[Code of Federal Regulations]
[Title 26, Volume 10]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.936-6]

[Page 155-178]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.936-6  Intangible property income when an election out is made: 
Cost sharing and profit split options; covered intangibles.

    The rules in this section apply for purposes of section 936(h) and 
also for purposes of section 934(e) where applicable.
    (a) Cost sharing option--(1) Product area research.
    Q. 1: Cost sharing payments are based on research undertaken by the 
affiliated group in the ``product area'' which includes the possession 
product. The term ``product area'' is defined by reference to the three-
digit classification under the Standard Industrial Classification (SIC) 
code. Which governmental agency has jurisdiction to decide the proper 
SIC category for any specfic product?
    A. 1: Solely for the purpose of determining the tax consequences of 
operating in a possession, the Secretary or his delegate has exclusive 
jurisdiction to decide the proper SIC category under which a product is 
classified. For this purpose, the product area under which a product is 
classified will be determined according to the 1972 edition of the SIC 
code. From time to time and in appropriate cases, the Secretary may 
prescribe regulations or issue rulings determining the proper SIC 
category under which a particular product is to be classified, and may 
prescribe regulations for aggregating two or more three-digit 
classifications of the SIC code and for classifying product areas 
according to a system other than under the SIC code.
    Q. 2: How is the term ``affiliated group'' defined for purposes of 
the cost sharing option?
    A. 2: For purposes of the cost sharing option, the term ``affiliated 
group'' means the possessions corporation and all other organizations, 
trades or businesses (whether or not incorporated, whether or not 
organized in the United States, and whether or not affiliated) owned or 
controlled directly or indirectly by the same interests, within the 
meaning of section 482.
    Q. 3: Are research and development expenditures that are included in 
product area research limited to research and development expenditures 
that are deductible under section 174 or that are incurred by U.S. 
affiliates?
    A. 3: No, product area research is not limited to product area 
research expenditures deductible under section 174 or to expenses 
incurred by U.S. affiliates. Product area research also includes 
deductions permitted under section 168 with respect to research property 
which are not deductible under section 174; qualified research expenses 
within the meaning of section 30(b); payments (such as royalities) for 
the use of, or right to use, a patent, invention, formula, process, 
design, pattern or know-how; and a proper allowance for amounts incurred 
in the acquisition of manufacturing intangible property. In the case of 
an acquisition of depreciable or amortizable manufacturing intangible 
property, the annual amount of product area research shall be be equal 
to the allowable depreciation or amortization on the intangible property 
for the taxable year. In the case of an acquisition of nondepreciable or 
nonamortizable manufacturing intangible property, the amount expended 
for the acquisition shall be deemed to be amortized over a five year 
period and included in product area research in the year of the deemed 
amortization. Any contingent payment made with respect to the 
acquisition of nonamortizable manufacturing intangible property shall be 
treated as amounts incurred in the acquisition of nonamortizable 
manufacturing intangible property when paid or accrued.
    Q. 4: Does royalty income from a person outside the affiliated group 
with respect to the manufacturing intangibles within a product area 
reduce the product area research pool within the same product area?

[[Page 156]]

    A. 4: Yes.
    Q. 5: Does income received from a person outside the affiliated 
group from the sale of a manufacturing intangible reduce the product 
area research pool within the same product area?
    A. 5: In determining product area research, the income from the sale 
attributable to noncontingent payments will reduce product area research 
ratably over the remaining useful life of the property in the case of an 
amortizable intangible and ratably over a 5-year period in the case of a 
nonamortizable intangible. Any income attributable to contingent amounts 
received with respect to the sale of manufacturing intangible property 
shall be treated as amounts received from the sale of the manufacturing 
intangible property in the year in which such contingent amounts are 
received or accrued.
    Q. 6: If a member of an affiliated group incurs research and 
development expenses pursuant to a contract with an unrelated person who 
is entitled to exclusive ownership of all the technology resulting from 
the expenditures, is the amount of product area research reduced by the 
amount of such expenditures?
    A. 6: To the extent that the product area research expenditures can 
be allocated solely to the technology produced for the unrelated person, 
such expenditures will not be included in product area research 
expenditures provided, however, that the unrelated person has exclusive 
ownership of all the technology resulting from these expenditures, and 
further that no member of the affiliated group has a right to use any of 
the technology.
    Q. 7: What is the treatment of product area research expenditures 
attributable to a component where the component and the integrated 
product fall within different product areas?
    A. 7: For purposes of the computation of product area research 
expenditures in the product area by the affiliated group, the product 
area in which the component falls is aggregated with the product area in 
which the integrated product falls. However, if the component product 
and integrated product are in separate SIC codes and if the component 
product is not included in the definition of the possession product, 
then the product area research expenditures are not aggregated. The same 
rule applies where the taxpayer elects a component product which 
encompasses another component product and the two component products 
fall into separate SIC codes. In such case, the product area in which 
the first component falls is aggregated with the product area in which 
the second component falls.
    (2) Possession sales and total sales.
    Q. 1: The cost sharing payment is the same proportion of the total 
cost of product area research which the amount of ``possession sales'' 
of the affiliated group bears to the ``total sales'' of the affiliated 
group within the product area. How are ``possession sales'' defined for 
purposes of the cost sharing fraction?
    A. 1: The term ``possession sales'' means the aggregate sales or 
other dispositions of the possession product, to persons who are not 
members of the affiliated group, less returns and allowances and less 
indirect taxes imposed on the production of the product, for the taxable 
year. Except as otherwise indicated in Sec. 1.936-6(a)(2), the sales 
price to be used is the sales price received by the affiliated group 
from persons who are not members of the affiliated group.
    Q. 2: For purposes of the numerator of the cost sharing fraction, 
how are possession sales computed where the possession product is a 
component product or an end-product form?
    A. 2: (i) The sales price of the component product or end-product 
form is determined as follows. With respect to a component product, an 
independent sales price from comparable uncontrolled transactions must 
be used if such price can be determined in accordance with Sec. 1.482-
2(e)(2). If an independent sales price of the component product from 
comparable uncontrolled transactions cannot be determined, then the 
sales price of the component product shall be deemed to be equal to the 
transfer price, determined under the appropriate section 482 method, 
which the possessions corporation uses under the cost sharing method in 
computing the income it derives from the

[[Page 157]]

active conduct of a trade or business in the possession with respect to 
the component product. The possessions corporation in lieu of using the 
transfer price determined under the preceding sentence may treat the 
sales price for the component product as equal to the same proportion of 
the third party sales price of the integrated product which the 
production costs attributable to the component product bear to the total 
production cost for the integrated product. Production cost will be the 
sum of direct and indirect production costs as defined in Sec. 1.936-
5(b)(4). If the possessions corporation determines the sales price of 
the component product using the production cost ratio, the transfer 
price used by the possessions corporation in computing its income from 
the component product under the cost sharing method may not be greater 
than such sales price.
    (ii) With respect to an end-product form, the sales price of the 
end-product form is equal to the difference between the third party 
sales price of the integrated product and the independent sales price of 
the excluded component(s) from comparable uncontrolled transactions, if 
such price can be determined under Sec. 1.482-2(e)(2). If an 
independent sales price of the excluded component(s) from uncontrolled 
transactions cannot be determined, then the sales price of the end-
product form shall be deemed to be equal to the transfer price, 
determined under the appropriate section 482 method, which the 
possessions corporation uses under the cost sharing method in computing 
the income it derives from the active conduct of a trade or business in 
the possession with respect to such end-product form. The possessions 
corporation in lieu of using the transfer price determined under the 
preceding sentence may use the production cost ratio method described 
above to determine the sales price of the end-product form (i.e., the 
same proportion of the third party sales price of the integrated product 
which the production costs attributable to the end-product form bear to 
the total production costs for the integrated product). If the 
possessions corporation determines the sales price of the end-product 
form using the production cost ratio, the transfer price used by the 
possessions corporation in computing its income from the end-product 
form under the cost sharing method may not be greater than such sales 
price. For similar rules applicable to the profit split option see Sec. 
1.936-6(b)(1), question and answer 12.
    Q. 3: For purposes of determining possessions sales in the numerator 
of the cost sharing fraction, will the replacement part price of the 
product be treated as a price from comparable uncontrolled transactions?
    A. 3: Prices for replacement parts are generally higher than prices 
for equipment sold as part of an original system. Thus, prices for 
replacement parts cannot generally be used directly as prices for 
comparable uncontrolled transactions. However, replacement part prices 
may be used for estimating comparable uncontrolled prices where the 
price differential can be reasonably determined and taken into account 
under Sec. 1.482-2(e)(2).
    Q. 4: For purposes of determining possession sales in the cost 
sharing fraction, what is the treatment of components that are purchased 
by one possessions corporation from an affiliated possessions 
corporation and which are incorporated into a possession product where 
the transferor possessions corporation treats the transferred component 
as a possession product?
    A. 4: When one possessions corporation purchases components from a 
second possessions corporation which is an affiliated corporation, the 
purchase price of the components paid to the second possessions 
corporation shall be subtracted from the sales proceeds of the product 
produced in the possession by the first possessions corporation, and 
only the remainder is included in the numerator of the cost sharing 
formula for the first corporation. For example, assume that N 
corporation manufactures a component for sale to O corporation for $100 
(a price which reflects prices in comparable uncontrolled transactions). 
Both N and O are affiliated possessions corporations. N has designated 
that component product as its possession product. O then incorporates 
that product into a second product which is sold to customers for

[[Page 158]]

