Authors: Michael R. Pearson, Scott W. Simpson and Jack Millhouse
Section 863 - A Very Brief History
Prior to tax reform, many multinational corporations relied upon Section 863(b) to provide “50/50” income sourcing, between the U.S. and foreign jurisdictions, for sales of manufactured inventory. Under prior law, if a domestic corporation manufactured inventory in the United States and passed title and risk of loss outside the United States, 50 percent of the income would be U.S. source (based on location of manufacture) and 50 percent would be foreign source (based on title passage). The old statute and the regulations thereunder provided for an equal split of the sourcing of income between U.S. and foreign for inventory property produced (in whole or in part) within the U.S. and sold abroad, or vice versa. The Tax Cuts and Jobs Act of 2017 (the “TCJA”) repealed the “50/50” sourcing rule for U.S. exporters of manufactured product. The new rules source income solely to the place of production. Thus, where a taxpayer produces or manufactures inventory becomes the sole factor to consider for sourcing for years beginning after December 31, 2017.
Consistent with the tax reform changes to flush language of Section 863(b) which modifies Section 863(b)(2), newly proposed regulations issued on December 23, 2019 amend Treas. Reg. § 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 no longer relevant methods for allocation of gross income between the production and sales activity. This modification could create adverse foreign tax credit limitation issues for many multinational corporations that have historically relied upon receiving 50 percent foreign source income treatment where title passage of exports occurs outside the U.S. These companies may now find themselves in need of additional foreign source income in order to monetize their foreign tax credits. On the other hand, a non-U.S. manufacturer that imports inventory into the U.S. may now have entirely foreign-source sales, even where title passage occurs in the U.S.
New Rules, Proposed Guidance – Where Are We Now?
The new proposed regulations issued under Sections 863 and 865 modify income sourcing rules from sales of inventory produced domestically and sold outside the U.S. or vice versa.
Income from Sales of Manufactured Inventory – Production Rules
The newly proposed regulations require sourcing of Section 863(b)(2) sales based solely on the location of production activities. With respect to expense apportionment, the proposed regulations provide that expenses should be allocated and apportioned based on the applicable rules in Treas. Reg. § 1.861-8 through § 1.861-17.
Deciding where engaging in production activity occurs for purposes of Section 863(b) remains an exercise of determining where activity is being conducted directly by the taxpayer to manufacture, create, fabricate, process, extract, cure and/or age inventory. Similarly, assets owned directly by the taxpayer that are used in production activity constitute production assets. The regulations modify the rules measuring the basis of assets for purposes of sourcing gross income where production occurs within and without the U.S. These rules compute asset basis using the straight-line method of deprecation under the Alternative Depreciation System (“ADS”), thus bringing parity between adjusted basis of U.S. and non-U.S. producing assets. This effectively mitigates issues where U.S. bonus depreciation would otherwise deplete U.S. producing asset basis as compared to non-U.S. producing assets where bonus depreciation is not permitted.
Sales of Inventory into the U.S. by Non-U.S. Manufacturers
The new proposed regulations coordinate the interaction of Sections 863(b) and 865(e)(2). Long-standing Section 865(e)(2) provides that a nonresidents’ income from sale of inventory was U.S. source income if the sale was attributable to the U.S. office of the nonresident. 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. Accordingly, Proposed Treas. Reg. § 1.865-3 addresses these issues and 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; and
- Whether a sale of personal property is attributable to that office or other fixed place of business in the United States.
These new rules provide that a nonresident selling non-U.S. manufactured inventory through a U.S. office will earn 50 percent U.S.-source income, which is counter to new changes to Section 863(b) in these specific contexts. 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 result appears to provide (based on initial interpretation of the proposed regulations under Section 865) that a nonresident seller of non-U.S. produced inventory will receive 50 percent U.S. sourcing of income under Section 865(e)(2) where the sale is effected through a U.S. office as opposed to zero U.S. source income if the sale was made without the use of a U.S. office.
The proposed regulations provide separate source rules for income from sales of inventory subject to Section 865(e)(2), depending on whether the inventory was produced or purchased by the nonresident. If the nonresident produced the inventory, then either the “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 is properly allocable to the office or other fixed place of business domestically (i.e., 100 percent U.S. source). Under both scenarios, the income that is treated as sourced to the U.S. would generally be considered effectively connected income (“ECI”) associated with the conduct of a U.S. trade or business under Section 864(c)(3). Additionally, the regulations provide that gain (not in excess of depreciation) on the sale of depreciable personal property would be sourced under the rules of Section 865(c)(1), based on the source of income that was reduced by any prior depreciation. Any gain in excess of depreciation would be sourced similar to inventory.
Further, the proposed rules would amend the regulations under Section 864(c)(4) to be consistent in its treatment in the context of a sale of inventory property either purchased or manufactured through a U.S. office by a nonresident alien seller with a U.S. tax home. The proposed regulations clarify that the new rules of Section 863(b) and related regulations do not apply in Section 864(c)(4) context to treat inventory sales as only giving rise to foreign source income if the inventory sold was non-U.S. produced.
Section 250 Foreign-Derived Intangible Income (“FDII”) Impacts
The modifications and newly proposed regulations under Sections 863 and 865 should not adversely impact the eligibility for the FDII deduction under Section 250 with respect to sourcing rules for income from sales of inventory to foreign customers. This is because FDII eligibility has its own “foreign derived” rules promulgated under Treas. Reg. §§ 1.250(b)-4 and -5 which are separate from the proposed regulations and rules of income sourcing in Sections 863 and 865.
Section 199A Impacts
While sourcing rules were always very centric to C-Corporation multinational importers and exporters for foreign tax credit utilization purposes, the new rules should also be viewed in the context of Section 199A, specifically in terms of its impacts on sole proprietors and pass-through entities looking to maximize their respective Section 199A deduction. Individuals operating a business as a sole proprietorship or in pass-through form (S-corporation or Partnership) should understand how these new sourcing rules impact Section 864(c) ECI, which is both central to and a required component of the Section 199A deduction.
Qualified business income (“QBI”) is the basis upon which a 20 percent deduction is allowed for under Section 199A. QBI is income that is otherwise ECI pursuant to Section 864(c). ECI determinations are largely dependent on the source of income determination. Thus, we have come full circle and with the Sections 863 and 865 proposed regulations now issued, a foreign producer selling into the U.S. market through its fixed place of business (i.e., its U.S. based office) could assert 50 percent is U.S. sourced income (i.e., ECI); and thus eligible for the Section 199A deduction. This is due to the new coordination of Section 865(e)(2) with Section 863(b).
Effective Date
Taxpayers may rely on the proposed regulations for taxable years beginning after Dec. 31, 2017, and before the final regulations are applicable, provided the proposed regulations are applied in their entirety. The regulations are proposed to apply to taxable years ending on or after Dec. 23, 2019. Thus, they will apply to the 2019 calendar tax year if finalized in current form. It should be noted that the initial interpretation and discussion herein are ultimately subject to change based on future guidance and/or final regulations issued by the IRS and Treasury.
If you have inquiries about this article or the related modifications to the sourcing of income rules provided by the proposed regulations and related impacts, please contact any member of the international team at FGMK.
