United States: IRS Reproposes Regulations for Taxing the Final Frontier

By Michael S. Lebowitz & Stacy M. Paz

The Internal Revenue Service (the Service) has issued reproposed regulations governing the character and source of income derived from communications activities conducted in space and international waters as well as income derived from international communication activities. With these proposed regulations, the Service has made a second attempt to implement changes in the Tax Reform Act of 1986 (1986 Act) to the treatment of space, ocean, and international

Assuming these proposed regulations are finalized in 2006, 20 years will have passed since Congress first enacted rules for taxing space, ocean, and international communications income. During those 20 years, the satellite and communications industries have changed dramatically. The use of satellite technology has increased significantly. Moreover, the telecommunications industry has expanded and fragmented with major companies in the industry emerging and disappearing.

The reproposed regulations address the changes in the telecommunications industries as well as changes in the Internal Revenue Code (the Code) that concern space, ocean, and international communications income resulting from the American Jobs Creation Act of 2004 (2004 Jobs Act).

This article will provide an overview of the new proposed regulations and identify some of the challenges taxpayers in these industries will face in complying with the new rules.

Prior to 1986, the Code did not contain special rules for space, ocean, and international communications income. The advent of the foreign tax credit basket regime in 1986 and its underlying policy of preventing "cross-crediting" different types of income, however, triggered concern in Congress about the treatment of income that arose outside of a country’s taxing jurisdiction.¹ Congress was particularly concerned that the ability of taxpayers to generate foreign source income from activities conducted in space or international waters enabled them to artificially increase their foreign tax credit limitation.² Congress expressed similar concerns with respect to international communications income.

In 1986, Congress enacted new rules to deal specifically with space, ocean, and international communications income. Broadly, these rules provide the following:

• income from space or ocean activities conducted by a United States (US) person shall be considered US source income;³
• income from space or ocean activities conducted by a non-US person shall be considered foreign source income;⁴
• international communications income earned by a US person shall be considered to be 50 percent US source income and 50 percent foreign source income;⁵ and
• international communications income earned by a non-US person shall be considered to be entirely foreign source income except to the extent such income is attributable to an office or fixed place of business in the US.⁶

For this purpose, international communications income is defined as income derived from the transmission of communications or data between the US and a point outside of the US.⁷

As can be observed, the purpose of these rules is to preserve the US ’s primary taxing jurisdiction over income earned by a US person from activities that do not come to rest in another taxing jurisdiction. These rules also largely cede US taxing jurisdiction over space and ocean income earned by non-US persons by treating such income as foreign source. The difference in treatment between space and ocean income and international communication income is derived from Congressional recognition that international communications income had the potential to be subject to some foreign taxation.⁸ As a result, treating a portion of that income as foreign source enabled a US taxpayer to claim foreign tax credits on such income.

As a further backstop to these rules, Congress also expanded the reach of Subpart F by including space and ocean income in foreign base company shipping income so that to the extent such income was earned by a controlled foreign corporation (CFC), the income was potentially subject to current US tax.⁹ Since space and ocean income earned by a CFC would otherwise be foreign source income, by including space and ocean income within the reach of Subpart F, the US preserved taxing authority on such income.

On January 17, 2001, fully fifteen years after the 1986 Act changes to the rules for space, ocean, and international communications income became law, the Service proposed regulations implementing the rules (the 2001 Proposed Regulations).¹⁰ One factor contributing to the significant delay in issuing regulations was the rapid change and expansion under way in the satellite and communications industries.

Some of the important provisions of the 2001 Proposed Regulations included:

• key definitions for space, ocean, and international communications income and rules for characterizing such income;
• rules for the overlap of communications income earned in part through the conduct of space or ocean activities;
• rules for the treatment of space, ocean, and international communications income earned by CFCs and non-CFC US-owned foreign corporations;
• rules for allocating income between space, ocean, international communications, and other income;
• entity level treatment for space, ocean, and international communication income earned by a domestic partnership or pass-through entity; and
• significant reporting and recordkeeping rules.

Although numerous comments were received on the 2001 Proposed Regulations and a public hearing was held on the regulations in May 2001, the 2001 Proposed Regulations were never finalized. Meanwhile, the satellite and communications industries continued to expand, consolidate, and fragment, as well as experience significant and rapid technological change.

In addition, beginning in 1997 and culminating in the 2004 Jobs Act, Congress began to disassemble the foreign tax credit basket regime.¹¹ As part of the 2004 Jobs Act, Congress eliminated all of the foreign tax credit baskets with the exception of the passive basket and the general limitation basket effective for taxable years beginning after December 31, 2006.¹² Moreover, Congress also repealed the rules which included foreign base company shipping income in Subpart F income.¹³ Because space and ocean income was included in foreign base company shipping income, this change resulted in removing space and ocean income from the reach of Subpart F.

