personal The proposed regs 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 U.S. Finally, the proposed regs modify certain rules for determining whether foreign source income is effectively connected with the conduct of a trade or business within the U.S. Prop Reg §1.864-6
Background—Section 863
Code Sec. 863 provides rules for determining the source of income, including income partly from within and partly from without the U.S. Before the Tax Cuts and Jobs Act, (PL 115-97) (the “Act”), Code Sec. 863(b) provided that income from the sale or exchange of inventory property produced (in whole or in party) by a taxpayer within, and sold or exchanged without, the U.S. or produced (in whole or in part) by the taxpayer without and sold or exchanged within the U.S. (collectively, “Section 863(b)(2) Sales”) was treated as derived partly from sources within and partly from sources without the U.S. without providing the basis for such allocation or apportionment.
The Act amended Code Sec. 863(b) so that it now allocates or apportions income from Section 863(b)(2) Sales solely on the basis of production activities related to that inventory.
Current Reg. §1.863-3 provides rules for allocating or apportioning gross income from Section 863(b)(2) Sales. Those rules provide several methods for determining the amount of gross income from Section 863(b)(2) Sales that is attributable to production activity and the amount of gross income attributable to sales activity, with different rules then applying to source the portion of the income derived from production activity versus sales activity. (Reg. §1.863-3(b)). Current Reg. §1.863-3(f) provides rules for gains, profits, and income that are treated as derived partly from sources within the U.S. and partly from sources within a possession of the U.S. (generally referred to herein as a “U.S. territory”).
The Act also amended Code Sec. 168(k) to allow an additional first-year depreciation deduction of 100% of the basis of certain property placed in service after September 27, 2017, and before January 1, 2023. Therefore, certain new and used production assets placed in service and used predominantly within the U.S. during this period may have an adjusted basis of zero. After December 31, 2022, qualifying property placed in service before January 1, 2027 (or, in the case of certain property, January 1, 2028), is still subject to accelerated depreciation for an amount equal to the applicable percentage of the basis of the property. (Code Sec. 168(k)(1) and Code Sec. 168(k)(6)). However, production assets placed in service or used predominantly without the U.S., or both, do not qualify for this accelerated depreciation and must be depreciated using the straight line method under the alternative depreciation system (“ADS”) of Code Sec. 168(g)(2). (Code Sec. 168(g)(1)(A))
Background—Section 865
Code Sec. 865 provides special sourcing rules for sales of personal property. The general rule of Code Sec. 865(a)(1) is that income from a sale of personal property is sourced based on the residence of the seller. Code Sec. 865(b) excepts inventory from this rule and sources income from the sale of inventory generally based on either the place of sale (for purchased inventory) or based on the allocation and apportionment rules of Code Sec. 863 (for inventory produced by the taxpayer).
Code Sec. 865(c) provides special rules for sourcing gain from the sale of depreciable personal property. Under Code Sec. 865(c)(1), gain from the sale of depreciable personal property that is not in excess of depreciation adjustments is allocated between sources within and without the U.S. by treating the same proportion of such gain as sourced within the U.S. as the U.S. depreciation adjustments (as defined in Code Sec. 865(c)(3)) with respect to such property bear to the total depreciation adjustments, and by treating the remaining portion of such gain as sourced without the U.S. Under Code Sec. 865(c)(2), gain in excess of the depreciation adjustments is sourced as if such property were inventory.
Code Sec. 865(e)(2) provides that “[n]otwithstanding any other provisions of this part,” if a nonresident has an office or other fixed place of business in the U.S., “income from any sale of personal property (including inventory property) attributable to such office or other fixed place of business” is U.S. source. Accordingly, to the extent that inventory income described in Code Sec. 863(b)(2) is considered to be derived from a sale by a nonresident attributable to an office or other fixed place of business in the U.S., Code Sec. 865(e)(2) must be given effect in determining the source of the income.
