Source & Grouping Rules for
Foreign Sales Corporation Transfer Pricing

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8764] RIN 1545-AV91

TITLE: Source and Grouping Rules for Foreign Sales Corporation
Transfer Pricing

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

SUMMARY: This document contains temporary regulations that provide
guidance to taxpayers who have made an election to be treated as a
foreign sales corporation (FSC). The regulations provide rules that
clarify the special sourcing rules under section 927(e)(1) and
provide a deadline for the election to group transactions. The text
of the temporary regulations also serves as the text of the proposed
regulations on this subject in the Proposed Rules section of this
issue of the Federal Register.

DATES: Effective date: These regulations are effective March 3,
1998.

Applicability: For dates of applicability, see §§1.925(a)-1T( c)(8)
(i) and 1.927(e)-1T(c).

FOR FURTHER INFORMATION CONTACT: Elizabeth Beck (202) 622-3880 (not
a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains amendments to the Income Tax Regulations (26
CFR part 1) under sections 925 and 927 which were added by the
Deficit Reduction Act of 1984, applicable for taxable years of
foreign sales corporations beginning after December 31, 1984.
Temporary regulations were published in the Federal Register (52 FR
6468) as a Treasury Decision (TD 8126) on March 3, 1987. Treasury
and IRS believe that immediate guidance in the form of these
temporary regulations is necessary for the reasons stated below.

Explanation of Provisions

These regulations set a deadline for an election to group
transactions for purposes of the foreign sales corporation (FSC)
administrative pricing methods and clarify that the foreign source
limit for a FSC's related supplier extends to all transactions
giving rise to foreign trading gross receipts.

I. Grouping Election Deadline.

A. Current temporary regulations.

Current §1.925(a)-1T(c)(8) and §1.925(b)-1T(b)(3) permit taxpayers
annually to group transactions in applying the administrative
pricing (including the marginal costing) rules to determine FSC
benefits. Current §1.925(a)-1T(c)(8)(i) requires an election to
group to be evidenced on the FSC income tax return for the taxable
year. Current §1.925(a)-1T(e)(4) authorizes taxpayers to file
amended returns subsequently (within the statute of limitations
period) to redetermine FSC benefits based on a different grouping of
transactions than that originally elected. Pursuant to this
provision, taxpayers may change their grouping basis, or change from
a grouping to a transaction-by-transaction basis. The IRS and the
Treasury have become increasingly aware of taxpayers who, through
the use of sophisticated computer programs, substantially revise
their transaction groupings just prior to the expiration of the
statute of limitations and many years after the original returns
were filed. These revised groupings typically employ complex
estimating techniques. The recent rise in this practice is placing a
significant burden on the auditing process and is creating a
potential for abuse.

B. Revised temporary regulations.

Under §1.925(a)-1T(c)(8)(i), the election to group must be made on
Schedule P of the FSC's timely filed U.S. income tax return
(including extensions thereof) for the taxable year. No untimely or
amended returns will be allowed to elect to group, to change a
grouping basis, or to change from a grouping basis to a transaction-
by-transaction basis for such year.

Conforming changes and cross-references are reflected in
§1.925(a)-1T(e)(4) and §1.925(b)-1T(b)(3).

The regulations apply to taxable years beginning after December 31,
1997. There is also a transition rule providing that the regulations
also apply to taxable years beginning before January 1, 1998. For
these taxable years, the transition rule allows taxpayers to
redetermine their grouping of transactions with respect to such
years provided such redetermination is made no later than the due
date of the FSC's timely filed U.S. income tax return (including
extensions thereof) for its first taxable year beginning after
December 31, 1997.

II. Scope of Related Supplier Foreign Source Limit.

A. Current temporary regulations and TRA 97.

Section 927(e)(1) provides that "[u]nder regulations, the income of
a person described in section 482 from a transaction giving rise to
foreign trading gross receipts of a FSC which is treated as from
sources outside the United States shall not exceed the amount which
would be treated as foreign source income earned by such person if
the pricing rule under section 994 which corresponds to the rule
used under section 925 with respect to such transaction applied to
such transaction." Transactions giving rise to foreign trading gross
receipts include qualifying sales, leases, licenses and services.
Current §1.927(e)-1T restates the section 927(e)(1) rule as
applicable on "the sale of export property." While the statute is
not limited to export sale transactions in that it applies to any
transaction giving rise to foreign trading gross receipts of a FSC,
the current regulation might be interpreted to apply the special
foreign sourcing limit only to sales of export property.

Section 1171 of the Taxpayer Relief Act of 1997 (TRA 97) amended
section 927(a)(2)(B) (without any inference intended regarding prior
law) to provide that computer software licensed for reproduction
abroad is included within the definition of export property for
purposes of the FSC provisions. The amendment applies to gross
receipts from computer software licenses attributable to periods
after December 31, 1997, in tax years ending after such date.

In light of TRA 97, it is important to clarify the scope of the
related supplier's foreign source limit under the regulations. This
clarification needs to be implemented immediately in order to
provide clear guidance to taxpayers, including those utilizing the
TRA 97 amendment to section 927(a)(2)(B).