In light of the extensive comments received on the 2001 Proposed Regulations, the significant changes and technological evolution in the industry, and the 2004 Jobs Act changes, the Service withdrew the 2001 Proposed Regulations and issued a fresh set of rules. The new rules were proposed on September 16, 2005 (the 2005 Proposed Regulations or the Regulations).¹⁴ The 2005 Proposed Regulations make a number of important changes to the 2001 Proposed Regulations and are in large part a relaxation of some of the more problematic provisions in the prior version. However, the new rules still leave a number of issues unresolved and put significant burdens on taxpayers operating in these industries.

A key aspect of the 2005 Proposed Regulations is characterization of the income stream from activities performed in space or international waters. The description of an activity as a space or ocean activity is significant because that characterization will impact the source of income produced by that activity, and other source rules in the Code and regulations will be overridden.

The 2005 Proposed Regulations follow the 2001 Proposed Regulations by broadly defining space and ocean activities. For example, the 2005 Proposed Regulations provide that space and ocean activities include:

• the performance and provision of services in space or international waters
• the leasing of equipment located in space or international waters (for example, satellites, transponders, or underwater cable)
• the licensing of technology or other intangibles for use in space or international waters (for example, a satellite orbital slot)
• underwriting income from the insurance of risks on activities that produce space or ocean income; and
• the sale of non-inventory property in space or international waters.¹⁵

It should be noted that if income is characterized as international communication income (as discussed below), the rules in Section 863(e) apply, rather than those in Section 863(d). The segregation of income between space and ocean income and international communications income is discussed below.

A number of challenging issues arise when a transaction includes an activity conducted in space or international water but also includes land-based activities. This can be seen in the rules for determining the source of income from the performance of services. The 2001 Proposed Regulations contained a general rule that income from the performance of services is entirely space and ocean income if part of the service, even if de minimis, is conducted in space.¹⁶ Recognizing that this rule was potentially overbroad, the 2001 Proposed Regulations contained a facilitation exception which allowed taxpayers to avoid space and ocean treatment if they could establish that the taxpayer's only activity in space or international water is to facilitate the taxpayer's own communications as part of the provision or delivery of a service provided by the taxpayer.¹⁷

The 2005 Proposed Regulations eliminate the facilitation exception and replace it with a de minimis test.¹⁸ Under the revised rule, to the extent the taxpayer can establish that the value of the services attributable to the functions performed in space or international waters is de minimis, the service performed would not be considered space or ocean income.¹⁹

The examples in the 2005 Proposed Regulations illustrate the challenges inherent in complying with the new rules. In Example 3,²⁰ R owns a retail outlet in the US . R engages S to provide a security system for R's premises. S operates its security system by transmitting images from R's premises directly to a satellite, and from the satellite to a group of S employees located in Country B, who monitor the premises by viewing the transmitted images. O provides S with transponder capacity on O's satellite, which S uses to transmit those images. S derives income from providing monitoring services. S is able to demonstrate that the value of S's service transaction attributable to performance in space is de minimis. Thus, S is not treated as engaged in a space activity, and none of S's income from the service transaction is space income. O's provision of transponder capacity is viewed as the provision of a service and the value of O's service transaction attributable to performance in space is not de minimis. O's activity will be considered space activity, to the extent the value of the services transaction is attributable to performance in space unless O's activity in space is international communications activity. R does not derive any income from space activity.

Unfortunately, neither the example nor the 2005 Proposed Regulations themselves provide any guidance as to when activity performed in space or international waters would be de minimis. As a result, the Service has simply replaced one vague standard with another.

Example 4 illustrates the complexities when the de minimis threshold is exceeded.²¹

In this example, L, a domestic corporation, offers programming and certain other services to customers located both in the US and in foreign countries. L uses satellite capacity acquired from S to deliver the programming service directly to customers' television sets, so that part of the value of the delivery transaction derives from functions performed and resources employed in space. The example assumes that value of the delivery transaction occurring in space is not considered de minimis. The example concludes that L's activities are treated as two separate service transactions: the provision of programming and the delivery of programming. L's income derived from provision of programming and other services is not income derived from space activity. L's delivery of programming and other services is considered space activity to the extent the value of the delivery transaction is attributable to performance in space.

