain 
sales of inventory.

    (a) In general--(1) Scope. Subject to the rules of Sec.  1.865-3, 
paragraphs (a) through (d) of this section apply to determine the 
source of income derived from the sale of inventory property 
(inventory) that a taxpayer produces (in whole or in part) within the 
United States and sells without the United States, or that a taxpayer 
produces (in whole or in part) without the United States and sells 
within the United States (collectively, Section 863(b)(2) Sales). See 
section 865(i)(1) for the definition of inventory. Paragraph (b) of 
this section provides that the source of gross income from Section 
863(b)(2) Sales is based solely on the production activities with 
respect to the inventory. Paragraph (c) of this section describes how 
to determine source based on production activity, including when 
inventory is produced partly within the United States and partly 
without the United States. Paragraph (d) of this section determines 
taxable income from Section 863(b)(2) Sales. Paragraph (e) of this 
section applies to determine the source of certain income derived from 
a possession of the United States. Paragraph (f) of this section 
provides special rules for partnerships for all sales subject to 
Sec. Sec.  1.863-1 through 1.863-3. Paragraph (g) of this section 
provides applicability dates for the rules in this section.
    (2) Cross references. To determine the source of income derived 
from the sale of personal property (including inventory) by a 
nonresident that is attributable to the nonresident's office or other 
fixed place of business in the United States under section 865(e)(2) 
and Sec.  1.865-3(c), the rules of Sec.  1.865-3 apply, and the rules 
of this section do not apply except to the extent provided in Sec.  
1.865-3. 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, as defined in Sec.  1.863-8(d)(1)(i), or 
international water, as defined in Sec.  1.863-8(d)(1)(ii), or is sold 
in space or international water, the rules of Sec.  1.863-8 apply, and 
the rules of this section do not apply except to the extent provided in 
Sec.  1.863-8.
    (b) Sourcing based solely on production activities. Subject to the 
rules of Sec.  1.865-3, all income, gain, or loss derived from Section 
863(b)(2) Sales is allocated and apportioned solely on the basis of the 
production activities with respect to the inventory.

[[Page 79847]]

    (c) Determination of the source of gross income from production 
activity--(1) Production only within the United States or only within 
foreign countries--(i) Source of income. For purposes of this section, 
production activity means an activity that creates, fabricates, 
manufactures, extracts, processes, cures, or ages inventory. See Sec.  
1.864-1. Whether a taxpayer's activities constitute production activity 
is determined under the principles of Sec.  1.954-3(a)(4) (except for 
Sec.  1.954-3(a)(4)(iv)). Subject to the provisions in Sec.  1.1502-13 
or paragraph (f)(2)(ii) of this section, the 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. Where 
the taxpayer's production assets are located only within the United 
States or only outside the United States, gross income is sourced where 
the taxpayer's production assets are located. For rules regarding the 
source of income when production assets are located both within the 
United States and without the United States, see paragraph (c)(2) of 
this section. For rules regarding the source of income when production 
takes place, in whole or in part, in space or international water, the 
rules of Sec.  1.863-8 apply, and the rules of this section do not 
apply except to the extent provided in Sec.  1.863-8.
    (ii) Definition of production assets. Subject to the provisions of 
Sec.  1.1502-13 and paragraph (f)(2)(ii) of this section, production 
assets include only tangible and intangible assets owned directly by 
the taxpayer that are directly used by the taxpayer to produce 
inventory described in paragraph (a) of this section. Production assets 
do not include assets that are not directly used to produce inventory 
described in paragraph (a) of this section. Thus, production assets do 
not include such assets as accounts receivables, intangibles not 
related to production of inventory (e.g., marketing intangibles, 
including trademarks and customer lists), transportation assets, 
warehouses, the inventory itself, raw materials, or work-in-process. In 
addition, production assets do not include cash or other liquid assets 
(including working capital), investment assets, prepaid expenses, or 
stock of a subsidiary.
    (iii) Location of production assets. For purposes of this section, 
a tangible production asset will be considered located where the asset 
is physically located. An intangible production asset will be 
considered located where the tangible production assets owned by the 
taxpayer to which it relates are located.
    (2) Production both within and without the United States--(i) 
Source of income. Where the taxpayer's production assets are located 
