TARGETING THE INTERNATIONAL TELECOMMUNICATIONS INDUSTRY FOR U.S. TAXATION: SELECTED ISSUES...

In January of 2001, the United States Department of the Treasury (Treasury) and the Internal Revenue Service (1RS) unveiled their Proposed Regulation section 1.863-91 under section 863 (e) of the Internal Revenue Code of 1986 (Code), as amended, sourcing international communications income.2 They sought comments from the telecommunications industry on the proposed regulation and recognized that the communications industry is subject to "rapid technological evolution."3 Domestic, foreign, and multinational commenters from all areas of the telecommunications industry responded to the request for comments with few compliments and many criticisms.

This Article discusses Code section 863(e), its legislative history, the proposed International Communications Income Sourcing Regulations,4 and the comments submitted by industry professionals (commenters) during the public comment period. The Article also addresses the problems involved in certain rules promulgated in the proposed regulations: the ETB Rule, the Default Rule, the Resourcing Rule, and the Space and Ocean Characterization RuIe.5 The Article discusses, when available, the reasons for the inclusion of the rule in the proposed regulations from the viewpoints of the Treasury and the 1RS.

The problems and potential inequities raised by the rules are analyzed from the commenters' points of view and are also analyzed through a fictitious foreign telecommunications joint venture, the X-Land Group. This fictitious joint venture, explained in detail in the following section, includes many, although not all, of the players that are involved in foreign joint ventures providing telecommunications services to the inhabitants of foreign countries.6

The 1RS is currently revisiting these proposed regulations. It issued a new notice and request for comments on the proposed regulations regulating the sourcing of communications and space and ocean income on October 14, 2003.7 There have been no changes made to the proposed regulations.8

II. DISCUSSION OF THE INTERNATIONAL ASPECTS OF THE TELECOMMUNICATIONS INDUSTRY

The Explanation of Provisions section of the Notice of Proposed Rulemaking for the proposed regulations under Code section 863(e) states: "[t]he 1RS and Treasury are fully aware of the rapid technological evolution in the space and communications industries since Congress enacted sections 863 (d) and (e) in 1986, and have attempted to take into account these changes as well as changes in the space and communications industries and business practices and business models."9 While the 1RS and Treasury made a valiant effort to propose regulations that could apply fairly to the vast range of complex transactions and relationships in the telecommunications industry, commenters on the proposed regulations raised several areas in which the proposed regulations would have potentially unfair and, in some cases, unexpected results for members of the telecommunications industry, both in the United States and abroad. In order to demonstrate these unfair and unexpected effects, this Article will analyze the tax implications of these proposed regulations for an invented, but representative, group of related telecommunications corporations, the X-Land Group.10

In the fictitious country of X-Land, a country with a population of one million and an economy based on tourism, the leaders, after signing the World Trade Organization's Basic Agreement on Telecommunications (BAT) in 1997,u agreed to deregulate their telephone service. Prior to X-Land joining the BAT, telephone service was provided by an X-Land government agency called the "Post, Telephone & Telegraph Administration" (PTTA).12 Under its BAT commitments, X-Land agreed to privatize the PTTA.13 X-Land also agreed to allow foreign companies to enter into contracts with the new local telecommunications company and own X-Land corporations created to provide long-distance, Internet, cable or satellite television and wireless telephony services inside X-Land. X-Land has no treaty with the United States.

A consortium of X-Land millionaires eager to bring their homeland into the 21st century purchased PTTA and incorporated it under the laws of X-Land under the name PTT, Inc. (PTT). PTT provides local telephone service within the small country. PTT's owners, with the encouragement of the X-Land government, decided to form a joint venture with a large foreign telecommunications company that has indefeasible rights of use14 in an established satellite system, fiber optic network, and under ocean cable system. PTT felt that this would afford X-Land access to the technology necessary to attract conventions and high income tourists at a lower cost than attempting to enter into several contracts with multiple service providers. A coalition of five of the owners of PTT, along with staff, traveled to the headquarters of several large telecommunications companies worldwide. Their travels took them into the United States for several months during the first year in which they explored options with these companies. In the second year, the owners decided that a U.S. corporation, Large Telecom, Inc. (LT), which also owned satellite television, Internet, and cellular subsidiaries, was the best choice with which to form a joint venture to provide long-distance, Internet, satellite television, arid wireless telephony inside X-Land. LT agreed that a joint venture with PTT would be beneficial to all concerned, and the PTT owners and staff members spent approximately ten months of the second year in the United States negotiating contracts with LT and working on the logistics of the joint venture. Shortly after this, with the permission of the X-Land government, LT and its subsidiaries began construction of a satellite earth station, an undersea cable link, cellular antennas, base stations, and switching offices, and other necessary infrastructure in X-Land. This supporting infrastructure would be owned and operated by a branch of LT set up in X-Land; LT would lease transmission services to the joint venture and LT's other subsidiaries as necessary.

The X-Land joint venture, XJV, Inc. (XJV), is incorporated in X-Land, and it opened for business on January 1 of the third year following deregulation. LT and PTT own XJV in equal shares.I5 Through contracts with LT and PTT, XJV acts as an inter-exchange carrier, carrying international telephone calls and other services between PTT's local telephone system and LT's satellites and under-ocean fiber optic cable system. XJV also established and oversees an agreement between local television programming and Sat-Elite TV, Inc., a LT subsidiary, for which XJV provides, through its contracts with LT, satellite transmissions between the local television station and Sat-Elite TV, Inc., and between LT's satellites and the satellite dishes of X-Land's residents to provide satellite television with local programming inside X-Land. In addition to the long-distance telephone and satellite TV services, XJV markets and sells cellular telephony and Internet services to X-Land residents through agreements with LT's cellular and Internet provider subsidiaries. Finally, XJV sells wholesale long-distance telephone calling cards to retailers in X-Land. XJV estimates that approximately sixty percent of these cards are purchased by tourists to X-Land from all over the world. XJV pays taxes on its earnings to the X-Land government.

Officers and staff of XJV, all of whom are X-Land citizens, regularly visit the United States to update contracts, discuss new services and technology that could be made available to X-Land residents, and provide training to XJV's employees. Because of the frequent visits, XJV leases a small suite of offices in a building owned by LT in its McLean, Virginia headquarters. This office is staffed solely by clerical and administrative workers who coordinate employee-training sessions and arrange hotel accommodations for visiting officers and employees of XJV.

The proposed regulations will affect the U.S. taxes paid by every member of the X-Land Group.

III. DISCUSSION OF STATUTES FOR SOURCING INCOME FROM INTERNATIONAL COMMUNICATIONS ACTIVITIES AND SPACE AND OCEAN ACTIVITIES

A. International Communications Activities

The Code defines international communications income as all income derived from communications activities in which the transmission of the communication or other data has its starting point in either the United States, or a foreign country or possession of the United States and its ending point in either a foreign country or possession of the United States, or in the United States."' To clarify, the proposed regulation requires that one end of the transmission must be in the United States and the other end must be in a foreign country or possession of the United States. For example, a telephone call from a person in the United States to a person in a foreign country or a possession of the United States would be defined as international communications activity resulting in international communications income for the long distance company that carried the call. International communications income is subject to specific sourcing rules for U.S. persons and foreign persons under Code section 863 (e).

section 863 (e) provides:

International Communications Income. -

(1) Source Rules. -

(A) United States Persons. -

In the case of any United States person, 50 percent of any international communications income shall be sourced in the United States and 50 percent of such income shall be sourced outside the United States.

(B) Foreign Persons. -

(i) IN GENKIWL. - Except as provided in regulations or in clause (ii), in the case of any person other than a United States person, any international communications income shall be sourced outside the United States.

(ii) Special Rule for Income Attributable to Office or Fixed Place oi Business in the United States. In the case of any person (other than a United States person) who maintains an office or other fixed place of business in the United States, any international communications income attributable to such office or other fixed place of business shall be sourced in the United States.

(2) Definition. -

For purposes of this section, the term "international communications income" includes-all income derived from the transmission of communications or data from the United States to any foreign country (or possession of the United States) or from any foreign country (or possession of the United States) to the United States.

