Source of Income From Certain Sales of Personal Property
| Published date | 30 December 2019 |
| Citation | 84 FR 71836 |
| Record Number | 2019-27813 |
| Section | Proposed rules |
| Court | Internal Revenue Service |
Federal Register, Volume 84 Issue 249 (Monday, December 30, 2019)
[Federal Register Volume 84, Number 249 (Monday, December 30, 2019)]
[Proposed Rules]
[Pages 71836-71851]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-27813]
=======================================================================
-----------------------------------------------------------------------
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-100956-19]
RIN 1545-BP16
Source of Income From Certain Sales of Personal Property
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking.
-----------------------------------------------------------------------
SUMMARY: This document contains proposed regulations 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. These 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, these 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.
DATES: Comments and requests for a public hearing must be received by
February 28, 2020.
ADDRESSES: Submit electronic submissions via the Federal eRulemaking
Portal at www.regulations.gov (indicate IRS and REG-100956-19) by
following the online instructions for submitting comments. Once
submitted to the Federal eRulemaking Portal, comments cannot be edited
or withdrawn. The Department of the Treasury (``Treasury Department'')
and the IRS will publish for public availability any comment received
to its public docket, whether submitted electronically or in hard copy.
Send hard copy submissions to: CC:PA:LPD:PR (REG-100956-19), Room 5203,
Internal Revenue Service, P.O. Box 7604, Ben Franklin Station,
Washington, DC 20044.
FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations
Brad McCormack, (202) 317-6911 or Anisa Afshar, (202) 317-4999;
concerning submissions of comments and requests for a public hearing,
Regina L. Johnson, (202) 317-6901 (not toll free numbers).
SUPPLEMENTARY INFORMATION:
Background
These regulations (the ``proposed regulations'') contain proposed
amendments to 26 CFR part 1 revising the rules under section 863 of the
Internal Revenue Code (the ``Code'') for determining the source of
gross income from sales of certain property, and under section 864 for
treating foreign source income as effectively connected with the
conduct of a trade or business within the United States. Conforming
revisions are made to current regulations that reference section 863.
The proposed regulations also provide guidance under section 865(e)(2)
and (3) regarding the source of income from the sale of personal
property, including inventory property, within the meaning of section
865(i)(1) (``inventory''), by nonresidents.
The Tax Cuts and Jobs Act, Pub. L. 115-97 (2017) (the ``Act''),
enacted on December 22, 2017, amended section 863 of the Code, which
provides special rules for determining the source of income, including
income partly from within and partly from without the United States.
Specifically, section 14303 of the Act 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. Before the
Act, section 863(b) provided that income from Section 863(b)(2) Sales
would be treated as derived partly from sources within and partly from
sources without the United States without providing the basis for such
allocation or apportionment.
Current Sec. 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. See current Sec. 1.863-
3(b). Current Sec. 1.863-3(f) provides rules for gains, profits, and
income that are treated as derived partly from sources within the
United States and partly from sources within a possession of the United
States (generally referred to herein as a ``U.S. territory'').
[[Page 71837]]
With respect to production activity, current Sec. 1.863-
3(c)(1)(ii) provides a formula for allocating or apportioning gross
income where there is production activity both within and without the
United States. Current Sec. 1.863-3(c)(1)(ii)(A) determines the amount
of income from sources without the United States by multiplying all the
income attributable to taxpayer's production activities by a fraction,
the numerator of which is the average adjusted basis of production
assets that are located outside the United States and the denominator
of which is the average adjusted basis of all the production assets
located within and without the United States. For purposes of applying
this formula, the adjusted basis of production assets is determined
under section 1011, which is adjusted under section 1016 for
depreciation deductions allowed. Section 13201 of the Act 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. Therefore, certain new
and used production assets placed in service and used predominantly
within the United States 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. Section
168(k)(1) and (6). However, production assets placed in service or used
predominantly without the United States, 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 section 168(g)(2). See section 168(g)(1)(A).
Section 865, added to the Code as part of the Tax Reform Act of
1986, Pub. L. 99-514 (1986) (the ``TRA''), provides rules for sourcing
sales of personal property. The general rule of section 865(a)(1) is
that income from a sale of personal property is sourced based on the
residence of the seller. Section 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 under section
861(a)(6) or 862(a)(6)) or based on the allocation and apportionment
rules of section 863 (for inventory produced by the taxpayer). The
place of sale rules typically depend upon the location where title to
the inventory passes from the seller to the buyer. See Sec. 1.861-
7(c).
Section 865(c) provides special rules for sourcing gain from the
sale of depreciable personal property. Under section 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 United States by treating the same proportion of such gain
as sourced within the United States as the United States depreciation
adjustments (as defined in section 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 United
States. Under section 865(c)(2), gain in excess of the depreciation
adjustments is sourced as if such property were inventory.
Section 865(e)(2) provides a further overlay to these rules with
respect to all sales of personal property (including inventory) by
nonresidents, as that term is defined in section 865(g)(1)(B),
attributable to an office or other fixed place of business in the
United States. Section 865(e)(2)(A) generally provides that income from
any sale of personal property attributable to such an office or other
fixed place of business is sourced in the United States. An exception
is provided in section 865(e)(2)(B) for a sale of inventory for use,
disposition, or consumption outside the United States if a foreign
office of the nonresident ``materially participated'' in the sale.
Section 865(e)(3) provides that the ``principles of section 864(c)(5)
shall apply'' to determine whether a nonresident has an office or other
fixed place of business and whether a sale is attributable to such
office or other fixed place of business. Where applicable, section
865(e)(2) applies ``[n]otwithstanding any other provisions'' of
subchapter N, part I, including sections 863(b), 861(a)(6), and
862(a)(6).
Section 864(c) provides the general rules for determining whether
income is treated as effectively connected with the conduct of a trade
or business within the United States. Nonresident alien individuals,
foreign corporations, and bona fide residents of a U.S. territory
(``non-U.S. persons'') engaged in a trade or business within the United
States are generally subject to U.S. net basis taxation on income that
is effectively connected with that trade or business. Section 864(c)(2)
provides that income described in section 871(a)(1) or (h) or section
881(a) or (c), as well as U.S. source capital gains or losses, are
determined to be effectively connected or not based on two tests--
whether the income is ``derived from assets'' used in the non-U.S.
person's trade or business or whether the activities of the trade or
business were a ``material factor'' in the realization of the income.
Section 864(c)(3) generally treats U.S. source income not described in
section 864(c)(2) as effectively connected with a non-U.S. person's
trade or business within the United States. Section 864(c)(4)(B) sets
forth additional rules that treat certain foreign source income as
effectively connected with the conduct of a U.S. trade or business if a
non-U.S. person has an office or other fixed place of business within
the United States to which the income is attributable, including income
from certain sales of inventory as described in section
864(c)(4)(B)(iii).
Section 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
section 864(c)(4)(B) may apply as the result of the presence of an
agent in the United States, and section 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. Once
it is determined that an office or other fixed place of business in the
United States exists and income is attributable thereto, section
864(c)(5)(C) provides that the amount of income so attributable is
generally the amount that is properly allocable to the office or other
fixed place of business. Section 864(c)(5)(C) further provides that,
with respect to certain sales of inventory described in section
864(c)(4)(B)(iii), the amount attributable to the office or fixed place
of business cannot exceed the income that would otherwise have been
U.S. source had the sale been made in the United States. As noted, the
principles of section 864(c)(5) apply in the context of section
865(e)(2) pursuant to section 865(e)(3).
Explanation of Provisions
Consistent with the Act's changes to section 863(b)(2), these
proposed regulations amend Sec. 1.863-3 in order 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. In
addition, because of the Act's change to section 168(k) to allow
accelerated depreciation in some circumstances, these 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
[[Page 71838]]
without the United States. These proposed regulations also contain
conforming amendments to other regulations that allocate or apportion
income between production and sales activity. In addition, these
proposed regulations make minor changes to Sec. Sec. 1.937-2, 1.937-3,
and 1.1502-13 to update relevant cross references and examples.
These regulations also add proposed Sec. 1.865-3 to clarify the
proper scope and application of section 865(e)(2), as well as the
interaction between section 865(e)(2) and section 865(c) regarding the
sourcing of income from the sale of certain depreciable personal
property. The proposed regulations also 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). The
proposed regulations amend Sec. 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).
I. Modification of Current Sec. 1.863-3 and Other Regulations To
Reflect the Amendments of Section 863(b) and Section 168(k)
A. Proposed Changes to Sec. 1.863-3 To Reflect the Amendment of
Section 863(b)
Before amendment by the Act, section 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 United States,
but did not prescribe a particular method of allocating or apportioning
between these two sources. Accordingly, current Sec. 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 Sec. 1.863-
3(b): The 50/50 method described in paragraph (b)(1), the independent
factory price (``IFP'') method described in paragraph (b)(2), or the
books and records method described in paragraph (b)(3). Current Sec.
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 Sec. 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 section 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, these proposed regulations remove the three
methods in paragraph (b) and the related election rules in paragraph
(e). Proposed Sec. 1.863-3(b) requires sourcing of Section 863(b)(2)
Sales based solely on the location of production activities, consistent
with section 863(b)(2), as amended. Given the elimination of the 50/50
method, the proposed regulations no longer provide for the
apportionment of expenses based solely on relative gross income from
U.S. and foreign sources. Instead, the proposed regulations provide
that expenses are allocated and apportioned based on the generally-
applicable rules in Sec. Sec. 1.861-8 through 1.861-17.
B. Proposed Changes to Sec. 1.863-3(e)
Proposed Sec. 1.863-3(e) (which replaces current Sec. 1.863-3(f))
does 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 United States 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 United States. Instead, proposed Sec. 1.863-3(e) provides a cross-
reference directing taxpayers to source such income under the rules
provided by proposed Sec. 1.863-3(c). Proposed Sec. 1.863-3(e)
modifies the rule for sourcing gross income derived from the purchase
of personal property within a U.S. territory and its sale within the
United States under section 863(b)(3). Consistent with proposed Sec.
1.863-3(b), proposed Sec. 1.863-3(e) removes the books and records
method provided by current Sec. 1.863-3(f)(3)(i)(B). Instead, proposed
Sec. 1.863-3(e)(3)(i) requires sourcing such income based solely upon
the taxpayer's business activity.
C. Proposed Changes to Sec. 1.863-3 To Reflect the Amendment of
Section 168(k)
Notwithstanding the changes to section 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 United States. The proposed regulations retain the existing
rules in current Sec. 1.863-3(c)(1)(ii) for sourcing gross income from
production activity where there is production activity both within and
without the United States. The proposed regulations do not amend
current Sec. 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 United States and the denominator of which is all
production assets within and without the United States. The remaining
income is treated as U.S. source.
