As stated above, the proposed regulations require that the consideration in a contract be fixed in order for the signing date rule to apply. One commentator identified a number of contractual arrangements that do not provide for fixed consideration within the meaning of the proposed regulations, but, nevertheless, are arrangements in which the consideration should be treated as fixed and, therefore, eligible for the signing date rule. In particular, the commentator identified a number of circumstances in which, rather than stating the number of shares and money to be exchanged for target corporation shares, a contract may provide that a certain percentage of target corporation shares will be exchanged for stock of the issuing corporation. One such circumstance is where a merger agreement permits the target corporation some flexibility in issuing its shares between the signing date and effective date of the potential reorganization. Such an issuance may occur, for example, upon the exercise of employee stock options. As a result, the total number of outstanding target corporation shares at the effective time of the merger and, therefore, the total number of shares of the acquiring corporation to be issued in the merger, may not be known when the merger agreement is signed.

In addition, a contract may permit the target corporation shareholders to elect to receive stock (the number of shares of which may be determined pursuant to a collar) and/or money or other property in respect of target corporation stock, but provide that a particular percentage of target corporation shares will be exchanged for stock of the issuing corporation and a particular percentage of target corporation stock will be exchanged for money. In these cases, if either the stock or the cash consideration is oversubscribed, adjustments are made to the consideration to be tendered in respect of the target corporation shares such that the specified percentage of target corporation shares is, in fact, exchanged for stock of the issuing corporation.

The IRS and Treasury Department agree that a contract that provides for either the percentage of the number of shares of each class of target corporation stock, or the percentage by value of the target corporation shares, to be exchanged for issuing corporation stock should be treated as providing for fixed consideration, as long as the target corporation shares to be exchanged for issuing corporation stock and the target corporation shares to be exchanged for consideration other than issuing corporation stock each represents an economically reasonable exchange. Just as in cases in which the contract states the number of shares of the issuing corporation and the amount of money, if any, to be exchanged for the proprietary interests in the target corporation, in these cases, the target corporation shareholders generally can be viewed as being subject to the economic fortunes of the issuing corporation as of the signing date. Accordingly, these final regulations include an expanded set of circumstances in which a contract will be treated as providing for fixed consideration.

The fact that a contract provides for contingent consideration will generally prevent a contract from being treated as providing for fixed consideration. One commentator suggested that a contract should not be treated as failing to provide for fixed consideration solely because it provides for contingent consideration that can only increase the proportion of issuing corporation stock to cash to be exchanged for target corporation shares. Where stock of the issuing corporation is the only type of consideration that is subject to a contingency, the delivery of any of the contingent consideration to the target corporation shareholders will enhance the preservation of the target corporation’s shareholders’ proprietary interests. Therefore, these final regulations provide for a limited exception to the general rule that an arrangement that provides for contingent consideration will not be one to which the signing date rule applies. The exception applies to cases in which the contingent consideration consists solely of stock of the issuing corporation and the execution of the potential reorganization would have resulted in the preservation of a substantial part of the value of the target corporation shareholders’ proprietary interests in the target corporation if none of the contingent consideration were delivered to the target corporation shareholders.

The IRS and Treasury Department continue to study whether other arrangements involving contingent consideration should be within the scope of the signing date rule. Among these arrangements are cases in which the contingent consideration consists not only of issuing corporation stock but also of money or other property and cases in which the issuing corporation stock to be issued in respect of target corporation stock is determined pursuant to a collar.

As described above, under the proposed regulations, the signing date rule applies only when the consideration to be provided in respect of target corporation shares includes only stock of the issuing corporation and money. One commentator suggested that the signing date rule should be expanded to apply to transactions in which the non-stock consideration includes property other than money. Under these final regulations, the signing date rule may apply in such cases. Therefore, under these final regulations, the signing date rule may apply, for example, in cases in which proprietary interests in the target corporation are exchanged for stock and securities of the issuing corporation.

The proposed regulations require that, if the signing date rule applies, the consideration to be tendered in respect of the target corporation shares surrendered be valued as of the end of the last business day before the first date there is a binding contract to effect the potential reorganization. One comment requested clarification of the meaning of as of the end of the last business day. That comment suggested that an average of the high and low trade price on that day should be an acceptable value for this purpose. Alternatively, the comment suggested that if a single trade were to determine the value of the issuing corporation stock, the closing price of the issuing corporation stock on the relevant market should be used. The comment further described an approach for identifying the relevant stock market.

In response to these comments, these final regulations remove the requirement that the consideration be valued as of the end of the last business day before the first date that there is a binding contract. Instead, they provide general guidance that the consideration to be exchanged for target corporation shares pursuant to a contract must be valued the day before such contract is a binding contract.

The IRS and Treasury Department recognize that the application of the requirement that the consideration to be exchanged for proprietary interests in the target corporation be valued on the last business day before the first date there is a binding contract to effect the potential reorganization may be unclear in cases in which the consideration does not exist prior to the effective date of the reorganization. For example, suppose that, in the potential reorganization, the issuing corporation will issue a new class of its stock in exchange for the shares of the target corporation. The question has arisen as to how to value those to be issued shares under the signing date rule, given that they do not exist on the last business day before the first date that there is a binding contract to effect the potential reorganization. Thus, these final regulations clarify that this new class of stock will be deemed to have been issued on the last business day before the first date there is a binding contract to effect the potential reorganization for purposes of applying the signing date rule.

The proposed regulations provide that placing part of the stock issued or money paid into escrow to secure customary target representations and warranties will not prevent the consideration in a contract from being fixed. One comment suggested that this rule should be expanded to include consideration placed in escrow to secure target’s performance of customary pre-closing covenants (rather than representations and warranties). That commentator stated that there is no reason to distinguish between customary pre-closing covenants, on the one hand, and customary representations and warranties, on the other hand. The IRS and Treasury Department agree. Accordingly, these final regulations extend the rule related to escrows to include consideration placed in escrow to secure target’s performance of customary pre-closing covenants.

Some commentators have indicated that certain examples in the proposed regulations suggest that escrowed stock, even if it is forfeited to the issuing corporation, is treated as preserving the target shareholders’ proprietary interests in the target corporation. The IRS and Treasury Department believe that escrowed consideration that is forfeited should not be taken into account in determining whether the COI requirement is satisfied. This conclusion reflects the view that the forfeiture of escrowed consideration is in substance a purchase price adjustment. Accordingly, the examples in these final regulations reflect that forfeited stock is not treated as preserving the target corporation shareholders’ proprietary interests in the target corporation and forfeited non-stock consideration is not treated as counting against the preservation of the target corporation’s shareholders’ proprietary interest in the target corporation. The IRS and Treasury Department continue to consider the effect on COI of escrowed consideration and contingent consideration.

One commentator requested clarification regarding the impact of the proposed regulations on Revenue Procedure 84-42, 1984-1 C.B. 521. Rev. Proc. 84-42 includes certain operating rules of the IRS regarding the issuance of letter rulings, including the circumstances in which the placing of stock in escrow will not prevent the IRS from issuing a private letter ruling. The IRS and Treasury Department continue to review the existing revenue procedures relating to reorganizations in light of the numerous regulatory changes since the publication of these procedures and the policy against issuing rulings in the reorganization area unless there is a significant issue, which is reflected in Rev. Proc. 2005-3. Rev. Proc. 84-42 is not amended at this time.

One comment suggested that consideration in a contract should not be treated as fixed unless the contract includes a customary anti-dilution provision. The commentator posited an example in which the absence of an anti-dilution clause and the occurrence of a stock split with respect to the stock of the issuing corporation prior to the effective date of a potential reorganization results in the value of the consideration received in respect of the target corporation shares being substantially different from its value on the day before the first date there is a binding contract.

The IRS and Treasury Department do not believe that the absence of a customary anti-dilution provision should necessarily preclude the application of the signing date rule as dilution may not, in fact, occur. However, the IRS and Treasury Department are concerned that application of the signing date rule is not appropriate if the contract does not contain an anti-dilution clause relating to the stock of the issuing corporation and the issuing corporation alters its capital structure between the first date there is an otherwise binding contract to effect the potential reorganization and the effective date of the potential reorganization in a manner that materially alters the economic arrangement of the parties to the binding contract. Accordingly, these final regulations provide that, in such cases, the consideration will not be treated as fixed.

The proposed regulations require that if a term of a binding contract that relates to the amount or type of consideration the target shareholders will receive in a potential reorganization is modified before the closing date of the potential reorganization, and the contract as modified is a binding contract, then the date of the modification shall be treated as the first date there is a binding contract. Thus, such a modification requires that the stock of the issuing corporation be valued as of the end of the last business day before the date of the modification in order to determine whether the transaction satisfies the COI requirement.

One commentator suggested that a contract should not be treated as being modified for this purpose if the modification has the sole effect of increasing the number of shares of the issuing corporation to be received by the target shareholders. The IRS and Treasury Department agree that, because such a modification only enhances the preservation of the target corporation’s shareholders’ proprietary interests, it is not appropriate to value the consideration to be provided to the target corporation shareholders as of the day before the date of the modification rather than as of the day before the date of the original contract, at least in cases in which the transaction would have satisfied the COI requirement under the signing date rule if there had been no modification. Therefore, these final regulations provide that a modification that has the sole effect of providing for the issuance of additional shares of issuing corporation stock to the target corporation shareholders will not be treated as a modification if the execution of the potential reorganization would have resulted in the preservation of a substantial part of the value of the target corporation shareholders’ proprietary interest in the target corporation if there had been no modification. In such cases, the determination of whether a proprietary interest in the target corporation has been preserved is made by reference to the value of the consideration as of the last business day before the first date the contract was binding, not the last business day before the modification. The IRS and Treasury Department continue to consider whether this exception should be extended to certain cases in which the modification results in not only additional shares of the issuing corporation to be issued to target corporation shareholders, but also additional money or other property to be transferred to target corporation shareholders.

One commentator asked whether the principle that the COI requirement is satisfied where 40 percent of the target corporation stock is exchanged for stock in the issuing corporation that is illustrated in the examples of the proposed regulations (which relate to the application of the signing date rule) also applies in cases in which the signing date rule does not apply. The IRS and Treasury Department believe that this principle is equally applicable to cases in which the signing date rule does not apply as it is to cases in which the signing date rule does apply.

The IRS and Treasury Department are continuing to consider the appropriate treatment of restricted stock in the determination of whether the COI requirement is satisfied.

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(e) * * *

(2) Measuring continuity of interest—(i) In general. In determining whether a proprietary interest in the target corporation is preserved, the consideration to be exchanged for the proprietary interests in the target corporation pursuant to a contract to effect the potential reorganization shall be valued on the last business day before the first date such contract is a binding contract, if such contract provides for fixed consideration.

(ii) Binding contract—(A) In general. A binding contract is an instrument enforceable under applicable law against the parties to the instrument. The presence of a condition outside the control of the parties (including, for example, regulatory agency approval) shall not prevent an instrument from being a binding contract. Further, the fact that insubstantial terms remain to be negotiated by the parties to the contract, or that customary conditions remain to be satisfied, shall not prevent an instrument from being a binding contract.

(B) Modifications—(1) In general. If a term of a binding contract that relates to the amount or type of the consideration the target shareholders will receive in a potential reorganization is modified before the closing date of the potential reorganization, and the contract as modified is a binding contract, the date of the modification shall be treated as the first date there is a binding contract.

(2) Exception. Notwithstanding paragraph (e)(2)(ii)(B)(1) of this section, a modification of a term that relates to the amount or type of consideration the target shareholders will receive in a potential reorganization will not be treated as a modification for purposes of that provision if—

(i) That modification has the sole effect of providing for the issuance of additional shares of issuing corporation stock to the target corporation shareholders; and

(ii) The execution of the potential reorganization would have resulted in the preservation of a substantial part of the value of the target corporation shareholders’ proprietary interest in the target corporation if there had been no modification.

(C) Tender offers. For purposes of this paragraph (e)(2), a tender offer that is subject to section 14(d) of the Securities and Exchange Act of 1934 [15 U.S.C. 78n(d)(1)] and Regulation 14D (17 CFR 240.14d-1 through 240.14d-101) and is not pursuant to a binding contract, is treated as a binding contract made on the date of its announcement, notwithstanding that it may be modified by the offeror or that it is not enforceable against the offerees. If a modification (not pursuant to a binding contract) of such a tender offer is subject to the provisions of Regulation 14d-6(c) (17 CFR 240.14d-6(c)) and relates to the amount or type of the consideration received in the tender offer, then the date of the modification shall be treated as the first date there is a binding contract.

(iii) Fixed consideration—(A) In general. A contract provides for fixed consideration if it provides—

(1) The number of shares of each class of stock of the issuing corporation, the amount of money, and the other property (identified either by value or by specific description), if any, to be exchanged for all of the proprietary interests in the target corporation;

(2) The number of shares of each class of stock of the issuing corporation, the amount of money, and the other property (identified either by value or by specific description), if any, to be exchanged for each proprietary interest in the target corporation;

(3) The percentage of the number of shares of each class of proprietary interests in the target corporation, or the percentage (by value) of the proprietary interests in the target corporation, to be exchanged for stock of the issuing corporation, provided that the proprietary interests in the target corporation to be exchanged for stock of the issuing corporation and the proprietary interests in the target corporation to be exchanged for consideration other than stock of the issuing corporation each represents an economically reasonable exchange as of the last business day before the first date there is a binding contract to effect the potential reorganization; or

(4) The percentage of each proprietary interest in the target corporation to be exchanged for stock of the issuing corporation, provided that the portion of each proprietary interest in the target corporation to be exchanged for stock of the issuing corporation and the portion of each proprietary interest in the target corporation to be exchanged for consideration other than stock of the issuing corporation each represents an economically reasonable exchange as of the last business day before the first date there is a binding contract to effect the potential reorganization.

(B) Shareholder elections—(1) In general. A contract that is not described in paragraph (e)(2)(iii)(A) of this section and pursuant to which a target corporation shareholder has an election to receive stock and/or money and other property in respect of target corporation stock is treated as providing for fixed consideration if the contract provides—

(i) The minimum number of shares of each class of stock of the issuing corporation and the maximum amount of money and other property (identified either by value or by specific description) to be exchanged for all of the proprietary interests in the target corporation; or

(ii) The minimum percentage of the number of shares of each class of proprietary interests in the target corporation, or the minimum percentage (by value) of the proprietary interests in the target corporation, to be exchanged for stock of the issuing corporation, provided that the proprietary interests in the target corporation to be exchanged for stock of the issuing corporation and the proprietary interests in the target corporation to be exchanged for consideration other than stock of the issuing corporation each represents an economically reasonable exchange as of the last business day before the first date there is a binding contract to effect the potential reorganization.

(2) Special rules. (i) In the case of a shareholder election described in paragraph (e)(2)(iii)(B)(1)(i) of this section, the determination of whether a proprietary interest in the target corporation is preserved shall be made by assuming the issuance by the issuing corporation of the minimum number of shares of each class of stock of the issuing corporation and the maximum amount of money and other property allowable under the contract and without regard to the number of shares of each class of stock of the issuing corporation and the amount of money and other property actually exchanged thereafter for proprietary interests in the target corporation.

(ii) In the case of a shareholder election described in paragraph (e)(2)(iii)(B)(1)(ii) of this section, the determination of whether a proprietary interest in the target corporation is preserved shall be made by assuming the issuance of issuing corporation stock in exchange for the minimum percentage of the number of shares of each class of proprietary interests in the target corporation, or the minimum percentage (by value) of proprietary interests in the target corporation, as the case may be, to be exchanged for stock of the issuing corporation allowable under the contract and without regard to the percentage of the number of shares of each class of proprietary interests in the target corporation, or the percentage (by value) of proprietary interests in the target corporation, actually exchanged for stock of the issuing corporation.

(C) Contingent consideration—(1) In general. In general, the fact that a contract provides for contingent consideration will prevent a contract from being treated as providing for fixed consideration. However, a contract will not fail to be treated as providing for fixed consideration solely as a result of a provision that provides for contingent consideration, if—

(i) The contingent consideration consists solely of stock of the issuing corporation; and

(ii) The execution of the potential reorganization would have resulted in the preservation of a substantial part of the value of the target corporation shareholders’ proprietary interests in the target corporation if none of the contingent consideration were delivered to the target corporation shareholders.

(2) Exception for escrows. For purposes of paragraph (e)(2)(iii)(C)(1) of this section, contingent consideration does not include consideration paid in escrow to secure target’s performance of customary pre-closing covenants or customary target representations and warranties.

(D) Escrows. Placing part of the consideration to be exchanged for proprietary interests in the target corporation in escrow to secure target’s performance of customary pre-closing covenants or customary target representations and warranties will not prevent a contract from being treated as providing for fixed consideration.

(E) Anti-dilution clauses. The presence of a customary anti-dilution clause will not prevent a contract from being treated as providing for fixed consideration. However, the absence of such a clause will prevent a contract from being treated as providing for fixed consideration if the issuing corporation alters its capital structure between the first date there is an otherwise binding contract to effect the potential reorganization and the effective date of the potential reorganization in a manner that materially alters the economic arrangement of the parties to the binding contract.

(F) Dissenters’ rights. The possibility that some shareholders may exercise dissenters’ rights and receive consideration other than that provided for in the binding contract will not prevent the contract from being treated as providing for fixed consideration.

(G) Fractional shares. The fact that money may be paid in lieu of issuing fractional shares will not prevent a contract from being treated as providing for fixed consideration.

(iv) Valuation of new issuances. For purposes of applying paragraph (e)(2)(i) of this section, any class of stock, securities, or indebtedness that the issuing corporation issues to the target corporation shareholders pursuant to the potential reorganization and that does not exist before the first date there is a binding contract to effect the potential reorganization is deemed to have been issued on the last business day before the first date there is a binding contract to effect the potential reorganization.