B. Revised temporary regulations.

Under §1.927(e)-1T(a)(1), the related supplier's foreign source
limit applies to any transaction, including but not limited to any
sale, lease, license or service, giving rise to foreign trading
gross receipts of a FSC. No inference is intended regarding the
scope of application of the prior regulation.

Conforming changes are reflected in §1.927(e)-1T(a)(2) and (3).
Special rules are added in §1.927(e)-1T(a)(3)(ii) to clarify how the
corresponding DISC transfer pricing rules are to be applied for
purposes of the foreign source limit. Three examples set forth in
§1.927(e)-1T(b) illustrate how the limit is applied under different
transfer pricing methods and for different types of transactions.

The regulations apply to taxable years beginning after December 31,
1997.

Special Analyses

It has been determined that this Treasury Decision is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required. It has also 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 the regulation does not impose a collection of information
on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter
6) does not apply. Pursuant to section 7805(f) of the Internal
Revenue Code, these temporary regulations will be submitted to the
Chief Counsel for Advocacy of the Small Business Administration for
comment on their impact on small business.

Drafting Information

The principal author of these regulations is Elizabeth Beck of the
Office of the Associate Chief Counsel (International).

Other personnel from the IRS and Treasury Department also
participated in the development of these regulations.

List of Subjects

26 CFR Part l Income taxes, Reporting and recordkeeping requirement
Adoption of Amendments to the Regulations Accordingly, 26 CFR part 1
is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by
revising the entries for sections 1.925(a)-1T and 1.925(b)-1T to
read as follows:

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

Section 1.925(a)-1T is also issued under 26 U.S.C. 925(b)(1) and (2)
and 927(d)(2)(B).

Section 1.925(b)-1T is also issued under 26 U.S.C. 925(b)(1) and (2)
and 927(d)(2)(B) * * *

Par. 2. Section 1.925(a)-1T is amended by:

1. Removing the last sentence of paragraph (c)(8)(i) and adding five
sentences in its place.

2. Paragraph (e)(4) is amended by:

a. Removing the language "or grouping of transactions" from the
fourth sentence.

b. Adding a sentence to the end of the paragraph.

The additions read as follows:

§1.925(a)-1T Temporary Regulations; Transfer pricing rules for FSCs.

* * * * *

(c) * * *

(8) * * * (i) * * * The election to group transactions shall be
evidenced on Schedule P of the FSC's timely filed U.S.
income tax return (including extensions thereof) for the taxable
year. No untimely or amended returns will be allowed to elect to
group, to change a grouping basis, or to change from a grouping
basis to a transaction-by-transaction basis. The rules of the
previous two sentences of this paragraph (c)(8)(i) are applicable to
taxable years beginning after December 31, 1997. For any taxable
year beginning before January 1, 1998, for which a redetermination
is otherwise permissible under paragraph (e)(4) of this section as
in effect for taxable years beginning before January 1, 1998, a
redetermination of grouping of transactions cannot be made later
than the due date of the FSC's timely filed U.S. income tax return
(including extensions thereof) for the FSC's first taxable year
beginning after December 31, 1997. The language "or grouping of
transactions" is removed from the fourth sentence of paragraph (e)
(4) of this section, applicable to taxable years beginning after
December 31, 1997.

* * * * *

(e) * * *

(4) * * * For the election to group transactions for purposes of
applying the administrative pricing methods, see paragraph (c)(8)(i)
of this section.

* * * * *

Par. 3. In §1.925(b)-1T, paragraph (b)(3)(i) is amended by adding at
the end of the paragraph the following sentence:

§1.925(b)-1T Temporary regulations; marginal costing rules.

* * * * *

(b) * * *

(3) * * * (i) * * * For the election to group transactions for
purposes of applying the administrative pricing methods, see
§1.925(a)-1T(c)(8)(i).

* * * * *

Par. 4. Section 1.927(e)-1T is revised to read as follows:

§1.927(e)-1T Temporary regulations; special sourcing rule.

(a) Source rules for related persons--(1) In general. The income of
a person described in section 482 from a transaction giving rise to
foreign trading gross receipts of a FSC which is treated as from
sources outside the United States shall not exceed the amount which
would be treated as foreign source income earned by such person if
the pricing rule under section 994 which corresponds to the rule
used under section 925 with respect to such transaction applied to
such transaction. This section applies to any transaction, including
but not limited to any sale, lease, license or service, giving rise
to foreign trading gross receipts of a FSC. This special sourcing
rule also applies if the FSC is acting as a commission agent for the
related supplier with respect to the transaction described above
which gives rise to foreign trading gross receipts and the transfer
pricing rules of section 925 are used to determine the commission
payable to the FSC. No limitation results under this section with
respect to a transaction to which the section 482 pricing rule under
section 925(a)(3) applies.

(2) Grouping of transactions. If, for purposes of determining the
FSC's profits under the administrative pricing rules of sections
925(a)(1) and (2), grouping of transactions under §1.925(a)-1T(c)(8)
was elected, the same grouping shall be used for making the
determinations under this special sourcing rule.

