For Tax Professionals  
T.D. 8786 October 13, 1998

Source of Income From Sales of Inventory Partly From Sources Within a
Possession of the United States; Also, Source of Income Derived From
Certain Purchases From a Corporation Electing Section 936

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Parts 1 and 602 [TD 8786] RIN 1545-
AU79

TITLE: Source of Income From Sales of Inventory Partly From Sources
Within a Possession of the United States; Also, Source of Income
Derived From Certain Purchases From a Corporation Electing Section
936

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations under section 863
governing the source of income from sales of inventory produced in
the United States and sold in a possession of the United States or
produced in a possession of the United States and sold in the United
States; final regulations under section 863 governing the source of
income from sales of inventory purchased in a possession of the
United States and sold in the United States; and final regulations
under section 936 governing the source of income of a taxpayer from
the sale in the United States of property purchased from a
corporation that has an election under section 936 in effect. This
document affects persons who produce (in whole or in part) inventory
in the United States and sell in a possession, or produce (in whole
or in part) inventory in a possession and sell in the United States,
as well as persons who purchase inventory in a possession and sell
in the United States, and also persons who sell in the United States
property purchased from a corporation that has a section 936
election in effect.

DATES: Effective Date. These regulations are effective November 13,
1998.

Applicability Date. These regulations apply to taxable years
beginning on or after November 13, 1998.

FOR FURTHER INFORMATION CONTACT: Anne Shelburne, (202) 874-1305 (not
a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this final regulation has
been reviewed and approved by the Office of Management and Budget in
accordance with the requirements of the Paperwork Reduction Act of
1995 (44 U.S.C. 3507(d)) under control number 1545-1556. Responses
to this collection of information are mandatory.

An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless the collection of
information displays a valid control number.

The estimated average annual burden per respondent is approximately
2.5 hoU.S.

Comments concerning the accuracy of this burden estimate and
suggestions for reducing this burden should be sent to the Internal
Revenue Service, Attn: IRS Reports Clearance Officer, OP:FS:FP,
Washington, DC 20224, and the Office of Management and Budget, Attn:
Desk Officer for the Department of Treasury, Office of Information
and Regulatory Affairs, Washington, DC 20503.

Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns
and tax return information are confidential, as required by 26
U.S.C. 6103.

Background

This document contains final regulations under section 863 of the
Internal Revenue Code (Code), providing rules to source income from
cross-border sales of certain property, where the property is
manufactured in a possession of the United States and sold in the
United States, or vice versa, or purchased in a possession and sold
in the United States. These regulations also contain rules under
section 936 to source income of a taxpayer from the sale in the
United States of property purchased from a corporation that has an
election under section 936 in effect.

On October 10, 1997, proposed regulations [REG-251985-96] were
published in the Federal Register (62 FR 52953). Having considered
the comments, the IRS and the Treasury Department adopt the proposed
regulations without significant change in this Treasury decision.

Explanation of Provisions

I. Income Partly From Sources Within a Possession Section 863
authorizes the Secretary to promulgate regulations allocating or
apportioning, to sources within or without the United States, all
items of gross income, expenses, losses, and deductions other than
those items specified in sections 861(a) and 862(a).

Guidance in these regulations to determine the source of possession
income under section 863 concerns two types of transactions:
transactions described in section 863(b)(2) for property produced in
the United States and sold in a possession (or vice versa), and
transactions described in section 863(b)(3) for property purchased
in a possession and sold in the United States (collectively, Section
863 Possession Sales).

1. Methods for allocating or apportioning gross income from Section
863 Possession Sales

a. Property produced and sold

Under the final regulations, income from sales of inventory produced
in the United States and sold in a possession of the United States
or produced in a possession and sold in the United States
(collectively, Possession Production Sales), is allocated or
apportioned according to one of three methods.

Paragraph (f)(2)(i)(A) of the regulations makes the 50/50 method the
general rule to allocate gross income from Possession Production
Sales between production activity and business sales activity, so
that the income from each type of activity can then be apportioned
between U.S. and foreign sources. The taxpayer, however, may elect
to apply the independent factory price (IFP) method (described in
paragraph (f)(2)(i)(B)), or, with the consent of the District
Director, the books and records method (described in paragraph (f)
(2)(i)(C)).