both within and without the United States, income from sources without 
the United States will be determined by multiplying the gross income by 
a fraction, the numerator of which is the average adjusted basis of 
production assets that are located outside the United States and the 
denominator of which is the average adjusted basis of all production 
assets within and without the United States. The remaining income is 
treated as from sources within the United States.
    (ii) Adjusted basis of production assets--(A) In general. For 
purposes of paragraph (c)(2)(i) of this section, the adjusted basis of 
an asset is determined by using the alternative depreciation system 
under section 168(g)(2). The adjusted basis of all production assets 
for purposes of paragraph (c)(2)(i) of this section is determined as 
though the production assets were subject to the alternative 
depreciation system set forth in section 168(g)(2) for the entire 
period that such property has been in service. The adjusted basis of 
the production assets is determined without regard to the election to 
expense certain depreciable assets under section 179 and without regard 
to any additional first-year depreciation provision (for example, 
section 168(k), (l), and (m), and former sections 1400L(b) and 
1400N(d)). The average adjusted basis of assets is computed by 
averaging the adjusted basis at the beginning and end of the taxable 
year, unless by reason of changes during the taxable year, as might be 
the case in the event of a major acquisition or disposition of assets, 
the average would materially distort the calculation in paragraph 
(c)(2)(i) of this section. In this event, the average adjusted basis is 
determined upon a more appropriate basis that is weighted to reasonably 
reflect the period for which the assets are held by the taxpayer during 
the taxable year.
    (B) Production assets used to produce other property. If a 
production asset is used to produce inventory sold in Section 863(b)(2) 
Sales and also used to produce other property during the taxable year, 
the portion of its adjusted basis that is included in the fraction 
described in paragraph (c)(2)(i) of this section will be determined 
under any method that reasonably reflects the portion of the asset that 
produces inventory sold in Section 863(b)(2) Sales. For example, the 
portion of such an asset that is included in the formula may be 
determined by multiplying the asset's average adjusted basis by a 
fraction, the numerator of which is the gross receipts from sales of 
inventory from Section 863(b)(2) Sales produced by the asset, and the 
denominator of which is the gross receipts from all property produced 
by that asset.
    (3) Anti-abuse rule. The purpose of paragraph (b) of this section 
and this paragraph (c) is to attribute the source of the taxpayer's 
gross income from certain sales of inventory property to the location 
of the taxpayer's production activity. Therefore, if the taxpayer has 
entered into or structured one or more transactions with a principal 
purpose of reducing its U.S. tax liability in a manner inconsistent 
with the purpose of paragraph (b) of this section or this paragraph 
(c), the Commissioner may make appropriate adjustments so that the 
source of the taxpayer's gross income more clearly reflects the 
location of production activity. For example, a taxpayer may be subject 
to the rule in this paragraph (c)(3) if domestic production assets are 
acquired by a related partnership (or a subsidiary of a related 
partnership) with a principal purpose of reducing its U.S. tax 
liability by claiming that the taxpayer's income from sales of 
inventory is subject to section 862(a)(6) rather than section 863(b).
    (4) Examples. The following examples illustrate the rules of this 
paragraph (c):
    (i) Example 1. Source of gross income--(A) Facts. A, a U.S. 
corporation, produces widgets that are sold both within the United 
States and within a foreign country. The initial manufacture of all 
widgets occurs in the United States. The second stage of production of 
widgets that are sold within a foreign country is completed within the 
country of sale. A's U.S. plant and machinery which is involved in the 
initial manufacture of the widgets has an average adjusted basis of 
$200, as determined using the alternative depreciation system under 
section 168(g)(2). A also owns warehouses used to store work-in-
process. A owns foreign equipment with an average adjusted basis of 
$25. A's gross receipts from all sales of widgets is $100, and its 
gross receipts from export sales of widgets is $25. Assume that 
apportioning average adjusted basis using gross receipts is reasonable. 
Assume A's cost of goods sold from the sale of widgets in the foreign 
countries is $13 and thus, its gross income from widgets sold in 
foreign countries is $12.
    (B) Analysis. A determines its gross income from sources without 
the United States by multiplying A's $12 of gross income from sales of 
widgets in foreign countries by a fraction, the numerator of which is 
all relevant foreign production