Because of the Act's change to section 168(k) to allow accelerated
depreciation in some circumstances, the Treasury Department and the IRS
have determined that a new rule is needed in current Sec. 1.863-
3(c)(1)(ii)(B) for computing the adjusted basis of production assets
for purposes of the formula for allocating or apportioning gross income
where there is production activity both within and without the United
States. Absent a change to the rules of current Sec. 1.863-
3(c)(1)(ii)(B), the Act's modifications to the depreciation treatment
of U.S. production assets will have the unintended effect of skewing
the apportionment formula in favor of foreign source income because
non-U.S. production assets (relative to U.S. production assets) will
generally have a higher adjusted basis. Therefore, these proposed
regulations modify the measurement of the basis of U.S. production
assets under current Sec. 1.863-3(c)(1)(ii)(B) for purposes of the
apportionment formula of proposed Sec. 1.863-3(c)(2)(i). The proposed
regulations measure the basis of U.S. production assets based on ADS
under 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 Treasury Department and the IRS have determined that requiring
the use of ADS for purposes of proposed Sec. 1.863-3 is consistent
with other provisions of the Act that require the use of ADS. For
example, sections 951A(d)(3) and 250(b)(2)(B) (by cross reference to
section 951A(d)) both require the use of ADS for purposes of
determining qualified business asset investment to calculate global
intangible low-taxed income and foreign-derived intangible income,
respectively. The use of ADS is also consistent with the interest
allocation rules in Sec. 1.861-9(i)(1)(i). Nevertheless, the Treasury
Department and the IRS request
[[Page 71839]]
comments regarding the suitability of using ADS for these purposes and
whether there is a more appropriate way to compare U.S. and non-U.S.
production assets for purposes of proposed Sec. 1.863-3, such as the
relative U.S. and non-U.S. production assets reported on the taxpayer's
financial statements.
The proposed regulations do not otherwise modify the rules in
current Sec. 1.863-3 for determining the location or existence of
production activity, a topic the Treasury Department and the IRS may
address in future guidance. The Treasury Department and the IRS request
comments regarding other potential approaches to determine the location
or existence of production activity or other modifications to current
or proposed Sec. 1.863-3 that may be appropriate.
D. Proposed Changes to Other Regulations Under Section 863 To Reflect
the Changes to Sec. 1.863-3
The proposed regulations also modify current Sec. 1.863-1, current
Sec. 1.863-2, and current Sec. 1.863-8 to reflect the changes to
current Sec. 1.863-3. Proposed Sec. 1.863-1(b) provides special rules
for allocating or apportioning gross income from the sale of natural
resources, which can be a subset of inventory generally. See proposed
Sec. 1.863-2(b). Current Sec. 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
Sec. 1.863-3, depending on the circumstances.
Current Sec. 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 United States 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 Sec. 1.863-3.
As it is generally no longer appropriate under section 863(b)(2) to
allocate or apportion any gross income from sales of inventory,
including natural resources, to sales activity, the proposed
regulations modify current Sec. 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 is 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. In other words, where there are no
additional production activities, the location of the farm, mine, oil
or gas well, other natural deposit, or uncut timber is considered the
place of production generally.\1\
---------------------------------------------------------------------------
\1\ Treasury Decision 8687, 1996-2 C.B. 47, added the export
terminal rule in current Sec. 1.863-1(b) partly in response to the
decision in Phillips Petroleum Co. v. Commissioner, 97 T.C. 30
(1991), aff'd without published opinion, 70 F.3d 1282 (10th Cir.
1995). These proposed regulations follow Phillips Petroleum in
treating natural resources, once extracted, in the same way as other
types of inventory and therefore subject to section 863(b)(2), as
amended.
---------------------------------------------------------------------------
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 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 between sources within and without the
United States under proposed Sec. 1.863-3 principles based on the
location of the assets used in the additional production activities.
See proposed Sec. 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
United States of such nonresident, the foregoing rules are subject to
the rules of section 865(e)(2) and proposed Sec. 1.865-3.
Current Sec. 1.863-8(b)(3)(ii) provides a special rule for
allocating and apportioning income under section 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 section
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 regulations modify
current Sec. 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.
E. Proposed Changes to Regulations Under Section 1502 To Reflect the
Changes to Sec. 1.863-3
To reflect section 863(b)(2), as amended by the Act, and the
proposed regulations' amendments to Sec. 1.863-3, the proposed
regulations also amend example 14 of Sec. 1.1502-13(c)(7)(ii)(N). This
example illustrates the interaction between the intercompany
transaction rules under current Sec. 1.1502-13 and the sourcing rules
in section 863. As revised by the proposed regulations, the example
continues to illustrate the same matching principles for intercompany
transactions under proposed Sec. 1.1502-13 while updating the facts
and analysis to reflect the changes in section 863(b)(2) and Sec.
1.863-3.
II. Proposed Rules for Sales of Personal Property by Nonresidents
A. Proposed Source Rules Under Sec. 1.865-3 To Take Into Account
Section 863(b)
1. Interaction of Section 863(b), as Amended, With Section 865(e)(2)
In light of the changes made by the Act to section 863(b), the
Treasury Department and the IRS are concerned that nonresident
taxpayers may take an improper position that these changes override the
application of section 865(e)(2) as it applies to sales \2\ of
inventory \3\ produced by a nonresident taxpayer and sold through a
U.S. sales office, despite the fact that section 865(e)(2) applies
``[n]otwithstanding any other provisions in [sections 861 through
865].'' To address this improper interpretation of section 865(e)(2),
and to provide guidance for the application of section 865(e)(2) in
general, the proposed regulations add proposed Sec. 1.865-3.
---------------------------------------------------------------------------
\2\ As defined in section 865(i)(2).
\3\ Inventory property, as defined in section 865(i)(1).
---------------------------------------------------------------------------
Section 865, enacted in 1986 as part of the TRA, provides special
sourcing rules for sales of personal property. In particular, section
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 United States, ``income
[[Page 71840]]
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
section 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 United States, section 865(e)(2) must be given effect in
determining the source of the income.
For purposes of section 865(e)(2), section 865(e)(3) provides that
the ``principles of section 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. As described in the
Background section of this preamble, section 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 section 864(c)(4)(B) may apply as the
result of the presence of an agent in the United States, section
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 section 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 United States cannot exceed ``the income which would be
derived from sources within the United States if the sale or exchange
were made in the United States.''
Section 865(e)(2) may properly be read to treat all income from a
sale of personal property by a nonresident as U.S. source so long as
the sale is ``attributable'' to the nonresident's office or other fixed
place of business in the United States. By its terms, section 865(e)(3)
does not necessarily change this result because it references section
864(c)(5) only for purposes of (1) determining whether a taxpayer has
an office or other fixed place of business and (2) whether a sale is
attributable to such office or other fixed place of business. Section
865(e)(3) does not by its terms reference section 864(c)(5) for
determining the amount of income attributable to such office or other
fixed place of business. On this basis, section 865(e) may fairly be
read to override section 863(b) where Section 863(b)(2) Sales of a
nonresident are attributable to an office or other fixed place of
business in the United States, with the result that all of the income
from such sales is sourced within the United States.
On the other hand, section 865 concerns the source of income, gain,
and loss, and section 865(e)(3) refers to ``the principles of section
864(c)(5),'' which determines ``income, gain or loss'' attributable to
an office or other fixed place of business in the United States (as
noted in subparagraphs 864(c)(5)(B) and 864(c)(5)(C), which operate
together). On this basis, the Treasury Department and the IRS have
determined that section 864(c)(5) may serve not only as the basis to
attribute a sale to an office or other fixed place of business in the
United States within the meaning of section 865(e)(2), but also as the
basis, in the context of section 865(e)(2) as applicable to Section
863(b)(2) Sales, for allowing a limitation on the amount of income and
gain from sales of inventory property attributable to such office or
other fixed place of business and, therefore, sourced in the United
States. In particular, as relevant here, section 864(c)(5)(C) limits
the amount of ``income, gain, or loss'' from sales that meet the
``material factor'' threshold of section 864(c)(5)(B) to the amount of
income ``properly allocable'' to the office or other fixed place of
business in the United States \4\ (which is a lesser amount of income
than would be allocated based on such sale under a literal reading of
section 865(e)(2) (the entire amount of income)).
---------------------------------------------------------------------------
\4\ Section 864(c)(5)(C) actually states ``the income, gain or
loss property [sic] allocable thereto.'' Based on the legislative
history behind The Foreign Investors Tax Act, Public Law 89-809
(1966), which added section 864(c) to the Code, the use of
``property'' in the final bill appears to be a typographical error.
The Senate Report that added this provision used the word
``properly'' not ``property.'' See S. Rep. No. 1707 at 1275 (1966).
---------------------------------------------------------------------------
The last clause of section 864(c)(5)(C) also imposes a limitation
in the case of sales described in section 864(c)(4)(B)(iii) (sales
outside the United States made through an office or other fixed place
of business in the United States) that ``the income which shall be
treated as attributable to an office or other fixed place of business
within the United States shall not exceed the income which would be
derived from sources within the United States if the sale or exchange
were made in the United States.'' Before the enactment of section
865(e)(2), which generally caused such sales to result in U.S. source
income and hence fall outside the scope of section 864(c)(4)(B)(iii),
this clause was intended to limit the application of section
864(c)(4)(B) to income from sales activities, thus excluding income
from production activities. The clause did not determine how much
income was attributable to sales versus production activities.
Following the Act, which did not amend section 865(e)(2), the Treasury
Department and the IRS continue to believe that this clause has no
relevance to the determination of how much income is attributable to
sales activities or to sales governed by section 865(e)(2).
By incorporating the principles of section 864(c)(5), section
865(e)(3) thus authorizes regulations that would bifurcate the income
from a sale of inventory property produced by a nonresident outside the
United States and sold through an office or other fixed place of
business in the United States so that only the ``properly allocable''
amount of income from that sale is attributable to an office or other
fixed place of business in the United States and treated as U.S.
source. In such a case, this amount reflects the nonresident's sales
activity, not its production activities, with respect to the personal
property sale, which is the portion of the income that Congress
intended to treat as U.S. source when it enacted section 865(e)(2) in
1986.\5\ H.R. Rep. No. 99-426, at 360-61 (1985).
---------------------------------------------------------------------------
\5\ In the case of inventory property purchased outside the
United States (other than in a U.S. territory of the United States)
and sold through an office or other fixed place of business in the
United States, section 863(b) has no application and hence,
regardless of where title passage occurs, all of the income is
considered attributable to such office or other fixed place of
business and sourced in the United States.
---------------------------------------------------------------------------
The 1986 legislative history of section 865(e)(2) shows that
Congress intended, by enacting that provision, to repeal (in certain
cases) the title passage rule that formerly controlled the source of
the ``sales income'' from the sale of personal property, regardless of
where the ``sales activities'' occurred. See H.R. Rep. No. 99-426, at
360 (1985) (providing that ``[a]lthough the title passage rule operates
clearly, it is manipulable''); see also S. Rep. No. 99-313, at 330-33
(1986). The legislative history shows that Congress rather sought to
tax ``income derived from sales'' based on the ``location of the
economic activity generating the income.'' See S. Rep. No. 99-313, at
330 (1986); H.R. Rep. No. 99-426, at 360 (1985). ``If the seller
maintains a fixed place of business outside the seller's country of
residence which materially participates in a sale, . . . the committee
generally believes that the level of economic activity with respect to
the sale that is associated with that place of business is high enough
such that the location of that place of business should govern the
source of the sales income.'' H.R. Rep. No. 99-426, at 360-61 (1985).