For purposes of Code Sec. 865(e)(2), Code Sec. 865(e)(3) provides that the “principles of Code Sec. 864(c)(5)” apply in determining “whether a taxpayer has an office or other fixed place of business” and “whether a sale is attributable” thereto.
Code Sec. 864(c)(5)(A) provides rules for determining whether a non-U.S. person has an office or other fixed place of business to which Code Sec. 864(c)(4)(B) may apply. Code Sec. 864(c)(5)(B) provides a threshold requirement for determining whether any income is attributable to such an office or other fixed place of business. And Code Sec. 864(c)(5)(C) addresses the extent to which the income, gain, or loss is attributable to an office or other fixed place of business and includes a limitation that for sales of inventory, the income attributable to an office or other fixed place of business within the U.S. cannot exceed “the income which would be derived from sources within the U.S. if the sale or exchange were made in the U.S.”
Proposed changes to §1.863-3 to reflect the amendment of Sec. 863(b)
Before amendment by the Act, Code Sec. 863(b)(2) provided that gains, profits, and income from Section 863(b)(2) Sales were sourced partly from sources within and partly from sources without the U.S., but did not prescribe a particular method of allocating or apportioning between these two sources. Accordingly, current Reg. §1.863-3 provides allocation or apportionment methods for Section 863(b)(2) Sales. Under those regulations, a taxpayer must allocate or apportion gross income from Section 863(b)(2) Sales between production activity and sales activity using one of three methods described in current Reg. §1.863-3(b): the 50/50 method; the independent factory price (“IFP”) method; or the books and records method. Current Reg. §1.863-3(d) provides rules for allocating and apportioning expenses to gross income from Section 863(b)(2) Sales, including a requirement to apportion expenses pro rata based on the source of gross income where the 50/50 method has been used. Current Reg. §1.863-3(e) provides rules for electing one of these methods and the related information that a taxpayer must disclose on a tax return.
The Act amended Code Sec. 863(b) to source income from Section 863(b)(2) Sales solely on the basis of the production activity with respect to the inventory sold, and as a result sales activity is no longer a relevant factor for allocating or apportioning income under that section. Therefore, the proposed regs would remove the three methods in Reg. §1.863-3(b) and the related election rules in paragraph Reg. §1.863-3(e). Proposed Reg §1.863-3(b) would require sourcing of Section 863(b)(2) Sales based solely on the location of production activities, consistent with Code Sec. 863(b)(2), as amended. (Preamble to Prop Reg REG-100956-19)
Given the elimination of the 50/50 method, the proposed regs would no longer provide for the apportionment of expenses based solely on relative gross income from U.S. and foreign sources. Instead, the proposed regs would provide that expenses are allocated and apportioned based on the generally-applicable rules in Reg. §1.861-8 through Reg. §1.861-17. (Preamble to Prop Reg REG-100956-19)
Proposed changes to §1.863(e)
Prop Reg §1.863-3(e) (which would replace current Reg. §1.863-3(f)) would not provide a specific rule for sourcing gross income derived from the sale of inventory produced (in whole or in part) by the taxpayer within the U.S. and sold within a U.S. territory, or produced (in whole or in part) by a taxpayer in a U.S. territory and sold within the U.S. Instead, Prop Reg §1.863-3(e) would provide a cross-reference directing taxpayers to source such income under the rules provided by Prop Reg §1.863-3(c). (Preamble to Prop Reg REG-100956-19)
Prop Reg §1.863-3(e) would modify the rule for sourcing gross income derived from the purchase of personal property within a U.S. territory and its sale within the U.S. under Code Sec. 863(b)(3). Consistent with Prop Reg §1.863-3(b), Prop Reg §1.863-3(e) would remove the books and records method provided by current Reg. §1.863-3(f)(3)(i)(B). Instead, Prop Reg §1.863-3(e)(3)(i) would require sourcing such income based solely upon the taxpayer’s business activity.
