Section 863(d)(2)(A)(i) defines space activity to include any activity conducted in space. Section 863(d)(2)(A)(ii) defines ocean activity to include any activity conducted on or under water not within the jurisdiction (as recognized by the United States) of a foreign country, possession of the United States, or the United States. Section 863(d)(2)(B) excludes three specific types of activities from the definition of space or ocean activity. Section 863(d)(1) generally provides that, except as provided in regulations, any income derived from a space or ocean activity (space and ocean income) is U.S. source income if derived by a U.S. person and foreign source income if derived by a foreign person.

Pursuant to the statute’s grant of regulatory authority, the reproposed regulations provide that a U.S. person’s space and ocean income will be sourced outside the United States to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in a foreign country or countries. This approach to allocation of space and ocean income between U.S. and foreign sources is pursuant to broad regulatory authority in section 863(d). The reproposed regulations also contain certain exceptions to the general foreign source rule for space and ocean income of foreign persons.

Section 1.863-8(b)(2) of the 2001 proposed regulations provides that if U.S. persons own 50 percent or more of a foreign corporation by vote or value (directly, indirectly, or constructively) and such corporation is not a controlled foreign corporation within the meaning of section 957 (CFC), all space and ocean income derived by the corporation (hereinafter a U.S.-owned foreign corporation) is U.S. source income.

Several commentators requested that §1.863-8(b)(2) of the 2001 proposed regulations be withdrawn. Commentators stated that the rule expanded the scope of U.S. taxing jurisdiction beyond the apparent intent of Congress by subjecting income not covered by subpart F to immediate U.S. taxation. Several commentators also stated that under the rule space and ocean income could in some cases be subject to multiple levels of taxation. In this regard, some commentators noted that the space and ocean income of a U.S.-owned foreign corporation could be subject to potential double taxation at the corporate level (by the United States and by the U.S.-owned foreign corporation’s country of residence or the countries where such corporation does business) because §1.863-8(b)(2) of the 2001 proposed regulations makes such space and ocean income U.S. source. When the U.S.-owned foreign corporation’s space and ocean income is distributed as a dividend, that income could be subject to an additional level of tax in the hands of its shareholders. Consequently, some commentators suggested that, if the rule were retained, the space and ocean income of U.S.-owned foreign corporations should be considered U.S. source solely for purposes of the U.S. shareholder’s foreign tax credit limitation under section 904(a). Some commentators noted that although section 245 may partially ameliorate this situation by providing a dividends received deduction (DRD) to shareholders of foreign corporations in certain circumstances, the DRD would be limited to 80 percent of qualifying dividends.

Some commentators also noted potential withholding tax issues with the source rules for U.S.-owned foreign corporations. In such cases, U.S. source fixed or determinable annual or periodic income (FDAP) of a U.S.-owned foreign corporation would (in the absence of an applicable treaty) likely be subject to the 30-percent gross income tax imposed by section 881, which is typically collected through withholding by the payors of such income. Commentators stated that enforcement and administration of the 30-percent tax and withholding requirements could present multiple challenges (and potential multiple withholding tax obligations) for payments between foreign persons.

Several commentators addressed the stock ownership test applicable to U.S.-owned foreign corporations. They stated that determining whether a foreign corporation is 50-percent U.S.-owned, especially without regard to the size of an owner’s holding, presents potential difficulties (for example, when the foreign corporation is widely-held). Some commentators stated that the indirect and constructive ownership rules are complex and would make it difficult for payors of space and ocean income to determine withholding tax obligations. Some commentators suggested that if the rule were retained, the determination whether a foreign corporation is 50-percent U.S.-owned should be similar to the determination of CFC status, that is, only U.S. persons who own or are considered to own 10 percent or more of the total combined voting power of all classes of stock entitled to vote should be counted. Some commentators stated that the rule should not apply to publicly-traded foreign corporations.

In light of the potential complexity in determining whether a foreign corporation is a U.S.-owned foreign corporation and the belief of the Treasury Department and the IRS that space and ocean income earned by foreign corporations should be sourced in accord with the rules for foreign persons, with the limited exception for certain CFCs discussed below, the reproposed regulations do not include a special source rule for space and ocean income earned by a U.S.-owned foreign corporation. Instead, the space and ocean income of foreign corporations (other than CFCs) is sourced under the applicable provisions of reproposed §1.863-8(b)(2)(i) or (iii). Under these provisions, space and ocean income of a foreign person is generally foreign source income. Space and ocean income of a foreign person (other than a CFC) that is engaged in trade or business within the United States is U.S. source income to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed within the United States.

In enacting section 863(d), Congress ultimately did not adopt a provision included in early versions of the legislation that would have treated a CFC as a U.S. person for purposes of determining the source of a CFC’s space and ocean income. The legislative history to the 1986 Act indicates that Congress at that time viewed the provision as unnecessary because “[t]he application of the separate foreign tax credit limitation for shipping income to any space or ocean income derived by a [CFC] provides adequate assurance, in the conferee’s view, that high foreign taxes on unrelated income will not inappropriately offset U.S. taxes on this generally low-taxed income.” H.R. Conf. Rep. No. 99-841, 99^th Cong., 2d Sess., Vol. II, at II-600 (Sept. 18, 1986); see also Staff of Joint Comm. on Taxation, General Explanation of the Tax Reform Act of 1986, JCS-10-87, at 934 (May 4, 1987). Consequently, the 2001 proposed regulations also did not contain such a rule and only treated a U.S.-owned foreign corporation as a U.S. person for purposes of determining the source of space and ocean income.

In 2004, AJCA enacted a number of significant statutory changes to subpart F and the foreign tax credit regimes as applicable to space and ocean income. These statutory changes have been taken into account in issuing the reproposed regulations.

Section 415 of AJCA eliminated foreign base company shipping income from the definition of foreign base company income. This change is effective for taxable years of foreign corporations beginning after December 31, 2004, and for taxable years with or within which such taxable years of foreign corporations end. Prior to AJCA, foreign base company shipping income was defined by section 954(f) to include any income derived from a space or ocean activity as defined in section 863(d)(2).