[[Page 79848]]

assets, or $25, and the denominator of which is all relevant production 
assets, or $75 ($25 foreign assets + ($200 U.S. assets x $25 gross 
receipts from export sales/$100 gross receipts from all sales)). 
Therefore, A's gross income from sources without the United States is 
$4 ($12 x ($25/$75)).
    (ii) Example 2. Location of intangible property. Assume the same 
facts as in paragraph (c)(4)(i)(A) of this section (the facts in 
Example 1), except that A employs a patented process that applies only 
to the initial production of widgets. In computing the formula used to 
determine the source of gross income, A's patent, if it has an average 
adjusted basis, would be located in the United States.
    (iii) Example 3. Anti-abuse rule--(A) Facts. Assume the same facts 
as in paragraph (c)(4)(i)(A) of this section (the facts in Example 1). 
A sells its U.S. assets to B, an unrelated U.S. corporation, with a 
principal purpose of reducing its U.S. tax liability by manipulating 
the property fraction. A then leases these assets from B. After this 
transaction, under the general rule of paragraph (c)(2) of this 
section, all of A's gross income would be considered from sources 
without the United States, because all of A's relevant production 
assets are located within a foreign country. Since the leased property 
is not owned by the taxpayer, it is not included in the fraction.
    (B) Analysis. Because A has entered into a transaction with a 
principal purpose of reducing its U.S. tax liability by manipulating 
the formula described in paragraph (c)(2)(i) of this section, A's 
income must be adjusted to more clearly reflect the source of that 
income. In this case, the Commissioner may redetermine the source of 
A's gross income by ignoring the sale-leaseback transactions.
    (d) Determination of source of taxable income. Once the source of 
gross income has been determined under paragraph (c) of this section, 
the taxpayer must properly allocate and apportion its expenses, losses, 
and other deductions to its respective amounts of gross income from 
sources within and without the United States from its Section 863(b)(2) 
Sales. See Sec. Sec.  1.861-8 through 1.861-14T and 1.861-17.
    (e) Income partly from sources within a possession of the United 
States--(1) In general. This paragraph (e) relates to certain sales 
that give rise to income, gain, or loss that is treated as derived 
partly from sources within the United States and partly from sources 
within a possession of the United States (Section 863 Possession 
Sales). This paragraph (e) applies to determine the source of income 
derived from the sale of inventory produced (in whole or in part) by a 
taxpayer within the United States and sold within a possession of the 
United States, or produced (in whole or in part) by a taxpayer in a 
possession of the United States and sold within the United States 
(collectively, Possession Production Sales). It also applies to 
determine the source of income derived from the purchase of personal 
property within a possession of the United States and its sale within 
the United States (Possession Purchase Sales). A taxpayer subject to 
this paragraph (e) must apportion gross income from Section 863 
Possession Sales under paragraph (e)(2) of this section (in the case of 
Possession Production Sales) or under paragraph (e)(3) of this section 
(in the case of Possession Purchase Sales). The source of taxable 
income from Section 863 Possession Sales is determined under paragraph 
(d) of this section.
    (2) Allocation or apportionment for Possession Production Sales. 
The source of gross income from Possession Production Sales is 
determined under the rules of paragraph (c) of this section, except 
that the term possession of the United States is substituted for 
foreign country wherever it appears.
    (3) Allocation or apportionment for Possession Purchase Sales--(i) 
Determination of source of gross income from Possession Purchase Sales. 
Gross income from Possession Purchase Sales is allocated in its 
entirety to the taxpayer's business activity, and is then apportioned 
between sources within the United States and sources within a 
possession of the United States under paragraph (e)(3)(ii) of this 
section.
    (ii) Determination of source of gross income from business 
activity--(A) Source of gross income. Gross income from the taxpayer's 
business activity is sourced in the possession in the same proportion 
that the amount of the taxpayer's business activity for the taxable 
year within the possession bears to the amount of the taxpayer's 
business activity for the taxable year both within the possession and 
outside the possession, with respect to Possession Purchase Sales. The 
remaining income is sourced in the United States.
    (B) Business activity. For purposes of this paragraph (e)(3)(ii), 
the taxpayer's business activity is equal to the sum of--
    (1) The amounts for the taxable period paid for wages, salaries, 
and other compensation of employees, and other expenses attributable to 
Possession Purchase Sales (other than amounts that are nondeductible 
under section 263A, interest, and research and development);
    (2) Cost of goods sold attributable to Possession Purchase Sales 
during the taxable period; and
    (3) Possession Purchase Sales for the taxable period.
    (C) Location of business activity. For purposes of determining the 
location of the taxpayer's business activity within a possession, the 
following rules apply:
    (1) Sales activity. Receipts from gross sales will be attributed to 
a possession in accordance with the principles of Sec.  1.861-7(c).
    (2) Cost of goods sold. Payments for cost of goods sold will be 
properly attributable to gross receipts from sources within the 
possession only to the extent that the property purchased was 
manufactured, produced, grown, or extracted in the possession (within 
the meaning of section 954(d)(1)(A)).
    (3) Expenses. Expenses will be attributed to a possession under the 
rules of Sec. Sec.  1.861-8 through 1.861-14T.
    (4) Examples. The following examples illustrate the rules of 
paragraph (e)(3)(ii) of this section relating to the determination of 
source of gross income from business activity:
    (i) Example 1. Purchase of goods manufactured in possession--(A) 
Facts. U.S. Co. purchases in a possession product X for $80 from A. A 
manufactures X in the possession. Without further production, U.S. Co. 
sells X in the United States for $100. Assume U.S. Co. has sales and 
administrative expenses in the possession of $10.
    (B) Analysis. To determine the source of U.S. Co.'s gross income, 
the $100 gross income from sales of X is allocated entirely to U.S. 
Co.'s business activity. Forty-seven dollars of U.S. Co.'s gross income 
is sourced in the possession. [Possession expenses ($10) plus 
possession purchases (i.e., cost of goods sold) ($80) plus possessions 
sales ($0), divided by total expenses ($10) plus total purchases ($80) 
plus total sales ($100).] The remaining $53 is sourced in the United 
States.
    (ii) Example 2. Purchase of goods manufactured outside possession--
(A) Facts. Assume the same facts as in paragraph (e)(4)(i)(A) of this 
section (the facts in Example 1), except that A manufactures X outside 
the possession.
    (B) Analysis. To determine the source of U.S. Co.'s gross income, 
the $100 gross income is allocated entirely to U.S. Co.'s business 
activity. Five dollars of U.S. Co.'s gross income is sourced in the 
possession. [Possession expenses ($10) plus possession purchases ($0) 
plus possession sales ($0), divided by total expenses ($10) plus total 
purchases ($80) plus total sales ($100).] The $80 purchase is not 
included in the

[[Page 79849]]

