Final regs. on allocating income between U.S. and possessions.

On Oct. 14, 1998, Treasury published final regulations under Sec. 863 on sourcing income derived from cross-border sales of inventory between the U.S. and possessions. Final regulations were also issued under Sec. 936 on the source of income derived from the sale of property purchased from a corporation with a Sec. 936 election in effect and sold in the U.S. The final regulations are nearly identical to proposed regulations issued under Secs. 863 and 936 on Oct. 9,1997.

The final Sec. 863 regulations are relevant when a taxpayer produces inventory in the U.S. and sells it in a possession or vice versa (Possession Production Sales), and when a taxpayer purchases inventory in a possession and sells it in the U.S. (Possession Purchase Sales).

Previously, if an independent factory or production price (IFP) existed for Possession Production Sales, taxpayers had to use the IFP method to determine the taxable income attributable to production activities in both the sale establishing the IFP and in sales of similar products. If an IFP did not exist, taxpayers could use the 50/50 allocation method or (with IRS permission) the books-and-records method.

Under the 50/50 method of the prior rules, one-half of taxable income from Possession Production Sales was apportioned based on the value of the taxpayer's property in the U.S. and within the possession. For this purpose, "property" meant all property held or used to produce income from Possession Production Sales. The other half of taxable income was apportioned on the basis of the taxpayer's business activity within the U.S. and within the possession (as measured by the sum of certain expenses and receipts from Possession Production Sales).

The new regulations make the 50/50 method mandatory unless the taxpayer elects either the IFP method or the books-and-records method, which still requires the Service's permission. The new 50/50 method allocates 50% of gross income (versus taxable income under prior law) from Possession Production Sales to production activity and 50% to business sales activity. By reference to Regs. Sec. 1.863-3(c)(1), production-related income is apportioned based on the tax basis (versus value) of directly owned tangible and intangible production assets in the U.S. and in the possession. This is a change from the prior regulation, which permitted the use of all assets (including selling and marketing assets, for example) that produce income from Possession Production Sales to be in the factor.

With respect to the remaining 50% of gross income from Possession Production Sales, the new regulations allocate according to the relative business sales activities. In effect, gross income not allocated to the possession is allocated to the U.S., even though some income may not actually relate to business activity in either the U.S. or the possession. New Regs. Sec. 1.863-3(f)(3) modifies the factors used in the business sales activity fraction. Business sales activity is measured by the sum of certain expenses, including amounts paid for labor, materials, advertising and marketing (but excluding amounts nondeductible under Sec. 263A, interest, and research and development), plus receipts from Possession Production Sales. Cost of goods sold (included under the prior regulations) is excluded from the business sales activity ratio, because it generally reflects production activity.

Under prior regulations, taxable income from Possession Purchase Sales was divided between the U.S. and possessions under one of two methods: apportionment or (with IRS permission) books and records.

Under the apportionment method, taxable income from Possession Purchase Sales was apportioned by a fraction, the numerator being the "business of the taxpayer" in the U.S. and the denominator being the total "business of the taxpayer" in the U.S. and in the possession. The fraction was computed in the same manner as the business fraction used for Possession Production Sales, except that such expenses, purchases and sales were limited to those attributable to Possession Purchase Sales.

Under the new regulations, gross income from Possession Purchase Sales is divided between the U.S. and possessions under one of two methods: apportionment or (with the Service's permission) books and records. The new regulations retain the structure of the prior regulations by apportioning the taxpayer's income from Possession Purchase Sales on the basis of a business activity fraction. As with the sales half of Possession Production Sales under the new regulations, any income not apportionable to a possession is apportioned to the U.S., even if business activity occurred elsewhere.

The business activity fraction is similar to that used to apportion sales-related income from Possession Production Sales. Cost of goods sold is included in this fraction, but not in the business sales activity fraction, used for Possession Production Sales. Such costs are attributed to the possession only to the extent the property purchased is manufactured, produced, grown or extracted in the possession.

A taxpayer may elect the IFP method (for Possession Production Sales) or the books-and-records method (for Possession Production Sales and Possession Purchase Sales) by using it on a timely filed return (including extensions). IRS permission must be requested for a subsequent change in method.

Regardless of which method is used, a taxpayer must fully explain in a statement attached to the tax return the methodology used, the circumstances justifying use of that methodology, the extent to which sales are aggregated and the amount of income so allocated.

The new regulations provide that the existing rules of Regs. Sec. 1.863-3(g) apply to Possession Production Sales and Possession Purchase Sales involving partners and partnerships. Under those rules, the aggregate approach applies to a partnership's production and sales activity for the following purposes: first, in determining the source of a partner's distributive share of partnership income; second, in determining the source of a partner's income from sales of inventory property that the partnership distributes to the partner in kind.

The new regulations also add a question and answer section to Regs. Sec. 1.936-6(a)(5), relevant when a taxpayer purchases a product from a corporation that has a Sec. 936 election in effect. Specifically, the taxpayer's gross income derived from sales of that product in the U.S. is U.S.-source if the taxpayer takes into account income from the sale of that product when determining benefits under Sec. 936(h)(5)(C)(i).

The new regulations apply to tax years beginning on or after Nov. 13, 1998.

FROM MIKE COOPER, ESQ., AND JIM THOMAS, CPA, WASHINGTON, DC