In addition, section 404 of AJCA reduced the number of foreign tax credit limitation categories from nine to two (i.e., passive category income and general category income) in order to address Congressional concerns regarding the complexity of the foreign tax credit calculation. See H.R. Rep. No 108-548, 108^th Cong., 2d Sess., at 190 (June 16, 2004). This change is effective for taxable years beginning after December 31, 2006. Prior to AJCA, section 904(d) treated shipping income, defined as income “which would be foreign base company shipping income (as defined in section 954(f)),” as a separate category of income for foreign tax credit limitation purposes. For taxable years beginning after December 31, 2006, space and ocean income will generally fall into the general limitation category. See H.R. Conf. Rep. No. 108-755, 108^th Cong., 2d Sess., at 383 (Oct. 7, 2004).

The Treasury Department and the IRS believe that the changes made by AJCA with respect to the foreign tax credit reflect a decision to reduce the complexity in the foreign tax credit calculation caused by having nine foreign tax credit categories of income as well as a willingness to allow additional cross-crediting in order to minimize such complexity. However, the Treasury Department and the IRS also believe that for taxable years beginning after December 31, 2006, Congress’s concern expressed in the 1986 Act that high foreign taxes on unrelated income may inappropriately offset U.S. taxes on space and ocean income, which is generally subject to low foreign taxes, is no longer addressed by the foreign tax credit rules because space and ocean income likely will be general limitation category income. In addition, Congress provided a broad grant of regulatory authority to the Treasury Department and the IRS in section 863(d) to issue guidance with respect to the source of space and ocean income.

In light of AJCA, the reproposed regulations provide that if a foreign corporation is a CFC, its space and ocean income, like that of a U.S. person, is income from sources within the United States. However, a CFC’s space and ocean income is sourced outside the United States to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in a foreign country or countries. This allocation approach is pursuant to broad regulatory authority under section 863(d).

As noted above, several commentators stated that under the rule for U.S.-owned foreign corporations in the 2001 proposed regulations, space and ocean income could in some cases be subject to multiple levels of taxation. The Treasury Department and the IRS believe that the reproposed regulations mitigate such a possibility for CFCs because the reproposed regulations provide for foreign sourcing when a CFC’s space and ocean income is attributable to functions performed, resources employed, or risks assumed in a foreign country or countries. The rule for CFCs in the reproposed regulations is thus a rule of limited application that, consistent with the legislative history of the 1986 Act, provides U.S. source treatment only with respect to space and ocean income attributable to activities in space or international water that are not likely to be subject to tax in any foreign country. The rule for CFCs will permit a United States shareholder to establish as foreign source the amount of income attributable to the CFC’s operations in a foreign country or countries.

Several commentators submitted comments on potential withholding tax issues posed by the 2001 proposed regulations. The Treasury Department and the IRS recognize that certain provisions of the reproposed regulations (such as the source rule for the space and ocean income of CFCs in reproposed §1.863-8(b)(2)(ii)) may raise similar withholding tax issues. The Treasury Department and the IRS accordingly seek comments on these issues, in particular with regard to the following: (1) the extent to which Form W-8ECI, “Certificate of Foreign Person’s Claim for Exemption From Withholding on Income Effectively Connected With the Conduct of a Trade or Business in the United States”, may practically address these issues; (2) the nature of situations in which withholding tax issues will arise (for example, how particular businesses involving space, ocean, or communications activities are conducted, whether payors of income potentially subject to withholding under the reproposed regulations are typically related or unrelated parties, etc.); and (3) suggestions to address these issues in the cases in which they arise.

Section 1.863-3(b)(3) of the 2001 proposed regulations provides that if a foreign person is engaged in a trade or business within the United States, the foreign person’s income derived from a space or ocean activity is presumed to be U.S. source income. The rule reflects the general view of the Treasury Department and the IRS that Congress intended that a foreign person engaged in a substantial business within the United States be subject to U.S. tax on related space or ocean income. However, the Treasury Department and the IRS recognize that the presumption may be over-inclusive in certain cases. Therefore, the 2001 proposed regulations provide that if the foreign person can allocate gross space or ocean income between income from sources within the United States, space, or international water, and sources without the United States, space, and international water, to the satisfaction of the Commissioner, based on all the facts and circumstances, income allocated to sources without the United States, space, and international water will be treated as foreign source income.

Several commentators stated that the presumption is overbroad, given that it applies to all space and ocean income regardless of any nexus with the foreign corporation’s U.S. trade or business. Several commentators suggested that if the presumption were retained, objective standards consistent with existing rules for effectively connected income should be included to ensure that the space and ocean income has a meaningful connection with the foreign corporation’s U.S. trade or business. In the absence of objective standards, commentators stated that taxpayers should be permitted to apply a reasonable allocation method on a consistent basis to all of their space and ocean income. In addition, as with §1.863-8(b)(2) of the 2001 proposed regulations, several commentators stated that under §1.863-8(b)(3) of the 2001 proposed regulations space and ocean income could in some cases be subject to multiple levels of taxation.

In response to these comments, the reproposed regulations provide that if a foreign person, other than a CFC, is engaged in a trade or business within the United States, its space or ocean income is from sources within the United States to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed within the United States.

The Treasury Department and the IRS believe that the revision in reproposed §1.863-8(b)(2)(iii) providing that space or ocean income will be U.S. source income to the extent the space or ocean income is attributable to functions performed, resources employed, or risks assumed in the United States should mitigate commentators’ concerns about potential multiple levels of taxation.

Examples 12 and 13 in §1.863-8(f) of the 2001 proposed regulations illustrate the application of §1.863-8(b)(3) of those regulations to foreign persons that conduct certain activities in the United States. One commentator noted that these examples appear to state that engaging in certain activities would constitute the conduct of a trade or business in the United States. In response to this comment, Examples 12 and 13 have been clarified in the reproposed regulations to state that they assume, on the facts of the example, that the activities constitute the conduct of a trade or business within the United States within the meaning of section 864(b). The Treasury Department and the IRS intend that the determination whether a foreign person is engaged in a trade or business in the United States continue to be made under general section 864(b) principles.