(v) Examples. For purposes of the examples in this paragraph (e)(2)(v), P is the issuing corporation, T is the target corporation, S is a wholly owned subsidiary of P, all corporations have only one class of stock outstanding, A is an individual, no transactions other than those described occur, and the transactions are not otherwise subject to recharacterization. The following examples illustrate the application of this paragraph (e)(2):

Example 1. Application of signing date rule. On January 3 of Year 1, P and T sign a binding contract pursuant to which T will be merged with and into P on June 1 of Year 1. Pursuant to the contract, the T shareholders will receive 40 P shares and $60 of cash in exchange for all of the outstanding stock of T. Twenty of the P shares, however, will be placed in escrow to secure customary target representations and warranties. The P stock is listed on an established market. On January 2 of Year 1, the value of the P stock is $1 per share. On June 1 of Year 1, T merges with and into P pursuant to the terms of the contract. On that date, the value of the P stock is $.25 per share. None of the stock placed in escrow is returned to P. Because the contract provides for the number of shares of P and the amount of money to be exchanged for all of the proprietary interests in T, under paragraph (e)(2) of this section, there is a binding contract providing for fixed consideration as of January 3 of Year 1. Therefore, whether the transaction satisfies the continuity of interest requirement is determined by reference to the value of the P stock on January 2 of Year 1. Because, for continuity of interest purposes, the T stock is exchanged for $40 of P stock and $60 of cash, the transaction preserves a substantial part of the value of the proprietary interest in T. Therefore, the transaction satisfies the continuity of interest requirement.

Example 2. Treatment of forfeited escrowed stock. (i) The facts are the same as in Example 1 except that T’s breach of a representation results in the escrowed consideration being returned to P. Because the contract provides for the number of shares of P and the amount of money to be exchanged for all of the proprietary interests in T, under paragraph (e)(2) of this section, there is a binding contract providing for fixed consideration as of January 3 of Year 1. Therefore, whether the transaction satisfies the continuity of interest requirement is determined by reference to the value of the P stock on January 2 of Year 1. Because, for continuity of interest purposes, the T stock is exchanged for $20 of P stock and $60 of cash, the transaction does not preserve a substantial part of the value of the proprietary interest in T. Therefore, the transaction does not satisfy the continuity of interest requirement.

(ii) The facts are the same as in Example 2 (i) except that the consideration placed in escrow consists solely of eight of the P shares and $12 of the cash. Because the contract provides for the number of shares of P and the amount of money to be exchanged for all of the proprietary interests in T, under paragraph (e)(2) of this section, there is a binding contract providing for fixed consideration as of January 3 of Year 1. Therefore, whether the transaction satisfies the continuity of interest requirement is determined by reference to the value of the P stock on January 2 of Year 1. Because, for continuity of interest purposes, the T stock is exchanged for $32 of P stock and $48 of cash, the transaction preserves a substantial part of the value of the proprietary interest in T. Therefore, the transaction satisfies the continuity of interest requirement.

Example 3. Redemption of stock received pursuant to binding contract. The facts are the same as in Example 1 except that A owns 50 percent of the outstanding stock of T immediately prior to the merger and receives 10 P shares and $30 in the merger and an additional 10 P shares upon the release of the stock placed in escrow. In connection with the merger, A and S agree that, immediately after the merger, S will purchase any P shares that A acquires in the merger for $1 per share. Shortly after the merger, S purchases A’s P shares for $20. Because the contract provides for the number of shares of P and the amount of money to be exchanged for all of the proprietary interests in T, under paragraph (e)(2) of this section, there is a binding contract providing for fixed consideration as of January 3 of Year 1. Therefore, whether the transaction satisfies the continuity of interest requirement is determined by reference to the value of the P stock on January 2 of Year 1. In addition, S is a person related to P under paragraph (e)(4)(i)(A) of this section. Accordingly, A is treated as exchanging his T shares for $50. Because, for continuity of interest purposes, the T stock is exchanged for $20 of P stock and $80 of cash, the transaction does not preserve a substantial part of the value of the proprietary interest in T. Therefore, the transaction does not satisfy the continuity of interest requirement.

Example 4. Modification of binding contract—continuity not preserved. The facts are the same as in Example 1 except that on April 1 of Year 1, the parties modify their contract. Pursuant to the modified contract, which is a binding contract, the T shareholders will receive 50 P shares (an additional 10 shares) and $75 of cash (an additional $15 of cash) in exchange for all of the outstanding T stock. On March 31 of Year 1, the value of the P stock is $.50 per share. Under paragraph (e)(2) of this section, although there was a binding contract providing for fixed consideration as of January 3 of Year 1, terms of that contract relating to the consideration to be provided to the target shareholders were modified on April 1 of Year 1. Because the modified contract provides for the number of P shares and the amount of money to be exchanged for all of the proprietary interests in T, under paragraph (e)(2) of this section, the modified contract is a binding contract providing for fixed consideration as of April 1 of Year 1. Therefore, whether the transaction satisfies the continuity of interest requirement is determined by reference to the value of the P stock on March 31 of Year 1. Because, for continuity of interest purposes, the T stock is exchanged for $25 of P stock and $75 of cash, the transaction does not preserve a substantial part of the value of the proprietary interest in T. Therefore, the transaction does not satisfy the continuity of interest requirement.

Example 5. Modification of binding contract disregarded—continuity preserved. The facts are the same as in Example 4 except that, pursuant to the modified contract, which is a binding contract, the T shareholders will receive 60 P shares (an additional 20 shares as compared to the original contract) and $60 of cash in exchange for all of the outstanding T stock. In addition, on March 31 of Year 1, the value of the P stock is $.40 per share. Under paragraph (e)(2) of this section, although there was a binding contract providing for fixed consideration as of January 3 of Year 1, terms of that contract relating to the consideration to be provided to the target shareholders were modified on April 1 of Year 1. Nonetheless, the modification has the sole effect of providing for the issuance of additional P shares to the T shareholders. In addition, the execution of the terms of the contract without regard to the modification would have resulted in the preservation of a substantial part of the value of the T shareholders’ proprietary interest in T because, for continuity of interest purposes, the T stock would have been exchanged for $40 of P stock and $60 of cash. Therefore, the modification is not treated as a modification under paragraph (e)(2) of this section. Accordingly, whether the transaction satisfies the continuity of interest requirement is determined by reference to the value of the P stock on January 2 of Year 1. Despite the modification, the transaction continues to satisfy the continuity of interest requirement.

Example 6. New issuance. The facts are the same as in Example 1, except that, in lieu of the $60 of cash, the T shareholders will receive a new class of P securities that will be publicly traded. In the aggregate, the securities will have a stated principal amount of $60 and bear interest at the average LIBOR (London Interbank Offered Rates) during the 10 days prior to the potential reorganization. If the T shareholders had been issued the P securities on January 2 of Year 1, the P securities would have had a value of $60 (determined by reference to the value of comparable publicly traded securities). Whether the transaction satisfies the continuity of interest requirement is determined by reference to the value of the P stock and the P securities to be issued to the T shareholders on January 2 of Year 1. Under paragraph (e)(2)(iv) of this section, for purposes of valuing the new P securities, they will be treated as having been issued on January 2 of Year 1. Because, for continuity of interest purposes, the T stock is exchanged for $40 of P stock and $60 of other property, the transaction preserves a substantial part of the value of the proprietary interest in T. Therefore, the transaction satisfies the continuity of interest requirement.

Example 7. Economically unreasonable exchange. On January 3 of Year 1, P and T sign a binding contract pursuant to which T will be merged with and into P on June 2 of Year 1. At that time, A is T’s sole shareholder. Pursuant to the contract, 60 percent of the T stock will be exchanged for $80 of cash and 40 percent of the T stock will be exchanged for 20 shares of P stock. As of January 2, 20 shares of P stock have a value of $20, representing only 20 percent of the value of the total consideration to be received by the T shareholders. Because the percentage of proprietary interests in the target corporation to be exchanged for stock of the issuing corporation and the proprietary interests in the target corporation to be exchanged for money do not each represent an economically reasonable exchange as of the last business day before the first date there is a binding contract to effect the potential reorganization, under paragraph (e)(2)(iii)(A)(3) of this section, the contract is not treated as a binding contract that provides for fixed consideration.

Example 8. Absence of anti-dilution clause. On January 3 of Year 1, P and T sign a binding contract pursuant to which T will be merged with and into P on June 1 of Year 1. Pursuant to the contract, the T shareholders will receive 40 P shares and $60 of cash in exchange for all of the outstanding stock of T. The contract does not contain a customary anti-dilution provision. The P stock is listed on an established market. On January 2 of Year 1, the value of the P stock is $1 per share. On April 10 of Year 1, P issues its stock to effect a stock split; each shareholder of P receives an additional share of P for each P share that it holds. On April 11 of Year 1, the value of the P stock is $.50 per share. Because P altered its capital structure between January 3 and June 1 of Year 1 in a manner that materially alters the economic arrangement of the parties, under paragraph (e)(2)(iii)(E) of this section, the contract is not treated as a binding contract that provides for fixed consideration.

Example 9. Shareholder election with a proration mechanism. On January 3 of Year 1, P and T sign a binding contract pursuant to which T will be merged with and into P on June 1 of Year 1. Pursuant to the contract, at the shareholders’ election, each share of T will be exchanged for cash of $1 or, alternatively, P stock that has a value of $1, if the value of each share of P stock is at least $.80 and no more than $1.20 on the effective date of the potential reorganization; 1.25 shares of P stock, if the value of each share of P stock is less than $.80 on the effective date of the potential reorganization; or .83 shares of P stock, if the value of each share of P stock is more than $1.20 on the effective date of the potential reorganization. In addition, the contract provides for a proration mechanism to ensure that 50 percent of the T shares will be exchanged for cash and 50 percent of the T shares will be exchanged for P stock. On January 2 of Year 1, T has 100 shares outstanding. The P stock is listed on an established market. On January 2 of Year 1, the value of the P stock is $1 per share. Because the contract provides for the percentage of the number of shares of each class of proprietary interests in T, and the percentage (by value) of the proprietary interests in T, to be exchanged for stock of P and the other requirements of paragraph (e)(2)(iii)(A)(3) of this section are satisfied, there is a binding contract providing for fixed consideration as of January 3 of Year 1. Therefore, whether the transaction satisfies the continuity of interest requirement is determined by reference to the value of the P stock on January 2 of Year 1. Because, for continuity of interest purposes, the T stock is exchanged for $50 of P stock and $50 of cash, the transaction preserves a substantial part of the value of the proprietary interest in T. Therefore, the transaction satisfies the continuity of interest requirement.

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(8) Effective date. Paragraphs (e)(1) and (e)(3) through (e)(7) of this section apply to transactions occurring after January 28, 1998, except that they do not apply to any transaction occurring pursuant to a written agreement which is binding on January 28, 1998, and at all times thereafter. Paragraph (e)(1)(ii) of this section, however, applies to transactions occurring after August 30, 2000, unless the transaction occurs pursuant to a written agreement that is (subject to customary conditions) binding on that date and at all times thereafter. Taxpayers who entered into a binding agreement on or after January 28, 1998, and before August 30, 2000, may request a private letter ruling permitting them to apply the final regulation to their transaction. A private letter ruling will not be issued unless the taxpayer establishes to the satisfaction of the IRS that there is not a significant risk of different parties to the transaction taking inconsistent positions, for Federal tax purposes, with respect to the applicability of the final regulations to the transaction. Paragraph (e)(2) of this section applies to transactions occurring pursuant to binding contracts entered into after September 16, 2005.

Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.

Approved September 6, 2005.

Eric Solomon,
Acting Deputy Assistant Secretary of the Treasury (Tax Policy).

Section 863(d)(2)(A)(i) defines space activity to include any activity conducted in space. Section 863(d)(2)(A)(ii) defines ocean activity to include any activity conducted on or under water not within the jurisdiction (as recognized by the United States) of a foreign country, possession of the United States, or the United States. Section 863(d)(2)(B) excludes three specific types of activities from the definition of space or ocean activity. Section 863(d)(1) generally provides that, except as provided in regulations, any income derived from a space or ocean activity (space and ocean income) is U.S. source income if derived by a U.S. person and foreign source income if derived by a foreign person.

Pursuant to the statute’s grant of regulatory authority, the reproposed regulations provide that a U.S. person’s space and ocean income will be sourced outside the United States to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in a foreign country or countries. This approach to allocation of space and ocean income between U.S. and foreign sources is pursuant to broad regulatory authority in section 863(d). The reproposed regulations also contain certain exceptions to the general foreign source rule for space and ocean income of foreign persons.

Section 1.863-8(b)(2) of the 2001 proposed regulations provides that if U.S. persons own 50 percent or more of a foreign corporation by vote or value (directly, indirectly, or constructively) and such corporation is not a controlled foreign corporation within the meaning of section 957 (CFC), all space and ocean income derived by the corporation (hereinafter a U.S.-owned foreign corporation) is U.S. source income.

Several commentators requested that §1.863-8(b)(2) of the 2001 proposed regulations be withdrawn. Commentators stated that the rule expanded the scope of U.S. taxing jurisdiction beyond the apparent intent of Congress by subjecting income not covered by subpart F to immediate U.S. taxation. Several commentators also stated that under the rule space and ocean income could in some cases be subject to multiple levels of taxation. In this regard, some commentators noted that the space and ocean income of a U.S.-owned foreign corporation could be subject to potential double taxation at the corporate level (by the United States and by the U.S.-owned foreign corporation’s country of residence or the countries where such corporation does business) because §1.863-8(b)(2) of the 2001 proposed regulations makes such space and ocean income U.S. source. When the U.S.-owned foreign corporation’s space and ocean income is distributed as a dividend, that income could be subject to an additional level of tax in the hands of its shareholders. Consequently, some commentators suggested that, if the rule were retained, the space and ocean income of U.S.-owned foreign corporations should be considered U.S. source solely for purposes of the U.S. shareholder’s foreign tax credit limitation under section 904(a). Some commentators noted that although section 245 may partially ameliorate this situation by providing a dividends received deduction (DRD) to shareholders of foreign corporations in certain circumstances, the DRD would be limited to 80 percent of qualifying dividends.

Some commentators also noted potential withholding tax issues with the source rules for U.S.-owned foreign corporations. In such cases, U.S. source fixed or determinable annual or periodic income (FDAP) of a U.S.-owned foreign corporation would (in the absence of an applicable treaty) likely be subject to the 30-percent gross income tax imposed by section 881, which is typically collected through withholding by the payors of such income. Commentators stated that enforcement and administration of the 30-percent tax and withholding requirements could present multiple challenges (and potential multiple withholding tax obligations) for payments between foreign persons.

Several commentators addressed the stock ownership test applicable to U.S.-owned foreign corporations. They stated that determining whether a foreign corporation is 50-percent U.S.-owned, especially without regard to the size of an owner’s holding, presents potential difficulties (for example, when the foreign corporation is widely-held). Some commentators stated that the indirect and constructive ownership rules are complex and would make it difficult for payors of space and ocean income to determine withholding tax obligations. Some commentators suggested that if the rule were retained, the determination whether a foreign corporation is 50-percent U.S.-owned should be similar to the determination of CFC status, that is, only U.S. persons who own or are considered to own 10 percent or more of the total combined voting power of all classes of stock entitled to vote should be counted. Some commentators stated that the rule should not apply to publicly-traded foreign corporations.

In light of the potential complexity in determining whether a foreign corporation is a U.S.-owned foreign corporation and the belief of the Treasury Department and the IRS that space and ocean income earned by foreign corporations should be sourced in accord with the rules for foreign persons, with the limited exception for certain CFCs discussed below, the reproposed regulations do not include a special source rule for space and ocean income earned by a U.S.-owned foreign corporation. Instead, the space and ocean income of foreign corporations (other than CFCs) is sourced under the applicable provisions of reproposed §1.863-8(b)(2)(i) or (iii). Under these provisions, space and ocean income of a foreign person is generally foreign source income. Space and ocean income of a foreign person (other than a CFC) that is engaged in trade or business within the United States is U.S. source income to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed within the United States.

In enacting section 863(d), Congress ultimately did not adopt a provision included in early versions of the legislation that would have treated a CFC as a U.S. person for purposes of determining the source of a CFC’s space and ocean income. The legislative history to the 1986 Act indicates that Congress at that time viewed the provision as unnecessary because “[t]he application of the separate foreign tax credit limitation for shipping income to any space or ocean income derived by a [CFC] provides adequate assurance, in the conferee’s view, that high foreign taxes on unrelated income will not inappropriately offset U.S. taxes on this generally low-taxed income.” H.R. Conf. Rep. No. 99-841, 99^th Cong., 2d Sess., Vol. II, at II-600 (Sept. 18, 1986); see also Staff of Joint Comm. on Taxation, General Explanation of the Tax Reform Act of 1986, JCS-10-87, at 934 (May 4, 1987). Consequently, the 2001 proposed regulations also did not contain such a rule and only treated a U.S.-owned foreign corporation as a U.S. person for purposes of determining the source of space and ocean income.

In 2004, AJCA enacted a number of significant statutory changes to subpart F and the foreign tax credit regimes as applicable to space and ocean income. These statutory changes have been taken into account in issuing the reproposed regulations.

Section 415 of AJCA eliminated foreign base company shipping income from the definition of foreign base company income. This change is effective for taxable years of foreign corporations beginning after December 31, 2004, and for taxable years with or within which such taxable years of foreign corporations end. Prior to AJCA, foreign base company shipping income was defined by section 954(f) to include any income derived from a space or ocean activity as defined in section 863(d)(2).

In addition, section 404 of AJCA reduced the number of foreign tax credit limitation categories from nine to two (i.e., passive category income and general category income) in order to address Congressional concerns regarding the complexity of the foreign tax credit calculation. See H.R. Rep. No 108-548, 108^th Cong., 2d Sess., at 190 (June 16, 2004). This change is effective for taxable years beginning after December 31, 2006. Prior to AJCA, section 904(d) treated shipping income, defined as income “which would be foreign base company shipping income (as defined in section 954(f)),” as a separate category of income for foreign tax credit limitation purposes. For taxable years beginning after December 31, 2006, space and ocean income will generally fall into the general limitation category. See H.R. Conf. Rep. No. 108-755, 108^th Cong., 2d Sess., at 383 (Oct. 7, 2004).

The Treasury Department and the IRS believe that the changes made by AJCA with respect to the foreign tax credit reflect a decision to reduce the complexity in the foreign tax credit calculation caused by having nine foreign tax credit categories of income as well as a willingness to allow additional cross-crediting in order to minimize such complexity. However, the Treasury Department and the IRS also believe that for taxable years beginning after December 31, 2006, Congress’s concern expressed in the 1986 Act that high foreign taxes on unrelated income may inappropriately offset U.S. taxes on space and ocean income, which is generally subject to low foreign taxes, is no longer addressed by the foreign tax credit rules because space and ocean income likely will be general limitation category income. In addition, Congress provided a broad grant of regulatory authority to the Treasury Department and the IRS in section 863(d) to issue guidance with respect to the source of space and ocean income.

In light of AJCA, the reproposed regulations provide that if a foreign corporation is a CFC, its space and ocean income, like that of a U.S. person, is income from sources within the United States. However, a CFC’s space and ocean income is sourced outside the United States to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in a foreign country or countries. This allocation approach is pursuant to broad regulatory authority under section 863(d).

