is the entire taxable income. Accordingly, in this case, the statutory grouping is foreign source income (including, for example, interest received from a domestic corporation which meets the tests of section 861(a)(1)(B), dividends received from a domestic corporation which has an election in effect under section 936, and other types of income specified in section 862). Pursuant to sections 862(b) and 863(a) and §§ 1.862-1 and 1.863-1, this section provides rules for identifying the deductions to be taken into account in determining taxable income from sources without the United States. See section 904(d) (as in effect after enactment of the Tax Reform Act of 1976) and the regulations thereunder which require separate treatment of certain types of income. See example (3) of paragraph (g) of this section for one example of the application of this section to the overall limitation. (ii) Per-country limitation to the foreign tax credit. Under the per-country limitation to the foreign tax credit, as provided in section 904(a)(1) (as in effect before enactment of the Tax Reform Act of 1976), the amount of the foreign tax credit for income taxes paid to a specific foreign country (or possession of the United States) may not exceed the tentative U.S. tax (i.e., the U.S. tax before application of the foreign tax credit) multiplied by a fraction, the numerator of which is the taxable income from sources within the foreign country and the denominator of which is the entire taxable income. Pursuant to § 1.863-6, the gross income and the taxable income from sources within a specific foreign country are determined under the same principles as are applied in determining gross income from sources within the United States (generally §§ 1.861-1 to 1.861-7) and taxable income from sources within the United States (generally this section). See section 904(d) (as in effect after enactment of the Tax Reform Act of 1976) and the regulations thereunder which require separate treatment of certain types of income. See example (16) of paragraph (g) of this section for an example of the application of this section to the per-country limitation. (iii) DISC taxable income. Section 994 provides rules for determining the taxable income of a DISC with respect to qualified sales and leases of export property and qualified services. The "50-50" combined taxable income method available for making such determination provides, without consideration of export promotion expenses, that the taxable income of the DISC shall be 50 percent of the combined taxable income of the DISC and the related supplier derived from such sales and leases of export property and such services. Pursuant to regulations under section 994, this section provides rules for determining the deductions to be taken into account in determining such combined taxable income, except to the extent modified by the marginal costing rules set forth in the regulations under section 994(b)(2) if used by the taxpayer as provided therein. See examples (22) and (23) of paragraph (g) of this section. In addition, the computation of combined taxable income is necessary to determine the applicability of both the general and special "no loss" rules of the regulations under section 994. (iv) Effectively connected taxable income. Nonresident alien individuals and foreign corporations engaged in trade or business within the United States, under sections 871(b) and 882, are taxable at ordinary rates, as provided in section 1 or 1201(b), and section 11 or 201(a), on taxable income which is effectively connected with the conduct of a trade or business within the United States. Such taxable income is determined in most instances by initially determining, under section 864(c), the amount of gross income which is effectively connected with the conduct of a trade or business within the United States. Pursuant to sections 873 and 882(c), this section is applicable for purposes of identifying the deductions from such gross income to be taken into account in determining such taxable income. In certain cases the provisions of an income tax treaty between the United States and a foreign country may apply in determining the taxable income of a nonresident alien individual or foreign corporation. In such cases the provisions of the treaty shall take prece dence over this section. See example (21) of paragraph (g) of this section. (v) Foreign base company income. Section 954 defines the term "foreign base company income" with respect to controlled foreign corporations. Section 954(b)(5) provides that in determining foreign base company income the gross income shall be reduced by the deductions of the controlled foreign corporation "properly allocable to such income". This section provides rules for identifying which deductions are properly allocable to foreign base company income. (vi) Other operative sections. The rules provided in this section also apply in determining (A) The amount of foreign source items of tax preference under section 58(g) determined for purposes of the minimum tax; (B) The amount of foreign mineral income under section 901(e); (C) The amount of