numerator used to determine U.S. Co.'s business activity in the 
possession, since product X was not manufactured in the possession. The 
remaining $95 is sourced in the United States.
    (5) Special rules for partnerships. In applying the rules of this 
paragraph (e) to transactions involving partners and partnerships, the 
rules of paragraph (f) of this section apply.
    (f) Special rules for partnerships--(1) General rule. For purposes 
of Sec.  1.863-1 and this section, a taxpayer's production activity 
does not include production activities conducted by a partnership of 
which the taxpayer is a partner either directly or through one or more 
partnerships, except as otherwise provided in paragraphs (c)(3) or 
(f)(2) of this section.
    (2) Exceptions--(i) In general. For purposes of determining the 
source of the partner's distributive share of partnership income or 
determining the source of the partner's income from the sale of 
inventory property which the partnership distributes to the partner in 
kind, the partner's production activity includes an activity conducted 
by the partnership. In addition, the production activity of a 
partnership includes the production activity of a taxpayer that is a 
partner either directly or through one or more partnerships, to the 
extent that the partner's production activity is related to inventory 
that the partner contributes to the partnership in a transaction 
described under section 721.
    (ii) Attribution of production assets to or from a partnership. A 
partner will be treated as owning its proportionate share of the 
partnership's production assets only to the extent that, under 
paragraph (f)(2)(i) of this section, the partner's activity includes 
production activity conducted through a partnership. A partner's share 
of partnership assets will be determined by reference to the partner's 
distributive share of partnership income for the year attributable to 
such production assets. Similarly, to the extent a partnership's 
activities include the production activities of a partner, the 
partnership will be treated as owning the partner's production assets 
related to the inventory that is contributed in kind to the 
partnership. See paragraph (c)(2)(ii) of this section for rules 
apportioning the basis of assets to Section 863 Sales.
    (iii) Basis. For purposes of this section, in those cases where the 
partner is treated as owning its proportionate share of the 
partnership's production assets, the partner's basis in production 
assets held through a partnership shall be determined by reference to 
the partnership's adjusted basis in its assets (including a partner's 
special basis adjustment, if any, under section 743). Similarly, a 
partnership's basis in a partner's production assets is determined with 
reference to the partner's adjusted basis in its assets.
    (3) Examples. The following examples illustrate the rules of this 
paragraph (f):
    (i) Example 1. Distributive share of partnership income. A, a U.S. 
corporation, forms a partnership in the United States with B, a country 
X corporation. A and B each have a 50 percent interest in the income, 
gains, losses, deductions and credits of the partnership. The 
partnership is engaged in the manufacture and sale of widgets. The 
widgets are manufactured in the partnership's plant located in the 
United States and are sold by the partnership outside the United 
States. The partnership owns the manufacturing facility and all other 
production assets used to produce the widgets. A's distributive share 
of partnership income includes 50 percent of the sales income from 
these sales. In applying the rules of section 863 to determine the 
source of its distributive share of partnership income from the export 
sales of widgets, A is treated as carrying on the activity of the 
partnership related to production of these widgets and as owning a 
proportionate share of the partnership's assets related to production 
of the widgets, based upon its distributive share of partnership 
income.
    (ii) Example 2. Distribution in kind. Assume the same facts as in 
paragraph (f)(3)(i) of this section (the facts in Example 1) except 
that the partnership, instead of selling the widgets, distributes the 
widgets to A and B. A then further processes the widgets and then sells 
them outside the United States. In determining the source of the income 
earned by A on the sales outside the United States, A is treated as 
conducting the activities of the partnership related to production of 
the distributed widgets. Thus, the source of gross income on the sale 
of the widgets is determined under section 863 and this section. In 
applying paragraph (c) of this section, A is treated as owning its 
proportionate share of the partnership's production assets based upon 
its distributive share of partnership income.
    (g) Applicability dates. This section applies to taxable years 
ending on or after December 23, 2019. However, a taxpayer may apply 
this section in its entirety for taxable years beginning after December 
31, 2017, and ending before December 23, 2019, provided that the 
taxpayer and all persons related to the taxpayer (within the meaning of 
section 267 or 707) apply this section and Sec. Sec.  1.863-1(b), 
1.863-2(b), 1.863-8(b)(3)(ii), 1.864-5(a) and (b), 1.864-6(c)(2), and 
1.865-3 in their entirety for the taxable year, and once applied, the 
taxpayer and all persons related to the taxpayer (within the meaning of 
section 267 or 707) continue to apply these regulations in their 
entirety for all subsequent taxable years. For regulations generally 
applicable to taxable years ending before December 23, 2019, see Sec.  
1.863-3 as contained in 26 CFR part 1 revised as of April 1, 2020.

0
Par. 7. Section 1.863-8 is amended as follows:
0
a. Revising paragraph (b)(3)(ii)(A).
0
b. In paragraph (b)(3)(ii)(B):
0
i. Removing ``income allocable to production activity'' wherever it 
appears and adding in its place ``gross income''.
0
ii. Removing ``Sec.  1.863-3(c)(1)'' from the second sentence and 
adding in its place ``Sec.  1.863-3(c)''.
0
c. In paragraph (b)(3)(ii)(C):
0
i. Removing ``allocable to production activity'' wherever it appears.
0
ii. Removing ``allocated to production activity'' from the fifth 
sentence.
0
iii. Removing ``Sec.  1.863-3(c)(1)'' from the fifth sentence and 
adding in its place ``Sec.  1.863-3(c)''.
0
d. Removing paragraph (b)(3)(ii)(D).
0
e. In paragraph (c), removing ``(b)(3)(ii)(C)'' from the first sentence 
and adding in its place ``(b)(3)(ii)''.
0
f. Designating Examples 1 through 14 of paragraph (f) as paragraphs 
(f)(1) through (14).
0
g. In newly designated paragraphs (f)(1) through (14), removing the 
period between the second and third level paragraph headings and adding 
an em-dash in its place.
0
h. Removing ``this Example 4'' from newly designated paragraph 
(f)(4)(i) wherever it appears and adding in its place ``paragraph 
(f)(4)(i) (Example 4)''.
0
i. Removing ``Example 4'' from newly designated paragraph (f)(5)(i) and 
adding in its place ``paragraph (f)(4)(i) of this section (the facts in 
Example 4)''.
0
j. Revising newly designated paragraph (f)(6)(ii).
0
k. Removing ``Example 8'' from newly designated paragraph (f)(9)(i) and 
adding in its place ``in paragraph (f)(8)(i) of this section (the facts 
in Example 8)''.
0
l. Removing ``Example 8'' from newly designated paragraph (f)(9)(ii) 
and adding in its place ``paragraph (f)(8)(ii) of this section (the 
analysis in Example 8)''.
0
m. Revising newly designated paragraph (f)(11)(ii).
0
n. In paragraph (g)(1), removing ``(b)(3)(ii)(C)'' from the first 
sentence and adding in its place ``(b)(3)(ii)''.

[[Page 79850]]

0
o. In paragraph (g)(4) introductory text, removing ``(b)(3)(ii)(C)'' 
from the first sentence and adding in its place ``(b)(3)(ii)''.
0
p. In paragraph (h), adding three sentences at the end of the 
paragraph.
    The revisions and additions read as follows:


Sec.  1.863-8   Source of income derived from space and ocean activity 
under section 863(d).

