Section 863(d) governs the source of income from certain space or ocean activities. In general, section 863(d)(1) provides that, except as provided in regulations, any income derived from a space or ocean activity (space and ocean income) is income from sources within the United States (U.S. source income) if derived by a United States person and is income from sources without the United States (foreign source income) if derived by a foreign person. 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 types of activities from the definition of space or ocean activity. Space or ocean activity does not include any activity giving rise to transportation income governed by section 863(c), international communications income governed by section 863(e), or income with respect to mines, oil and gas wells, or other natural deposits to the extent within the United States or any foreign country or possession of the United States (as defined in section 638). See Section 863(d)(2)(B).

Section 1.863-8 of the proposed regulations generally provided rules for determining the source of income derived from space or ocean activity under section 863(d). Section 1.863-8(b)(1) of the proposed regulations reflected the general source rule under section 863(d)(1) that a United States person’s space and ocean income is U.S. source income. Pursuant to the grant of regulatory authority under section 863(d)(1), however, the proposed regulations provided an exception to this general rule. Under that exception, a United States person’s space and ocean income is foreign source income (and therefore not sourced on the basis of citizenship or residency) 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.

For a foreign person, proposed §1.863-8(b)(2) reflected the general source rule under section 863(d)(1) that a foreign person’s space and ocean income is foreign source income. Pursuant to regulatory authority under section 863(d)(1), however, the proposed regulations contained two exceptions to this general rule, one for controlled foreign corporations (CFCs), the other for foreign persons engaged in a U.S. trade or business. The proposed regulations generally sourced space and ocean income derived by a CFC, like that of a United States person, as U.S. source income. However, also like the rule for a United States person, a CFC’s space and ocean income is foreign source income 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. For a foreign person, other than a CFC, engaged in a trade or business within the United States, space and ocean income is U.S. source income to the extent it is attributable to functions performed, resources employed, or risks assumed within the United States.

In addition to the general source rules for United States and foreign persons, the proposed regulations provided special rules, applicable to both United States and foreign persons, for income from services, certain sales of property, and communications activities (other than international communications activities). These special rules, as well as modifications to the proposed regulations, are discussed below.

Section 1.863-8 of the proposed regulations provided source rules only for income from space or ocean activity. Thus, in some cases, income derived from a transaction must be allocated between space and ocean income and other income.

For example, §1.863-8(b)(3)(ii)(C) of the proposed regulations provided that when property is produced both in space or international water and outside space and international water, gross income allocable to production activity is allocated to production occurring in space or international water and production occurring outside space and international water based on where functions are performed, resources are employed, or risks are assumed. The proposed regulations also provided a similar analysis of functions performed, resources employed, or risks assumed to allocate income in the case of performance of services. See Prop. Treas. Reg. §1.863-8(d)(2). Under the proposed regulations, only the amount allocated to production or performance of a service occurring in space or international water is treated as space and ocean income (character rule). The source of gross income allocated to production or performance of a service occurring in space or international water is then determined under the rules of proposed §1.863-8(b)(1) or (2), as applicable (source rule).

Section 1.863-8(b)(1) of the proposed regulations reflected the general source rule that a United States person’s space and ocean income is U.S. source income. Proposed §1.863-8(b)(2) reflected the general source rule that a foreign person’s space and ocean income is foreign source income. Both proposed §1.863-8(b)(1) and (2), however, provided exceptions to their respective general source rules. As discussed above, under the exceptions, a United States person’s space and ocean income may be foreign source income and a foreign person’s space and ocean income may be U.S. source income based on where functions are performed, resources are employed, or risks are assumed.

One commentator noted that in some situations, the allocation of income derived from a transaction to determine space and ocean income based on functions performed, resources employed, or risks assumed presumably would remove the subsequent need to further analyze functions performed, resources employed, or risks assumed within a country to determine the source of the space and ocean income. In other words, the very act of determining the character of income seems to also determine the source of such income.

The Treasury Department and the IRS agree with the commentator that use of the same standard to classify the transaction as space or ocean activity and to source the space and ocean income may be duplicative in some cases. However, there are other cases where a transaction with some land-based activity may be classified in its entirety as a space or ocean activity (for example, a lease of a satellite), but the income may be partially U.S. source and partially foreign source under the source rules of proposed §1.863-8(b)(1) and (2) based on functions performed, resources employed, or risks assumed within the United States or a foreign country. Consequently, the character and source rules are not always duplicative.