The separation of L’s activities into two transactions derives from Prop. Reg. Sec. 1.863-8(d) which gives the Commissioner the authority to separate parts of a single transaction into separate transactions for purposes of the proposed rules. As drafted, this is a "one-way street" only, i.e., taxpayers do not have the authority to affirmatively bifurcate their transactions for purposes of complying with the new rules. While the 2005 Regulations, like the 2001 Regulations, provide an attribution exception which permits the taxpayer to bifurcate the space and ocean component of a transaction, this differs significantly from the Service’s power to bifurcate one transaction into separate transactions for all purposes of the regulations.

The 2005 Proposed Regulations follow the statutory framework for sourcing space and ocean income based on the residency of the taxpayer involved. In addition, the Regulations eliminate two controversial provisions included in the 2001 version.

Consistent with Section 863(d), the Regulations provide that space or ocean income derived by a US person is US source income.²² In the 2001 Proposed Regulations, this was an all-or-nothing determination, notwithstanding the fact that a US person might derive space and ocean income from activities conducted partly in space and partly in a foreign country.²³ US source treatment of all income would impact a taxpayer’s foreign tax credit position.

The 2005 Proposed Regulations depart from this approach by providing that a US person’s space or ocean income will be sourced outside the United States to the extent the taxpayer can demonstrate that the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in a foreign country or countries.²⁴

Example 1 of the Proposed Regulations illustrates this point.²⁵ There, S, a US satellite owner owns satellites currently in orbit. S leases the satellite (or presumably one or more transponders on a satellite) to a third party. The transaction is characterized as a lease of property in space which would otherwise be entirely US source income. However, if, as part of the transaction, S is required to conduct certain ground station operations (such as orbital monitoring) in various locations around the world, and S can demonstrate, based on a functional analysis, that income is partially attributable to functions and risks located outside the United States, then part of the income will be considered foreign source income.

Consistent with Section 863(d), the Regulations provide that space or ocean income derived by a non-US person (other than a CFC) is foreign source income.²⁶ The 2001 Proposed Regulations contained an important exception to this rule. If the foreign person was engaged in a trade or business in the United States , then all space and ocean income of the taxpayer was presumed to be US source income.²⁷

This presumption drew a number of criticisms charging that the presumption was overbroad. In response to these comments, the presumption was removed from the 2005 Proposed Regulations in favor of a pure allocation approach. Under the revised rules, to the extent the income is attributable to functions performed, resources employed, or risks assumed in the United States , the income will be considered US source income.²⁸ In a manner similar to Example 1 described above, a functional analysis is essentially required to allocate income between the US trade or business activities and non-US based activities. The documentation and recordkeeping challenges associated with this are discussed in greater detail below.

When the 2001 Proposed Regulations were issued, space and ocean income was an item of income potentially subject to current taxation under Subpart F.²⁹ With the removal of foreign base company shipping income as an item of Subpart F, the 2005 Proposed Regulations provide a default rule that space and ocean income of a CFC is treated entirely as US source income except to the extent the taxpayer can demonstrate that the income, based on all the facts and circumstances, is attributable to functions performed, resources employed, or risks assumed in a foreign country or countries.³⁰ Again, a functional analysis would be necessary to determine the portion allocable to functions and risks located abroad.

The 2001 Proposed Regulations contained a special rule for sourcing space and ocean income earned by a US-owned foreign corporation (USOFC) that was not a CFC (for example, a widely held foreign consortium). The 2001 version provided that space and ocean income of a USOFC was US source income.³¹ Commentators noted that this rule expanded US taxing jurisdiction of foreign corporations beyond Subpart F. Commentators also noted the complexity in complying with and enforcing the withholding tax obligations associated with the rule. In a welcome change, the Service acknowledged this complexity and removed this provision from the 2005 Proposed Regulations.

As noted above, the 1986 Act created new rules for the taxation of international communications income. Under Section 863(e):

• international communications income earned by a US person shall be considered to be 50 percent US source income and 50 percent foreign source income.³²
• international communications income earned by a non-US person shall be considered to be entirely foreign source income except to the extent such income is attributable to an office or fixed place of business in the United States.³³

International communications income is defined as income derived from the transmission of communication or data between the US and a point outside of the US.³⁴ Since activities which generate international communications income will routinely also involve activities conducted in space or international waters, challenging issues arise in separating the income generated by these activities for purposes of their separate treatment under the Code. Moreover, Section 863(e) only deals with "international communications income," namely communications income between the US and a non-US point. Section 863(e) generally does not apply to communications between two US points (even if part of the communication is in space or international waters), although, supplying communication capacity through the US is considered to be communication in the US . Nor does Section 863(e) apply to foreign-to-foreign communication even if some of the activities producing such income take place in the US . The 2005 Proposed Regulations attempt to deal with this complexity.