The 2001 proposed regulations provide generally that taxpayers must apply the rules of section 863(d) and the 2001 proposed regulations to determine the source of income from sales of property purchased or produced by the taxpayer, either when production occurs in whole or in part in space or international water, or when the sale occurs in space or international water. Under the 2001 proposed regulations, income from sales of inventory property (within the meaning of section 1221(a)(1)) on international water is sourced under §1.863-3(c)(2). Section 1.863-3(c)(2), as amended by the 2001 proposed regulations, provides that the place of sale will be presumed to be the United States when property is produced in the United States and the property is sold to a U.S. resident for use in space or international water; in such cases, the property will be treated as sold for use, consumption, or disposition in the United States.

Section 1.863-8(d)(1)(i) of the 2001 proposed regulations defines space activity to include the sale of property in space. Section 1.863-8(d)(1)(ii) of the 2001 proposed regulations defines ocean activity to include the sale of property in international water, but not the sale of inventory property on international water. Under §1.863-8(d)(2)(iii) of the 2001 proposed regulations, a sale occurs in space or international water if the property is located in space or international water at the time the rights, title, and interest of the seller in the property are transferred to the purchaser, or if the property is sold for use in space or international water.

For sales in space or international water of property produced by the taxpayer, §1.863-8(b)(4)(ii)(A) of the 2001 proposed regulations generally provides that the source of income attributable to sales activity is determined under §1.863-8(b)(1), (2), or (3) of the 2001 proposed regulations. If, however, the taxpayer sells such property outside space and international water, the source of income attributable to sales activity is determined under §1.863-3(c)(2).

Commentators stated that the inclusion of sales of inventory property in space or international water in the definitions of space and ocean activity is inconsistent with the legislative history of the 1986 Act, which indicates that the Senate Committee on Finance did not intend sales of inventory property on the high seas to be considered space or ocean activity. See S. Rep. No. 99-313, at 359.

In response to comments, the reproposed regulations provide that sales of inventory property in space or international water will be considered space or ocean activity only if the inventory property is sold for use, consumption, or disposition in space or international water. In such cases, the source of income will be determined under the source rules provided for space and ocean income by the reproposed regulations. The source of income from sales in space or international water of inventory property when the inventory property is sold for use, consumption, or disposition outside space and international water will be determined under §§1.861-7(c) and 1.863-3(c)(2). The Treasury Department and the IRS believe that sales of property in space or international water — with the exception of sales of inventory property in space or international water for use, consumption, or disposition outside space or international water — should be considered space or ocean activity, and that the source of income from such sales should be determined under section 863(d). The Treasury Department and the IRS believe that this result is consistent with both the statute and the legislative history. The statute provides that space or ocean activity includes any activity in space or international water. However, the Senate Report states that the Senate Committee on Finance did not intend to override the general source rule in §1.861-7(c) for sales of property on the high seas. See S. Rep. No. 99-313, at 359. Thus, sales of inventory property in transit between the United States and a foreign country will continue to be sourced under sections 861 through 865, and not section 863(d).

The reproposed regulations do not contain the presumption in §1.863-3(c)(2) of the 2001 proposed regulations regarding sales of property produced by the taxpayer in the United States to U.S. residents for use in space or international water. Under the reproposed regulations, if such sales occur in space or international water, the source of income attributable to sales activity will be determined under reproposed §1.863-8(b)(3)(ii)(D).

Section 1.863-8(b)(5) of the 2001 proposed regulations provides that income derived from the performance of services in space or international water is sourced under §1.863-8(b)(1), (2), or (3) of the 2001 proposed regulations, as applicable. Section 1.863-8(d)(2)(ii)(A) of the 2001 proposed regulations contains a general rule providing that the performance of a service is a space or ocean activity in its entirety when a part of the service, even if de minimis, is performed in space or international water.

The Treasury Department and the IRS recognized that this rule could be over-inclusive in certain cases. Therefore, §1.863-8(d)(2)(ii)(A) of the 2001 proposed regulations provides a facilitation exception, under which a service will not be treated as either space or ocean activity if the taxpayer’s only activity in space or international water is to facilitate the taxpayer’s own communications as part of the provision or delivery of a service provided by the taxpayer, and the service would not otherwise be a space or ocean activity. Section 1.863-8(b)(5) of the 2001 proposed regulations also provides that if the taxpayer can allocate, to the satisfaction of the Commissioner, gross income from the services transaction between performance occurring outside space and international water, and performance occurring in space or international water, the source of income allocated to performance occurring outside space and international water will be determined under sections 861, 862, 863, and 865.

Several commentators commented unfavorably on a rule that characterizes an entire services transaction as space or ocean activity when only de minimis performance occurs in space or international water. Several commentators noted that even though §1.863-8(b)(5) of the 2001 proposed regulations permits a taxpayer to source services income to sources outside space or international water, the entire transaction continues to be characterized as space or ocean activity, and all income derived from the services transaction is thus included in the separate subpart F and foreign tax credit limitation category for shipping income. Some commentators stated that under the 2001 proposed regulations significant consequences result from characterization as a services transaction, even though the characterization rules are themselves unclear. Some commentators also stated that the facilitation exception to space or ocean activity characterization is confusing, and that the example intended to illustrate the application of the facilitation exception (Example 4 in §1.863-8(f) of the 2001 proposed regulations) is itself unclear.

As noted above, subsequent to the publication of the 2001 proposed regulations, AJCA amended the subpart F rules relating to space and ocean income by eliminating shipping income as a category of subpart F income and reduced the number of foreign tax credit limitation categories from nine to two (with space and ocean income generally falling into the general limitation category) for taxable years beginning after December 31, 2006. The Treasury Department and the IRS believe that these statutory changes should allay commentators’ concerns regarding the characterization of a services transaction as space or ocean activity. In addition, as discussed below, the reproposed regulations provide that if the taxpayer can demonstrate the value of the service attributable to performance in space or international water and the value of the service attributable to performance outside space and international water, then the service will be treated as a space or ocean activity only to the extent of the activity performed in space or international water. The value of the service is attributable to performance occurring in space or international water to the extent the performance of services, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in space or international water.

