On September 29, 2020, Treasury and the IRS issued final regulations on how to source gain from inventory sales. The question of sourcing is relevant to (1) non-U.S. persons in calculating the amount of gain that is taxable by the United States (for example, U.S.-source gain from the sale of inventory is always taxable) and (2) U.S. persons in calculating their foreign tax credit limitations.

Background

In 2017, the Tax Cuts and Jobs Act (TCJA) amended section 863 of the tax code, which provides rules for determining the source of gain from personal property sales. Before the TCJA, section 863(b) provided that gain from the sale of inventory property produced by a taxpayer within the United States and sold outside the United States or vice versa would be treated as part-U.S. and part-foreign source, but did not outline a basis for the allocation. The TCJA amended section 863(b) to require the allocation to be made based on the taxpayer’s production activities with respect to the inventory.

Additionally, section 865(e)(2) provides that a nonresident that has a U.S. office must treat gain from all sales of personal property (including inventory) that is attributable to that U.S. office as U.S. source. Because both section 865(e)(2) and section 863 contain sourcing rules for gain from inventory sales, guidance was needed to address the interaction of the two sections.

The Final Regulations

The final regulations largely adopt regulations that were proposed in December 2019. Under the regulations, the source of gain from inventory sales is determined based solely on the location of the taxpayer’s production activities with respect to the inventory. If the production activities are both inside and outside the United States, gain is allocated based on the adjusted bases of the production assets.

The regulations further clarify the scope of section 865(e)(2) by providing two methods for determining the source of gross income from a sale of produced inventory sold through a nonresident’s U.S. office (an 865(e)(2) sale). The default “50/50 method” allocates 50% of a nonresident’s gross income from an 865(e)(2) sale to the U.S. office and treats it as U.S. source. The remaining 50% is allocated according to the rules under section 863(b), discussed above. Alternatively, the nonresident taxpayer can allocate gross income from 865(e)(2) sales based on production and sales activities determined under transfer pricing principles. If a nonresident taxpayer elects to use transfer pricing principles, the election may not be revoked without IRS consent until 48 months after the tax year in which the election is made.

The final regulations generally apply to tax years ending on or after December 23, 2019, but taxpayers may apply the regulations in their entirety for tax years beginning after December 31, 2017 if they continue to apply the regulations for subsequent years.