Firm Addresses Inventory Sales Provisions in Income-Sourcing Regs

February 28, 2020

Internal Revenue Service, Room 5203
CC:PA:LPD:PR (REG-100956-19)
P.O. Box 7604
Ben Franklin Station, Washington, D.C. 20044
Brad.McCormack@IRSCOUNSEL.TREAS.GOV
FDMSDatabase@IRSCOUNSEL.TREAS.GOV

Re: Comments on Notice of Proposed Rulemaking: Proposed Amendments to Regulation Section 1.863-3 on Source of Income from Certain Sales of Personal Property IREG-100956-191, 84 FR 71836-71851; 2020-4 IRB 938

Dear Ms. Johnson and Mr. McCormack:

This Comment submission is made in response to the proposed rule-making that the US Treasury and the National Office of the Internal Revenue Service issued on December 23, 2019 and published in the Federal Registrar. The Comment is limited in scope and concerns proposed amendments to Regulation Section 1.863-3 with respect to sourcing from sales of inventory produced partly within and without the United States and sold without the United States.¹

It is clear that Congress, in enacting the amendment to Section 863(b)(2) contained in The Tax Cuts and Jobs Act, Pub. L. 115-97 (2017) (TCJA), §14303, wanted to eliminate sales and similar activities from entering into the computational formula of allocating gross income from sales of Section 863(b)(2) property ("Section 863(b)(2) Sales"). Instead, Congress wanted the allocation to be determined based solely on production activities. The proposed rule-making uses the existing regulations to set forth a single standard for making the required allocation with respect to Section 863(b)(2) Sales, i.e., identifying foreign source sales income from inventory, based on the adjusted basis in property used in production outside the United States as compared with the adjusted basis in property used in production by the taxpayer within and without the United States.

It is submitted that, in amending Section 863(b)(2), as a part of the larger set of international tax reforms enacted in the TCJA, Congress was more focused with respect to addressing the issues and problems that might arise with respect to domestic C corporations directly engaged in foreign business operations or indirectly engaged through a controlled foreign corporation. The focal point was not the impact of conducting international business operations by S corporations or domestic partnerships.

In following up on the Congressional mandate to focus only on production activities for purposes of Section 863(b)(2) Sales, the Treasury and the National Office of the IRS may not yet be fully aware of the adverse impact that Section 863(b)(2) has on US citizen and resident partners in domestic partnerships and shareholders of S corporations engaged in domestic and foreign manufacturing and production activities both within and without the United States. The proposed rule-making further reveals the potential magnitude or this problem by proposing the elimination of the three allocation conventions previously allowed under the regulations to Section 863(b) and limiting the applicable allocation rule simply to the adjusted basis of production property located outside the United States to the adjusted basis of production property located within and without the United States.

The problem faced by US taxpayers who are shareholders in S corporations and/or partners in partnerships engaged in Section 863(b)(2) Sales is double taxation, an outcome presumably unintended by Congress in enacting the amendment to Section 863(b) as part of the Tax Cuts and Jobs Act of 2017, Pub. L. 115-97 (2017).² Perhaps the Congress had other policy objectives that needed to be addressed and fulfilled by resourcing inventory sales income from manufacturing conducted partly within and partly without the United States.³ There may have also been a sound tax administration objective as well in supporting the amendment to Section 863(b)(2) as it eliminates what may have been problems or issues in auditing taxpayers that used the 50/50 method since it has now been discarded. Ironically, the 50/50 rule has "new life under the proposed regulations in allocating gross income from sales of inventory property by foreign manufacturers by virtue of maintaining a sales office in the United States.

Congress further intended that S corporations and domestic partnerships with individual US citizen and resident owners would not qualify for the deductions under Section 250 (FDII) (and GILTI) afforded to C corporations.⁴ Congress presumably knew that such individual taxpayers would be taxed in the United States at a maximum rate of 37% of their company's worldwide manufacturing income. Compare this to the 13.125% (less applicable percentage of FTCs) rate of tax realized by a domestic corporation that is engaged in the manufacturing business here in the United States and sells inventory overseas for foreign use.⁵ Where manufacturing and production operations are taxed in foreign jurisdictions, the resulting direct foreign tax credits under Section 901 may now have to be stored for future use. This "double tax" problem may require that US companies and their owners faced with this problem build new production facilities or expand existing production facilities overseas in order to increase the "numerator" value of the required allocation fraction. This consequence runs counter to the stated purposes that the international tax reforms were intended to have.⁶ In order to meet required global service levels, some businesses are required to have a portion of manufacturing overseas. Using the production asset formula for calculating foreign source income will encourage these businesses to move or add capital intensive manufacturing overseas to facilitate use of foreign tax credits.

It is axiomatic that a fair amount of US based manufacturers of inventory (or other assets) must have assembly and production facilities to some extent overseas. They have to have other production facilities located outside of the US to service their clients, such as in the assembly, servicing and warranty work phases. US citizens and residents in S corporations and partnerships engaging in such business operations are now going to have a "warehouse" of unused excess foreign tax credits as a result of the resourcing of manufacturing income based solely on production facilities under ADS.

