For Tax Professionals  
T.D. 8782 September 24, 1998

Source Rules for Foreign Sales Corporation Transfer Pricing

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 TD 8782 RIN 1545-AV90

TITLE: Source Rules for Foreign Sales Corporation Transfer Pricing

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations that provide
guidance to taxpayers who have made an election to be treated as a
foreign sales corporation (FSC). The regulations clarify that the
special source rule under section 927(e)(1) applies only to income
of related suppliers from sales of export property giving rise to
foreign trading gross receipts of a FSC.

DATES: Effective date. These regulations are effective March 3,
1998.

Applicability date. These regulations apply to taxable years
beginning after December 31, 1997.

FOR FURTHER INFORMATION CONTACT: Elizabeth Beck (202) 874-1490 (not
a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains amendments to the Income Tax Regulations (26
CFR part 1) under section 927 which was added by the Deficit
Reduction Act of 1984, applicable for taxable years of foreign sales
corporations beginning after December 31, 1984.

Temporary regulations (TD 8126) were published in the Federal
Register (52 FR 6468) on March 3, 1987. These temporary regulations
were amended by temporary regulations published in the Federal
Register (63 FR 10305) as a Treasury decision (TD 8764) on March 3,
1998. On the same date, a notice of proposed rulemaking cross-
referencing TD 8764 was published in the Federal Register (63 FR
10351). The proposed rule proposed changes to the grouping and
source rules for foreign sales corporation transfer pricing.
Comments responding to this notice were received. On June 24, 1998,
a public hearing was held limited to the proposed changes to the
grouping rules, since no hearing was requested with respect to the
source rule. After consideration of all comments received, the
proposed regulations regarding the source rule are adopted as
revised by this Treasury decision.

Explanation of Provisions A. Current Temporary Regulations.

Section 927(e)(1) provides that "under regulations, the income of a
person described in section 482 from a transaction giving rise to
foreign trading gross receipts of a FSC which is treated as from
sources outside the United States shall not exceed the amount which
would be treated as foreign source income earned by such person if
the pricing rule under section 994 which corresponds to the rule
used under section 925 with respect to such transaction applied to
such transaction." Transactions giving rise to foreign trading gross
receipts include qualifying sales, leases, licenses and services.
Because TD 8126 could be interpreted to apply the special foreign
source limit only to sales of export property, 1.927(e)-1T was
amended by TD 8764 to clarify that the regulation applies to any
transaction giving rise to foreign trading gross receipts of a FSC,
including but not limited to sales, leases, licenses and services.
TD 8764 also made conforming changes, added special rules and gave
examples regarding the special source rule.

B. Discussion of Comments No comments were received on the special
rules added in proposed 1.927(e)-1(a)(3)(ii). These rules clarify
how the corresponding DISC transfer pricing rules are to be applied
for purposes of the foreign source limit and are generally taxpayer
favorable. No comments were received on Examples (1) and (3) set
forth in proposed 1.927(e)-1(b). These examples illustrate how the
limit is applied under different transfer pricing methods for sales
transactions.

Comments received did suggest that the rule distinguish between the
foreign source income limitation applicable to sales and the
limitation applicable to other transactions giving rise to foreign
trading gross receipts. In light of these comments, Treasury and the
IRS believe that additional consideration should be given to the
appropriate scope of the special source rule of section 927(e)(1)
and that the expanded special source rule should be withdrawn.
Accordingly, the final regulation applies the special source rule
only to sales of export property.

Example (2) of the proposed regulation, which addressed a licensing
transaction, has been removed.

Special Analyses

It has been determined that this Treasury decision is not a
significant regulatory action as defined in E.O. 12866.

Therefore, a regulatory assessment is not required. It has also been
determined that section 553(b) of the Administrative Procedure Act
(5 U.S.C. chapter 5) does not apply to these regulations, and
because the regulation does not impose a collection of information
on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter
6) does not apply. Pursuant to section 7805(f) of the Internal
Revenue Code, the notice of proposed rulemaking preceding these
regulations was submitted to the Chief Counsel for Advocacy of the
Small Business Administration for comment on their impact on small
business.

Drafting Information

The principal author of these regulations is Elizabeth Beck of the
Office of the Associate Chief Counsel (International).

Other personnel from the IRS and Treasury Department also
participated in the development of these 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 l
is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by
removing the entry for 1.927(e)-1T and adding an entry in numerical
order to read as follows:

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

Section 1.927(e)-1 also issued under 26 U.S.C. 927(e)(1). * * *

1.927(e)-1T [Removed] Par. 2. Section 1.927(e)-1T is removed.

Par. 3. Section 1.927(e)-1 is added to read as follows:

1.927(e)-1 Special sourcing rule.