$300 N and O must make separate cost sharing payments. The cost sharing 
payment of N corporation is determined by including $100 as possession 
sales, and the payment of O is determined by subtracting that $100 
purchase price from the $300 received from customers. Thus, the 
possessions sales amount of O is $200. This rule is intended to prevent 
the double counting of the sales of a component produced by one 
possessions corporation and incorporated into another product by an 
affiliated possessions corporation.
    Q. 5: Are pre-TEFRA sales included in the cost sharing fraction?
    A. 5: No. Pre-TEFRA sales are sales of products produced by the 
possessions corporation and transferred to an affiliate prior to a 
possessions corporation's first taxable year beginning after December 
31, 1982. Pre-TEFRA sales are not included in either the numerator or 
denominator of the cost sharing fraction. If the U.S. affiliate uses the 
FIFO method of costing inventory, the pre-TEFRA inventory will be 
treated as the first inventory sold by the U.S. affiliate during the 
first year in which section 936(h) applies. If the U.S. affiliate uses 
the LIFO method of costing inventory (either dollar-value or specific 
goods LIFO), pre-TEFRA inventor will be treated as inventory sold by the 
U.S. affiliate in the year in which the U.S. afiliate's LIFO layer 
containing pre-TEFRA LIFO inventory is liquidated.
    Q. 6: How are ``possession sales'' determined under the cost sharing 
formula if members of the affiliated group (other than the possessions 
corporation) include purchases of the possession product, X, in a 
dollar-value LIFO inventory pool (as provided under Sec. 1.472-8)?
    A. 6: Possession sales may be determined by applying the revenue 
identification method provided under paragraph (b)(1) Question and 
Answer 18 of this section.
    Q. 7: Do possession sales include excise taxes paid by the 
possessions corporation when the product is sold for ultimate use or 
consumption in the possession?
    A. 7: No. The amount of excise taxes is excluded from both the 
numerator and denominator of the cost sharing fraction.
    Q. 8: How are ``total sales'' defined for purposes of the cost 
sharing fraction?
    A. 8: The term ``total sales'' means aggregate sales or other 
dispositions of products in the same product area as the possession 
product, less returns and allowances and less indirect taxes imposed on 
the production of the product, for the taxable year to persons who are 
not members of the affiliated group. The sales price to be used is the 
sales price received by the affiliated group from persons who are not 
members of the affiliated group.
    Q. 9: In computing that cost sharing payment, how are ``total 
sales'' computed if the dollar-value LIFO inventory pool includes some 
products which are not included in the product area (determined under 
the 3-digit SIC code) on which the denominator of the cost sharing 
fraction is based?
    A. 9: In such case, the amount of the total sales within the product 
area to persons who are not members of the affiliated group by persons 
who are members of the affiliated group is determined by multiplying the 
total sales of the products within the dollar-value LIFO inventory pool 
by a fraction. The numerator of the fraction includes the dollar-value 
of purchases by members of the affiliated group (including the 
possessions corporation) of products within the product area made during 
the year, plus any added production costs (as defined in Sec. 1.471-
11(b), (c), and (d) but not including the costs of materials) incurred 
by the affiliates during the same period. The denominator of the 
fraction includes the dollar-value of purchases by members of the 
affiliated group (including the possessions corporation) of products 
within the dollar-value LIFO inventory pool made during the same period 
(including any production costs, as described above, incurred by the 
affiliate during the same period). For these purposes, purchases of a 
possession product are determined on the basis of the possessions 
corporation's cost for its inventory purposes.
    Q. 10: May a possessions corporation compute its income under the 
cost

[[Page 159]]

sharing method with respect to a possession product which the 
possessions corporation sells to a member of its affiliated group and 
which that member then leases to an unrelated person or uses in its own 
trade or business?
    A. 10: Yes, provided that an independent sales price for the 
possession product from comparable uncontrolled transactions can be 
determined in accordance with Sec. 1.482-2(e)(2), and, provided 
further, that such member complies with the requirements of Sec. 1.936-
6(a)(2), question and answer 14. If, however, there is a comparable 
uncontrolled price for an integrated product and the possession product 
is a component product or end-product form thereof, the possessions 
corporation may, if such member complies with the requirements of Sec. 
1.936-6(a)(2), question and answer 14, compute its income under the cost 
sharing method with respect to such possession product. In that case, 
the cost sharing payment shall be computed under the following question 
and answer.
    Q. 11: How are possession sales and total sales to be determined for 
purposes of computing the cost sharing payment with respect to a 
possession product which the possessions corporation sells to a member 
of its affiliated group where that member then leases the possession 
product to unrelated persons or uses it in its own trade or business?
    A. 11: If the possessions corporation is entitled to compute its 
income from such sales of the possession product under the cost sharing 
method, both possession sales and total sales shall be determined as if 
the possession product had been sold by the affiliate to an unrelated 
person at the time the possession product was first leased or otherwise 
placed in service by the affiliate. The sales price on such deemed sale 
shall be equal to the independent sales price from comparable 
uncontrolled transactions determined in accordance with Sec. 1.482-
2(e)(2), if any. If the possession product is a component product or an 
end-product form for which there is no such independent sales price but 
there is a comparable uncontrolled price for the integrated product 
which includes the possession product, the deemed sales price of the 
possession product shall be computed under the rules of Sec. 1.936-
6(a)(2) question and answer 2. The full amount of income received under 
the lease shall be treated as income of (and taxed to) the affiliate and 
not the possessions corporation.
    Q. 12: When may a possessions corporation take into account in 
computing total sales under the cost sharing method products in the same 
product area as the possession product (other than the possession 
product itself) where such products are leased by members of the 
affiliated group to unrelated persons or used by any such member in its 
own trade or business?
    A. 12: For purposes of computing total sales under the cost sharing 
method, the possessions corporation may take into account products in 
the same product area as the possession product itself where such 
products are leased by members of the affiliated group to unrelated 
persons or used in the trade or business of any such member, but only if 
an independent sales price of such products from comparable uncontrolled 
transactions may be determined under Sec. 1.482-2(e)(2). In such cases, 
the units of such products which are leased or otherwise used internally 
by members of the affiliated group may be treated as sold to unrelated 
persons for such independent sales price for purposes of computing total 
sales.
    Q. 13: Assuming that a possessions corporation is entitled to 
compute its income under the cost sharing method with respect to sales 
of a possession product to affiliates in cases where those affiliates 
lease units of the possession product to unrelated persons or use them 
internally, is the possessions corporation's income from the possession 
product any different than if the affiliates had sold the product to 
unrelated parties?
    A. 13: No.
    Q. 14: If a possessions corporation sells units of a possession 
product to a member of its affiliated group and that affiliate then 
leases those units to an unrelated person or uses the units in its own 
trade or business, what requirements must the affilate meet in order for 
the possessions corporation to be entitled to the benefits of the cost 
sharing method with respect to such units?

[[Page 160]]

    A. 14: (i) For taxable years of the possessions corporation 
beginning on or before June 13, 1986, the affiliate need not meet any 
special requirements in order for the possessions corporation to be 
entitled to the beneifts of the cost sharing method with respect to such 
units. Thus, the affiliate's basis in such units shall be equal to the 
transfer price used for computing the possessions corporation's gross 
income with respect to such units under section 936(h)(5)(C)(i)(II), and 
the income derived by the affiliate from such lease or internal use 
shall be reported by the affiliate when and to the extent actually 
derived. The affiliate shall not be deemed to have sold such units to an 
unrelated party at the time they were first leased or otherwise placed 
in service for any purpose other than the computation of possession 
sales and total sales. A similar rule applies to other products in the 
same product area as the possession product which are sold by any member 
in its own trade or business and which the possessions corporation takes 
into account in computing total sales under the cost sharing method.
    (ii) For taxable years of the possessions corporations beginning 
after June 13, 1986, a possessions corporations will not be entitled to 
the benefits of the cost sharing method with respect to units of the 
possession product which the possessions corporation sells to an 
affiliate where the affiliate then leases such units to an unrelated 
person or uses them in its own trade or business, unless the affiliate 
agrees to be treated for all tax purposes as having sold such units to 
an unrelated party at the time they were first leased or otherwise 
placed in service by such affiliate. The affiliate must demonstrate such 
agreement by reporting its income from such units as if:
    (A) It had sold such units to an unrelated person at such time at a 
price equal to the price used to compute possessions sales under Sec. 
1.936-6(a)(2), question and answer 11;
    (B) It had immediately repurchased such units for the same price; 
and
    (C) Its basis in such units for all subsequent purposes was equal to 
its cost basis from such deemed repurchase.

For treatment of other products in the same product area as the 
possession product see Sec. 1.936-6(a)(2), question and answer 12.
    (iii) The principles contained in questions and answers 11, 12, 13, 
and 14 are illustrated by the following example:

    Example. Possessions corporation S and its affiliate A are calendar 
year taxpayers. In 1985, S manufactures 100 units of possession product 
X. S sells 50 units of X to unrelated persons in arm's length 
transactions for $10 per unit. In applying the cost sharing method to 
determine the portion of its gross income from such sales which 
qualifies for the possessions tax credit, S determines that $8 of the 
$10 sales price may be taken into account. S sells the remaining 50 
units of X to A, and A then leases such units to unrelated persons. In 
1985, A also manufacturers 100 units of product Y, the only other 
product in the same product area as X manufactured or sold by any member 
of the affiliated group. A manufactured the 100 units of Y at a cost of 
$15 per unit, sold 50 units of Y to unrelated persons in arm's length 
transactions for $20 per unit, and leased the remaining 50 units of Y to 
unrelated persons.
    S may compute its income under the cost sharing method with respect 
to the 50 units of X it sold to A because S can determine an independent 
sales price of X from comparable uncontrolled transactions under Sec. 
1.482-2(e)(2). For purposes of computing both possessions sales and 
total sales, the 50 units of X sold to A will be deemed to have been 
sold by A to an unrelated person for $10 per unit. The income of S 
qualifying for the possessions tax credit from the sale of those 50 
units of X to A, and A's basis in those units, will both be determined 
using the $8 transfer price determined under section 936 
(h)(5)(C)(i)(II). For purposes of computing total sales in the 
denominator of the cost sharing fraction, S may also take into account 
the 50 units of Y leased by A to unrelated persons, as if A had sold 
those units for $20 per unit. A's basis in those units of Y will 
continue to be its actual cost basis of $15 per unit.
    If all of the above transactions had occurred in 1987, S would be 
entitled to compute its income under the cost sharing method with 
respect to the 50 units of X it sold to A only if A agreed to be treated 
for all tax purposes as if it had sold such units for $10 per unit, 
realized income on such deemed sale of $2 per unit, repurchased such 
units immediately for $10 per unit, and then leased such units, which 
would then have a $10 per unit basis in A's hands. For purposes of 
computing total sales, S would be entitled to take into account the 50 
units of X leased by A to unrelated persons as if A had sold such units 
for $20 per unit.