After giving consideration to the unintended impacts of the new sourcing rule on owners of small business engaged in manufacturing and production operations both within and without the United States, and with due regard to the un-level playing field between owners (taxpayers) in pass through entities versus C corporation competitors, the proposed regulations may be able to provide some form of mitigation of the double taxation problem presently faced by owners of passed through domestic businesses.⁷

The following recommendations are submitted for your consideration in issuing final regulations with respect to amended Section 863(b)(2). I further request that I be allowed to testify at the public hearing that, presumably, will be scheduled in the near future.⁸ Again, this Comment is limited to application of Section 863(b)(2) Sales and the proposed rule-making to domestic taxpayers engaged in production of inventory sold without (and within) the United States.

Proposed Changes to Regulation Section 1.863-3 to Reflect the Amendment of Section 168(k) In Allocating or Apportioning Gross Income Where There is Production Activity Both Within and Without the United States

Regulation Section 1.863-3 provides rules for making the required allocation/apportionment of gross income with respect to Section 863(b)(2) Sales. The current regulation sets forth 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. See Regulation Section 1.863-3(b).⁹ The outcomes derived from the applicable method provides information on foreign-source income required to claim foreign tax credits under Sections 901 and 904. The use of the allocation methods, particularly the 50/50 method, accounts for the obvious reality that foreign countries will, in certain instances, impose income tax on a US person's marketing and sales activity.¹⁰ It is ironic that that is exactly what the proposed regulations propose to do with respect to foreign manufacturers selling inventory through a US sales office. By removing sales activity from the formula for US domestic income tax purposes, there is, at present, no assurance that a foreign country will reduce its taxable base in yielding to this new calculus.

Where there is production activity both within and without the United States, Regulation Section 1.863-3(c)(1)(ii)(A) sets forth a formula for allocating or apportioning gross income by multiplying all the income attributable to taxpayer's production activities by a fraction. The numerator is the average adjusted basis of production assets located outside of the United States. The denominator is the average adjusted basis of all production assets of the taxpayer located within and without the United States. Adjusted basis of production assets is determined in accordance with Section 1011 and as further adjusted under Section 1016 for cost recovery deductions allowed or allowable.

The TCJA amended Section 168(k) to allow an additional first-year depreciation deduction provided by Section 167(a) for the taxable year in which such property is placed in service of 100 percent of the adjusted basis or cost of the qualified property, as defined in Section 168(k)(2). This rule applies to qualified property placed in service after September 27, 2017 but prior to January 1, 2023. Therefore, for qualified property used in production within the United States by a taxpayer, the adjusted basis of such property may be zero. In contrast, production assets placed in service or used predominantly without the United States (or both) do not qualify under Section 168(k) or accelerated depreciation. Instead, such assets must be using the straight-line method under the alternative depreciation system (ADS) of under Section 168(g)(2).¹¹

The proposed regulations retain the rule presently in Regulation Section 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.¹² The existing fraction based on average adjusted basis of production assets between assets located outside the United States as the numerator and all production assets within and without the United States as the denominator is retained. That fraction is multiplied by total gross income from Section 863(b)(2) sales to determine the portion of foreign source income and provide that the balance is US source income.

The proposed rule-making's prescription states that Section 168(k) should not apply and that the ADS rules in Section 168(g)(2) be applied in full to allocating income with respect to Section 863(b)(2) Sales and use the straight line method as well as the recovery periods set forth in Section 168(g)(2). The adoption of this rule seems to stray beyond the statutory language in the TCJA. There also does not appear to be legislative history either as to the amendment to Section 863(b)(2) or Section 168(k) that requires or makes reference to using ADS under amended Section 863(b)(2).

The rationale given for this position in the Explanation of Provisions is that the "Act's modifications to the depreciation treatment of US production assets will have the unintended effect of skewing the apportionment formula in favor of foreign source income because non-US production assets . . . will generally have a higher adjusted basis". Foreign based production assets use the ADS rules under Section 168(g)(2). The added rationale that GILTI uses ADS and so does Section 250 appears to ignore that many US taxpayers are denied access to Section 250, such as shareholders in S corporations and US partners in domestic partnerships.¹³

As mentioned above, in taking into account "unintended effects" of the new tax law changes in the international area, one stark unintended effect appears to be the resulting differences in effective worldwide income tax rates between US domestic corporations engaged in foreign and domestic operations and the US owners of flow through entities, including S corporations, also engaged in foreign and domestic operations. While it may seem fair and reasonable from one perspective to level the playing field and use ADS throughout for purposes of amended Regulation Section 1.863-3(c), there is a reverse "skewing" present in deflecting what was previously foreign source Section 863(b)(2) Sales income back into the United States. The reverse "skewing" is that significant if not substantial amounts of foreign tax credits paid by foreign branches,¹⁴ S corporations or domestic partnerships non-corporate US taxpayers, will be "banked" and left unused offshore. On a current basis the outcome is double taxation. The resulting tax benefit from allowing 100% expensing under Section 168(k) under the TCJA to owners of pass through entities may be small in comparison to the potential enormous tax burden imposed on such owners in resourcing income from foreign jurisdictions so that foreign tax credits cannot be used. The use of ADS for domestic production facilities may tend to make the adverse impact of this by-product of the TCJA worse.