interest income and the income from certain distributions from a DISC or former DISC to which the foreign tax credit limitation is applied separately under section 904(d) (as in effect after enactment of the Tax Reform Act of 1976); (D) The amount of foreign oil and gas extraction income and the amount of foreign oil related income under section 907; (E) The tax base for citizens entitled to the benefits of section 931 and the section 936 tax credit of a domestic corporation which has an election in effect under section 936; (F) The exclusion for income from Puerto Rico for residents of Puerto Rico under section 933; (G) The limitation under section 934 on the maximum reduction in income tax liability incurred to the Virgin Islands; (H) The income derived from Guam by an individual who is subject to section 935; (I) The special deduction granted to China Trade Act corporations under section 941; (J) The amount of certain U.S. source income excluded from the subpart F income of a controlled foreign corporation under section 952(b); (K) The amount of income from the insurance of U.S. risks under section 953(b)(5); (L) The international boycott factor and the specifically attributable taxes and income under section 999; and (M) The taxable income attributable to the operation of an agreement vessel under section 607 of the Merchant Marine Act of 1936, as amended, and the Capital Construction Fund Regulations thereunder (26 CFR, pt. 3). See 26 CFR 3.2(b)(3). (2) Application to more than one operative section. Where more than one operative section applies, it may be necessary for the taxpayer to apply this section separately for each applicable operative section. In such a case, the taxpayer is required to use the same method of allocation and the same principles of apportionment for all operative sections. (3) Special rules of section 863(b)— (i) In general. Special rules under section 863(b) provide for the application of rules of general apportionment provided in §§ 1.863-3 to 1.863-5, to worldwide taxable income in order to attribute part of such worldwide taxable income to U.S. sources and the remainder of such worldwide taxable income to foreign sources. The activities specified in section 863(b) are— (A) Transportation or other services rendered partly within and partly without the United States, (B) Sales of personal property produced by the taxpayer within and sold without the United States, or produced by the taxpayer without and sold within the United States, and (C) Sales within the United States of personal property purchased within a possession of the United States. In the instances provided in §§ 1.863-3 and 1.863-4 with respect to the activities described in (A), (B), and (C) of this subdivision, this section is applicable only in determining worldwide taxable income attributable to these activities. (ii) Relationship of sections 861, 862, 863(a), and 863(b). Sections 861, 862, 863(a), and 863(b) are the four provisions applicable in determining taxable income from specific sources. Each of these four provisions applies independently. Where a deduction has been allocated and apportioned to income under one of these four provisions, the deduction shall not again be in allocated and apportioned to gross income under any of the other three provisions. However, two or more of these provisions may have to be applied at the same time to determine the proper allocation and apportionment of a deduction. The special rules under section 863(b) take precedence over the general rules of Code sections 861, 862 and 863(a). For example, where a deduction is allocable whole or in part to gross income to which section 863(b) applies, such deduction or part thereof shall not otherwise be allocated under section 861, 862, or 863(a). However, where the gross income to which the deduction is allocable includes both gross income to which section 863(b) applies and gross income to which section 861, 862, or 863(a) applies, more than one section must be applied at the same time in order to determine the proper allocation and apportionment of the deduction. (4) Adjustments made under other provisions of the Code-(i) In general. If an adjustment which affects the taxpayer is made under section 482 or any other provision of the Code, it may be necessary to recompute the allocations and apportionments required by this section in order to reflect changes resulting from the adjustment. The recomputation made by the District Director shall be made using the same method of allocation and apportionment as was originally used by the taxpayer, provided such method as originally used conformed with paragraph (a)(5) of this section and, in light of the adjustment, such method does not result in a material distortion. In addition to adjustments which would be made aside from this section, adjustments to the taxpayer's income and deductions which would not otherwise be made may be required before applying this section in order to prevent a distortion in determining taxable income from a particular source of activity. For example, if an item included as a part of the cost of goods sold has been