Part IV. Items — Internal Revenue Bulletin 1997-48

garded entity or a disregarded entity converts to a partnership) but these changes occur only as a result of a change in the number of members, not as the result of an elective change. The proposed regulations do not address the form of these two possible types of changes.

The proposed regulations provide a specific characterization for each of the four possible elective changes. In each case, the characterization provided in the proposed regulations attempts to minimize the tax consequences of the change in classification and achieve administrative simplicity. The proposed regulations provide that if an association elects to be classified as a partnership, the association is deemed to liquidate by distributing its assets and liabilities to its shareholders. Then, the shareholders are deemed to contribute all of the distributed assets and liabilities to the partnership. This characterization of an elective change from an association to a partnership is consistent with Rev. Rul. 63–107 (1963–1 C.B. 71).

If a partnership elects to be classified as an association, the partnership is deemed to contribute all of its assets and liabilities to the association in exchange for stock in the association. Then, the partnership is deemed to liquidate by distributing stock in the association to its partners. The proposed regulations do not affect the holdings in Rev. Rul. 84–111 (1984–2 C.B. 88), in which the IRS ruled that it would respect the particular form undertaken by the taxpayers when a partnership converts to a corporation.

If an association elects to be disregarded as an entity separate from its owner, the association is deemed to liquidate by distributing its assets and liabilities to its sole owner. Conversely, if an eligible entity that is disregarded as an entity separate from its owner elects to be classified as an association, the owner of the eligible entity is deemed to contribute all of the assets and liabilities of that entity to the association in exchange for stock of the association.

The proposed regulations also provide that the tax treatment of an elective change in classification is determined under all relevant provisions of the Internal Revenue Code and general principles of tax law, including the step transaction

Notice of Proposed Rulemaking and Notice of Public Hearing

Treatment of Changes in Elective Entity Classification

REG–105162–97

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains proposed regulations addressing elective changes in entity classification. The proposed regulations describe how elective changes in classification will be treated for federal tax purposes. The proposed regulations would affect business entities and their members. This document also contains a notice of public hearing on these proposed regulations.

DATES: Written comments must be received by January 26, 1998. Requests to speak (with outlines of oral comments) at the public hearing scheduled for February 24, 1998, must be submitted by January 26, 1998.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-105162–97), room 5228, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. In the alternative, submissions may be hand delivered between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG–105162–97), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC. Alternatively, taxpayers may submit comments electronically via the Internet by selecting the “Tax Regs” option of the IRS Home Page, or by submitting comments directly to the IRS Internet site at: http://www.irs.ustreas.gov/prod/tax_regs/comments.html. The public hearing will be held in room 2615, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Jeff Erickson, (202) 622-3070 (not a tollfree number); concerning international is

sues, Philip Tretiak or Ronald M. Gootzeit, (202) 622-3860 (not a toll free number); concerning submissions and the hearing, Evangelista Lee, (202) 622-7190 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document proposes to amend the current Income Tax Regulations (26 CFR Parts 1 and 301) relating to the classification of entities for federal tax purposes. On December 18, 1996, the IRS and Treasury published final regulations under section 7701 (final regulations), replacing the former classification rules with an elective regime. See T.D. 8697 (1997–2 I.R.B. 11).

Under the final regulations, a business entity that is not specifically classified as a corporation in the final regulations (an eligible entity) can elect its classification for federal tax purposes under certain circumstances. An eligible entity with at least two members can elect to be classified as a partnership or as an association taxable as a corporation. An eligible entity with a single member can elect to be classified as an association or as an entity that is disregarded as an entity separate from its owner. An eligible entity may also elect to change its classification, except that an election may not be made more than once in any sixty month period. An eligible entity that does not make an election is classified under certain default provisions.

Explanation of Provisions

Characterization of Elective Changes in Classification

The proposed regulations describe how elective changes in an entity’s classification will be treated for federal tax purposes. Under the final regulations, there are four possible changes in classification by election: (i) a partnership elects to be an association; (ii) an association elects to be a partnership; (iii) an association elects to be a disregarded entity; and (iv) a disregarded entity elects to be an association. There are two other possible ways in which an entity’s classification could change (a partnership converts to a disre

1997–48 I.R.B. 13 December 1, 1997

doctrine. This provision in the proposed regulations is intended to ensure that the tax consequences of an elective change will be identical to the consequences that would have occurred if the taxpayer had actually taken the steps described in the proposed regulations. The IRS and Treasury request comments on the application of general principles of tax law to the transactions that are deemed to occur on an elective change in classification.

Change in Number of Members of Entity

The proposed regulations address the effect of a change in the number of members on the classification of an entity. Under the proposed regulations, if there is a change in the number of members of an association, the classification of the entity is not affected. If an eligible entity classified as a partnership subsequently has only one member (and is still treated as an entity under local law), the entity will be disregarded as an entity separate from its owner. If a single member entity that is disregarded as an entity separate from its owner subsequently has more than one member, the entity is classified as a partnership as of the date the entity has more than one member. The classifications provided in the proposed regulations can be changed by election, assuming that the entity is not subject to the sixty month limitation on elections.

Timing of Elective Changes in Classification

The proposed regulations provide that an election to change the classification of an entity is treated as occurring at the start of the day for which the election is effective. Any transactions that are deemed to occur as a result of the change in classification are treated as occurring immediately before the close of the day before the effective date of the election. For example, if an election is made to convert from an association to a partnership effective on January 1, the entity is treated as a partnership on January 1, and the deemed transactions specified in the proposed regulations are treated as occurring immediately before the close of December 31. As a result, the last day of the association’s taxable year will be December 31 and the first day of the partnership’s taxable year will be January 1.

