Treasury Releases Final Sourcing Regulations

October 2020

Summary

On September 29, 2020, the Department of the Treasury and the Internal Revenue Service (collectively, Treasury) released an early version of final regulations for publication in the Federal Register that modify 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 final 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 final 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.
 

Background

On December 30, 2019, Treasury published proposed regulations (REG-100956-19) under Internal Revenue Code Sections 863, 864, 865, 937 and 1502 in the Federal Register (84 FR 71836). The proposed regulations modified the rules for sourcing income from certain sales of personal property. For a summary discussion of the proposed regulations, see our January 2020 tax alert.
 
The final regulations retain the overall approach of the proposed regulations, with certain revisions. Some of the key revisions are summarized below.
 

Final Rules Contain Changes Affecting Inventory Sourcing, Apportionment and More

Reg. §1.863-3, as in effect before the final regulations, provided rules and corresponding methods for allocating or apportioning gross income from the sale or exchange of inventory property produced (in whole or in part) by a taxpayer within the United States and sold or exchanged without the United States or produced (in whole or in part) by the taxpayer without the United States and sold or exchanged within the United States between production activity and sales activity. To implement the changes to Section 863(b) under the Tax Cuts and Jobs Act, the proposed regulations proposed removing §1.863-3(c)(2), which allocates and apportions income attributable to sales activity. The final regulations remove §1.863-3(c)(2) but include the rule in prior §1.863-3(c)(2) that treats inventory as wholly produced in the United States for purposes of determining whether the place of sale is presumed to be in the United States if only minor assembly, packaging, repackaging or labeling occurs outside the United States in §1.863-3(c)(1)(i) by incorporating the “principles of §1.954-3(a)(4)” (other than the “substantial contribution to the manufacturing of personal property” under §1.954-3(a)(4)(iv)).
 
Under the final regulations, §§1.863-3 and 1.865-3 incorporate the principles of §1.954-3(a)(4), with the exception of the rules regarding a “substantial contribution to the manufacturing of personal property” under §1.954-3(a)(4)(iv).[1] The final regulations also modify §1.863-1(b)(3)(ii) to incorporate the principles of §1.954-3(a)(4), other than the “substantial contribution to the manufacturing of personal property” under §1.954-3(a)(4)(iv).
 
Proposed §1.865-3(e) also included a cross-reference to the rules for allocating and apportioning expenses to gross income effectively connected with the conduct of a trade or business in the United States in §§1.882-4 and 1.882-5. The final regulations broaden the cross-references to include Sections 882(c)(1) and 873(a) for purposes of allocating and apportioning expenses.[2]
 
The final regulations also reorder and revise parts of §1.865-3 in a non-substantive manner to improve clarity and ease of application. The revision also helps to clarify that §1.865-3 applies only if a nonresident maintains an office or other fixed place of business in the United States to which a sale of personal property is attributable.
 
The final regulations retain, with certain modifications, the rules for determining the portion of gross income from sales and production activities under §1.865-3(d). Under the proposed regulations, the “50/50 method,” described in §1.865-3(d)(2)(i), was the default method because it was “an appropriate and administrable way” to apply Section 865(e)(2). The proposed regulations also allowed nonresidents to elect a books and records method that would “more precisely" reflect their gross income from both sales and production activities, if any, in the United States, provided the nonresidents met certain requirements for maintaining their books of account under proposed §1.865-3(d)(2)(ii)(B)(1) through (3). Under the final regulations, an election to apply the books and records method continues until revoked and may not be revoked, without the consent of the Commissioner, for any taxable year beginning within 48 months of the end of the taxable year in which the election was made.
 
The final regulations also revise §1.864-5 to clarify the interaction with Section 865(e)(2) and (3) and the promulgation of §1.865-3. Gross income, gain or loss from the sale of personal property treated as from sources within the United States under §1.865-3 will generally be effectively connected with the conduct of a trade or business in the United States to the extent provided in Section 864(c), other than Section 864(c)(4) or (5). Gross income, gain or loss from the sale of personal property treated as from sources without the United States under §1.865-3 is not described in §1.864-5(b) and thus will generally not be effectively connected with the conduct of a trade or business in the United States.
 
The rules of §§1.864-5, 1.864-6 and 1.864-7 continue to apply in determining whether foreign-source income of nonresident aliens and foreign corporations that does not arise from the sale of personal property described in §1.865-3(c) is effectively connected with the conduct of a trade or business in the United States. The rules of §§1.864-5, 1.864-6 and 1.864-7 also continue to apply in determining whether foreign-source income from the sale of inventory by nonresident aliens, who would be residents under Section 865(g)(1)(A), is effectively connected with the conduct of a trade or business in the United States.
 
The final regulations clarify the determination of the adjusted basis of production assets under §1.863-3(c)(1)(ii)(B) (which has been redesignated in the final regulations as §1.863-3(c)(2)(ii)(A)). Under the final regulations, the adjusted basis of production assets for a taxable year is determined by averaging the basis of the assets at the beginning and end of the year, except in the event that a change during the year would cause the average to “materially distort” the calculation for sourcing of income attributable to production activity under §1.863-3(c)(1)(ii)(A) (which has been redesignated in the final regulations as §1.863-3(c)(2)(i)).
 
The final regulations provide that the anti-abuse rule in §1.863-3(c) applies to transactions inconsistent with the purpose of §1.863-3(b) or (c), and adds as an example that the anti-abuse rule may cover acquisitions of domestic production assets by related partnerships (or subsidiaries thereof) with a principal purpose of reducing the transferor’s U.S. tax liability by treating income from the sale of inventory property as subject to Section 862(a)(6) rather than Section 863(b).
 
The final regulations generally apply to taxable years ending on or after December 23, 2019. Taxpayers may choose to apply the final regulations for any taxable year beginning after December 31, 2017, and ending before December 23, 2019, provided that the taxpayer and all persons that are related to the taxpayer (within the meaning of Section 267 or 707) apply the final regulations in their entirety and, once applied, the taxpayer and all persons related to the taxpayer (within the meaning of Section 267 or 707) continue to apply the final regulations in their entirety for all subsequent taxable years.[3] Alternatively, taxpayers may rely on the proposed regulations for any taxable year beginning after December 31, 2017, and ending on or before the date the final regulations are posted on the IRS website, provided that the taxpayer and all persons that are related to the taxpayer (within the meaning of Section 267 or 707) rely on the proposed regulations in their entirety and provided that the taxpayer and all persons that are related to the taxpayer (within the meaning of Section 267 or 707) have not applied the final regulations to any preceding year.
 


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[1] See §§1.863-3(c)(1)(i) and 1.865-3(d)(2).
[2] See §1.865-3(e).
[3] See Section 7805(b)(7).