As noted above, several commentators stated that under the rule for U.S.-owned foreign corporations in the 2001 proposed regulations, space and ocean income could in some cases be subject to multiple levels of taxation. The Treasury Department and the IRS believe that the reproposed regulations mitigate such a possibility for CFCs because the reproposed regulations provide for foreign sourcing when a CFC’s space and ocean income is attributable to functions performed, resources employed, or risks assumed in a foreign country or countries. The rule for CFCs in the reproposed regulations is thus a rule of limited application that, consistent with the legislative history of the 1986 Act, provides U.S. source treatment only with respect to space and ocean income attributable to activities in space or international water that are not likely to be subject to tax in any foreign country. The rule for CFCs will permit a United States shareholder to establish as foreign source the amount of income attributable to the CFC’s operations in a foreign country or countries.

Several commentators submitted comments on potential withholding tax issues posed by the 2001 proposed regulations. The Treasury Department and the IRS recognize that certain provisions of the reproposed regulations (such as the source rule for the space and ocean income of CFCs in reproposed §1.863-8(b)(2)(ii)) may raise similar withholding tax issues. The Treasury Department and the IRS accordingly seek comments on these issues, in particular with regard to the following: (1) the extent to which Form W-8ECI, “Certificate of Foreign Person’s Claim for Exemption From Withholding on Income Effectively Connected With the Conduct of a Trade or Business in the United States”, may practically address these issues; (2) the nature of situations in which withholding tax issues will arise (for example, how particular businesses involving space, ocean, or communications activities are conducted, whether payors of income potentially subject to withholding under the reproposed regulations are typically related or unrelated parties, etc.); and (3) suggestions to address these issues in the cases in which they arise.

Section 1.863-3(b)(3) of the 2001 proposed regulations provides that if a foreign person is engaged in a trade or business within the United States, the foreign person’s income derived from a space or ocean activity is presumed to be U.S. source income. The rule reflects the general view of the Treasury Department and the IRS that Congress intended that a foreign person engaged in a substantial business within the United States be subject to U.S. tax on related space or ocean income. However, the Treasury Department and the IRS recognize that the presumption may be over-inclusive in certain cases. Therefore, the 2001 proposed regulations provide that if the foreign person can allocate gross space or ocean income between income from sources within the United States, space, or international water, and sources without the United States, space, and international water, to the satisfaction of the Commissioner, based on all the facts and circumstances, income allocated to sources without the United States, space, and international water will be treated as foreign source income.

Several commentators stated that the presumption is overbroad, given that it applies to all space and ocean income regardless of any nexus with the foreign corporation’s U.S. trade or business. Several commentators suggested that if the presumption were retained, objective standards consistent with existing rules for effectively connected income should be included to ensure that the space and ocean income has a meaningful connection with the foreign corporation’s U.S. trade or business. In the absence of objective standards, commentators stated that taxpayers should be permitted to apply a reasonable allocation method on a consistent basis to all of their space and ocean income. In addition, as with §1.863-8(b)(2) of the 2001 proposed regulations, several commentators stated that under §1.863-8(b)(3) of the 2001 proposed regulations space and ocean income could in some cases be subject to multiple levels of taxation.

In response to these comments, the reproposed regulations provide that if a foreign person, other than a CFC, is engaged in a trade or business within the United States, its space or ocean income is from sources within the United States to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed within the United States.

The Treasury Department and the IRS believe that the revision in reproposed §1.863-8(b)(2)(iii) providing that space or ocean income will be U.S. source income to the extent the space or ocean income is attributable to functions performed, resources employed, or risks assumed in the United States should mitigate commentators’ concerns about potential multiple levels of taxation.

Examples 12 and 13 in §1.863-8(f) of the 2001 proposed regulations illustrate the application of §1.863-8(b)(3) of those regulations to foreign persons that conduct certain activities in the United States. One commentator noted that these examples appear to state that engaging in certain activities would constitute the conduct of a trade or business in the United States. In response to this comment, Examples 12 and 13 have been clarified in the reproposed regulations to state that they assume, on the facts of the example, that the activities constitute the conduct of a trade or business within the United States within the meaning of section 864(b). The Treasury Department and the IRS intend that the determination whether a foreign person is engaged in a trade or business in the United States continue to be made under general section 864(b) principles.

The 2001 proposed regulations provide generally that taxpayers must apply the rules of section 863(d) and the 2001 proposed regulations to determine the source of income from sales of property purchased or produced by the taxpayer, either when production occurs in whole or in part in space or international water, or when the sale occurs in space or international water. Under the 2001 proposed regulations, income from sales of inventory property (within the meaning of section 1221(a)(1)) on international water is sourced under §1.863-3(c)(2). Section 1.863-3(c)(2), as amended by the 2001 proposed regulations, provides that the place of sale will be presumed to be the United States when property is produced in the United States and the property is sold to a U.S. resident for use in space or international water; in such cases, the property will be treated as sold for use, consumption, or disposition in the United States.

Section 1.863-8(d)(1)(i) of the 2001 proposed regulations defines space activity to include the sale of property in space. Section 1.863-8(d)(1)(ii) of the 2001 proposed regulations defines ocean activity to include the sale of property in international water, but not the sale of inventory property on international water. Under §1.863-8(d)(2)(iii) of the 2001 proposed regulations, a sale occurs in space or international water if the property is located in space or international water at the time the rights, title, and interest of the seller in the property are transferred to the purchaser, or if the property is sold for use in space or international water.

For sales in space or international water of property produced by the taxpayer, §1.863-8(b)(4)(ii)(A) of the 2001 proposed regulations generally provides that the source of income attributable to sales activity is determined under §1.863-8(b)(1), (2), or (3) of the 2001 proposed regulations. If, however, the taxpayer sells such property outside space and international water, the source of income attributable to sales activity is determined under §1.863-3(c)(2).

Commentators stated that the inclusion of sales of inventory property in space or international water in the definitions of space and ocean activity is inconsistent with the legislative history of the 1986 Act, which indicates that the Senate Committee on Finance did not intend sales of inventory property on the high seas to be considered space or ocean activity. See S. Rep. No. 99-313, at 359.

In response to comments, the reproposed regulations provide that sales of inventory property in space or international water will be considered space or ocean activity only if the inventory property is sold for use, consumption, or disposition in space or international water. In such cases, the source of income will be determined under the source rules provided for space and ocean income by the reproposed regulations. The source of income from sales in space or international water of inventory property when the inventory property is sold for use, consumption, or disposition outside space and international water will be determined under §§1.861-7(c) and 1.863-3(c)(2). The Treasury Department and the IRS believe that sales of property in space or international water — with the exception of sales of inventory property in space or international water for use, consumption, or disposition outside space or international water — should be considered space or ocean activity, and that the source of income from such sales should be determined under section 863(d). The Treasury Department and the IRS believe that this result is consistent with both the statute and the legislative history. The statute provides that space or ocean activity includes any activity in space or international water. However, the Senate Report states that the Senate Committee on Finance did not intend to override the general source rule in §1.861-7(c) for sales of property on the high seas. See S. Rep. No. 99-313, at 359. Thus, sales of inventory property in transit between the United States and a foreign country will continue to be sourced under sections 861 through 865, and not section 863(d).

The reproposed regulations do not contain the presumption in §1.863-3(c)(2) of the 2001 proposed regulations regarding sales of property produced by the taxpayer in the United States to U.S. residents for use in space or international water. Under the reproposed regulations, if such sales occur in space or international water, the source of income attributable to sales activity will be determined under reproposed §1.863-8(b)(3)(ii)(D).

Section 1.863-8(b)(5) of the 2001 proposed regulations provides that income derived from the performance of services in space or international water is sourced under §1.863-8(b)(1), (2), or (3) of the 2001 proposed regulations, as applicable. Section 1.863-8(d)(2)(ii)(A) of the 2001 proposed regulations contains a general rule providing that the performance of a service is a space or ocean activity in its entirety when a part of the service, even if de minimis, is performed in space or international water.

The Treasury Department and the IRS recognized that this rule could be over-inclusive in certain cases. Therefore, §1.863-8(d)(2)(ii)(A) of the 2001 proposed regulations provides a facilitation exception, under which a service will not be treated as either space or ocean activity if the taxpayer’s only activity in space or international water is to facilitate the taxpayer’s own communications as part of the provision or delivery of a service provided by the taxpayer, and the service would not otherwise be a space or ocean activity. Section 1.863-8(b)(5) of the 2001 proposed regulations also provides that if the taxpayer can allocate, to the satisfaction of the Commissioner, gross income from the services transaction between performance occurring outside space and international water, and performance occurring in space or international water, the source of income allocated to performance occurring outside space and international water will be determined under sections 861, 862, 863, and 865.

Several commentators commented unfavorably on a rule that characterizes an entire services transaction as space or ocean activity when only de minimis performance occurs in space or international water. Several commentators noted that even though §1.863-8(b)(5) of the 2001 proposed regulations permits a taxpayer to source services income to sources outside space or international water, the entire transaction continues to be characterized as space or ocean activity, and all income derived from the services transaction is thus included in the separate subpart F and foreign tax credit limitation category for shipping income. Some commentators stated that under the 2001 proposed regulations significant consequences result from characterization as a services transaction, even though the characterization rules are themselves unclear. Some commentators also stated that the facilitation exception to space or ocean activity characterization is confusing, and that the example intended to illustrate the application of the facilitation exception (Example 4 in §1.863-8(f) of the 2001 proposed regulations) is itself unclear.

As noted above, subsequent to the publication of the 2001 proposed regulations, AJCA amended the subpart F rules relating to space and ocean income by eliminating shipping income as a category of subpart F income and reduced the number of foreign tax credit limitation categories from nine to two (with space and ocean income generally falling into the general limitation category) for taxable years beginning after December 31, 2006. The Treasury Department and the IRS believe that these statutory changes should allay commentators’ concerns regarding the characterization of a services transaction as space or ocean activity. In addition, as discussed below, the reproposed regulations provide that if the taxpayer can demonstrate the value of the service attributable to performance in space or international water and the value of the service attributable to performance outside space and international water, then the service will be treated as a space or ocean activity only to the extent of the activity performed in space or international water. The value of the service is attributable to performance occurring in space or international water to the extent the performance of services, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in space or international water.

Based on the comments, the reproposed regulations eliminate the facilitation exception. Under reproposed §1.863-8(d)(2)(ii), to the extent, based on all the facts and circumstances, the value of the service attributable to functions performed, resources employed, or risks assumed in space or international water is de minimis, such service is not treated as space or ocean activity. The adoption of the de minimis rule is intended to address taxpayer concerns about potential confusion in qualifying for the facilitation exception. Example 4 of reproposed §1.863-8(f) has been revised accordingly.

The rule for determining the source of income from performance of services that occur in part in space or international water and in part outside space and international water has been adapted to conform to the changes made to reproposed §1.863-8(d)(2)(ii). To the extent a service is characterized as space or ocean activity under reproposed §1.863-8(d)(2)(ii), the source of gross income derived from such transaction is determined under reproposed §1.863-8(b)(1) or (2), as applicable, as provided by reproposed §1.863-8(b)(4). Accordingly, to the extent the value of the service, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed outside space and international water, the service will not constitute space or ocean activity, and, to that extent, the source of income from the service will be determined under section 861, 862, or 863, as applicable.

Section 1.863-8(b)(6) of the 2001 proposed regulations provides that space and ocean activity include communications activity (but not international communications activity) occurring in space or international water. Foreign communications activity is thus characterized under the 2001 proposed regulations as space or ocean activity when, for example, part of the transmission is via satellite or via underwater cable located in international water.

Commentators requested that the regulations characterize income from foreign-to-foreign communications as international communications income, which is specifically excluded from the definition of space and ocean activity by section 863(d)(2)(B) and §1.863-8(d)(3) of the 2001 proposed regulations, but retain the 100 percent foreign source rule otherwise provided for foreign communications income by §1.863-9(b)(4) of the 2001 proposed regulations. International communications income is defined by section 863(e)(2) as income derived from the transmission of communications between the United States and a foreign country (or possession of the United States) and is discussed in greater detail below.

Commentators noted that this rule puts telecommunications companies using satellite or underwater cable methods of transmission at a competitive disadvantage vis--vis competitors in foreign marketplaces that use solely land-based facilities. For example, if a CFC were paid to transmit a telephone call between two foreign countries and used a land line connecting the two countries to transmit the call, the CFC’s income from the transmission would be included in the general limitation category for foreign tax credit purposes. If the communication were transmitted using fiber optic cable located in international water or a satellite, the CFC’s income from the transmission would be foreign source space or ocean income included in the separate subpart F and foreign tax credit limitation category for shipping income.

The reproposed regulations do not characterize income from foreign-to-foreign communications as international communications income as suggested by commentators. Section 863(d)(2)(A) broadly defines space and ocean activity as any activity conducted in space or international water. The statutory exception to space and ocean activity in section 863(d)(2)(B) removes only activities giving rise to international communications income from the scope of space and ocean activity. In addition, if foreign-to-foreign communications income were characterized as international communications income, U.S. persons with such income would be subject to the statutory source rule in section 863(e)(1)(A), which provides for the split-sourcing of a U.S. person’s international communications income. The Treasury Department and the IRS thus consider the language of the statute to preclude the approach suggested by commentators with respect to the characterization and sourcing of income from foreign-to-foreign communications. The legislative history of the 1986 Act also indicates that Congress intended income from foreign-to-foreign communications to be foreign source income. See S. Rep. No. 99-313, at 359, “Finally, if the communication is between two foreign locations, the committee intends income attributable thereto to be foreign source.” This would not be the result, however, if foreign-to-foreign communications income were included in the definition of international communications income and thus subject to the statute’s 50/50 source rule for U.S. persons.

In addition, as noted above, AJCA made significant changes to subpart F and the foreign tax credit regime as applicable to space and ocean income. The Treasury Department and the IRS believe that these statutory changes should allay commentators’ concerns regarding the characterization of foreign-to-foreign communications as space or ocean activity.

The Treasury Department and the IRS believe that the modifications in the reproposed regulations with respect to the characterization of services involving space or ocean activities address some of the commentators’ concerns regarding the characterization of foreign-to-foreign communications activities involving services performed both in space or international water and in foreign countries. Reproposed §1.863-8(d)(2)(ii) provides that a transaction characterized as the performance of a service will be treated as a space or ocean activity only to the extent the value of the service, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in space or international water.

Section 1.863-8(d)(1)(i) of the 2001 proposed regulations defines space as any area not within the jurisdiction (as recognized by the United States) of a foreign country, possession of the United States, or the United States, and not in international water. Under the 2001 proposed regulations, space comprises the entire area outside the jurisdiction of any country or U.S. possession, extending from just above the surface of international water (and Antarctica) through, and beyond, the earth’s atmosphere. Space thus includes international airspace.

Several commentators stated that the definition of space should be limited to the area beyond the earth’s atmosphere. One commentator proposed a definition of space that conforms to a definition used for non-tax purposes (for example, beyond the maximum altitude at which powered flight by aircraft equipped with air-breathing engines is possible). Another commentator stated that the definition of space could be read to include cyberspace, the electronic medium in which online communication takes place, and suggested that cyberspace be specifically excluded from the definition of space. One commentator noted language in the legislative history stating that space activities had not been very prevalent at the time of the 1986 Act (see, for example, S. Rep. No. 99-313, at 358) and argued that Congress did not intend to include international airspace in space.

No changes were made to the reproposed regulations in response to these comments. The Treasury Department and the IRS believe a broad definition of space that includes international airspace is consistent with legislative intent to assert primary tax jurisdiction over income earned by U.S. residents that is not within any foreign country’s taxing jurisdiction. See, e.g., S. Rep. No. 99-313, at 357. The Treasury Department and the IRS also believe that providing guidance with respect to the place of performance of activities involving online communications is beyond the scope of the present regulations, and that taxpayers should rely on generally applicable principles to determine where functions are performed, resources are employed, or risks are assumed in a specific online transaction.

Certain activities occurring in space or international water are not considered either space or ocean activity. Section 1.863-8(d)(3)(i) of the 2001 proposed regulations, consistent with section 863(d), provides that space or ocean activity does not include any activity that gives rise to transportation income as defined in section 863(c).

One commentator stated that a portion of a bareboat charter — the return of an empty vessel that has unloaded its cargo (backhaul) — may potentially be considered ocean activity under the 2001 proposed regulations. Another commentator stated that income from container leasing by a party other than the ship operator could constitute space or ocean income, and could be subject to withholding tax. One commentator also suggested that the regulations should state that they do not apply to the income of foreign corporations derived from the international operation of ships, or to container leasing.

The reproposed regulations do not adopt changes to reflect these comments. The reproposed regulations reflect the broad statutory definition of ocean activity in section 863(d)(2) as “any activity conducted on or under water not within the jurisdiction (as recognized by the United States) of a foreign country, possession of the United States, or the United States.” The Treasury Department and the IRS do not consider it appropriate to construe the definition of section 863(c) transportation income in the context of these regulations. The Treasury Department and the IRS will consider addressing the definition of section 863(c) transportation income in separate guidance.

Section 1.863-8(e) of the 2001 proposed regulations generally provides that section 863(d) and the regulations thereunder will be applied to domestic partnerships at the partnership level and to foreign partnerships at the partner level. Commentators suggested that the source rules of §1.863-8 of the 2001 proposed regulations be applied to all partnerships either at the entity level or at the partner level.

The Treasury Department and the IRS believe that section 863(d) should be applied to domestic and foreign partnerships in the same manner. Accordingly, the reproposed regulations do not provide a different rule for foreign partnerships and domestic partnerships. Section 1.863-8(e) of the reproposed regulations provides that section 863(d) and the regulations thereunder will be applied to domestic partnerships at the partner level. In order to conform the treatment of domestic and foreign partnerships, no change was made with respect to the rule in the 2001 proposed regulations that section 863(d) and the regulations thereunder will be applied to foreign partnerships at the partner level.

When a taxpayer must allocate gross income to the satisfaction of the Commissioner, based on all the facts and circumstances, under the provisions of the 2001 proposed regulations, the Treasury Department and the IRS believe such allocations generally should be based on section 482 principles.

Several commentators stated that allocation of gross income based on section 482 principles will be burdensome and expensive and will create uncertainty. Commentators also noted that the 2001 proposed regulations provide no guidance on allocating income other than a facts and circumstances approach.