Treatment of Foreign Eligible Entities

Any eligible entity, including a foreign eligible entity whose classification is not relevant for federal tax purposes, may elect to change its classification. The IRS and Treasury request comments on the appropriateness of allowing such a foreign eligible entity to make a classification election, and comments on what the federal tax consequences of such an election should be (e.g., with respect to the basis of property held by the entity).

Foreign Per Se Entities

The final regulations provide a list of the names of certain foreign business entities that are treated as corporations for federal tax purposes. In most cases, the name by which an entity will be known is provided by the statutory corporate law of the relevant jurisdiction. In certain cases, however, the corporate law does not provide a statutory name. In these jurisdictions, taxpayers and practitioners often fill the statutory void with a name derived from a number of the statutory characteristics of the entity. In an effort to make the list of foreign per se corporations more accessible, the final regulations use the commonly used non-statutory term in certain cases where the statute does not provide a defined name. To minimize any uncertainty, however, the provisions of §301.7701–2(b)(8)(iii) and (iv) were included in the final regulations to address this issue. In response to comments from taxpayers, these subsections of the final regulations are clarified to provide guidance on the terms used in the final regulations. Furthermore, the regulations clarify that the term Berhad used with regard to Malaysia does not include a “Sendirian Berhad” (the equivalent of a private limited company). The regulations also clarify that, in relation to Mexico, the term Sociedad Anonima includes a Sociedad Anonima that chooses to apply the variable capital provision of Mexican corporate law (Sociedad Anonima de Capital Variable). The fact that capital may be varied does not make this a different type of entity from a Sociedad Anonima that does not choose to apply the variable capital provision. These clarifications are not intended to change the interpretation of the final regulations.

The proposed regulations also clarify

the treatment of the Finnish, Maltese, and Norwegian entities specified in the final regulations. Effective January 1, 1996, Maltese and Norwegian corporate law recognized a distinction between public and private companies, and the proposed regulations reflect this change. The proposed regulations also provide that the rules of the final regulations with regard to the Maltese and Norwegian entities may be applied (when these proposed regulations are finalized) as though the entities specified in the proposed regulations had been included in the final regulations issued on December 18, 1996. Thus, a Maltese or Norwegian entity that is no longer treated as a per se corporation under the regulations would be able to make an election within 75 days of the date these proposed regulations are finalized, and such election could be effective as of January 1, 1997. Finnish law, since September 1, 1997, has recognized a similar distinction between public and private companies. It is proposed that a Finnish entity that is no longer treated as a per se corporation under the regulations would be able to make an election within 75 days of the date these proposed regulations are finalized, and such election could be effective as of September 1, 1997.

Special Basis Adjustments Under Section 743

Section 743 provides that the basis of partnership property is not adjusted as the result of a transfer of an interest in the partnership by sale or exchange unless the partnership has made an election under section 754. If a section 754 election is made, the transferee partner is treated as having a special basis adjustment with respect to partnership property. This adjustment constitutes an adjustment to the basis of partnership property with respect to the transferee partner only. Some uncertainty has remained as to the treatment of this special basis adjustment upon the contribution of the partnership property to a corporation in a section 351 exchange, and because the proposed regulations provide for a deemed contribution by the partnership to a corporation in an elective conversion to an association, the proposed regulations address this uncertainty.

The proposed regulations provide that a

December 1, 1997 14 1997–48 I.R.B.

corporate transferee’s basis in property transferred by a partnership in a transfer described in section 351 includes any special basis adjustment under section 743. The special basis adjustment is also taken into account in determining the partner’s basis in the stock received in the exchange. For example, assume a partnership owns Property X, which has a common basis of $100 for the partnership and in which Partner A has a $5 special basis adjustment under section 743(b). Subsequently, the partnership validly elects to be classified as an association. The partnership is deemed to contribute all of its assets and liabilities to the association in exchange for stock in the association, and immediately thereafter, the partnership liquidates by distributing the stock of the association to its partners. If the transfer of the assets to the association would be a transfer described in section 351, then under the proposed regulations, the association’s basis in Property X includes Partner A’s $5 special basis adjustment. Thus, the association has a $105 basis in Property X (Partner A’s $5 special basis adjustment plus the partnership’s $100 common basis). Partner A’s basis in the association’s stock will reflect the $5 special basis adjustment previously on Property X.

The proposed regulations also provide, however, that the amount of gain, if any, recognized by the partnership on the transfer is determined without reference to any special basis adjustment. The partner with the special basis adjustment can then use the special basis adjustment to reduce its share of any gain recognized by the partnership. This approach of determining gain at the partnership level and allowing the partner to use the special basis adjustment as an offset is similar to the treatment of a sale of property with a special basis adjustment.

Proposed Effective Date

Except as otherwise specified, these regulations are proposed to apply as of the date the final regulations are published in the Federal Register .

Special Analyses

It has been determined that this notice of proposed rulemaking is not a signifi

cant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It also has 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 these regulations do not impose on small entities a collection of information requirement, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments (preferably a signed original and eight (8) copies) that are submitted timely to the IRS. All comments will be available for public inspection and copying.