Based on the comments, the reproposed regulations eliminate the facilitation exception. Under reproposed §1.863-8(d)(2)(ii), to the extent, based on all the facts and circumstances, the value of the service attributable to functions performed, resources employed, or risks assumed in space or international water is de minimis, such service is not treated as space or ocean activity. The adoption of the de minimis rule is intended to address taxpayer concerns about potential confusion in qualifying for the facilitation exception. Example 4 of reproposed §1.863-8(f) has been revised accordingly.

The rule for determining the source of income from performance of services that occur in part in space or international water and in part outside space and international water has been adapted to conform to the changes made to reproposed §1.863-8(d)(2)(ii). To the extent a service is characterized as space or ocean activity under reproposed §1.863-8(d)(2)(ii), the source of gross income derived from such transaction is determined under reproposed §1.863-8(b)(1) or (2), as applicable, as provided by reproposed §1.863-8(b)(4). Accordingly, to the extent the value of the service, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed outside space and international water, the service will not constitute space or ocean activity, and, to that extent, the source of income from the service will be determined under section 861, 862, or 863, as applicable.

Section 1.863-8(b)(6) of the 2001 proposed regulations provides that space and ocean activity include communications activity (but not international communications activity) occurring in space or international water. Foreign communications activity is thus characterized under the 2001 proposed regulations as space or ocean activity when, for example, part of the transmission is via satellite or via underwater cable located in international water.

Commentators requested that the regulations characterize income from foreign-to-foreign communications as international communications income, which is specifically excluded from the definition of space and ocean activity by section 863(d)(2)(B) and §1.863-8(d)(3) of the 2001 proposed regulations, but retain the 100 percent foreign source rule otherwise provided for foreign communications income by §1.863-9(b)(4) of the 2001 proposed regulations. International communications income is defined by section 863(e)(2) as income derived from the transmission of communications between the United States and a foreign country (or possession of the United States) and is discussed in greater detail below.

Commentators noted that this rule puts telecommunications companies using satellite or underwater cable methods of transmission at a competitive disadvantage vis-à-vis competitors in foreign marketplaces that use solely land-based facilities. For example, if a CFC were paid to transmit a telephone call between two foreign countries and used a land line connecting the two countries to transmit the call, the CFC’s income from the transmission would be included in the general limitation category for foreign tax credit purposes. If the communication were transmitted using fiber optic cable located in international water or a satellite, the CFC’s income from the transmission would be foreign source space or ocean income included in the separate subpart F and foreign tax credit limitation category for shipping income.

The reproposed regulations do not characterize income from foreign-to-foreign communications as international communications income as suggested by commentators. Section 863(d)(2)(A) broadly defines space and ocean activity as any activity conducted in space or international water. The statutory exception to space and ocean activity in section 863(d)(2)(B) removes only activities giving rise to international communications income from the scope of space and ocean activity. In addition, if foreign-to-foreign communications income were characterized as international communications income, U.S. persons with such income would be subject to the statutory source rule in section 863(e)(1)(A), which provides for the split-sourcing of a U.S. person’s international communications income. The Treasury Department and the IRS thus consider the language of the statute to preclude the approach suggested by commentators with respect to the characterization and sourcing of income from foreign-to-foreign communications. The legislative history of the 1986 Act also indicates that Congress intended income from foreign-to-foreign communications to be foreign source income. See  S. Rep. No. 99-313, at 359, “Finally, if the communication is between two foreign locations, the committee intends income attributable thereto to be foreign source.” This would not be the result, however, if foreign-to-foreign communications income were included in the definition of international communications income and thus subject to the statute’s 50/50 source rule for U.S. persons.

In addition, as noted above, AJCA made significant changes to subpart F and the foreign tax credit regime as applicable to space and ocean income. The Treasury Department and the IRS believe that these statutory changes should allay commentators’ concerns regarding the characterization of foreign-to-foreign communications as space or ocean activity.

The Treasury Department and the IRS believe that the modifications in the reproposed regulations with respect to the characterization of services involving space or ocean activities address some of the commentators’ concerns regarding the characterization of foreign-to-foreign communications activities involving services performed both in space or international water and in foreign countries. Reproposed §1.863-8(d)(2)(ii) provides that a transaction characterized as the performance of a service will be treated as a space or ocean activity only to the extent the value of the service, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in space or international water.

Section 1.863-8(d)(1)(i) of the 2001 proposed regulations defines space as any area not within the jurisdiction (as recognized by the United States) of a foreign country, possession of the United States, or the United States, and not in international water. Under the 2001 proposed regulations, space comprises the entire area outside the jurisdiction of any country or U.S. possession, extending from just above the surface of international water (and Antarctica) through, and beyond, the earth’s atmosphere. Space thus includes international airspace.

Several commentators stated that the definition of space should be limited to the area beyond the earth’s atmosphere. One commentator proposed a definition of space that conforms to a definition used for non-tax purposes (for example, beyond the maximum altitude at which powered flight by aircraft equipped with air-breathing engines is possible). Another commentator stated that the definition of space could be read to include cyberspace, the electronic medium in which online communication takes place, and suggested that cyberspace be specifically excluded from the definition of space. One commentator noted language in the legislative history stating that space activities had not been very prevalent at the time of the 1986 Act (see, for example, S. Rep. No. 99-313, at 358) and argued that Congress did not intend to include international airspace in space.

No changes were made to the reproposed regulations in response to these comments. The Treasury Department and the IRS believe a broad definition of space that includes international airspace is consistent with legislative intent to assert primary tax jurisdiction over income earned by U.S. residents that is not within any foreign country’s taxing jurisdiction. See, e.g., S. Rep. No. 99-313, at 357. The Treasury Department and the IRS also believe that providing guidance with respect to the place of performance of activities involving online communications is beyond the scope of the present regulations, and that taxpayers should rely on generally applicable principles to determine where functions are performed, resources are employed, or risks are assumed in a specific online transaction.