[[Page 161]]

    (3) Credits against cost sharing payments.
    Q. 1: Is the cost of product area research paid or accrued by the 
possessions corporation in a taxable year creditable against the cost 
sharing payment?
    A. 1: Yes, if the cost of the product area research is paid or 
accrued solely by the possessions corporation. Thus, payments by the 
possessions corporation under cost sharing arrangements with, or 
royalties paid to, unrelated persons are so creditable. Amounts (such as 
royalties) paid directly or indirectly to, or on behalf of, related 
persons and amounts paid under any cost sharing agreements with related 
persons are not creditable against the cost sharing payment.
    Q. 2: Do royalties or other payments made by an affiliate of the 
possessions corporation to another member of the affiliated group reduce 
the cost sharing payment if such royalties or other payments are based, 
in part, on activity of the possessions corporation?
    A. 2: No. Payments made between affiliated corporations do not 
reduce the cost sharing payment. Thus, for example, if a possessions 
corporation sells a component to a foreign affiliate for incorporation 
by the foreign affiliate into an integrated product sold to unrelated 
persons, and the foreign affiliate pays a royalty to the U.S. parent of 
the possessions corporation based on the total value of the integrated 
product, the cost sharing payment of the possessions corporation is not 
reduced.
    (4) Computation of cost sharing payment.
    Q. 1: S is a possessions corporation engaged in the manufacture and 
sale of four products (A, B, C, and D) all of which are classified under 
the same three-digit SIC code. S sells its production to a U.S. 
affiliate, P, which resells it to unrelated parties in the United 
States. P's third party sales of each of these products produced in 
whole or in part by S (computed as provided under paragraph (a)(2) of 
Sec. 1.936-6) are $1 million or a total of $4 million for A, B, C, and 
D. P's other sales of products in the same SIC code are $3,000,000; and 
the defined worldwide product area research of the affiliated group is 
$350,000. How should S compute the cost sharing amount for products A, 
B, C, and D?
    A. 1: The cost sharing amount is computed separately for each 
product on Schedule P of Form 5735. S should use the following formula 
for each of the products A, B, C, and D:
[GRAPHIC] [TIFF OMITTED] TC09OC91.006

[GRAPHIC] [TIFF OMITTED] TC09OC91.007

    Q. 2: The facts are the same as in question 1 except that S 
manufactures product D under a license from an unrelated person. S pays 
the unrelated party an annual license fee of $20,000. Thus, the 
worldwide product area research expense of the affiliated group is 
$370,000. How should the cost sharing payment be adjusted?
    A. 2: The cost sharing fee should be reduced by the $20,000 license 
fee made as a direct annual payment to a third party on account of 
product D. The cost sharing payment with respect to product D in this 
example will be adjusted as follows:

[[Page 162]]

[GRAPHIC] [TIFF OMITTED] TC09OC91.008

[GRAPHIC] [TIFF OMITTED] TC09OC91.009

    Q. 3: The facts are the same as in question 1 except that S also 
manufactures and exports product E to a foreign affiliate, which resells 
it to unrelated persons for $1 million. S makes a separate election for 
its export sales. How should S compute the cost sharing amount for 
product E?
    A. 3: The numerator of the cost sharing fraction is the aggregate 
sales or other dispositions by members of the affiliated group of the 
units of product E produced in whole or in part in the possession to 
persons who are not members of the affiliated group. The cost sharing 
amount for product E would be computed as follows:
[GRAPHIC] [TIFF OMITTED] TC09OC91.010

 or
[GRAPHIC] [TIFF OMITTED] TC09OC91.011

    Q. 4: The facts are the same as in question 1, except that S also 
receives $10,000 in royalty income from unrelated persons for the 
licensing of certain manufacturing intangible property rights. What is 
the amount of the product area research that must be allocated in 
determining the cost sharing amount?
    A. 4: If the affiliated group receives royalty income from unrelated 
persons with respect to manufacturing intangibles in the same product 
area, then the product area research to be considered shall be first 
reduced by such royalty income. In this case, the amount of product area 
research to be used in determining S's cost sharing payment should be 
reduced by the $10,000 royalty payment received to $340,000.
    Q. 5: May a possessions corporation redetermine the amount of its 
required cost sharing payment after filing its tax return?
    A. 5: If after filing its tax return, a possessions corporation 
files an amended return, or if an adjustment is made on audit, either of 
which affects the amount of the cost sharing payment required, then a 
redetermination of the cost sharing payment must be made. See, however, 
section 936(h)(5)(C)(i)(III)(a) with respect to the increase in the cost 
sharing payment due to interest imposed under section 6601(a).
    (5) Effect of election under the cost sharing method.
    Q. 1: What is the effect of the cost sharing method?

[[Page 163]]

    A. 1: The cost sharing payment reduces the amount of deductions (and 
the amount of reductions in earnings and profits) otherwise allowable to 
the U.S. affiliates (other than tax-exempt affiliates) within the 
affiliated group as determined under section 936(h)(5)(C)(i)(I)(b) which 
have incurred research expenditures (as defined in Sec. 1.936-6(a)(1), 
question and answer (3) in the same product area for which the cost 
sharing option is elected, during the taxable year in which the cost 
sharing payment accrues. If there are no such U.S. affiliates, the 
reductions with respect to deductions and earnings and profits, as the 
case may be, are made with respect to foreign affiliates within the same 
affiliated group which have incurred product area research expenditures 
in such product area attributable to a U.S. trade or business. If there 
are no affiliates which have incurred research expenditures in such 
product area, the reductions are then made with respect to any other 
U.S. affiliate and, if there is no such U.S. affiliate, then to any 
other foreign affiliate. The allocations of these reductions in each 
case shall be made in proportion to the gross income of the affiliates. 
In the case of foreign affiliates, the allocation shall be made in 
proportion to gross income attributable to the U.S. trade or business or 
worldwide gross income, as the case may be. With respect to each group 
above, the reduction of deductions shall be applied first to deductions 
under section 174, then to deductions under section 162, and finally to 
any other deductions on a pro rata basis.
    Q. 2: For purposes of estimated tax payments, when is the cost 
sharing amount deemed to accrue?
    A. 2: The cost sharing amount is deemed to accrue to the appropriate 
affiliate on the last day of the taxable year of each such affiliate in 
which or with which the taxable year of the possessions corporation 
ends.
    Q. 3: If the cost sharing method is elected and the year of accrual 
of the cost sharing payment to the appropriate affiliate (described in 
question and answer 1 of this paragraph (a)(5)) differs from the year of 
actual payment by the possessions corporation, in what year are the 
deductions of the recipients reduced?
    A. 3: In the year the cost sharing payment has accrued.
    Q. 4: What is the treatment of income from intangibles under the 
cost sharing method?
    A. 4: Under the cost sharing method, a possessions corporation is 
treated as the owner, for purposes of obtaining a return thereon, of 
manufacturing intangibles related to a possession product. The term 
``manufacturing intangible'' means any patent, invention, formula, 
process, design, pattern, or know-how. The possessions corporation will 
not be treated as the owner, for purposes of obtaining a return thereon, 
of any manufacturing intangibles related to a component product produced 
by an affiliated corporation and transferred to the possessions 
corporation for incorporation into the possession product, except in the 
case that the possession product is treated as including such component 
product for all purposes of section 936(h)(5). Further, the possessions 
corporation will not be treated as the owner, for purposes of obtaining 
a return thereon, of any marketing intangibles except ``covered 
intangibles.'' (See Sec. 1.936-6(c).)
    Q. 5: If the cost sharing option is elected, is it necessary for the 
possessions corporation to be the legal owner of the manufacturing 
intangibles related to the possession product in order for the 
possessions corporation to receive a full return with respect to such 
intangibles?
    A. 5: No. There is no requirement that manufacturing intangibles be 
owned by the possessions corporation.
    Q. 6: How is income attributable to marketing intangibles treated 
under the cost sharing method?
    A. 6: Except in the case of ``covered intangibles'' (see Sec. 
1.936-6(c)), the possessions corporation is not treated as the owner of 
any marketing intangibles, and income attributable to marketing 
intangible of the possessions corporation will be allocated to the 
possessions corporation's U.S. shareholders with the proration of income 
based on shareholdings. If a shareholder of the possessions corporation 
is a foreign, person or is otherwise tax exempt, the possessions 
corporation is

[[Page 164]]

taxable on that shareholder's pro rata amount of the intangible property 
income. If the possessions corporation is a corporation any class of the 
stock of which is regularly traded on an established securities market, 
then the income attributable to marketing intangibles will be taxable to 
the possessions corporation rather than the corporation's U.S. 
shareholders.
    Q. 7: What is the source of the intangible property income described 
in question and answer 6?
    A. 7: The intangible property income is U.S. source whether taxed to 
the U.S. shareholder or taxed to the possessions corporation and section 
863 (b) does not apply for this purpose. However, such intangible 
property income, if treated as income of the possessions corporation, 
does not enter into the calculation of the 80-percent possession source 
test or the 65-percent active trade or business test.
    Q.7a: What is the source of the taxpayer's gross income derived from 
a sale in the United States of a possession product purchased by the 
taxpayer (or an affiliate) from a corporation that has an election in 
effect under section 936, if the income from such sale is taken into 
account to determine benefits under cost sharing for the section 936 
corporation? Is the result different if the taxpayer (or an affiliate) 
derives gross income from a sale in the United States of an integrated 
product incorporating a possession product purchased by the taxpayer (or 
an affiliate) from the section 936 corporation, if the taxpayer (or an 
affiliate) processes the possession product or an excluded component in 
the United States?
    A.7a: Under either scenario, the income is U.S. source, without 
regard to whether the possession product is a component, end-product, or 
integrated product. Section 863 does not apply in determining the source 
of the taxpayer's income. This Q&A 7a is applicable for taxable years 
beginning on or after November 13, 1998.
    Q. 8: May marketing intangible income, if any, be allocated to the 
possessions corporation with respect to custom-made products?
    A. 8: No. If the cost sharing option is elected, then income 
attributable to marketing intangibles (other than ``covered 
intangibles'' described in Sec. 1.936-6(c)) will be taxed as discussed 
in questions and answers 6 and 7 of paragraph (a)(5) of this section. It 
is immaterial whether the product is custom-made.
    Q. 9: In order to sell a pharmaceutical product in the United 
States, a New Drug Application (``NDA'') for the product must be 
approved by the U.S. Food and Drug Administration. Is an NDA considered 
a manufacturing or marketing intangible for purposes of the allocation 
of income under the cost sharing method?
    A. 9: A manufacturing intangible.
    Q. 10: Can a copyright be, in whole or in part, a manufacturing 
intangible for purposes of the allocation of income under the cost 
sharing method?
    A. 10: In general, a copyright is a marketing intangible. See 
section 936(h)(3)(B)(ii). However, copyrights may be treated either as 
manufacturing intangibles or nonmanufacturing intangibles (or as partly 
each) depending upon the function or the use of the copyright. If the 
copyright is used in manufacturing, it will be treated as a 
manufacturing intangible; but if it is used in marketing, even if it is 
also classified as know-how, it will be treated as a marketing 
intangible.
    Q. 11: If the cost sharing option is elected and a patent is related 
to the product produced by the possessions corporation, does the return 
to the possessions corporation with respect to the manufacturing 
intangible include the make, use, and sell elements of the patent?
    A. 11: Yes. A patent confers an exclusive right for 17 years to sell 
a product covered by the patent. During this period, the return to the 
possessions corporation includes the make, use and sell elements of the 
patent.
    Q. 12: For purposes of the cost sharing option, may a safe haven 
rule be applied to determine the amount of marketing intangible income?
    A. 12: No. The amount of marketing intangible income is determined 
on the basis of all relevant facts and circumstances. The section 482 
regulations will continue to apply except to the extent modified by the 
election. Rev. Proc. 63-10 and Rev. Proc. 68-22 do not apply for this 
purpose.

