In December of 2019, the Department of the Treasury and the Internal Revenue Service (collectively, Treasury) issued proposed regulations (REG-100956-19) 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. The 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, the 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.
Section 14303 of the Tax Cuts and Jobs Act (TCJA) 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. Consistent with the TCJA’s changes to Section 863(b)(2), the proposed regulations amend §1.863-3 to properly allocate or apportion gross income from Section 863(b)(2) Sales based solely on production activity and remove the methods for allocating or apportioning gross income between production and sales activity.
Section 13201 of the TCJA amended Section 168(k) to allow an additional first-year depreciation deduction of 100 percent of the basis of certain property placed in service after September 27, 2017, and before January 1, 2023. Because of the TCJA’s change to Section 168(k) to allow accelerated depreciation in certain circumstances, 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 without the United States. The proposed regulations modify the measurement of the basis of U.S. production assets under current §1.863-3(c)(1)(ii)(B) for purposes of the apportionment formula of proposed §1.863-3(c)(2)(i). The proposed regulations measure the basis of U.S. production assets based on the alternative depreciation system of Section 168(g)(2) 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.
The proposed regulations also contain conforming amendments to other regulations that allocate or apportion income between production and sales activity. In addition, the proposed regulations make minor changes to §§1.937-2, 1.937-3, and 1.1502-13 to update relevant cross references and examples.
The proposed regulations also add proposed §1.865-3 to clarify the proper scope and application of Section 865(e)(2). The proposed regulations clarify the application of the principles of Section 864(c)(5) in the context of Section 865(e)(2) and provide that sales of inventory produced outside the United States and sold through an office maintained by the nonresident in the United States must be sourced in the United States in part.
The proposed 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 other fixed place of business in the United States as U.S. source income attributable to the sales activity of the office maintained by the nonresident. The remaining 50 percent of the income is allocated or apportioned between U.S. and foreign sources by applying Section 863(b) and the regulations thereunder (as amended by the proposed regulations) based upon the location of production activities. Thus, where inventory is produced entirely outside the United States and sold through a U.S. sales office in a transaction subject to Section 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 source income. As an elective alternative to the default 50/50 method, taxpayers may use a books and records method as provided in the proposed regulations. However, the proposed regulations include more detailed guidance regarding the requirements that must be met before a taxpayer will be permitted to use this method.
With respect to inventory purchased and sold by a nonresident in a sale attributable to an office or other fixed place of business in the United States and subject to Section 865(e)(2), none of the income from the sale is attributable to production activity, and therefore, unless the exception in Section 865(e)(2)(B) applies, all of the income from the sale is properly allocable to the office or other fixed place of business in the United States. Thus, the proposed regulations clarify that in these cases Section 865(e)(2) causes all of the gross income derived from the disposition to be U.S. source.
Proposed §1.865-3 also clarifies the interaction between Section 865(e)(2) and Section 865(c) regarding the sourcing of income from the sale of certain depreciable personal property. In the case of income subject to Section 865(e)(2) from the sale of depreciable personal property, the amount of gain, not in excess of depreciation deductions, that is allocable to the nonresident’s office or fixed place of business within the United States is the amount of gain that would be attributable to United States depreciation deductions under the recapture rule of Section 865(c)(1). To the extent the gain exceeds prior U.S. and non-U.S. depreciation deductions, Sections 865(c)(2) and 865(e)(2) apply and source that gain as if the property were inventory. Thus, the residual gain in excess of depreciation deductions is sourced under the rules of Section 865(e)(2) as described in proposed §1.865-3(d)(2) (for produced inventory, the 50/50 method and the books and records method) and (d)(3) (for purchased inventory, 100 percent U.S. source income).
The proposed regulations also amend §1.864-6(c), the current rules for determining the amount of foreign source effectively connected income attributable to an office or other fixed place of business within the United States, to be consistent with the proposed sourcing rules applicable to produced inventory sales under Section 865(e)(2).
In addition, the proposed regulations clarify the interaction between the Section 865(e)(2) rules and the rules governing effectively connected income under Section 864(c)(4)(B)(iii) and (c)(5).
With respect to taxpayers entitled to the benefits of an income tax treaty, Treasury states in the preamble to the proposed regulations that the amount of profits attributable to a U.S. permanent establishment will not be affected by the proposed 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 the regulations apply. In addition, taxpayers may rely on the rules in the proposed regulations for taxable years beginning after December 31, 2017, and before the final regulations are applicable, provided that the taxpayer and persons that are related (within the meaning of Section 267 or 707) to the taxpayer apply the proposed regulations in their entirety.