(a) Source rules for related persons--(1) In general. The income of
a person described in section 482 from a sale of export property
giving rise to foreign trading gross receipts of a FSC that is
treated as from sources outside the United States shall not exceed
the amount that would be treated as foreign source income earned by
such person if the pricing rule under section 994 that corresponds
to the rule used under section 925 with respect to such transaction
applied to such transaction. This special sourcing rule also applies
if the FSC is acting as a commission agent for the related supplier
with respect to the transaction described in the first sentence of
this paragraph (a)(1) that gives rise to foreign trading gross
receipts and the transfer pricing rules of section 925 are used to
determine the commission payable to the FSC. No limitation results
under this section with respect to a transaction to which the
section 482 pricing rule under section 925(a)(3) applies.

(2) Grouping of transactions. If, for purposes of determining the
FSC's profits under the administrative pricing rules of sections
925(a)(1) and (2), grouping of transactions under 1.925(a)-1T(c)(8)
was elected, the same grouping shall be used for making the
determinations under the special sourcing rule in this section.

(3) Corresponding DISC pricing rules--(i) In general. For purposes
of this section--

(A) The DISC gross receipts pricing rule of section 994(a)(1)
corresponds to the gross receipts pricing rule of section 925(a)(1);

(B) The DISC combined taxable income pricing rule of section 994(a)
(2) corresponds to the combined taxable income pricing rule of
section 925(a)(2); and

(C) The DISC section 482 pricing rule of section 994(a)(3)
corresponds to the section 482 pricing rule of section 925(a)(3).

(ii) Special rules. For purposes of this section--

(A) The DISC pricing rules of section 994(a)(1) and (2) shall be
determined without regard to export promotion expenses;

(B) Qualified export receipts under section 994(a)(1) and

(2) shall be deemed to be an amount equal to the foreign trading
gross receipts arising from the transaction; and.77

(C) Combined taxable income for purposes of section 994(a)(2) shall
be deemed to be an amount equal to the combined taxable income for
purposes of section 925(a)(2) arising from the transaction.

(b) Examples. The provisions of this section may be illustrated by
the following examples:

Example 1. (i) R and F are calendar year taxpayers.

R, a domestic manufacturing company, owns all the stock of F, which
is a FSC acting as a commission agent for R. For the taxable year, R
and F used the combined taxable income pricing rule of section
925(a)(2). For the taxable year, the combined taxable income of R
and F is $100 from the sale of export property, as defined in
section 927(a), manufactured by R using production assets located in
the United States. Title to the export property passed outside of
the United States.

(ii) Under section 925(a)(2), 23 percent of the $100 combined
taxable income of R and F ($23) is allocated to F and the remaining
$77 is allocated to R. Absent the special sourcing rule, under
section 863(b) the $77 income allocated to R would be sourced $38.50
U.S. source and $38.50 foreign source. Under the special sourcing
rule, the amount of foreign source income earned by a related
supplier of a FSC shall not exceed the amount that would result if
the corresponding DISC pricing rule applied. The DISC combined
taxable income pricing rule of section 994(a)(2) corresponds to the
combined taxable income pricing rule of section 925(a)(2). Under
section 994(a)(2), $50 of the combined taxable income ($100 x .50)
would be allocated to the DISC and the remaining $50 would be
allocated to the related supplier.

Under section 863(b), the $50 income allocated to the DISC's related
supplier would be sourced $25 U.S. source and $25 foreign source.
Accordingly, under the special sourcing rule, the foreign source
income of R shall not exceed $25.

Example 2. (i) Assume the same facts as in Example 1 except that R
and F used the gross receipts pricing rule of section 925(a)(1). In
addition, for the taxable year foreign trading gross receipts
derived from the sale of the export property are $2,000.

(ii) Under section 925(a)(1), 1.83 percent of the $2,000 foreign
trading gross receipts ($36.60) is allocated to F and the $63.40
remaining combined taxable income ($100 - $36.60) is allocated to R.
Absent the special sourcing rule, under section 863(b) the $63.40
income allocated to R would be sourced $31.70 U.S. source and $31.70
foreign source. Under the special sourcing rule, the amount of
foreign source income earned by a related supplier of a FSC shall
not exceed the amount that would result if the corresponding DISC
pricing rule applied. The DISC gross receipts pricing rule of
section 994(a)(1) corresponds to the gross receipts pricing rule of
section 925(a)(1). Under section 994(a)(1), $80 ($2,000 x .04) would
be allocated to the DISC and the $20 remaining combined taxable
income would be allocated to the related supplier. Under section
863(b), the $20 income allocated to the DISC's related supplier
would be sourced $10 U.S. source and $10 foreign source.
Accordingly, under the special sourcing rule, the foreign source
income of R shall not exceed $10.

(c) Effective date. The rules of this section are applicable to
taxable years beginning after December 31, 1997.

Deputy Commissioner of Internal Revenue
Approved:
Assistant Secretary of the Treasury


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