Thus, the extent to which the character rules overlap with the source rules is particular to the type of transaction involved. The Treasury Department and the IRS recognize that the overlap in the character and source rules may produce equivalent results. But, the overlap is necessary to provide taxpayers and the IRS with workable rules. As a result, the final regulations do not follow this comment as a general matter.

Nonetheless, a conforming amendment has been made to the lease transaction in Example 1 in §1.863-8(f) of the final regulations to more clearly illustrate how the rules work. That example illustrates that the transaction involved is first classified in its entirety as a space or ocean activity, and then the resulting space and ocean income is subjected to the source rules. The space and ocean income is sourced as foreign source income 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.

Section 1.863-8(a) of the proposed regulations provided that a taxpayer will not be considered to derive income from space or ocean activity if such activity is performed by another person. The approach under §1.863-8(a) of the proposed regulations, providing that a taxpayer derives income from a space or ocean activity only if it conducts such activity directly, is consistent with the approach adopted in the §1.863-3 regulations governing the source of income from certain sales of inventory. See, e.g., Treas. Reg. §1.863-3(c) (“[T]he only production activities that are taken into account for purposes of §§1.863-1, 1.863-2, and this section are those conducted directly by the taxpayer.”).

Accordingly, commentators believed that this provision assured that a content provider that retains a satellite operator to transmit programming abroad would not derive space and ocean income based on attribution of the satellite operator’s activity. The Treasury Department and the IRS agree.

One commentator noted, however, that Examples 2 and 4 in §1.863-8(f) of the proposed regulations seem to indicate that this is not what was intended. In Example 2, the taxpayer, an Internet service provider, transmits information requested by its customer, in part using satellite capacity leased from a third party. Example 2 concludes that the service performed by the taxpayer is considered space activity to the extent the value of the service is attributable to functions performed, resources employed, and risks assumed in space. In Example 4, the taxpayer uses satellite capacity acquired from a third party to deliver programming services directly to its customers’ televisions sets. Example 4 concludes that the taxpayer’s delivery of programming and other services is considered space activity to the extent the value of the delivery transaction is attributable to performance in space. In the commentator’s view, the results reached in the examples conflict with the provision stating that activities performed by another person are not attributable to the taxpayer.

The Treasury Department and the IRS do not believe that Examples 2 and 4 of §1.863-8(f) of the proposed regulations produce the result that the commentator raised. In Examples 2 and 4, the taxpayer performed the transmission or delivery activities using satellite capacity leased or acquired from a third party. Both Examples 2 and 4 correctly conclude that the taxpayers derived space and ocean income from their own activities rather than from activities of another person. Thus, the examples do not, in fact, conflict with the text of the proposed regulations. Nevertheless, the Treasury Department and the IRS are concerned that Examples 2 and 4 have been misinterpreted as suggesting that activities performed by another person may be attributable to the taxpayer in certain situations. This was not the intent of these examples. Consequently, Examples 2 and 4 in §1.863-8(f) of the final regulations have been modified to make clear that the taxpayers in the examples directly engage in a space activity by performing the uplink (transmitting to the satellite) and downlink functions.

These examples differ from cases in which the taxpayer is a mere content provider that derives income either from the creation of content or from the creation and delivery of content, but in either case contracts with another person to deliver the content via satellite. Pursuant to §1.863-8(a) of the final regulations, content providers of this type would not derive space and ocean income because the delivery of the content via satellite is performed by another person. This would be the result even though the value of the customer contract includes a payment to the content provider for space or ocean activity. To clarify the distinction between these situations and Examples 2 and 4, a new Example 5 has been added to the final regulations. That example involves a content provider that does not derive space and ocean income because the taxpayer does not directly perform any space or ocean activity.

Under §1.863-8(b)(4) of the proposed regulations, to the extent a service is characterized as space or ocean activity, the source of gross income derived from such transaction is determined under proposed §1.863-8(b)(1) or (2), as applicable. Section 1.863-8(d)(2)(ii)(B) of the proposed regulations provided, however, that 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. The de minimis rule was adopted to address taxpayers’ concerns about potential confusion in qualifying for the “facilitation exception” under the 2001 proposed regulations. One commentator stated that the de minimis rule simply replaced one vague standard with another, as neither Example 3 in §1.863-8(f) of the proposed regulations nor the text of the proposed regulations provides any guidance as to when activities performed in space or international water would be de minimis under a facts and circumstances approach.

