The Tax Cuts and Jobs Act (TCJA) repealed the long-standing “50/50” sourcing rule for United States exporters of manufactured products. Under the new rules, which source income of a “producer” solely to the place of production, U.S. exporters claiming foreign tax credits may find themselves in a foreign tax credit limitation. Conversely, non-U.S. manufacturers that import goods into the U.S. may find themselves benefiting from new Section 863(b) in that income from the import of goods the taxpayer manufactures outside of the U.S. may be entirely foreign source, even if title passes in the U.S.
Newly released proposed regulations implement the statutory rules. The new regulations would apply to sales occurring in tax years ending on or after December 23, 2019. Thus, if finalized, they would apply for all of 2019 for calendar year taxpayers.
In addition to being relevant to multinational corporations that import or export goods, the new regulations are also relevant for pass-through entities seeking to apply Section 199A to cross-border sales of inventory.
New Source of Income Rules for Manufactured Inventory
Consistent with the changes to Section 863(b)(2) in TCJA, newly proposed regulations amend Treasury Regulation Section 1.863-3 to require the sourcing of income from sales of inventory produced within the U.S. and sold without the U.S. or vice versa (§ 863(b)(2) Sales) be based solely on the location of production activities. The proposed regulations also remove the three methods for allocating between production and sales activity, since they are no longer relevant.
Removing the allocation of income attributable to sales activities could adversely impact the foreign tax credits (FTC) of U.S. manufacturers exporting inventory. U.S. exporters were generally able to allocate some income to foreign source based on the title and risk of loss being transferred outside the U.S. While well-advised companies generally should be able to benefit from the favorable foreign derived intangible income (FDII) deduction with respect to the export of U.S. manufactured inventory, the effect of the new rules on their foreign tax credit may claw back some of the benefits FDII provides.
The current rules for determining whether a taxpayer is engaged in production activity for Section 863(b) purposes and the location or existence of production activity remain unchanged. Under the current regulations, production activity is an activity conducted directly by the taxpayer to create, fabricate, manufacture, extract, process, cure or age inventory, and production assets are assets owned directly by the taxpayer that are used in production activities. The preamble notes that the definition of production for Section 863(b) purposes may be the subject of further guidance.
Notwithstanding the changes to Section 863(b), there remains a need for rules to allocate or apportion gross income between U.S. and foreign source when there is production activity both inside and outside the U.S. The proposed regulations retain the current rules that apportion production income based on the fraction of U.S. and foreign assets by adjusted tax basis. Because of TCJA’s change to Section 168(k) to allow immediate expensing of purchases of tangible property, the adjusted tax basis of many U.S. producers in their newly acquired U.S. production assets will be zero. To prevent Section 168(k) from causing distortions, Treasury and the IRS proposed a new rule for computing the adjusted basis of production assets for Section 863(b) purposes. The proposed regulations measure the basis of U.S. production assets based on the alternative depreciation system (ADS) under Section 168(g)(2) so that the basis of both U.S. and non-U.S. production assets are measured consistently on a straight-line method over the same recovery period. Absent this change, non-U.S. production assets would generally have a higher adjusted basis than equivalent U.S. production assets, particularly for those US production assets placed in service before 2023.
Sourcing Income from Sales of Natural Resources Extracted by the Taxpayer
The current rules under Section 1.863-1 have a special “export terminal” rule for sales of natural resources extracted by the taxpayer. Where there is no production, the income equal to the value of the resource at the export terminal is sourced to the place of extraction, with the balance sourced to the place of sale.
The proposed regulations interpret the export terminal rule as having been overridden by the TCJA amendment to Section 863(b). Accordingly, the proposed regulations remove the export terminal rule for natural resources so that when there is no additional production activity, inventory income is sourced at the location of the natural resource. If there are additional production activities, the gross income is allocated or apportioned first to the jurisdiction where the farm, mine, oil or gas well, other natural deposit, or uncut timber is located, in an amount equal to the fair market value of the product before the additional production activities. Any income in excess of that fair market value is then allocated or apportioned based on the location of the assets used in the additional production activities.
Sales by Foreign Producers into the U.S. and Proposed Regulations under the Office Rule
As noted above, new Section 863(b) will generally have an adverse impact on U.S. manufacturers. By the same token, the change may prove favorable for a foreign producer that sells inventory in the U.S. Historically, if such a producer passed title to goods in the U.S., the income would be apportioned between foreign and U.S. sources. Under new Section 863(b), U.S. title passage by a foreign producer is no longer relevant to the source of its sales income.
Where a non-U.S. person has a U.S. office or fixed place of business, Section 865(e)(2) treats as U.S. source income any sales that are “attributable to” the U.S. office. Where that person is a producer, new Section 863(b) would seem to provide that its income is entirely foreign source (if all production assets are foreign).
