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IRS issues final income sourcing rules

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Tax Hot Topics newsletter The IRS released final regulations (TD 9921) under Section 863(b)(2) 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 rules 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.

Prior to the Tax Cuts and Jobs Act (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, 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 IRS issued proposed regulations (REG-100956-19) under Section 863(b)(2) in December 2019, implementing these and other rules relating to sourcing of certain personal property sales. For more information on the proposed regulations, see our story “Proposed regs clarify income sourcing rules.”

The final regulations generally adopt the proposed regulations, but make some key changes, including:

  • Incorporating principles of Treas. Reg. Sec. 1.954-3(a)(4) (other than the “substantial contribution to the manufacturing of personal property” under Treas. Reg. Sec. 1.954-3(a)(4)(iv)) for purposes of determining whether a taxpayer’s activities qualify as a production activity
  • Adding limitations on revocation of a nonresident’s election to use the “books and records method” for allocating certain income
  • Clarifying how to determine the adjusted basis of production assets by providing a limitation when an average of production assets would “materially distort” the sourcing calculation

Generally, the final regulations apply for taxable years ending on or after Dec. 23, 2019. However, taxpayers may choose to apply the final regulations for any taxable year beginning after Dec. 31, 2017, and ending before Dec. 23, 2019, provided that the taxpayer and all related persons apply the final regulations in their entirety and, once applied, the taxpayer and all related persons apply the final regulations in their entirety for all subsequent taxable years. Alternatively, taxpayers may rely on the proposed regulations for any taxable year beginning after Dec. 31, 2017, and ending on or before Sept. 29, 2020, provided that the taxpayer and all related parties have not applied the final regulations to any preceding years.

Contacts:
David Sites
Partner
Washington National Tax Office
T +1 202 861 4104

Cory Perry
Senior Manager
Washington National Tax Office
T +1 202 521 1509

Yasmin Dirks
Manager
Washington National Tax Office
T +1 202 521 1506

Olivia Arnold
Manager
Washington National Tax Office
T +1 678 515 2490

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