[[Page 165]]

    Q. 13: If a product covered by the cost sharing election is sold by 
a possessions corporation to an affiliated corporation for resale to an 
unrelated party, may the resale price method under section 482 be used 
to determine the intercompany price of the possessions corporation?
    A. 13: In general, the resale price method may be used if (a) no 
comparable uncontrolled price for the product exists, and (b) the 
affiliated corporation does not add a substantial amount of value to the 
product by manufacturing or by the provision of services which are 
reflected in the sales price of the product to the customer. The 
possessions corporation will not be denied use of the resale price 
method for purposes of such inter-company pricing merely because the 
reseller adds more than an insubstantial amount to the value of the 
product by the use of intangible property.
    Q. 14: If a possessions corporation makes the cost sharing election 
and uses the cost-plus method under section 482 to determine the arm's-
length price of a possession product, will the cost base include the 
cost of materials which are subject to processing or which are 
components in the possession product?
    A. 14: A taxpayer may include the cost of materials in the cost base 
if it is appropriate under the regulations under Sec. 1.482-2(e)(4).
    Q. 15: If the possessions corporation computes its income with 
respect to a product under the cost sharing method, and the price of the 
product is determined under the cost-plus method under section 482, does 
the cost base used in computing cost-plus under section 482 include the 
amount of the cost sharing payment?
    A. 15: The amount of the cost sharing payment is included in the 
cost base. However, no profit with respect to the cost sharing payment 
will be allowed.
    Q. 16: If a member of the affiliated group transfers to a 
possessions corporation a component which is incorporated into a 
possession product, how will the transfer price for the component be 
determined?
    A. 16: The transfer price for the component will be determined under 
section 482, and as follows. If the possession product is treated as not 
including such component for purposes of section 936(h)(5), the transfer 
price paid for the component will include a return on all intangibles 
related to the component product. If the posssession product is treated 
as including such component for purposes of section 936(h)(5), then the 
transfer price paid for the component by the possessions corporation 
will not include a return on any manufacturing intangible related to the 
component product, and the possessions corporation will obtain the 
return on the manufacturing intangibles associated with the component.
    Q. 17: If the possessions corporation computes its income with 
respect to a product under the cost sharing method, with respect to 
which units of the product shall the possessions corporation be treated 
as owning intangible property as a result of having made the cost 
sharing election?
    A. 17: The possessions corporation shall not be treated as owning 
intangible property, as a result of having made the cost sharing 
election, with respect to any units of a possession product which were 
not taken into account by the possessions corporation in applying the 
significant business presence test for the current taxable year or for 
any prior taxable year in which the possessions corporation also had a 
significant business presence in the possession with respect to such 
product.
    (b) Profit split option--(1) Computation of combined taxable income.
    Q. 1: In determining combined taxable income from sales of a 
possession product, how are the allocations and apportionments of 
expenses, losses, and other deductions to be determined?
    A. 1: (i) Expenses, losses, and other deductions are to be allocated 
and apportioned on a ``fully-loaded'' basis under Sec. 1.861-8 to the 
combined gross income of the possessions corporation and other members 
of the affiliated group (other than foreign affiliates). For purposes of 
the profit split option, the term ``affiliated group'' is defined the 
same as under Sec. 1.936-6 (a)(1) question and answer 2. The amount of 
research, development, and experimental expenses allocated and 
apportioned to

[[Page 166]]

combined gross income is to be determined under Sec. 1.861-8(e)(3). The 
amount of research, development and experimental expenses and related 
deductions (such as royalties paid or accrued with respect to 
manufacturing intangibles by the possessions corporation or other 
domestic members of the affiliated group to unrelated persons or to 
foreign affiliates) allocated and apportioned to combined gross income 
shall in no event be less than the amount of the cost sharing payment 
that would have been required under the rules set forth in section 
936(h)(5)(C)(i)(II) and paragraph (a) of this section if the cost 
sharing option had been elected. Other expenses which are subject to 
Sec. 1.861-8(e) are to be allocated and apportioned in accordance with 
that section. For example, interest expense (including payments made 
with respect to bonds issued by the Puerto Rican Industrial, Medical and 
Environmental Control Facilities Authority (AFICA)) is to be allocated 
and apportioned under Sec. 1.861-8(e)(2). With the exception of 
marketing and distribution expenses discussed below, the other remaining 
expenses which are definitely related to a class of gross income shall 
be allocated to that class of gross income and shall be apportioned on 
the basis of any reasonable method, as described in Sec. 1.861-8 (b)(3) 
and (c)(1). Examples of such methods may include, but are not limited 
to, those specified in Sec. 1.861-8(c)(1)(i) through (vi).
    (ii) The class of gross income to which marketing and distribution 
expenses relate and shall be allocated is generally to be defined by the 
same ``product area'' as is determined for the relevant research, 
development, and experimental expenses (i.e., the appropriate 3-digit 
SIC code), but shall include only gross income generated or reasonably 
expected to be generated from the geographic area or areas to which the 
expenses relate. It shall be presumed that marketing and distribution 
expenses relate to all product sales within the same product area. If, 
however, it can be established that any of these expenses are separately 
identifiable expenses, such as advertising, and relate, directly or 
indirectly, solely to a specific product or a specific group of 
products, such expenses shall be allocated to the class of gross income 
defined by the specific product or group of products. Thus, advertising 
and other separately identifiable marketing expenses which relate 
specifically and exclusively to a particular product must be allocated 
entirely to the gross income from that product, even though the taxpayer 
or other members of an affiliated group which includes the taxpayer 
produce and market other products in the same 3-digit SIC code 
classification. The mere display of a company logo or mention of a 
company name solely in the context of identifying the manufacturer shall 
not prevent an advertisement from relating specifically and exclusively 
to a particular product or group of products.
    (iii) If marketing and distribution expenses are allocated to a 
class of gross income which consists both of income from sales of 
possession products (the statutory grouping) and other income such as 
from sale by U.S. affiliates of products not produced in the possession 
(the residual grouping), then these marketing and distribution expenses 
shall be apportioned on a ``fully loaded'' basis which reflects, to a 
reasonably close extent, the factual relationship between these 
deductions and the statutory and residual groupings of gross income. 
Apportionment methods based upon comparisons of amounts incurred before 
ultimate sale of a product (including apportionment on a comparison of 
costs of goods sold, other expenses incurred, or other comparisons set 
forth in Sec. 1.861-8 (c)(1)(v), such as time spent) are not on a 
``fully-loaded'' basis and do not reflect this required factual 
relationship. These deductions shall be apportioned on a basis of 
comparison of the amount of gross sales or receipts or another method if 
it is established that such method similarly reflects the required 
factual relationship. Thus, for example, a comparison of units sold may 
be used only where the units are of the same or similar value and are, 
thus, in fact comparable.
    (iv) The rules for allocation and apportionment of marketing and 
distribution expenses may be illustrated by the following examples:


[[Page 167]]


    Example 1. Assume that possessions corporation A manufacturers 
prescription pharmaceutical product 1 for resale by P, its U.S. 
parent corporation, in the United States. Additionally, assume that P 
manufactures prescription pharmaceutical products 2 and 
3 in the United States for sale there. Further, assume that all 
three products are within the same product area, and that marketing and 
distribution expenses are internally divided by P among the three 
products on the basis of time spent by sales persons of P on marketing 
of the three products, as follows:




Product 1.............................................      50X
Product 2.............................................      80X
Product 3.............................................     110X
                                                                --------
    Total......................................................     240X



