The source of income is a critical component of U.S. tax rules for both U.S. taxpayers operating internationally (namely, with respect to foreign tax credit planning) and foreign persons with investment or other activity in the United States (who generally are subject to U.S. tax on U.S. source annual or periodic income and income “effectively connected” with the conduct of a trade or business in the United States). Identifying the source of income from the sale of property where related activity is conducted both inside and outside the United States long has been a tricky issue. In general, such income can be sourced partly within and partly outside the United States. The 2017 Tax Cuts and Jobs Act (TCJA) changed the income sourcing rules under Internal Revenue Code (Code) Section 863(b) that apply to the sale of goods, specifically inventory, whether produced by a taxpayer outside the United States and sold within the United States or produced by a taxpayer within the United States and sold outside the United States.
Prior to TCJA, the source of gross income from the sale of goods that were produced by a taxpayer was determined based on, and by allocating between, the location of production and sales activities. TCJA changed the rules with respect to sales of inventory produced by the taxpayer, so that income from such sales, despite where the inventory is sold, is sourced based solely on where the inventory is produced. In December, the Treasury issued proposed regulations to implement the TCJA changes (the Proposed Regulations), which as currently drafted would apply to sales for taxable years ending on or after December 23, 2019. Consistent with such TCJA changes, under the Proposed Regulations income from the sale of inventory produced within the United States, regardless of where sold, is U.S. source income.
U.S. taxpayers, who historically have been able to benefit from a foreign tax credit with respect to foreign sales, may not welcome these broad production-based sourcing rules. For example, where a U.S. corporation produces inventory in the United States, but sells abroad, 100% of the income now is U.S. source, which reduces its ability to utilize a foreign tax credit. While a discussion of the foreign tax credit rules is outside the scope of this article, very generally the availability of foreign tax credits depends on the amount of the U.S. taxpayer’s foreign source income (as determined under U.S. tax law, and as a ratio to overall income, including U.S. source); thus, to the extent sales activity outside the United States was critical to a taxpayer’s foreign tax credit position, the TCJA changes, and accordingly the Proposed Regulations, materially could disrupt its tax planning.
Notably for the oil and gas industry, the Proposed Regulations changed the sourcing rules with respect to income from the sale of natural resources, primarily to bring them in line with TCJA to reflect the elimination of sales activity as a relevant allocation factor. Consistent with pre-TCJA law, current Treasury regulations under Code Section 863 allocate natural resource sales income to the export terminal for the product and source gross receipts in an amount equal to the fair market value (FMV) of the product at such terminal to the location of the farm, mine, well, deposit, or uncut timber. Gross receipts in excess of that amount are allocated according to either the current Code Section 863(b) rules described above or place of sale, as determined under the relevant circumstances. Where taxpayers perform additional production activities before the relevant product is shipped from the terminal, the current Treasury Regulations provide that gross receipts equal to the FMV of the product 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 such FMV are sourced based on current Treasury Regulation Section 1.863-3 (the general allocation rules summarized above allocating between sales and production activities).
Under the Proposed Regulations, which (but for Code Section 865(e)(2), as described in more detail below) allocate based solely on production, where there are no additional production activities, the place of production is the location of the natural resource (i.e., the location of the farm, mine, well, other natural deposit or uncut timber). Where there are additional production activities, the gross income is allocated or apportioned first to the location of the natural resource product in an amount equal to the FMV of the product before the additional production activity. Any income in excess of such FMV then is allocated and apportioned between the sources within and outside the United States based on the location of the assets used in the additional production activities. The Proposed Regulations also provide examples illustrating what constitutes additional production – for example, liquifying natural gas in anticipation of shipment is not additional production, but refining oil will be considered additional production. Thus, where there is no additional production, the sale of oil or gas from a well located in the United States should result in solely U.S. source income and, absent a USOFPB (defined and discussed below), the sale of oil or gas from a well located outside the United States should result in solely non-U.S. source income.
In addition to Code Section 863(b) changes to the sourcing rules, the Proposed Regulations contain rules under Code Section 865, which governs the sale of personal property (including inventory) as well as under Code Section 864(c)(5), which governs the allocation of income to an office or other fixed place of business in the United States (USOFPB). Historically, under Code Section 865, the sale of personal property generally is sourced based on the residency of the seller; Code Section 865(b) exempts sales of inventory from this rule and sources income from the sale of inventory either based on place of sale or based on the Code Section 863(b) allocation. However, Code Section 865(e)(2) provides that if a nonresident maintains an USOFPB, income from the sale of any personal property (including inventory) attributable to such USOFPB is U.S. source (unless an office or other fixed place of business in another country materially participates in the sale).
As made clear in the lengthy explanation in the preamble to the Proposed Regulations (Preamble), Treasury and the IRS do not believe that the TCJA changes to Code Section 863(b) should limit the U.S.-sourcing of income under Code Section 865(e)(2) with respect to income of non-residents who have USOFPBs. Accordingly, under the Proposed Regulations, even if inventory is produced outside the United States by a nonresident (including from a well located outside the United States), a portion of the income from the sale by such nonresident still should be allocated to the United States if such nonresident has an USOFPB, using the principles of Code Section 864(c)(5) (rather than revised Code Section 863(b)). Under such governing principles, the income will be attributable to an USOFPB (and thus, U.S. source) if the USOFPB is material in the production of such income (in other words, same as pre-TCJA law). Where the USOFPB is not involved in production of the income, the Proposed Regulations provide that, as a default, 50% of the gross income is U.S. source income and the other 50% is sourced based on the provisions of Code 863(b); in other words, based on production, meaning that where there is no U.S. production, the 50% balance would be sourced outside of the United States.
The Preamble takes the extra step of effectively “turning off” (for purposes of Code Section 865(e)(2)) the last clause of Code Section 864(c)(5)(C), which limits the income that is treated as attributable to an USOFPB to the amount that would be U.S. source if the sale were made in the United States. The Preamble rejects the position that this clause can be read to cause income from the sale of property to be foreign source if it would be foreign source under Code Section 863(b) (following TCJA). Otherwise, such clause by its terms creates a conflict between Code Section 865(e)(2) (which references the principles of Code Section 864(c)(5)) and revised Code Section 863(b), because after TCJA, if there is no production within the United States, then under Code Section 863(b) there should be no U.S. source income. Arguably, the view of Treasury and the IRS is supported by the legislative history to TCJA, which simply notes the apparent conflict between revised Code Section 863(b) (looking to production activity only) and Code Section 865(e)(2), but then goes on to say that a nonresident manufacturing property outside the United States for sale within the United States will have income that generally is part U.S. source and part non-U.S. source; it does not note or refer to any exception even where all production is outside the United States, even though the last clause of Code Section 864(c)(5)(C) would cause the income in that case to all be non-U.S. source under Code Section 863(b). Still, it may be worth considering whether Treasury and the IRS effectively and unilaterally can cause taxpayers to ignore a provision of the Code where Congress has not acted. Even if, as the legislative history suggests, Treasury and IRS are correct in principle (and Congress agrees), the resolution may need to be legislative, not regulatory.
In any event, it is clear that under the Proposed Regulations, the only surefire method for non-U.S. persons to avoid U.S. source income from the sale of inventory produced outside the United States is to avoid having an USOFPB. That said, we may see adventurous taxpayers (though arguably on notice) try to take a contrary position unless or until the Code is amended.