Certain activities occurring in space or international water are not considered either space or ocean activity. Section 1.863-8(d)(3)(i) of the 2001 proposed regulations, consistent with section 863(d), provides that space or ocean activity does not include any activity that gives rise to transportation income as defined in section 863(c).

One commentator stated that a portion of a bareboat charter — the return of an empty vessel that has unloaded its cargo (backhaul) — may potentially be considered ocean activity under the 2001 proposed regulations. Another commentator stated that income from container leasing by a party other than the ship operator could constitute space or ocean income, and could be subject to withholding tax. One commentator also suggested that the regulations should state that they do not apply to the income of foreign corporations derived from the international operation of ships, or to container leasing.

The reproposed regulations do not adopt changes to reflect these comments. The reproposed regulations reflect the broad statutory definition of ocean activity in section 863(d)(2) as “any activity conducted on or under water not within the jurisdiction (as recognized by the United States) of a foreign country, possession of the United States, or the United States.” The Treasury Department and the IRS do not consider it appropriate to construe the definition of section 863(c) transportation income in the context of these regulations. The Treasury Department and the IRS will consider addressing the definition of section 863(c) transportation income in separate guidance.

Section 1.863-8(e) of the 2001 proposed regulations generally provides that section 863(d) and the regulations thereunder will be applied to domestic partnerships at the partnership level and to foreign partnerships at the partner level. Commentators suggested that the source rules of §1.863-8 of the 2001 proposed regulations be applied to all partnerships either at the entity level or at the partner level.

The Treasury Department and the IRS believe that section 863(d) should be applied to domestic and foreign partnerships in the same manner. Accordingly, the reproposed regulations do not provide a different rule for foreign partnerships and domestic partnerships. Section 1.863-8(e) of the reproposed regulations provides that section 863(d) and the regulations thereunder will be applied to domestic partnerships at the partner level. In order to conform the treatment of domestic and foreign partnerships, no change was made with respect to the rule in the 2001 proposed regulations that section 863(d) and the regulations thereunder will be applied to foreign partnerships at the partner level.

When a taxpayer must allocate gross income to the satisfaction of the Commissioner, based on all the facts and circumstances, under the provisions of the 2001 proposed regulations, the Treasury Department and the IRS believe such allocations generally should be based on section 482 principles.

Several commentators stated that allocation of gross income based on section 482 principles will be burdensome and expensive and will create uncertainty. Commentators also noted that the 2001 proposed regulations provide no guidance on allocating income other than a facts and circumstances approach.

The Treasury Department and the IRS consider the allocation of gross income based on the general guidance of section 482 to be an approach that is well-suited to application in the wide variety of factual contexts within the scope of the reproposed regulations. The Treasury Department and the IRS solicit comments on alternative methods of allocation for particular industries and criteria that could be used to evaluate the reasonableness of such methods.

In order to satisfy the Commissioner with respect to a taxpayer’s allocation of gross income under §1.863-8(b)(3), (b)(4)(ii)(C), or (b)(5) of the 2001 proposed regulations, the taxpayer must make the allocation on a timely filed original return (including extensions). An amended return does not qualify for this purpose, and section 9100 relief will not be available. In all cases, a taxpayer must also maintain contemporaneous documentation regarding the allocation of gross income, allocation and apportionment of expenses, losses, and other deductions, the methodologies used, and the circumstances justifying use of those methodologies. The taxpayer must produce such documentation within 30 days upon request.

Commentators stated that neither the statute nor the legislative history provides a basis for the reporting, recordkeeping, and contemporaneous documentation requirements in the 2001 proposed regulations. Commentators also noted that the Code and regulations do not contain similar requirements with respect to certain other expense allocation provisions.

The reproposed regulations generally retain the recordkeeping and documentation requirements. The Treasury Department and the IRS believe that it is appropriate to require taxpayers to keep proper records, and additionally note the potentially considerable difficulties the IRS would face in performing the allocations required by the reproposed regulations without appropriate taxpayer records.

The Treasury Department and the IRS recognize, however, that taxpayers may not have all the information necessary to make allocations at the time a return is originally filed. The reproposed regulations therefore provide that a taxpayer may make changes to allocations made on the taxpayer’s original return with respect to any taxable year for which the statute of limitations has not closed, subject to certain conditions. Nonetheless, changes to such allocations that are not made until an audit of the taxable year to which the allocations relate has commenced, or a taxpayer’s failure timely to provide documentation and other information supporting the allocations, create administrative difficulties for the IRS. Accordingly, reproposed §1.863-8(g)(4) sets forth the actions required of taxpayers and the procedures the IRS will follow in the case of taxpayers that change their allocations.

The reproposed regulations also require taxpayers, upon request, to provide access to the software programs and other systems used by the taxpayer to make allocations under these regulations. For this purpose, software has the meaning provided in section 7612(d). The Treasury Department and the IRS believe that the IRS could face significant administrative and other difficulties in the examination of allocations made under these regulations without access to such software.

Certain examples in §1.863-8(f) of the 2001 proposed regulations contain statements regarding the characterization of certain activities (as, for example, the lease of equipment or the performance of services). One commentator suggested that the examples clarify that the character of the transactions at issue is only assumed for purposes of the specific example. In response to this comment, the examples in reproposed §1.863-8(f) have been revised to make clear that the characterization of certain transactions is assumed based on the facts of the specific example. The Treasury Department and the IRS did not consider it necessary to modify certain other examples (for example, Example 1 of reproposed §1.863-8(f)) in which the character of the transaction at issue should be clear under the facts presented.

In addition, Examples 2, 3, 4, and 7 of reproposed §1.863-8(f), have been revised to reflect substantive changes made to reproposed §1.863-8(b)(4) and (d)(2)(ii) with respect to services that involve activities performed in space or international water.

International communications income is defined by section 863(e)(2) as income derived from the transmission of communications between the United States and a foreign country (or possession of the United States). Section 863(e)(1)(A) provides that in the case of any U.S. person, 50 percent of any international communications income will be sourced in the United States and 50 percent of such income will be sourced outside the United States. Section 863(e)(1)(B)(i) provides that any international communications income of a foreign person will be foreign source income except as provided in regulations or in section 863(e)(1)(B)(ii). Section 1.863-9(b)(2)(ii)(A) of the 2001 proposed regulations states the general rule that international communications income of a foreign person is foreign source income. However, the 2001 proposed regulations contain certain exceptions to the general rule.