A public hearing has been scheduled for February 24, 1998, at 10 a.m., in room 2615, Internal Revenue Building, 1111 Constitution Avenue NW, Washington, DC. Because of access restrictions, visitors will not be admitted beyond the Internal Revenue Building lobby more than 15 minutes before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons that wish to present oral comments at the hearing must submit timely written comments and an outline of the topics to be discussed and the time to be devoted to each topic by (preferably a signed original and eight (8) copies) January 26, 1998.

A period of 10 minutes will be allotted to each person for making comments.

An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Drafting Information

The principal authors of these regulations are Ann M. Veninga, Office of Chief Counsel (Passthroughs and Special Indus

tries) and Philip Tretiak, Office of Associate Chief Counsel (International). However, other personnel from the IRS and Treasury Department participated in their development.

Proposed Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 301 are proposed to be amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.743-2 is added under the undesignated centerheading “Transfer of Interests in a Partnership” to read as follows:

§1.743-2 Transfer of property to a corporation.

(a) Basis in transferred property. A corporation’s adjusted tax basis in property transferred to the corporation by a partnership in a transfer described in section 351 is determined with reference to any special basis adjustment to the property under section 743(b) (other than any special basis adjustment that reduces a partner’s gain under paragraph (b) of this section).

(b) Partnership gain. The amount of gain, if any, recognized by a partnership on a transfer of property by the partnership to a corporation in a transfer described in section 351 is determined without reference to any special basis adjustment to the transferred property under section 743(b). The amount of gain, if any, recognized by the partnership on the transfer that is allocated to a partner with a special basis adjustment in the transferred property is adjusted to reflect the partner’s special basis adjustment in the transferred property.

(c) Basis in stock. The partnership’s adjusted tax basis in stock received from a corporation in a transfer described in section 351 is determined without reference to the special basis adjustment in property transferred to the corporation in the section 351 exchange. A partner with a special basis adjustment in property transferred to the corporation, however, has a special basis adjustment in the stock re

1997–48 I.R.B. 15 December 1, 1997

(B) Inclusions in certain cases. With regard to Mexico, the term Sociedad Anonima includes a Sociedad Anonima that chooses to apply the variable capital provision of Mexican corporate law (Sociedad Anonima de Capital Variable).

(iii) Public companies. For purposes of paragraph (b)(8)(i) of this section, with regard to Cyprus, Hong Kong, Jamaica, and Trinidad and Tobago, the term Public Limited Company includes any Limited Company that is not defined as a private company under the corporate laws of those jurisdictions. In all other cases, where the term Public Limited Company is not defined, that term shall include any Limited Company defined as a public company under the corporate laws of the relevant jurisdiction.

(iv) Limited companies. For purposes of this paragraph (b)(8), any reference to a Limited Company includes, as the case may be, companies limited by shares and companies limited by guarantee.

(e) Effective date . Except as otherwise provided in this paragraph (e), the rules of this section apply as of January 1, 1997. The reference to the Finnish, Maltese, and Norwegian entities in paragraph (b)(8)(i) of this section is applicable on the date the final regulations are published in the Fed- eral Register . Any Maltese or Norwegian entity that becomes an eligible entity as a result of paragraph (b)(8)(i) of this section in effect on the date final regulations are published in the Federal Regis- ter may elect (within 75 days of the date final regulations are published in the Fed- eral Register) to be classified for federal tax purposes as an entity other than a corporation retroactive to any period from and including January 1, 1997. Any Finnish entity that becomes an eligible entity as a result of paragraph (b)(8)(i) of this section in effect on the date final regulations are published in the Federal Register may elect (within 75 days of the date final regulations are published in the Federal Register ) to be classified for federal tax purposes as an entity other than a corporation retroactive to any period from and including September 1, 1997.

Par. 6. Section 301.7701–3 is amended as follows:

A sentence is added at the end of paragraph (c)(1)(iv).

ceived by the partnership in the section 351 exchange in an amount equal to the partner’s special basis adjustment in the transferred property, reduced by any special basis adjustment that reduced the partner’s gain under paragraph (b) of this section.

(d) Effective date. This section applies to transfers that occur on or after the date final regulations are published in the Fed- eral Register .

PART 301—PROCEDURE AND ADMINISTRATION

Par. 3. The authority citation for part 301 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * Par. 4. Section 301.6109-1 is amended as follows:

Paragraph (d)(2)(ii) is removed and reserved.
Paragraph (h) is redesignated as paragraph (i) and the first sentence of newly designated paragraph (i)(1) is amended by removing the language “paragraph (h)” and adding “paragraph (i)” in its place.
A new paragraph (h) is added. The addition reads as follows:

§301.6109-1 Identifying numbers.

(h) Special rules for certain entities under §301.7701–3 —(1) General rule. Any entity that has an employer identification number (EIN) will retain that EIN if its federal tax classification changes under §301.7701–3.

(2) Special rules for entities that are disregarded as entities separate from their owners —(i) When an entity becomes disregarded as an entity separate from its owner. Except as otherwise provided in regulations or other guidance, a single owner entity that is disregarded as an entity separate from its owner under §301.7701–3, must use its owner’s taxpayer identifying number (TIN) for federal tax purposes.

(ii) When an entity that was disre- garded as an entity separate from its owner becomes recognized as a separate entity . If a single owner entity’s classification changes so that it is recognized as a separate entity for federal tax purposes, and that entity had an EIN, then the entity must use that EIN and not the TIN of the

single owner. If the entity did not already have its own EIN, then the entity must acquire an EIN and not use the TIN of the single owner.