* * * * *
    (b) * * *
    (3) * * *
    (ii) Sales of property produced by the taxpayer--(A) General. If 
the taxpayer both produces property and sells such property and either 
the production (in whole or in part) or the sale takes place in space 
or international water, the taxpayer must allocate and apportion all 
income, gain, or loss derived from sales of such property solely on the 
basis of the production activities with respect to such property, and 
the source of that income will be determined under paragraph 
(b)(3)(ii)(B) or (C) of this section. To determine the source of income 
derived from the sale of personal property (including inventory) by a 
nonresident that is attributable to the nonresident's office or other 
fixed place of business in the United States under section 865(e)(2), 
the rules of Sec.  1.865-3 apply, and the rules of this section do not 
apply.
* * * * *
    (f) * * *
    (6) * * *
    (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, the source of the gross income from 
the sale of the data is determined under paragraph (b)(3)(ii) of this 
section solely on the basis of the production activities. The source of 
S's gross income is determined under paragraph (b)(3)(ii)(C) of this 
section because production activities occur both in space and on land.
* * * * *
    (11) * * *
    (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 Sec.  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 manufactured in the United States and 
sold in space is determined under paragraph (b)(3)(ii) of this section 
solely on the basis of the production activities with respect to the 
satellite.
* * * * *
    (h) * * * Paragraph (b)(3)(ii) of this section applies to taxable 
years ending on or after December 23, 2019. However, a taxpayer may 
apply paragraph (b)(3)(ii) of this section in its entirety for taxable 
years beginning after December 31, 2017, and ending before December 23, 
2019, provided that the taxpayer and all persons related to the 
taxpayer (within the meaning of section 267 or 707) apply paragraph 
(b)(3)(ii) of this section and Sec. Sec.  1.863-1(b), 1.863-2(b), 
1.863-3, 1.864-5(a) and (b), 1.864-6(c)(2), and 1.865-3 in their 
entirety for the taxable year, and once applied, the taxpayer and all 
persons related to the taxpayer (within the meaning of section 267 or 
707) continue to apply these regulations in their entirety for all 
subsequent taxable years. For regulations generally applicable to 
taxable years ending before December 23, 2019, see Sec.  1.863-8 as 
contained in 26 CFR part 1 revised as of April 1, 2020.

0
Par. 8. Section 1.864-5 is amended as follows:
0
a. Adding a sentence to the end of paragraph (a);
0
b. Revising the first sentence of paragraph (b) introductory text; and
0
c. Adding paragraph (e).
    The additions read as follows:


Sec.  1.864-5   Foreign source income effectively connected with U.S. 
business.

    (a) * * * To determine the source of income, gain or loss from the 
sale of personal property (including inventory property) attributable 
to an office or other fixed place of business in the United States by 
nonresidents, as defined in section 865(g)(1)(B), see Sec.  1.865-3.
    (b) * * * Income, gain, or loss from sources without the United 
States other than income described in paragraph (c) of this section or 
income from section 865(e)(2) sales, as defined in Sec.  1.865-3(c), 
shall be taken into account pursuant to paragraph (a) of this section 
in applying Sec. Sec.  1.864-6 and 1.864-7 only if it consists of--
* * * * *
    (e) Applicability dates. Paragraphs (a) and (b) of this section 
apply to taxable years ending on or after December 23, 2019. However, a 
taxpayer may apply paragraphs (a) and (b) of this section in their 
entirety for taxable years beginning after December 31, 2017, and 
ending before December 23, 2019, provided that the taxpayer and all 
persons related to the taxpayer (within the meaning of section 267 or 
707) apply paragraphs (a) and (b) of this section and Sec. Sec.  1.863-
1(b), 1.863-2(b), 1.863-3, 1.863-8(b)(3)(ii), 1.864-6(c)(2), and 1.865-
3 in their entirety for the taxable year, and once applied, the 
taxpayer and all persons related to the taxpayer (within the meaning of 
section 267 or 707) continue to apply these regulations in their 
entirety for all subsequent taxable years. For regulations generally 
applicable to taxable years ending before December 23, 2019, see Sec.  
1.864-5 as contained in 26 CFR part 1 revised as of April 1, 2020.

0
Par. 9. Section 1.864-6 is amended as follows:
0
a. Revising paragraph (c)(2).
0
b. Revising paragraph (c)(3).
0
c. Adding paragraph (c)(4).
    The revisions and additions read as follows:


Sec.  1.864-6   Income, gain, or loss attributable to an office or 
other fixed place of business in the United States.

* * * * *
    (c) * * *
    (2) Special limitation in case of sales of goods or merchandise 
through U.S. office. Notwithstanding paragraph (c)(1) of this section, 
the special rules described in this paragraph (c)(2) apply with respect 
to a sale of goods or merchandise specified in Sec.  1.864-5(b)(3), to 
which paragraph (b)(3)(i) of this section does not apply. In the case 
of a nonresident alien with a tax home within the United States, as 
defined in section 911(d)(3), the amount of income from the sale of 
goods or merchandise that is properly allocable to the individual's 
U.S. office is determined under Sec.  1.865-3(d).
    (3) Examples. The application of this paragraph (c) may be 
illustrated by the following examples--
    (i) Example 1. Sales of produced inventory through a U.S. sales 
office. Individual A, who is a nonresident alien within the meaning of 
section 7701(b)(1)(B) and has a tax home in the United States, 
manufactures machinery in a foreign country and sells the machinery 
outside the United States through A's sales office in the United States 
for use in foreign countries. A is not a nonresident within the meaning 
of section 865(g)(1)(B). Therefore, Sec.  1.865-3 does not apply to A's 
sale of the machinery, except to the extent provided in paragraph 
(c)(2) of this section. Title to the property sold is transferred to 
the foreign purchaser outside the United States, but no office or other 
fixed place of business of A in a foreign country materially 
participates in the sale made through A's U.S. office. By reason of its 
sales activities in the United States, A is engaged in business in the 
United States during the taxable year. During the taxable year, A 
derives a total income of $250,000x from these sales. Under paragraph 
(c)(2) of this