The first exception, in §1.863-9(b)(2)(ii)(B) of the 2001 proposed regulations, provides that if U.S. persons own 50 percent or more of a foreign corporation by vote or value (directly, indirectly, or constructively), including a CFC within the meaning of section 957, international communications income derived by that corporation is entirely U.S. source income.

As with the similar rule provided for the space and ocean income of U.S.-owned foreign corporations in §1.863-8(b)(2) of the 2001 proposed regulations, several commentators requested that the rule be withdrawn because it expands the scope of U.S. taxing jurisdiction beyond the apparent intent of Congress. Commentators stated that the rule is punitive in nature because it is less favorable than the 50/50 source rule applied to international communications income earned directly by U.S. persons. As with §1.863-8(b)(2) and (3) of the 2001 proposed regulations, commentators also stated that under the rule the international communications income of certain foreign corporations may be subject to multiple levels of taxation.

Commentators noted that in certain circumstances international communications income could be subject to the 30-percent gross income tax imposed by section 881, which is typically collected through withholding by the payors of such income. Commentators stated that although most tax treaties should prevent the imposition of the 30-percent tax (international communications income would likely be characterized as business profits under most treaties and would accordingly be exempt from U.S. taxation unless attributable to a permanent establishment in the United States), the rule in the 2001 proposed regulations would result in disparate treatment for corporations from treaty countries vis-à-vis corporations from non-treaty countries. The requirement to withhold the 30-percent tax could also create numerous administrative and enforcement difficulties. In addition, given the extent of resale of capacity between telecommunications providers, commentators noted that payments relating to the same transmission could be subject to multiple withholding. Finally, as with the similar rule provided for the space and ocean income of U.S.-owned foreign corporations in §1.863-8(b)(2) of the 2001 proposed regulations, commentators raised the issue of potential difficulties in determining whether a foreign corporation is 50-percent or more U.S.-owned.

As noted above, several commentators addressed the stock ownership test applicable to U.S.-owned foreign corporations. They stated that determining whether a foreign corporation is 50-percent U.S. owned, especially without regard to the size of an owner’s holding, presents potential difficulties (for example, when the foreign corporation is widely-held).

In light of the potential complexity in determining whether a foreign corporation is a U.S.-owned foreign corporation and the belief of the Treasury Department and the IRS that international communications income earned by foreign corporations should be sourced in accord with the rules for foreign persons, with the limited exception for CFCs discussed below, the reproposed regulations do not include a special source rule for international communications income earned by a 50 percent or more U.S.-owned foreign corporation. Instead, the international communications income of foreign corporations (other than CFCs) is sourced under the applicable provisions of reproposed §1.863-9(b)(2)(i), (iii), and (iv).

In light of the comments with respect to CFCs described above, the reproposed regulations provide that in the case of a CFC, 50 percent of any international communications income will be sourced in the United States and 50 percent of such income will be sourced outside the United States. The 100-percent U.S. source rule is eliminated. Consequently, the source rule for international communications income in the hands of a CFC is the same rule that applies to U.S. persons. In both cases, the source rules take into account that international communications activities must have both a U.S. and a foreign connection (i.e., one endpoint in the United States and the other in a foreign country or possession of the United States). The Treasury Department and the IRS believe that the revision of the source rule for CFCs deriving international communications income should mitigate commentators’ concerns about potential multiple levels of taxation because 50 percent of this income is foreign source.

The Treasury Department and the IRS recognize that this and other provisions of reproposed §1.863-9 may raise withholding tax issues similar to those discussed above in connection with the source rule for the space and ocean income of CFCs (in reproposed §1.863-8(b)(2)(ii)). As noted above, the Treasury Department and the IRS seek comments on these issues and practical suggestions to address them in the specific factual contexts in which they may arise.

Section 863(e)(1)(B)(ii) and §1.863-9(b)(2)(ii)(C) of the 2001 proposed regulations provide that international communications income derived by a foreign person that is attributable to an office or other fixed place of business in the United States is from sources within the United States. Section 864 and the regulations thereunder provide guidance in determining “income ... attributable to an office or other fixed place of business” in specific contexts. However, the Treasury Department and the IRS believe that, for purposes of section 863(e), international communications income should be attributed to an office or fixed place of business based on functions performed, resources employed, and risks assumed. Therefore, pursuant to the regulatory authority in section 863(e)(1)(B)(i), the reproposed regulations provide that, for purposes of this section, income is attributable to an office or other fixed place of business in the United States to the extent of functions performed, resources employed, or risks assumed by the office or other fixed place of business.

The second exception to §1.863-9(b)(2)(ii)(A) of the 2001 proposed regulations is contained in §1.863-9(b)(2)(ii)(D), which provides that if a foreign person (other than a 50 percent or more U.S.-owned foreign corporation described in §1.863-9(b)(2)(ii)(B) of the 2001 proposed regulations) is engaged in a trade or business within the United States, the foreign person’s international communications income is presumed to be U.S. source income. However, if the foreign person can allocate its international communications income between sources within the United States, space, and international water and sources outside the United States, space, and international water to the satisfaction of the Commissioner, based on all the facts and circumstances, which may include functions performed, resources employed, or risks assumed, then the income allocated to sources outside the United States, space, and international water will be foreign source income.

Several commentators stated that the presumption is overbroad because it applies to all international communications income regardless of any nexus with the foreign corporation’s U.S. trade or business. These commentators claimed that the presumption is inconsistent with U.S. tax policy and international norms that require a connection between the income and the foreign person’s activities in the United States before U.S. taxing jurisdiction is exercised.

In response to comments, the reproposed regulations provide that if a foreign person, other than a CFC, is engaged in a trade or business within the United States, gross income derived by that person from international communications activity is from sources within the United States to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed within the United States. This rule is similar to the rule in the reproposed regulations under section 863(d) for foreign persons engaged in a trade or business within the United States. There is no longer a presumption of U.S. source income.