These expenses of 240X are allocated to gross income generated by all 
three products and shall be apportioned on the basis of gross sales or 
receipts of product 1 as compared to products 2 and 
3 or another method which similarly reflects the factual 
relationship between these expenses and gross income derived from 
product 1 and products 2 and 3. Thus, if a 
sales method were used and sales of product 1 accounted for 
one-third of sales receipts from the three products, 80X (240 / 3) of 
marketing and distribution expenses would be apportioned to the combined 
gross income from product 1.
    Example 2. Corporation B produces and sells Brand W whiskey, in the 
United States. B's subsidiary, S, which is a possessions corporation, 
produces soft drink extract in Puerto Rico which it sells to independent 
bottlers to produce Brand S soft drinks for sale in the United States. 
Corporation B's advertisements and other promotional materials for Brand 
W whiskey make no reference to Brand S soft drinks (or any other 
Corporation B products), and Brand S soft drink advertisements and other 
promotional materials make no reference to Brand W whiskey (or any other 
corporation B products). For purposes of section 936(h), the advertising 
and other promotional expenses for Brand W whiskey must be allocated 
entirely to the gross income from sales of Brand W whiskey and the 
advertising and other promotional expenses for Brand S soft drink must 
be allocated entirely to the gross income from the sales of soft drink 
extract, notwithstanding the fact that whiskey and soft drink extract 
are both included in SIC code 208. A similar result would apply, for 
example, to separately identifiable advertising and other marketing 
expenses which relate specifically and exclusively to one or the other 
of the following pairs of products: chewing gum and granulated sugar 
(SIC code 206); canned tuna fish and freeze-dried coffee (SIC code 209); 
children's underwear and ladies' brassieres (SIC code 234); aspirin 
tablets and prescription antibiotic tablets (SIC code 283); floor wax 
and perfume (SIC code 284); adhesives and inks (SIC code 289); semi-
conductors and cathode-ray tubes (SIC code 367); batteries and extension 
cords (SIC code 369); bandages and dental supplies (SIC code 384); 
stainless steel flatware and jewelry parts (SIC code 391); children's 
toys and sporting goods (SIC code 394); hair curlers and zippers (SIC 
code 396); and paint brushes and linoleum tiles (SIC code 399).
    Example 3. Assume the same facts as in Example 1 and that 
possessions corporation A also manufactures aspirin, a non-prescription 
product, for resale by its U.S. parent corporation, P. Further, assume 
that the advertising and separately identifiable marketing expenses 
which relate specifically and exclusively to aspirin sales total $100 
and that these expenses are allocable solely to gross income derived 
from aspirin sales. The sales method continues to be used to apportion 
the marketing and distribution expenses related, directly or indirectly, 
to products 1, 2, and 3, and the 
apportionment of such expenses to product 1 for purposes of 
determining combined taxable income from product 1 will remain 
as stated in Example 1. None of the advertising and other separately 
identifiable marketing expenses which relate specifically and 
exclusively to aspirin will be taken into account in allocating and 
apportioning the marketing and distribution expenses relating to the 
gross income attributable to products 1, 2, and 
3. Gross income attributable to aspirin will be considered as a 
separate class of gross income, and all the advertising and separately 
identifiable marketing expenses which relate specifically and 
exclusively to aspirin sales of $100 will be allocated to the class of 
gross income derived from aspirin sales. Similarly, none of the 
marketing and distribution expenses, directly or indirectly, related 
solely to the group of products 1, 2, and 3 
will be taken into account in determining the combined taxable income 
from aspirin sales. the remaining marketing and distribution expenses 
which do not, directly or indirectly, relate solely to any specific 
product or group of products (e.g., the salaries of a Vice-President of 
Marketing who has responsibility for marketing all products and his 
staff) shall be allocated and apportioned on the basis of the gross 
receipts from the sales of all of the products (or a similar method) in 
determining combined taxable income of any product.

    Q. 2: How may the allocation and apportionment of expenses to 
combined gross income be verified?
    A. 2: Substantiation of the allocation and apportionment of expenses 
will be required upon audit of the possessions corporation and 
affiliates. Detailed

[[Page 168]]

substantiation may be necessary, particularly where the entities are 
engaged in multiple lines of business involving distinct product areas. 
Sources of substantiation may include certified financial reports. Form 
10-K's, annual reports, internal production reports, product line 
assembly work papers, and other relevant materials. In this regard, see 
Sec. 1.861-8(f)(5).
    Q. 3: Does section 936(h) override the moratorium provided by 
section 223 of the Economic Recovery Tax Act of 1981 and any subsequent 
similar moratorium?
    A. 3: Yes. Thus, the allocation and apportionment of product area 
research described in question and answer 1 must be made without regard 
to the moratorium.
    Q. 4: Is the cost of samples treated as a marketing expense?
    A. 4: Yes. The cost of producing samples will be treated as a 
marketing expense and not as inventoriable costs for purposes of 
determining combined taxable income (and compliance with the significant 
business presence test). However, for taxable years beginning prior to 
January 1, 1986, the cost of producing samples may be treated as either 
a marketing expense or as inventoriable costs.
    Q. 5: If a possessions corporation uses the profit split method to 
determine its taxable income from sales of a product, how does it 
determine its gross income for purposes of the 80-percent possession 
source test and the 65-percent active trade or business test of section 
936(a)(2)?
    A. 5: One-half of the deductions of the affiliated group (other than 
foreign affiliates) which are used in determining the combined taxable 
income from sales of the product are added to the portion of the 
combined taxable income allocated to the possessions corporation in 
order to determine the possessions corporation's gross income from sales 
of such product.
    Q. 6: How will income from intangibles related to a possession 
product be treated under the profit split method?
    A. 6: Combined taxable income of the possessions corporation and 
affiliates from the sale of the possession product will include income 
attributable to all intangibles, including both manufacturing and 
marketing intangibles, associated with the product.
    Q. 7: Can a possessions corporation apply the profit split option to 
a possession product if no U.S. affiliates derive income from the sale 
of the possession product?
    A. 7: Yes.
    Q. 8: With respect to the factual situation discussed in question 
and answer 7 how is combined taxable income computed?
    A. 8: The profit split option is applied to the taxable income of 
the possessions corporation from sales of the possession product to 
foreign affiliates and unrelated persons. Fifty percent of that income 
is allocated to the possessions corporation, and the remainder is 
allocated to the appropriate affiliates as described in question and 
answer 13 of this paragraph (b)(1).
    Q. 9: May a possessions corporation compute its income under the 
profit split method with respect to units of a possession product which 
it sells to a U.S. affiliate if the U.S. affiliate leases such units to 
unrelated persons or to foreign affiliates or uses such units in its own 
trade or business?
    A. 9: Yes, provided that an independent sales price for the 
possession product from comparable uncontrolled transactions can be 
determined in accordance with Sec. 1.482-2 (e)(2). If, however, there 
is a comparable uncontrolled price for an integrated product and the 
possession product is a component product or end-product form thereof, 
the possessions corporation may compute its income under the profit 
split method with respect to such units. In either case, the possessions 
corporation shall compute combined taxable income with respect to such 
units under the following question and answer.
    Q. 10: If the possessions corporation is entitled to use the profit 
split method in the situation described in Q. 9 (leasing units of the 
possession product or use of such units in the taxpayer's own trade or 
business), how should it compute combined taxable income with respect to 
such units?
    A. 10: (i) Combined taxable income shall be computed as if the U.S. 
affiliate had sold the units to an unrelated person (or to a foreign 
affiliate) at the

[[Page 169]]

time the units were first leased or otherwise placed in service by the 
U.S. affiliate. The sales price on such deemed sale shall be equal to 
the independent sales price from comparable uncontrolled transactions 
determined in accordance with Sec. 1.482-2(e)(2), if any.
    (ii) If the possession product is a component product or an end-
product form, the combined taxable income with respect to the possession 
product shall be determined under Q&A. 12 of this paragraph (b)(1).
    (iii) For purposes of determining the basis of a component product 
or an end-product form, the deemed sales price of such product must be 
determined. The deemed sales price of the component product shall be 
determined by multiplying the deemed sales price of the integrated 
product that includes the component product by a ratio, the numerator of 
which is the production costs of the component product and the 
denominator of which is the production costs of the integrated product 
that includes the component product. The deemed sales price of an end-
product form shall be determined by multiplying the deemed sales price 
of the integrated product that includes the end-product form by a ratio, 
the numerator of which is the production costs of the end-product form 
and the denominator of which is the production costs of the integrated 
product that includes the end-product form. For the definition of 
production costs, see Q&A. 12 of this paragraph (b)(1).
    (iv)(A) If combined taxable income is determined under paragraph (v) 
of A. 12 of this paragraph (b)(1), in the case of a component product, 
the deemed sales price shall be determined by using the actual sales 
price of that product when sold as an integrated product (as adjusted 
under the rules of the fourth sentence of Sec. 1.482-3(b)(2)(ii)(A)).
    (B) If combined taxable income is determined under paragraph (v) of 
A. 12 of this paragraph (b)(1), in the case of an end-product form, the 
deemed sales price shall be determined by subtracting from the deemed 
sales price of the integrated product that includes the end-product form 
(e.g., the leased property) the actual sales price of the excluded 
component when sold as an integrated product to an unrelated person (as 
adjusted under the rules of the fourth sentence of Sec. 1.482-
3(b)(2)(ii)(A)).
    (v) The full amount of income received under the lease shall be 
treated as income of (and be taxed to) the U.S. affiliate and not the 
possessions corporation.
    Q. 11: In the situation described in question 9, how does the U.S. 
affiliate determine its basis in such units for purposes of computing 
depreciation and similar items?
    A. 11: The U.S. affiliate shall be treated, for purposes of 
computing its basis in such units, as if it had repurchased such units 
immediately following the deemed sale and at the deemed sales price as 
provided in Q&A. 10 of this paragraph (b)(1).

The principles of questions and answers 10 and 11 are illustrated by the 
following example:

    Example: Possessions corporation S manufactures 100 units of 
possession product X. S sells 50 units of X to an unrelated person in an 
arm's length transaction for $10 per unit. S sells the remaining 50 
units to its U.S. affiliate, A, which leases such units to unrelated 
persons. The combined taxable income for the 100 units of X is computed 
below on the basis of the given production, sales, and cost data:




Sales:
  1. Total sales by S to unrelated persons (50 x $10)..........     $500
  2. Total deemed sales by A to unrelated persons (50 x $10)...      500
  3. Total gross receipts (line 1 plus line 2).................    1,000
Total costs:
  4. Material costs............................................      200
  5. Production costs..........................................      300
  6. Research expenses.........................................        0
  7. Other expenses............................................      100
  8. Total (add lines 4 through 7).............................      600
Combined taxable income attributable to the 100 units of X:
  9. Combined taxable income (line 3 minus line 8).............      400
  10. Share of combined taxable income apportioned to S (50% of      200
   line 9).....................................................
  11. Share of combined taxable income apportioned to A (line 9      200
   minus line 10)..............................................
A's basis in 50 units of X leased by it to unrelated persons:
  12. 50 units times $10 deemed repurchase price...............      500



Subsequent leasing income is entirely taxed to A.