The Treasury Department and the IRS consider the allocation of gross income based on the general guidance of section 482 to be an approach that is well-suited to application in the wide variety of factual contexts within the scope of the reproposed regulations. The Treasury Department and the IRS solicit comments on alternative methods of allocation for particular industries and criteria that could be used to evaluate the reasonableness of such methods.

In order to satisfy the Commissioner with respect to a taxpayer’s allocation of gross income under §1.863-8(b)(3), (b)(4)(ii)(C), or (b)(5) of the 2001 proposed regulations, the taxpayer must make the allocation on a timely filed original return (including extensions). An amended return does not qualify for this purpose, and section 9100 relief will not be available. In all cases, a taxpayer must also maintain contemporaneous documentation regarding the allocation of gross income, allocation and apportionment of expenses, losses, and other deductions, the methodologies used, and the circumstances justifying use of those methodologies. The taxpayer must produce such documentation within 30 days upon request.

Commentators stated that neither the statute nor the legislative history provides a basis for the reporting, recordkeeping, and contemporaneous documentation requirements in the 2001 proposed regulations. Commentators also noted that the Code and regulations do not contain similar requirements with respect to certain other expense allocation provisions.

The reproposed regulations generally retain the recordkeeping and documentation requirements. The Treasury Department and the IRS believe that it is appropriate to require taxpayers to keep proper records, and additionally note the potentially considerable difficulties the IRS would face in performing the allocations required by the reproposed regulations without appropriate taxpayer records.

The Treasury Department and the IRS recognize, however, that taxpayers may not have all the information necessary to make allocations at the time a return is originally filed. The reproposed regulations therefore provide that a taxpayer may make changes to allocations made on the taxpayer’s original return with respect to any taxable year for which the statute of limitations has not closed, subject to certain conditions. Nonetheless, changes to such allocations that are not made until an audit of the taxable year to which the allocations relate has commenced, or a taxpayer’s failure timely to provide documentation and other information supporting the allocations, create administrative difficulties for the IRS. Accordingly, reproposed §1.863-8(g)(4) sets forth the actions required of taxpayers and the procedures the IRS will follow in the case of taxpayers that change their allocations.

The reproposed regulations also require taxpayers, upon request, to provide access to the software programs and other systems used by the taxpayer to make allocations under these regulations. For this purpose, software has the meaning provided in section 7612(d). The Treasury Department and the IRS believe that the IRS could face significant administrative and other difficulties in the examination of allocations made under these regulations without access to such software.

Certain examples in §1.863-8(f) of the 2001 proposed regulations contain statements regarding the characterization of certain activities (as, for example, the lease of equipment or the performance of services). One commentator suggested that the examples clarify that the character of the transactions at issue is only assumed for purposes of the specific example. In response to this comment, the examples in reproposed §1.863-8(f) have been revised to make clear that the characterization of certain transactions is assumed based on the facts of the specific example. The Treasury Department and the IRS did not consider it necessary to modify certain other examples (for example, Example 1 of reproposed §1.863-8(f)) in which the character of the transaction at issue should be clear under the facts presented.

In addition, Examples 2, 3, 4, and 7 of reproposed §1.863-8(f), have been revised to reflect substantive changes made to reproposed §1.863-8(b)(4) and (d)(2)(ii) with respect to services that involve activities performed in space or international water.

International communications income is defined by section 863(e)(2) as income derived from the transmission of communications between the United States and a foreign country (or possession of the United States). Section 863(e)(1)(A) provides that in the case of any U.S. person, 50 percent of any international communications income will be sourced in the United States and 50 percent of such income will be sourced outside the United States. Section 863(e)(1)(B)(i) provides that any international communications income of a foreign person will be foreign source income except as provided in regulations or in section 863(e)(1)(B)(ii). Section 1.863-9(b)(2)(ii)(A) of the 2001 proposed regulations states the general rule that international communications income of a foreign person is foreign source income. However, the 2001 proposed regulations contain certain exceptions to the general rule.

The first exception, in §1.863-9(b)(2)(ii)(B) of the 2001 proposed regulations, provides that if U.S. persons own 50 percent or more of a foreign corporation by vote or value (directly, indirectly, or constructively), including a CFC within the meaning of section 957, international communications income derived by that corporation is entirely U.S. source income.

As with the similar rule provided for the space and ocean income of U.S.-owned foreign corporations in §1.863-8(b)(2) of the 2001 proposed regulations, several commentators requested that the rule be withdrawn because it expands the scope of U.S. taxing jurisdiction beyond the apparent intent of Congress. Commentators stated that the rule is punitive in nature because it is less favorable than the 50/50 source rule applied to international communications income earned directly by U.S. persons. As with §1.863-8(b)(2) and (3) of the 2001 proposed regulations, commentators also stated that under the rule the international communications income of certain foreign corporations may be subject to multiple levels of taxation.

Commentators noted that in certain circumstances international communications income could be subject to the 30-percent gross income tax imposed by section 881, which is typically collected through withholding by the payors of such income. Commentators stated that although most tax treaties should prevent the imposition of the 30-percent tax (international communications income would likely be characterized as business profits under most treaties and would accordingly be exempt from U.S. taxation unless attributable to a permanent establishment in the United States), the rule in the 2001 proposed regulations would result in disparate treatment for corporations from treaty countries vis--vis corporations from non-treaty countries. The requirement to withhold the 30-percent tax could also create numerous administrative and enforcement difficulties. In addition, given the extent of resale of capacity between telecommunications providers, commentators noted that payments relating to the same transmission could be subject to multiple withholding. Finally, as with the similar rule provided for the space and ocean income of U.S.-owned foreign corporations in §1.863-8(b)(2) of the 2001 proposed regulations, commentators raised the issue of potential difficulties in determining whether a foreign corporation is 50-percent or more U.S.-owned.

As noted above, several commentators addressed the stock ownership test applicable to U.S.-owned foreign corporations. They stated that determining whether a foreign corporation is 50-percent U.S. owned, especially without regard to the size of an owner’s holding, presents potential difficulties (for example, when the foreign corporation is widely-held).

In light of the potential complexity in determining whether a foreign corporation is a U.S.-owned foreign corporation and the belief of the Treasury Department and the IRS that international communications income earned by foreign corporations should be sourced in accord with the rules for foreign persons, with the limited exception for CFCs discussed below, the reproposed regulations do not include a special source rule for international communications income earned by a 50 percent or more U.S.-owned foreign corporation. Instead, the international communications income of foreign corporations (other than CFCs) is sourced under the applicable provisions of reproposed §1.863-9(b)(2)(i), (iii), and (iv).

In light of the comments with respect to CFCs described above, the reproposed regulations provide that in the case of a CFC, 50 percent of any international communications income will be sourced in the United States and 50 percent of such income will be sourced outside the United States. The 100-percent U.S. source rule is eliminated. Consequently, the source rule for international communications income in the hands of a CFC is the same rule that applies to U.S. persons. In both cases, the source rules take into account that international communications activities must have both a U.S. and a foreign connection (i.e., one endpoint in the United States and the other in a foreign country or possession of the United States). The Treasury Department and the IRS believe that the revision of the source rule for CFCs deriving international communications income should mitigate commentators’ concerns about potential multiple levels of taxation because 50 percent of this income is foreign source.

The Treasury Department and the IRS recognize that this and other provisions of reproposed §1.863-9 may raise withholding tax issues similar to those discussed above in connection with the source rule for the space and ocean income of CFCs (in reproposed §1.863-8(b)(2)(ii)). As noted above, the Treasury Department and the IRS seek comments on these issues and practical suggestions to address them in the specific factual contexts in which they may arise.

Section 863(e)(1)(B)(ii) and §1.863-9(b)(2)(ii)(C) of the 2001 proposed regulations provide that international communications income derived by a foreign person that is attributable to an office or other fixed place of business in the United States is from sources within the United States. Section 864 and the regulations thereunder provide guidance in determining “income ... attributable to an office or other fixed place of business” in specific contexts. However, the Treasury Department and the IRS believe that, for purposes of section 863(e), international communications income should be attributed to an office or fixed place of business based on functions performed, resources employed, and risks assumed. Therefore, pursuant to the regulatory authority in section 863(e)(1)(B)(i), the reproposed regulations provide that, for purposes of this section, income is attributable to an office or other fixed place of business in the United States to the extent of functions performed, resources employed, or risks assumed by the office or other fixed place of business.

The second exception to §1.863-9(b)(2)(ii)(A) of the 2001 proposed regulations is contained in §1.863-9(b)(2)(ii)(D), which provides that if a foreign person (other than a 50 percent or more U.S.-owned foreign corporation described in §1.863-9(b)(2)(ii)(B) of the 2001 proposed regulations) is engaged in a trade or business within the United States, the foreign person’s international communications income is presumed to be U.S. source income. However, if the foreign person can allocate its international communications income between sources within the United States, space, and international water and sources outside the United States, space, and international water to the satisfaction of the Commissioner, based on all the facts and circumstances, which may include functions performed, resources employed, or risks assumed, then the income allocated to sources outside the United States, space, and international water will be foreign source income.

Several commentators stated that the presumption is overbroad because it applies to all international communications income regardless of any nexus with the foreign corporation’s U.S. trade or business. These commentators claimed that the presumption is inconsistent with U.S. tax policy and international norms that require a connection between the income and the foreign person’s activities in the United States before U.S. taxing jurisdiction is exercised.

In response to comments, the reproposed regulations provide that if a foreign person, other than a CFC, is engaged in a trade or business within the United States, gross income derived by that person from international communications activity is from sources within the United States to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed within the United States. This rule is similar to the rule in the reproposed regulations under section 863(d) for foreign persons engaged in a trade or business within the United States. There is no longer a presumption of U.S. source income.

The Treasury Department and the IRS believe that the provision in the reproposed regulations that such a foreign person’s international communications income is U.S. source only to the extent attributable to functions performed, resources employed, or risks assumed in the United States addresses taxpayers’ concerns regarding a nexus between the foreign person’s international communications income and its business activities in the United States.

Several commentators objected to the rule that international communications income could be foreign source income only to the extent that the foreign person could allocate international communications income to activity occurring in a foreign country. Because the reproposed regulations provide for U.S. sourcing only to the extent that the foreign person’s international communications income is attributable to functions performed, resources employed, or risks assumed in the United States, this concern should be mitigated.

Several commentators stated that section 863(e) makes international communications income that is attributable to a U.S. office U.S. source income, and that the regulations should not adopt a broader U.S. trade or business rule. Section 863(e)(1)(B)(ii) provides that if a foreign person has a fixed place of business in the United States, international communications income attributable to such fixed place of business is U.S. source income. The Treasury Department and the IRS have not made changes to the reproposed regulations in response to these comments. Section 863(e)(1)(B)(i) by its terms gives the Secretary broad authority to source international communications income of a foreign person as U.S. source income. The Treasury Department and the IRS believe that it is appropriate to exercise that authority in this case. The trade or business rule reflects the concern of the Treasury Department and the IRS that a foreign person could avoid a U.S. fixed place of business under section 863(e)(1)(B)(ii), yet engage in significant communications activity in the United States. The Treasury Department and the IRS believe that Congress intended that a foreign person engaged in substantial business in the United States be subject to U.S. tax on that communications activity.

Income derived from communications activity is defined in §1.863-9(d)(2) of the 2001 proposed regulations as income derived from the transmission of communications, including income derived from the provision of capacity to transmit communications. There is no requirement that the recipient of communications income perform the transmission function itself. This rule reflects the understanding of the Treasury Department and the IRS that providers of communications services often use capacity owned or operated by others. However, income is derived from communications activity only if the taxpayer is paid to transmit, and bears the risk of transmitting, the communications.

Section 1.863-9(d)(3) of the 2001 proposed regulations provides rules for characterizing income derived from a communications activity for purposes of sourcing the income derived from such activity. The character of income derived from communications activity is determined by establishing the two points between which the taxpayer is paid to transmit, and bears the risk of transmitting, the communication (the paid-to-do rule). Under the paid-to-do rule, the path the communication takes between the two points is not relevant in determining the character of the transmission. If a taxpayer is paid to take a communication from one point to another point, income derived from the transmission is characterized based on the transmission between those two points, even if the taxpayer contracts out part of the transmission to another party. This rule reflects the recognition by the Treasury Department and the IRS, as noted above, that providers of communications services often use capacity owned or operated by others.

When the taxpayer cannot establish the two points between which the taxpayer is paid to transmit the communication, §1.863-9(b)(6) of the 2001 proposed regulations provides a default source rule, under which all income from the communications activity, whether derived by a U.S. person or a foreign person, is deemed to be from sources within the United States. Thus, for example, when a provider of communications services provides both local and international long distance services in one-price bundles for a set amount each month and tracing each transmission is not possible or practical, the income derived from the communications activity is U.S. source income. The Treasury Department and the IRS understand that many taxpayers in the communications industry may consider it impractical or impossible to prove the endpoints of the communications they transmit. The Treasury Department and the IRS accordingly solicited comments as to proposals for those situations when taxpayers cannot establish the points between which the taxpayer is paid to transmit the communication.

One commentator stated that the phrase “bears the risk of transmitting,” contained in §1.863-9(d)(2) and (d)(3)(i) of the 2001 proposed regulations, is ambiguous and does not meaningfully improve the determination of when income is derived from communications activity. This commentator noted that the nature of the risk a taxpayer must bear to be treated as deriving communications income was unclear, and that the determination of risk would pose administrative difficulties given the complexity of business models and structures. No change was made to the reproposed regulations in response to this comment. The Treasury Department and the IRS believe that, in determining whether a taxpayer derives communications income, risk is more important than the mere fact of payment. The Treasury Department and the IRS thus believe that a taxpayer should not be considered to derive communications income unless the taxpayer bears the economic risk of nonpayment with respect to the transmission of communications or the provision of capacity to transmit communications.

Commentators stated that the paid-to-do rule is overbroad because it asserts primary U.S. taxing jurisdiction over certain communications income regardless of any nexus between the income and the United States. Commentators also noted that when certain taxpayers cannot establish the two points between which they are paid to transmit a communication, the income from such communications activity may be subject to potential double taxation at the corporate level (for example, a foreign corporation could be subject to tax on such communications income in both the United States and in the foreign corporation’s country of residence or incorporation or countries where it does business).

Commentators stated that the paid-to-do rule places undue burdens on taxpayers who want to obtain the benefit of foreign source income characterization. Commentators noted that, in many cases, it may be impractical or technologically impossible to track the origination and termination points of an individual transmission, and that development of the required technology, software, and other systems would require significant capital investments. Maintenance of the records needed to substantiate proper income sourcing could also be onerous for those taxpayers who perform extremely large numbers of transmissions. Commentators thus requested that the regulations provide assurance that reasonable methods of proof, consistent with industry practice and consistently applied, would be accepted in establishing the points of origin and/or destination of a communication.

Commentators submitted suggested modifications to the paid-to-do rule. One commentator suggested that the paid-to-do rule be modified to characterize all income from a communication based on the two endpoints between which the transmission is made. Under this commentator’s suggested rule, whether a particular taxpayer itself carried out all, or only a portion, of the transmission would be irrelevant, and the characterization of the communication would be the same for all taxpayers involved in the transmission. One commentator suggested that the paid-to-do rule be applied on a single entity basis for United States corporations that join in the filing of a consolidated U.S. income tax return.

Commentators also suggested reasonable method approaches to determine the endpoints between which a taxpayer is paid to transmit communications (for example, based on technical characteristics of the communication or contractual terms, or on a per transaction, per customer, or aggregate basis). One commentator suggested factors that could be taken into account in determining whether a particular method is reasonable, including the reliability of the method chosen, the degree to which the method is in line with generally accepted industry practices and norms, and the extent to which the method takes into account all the information available to the taxpayer.

Commentators suggested that the U.S. source default rule for income from communications for which the endpoints of transmission cannot be identified should only apply to foreign taxpayers that directly own or operate communications facilities, or otherwise directly hold rights to communications capacity, in the United States; when a foreign taxpayer does not own or otherwise have rights to telecommunications capacity in the United States, income from such communications would thus be foreign source. Other commentators suggested that income from communications for which the endpoints of transmission cannot be identified be treated in the same manner as international communications income, with a 100-percent U.S. source exception provided for telecommunications service providers who are paid to transmit communications that are substantially all between multiple points located within the United States.

The Treasury Department and the IRS continue to believe that communications activity is most appropriately characterized based on the two points between which the taxpayer is paid to transmit, and bears the risk of transmitting, the communication. The Treasury Department and the IRS consider the endpoint-based source rule in the reproposed regulations to be an approach that best matches the source of communications income to the location where functions are performed, resources are employed, or risks are assumed in a taxpayer’s communications transaction. Moreover, although commentators noted potential difficulties in identifying the endpoints of a communication, the industry-specific comments received in response to the 2001 proposed regulations generally focused on recordkeeping burdens. Taxpayers have much better access to the relevant information regarding the facts and circumstances of their communications transactions than the IRS. The Treasury Department and the IRS accordingly solicit comments on the challenges to identifying the endpoints of communications in specific industries or situations, as well as suggestions for rules that are responsive to these particular challenges. The Treasury Department and the IRS also again solicit comments on methods to identify the endpoints of a communication that may be reasonable for particular industries, as well as criteria that may be appropriate to evaluate the reasonableness of such methods.

Section 1.863-9(d)(1)(ii) of the 2001 proposed regulations provides that, to the extent a taxpayer’s transaction consists in part of non-de minimis communications activities and in part of non-de minimis non-communications activities, such parts of the transaction must be treated as separate transactions. Section 1.863-9(d)(1)(ii) of the 2001 proposed regulations then provides that gross income derived from the activities must be allocated to each separate transaction, to the satisfaction of the Commissioner, based on all the facts and circumstances, which may include functions performed, resources employed, or risks assumed in the respective transactions.

One commentator suggested that the regulations be clarified to provide that a content company (for example, the creator of a television or radio program) that does not possess or operate communications equipment or itself perform any communications function is not engaged in communications activities. This commentator did not believe that communication activities should be attributed to a content provider and stated that delivery of a content provider’s programming by a third party should not change the character of the content provider’s income to communications income.

No changes were made to the reproposed regulations in response to this comment. The Treasury Department and the IRS believe that the transmission of any communications, including content, is appropriately considered a communications activity. The Treasury Department and the IRS also believe that when a content provider is paid to transmit, and bears the risk of transmitting, content to a customer, the content provider should be considered to derive communications income. Under reproposed §1.863-9(h)(1)(ii), as under the 2001 proposed regulations, the content provider will derive communications income only to the extent of the gross income allocated to the separate transaction involving the communications activity. The Treasury Department and the IRS believe that it is appropriate for a content provider to derive communications income when communications activities make more than a de minimis contribution to the value of the content provider’s overall transaction with its customer.