B. The Legislative History of section 863(e)

section 863(e) was added to the Internal Revenue Code in the Tax Reform Act of 1986 at the same time that section 863(d), the source rule for income derived from space and ocean activities, was enacted.17 The legislative history of section 863 (e) consists of references in a Senate Report,IK a Conference Committee Report,19 and the Joint Committee on Taxation's General Explanation of the Tax Reform Act ofl986("Bluebook").20

1. The Senate Report

The Senate Report establishing sections 863 (e) and 863(d) stated that the bill excluded international communication income from the definition of "space and ocean activities" and provided that international communications income "is to be sourced 50 percent in the U.S. and 50 percent foreign to the extent the income is attributable to communications between the U.S. and a foreign country."21 The Senate Report further provided that "if the communication is between two points within the U.S. the income attributable thereto is to be sourced entirely as U.S. source income."22 The Senate intended this "result even if the communication is routed through a satellite located in space, regardless of the satellite's location."23 The report further stated that "[i]f the communication is between the U.S. and an airborne plane or a vessel at sea, the committee intends the communication to be treated as between two U.S. points and, thus, to be sourced in the U.S."'24 Finally the report stated that "if the communication is between two foreign locations, the committee intends income attributable thereto to be foreign source."25 In the Senate Report, the committee intended "international communications income [to] include income attributable to any transmission between two countries of signals, images, sounds, or data transmitted in whole or in part by buried or underwater cable or by satellite."2'1 The Senate Report estimated the revenue effect of the sourcing rules for ocean and satellite income and international communications income to be less than five million dollars annually.27

2. The Conference Committee Report

In the Conference Committee Report on the 1986 Tax Reform Act, Congress modified the Senate's version of the bill to source international communications income earned only by U.S. persons, rather than by all persons, as fifty percent U.S. source and fifty percent foreign source (the 50-50 Method).28 The Conference Committee Report treated international communications income earned by foreign persons as U.S. source only if attributable to a U.S. office or fixed place of business.29 The Conference Committee added a substantial grant of regulatory authority to the Treasury and the 1RS to treat international communications income earned by a foreign person "as other than foreign source."M They suggested that this authority should be used to treat international communications income earned by controlled foreign corporations under subpart ?? like international communications income earned by U.S. persons "to preserve the integrity of the provision."32

3. The Joint Committee on Taxation Bluebook

The Bluebook also provided an explanation of section 863(e).33 In the Bluebook, the staff of the Joint Committee on Taxation (Joint Committee) noted that "Congress recognized . . . that international communications income had some potential to be taxed in a foreign country and believed that prior law's source rules applicable to U.S. persons with respect to this income warranted partial modification."34 The Joint Committee also stated that "Congress believed that the prior law source rules may not have appropriately dealt with the U.S. taxation of international communications income derived by foreign persons." And Congress found it significant that "prior law potentially allowed foreign persons to maintain a U.S. office but to conduct their35 activities so as to generate nontaxable foreign source income through their U.S. offices."36

The Joint Committee explained that the Act excluded international communications income from the definition of space or ocean activities, and that the Act provided that international communications income derived by U.S. persons is to be sourced as follows:

(1) if the income is attributable to communications between the U.S. and a foreign country, fifty percent in the U.S. and fifty percent foreign;

(2) if the communication is between two points within the U.S., the income attributable thereto is not international communications income and is to be entirely U.S. source, even if the communication is routed through a satellite located in space, regardless of the satellite's location;

(3) if the communication is between the U.S. and an airborne plane or a vessel at sea outside the jurisdiction of any foreign country, Congress intended the communication to be treated as between two U.S. points and, thus, to be sourced in the U.S.; and

(4) if the communication is between two foreign locations, Congress intended income attributable thereto to be entirely foreign source.37

The Joint Committee stated that "Congress intended . . . international communication income to include income attributable to any transmission between two countries of signals, images, sounds, or data transmitted in whole or in part by buried or underwater cable or by satellite."38

The Joint Committee noted that "when derived by foreign persons, the Act generally treats international communication income as foreign source."39 The Joint Committee also noted that if a foreign person maintains an office or other fixed place of business in the United States, the Act provides an exception to this general rule if the income is attributable to the U.S. office or other U.S. fixed place of business.40 In this situation, the income is entirely U.S. source.41 The Joint Committee noted that Congress gave the secretary "regulatory authority to treat other international communications income derived by a foreign person (e.g., a controlled foreign corporation) as other than foreign source."42 It explained that Congress "anticipated that treatment of this income in the hands of controlled foreign corporations like similar income in the hands of U.S. persons would be necessary in certain circumstances to prevent manipulation of the provision."43 The Joint Committee concluded that the provision was estimated to increase "fiscal year budget receipts by less than $5 million annually."44

While the statute granted great latitude to the Treasury and the 1RS in promulgating regulations for sourcing international communications activity, the Treasury and the 1RS did not issue proposed regulations in this area until 2001.

C. Space and Ocean Activities

At the same time that Congress promulgated section 863 (e), it also passed into law section 863 (d).45 It provides as follows:

(d) Source Rules for Space and Certain Ocean Activities.-

(1) In General. - Except as provided in regulations, any income derived from a space or ocean activity-

(A) if derived by a United States person, shall be sourced in the United States, and

(B) if derived by a person other than a United States person, shall be sourced outside the United States.

(2) Space or Ocean Activity. - For purposes of paragraph (1)-(A) In General. - The term 'space or ocean activity' means -

(i) any activity conducted in space, and

(ii) any activity conducted on or under water not within the jurisdiction (as recognized by the United States) of a foreign country, possession of the United States, or the United States.

Such term includes any activity conducted in Antarctica.

(B) Exception for Certain Activities. - The term "space or ocean activity" shall not include -

(i) any activity giving rise to transportation income (as defined in section 863(c)),

(ii) any activity giving rise to international communications income (as defined in subsection (e)(2)), and

(iii) any activity with respect to mines, oil and gas wells, or other natural deposits to the extent within the United States or any foreign country or possession of the United States (as defined in section 638).

For purposes of applying section 638, the jurisdiction of any foreign country shall not include any jurisdiction not recognized by the United States.46

Under section 863 (d), a U.S person who derives income from the transmission of space or ocean communications activity would have U.S. source income and a foreign person who derives income from the same transmission would have foreign source income.47 The Joint Committee wrote that "Congress did not believe the prior rules governing the source of income were appropriate in their application to income derived from space or high-seas activities by U.S. residents."48 It noted that Congress found it significant "that activities conducted in space and on or beneath the ocean were not prevalent at that time."49 The Joint Committee explained that "[w]ith this in mind, Congress believed that the Code's general source rules needed reexamination in their application to space and ocean activities."50

IV. DISCUSSION OF PROPOSKD TREASURY REGUIATIONS FOR SOURCING INCOME FROM INTERNATIONAL COMMUNICATIONS ACTIVITIES

Approximately fifteen years after the enactment of section 863(e) and 863(d), the Treasury and the 1RS made public the proposed regulations for sourcing communications income.51 At this time, they solicited comments from the industries affected by the proposed regulations and scheduled a public hearing during which comments on the proposed regulations could be presented.52

A. Overview of the Proposed Regulations

The proposed regulations under section 863 (e) for sourcing international communications are contained in Proposed Treasury Regulation section 1.863-9.53 This section sources all communications income notwithstanding any other section of the Code.54 If a communications activity is also characterized as a space or ocean activity, it may be sourced under Code section 863 (d) and Proposed Treasury Regulation section 1.863-8.55 Income from a U.S. communications activity (that is, a transmission that begins and ends within the United States) is U.S. sourced no matter by whom earned.50 Income from a foreign communications activity (that is, a transmission that begins and ends outside of the United States) is foreign sourced, no matter by whom earned.57 If the two points between which the transmission occurred cannot be established, the Default Rule provides that the income from that transmission is deemed to be U.S. source income.58

Communications activity is defined in the proposed regulations as the delivery by transmission of communications or data communications and the provision of capacity to transmit communications.59 Income derived from the delivery of communications using methods other than transmission, such as the delivery of a letter, is not considered communications activity income taxable under this section.60 Income derived from communications activity is income from transmission of communications.61 The income may be considered "derived from communications activity even if the taxpayer does not perform the transmission function . . . ."62 Under the paid-to-do rule in the proposed regulations, a taxpayer derives communications income only if the taxpayer is paid to transmit the communications and bears the risk in the transmission.63 The content of a transmission or other services provided with the transmission are not considered communications activity unless they are de minimise4 Income produced from these activities must be treated as a separate transaction from the income derived from the communications activity, and gross income must be allocated separately based on all relevant facts and circumstances to the satisfaction of the Commissioner.65

The proposed regulation details the method used to characterize the communications activity as one of the following: international communications activity; U.S. communications activity; foreign communications activity; or space and ocean communications activity.66 The communications activity is characterized based on where the beginning and end points of the transmission are located.67 Whether the taxpayer conducts the entire transmission itself, or contracts all or a portion of the transmission to another, is not relevant in determining the beginning and end points of the transmission.58 The taxpayer must establish the beginning and end points to the satisfaction of the Commissioner.69

Income derived from communications activity is considered international communications income "when the taxpayer is paid to transmit between a point in the United States and a point in a foreign country or a possession of the United States."70 The proposed regulations mirror the Code in requiring that, if a U.S. person derives income from international communications activity, it is sourced half as foreign sourced and half as U.S. sourced, otherwise known as the 50-50 Method.71 For international communications income that is sourced using the 50-50 Method under section 863(e), the taxpayer must apportion expenses, losses and other deductions between sources within the United States and foreign sources on a pro rata basis as to the amounts of U.S. sourced gross income and foreign sourced gross income.72 The proposed regulations state that, in most cases, income from international communications activity that is earned by a person other than a U.S. person is completely foreign sourced.73 This general statement, however, is subject to exceptions.