Under the possession 50/50 method, the final regulations allocate
half of the taxpayer's gross income from Possession Production Sales
to production activity and half to business sales activity. The
income is then apportioned between U.S. and possession sources based
on a property fraction and a business sales activity fraction.

The final regulations apply the property fraction in 1.863- 3(c) to
apportion the half of a taxpayer's income allocated to production
activity. Thus, income is apportioned to the United States or to a
possession or to other foreign sources based on the location of the
taxpayer's production assets. Consistent with the changes made to
the regulations under 1.863-3(c), production assets are defined as
tangible and intangible assets owned directly by the taxpayer that
are directly used by the taxpayer to produce inventory sold in
Possession Production Sales. Production assets are included in the
fraction at their adjusted tax basis, consistent with the changes
made to the regulations under 1.863-3(c).

The other half of the taxpayer's gross income, allocated to business
sales activity, is apportioned according to a business sales
activity fraction. The portion of this income that is possession
source income is determined by multiplying the income by a fraction,
the numerator being the business sales activity of the taxpayer in
the possession, and the denominator being the business sales
activity of the taxpayer within the possession and outside the
possession. The remaining income is sourced in the United States.
Although some of the business sales activity factors not incurred in
a possession may be incurred in a foreign country, Treasury and the
IRS believe that the business sales activity fraction is only
intended to source the business sales activity portion of Possession
Production Sales outside the United States to the extent of business
sales activity located in a possession.

Under the final regulations, as opposed to the current regulations,
business sales activity is measured by the sum of certain expenses,
including amounts paid for labor, materials, advertising, and
marketing (but excluding any expenses or other amounts that are
nondeductible under section 263A, interest, and research and
development), plus receipts for the sale of goods.

This formula is intended to reflect better the business sales
activity producing the income by including more of the factors
responsible for producing that income. Also, cost of goods sold is
now excluded from the business sales activity fraction apportioning
income from Possession Production Sales, because such costs
generally reflect production activity. Production activity is
already represented in the formula by the one-half of the taxpayer's
income apportioned according to the location of production assets.

The final regulations provide explicit guidance for attributing
business sales activity between the United States and a possession.
In attributing business sales activity between the United States and
a possession, expenses are allocated and apportioned between the
United States and a possession based on the rules in 1.861-8
through 1.861-14T. Gross sales are allocated to the United States or
a possession based on the place of sale.

The final regulations make the IFP method elective, and thus
eliminate any bias against taxpayers choosing to export through
independent distributors. The regulations rely upon the regulations
under 1.863-3 for rules in applying the IFP method.

The final regulations permit taxpayers to request permission from
the District Director to use their books and records to determine
the source of their income. The final regulations refer to
1.863-3(b)(3) in applying the method to Possession Production
Sales.

b. Property purchased and sold

Paragraph (f)(3)(i)(A) makes the business activity method the
general rule to apportion income between the United States and a
possession, from sales of property purchased in a possession and
sold in the United States (Possession Purchase Sales). The taxpayer
may, however, elect to apply, with consent of the District Director,
the books and records method.

The final regulations apportion the taxpayer's income from
Possession Purchase Sales on the basis of a business activity
fraction. The portion of this income that is possession source
income is determined by multiplying the income by a fraction, the
numerator being the business of the taxpayer in the possession, and
the denominator being the business of the taxpayer within the
possession and outside the possession. The remaining income is
sourced in the United States.

The business activity fraction is similar to the business sales
activity fraction discussed previously, used to apportion the
taxpayer's income in Possession Production Sales, except that the
fraction applies only to expenses, cost of goods sold, and sales
attributable to Possession Purchase Sales. In addition, the business
activity fraction apportioning Possession Purchase Sales includes
amounts paid for cost of goods sold. Such costs are attributed to
the possession, however, only to the extent the property purchased
is manufactured, produced, grown, or extracted in the possession.
Treasury and the Internal Revenue Service anticipate that if a
taxpayer acts in the reasonable belief that the products were
manufactured in the possession, the taxpayer could act on that basis
in preparing its tax return. The business activity fraction reflects
the view of Treasury and the IRS that the purchase rule of section
863(b)(3) was intended to apply only to purchase and resale
transactions where the goods purchased are created or derived from
the possession.