[[Page 79851]]

section, the amount of income that is allocable to A's U.S. office is 
determined under Sec.  1.865-3(d)(2). The taxpayer does not allocate 
income from the sale under the books and records method described in 
Sec.  1.865-3(d)(2)(ii). Thus, 50 percent of A's foreign source income 
of $250,000x, plus any additional income allocable based on the 
location of production activities under Sec. Sec.  1.865-3(d)(2)(i) and 
1.863-3 (in this case, $0x), is effectively connected for the taxable 
year with the conduct of A's U.S. trade or business, or $125,000x.
    (ii) Example 2. Sales of inventory purchased and resold through a 
U.S. sales office by a nonresident alien with a tax home in the United 
States. Individual B, who is a nonresident alien within the meaning of 
section 7701(b)(1)(B) and has a tax home in the United States, has an 
office in a foreign country that purchases merchandise and sells it 
through B's sales office in the United States for use in various 
foreign countries, with title to the property passing outside the 
United States. B is not a nonresident within the meaning of section 
865(g)(1)(B). Therefore, Sec.  1.865-3 does not apply to B's sale of 
the merchandise, except to the extent provided in paragraph (c)(2) of 
this section. No other office of B materially participates in these 
sales made through its U.S. office. By reason of its sales activities 
in the United States, B is engaged in business in the United States 
during the taxable year. During the taxable year, B derives income of 
$300,000x from these sales made through its U.S. sales office. All of 
B's income from these sales is foreign source as B purchases the 
merchandise outside the United States and title to the merchandise also 
passes outside the United States. The amount of income properly 
allocable to B's U.S. office determined under Sec.  1.865-3(d)(3) is 
$300,000x, and thus $300,000x is effectively connected for the taxable 
year with the conduct of B's U.S. trade or business.
    (iii) Example 3. Foreign sales office also materially participates 
in sale. The facts are the same as in paragraph (c)(3)(ii) of this 
section (the facts in Example 2), except that B also has an office in a 
foreign country that is a material factor in the realization of income 
from the sales made through B's U.S. office. No income from the sale of 
merchandise is allocable to B's U.S. sales office for the taxable year, 
by reason of paragraph (b)(3)(i) of this section, and thus none of the 
$300,000x is effectively connected for the taxable year with the 
conduct of B's U.S. trade or business.
    (iv) Example 4. Sales of inventory purchased and resold through a 
U.S. sales office by a foreign corporation. The facts are the same as 
in paragraph (c)(3)(ii) of this section (the facts in Example 2), 
except that B is a foreign corporation. B is a nonresident within the 
meaning of section 865(g)(1)(B). The income from such sales will be 
sourced in accordance with Sec.  1.865-3(a) and (d)(3).
    (4) Applicability date. Paragraph (c)(2) of this section applies to 
taxable years ending on or after December 23, 2019. However, a taxpayer 
may apply paragraph (c)(2) of this section in its entirety for taxable 
years beginning after December 31, 2017, and ending before December 23, 
2019, provided that the taxpayer and all persons related to the 
taxpayer (within the meaning of section 267 or 707) apply paragraph 
(c)(2) of this section and Sec. Sec.  1.863-1(b), 1.863-2(b), 1.863-3, 
1.863-8(b)(3)(ii), 1.864-5(a) and (b), and 1.865-3 in their entirety 
for the taxable year, and once applied, the taxpayer and all persons 
related to the taxpayer (within the meaning of section 267 or 707) 
continue to apply these regulations in their entirety for all 
subsequent taxable years. For regulations generally applicable to 
taxable years ending before December 23, 2019, see Sec.  1.864-6 as 
contained in 26 CFR part 1 revised as of April 1, 2020.

0
Par. 10. Section 1.865-3 is added to read as follows:


Sec.  1.865-3   Source of gross income from sales of personal property 
(including inventory property) by a nonresident attributable to an 
office or other fixed place of business in the United States.

    (a) In general. Notwithstanding any provision of section 861 
through 865 or other regulations in this part, this section provides 
the sole sourcing rules for gross income, gain, or loss from section 
865(e)(2) sales. Gross income, gain, or loss from a section 865(e)(2) 
sale is U.S. source income to the extent that the gross income, gain, 
or loss is properly allocable to an office or other fixed place of 
business in the United States under paragraph (d) of this section.
    (b) Exception for certain inventory sales for use, disposition or 
consumption outside the United States. A section 865(e)(2) sale does 
not include any sale of inventory property that is sold for use, 
disposition, or consumption outside the United States if an office or 
other fixed place of business of the nonresident in a foreign country 
materially participates in the sale. See Sec.  1.864-6(b)(3) to 
determine whether a foreign office materially participates in the sale 
and whether the property was destined for foreign use.
    (c) Section 865(e)(2) sales. For purposes of this section, a 
``section 865(e)(2) sale'' is a sale of personal property by a 
nonresident, including inventory property, other than a sale described 
in paragraph (b) of this section, that is attributable to an office or 
other fixed place of business in the United States under the principles 
of section 864(c)(5)(B) as prescribed in Sec.  1.864-6(b)(1) and (2). 
In determining whether a nonresident maintains an office or other fixed 
place of business in the United States, the principles of section 
864(c)(5)(A) as prescribed in Sec.  1.864-7 apply, including the rules 
of paragraph (d) of that section regarding the office or other fixed 
place of business of a dependent agent of the nonresident. For purposes 
of this section, ``inventory property'' has the meaning provided in 
section 865(i)(1), and ``nonresident'' has the meaning provided in 
section 865(g)(1)(B).
    (d) Amount of gross income, gain, or loss on sale of personal 
property properly allocable to a U.S. office--(1) In general. Except as 
otherwise provided in paragraphs (d)(2) through (4) of this section, 
the amount of gross income, gain, or loss from a section 865(e)(2) sale 
that is properly allocable to an office or other fixed place of 
business in the United States is determined under the principles of 
Sec.  1.864-6(c)(1).
    (2) Produced inventory property. Gross income, gain, or loss from a 
section 865(e)(2) sale of inventory property that is produced by the 
nonresident seller is properly allocable to an office or other fixed 
place of business in the United States or to production activities in 
accordance with the ``50/50 method'' described in paragraph (d)(2)(i) 
of this section. However, in lieu of the 50/50 method, the nonresident 
seller may elect to allocate the gross income, gain, or loss under the 
``books and records method'' described in paragraph (d)(2)(ii)(A) of 
this section, provided that the nonresident satisfies all of the 
requirements described in paragraph (d)(2)(ii)(B) of this section to 
the satisfaction of the Commissioner. Gross income allocable to 
production activities under this paragraph (d)(2) is sourced in 
accordance with Sec.  1.863-3. For purposes of this paragraph (d)(2), 
the term ``produced'' includes created, fabricated, manufactured, 
extracted, processed, cured, and aged, as determined under the 
principles of Sec.  1.954-3(a)(4) (except for Sec.  1.954-3(a)(4)(iv)). 
See section 864(a) and Sec.  1.864-1.