(3) Effective date . This paragraph (h) applies to changes in classification that occur on or after the date on which these regulations are published as final regulations in the Federal Register .

Par. 5. Section 301.7701–2 is amended as follows:

Paragraph (b)(8)(i) is amended by revising the entries for Finland, Malta, and Norway.
Paragraph (b)(8)(ii)(A) is redesignated as paragraph (b)(8)(ii)(A)( 1 ) and the language “and” at the end of the paragraph is removed.
Paragraph (b)(8)(ii)(B) is redesignated as paragraph (b)(8)(ii)(A)( 2 ) and the period at the end of the paragraph is removed and the language “; and “ is added in its place.
Paragraph (b)(8)(ii) heading and introductory text are redesignated as paragraph (b)(8)(ii)(A) heading and introductory text, and a new paragraph heading is added for paragraph (b)(8)(ii).
Paragraphs (b)(8)(ii)(A)( 3 ) and (b)(8)(ii)(B) are added.
Paragraphs (b)(8)(iii), (b)(8)(iv), and (e) are revised.

The revisions and additions read as follows:

§301.7701-2 Business entities; definitions.

(b) * * * (8) * * * (i) * * * Finland, Julkinen Osakeyhtio/Publikt Aktiebolag

Malta, Public Limited Company

Norway, Allment Aksjeselskap

(ii) Clarification of list of corporations in paragraph (b)(8)(i) of this section (A) Exceptions in certain cases. - * *

( 3 ) With regard to Malaysia, a Sendirian Berhad.

December 1, 1997 16 1997–48 I.R.B.

Paragraph (c)(2)(iii) is added.
A heading is added to paragraph (d)(1).
Paragraph (f) is redesignated as paragraph (h) and newly designated paragraph (h)(1) is revised.
Paragraphs (f) and (g) are added. The revision and additions read as follows:

§301.7701–3 Classification of certain business entities.

(c) * * * (1) * * * (iv) Limitation . * * * An election by a newly-formed eligible entity that is effective on the date of formation is not considered a change for purposes of this paragraph (c)(1)(iv).

(2) * * * (iii) Changes in classification. For purposes of paragraph (c)(2)(i) of this section, if an election under paragraph (c)(1)(i) of this section is made to change the classification of an entity, each person who was an owner on the date that any transactions under paragraph (g) of this section are deemed to occur, and who is not an owner at the time the election is filed, must also sign the election. This paragraph (c)(2)(iii) applies to elections filed on or after the date final regulations are published in the Federal Register .

(d) Special rules for foreign eligible en- tities —(1) Definition of relevance. - * *

(f) Changes in number of members of an entity —(1) Associations. The classification of an eligible entity as an association is not affected by any change in the number of members of the entity.

(2) Partnerships and single member entities . An eligible entity classified as a partnership is disregarded as an entity separate from its owner as of the date the entity has only one member. A single member entity disregarded as an entity separate from its owner is classified as a partnership as of the date the entity has more than one member.

(3) Effect on sixty month limitation. A change in the number of members of an entity does not result in the creation of a

new entity for purposes of the sixty month limitation on elections under paragraph (c)(1)(iv) of this section.

(4) Examples . The following examples illustrate the application of this paragraph (f):

Example 1. (i) On April 1, 1998, A and B, U.S. persons, form X, a foreign eligible entity. X is treated as an association under the default provisions of paragraph (b)(2)(i) of this section, and X does not make an election to be classified as a partnership. A subsequently purchases all of B’s interest in X.

(ii) Under paragraph (f)(1) of this section, X continues to be classified as an association. X, however, can subsequently elect to be disregarded as an entity separate from A. The sixty month limitation of paragraph (c)(1)(iv) of this section does not prevent X from making an election because X has not made a prior election under paragraph (c)(1)(i) of this section.

Example 2. (i) On April 1, 1998, A and B, U.S. persons, form X, a foreign eligible entity. X is treated as an association under the default provisions of paragraph (b)(2)(i) of this section, and X does not make an election to be classified as a partnership. On January 1, 1999, X elects to be classified as a partnership effective on that date. Under the sixty month limitation of paragraph (c)(1)(iv) of this section, X cannot elect to be classified as an association until January 1, 2004 (i.e., sixty months after the effective date of the election to be classified as a partnership).

(ii) On June 1, 1999, A purchases all of B’s interest in X. After A’s purchase of B’s interest, X can no longer be classified as a partnership because X has only one member. Under paragraph (f)(2) of this section, X is disregarded as a separate entity as of the date A becomes the only member of X. X, however, is not treated as a new entity for purposes of paragraph (c)(1)(iv) of this section. As a result, the sixty month limitation of paragraph (c)(1)(iv) of this section continues to apply to X and X cannot elect to be classified as an association until January 1, 2004 (i.e., sixty months after January 1, 1999, the effective date of the election by X to be classified as a partnership).

(5) Effective date. This paragraph (f) applies as of the date the final regulations are published in the Federal Register .

(g) Elective changes in classification (1) Deemed treatment of elective change —(i) Partnership to association. If an eligible entity classified as a partnership elects under paragraph (c)(1)(i) of this section to be classified as an association, the following is deemed to occur: The partnership contributes all of its assets and liabilities to the association in exchange for stock in the association, and immediately thereafter, the partnership liquidates by distributing the stock of the association to its partners.