Proposed changes to §1.863-3 to reflect the amendment of section 168(k)
Notwithstanding the changes to Code Sec. 863(b) required by the Act, 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 activity both within and without the U.S. (Preamble to Prop Reg REG-100956-19)
The proposed regs would retain the existing rules in current Reg. §1.863-3(c)(1)(ii) for sourcing gross income from production activity where there is production activity both within and without the U.S. The proposed regs would not amend current Reg. §1.863-3(c)(1)(ii)(A), which determines the amount of foreign source income in such cases by multiplying the total gross income 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. (Preamble to Prop Reg REG-100956-19)
But the proposed regs would modify the measurement of the basis of U.S. production assets under current Reg. §1.863-3(c)(1)(ii)(B) for purposes of the apportionment formula of Prop Reg §1.863-3(c)(2)(i). The proposed regs would measure the basis of U.S. production assets based on ADS under Code Sec. 168(g)(2) so that the basis of both U.S. and non-U.S. production assets would be measured consistently on a straight line method over the same recovery period. (Preamble to Prop Reg REG-100956-19)
The proposed regs would not otherwise modify the rules in current Reg. §1.863-3 for determining the location or existence of production activity. (Preamble to Prop Reg REG-100956-19)
Proposed changes to other regulations under Sec. 863 to reflect the changes to §1.863-3.
The proposed regs would modify current Reg. §1.863-1, current Reg. §1.863-2, and current Reg. §1.863-8 to reflect the changes to current Reg. §1.863-3. Prop Reg §1.863-1(b) would provide special rules for allocating or apportioning gross income from the sale of natural resources, which can be a subset of inventory generally. (Preamble to Prop Reg REG-100956-19)
Current Reg. §1.863-1(b)(1) provides a general “export terminal” rule that allocates sales income at the export terminal, sourcing gross receipts equal to the fair market value of the natural resources at the export terminal to the location of the farm, mine, well, deposit, or uncut timber, and gross receipts in excess of that amount either to the place of sale or according to the rules in Reg. §1.863-3, depending on the circumstances.
Current Reg. §1.863-1(b)(2) provides a special rule for taxpayers performing additional production activities before the relevant product is shipped from the export terminal. The gross receipts are allocated between sources within and without the U.S. based on the fair market value of the product immediately before the additional production activities. Gross receipts equal to the fair market value of the natural resources immediately before the additional production activities are sourced to the location of the farm, mine, well, deposit or uncut timber, and the gross receipts in excess of that fair market value are sourced based on Reg. §1.863-3.
As it is generally no longer appropriate under Code Sec. 863(b)(2) to allocate or apportion any gross income from sales of inventory, including natural resources, to sales activity, the proposed regs would modify current Reg. §1.863-1(b) to remove the export terminal rule so that, where there is no additional production activity with respect to the natural resource, all gross income from sales of natural resources inventory would be based on the location of the farm, mine, oil or gas well, other natural deposit, or uncut timber from which the natural resource is derived. (Preamble to Prop Reg REG-100956-19)
Where there are additional production activities with respect to the natural resource either within or without the jurisdiction from which the natural resource is derived, the gross income would be 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 would then be allocated or apportioned between sources within and without the U.S. under Prop Reg §1.863-3 principles based on the location of the assets used in the additional production activities. (Prop Reg §1.863-1(b)(2))
In the case of sales of natural resources by a nonresident that are attributable to an office or other fixed place of business in the U.S. of such nonresident, the foregoing rules would be subject to the rules of Code Sec. 865(e)(2) and Prop Reg. §1.865-3. (Preamble to Prop Reg REG-100956-19)
Current Reg. §1.863-8(b)(3)(ii) provides a special rule for allocating and apportioning income under Code Sec. 863(d) derived from sales of property (including inventory) produced by a taxpayer if the property is produced or sold, at least in part, in space or international water. This rule requires the taxpayer to allocate gross income from such sales between production and sales activity under a 50/50 method, whereby half of the taxpayer’s gross income will be considered income allocable to production activity and the remaining half of such gross income will be considered income allocable to sales activity.
