On December 30, 2019 the Internal Revenue Service and Treasury issued proposed regulations modifying the rules for determining the source of income from sales of inventory produced within the United States and sold without the United States or vice versa. These proposed regulations also contain new rules for determining the source of income from sales of personal property (including inventory) by nonresidents that are attributable to an office or other fixed place of business that the nonresident maintains in the United States. Finally, these proposed regulations modify certain rules for determining whether foreign source income is effectively connected with the conduct of a trade or business within the United States.
Sourcing of Manufactured Personal Property
Prior to The Tax Cuts and Jobs Act of 2017 (“the Act”), section 863 provided special rules for determining the source of income from certain sales of personal property. Generally, the sales would be treated as derived partly from sources within and partly from sources without the United States based upon both the manufacturing and sales activity.
The Act amended section 863 of the Code, providing new rules for determining the source of income. Specifically, the Act amended section 863(b) to allocate or apportion income from the sale or exchange of inventory property produced (in whole or in part) by a taxpayer within and sold or exchanged without the United States or produced (in whole or in part) by the taxpayer without and sold or exchanged within the United States (collectively, “Section 863(b)(2) Sales”) solely on the basis of production activities with respect to that inventory. The methods for allocation or apportioning income between production and sales activity were removed.
Notwithstanding the changes to section 863(b) there remains a need for rules to allocate or apportion gross income from Section 863(b)(2) Sales between U.S. and foreign sources where with respect to inventory, there is production both within and without the U.S. The proposed regulations retain the existing allocation/apportionment rules in §1.863-3(c)(1)(ii). Foreign sourced income is determined from Section 863(b)(2) Sales by a fraction the numerator of which is the average adjusted basis of production assets located outside the U.S. and the denominator of which is all production assets within and without the U.S. The remaining income is treated as U.S. source. The proposed regulations require the consistent use of alternative depreciation system (“ADS”) under section 168(g)(2) for determination of adjusted basis of assets both within and without the U.S.
Sourcing of Sales Allocable to Nonresident’s Office or Fixed Place of Business
Section 865(e)(2) generally sources the income from sales attributable to a nonresident’s office or fixed place of business in the U.S. (as defined in section 864(c)(5)(C)) as U.S. sourced income (“Section 865(e)(2)Sales”). The amount of U.S. sourced income depends upon whether the property sold is inventory or other personal property attributable to an office or fixed place of business in the U.S. of the nonresident. Proposed §1.865-3(d) provides separate source rules for income from sales of inventory by a nonresident attributable to an office or fixed place of business depending upon whether the nonresident produced the inventory (either the default 50/50 method in paragraph (d)(2)(i) or the elective books and records method in paragraph (d)(2)(ii), or purchased the inventory, 100 percent U.S. source income in paragraph (d)(3). To the extent the income is U.S. sourced it will generally be considered effectively connected with the conduct of a U.S. trade or business.
Proposed Rules for Non-Inventory Property
Section 864(c)(2) applies to determine whether U.S. source of gain from the sales of non-inventory personal property and other personal property capital assets by a nonresident is effectively connected with the conduct of a U.S. trade or business. The proposed regulations implement section 865 and provide source rules for determining whether gain is U.S. source for purposes of section 864(c)(2).
Generally, gain from the sale of depreciable personal property, to the extent of prior depreciation deductions, is sourced within the U.S. in proportion to the extent of the depreciation deductions that were previously allocated against U.S. source income (and vice versa). Gain in excess of depreciation is sourced as if such property were inventory property. Thus the residual gain in excess of depreciation deductions is sourced under the rules of section 865(e)(2) (for produced inventory, the 50/50 method and books, and records method and for purchased inventory, 100 percent U.S. source income).
Proposed Rules for Inventory
The proposed regulations provide rules specifically for Section 865(e)(2) Sales involving inventory produced by the nonresident that distinguishes generally between sales and production activities in determining source of income from sales of produced inventory. These regulations continue to apply the 50/50 method as the general rule to treat 50 percent of a nonresident’s income with respect to produced inventory sold through an office or fixed place of business in the U.S. as U.S. source income attributable to the sales activity of the office maintained by the nonresident. The remaining 50 percent is allocated or apportioned between U.S. and foreign sources by applying 863(b) based upon the location of the production activities. Thus, where inventory is produced entirely outside of the U.S. and sold through a U.S. sales office in a transaction subject to 865(e)(2), 50 percent of the gross income is U.S. source income allocable to the U.S. sales office or other fixed place of business and the remaining 50 percent is foreign-sourced income. Taxpayers may elect the alternative books and records method (subject to additional requirements) but the Independent Factory Price method is not included in the proposed regulations.
U.S. Income Tax Treaties
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 United States. With respect to taxpayers entitled to the benefits of an income tax treaty, the amount of profits attributable to a U.S. permanent establishment will not be affected by these regulations.
The regulations are proposed to apply to taxable years ending on or after December 23, 2019. As proposed, the regulations will permit taxpayers to apply the rules therein in their entirety for taxable years beginning after December 31, 2017, and before these regulations apply.
Consult the Elliott Davis team for more information and to answer other questions you may have regarding the proposed regulations.