The final regulations permit taxpayers to request permission from
the District Director to use their books and records to determine
the source of their income. The proposed regulations refer to
1.863-3(b)(3) in applying the method to Possession Purchase Sales.

2. Determination of source of gross income

Under the final regulations, once gross income attributable to
production activity, business activity, or sales activity has been
determined under one of the prescribed methods, the source of the
gross income is determined separately for each type of income. The
source of gross income attributable to production activity (when
applying the possession 50/50 method) is determined under paragraph
(c)(1), based on the location of production assets. The source of
gross income attributable to sales activity (when applying the IFP
method or the books and records method) is determined under
paragraph (c)(2), based generally on the location of the sale. The
source of gross income attributable to business sales activity (when
applying the possession 50/50 method) is determined under paragraph
(f)(2)(ii)(B), based on expenses and gross sales attributable to
Possession Production Sales. The source of gross income attributable
to business activity (when applying the business activity method) is
determined under paragraph (f)(3)(ii), based on expenses, cost of
goods sold, and gross sales attributable to Possession Purchase
Sales.

3. Determination of source of taxable income

Once the source of gross income is determined under paragraph (f)(2)
or (3), taxpayers then determine the source of taxable income. Under
paragraph (f)(4), taxpayers must allocate and apportion under
1.861-8 through 1.861-14T the amounts of expenses, losses and
other deductions to gross income determined under each of the
prescribed methods. In the case of amounts of expenses, losses and
other deductions allocated and apportioned to gross income
determined under the IFP method or the books and records method, the
taxpayer must apply the rules of 1.861-8 through 1.861-14T to
allocate and apportion these amounts between gross income from
sources within the United States and within a possession. However,
for expenses, losses and other deductions allocated and apportioned
to gross income determined under the possessions 50/50 method or
gross income from Possession Purchase Sales determined under the
business activity method, taxpayers must apportion expenses and
other deductions pro rata based on the relative amounts of U.S. and
possession source gross income.

Nevertheless, the research and experimental (R&E) expense allocation
rules in 1.861-17 apply to taxpayers using the 50/50 method, so
that the R&E set aside (described in 1.861-17) remains available to
such taxpayers.

4. Treatment of gross income derived from certain purchases from a
corporation that has an election in effect under section 936 The
final regulations clarify that section 863 does not apply to
determine the source of a taxpayer's gross income derived from a
purchase of inventory from a corporation that has an election in
effect under section 936, if the taxpayer's income from sales of
that inventory is taken into account to determine benefits under
section 936(h)(5)(C) for the section 936 corporation.

5. Treatment of partners and partnerships

The final regulations rely on the rules in 1.863-3(g) for
determining the appropriate treatment in transactions involving
partnerships. Under those rules, the aggregate approach applies to a
partnership's production and sales activity for two purposes only.
First, the aggregate approach applies in determining the character
of a partner's distributive share of partnership income. Second, the
aggregate approach applies in sourcing income from sales of
inventory property that is transferred in-kind from or to a
partnership.

6. Election and reporting rules

Under paragraph (f)(6)(i) of the final regulations, a taxpayer must
use the 50/50 method to determine the source of income from
Possession Production Sales unless the taxpayer elects to use the
IFP method, or elects the books and records method. For Possession
Purchase Sales, a taxpayer must use the business activity method,
unless the taxpayer elects the books and records method. The
taxpayer makes an election by using the method on its timely filed
original tax return. That method must be used in later taxable years
unless the Commissioner or his delegate consents to a change.
Permission to change methods in later years will be granted unless
the change would result in a substantial distortion of the source of
income.

A taxpayer must fully explain the methodology used in applying
either paragraph (f)(2) or (3), and the amount of income allocated
or apportioned to U.S. and foreign sources, in a statement attached
to its tax return.

