Proposed regs clarify income sourcing rules

The IRS issued proposed regulations [REG-100956-19] under Section 863(b)(2) on Dec. 23, 2019, that provide rules for determining the source of income associated with the sale or exchange of inventory produced within or outside the United States. The proposed regulations were issued to implement changes made by the Tax Cuts and Jobs Act (TCJA) to Section 863(b). They also provide guidance on determining the source of income from sales by nonresidents that are attributable to an office or other fixed place of business maintained in the United States and modify the rules for determining whether foreign-source income is effectively connected with the conduct of a trade or business within the country.

Background In general, Section 863 provides rules for determining the source of income, including income derived from sales of inventory produced partly within and partly outside the United States. Prior to the TCJA, Section 863(b) provided that income from the sale or exchange of inventory property produced (in whole or in part) by a taxpayer within the United States and sold or exchanged abroad, or vice versa (collectively, Section 863(b)(2) sales), would be treated as derived partly from sources within and partly from sources outside the country, without providing the basis for such allocation or apportionment. The TCJA amended Section 863(b) to allocate or apportion income from Section 863(b)(2) sales on the basis of production activities. Specifically, it provides that for tax years beginning after Dec. 31, 2017, gross income from sales of inventory that is “produced by the taxpayer,” is sourced “solely on the basis of the production activities” with respect to the inventory.

The current regulations under Section 863 provide several methods for determining the amount of gross income that is attributable to production activity and the amount of gross income attributable to sales activity. A taxpayer must allocate or apportion gross income from Section 863(b)(2) sales between production activity and sales activity using one of three methods described in current Treas. Reg. Sec. 1.863-3(b):

• The 50/50 method,  which provides that 50% of the gross income from Section 863(b)(2) sales is allocated to production activity and 50% is allocated to sales activity
• The independent factory price (IFP) method, which permits a taxpayer to allocate its gross income based on the price at which the taxpayer regularly sells its products to wholly independent distributors or other selling concerns or the books and records method
• The books and records method, under which a taxpayer may elect to allocate its gross income from Section 863(b)(2) sales between production and sales activities based upon the taxpayer’s books of account.

Current Treas. Reg. Sec. 1.863-3(c)(1)(ii) also provides a formula for allocating or apportioning gross income where there is production activity both within and outside the United States. For purposes of applying this formula, the adjusted basis of production assets includes the effect of bonus depreciation allowed on U.S. production assets. Therefore, the adjusted basis of production assets domestically may be zero while the adjusted basis of production assets located outside the country is based on a straight-line depreciation method under the alternative depreciation system (ADS) which is used in special circumstances to calculate depreciation on certain assets. As a result, where there is production activity both within and outside the United States, the formula could result in more income from foreign sources if bonus depreciation is claimed on U.S. production assets.

Under Section 865(a), income from the sale of personal property generally is sourced where the taxpayer resides. However, Section 865(b) provides special sourcing rules that source income from the sale of inventory based on either the place of sale (for purchased inventory), or the allocation and apportionment rules of Section 863 (for inventory produced by the taxpayer). A special “U.S. office” exception under Section 865(e)(2)(A) provides that if a nonresident maintains an office or fixed place of business in the United States, income from the sale of personal property that is attributable to an office or fixed place of business is sourced domestically. Therefore, to the extent that inventory income described in Section 863(b)(2) is derived from a sale by a nonresident attributable to an office or other fixed place of business in the United States, Section 865(e)(2) must be given effect in determining the source of the income.

Further, Section 865(e)(3) provides that in order to determine whether income from a sale of inventory is attributable to a fixed place of business in the United States, the principles of Section 864(c)(5) apply. Section 864(c)(5)(B) provides that income is attributable to a fixed place of business domestically if the place of business is a “material factor” in the production of such income and “regularly carries on activities” that generate such income.

Proposed regulations The newly proposed regulations modify the rules under Sections 863 and 865 for sourcing income from sales of inventory produced domestically and sold outside the United States or vice versa. As the proposed regulations are meant to reflect the amendments made by TCJA, the rule under Section 863(b) which sources income from Section 863(b)(2) sales based on the location of a taxpayer’s production assets remains largely intact. It is important to note that the new sourcing rules under Section 863(b) continue to apply only with respect to income, profits and gain from the sale of inventory “produced by the taxpayer.”

Apportionment of gross income from Section 863(b)(2) sales Consistent with the TCJA changes to Section 863(b)(2), the proposed regulations amend Treas. Reg. Sec. 1.863-3 to properly allocate or apportion gross income from Section 863(b)(2) sales based solely on production activity of the taxpayer, and remove the methods for allocating or apportioning gross income between production and sales activity. Specifically, the proposed regulations remove the three methods provided under Treas. Reg. Section 1.863-3(b) and the related election rules in Treas. Reg. Section 1.863-3(e).