The Treasury Department and the IRS recognize that issues of interpretation may arise in any facts and circumstances approach. Nevertheless, the Treasury Department and the IRS generally have refrained from adopting the alternative approach, to wit, adopting precise definitions and quantitative measures for a de minimis standard. Moreover, the inclusion of a precise definition and quantitative measures for determining de minimis value could raise equal, if not greater, concerns in terms of the quantitative threshold and other issues. Thus, the final regulations retain the de minimis standard for determining whether a taxpayer has space and ocean income. If the value of the service attributable to space or ocean activity is de minimis based on the facts and circumstances, the taxpayer will not derive space and ocean income. Nevertheless, the Treasury Department and the IRS agree that more guidance could be provided as to the application of the retained de minimis rule. Accordingly, Examples 3 and 8 in §1.863-8(f) of the final regulations (Example 7 in the proposed regulations) provide clearer illustrations of when activities performed in space or international water would be considered de minimis for this purpose and when those types of activities would not be considered de minimis.

The proposed regulations provided special rules for income from certain sales of property, either when any production occurs in space or international water, or when the sale occurs in space or international water. In either case, section 863(d) and the proposed regulations applied to determine the source of income from the sales of property, and the rules of sections 861(a)(6), 862(a)(6), 863(a), 863(b), and 865 apply only to the extent provided in the proposed regulations.

Section 1.863-8(b)(3)(ii) of the proposed regulations provided that when the taxpayer both produces property and sells such property, one-half of the taxpayer’s gross income will be considered income allocable to production activity and one-half of such gross income will be considered income allocable to sales activity. Taxpayers generally must then apply the rules of section 863(d) and the proposed regulations to determine the source of income allocable to production activity and sales activity.

For production activity, the source of gross income allocable to production occurring in space or international water is generally based on the citizenship or residence of the taxpayer, applying the rules of proposed §1.863-8(b)(1) or (2), as applicable. The source of gross income allocable to production occurring outside space and international water is determined under section 863(b) rather than section 863(d). See Prop. Treas. Reg. §1.863-8(b)(3)(ii)(B) (referencing Treas. Reg. §1.863-3(c)(1)).

As for sales activity, when property is sold in space or international water, the source of gross income allocable to sales activity is generally based on the citizenship or residence of the taxpayer, applying the rules of proposed §1.863-8(b)(1) or (2), as applicable. An exception to this general rule applied in cases when the property sold is inventory, 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, and the United States. In that case, the source of gross income allocable to sales activity is determined under Treas. Reg. §1.861-7(c) and §1.863-3(c)(2). Treas. Reg. §1.861-7(c) and §1.863-3(c)(2) generally provide for foreign source income where the seller’s rights, title, and interest in the property are transferred to the buyer (the title passage rule) outside the United States and the property is not sold for use, consumption, or disposition in the United States. Treas. Reg. §1.861-7(c) and §1.863-3(c)(2) also applied to property sold outside space and international water. See Prop. Treas. Reg. §1.863-8(b)(3)(ii)(D).

One commentator believed that because certain U.S. manufacturers, such as U.S. satellite manufacturers, produce property that is sold in space or international water for use, consumption, or disposition in space or international water, they are at a disadvantage relative to U.S. manufacturers of other export property because the former may have U.S. source income with respect to income allocable to sales activity, while the latter may have foreign source income from sales activity.

In response to comments on the 2001 proposed regulations, proposed §1.863-8(b)(1) was revised to provide that space and ocean income will be foreign source income to the extent the space and ocean income is attributable to functions performed, resources employed, or risks assumed in a foreign country or countries. The Treasury Department and the IRS believe that this change may in many cases mitigate concerns about U.S. manufacturers potentially deriving 100 percent U.S. source income in these cases. Moreover, the Treasury Department and the IRS believe that the rules under the proposed regulations for determining the source of income allocable to sales activity are consistent with legislative intent to assert primary tax jurisdiction over income earned by United States persons that is not subject to foreign tax. See S. REP. NO. 99-313, 1986-3 C.B. 357-358 (“[T]he committee believes the United States should assert primary tax jurisdiction over income earned by its residents that is not within any foreign country’s taxing jurisdiction….Moreover, when a U.S. taxpayer conducts activities in space or international waters, foreign countries generally do not tax the income. Thus, the foreign tax credit limitation is inflated by income that is not within any foreign country’s tax jurisdiction.”). Based on the legislative history, 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, international water, and the United States — should be considered space or ocean activity and that the source of income from such sales activity should be determined under section 863(d). As a result, no changes were made in response to this comment.