These statements show, both individually and
[[Page 71841]]
in the aggregate, that Congress enacted section 865(e)(2) with a focus
upon sourcing income from sales activity based on the economic location
of the activity, rather than the location of title passage. The
principles of section 864(c)(5) (and in particular subparagraph (C)
thereof) give effect to this intent through section 865(e)(3) by
limiting the application of section 865(e)(2) to sales income properly
allocable to the office or other fixed place of business in the United
States.
Before the issuance of these proposed regulations, the Treasury
Department and the IRS had never issued formal guidance on the sourcing
rules of section 865(e)(2) in the case of inventory property produced
outside the United States and sold within the United States.
Nevertheless, in light of the statutory text of section 865(e)(2) and
(3) (as well as section 864(c)(5)(C) by reference) and the legislative
history of these provisions, in practice, the IRS has historically
interpreted section 865(e)(2) to include a limitation that treated as
U.S. source only the sales income allocable to the office or other
fixed place of business in the United States reflecting the sales
activity from the transaction. See, e.g., 1996 Field Service Advice
(FSA) LEXIS 68 (Sept. 24, 1996); 1996 FSA LEXIS 465 (Feb. 29, 1996).
This historical interpretation utilized the rules of section 863(b)
before amendment by the Act (referenced in current Sec. 1.864-6(c)) to
determine the amount of income allocable to the office or other fixed
place of business in the United States, thereby allowing taxpayers to
apply, among other rules, a 50/50 split between U.S. source income
(allocable to the office or other fixed place of business in the United
States and reflective of sales activity) and foreign source income
(reflective of production activity) for sales subject to section
865(e)(2) (the ``50/50 method''). The IRS has historically allowed the
50/50 method for establishing the amount allocable to the office or
other fixed place of business in the United States (and the sales
activity) under section 864(c)(5). Section 865(e)(3) incorporates into
section 865(e)(2) the principles of section 864(c)(5), and so the 50/50
method approximated the effect of applying the principles of section
864(c)(5) under section 865(e)(2).
Although the Act amended section 863(b), it made no changes to
section 865(e)(2), which does not explicitly reference or depend upon
section 863. The 2018 Blue Book notes the absence of any change to
section 865(e)(2). See 2018 Blue Book at 397 n.1798. Consistent with
historical IRS practice, in its description of prior law, the 2018 Blue
Book explains that although sections 863(b) and 865(e)(2) may appear to
conflict, in the case of a nonresident manufacturing property without
the United States for sale within the United States, the result is that
``the income generally is partly U.S.-source and partly foreign-
source.'' \6\ Id. at 328 n.1519.
---------------------------------------------------------------------------
\6\ This statement appears to conflict with another statement in
the 2018 Blue Book with respect to prior law to the effect that the
application of section 865(e)(2) to a sale of personal property made
by a nonresident attributable to its office or fixed place of
business in the United States results in all income from the sale
being sourced in the United States. Id. at 396-97.
---------------------------------------------------------------------------
Further, despite the changes to section 863(b) in the Act,
structurally, the bifurcated approach is maintained, and section
863(b)(2) continues to refer to inventory that is produced within the
United States and sold without the United States, or produced without
the United States and sold within the United States. The statutory
provision preserves the distinction between sales and production
economic activity. If Congress intended to eliminate the sales versus
production dichotomy for all purposes, it presumably would have deleted
those phrases as the new flush language (that any sale of manufactured
inventory property is sourced in whole based on the location of
production activities) would have made them surplusage.
In light of Congress's decision to retain the underlying structure
of section 863(b)(2) and append the flush language as an overlay, the
IRS's longstanding interpretation of the relationship of sections
863(b)(2) and 865(e)(2) under pre-Act law, and the fact that section
865(e)(2) was left unaltered by the Act, the Treasury Department and
the IRS have determined that the relationship between section 863(b)(2)
and section 865(e)(2) should not be interpreted differently before and
after the Act. Thus, section 865(e)(2) should continue to apply to
inventory property sales income ``properly allocable'' to an office or
other fixed place of business in the United States (reflecting sales
activity rather than production activity) just as before the Act.
As noted, the Treasury Department and the IRS understand that some
nonresident taxpayers may be taking the position that, applied after
the Act, the last clause of section 864(c)(5)(C) (limiting the income
treated as attributable to an office or other fixed place of business
in the United States to the amount that would be U.S. source if the
sale were made in the United States) causes the income from the sale of
inventory produced outside the United States and subject to section
865(e)(2) to be foreign source to the same extent that it would be
foreign source under section 863(b), standing alone, which would cause
the sourcing of both the sales and production income from the
disposition to be based on the location of production activities. Such
a reading cannot be correct, because it would inappropriately construe
a provision (section 865(e)(2)) intended as a separate restriction on
the source rule under section 863(b)(2) (and which literally can be
read as entirely overriding that rule) to be determined solely by
reference to the terms of such source rule itself (rather than at most
in a manner giving effect to both rules). Further, such a construction
would cause section 865(e)(2) to have no effect with respect to sales
of inventory that are also described in section 863(b)(2), contrary to
longstanding statutory construction principles. See, e.g., Watt v.
Alaska, 451 U.S. 259, 267 (1981) (statutes should be read to give
effect to each if it can be done so while preserving their sense and
purpose).
Moreover, such a reading would, in effect, import the change in
section 863(b) from the Act into section 865(e)(2), which Congress did
not do. As noted, section 865(e)(2) applies ``[n]otwithstanding any
other provisions.'' Section 865(e)(3) applies the ``principles'' of
section 864(c)(5), which reflects the sometimes imprecise fit between
sections 864(c)(5) and 865(e)(2), such as the fact that section
864(c)(5) refers to ``income, gain or loss,'' rather than a ``sale,''
attributable to an office or other fixed place of business in the
United States. The relevant principles referenced in section 865(e)(3)
are those that apply for purposes of determining the income, gain, or
loss attributable to an office or fixed place of business in the United
States. As discussed previously in this section of the Explanation of
Provisions, the last clause of section 864(c)(5)(C) is not relevant to
that determination and therefore is not relevant to the application of
sections 863(b) or 865(e)(2). The principles of section 864(c)(5) are
those self-contained in the words of the provision itself (``properly
allocable''), and not the limitation provided in the last clause of
section 864(c)(5)(C) that serves a different purpose. The amendment to
section 863(b)(2) did not change the traditional analysis regarding the
attribution of inventory sales to an office or other fixed place of
business in the United States.
In light of the foregoing, these proposed regulations clarify the
application of the principles of section
[[Page 71842]]
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.
2. Overview of the Proposed Regulations Under Section 865(e)(2)
Section 865(e)(2) sources the amount of income from sales described
in section 865(e)(2)(A) to which the exception in section 865(e)(2)(B)
does not apply (Section 865(e)(2) Sales) that is determined to be
properly allocable to the nonresident's office or other fixed place of
business in the United States under the principles of section
864(c)(5)(C) as referenced by section 865(e)(3). In cases where a sale
of personal property is not a Section 865(e)(2) Sale, other sourcing
provisions continue to apply.
Proposed Sec. 1.865-3(a) sets forth the general rule in section
865(e)(2)(A), and proposed Sec. 1.865-3(b) sets forth the exception in
section 865(e)(2)(B) and cross-references the rules of Sec. 1.864-
6(b)(3) to determine if a foreign office materially participated in the
sale. Proposed Sec. 1.865-3(c) sets forth the rules for determining
whether a nonresident has an office or other fixed place of business in
the United States by incorporating the principles of Sec. 1.864-7, and
whether a sale of personal property is attributable to that office or
other fixed place of business in the United States by incorporating the
principles of Sec. 1.864-6(b) and (c), as amended.
Proposed Sec. 1.865-3(d) then 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 section 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 United States of the nonresident. Proposed
Sec. 1.865-3(d) provides separate source rules for income from sales
of inventory subject to section 865(e)(2), dependent on whether the
nonresident produced the inventory (either the default 50/50 method in
paragraph (d)(2)(i) or the elective books and records method in
paragraph (d)(2)(ii)), or purchased the inventory, 100 percent U.S.
source income in paragraph (d)(3). Proposed Sec. 1.865-3(d)(2)(ii)
provides the books and records method that a taxpayer can elect to
apply in lieu of the default 50/50 method, including the rules for
making that election and the records that must be provided to the
Commissioner upon request. To the extent income from either type of
inventory sale is treated as U.S. source under proposed Sec. 1.865-
3(d)(2) or (3), the income will generally be effectively connected with
the conduct of a U.S. trade or business under section 864(c)(3).
Proposed Sec. 1.865-3(e) provides a cross reference to the rules
in Sec. Sec. 1.882-4 and 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
United States.
3. The Proposed Rules for Non-Inventory Property
Section 864(c)(2) applies to determine whether U.S. source gain
from the sale of non-inventory property and other capital assets by a
non-U.S. person is effectively connected with the conduct of a U.S.
trade or business. The proposed regulations implement section 865 and
provide source rules for determining whether gain is U.S. source for
purposes of section 864(c)(2).
In the case of income derived from the sale of depreciable personal
property, section 865(c) distinguishes between gain not in excess of
depreciation adjustments and gain in excess of depreciation
adjustments, and bifurcates the gain not in excess of depreciation
adjustments pro rata to depreciation deductions allowable in computing
taxable income from sources within the United States and without the
United States. Section 865(c)(1). Gain in excess of depreciation is
sourced as if such property were inventory property. Section 865(c)(2)
and proposed Sec. 1.865-3(d)(4). See section II.A.4 of this
Explanation of Provisions for discussion of the sourcing of inventory
property. The legislative history of section 865(c), which was enacted
at the same time as section 865(e)(2), indicates that Congress intended
to create a special rule for depreciable personal property to source
the income derived from the sale of depreciable personal property, to
the extent of prior depreciation deductions, under a recapture
principle. Under this rule, gain from the sale of depreciable personal
property, to the extent of prior depreciation deductions, is sourced
within the United States in proportion to the extent of the
depreciation deductions that were previously allocated against U.S.
source income. On the other hand, the gain, to the extent of prior
depreciation deductions, is sourced without the United States in
proportion to the extent of the depreciation deductions that were
previously allocated against foreign source income. See H.R. Rep. No.
99-426, at 364 (1985); S. Rep. No. 99-313, at 331-32 (1986); Joint
Committee on Taxation, General Explanation of the Tax Reform Act of
1986 (Pub. L. 99-514), JCS-10-87, at 63 (1987). Thus, Congress intended
to apply the recapture rule to source gain, not in excess of
depreciation, from a sale of depreciable personal property (as opposed
to sourcing that gain based on the location of the taxpayer's office).
Consistent with this legislative history, the Treasury Department
and the IRS have determined that, to the extent a nonresident
previously allocated depreciation deductions against foreign source
income, in the event of a sale of such property through an office or
other fixed place of business in the United States, the associated gain
is not ``properly allocable'' to an office or other fixed place of
business in the United States under the principles of section
864(c)(5), and therefore to such extent the sale (and gain) is not
attributable to a nonresident's office or other fixed place of business
in the United States under section 865(e)(2). Therefore, 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 Sec.