[[Page 79852]]

    (i) The 50/50 method. Fifty percent of the gross income, gain, or 
loss from a section 865(e)(2) sale of inventory property that is 
produced by the nonresident seller is properly allocable to an office 
or other fixed place of business in the United States, and the 
remaining 50 percent of the gross income, gain, or loss is properly 
allocable to production activities (the ``50/50 method'').
    (ii) Books and records method--(A) Method. Subject to paragraph 
(d)(2)(ii)(B) of this section, a nonresident may elect to determine the 
amount of its gross income, gain, or loss from the sale of inventory 
property produced by the nonresident seller that is properly allocable 
to production activities and sales activities for the taxable year 
based upon its books of account (the ``books and records method''). The 
gross income, gain, or loss allocable to sales activities under this 
method is treated as properly allocable to an office or other fixed 
place of business in the United States and the remaining gross income, 
gain, or loss is treated as properly allocable to production 
activities.
    (B) Election and reporting rules--(1) In general. A nonresident may 
not make the election described in paragraph (d)(2)(ii)(A) of this 
section unless the requirements of paragraphs (d)(2)(ii)(B)(2) through 
(4) of this section are satisfied. Once the election is made, the 
nonresident must continue to satisfy the requirements of paragraphs 
(d)(2)(ii)(B)(2) through (4) of this section until the election is 
revoked. If the nonresident fails to satisfy the requirements in 
paragraphs (d)(2)(ii)(B)(2) through (4) of this section to the 
satisfaction of the Commissioner, the Commissioner may, in its sole 
discretion, apply the 50/50 method described in paragraph (d)(2)(i) of 
this section.
    (2) Books of account. The nonresident must establish that it, in 
good faith and unaffected by considerations of tax liability, regularly 
employs in its books of account a detailed allocation of receipts and 
expenditures that, under the principles of section 482, clearly 
reflects both the amount of the nonresident's gross income, gain, or 
loss from its inventory sales that are attributable to its sales 
activities, and the amount of its gross income, gain, or loss from its 
inventory sales that are attributable to its production activities. For 
purposes of this paragraph (d)(2)(ii)(B)(2), section 482 principles 
apply as if the office or other fixed place of business in the United 
States were a separate organization, trade, or business (and, thus, a 
separate controlled taxpayer) from the nonresident (whether or not 
payments are made between the United States office or other fixed place 
of business and the nonresident's other offices, and whether or not the 
nonresident itself would otherwise constitute an organization, trade, 
or business).
    (3) Required records. The nonresident must prepare and maintain the 
records described in paragraph (d)(2)(ii)(B)(2) of this section, which 
must be in existence when its return is filed. The nonresident must 
also prepare an explanation of how the allocation clearly reflects the 
nonresident's gross income, gain, or loss from production and sales 
activities under the principles of section 482. The nonresident must 
make available the explanation and records of the nonresident 
(including for the office or other fixed place of business in the 
United States and the offices or branches that perform the production 
activities) upon request of the Commissioner, within 30 days, unless 
some other period is agreed upon between the Commissioner and the 
nonresident.
    (4) Making and revoking the books and records method election; 
disclosure of election. Except as otherwise provided in publications, 
forms, instructions, or other guidance, a nonresident makes or revokes 
the election to apply the books and records method by attaching a 
statement to its original timely filed Federal income tax return 
(including extensions) providing that it elects, or revokes the 
election, to apply the books and records method described in paragraph 
(d)(2)(ii)(A) of this section. For nonresidents making the election, 
the statement must provide that the nonresident has prepared the 
records described in paragraph (d)(2)(ii)(B)(2) and (3) of this 
section.
    (5) Limitation on revoking the books and records method election. 
Once made, the books and records method election continues until 
revoked. An election cannot be revoked, without the consent of the 
Commissioner, for any taxable year beginning within 48 months of the 
last day of the taxable year for which the election was made.
    (3) Purchased inventory property. All gross income, gain, or loss 
from a section 865(e)(2) sale of inventory property that is both 
purchased and sold by a nonresident is properly allocable to an office 
or other fixed place of business in the United States.
    (4) Depreciable personal property. Gain from a section 865(e)(2) 
sale of depreciable personal property (as defined in section 865(c)(4)) 
is allocated under paragraphs (d)(4)(i) and (ii) of this section.
    (i) The gain not in excess of the depreciation adjustments, if any, 
is properly allocable to an office or other fixed place of business in 
the United States to the same extent that the gain would be allocated 
to sources within the United States under the rules of section 
865(c)(1). The remaining gain not in excess of the depreciation 
adjustments, if any, is allocated to sources without the United States 
in accordance with section 865(c)(1). However, notwithstanding the 
preceding sentences, if the property was predominantly used in the 
United States, within the meaning of section 865(c)(3)(B)(i), for a 
particular taxable year, all of the gain not in excess of depreciation 
for that year is properly allocable to the office or other fixed place 
of business in the United States.
    (ii) The gain in excess of the depreciation adjustments, if any, is 
treated as if such gain was from the sale of inventory and the amount 
allocable to an office or fixed place of business in the United States 
is determined under paragraph (d)(2) or (3) of this section, as 
applicable.
    (e) Determination of source of taxable income. For rules allocating 
and apportioning expenses to gross income effectively connected with 
the conduct of a trade or business of a foreign corporation in the 
United States (including gross income, gain, or loss sourced under this 
section), see section 882(c)(1). For rules allocating and apportioning 
expenses to gross income, gain, or loss effectively connected with the 
conduct of a trade or business of a nonresident alien in the United 
States (including gross income, gain, or loss sourced under this 
section), see section 873(a).
    (f) Export trade corporations. This section does not apply for 
purposes of defining an export trade corporation under section 971(a).
    (g) Applicability date. This section applies to taxable years 
ending on or after December 23, 2019. However, a nonresident may apply 
this section in its entirety for taxable years beginning after December 
31, 2017, and ending before December 23, 2019, provided that the 
nonresident and all persons related to the nonresident (within the 
meaning of section 267 or 707) apply this section and Sec. Sec.  1.863-
1(b), 1.863-2(b), 1.863-3, 1.863-8(b)(3)(ii), 1.864-5(a) and (b), and 
1.864-6(c)(2) in their entirety for the taxable year, and once applied, 
the nonresident and all persons related to the nonresident (within the 
meaning of section 267 or 707) continue to apply these regulations in 
their entirety for all subsequent taxable years.