One commentator questioned the appropriateness of differences in determining the source of sales income depending on whether the taxpayer produced or purchased the property sold. Under the proposed regulations, when property produced by the taxpayer is sold in space or international water, the source of gross income allocable to sales activity is generally based on the citizenship or residence of the taxpayer, applying the rules of proposed §1.863-8(b)(1) or (2), as applicable (and not the title passage rule) — subject to the foregoing inventory exception for property that will be used, consumed, or disposed of outside space, international water, and the United States. A slightly different rule applied to sales of property that had been purchased by the taxpayer. While the proposed regulations also provided that, for purchased property, the source of gross income allocable to sales activity is generally based on the citizenship or residence of the taxpayer, the inventory exception for purchased property only required that the property be used, consumed, or disposed of outside space and international water.

The inventory exceptions for produced and purchased property were intended to produce different results when inventory property is used, consumed, or disposed of in the United States. In such case, the source of produced inventory property sales income is generally based on the citizenship or residence of the taxpayer, applying the rules of proposed §1.863-8(b)(1) or (2), because the inventory exception did not extend to produced property sold for use, consumption, or disposition in the United States. In contrast, the source of purchased inventory property sales income is generally based on title passage under Treas. Reg. §1.861-7(c) because the inventory exception did extend to purchased property even if it was sold for use, consumption, or disposition in the United States. The Treasury Department and the IRS believe that this difference between the produced and purchased property rules in the space and ocean context is consistent with the difference in the rules for sales of produced and purchased property outside the space and ocean context. In particular, under section 863(a) and (b) and the regulations thereunder, if property is produced in the United States and sold for use, consumption, or disposition in the United States, the place of sale will be presumed to be the United States, and income attributable to the sales activity will be U.S. source income. See §1.863-3(c)(2). There is, however, no comparable rule for purchased property under section 862(a)(6) or the regulations thereunder. Thus, the final regulations simply continue in the space and ocean context the varying treatment elsewhere for sales of purchased property and sales of produced property.

In response to comments, however, the produced and purchased property rules have been modified to be similar in structure and style, to better reflect and highlight the differences between these two rules.

Taxpayers must allocate gross income under paragraphs (b)(1) and (b)(2) of proposed §1.863-8 among U.S., foreign, and space or ocean activities. Under proposed §1.863-8(b)(3)(ii)(C), allocations are also made between production activity occurring in space or international water and that occurring outside space and international water. Finally, allocations are also made under proposed §1.863-8(b)(4) between services performed in space or international water and services performed outside space and international water. In performing these allocations, the proposed regulations generally provided that taxpayers should consider the relative value of functions performed, resources employed, or risks assumed in different locations. Moreover, the preamble to the proposed regulations provided that allocations should be based generally on section 482 principles. Commentators noted that little guidance is given as to the mechanics of allocation other than the statement that the principles of section 482 should be used. Commentators stated that allocation of gross income based on section 482 principles will result in added expense, uncertainty, and extra burden on multinational taxpayers who are already required to undertake and update functional analyses and satisfy substantial documentation requirements.

While the final regulations were not changed in response to these comments, the Treasury Department and the IRS believe that some clarification is warranted. In suggesting the use of section 482 principles as a guide, the Treasury Department and the IRS intend for taxpayers to adopt a reasonable approach to the allocations required in this area. Taxpayers know their businesses and will generally be in the best position to fashion a reasonable method that most reliably reflects the relative value of functions performed, resources employed, and risks assumed in different locations. In the preamble to the proposed regulations, the Treasury Department and the IRS solicited comments on alternative methods of allocation for particular industries and criteria that could be used to evaluate the reasonableness of such methods. No such comments were received. One commentator noted, however, that the proposed regulations perhaps reflected what taxpayers in these industries have already been doing in order to determine the character and source of their space and ocean income. Consequently, the Treasury Department and the IRS believe that allocations of gross income based on functions performed, resources employed, and risks assumed are appropriate in these circumstances.

Paragraphs (d)(1)(i) and (d)(1)(ii) of §1.863-8 of the proposed regulations provided that for purposes of determining space or ocean activity, the Commissioner may separate parts of a single transaction or combine separate transactions into a single transaction. One commentator stated that this is a “one-way” street, as only the Commissioner has the authority to separate or combine transactions for purposes of the proposed regulations.