The Treasury Department and the IRS believe that the provision in the reproposed regulations that such a foreign person’s international communications income is U.S. source only to the extent attributable to functions performed, resources employed, or risks assumed in the United States addresses taxpayers’ concerns regarding a nexus between the foreign person’s international communications income and its business activities in the United States.

Several commentators objected to the rule that international communications income could be foreign source income only to the extent that the foreign person could allocate international communications income to activity occurring in a foreign country. Because the reproposed regulations provide for U.S. sourcing only to the extent that the foreign person’s international communications income is attributable to functions performed, resources employed, or risks assumed in the United States, this concern should be mitigated.

Several commentators stated that section 863(e) makes international communications income that is attributable to a U.S. office U.S. source income, and that the regulations should not adopt a broader U.S. trade or business rule. Section 863(e)(1)(B)(ii) provides that if a foreign person has a fixed place of business in the United States, international communications income attributable to such fixed place of business is U.S. source income. The Treasury Department and the IRS have not made changes to the reproposed regulations in response to these comments. Section 863(e)(1)(B)(i) by its terms gives the Secretary broad authority to source international communications income of a foreign person as U.S. source income. The Treasury Department and the IRS believe that it is appropriate to exercise that authority in this case. The trade or business rule reflects the concern of the Treasury Department and the IRS that a foreign person could avoid a U.S. fixed place of business under section 863(e)(1)(B)(ii), yet engage in significant communications activity in the United States. The Treasury Department and the IRS believe that Congress intended that a foreign person engaged in substantial business in the United States be subject to U.S. tax on that communications activity.

Income derived from communications activity is defined in §1.863-9(d)(2) of the 2001 proposed regulations as income derived from the transmission of communications, including income derived from the provision of capacity to transmit communications. There is no requirement that the recipient of communications income perform the transmission function itself. This rule reflects the understanding of the Treasury Department and the IRS that providers of communications services often use capacity owned or operated by others. However, income is derived from communications activity only if the taxpayer is paid to transmit, and bears the risk of transmitting, the communications.

Section 1.863-9(d)(3) of the 2001 proposed regulations provides rules for characterizing income derived from a communications activity for purposes of sourcing the income derived from such activity. The character of income derived from communications activity is determined by establishing the two points between which the taxpayer is paid to transmit, and bears the risk of transmitting, the communication (the paid-to-do rule). Under the paid-to-do rule, the path the communication takes between the two points is not relevant in determining the character of the transmission. If a taxpayer is paid to take a communication from one point to another point, income derived from the transmission is characterized based on the transmission between those two points, even if the taxpayer contracts out part of the transmission to another party. This rule reflects the recognition by the Treasury Department and the IRS, as noted above, that providers of communications services often use capacity owned or operated by others.

When the taxpayer cannot establish the two points between which the taxpayer is paid to transmit the communication, §1.863-9(b)(6) of the 2001 proposed regulations provides a default source rule, under which all income from the communications activity, whether derived by a U.S. person or a foreign person, is deemed to be from sources within the United States. Thus, for example, when a provider of communications services provides both local and international long distance services in one-price bundles for a set amount each month and tracing each transmission is not possible or practical, the income derived from the communications activity is U.S. source income. The Treasury Department and the IRS understand that many taxpayers in the communications industry may consider it impractical or impossible to prove the endpoints of the communications they transmit. The Treasury Department and the IRS accordingly solicited comments as to proposals for those situations when taxpayers cannot establish the points between which the taxpayer is paid to transmit the communication.

One commentator stated that the phrase “bears the risk of transmitting,” contained in §1.863-9(d)(2) and (d)(3)(i) of the 2001 proposed regulations, is ambiguous and does not meaningfully improve the determination of when income is derived from communications activity. This commentator noted that the nature of the risk a taxpayer must bear to be treated as deriving communications income was unclear, and that the determination of risk would pose administrative difficulties given the complexity of business models and structures. No change was made to the reproposed regulations in response to this comment. The Treasury Department and the IRS believe that, in determining whether a taxpayer derives communications income, risk is more important than the mere fact of payment. The Treasury Department and the IRS thus believe that a taxpayer should not be considered to derive communications income unless the taxpayer bears the economic risk of nonpayment with respect to the transmission of communications or the provision of capacity to transmit communications.

Commentators stated that the paid-to-do rule is overbroad because it asserts primary U.S. taxing jurisdiction over certain communications income regardless of any nexus between the income and the United States. Commentators also noted that when certain taxpayers cannot establish the two points between which they are paid to transmit a communication, the income from such communications activity may be subject to potential double taxation at the corporate level (for example, a foreign corporation could be subject to tax on such communications income in both the United States and in the foreign corporation’s country of residence or incorporation or countries where it does business).

Commentators stated that the paid-to-do rule places undue burdens on taxpayers who want to obtain the benefit of foreign source income characterization. Commentators noted that, in many cases, it may be impractical or technologically impossible to track the origination and termination points of an individual transmission, and that development of the required technology, software, and other systems would require significant capital investments. Maintenance of the records needed to substantiate proper income sourcing could also be onerous for those taxpayers who perform extremely large numbers of transmissions. Commentators thus requested that the regulations provide assurance that reasonable methods of proof, consistent with industry practice and consistently applied, would be accepted in establishing the points of origin and/or destination of a communication.

Commentators submitted suggested modifications to the paid-to-do rule. One commentator suggested that the paid-to-do rule be modified to characterize all income from a communication based on the two endpoints between which the transmission is made. Under this commentator’s suggested rule, whether a particular taxpayer itself carried out all, or only a portion, of the transmission would be irrelevant, and the characterization of the communication would be the same for all taxpayers involved in the transmission. One commentator suggested that the paid-to-do rule be applied on a single entity basis for United States corporations that join in the filing of a consolidated U.S. income tax return.