II. Income Derived From Certain Purchases From a Corporation That
Has an Election in Effect Under Section 936 These regulations
clarify that, where a taxpayer purchases a product from a
corporation that has an election in effect under section 936, the
source of the taxpayer's gross income derived from sales of that
product (in whatever form sold) in the United States is U.S. source,
if the taxpayer's income from sales of that product is taken into
account to determine benefits under section 936(h)(5)(C)(i) for the
section 936 corporation. The taxpayer's income is U.S. source
without regard to whether a possession product is a component, end-
product form, or integrated product. No inference should be drawn
concerning the treatment of transactions involving sales of property
purchased from a section 936 corporation entered into before the
regulations are applicable.

Special Analyses

It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required. It is hereby certified that
these regulations will not have a significant economic impact on a
substantial number of small entities. This certification is based on
the fact that the rules of this section principally impact large
multinationals who pay foreign taxes on substantial foreign
operations and therefore the rules will impact very few small
entities. Moreover, in those few instances where the rules of this
section impact small entities, the economic impact on such entities
is not likely to be significant.

Accordingly, a regulatory flexibility analysis is not required.

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 its impact on small business.

Drafting Information

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

List of Subjects

26 CFR Part 1 Income taxes, Reporting and recordkeeping
requirements.

26 CFR Part 602 Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations Accordingly, 26 CFR parts
1 and 602 are amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by
revising the entry for "Section 1.863-3", removing the entry for
"Sections 1.936-4 through 1.936-7" and adding entries in numerical
order to read as follows:

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

Section 1.863-3 also issued under 26 U.S.C. 863(a) and (b), and 26
U.S.C. 936(h).***

Section 1.936-4 also issued under 26 U.S.C. 936(h).

Section 1.936-5 also issued under 26 U.S.C. 936(h).

Section 1.936-6 also issued under 26 U.S.C. 863(a) and (b), and 26
U.S.C. 936(h).

Section 1.936-7 also issued under 26 U.S.C. 936(h).***

Par. 2 Section 1.863-3 is amended as follows:

1. Paragraph (f) is revised.

2. Paragraph (h) is amended by adding a sentence at the end of the
paragraph.

The revision and addition read as follows:

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

* * * * *

(f) Income partly from sources within a possession of the United
States--(1) In general. This paragraph (f) relates to gains,
profits, and income, which are 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 (f) applies to determine the source of income derived from
the sale of inventory produced (in whole or in part) by the taxpayer
within the United States and sold within a possession, or produced
(in whole or in part) by a taxpayer in a possession and sold within
the United States (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 (f) must divide gross income from Section
863 Possession Sales using one of the methods described in either
paragraph (f)(2)(i) of this section (in the case of Possession
Production Sales) or paragraph (f)(3)(i) of this section (in the
case of Possession Purchase Sales). Once a taxpayer has elected a
method, the taxpayer must separately apply that method to the
applicable category of Section 863 Possession Sales in the United
States and to those in a possession. The source of gross income from
each type of activity must then be determined under either paragraph
(f)(2)(ii) or (3)(ii) of this section, as appropriate.

The source of taxable income from Section 863 Possession Sales is
determined under paragraph (f)(4) of this section. The taxpayer must
apply the rules for computing gross and taxable income by
aggregating all Section 863 Possession Sales to which a method in
this section applies after separately applying that method to
Section 863 Possession Sales in the United States and to Section 863
Possession Sales in a possession. This section does not apply to
determine the source of a taxpayer's gross income derived from a
sale of inventory purchased from a corporation that has an election
in effect under section 936, if the taxpayer's income from sales of
that inventory is taken into account to determine benefits under
section 936 for the section 936 corporation. For rules to be applied
to determine the source of such income, see 1.936-6(a)(5) Q&A 7a
and 1.936-6(b)(1) Q&A 13.

(2) Allocation or apportionment for Possession Production Sales--(i)
Methods for determining the source of gross income for Possession
Production Sales--(A) Possession 50/50 method.

