Second Apportionment of Expenses of a Related Supplier to FSC or DISC Dividends Discontinued -- Final Regs Under Section 861

 [4830-01]

 ACTION: Final regulations.

 SUMMARY: This document contains final Income Tax Regulations relating to apportionment of expenses in the Foreign Service Corporations (FSC) and Domestic International Sales Corporation (DISC) contexts. This action is being taken in order to discontinue the apportionment of expenses of the related supplier of a DISC or a FSC to dividends from the DISC or FSC. This regulation is necessary to prevent a second apportionment to the dividend from a FSC or DISC of expenses already apportioned to determine the combined taxable income of the FSC or DISC and its related supplier.

 EFFECTIVE DATE: These regulations are effective for taxable years beginning after December 31, 1986.

 FOR FURTHER INFORMATION CONTACT: Richard L. Chewning of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel. Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. 20224, Attention: CC:CORP:T:R(INTL-28-86) (202-566-3452, not a toll-free call).

SUPPLEMENTARY INFORMATION:

BACKGROUND

On May 17, 1988, the Federal Register published proposed amendments (53 FR 17473) to the Income Tax Regulations (26 CFR Part 1) under section 861(b) of the Internal Revenue Code of 1986. Corrections were published in the Federal Register on May 27, 1988 (53 FR 19369). Written comments responding to this notice were received. A public hearing was not requested and none was held. After consideration of all comments regarding the proposed amendments, those amendments are adopted by this Treasury Decision with revisions in response to those comments. The comments and revisions are discussed below.

EXPLANATION OF PROVISIONS

 The language in section 1.861-8(f)(1)(vi)(C) as proposed has been moved to section 1.861-8(f)(2)(ii) and modified to clarify that for taxable years beginning after December 31, 1986, there will not be a "second stage" apportionment whenever either of the administrative pricing methods of sections 994 and 925 (i.e. the combined taxable income method and the gross receipts method) is used to determine the profit of the DISC or FSC, respectively.

 Subdivision (iii)(A) of Example (23) in section 1.861-8(g) is modified to clarify that the statutory grouping is gross income from R's sale of the export property, the electronic equipment, and not gross income under section 863(b).

 One commentator suggested that the proposed regulations at subdivision (iv) of section 1.861-8(g) Example (23) incorrectly determined, relying on section 927(e)(1), the related supplier's foreign source income from the export sales. Section 927(e)(1) provides that the foreign source income of the related supplier of a FSC from transactions which give rise to foreign trading gross receipts may not exceed the foreign source income that would have been earned by the related supplier had the analogous DISC pricing rule applied to the transaction. Accordingly, the proposed regulations, in applying section 927(e)(1), determined the related supplier's foreign source income using the 50% combined taxable income DISC pricing method which is analogous to the 23% combined taxable income FSC pricing method. The proposed regulations did not apply the second stage apportionment of general and administrative expenses and research and development expenses to the DISC dividends in determining what would have been the related supplier's foreign source income from the sales. The commentator suggested that the failure to use the second stage apportionment procedure did not follow Congressional intent to maintain parity in the level of foreign source income whether the transaction involves a FSC or a DISC prior to the enactment of the Tax Reform Act of 1986 (Pub. L. 99-514) since the second stage apportionment procedure could be used to determine a related supplier's foreign source income in 1986.

 We believe, however, that section 927(e)(1) requires only a comparison to the analogous DISC pricing method as applicable for the year in which the related supplier's foreign source income is being determined. Therefore, the second stage apportionment procedure may be used only with regard to taxable years beginning before January 1, 1987, since the procedure is only applicable to those years. See subdivision (iv) of section 1.861-8(g) Example (22) and subdivision (vi) of section 1.861-8(g) Example (23).

SPECIAL ANALYSES

 It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. Chapter 5) and the Regulatory Flexibility Act (5 U.S.C. Chapter 6) do not apply to these regulations, and, therefore, a final Regulatory Flexibility Analysis is not required.

DRAFTING INFORMATION

 The principal author of these regulations is Richard L. Chewning of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service. Other personnel from the Internal Revenue Service and Treasury Department participated in developing these regulations.

LIST OF SUBJECTS IN 26 CFR SECTIONS 1.861-1 THROUGH 1.997-1

Income taxes, Corporate deductions, Aliens, Exports, DISC, Foreign Investments in U.S., Foreign tax credit, FSC, Source of income, U.S. investments abroad.