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).
4. The Proposed Rules for Inventory
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
[[Page 71843]]
income derived from the disposition to be U.S. source. See Sec. 1.865-
3(d)(3).
With respect to inventory produced 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), the Treasury Department
and the IRS have determined that the disposition continues to give rise
to gross income that is partly allocable to the nonresident's office or
other fixed place of business in the United States (representative of
the sales activity with respect to the transaction) and sourced under
section 865(e)(2), with the remainder allocable to production activity
and sourced under section 863(b). Therefore, these proposed regulations
provide a rule specifically for Section 865(e)(2) Sales involving
inventory produced by the nonresident that distinguishes generally
between sales and production activities in determining the source of
the income from sales of produced inventory and is consistent with the
overall structure of subchapter N, part I (sections 861-865).
The Treasury Department and the IRS understand that Congress
intended for the source rules to ``operate clearly without the
necessity for burdensome factual determinations.'' H.R. Rep. No. 99-
426, at 360 (1985). Additionally, it is noteworthy that the
``principles'' of section 864(c)(5)(C), rather than the exact rules
thereof, apply in the section 865(e)(2) context. Finally, the Treasury
Department and the IRS are mindful of the fact that section 865(e)(2)
was not modified by the Act. Before the Act, by applying the principles
of current Sec. 1.863-3(b) to determine the amount of income allocable
to the office or other fixed place of business in the United States,
the 50/50 method allowed for a 50 percent U.S. source result with
respect to sales of produced inventory.
Based on the foregoing considerations, these 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
these 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.
In prescribing the 50/50 method for dividing gross income from
Section 865(e)(2) Sales between production and sales activity, the
Treasury Department and the IRS appreciate that this method may not
correspond precisely to the economic genesis of the gross income with
respect to the sales and production activity involved. Nevertheless,
the Treasury Department and the IRS have determined that this is an
appropriate and administrable way to give effect to the principles of
section 864(c)(5) in allocating income to the office or other fixed
place of business in the United States (and focusing on sales activity)
when applying section 865(e)(2). First, the 50/50 method has
historically been recognized as a reasonable method for allocating
income between production and sales activity. Before the Act, section
863(b) specified that income from Section 863(b)(2) Sales ``be treated
as derived partly from sources within and partly from sources without
the United States,'' and imposed no standard for allocating or
apportioning the income. As discussed, the 50/50 method was a commonly
used and well-understood sourcing method that ensured some income was
allocated or apportioned to sales activity and some to production
activity under section 863(b). For example, in 1984 the Treasury
Department stated that ``[g]enerally, [income derived from the
manufacture and sale of property] is allocated one-half on the basis of
the place of manufacture and half on the basis of the place of sale.''
Treasury Department, Tax Reform for Fairness, Simplicity, and Economic
Growth, Nov. 1984 at 364. The House, Senate, and Conference Committees
each stated with respect to the TRA that ``[under the 50/50 method],
half of such income generally is sourced in the country of manufacture,
and half of the income is sourced on the basis of the place of sale.''
H.R. Rep. No. 99-426, at 359 (1985); S. Rep. No. 99-313, at 329 (1986);
H.R. Rep. No. 99-841, at 917 (1986) (``Conf. Rep.''). Finally, the
staff of the Joint Committee on Taxation has referred to the 50/50
method as the ``production/marketing split'' and stated that under this
method ``50 percent of such income generally is attributed to the place
of production.'' Joint Committee on Taxation, Factors Affecting
International Competitiveness of the United States, JCS-6-91, at 148-
149 (1991). Second, the 50/50 method was the most administrable of the
permissible means of applying section 865(e)(2) through the application
of section 864(c)(5)(C) and current Sec. 1.864-6(c)(2) before the Act.
Therefore, these proposed regulations adopt the 50/50 method as the
default method for allocating or apportioning gross income attributable
to Section 865(e)(2) Sales between sources within and without the
United States.
Nevertheless, the Treasury Department and the IRS are aware that
some taxpayers may be able to more precisely allocate or apportion
their gross income between sales and production activities based on
their books of account. Taxpayers, at their election, have historically
used such a ``books and records'' method under current Sec. 1.863-
3(b)(3) to allocate or apportion their gross income from sales of
inventory between production and sales activities. Therefore, as an
elective alternative to the default 50/50 method, taxpayers may
continue to use a books and records method as provided in these
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.
A taxpayer electing the books and records method must prepare and
maintain records that are in existence when its return is filed
regarding the allocation of gross income between sales and production
activities in its books of account and indicate in a statement attached
to its tax return that it elects to apply this method. As part of its
records that exist when its return is filed, the taxpayer must include
an explanation of how such allocation clearly reflects the taxpayer's
income from production and sales activities under the principles of
section 482. The Treasury Department and the IRS intend the taxpayer's
explanation to allow a potential examiner to have a roadmap for
understanding the method by which the taxpayer determined the
allocation of gross income between the U.S. sales activities and the
foreign production activities, respectively. The use of section 482 in
the proposed regulations is not intended to imply that the taxpayer's
explanation must satisfy the documentation requirements of section
6662(e) and Sec. 1.6662-6(d). The taxpayer must make available its
books and records for both its sales activities and its production
activities and the related explanation upon request of the
Commissioner. If a taxpayer fails to satisfy these requirements in
full, the default 50/50 method will apply.
[[Page 71844]]
These proposed regulations, however, do not also provide for an
elective IFP method as allowed by current Sec. 1.863-3(b)(2). The
Treasury Department and the IRS have determined that this method is
applicable only in very narrow circumstances when an IFP exists and
therefore has rarely been elected by taxpayers in practice. Any
taxpayer that wishes to continue using an IFP could generally continue
to reach a similar result by electing the books and records method and
basing the allocation or apportionment in its books and records on the
IFP. Nevertheless, the Treasury Department and the IRS request comments
on whether the IFP or any other methods for allocating or apportioning
gross income attributable to Section 865(e)(2) Sales between sources
within and without the United States should be included in these
regulations.
B. Modification of Current Sec. 1.864-6(c)(2) To Ensure Consistency
With Sec. 1.865-3
Section 864(c)(4)(B)(iii) generally provides that income derived
from the sale of inventory (outside the United States) by a non-U.S.
person through an office or other fixed place of business in the United
States may be effectively connected income, notwithstanding that it
would be foreign source income under the title passage rules in Sec.
1.861-7(c). It provides an exception for inventory sold for use or
consumption outside the United States, similar to the exception in
section 865(e)(2)(B).
Accordingly, sections 864(c)(4)(B)(iii) and 865(e)(2), as a
statutory matter, 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 United States. This was not the case, however, in 1986
because Congress removed section 864(c)(4)(B)(iii) from the Code when
section 865(e)(2) was added. The Tax Reform Act of 1986, Public Law 99-
514 (1986) (section 1211(a) added section 865, while section 1211(b)(2)
removed section 864(c)(4)(B)(iii)). Two years later, however, in the
Technical and Miscellaneous Revenue Act of 1988 (``TAMRA 1988''),
Congress added section 864(c)(4)(B)(iii) back to the Code, with the
Senate Report to TAMRA 1988 explaining that the provision was
reinstated because it ``is necessary to ensure that foreign persons who
have a substantial presence in the United States, who may be treated as
U.S. residents for source rule purposes but as nonresidents for general
purposes, are taxed on income derived from sales of inventory
property.'' S. Rep. No. 100-445, at 239 (1988); see also Joint
Committee on Taxation, Description of the Technical Correction Act of
1988, JCS-10-88, at 250 (1988); TAMRA 1988 (section 1012(d)(7) restored
section 864(c)(4)(B)(iii)).
The Treasury Department and the IRS have thus determined that where
both provisions potentially could apply, as in the case of foreign
corporations and most nonresident alien individuals, section 865(e)(2)
takes precedence over section 864(c)(4)(B)(iii) because section
865(e)(2) applies ``[n]otwithstanding any other provisions of this
part.'' Consistent with the TAMRA 1988 legislative history, the
Treasury Department and the IRS have determined that section
864(c)(4)(B)(iii) applies solely to nonresident alien individuals
(defined in section 7701(b)) who under section 865(g)(1) have a tax
home (as defined in section 911(d)(3)) in the United States (and whose
inventory sales thus would not be subject to section 865(e)(2) as those
individuals would not be ``nonresidents'' under section 865(g)(1)(B)).
Note that these nonresident alien individuals would be subject to
section 864(c)(4)(B)(iii) and section 864(c)(5) only with respect to
income from inventory sales that is determined to be foreign source
after application of sections 861(a)(6), 862(a)(6), and 863(b) pursuant
to section 865(b). Thus, for example, a nonresident alien individual
engaged in a U.S. trade or business, with a tax home in the United
States, who purchases inventory outside the United States and resells
inventory attributable to a U.S. office (with title passing offshore)
would have foreign source income under section 862(a)(6) (by reference
from section 865(b)), but that foreign source income would then be
subject to section 864(c)(4)(B)(iii) and section 864(c)(5) to determine
the amount of the individual's foreign source effectively connected
income.
Although the scope of section 864(c)(4)(B)(iii) is narrow, the
Treasury Department and the IRS have 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 section 865(e)(2), depending on whether
the inventory was either purchased abroad or produced abroad. Section
1.864-6(c)(2)is therefore modified so that it applies exclusively to
this distinct class of nonresident aliens, those with a tax home in the
United States who are not covered under section 865(e)(2). Further, in
order for these individuals to be subject to tax to the same extent as
other nonresident taxpayers under section 865(e)(2), the proposed
regulations remove any current references in Sec. 1.864-6(c)(2) to
section 863(b) and Sec. 1.863-3, thereby clarifying that the rules of
section 863(b) and Sec. 1.863-3 do not apply in the context of section
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 United States. The proposed regulations do not modify
the treatment of sales by these individuals of intangible personal
property described in Sec. 1.864-5(b)(1) or of stock or securities
described in Sec. 1.864-5(b)(2), which continue to be governed by
Sec. 1.864-6(c)(1). Current and proposed Sec. 1.864-6(c)(2) implement
the rule in section 864(c)(5)(C) that applies solely to sales of
personal property described in section 864(c)(4)(B)(iii) and Sec.
1.864-5(b)(3).
These proposed regulations also may impact the determination of
qualified business income for purposes of section 199A. Section
199A(c)(3)(A)(i) provides that ``qualified items of income, gain,
deduction, and loss'' under section 199A(c)(3) are those items that
are, among other things, effectively connected with the conduct of a
trade or business in the United States within the meaning of section
864(c) (subject to certain modifications). The Treasury Department and
the IRS continue to study the application of section 864(c) in the
context of section 199A, and request comments on this topic.
C. U.S. Income Tax Treaties
The Treasury Department and the IRS are aware that under U.S.
income tax treaties, the business profits of foreign treaty residents
may be taxable in the United States only if the profits are
attributable to a permanent establishment in the United States. With
respect to taxpayers entitled to the benefits of an income tax treaty,
the amount of profits attributable to a U.S. permanent establishment
will not be affected by these regulations.