As it is generally no longer appropriate under Code Sec. 863(b)(2) to allocate or apportion any gross income from sales of inventory produced by a taxpayer (including production in space or international water) to sales activity, the proposed regs would modify current Reg. §1.863-8(b)(3)(ii) to remove the 50/50 method and replace it with a rule that allocates gross income solely on the basis of production activity.
Proposed rules for sales of personal property by nonresidents
New Prop Reg 1.863-3 and proposed revisions to an existing reg under Code Sec. 864 address sourcing of income from sales of personal property by nonresidents. The proposed regs also provide information regarding their effect on treaties.
New proposed reg.In light of the changes made by the Act to Code Sec. 863(b), the IRS is concerned that nonresident taxpayers may take an improper position that these changes override the application of Code Sec. 865(e)(2) as it applies to sales of inventory produced by a nonresident taxpayer and sold through a U.S. sales office, despite the fact that Code Sec. 865(e)(2) applies “[n]otwithstanding any other provisions in [Code Sec. 861 through Code Sec. 865].”
To address this improper interpretation of Code Sec. 865(e)(2), and to provide guidance for the application of Code Sec. 865(e)(2) in general, the proposed regs add Prop Reg §1.865-3.
Prop Reg §1.865-3(a) sets forth the general rule in Code Sec. 865(e)(2)(A), and Prop Reg §1.865-3(b) sets forth the exception in Code Sec. 865(e)(2)(B) and cross-references the rules of Reg §1.864-6(b)(3) (“Limitation where foreign office is a material factor in realization of income”) to determine if a foreign office materially participated in the sale. Prop Reg §1.865-3(c) sets forth the rules for determining whether a nonresident has an office or other fixed place of business in the U.S. by incorporating the principles of Reg §1.864-7 (“Definition of office or other fixed place of business”), and whether a sale of personal property is attributable to that office or other fixed place of business in the U.S. by incorporating the principles of Reg §1.864-6(b) and (c) (as amended; see “Changes to Section 864 reg, ” below)
Prop Reg §1.865-3(d) provides rules for determining the amount of income that is treated as U.S. source; the rules depend on whether the property sold is inventory (including property treated as inventory under Code Sec. 865(c)(2)) or other personal property of a nonresident sold in a sale attributable to an office or other fixed place of business in the U.S. of the nonresident.
Prop Reg §1.865-3(d) provides separate source rules for income from sales of inventory subject to Code Sec. 865(e)(2), dependent on whether the nonresident produced the inventory or purchased the inventory. If the nonresident produced the inventory, he would be able to apply either the default 50/50 method in Prop Reg §1.865-3 (d)(2)(i) or the elective books and records method in Prop Reg §1.865-3(d)(2)(ii)). If he purchased the inventory, Prop Reg §1.865-3(d)(3) provides that the entire income from the sale would be properly allocable to the office or other fixed place of business in the U.S.
To the extent income from either type of inventory sale is treated as U.S. source under Prop Reg §1.865-3(d)(2) or Prop Reg §1.865-3(d)(3), the income would generally be effectively connected with the conduct of a U.S. trade or business under Code Sec. 864(c)(3).
Prop Reg 1.865-3(d)(4) provides rules with respect to depreciable personal property.
Prop Reg §1.865-3(e) provides a cross reference to the rules in Reg §1.882-4 and Reg §1.882-5, which determine the amount of expenses that are properly allocated and apportioned to gross income effectively connected with the conduct of a trade or business in the U.S.
Changes to Section 864 reg. Code Sec. 864(c)(4)(B)(iii) generally provides that income derived from the sale of inventory outside the U.S. by a non-U.S. person through an office or other fixed place of business in the U.S. may be effectively connected income, notwithstanding that it would be foreign source income under the title passage rules in Reg. §1.861-7(c). It provides an exception for inventory sold for use or consumption outside the U.S., similar to the exception in Code Sec. 865(e)(2)(B).