improperly attributed to specific sales, and, as a result, gross income under one of the operative sections referred to in paragraph (f)(1) of this section is improperly determined, it may be necessary for the District Di rector to make an adjustment to the cost of goods sold, consistent with the principles of this section, before applying this section. Similarly, if a domestic corporation transfers the stock in its foreign subsidiaries to a domestic subsidiary and the parent continues to incur expenses in connection with the supervision of the foreign subsidiaries (see paragraph (e)(4) of this section), it may be necessary for the District Director to make an allocation under section 482 with respect to such expenses before making allocations and apportionments required by this section, even though the section 482 allocation might not otherwise be made. (ii) Example. X, a domestic corporation, purchases and sells consumer items in the United States and foreign markets. Its sales in foreign markets are made to related foreign subsidiaries. X reported $1,500,000 as sales during the taxable year of which $1,000,000 was domestic sales and $500,000 was foreign sales. X took a deduction for expenses incurred by its marketing department during the taxable year in the amount of $150,000. These expenses were determined to be allocable to both domestic and foreign sales and are apportionable between such sales. Thus, X allocated and apportioned the marketing department deduction as follows: To gross income from domestic sales: Total $100,000 50,000 150,000 On audit of X's return for the taxable year, the District Director adjusted, under section 482, X's sales to related foreign subsidiaries by increasing the sales price by a total of $100,000, thereby increasing X's foreign sales and total sales by the same amount. As a result of the section 482 adjustment, the apportionment of the deduction for the marketing department expenses is redetermined as follows: To gross income from domestic sales: Total $93,750 56,250 150,000 (5) Verification of allocations and apportionments. Since, under this section, allocations and apportionments are made on the basis of the factual or relationship between deductions and gross income, the taxpayer is required to furnish, at the request of the District Director, information from which such factual relationships can be determined. In reviewing the overall limitation to the foreign tax credit of a domestic corporation, for example, the District Director should consider information which would enable him to determine the extent to which deductions attributable to functions performed in the United States are related to earning foreign source income, United States source income, income from both sources. In addition to functions with a specific international purpose, consideration should be given to the functions of management, the direction and results of an acquisition program, the functions of operating units and personnel located at the head office, the functions of support units (including but not limited to engineering, legal, budget, accounting, and industrial relations), the functions of selling and advertising units and personnel, the direction and uses of research and development and the direction and uses of services furnished by independent contractors. Thus, for example when requested by the District Director, the taxpayer shall make available any of its organization charts, manuals, and other writings which relate to the manner in which its gross income arises and to the functions of organizational units, employees, and assets of the taxpayer and arrange for the interview of such of its employees as the District Director deems desirable in order to determine the gross income to which deductions relate. See section 7602 and the regulations thereunder which generally provide for the examination of books and witnesses. See also section 905(b) and the regulations thereunder which require proof of foreign tax credits to the satisfaction of the Secretary or his delegate. (g) General examples. The following examples illustrate the principles of this section. In each example, unless otherwise specified, the operative section which is applied and gives rise to the statutory grouping of gross income is the overall limitation to the foreign tax credit under section 904(a). In ad dition, in each example, where a method of allocation or apportionment is illustrated as an acceptable method, it is assumed that such method is used by the taxpayer on a consistent basis from year to year (except in the case of the optional method for apportioning interest under paragraph (e)(2)(vi) of this section or the optional method for apportioning research and development expense under paragraph (e)(3)(iii) of this section). Further, it is assumed that each party named in each example operates on a calendar year accounting basis and, where the party is a U.S. taxpayer, files returns on a calendar year basis. Example (1)—Interest—(i) Facts. X, a domestic corporation, conducts a trade or business in the United States and owns all the stock of Y, a foreign corporation. In 