Section 1.863-9(e)(1) of the 2001 proposed regulations generally provides that section 863(e) and the regulations thereunder will be applied to domestic partnerships at the partnership level. Section 1.863-9(e)(1) of the 2001 proposed regulations also provides that section 863(e) and the regulations thereunder will be applied at the partner level to foreign partnerships. Section 1.863-9(e)(2) of the 2001 proposed regulations similarly provides that section 863(e) and the regulations thereunder will be applied at the partner level to domestic partnerships in which 50 percent or more of the partnership interests are owned by foreign persons.

One commentator stated that §1.863-9(e)(2) of the 2001 proposed regulations conflicts with sections 863(e)(1)(A) (which provides that the international communications income of any United States person shall be 50-percent U.S. source and 50-percent foreign source) and 7701(a)(3) (which defines United States person to include a domestic partnership). According to this commentator, the rule potentially discriminates against foreign partners in a domestic partnership owned 50 percent or more by foreign partners vis--vis the U.S. partners in such a partnership. For example, the international communications income of a foreign partner could be 100-percent U.S. source under §1.863-9(b)(2)(ii)(B) or (C) of the 2001 proposed regulations, whereas the international communications income of a U.S. partner would be 50-percent U.S. source and 50-percent foreign source, creating the potential for double taxation of the foreign partner. Another commentator stated that §1.863-9(e)(1) of the 2001 proposed regulations could result in the double taxation of the U.S. partners of foreign partnerships. This commentator noted that the international communications income of a foreign partnership could be subject to tax in the country in which the foreign partnership is organized. Under §1.863-9(e) of the 2001 proposed regulations, a U.S. partner’s share of such international communications income would be subject to the 50/50 source rule in §1.863-9(b)(2)(i) of the 2001 proposed regulations. As a result, the U.S. partner may be unable to credit its proportionate share of tax paid in the foreign country. Commentators suggested that the source rules of §1.863-9 of the 2001 proposed regulations be applied to all partnerships at the entity level.

As is the case for reproposed §1.863-8(e) with respect to section 863(d), the Treasury Department and the IRS believe that section 863(e) should be applied to domestic and foreign partnerships in the same manner. Accordingly, the reproposed regulations do not provide a different rule for foreign partnerships and domestic partnerships. Section 1.863-9(i) of the reproposed regulations provides that the regulations will be applied at the partner level for all partnerships.

When a taxpayer must allocate gross income to the satisfaction of the Commissioner, based on all the facts and circumstances, under §1.863-9(b)(2)(ii)(D) or (d)(1)(ii) of the 2001 proposed regulations, the Treasury Department and the IRS believe that such allocations should be based generally on section 482 principles. As with §1.863-8 of the 2001 proposed regulations, commentators stated that allocation of income based on section 482 principles would be burdensome and expensive and would create uncertainty.

The Treasury Department and the IRS consider the allocation of gross income based on the general guidance of section 482 to be an approach that is well-suited to application in the wide variety of factual contexts within the scope of the reproposed regulations. The Treasury Department and the IRS solicit comments on alternative methods of allocation for particular industries and criteria that could be used to evaluate the reasonableness of such methods.

Examples 5, 10, and 12 of §1.863-9(f) of the 2001 proposed regulations involve communications activities that include the performance of satellite uplink and downlink functions. One commentator stated that these examples do not provide clear guidance as to whether the satellite operator must itself perform the uplink function in order for its income to qualify as international communications income, and could be read to treat a satellite operator that contracts with another party to transmit signals as not engaged in international communications activity because the uplink function is performed by that other party.

No changes were made to the reproposed regulations in response to this comment. Reproposed §1.863-9(h)(2) provides that income may be considered derived from a communications activity even if the taxpayer does not perform the transmission function, but, in all cases, a taxpayer derives communications income only if the taxpayer is paid to transmit, and bears the risk of transmitting, the communications. The Treasury Department and the IRS believe that whether a satellite operator should be considered to derive international telecommunications income from a transaction is appropriately determined by applying reproposed §1.863-9(h)(2), as well as the other substantive provisions of the reproposed regulations, to the specific facts of the taxpayer’s transaction.

One commentator stated that the regulations should be clarified to provide that they do not purport to establish general rules for the characterization of income and that the characterization of income items for purposes of the application of section 863(d) and (e) is to be made under general principles of tax law. This commentator stated that some examples in the 2001 proposed regulations could suggest conflicting characterizations of income from what appear to be the same activities. In response to this comment, the examples in the reproposed regulations have been clarified to state that the characterization of the transactions at issue is assumed for purposes of the specific example. In addition, certain examples have been reconciled to the extent they could suggest different characterizations of the same activities.

In order to satisfy the Commissioner with respect to a taxpayer’s allocation of gross income under §1.863-9(b)(2)(ii)(D) or (d)(1)(ii) of the 2001 proposed regulations, the taxpayer must make the allocation on a timely filed original return (including extensions). An amended return does not qualify for this purpose, and section 9100 relief will not be available. In all cases, a taxpayer must also maintain contemporaneous documentation regarding the allocation of gross income, allocation and apportionment of expenses, losses and other deductions, the methodologies used, and the circumstances justifying use of those methodologies. The taxpayer must produce such documentation within 30 days upon request.

As with the similar requirements under §1.863-8 of the 2001 proposed regulations, commentators stated that there is no basis in the statute or the legislative history for the reporting, recordkeeping, and contemporaneous documentation requirements in the 2001 proposed regulations. Commentators also noted that the Code and regulations do not contain similar requirements with respect to other expense allocation provisions.

The reproposed regulations generally retain the recordkeeping and documentation requirements. The Treasury Department and the IRS believe that it is appropriate to require taxpayers to keep proper records, and additionally note the potentially considerable difficulties the IRS would face in performing the allocations required by the reproposed regulations without appropriate taxpayer records.

The Treasury Department and the IRS recognize, however, that taxpayers may not have all the information necessary to make allocations at the time a return is originally filed. The reproposed regulations therefore provide that a taxpayer may make changes to allocations made on the taxpayer’s original return with respect to any taxable year for which the statute of limitations has not closed, subject to certain conditions. Nonetheless, changes to such allocations that are not made until an audit of the taxable year to which the allocations relate has commenced, or a taxpayer’s failure timely to provide documentation and other information supporting the allocations, create administrative difficulties for the IRS. Accordingly, reproposed §1.863-9(k)(4) sets forth the actions required of taxpayers and the procedures the IRS will follow in the case of taxpayers changing their allocations.

The reproposed regulations also require taxpayers, upon request, to provide access to the software programs and other systems used by the taxpayer to make allocations under these regulations. For this purpose, software has the meaning provided in section 7612(d). The Treasury Department and the IRS believe that the IRS could face significant administrative and other difficulties in the examination of income allocations made under these regulations without access to such software.

(a) * * * (1) * * * To determine the source of income from sales of property produced by the taxpayer, when the property is either produced in whole or in part in space or on or under water not within the jurisdiction (as recognized by the United States) of a foreign country, possession of the United States, or the United States (in international water), or is sold in space or international water, the rules of §1.863-8 apply, and the rules of this section do not apply except to the extent provided in §1.863-8. * * *

* * * * *

(c) * * * (1) * * * (i) * * * (A) * * * For rules regarding the source of income when production takes place, in whole or in part, in space or international water, the rules of §1.863-8 apply, and the rules of this section do not apply except to the extent provided in §1.863-8.

* * * * *

(2) * * * Notwithstanding any other provision, for rules regarding the source of income when a sale takes place in space or international water, the rules of §1.863-8 apply, and the rules of this section do not apply except to the extent provided in §1.863-8. * * *

* * * * *

Par. 3. Sections 1.863-8 and 1.863-9 are added to read as follows:

(a) In general. Income of a United States or a foreign person derived from space and ocean activity (space and ocean income) is sourced under the rules of this section, notwithstanding any other provision, including sections 861, 862, 863, and 865. A taxpayer will not be considered to derive income from space or ocean activity, as defined in paragraph (d) of this section, if such activity is performed by another person, subject to the rules for the treatment of consolidated groups in §1.1502-13.

(b) Source of gross income from space and ocean activity—(1) Space and ocean income derived by a U.S. person. Space and ocean income derived by a U.S. person is income from sources within the United States. However, space and ocean income derived by a U.S. person is income from sources without the United States to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in a foreign country or countries.

(2) Space and ocean income derived by a foreign person—(i) In general. Space and ocean income derived by a person other than a U.S. person is income from sources without the United States, except as otherwise provided in this paragraph (b)(2).

(ii) Space and ocean income derived by a controlled foreign corporation. Space and ocean income derived by a controlled foreign corporation within the meaning of section 957 (CFC) is income from sources within the United States. However, space and ocean income derived by a CFC is income from sources without the United States to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in a foreign country or countries.

(iii) Space and ocean income derived by foreign persons engaged in a trade or business within the United States. Space and ocean income derived by a foreign person (other than a CFC) engaged in a trade or business within the United States is income from sources within the United States to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed within the United States.

(3) Source rules for income from certain sales of property—(i) Sales of purchased property. When a taxpayer sells purchased property in space or international water, the source of gross income from the sale generally will be determined under paragraph (b)(1) or (2) of this section, as applicable. However, if such property is inventory property within the meaning of section 1221(a)(1) (inventory property) and is not sold for use, consumption, or disposition in space or international water, the source of income from the sale will be determined under §1.861-7(c).

(ii) Sales of property produced by the taxpayer—(A) General. If the taxpayer both produces property and sells such property, the taxpayer must allocate gross income from such sales between production activity and sales activity under the 50/50 method. Under the 50/50 method, one-half of the taxpayer’s gross income will be considered income allocable to production activity, and the source of that income will be determined under paragraph (b)(3)(ii)(B) or (C) of this section. The remaining one-half of such gross income will be considered income allocable to sales activity, and the source of that income will be determined under paragraph (b)(3)(ii)(D) of this section.

(B) Production only in space or international water, or only outside space and international water. When production occurs only in space or international water, income allocable to production activity is sourced under paragraph (b)(1) or (2) of this section, as applicable. When production occurs only outside space and international water, income allocable to production activity is sourced under §1.863-3(c)(1).

(C) Production both in space or international water and outside space and international water. When property is produced both in space or international water and outside space and international water, gross income allocable to production activity must be allocated to production occurring in space or international water and production occurring outside space and international water. Such gross income is allocated to production activity occurring in space or international water to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in space or international water. The balance of such gross income is allocated to production activity occurring outside space and international water. The source of gross income allocable to production activity in space or international water is determined under paragraph (b)(1) or (2) of this section, as applicable. The source of gross income allocated to production activity occurring outside space and international water is determined under §1.863-3(c)(1).

(D) Source of income allocable to sales activity. When property produced by the taxpayer is sold outside space and international water, the source of gross income allocable to sales activity will be determined under §§1.861-7(c) and 1.863-3(c)(2). When property produced by the taxpayer is sold in space or international water, the source of gross income allocable to sales activity generally will be determined under paragraph (b)(1) or (2) of this section, as applicable. However, if such property is inventory property within the meaning of section 1221(a)(1) and is sold in space or international water for use, consumption, or disposition outside space, international water, or the United States, the source of gross income allocable to sales activity will be determined under §§1.861-7(c) and 1.863-3(c)(2).

(4) Special rule for determining the source of gross income from services. To the extent a transaction characterized as the performance of a service constitutes a space or ocean activity, as determined under paragraph (d)(2)(ii) of this section, the source of gross income derived from such transaction is determined under paragraph (b)(1) or (2) of this section.

(5) Special rule for determining source of income from communications activity (other than income from international communications activity). Space and ocean activity, as defined in paragraph (d) of this section, includes activity that occurs in space or international water that is characterized as a communications activity as defined in §1.863-9(h)(1) (other than international communications activity). The source of space and ocean income that is also communications income as defined in §1.863-9(h)(2) (but not space/ocean communications income as defined in §1.863-9(h)(3)(v)) is determined under the rules of §1.863-9(c), (d), and (f), as applicable, rather than under paragraph (b) of this section. The source of space and ocean income that is also space/ocean communications income as defined in §1.863-9(h)(3)(v) is determined under the rules of paragraph (b) of this section. See §1.863-9(e).

(c) Taxable income. When a taxpayer allocates gross income under paragraph (b)(1), (b)(2), (b)(3)(ii)(C), or (b)(4) of this section, the taxpayer must allocate expenses, losses, and other deductions as prescribed in §§1.861-8 through 1.861-14T to the class or classes of gross income that include the income so allocated in each case. A taxpayer must then apply the rules of §§1.861-8 through 1.861-14T to apportion properly amounts of expenses, losses, and other deductions so allocated to such gross income between gross income from sources within the United States and gross income from sources without the United States.

(d) Space and ocean activity—(1) Definition—(i) Space activity. In general, space activity is any activity conducted in space. For purposes of this section, space means any area not within the jurisdiction (as recognized by the United States) of a foreign country, possession of the United States, or the United States, and not in international water. For purposes of determining space activity, the Commissioner may separate parts of a single transaction into separate transactions or combine separate transactions as part of a single transaction. Paragraph (d)(3) of this section lists specific exceptions to the general definition of space activity. Activities that constitute space activity include but are not limited to—

(A) Performance and provision of services in space, as defined in paragraph (d)(2)(ii) of this section;

(B) Leasing of equipment located in space, including spacecraft (for example, satellites) or transponders located in space;

(C) Licensing of technology or other intangibles for use in space;

(D) Production, processing, or creation of property in space, as defined in paragraph (d)(2)(i) of this section;

(E) Activity occurring in space that is characterized as communications activity (other than international communications activity) under §1.863-9(h)(1);

(F) Underwriting income from the insurance of risks on activities that produce space income; and

(G) Sales of property in space (see §1.861-7(c)), but not sales of inventory property for use, consumption, or disposition outside space or international water.

(ii) Ocean activity. In general, ocean activity is any activity conducted on or under water not within the jurisdiction (as recognized by the United States) of a foreign country, possession of the United States, or the United States (collectively, in international water). For purposes of determining ocean activity, the Commissioner may separate parts of a single transaction into separate transactions or combine separate transactions as part of a single transaction. Paragraph (d)(3) of this section lists specific exceptions to the general definition of ocean activity. Activities that constitute ocean activity include but are not limited to—

(A) Performance and provision of services in international water, as defined in paragraph (d)(2)(ii) of this section;

(B) Leasing of equipment located in international water, including underwater cables;

(C) Licensing of technology or other intangibles for use in international water;

(D) Production, processing, or creation of property in international water, as defined in paragraph (d)(2)(i) of this section;

(E) Activity occurring in international water that is characterized as communications activity (other than international communications activity) under §1.863-9(h)(1);

(F) Underwriting income from the insurance of risks on activities that produce ocean income;

(G) Sales of property in international water (see §1.861-7(c)), but not sales of inventory property for use, consumption, or disposition outside space or international water;

(H) Any activity performed in Antarctica;

(I) The leasing of a vessel that does not transport cargo or persons for hire between ports-of-call (for example, the leasing of a vessel to engage in research activities in international water); and

(J) The leasing of drilling rigs, extraction of minerals, and performance and provision of services related thereto, except as provided in paragraph (d)(3)(ii) of this section.

(2) Determining a space or ocean activity—(i) Production of property in space or international water. For purposes of this section, production activity means an activity that creates, fabricates, manufactures, extracts, processes, cures, or ages property within the meaning of section 864(a) and §1.864-1.

(ii) Special rule for performance of services—(A) General. Except as provided in paragraph (d)(2)(ii)(B) of this section, if a transaction is characterized as the performance of a service, then such service will be treated as a space or ocean activity in its entirety when any part of the service is performed in space or international water. Services are performed in space or international water if functions are performed, resources are employed, or risks are assumed in space or international water, regardless of whether performed by personnel, equipment, or otherwise.

(B) Exception to the general rule. If the taxpayer can demonstrate the value of the service attributable to performance occurring in space or international water, and the value of the service attributable to performance occurring outside space and international water, then such service will be treated as space or ocean activity only to the extent of the activity performed in space or international water. The value of the service is attributable to performance occurring in space or international water to the extent the performance of the service, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in space or international water. In addition, if the taxpayer can demonstrate, based on all the facts and circumstances, that the value of the service attributable to performance in space or international water is de minimis, such service will not be treated as space or ocean activity.

(3) Exceptions to space or ocean activity. Space or ocean activity does not include the following types of activities:

(i) Any activity giving rise to transportation income as defined in section 863(c).

(ii) Any activity with respect to mines, oil and gas wells, or other natural deposits, to the extent the mines, wells, or natural deposits are located within the jurisdiction (as recognized by the United States) of any country, including the United States and its possessions.

(iii) Any activity giving rise to international communications income as defined in §1.863-9(h)(3)(ii).

(e) Treatment of partnerships. This section is applied at the partner level.

(f) Examples. The following examples illustrate the rules of this section:

Example 1. Space activity—activity occurring on land and in space—(i) Facts. S, a U.S. person, owns satellites in orbit. S leases one of its satellites to A. S, as lessor, will not operate the satellite. Part of S’s performance as lessor in this transaction occurs on land. Assume that the combination of S’s activities is characterized as the lease of equipment.

(ii) Analysis. Because the leased equipment is located in space, the transaction is defined as space activity under paragraph (d)(1)(i) of this section. Income derived from the lease will be sourced in its entirety under paragraph (b)(1) of this section. Under paragraph (b)(1) of this section, S’s space income is sourced outside the United States to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in a foreign country or countries.

Example 2. Space activity—(i) Facts. X is an Internet service provider. X offers a service that permits a customer (C) to connect to the Internet via a telephone call, initiated by the modem of C’s personal computer, to a control center. X transmits information requested by C to C’s personal computer, in part using satellite capacity leased by X from S. X charges its customers a flat monthly fee. Assume that neither X nor S derive international communications income within the meaning of §1.863-9(h)(3)(ii). In addition, assume that X is able to demonstrate, pursuant to paragraph (d)(2)(ii)(B) of this section, the extent to which the value of the service is attributable to functions performed, resources employed, and risks assumed in space.