The final regulations do not change this rule. The Treasury Department and the IRS believe taxpayers are not inappropriately disadvantaged by this rule because taxpayers generally have the ability to structure their transactions in line with the economic prospects of their businesses. In addition, the Commissioner’s ability to separate or combine transactions is not unfettered. Rather, the Commissioner may only separate or combine transactions to better reflect the value of functions performed, resources employed, or risks assumed. A taxpayer can always protect itself against recharacterization by adopting an arrangement that appropriately reflects the economic realities of a transaction or series of transactions. The taxpayer is clearly in the best position at the outset to structure its arrangements in this manner. In addition, taxpayers traditionally are not permitted to restructure retroactively the form of their completed transactions. Thus, the Treasury Department and the IRS believe that the limited “one-way” rule is appropriate in this case.

One commentator requested that the Treasury Department and the IRS make clear that the final regulations under section 863(d) do not apply to income derived from the leasing of shipping cargo containers and that such income should be treated as rental income, sourced under sections 861 and 862. This commentator noted that valid arguments also exist for treating income derived from the leasing of shipping cargo containers as transportation income; however, in the commentator’s view, the most appropriate treatment is rental income treatment, sourced under sections 861 and 862.

The treatment of income derived from the leasing of shipping cargo containers is not covered by these final regulations. Instead, the Treasury Department and the IRS intend to address the treatment of such income explicitly in separate guidance. That guidance may apply section 863(c), section 863(d), or other provisions to source income derived from the leasing of shipping cargo containers. Any such guidance will be prospective in nature. Until such time, the treatment of such income will be determined under existing law.

Section 863(e) governs the source of income from international communications activities (international communications income). International communications income is defined in section 863(e)(2) as income derived from the transmission of communications or data between the United States and a foreign country (or possession of the United States). Section 863(e)(1)(A) provides that any international communications income of a United States person is sourced 50 percent in the United States and 50 percent outside the United States (50/50 source rule). Section 863(e)(1)(A) does not provide for any statutory or regulatory exceptions to this 50/50 source rule. In contrast, section 863(e)(1)(B)(i) provides that any international communications income of a foreign person is sourced outside the United States, except as provided in regulations or in section 863(e)(1)(B)(ii). The exception under section 863(e)(1)(B)(ii) provides that if a foreign person maintains an office or other fixed place of business in the United States, any international communications income attributable to such office or other fixed place of business is U.S. source income.

Section 1.863-9 of the proposed regulations generally provided rules for determining the source of international communications income under section 863(e) and other communications income under section 863(a) and (d). Proposed §1.863-9(b)(1) reflected the rule under section 863(e)(1)(A) that a United States person’s international communications income is 50 percent U.S. source income and 50 percent foreign source income. Proposed §1.863-9(b)(2) reflected the general rule under section 863(e)(1)(B) that a foreign person’s international communications income is foreign source income.

Consistent with the statutory exception under section 863(e)(1)(B)(ii), proposed §1.863-9(b)(2)(iii) provided that any 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 U.S. source income. 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. In addition to the statutory exception under section 863(e)(1)(B)(ii), section 863(e)(1)(B) provides general regulatory authority to depart from the general 100 percent foreign source rule for foreign persons. Thus, pursuant to this regulatory authority, the proposed regulations contained additional exceptions to the general rule applicable to foreign persons. In particular, the proposed regulations provided that international communications income derived by a CFC is 50 percent U.S. source income and 50 percent foreign source income (the same as for United States persons). The proposed regulations also provided that 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.

In addition to the general source rules for international communications income of United States and foreign persons, the proposed regulations also provided rules, applicable to both United States and foreign persons, for income from U.S. communications, foreign communications, space/ocean communications, and communications where endpoints are indeterminate. These rules, as well as modifications to the proposed regulations, are discussed below.

Section 1.863-9(h)(3) of the proposed regulations provided that the type of communications activity (and thus the applicable source rule) is determined by identifying the two points between which the taxpayer is paid to transmit the communication. For United States and foreign persons, U.S. communications income is entirely U.S. source income. A taxpayer derives U.S. communications income when the taxpayer is paid to transmit between two points in the United States or between the United States and a point in space or international water. In contrast, foreign communications income is entirely foreign source income for United States and foreign persons. A taxpayer derives foreign communications income when the taxpayer is paid to transmit between two points in a foreign country or countries (or a possession or possessions of the United States), between a foreign country and a possession of the United States, or between a foreign country (or a possession of the United States) and a point in space or international water. Finally, the proposed regulations provided different source rules for international communications income of United States and foreign persons. See section B.3 of this preamble for further discussion. A taxpayer derives international communications income 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). When a taxpayer cannot establish the two points between which the taxpayer is paid to transmit the communication, §1.863-9(f) of the proposed regulation provided a default source rule under which all the income derived by the taxpayer from such communications activity is U.S. source income.