Under the possession 50/50 method, gross income from Possession
Production Sales is allocated between production activity and
business sales activity as described in this paragraph (f)(2)(i)(A).
Under the possession 50/50 method, one-half of the taxpayer's gross
income will be considered income attributable to production activity
and the source of that income will be determined under the rules of
paragraph (f)(2)(ii)(A) of this section. The remaining one-half of
such gross income will be considered income attributable to business
sales activity and the source of that income will be determined
under the rules of paragraph (f)(2)(ii)(B) of this section.

(B) IFP method. In lieu of the possession 50/50 method, a taxpayer
may elect the independent factory price (IFP) method.

Under the IFP method, gross income from Possession Production Sales
is allocated to production activity or sales activity using the IFP
method, as described in paragraph (b)(2) of this section, if an IFP
is fairly established under the rules of paragraph (b)(2) of this
section. See paragraphs (f)(2)(ii)(A) and (C) of this section for
rules for determining the source of gross income attributable to
production activity and sales activity.

(C) Books and records method. A taxpayer may elect to allocate gross
income using the books and records method described in paragraph (b)
(3) of this section, if it has received in advance the permission of
the District Director having audit responsibility over its return.
See paragraph (f)(2)(ii) of this section for rules for determining
the source of gross income.

(ii) Determination of source of gross income from production,
business sales, and sales activity--(A) Gross income attributable to
production activity. The source of gross income from production
activity is determined under the rules of paragraph (c)(1) of this
section, except that the term possession is substituted for foreign
country wherever it appears.

(B) Gross income attributable to business sales activity--

(1) Source of gross income. Gross income from the taxpayer's
business sales activity is sourced in the possession in the same
proportion that the amount of the taxpayer's business sales activity
for the taxable year within the possession bears to the amount of
the taxpayer's business sales activity for the taxable year both
within the possession and outside the possession, with respect to
Possession Production Sales. The remaining income is sourced in the
United States.

(2) Business sales activity. For purposes of this paragraph (f)(2)
(ii)(B), the taxpayer's business sales activity is equal to the sum
of--

(i) The amounts for the taxable period paid for wages, salaries, and
other compensation of employees, and other expenses attributable to
Possession Production Sales (other than amounts that are
nondeductible under section 263A, interest, and research and
development); and

(ii) Possession Production Sales for the taxable period.

(3) Location of business sales activity. For purposes of determining
the location of the taxpayer's business activity within a
possession, the following rules apply:

(i) Sales. Receipts from gross sales will be attributed to a
possession under the provisions of paragraph (c)(2) of this section.

(ii) Expenses. Expenses will be attributed to a possession under the
rules of 1.861-8 through 1.861-14T.

(C) Gross income attributable to sales activity. The source of the
taxpayer's income that is attributable to sales activity, as
determined under the IFP method or the books and records method,
will be determined under the provisions of paragraph (c)(2) of this
section.

(3) Allocation or apportionment for Possession Purchase Sales--(i)
Methods for determining the source of gross income for Possession
Purchase Sales--(A) Business activity method.

Gross income from Possession Purchase Sales is allocated in its
entirety to the taxpayer's business activity, and is then
apportioned between U.S. and possession sources under paragraph (f)
(3)(ii) of this section.

(B) Books and records method. A taxpayer may elect to allocate gross
income using the books and records method described in paragraph (b)
(3) of this section, subject to the conditions set forth in
paragraph (b)(3) of this section. See paragraph (f)(2)(ii) of this
section for rules for determining the source of gross income.

(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 (f)(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. Receipts from gross sales will be attributed to a
possession under the provisions of paragraph (c)(2) of this section.

(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.

(iii) Examples. The following examples illustrate the rules of
paragraph (f)(3)(ii) of this section relating to the determination
of source of gross income from business activity:

Example 1. (i) 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.

(ii) 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.

Example 2. (i) Assume the same facts as in Example 1, except that A
manufactures X outside the possession.

(ii) 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 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.