(ii) Association to partnership. If an eligible entity classified as an association elects under paragraph (c)(1)(i) of this

section to be classified as a partnership, the following is deemed to occur: The association distributes all of its assets and liabilities to its shareholders in liquidation of the association, and immediately thereafter, the shareholders contribute all of the distributed assets and liabilities to a newly formed partnership.

(iii) Association to disregarded entity. If an eligible entity classified as an association elects under paragraph (c)(1)(i) of this section to be disregarded as an entity separate from its owner, the following is deemed to occur: The association distributes all of its assets and liabilities to its single owner in liquidation of the association.

(iv) Disregarded entity to an associa- tion . If an eligible entity that is disregarded as an entity separate from its owner elects under paragraph (c)(1)(i) of this section to be classified as an association, the following is deemed to occur: The owner of the eligible entity contributes all of the assets and liabilities of the entity to the association in exchange for stock of the association.

(2) Effect of elective changes. The tax treatment of a change in the classification of an entity for federal tax purposes by election under paragraph (c)(1)(i) of this section is determined under all relevant provisions of the Internal Revenue Code and general principles of tax law, including the step transaction doctrine.

(3) Timing of election. An election under paragraph (c)(1)(i) of this section that changes the classification of an eligible entity for federal tax purposes is treated as occurring at the start of the day for which the election is effective. Any transactions that are deemed to occur under this paragraph (g) as a result of a change in classification are treated as occurring immediately before the close of the day before the election is effective. For example, if an election is made to change the classification of an entity from an association to a partnership effective on January 1, the deemed transactions specified in paragraph (g)(1)(ii) of this section (including the liquidation of the association) are treated as occurring immediately before the close of December 31 and must be reported by the owners of the entity on December 31. As a result, the last day of the association’s taxable year will be December 31 and the first

1997–48 I.R.B. 17 December 1, 1997

fairs, Washington, DC 20503, with copies to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington, DC 20224. Comments on the collection of information should be received by December 9, 1998. Comments are specifically requested concerning: Whether the proposed collection of information is necessary for the proper performance of the functions of the IRS, including whether the information will have practical utility; The accuracy of the estimated burden associated with the proposed collection of information (see below); How the quality, utility, and clarity of the information to be collected may be enhanced; How the burden of complying with the proposed collection of information may be minimized, including through the application of automated collection techniques or other forms of information technology; and Estimates of capital or start-up costs and costs of operation, maintenance, and purchase of services to provide information.

The collection of information requirements are in proposed §1.863–3(f)(6). This information is required by the IRS to monitor compliance with the federal tax rules for determining the source of income from the sale 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, or from the sale of inventory purchased in a possession of the United States and sold in the United States. The likely respondents are taxpayers who produce inventory in the United States and sell in a possession, or who produce inventory in a possession and sell in the United States, or who purchase inventory in a possession and sell in the United States. Responses to this collection of information are required to properly determine the source of a taxpayer’s income from such sales.

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.

day of the partnership’s taxable year will be January 1.

(4) Effective date. This paragraph (g) applies to elections that are filed on or after the date the final regulations are published in the Federal Register .

(h) Effective date —(1) In general. Except as otherwise provided in this section, the rules of this section are applicable as of January 1, 1997.

Michael P. Dolan, Acting Commissioner of

Internal Revenue.

(Filed by the Office of the Federal Register on October 27, 1997, 8:45 a.m., and published in the issue of the Federal Register for October 28, 1997, 62 F.R. 55768)

Notice of Proposed Rulemaking and Notice Of Public Hearing

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

REG–251985–96

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains proposed 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. It also contains proposed 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. 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. This document also contains proposed 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 also provides notice of a public hearing on these proposed regulations.

DATES: Comments and outlines of oral comments to be presented at the public hearing scheduled for January 29, 1998, at 10 a.m. must be received by January 8, 1998.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (INTL–0003–95), room 5228, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. In the alternative, submissions may be hand delivered between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG–251985–96), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC, or electronically, via the IRS Internet site at: http://www.irs ustreas.gov/prod/tax_regs/comments.html. The public hearing will be held in room 2615, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Anne Shelburne, (202) 622-3880; concerning submissions and the hearing, Ms. Evangelista Lee, (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed rulemaking has been submitted to the Office of Management and Budget (OMB) for review in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)). Comments on the collection of information should be sent to the Office of Management and Budget, Attn: Desk Officer for the Department of Treasury, Office of Information and Regulatory Af

December 1, 1997 18 1997–48 I.R.B.

Estimated total annual reporting burden: 500 hours. The estimated annual burden per respondent varies from 1 hour to 5 hours, depending on individual circumstances, with an estimated average of 2.5 hours. Estimated number of respondents: 200 Estimated annual frequency of responses: One time per year.

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 assigned by the Office of Management and Budget.

Background

These proposed regulations contain rules under section 863 relating to the source of income from cross-border sales of certain property. These regulations also contain rules under section 936 relating to 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. These regulations are proposed to be effective for taxable years beginning 30 days after publication of final regulations.

Explanation of Provisions

I. Income Partly From Sources Within a Possession

A. Current Regulations

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 to determine the source of possession income is divided into 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).

Section 1.863–3 of the income tax regulations contains rules for determining the source of income derived from sales of certain property. These regulations were published in the Federal Register on No

vember 29, 1996 (61 F.R. 60540), and the prior regulations were renumbered §§1.863–3A and 1.863–3AT. The new regulations retain the prior rules for Section 863 Possession Sales by providing in paragraph §1.863–3(f) that taxpayers must apply the rules of §1.863–3A(c) in allocating and apportioning income derived from sources partly within the United States and partly within a possession of the United States. These proposed regulations would modify the existing rules for allocating and apportioning income between the United States and a possession.