[[Page 170]]


    Q. 12: If the possession product is a component product or an end-
product form, how is the combined taxable income for such product to be 
determined?
    A. 12: (i) Except as provided in paragraph (v) of this A. 12, 
combined taxable income for a component product or an end-product form 
is computed under the production cost ratio (PCR) method.
    (ii) Under the PCR method, the combined taxable income for a 
component product will be the same proportion of the combined taxable 
income for the integrated product that includes the component product 
that the production costs attributable to the component product bear to 
the total production costs (including costs incurred by the U.S. 
affiliates) for the integrated product that includes the component 
product. Production costs will be the sum of the direct and indirect 
production costs as defined under Sec. 1.936-5(b)(4) except that the 
costs will not include any costs of materials. If the possession product 
is a component product that is transformed into an integrated product in 
whole or in part by a contract manufacturer outside of the possession, 
within the meaning of Sec. 1.936-5(c), the denominator of the PCR shall 
be computed by including the same amount paid to the contract 
manufacturer, less the costs of materials of the contract manufacturer, 
as is taken into account for purposes of the significant business 
presence test under Sec. 1.936-5(c) Q&A. 5.
    (iii) Under the PCR method the combined taxable income for an end-
product form will be the same proportion of the combined taxable income 
for the integrated product that includes the end-product form that the 
production costs attributable to the end-product form bear to the total 
production costs (including costs incurred by the U.S. affiliates) for 
the integrated product that includes the end-product form. Production 
costs will be the sum of the direct and indirect production costs as 
defined under Sec. 1.936-5(b)(4) except that the costs will not include 
any costs of materials. If the possession product is an end-product form 
and an excluded component is contract manufactured outside of the 
possession, within the meaning of Sec. 1.936-5(c), the denominator 
shall be computed by including the same amount paid to the contract 
manufacturer, less cost of materials of the contract manufacturer, as is 
also taken into account for purposes of the significant business 
presence test under Sec. 1.936-5(c) Q&A. 5.
    (iv) This paragraph (iv) of A. 12 illustrates the computation of 
combined taxable income for a component product or end-product form 
under the PCR method. S, a possessions corporation, is engaged in the 
manufacture of microprocessors. S obtains a component from a U.S. 
affiliate, O. S sells its production to another U.S. affiliate, P, which 
incorporates the microprocessors into central processing units (CPUs). P 
transfers the CPUs to a U.S. affiliate, Q, which incorporates the CPUs 
into computers for sale to unrelated persons. S chooses to define the 
possession product as the CPUs. The combined taxable income for the sale 
of the possession product on the basis of the given production, sales, 
and cost data is computed as follows:

Production costs (excluding costs of materials):
    1. O's costs for the component.........................          100
    2. S's costs for the microprocessors...................          500
    3. P's costs for the CPUs (the possession product).....          200
    4. Q's costs for the computers.........................          400
    5. Total production costs for the computer (Add lines 1        1,200
     through 4)............................................
    6. Combined production costs for the CPU (the                    800
     possession product) (Add lines 1 through 3)...........
    7. Ratio of production costs for the CPUs (the                 0.667
     possession product) to the production costs for the
     computer..............................................
Determination of combined taxable income for computers:
  Sales:
    8. Total possession sales of computers to unrelated            7,500
     customers and foreign affiliates......................
  Total costs of O, S, P, and Q incurred in production of a
   computer:
    9. Production costs (enter from line 5)................        1,200
    10. Material costs.....................................          100

[[Page 171]]


    11. Total costs (line 9 plus line 10)..................        1,300
    12. Combined gross income from sale of computers (line         6,200
     8 minus line 11)......................................
  Expenses of the affiliated group (other than foreign
   affiliates) allocable and apportionable to the computers
   or any component thereof under the rules of Sec. Sec.
   1.861-8 through 1.861-14T and 1.936-6 (b)(1), Q&A. 1:
    13. Expenses (other than research expenses)............          980
  Research expenses of the affiliated group allocable and
   apportionable to the computers:
    14. Total sales in the 3-digit SIC Code................       12,500
    15. Possession sales of the computers (enter from line         7,500
     8)....................................................
    16. Cost sharing fraction (divide line 15 by line 14)..          0.6
    17. Research expenses incurred by the affiliated group           700
     in 3-digit SIC Code multiplied by 120 percent.........
    18. Cost sharing amount (multiply line 16 by line 17)..          420
    19. Research of the affiliated group (other than                 300
     foreign affiliates) allocable and apportionable under
     Sec. Sec.  1.861-17 and 1.861-14T(e)(2) to the
     computers.............................................
    20. Enter the greater of line 18 or line 19............          420
Computation of combined taxable income of the computer and
 the CPU:
    21. Combined taxable income attributable to the                4,800
     computer (line 12 minus line 13 and line 20)..........
    22. Combined taxable income attributable to CPUs               3,200
     (multiply line 21 by line 7) (production cost ratio)..
    23. Share of combined taxable income apportioned to S          1,600
     (50 percent of line 22)...............................
Share of combined taxable income apportioned to U.S.
 affiliate(s) of S:
    24. Adjustments for research expenses (line 18 minus              80
     line 19 multiplied by line 7).........................
    25. Adjusted combined taxable income (line 22 plus line        3,280
     24)...................................................
    26. Share of combined taxable income apportioned to            1,680
     affiliates of S (line 25 minus line 23)...............


    (v)(A) If a possession product is sold by a taxpayer or its 
affiliate to unrelated persons in covered sales both as an integrated 
product and as a component product and the conditions of paragraph 
(v)(C) of this A. 12 are satisfied, the taxpayer may elect to determine 
the combined taxable income derived from covered sales of the component 
product under this paragraph (v). In that case, the combined taxable 
income derived from covered sales of the component product shall be 
determined by using the same per unit combined taxable income as is 
derived from covered sales of the product as an integrated product, but 
subject to the limitation of paragraph (v)(D) of this A. 12.
    (B) In the case of a possession product that is an end-product form, 
if all of the excluded components are also separately sold by the 
taxpayer or its affiliate to unrelated persons in uncontrolled 
transactions and the conditions of paragraph (v)(C) of this A. 12 are 
satisfied, the taxpayer may elect to determine the combined taxable 
income of such end-product form under this paragraph (v). In that case, 
the combined taxable income derived from covered sales of the end-
product form shall be determined by reducing the per unit combined 
taxable income from the integrated product that includes the end-product 
form by the per unit combined taxable income for excluded components 
determined under the rules of this paragraph (v), but subject to the 
limitation of paragraph (v)(D) of this A. 12. For this purpose, combined 
taxable income of the excluded components must be determined under 
section 936 as if the excluded components were possession products.
    (C) In the case of component products, this paragraph (v) applies 
only if the sales price of the possession product sold in covered sales 
as an integrated product (i.e., in uncontrolled transactions) would be 
the most direct and reliable measure of an arm's length price within the 
meaning of the fourth sentence of Sec. 1.482-3(b)(2)(ii)(A) for the 
component product. For purposes of applying the fourth sentence of Sec. 
1.482-3(b)(2)(ii)(A), the sale of the integrated product that includes 
the component product is treated as being immediately preceded by a sale 
of the component (i.e. without further processing) in a controlled 
transaction. In the case of end-product forms, this paragraph

[[Page 172]]

(v) applies only if the sales price of excluded components separately 
sold in uncontrolled transactions would be the most direct and reliable 
measure of an arm's length price within the meaning of the fourth 
sentence of Sec. 1.482-3(b)(2)(ii)(A) for all excluded components of an 
integrated product that includes an end-product form. For purposes of 
applying the fourth sentence of Sec. 1.482-3(b)(2)(ii)(A), the sale of 
the integrated product that includes excluded components is treated as 
being immediately preceded by a sale of the excluded components (i.e. 
without further processing) in a controlled transaction. Under the 
fourth sentence of Sec. 1.482-3(b)(2)(ii)(A), the uncontrolled 
transactions referred to in this paragraph (v)(C) must have no 
differences with the controlled transactions that would affect price, or 
have only minor differences that have a definite and reasonably 
ascertainable effect on price and for which appropriate adjustments are 
made (resulting in appropriate adjustments to the computation of 
combined taxable income). If such adjustments cannot be made, or if 
there are more than minor differences between the controlled and 
uncontrolled transactions, the method provided by this paragraph (v)(C) 
cannot be used. Thus, for example, these uncontrolled transactions must 
involve substantially identical property in the same or a substantially 
identical geographic market, and must be substantially identical to the 
controlled transaction in terms of their volumes, contractual terms, and 
market level. See Sec. 1.482-3(b)(2)(ii)(B).
    (D) In no case can the per unit combined taxable income as 
determined under paragraph (v)(A) or (B) of this A. 12 be greater than 
the per unit combined taxable income of the integrated product that 
includes the component product or end-product form.
    (E) The provisions of this paragraph (v) are illustrated by the 
following example. Taxpayer manufactures product A in a U.S. possession. 
Some portion of product A is sold to unrelated persons as an integrated 
product and the remainder is sold to related persons for transformation 
into product AB. The combined taxable income of integrated product A is 
$400 per unit and the combined taxable income of product AB is $300 per 
unit. The production cost ratio with respect to product A when sold as a 
component of product AB, is 2/3. Unless the taxpayer elects and 
satisfies the conditions of this paragraph (v), the combined taxable 
income with respect to A will be $200 per unit (combined taxable income 
for AB of $300 x the production cost ratio of 2/3). If, however, the 
comparability standards of paragraph (v)(C) of this A. 12 are met, the 
taxpayer may elect to determine combined taxable income of product A 
when sold as a component of product AB using the same per unit combined 
taxable income as product A when sold as an integrated product. However, 
the per unit combined taxable income from sales of product A as a 
component product may not exceed the per unit combined taxable income on 
the sale of product AB. Therefore, the combined taxable income of 
component product A may not exceed $300 per unit.
    (vi) Taxpayers that have not elected the percentage limitation under 
section 936(a)(1) for the first taxable year beginning after December 
31, 1993, may do so if the taxpayer has elected the profit split method 
and computation of combined taxable income is affected by Q&A.12 of this 
paragraph (b)(1).
    (vii) The rules of Q&A. 12 of this paragraph (b)(1) apply for 
taxable years ending after June 9, 1996. If, however, the election under 
paragraph (v) of A. 12 of Sec. 1.936-6(b)(1) is made, this election 
must be made for the taxpayer's first taxable year beginning after 
December 31, 1993, and if not made effective for that year, the election 
cannot be made for any later taxable year. A successor corporation that 
makes the same or substantially similar products as its predecessor 
corporation cannot make an election under paragraph (v) of A.12 of Sec. 
1.936-6(b)(1) unless the election was made by its predecessor 
corporation for its first taxable year beginning after December 31, 
1993.
    Q. 13: If the profit split option is elected, how is the portion of 
combined taxable income not allocated to the possessions corporation to 
be treated?
    A. 13: (i) The income shall be allocated to affiliates in the 
following order, but no allocations will be made