[[Page 79853]]

Sec.  1.937-2   [Amended]

0
Par. 11. In Sec.  1.937-2 amend paragraph (d) by removing ``Sec.  
1.863-3(f)'' and adding in its place ``Sec.  1.863-3(e)''.


Sec.  1.937-3   [Amended]

0
Par. 12. In Sec.  1.937-3 amend paragraph (d) by removing ``Sec.  
1.863-3(f)'' and adding in its place ``Sec.  1.863-3(e)''.

0
Par. 13. Section 1.1502-13 is amended by revising paragraph 
(c)(7)(ii)(N) to read as follows:


Sec.  1.1502-13   Intercompany transactions.

* * * * *
    (c) * * *
    (7) * * *
    (ii) * * *
    (N) Example (14): Source of income under section 863--(1) 
Intercompany sale--(i) Facts. S manufactures inventory property solely 
in the United States and recognizes $75x of income on sales to B in 
Year 1. B conducts further production activity on the inventory 
property solely in Country Y and then sells the inventory property to X 
in Country Y and recognizes $25x of income on the sale to X, also in 
Year 1. Title passes from S to B, and from B to X, in Country Y. Assume 
that applying Sec.  1.863-3 on a single entity basis, including the 
formula for apportionment of multi-country production activities by 
reference to the basis of production assets, $10x would be treated as 
foreign source income and $90x would be treated as U.S. source income 
(that is, 10 percent of the production occurred outside the United 
States and 90 percent occurred within the United States, as measured by 
the basis of assets used in production activities with respect to the 
property). Assume further that, on a separate entity basis, S would 
have $0x of foreign source income and $75x of U.S. source income and 
all of B's $25x of income would be foreign source income.
    (ii) Analysis. Under the matching rule, both S's $75x intercompany 
item and B's $25x corresponding item are taken into account in Year 1. 
In determining the source of S and B's income from the inventory 
property sales, the attributes of S's intercompany item and B's 
corresponding item are redetermined to the extent necessary to produce 
the same effect on consolidated taxable income (and consolidated tax 
liability) as if S and B were divisions of a single corporation. See 
paragraph (c)(1)(i) of this section. On a single entity basis, S and B 
would have $10x that would be treated as foreign source income and $90x 
that would be treated as U.S. source income, but without application of 
this section (that is, on a separate entity basis), S would have $75x 
of U.S. source income and B would have $25x of foreign source income. 
Under paragraph (c)(4)(ii) of this section, a redetermined attribute 
must be allocated between S and B using a reasonable method. On a 
separate entity basis B would have only foreign source income and S 
would have only U.S. source income. Accordingly, under paragraph 
(c)(1)(i) of this section, $15x of B's $25x sales income that would be 
treated as foreign source income on a separate entity basis is 
redetermined to be U.S. source income.
    (2) Sale of property reflecting intercompany services or 
intangibles--(i) Facts. S earns $10x of income performing services in 
the United States for B. B capitalizes S's fees into the basis of 
inventory property that it manufactures in the United States and sells 
to an unrelated person in Year 1 at a $90x profit, with title passing 
in Country Y. Assume that on a single entity basis, $100x is treated as 
U.S. source income and $0x is treated as foreign source income. Further 
assume that on a separate entity basis, S would have $10x of U.S. 
source income, and B would have $90x of U.S. source income, with 
neither having any foreign source income.
    (ii) Analysis. Under the matching rule, S's $10x income and B's 
$90x income are taken into account in Year 1. In determining the source 
of S and B's income, the attributes of S's intercompany item and B's 
corresponding item are redetermined to the extent necessary to produce 
the same effect on consolidated taxable income (and consolidated tax 
liability) as if S and B were divisions of a single corporation. 
Because the results are the same on a single entity basis and a 
separate entity basis ($100x of U.S. source income and $0x of foreign 
source income), the attributes are not redetermined under paragraph 
(c)(1)(i) of this section.

Sunita Lough,
Deputy Commissioner for Services and Enforcement.
    Approved: September 21, 2020.
David J. Kautter,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2020-21817 Filed 12-10-20; 8:45 am]
BILLING CODE 4830-01-P