Proposed Applicability Date
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 these 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
[[Page 71845]]
(within the meaning of section 267 or 707) to the taxpayer apply the
proposed regulations in their entirety. For taxable years before these
regulations apply, the IRS may, where appropriate, challenge certain
positions described in this preamble, including that following the
amendment to section 863(b)(2) income earned by nonresidents from sales
of personal property produced outside the United States and sold
through an office or other fixed place of business in the United States
is 100 percent foreign source.
Special Analyses
The Administrator of the Office of Information and Regulatory
Affairs (OIRA), Office of Management and Budget, has determined that
this proposed rule is not a significant regulatory action, as that term
is defined in section 3(f) of Executive Order 12866. Therefore, OIRA
has not reviewed this proposed rule pursuant to section 6(a)(3)(A) of
Executive Order 12866 and the April 11, 2018, Memorandum of Agreement
between the Treasury Department and the Office of Management and Budget
(``OMB'').
I. Regulatory Flexibility Act
Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it
is hereby certified that these proposed regulations, if adopted, will
not have a significant economic impact on a substantial number of small
entities. Although data are not readily available to assess the number
of small entities potentially affected, any economic impact of these
regulations is unlikely to be significant. Specifically, the
regulations in Sec. Sec. 1.863-1 and 1.863-3 (with conforming changes
in cross-referencing regulations) implement the statutory change made
to section 863(b) by the Act. This change affects sales of inventory
property by any taxpayer where the taxpayer produces the inventory (in
whole or in part) within the United States and sells that inventory
without the United States, or vice versa. The change in sourcing for
those entities is attributable to the change in section 863(b) made by
the Act. Proposed Sec. Sec. 1.863-1 and 1.863-3 merely implement the
statutory change with limited additional guidance. The Treasury
Department and the IRS do not anticipate that any differences between
the changes in section 863(b) made by the Act and the changes in
proposed Sec. Sec. 1.863-1 and 1.863-3 made by these proposed
regulations will have a significant economic impact on a substantial
number of small entities. Notwithstanding this certification, the
Treasury Department and the IRS invite comments on the impact of this
rule on small entities.
The other regulations in this publication (other than changes to
ensure consistency with section 863(b)) are the proposed regulations in
Sec. Sec. 1.864-6 and 1.865-3. These proposed regulations solely
affect non-U.S. taxpayers, which are not subject to the Regulatory
Flexibility Act.
Pursuant to section 7805(f), this notice of proposed rulemaking has
been submitted to the Chief Counsel for Advocacy of the Small Business
Administration for comment on its impact on small businesses.
II. Unfunded Mandates Reform Act
Section 202 of the Unfunded Mandates Reform Act of 1995 requires
that agencies assess anticipated costs and benefits and take certain
other actions before issuing a final rule that includes any Federal
mandate that may result in expenditures in any one year by a state,
local, or tribal government, in the aggregate, or by the private
sector, of $100 million in 1995 dollars, updated annually for
inflation. In 2019, that threshold is approximately $154 million. These
proposed regulations do not include any Federal mandate that may result
in expenditures by state, local, or tribal governments, or by the
private sector in excess of that threshold.
III. Executive Order 13132: Federalism
Executive Order 13132 (entitled ``Federalism'') prohibits an agency
from publishing any rule that has federalism implications if the rule
either imposes substantial, direct compliance costs on state and local
governments, and is not required by statute, or preempts state law,
unless the agency meets the consultation and funding requirements of
section 6 of the Executive Order. These proposed regulations do not
have federalism implications and do not impose substantial direct
compliance costs on state and local governments or preempt state law
within the meaning of the Executive Order.
Comments and Requests for Public Hearing
Before the proposed regulations are adopted as final regulations,
consideration will be given to any comments that are submitted timely
to the IRS as prescribed in this preamble under ADDRESSES. The Treasury
Department and the IRS request comments on all aspects of the proposed
rules. See also sections I.C, II.A.4, and II.B of the Explanation of
Provisions (requesting specific comments related to the suitability of
using ADS, other potential approaches to determine the location or
existence of production activity, or other modifications to Sec.
1.863-3 that may be appropriate; related to whether there are other
suitable methods for allocating or apportioning income attributable to
Section 865(e)(2) Sales between U.S. and foreign sources; and related
to the impact of these proposed regulations on the determination of
qualified business income for purposes of section 199A, respectively).
All comments will be available at www.regulations.gov or upon request.
A public hearing will be scheduled if requested in writing by any
person that timely submits comments. If a public hearing is scheduled,
notice of the date, time, and place for the public hearing will be
published in the Federal Register.
Drafting Information
The principal authors of the proposed regulations are Brad
McCormack and Anisa Afshar of the Office of Associate Chief Counsel
(International). However, other personnel from the Treasury Department
and the IRS participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAXES
0
Paragraph 1. The authority citation for part 1 is amended by:
0
1. Revising the entries for Sec. Sec. 1.863-1, 1.863-2, 1.863-3, and
1.863-8.
0
2. Adding an entry for Sec. 1.865-3 in numerical order.
0
3. Revising the entries for Sec. Sec. 1.937-2, 1.937-3, and 1.1502-13.
The revisions and addition read in part as follows:
Authority: 26 U.S.C. 7805 * * *.
Section 1.863-1 also issued under 26 U.S.C. 863(a).
Section 1.863-2 also issued under 26 U.S.C. 863(a).
Section 1.863-3 also issued under 26 U.S.C. 863(a).
* * * * *
Section 1.863-8 also issued under 26 U.S.C. 863(a).
* * * * *
Section 1.865-3 also issued under 26 U.S.C. 865(j).
* * * * *
Section 1.937-2 also issued under 26 U.S.C. 937(b).
[[Page 71846]]
Section 1.937-3 also issued under 26 U.S.C. 937(b).
* * * * *
Section 1.1502-13 also issued under 26 U.S.C. 1502.
* * * * *
0
Par. 2. Section 1.863-1 is amended as follows:
0
1. In paragraph (a):
0
i. Revising the third sentence.
0
ii. Removing ``Sec. 1.863-3(g)'' and adding in its place ``Sec.
1.863-3(f)''.
0
2. In paragraph (b)(1):
0
i. Removing ``, must be allocated between sources within and without
the United States based on the fair market value of the product at the
export terminal (as defined in paragraph (b)(3)(iii) of this section)''
from the first sentence and adding in its place ``shall be treated as
income from sources within the United States''.
0
ii. Revising the second sentence.
0
iii. Removing the third, fourth, and fifth sentences.
0
3. Removing paragraphs (b)(1)(i) and (ii).
0
4. In paragraph (b)(2):
0
i. Removing ``prior to export terminal'' from the heading and adding in
its place ``activities''.
0
ii. Removing ``before the relevant product is shipped from the export
terminal'' from the first sentence.
0
5. Removing ``Sec. Sec. 1.1502-13 or 1.863-3(g)(2)'' from paragraph
(b)(3)(i) and adding in its place ``Sec. 1.1502-13 or Sec. 1.863-
3(f)(2)''.
0
6. Removing ``to or from the export terminal'' from the third sentence
of paragraph (b)(3)(ii).
0
7. Removing paragraph (b)(3)(iii).
0
8. In paragraph (b)(6), removing ``this paragraph (b)'' from the first
sentence and adding in its place ``paragraph (b)(2) of this section''.
0
9. Designating Examples 1, 2, 3, 4, and 5 of paragraph (b)(7) as
paragraphs (b)(7)(i) through (v).
0
10. Revising newly designated paragraphs (b)(7)(i) through (iv).
0
11. In newly designated paragraph (b)(7)(v):
0
i. Removing ``Example 1'' from the first sentence and adding
``paragraph (b)(7)(i) of this section (Example 1)''.
0
ii. Removing ``country'' from the first sentence and adding in its
place ``Country''.
0
iii. Removing ``Mine's'' from the seventh sentence and adding in its
place ``Mines'''.
The revisions read as follows:
Sec. 1.863-1 Allocation of gross income under section 863(a).
(a) * * * See also section 865(b) for rules for sourcing income
from the sale of inventory property, within the meaning of section
865(i)(1) (inventory), generally, and section 865(e)(2) and Sec.
1.865-3 for sourcing income from the sale of personal property
(including inventory) by a nonresident that is attributable to the
nonresident's office or other fixed place of business in the United
States. * * *
(b) * * *
(1) * * * Notwithstanding any other provision of this part, except
to the extent provided in paragraph (b)(2) of this section or Sec.
1.865-3, gross receipts from the sale within the United States of
products derived from the ownership or operation of any farm, mine, oil
or gas well, other natural deposit, or timber outside the United States
shall be treated as attributable to production activities without the
United States and therefore treated as income from sources without the
United States.
* * * * *
(7) * * *
(i) Example 1. No additional production. U.S. Mines, a domestic
corporation, operates a copper mine and mill in Country X. U.S. Mines
extracts copper-bearing rocks from the ground and transports the rocks
to the mill where the rocks are ground and processed to produce copper-
bearing concentrate. The concentrate is transported to a port where it
is dried in preparation for export, stored, and then shipped to
purchasers in the United States. Because there is no additional
production, paragraph (b)(3)(ii) of this section does not apply, and
under paragraph (b)(1) of this section, gross receipts from the sale of
the concentrate will be from sources without the United States.
(ii) Example 2. No additional production. U.S. Gas, a domestic
corporation, extracts natural gas within the United States, and
transports the natural gas to a Country X port where it is liquefied in
preparation for shipment. The liquefied natural gas is then transported
via freighter and sold without additional production activities in a
foreign country. Liquefaction of natural gas is not an additional
production activity because liquefaction prepares the natural gas for
transportation. Therefore, under paragraph (b)(1) of this section,
gross receipts from the sale of the liquefied natural gas will be from
sources within the United States.
(iii) Example 3. Production in United States. U.S. Gold, a domestic
corporation, mines gold in Country X, produces gold jewelry using
production assets located in the United States, and sells the jewelry
in Country Y. Assume that the fair market value of the gold before the
additional production activities in the United States is $40x and that
U.S. Gold ultimately sells the gold jewelry in Country Y for $100x.
Under paragraph (b)(2) of this section, $40x of U.S. Gold's gross
receipts will be allocated to sources without the United States, and
the remaining $60x of gross receipts will be U.S. source under Sec.
1.863-3.
(iv) Example 4. Production in United States. U.S. Oil, a domestic
corporation, extracts oil in Country X, transports the oil via a
pipeline to the United States, refines the oil using production assets
located in the United States, and sells the refined product in the
United States to unrelated persons. Assume that the fair market value
of the oil before refinement in the United States is $80x and U.S. Oil
ultimately sells the refined product for $100x. Under paragraph (b)(2)
of this section, $80 of gross receipts will be allocated to sources
without the United States, and the remaining $20 of gross receipts will
be allocated to sources within the United States.