(4) Determination of source of taxable income. Once the source of
gross income has been determined under paragraph (f)(2) or (3) of
this section, the taxpayer must properly allocate and apportion
separately under 1.861-8 through 1.861-14T the amounts of its
expenses, losses, and other deductions to its respective amounts of
gross income from Section 863 Possession Sales determined separately
under each method described in paragraph (f)(2) or (3) of this
section. In addition, if the taxpayer deducts expenses for research
and development under section 174 that may be attributed to its
Section 863 Possession Sales under 1.861-17, the taxpayer must
separately allocate or apportion expenses, losses, and other
deductions to its respective amounts of gross income from each
relevant product category that the taxpayer uses in applying the
rules of 1.861- 17. Thus, in the case of gross income from Section
863 Possession Sales determined under the IFP method or books and
records method, a taxpayer must apply the rules of 1.861-8 through
1.861-14T to properly allocate or apportion amounts of expenses,
losses and other deductions, allocated and apportioned to such gross
income, between gross income from sources within and without the
United States. However, in the case of gross income from Possession
Production Sales determined under the possessions 50/50 method or
gross income from Possession Purchase Sales computed under the
business activity method, the amounts of expenses, losses, and other
deductions allocated and apportioned to such gross income must be
apportioned between sources within and without the United States pro
rata based on the relative amounts of gross income from sources
within and without the United States determined under those methods,
except that the rules regarding the allocation and apportionment of
research and experimental expenditures in 1.861-17 shall apply to
such expenditures of taxpayers using the 50/50 method.

(5) Special rules for partnerships. In applying the rules of this
paragraph (f) to transactions involving partners and partnerships,
the rules of paragraph (g) of this section apply.

(6) Election and reporting rules--(i) Elections under paragraph (f)
(2) or (3) of this section. If a taxpayer does not elect one of the
methods specified in paragraph (f)(2) or (3) of this section, the
taxpayer must apply the possession 50/50 method in the case of
Possession Production Sales or the business activity method in the
case of Possession Purchase Sales. The taxpayer may elect to apply a
method specified in either paragraph (f)(2) or (3) of this section
by using the method on a timely filed original return (including
extensions). Once a method has been used, that method must be used
in later taxable years unless the Commissioner consents to a change.
Permission to change methods from one year to another year will be
granted unless the change would result in a substantial distortion
of the source of the taxpayer's income.

(ii) Disclosure on tax return. A taxpayer who uses one of the
methods described in paragraph (f)(2) or (3) of this section must
fully explain in a statement attached to the tax return the
methodology used, the circumstances justifying use of that
methodology, the extent that sales are aggregated, and the amount of
income so allocated.

* * * * *

(h) Effective dates. * * * However, the rules of paragraph (f) of
this section apply to taxable years beginning on or after November
13, 1998.

Par. 3. In 1.936-6, paragraph (a)(5) Q&A 7a is added to read as
follows:

1.936-6 Intangible property income when an election out is made:
Cost sharing and profit split options; covered intangibles.

* * * * *

(a) * * *

(5) * * *

Q.7a: What is the source of the taxpayer's gross income derived from
a sale in the United States of a possession product purchased by the
taxpayer (or an affiliate) from a corporation that has an election
in effect under section 936, if the income from such sale is taken
into account to determine benefits under cost sharing for the
section 936 corporation? Is the result different if the taxpayer (or
an affiliate) derives gross income from a sale in the United States
of an integrated product incorporating a possession product
purchased by the taxpayer (or an affiliate) from the section 936
corporation, if the taxpayer (or an affiliate) processes the
possession product or an excluded component in the United States?

A.7a: Under either scenario, the income is U.S. source, without
regard to whether the possession product is a component, end-
product, or integrated product. Section 863 does not apply in
determining the source of the taxpayer's income. This Q&A 7a is
applicable for taxable years beginning on or after November 13,
1998.

* * * * *

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT Par.
4. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 5. In 602.101, paragraph (c) is amended in the table by
revising the entry for 1.863-3 to read as follows:

602.101 OMB Control numbers.

* * * * *

(c) * * *

CFR part or section where Current OMB identified and described
control No.

* * * * *

1.863-3...........................................1545-1476
1545-1556

* * * * *

Michael P. Dolan
Deputy Commissioner of Internal Revenue
Approved: September 18, 1998
Donald C. Lubick
Assistant Secretary of the Treasury for Tax Policy


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