As amended, the new proposed regulations would simply require sourcing of Section 863(b)(2) sales based solely on the location of production activities. The proposed regulations no longer would provide for the apportionment of expenses based solely on relative gross income from United States and foreign sources. Instead, the proposed regulations would provide that expenses are allocated and apportioned based on the generally-applicable rules in Treas. Reg. Secs. 1.861-8 through 1.861-17.

Sourcing of gross income within and outside the United States Out of concern that expensing of U.S. assets under the new Section 168(k) rules would skew the income from inventory sales towards foreign sources, the regulations also modify the rules for determining the basis of assets for purposes of sourcing gross income from production activity under the new Section 863(b)(2). The proposed regulations provide a new rule for computing the adjusted basis of production assets for purposes of applying the formula for allocating or apportioning gross income where there is production activity both within and outsidethe United States. The new rule would measure the basis of U.S. production assets based on ADS so that the basis of both U.S. and non-U.S. production assets is measured consistently on a straight-line method over the same recovery period. This new rule should prevent the result under the existing formula of having more income from sources without the United States if bonus depreciation is claimed on U.S. production assets.

Grant Thornton Insight: For U.S. manufacturers, this represents a significant change and could impact the general basket income. Taxpayers should also review their foreign tax credit planning and consider options for increasing foreign source income.
Sales of personal property by nonresidents Section 865(e)(2) generally provides that sales of inventory property through a U.S. office or fixed place of business are considered U.S. source income. The TCJA changes to Section 863(b) raised IRS concerns that nonresident taxpayers may take the position that these changes override the application of Section 865(e)(2) to sales of inventory produced by a nonresident taxpayer and sold through a U.S. sales office. To address this, Prop. Treas. Reg. Sec .1.865-3 provides new rules to determine:

• If a foreign office materially participated in the sale
• Whether a nonresident has an office or other fixed place of business in the United States
• Whether a sale of personal property is attributable to that office or other fixed place of business in the United States

The proposed regulations also provide rules for determining the amount of income that is treated as U.S. sourced. The rules depend on whether the property sold is inventory or other personal property of a nonresident sold in a sale attributable to an office or other fixed place of business in the United States of the nonresident.

The proposed regulations provide separate source rules for income from sales of inventory subject to Section 865(e)(2), dependent on whether the nonresident produced the inventory or purchased the inventory. If the nonresident produced the inventory, then either the default 50/50 method or the elective books and records method would be applied. If the nonresident purchased the inventory, the proposed regulations provide that all income from the sale would be properly allocable to the office or other fixed place of business domestically. To the extent income from either type of inventory sale is treated as U.S. sourced, the income would generally be effectively connected with the conduct of a U.S. trade or business under Section 864(c)(3).

Rules with respect to depreciable personal property The proposed regulations also modify Section 864(c)(4)(B)(iii), which generally provides that income derived from the sale of inventory outside the United States by a non-U.S. person through an office or other fixed place of business in the country may be effectively connected income. The new rules would modify this provision so that it would apply exclusively to a distinct class of nonresident aliens (i.e., those with a tax home in the United States. who are not covered under Section 865(e)(2)). The proposed regulations would clarify that the rules of Section 863(b) and Treas. Reg. Sec. 1.863-3 do not apply in the context of Section 864(c)(4)(B)(iii) to treat inventory sales as exclusively giving rise to foreign source income if the inventory sold was produced exclusively outside of the country.

Effect of nonresident regulations on treaties According to the IRS, under U.S. income tax treaties, the business profits of foreign treaty residents may be taxable in the United States only if the profits are attributable to a permanent establishment in the country. With respect to taxpayers entitled to the benefits of an income tax treaty, the amount of profits attributable to a U.S. permanent establishment would not be affected by these nonresident taxpayer regulations.

Effective date The regulations are proposed to apply to taxable years ending on or after Dec. 23, 2019. As such, they will apply to the 2019 calendar tax year if finalized in current form. Taxpayers are permitted to apply the rules in their entirety for taxable years beginning after Dec. 31, 2017, and before Dec. 23, 2019. Taxpayers may also rely on the proposed regulations for taxable years beginning after Dec. 31, 2017, and before the final regulations are applicable, provided the taxpayer and persons that are related to the taxpayer apply the proposed regulations in their entirety. For taxable years before the regulations apply, the IRS may, where appropriate, challenge certain positions taken by a taxpayer.

Next steps The application of the proposed regulations may change the amount of foreign-source income, thereby potentially changing the amount of foreign tax credits. Taxpayers should evaluate the relevance of the changes, including their impact on foreign-source income and foreign tax credits, and determine whether to apply the proposed regulations prior to when they are finalized.

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