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

• Author: Cooper, Mike
• Position: IRS regulations

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...