Commentators stated that the treatment of communications income as U.S. source income when the endpoints are indeterminate is overbroad and harsh, particularly as it relates to foreign taxpayers. Commentators also stated that taxpayers would have to commit significant resources to develop the technology necessary to identify the endpoints of communications. One commentator stated that it is unclear that a reliable system can be created at any expense to establish the endpoints of the transmission under all circumstances. Commentators suggested instead the use of any reasonable method to establish the endpoints between which a taxpayer is paid to transmit the communications. One commentator suggested that the Treasury Department and the IRS consider employing the Industry Issue Resolution Program or Prefiling Agreement Program as aids in the administration of a reasonable method rule.

The Treasury Department and the IRS solicited 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 solicited comments on methods to establish 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. In response, one commentator submitted examples of reasonable methods to establish the endpoints between which a taxpayer is paid to transmit the communications. The examples relied on statistical reports of data such as minutes used, areas of transmission, port locations, and transport charges. This commentator noted that current federal regulations already require telecommunications companies to submit some of these reports to certain governmental agencies, for example, the Federal Communications Commission.

In light of the potential complexity in identifying the type of communications activity and in response to comments, the final regulations provide that a taxpayer may satisfy the requirement that the taxpayer establish the two points between which the taxpayer is paid to transmit, and bears the risk of transmitting, the communication by using any consistently applied reasonable method to establish one or both endpoints. In doing so, the taxpayer carries the burden of proof and must establish that the method used is reasonable (taking into account all of the facts and circumstances) and is consistently applied. In satisfying its burden of proof, a taxpayer will need to maintain reasonable records of communications activities. Depending on the facts and circumstances, methods based on, for example, records of port or transport charges, customer billing records, a satellite footprint, or records of termination fees made pursuant to an international settlement agreement may be reasonable. In addition, practices used by taxpayers to classify or categorize certain communications activity in connection with preparation of statements and analyses for the use of management, creditors, minority shareholders, joint ventures, or other parties or governmental agencies in interest may be reliable indicators of the reasonableness of the method chosen, but need not be accorded conclusive weight by the Commissioner. Furthermore, in evaluating the reasonableness of the method chosen, consideration will be given to all the facts and circumstances, including whether the endpoints would otherwise be identifiable absent this reasonable method provision.

Along with resultant changes made to the text of the final regulations, several examples have been added to §1.863-9(j) of the final regulations that illustrate instances where the taxpayer may be able to use reasonable methods to determine the endpoints between which the taxpayer is paid to transmit the communications.

Under the proposed regulations, a taxpayer derives income from a certain type of communications activity (for example, foreign communications or international communications) only if the taxpayer is paid to transmit, and bears the risk of transmitting (the paid-to-do rule), the communications of such type. See Prop. Treas. Reg. §1.863-9(h)(2) and (3). This is the case even if the taxpayer contracts out the transmission function.

Commentators stated that application of the paid-to-do rule in all instances would give rise to results that are inconsistent with Congressional intent and may result in excessive amounts of U.S. source income. One commentator noted that in some cases, while it is clear that a communication originated in a foreign country and that a U.S. telecommunications company is paid to terminate the foreign-originating traffic in the United States, it is unclear exactly where the U.S. telecommunications company picked up the communication. This lack of clarity often may be due to legal restrictions in certain foreign countries on ownership of capacity and carriage of transmissions by non-nationals. It can also be due to the fact that the international settlement agreements under which major international telecommunications carriers operate often do not specify where the traffic is picked up or handed off, and in some cases the hand-off point is specified by reference to a mid-point convention, even though the transmission signal, from a technical standpoint, travels from end-to-end with no real points in-between. The commentator further stated that at the time section 863(e) was enacted, U.S. carriers were generally not allowed to own and operate facilities in foreign countries; specifically, no U.S. carrier could carry a foreign-to-U.S. or U.S.-to-foreign transmission end-to-end. Thus, concluded the commentator, Congress focused on the endpoints of the communications rather than where the activities constituting the transmission of communications take place. The commentator suggested a rule that would provide that when a taxpayer is paid to transmit foreign-originating communications from a point outside the United States to a point in the United States, the taxpayer should be deemed to have been paid to transmit the communications from a point in the foreign country in which the communication originated.