Treasury Decision 8286

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR Part 1 is amended as follows:

Part 1 -- INCOME TAX REGULATIONS

Paragraph 1. The authority for Part 1 continues to read in part:

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

Par. 2. Section 1.861-8 is amended by revising paragraph (f)(1)(iii) by removing and reserving paragraphs (f)(1)(ii) and (f)(1)(vi)(C), by designating paragraph (f)(2) as (f)(2)(i) and by adding a new paragraph (f)(2)(ii) to read as follows:

SEC. 1.861-8 COMPUTATION OF TAXABLE INCOME FROM SOURCES WITHIN THE UNITED STATES AND FROM OTHER SOURCES AND ACTIVITIES.

* * * * *

(f) MISCELLANEOUS MATTERS -- (1) OPERATIVE SECTIONS. * * *

(iii) DISC AND FSC TAXABLE INCOME. Sections 925 and 994 provide rules for determining the taxable income of a FSC and DISC, respectively, with respect to qualified sales and leases of export property and qualified services. The combined taxable income method available for determining a DISC's taxable income provides, without consideration of export promotion expenses, that the taxable income of the DISC shall be 50 percent of the combined taxable income of the DISC and the related supplier derived from sales and leases of export property and from services. In the FSC context, the taxable income of the FSC equals 23 percent of the combined taxable income of the FSC and the related supplier. Pursuant to regulations under sections 925 and 994, this section provides rules for determining the deductions to be taken into account in determining combined taxable income, except to the extent modified by the marginal costing rules set forth in the regulations under sections 925(b)(2) and 994(b)(2) if used by the taxpayer. See Examples (22) and (23) of paragraph (g) of this section. In addition, the computation of combined taxable income is necessary to determine the applicability of the section 925(d) limitation and the "no loss" rules of the regulations under sections 925 and 994.

* * * * *

(vi) * * *

(C) [RESERVED].

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(2) APPLICATION TO MORE THAN ONE OPERATIVE SECTION. (i) * * *

(ii) When expenses, losses, and other deductions that have been properly allocated and apportioned between combined gross income of a related supplier and a DISC or former DISC and residual gross income, regardless of which of the administrative pricing methods of section 994 has been applied, such deductions are not also allocated and apportioned to gross income consisting of distributions from the DISC or former DISC attributable to income of the DISC or former DISC as determined under the administrative pricing methods with respect to DISC or former DISC taxable years beginning after December 31, 1986. Accordingly, Example (22) of paragraph (g) of this section does not apply to distributions from a DISC or former DISC with respect to DISC or former DISC taxable years beginning after December 31, 1986. This rule does not apply to the extent that the taxable income of the DISC or former DISC is determined under the section 994(a)(3) transfer pricing method. In addition, for taxable years beginning after December 31, 1986, in the case of expenses, losses, and other deductions that have been properly allocated and apportioned between combined gross income of a related supplier and a FSC and residual gross income, regardless of which of the administrative pricing methods of section 925 has been applied, such deductions are not also allocated and apportioned to gross income consisting of distributions from the FSC or former FSC which are attributable to the foreign trade income of the FSC or former FSC as determined under the administrative pricing methods. This rule does not apply to the extent that the foreign trade income of the FSC or former FSC is determined under the section 925(a)(3) transfer pricing method. See Example (23) of paragraph (g) of this section.

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Par. 4. Example (22) of section 1.861-8 (g) is amended by adding immediately after subdivision (iii) a subdivision (iv) to read as follows:

SEC. 1.861-8 COMPUTATION OF TAXABLE INCOME FROM SOURCES WITHIN THE UNITED STATES AND FROM OTHER SOURCES AND ACTIVITIES.

* * * * *

(g) General examples. * * *

EXAMPLE (22). * * *

(iv) This Example (22) applies only to DISC taxable years ending before January 1, 1987 and to distributions from a DISC or former DISC with respect to DISC or former DISC taxable years ending before January 1, 1987.

* * * * *

Par. 4. Example (23) of section 1.861-8(g) is removed and replaced with new Example (23) to read as follows:

SEC. 1.861-8 COMPUTATION OF TAXABLE INCOME FROM SOURCES WITHIN THE UNITED STATES AND FROM OTHER SOURCES AND ACTIVITIES.