* * * * *
0
Par. 3. Section 1.863-2 is amended as follows:
0
1. Removing ``(and that is treated as derived partly from sources
within and partly from sources without the United States)'' from the
third sentence of paragraph (a) and adding a colon at the end of the
paragraph.
0
2. Revising paragraph (b).
The revision reads as follows:
Sec. 1.863-2 Allocation and apportionment of taxable income.
* * * * *
(b) Determination of source of taxable income. Income treated as
derived from sources partly within and partly without the United States
under paragraph (a) of this section may be allocated or apportioned to
sources within and without the United States pursuant to Sec. Sec.
1.863-1, 1.863-3, 1.863-4, 1.863-8, and 1.863-9. To determine the
source of certain types of income described in paragraph (a)(1) of this
section, see Sec. 1.863-4. To determine the source of gross income
described in paragraph (a)(2) of this section, see Sec. 1.863-1 for
natural resources and Sec. 1.863-3 for all other sales of inventory
property. Section 1.865-3 may apply instead of the provisions in this
part to source gross income from sales of personal property (including
inventory property) by nonresidents attributable to an office or other
fixed place of business in the United States. To determine the source
of income partly from sources within a possession of the United States,
including income described in
[[Page 71847]]
paragraph (a)(3) of this section, see Sec. 1.863-3(e).
* * * * *
0
Par. 4. Section 1.863-3 is amended as follows:
0
1. Revising paragraphs (a) and (b).
0
2. Removing ``and sales activity'' from the heading in paragraph (c).
0
3. In paragraph (c)(1)(i)(A):
0
i. Removing ``(g)(2)(ii)'' and adding in its place ``(f)(2)(ii)'';
0
ii. Removing ``the income attributable to production activity'' and
adding in its place ``gross income''; and
0
iii. Removing ``(c)(1)(ii)'' and adding in its place ``(c)(2)''.
0
4. Removing ``(g)(2)(ii)'' from paragraph (c)(1)(i)(B) and adding in
its place ``(f)(2)(ii)''.
0
5. Removing ``within the United States and within foreign countries''
from the heading to paragraph (c)(1)(ii) and adding in its place
``within and without the United States''.
0
6. Removing ``income attributable to the taxpayer's production
activity'' from paragraph (c)(1)(ii)(A) and adding in its place ``gross
income''.
0
7. In paragraph (c)(1)(iii):
0
i. Removing ``(c)(1)'' from the first and second sentences and adding
in its place ``(c)'';
0
ii. Removing ``by manipulating the formula described in paragraph
(c)(1)(ii)(A) of this section'';
0
iii. Removing ``production income'' and adding in its place ``gross
income''; and
0
iv. Removing ``income from production activity'' and adding in its
place ``gross income''.
0
8. Removing paragraph (c)(2) and the paragraph designation and heading
for (c)(1);
0
9. In paragraphs (c)(i) through (iv), redesignating the paragraphs in
the first column as the paragraphs in the second column:
------------------------------------------------------------------------
Old paragraphs New paragraphs
------------------------------------------------------------------------
(c)(i).................................... (c)(1)
(c)(i)(A)................................. (c)(1)(i)
(c)(i)(B)................................. (c)(1)(ii)
(c)(i)(C)................................. (c)(1)(iii)
(c)(ii)................................... (c)(2)
(c)(ii)(A)................................ (c)(2)(i)
(c)(ii)(B)................................ (c)(2)(ii)
(c)(iii).................................. (c)(3)
(c)(iv)................................... (c)(4)
------------------------------------------------------------------------
0
10. Revising newly redesignated paragraph (c)(2)(ii).
0
11. In newly redesignated paragraph (c)(4):
0
i. In the introductory text, removing ``(c)(1)'' and adding in its
place ``(c)''; and
0
ii. Designating Examples 1, 2, and 3 as paragraphs (c)(4)(i) through
(iii).
0
12. In newly designated paragraph (c)(4)(i):
0
i. Removing ``production'' from the heading and adding in its place
``gross''; and
0
ii. Redesignating paragraphs (c)(1)(i)(i) and (ii) as paragraphs
(c)(4)(i)(A) and (B).
0
13. In newly redesignated paragraph (c)(4)(i)(A), removing the ninth
sentence.
0
14. In newly redesignated paragraph (c)(4)(i)(B):
0
i. Removing ``production'', ``one half of'', and ``or $6,'' from the
first sentence;
0
ii. Removing ``production'' from the second sentence; and
0
iii. In the last sentence, removing ``$2'' and ``$6'' and adding in
their places ``$4'' and ``$12'', respectively.
0
15. In newly designated paragraph (c)(4)(ii):
0
i. Removing ``Example 1'' from the first sentence and adding in its
place ``in paragraph (c)(4)(i)(A) of this section (Example 1)''; and
0
ii. Removing ``from production activity'' from the second sentence.
0
16. In newly designated paragraph (c)(4)(iii), redesignating paragraphs
(c)(4)(iii)(i) and (ii) as paragraphs (c)(4)(iii)(A) and (B).
0
17. In newly redesignated paragraph (c)(4)(iii)(A):
0
i. Removing ``Example 1'' from the first sentence and adding in its
place ``in paragraph (c)(4)(i)(A) of this section (Example 1)''; and
0
ii. Removing ``(c)(1)(ii)'' and ``production income'' from the fourth
sentence and adding in their places ``(c)(2)'' and ``gross income'',
respectively.
0
18. In newly redesignated paragraph (c)(4)(iii)(B):
0
i. Removing ``(c)(1)(ii)(A)'' from the first sentence and adding in its
place ``(c)(2)(i)''; and
0
ii. Removing ``production income'' from the second sentence and adding
in its place ``gross income''.
0
19. Revising paragraph (d).
0
20. Removing paragraph (e).
0
21. Redesignating paragraph (f) as paragraph (e).
0
22. Revising newly redesignated paragraphs (e)(1) and (2) and
(e)(3)(i).
0
23. Removing ``(f)(3)(ii)'' from newly redesignated paragraph
(e)(3)(ii)(B) introductory text and adding in its place ``(e)(3)(ii)''.
0
24. Revising newly redesignated paragraph (e)(3)(ii)(C)(1).
0
25. Removing newly redesignated paragraph (e)(4).
0
26. Further redesignating paragraph (e)(3)(iii) as paragraph (e)(4).
0
27. In newly redesignated paragraph (e)(4):
0
i. Removing ``(f)(3)(ii)'' from the introductory text and adding in its
place ``(e)(3)(ii)''; and
0
ii. Designating Examples 1 and 2 as paragraphs (e)(4)(i) and (ii).
0
28. In newly designated paragraph (e)(4)(i), redesignating paragraphs
(e)(4)(i)(i) and (ii) as paragraphs (e)(4)(i)(A) and (B).
0
29. In newly designated paragraph (e)(4)(ii), redesignating paragraphs
(e)(4)(ii)(i) and (ii) as paragraphs (e)(4)(ii)(A) and (B).
0
30. In newly redesignated paragraph (e)(4)(ii)(A), removing ``Example
1'' and adding ``paragraph (e)(4)(i)(A) of this section (Example 1)''.
0
31. Removing ``(f)'' from newly redesignated paragraph (e)(5) and
adding in its place ``(e)'' and removing ``(g)'' and adding in its
place ``(f)''.
0
32. Removing newly redesignated paragraph (e)(6).
0
33. Redesignating paragraph (g) as paragraph (f).
0
34. In newly redesignated paragraph (f)(1), removing ``(g)(2)'' and
adding in its place ``(f)(2)''.
0
35. In newly redesignated paragraph (f)(2)(ii), removing ``(g)(2)(i)''
and adding in its place ``(f)(2)(i)'' and removing ``(c)(1)(ii)(B)''
and adding in its place ``(c)(2)(ii)''.
0
36. Removing newly redesignated paragraph (f)(2)(iv).
0
37. In newly redesignated paragraph (f)(3):
0
i. Removing ``(g)'' from the introductory text and adding in its place
``(f)''; and
0
ii. Designating Examples 1 and 2 as paragraphs (f)(3)(i) and (ii).
0
38. In newly designated paragraph (f)(3)(ii):
0
i. Removing ``Example 1'' from the first sentence and adding in its
place ``paragraph (f)(3)(i) of this section (Example 1)'';
0
ii. Removing ``these regulations'' in the fourth sentence and adding in
its place ``this section'';
0
iii. Removing the fifth sentence; and
0
iii. Removing ``(1)'' from the last sentence.
0
39. Redesignating paragraph (h) as (g) and revising newly redesignated
paragraph (g).
The revisions read as follows:
Sec. 1.863-3 Allocation and apportionment of income from certain
sales of inventory.
(a) In general--(1) Scope. Subject to the rules of Sec. 1.865-3,
paragraphs (a) through (d) of this section apply to determine the
source of income derived from the sale of inventory property
(inventory) that a taxpayer produces (in whole or in part) within the
United States and sells without the United
[[Page 71848]]
States, or that a taxpayer produces (in whole or in part) without the
United States and sells within the United States (Section 863(b)(2)
Sales). See section 865(i)(1) for the definition of inventory.
Paragraph (b) of this section provides that the source of gross income
from the sale or exchange of inventory in Section 863(b)(2) Sales is
based solely on the production activities with respect to the
inventory. Paragraph (c) of this section describes how to determine
source based on production activity, including where inventory is
produced partly within the United States and partly without the United
States. Paragraph (d) of this section determines taxable income from
Section 863(b)(2) Sales. Paragraph (e) of this section applies to
determine the source of certain income derived from a possession of the
United States. Paragraph (f) of this section provides special rules for
partnerships for all sales subject to Sec. Sec. 1.863-1 through 1.863-
3. Paragraph (g) of this section provides applicability dates for the
rules in this section.
(2) Cross references. To determine the source of income derived
from the sale of personal property (including inventory) by a
nonresident that is attributable to the nonresident's office or other
fixed place of business in the United States under section 865(e)(2),
the rules of Sec. 1.865-3 apply, and the rules of this section do not
apply. To determine the source of income from sales of property
produced by the taxpayer, when the property is either produced in whole
or in part in space or on or under water not within the jurisdiction
(as recognized by the United States) of a foreign country, possession
of the United States, or the United States (in international water), or
is sold in space or international water, the rules of Sec. 1.863-8
apply, and the rules of this section do not apply except to the extent
provided in Sec. 1.863-8.
(b) Sourcing based solely on production activities. Subject to the
rules of Sec. 1.865-3, all gain, profit, and income derived from
Section 863(b)(2) Sales is allocated and apportioned solely on the
basis of the production activities with respect to the inventory.
(c) * * *
(2) * * *
(ii) Adjusted basis of production assets--(A) In general. For
purposes of paragraph (c)(2)(i) of this section, the adjusted basis of
an asset is determined by using the alternative depreciation system
under section 168(g)(2). The adjusted basis of all production assets
for purposes of paragraph (c)(2)(i) of this section is determined as
though such production assets were subject to the alternative
depreciation system set forth in section 168(g)(2) for the entire
period that such property has been in service. The adjusted basis of
the production assets is determined without regard to the election to
expense certain depreciable assets under section 179 and without regard
to any additional first-year depreciation provision (for example,
sections 168(k), 168(l), and 168(m), and former sections 1400L(b) and
1400N(d)). The average adjusted basis is computed by averaging the
adjusted basis of the asset at the beginning and end of the taxable
year, unless by reason of material changes during the taxable year such
average does not fairly represent the average for such year. In this
event, the average adjusted basis is determined upon a more appropriate
basis.