Upon further consideration, the Treasury Department and the IRS believe that the paid-to-do rule may be over-inclusive in certain cases. Accordingly, the final regulations provide that international communications income also includes income derived from communications activity when the taxpayer is paid to transmit foreign-originating communications (communications with a beginning point in a foreign country or a possession of the United States) from a point in space or international water to a point in the United States. Also, a new example has been added to §1.863-9(j) of the final regulations to illustrate the changes made in the final regulations with respect to foreign-originating communications.

The changes made in the final regulations only affect communications that originate in a foreign country (or a possession of the United States) and does not affect communications that originate in space, international water, or 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.

As discussed above, the proposed regulations provided that the source of communications income is largely dependant on the type of communications activity and the citizenship or residence of the taxpayer. However, the proposed regulations provided for two instances where (in addition to the type of communications activity and the citizenship or residence of the taxpayer) the source of communications income may depend on functions performed, resources employed, or risks assumed. First, the proposed regulations provided that 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 U.S. source income. The proposed regulations provided that 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. Second, the proposed regulations provided that 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.

Commentators suggested that the final regulations also provide for similar rules that would source communications income as foreign source income based on functions performed, resources employed, or risks assumed in a foreign country or countries. For example, one commentator suggested that the source of international and U.S. communications income derived by any United States or foreign person (including branches, partnerships, and disregarded entities) engaged in a trade or business in a foreign country or countries 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 such foreign country or countries.

While the Treasury Department and the IRS recognize that commentators’ suggestion to provide for a source rule based on functions performed, resources employed, or risks assumed in a foreign country or countries is reasonable, as explained below, the Treasury Department and the IRS believe that the statute and legislative history preclude such an option.

Consistent with section 863(e)(1)(A), proposed §1.863-9(b)(1) provided that international communications income of a United States person is 50 percent U.S. source income and 50 percent foreign source income. One commentator suggested that it may be appropriate, in certain situations, to depart from the 50/50 source rule to provide special rules for foreign activities. According to the commentator, as a result of local regulatory requirements, U.S.-based international telecommunications providers often need to conduct portions of their international business through locally formed entities, and such entities are fully subject to foreign tax on their income. The commentator therefore concluded that a source rule for international communications income based on functions performed, resources employed, or risks assumed in a foreign country or countries is not only equitable but also consistent with treatment accorded to foreign persons having a U.S. fixed placed of business or engaged in a U.S. trade or business.

The Treasury Department and the IRS recognize that a source rule based on functions performed, resources employed, or risks assumed may be a reasonable alternative to the 50/50 source rule. Nonetheless, they continue to believe that the 50/50 source rule is the method that must be used to determine the source of a United States person’s international communications income. This is because section 863(e)(1)(A) provides for an explicit 50/50 source rule for those persons without exception. In contrast, section 863(e)(1)(B) provides that a foreign person’s international communications income is generally sourced outside the United States, except as provided in regulations. The Treasury Department and the IRS believe that the express grant of regulatory authority in the case of foreign persons and the omission of any such authority in the case of United States persons indicate that Congress intended the 50/50 sourcing rule be applied to United States persons without regulatory modification. There is nothing in the statute or legislative history that clearly demonstrates a different intention. In contrast, section 863(e)(1)(B)(ii) provides for a special source rule with respect to foreign persons with an office or other fixed place of business in the United States. A similar rule is not provided with respect to a United States person’s foreign activities. Thus, Congress chose a rule that sourced international communications income of foreign persons in certain instances based on the place of their activities, but expressly chose the 50/50 method to source international communications income of United States persons, regardless of the place of their activities.

The Treasury Department and the IRS recognize that the statute does not require strict application of the 50/50 source rule for CFCs. Section 863(e)(1)(B) only provides that the international communications income of a foreign person is foreign source income, except as provided in regulations. Consistent with and in light of this regulatory authority, however, the Treasury Department and the IRS believe that the 50/50 source rule is the most appropriate method to determine the source of a CFC’s international communications income. This approach addresses the concern of the Treasury Department and the IRS that United States persons may use CFCs to obtain benefits that are inconsistent with the purposes of section 863(e). Consequently, the rules for determining the source of international communications income derived by a CFC should be the same as the rules for determining the source of such income if it is derived by a United States person. In addition, the Treasury Department and the IRS believe that the 50/50 source rule for CFCs, as opposed to the 100 percent U.S. source rule that was originally proposed as part of the 2001 proposed regulations, should limit the potential for multiple levels of taxation that commentators raised with respect to those prior proposed regulations.