1977, X takes a deduction for interest expenses of $150,000. No portion of this interest expense relates to an obligation issued before January 1, 1977. In 1977, X has gross receipts of $968,000, cost of goods sold of $600,000, and gross income of $368,000. X also receives a total of $32,000 in gross income from Y, consisting of $20,000 in dividends, $8,000 in royalties, and $4,000 in interest payments. (ii) Allocation. No portion of the $150,000 deduction is definitely related solely to specific property within the meaning of paragraph (e)(2)(iv) of this section. Thus, X's deduction for interest is related to all of its activities and properties. (iii) Apportionment. Since X computes its foreign tax credit limitation under the overall method there is one statutory grouping, gross income from sources outside the United States, and one residual grouping, gross income from sources within the United States. The interest deduction of $150,000 must be apportioned between these two groupings. In accordance with paragraph (e)(2) (v) and (vi) (but not (vii)) of this section, X calculates the apportionment of the interest deduction under both the asset and gross income methods. X determines the amount of capital utilized or invested in its income producing activities and properties by computing an average book value for the year for all of its assets on the basis of book values of assets as of the beginning and end of its year. In this example, it is assumed that a substantial distortion does not result from the use of beginning and end of year balances. Tentative apportionment on the basis of assets [Average beginning-end of year] Assets (net of depreciation) which relate to activities and properties that generate U.S.-source income (including inventory, working capital for U.S. business, trade accounts receivable, factory equipment). Assets (net of depreciation) which relate to activities and properties that generate foreign-source income (including X's investment in Y and loan to Y, trade accounts receivable, a portion of X's home office based on space and equipment utilized for subsidiary supervision and working capital required for such supervision).. Total As a result of the above computations, X would apportion its interest deduction as follows: To gross income from sources within the United States (residual grouping): $150,000 ($200,000/$4,000,000)....... To gross income from sources outside the United States (statutory grouping): $150,000 ×(800,000/$4,000,000). Total.......... $3,200,000 800,000 4,000,000 120,000 30,000 150,000 Tentative apportionment on the basis of gross income Interest expense apportioned to the residual grouping, gross income from sources within the U.S.: $150,000 ($368,000/$400,000)... Interest expense apportioned to the statutory grouping, gross income from sources outside the U.S.: $150,000 ($20,000+ $8,000+ $4,000)/ ($400,000)... Total. $500,000 consisting of: $392,000 from its domestic activities; $30,000 of dividends from foreign corporation Y; and $78,000 of dividends from foreign corporation Z. X's balance sheets show an average of beginning and ending asset values as follows: $3,200,000 in book value of assets related to its domestic source income; $800,000 in book value of assets related to its income from Y; and $1,000,000 in book value of assets related to its income from Z. X uses the overall method for calculating the limit on its foreign tax credit. (ii) Allocation. No portion of X's $200,000 deduction for interest expense is definitely related solely to specific property within the meaning of paragraph (e)(2)(iv) of this section. Thus, X's deduction for interest is related to all of its income producing activities and properties. from (iii) Apportionment. For purposes of applying the overall limitation, there is one statutory grouping, gross income from sources outside the United States, and the residual grouping, gross income sources within the United States. X's interest expense must be apportioned between these two groupings. Corporation X calculates tentative apportionments under the asset and gross income methods, in accordance with paragraphs (e)(2) (v) and (vi) (but not (vii)) of this section, as follows: Tentative apportionment on the basis of assets Interest expense apportioned to sources outside the United States (statutory grouping): $200,000 ×[($800,000+ $1,000,000)/ Since the tentative apportionment ($12,000) to the statutory grouping on the basis of gross income is only 40 percent of the tentative apportionment ($30,000) on the basis of assets, X may use Option Two of the gross income method (paragraph (e)(2)(vi)(B) of this section) and apportion to the statutory grouping fifty percent (50%) of the $30,000 apportioned to that grouping under the asset method. Thus X's actual apportionment to the statutory grouping would be $15,000. Example (2)-Interest-(i) Facts. X, a domestic corporation, has two wholly owned subsidiaries, Y and Z, which operate in foreign countries. In 1977, X, incurs an interest expense of $200,000 (not in any part attributable to an obligation issued before January 1, 1977) and has gross income of |