(B) Production assets used to produce other property. If a
production asset is used to produce inventory sold in Section 863(b)(2)
Sales and also used to produce other property during the taxable year,
the portion of its adjusted basis that is included in the fraction
described in paragraph (c)(2)(i) of this section will be determined
under any method that reasonably reflects the portion of the asset that
produces inventory sold in Section 863(b)(2) Sales. For example, the
portion of such an asset that is included in the formula may be
determined by multiplying the asset's average adjusted basis by a
fraction, the numerator of which is the gross receipts from sales of
inventory from Section 863(b)(2) Sales produced by the asset, and the
denominator of which is the gross receipts from all property produced
by that asset.
* * * * *
(d) Determination of source of taxable income. Once the source of
gross income has been determined under paragraph (c) of this section,
the taxpayer must properly allocate and apportion under Sec. Sec.
1.861-8 through 1.861-14T and 1.861-17 its expenses, losses and other
deductions to its respective amounts of gross income from sources
within and without the United States from its Section 863(b)(2) Sales.
(e) Income partly from sources within a possession of the United
States--(1) In general. This paragraph (e) relates to certain sales
that give rise to gains, profits, and income that are treated as
derived partly from sources within the United States and partly from
sources within a possession of the United States (Section 863
Possession Sales). This paragraph (e) applies to determine the source
of income derived from the sale of inventory produced (in whole or in
part) by the taxpayer within the United States and sold within a
possession, or produced (in whole or in part) by a taxpayer in a
possession and sold within the United States (Possession Production
Sales). It also applies to determine the source of income derived from
the purchase of personal property within a possession of the United
States and its sale within the United States (Possession Purchase
Sales). A taxpayer subject to this paragraph (e) must apportion gross
income from Section 863 Possession Sales under paragraph (e)(2) of this
section (in the case of Possession Production Sales) or using the
business activity method described in paragraph (e)(3)(i) of this
section (in the case of Possession Purchase Sales). The source of gross
income from each type of activity from Possession Purchase Sales must
then be determined under paragraph (e)(3)(ii) of this section. The
source of taxable income from Possession Production Sales is determined
under paragraph (c) of this section. The source of taxable income from
Section 863 Possession Sales is determined under paragraph (d) of this
section.
(2) Allocation or apportionment for Possession Production Sales.
The source of gross income from Possession Production Sales is
determined under the rules of paragraph (c) of this section, except
that the term possession of the United States is substituted for
foreign country wherever it appears.
(3) Allocation or apportionment for Possession Purchase Sales--(i)
Determination of source of gross income for Possession Purchase Sales.
Gross income from Possession Purchase Sales is allocated in its
entirety to the taxpayer's business activity, and is then apportioned
between sources within the United States and sources within a
possession of the United States under paragraph (e)(3)(ii) of this
section.
(ii) * * *
(C) * * *
(1) Sales activity. The source of the taxpayer's income that is
attributable to sales activity will be determined under the provisions
of Sec. 1.861-7(c). Notwithstanding any other provision of this part,
for rules regarding the source of income when a sale takes place in
space or international water, the rules of Sec. 1.863-8 apply, and the
rules of this section do not apply except to the extent provided in
Sec. 1.863-8.
* * * * *
(g) Applicability dates. This section applies to taxable years
ending on or after December 23, 2019. However, taxpayers may apply this
section in its entirety for taxable years beginning after December 31,
2017, and ending before
[[Page 71849]]
December 23, 2019, provided that the taxpayer and persons that are
related (within the meaning of section 267 or 707) to the taxpayer
apply this section in its entirety.
0
Par. 5. Section 1.863-8 is amended as follows:
0
1. Revising paragraph (b)(3)(ii)(A).
0
2. In paragraph (b)(3)(ii)(B), removing ``allocable to production
activity'' wherever it appears and by removing ``Sec. 1.863-3(c)(1)''
from the second sentence and adding in its place ``Sec. 1.863-3(c)''.
0
3. In paragraph (b)(3)(ii)(C), removing ``allocable to production
activity'' wherever it appears and by removing ``Sec. 1.863-3(c)(1)''
from the fifth sentence and adding in its place ``Sec. 1.863-3(c)''.
0
4. Removing paragraph (b)(3)(ii)(D).
0
5. Designating Examples 1 through 14 of paragraph (f) as paragraphs
(f)(1) through (14).
0
6. In newly designated paragraphs (f)(1) through (14), removing the
period between the second and third level paragraph headings and adding
an em-dash in its place.
0
7. Removing ``Example 4'' from newly designated paragraph (f)(4)(i) and
adding in its place ``paragraph (f)(4)(i) (Example 4)''.
0
8. Removing ``Example 4'' from newly designated paragraph (f)(5)(i) and
adding in its place ``paragraph (f)(4)(i) of this section (Example
4)''.
0
9. Revising the first, second, and third sentences of newly designated
paragraphs (f)(6)(ii).
0
10. Removing ``Example 8'' from newly designated paragraph (f)(9)(i)
and adding in its place ``in paragraph (f)(8)(i) of this section
(Example 8)''.
0
11. Removing ``Example 8'' from newly designated paragraph (f)(9)(ii)
and adding in its place ``paragraph (f)(8)(i) of this section (Example
8)''.
0
12. Revising newly designated paragraph (f)(11)(ii).
0
13. In paragraph (g)(1), removing ``(C)'' from the first sentence.
0
14. In paragraph (g)(4) introductory text, removing ``(C)'' from the
first sentence.
The revisions read as follows:
Sec. 1.863-8 Source of income derived from space and ocean activity
under section 863(d).
* * * * *
(b) * * *
(3) * * *
(ii) Sales of property produced by the taxpayer--(A) General. If
the taxpayer both produces property and sells such property, the
taxpayer must allocate and apportion all gain, profit, and income
derived from sales of such property solely on the basis of the
production activities with respect to such property, and the source of
that income will be determined under paragraph (b)(3)(ii)(B) or (C) of
this section. To determine the source of income derived from the sale
of personal property (including inventory) by a nonresident that is
attributable to the nonresident's office or other fixed place of
business in the United States under section 865(e)(2), the rules of
Sec. 1.865-3 apply, and the rules of this section do not apply.
* * * * *
(f) * * *
(6) * * *
(ii) Analysis. The collection of data and creation of images in
space is characterized as the creation of property in space. Because S
both produces and sells the data, the source of the gross income from
the sale of the data is determined under paragraph (b)(3)(ii) of this
section (by reference to Sec. 1.863-3(c)) solely on the basis of the
production activities. The source of S's gross income is determined
under Sec. 1.863-3(c)(2) because production activities occur both in
space and on land. * * *
(11) * * *
(ii) Analysis. Because S's rights, title, and interest in the
satellite pass to the customer in space, the sale takes place in space
under Sec. 1.861-7(c), and the sale transaction is space activity
under paragraph (d)(1)(i) of this section. The source of income derived
from the sale of the satellite in space is determined under paragraph
(b)(3)(ii) of this section (by reference to Sec. 1.863-3(c)) solely on
the basis of the production activities with respect to the satellite.
* * * * *
0
Par. 6. Section 1.864-6 is amended by revising paragraphs (c)(2) and
(3) and adding paragraph (c)(4) to read as follows:
Sec. 1.864-6 Income, gain, or loss attributable to an office or
other fixed place of business in the United States.
* * * * *
(c) * * *
(2) Special limitation in case of sales of goods or merchandise
through U.S. office. Notwithstanding paragraph (c)(1) of this section,
the special rules described in this paragraph (c)(2) apply with respect
to a sale of goods or merchandise specified in Sec. 1.864-5(b)(3), to
which paragraph (b)(3)(i) of this section does not apply. In the case
of a nonresident alien with a tax home within the United States, as
defined in section 911(d)(3), the amount of income from the sale of
goods or merchandise that is properly allocable to the individual's
U.S. office is determined under Sec. 1.865-3(d).
(3) Examples. The application of this paragraph (c) may be
illustrated by the following examples--
(i) Example 1. Nonresident alien individual A, who has a tax home
in the United States, manufactures machinery in a foreign country and
sells the machinery outside the United States through A's sales office
in the United States for use in foreign countries. Title to the
property sold is transferred to the foreign purchaser outside the
United States, but no office or other fixed place of business of A in a
foreign country participates materially in the sale made through its
U.S. office. By reason of its sales activities in the United States, A
is engaged in business in the United States during the taxable year.
During the taxable year, A derives a total income of $250,000x from
these sales. Under section 865(b)(2), all of A's income from these
sales is foreign source as production occurs outside the United States.
Under paragraph (c)(2) of this section, the amount of income that is
allocable to A's U.S. office is determined under Sec. 1.865-3(d)(2).
The taxpayer does not allocate income from the sale under the books and
records method described in Sec. 1.865-3(d)(2)(ii). Thus, 50 percent
of A's foreign source income, plus any additional income allocable
based on the location of production activities under Sec. Sec. 1.863-
3(b) and 1.865-3(d)(2)(i) (in this case, $0x), is effectively connected
for the taxable year with the conduct of A's U.S. trade or business, or
$125,000x.
(ii) Example 2. Nonresident alien individual B, who has a tax home
in the United States, has an office in a foreign country that purchases
merchandise and sells it through B's sales office in the United States
for use in various foreign countries, with title to the property
passing outside the United States. No other office of B participates
materially in these sales made through its U.S. office. By reason of
its sales activities in the United States, B is engaged in business in
the United States during the taxable year. During the taxable year, B
derives income of $300,000x from these sales made through its U.S.
sales office. Under section 865(b), all of B's income from these sales
is foreign source as title to the merchandise passes outside the United
States. The amount of income properly allocable to B's US office
determined under Sec. 1.865-3(d)(3) is $300,000x.
(iii) Example 3. The facts are the same as in paragraph (c)(3)(ii)
of this section (Example 2), except that B has an office in a foreign
country which participates materially in the sales which are made
through its U.S. office. The income which is allocable to B's U.S.
sales
[[Page 71850]]
office is not effectively connected for the taxable year with the
conduct of a trade or business in the United States by that
corporation.
(4) Applicability date. Paragraphs (c)(2) and (3) of this section,
to the extent they apply to sales of inventory described in section
864(c)(4)(B)(iii), apply to sales occurring in taxable years ending on
or after December 23, 2019. However, taxpayers may apply this section
in its entirety for taxable years beginning after December 31, 2017,
and ending before December 23, 2019, provided that the taxpayer and
persons that are related (within the meaning of section 267 or 707) to
the taxpayer apply this section in its entirety.
0
Par. 7. Section 1.865-3 is added to read as follows:
Sec. 1.865-3 Source of income from sales of personal property
(including inventory property) by a nonresident attributable to an
office or other fixed place of business in the United States.