(ii) Analysis. Under paragraph (d)(2)(ii) of this section, the service performed by X constitutes space activity to the extent the value of the service is attributable to functions performed, resources employed, and risks assumed in space. To the extent the service performed by X constitutes space activity, the source of X’s income from the service transaction is determined under paragraph (b) of this section. To the extent the service performed by X does not constitute space or ocean activity, the source of X’s income from the service is determined under sections 861, 862, and 863, as applicable. To the extent that X derives space and ocean income that is also communications income within the meaning of §1.863-9(h)(2), the source of X’s income is determined under paragraph (b) of this section and §1.863-9(c), (d), and (f), as applicable, as provided in paragraph (b)(5) of this section. S derives space and ocean income that is also communications income within the meaning of §1.863-9(h)(2), and the source of S’s income is therefore determined under paragraph (b) of this section and §1.863-9(c), (d), and (f), as applicable, as provided in paragraph (b)(5) of this section.

Example 3. Services as space activity—de minimis value attributable to performance occurring in space—(i) Facts. R owns a retail outlet in the United States. R engages S to provide a security system for R’s premises. S operates its security system by transmitting images from R’s premises directly to a satellite, and from the satellite to a group of S employees located in Country B, who monitor the premises by viewing the transmitted images. O provides S with transponder capacity on O’s satellite, which S uses to transmit those images. Assume that S’s transaction with R is characterized as the performance of a service. Assume that O’s provision of transponder capacity is also viewed as the provision of a service and that the value of O’s service transaction attributable to performance in space is not de minimis. In addition, assume that S is able to demonstrate, pursuant to paragraph (d)(2)(ii) of this section, that a de minimis portion of the value of S’s service transaction with R is attributable to performance in space. Assume also that S is able to demonstrate, pursuant to §1.863-9(h)(1), that the value of the transaction with R attributable to communications activities is de minimis.

(ii) Analysis. S derives income from providing monitoring services. Because S demonstrates that the value of S’s service transaction attributable to performance in space is de minimis, S is not treated as engaged in a space activity, and none of S’s income from the service transaction is space income. In addition, because S demonstrates that the value of the transaction with R attributable to communications activities is de minimis, S is not required under §1.863-9(h)(1)(ii) to treat the transaction as separate communications and non-communications transactions, and none of S’s gross income from the transaction is treated as communications income within the meaning of §1.863-9(h)(2). Because O’s provision of transponder capacity is viewed as the provision of a service and the value of O’s service transaction attributable to performance in space is not de minimis, O’s activity will be considered space activity, pursuant to paragraph (d)(2)(ii) of this section, to the extent the value of the services transaction is attributable to performance in space (unless O’s activity in space is international communications activity). To the extent that O derives communications income, the source of such income is determined under paragraph (b) of this section and §1.863-9(b), (c), (d), and (f), as applicable, as provided in paragraph (b)(5) of this section. R does not derive any income from space activity.

Example 4. Space activity—(i) Facts. L, a domestic corporation, offers programming and certain other services to customers located both in the United States and in foreign countries. Assume that L’s provision of programming and other services in this Example 4 is characterized as the provision of a service, and that no part of the service transaction occurs in space or international water. Assume that the delivery of the programming constitutes a separate transaction also characterized as the performance of a service. L uses satellite capacity acquired from S to deliver the programming service directly to customers’ television sets, so that part of the value of the delivery transaction derives from functions performed and resources employed in space. Assume that these contributions to the value of the delivery transaction occurring in space are not considered de minimis under paragraph (d)(2)(ii)(B) of this section. Customer C pays L to provide and deliver programming to C’s residence in the United States. Assume S’s provision of satellite capacity in this Example 4 is viewed as the provision of a service, and also that S does not derive international communications income within the meaning of §1.863-9(h)(3)(ii).

(ii) Analysis. S’s activity will be considered space activity. To the extent that S derives space and ocean income that is also communications income under §1.863-9(h)(2), the source of S’s income is determined under paragraph (b) of this section and §1.863-9(c), (d), and (f), as applicable, as provided in paragraph (b)(5) of this section. On these facts, L’s activities are treated as two separate service transactions: the provision of programming (and other services), and the delivery of programming. L’s income derived from provision of programming and other services is not income derived from space activity. L’s delivery of programming and other services is considered space activity, pursuant to paragraph (d)(2)(ii) of this section, to the extent the value of the delivery transaction is attributable to performance in space. To the extent that the delivery of programming is treated as a space activity, the source of L’s income derived from the delivery transaction is determined under paragraph (b)(1) of this section, as provided in paragraph (b)(4) of this section. To the extent that L derives space and ocean income that is also communications income within the meaning of §1.863-9(h)(2), the source of such income is determined under paragraph (b) of this section and §1.863-9(b), (c), (d), (e), and (f), as applicable, as provided in paragraph (b)(5) of this section.

Example 5. Space activity—treatment of land activity—(i) Facts. S, a U.S. person, offers remote imaging products and services to its customers. In year 1, S uses its satellite’s remote sensors to gather data on certain geographical terrain. In year 3, C, a construction development company, contracts with S to obtain a satellite image of an area for site development work. S pulls data from its archives and transfers to C the images gathered in year 1, in a transaction that is characterized as a sale of the data. S’s rights, title, and interest in the data pass to C in the United States. Before transferring the images to C, S uses computer software in its land-based office to enhance the images so that the images can be used.

(ii) Analysis. The collection of data and creation of images in space is characterized as the creation of property in space. Because S both produces and sells the data, S must allocate gross income from the sale of the data between production activity and sales activity under the 50/50 method of paragraph (b)(3)(ii)(A). The source of S’s income allocable to production activity is determined under paragraph (b)(3)(ii)(C) of this section because production activities occur both in space and on land. The source of S’s income attributable to sales activity is determined under paragraph (b)(3)(ii)(D) of this section (by reference to §1.863-3(c)(2)) as U.S. source income because S’s rights, title, and interest in the data pass to C in the United States.

Example 6. Use of intangible property in space—(i) Facts. X acquires a license to use a particular satellite slot or orbit, which X sublicenses to C. C pays X a royalty.

(ii) Analysis. Because the royalty is paid for the right to use intangible property in space, the source of the royalty paid by C to X is determined under paragraph (b) of this section.

Example 7. Performance of services—(i) Facts. E, a domestic corporation, operates satellites with sensing equipment that can determine how much heat and light particular plants emit and reflect. Based on the data, E will provide F, a U.S. farmer, a report analyzing the data, which F will use in growing crops. E analyzes the data from offices located in the United States. Assume that E’s combined activities are characterized as the performance of services.

(ii) Analysis. E’s activities will be considered space activities, pursuant to paragraph (d)(2)(ii) of this section, to the extent the value of E’s service transaction is attributable to performance in space. To the extent E’s service transaction constitutes a space activity, the source of E’s income derived from the service transaction will be determined under paragraph (b)(4) of this section, by reference to paragraph (b)(1) of this section. To the extent that E’s service transaction does not constitute a space or ocean activity, the source of E’s income derived from the service transaction is determined under sections 861, 862, and 863, as applicable.

Example 8. Separate transactions—(i) Facts. The same facts as Example 7, except that E provides the raw data to F in a transaction characterized as a sale of a copyrighted article. In addition, E provides an analysis in the form of a report to F. The price F pays E for the raw data is separately stated.

(ii) Analysis. To the extent that the provision of raw data and the analysis of the data are each treated as separate transactions, the source of income from the production and sale of data is determined under paragraph (b)(3)(ii) of this section. The provision of services would be analyzed in the same manner as in Example 7.

Example 9. Sale of property in international water—(i) Facts. T purchased and owns transatlantic cable that lies in international water. T sells the cable to B, with T’s rights, title, and interest in the cable passing to B in international water. Assume that the transatlantic cable is not inventory property within the meaning of section 1221(a)(1).

(ii) Analysis. Because T’s rights, title, and interest in the property pass to B in international water, the sale takes place in international water under §1.861-7(c), and the sale transaction is ocean activity under paragraph (d)(1)(ii) of this section. The source of T’s sales income is determined under paragraph (b)(3)(i) of this section, by reference to paragraph (b)(1) or (2) of this section.

Example 10. Sale of property in space—(i) Facts. S, a U.S. person, manufactures a satellite in the United States and sells it to a customer who is not a U.S. person. S’s rights, title, and interest in the satellite pass to the customer in space.

(ii) Analysis. Because S’s rights, title, and interest in the satellite pass to the customer in space, the sale takes place in space under §1.861-7(c), and the sale transaction is space activity under paragraph (d)(1)(i) of this section. The source of income derived from the sale of the satellite in space is determined under paragraph (b)(3)(ii) of this section, with the source of income allocable to production activity determined under paragraphs (b)(3)(ii)(A) and (B) of this section, and the source of income allocable to sales activity determined under paragraphs (b)(3)(ii)(A) and (D) of this section. Under paragraph (b)(1) of this section, S’s space income is sourced outside the United States to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in a foreign country or countries.

Example 11. Sale of property in space—(i) Facts. S has a right to operate from a particular position (satellite slot or orbit) in space. S sells the right to operate from that position to P. Assume that the sale of the satellite slot is characterized as a sale of property and that S’s rights, title, and interest in the satellite slot pass to P in space.

(ii) Analysis. The sale of the satellite slot takes place in space under §1.861-7(c) because S’s rights, title, and interest in the satellite slot pass to P in space. The sale of the satellite slot is space activity under paragraph (d)(1)(i) of this section, and income or gain from the sale is sourced under paragraph (b)(3)(i) of this section, by reference to paragraph (b)(1) or (2) of this section.

Example 12. Source of income of a foreign person—(i) Facts. FP, a foreign corporation that is not a CFC, derives income from the operation of satellites. FP operates ground stations in the United States and in foreign country FC. Assume that FP is considered engaged in a trade or business within the United States based on FP’s operation of the ground station in the United States.

(ii) Analysis. Under paragraph (b)(2)(iii) of this section, FP’s space income is sourced in the United States to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed within the United States.

Example 13. Source of income of a foreign person—(i) Facts. FP, a foreign corporation that is not a CFC, operates remote sensing satellites in space to collect data and images for its customers. FP uses an independent agent, A, in the United States who provides marketing, order-taking, and other customer service functions. Assume that FP is considered engaged in a trade or business within the United States based on A’s activities on FP’s behalf in the United States.

(ii) Analysis. Under paragraph (b)(2)(iii) of this section, FP’s space income is sourced in the United States to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed within the United States.

(g) Reporting and documentation requirements—(1) General. A taxpayer making an allocation of gross income under paragraph (b)(1), (b)(2), (b)(3)(ii)(C), or (b)(4) of this section must satisfy the requirements in paragraphs (g)(2), (3), and (4) of this section.

(2) Required documentation. In all cases, a taxpayer must prepare and maintain documentation in existence when its return is filed regarding the allocation of gross income and allocation and apportionment of expenses, losses, and other deductions, the methodologies used, and the circumstances justifying use of those methodologies. The taxpayer must make available such documentation within 30 days upon request.

(3) Access to software. If the taxpayer or any third party used any computer software, within the meaning of section 7612(d), to allocate gross income, or to allocate or apportion expenses, losses, and other deductions, the taxpayer must make available upon request—

(i) Any computer software executable code, within the meaning of section 7612(d), used for such purposes, including an executable copy of the version of the software used in the preparation of the taxpayer’s return (including any plug-ins, supplements, etc.) and a copy of all related electronic data files. Thus, if software subsequently is upgraded or supplemented, a separate executable copy of the version used in preparing the taxpayer’s return must be retained;

(ii) Any related computer software source code, within the meaning of section 7612(d), acquired or developed by the taxpayer or a related person, or primarily for internal use by the taxpayer or such person rather than for commercial distribution; and

(iii) In the case of any spreadsheet software or similar software, any formulae or links to supporting worksheets.

(4) Use of allocation methodology. In general, when a taxpayer allocates gross income under paragraph (b)(1), (b)(2), (b)(3)(ii)(C), or (b)(4) of this section, it does so by making the allocation on a timely filed original return (including extensions). However, a taxpayer will be permitted to make changes to such allocations made on its original return with respect to any taxable year for which the statute of limitations has not closed as follows:

(i) In the case of a taxpayer that has made a change to such allocations prior to the opening conference for the audit of the taxable year to which the allocation relates or who makes such a change within 90 days of such opening conference, if the IRS issues a written information document request asking the taxpayer to provide the documents and such other information described in paragraphs (g)(2) and (3) of this section with respect to the changed allocations and the taxpayer complies with such request within 30 days of the request, then the IRS will complete its examination, if any, with respect to the allocations for that year as part of the current examination cycle. If the taxpayer does not provide the documents and information described in paragraphs (g)(2) and (3) of this section within 30 days of the request, then the procedures described in paragraph (g)(4)(ii) of this section shall apply.

(ii) If the taxpayer changes such allocations more than 90 days after the opening conference for the audit of the taxable year to which the allocations relate or the taxpayer does not provide the documents and information with respect to the changed allocations as requested in accordance with paragraphs (g)(2) and (3) of this section, then the IRS will, in a separate cycle, determine whether an examination of the taxpayer’s allocations is warranted and complete any such examination. The separate cycle will be worked as resources are available and may not have the same estimated completion date as the other issues under examination for the taxable year. The IRS may ask the taxpayer to extend the statute of limitations on assessment and collection for the taxable year to permit examination of the taxpayer’s method of allocation, including an extension limited, where appropriate, to the taxpayer’s method of allocation.

(h) Effective date. This section applies to taxable years beginning on or after the date of publication of final regulations in the Federal Register.

(a) In general. Income of a United States or a foreign person derived from each type of communications activity, as defined in paragraph (h)(3) of this section, is sourced under the rules of this section, notwithstanding any other provision including sections 861, 862, 863, and 865. Notwithstanding that a communications activity would qualify as space or ocean activity under section 863(d) and the regulations thereunder, the source of income derived from such communications activity is determined under this section, and not under section 863(d) and the regulations thereunder, except to the extent provided in §1.863-8(b)(5).

(b) Source of international communications income—(1) International communications income derived by a U.S. person. Income derived from international communications activity (international communications income) by a U.S. person is one-half from sources within the United States and one-half from sources without the United States.

(2) International communications income derived by foreign persons—(i) In general. International communications income derived by a person other than a U.S. person is, except as otherwise provided in this paragraph (b)(2), wholly from sources without the United States.

(ii) International communications income derived by a controlled foreign corporation. International communications income derived by a controlled foreign corporation within the meaning of section 957 (CFC) is one-half from sources within the United States and one-half from sources without the United States.

(iii) International communications income derived by foreign persons with a fixed place of business in the United States. International communications income derived by a foreign person, other than a CFC, that is attributable to an office or other fixed place of business of the foreign person in the United States is from sources within the United States. The principles of section 864(c)(5) apply in determining whether a foreign person has an office or fixed place of business in the United States. See §1.864-7. International communications income is attributable to an office or other fixed place of business to the extent of functions performed, resources employed, or risks assumed by the office or other fixed place of business.

(iv) International communications income derived by foreign persons engaged in a trade or business within the United States. International communications income derived by a foreign person (other than a CFC) engaged in a trade or business within the United States is income from sources within the United States to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed within the United States.

(c) Source of U.S. communications income. Income derived by a United States or foreign person from U.S. communications activity is from sources within the United States.

(d) Source of foreign communications income. Income derived by a United States or foreign person from foreign communications activity is from sources without the United States.

(e) Source of space/ocean communications income. The source of income derived by a United States or foreign person from space/ocean communications activity is determined under section 863(d) and the regulations thereunder.

(f) Source of communications income when taxpayer cannot establish the two points between which the taxpayer is paid to transmit the communication. Income derived by a United States or foreign person from communications activity, when the taxpayer cannot establish the two points between which the taxpayer is paid to transmit the communication as required in paragraph (h)(3)(i) of this section, is from sources within the United States.

(g) Taxable income. When a taxpayer allocates gross income under paragraph (b)(2)(iii), (b)(2)(iv), or (h)(1)(ii) of this section, the taxpayer must allocate expenses, losses, and other deductions as prescribed in §§1.861-8 through 1.861-14T to the class or classes of gross income that include the income so allocated in each case. A taxpayer must then apply the rules of §§1.861-8 through 1.861-14T properly to apportion amounts of expenses, losses, and other deductions so allocated to such gross income between gross income from sources within the United States and gross income from sources without the United States. For amounts of expenses, losses, and other deductions allocated to gross income derived from international communications activity, when the source of income is determined under the 50/50 method of paragraph (b)(1) or (b)(2)(ii) of this section, taxpayers generally must apportion expenses, losses, and other deductions between sources within the United States and sources without the United States pro rata based on the relative amounts of gross income from sources within the United States and gross income from sources without the United States. However, the preceding sentence shall not apply to research and experimental expenditures qualifying under §1.861-17, which are to be allocated and apportioned under the rules of that section.

(h) Communications activity and income derived from communications activity—(1) Communications activity—(i) General rule. For purposes of this part, communications activity consists solely of the delivery by transmission of communications or data (communications). Delivery of communications other than by transmission (for example, by delivery of physical packages and letters) is not communications activity within the meaning of this section. Communications activity also includes the provision of capacity to transmit communications. Provision of content or any other additional service provided along with, or in connection with, a non-de minimis communications activity must be treated as a separate non-communications activity unless de minimis. Communications activity or non-communications activity will be treated as de minimis to the extent, based on the facts and circumstances, the value attributable to such activity is de minimis.

(ii) Separate transaction. To the extent that a taxpayer’s transaction consists in part of non-de minimis communications activity and in part of non-de minimis non-communications activity, each such part of the transaction must be treated as a separate transaction. Gross income is allocated to each such communications activity transaction and non-communications activity transaction to the extent the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in each such activity.

(2) Income derived from communications activity. Income derived from communications activity (communications income) is income derived from the delivery by transmission of communications, including income derived from the provision of capacity to transmit communications. Income may be considered derived from a communications activity even if the taxpayer itself does not perform the transmission function, but in all cases, the taxpayer derives communications income only if the taxpayer is paid to transmit, and bears the risk of transmitting, the communications.

(3) Determining the type of communications activity—(i) In general. Whether income is derived from international communications activity, U.S. communications activity, foreign communications activity, or space/ocean communications activity is determined by identifying the two points between which the taxpayer is paid to transmit the communication. The taxpayer must establish the two points between which the taxpayer is paid to transmit, and bears the risk of transmitting, the communication. Whether the taxpayer contracts out part or all of the transmission function is not relevant.

(ii) Income derived from international communications activity. Income derived by a taxpayer from international communications activity (international communications income) is income derived from communications activity, as defined in paragraph (h)(2) of this section, when the taxpayer is paid to transmit between a point in the United States and a point in a foreign country (or a possession of the United States).