* * * * *

(g) GENERAL EXAMPLES. * * *

EXAMPLE (23) -- FOREIGN SALES CORPORATIONS -- (i) FACTS. R, a domestic corporation, manufactures a product line of electronic equipment and sells it to retailers both in the United States and in foreign countries. On January 1, 1988, R established FSC, a wholly owned corporation, in a possession of the United States. FSC elected under section 922(a)(2) foreign sales corporation status. Both R and FSC are calendar year corporations. R entered into a written agreement with FSC whereby FSC was granted a sales franchise with respect to the export sales of the electronic equipment, which is export property as defined in section 927(a). Under the agreement, FSC would receive commissions with respect to those exports equal to the maximum amount permitted to be received under the administrative pricing rules of section 925(a)(1) and (2). The maximum amount will equal the expenses incurred by FSC plus the maximum profit permitted to be earned by FSC under the pricing rules. In 1988, the profit earned by FSC was $354,424. This profit was determined using the combined taxable income administrative pricing method of section 925(a)(2). FSC paid taxes to the United States in the amount of $41,914 (i.e., $354,424 x 8/23 x .34). The FSC did not pay any foreign tax. On September 15, 1989, FSC paid R a dividend of $312,510 (i.e., profit less United States tax). The 100% dividends received deduction of section 245(c) applied to this dividend. In 1988, R had total export sales of $7,700,000 for which its cost of goods sold was $6,000,000. Thus, its gross income on those sales was $1,700,000. Those sales occurred outside the United States. Moreover, R had U.S. domestic sales of $12,000,000 on which it earned gross income of $900,000. R received royalty income from the foreign license of its electronic technology in the amount of $1,000,000. R's deductible general and administrative expenses allocable to all gross income are $125,000. For purposes of this example, it is assumed that R did not incur any research and development expenses. In addition, it is assumed that R did not incur any direct selling expenses with respect to either its domestic or foreign sales. FSC incurred $100,000 of expenses relating to the activities and functions referred to in section 924(c), (d) and (e). FSC will receive the maximum commission and profit under the combined taxable income method of section 925(a)(2). Under this method, FSC will receive a profit equal to 23% of the combined taxable income attributable to the export sale of the electronic equipment computed on a product line basis.

(ii) ALLOCATION. For purposes of determining combined taxable income of R and FSC from export sales, R's general and administrative expenses of $125,000 must be allocated to and apportioned between gross income resulting from the production and sale of the electronic equipment for foreign markets, and from the production and sale of the electronic equipment for the domestic market.

(iii) APPORTIONMENT -- (A) COMBINED TAXABLE INCOME. In order to compute the combined taxable income from the production and sale of the electronic equipment, R's general and administrative expenses of $125,000 are apportioned between the statutory grouping of gross income from the export of the electronic equipment and the residual grouping of gross income from domestic sales and foreign licenses. None of R's general and administrative expenses are apportioned to the FSC distribution of $312,510. In the absence of more specific or contrary information, R's general end administrative expenses may be apportioned on the basis of gross income in the respective groupings, as follows:

Apportionment of general and administrative expenses to the statutory grouping, gross income from exports of electronic equipment:

 $1,700,000

 ($900,000 + $1,000,000)

 Gross income from exports                  $1,700,000

 Gross receipts                   $7,700,000

(C) R'S FOREIGN SOURCE ROYALTY INCOME. In order to determine the amount of taxable income of R from sources without the United States relating to the royalty income, the remaining general and administrative expenses of $65,972 are apportioned between the statutory grouping, foreign royalty income, and the residual grouping of gross income from sources within the United States. The computations below illustrate this apportionment:

Apportionment of the general and administrative expenses to the statutory grouping, foreign royalty income:

 $1,000,000

 $900,000

 Combined Taxable Income (CTI)        $1,540,972

(vi) APPORTIONMENT OF EXPENSES IN A DISC CONTEXT. For taxable years beginning after December 31, 1986, general and administrative expenses and R&D expenses of a related supplier in a DISC context are also allocated and apportioned as illustrated in this example. None of the expenses are apportioned to DISC dividends.

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Par. 5. Section 1.861-8T(f)(1)(iii) is redesignated as 1.861-8T(f)(1)(ii).