[[Page 173]]

to affiliates described in a later category if there are any affiliates 
in a prior category--
    (A) First, to U.S. affiliates (other than tax exempt affiliates) 
within the group (as determined under section 482) that derive income 
with respect to the product produced in whole or in part in the 
possession;
    (B) Second, to U.S. affiliates (other than tax exempt affiliates) 
that derive income from the active conduct of a trade or business in the 
same product area as the possession product;
    (C) Third, to other U.S. affiliates (other than tax-exempt 
affiliates);
    (D) Fourth, to foreign affiliates that derive income from the active 
conduct of a U.S. trade or business in the same product area as the 
possession product (or, if the foreign members are resident in a country 
with which the U.S. has an income tax convention, then to those foreign 
members that have a permanent establishment in the United States that 
derives income in the same product area as the possession product); and
    (E) Fifth, to all other affiliates.
    (ii) The allocations made under paragraph (i)(A) of this A. 13 shall 
be made on the basis of the relative gross income derived by each such 
affiliate with respect to the product produced in whole or in part in 
the possession. For this purpose, gross income must be determined 
consistently for each affiliate and consistently from year to year.
    (iii) The allocations made under paragraphs (i)(B) and (i)(D) of 
this A. 13 shall be made on the basis of the relative gross income 
derived by each such affiliate from the active conduct of the trade or 
business in the same product area.
    (iv) The allocations made under paragraphs (i)(C) and (i)(E) of this 
A. 13 shall be made on the basis of the relative total gross income of 
each such affiliate before allocating income under this section.
    (v) Income allocated to affiliates shall be treated as U.S. source 
and section 863(b) does not apply for this purpose.
    (vi) For purposes of determining an affiliate's estimated tax 
liability for income thus allocated for taxable years beginning prior to 
January 1, 1995, the income shall be deemed to be received on the last 
day of the taxable year of each such affiliate in which or with which 
the taxable year of the possessions corporation ends. For taxable years 
beginning after December 31, 1994, quarterly estimated tax payments will 
be required as provided under section 711 of the Uruguay Round 
Agreements, Public Law 103-465 (1994), page 230, and any administrative 
guidance issued by the Internal Revenue Service thereunder.
    Q. 14: What is the source of the portion of combined taxable income 
allocated to the possessions corporation?
    A. 14: Income allocated to the possessions corporation shall be 
treated as possession source income and as derived from the active 
conduct of a trade or business within the possession.
    Q. 15: How is the profit split option to be applied to properly 
account for costs incurred in a year with respect to products which are 
sold by the possessions corporation to a U.S. affiliate during such 
year, but are not resold by the U.S. affiliate to persons who are not 
members of the affiliated group or to foreign affiliates until a later 
year?
    A. 15: The rules under Sec. 1.994-1(c)(5) are to be applied. 
Incomplete transactions will not be taken into consideration in 
computing combined taxable income. Thus, for example, if in 1983, A, a 
possessions corporation, sells units of a product with a cost to A of 
$5000 to B corporation, its U.S. affiliate, which use the dollar-value 
LIFO method of costing inventory, and B sells units with a cost of $4000 
(representing A's cost) to C corporation, a foreign affiliate, only 
$4000 of such costs shall be taken into consideration in computing the 
combined taxable income of the possessions corporation and U.S. 
affiliates for 1983. If a specific goods LIFO inventory method is used 
by B, the determination of whether A's goods remain in B's inventory 
shall be based on whether B's specific goods LIFO grouping has 
experienced an increment or decrement for the year on the specific LIFO 
cost of such units, rather than on an average unit cost of such units. 
If the FIFO method of costing inventory is used by B, transfers may be 
based on

[[Page 174]]

the cost of the specific units transferred or on the average unit 
production cost of the units transferred, but in each case a FIFO flow 
assumption shall be used to identify the units transferred. For a 
determination of which goods are sold by taxpayers using the LIFO 
method, see question and answer 19.
    Q. 16: If a possessions corporation purchases materials from an 
affiliate and computes combined taxable income for a possession product 
which includes such materials, how are those materials to be treated in 
the possessions corporation's inventory?
    A. 16: The cost of those materials is considered to be equal to the 
affiliate's cost using the affiliate's method of costing inventory.
    Q. 17: If the possessions corporation uses the FIFO method of 
costing inventory and the U.S. affiliate uses the LIFO method of costing 
inventory, or vice versa, what method of costing inventory should be 
used in computing combined taxable income?
    A. 17: The transferor corporation's method of costing inventory 
determines the cost of inventory for purposes of combined taxable income 
while the transferee corporation's method of costing inventory 
determines the flow. Assume, for example, that X corporation, a 
possessions corporation, using the FIFO method of costing inventory 
purchases materials from Y corporation, U.S. affiliate, also using the 
FIFO method. X corporation produces a product which it transfers to Z 
corporation, another U.S. affiliate using the LIFO method. Assume also 
that the final product satisfies the significant business presence test. 
Under the facts, the cost of the materials purchased by X from Y is Y's 
FIFO cost. The costs of the inventory transferred by X to Z are 
determined under X's FIFO method of accounting as is the flow of the 
inventory from X to Z. The costs added by Z are determined under Z's 
LIFO method of inventory, as is the flow of the inventory from Z to 
unrelated persons or foreign affiliates.
    Q. 18: How are the costs of a possession product and the revenues 
derived from the sale of a possession product determined if the U.S. 
affiliate includes purchases of the possessions product in a dollar-
value LIFO inventory pool (as provided under Sec. 1.472-8)?
    A. 18: The following method will be accepted in determining the 
revenues derived from the sale of a possession product and the costs of 
a possession product if the U.S. affiliate includes purchases of the 
possession product in a dollar-value LIFO inventory pool. The rules 
apply solely for the cost sharing and profit split options under section 
936(h).
    (i) Revenue identification. The identification of revenues derived 
from sales of a possession product must generally be made on a specific 
identification basis. The particular method employed by a taxpayer for 
valuing its inventory will have no impact on the determination of what 
units are sold or how much revenue is derived from such sales. Thus, if 
a U.S. affiliate sells both item A (a possession product) and item B (a 
non-possession product), the actual sales revenues received by the U.S. 
affiliate from item A sales would constitute possession product revenue 
for purposes of the profit split option and possession sales for 
purposes of the cost sharing option regardless of whether the U.S. 
affiliate values its inventories on the FIFO or the LIFO method. In 
instances where sales of item A (i.e., the possession product) cannot be 
determined by use of specific identification (for example, in cases 
where items A and B are identical except that one is produced in the 
possession (item A) and the other (item B) is produced outside of the 
possession and it is not possible to segregate these items in the hands 
of the U.S. affiliate), it will be necessary to identify the portion of 
the combined sales of items A and B (which together can be identified on 
a specific identification basis) which is attributed to item A sales and 
the portion which is attributed to item B sales. The determination of 
the portion of aggregated sales attributable to item A and item B is 
independent of the LIFO method used to determine the cost of such sales 
and may be made under the following approach. A taxpayer may, for 
purposes of this section of the regulations, use the relative purchases 
(in units) of

[[Page 175]]

items A and B by the U.S. affiliate during the taxable year (or other 
appropriate measuring period such as the period during the taxable year 
used to determine current-year costs, i.e., earliest acquisitions 
period, latest acquisitions period, etc.) in determining the ratio to 
apply against the combined items A and B sales revenue. If the sales 
exceed current purchases, the taxpayer can use a FIFO unit approach 
which identifies actual unit sales on a first-in, first-out basis. 
Revenue determination where specific identification is not possible is 
illustrated by the following example:

    Example. At the end of year 1, there are 600 units of combined items 
A and B which are to be allocated between A and B on the basis of annual 
purchases of A and B units during year 1. During year 1, 1,000 units of 
item A, a possession product, and 2,000 units of item B, a non-
possession product, were purchased. Thus, the 600 units in year 1 ending 
inventory are allocated 200 (i.e. \1/3\) to item A units and 400 (i.e. 
\2/3\) to item B units based on the relative purchases of A (1,000) and 
B (2,000) in year 1. These units appear as beginning inventory in year 
2.
    In year 2, 1,500 units of item A are purchased and 1,500 units of 
item B are purchased. However, 3,300 units of items A and B in the 
aggregate are sold for $600,000. The relative proportion of the $600,000 
attributable to item A and to item B sales would be determined as 
follows:

------------------------------------------------------------------------
                      Year 2 sales                        Item A  Item B
------------------------------------------------------------------------
Unit sales from opening inventory.......................     200     400
Unit sale from current-year purchases...................   1,350   1,350
                                                         ---------------
    Total unit sales (3,300)............................   1,550   1,750
    Percentage..........................................      47      53
------------------------------------------------------------------------

                                                                  [GRAPHIC] [TIFF OMITTED] TC14NO91.144
                                                                  

------------------------------------------------------------------------
                    Year 2 Closing Inventory                       Units
------------------------------------------------------------------------
Item A..........................................................     150
Item B..........................................................     150
------------------------------------------------------------------------


Thus, revenues from Item A sales for purposes of computing possession 
sales for the cost sharing option and revenues for the profit split 
option are $281,818.
    (ii) Cost identification. The determination of the cost of 
possession product sales by the U.S. affiliate must be based on the LIFO 
inventory method of the U.S. affiliate. The LIFO cost of possession 
product sales will, for purposes of this section of the regulations, be 
determined by maintaining a separate LIFO cost for possession products 
in a taxpayer's opening and closing LIFO inventory and using this cost 
to calculate an independent cost of possession product sales. This 
separate LIFO cost for possession products in the LIFO pool of a 
taxpayer is to be determined as follows:
    (A) Determine the base-year cost of possession products in ending 
inventory in a LIFO pool.
    (B) Determine the percentage of the base-year cost of possession 
products in the pool as compared to the total base-year cost of all 
items in the pool.
    (C) Multiply the percentage determined in step (B) of this 
subdivision (ii) by the ending LIFO inventory value of the pool to 
determine the deemed LIFO cost attributable to possession products in 
the pool.
    (D) Subtract the LIFO cost of possession products in ending 
inventory in the pool (as calculated in step (C) of this subdivision 
(ii)) from the sum of:
    (1) Possession product purchases for the year, plus
    (2) The portion of the opening LIFO inventory value of the pool 
attributed to possession products (i.e., the result obtained in step (C) 
of this subdivision (ii) for the prior year).

The number determined by this calculation is the LIFO cost of possession

[[Page 176]]

product sales from the taxpayer's LIFO pool.