Income is considered derived from U.S. communications activity "when the taxpayer is paid to transmit" communications "[bjetween two points within the United States; or [b]etween a point in the United States and a point in space or in international water."74 Income is considered derived from foreign communications activity "when the taxpayer is paid to transmit communications [bjetween two points in one or more foreign countries or possessions of the U.S.; or [b]etween a point in a foreign country or possession of the U.S. and a point in space or international water."75 Income is considered derived from space or ocean communications activity "when the taxpayer is paid to transmit communications between a point in space or in international water and another point in space or in international water."7''

As in section 863(e), the Proposed Treasury Regulations defined income derived from international communications income that is attributable to a foreign person's office or fixed place of business in the United States as U.S. sourced.77 However, this section of the proposed regulations "does not apply if the foreign person is also engaged in a U.S. trade or business."78 Under the ETB Rule in the proposed regulations, " [i]f a foreign person is engaged in a U.S. trade or business, all of the foreign person's international communications income is presumed to be from sources within the United States."79 The foreign person can rebut this presumption only by allocating income between sources inside the United States, in space or international water, and sources outside the United States, in space and international water.80 This allocation must be "based on the facts and circumstances" of the situation, and "may include functions performed, resources employed, risks assumed and other contributions to value . . ." and "must be to the satisfaction of the Commissioner."81

In order to allocate income properly between U.S. sourced income that is subject to U.S. taxes and foreign sourced income not subject to U.S. taxes under these proposed regulations, the taxpayer must allocate gross income to the satisfaction of the Commissioner based on all of the facts and circumstances.82 "[T] he taxpayer must allocate or apportion expenses, losses and other deductions as prescribed in 1.861-8 through 1.861-14T to the class of gross income, which must include the total income so allocated in each case."83 Then the taxpayer must properly allocate or apportion the amounts of expenses, losses and other deductions allocated or apportioned to the gross income between U.S. sourced gross income and foreign sourced gross income using the rules in sections 1.861-8 to 1.861-14T.8 The taxpayer must make the "allocation on a timely filed original [tax] return, including extensions." '' The "taxpayer must maintain contemporaneous documentation in existence when such [tax] return is filed regarding the allocation of gross income, the allocation and apportionment of expenses, losses, and other deductions, the methodology used, and the circumstances justifying use of that methodology."81' "The taxpayer must [be able to] produce that documentation to the 1RS within 30 days of a request [for it] ."87

"If a foreign corporation, including a controlled foreign corporation within the meaning of section 957, [not engaged in a trade or business in the United States], is 50 percent or more owned by vote or value (directly, indirectly or constructively) by U.S. persons, all income derived by that foreign corporation from international communications income ..." is deemed U.S. source.88 This rule is the Resourcing Rule. The proposed regulations do not allow allocation of the communications income of a U.S.-owned foreign corporation.89

The proposed regulations contain specific rules for partnerships. U.S. partnerships are taxed at the partnership level for communications income.90 Foreign partnerships and U.S. partnerships that are owned fifty percent or more by foreign persons are taxed at the partner level.91

B. Controversial Issues Raised in the Public Comments to the Proposed Regulation

The public hearing and the comments presented raised many controversies and problems in the proposed regulations perceived by industry representatives. Several issues that dealt specifically with difficulties in the proposed regulations for international communications income arose in the course of the public comment period and were of interest to many, if not all, of the commenters.92 This Article will address only certain of these issues: the ETB Rule; the Default Rule; the Resourcing Rule; and the Space and Ocean Characterization Rule.

1. The ETB Rule

Proposed Treasury Regulation section 1.863-9 (b) (2) (ii) (D), the "ETB Rule," requires that if a foreign person, other than a foreign corporation fifty percent or more of which is owned by U.S. persons, but including a foreign person with an office or fixed place of business in the United States,93 is engaged in a U.S. trade or business, then all of the foreign person's international communications income is deemed to be from sources within the United States.94

[I]f the foreign person can allocate income between sources within the United States, or space, or international water and sources outside the United States and space and international water, to the satisfaction of the Commissioner, based on the facts and circumstances, which may include functions performed, resources employed, risks assumed, or other contribudons to value, then the income allocated to sources outside the United States and space and international water shall be treated as from sources . . . [outside] the United States.95

a. Treasury and 1RS Reasoning

Section 863 (e) makes no mention of sourcing income derived from international communications activity conducted by a foreign person who engages in a trade or business in the United States. Instead, it merely states that income earned by a foreign person derived from international communications income that is attributable to an office or fixed place of business in the United States shall be U.S. sourced.91' The 1RS and Treasury explained in the Explanation of Provisions that the ETB Rule was included because they believed a foreign person could avoid having a U.S. office or fixed place of business, as regulated under Proposed Treasury Regulation section 863(e) (1) (B) (ii), and still have significant communications income from the United States.97 "The 1RS and Treasury believe [d] that Congress intended that a foreign person engaged in substantial U.S. business. . .[should] be subject to U.S. tax on that communications activity."98 The 1RS and Treasury admitted that the ETB Rule may be overly inclusive.99 To help alleviate this inclusiveness, they added a section to the proposed regulations that allows a foreign person to allocate income to international communications activities outside of the United States and space and international water as long as the foreign person can do so to "the satisfaction of the Commissioner."100 There is no guidance in the proposed regulations as to what showing would be necessary to demonstrate to the Commissioner that the income is foreign sourced.

The Treasury and 1RS explained that allocation under the ETB Rule would generally be in accordance with the principles in section 482.101 To allocate income, "the taxpayer must [also] allocate or apportion expenses, losses and other deductions as described in 1.861-8 through 1.861-14T. . . to the class of gross income, which must include the total income so allocated in each case."102 Then, the taxpayer must source these allocations as either U.S. source or foreign source.10'5 In addition, the 1RS and Treasury stressed that any foreign person entitled to the benefits of a treaty can elect to be taxed under the treaty rather than under these regulations whether or not the foreign person is engaged in trade or business in the U.S.104

b. Analysis of Law Affecting the ETB Rule

The phrase "engaged in a trade or business" is not defined within the Code.105 There is very little guidance on the meaning of the term. The case law on the subject is generally very old. For instance, Snell v. Commissioner,106 decided in 1938, is still regarded as good law on the issue. In Snell, the court found that the term "engaged in a trade or business" requires "busyness" and the conduct of an activity that is an occupation on the part of the actor.10 As regards foreign income, the Code merely states that the term " 'trade or business within the United States' does include the performance of personal services within the United States . . . but does not include the performance of personal services for a foreign employer ..." or trading in securities or commodities.108 Generally, the term "engaged in a trade or business" in the United States is satisfied if the foreign person conducts "regular," "continuous," and "considerable" business activities in the United States.'09 For instance, if a foreign person merely owns and manages a portfolio of passive investments in stocks and securities in the United States, this activity does not constitute a trade or business, no matter how extensive the ownership is.110 Owning U.S. real estate and leasing it under long-term leases does not usually constitute a U.S. trade or business even if the foreign person who owns the property is involved in the lease negotiations."1 The mere purchase of goods in the United States does not constitute a U.S. trade or business.112 Finally, advertising in the United States by mailings, faxes, in publications, or by radio transmissions, and probably via the Internet, from another country does not constitute a U.S. trade or business.113

The regulations state that whether or not a foreign person is considered to be engaged in a trade or business in the United States is determined based on the facts and circumstances of each case.114 case law requires that the type of activity occurring in the United States must be central to the derivation of profit from the business, and not merely ministerial or clerical.115 This central activity does not have to be performed by the foreign person, however. If an agent performs a central business activity for the foreign person, the foreign person will be considered engaged in a trade or business in the United States even though the foreign person has never set foot outside of her own country.116

This standard is very difficult to pin clown to particulars and is quite imprecise. Many tax treaties, including the U.S. Model Treaty, do not use this standard, instead limiting taxation to situations in which the foreign person operates a permanent establishment in the other country."7 At least one group of tax experts has proposed that the engaged in trade or business standard be done away with entirely and that profits from a trade or business conducted in the United States should be taxed only when they are derived from the conduct of a trade or business through an office or fixed place of business in the United States.118

If a foreign person is engaged in a trade or business in the United States, generally the foreign person's income that is effectively connected to that trade or business is subject to U.S. tax on a net basis at graduated rates.119 The foreign person may allocate deductions against effectively connected income.120 Under the Proposed Regulations all income from communications activity that is earned by a foreign person who is engaged in a trade or business in the United States would be considered effectively connected income under section 864(c)(3) regardless of whether it is actually related to or earned from the U.S. trade or business. This is because, under the proposed regulations, it would be considered U.S. source absent an allocation that meets the requirements of the Commissioner.12' Without such an allocation, under section 864(c) (3), all of the U.S. source income that falls under this section is effectively connected income whether or not it is actually related to trade or business occurring in the United States.122

c. Issues Raised by Commenters

(i) Lack of Congressional Intent and Regulatory Authority

Several commenters argue that the ETB Rule does not comply with congressional intent, that the 1RS and Treasury have no regulatory authority to promulgate the rule, and that this section is inconsistent with U.S. tax policy and international tax norms.12'5 Commenters argue that Congress only intended to make a small exception to the general rule that income derived from international communications income by foreign persons was foreign sourced-when the international communication income was attributable to the U.S. office or fixed place of business-and that the Treasury and 1RS acted here without authority under the statute or the legislative history of the statute.124

One commenter claimed that the ETB Rule "departs completely" from congressional intent requiring a U.S. office or fixed place of business for international communications income of a foreign person to be U.S. sourced.125 She asserted that the ETB Rule is inconsistent with U.S. tax policy in that the Code generally taxes effectively connected income only from U.S. sources. She claimed that there are only four limited situations in which a foreign person can be taxed on foreign source income, and in all but one of these situations, dealing with the taxation of foreign sourced insurance income, the taxpayer must have a U.S. office or fixed place of business.120 Even in the case of foreign source insurance income, she asserted, "there must be a substantial and demonstrated connection between the taxpayer's U.S. activities" and the income taxed.i27 She argued that the ETB Rule runs directly contrary to this tax policy because the proposed regulation requires no nexus between the income and the United States.128