Property produced and sold

Currently, income derived 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 (Possession Production Sales), is allocated or apportioned between the United States and a possession according to one of three methods. Such income is allocated under the independent factory price method, apportioned under an apportionment method, or, with permission of the District Director, allocated or apportioned on the basis of the taxpayer’s books and records.

Under the current regulations, if an independent factory or production price (IFP) exists for Possession Production Sales, taxpayers must use the IFP method to determine the income attributable to production activities in both the sale establishing the IFP and in sales of similar products.

If an IFP does not exist, the current possessions regulations provide that the taxable income from Possession Production Sales is first computed and then apportioned between the United States and the possession. One-half of the taxable income is apportioned on the basis of the taxpayer’s property within the United States and within the possession. In applying the property fraction, the taxpayer’s property includes property held or used to produce income derived from Possession Production Sales. The other half of the taxpayer’s taxable income is apportioned between U.S. and possession sources on the basis of the business of the taxpayer within the United States and within the possession. Currently, busi

ness of the taxpayer is measured by the sum of certain expenses, including amounts paid for labor, and the purchase of certain supplies, plus receipts from Possession Production Sales. Finally, as a third method, the existing regulations allow a taxpayer to request permission from the District Director to use the taxpayer’s books and records to allocate or apportion income to sources within or without the United States if those books reflect more clearly than the other methods the taxable income derived from sources within the United States.

Property purchased and sold

The second type of possession transaction governed by the existing regulations is the sale of inventory purchased in a possession and sold in the United States (Possession Purchase Sales) as described in section 863(b)(3). Under the current regulations, the income from such sales is divided between the United States and possession sources under one of two methods. The income can be apportioned, or, with permission of the District Director, allocated or apportioned on the basis of the taxpayer’s books and records.

Under the apportionment method, taxable income is first determined, and then apportioned by a fraction, the numerator being the business of the taxpayer in the United States, the denominator being the total business of the taxpayer in the United States and in the possession. The fraction is computed in the same manner as the business fraction discussed previously, except that such expenses, purchases, and sales are limited to those attributable to Possession Purchase Sales.

B. Issues Under Current Regulations

The IRS and Treasury believe the rules for allocating and apportioning income between the United States and the possessions of the United States should be amended to reflect certain changes made to the regulations under §1.863–3 governing cross-border sales of inventory involving the United States and a foreign country (other than those involving possessions). Thus, for example, under the apportionment method provided in the proposed regulations, the property and business activity fractions apportioning income between the United States and a possession are modified to apportion

1997–48 I.R.B. 19 December 1, 1997

tion 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, instead of all its assets that produce income from Possession Production Sales. Production assets are included in the fraction at their adjusted tax basis.

The other half of the taxpayer’s gross income 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 Internal Revenue Service 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.

The proposed regulations make some modifications to the factors in the fraction representing the business sales activity of the taxpayer. 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. Cost of goods sold is also 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.

Finally, the proposed regulations provide more explicit guidance for attributing business sales activity between the

gross income attributable to an activity, rather than to apportion net income.

The IRS and Treasury also believe certain ambiguities exist in the current regulations. The possessions rules were originally promulgated in 1926, and may not reflect current business practices. The current regulations use examples to illustrate methods for allocating or apportioning income between the United States and a possession, and should be modified to state rules.

Further, although the apportionment method for allocating Possession Production Sales income under the existing possessions regulations treats half of the income as production income, the production formula is not necessarily limited to production assets. The current inclusion of sales assets in the formula apportioning production income results in excessive income being allocated to sales activities. The production income formula should only take into account assets directly involved in production of inventory. In addition, the IRS and Treasury have reexamined the business activity fraction, and have concluded it should be revised to more clearly reflect the taxpayer’s business other than production. The current fraction, for example, omits certain investments or expenses, such as marketing and advertising expenses, although income attributable in part to such expenses or investments is then included in the income apportioned by the fraction. The current regulations also take into account production expenses in the business activity fraction apportioning income from Possession Production Sales. The Service and Treasury believe that this is inappropriate in the context of Possession Production Sales because the business activity fraction is not intended to determine the source of income attributable to production activity. In the proposed regulations, the fraction apportioning Possession Production Sales is renamed the business sales activity fraction and excludes factors reflecting production activity.

The current regulations also do not address issues in attributing to the United States or to the possession, the activities reflected in the business activity fraction. For example, the current regulations provide no guidance on whether a particular expense should be represented in the frac

tion as attributable to the United States or to a possession.

Accordingly, the IRS and Treasury are issuing proposed regulations under section 863 to make the possessions rules more consistent with the other regulations governing the source of income from cross-border sales of inventory, and to address certain ambiguities and problems in the existing regulations.

C. Proposed Regulations

Section 1.863-3(f) generally retains the methods of the current regulations for dividing income between the United States and a possession of the United States, with several modifications.

Methods to allocate gross income to activities of the taxpayer a. Property produced and sold i. The possession 50/50 method

Consistent with the final regulations under §1.863–3, paragraph (f)(2)(i)(A) of the proposed regulations makes the 50/50 method the general rule to allocate gross income from Possession Production Sales between production 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 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 proposed 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. As described below, the proposed regulations make certain changes to the existing property fraction and to the existing business activity fraction.

