The rules in this section apply for purposes of section 936(h) and also for purposes of section 934(e) where applicable.
For treatment of other products in the same product area as the possession product see § 1.936-6(a)(2) , question and answer 12.
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 § 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.
or
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.
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 * $10) | $500 |
2. Total deemed sales by A to unrelated persons (50 * $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 line 9) | 200 |
11. Share of combined taxable income apportioned to A (line 9 minus line 10) | 200 |
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.
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 through 4) | 1,200 |
6. Combined production costs for the CPU (the possession product) (Add lines 1 through 3) | 800 |
7. Ratio of production costs for the CPUs (the possession product) to the production costs for the computer | 0.667 |
Determination of combined taxable income for computers: | |
Sales: | |
8. Total possession sales of computers to unrelated customers and foreign affiliates | 7,500 |
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 |
11. Total costs (line 9 plus line 10) | 1,300 |
12. Combined gross income from sale of computers (line 8 minus line 11) | 6,200 |
Expenses of the affiliated group (other than foreign affiliates) allocable and apportionable to the computers or any component thereof under the rules of §§ 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 8) | 7,500 |
16. Cost sharing fraction (divide line 15 by line 14) | 0.6 |
17. Research expenses incurred by the affiliated group in 3-digit SIC Code multiplied by 120 percent | 700 |
18. Cost sharing amount (multiply line 16 by line 17) | 420 |
19. Research of the affiliated group (other than foreign affiliates) allocable and apportionable under §§ 1.861-17 and 1.861-14T(e)(2) to the computers | 300 |
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 computer (line 12 minus line 13 and line 20) | 4,800 |
22. Combined taxable income attributable to CPUs (multiply line 21 by line 7) (production cost ratio) | 3,200 |
23. Share of combined taxable income apportioned to S (50 percent of line 22) | 1,600 |
Share of combined taxable income apportioned to U.S. affiliate(s) of S: | |
24. Adjustments for research expenses (line 18 minus line 19 multiplied by line 7) | 80 |
25. Adjusted combined taxable income (line 22 plus line 24) | 3,280 |
26. Share of combined taxable income apportioned to affiliates of S (line 25 minus line 23) | 1,680 |
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 |
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.
The number determined by this calculation is the LIFO cost of possession 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 units | Base-year cost/unit | Base-year 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 cost | LIFO 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 units | Base-year cost/unit | Base-year 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:
Example. Assume the following:
X | Y | |||
Possessions corporation | U.S. affiliate | |||
Number of units | Cost per unit | Number of units | Cost per 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.
26 C.F.R. §1.936-6