    Example: Assume that item A is a possession product and item B is a 
non-possession product and also assume the inventory and purchases with 
respect to the LIFO pool as provided below:

                        Year 1--Ending Inventory
------------------------------------------------------------------------
                                No. of   Base-year  Base-year
                                units    cost/unit     cost     Percent
------------------------------------------------------------------------
Item A......................        100      $2.00       $200         20
Item B......................        200       4.00        800         80
------------------------------------------------------------------------


                           Year 1--LIFO Value
------------------------------------------------------------------------
                                         Base-year
                                            cost      Index    LIFO cost
------------------------------------------------------------------------
Increment layer 2......................       $300        3.0       $900
Increment layer 1......................        400        2.0        800
Base layer.............................        300        1.0        300
                                        -----------           ----------
      Pool total.......................     $1,000  .........     $2,000
------------------------------------------------------------------------


                       Year 1--LIFO Value Per Item
------------------------------------------------------------------------
                                                    Base-year     LIFO
                                                       cost      value
------------------------------------------------------------------------
      Total pool..................................     $1,000     $2,000
                                                   ------------
Item A............................................        200        400
Item B............................................        800      1,600
------------------------------------------------------------------------


                            Year 2--Purchases
------------------------------------------------------------------------
                                                                 Total
                                                               purchases
------------------------------------------------------------------------
Item A.......................................................     $6,000
Item B.......................................................      4,000
------------------------------------------------------------------------


                        Year 2--Ending Inventory
------------------------------------------------------------------------
                                No. of   Base-year  Base-year
                                units    cost/unit     cost     Percent
------------------------------------------------------------------------
Item A......................        200      $2.00       $400         50
Item B......................        100       4.00        400         50
------------------------------------------------------------------------


                           Year 2--LIFO Value
------------------------------------------------------------------------
                                         Base-year
                                            cost      Index    LIFO cost
------------------------------------------------------------------------
Increment layer 2......................       $100        3.0       $300
Increment layer 1......................        400        2.0        800
Base layer.............................       $300        1.0        300
                                        -----------           ----------
Pool total.............................        800  .........      1,400
------------------------------------------------------------------------
The year 2 LIFO cost of possession product A sales will be calculated as
  follows:
(1) Base-year cost of item in year 2 ending inventory=$400
(2) Percentage of item A base-year cost to total base-year cost ($400 /
  $800) = 50%
(3) LIFO value of item A ($1,400 x 50%) = $700
(4) LIFO cost of item A sales is determined by adding to the beginning
  inventory in year 2 the purchases of item A in year 2 and subtracting
  from this amount the ending inventory in year 2 ($400 + $6000 - $700 =
  $5700). The beginning inventory in year 2 is determined by multiplying
  the LIFO cost of the year 1 ending inventory by a percentage of item A
  base year cost to the total base-year cost in year 1. The ending
  inventory in year 2 is determined under (3) above.


    Q. 19: If a possession product is purchased from a possessions 
corporation by a U.S. affiliate using the dollar-value LIFO method of 
costing its inventory and is included in a LIFO pool of the U.S. 
affiliate which includes products purchased from the possessions 
corporation in pre-TEFRA years, how should the LIFO index computation of 
the U.S. affiliate be made in the first year in which section 936(h) 
applies and in subsequent taxable years?
    A. 19: The U.S. affiliate should treat the first taxable year for 
which section 936(h) applies as a new base year in accordance with 
procedures provided by regulations under section 472. Thus, the opening 
inventory for the first year for which section 936(h) applies (valuing 
possession products purchased from the possessions corporation on the 
basis of the cost of such possession products), would equal the new base 
year cost of the inventory of such pool of the U.S. affiliate. 
Increments and decrements at new base year cost would be valued for LIFO 
purposes pursuant to the procedures provided by regulations under 
section 472.
    Q. 20: If the possessions corporation computes its income with 
respect to a product under the profit split method, with respect to 
which units of the product shall the profit split method apply?
    A. 20: The profit split method shall apply to units of the 
possession product produced in whole or in part by the possessions 
corporation in the possession and sold during the taxable year by 
members of the affiliated group (other than foreign affiliates) to 
unrelated parties or to foreign affiliates. In no event shall the profit 
split method apply to units of the product which were not taken into 
account by the possessions corporation in applying the significant 
business presence test for the current taxable year or for any prior 
taxable year in which the possessions corporation also had a significant 
business presence in the possession with respect to such product.
    (2) Pre-TEFRA inventory.

[[Page 177]]

    Q. 1: How is pre-TEFRA inventory to be determined if the profit 
split option is elected and the FIFO method of costing inventory is used 
by the U.S. affiliate?
    A. 1: Pre-TEFRA inventory is inventory which was produced by the 
possessions corporation and transferred to a U.S. affiliate prior to the 
possessions corporation's first taxable year beginning after December 
31, 1982. Pre-TEFRA inventory will not be included for purposes of the 
profit split option. If the U.S. affiliate uses the FIFO method of 
costing inventory, the pre-TEFRA inventory will be treated as the first 
inventory sold by the U.S. affiliate during the first year in which 
section 936(h) applies and will not be included in the computation of 
combined taxable income for purposes of the profit split option. The 
treatment of pre-TEFRA inventory when FIFO costing is used by both the 
U.S. affiliate and the possessions corporation is illustrated by the 
following example in which FIFO unit costing is used:

    Example. Assume the following:

------------------------------------------------------------------------
                                              X                 Y
                                     -----------------------------------
                                         Possessions     U.S. affiliate
                                         corporation   -----------------
                                     ------------------
                                       Number    Cost    Number    Cost
                                         of      per       of      per
                                       units     unit    units     unit
------------------------------------------------------------------------
Beginning inventory.................      500     $150      200     $225
Units produced during 1983..........    1,000      200  .......  .......
Ending inventory....................      400      200      300  .......
------------------------------------------------------------------------

    In 1983, the beginning inventory of X, a possessions corporation, is 
500 units with a unit cost of $150 and the beginning inventory of Y, the 
U.S. affiliate, is 200 units with a unit cost of $225, which represents 
the section 482 price paid by Y. Y's beginning inventory in 1983 
represents purchases made in 1982 of products produced by X in that 
year. Y sells all the units it purchases from X to Z, a foreign 
affiliate. In 1983, X produces 1000 units at a unit cost of $200 and 
sells 1100 units to Y (the difference between 1500 units, representing 
X's 1983 beginning inventory (500) and the units produced by X in 1983 
(1000), and X's ending inventory of 400 units). Of the 1100 units sold 
by X to Y in 1983 only 800 units (and not 1000 units) which were sold by 
Y to Z are taken into consideration in computing combined taxable income 
for 1983. Since FIFO costing by the possessions corporation is used, the 
cost is $150 per unit for the first 500 units and $200 per unit for the 
remaining 300 units. The 200 units sold by X to Y in 1982 are pre-TEFRA 
inventory and are not included in the computation of combined taxable 
income for 1983. They are also treated as the first units sold by Y to Z 
in 1983. This inventory has a unit cost of $225, which reflects the 
section 482 transfer price from X to Y in 1982. Y's 1983 ending 
inventory of 300 units will not be taken into consideration in computing 
the combined taxable income of X and Y for 1983 because the units have 
not been sold to a foreign affiliate or to persons who are not members 
of the affiliated group. In a subsequent year when the units are sold to 
Z, the cost to X and selling price to Z of these units will enter into 
the computation of combined taxable income for that year.

    (c) Covered Intangibles.
    Q. 1: What are ``covered intangibles'' under section 
936(h)(5)(C)(i)(II)?
    A. 1: The term ``covered intangibles'' means (1) intangible property 
developed in a possession solely by the possessions corporation and 
owned by it, (2) manufacturing intangible property (described in section 
936(h)(3)(B)(i)) which is acquired by the possessions corporation from 
unrelated persons, and (3) any other intangible property (described in 
section 936(h)(3)(B) (ii) through (v), to the extent not described in 
section 936(h)(3)(B)(i)) which relates to sales of products or services 
to unrelated persons for ultimate consumption or use in the possession 
in which the possessions corporation conducts its business. The 
possessions corporation is treated as the owner of covered intangibles 
for purposes of obtaining a return thereon.
    Q. 2: Do covered intangibles include manufacturing intangible 
property which is acquired by an affiliate and subsequently transferred 
to the possessions corporation?
    A. 2: No. In order for a manufacturing intangible to be treated as a 
covered intangible, the intangible property must be acquired directly by 
the possessions corporation from an unrelated person unless the 
manufacturing intangible was acquired by an affiliate from an unrelated 
person and was transferred to the possessions corporation by the 
affiliate prior to September 3, 1982.
    Q. 3: If a possessions corporation licenses a manufacturing 
intangible

[[Page 178]]

from an unrelated party, will the licensed intangible be treated as a 
covered intangible?
    A. 3: No.
    Q. 4: How is ultimate consumption or use determined for purposes of 
the definition of covered intangibles?
    A. 4: A product will be treated as having its ultimate use or 
consumption in a possession if it is sold by the possessions corporation 
to a related or unrelated person in a possession and is not resold or 
used or consumed outside of the possession within one year after the 
date of the sale.
    Q. 5: Are sales of products that relate to covered intangibles 
excluded from the cost sharing fraction?
    A. 5: If no manufacturing intangibles other than covered intangibles 
are associated with the possession product, then sales of such product 
will be excluded from the cost sharing fraction. If both covered and 
non-covered manufacturing intangibles are associated with the possession 
product, then sales of such product will be included in the cost sharing 
fraction.
    Q. 6: If the cost sharing option is elected, is it necessary for the 
possessions corporation to be the legal owner of covered intangibles 
described in section 936(h)(5)(C)(i)(II)(c) related to the product in 
order for the possessions corporation to receive a full return with 
respect to such intangibles?
    A. 6: No. For purposes of section 936(h), it is immaterial whether 
such covered intangibles are owned by the possessions corporation or by 
another member of the affiliated group. Moreover, if the legal owner of 
such covered intangibles which are subject to section 936(h)(5) is an 
affiliate of the possessions corporation, such person will not be 
required to charge an arm's-length royalty under section 482 to the 
possessions corporation.

[T.D. 8090, 51 FR 21532, June 13, 1986; 51 FR 27174, July 30, 1986, as 
amended by T.D. 8669, 61 FR 21367, May 10, 1996; 61 FR 39072, July 26, 
1996; T.D. 8786, 63 FR 55025, Oct. 14, 1998]