Section 1.863-9(c) of the proposed regulations provided that income derived by a United States or foreign person from U.S. communications activity is entirely from sources within the United States. One commentator noted that a foreign person deriving income from the transmission of communications between a point in the United States and another point in the United States or between a point in the United States and a point in space or international water has 100 percent U.S. source income, even if much or all of the activity involved is outside the United States. In contrast, under the space and ocean rules, a foreign person has U.S. source income only to the extent the income is attributable to functions performed, resources employed, or risks assumed within the United States. Commentators therefore suggested modification of the 100 percent U.S. source rule for U.S. communications income derived by United States and foreign persons to take into account foreign activities.

The Treasury Department and the IRS recognize that a source rule based on functions performed, resources employed, or risks assumed may be a reasonable alternative to the 100 percent U.S. source rule for U.S. communications. Nonetheless, the Treasury Department and the IRS believe that Congress did not intend such an option. The legislative history indicates that if a communication is between two points within the United States, the “income attributable thereto is to be sourced entirely as U.S. source income.” S. REP. NO. 99-313, 1986-3 C.B. 359 (emphasis added). Congress intended such a result “even if the communication is routed through a satellite located in space, regardless of the satellite’s location.” Id. Thus, the legislative history clearly provides that Congress intended that U.S. communications income be sourced entirely as U.S. source income.

Proposed §1.863-9(b)(2) reflected the general rule under section 863(e)(1)(B) that a foreign person’s international communications income is foreign source income. Consistent with the statutory exception under section 863(e)(1)(B)(ii), proposed §1.863-9(b)(2)(iii) provided that any 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 U.S. source income. 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. Pursuant to the grant of regulatory authority under section 863(e)(1)(B), the proposed regulations provided other exceptions to the general rule for foreign persons. The first exception is the 50/50 source rule for CFCs under §1.863-9(b)(2)(ii) of the proposed regulations, as discussed above. The second exception was provided in §1.863-9(b)(2)(iv) of the proposed regulations and applied to foreign persons other than CFCs. Section 1.863-9(b)(2)(iv) of the proposed regulations provided that international communications income derived by a foreign person, other than a CFC, engaged in a trade or business within the United States, that is attributable to functions performed, resources employed, or risks assumed within the United States is U.S. source income. One commentator noted that it is unclear why a separate rule is needed for a fixed place of business in the United States and a U.S. trade or business because international communications income attributable to a fixed place of business in the United States should also be attributable to functions performed, resources employed and risks assumed within the United States.

As indicated, the office or other fixed place of business rule under §1.863-9(b)(2)(iii) of the proposed regulations was derived from the statutory language of section 863(e), while the trade or business rule under §1.863-9(b)(2)(iv) of the proposed regulations was derived from the express grant of regulatory authority to source international communications income of foreign persons as other than foreign source. The Treasury Department and the IRS recognize that in most situations, the latter trade or business rule would indeed subsume the former fixed place of business rule, but still believe that the later rule serves an important function. The trade or business rule addresses 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.

Section 1.863-9(h)(1)(ii) of the proposed regulations provided that 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 part of the transaction must be treated as a separate transaction. Gross income is then allocated to each communications activity transaction and each 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. Moreover, the Treasury Department and the IRS suggested in the preamble to the proposed regulations that allocations of gross income should be based generally on section 482 principles. One commentator stated that the complexities inherent in allocating income, based on section 482 principles, between the separated transactions are significant.

While the final regulations were not changed in response to this comment, as in the case of allocations for space and ocean income, the Treasury Department and the IRS believe that some clarification is warranted. In suggesting the use of section 482 principles as a guide, the Treasury Department and the IRS intend for taxpayers to adopt a reasonable approach to the allocations required in this area. Taxpayers know their businesses and will generally be in the best position to fashion a reasonable method that most reliably reflects the relative value of functions performed, resources employed, and risks assumed in different locations. In the preamble to the proposed regulations, the Treasury Department and the IRS solicited comments on alternative methods of allocation for particular industries and criteria that could be used to evaluate the reasonableness of such methods. No such comments were received. One commentator noted, however, that the proposed regulations perhaps reflected what taxpayers in these industries have already been doing in order to determine the character and source of their communications income. Consequently, as in the case of space and ocean income, the Treasury Department and the IRS believe that allocations of gross income based on functions performed, resources employed, and risks assumed are appropriate in these circumstances.

(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. * * *

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(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. * * *

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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 United States person. Space and ocean income derived by a United States person is income from sources within the United States. However, space and ocean income derived by a United States 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 United States 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 sold for use, consumption, or disposition outside space and 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 de