Proposed section 863(b) regulations: sourcing of income from export sales.

• Position: Tax Executives Institute International Tax Committee

On May 24, 1996, Tax Executives Institute submitted the following comment to the Internal Revenue Service on proposed regulations under section 863(b) of the Internal Revenue Code concerning the sourcing of income from export sales of inventory and natural resources. The Institute's comments were prepared under the aegis of its International Tax Committee, whose chair is Joseph S. Tann, Jr., of Ameritech. The following members of the committee contributed materially to the development of the Institute's position: Richard M. Hoag of Tandem Computers, Inc., R. Bruce Jacobsohn of Georgia-Pacific Corp., and Raymond G. Rossi of Intel Corporation.

On December 7, 1995, the U.S. Department of the Treasury and the Internal Revenue Service issued proposed regulations under section 863(b) of the Internal Revenue Code, relating to the sourcing of income from export sales of inventory and natural resources. The proposed regulations were published in the Federal Register on December 11, 1995 (60 Fed. Reg. 63478) and in the Internat. Revenue Bulletin on February 5, 1996 (1996-6 I.R.B. 29).(1)

Sales of Inventory

Prop. Reg. [subsections] 1.863-3(b): Methods to Determine Income

1. The General Rule. Section 863 of the Code provides special rules for determining the source of certain income, including sales of inventory and natural resources. Section 863(a) provides the general rule that items of gross income, expenses, losses, and deductions are allocated or apportioned to sources within or without the United States under regulations prescribed by the Secretary. Section 863(b) provides a "mixed-source" rule for gross income derived from sources partly within and partly without the United States. The Treasury regulations generally provide three methods for allocating and apportioning section 863(b) income: the 50/50 method, the independent factory price (IFP) method, and the books-and-records method. See Treas. Reg. [sections] 1.863-3(b)(2), Exs. 1 & 3; Temp. Reg. [sections] 1.863-3T(b)(2), Ex. 2.

   The proposed regulations generally retain these three methods and clarify that the 50/50 method for determining the amount of income attributable to production or sales activities is the general rule.(2) Prop. Reg. [sections] 1.863-3(b)(1)(i) requires taxpayers to use the 50/50 method unless an affirmative election to use the IFP or books-and-records method is made.(3) Thus, the proposed regulations strive to end more than 10 years of controversy -- and the related dedication of taxpayer and government resources -- over whether the 50/50 method or the IFP method constitutes the general rule for allocating section 863(b) income.

   TEI commends the IRS for the position adopted by the proposed regulations with respect to inventory property (other than natural resources). As acknowledged in the preamble, business practices have changed over the 70-year period since the existing regulations were adopted and those regulations contain potentially heavy administrative burdens. 1996-6 I.R.B. at 32-33. The proposed regulations generally adopt the same interpretation used by taxpayers prior to the IRS's challenge in 1985 -- a challenge that engendered two failed legislative efforts, numerous audit challenges, and ultimately two taxpayer-favorable court cases. The proposed regulations will avoid the problems inherent in the use of the IFP method, thereby reducing compliance burdens, audit controversies, and costly litigation.

   TEI remains concerned, however, that some language used in the proposed regulations may be misconstrued by examining agents. Prop. Reg. [sections] 1.863-1(a) provides that items of gross income-other than those listed in sections 861(a) and 862(a) -- will...