Commentators also suggested reasonable method approaches to determine the endpoints between which a taxpayer is paid to transmit communications (for example, based on technical characteristics of the communication or contractual terms, or on a per transaction, per customer, or aggregate basis). One commentator suggested factors that could be taken into account in determining whether a particular method is reasonable, including the reliability of the method chosen, the degree to which the method is in line with generally accepted industry practices and norms, and the extent to which the method takes into account all the information available to the taxpayer.

Commentators suggested that the U.S. source default rule for income from communications for which the endpoints of transmission cannot be identified should only apply to foreign taxpayers that directly own or operate communications facilities, or otherwise directly hold rights to communications capacity, in the United States; when a foreign taxpayer does not own or otherwise have rights to telecommunications capacity in the United States, income from such communications would thus be foreign source. Other commentators suggested that income from communications for which the endpoints of transmission cannot be identified be treated in the same manner as international communications income, with a 100-percent U.S. source exception provided for telecommunications service providers who are paid to transmit communications that are substantially all between multiple points located within the United States.

The Treasury Department and the IRS continue to believe that communications activity is most appropriately characterized based on the two points between which the taxpayer is paid to transmit, and bears the risk of transmitting, the communication. The Treasury Department and the IRS consider the endpoint-based source rule in the reproposed regulations to be an approach that best matches the source of communications income to the location where functions are performed, resources are employed, or risks are assumed in a taxpayer’s communications transaction. Moreover, although commentators noted potential difficulties in identifying the endpoints of a communication, the industry-specific comments received in response to the 2001 proposed regulations generally focused on recordkeeping burdens. Taxpayers have much better access to the relevant information regarding the facts and circumstances of their communications transactions than the IRS. The Treasury Department and the IRS accordingly solicit comments on the challenges to identifying the endpoints of communications in specific industries or situations, as well as suggestions for rules that are responsive to these particular challenges. The Treasury Department and the IRS also again solicit comments on methods to identify the endpoints of a communication that may be reasonable for particular industries, as well as criteria that may be appropriate to evaluate the reasonableness of such methods.

Section 1.863-9(d)(1)(ii) of the 2001 proposed regulations provides that, to the extent a taxpayer’s transaction consists in part of non-de minimis communications activities and in part of non-de minimis non-communications activities, such parts of the transaction must be treated as separate transactions. Section 1.863-9(d)(1)(ii) of the 2001 proposed regulations then provides that gross income derived from the activities must be allocated to each separate transaction, to the satisfaction of the Commissioner, based on all the facts and circumstances, which may include functions performed, resources employed, or risks assumed in the respective transactions.

One commentator suggested that the regulations be clarified to provide that a content company (for example, the creator of a television or radio program) that does not possess or operate communications equipment or itself perform any communications function is not engaged in communications activities. This commentator did not believe that communication activities should be attributed to a content provider and stated that delivery of a content provider’s programming by a third party should not change the character of the content provider’s income to communications income.

No changes were made to the reproposed regulations in response to this comment. The Treasury Department and the IRS believe that the transmission of any communications, including content, is appropriately considered a communications activity. The Treasury Department and the IRS also believe that when a content provider is paid to transmit, and bears the risk of transmitting, content to a customer, the content provider should be considered to derive communications income. Under reproposed §1.863-9(h)(1)(ii), as under the 2001 proposed regulations, the content provider will derive communications income only to the extent of the gross income allocated to the separate transaction involving the communications activity. The Treasury Department and the IRS believe that it is appropriate for a content provider to derive communications income when communications activities make more than a de minimis contribution to the value of the content provider’s overall transaction with its customer.

Section 1.863-9(e)(1) of the 2001 proposed regulations generally provides that section 863(e) and the regulations thereunder will be applied to domestic partnerships at the partnership level. Section 1.863-9(e)(1) of the 2001 proposed regulations also provides that section 863(e) and the regulations thereunder will be applied at the partner level to foreign partnerships. Section 1.863-9(e)(2) of the 2001 proposed regulations similarly provides that section 863(e) and the regulations thereunder will be applied at the partner level to domestic partnerships in which 50 percent or more of the partnership interests are owned by foreign persons.

One commentator stated that §1.863-9(e)(2) of the 2001 proposed regulations conflicts with sections 863(e)(1)(A) (which provides that the international communications income of any United States person shall be 50-percent U.S. source and 50-percent foreign source) and 7701(a)(3) (which defines United States person to include a domestic partnership). According to this commentator, the rule potentially discriminates against foreign partners in a domestic partnership owned 50 percent or more by foreign partners vis-à-vis the U.S. partners in such a partnership. For example, the international communications income of a foreign partner could be 100-percent U.S. source under §1.863-9(b)(2)(ii)(B) or (C) of the 2001 proposed regulations, whereas the international communications income of a U.S. partner would be 50-percent U.S. source and 50-percent foreign source, creating the potential for double taxation of the foreign partner. Another commentator stated that §1.863-9(e)(1) of the 2001 proposed regulations could result in the double taxation of the U.S. partners of foreign partnerships. This commentator noted that the international communications income of a foreign partnership could be subject to tax in the country in which the foreign partnership is organized. Under §1.863-9(e) of the 2001 proposed regulations, a U.S. partner’s share of such international communications income would be subject to the 50/50 source rule in §1.863-9(b)(2)(i) of the 2001 proposed regulations. As a result, the U.S. partner may be unable to credit its proportionate share of tax paid in the foreign country. Commentators suggested that the source rules of §1.863-9 of the 2001 proposed regulations be applied to all partnerships at the entity level.

As is the case for reproposed §1.863-8(e) with respect to section 863(d), the Treasury Department and the IRS believe that section 863(e) should be applied to domestic and foreign partnerships in the same manner. Accordingly, the reproposed regulations do not provide a different rule for foreign partnerships and domestic partnerships. Section 1.863-9(i) of the reproposed regulations provides that the regulations will be applied at the partner level for all partnerships.

When a taxpayer must allocate gross income to the satisfaction of the Commissioner, based on all the facts and circumstances, under §1.863-9(b)(2)(ii)(D) or (d)(1)(ii) of the 2001 proposed regulations, the Treasury Department and the IRS believe that such allocations should be based generally on section 482 principles