The most significant challenge in applying the 2005 Proposed Regulations as they relate to international communications income is the characterization of such income. Before the source rules can be applied, the character of the transaction or separate transactions must be determined. These answers must be determined:

• Does the income arise from the performance of communications activity?
• Does the transaction give rise to international communications income? And
• What are the other component parts of the transaction?

The 2005 Proposed Regulations continue the analysis used under the 2001 version by providing that a transaction is considered to generate communications income if the taxpayer is paid to transmit communications.³⁵ Once the taxpayer is considered to earn communications income, then the end points of that communication determine whether a taxpayer has generated international communication income. Several examples in the 2005 Proposed Regulations illustrate this point.

In Example 1,³⁶ D provides its customers in various foreign countries with access to its data base which contains information on certain individuals' health care insurance coverage. Customer C obtains access to D's data base by placing a call to D's telephone number. C's telephone service, used to access D's data base, is provided by a third party, and D assumes no responsibility for the transmission of the information via telephone. Since D is not paid to transmit communications, D does not derive income from communications. An interesting question would arise if D bore some economic risk for the failure of the communication line to work. For example, if D were required to refund premiums or service fees for outage periods.

In Example 3,³⁷ a domestic telephone company (TC) owns an underwater fiber optic cable. Pursuant to contracts, TC makes available to its customers capacity to transmit communications via the cable. TC's customers then solicit telephone customers and arrange to transmit the telephone customers' calls. The cable runs in part through US waters, in part through international waters, and in part through foreign waters. TC derives communications income because it is paid to make communications capacity available. Moreover, TC derives international communications income because TC is paid to make available capacity to transmit communications between the US and a foreign country.

In Example 5,³⁸ TC is paid to transmit communications from Toronto , Canada , to Paris , France . TC transmits the communications from Toronto to New York . TC pays another communications company, IC, to transmit the communications from New York to Paris . Under the paid-to-do rule, TC does not derive international communications income because TC is paid to transmit communications between two points in foreign countries, Toronto and Paris . The character of TC’s communications activity is determined without regard to the fact that TC pays IC to transmit for a portion of the delivery path or the fact that TC transmits via the US . IC has international communications income because IC is paid to transmit the communications between a point in the US and a point in a foreign country.

As noted, it is the end point of the communication activity which determines whether the income is international communications income sourced under Section 863(e) or some other form of communications income sourced under an alternative rule. For example, the TC in Example 5 does not earn international communications income; rather, it earns foreign communications income. If TC earned such income by performing activities in space or international waters, for example by providing the communication through a satellite or undersea fiber optic cable, TC could be considered to earn space or ocean income.

An interesting question arises when a taxpayer cannot determine the end points of the communication. The 2005 Proposed Regulations provide that, in this situation, the income is US source, whether derived by a US person or a foreign person.³⁹ This harsh rule is a continuation of an equivalent provision in the 2001 Proposed Regulations.⁴⁰ When first proposed, the rule was criticized by commentators noting that the rule is overbroad particularly as it relates to foreign taxpayers and should only apply to foreign taxpayers which conduct operations in the US .⁴¹

The Service rejected these comments, noting that this was primarily an issue of recordkeeping, and remarked that taxpayers are in the best position to maintain records in this regard. Example 7 of the Regulations illustrates this rule in the context of a taxpayer selling prepaid telephone calling cards.⁴²

Further complexities arise when a taxpayer is paid to provide content as well as paid to transmit that content to a customer. Commentators suggested that a content provider (e.g., a creator of television or radio programming) should not be considered to generate communications income if the content provider did not own or operate communications equipment.⁴³

The Service rejected this approach and instead continued the rule from the 2001 Proposed Regulations which require the separation of the content and transmission activities into two separate transactions.⁴⁴ The complexities inherent in allocating income between the two transactions are significant.

The changes made by the 2005 Proposed Regulations to the source of communications income generally follow the approach taken for space and ocean income.

Consistent with Section 863(e), the 2005 Proposed Regulations provide that international communications income is sourced 50 percent US source and 50 percent foreign source.⁴⁵ Unlike the rules for space and ocean income, there is no special rule which enables a taxpayer to achieve foreign source income for international communications income attributable to functions and risks located abroad. A general 50-50 rule applies instead.