(ii) Double Taxation Problem and Overbroad Taxation

Many of the commenters to the proposed regulations stressed that the ETB Rule would require any foreign corporation that is "engaged in a trade or business" in the United States, a potentially slippery standard, to be subject to U.S. tax on all of their international communications income or would be required to undertake a potentially complicated and time-consuming proof to the Commissioner even though their presence in the United States is minimal.129 Two commenters argued that if the income of a company that the 1RS determined was engaged in trade or business in the U.S. was derived from the conduct of business solely in foreign countries, that income would be subject to double taxation, both in the United States and in the foreign country, even if the income was attributable solely to activities conducted in the foreign country.130 One coalition of U.S. telecommunications companies termed the ETB Rule "the Force of Attraction Presumption" because all of a foreign taxpayer's international communications income could potentially become U.S. sourced because of its attraction under the ETB Rule to the foreign person's U.S. trade or business.131 Another commenter observed that there is unlikely to be a situation in which a foreign person could engage in significant communications activity in the United States without having a presence in the United States that would also constitute an office or fixed place of business.132

One commenter criticized the allocation requirements, allowing foreign taxpayers to allocate international communications income to the U.S. trade or business and foreign trade or business, as too vague because the proposed regulations provide no guidance to the taxpayer.133

(iii) Negative Impact on Foreign and U.S. Companies

Many commenters noted that, for a foreign company with branches and subsidiaries in the United States, there is a fear that, while the income generated from international communications activity by the U.S. branch may be minimal, the existence of the branch will subject all of the foreign company's international communications income to U.S. tax absent a potentially complicated and time-consuming proof to the Commissioner.134 However, one commenter argued that the ETB Rule is also unfair to U.S. companies.135 he stated that the rule is aimed at non-U.S. corporations, but would also have a negative impact on the many U.S. telecommunications companies that take minority equity positions in foreign corporations in order to increase their business. If the foreign corporation's income is deemed U.S. source, and thus subject to U.S. taxes as well as foreign taxes, the U.S. company's investment becomes less profitable.1'56

(iv) Commenters' Recommendations

The commenters that addressed this issue each recommended that the ETB Rule be deleted from the final regulations.137 Various commenters also gave alternatives to complete deletion that they felt would alleviate the unfairness potentially caused by this section. For instance, one commenter suggested that Congress expand the "office or fixed place of business" exception in section 863(e) (I)(B) (ii) to include international communications income attributable to a U.S. trade or business.138 Under such an expansion, there would not be an automatic presumption that all international communications income is U.S. sourced for a foreign person who is deemed to be engaged in a trade or business in the United States. Instead, only the international communications income that is affirmatively attributable to the U.S. trade or business would be considered U.S. sourced. 139

One coalition of telecommunications companies recommended that the 1RS and Treasury include a "rebuttal mechanism" that would allow a foreign person to allocate international communications income derived outside of the United States to foreign sources.140 They asserted that, because telecommunications activities require physical property, such as transmission equipment, few, if any, telecommunications activities would not involve a U.S. office or fixed place of business.'41 They recommended that, to address the issue of a potential foreign person escaping taxation on her international communications income derived from a U.S. trade or business, the 1RS and Treasury could add a clarification to the final regulations that the ownership or right to use the tangible personal property necessary to conduct communications activity constitutes a fixed place of business.142 Similarly, another coalition recommended that an objective standard be established to ensure that the taxed income is attributable to the taxpayer's U.S. office.143

d. Application of ETB Rule to the Fictitious X-Land Group

The application of the ETB Rule to our fictitious X-Land Group shows the difficulty of determining if a foreign person is engaged in a trade or business in the United States. LT, as a U.S. corporation, would not fall into this rule because it applies only to foreign corporations. It may, however, be indirectly affected if the XJV is taxed because its profits from the joint venture could be diminished. Staff and owners of both PTT and XJV spent time in the United States, but it is difficult to determine whether either would be considered to be engaged in a U.S. trade or business. Neither PTT nor XJV earned any income from their dealings in the United States. PTT, the local telephone company, had representatives in the United States for substantial periods of time in both Year f, while it searched for a joint venture partner, and Year 2, during which it negotiated its contracts with LT. PTT did not establish a U.S. office or fixed place of business during that period. In addition, it is unlikely that LT would be considered an agent of PTT since LT did not conduct any business activities for PTT during the negotiations. Therefore, while it is far from certain, it is unlikely that the courts would consider PTT engaged in a U.S. trade or business in either year.144 However, like LT, PTT's profits from the joint venture could be diminished if XJV's income is subject to U.S. tax.

XJV, the joint venture, has a much more substantial presence in the United States than PTT. Its staff and officers regularly visit the United States in order to update its contracts and discuss new services and technology with LT that could be provided to its customers, and for employee training. It is difficult to say whether these activities could comprise on their own a U.S. trade or business. While XJV has an office in the United States, the office merely conducts routine clerical and administrative activities and does not take part in the management or conduct of XJV's telecommunications services. It is unlikely that an office engaged in merely clerical and administrative activities would be considered a U.S. office or fixed place of business generating income that is effectively connected with a U.S. trade or business.145

The 1RS may find that LT is an agent acting on XJV's behalf in a U.S. trade or business. At least a portion of XJV's income is generated by transmissions that are routed by XJV through LT's equipment and end in the United States.

XJV's U.S. activities are on the borderline with regard to whether it is engaged in a U.S. trade or business. If the 1RS determines that XJV is engaged in a trade or business in the U.S., the ETB Rule would classify all of XJV's income from international communications income (from communications between X-Land and the United States) as U.S. source income. XJV would be required to pay U.S. taxes on this income, minus deductions on a graduated rate scale, and would be subject to the allocation and record-keeping requirements of the proposed regulations.

2. The Default Rule

As discussed above, international communications activity is defined as a transmission in which the beginning and end points are between the United States and a foreign country or possession of the United States.146 Other communications activities include: (1) U.S. communications activity in which the transmission's beginning and end points are both within the United States;147 (2) foreign communications activity in which the transmission's beginning and end points are both within foreign countries;148 and (3) satellite or ocean communication activity in which both the beginning and end points are on a satellite or in international waters.149 Proposed Treasury Regulation section 1.863-9(b)(6), the Default Rule, requires that communications income is sourced in the U.S. when a "taxpayer cannot establish the two points between which the taxpayer is paid to transmit the communications."150

a. Treasury and 1RS Reasoning

In the Explanation of Provisions to the proposed regulations, the Treasury and the 1RS explained that they established the Default Rule because tracing each transmission sent by a telecommunications company "may not be possible or practical."151 As an example, the Treasury and 1RS point to companies providing both local and international long distance services and cable services with one monthly price to consumers.152 If the provider cannot trace the beginning and end point of each transmission for each of its customers, and so cannot determine whether income from the transmission is U.S. source income, foreign source income, or international communications income, all of the income from those transmissions is presumed to be U.S. sourced.153 The Default Rule allows the 1RS and Treasury to tax potentially all transmissions occurring anywhere in the world when the beginning and end points of those transmissions cannot be determined with certainty. In the Explanations of Provisions section, the 1RS and Treasury stated that they understand that many members of the communications industry may not consider it possible or practical to prove the end points of the communications that member is paid to transmit.154 They solicited comments for proposals for situations in which taxpayers cannot establish the beginning and end points of a transmission.155

b. Analysis oflhe Law !Mating to the Default Rule

If the beginning and end points of a U.S. person's communications activity cannot be established and the income from this activity is taxed under the Default Rule, all of the communications income minus deductions will be taxed, as though earned from transmissions with beginning and end points within the United States, as U.S. source income at the usual graduated rates.156 If a foreign person who is engaged in a trade or business in the United States has income from communications transmissions for which beginning and end points cannot be established, the foreign person's communications income will also be taxed as U.S. source income, minus deductions, at graduated rates.157 However, if the foreign person is not engaged in a trade or business in the United States, this communications income will be taxed on a gross basis at a flat thirty percent rate with no deductions allowed as fixed and determinable annual or periodic income (FDAP).158

(i) Fixed and Determinable Annual or Periodic Income

If the foreign person, who earns income from a transmission with unknown beginning and end points, is not engaged in a trade or business in the United States, the gross income it earns that falls within the Default Rule in the proposed regulations would be taxed under sections 871 (a) or 881 (a) as FDAP income.159 FDAP is U.S. sourced passive investment income that is not effectively connected to a U.S. trade or business.160 FDAP is taxed on a gross basis, allowing for no deductions, at a thirty percent rate, unless reduced by treaty.161

(ii) Withholding Agents

FDAP is collected by the imposition of a duty by the payor if the payor has "control, receipt, custody, disposal, or payment" of the income, no matter what the payor's citizenship, location, or status, to withhold the tax from the payment to the taxpayer.162 In other words, the foreign taxpayer's customers would be considered withholding agents and would be required to withhold the thirty percent tax and send it to the U.S. government even if they were foreign nationals with no knowledge or understanding of U.S. tax law.163 If a withholding agent does not withhold thirty percent of the bill she pays to the taxpayer, she could be held personally liable for the entire amount of the tax as well as interest and penalties on the tax.164 Even if the foreign taxpayer pays its tax, the withholding agent could still be held liable for interest and penalties.165 The only ways a withholding agent can prevent the imposition of liability if she does not withhold the tax are:

(1) if she knows that the taxpayer is a U.S. person and she receives a Form W-9 from the taxpayer;166

(2) if the beneficial owner of the income is a foreign person entitled to an exemption from FDAP withholding and the withholding agent receives a Form W-8BEN from the taxpayer;167 or