(a) In general. Notwithstanding any other provisions of sections
861 through 865 or the regulations in this part except paragraph (b) of
this section, if a nonresident, as defined in section 865(g)(1)(B),
maintains an office or other fixed place of business in the United
States, income from any sale of personal property (including inventory
property) attributable to such office or other fixed place of business
(as determined under paragraph (c) of this section) is sourced in the
United States in an amount described in paragraph (d) of this section.
See section 865(i)(1) for the definition of inventory property.
(b) Exceptions for inventory property. Paragraph (a) of this
section does not apply with respect to the income derived by a
nonresident from any sale of inventory property that is sold for use,
disposition, or consumption outside the United States if an office or
other fixed place of business of the nonresident in a foreign country
materially participated in the sale. See Sec. 1.864-6(b)(3) to
determine whether a foreign office materially participated in the sale
and whether the property was destined for foreign use.
(c) Attribution of a sale to a United States office. In determining
whether a sale of personal property by a nonresident is attributable to
an office or other fixed place of business in the United States, the
principles of section 864(c)(5)(B) as prescribed in Sec. 1.864-6(b)
and (c) apply. The rule in this paragraph (c) applies without regard to
whether the property is described in Sec. 1.864-5(b)(3)(iii). In
determining whether a nonresident maintains an office or other fixed
place of business in the United States, the principles of section
864(c)(5)(A) as prescribed in Sec. 1.864-7 apply, including the rules
of paragraph (d) of that section regarding the office or fixed place of
business of a dependent agent of the nonresident.
(d) Amount of income or loss on sale of personal property
attributable to a U.S. office--(1) In general. Subject to the special
rules described in paragraphs (d)(2), (3), and (4) of this section, the
amount of income, gain, or loss from the sale of personal property
attributable to an office or other fixed place of business in the
United States is determined under Sec. 1.864-6(c)(1).
(2) Produced inventory property--(i) In general. With respect to
income from the sale of inventory property subject to paragraph (a) of
this section that is produced by a nonresident, 50 percent of the gross
income from such sale is properly allocable to the office or fixed
place of business in the United States. The remaining 50 percent of the
gross income is allocable to production activities and is sourced in
accordance with Sec. 1.863-3 (the ``50/50 method''). However, in lieu
of the 50/50 method, a taxpayer may elect to allocate income from the
sale of inventory property that is produced by a nonresident under the
books and records method described in paragraph (d)(2)(ii) of this
section, provided it satisfies all of the requirements described in
that paragraph to the satisfaction of the Commissioner. For purposes of
this paragraph (d)(2)(i), the term ``produced'' includes created,
fabricated, manufactured, extracted, processed, cured, and aged. See
section 864(a) and Sec. 1.864-1.
(ii) Books and records method--(A) Method. A taxpayer may elect to
determine the amount of its gross income from the sale of inventory
property subject to paragraph (a) of this section and produced by a
nonresident that is allocable to production and sales activities for
the taxable year based upon its books of account. The taxpayer must
establish that the taxpayer, in good faith and unaffected by
considerations of tax liability, regularly employs in its books of
account a detailed allocation of receipts and expenditures that clearly
reflects the amount of the taxpayer's gross income from its inventory
sales that is attributable to its sales activities, and gross income
from sales that is attributable to its production activities under the
principles of section 482. For purposes of this paragraph
(d)(2)(ii)(A), section 482 principles will apply as if the office or
fixed place of business in the United States were a separate taxpayer
from the nonresident (whether or not payments are made between the
United States office or other fixed place of business and the
nonresident taxpayer's other offices). The gross income allocable to
sales activity under this method is treated as properly allocable to
the office or other fixed place of business in the United States. The
gross income allocable to production activities is sourced in
accordance with Sec. 1.863-3.
(B) Election and reporting rules--(1) In general. A taxpayer making
an allocation of gross income under the books and records method in
paragraph (d)(2)(ii)(A) of this section must satisfy the requirements
of paragraphs (d)(2)(ii)(B)(2) and (3) of this section. Failure to
satisfy the requirements in paragraphs (d)(2)(ii)(B)(2) and (3) in full
and to the satisfaction of the Commissioner will result in application
of the 50/50 method specified in paragraph (d)(2)(i) of this section.
(2) Required records. A taxpayer electing the books and records
method under paragraph (d)(2)(ii)(A) of this section must prepare and
maintain records that are in existence when its return is filed
regarding the allocation of gross income between sales and production
activities in its books of account. The taxpayer must also prepare an
explanation of how such allocation clearly reflects the taxpayer's
income from production and sales activities under the principles of
section 482. The taxpayer must make available such explanation and
records for both the U.S. sales office and the entity or entities that
perform the production activities upon request of the Commissioner,
generally within 30 days or some other time period as agreed between
the Commissioner and the taxpayer.
(3) Disclosure on a tax return. A taxpayer who chooses to apply the
books and records method under paragraph (d)(2)(ii)(A) of this section
must indicate in a statement attached to a timely filed return
(including extensions) that it elects to apply such method and has
prepared the records described in paragraph (d)(2)(ii)(B)(2) of this
section.
(3) Purchased inventory property. With respect to income from the
sale of inventory property subject to paragraph (a) of this section
that is purchased by the nonresident, the entire income from such sale
is properly allocable to the office or other fixed place of business in
the United States.
(4) Depreciable personal property. With respect to income from the
sale of depreciable personal property subject to paragraph (a) of this
section--
(i) The gain not in excess of the depreciation adjustments is
allocable to
[[Page 71851]]
an office or other fixed place of business in the United States to the
same extent that the gain would be allocated to sources within the
United States under the rules of section 865(c)(1). The remaining gain
not in excess of the depreciation adjustments is allocated to sources
without the United States in accordance with section 865(c)(1).
However, notwithstanding the preceding sentences, if the property was
predominantly used in the United States, within the meaning of section
865(c)(3)(B)(i), for a specific year, all of the gain not in excess of
depreciation for that year is allocated to sources within the United
States.
(ii) The gain in excess of the depreciation adjustments is treated
as if such property were inventory and is sourced under paragraph
(d)(2) or (3) of this section as applicable.
(e) Determination of source of taxable income. For rules allocating
and apportioning expenses to income effectively connected with the
conduct of a trade or business in the United States, see Sec. Sec.
1.882-4 and 1.882-5.
(f) Export trade corporations. This section is not applicable for
purposes of defining an export trade corporation under section 971.
(g) Applicability date. This section applies to sales occurring in
taxable years ending on or after December 23, 2019. However, taxpayers
may apply this section in its entirety for taxable years beginning
after December 31, 2017, and ending before December 23, 2019, provided
that the taxpayer and persons that are related (within the meaning of
section 267 or 707) to the taxpayer apply this section in its entirety.
Sec. 1.937-2 [Amended]
0
Par. 8. Section 1.937-2 is amended by removing ``Sec. 1.863-3(f)''
from paragraph (d) and adding in its place ``Sec. 1.863-3(e)''.
Sec. 1.937-3 [Amended]
0
Par. 9. Section 1.937-3 is amended by removing ``Sec. 1.863-3(f)''
from paragraph (d) and adding in its place ``Sec. 1.863-3(e)''.
0
Par. 10. Section 1.1502-13, as proposed to be amended at 83 FR 67490
(December 28, 2018), is further amended by revising paragraph
(c)(7)(ii)(N) to read as follows:
Sec. 1.1502-13 Intercompany transactions.
* * * * *
(c) * * *
(7) * * *
(ii) * * *
(N) Example (14): Source of income under section 863--(1)
Intercompany sale--(i) Facts. S manufactures inventory property solely
in the United States, and recognizes $75x of income on sales to B in
Year 1. B conducts further production activity on the inventory
property solely in Country Y and then sells the inventory property to X
in Country Y and recognizes $25x of income on the sale to X, also in
Year 1. Title passes from S to B, and from B to X, in Country Y. Assume
that applying Sec. 1.863-3 on a single entity basis, including the
formula for apportionment of multi-country production activities by
reference to the basis of production assets, $10x is treated as foreign
source income and $90x is treated as U.S. source income (that is, 10
percent of the production occurred outside the United States and 90
percent occurred within the United States, as measured by the basis of
assets used in production activities with respect to the property).
Assume further that, on a separate entity basis, S would have $0 of
foreign source income and $75x of U.S. source income and all of B's
$25x of income would be foreign source income.
(ii) Analysis. Under the matching rule, both S's $75x intercompany
income and B's $25x corresponding income are taken into account in Year
1. In determining the source of S and B's income from the inventory
property sales, the attributes of S's intercompany item and B's
corresponding item are redetermined to the extent necessary to produce
the same effect on consolidated taxable income (and consolidated tax
liability) as if S and B were divisions of a single corporation. See
paragraph (c)(1)(i) of this section. On a separate entity basis, S
would have $75x of U.S. source income because the product would be
treated as produced wholly in the United States and sold outside the
United States, and B would have $25x of foreign source income because
the product would be treated as produced wholly outside the United
States and sold outside the United States. On a single entity basis, S
and B are treated as divisions of a single corporation, and section 863
applies as if $100x of income were recognized from producing partly in
the United States and partly in Country Y and selling in Country Y.
This results in $10x of foreign source income and $90x of U.S. source
income. Accordingly, under single entity treatment, $15x of B's sales
income that would be treated as foreign source income on a separate
entity basis is redetermined to be U.S. source income. Under paragraph
(c)(1)(i) of this section, attributes are redetermined only to the
extent of the $15x necessary to achieve the same effect as if S and B
were divisions of a single corporation. Under paragraph (c)(4)(ii) of
this section, the redetermined attribute must be allocated between S
and B using a reasonable method. In this case, only B would have
foreign source income on a separate entity basis, and thus $15x of B's
foreign source income must be recharacterized as U.S. source income.
(2) Sale of property reflecting intercompany services or
intangibles--(i) Facts. S earns $10x of income performing services in
the United States for B. B capitalizes S's fees into the basis of
inventory property that it manufactures in the United States and sells
to an unrelated person in Year 1 at a $90x profit, with title passing
in Country Y. Assume that on a single entity basis, $100x is treated as
U.S. source income and $0 is treated as foreign source income. Further
assume that on a separate entity basis, S would have $10x of U.S.
source income, and B would have $90x of U.S. source income, with
neither having any foreign source income.
(ii) Analysis. Under the matching rule, S's $10x income and B's
$90x income are taken into account in Year 1. In determining the source
of S and B's income, the attributes of S's intercompany item and B's
corresponding item are redetermined to the extent necessary to produce
the same effect on consolidated taxable income (and consolidated tax
liability) as if S and B were divisions of a single corporation, such
that section 863 applies as if $100x were earned from manufacturing in
the United States and selling in Country Y. Because the results are the
same on a single entity basis and a separate entity basis ($100x of
U.S. source income and $0x of foreign source income), the attributes
are not redetermined under paragraph (c)(1)(i) of this section.
* * * * *
Sunita Lough,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2019-27813 Filed 12-23-19; 4:15 pm]
BILLING CODE 4830-01-P