New proposed regulations address the interaction of Section 863(b), as amended by TCJA, and Section 865(e)(2). Enacted in 1986, Section 865(e)(2) treats a nonresident’s income from any sale of personal property (including inventory property) as U.S. source income if the sale is attributable to the nonresident’s U.S. office. Section 865(e)(2) applies “notwithstanding any other provisions” of Sections 861 ‑ 865 but, through Section 865(e)(3), incorporates certain limiting principles of Section 864(c)(5). Section 864(c)(5)(C) provides that the income attributable to a U.S. office shall not exceed the income that would be U.S. source if the sale occurred (i.e., title passed) in the U.S.
Before TCJA, the IRS interpreted these provisions as limiting the amount of a nonresident’s U.S. source income under Section 865(e)(2) from a sale of foreign-manufactured goods through a U.S. office to the amount that would be U.S. source under Section 863(b). See 1996 Field Service Advice (FSA) LEXIS 68 (Sept. 24, 1996). Before TCJA, this ordinarily would result in 50% U.S. source income, reflecting a 50/50 split between foreign manufacturing and U.S. sales activity. Following on the FSA position giving precedence to Section 863(b), it would seem that the foreign producer’s income now would be entirely foreign source.
Proposed Section 1.865-3 would depart from this historic interpretation, providing that a nonresident selling foreign manufactured goods through a U.S. office will earn 50% U.S. source income, notwithstanding the TCJA amendment to Section 863(b) sourcing such income solely to the place of manufacture. A nonresident may use an alternative “books and records” method if it meets a laundry list of requirements, including the requirement that the books and records be kept in good faith and “unaffected by considerations of tax liability.” Thus, under the proposed rule, a nonresident seller of produced inventory would earn more U.S. source income under Section 865(e)(2) if the sales are effected through a U.S. office (generally, 50%), than it would if the sales were made with title passing in the U.S., but not through a U.S. office (none).
It is questionable whether the proposed rule is a correct, or even valid, interpretation of Section 865(e)(2). TCJA’s amendment to Section 863(b) made clear that Congress intended to source income from produced inventory sales solely to the location of manufacture for both outbound and inbound sales. Perhaps for this reason, and because of the government’s abrupt change in thinking, Treasury and the IRS spend nine pages of the preamble attempting to justify their new interpretation of Section 865(e)(2). The 50/50 split source income rule also represents something of a compromise. Reading Section 865(e)(2) literally and without context, one might conclude the nonresident’s income is 100% U.S. source.
Proposed Section 1.865-3 would also provide rules under Section 865(e)(2) for sales of purchased inventory and depreciable personal property through a U.S. office. In the case of purchased inventory, the entire gain on sale would be U.S. source income. In the case of depreciable personal property, the gain not in excess of depreciation adjustments would be sourced under the rules of Section 865(c)(1), based on the source of income that was reduced by prior depreciation deductions. Gain in excess of depreciation adjustments would be sourced in the same manner as inventory.
Finally, the proposed rules would amend Section 1.864-6 to provide for parallel treatment under Section 864(c)(4) in the case of a sale of inventory property (purchased or manufactured) through a U.S. office by a nonresident alien with a U.S. tax home. In light of the TCJA amendment to Section 863(b), Treasury’s authority to write this rule is subject to serious question.
Section 199A Implications
The proposed regulations also will have important implications for individuals who operate a business as a sole proprietorship, or through a partnership or S corporation with respect to their qualified business income (QBI) deduction under Section 199A. Subject to certain limitations, the Section 199A deduction generally equals 20% of the individual’s QBI. QBI arises from “qualified items of income, gain, loss and deduction” in a qualified trade or business. Section 199A(c)(3)(A) provides that those qualified items must be effectively connected income (ECI) within the meaning of Section 864(c), determined by substituting “qualified trade or business (within the meaning of Section 199A)” for “nonresident alien or a foreign corporation” or “a foreign corporation” each place it appears.
While QBI is generally thought to relate primarily to domestic business activity, it also can apply to income from cross-border activity conducted through a pass-through entity, provided that the income constitutes ECI. Thus, while foreign persons will generally prefer to earn income that is not ECI, U.S. sole proprietors and pass-through owners will, after TCJA, prefer to earn income that is ECI. In this context, the Proposed Regulations’ giving precedence to Section 865(e)(2) over Section 863(b) may be helpful.
Consider, for example, an S corporation (SCo) that, through a disregarded entity, manufactures goods outside the U.S. and sells them to U.S. customers through its U.S. office, with title passing in the U.S. The SCo’s Section 199A deduction with respect to its income from these sales will depend on whether, and the extent to which, the income is (or would be) ECI. Under Sections 864(c)(3) and (c)(4), the ECI determination will generally depend on the source of the income. Before the proposed regulations were issued, the SCo might have anticipated that none of its income is ECI because Section 863(b) sources such income entirely to the place of production. Now, under proposed Section 1.865-3, the SCo might be able to assert that 50% of its income from these sales is ECI eligible for the reduced rate of tax under Section 199A to the extent the sales are made through a U.S. office.
The proposed regulation preamble states that Treasury and the IRS continue to study the application of Section 864(c) in the context of Section 199A, and request comments on this topic. The interaction of Section 199A with the ECI rules is sure to raise a number of new interpretive and practical questions.