(3) if the withholding agent receives documentation from a qualified intermediary who is not the beneficial owner of the money that has the qualified intermediary assume responsibility for withholding.168

c. Issues Raised by the Commenters

In our highly technical and "shrinking" world, the number of transmissions on any given day is, by any calculation, enormous. Because of the sheer impossibility of tracing the points at which a transmission may begin and end for each of these transmissions, especially in the cases of prepaid calling cards, Internet Protocol services, and with the use of software routing systems, the Default Rule has been criticized for its potential to tax all of these types of transmissions as U.S. source income even though none of the involved parties or transmissions have any connection with the United States.169

(i) The Difficulty of Determining Beginning and End Points

Several commenters raised the issue that in many situations it will be impossible to determine the beginning and end points of a transmission.170 Because telecommunications businesses could provide millions or billions of transmissions each year, tracking each one is "highly impractical."171 A coalition of telecommunications companies argued that, even if identification of beginning and end points is possible, this rule will place a burden on telecommunications providers to commit significant resources to attempt to develop the technology necessary to identify the beginning and end points of their transmissions.172 Another asserted that since billing for telecommunications transmissions is frequently based on the capacity used by the transmission rather than the beginning and end points of the transmission, records of origination and termination points of transmissions are not likely to be currently kept by telecommunications providers.173 A telecom association asserted that the recordkeeping requirements alone would lead to "enormous" storage expenses.174

A commenter stressed that if the Default Rule is included in the final regulations, the impossibility of setting beginning and end points of transmissions would be a growing problem, particularly since Internet protocol telephony is increasing in popularity.175 One commenter provided a real world example of this, discussing how Boeing Company is planning to launch "Connexion" to provide satellite-based, wireless Internet access to commercial airline passengers.176 While Boeing will be able to identify the location of the aircraft at the time of the transmission, it will not be able to identify the endpoint of the customer's communication.177 This could result in all of Boeing's income from this product being taxed in the United States even if there is no connection with the United States.

(ii) The Default Rule Could Cause Double Taxation, Would Deny the Foreign Tax Credit to U.S. Shareholders, and Would Dampen Competitiveness of Industry

One commenter argued that the Default Rule could result in double taxation, because the rule could subject income that is already subject to tax in another country to U.S. tax even when the transmission has no connection with the United States.178 For foreign telecommunications companies that are not engaged in a trade or business in the United States, all of the income from these transmissions would be subject to FDAP tax even though the communication could be entirely outside of the United States.179 One commenter emphasized that "[t]he negative competitive impact of such [FDAP] taxes can hardly be overstated."180 Another commenter raised the issue that U.S. shareholders of telecom CFCs would not receive the indirect foreign tax credit and that the Default Rule could impose U.S. tax on communications income earned outside of the United States by foreign taxpayers who are engaged in trade or business in the United States.181

A coalition of telecommunications companies argued that the Default Rule will place U.S. telecommunications companies at a competitive disadvantage vis-a-vis foreign telecommunications providers.182 U.S. companies will be forced to expend significant resources to show the beginning and end points of their communications and, in the alternative, may be subject to double taxation on these revenue streams.183 In contrast, they argued, enforcement of this rule on foreign telecommunications companies will be difficult and the foreign companies may not be forced to incur additional expenses in determining the beginning and end points of their transmissions and may be able to evade double taxation.184

(iii) Withholding Requirements Applied to Telecom Customers

Certain commenters found fault with the result that, under the FDAP rules, customers would be held responsible for withholding the thirty percent FDAP tax from their payments to telecommunications companies. For instance, one commenter asserted that "foreign customers will be quite astonished that they are subject to U.S. withholding tax with respect to payments they make to foreign subsidiaries of U.S. telecommunications companies."185 In addition, because customers would presumably know the beginning and end points of their communications, it is unlikely that, even if aware of this rule, any customer could predict with any certainty whether the telecommunications company providing the service also knows the beginning and end points and whether the Default Rule would apply.

(iv) Commenters' Recommendations

The commenters generally recommended that the Default Rule be omitted from the final regulations. They also suggested alternatives to complete omission. One suggested that the Default Rule be made to apply only to foreign taxpayers that own or have rights to telecommunications capacity in the United States.186 Another recommended that this rule only apply to controlled foreign corporations and the 1RS and Treasury should work with the telecommunications industry to develop a reasonable method of determining the beginning and end points of a transmission.187 A third recommended that if the Default Rule is retained in the final regulations, it should apply only for the purposes of the foreign tax credit.188

One coalition suggested that the Default Rule should be replaced with a compromise default rule that sources income from transmissions for which the beginning and end points are unknown should be treated as international communications income.189 With that type of rule, a U.S. person with these types of communications would have income that is half U.S. source and half foreign source, and a foreign person would have 100% foreign source income unless the income was attributable to a U.S. office or fixed place of business. 190 It suggested an exception to this rule for U.S. telecommunications providers who are paid to transmit communications that are all or substantially all within the United States.191 For these entities, the compromise default rule would require that all of the income from transmissions with unidentified beginning and end points would be U.S. sourced.192

One commenter strongly urged that the final regulations include a "reasonable method of allocation" rule that would allow any reasonable method of sourcing communications to be used by businesses as long as the method was used consistently.193 he asserted that through industry norms and, potentially, an industry-wide statistical analysis, an easy way of sourcing income from transmissions of communications activity could be developed that properly taxes income that should be sourced to the U.S. and international communications income.194 He also recommended that the Default Rule be replaced with a less "draconian" rule requiring: (1) U.S. sourcing for U.S. companies without a foreign office; (2) international communications income sourcing for U.S. companies with a foreign office; (3) international communications income sourcing for foreign companies without a U.S. office or fixed place of business; and (4) U.S. sourcing for income attributable to a foreign company's U.S. office or fixed place of business.195

d. An Additional Issue

One major oversight in the Default Rule that was not mentioned by the commenters above is the situation in which one of the end points of a transmission is known. There is no discussion within the Explanation of Provisions regarding the situation in which a taxpayer can establish that at least one end of the transmission is within a foreign country or a possession of the United States. In this situation, it is not possible under the proposed regulations that such a transmission would be considered U.S. sourced regardless of where the other end of the transmission was located. It would be international communications activity if the other endpoint was within the United States and it would be foreign sourced if the other endpoint was within a foreign country or possession of the United States or in space or international waters.196 However, if the known endpoint was in space or international waters, the unknown endpoint could be in the United States and the communication could be U.S. sourced.197 So if the one known endpoint was in space or international waters, the Default Rule would presumably apply. Similarly, if the known transmission endpoint was within the United States, it could possibly be U.S. sourced if the unknown endpoint was within the United States and therefore, the Default Rule should apply.198

e. Impact of the Default Rule on/,he Fictitious X-Land Group

The Default Rule will impact our X-Land group. While it is likely that PTT, the local telephone company, will be able to prove to the satisfaction of the Commissioner that all of the communications income it earns is sourced in X-Land, XJV and LT will have to make more detailed allocations. Under the Default Rule, LT will be forced to pay taxes on 100% of its communications income, even if this income is subject to foreign lax, unless LT proves that the income was either international communications income, sourced half in the United States, or foreign source income. This proof may be difficult or impossible unless LT develops a system tracing all of its transmissions on all of its telecommunications equipment.

XJV, the joint venture, can, in almost all instances,199 prove at least one endpoint of all of its transmissions-X-Land. Therefore, the majority of communications activity conducted by XJV could not be U.S. source. Its communications activity will always be either international communications activity or foreign communications activity. While the proposed regulations do not discuss a situation in which a foreign company cannot necessarily prove both beginning and end points of all of its communications activity, but can prove that none of its communications activity is U.S. sourced, it is unlikely that the Commissioner could find a reasonable justification for sourcing XJVs income in the United States.

In the event the Commissioner does not find XJVs proof convincing and XJV cannot successfully determine both beginning and end points to all of its transmissions, XJV would owe the thirty percent FDAP tax on its gross communications income. XJVs customers would be required to withhold this tax and send it to the U.S. government. If not, they could be held liable for the thirty percent FDAP tax that they failed to withhold, including interest and penalties.

3. The Resourcing Rule

Proposed Treasury Regulation section 1.863-9 (b) (2) (ii) (B), the Resourcing Rule, requires that if a foreign corporation, including a controlled foreign corporation within the meaning of section 957, is owned fifty percent or more by vote or value, directly, indirectly, or constructively, by U.S. persons, all of the income derived by that corporation from international communications activity is U.S. sourced.200 These types of foreign corporations are exempted from the ETB Rule discussed above.201

a. Treasury & 1RS Reasoning

The Resourcing Rule was included in the proposed regulations because the 1RS and Treasury had concerns that U.S. persons might use a foreign corporation to circumvent the requirements of section 863 (e) "to obtain benefits that are inconsistent with the purposes of this section."202 The 1RS and Treasury gave no further explanation for the Resourcing Rule.

b. Analysis oflhe Resourcing Rule Contrasted with Subpart F

(i) Ownership Requirements

Subpart F of the Code203 taxes U.S. persons who individually own at least ten percent of certain types of foreign corporations on their foreign earnings.204 These earnings are taxed as dividends to the U.S. persons even if they are not distributed.205 Only a U.S. shareholder of a Controlled Foreign Corporation (CFC), as defined under section 957, is subject to this tax.206 In order to be considered a CFC, a foreign company must be a corporation that is owned and controlled by U.S. shareholders.207 A U.S. shareholder is a U.S. person who owns, directly, indirectly or constructively, ten percent or more of the total combined voting power of the classes of stock in the corporation that are entitled to vote.208 In order to be considered a CFC, the U.S. shareholders must own, directly, indirectly, or constructively, over fifty percent of the foreign corporation's combined voting power and value on any day of the taxable year.209 To make the determination of ownership, the Code requires that only the holdings of U.S. shareholders (U.S. persons that own individually at least ten percent of the corporation) are considered.210 This means that U.S. persons who own less than ten percent of the foreign corporation are not considered when determining whether the foreign corporation is a CFC.