(iii) Income derived from U.S. communications activity. Income derived by a taxpayer from U.S. communications activity (U.S. communications income) is income derived from communications activity, as defined in paragraph (h)(2) of this section, when the taxpayer is paid to transmit—

(A) Between two points in the United States; or

(B) Between the United States and a point in space or international water.

(iv) Income derived from foreign communications activity. Income derived by a taxpayer from foreign communications activity (foreign communications income) is income derived from communications activity, as defined in paragraph (h)(2) of this section, when the taxpayer is paid to transmit—

(A) Between two points in a foreign country or countries (or a possession or possessions of the United States);

(B) Between a foreign country and a possession of the United States; or

(C) Between a foreign country (or a possession of the United States) and a point in space or international water.

(v) Income derived from space/ocean communications activity. Income derived by a taxpayer from space/ocean communications activity (space/ocean communications income) is income derived from communications activity, as defined in paragraph (h)(2) of this section, when the taxpayer is paid to transmit between a point in space or international water and another point in space or international water.

(i) Treatment of partnerships. This section is applied at the partner level.

(j) Examples. The following examples illustrate the rules of this section:

Example 1. Income derived from non-communications activity—remote data base access—(i) Facts. D provides its customers in various foreign countries with access to its data base, which contains information on certain individuals’ health care insurance coverage. Customer C obtains access to D’s data base by placing a call to D’s telephone number. Assume that C’s telephone service, used to access D’s data base, is provided by a third party, and that D assumes no responsibility for the transmission of the information via telephone.

(ii) Analysis. D is not paid to transmit communications and does not derive income from communications activity within the meaning of paragraph (h)(2) of this section. Rather, D derives income from provision of content or provision of services to its customers. Therefore, the rules of this section do not apply to determine the source of D’s income.

Example 2. Income derived from U.S. communications activity—U.S. portion of international communication—(i) Facts. TC, a local telephone company, receives an access fee from an international carrier for picking up a call from a local telephone customer and delivering the call to a U.S. point of presence (POP) of the international carrier. The international carrier picks up the call from its U.S. POP and delivers the call to a foreign country.

(ii) Analysis. TC is not paid to carry the transmission between the United States and a foreign country. TC is paid to transmit a communication between two points in the United States. TC derives U.S. communications income as defined in paragraph (h)(3)(iii) of this section, which is sourced under paragraph (c) of this section as U.S. source income.

Example 3. Income derived from international communications activity—underwater cable—(i) Facts. TC, a domestic corporation, owns an underwater fiber optic cable. Pursuant to contracts, TC makes available to its customers capacity to transmit communications via the cable. TC’s customers then solicit telephone customers and arrange to transmit the telephone customers’ calls. The cable runs in part through U.S. waters, in part through international waters, and in part through foreign country waters.

(ii) Analysis. TC derives international communications income as defined in paragraph (h)(3)(ii) of this section because TC is paid to make available capacity to transmit communications between the United States and a foreign country. Because TC is a U.S. person, TC’s international communications income is sourced under paragraph (b)(1) of this section as one-half from sources within the United States and one-half from sources without the United States.

Example 4. Income derived from international communications activity-satellite—(i) Facts. S, a U.S. person, owns satellites in orbit and uplink facilities in Country X, a foreign country. B, a resident of Country X, pays S to deliver B’s programming from S’s uplink facility, located in Country X, to a downlink facility in the United States owned by C, a customer of B.

(ii) Analysis. S derives international communications income under paragraph (h)(3)(ii) of this section because S is paid to transmit the communications between a beginning point in a foreign country and an endpoint in the United States. Because S is a U.S. person, the source of S’s international communications income is determined under paragraph (b)(1) of this section as one-half from sources within the United States and one-half from sources without the United States.

Example 5. The paid-to-do rule—foreign communications via domestic route—(i) Facts. TC is paid to transmit communications from Toronto, Canada, to Paris, France. TC transmits the communications from Toronto to New York. TC pays another communications company, IC, to transmit the communications from New York to Paris.

(ii) Analysis. Under the paid-to-do rule of paragraph (h)(3)(i) of this section, TC derives foreign communications income under paragraph (h)(3)(iv) of this section because TC is paid to transmit communications between two points in foreign countries, Toronto and Paris. Under paragraph (h)(3)(i) of this section, the character of TC’s communications activity is determined without regard to the fact that TC pays IC to transmit the communications for some portion of the delivery path. IC has international communications income under paragraph (h)(3)(ii) of this section because IC is paid to transmit the communications between a point in the United States and a point in a foreign country.

Example 6. The paid-to-do rule—domestic communication via foreign route—(i) Facts. TC is paid to transmit a call between two points in the United States, but routes the call through Canada.

(ii) Analysis. Under paragraph (h)(3)(i) of this section, the character of income derived from communications activity is determined by the two points between which the taxpayer is paid to transmit, and bears the risk of transmitting, the communications, without regard to the path of the transmission between those two points. Thus, under paragraph (h)(3)(iii) of this section, TC derives income from U.S. communications activity because it is paid to transmit the communications between two U.S. points.

Example 7. Indeterminate endpoints—prepaid telephone calling cards—(i) Facts. S purchases capacity from TC to transmit telephone calls. S sells prepaid telephone calling cards that give customers access to TC’s telephone lines for a certain number of minutes. Assume that S cannot establish the endpoints of its customers’ telephone calls.

(ii) Analysis. S derives communications income as defined in paragraph (h)(2) of this section because S makes capacity to transmit communications available to its customers. In this case, S cannot establish the two points between which the communications are transmitted. Therefore, S’s communications income is U.S. source income, as provided by paragraph (f) of this section.

Example 8. Indeterminate endpoints—Internet access—(i) Facts. B, a domestic corporation, is an Internet service provider. B charges its customer, C, a monthly lump sum for Internet access. C accesses the Internet via a telephone call, initiated by the modem of C’s personal computer, to one of B’s control centers, which serves as C’s portal to the Internet. B transmits data sent by C from B’s control center in France to a recipient in England, over the Internet. B does not maintain records as to the beginning and endpoints of the transmission.

(ii) Analysis. B derives communications income as defined in paragraph (h)(2) of this section. The source of B’s communications income is determined under paragraph (f) of this section as income from sources within the United States because B cannot establish the two points between which it is paid to transmit the communications.

Example 9. De minimis non-communications activity—(i) Facts. The same facts as in Example 8. Assume in addition that B replicates frequently requested sites on B’s own servers, solely to speed up response time. Assume that B’s replication of frequently requested sites would be considered a de minimis non-communications activity under this section.

(ii) Analysis. On these facts, because B’s replication of frequently requested sites would be considered a de minimis non-communications activity, B is not required to treat the replication activity as a separate non-communications activity transaction under paragraph (h)(1) of this section. B derives communications income under paragraph (h)(2) of this section. The character and source of B’s communications income are determined by demonstrating the points between which B is paid to transmit the communications, under paragraph (h)(3)(i) of this section.

Example 10. Income derived from communications and non-communications activity—bundled services—(i) Facts. A, a domestic corporation, offers customers local and long distance phone service, video, and Internet services. Customers pay a flat monthly fee plus 10 cents a minute for all long-distance calls, including international calls.

(ii) Analysis. Under paragraph (h)(1)(ii) of this section, to the extent that A’s transaction with its customer consists in part of non-de minimis communications activity and in part of non-de minimis non-communications activity, each such part of the transaction must be treated as a separate transaction. A’s gross income from the transaction is allocated to each such communications activity transaction and non-communications activity transaction in accordance with paragraph (h)(1)(ii) of this section. To the extent A can establish that it derives international communications income as defined in paragraph (h)(3)(ii) of this section, A would determine the source of such income under paragraph (b)(1) of this section. If A cannot establish the points between which it is paid to transmit communications, as required by paragraph (h)(3)(i) of this section, A’s communications income is from sources within the United States, as provided by paragraph (f) of this section.

Example 11. Income derived from communications and non-communications activity—(i) Facts. B, a domestic corporation, is paid by D, a cable system operator in Foreign Country, to provide television programs and to transmit the television programs to Foreign Country. Using its own satellite transponder, B transmits the television programs from the United States to downlink facilities owned by D in Foreign Country. D receives the transmission, unscrambles the signals, and distributes the broadcast to D’s customers in Foreign Country. Assume that B’s provision of television programs is a non-de minimis non-communications activity, and that B’s transmission of television programs is a non-de minimis communications activity.

(ii) Analysis. Under paragraph (h)(1)(ii) of this section, B must treat its communications and non-communications activities as separate transactions. B’s gross income is allocated to each such separate communications and non-communications activity transaction in accordance with paragraph (h)(1)(ii) of this section. Income derived by B from the transmission of television programs to D’s Foreign Country downlink facility is international communications income as defined in paragraph (h)(3)(ii) of this section because B is paid to transmit communications from the United States to a foreign country.

Example 12. Income derived from foreign communications activity—(i) Facts. S provides satellite capacity to B, a broadcaster located in Australia. B beams programming from Australia to the satellite. S’s satellite picks the communications up in space and beams the programming over a footprint covering Southeast Asia.

(ii) Analysis. S derives communications income as defined in paragraph (h)(2) of this section. S’s income is characterized as foreign communications income under paragraph (h)(3)(iv) of this section because S picks up the communication in space, and beams it to a footprint entirely covering a foreign area. Under paragraph (d) of this section, S’s foreign communications income is from sources without the United States. If S were beaming the programming over a satellite footprint that covered area both in the United States and outside the United States, S would be required to allocate the income derived from the different types of communications activity.

(k) Reporting and documentation requirements—(1) In general. A taxpayer making an allocation of gross income under paragraph (b)(2)(iii), (b)(2)(iv), or (h)(1)(ii) of this section must satisfy the requirements in paragraphs (k)(2) and (3) of this section.

(2) Required documentation. In all cases, a taxpayer must prepare and maintain documentation in existence when its return is filed regarding the allocation of gross income, and allocation and apportionment of expenses, losses, and other deductions, the methodologies used, and the circumstances justifying use of those methodologies. The taxpayer must make available such documentation within 30 days upon request.

(3) Access to software. If the taxpayer or any third party used any computer software, within the meaning of section 7612(d), to allocate gross income, or to allocate or apportion expenses, losses, and other deductions, the taxpayer must make available upon request—

(i) Any computer software executable code, within the meaning of section 7612(d), used for such purposes, including an executable copy of the version of the software used in the preparation of the taxpayer’s return (including any plug-ins, supplements, etc.) and a copy of all related electronic data files. Thus, if software subsequently is upgraded or supplemented, a separate executable copy of the version used in preparing the taxpayer’s return must be retained;

(ii) Any related computer software source code, within the meaning of section 7612(d), acquired or developed by the taxpayer or a related person, or primarily for internal use by the taxpayer or such person rather than for commercial distribution; and

(iii) In the case of any spreadsheet software or similar software, any formulae or links to supporting worksheets.

(4) Use of allocation methodology. In general, when a taxpayer allocates gross income under paragraph (b)(2)(iii), (b)(2)(iv), or (h)(1)(ii) of this section, it does so by making the allocation on a timely filed original return (including extensions). However, a taxpayer will be permitted to make changes to such allocations made on its original return with respect to any taxable year for which the statute of limitations has not closed as follows:

(i) In the case of a taxpayer that has made a change to such allocations prior to the opening conference for the audit of the taxable year to which the allocation relates or who makes such a change within 90 days of such opening conference, if the IRS issues a written information document request asking the taxpayer to provide the documents and such other information described in paragraphs (k)(2) and (3) of this section with respect to the changed allocations and the taxpayer complies with such request within 30 days of the request, then the IRS will complete its examination, if any, with respect to the allocations for that year as part of the current examination cycle. If the taxpayer does not provide the documents and information described in paragraphs (k)(2) and (3) of this section within 30 days of the request, then the procedures described in paragraph (k)(4)(ii) of this section shall apply.

(ii) If the taxpayer changes such allocations more than 90 days after the opening conference for the audit of the taxable year to which the allocations relate or the taxpayer does not provide the documents and information with respect to the changed allocations as requested in accordance with paragraphs (k)(2) and (3) of this section, then the IRS will, in a separate cycle, determine whether an examination of the taxpayer’s allocations is warranted and complete any such examination. The separate cycle will be worked as resources are available and may not have the same estimated completion date as the other issues under examination for the taxable year. The IRS may ask the taxpayer to extend the statute of limitations on assessment and collection for the taxable year to permit examination of the taxpayer’s method of allocation, including an extension limited, where appropriate, to the taxpayer’s method of allocation.

(l) Effective date. This section applies to taxable years beginning on or after the date of publication of final regulations in the Federal Register.

Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.

To be described in section 501(c)(3), an organization must be organized and operated exclusively for religious, charitable, scientific, or educational purposes. In addition, no part of the net earnings of the organization may inure to the benefit of any private shareholder or individual, no substantial part of the organization’s activities may include attempts to influence legislation, and the organization may not intervene in political campaigns.

Existing regulations under section 501(c)(3) were adopted in substantially their present form in 1959. In explaining and clarifying the statutory requirements, these regulations provide that, to be described in section 501(c)(3), an organization must be both organized and operated for exempt purposes. An organization is not operated exclusively for exempt purposes and, thus, is not described in section 501(c)(3), if any of its net earnings inure to the benefit of a private shareholder or individual. §1.501(c)(3)-1(c)(2). The regulations define private shareholder or individual as referring to persons having a personal and private interest in the activities of the organization. §1.501(a)-1(c).

In addition, an organization is not organized or operated for one or more of the exempt purposes enumerated in §1.501(c)(3)-1(d)(1)(i) and, thus, is not described in section 501(c)(3), if it is organized or operated for the benefit of private interests such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such interests. §1.501(c)(3)-1(d)(1)(ii).

These proposed regulations amend the regulations under section 501(c)(3), adding several examples to illustrate the requirement in §1.501(c)(3)-1(d)(1)(ii) that an organization serve a public rather than a private interest. The examples illustrate that prohibited private benefits may involve non-economic benefits as well as economic benefits. In addition, prohibited private benefit may arise regardless of whether payments made to private interests are reasonable or excessive. The examples reflect current law.

Section 4958 was added to the Code by the Taxpayer Bill of Rights 2, Public Law 104-168 (110 Stat. 1452; July 30, 1996). Section 4958 imposes certain excise taxes on transactions that provide excess economic benefits to disqualified persons with respect to public charities and social welfare organizations described in sections 501(c)(3) and 501(c)(4), respectively. These organizations are collectively referred to as applicable tax-exempt organizations. Section 4958(e). An excess benefit is the amount by which the value of an economic benefit provided by an applicable tax-exempt organization directly or indirectly to or for the use of a disqualified person exceeds the value of the consideration (including the performance of services) received for providing such benefit. §53.4958-1(b). A disqualified person is defined as a person who is in a position to exercise substantial influence over the affairs of an applicable tax-exempt organization. Section 4958(f)(1). Section 4958(a) imposes the liability for excise taxes on disqualified persons who receive an excess benefit from, and on certain organization managers who knowingly participate in, an excess benefit transaction. Section 4958 imposes no corresponding sanctions on exempt organizations. The section 4958 excise taxes generally apply to excess benefit transactions occurring on or after September 14, 1995.

On August 4, 1998, a notice of proposed rulemaking (REG-246256-96, 1998-2 C.B. 224) clarifying certain definitions and rules contained in section 4958 was published in the Federal Register (63 FR 41486). Those 1998 proposed regulations were revised in response to written and oral comments and replaced by temporary and proposed regulations on January 10, 2001 (T.D. 8920, 2001-1 C.B. 654 [66 FR 2144], and REG-246256-96, 2001-1 C.B. 712 [66 FR 2173]). Final regulations under section 4958 were published on January 23, 2002 (T.D. 8978, 2002-1 C.B. 500 [67 FR 3076]).

Section 501(c)(3) and the longstanding regulations thereunder establish certain tests that an organization must meet to qualify for tax-exempt status. §1.501(c)(3)-1(a)(1). Section 4958, by its terms, does not address the tax-exempt status of applicable tax-exempt organizations, but instead imposes excise tax liability on disqualified persons and certain organization managers.

In the 1996 House Report on section 4958, Congress briefly addressed the relationship between section 4958 and tax-exempt status. Specifically, the Report stated that these “intermediate sanctions for excess benefit transactions may be imposed by the IRS in lieu of (or in addition to) revocation of the organization’s tax-exempt status.” H. Rep. No. 104-506, 104^th Cong., 2d Sess., at 59 (1996) (emphasis added). The Report also stated, in a footnote, that, in general, revocation of tax-exempt status, with or without the imposition of excise taxes, would occur only if an organization no longer operates as a charitable organization. H. Rep. No. 104-506, 104^th Cong., 2d Sess., at 59, note 15.

In keeping with the differences between section 501(c)(3) and section 4958, the Treasury Department and the IRS consistently have taken the position that the imposition of excise taxes under section 4958 does not foreclose revocation of tax-exempt status in appropriate cases. The 1998 proposed regulations under section 4958 stated that “[t]he excise taxes imposed by section 4958 do not affect the substantive statutory standards for tax exemption under section 501(c)(3) or (4).” Proposed §53.4958-7(a), (63 FR 41,505). Both the 2001 temporary and the 2002 final regulations stated that—

The preamble to the 1998 proposed regulations under section 4958 stated that the IRS will exercise its administrative discretion in enforcing the requirements of sections 4958, 501(c)(3), and 501(c)(4). The preamble to the 1998 proposed regulations listed the following four factors the IRS will consider in determining whether an applicable tax-exempt organization described in section 501(c)(3) continues to be described in section 501(c)(3) in cases in which section 4958 excise taxes are also imposed: (1) Whether the organization has been involved in repeated excess benefit transactions; (2) the size and the scope of the excess benefit transactions; (3) whether, after concluding that it has been party to an excess benefit transaction, the organization has implemented safeguards to prevent future recurrences; and (4) whether there was compliance with other applicable laws. (63 FR 41,488 through 41,489).

The preamble to the 2001 temporary regulations stated that the IRS intends to publish guidance regarding the factors it will consider as it gains more experience in administering section 4958. The preamble to the 2002 final regulations stated that, until such guidance is published, the IRS will consider all relevant facts and circumstances in the administration of section 4958 cases. These proposed regulations amend the regulations under section 501(c)(3) to provide guidance on certain factors that the IRS will consider in determining whether an applicable tax-exempt organization described in section 501(c)(3) that engages in one or more excess benefit transactions continues to be described in section 501(c)(3).