International communications income derived by a foreign person is generally treated as foreign source income in its entirety.⁴⁶ However, if the foreign person is engaged in a US trade or business or has a fixed place of business in the United States , then international communications income is treated as foreign source income to the extent the income is attributable to the functions and risks located in the United States .⁴⁷ As with the rules described above for space and ocean income derived by a foreign person, the 2005 Proposed Regulations also removed a presumption contained in the 2001 Proposed Regulations that treated all international communications income of a foreign taxpayer engaged in a US trade or business as US source income.⁴⁸ The presumption was removed from the 2005 Proposed Regulations in favor of a pure allocation approach.⁴⁹ As with the corollary rule for space and ocean income, a functional analysis would be necessary to allocate the income between the US and non-US activities.

The 2005 Proposed Regulations liberalized the source rules for international communications income derived by a CFC in a manner similar to the liberalization for space and ocean income. The 2001 Proposed Regulations provided that international communications income of a CFC was entirely US source income.⁵⁰ The 2005 Proposed Regulations replace this with a 50-50 rule so that 50 percent of the income is treated as US source and 50 percent is treated as foreign source.⁵¹

The 2005 Proposed Regulations also made a similar change to the treatment of international communications income derived by a USOFC that is not a CFC. As with the changes to the treatment of space and ocean income, the Regulations remove the special 100 percent US source income rule for international communications income earned by a USOFC.

As noted, Section 863(e) only applies to international communications income (i.e., communications income between the US and a non-US end point). The 2005 Proposed Regulations also clarify the treatment of communications income other than international communications income. Income from transmitting communication between two US end points (US communications income) is treated as US source income without regard to the residency of the taxpayer.⁵² Income from transmitting communication between two foreign end points (foreign communications income) is treated as foreign source income without regard to the residency of the taxpayer.⁵³ Finally, income from transmitting communication between two points in space or international waters (space/ocean communications income) is sourced under the space and ocean rules of Section 863(d).⁵⁴

The investments required to conduct space, ocean, or international communications operations are significant. As a result, taxpayers in these industries often collaborate through joint ventures or other consortia to reduce their investment and risk. Consequently, whether the rules of Section 863(d) and (e) are applied at the entity level or at the investor level can be a significant issue, especially when investors from different countries participate in a joint venture.

The 2001 Proposed Regulations provided that for domestic partnerships, the rules of Sections 863(d) and (e) were applied at the partnership level. For foreign partnerships, the rules were applied at the partner level. While some commentators expressed a preference for partner level characterization in general,⁵⁵ commentators suggested that the rules for domestic and foreign partnerships be applied consistently. In response to these comments, the 2005 Proposed Regulations provide that Sections 863(d) and (e) will be applied at the partner level without regard to the residency of the partnership.⁵⁶

An overarching aspect of the 2005 Proposed Regulations is the requirement to allocate income between various activities. For example:

• a foreign taxpayer deriving space and ocean income which is attributable in part to a US trade or business must allocate the income to the US trade or business based on relative functions and risks
• a taxpayer deriving both space or ocean and communications income must allocate the income between the activities

Little guidance is given to the mechanics of this allocation other than the statement in the Regulations that the principles of Section 482 should be used.⁵⁷ Thus, it seems likely that taxpayers in these industries will be forced to undertake functional analyses and similar studies to determine the characterization and source of space, ocean, and communications income.

A byproduct of the allocation requirement is the related recordkeeping and reporting burden. The 2005 Proposed Regulations adopt an approach similar to the contemporaneous documentation requirements in the transfer pricing area⁵⁸ by requiring that documentation supporting the allocation methodology used by the taxpayer must be in existence at the time the taxpayer’s return is filed.⁵⁹ As a result, allocation methodologies must generally be adopted on a timely filed return. Perhaps in recognition of the complexity of the allocation process, the Regulations permit a taxpayer to change the allocation methodology after the return has been filed under limited circumstances.⁶⁰

It has been 20 years since Congress first proposed specific rules for space, ocean, and international communications activities. In that time, taxpayers in these industries have had to rely largely on industry practice in order to comply with the provisions of Sections 863(d) and (e). The 2005 Proposed Regulations provide broad scope to taxpayers in these industries to allocate income according to the functions and risks of their activities conducted in the US , overseas, or in space or international waters, provided they maintain adequate contemporaneous documentation supporting the allocation. In this regard, the Regulations perhaps reflect what taxpayers in these industries have already been doing for the last 20 years in order to determine the character and source of their space, ocean, and international communications income.

This article is intended to provide information on recent legal developments. It should not be construed as legal advice or legal opinion on specific facts. Pursuant to applicable Rules of Professional Conduct, it may constitute advertising.