Under the Resourcing Rule in the proposed regulations all U.S. persons, no matter how small their holdings, who own a share of the foreign corporation are included in the determination of whether the foreign corporation is U.S. owned.211 This means that many more foreign corporations will be subject to these proposed regulations than are subject to the subpart F statutes and regulations.

(ii) Direct, Indirect and Constructive Ownership

In order to be taxed under subpart F, a U.S. person must own stock directly, indirectly or constructively in a CFC.212 Direct ownership is actual ownership of the stock by the U.S. person.213 Indirect ownership of stock occurs when stock owned by or for a foreign corporation, foreign partnership, or foreign trust, or estate is considered proportionately owned by its shareholders, partners, or beneficiaries.214 Constructive ownership applies the general corporate attribution rules under section 318(215) to the ownership of foreign corporations, with a few differences.216

Determining constructive and indirect ownership can be difficult even when dealing with U.S. shareholders who own at least ten percent of a CFC because the familial and business relationships of each U.S. person who is an owner must be known before the entirety of the U.S. ownership rights can be determined to discern whether the U.S. owners are U.S. shareholders and whether the foreign corporation is a CFC. A U.S. shareholder pays tax on subpart F income directly, though, rather than the CFC paying taxes on behalf of the U.S. shareholder.217 The U.S. shareholder is in a better position to know its relationships than is the CFC. In contrast, under the Resourcing Rule in the proposed regulations, the foreign corporation's customers would be responsible for paying the tax. Therefore, the foreign corporation would be required to know the familial and business relationships of all of the U.S. persons who own any portion of the foreign corporation and make that information public to all of its customers, who would be required to withhold the FDAP taxes on the income.

(iii) Foreign Tax Credit

Section 901 (a) allows an income tax credit for foreign income taxes paid or deemed paid by U.S. citixens, residents, and domestic corporations.218 Taxpayers must elect to use the foreign tax credit in lieu of deducting the taxes under section 164(a).219 The foreign tax credit is intended to lessen the burden of double taxation that results when income earned in a foreign country is taxed by both the United States and the foreign country.220 The foreign tax credit is limited under section 904(a) to an amount equal to the U.S. tax on the taxpayer's foreign source income.221 The foreign tax credit is not allowed for foreign taxes paid on U.S. source income.222 Under section 904(a), all of the foreign income earned and taxes paid by a U.S. person are lumped together in determining the credit limitation.223 However, this rule is frequently superceded by other rules that place certain types of income and credits into separate "baskets" to limit taxpayers' ability to manipulate the credit limitations and pay less tax.224

The Resourcing Rule extends the taxation of foreign corporations far beyond the subpart F taxation scheme for taxing the income of controlled foreign corporations owned by U.S. shareholders.225 Under the proposed regulations, it is not necessary for this type of corporation to have any connection at all with the United States beyond its ownership.226 In addition, there is no limitation on the number of individual U.S. owners that are considered in determining ownership.227 Nor does it consider how the status of the owners, either as U.S. persons or non-U.S. persons, is to be determined, particularly concerning indirect and constructive ownership.228

Income that is taxed under the proposed regulations regarding U.S. owned foreign corporations is subject to a thirty percent gross FDAP tax.229 If the foreign corporation has income that is effectively connected with a U.S. office or fixed place of business or is engaged in a trade or business in the United States, this section of the proposed regulations will not apply.230 Additionally, the collection of this tax will require withholding by the customers of the foreign corporation as withholding agents.251

Indirect and constructive ownership of the foreign corporation must be considered in determining whether the foreign corporation is fifty percent U.S. owned.232 While the proposed regulations do not specify where in the Code these terms are defined for the purposes of this section, indirect and constructive ownership in the corporate context is generally determined under the requirements of section 318. However, constructive and indirect ownership can also be determined under section 958.233

c. Issues Raised By Commenters

Several commenters to the proposed regulations commented on the Resourcing Rule.234 The Resourcing Rule greatly extends the reach of U.S. taxingjurisdiction for international communications income.

(i) No Basis for Resourcing Rule in the Code and Legislative History

Several commenters asserted that the legislative history of section 863(e) provided no basis for creating the Resourcing Rule, that it goes against congressional intent, and that the rule improperly extends the taxingjurisdiction of the United States. They argued that the intent of Congress in extending regulatory authority provided under section 863(e) was merely to allow the Treasury and 1RS to prevent the increase in the utilization of the foreign tax credit through the use of controlled foreign corporations, not to increase U.S. taxing jurisdiction.235 Another commenter argued that Congress's intent in granting regulatory authority to the 1RS and Treasury to treat international communications income derived by a foreign person like a controlled foreign corporation as other than foreign source was to maintain parity between controlled foreign corporations and U.S. persons.236 The legislative history did not anticipate imposing FDAP taxes and withholding rules on U.S. owned foreign corporations for international communications income while foreign corporations with little or no U.S. ownership are not taxed on their international communications income in any way.237

(ii) Impossibility of Determining Ownership and Residence

One of the main issues discussed by the commenters regarding the Resourcing Rule is the impossibility of determining exactly who owns a foreign corporation. Inherent in this difficulty is the impossibility of determining where each owner resides-a necessary part of establishing U.S. ownership under this rule. For instance, two commenters argued that the requirement that each foreign corporation determine its U.S. ownership is impossible to meet for any publicly traded corporation and many private corporations. Because the shares of publicly traded corporations and many large private corporations change hands frequently, the shares may be held in names other than their actual owners, and the owners' residences and citizenship cannot be determined practically.238 Attempting to determine the residence of a foreign corporation's owners becomes even more impossible when the indirect and constructive ownership rules of section 958 are consid-ered.239

(iii) Double Taxation and Difficulty in Collection

Many commenters emphasized that the Resourcing Rule will lead to double taxation of the U.S. owners of foreign corporations who will not be able to claim a foreign tax credit for income taxes they pay in other countries. Commenters discussed that the Resourcing Rule will prevent many U.S. shareholders from claiming U.S. foreign tax credits or other benefits for taxes paid by the foreign corporation, which would result in double taxation of this income.240 The commenters stressed that the Resourcing Rule penalizes U.S.-owned foreign corporations by making their international communications income entirely U.S. source (compared to a U.S. person's international communications income that is treated as only fifty percent U.S. sourced) and removes any foreign tax credit from this type of income.241

More than one commenter explained that the Resourcing Rule could subject a U.S.-owned foreign corporation to a tax of more than 100% of their pre-tax net income from international communications income if the foreign corporation has significant expenses and is taxed on FDAP income at thirty percent of the gross income of the taxpayer and if the taxpayer is also taxed by its country of residence or any other country claiming jurisdiction over the income.242 In addition to these corporate-level tax layers, the U.S. shareholders of the foreign corporation would be subject to tax on the dividends they receive from the corporation and would be unable to offset the U.S. tax using foreign tax credits.243 U.S. shareholders in such companies would not receive an offset for U.S. taxes paid by the foreign corporation because FDAP taxes, which are required to be withheld by the payor, are not creditable against the shareholders' U.S. tax liability.2'14 They would also be unable to use the direct or indirect foreign tax credit.245 The combination of all of the potential tax liability at all levels could result in double or triple taxation, at least partially on a gross basis.246 A commenter argued that "[t]he only possible justification for this result would be a policy that U.S. investors in foreign corporations incorporated in non-treaty countries that earn [international communications income] should be severely penali/ed."247

Two commenters addressed the difficulty of imposing, administering, and enforcing the FDAP withholding rules on customers of foreign telecommunications companies, and noted that it could lead to multiple withholdings by potentially multiple withholding agents.248 They argued that the rule imposes withholding obligations on foreign corporations that may not be able to be administered or enforced, and raises the possibility of multiple withholdings of taxes by withholding agents.249 They suggested that the imposition of this tax would be difficult to enforce because it would require foreign persons paying for telecommunications services to withhold portions of payments for FDAP purposes, which is unlikely to occur.250

(iv) Competition Issues

Several commenters proposed that the Resourcing Rule, if finalized, will act to prevent U.S. telecommunications companies from being competitive with foreign telecommunications companies and will limit U.S. companies' opportunities to expand their businesses globally. One commenter complained that this rule, for no stated reason, would penalize U.S. telecommunications companies that do business abroad through foreign corporations.251 Another asserted that the Resourcing Rule will have a punitive effect on U.S. telecommunications companies operating though foreign subsidiaries and would "severely impact their ability to form offshore joint ventures and to acquire foreign companies."252 Because of this, the Resourcing Rule will have the apparently unintended consequence of impeding the competitiveness of U.S. telecommunications companies.253 U.S. companies may not be able to enter into joint ventures with foreign companies for fear of creating a fifty percent owned foreign corporation subject to the rule.254