The proposed 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 based on the location of the taxpayer’s production assets. In a change from the current regulations, and consistent with the changes made to the regulations under §1.863–3(c), produc

December 1, 1997 20 1997–48 I.R.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.

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 proposed paragraph (f)(4), taxpayers must allocate or 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 or 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 or apportion these amounts between gross income from sources within the United States and within a possession. For expenses, losses and other deductions allocated or apportioned to gross income determined under the possessions 50/50 method, taxpayers must apportion expenses and other deductions pro rata based on the relative amounts of U.S. and possession source gross income. 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.

Treatment of gross income derived from certain purchases from a corporation that has an election in effect under section 936

The proposed 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.

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. ii. The IFP method

The proposed regulations make the IFP method elective, and thus eliminate any bias against taxpayers choosing to export through independent distributors. The regulations rely upon the revised regulations under §1.863–3 for rules in applying the IFP method. iii. Books and records method

The proposed regulations retain the books and records method of the existing regulations, permitting 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 revised §1.863–3(b)(3) in applying the method to Possession Production Sales. b. Property purchased and sold i. The business activity method

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

The proposed regulations retain the structure of the existing regulations by apportioning 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 that 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. As modified, the business activity fraction reflects the view of Treasury and the Internal Revenue Service that section 863(b)(3)’s purchase rule was intended to apply only to purchase and resale transactions, where the goods purchased are created or derived from the possession. ii. Books and records method

Determination of source of gross income

Unlike the current regulations which provide specific rules for determining the source of income attributable to production activity and business activity only for purposes of the 50/50 method, the proposed regulations adopt rules applicable to each of the methods. Under the proposed 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),

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Treatment of partners and partnerships

The proposed 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.

Election and reporting rules

Under paragraph (f)(6)(i) of the proposed 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 not be withheld 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 proposed 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, endproduct form, or integrated product. No inference should be drawn from the proposed effective date concerning the treatment of transactions involving sales of property purchased from a section 936 corporation entered into before the regulations are applicable.

Proposed Effective Dates

These regulations are proposed to be effective for taxable years beginning on or after the date that is 30 days after the date of publication of final regulations.

Special Analyses

It has been determined that this notice of proposed rulemaking 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, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any comments that are submitted timely (in the manner described under the ADDRESSES caption) to the IRS. All comments will be available for public inspection and copying.

A public hearing has been scheduled for January 29, 1998, at 10 a.m., in room 2615, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC. Because of access restrictions, visitors will not be admitted beyond the Inter

nal Revenue Building lobby more than 15 minutes before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons that wish to present oral comments at the hearing must submit comments and an outline of topics to be discussed and the time to be devoted to each topic (in the manner described under the ADDRESSES caption of this preamble) by January 8, 1998.

A period of 10 minutes will be allotted to each person for making comments.

An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

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.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be 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:

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

December 1, 1997 22 1997–48 I.R.B.

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 (b)(1) Q&A 13.

(2) Allocation or apportionment for Possession Production Sales —(i) Meth- ods 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 at- tributable 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 busi- ness sales activity —( 1 ) S ource 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 in- come 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

1997–48 I.R.B. 23 December 1, 1997

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) 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 ($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 Ex- ample 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 §1.861–8(e)(3), 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 §1.861–8(e)(3)(i)(A). 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 prop

erly 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. 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.

(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

December 1, 1997 24 1997–48 I.R.B.

after the date that is 30 days after the date of publication of final regulations.

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 the date that is 30 days after the date of publication of final regulations.

Michael P. Dolan, Acting Commissioner of

Internal Revenue.

(Filed by the Office of the Federal Register on October 9, 1997, 8:45 a.m., and published in the issue of the Federal Register for October 10, 1997, 62 F.R. 52953)

Baton Rouge, LA

Foundations Status of Certain Organizations

Announcement 97–116

Battered Women as Survivors Inc.,

Columbus, OH Bay Area Neighborhood Development

The following organizations have failed to establish or have been unable to maintain their status as public charities or as operating foundations. Accordingly, grantors and contributors may not, after this date, rely on previous rulings or designations in the Cumulative List of Organizations (Publication 78), or on the presumption arising from the filing of notices under section 508(b) of the Code. This listing does not indicate that the organizations have lost their status as organizations described in section 501(c)(3), eligible to receive deductible contributions.

Former Public Charities. The following organizations (which have been treated as organizations that are not private foundations described in section 509(a) of the Code) are now classified as private foundations: Babys Exchange, Parker, AZ Bachman Northwest Highway

Corporation, Sandusky, OH Bay Area Raiders Football Inc.,

Lexington, KY Bel Canto Lyric Opera Company,

Philadelphia, PA Belle Babb Nansfield Foundation,

Tampa, FL Bay Area Youth Wheelchair Athletic

Association, St. Petersburg, FL Bay Hope House, Bokeelia, FL Bayou-River Social Services, Luling, LA Bayshore Volunteer Fire Department,

Inc., North Ft. Myers, FL Baytown Youth Development Center,

Inc., Baytown, TX Beall Society for Sight Preservation, Inc.,

Cleveland, OH Bear Buddies Educational Resources,

Inc., Hudson, WI Bedford City Schools Foundation,

Bedford, OH Beech Economic Development

Association, Philadelphia, PA Beechwood Resource Center Inc.,

River Rouge, MI Behavioral Communication Research,

Community Association, Dallas, TX Baillie Players Inc., Columbia, SC Bainbridge-Decatur County Council for

Des Moines, IA Belleville Public Library Foundation,

the Arts, Inc., Bainbridge, GA Balkan Relief Fund, Inc.,

Belleville, KS Ben Davis Youth Sports Association,

Fern Park, FL Bamberg Kiddie Kampus Inc.,

Bamberg, SC Bandits Football Association,

Ofallon, MO Bankhead Learning Academy Inc.,

Inc., Indianapolis, IN Bengali Association of Greater Dallas-Ft.