Accordingly, Code Sec. 864(c)(4)(B)(iii) and Code Sec. 865(e)(2) appear to overlap in their treatment of sales of inventory by non-U.S. persons through an office or other fixed place of business in the U.S.
IRS has determined that income from sales of inventory by these individuals should be taxable as effectively connected income to the same extent as if inventory sales by these individuals were governed by Code Sec. 865(e)(2), depending on whether the inventory was either purchased abroad or produced abroad.
Reg §1.864-6(c)(2) is therefore modified so that it would apply exclusively to a distinct class of nonresident aliens, i.e., those with a tax home in the U.S. who are not covered under Code Sec. 865(e)(2). Further, in order for these individuals to be subject to tax to the same extent as other nonresident taxpayers under Code Sec. 865(e)(2), the proposed regs would remove any current references in Reg §1.864-6(c)(2) to Code Sec. 863(b) and Reg §1.863-3, thereby clarifying that the rules of Code Sec. 863(b) and Reg §1.863-3 do not apply in the context of Code Sec. 864(c)(4)(B)(iii) to treat inventory sales as exclusively giving rise to foreign source income if the inventory sold was produced exclusively outside of the U.S.
The proposed regs would not modify the treatment of sales by these individuals of intangible personal property described in Reg §1.864-5(b)(1) or of stock or securities described in Reg §1.864-5(b)(2), which would continue to be governed by Reg §1.864-6(c)(1). Current Reg §1.864-6(c)(2) and Prop Reg §1.864-6(c)(2) implement the rule in Code Sec. 864(c)(5)(C) that applies solely to sales of personal property described in Code Sec. 864(c)(4)(B)(iii) and Reg §1.864-5(b)(3). (Preamble to Prop Reg REG-100956-19)
IRS notes that these nonresident taxpayer proposed regs also could impact the determination of qualified business income for purposes of Code Sec. 199A. Code Sec. 199A(c)(3)(A)(i) provides that “qualified items of income, gain, deduction, and loss” under Code Sec. 199A(c)(3) are those items that are, among other things, effectively connected with the conduct of a trade or business in the U.S. (subject to certain modifications). IRS continues to study the application of Code Sec. 864(c) in the context of Code Sec. 199A, and requests comments on this topic. (Preamble to Prop Reg REG-100956-19)
Effect of nonresident regs on treaties. IRS notes that, under U.S. income tax treaties, the business profits of foreign treaty residents may be taxable in the U.S. only if the profits are attributable to a permanent establishment in the U.S. With respect to taxpayers entitled to the benefits of an income tax treaty, the amount of profits attributable to a U.S. permanent establishment would not be affected by these nonresident taxpayer regs. (Preamble to Prop Reg REG-100956-19)
Proposed applicability date
The proposed regs are proposed to apply to tax years ending on or after December 23, 2019. In addition, taxpayers may rely on the rules in the proposed regs for tax years beginning after December 31, 2017, and before the final regs are applicable, provided that the taxpayer and persons that are related (within the meaning of Code Sec. 267 or Code Sec. 707) to the taxpayer apply the proposed regs in their entirety. (Prop Reg §1.863-3(g), Preamble to Prop Reg REG-100956-19)
For tax years before the proposed regs would apply, the IRS may, where appropriate, challenge certain positions described in the preamble, including that following the amendment to Code Sec. 863(b)(2) income earned by nonresidents from sales of personal property produced outside the U.S. and sold through an office or other fixed place of business in the U.S. is 100% foreign source. (Preamble to Prop Reg REG-100956-19)
To continue your research on sale of inventory produced in the U.S. and sold in a foreign country (or vice versa), see FTC 2d/FIN ¶O-10962; United States Tax Reporter ¶8634.
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