A commenter asserted that, while U.S-owned foreign telecommunications companies were rare at the time section 863 (e) was enacted, these types of companies are now common and will likely become even more common in the future because foreign governments have and will continue to privatize local telephone companies and allow foreign investors to purchase large stakes in those companies.255 Many of these stakes have been purchased by U.S. telecommunications companies in concert with foreign telecommunications companies, often in joint venture form.25*' A commenter argued that these companies were not formed to manipulate the U.S. tax laws and they should not be penali/.ed by the Resourcing Rule for doing so.257

(v) Commenters' Recommendations

Most of the commenters to the Resourcing Rule suggested that the Resourcing Rule be omitted from the final regulations. They also provided alternative solutions. For instance, one recommended that the rule be limited to resourcing income for foreign tax credit purposes only,258 while another argued that this rule is not actually a sourcing rule, but rather is an extension of the anti-deferral rules governing controlled foreign corporations under subpart F of the Code.259 They recommended that if changes are to be made in the anti-deferral rules, they should be made in subpart F.260

One commenter emphasized that international communications income derived by foreign persons is generally foreign source under section 863(e), and that the 1RS and Treasury should apply this general principle to the proposed regulations.251 he recommended that the 1RS and Treasury source this income in the same way that it is sourced under section 863(e), which sources international communications income derived by U.S. persons-as half U.S. sourced and half foreign sourced.262

Another commenter recommended that the Resourcing Rule be considered an anti-abuse rule and that the Treasury and 1RS limit its application to situations in which there is an actual attempt to manipulate the foreign tax credit limitation by shifting previously U.S. based international communications income to a foreign company.263 He suggested that the Resourcing Rule not be applied if any of the following circumstances exist: (1) the foreign corporation is publicly traded or widely held; (2) the international communications income is subject to a ten percent foreign tax; or (3) the company conducts an active business in a foreign country.264

d. Application of the Resourcing Rule to the Fictilious X-Land Group

In our fictitious scenario, only XJV, the joint venture between LT and PTT, would be affected by this rule. XJV is clearly fifty percent U.S. owned because LT owns fifty percent of XJV's stock. However, as discussed above, XJV can prove that none of its communications activity is U.S. communications activity because at least one endpoint of every transmission it is paid to do is located in X-Land. This means that the income derived from XJV's communications activity is either international communications income or foreign communications income. While no standard for allocating income was set out in the proposed regulations, one would hope that the Commissioner would find such an argument compelling.

In the event that the Commissioner decides that this proof is not sufficient, and if XJV is not determined to be engaged in a U.S. trade or business, it would be subject to a thirty percent FDAP tax rate on potentially all its communications income. These taxes would have to be withheld by XJV's customers, the citi/ens and tourists of X-Land, and sent to the U.S. government. If they were not properly withheld, the U.S. government would have an action against the customers for the amount of the tax plus penalties and interest. In any event, LT would not be entitled to a foreign tax credit on this income because XJV is not a CFC.

4. The Space and Ocean Characterization Rule

Perhaps the most complicated issue in the proposed regulations is the characterization and sourcing of non-international communications income, known as the Space and Ocean Characterization Rule. To grasp the consequences of this rule, one must first untangle several confusingly worded sections of Proposed Treasury Regulations sections 1.863-8 and 1.863-9, and then apply the foreign tax credit rules.

It is clear under sections 863 (e) and 863 (d) and Proposed Treasury Regulations sections 1.863-9 and 1.863-8 that income from international communications activity is not sourced or characterized as space and ocean activity, even if the transmission involves the use of satellites or ocean vessels or cables running beneath the ocean.265 However, the characterization and sourcing of income from communications activity that utilizes satellites and under ocean cable that is not international communications activity is not as clear. One difficulty is that the two proposed regulations sections must be read together to arrive at the means of sourcing and characterizing this type of communications income, and in places, the proposed regulations appear contradictory. In addition, income from non-international communications activities that partially occur in space or international water must be characterized twice, both as a specific type of communications income under the Proposed Treasury Regulation section 1.863-9 and as space or ocean communications activity under Proposed Treasury Regulation section 1.863-8. Proposed Treasury Regulation section 1.863-9 determines how the income is sourced and Proposed Treasury Regulation section 1.863-8 affects how the income is dealt with for subpart F purposes.

Other non-international communications activity,266 as denned within the Proposed Regulations, includes:

(1) "U.S. communications activity" defined as communications activity occurring completely within the U.S. or between the U.S. and a point in space or international water, income from which is U.S. sourced;267

(2) "foreign communications activity," defined as communications activity occurring entirely within foreign countries and/or possessions of the U.S. or between a foreign country or possession of the U.S. and space or international water, income from which is foreign sourced;268 and

(3) "space/ocean communications activity" defined as communications activity occurring between two points in space and/or international water, income from which is sourced under section 863 (d) and Proposed Treasury Regulations section 1.863-8.269

U.S. communications activity and foreign communications activity are characterized as space and ocean communications activity if any portion of the transmission constituting the communications activity occurs in space or international water, but are still sourced under Proposed Treasury Regulation section 1.863-8.270 However, income from U.S. communications activity that is also space and ocean activity is not affected by the Space and Ocean Characterization Rule. Whether or not U.S. communications activity is also space and ocean activity, it will be U.S. sourced no matter by whom it is earned and will be subject to U.S. taxes, either at graduated rates if earned by either a U.S. person or a foreign person engaged in U.S. trade or business, or at the thirty percent gross FDAP tax rate if earned by a foreign person not engaged in a trade or business in the United States.271 Similarly, income earned from space or ocean communications is not affected by this rule because such income is always characterized as space or ocean communications income and is sourced depending on whether the income was earned by a U.S. person or a foreign person as required by section 863 (d) and Proposed Treasury Regulation section 1.863-8, completely without regard to the sourcing rules in Proposed Treasury Regulation 1.863-9.272

The main problem with the Space and Ocean Characterization Rule arises with income earned from foreign communications activity. This income will still be considered foreign source no matter by who earned, just like foreign communications income that does not utilize satellites or under ocean cables. However, foreign communications income that is also space and ocean income earned by CFCs will be characterized as shipping income and will be placed in the shipping basket for foreign tax credit purposes.273

a. Treasury and 1RS Reasoning

The Treasury and 1RS relied on the authority granted to them in section 863(d)(l) in requiring that income from communications activity that is also space or ocean activity is sourced under the space and ocean sourcing rules.274 The Treasury and 1RS did not discuss the subpart F and foreign tax credit consequences of this provision on the telecommunications CFCs and their U.S. shareholders. It is not clear whether the Treasury and 1RS intended these consequences.

b. Analysis of the Space and Ocean Characterization Rule

Prior to the issuance of these proposed regulations, communications satellites and transoceanic cables were considered to be exempted from section 863 (d), and instead income from their use was taxed completely under section 863(e).275 However, as a result of this proposed regulation, foreign communications income that is also space and ocean activity will be characterized as subpart F income and will be included in the shipping basket for foreign tax credit purposes.276 In order to comply with the proposed regulations, telecommunication companies must track every foreign communication to determine whether it begins and ends in a satellite or in international water, or whether it utilizes satellites or under ocean cables in any portion of the transmission. In many cases this may be difficult or impossible because of the number of transmissions made by large telecommunications companies and the automatic routing systems used that route transmissions along certain routes on the basis of other criteria and do not keep track of the routes.277

(i) Characterization and Sourcing

Under the proposed regulations, the characterization and sourcing of communications income (other than international communications income) that utilizes satellites or underwater cable are addressed in different sections.278 The proposed regulations characterize communications income (other than international communication income) as space or ocean activity if the transmission occurs in space or international water under section 863 (d) and Proposed Treasury Regulations section 1.863-8.279 However, all communications income, with the exception of space or ocean communications income, is sourced under section 863 (e) and Proposed Treasury Regulations section 1.863-9. Proposed Treasury Regulation section 1.863-8 (b) (6) states:

Special Rule for determining source of income from communications activity (other than income from international communications activity). Space and ocean activity, as defined in paragraphs (d)(l) and (2) of this section, includes activity occurring in space or in international water that is characterized as a communications activity as defined in 1.863-9(d). The source of gross income from space or ocean activity as defined in 1.863-9 (d) is determined under the rules of 1.863-9 (b), rather than under paragraph (b) of this section.280

Although the first sentence in this section states that space and ocean activity as characterized under Proposed Treasury Regulation section 1.863-8 includes communications activity occurring in space or in international water, which could include communications transmissions that are transmitted via satellite or underwater fiber optic cable, the second sentence requires that the source of gross income from communications activity that is also space and ocean activity is determined under Proposed Treasury Regulation section 1.863-9 rather than in Proposed Treasury Regulation section 1.863-8. Proposed Treasury Regulation section 1.863-8 (d) (1) states that space and ocean activity includes activities occurring in space or international waters that are characterized as communications activity.281 Proposed Treasury Regulation section 1.863-9 (b) (1) further states that the performance of services (like the transmission of a communication) will be treated as a space or ocean activity when a part of the service, even if de minimis, is performed in space or international water.282 Therefore, under the proposed regulations for sourcing space and ocean activities, every communications activity, with the exception of international communications activity, which is specifically excluded from Proposed Treasury Regulation section 1.863-8,283 will be characterized as a space or ocean activity even if only a small portion of the transmission utilizes satellites or underwater cables.