Atlanta, GA Baptist Hill House Inc., Detroit, MI Baptist Ministrers Conference of

Cincinnati and Vicinity, Cincinnati, OH Baptist Village Residents Association,

Worth, Plano, TX Benjamin House Inc., Cleveland, OH Benzie Housing Council, Benzonia, MI Berlitz Gallery Theatre, Chandler, AZ Berryville Baseball Association, Inc.,

Berryville, AR Best Southwest Business Center,

Duncanville, TX Bethel Foundation, Des Moines, IA Bethlehem Ministries Inc., Paterson, NJ Better Business Bureau of the Golden

Phoenix, AZ Barnabas Ministries, Springfield, OH Bartow County Coalition for Substance

Abuse Prevention, Cartersville, GA BASE Camp Childrens Cancer

Foundation, Inc., Windermere, FL Basic Interdenominational Lackland

Shelter, Incorporated, San Antonio, TX Bastrop County Crime Stoppers, Inc.,

Spread Educational Foundation, Amarillo, TX Better Community Relations Inc.,

Raleigh, NC Better Life Inc., Birmingham, MI Better Way of Life, Chicago, IL

Bastrop, TX Baton Rouge Black Alcoholism Council,

Toledo, OH Better Homes for North Carolina Inc.,

1997–48 I.R.B. 25 December 1, 1997

Bexar Metropolitan Housing Association,

Birthright of Sterling, Sterling, CO BJ Nutritional Service Inc., Houston, TX Black & White Medical Transportation,

Bogalusa Humane Society, Bogalusa, LA Bone Marrow International,

Greensboro, NC Book Bank Project, Mesa, AZ Book of Hope Inc., Deerfield, FL Booksellers for Social Responsibility,

San Antonio, TX Beyer School Parent Teacher

Organization, Rockford, IL Beyond the Limits–Childrens Outreach

Inc., Pine Bluff, AR Black Activities at a Glance,

Services, Jackson, MS Bhagavat Dharma Samaj Inc.,

Baltimore, MD Bibleway Community Outreach Projects,

Columbus, OH Black Bear Awareness, Trufant, MI Black Belt Improvement Group,

Hope Hull, AL Black Business Entrepreneurs, Sandy, UT Black Professional Men Inc.,

Chicago, IL Boone County Youth Soccer Association,

Florence, KY Bootstrap Inc., New Berlin, WI Boston Township Hall Committee Inc.,

Peninsula, OH Bowling Green Choral Society Inc.,

Inc., Annapolis, MD Biblical Counseling Ministries Inc.,

Merrian, KS Big Bend People and Goats, Alpine, TX Big Brothers-Big Sisters of Ford County,

Baltimore, MD Black State Employees Association,

Dallas, TX Blind Comprehensive Action Network,

St. John, MO Blind People of America Entertainment

BPOA, Inc., Albuquerque, NM Blossomland Arts and Cultural Council,

Bowling Green, KY Boys & Girls Club of the Smoky

Inc., Dodge City, KS Big Brothers-Big Sisters of Owensboro,

Mountains, Inc., Sevierville, TN BRACE Inc., Winston-Salem, NC BREATHE, Boulder, CO

Inc., Owensboro, KY Big Brothers-Big Sisters of Morgan

County, Inc., Decatur, AL Big Horn Basin of Wyoming Resource

Conservation and Developmental Project, Worland, WY Billings Senior High Band Parents Inc.,

Saint Joseph, MI Blue Ash Revitalization Inc.,

Billings, MT Binghampton Fellowship Foundation,

Inc., Memphis, TN Birmingham Chapter of the American

Association of Energy, Birmingham, AL Birmingham Regional Sports Club Inc.,

Blue Ash, OH Blue Ridge Home for Boys, Greer, SC Bluebirds Over Georgia Inc., Atlanta, GA Bluegrass Brass Inc., Lexington, KY Blues Club Inc., Jonesboro, AR Blues Society of Indiana Incorporated,

Indianapolis, IN Bnai Brith Athletic and Achievement

If an organization listed above submits information that warrants the renewal of its classification as a public charity or as a private operating foundation, the Internal Revenue Service will issue a ruling or determination letter with the revised classification as to foundation status. Grantors and contributors may thereafter rely upon such ruling or determination letter as provided in section 1.509(a)–7 of the Income Tax Regulations. It is not the practice of the Service to announce such revised classification of foundation status in the Internal Revenue Bulletin.

Birmingham, AL Birmingham Schools Athletic Foundation,

Award Endowment Fund, Roanoke, VA Bnai Brith Covenant House of Tucson

Arizona Inc., Tucson, AZ Boardwalk Estates Inc., Garden City, KS Bob Johnson Ice Hockey Foundation,

Birmingham, AL Birthline of Wellington Inc.,

Colorado Springs, CO

Wellington, KS

December 1, 1997 26 1997–48 I.R.B.