(3) Corresponding DISC pricing rules--(i) In general. For purposes
of this section--

(A) The DISC gross receipts pricing rule of section 994(a)(1)
corresponds to the gross receipts pricing rule of section 925(a)(1);

(B) The DISC combined taxable income pricing rule of section 994(a)
(2) corresponds to the combined taxable income pricing rule of
section 925(a)(2); and

(C) The DISC section 482 pricing rule of section 994(a)(3)
corresponds to the section 482 pricing rule of section 925(a)(3).

(ii) Special rules. For purposes of this section--

(A) The DISC pricing rules of section 994(a)(1) and (2) shall be
determined without regard to export promotion expenses;

(B) Qualified export receipts under section 994(a)(1) and (2) shall
be deemed to be an amount equal to the foreign trading gross
receipts arising from the transaction; and

(C) Combined taxable income for purposes of section 994(a)(2) shall
be deemed to be an amount equal to the combined taxable income for
purposes of section 925(a)(2) arising from the transaction.

(b) Examples. The provisions of this section may be illustrated by
the following examples:

Example 1. (i) R and F are calendar year taxpayers.

R, a domestic manufacturing company, owns all the stock of F, which
is a FSC acting as a commission agent for R. For the taxable year, R
and F used the combined taxable income pricing rule of section
925(a)(2). For the taxable year, the combined taxable income of R
and F is $100 from the sale of export property, as defined in
section 927(a), manufactured by R using production assets located in
the United States. Title to the export property passed outside of
the United States.

(ii) Under section 925(a)(2), 23 percent of the $100 combined
taxable income of R and F, that is $23, is allocated to F and the
remaining $77 is allocated to R. Absent the special sourcing rule,
under section 863(b) the $77 income allocated to R would be sourced
$38.50 U.S. source and $38.50 foreign source.

Under the special sourcing rule, the amount of foreign source income
earned by a related supplier of a FSC shall not exceed the amount
that would result if the corresponding DISC pricing rule applied.
The DISC combined taxable income pricing rule of section 994(a)(2)
corresponds to the combined taxable income pricing rule of section
925(a)(2). Under section 994(a)(2), $50 of the combined taxable
income ($100 x .50) would be allocated to the DISC and the remaining
$50 would be allocated to the related supplier. Under section
863(b), the $50 income allocated to the DISC's related supplier
would be sourced $25 U.S. source and $25 foreign source.
Accordingly, under the special sourcing rule, the foreign source
income of R shall not exceed $25.

Example 2. (i) Assume the same facts as in Example 1 except that the
combined taxable income arises from the licensing of the copyright
rights in computer software for use outside of the United States and
that R developed the computer software in the United States.

(ii) Under section 925(a)(2), 23 percent of the $100 combined
taxable income of R and F, that is $23, is allocated to F and the
remaining $77 is allocated to R. Absent the special sourcing rule,
under section 862(a)(4) the $77 income allocated to R would be
sourced $77 foreign source in its entirety. Under the special
sourcing rule, the amount of foreign source income earned by a
related supplier of a FSC shall not exceed the amount that would
result if the corresponding DISC pricing rule applied.

The DISC combined taxable income pricing rule of section 994(a)(2)
corresponds to the combined taxable income pricing rule of section
925(a)(2). Under section 994(a)(2), $50 of the combined taxable
income ($100 x .50) would be allocated to the DISC and the remaining
$50 would be allocated to the related supplier. Under section 862(a)
(4), the $50 income allocated to the DISC's related supplier would
be sourced $50 foreign source in its entirety. Accordingly, under
the special sourcing rule, the foreign source income of R shall not
exceed $50.

Example 3. (i) Assume the same facts as in Example 1 except that R
and F used the gross receipts pricing rule of section 925(a)(1). In
addition, for the taxable year foreign trading gross receipts
derived from the sale of the export property are $2,000.

(ii) Under section 925(a)(1), 1.83 percent of the $2,000 foreign
trading gross receipts, that is $36.60, is allocated to F and the
$63.40 remaining combined taxable income ($100 - $36.60) is
allocated to R. Absent the special sourcing rule, under section
863(b) the $63.40 income allocated to R would be sourced $31.70 U.S.
source and $31.70 foreign source. Under the special sourcing rule,
the amount of foreign source income earned by a related supplier of
a FSC shall not exceed the amount that would result if the
corresponding DISC pricing rule applied. The DISC gross receipts
pricing rule of section 994(a)(1) corresponds to the gross receipts
pricing rule of section 925(a)(1). Under section 994(a)(1), $80
($2,000 x .04) would be allocated to the DISC and the $20 remaining
combined taxable income would be allocated to the related supplier.
Under section 863(b), the $20 income allocated to the DISC's related
supplier would be sourced $10 U.S. source and $10 foreign source.
Accordingly, under the special sourcing rule, the foreign source
income of R shall not exceed $10..(c) Effective Date. The rules of
this section are applicable to taxable years beginning after
December 31, 1997.

Michael P. Dolan
Deputy Commissioner of Internal Revenue
Approved: February 20, 1998
Donald C. Lubick
Acting Assistant Secretary of the Treasury

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