Proposed Treasury Regulation section 1.863-9 limits the communications activities that are sourced under the space and ocean proposed regulations to space or ocean communications and provides the source for every other type of communications activity. Proposed Treasury Regulation section 1.863-9(b) (1) states:

Source of gross income derived from communications activity -(1) In general. The source of gross income derived from each type of communications activity, as defined in paragraph (d) (3) of this section, is determined under this paragraph (b). If a communications activity would qualify as space or ocean activity under section 863 (d) and the regulations thereunder, the source of income derived from such communications activity is determined under this section, and not under section 863 (d) and the regulations thereunder.284

This section usurps the authority of section 863 (d) and Proposed Treasury Regulation section 1.863-8 to source communications activity, with the exception of space or ocean communications activity, in which the taxpayer is paid to transmit between two points in space and/or international waters.285 The source of income derived from space or ocean activity is determined under section 863 (d) and the regulations thereunder, "without regard to 1.863-8(b) (6) ."286

c. Issues Raised by Commenters

Several commenters criticized the Space and Ocean Characterization Rule on several grounds.

(i) Unfairness from Different Treatment of Communications Income

Many commenters noted the unfair and unjustified consequences the Space and Ocean Characterization Rule causes under subpart F. For instance, several commenters have argued that the cross references in the Code and the overlap between the definitions of space and ocean income and communications income have a major impact on the foreign tax credits and subpart F income of telecommunications companies because the proposed regulations would cause the communications income that is also space and ocean income to be treated as shipping income.287 This would mean that telecommunications companies would have their communications income and foreign tax credits attributable to that income split between the general limitations basket and the shipping basket.288 If the income and foreign tax credits are split in this manner between the baskets, they will not be able to offset taxes on each other and other income earned by the telecommunications company. One commenter asserted that the result of this "strange dichotomy" would be that cross crediting would be prohibited between these baskets, and telecommunications companies would have an "enormous administrative and technological burden of keeping track of the means by which foreign-to-foreign communications were transmitted."289 he also asserted that the U.S. shareholders of CFCs that earn this type of communications income would have to take this income into account under subpart F.290

Another commenter argued that the disparity in the foreign tax credit treatment of space and ocean communications income and non-space and ocean communications income is not appropriate because all types of active business income should be included in the general limitations basket, and there is no justification for treating the types of communications income differently.291 Using a real world example, another commenter claimed that this change in the law would have a major negative economic impact on the IDT Corporation's operations because it would be required to devote significant resources to redesign its system to track foreign communications activity that occurs in space or international waters and will add to its tax costs.292 he asserted that, especially considering the current difficult environment for telecommunications companies, this rule will "destroy competitive economic advantages and threaten the economic viability of members of [the] telecommunications industry."293

(ii) Rule Opposes Legislative History and Tax Policy

Commenters argued that the results of the Space and Ocean Characteri/ation Rule are contrary to the legislative intent behind sections 863(d) and (e) and that putting foreign communications income into the shipping basket is inconsistent with U.S. tax policy.294 They argued that the legislative history of section 863 (e) shows that the reason international communications income was carved out of space and ocean income was because it has the potential to be taxed in a foreign country.295 Similarly, foreign communications income was sourced as 100% foreign source because it has the potential to be taxed in more than one country.296 One commenter also cited to the legislative history of section 904 in arguing that foreign communications income should not be placed in a separate basket, because the reasons for separating the income-(1) the income's source can be manipulated; (2) the income typically bears little to no foreign tax; or (3) the income often bears a rate of foreign tax that is abnormally high-do not apply here.297

(iii) Commenters' Recommendations

Commenters suggested that foreign communications income be either recharacterized as international communications income298 or that all communications income be specifically excluded from the definition of space and ocean income.299 Commenters asserted that the results discussed above were likely unintended by the 1RS and Treasury.300 They recommended that all communications income be specifically excluded from the definition of space and ocean income in order to "rationalize the basket treatment of income from communications activity and prevent unwarranted subpart F consequences."301 One commenter recommended that the definition of international communications income simply be broadened to include all communications income that occurs outside the United States.302

d. Impact of the Space and Ocean Characterization Rule on our Fictitious X-Land Group

This rule would not negatively affect our X-Land Consortium. XJV, the joint venture, and LT, the large U.S. corporation, both earn income derived from communications activity that passes through underwater cable or satellites. This income could be foreign sourced or U.S. sourced. In either case it would be characterized as space and ocean activity under Proposed Treasury Regulation section 1.863-8. However, this characterization would have no impact on XJV or LT because XJV is not a CFC. Therefore, the foreign communications income that is included in X]Vs earnings and profits would not be taxed to LT as a dividend. And LT would not be allowed a foreign tax credit for taxes paid to X-Land and other foreign governments.

V. CONCLUSION

The proposed regulations promulgated by the Treasury and 1RS under sections 863(e) and 863 (d) contain many controversial and complicated issues. In particular, the issues raised by four of the rules contained in the proposed regulations, the ETB Rule, the Default Rule, the Resourcing Rule, and the Space and Ocean Characterization Rule, raise many difficult questions. For instance, what was the intent of Congress in granting broad authority to the Treasury and 1RS to promulgate regulations for the sourcing of communications income? What is a fair way to collect taxes on telecommunications income when the industry changes constantly and billions of transmissions are made all over the world every day? How can the government modify the current tax structure to deal with specific challenges within the telecommunications industry without causing a ripple effect into the myriad of other tax laws that affect the industry, such as subpart F, the foreign tax credit, and FDAP taxes? The 1RS and Treasury made a valiant effort to address these issues in the proposed regulations. However, the telecommunications industry, both in the United States and abroad, is being hit hard by current economic and societal woes.303 To prevent harming the already beleaguered telecommunications industry, the Treasury and 1RS should make changes to these proposed regulations.

The ETB Rule stands on a foundation that is ephemeral and imprecise-the "engaged in U.S. trade or business" standard. In addition, the ETB Rule results in the potential taxation of all of the communications income of a foreign company, whether or not it has a connection with the United States. This rule is designed to prevent tax avoidance by telecommunications companies who engage in a trade or business in the United States but do not pay taxes because they do not have a U.S. office or fixed place of business. This abuse does not appear to be widespread. Even Congress, in promulgating Code section 863(e), used the "office or fixed place of business" standard rather than the "engaged in trade or business" standard to tax foreign telecommunications companies operating in the United States. As recommended by several commenters, the ETB Rule should be removed from these regulations when finalized in order to prevent unfair taxation of communications income that has no connection with the United States.

The Default Rule is overbroad and does not take into account the complexity and volume of transmissions that are made every day. It is unlikely that Congress intended the 1RS and the Treasury to extend the authority of the United States to tax all income from communications around the world for which both beginning and end points are unknown. It is apparent that neither Congress nor the Treasury and 1RS foresaw the difficulties in tracking the beginning and end points of each individual transmission. The proposed regulations should be rewritten to provide objective and reasonable standards that can be used by the telecommunications industry to make broad estimates as to the location of the beginning and end points of their communications activity. The Default Rule could then be used only in the limited instances in which a telecommunications company could not or refused to apply the estimation techniques. The Default Rule should also be rewritten to cause the income from such transmissions to be sourced as international communications income, rather than U.S. communications income. This would be a fair compromise because then only half of the income would be taxed in the United States (rather than all of the income being taxed in the United States). Further, this income should be expressly considered effectively connected income taxed on a net basis at graduated rates. The complexity of requiring FDAP withholding by telecommunications customers is too great considering the number of withholding agents that would be involved and the likelihood that these agents would not even know of their status.

The Resourcing Rule is a complete departure from the tax policies currently observed under the Code and regulations and would lead to gross unfairness to both U.S.-owned foreign telecommunications companies and their shareholders. Instead of imposing the herculean, and likely impossible, task of determining the level of U.S. ownership in every telecommunications company in the world and risking increased competitive stagnation in the U.S. telecommunications industry, the 1RS and Treasury should delete the Resourcing Rule from the final regulations, and instead simply utilize the anti-deferral rules under subpart F to prevent any potential abuses under section 863(c).

The Space and Ocean Characterization Rule is simply too complex. Because the Explanation of Provisions does not discuss the foreign tax credit issues raised by this rule, it seems that these results were not intended by the Treasury or 1RS and the final regulations should be altered to prevent these unintended results. The simplest solution, and the one that would comply with the legislative intent in section 863 (e), would be to simply exempt all communications income from section 863(d) and Proposed Treasury Regulation section 1.863-8, which source space and ocean activity. The sourcing of communications income would be unaffected by this change, but foreign tax credits and income from foreign communications activity that use satellites and under ocean cable would be included in the general limitations basket with other foreign communications income and tax credits.

As with most international telecommunications joint ventures, the proposed regulations, in their current form, would cause many difficulties for the hypothetical X-Land Group, as discussed above. Not only would the companies involved be forced to substantially modify their systems to track and record the beginning and end points of all of the communications that they are paid to transmit, they would be subject to potentially substantial increases in the U.S. taxes they pay and enormous increases in the complexity of filing those taxes. The 1RS and Treasury had a difficultjob in drafting these proposed regulations. The telecommunications industry is very complicated and does not meld well into the "bricks and mortar" style income sourcing rules.304 However, drafting regulations to allow for the fair taxation of communications income is not impossible. The current proposed regulations have so many unfair, and apparently unforeseen, consequences on this industry, that they should be seriously reconsidered.305 Modifying, and in some cases, deleting the rules discussed above in the final regulations would decrease the complexity and unfairness of these regulations, while ensuring that the United States collects an appropriate level of tax on communications income.