Section 4958 and the regulations thereunder do not apply to organizations that are not applicable tax-exempt organizations as defined therein. These proposed regulations amend the regulations under section 4958 to clarify that the IRS has discretion to refuse to issue a ruling recognizing exemption under section 501(c)(3) to any applicant whose purpose or activities violate any provision of section 501(c)(3), including the inurement prohibition and the limitation on private benefit, even though such violation could serve as grounds for imposing section 4958 excise taxes if the applicant’s tax-exempt status were recognized.

These regulations are proposed to be applicable on the date of publication in the Federal Register of a Treasury Decision adopting them as final regulations.

* * * * *

(d) * * *

(1) * * *

(iii) Examples. The following examples illustrate the requirement of paragraph (d)(1)(ii) of this section that an organization serve a public rather than a private interest:

Example 1. (i) O is an educational organization the purpose of which is to study history and immigration. The focus of O’s historical studies is the genealogy of one family, tracing the descent of its present members. O actively solicits for membership only individuals who are members of that one family. O’s research is directed toward publishing a history of that family that will document the pedigrees of family members. A major objective of O’s research is to identify and locate living descendants of that family to enable those descendants to become acquainted with each other.

(ii) O’s educational activities primarily serve the private interests of members of a single family rather than a public interest. Therefore, O is operated for the benefit of private interests in violation of the restriction on private benefit in §1.501(c)(3)-1(d)(1)(ii). Based on these facts and circumstances, O is not operated exclusively for exempt purposes and, therefore, is not described in section 501(c)(3).

Example 2. (i) O is an art museum. O’s sole activity is exhibiting art created by a group of unknown but promising local artists. O is governed by a board of trustees unrelated to the artists whose work O exhibits. All of the art exhibited is offered for sale at prices set by the artist. Each artist whose work is exhibited has a consignment arrangement with O. Under this arrangement, when art is sold, the museum retains 10 percent of the selling price to cover the costs of operating the museum and gives the artist 90 percent.

(ii) The artists in this situation directly benefit from the exhibition and sale of their art. As a result, the sole activity of O serves the private interests of these artists. Because O gives 90 percent of the proceeds from its sole activity to the individual artists, the direct benefits to the artists are substantial and O’s provision of these benefits to the artists is more than incidental to its other purposes and activities. This arrangement causes O to be operated for the benefit of private interests in violation of the restriction on private benefit in §1.501(c)(3)-1(d)(1)(ii). Based on these facts and circumstances, O is not operated exclusively for exempt purposes and, therefore, is not described in section 501(c)(3).

Example 3. (i) O is an educational organization the purpose of which is to train individuals in a program developed by P, O’s president. All of the rights to the program are owned by Company K, a for-profit corporation owned by P. Prior to the existence of O, the teaching of the program was conducted by Company K. O licenses, from Company K, the right to use a reference to the program in O’s name and the right to teach the program, in exchange for specified royalty payments. Under the license agreement, Company K provides O with the services of trainers and with course materials on the program. O may develop and copyright new course materials on the program but all such materials must be assigned to Company K without consideration if the license agreement is terminated. Company K sets the tuition for the seminars and lectures on the program conducted by O. O has agreed not to become involved in any activity resembling the program or its implementation for 2 years after the termination of O’s license agreement.

(ii) O’s sole activity is conducting seminars and lectures on the program. This arrangement causes O to be operated for the benefit of P and Company K in violation of the restriction on private benefit in §1.501(c)(3)-1(d)(1)(ii), regardless of whether the royalty payments from O to Company K for the right to teach the program are reasonable. Based on these facts and circumstances, O is not operated exclusively for exempt purposes and, therefore, is not described in section 501(c)(3).

* * * * *

(g) Interaction with section 4958—(1) Application process. An organization that applies for recognition of exemption under section 501(a) as an organization described in section 501(c)(3) must establish its eligibility under this section. The Commissioner may deny an application for exemption for failure to establish any of this section’s requirements for exemption. Section 4958 does not apply to transactions with an organization that has failed to establish that it satisfies all of the requirements for exemption under section 501(c)(3). See §53.4958-2 of this chapter.

(2) Substantive requirements for exemption still apply to applicable tax-exempt organizations described in section 501(c)(3)—(i) In general. Regardless of whether a particular transaction is subject to excise taxes under section 4958, the substantive requirements for tax exemption under section 501(c)(3) still apply to an applicable tax-exempt organization (as defined in section 4958(e) and §53.4958-2 of this chapter) described in section 501(c)(3) whose disqualified persons or organization managers are subject to excise taxes under section 4958. Accordingly, an organization may no longer meet the requirements for tax-exempt status under section 501(c)(3) because the organization fails to satisfy the requirements of paragraph (b), (c) or (d) of this section. See §53.4958-8(a) of this chapter.

(ii) Determining whether revocation of tax-exempt status is appropriate when section 4958 excise taxes also apply. In determining whether to continue to recognize the tax-exempt status of an applicable tax-exempt organization (as defined in section 4958(e) and §53.4958-2 of this chapter) described in section 501(c)(3) that engages in one or more excess benefit transactions (as defined in section 4958(c) and §53.4958-4 of this chapter) that violate the prohibition on inurement under this section, the Commissioner will consider all relevant facts and circumstances, including, but not limited to, the following—

(A) The size and scope of the organization’s regular and ongoing activities that further exempt purposes before and after the excess benefit transaction or transactions occurred;

(B) The size and scope of the excess benefit transaction or transactions (collectively, if more than one) in relation to the size and scope of the organization’s regular and ongoing activities that further exempt purposes;

(C) Whether the organization has been involved in repeated excess benefit transactions;

(D) Whether the organization has implemented safeguards that are reasonably calculated to prevent future violations; and

(E) Whether the excess benefit transaction has been corrected (within the meaning of section 4958(f)(6) and §53.4958-7 of this chapter), or the organization has made good faith efforts to seek correction from the disqualified persons who benefited from the excess benefit transaction.

(iii) All factors will be considered in combination with each other. Depending on the particular situation, the Commissioner may assign greater or lesser weight to some factors than to others. The factors listed in paragraphs (g)(2)(ii)(D) and (E) of this section will weigh more strongly in favor of continuing to recognize exemption where the organization discovers the excess benefit transaction or transactions and takes action before the Commissioner discovers the excess benefit transaction or transactions. Further, with respect to the factor listed in paragraph (g)(2)(ii)(E) of this section, correction after the excess benefit transaction or transactions are discovered by the Commissioner, by itself, is never a sufficient basis for continuing to recognize exemption.

(iv) Examples. The following examples illustrate the principles of paragraph (g)(2)(ii) of this section. For purposes of each example, assume that O is an applicable tax-exempt organization (as defined in section 4958(e) and §53.4958-2 of this chapter) described in section 501(c)(3) for all relevant periods. The examples are as follows:

Example 1. (i) O was created as a museum for the purpose of exhibiting art to the general public. In Years 1 and 2, O engages in fundraising and in selecting, leasing, and preparing an appropriate facility for a museum. In Year 3, a new board of trustees is elected. All of the new trustees are local art dealers. Beginning in Year 3 and continuing to the present, O uses almost all of its revenues to purchase art solely from its trustees at prices that exceed fair market value. O exhibits and offers for sale all of the art it purchases. O’s Form 1023, “Application for Recognition of Exemption,” did not disclose the possibility that O’s trustees would be selling art to O.

(ii) O’s purchases of art from its trustees at more than fair market value constitute excess benefit transactions between an applicable tax-exempt organization and disqualified persons under section 4958. Therefore, these transactions are subject to the appropriate excise taxes provided in that section. In addition, O’s purchases of art from its trustees at more than fair market value violate the proscription against inurement under section 501(c)(3) and §1.501(c)(3)-1(c)(2).

(iii) The application of the factors in §1.501(c)(3)-1(g)(2)(ii) to these facts is as follows. Beginning in Year 3, O does not engage in any regular and ongoing activities that further exempt purposes because almost all of O’s activities consist of purchasing art from its trustees and exhibiting and offering for sale all of the art it purchases. The size and scope of the excess benefit transactions collectively are significant in relation to the size and scope of any of O’s ongoing activities that further exempt purposes. O has been involved in repeated excess benefit transactions, namely, purchases of art from its trustees at more than fair market value. O has not implemented safeguards that are reasonably calculated to prevent such improper purchases in the future. The excess benefit transactions have not been corrected, nor has O made good faith efforts to seek correction from the disqualified persons who benefited from the excess benefit transactions (the trustees). The trustees continue to control O’s Board. Based on the application of the factors to these facts, O is no longer described in section 501(c)(3) effective in Year 3.

Example 2. (i) The facts are the same as in Example 1, except that in Year 4, O’s entire board of trustees resigns, and O no longer offers all exhibited art for sale. The former board is replaced with members of the community who are not in the business of buying or selling art and who have skills and experience running educational programs and institutions. O promptly discontinues the practice of purchasing art from current or former trustees, adopts a written conflicts of interest policy, adopts written art valuation guidelines, hires legal counsel to recover the excess amounts O had paid its former trustees, and implements a new program of educational activities.

(ii) O’s purchases of art from its former trustees at more than fair market value constitute excess benefit transactions between an applicable tax-exempt organization and disqualified persons under section 4958. Therefore, these transactions are subject to the appropriate excise taxes provided in that section. In addition, O’s purchases of art from its trustees at more than fair market value violate the proscription against inurement under section 501(c)(3) and §1.501(c)(3)-1(c)(2).

(iii) The application of the factors in §1.501(c)(3)-1(g)(2)(ii) to these facts is as follows. In Year 3, O does not engage in any regular and ongoing activities that further exempt purposes. However, in Year 4, O elects a new board of trustees comprised of individuals who have skills and experience running educational programs and implements a new program of educational activities. As a result of these actions, beginning in Year 4, O engages in regular and ongoing activities that further exempt purposes. The size and scope of the excess benefit transactions that occurred in Year 3, taken collectively, are significant in relation to the size and scope of O’s regular and ongoing exempt function activities that were conducted in Year 3. Beginning in Year 4, however, as O’s exempt function activities are established and grow, the size and scope of the excess benefit transactions that occurred in Year 3 become less and less significant as compared to the size and extent of O’s regular and ongoing exempt function activities that began in Year 4 and continued thereafter. O was involved in repeated excess benefit transactions in Year 3. However, by discontinuing its practice of purchasing art from its current and former trustees, by replacing its former board with independent members of the community, and by adopting a conflicts of interest policy and art valuation guidelines, O has implemented safeguards that are reasonably calculated to prevent future violations. In addition, O has made a good faith effort to seek correction from the disqualified persons who benefited from the excess benefit transactions (its former trustees). Based on the application of the factors to these facts, O continues to meet the requirements for tax exemption under section 501(c)(3).

Example 3. (i) O conducts educational programs for the benefit of the general public. Since its formation, O has employed its founder, C, as its Chief Executive Officer. Beginning in Year 5 of O’s operations and continuing to the present, C caused O to divert significant portions of O’s funds to pay C’s personal expenses. The diversions by C significantly reduced the funds available to conduct O’s ongoing educational programs. The board of trustees never authorized C to cause O to pay C’s personal expenses from O’s funds. Certain members of the board were aware that O was paying C’s personal expenses. However, the board did not terminate C’s employment and did not take any action to seek repayment from C or to prevent C from continuing to divert O’s funds to pay C’s personal expenses. C claimed that O’s payments of C’s personal expenses represented loans from O to C. However, no contemporaneous loan documentation exists, and C never made any payments of principal or interest.

(ii) The diversions of O’s funds to pay C’s personal expenses constituted excess benefit transactions between an applicable tax-exempt organization and a disqualified person under section 4958. Therefore, these transactions are subject to the appropriate excise taxes provided in that section. In addition, these transactions violate the proscription against inurement under section 501(c)(3) and §1.501(c)(3)-1(c)(2).

(iii) The application of the factors in §1.501(c)(3)-1(g)(2)(ii) to these facts is as follows. O has engaged in regular and ongoing activities that further exempt purposes both before and after the excess benefit transactions occurred. However, the size and scope of the excess benefit transactions engaged in by O beginning in Year 5, collectively, are significant in relation to the size and scope of O’s activities that further exempt purposes. Moreover, O has been involved in repeated excess benefit transactions. O has not implemented any safeguards that are reasonably calculated to prevent future diversions. The excess benefit transactions have not been corrected, nor has O made good faith efforts to seek correction from C, the disqualified person who benefited from the excess benefit transactions. Based on the application of the factors to these facts, O is no longer described in section 501(c)(3) effective in Year 5.

Example 4. (i) O conducts activities that further exempt purposes. O employs C as its Chief Executive Officer. C, on behalf of O, entered into a contract with Company K to construct an addition to O’s existing building. The addition to O’s building is a significant undertaking in relation to O’s other activities. C owns all of the voting stock of Company K. Under the contract, O paid Company K an amount that substantially exceeded the fair market value of the services Company K provided. When O’s board of trustees approved the contract with Company K, the board did not perform due diligence that could have made it aware that the contract price for Company K’s services was excessive. Subsequently, but before the IRS commences an examination of O, O’s board of trustees determines that the contract price was excessive. Thus, O concludes that an excess benefit transaction has occurred. After the board makes this determination, it promptly removes C as Chief Executive Officer, terminates C’s employment with O, and hires legal counsel to recover the excess payments to Company K. In addition, O promptly adopts a conflicts of interest policy and significant new contract review procedures designed to prevent future recurrences of this problem.

(ii) The purchase of services by O from Company K at more than fair market value constitutes an excess benefit transaction between an applicable tax-exempt organization and disqualified persons under section 4958. Therefore, this transaction is subject to the appropriate excise taxes provided in that section. In addition, this transaction violates the proscription against inurement under section 501(c)(3) and §1.501(c)(3)-1(c)(2).

(iii) The application of the factors in §1.501(c)(3)-1(g)(2)(ii) to these facts is as follows. O has engaged in regular and ongoing activities that further exempt purposes both before and after the excess benefit transaction occurred. Although the size and scope of the excess benefit transaction were significant in relation to the size and scope of O’s activities that further exempt purposes, the transaction with Company K was a one-time occurrence. By adopting a conflicts of interest policy and significant new contract review procedures and by terminating C, O has implemented safeguards that are reasonably calculated to prevent future violations. Moreover, O took corrective actions before the IRS commenced an examination of O. In addition, O has made a good faith effort to seek correction from Company K, the disqualified person who benefited from the excess benefit transaction. Based on the application of the factors to these facts, O continues to be described in section 501(c)(3).

Example 5. (i) O is a large organization with substantial assets and revenues. O conducts activities that further exempt purposes. O employs C as its Chief Financial Officer. During Year 1, O pays $2,500 of C’s personal expenses. O does not make these payments under an accountable plan under §53.4958-4(a)(4) of this chapter. In addition, O does not report any of these payments on C’s Form W-2, “Wage and Tax Statement,” or on a Form 1099-MISC, “Miscellaneous Income,” for C for Year 1, and O does not report these payments as compensation on its Form 990, “Return of Organization Exempt From Income Tax,” for Year 1. Moreover, none of these payments can be disregarded under section 4958 as nontaxable fringe benefits and none consisted of fixed payments under an initial contract under §53.4958-4(a)(3) of this chapter. C does not report the $2,500 of payments as income on his individual federal income tax return for Year 1. O does not repeat this reporting omission in subsequent years and, instead, reports all payments of C’s personal expenses not made under an accountable plan as income to C.

(ii) O’s payment in Year 1 of $2,500 of C’s personal expenses constitutes an excess benefit transaction between an applicable tax-exempt organization and a disqualified person under section 4958. Therefore, this transaction is subject to the appropriate excise taxes provided in that section. In addition, this transaction violates the proscription against inurement in section 501(c)(3) and §1.501(c)(3)-1(c)(2).

(iii) The application of the factors in §1.501(c)(3)-1(g)(2)(ii) to these facts is as follows. O engages in regular and ongoing activities that further exempt purposes. The payment of $2,500 of C’s personal expenses represented only a de minimis portion of O’s assets and revenues; thus, the size and scope of the excess benefit transaction were not significant in relation to the size and scope of O’s activities that further exempt purposes. The reporting omission that resulted in the excess benefit transaction in Year 1 is not repeated in subsequent years. Based on the application of the factors to these facts, O continues to be described in section 501(c)(3).

(3) Effective date. The rules in paragraph (g) of this section will apply with respect to excess benefit transactions occurring after the date of publication in the Federal Register of a Treasury Decision adopting these rules as final regulations.

(a) * * *

(6) Examples. The following examples illustrate the principles of this section, which defines an applicable tax-exempt organization for purposes of section 4958:

Example 1. O is a nonprofit corporation formed under state law. O filed its application for recognition of exemption under section 501(c)(3) within the time prescribed under section 508(a). In its application, O described its plans for purchasing property from some of its directors at prices that would exceed fair market value. After reviewing the application, the IRS determined that because of the proposed property purchase transactions, O failed to establish that it met the requirements for an organization described in section 501(c)(3). Accordingly, the IRS denied O’s application. While O’s application was pending, O engaged in the purchase transactions described in its application at prices that exceeded the fair market value of the property. Although these transactions would constitute excess benefit transactions under section 4958, because the IRS never recognized O as an organization described in section 501(c)(3), O was never an applicable tax-exempt organization under section 4958. Therefore, these transactions are not subject to the excise taxes provided in section 4958.

Example 2. O is a nonprofit corporation formed under state law. O files its application for recognition of exemption under section 501(c)(3) within the time prescribed under section 508(a). The IRS issues a favorable determination letter in Year 1 that recognizes O as an organization described in section 501(c)(3). Subsequently, in Year 5 of O’s operations, O engages in certain transactions that constitute excess benefit transactions under section 4958 and violate the proscription against inurement under section 501(c)(3) and §1.501(c)(3)-1(c)(2). The IRS examines the Form 990, “Return of Organization Exempt From Income Tax”, that O filed for Year 5. After considering all the relevant facts and circumstances in accordance with §1.501(c)(3)-1(g), the IRS concludes that O is no longer described in section 501(c)(3) effective in Year 5. The IRS does not examine the Forms 990 that O filed for its first four years of operations and, accordingly, does not revoke O’s exempt status for those years. Although O’s tax-exempt status is revoked effective in Year 5, under the lookback rules in §53.4958-2(a)(1) and §53.4958-3(a)(1) of this chapter, for a period of five years prior to the excess benefit transactions that occurred in Year 5, O was an applicable tax-exempt organization and O’s directors were disqualified persons as to O. Therefore, the transactions between O and its directors during Year 5 are subject to the appropriate excise taxes provided in section 4958.

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Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.