It is understood that the use of ADS is used under GILTI and FDII. That seems appropriate. But use of ADS in this context for US owners of pass through entities engage in Section 863(b) Sales seems to go too far. Consideration should be given therefore to allowing domestic pass through entities to continue to use the existing rule of adjusted basis under Section 1011 as adjusted per Section 1016. Granted this rule will not eliminate the "problem" that Section 863(b)(2) has generated, but some form of mitigation in the final regulations would be appropriate.

Overall, the United States should permit a US taxpayer engaged in business operations through a permanent establishment in a treaty country, to claim foreign tax credits under Section 901 for US purposes notwithstanding the TCJA's amendment to Section 863(b)(2).¹⁵

Request for Use of a Rule in Regulation Section 1.863-3 Besides ADS Adjusted Basis As Proposed

The adoption of an ADS requirement for taxpayers in this context adds additional administrative burdens to business entities engaged in production activities involving Section 863(b)(2) Sales both within and without the United States. Such taxpayers may have to maintain as many as four sets of depreciation schedules including Section 863(b)(2) Sales, alternative minimum tax purposes, overall federal income tax purposes and for financial accounting purposes. This area may become further complicated by pending changes in the accounting field with respect to capitalization of leased property. For now, I would recommend maintaining the current rule of using Section 1011 adjusted basis for production property in the final regulations. Congress should re-think part of the international tax reforms contained in the TJCA. From this vantage point, it created two worlds, one which benefits from the reforms and one which does not. It is domestic C corporations that get to harvest the tax savings and incentives set forth in the TCJA. It is not S corporations and partnerships to the extent owned by individual US citizens and residents.

Request for Determining the Location or Existence of Production Activity

The proposed-rulemaking requested comments on "other potential approaches to determine the location or existence of production activity or other modifications to current or proposed [Regulation Section] 1.863-3 that may be appropriate'. While there may be some inherent weakness of disregarding workforce, marketing and sales activities in arriving at the proper allocation or apportionment of Section 863(b)(2) Sales income, Congress has spoken on the subject, of course. Location of production activity is fairly obvious.¹⁶ But what about the "existence" of production activity or modifications?¹⁷

One of the goals of the proposed regulations, after Congress eliminated the 50/50 rule, should be to avoid double taxation. Section 901 has that as its underlying purpose. The same is true of our bilateral income tax conventions, but the impact of the change in the law with respect to Section 863(b)(2) Sales runs off in the opposite direction. Therefore, if there is to be a change in the notion of the "existence" of production activity, jurisdictions in which the Section 863(b)(2) Sales income is taxed by other countries should be taken into account.¹⁸ Perhaps a technical correction is required in this area. It is also possible that a change in the law is required more than just a "correction".¹⁹

U.S. Income Tax Treaties

The proposed rule-making Explanation provides that, despite the changes in Section 865(e)(2) and resourcing of foreign manufacturers sales of inventory through a sales office in the US or otherwise connected with the conduct of a US trade or business under Section 864(c) principles, such provisions will not be applied in a manner inconsistent with nonresident taxpayers entitled to the benefits of an income tax treaty. The Explanation, therefore, provides that, in such instance, the amount of profits attributable to a US permanent establishment will not be affected by these regulations. This is a good rule.

Consideration should be given, consistent with this statement, by the Treasury and the IRS that the rules under the final regulations to Section 863(b)(2) Sales will also not be applied in a manner which will result in double taxation to a US taxpayer entitled to treaty protection engaged in business operations in one or more foreign jurisdictions that imposing a tax on income. The problem is the inconsistent outcomes derived by the foreign jurisdiction(s) and the US. In many cases the tax base between both taxing jurisdictions will exceed 100% of net taxable income. The Treasury and Internal Revenue Service should provide that, with respect to treaty countries, Competent Authority relief will be provided to such adversely affected US taxpayers.²⁰ But for many, the cost of engaging lawyers and accountants to set the foundation for Competent Authority may be quite substantial.

Proposed Applicability Date

The regulations, when finalized, should have a starting date that is no earlier than for taxable years beginning after December 31, 2019. The proposed regulations provide otherwise in that the new rules would be applied to taxable years ending on or after December 23, 2019. Many taxpayers have relied upon, in some cases for many years applied on a consistent basis, one of the three methods prescribed under current Regulation Section 1.863-3(b) in determining income attributable to production activity and sales activity.²¹ Such taxpayers should be allowed to use such method through tax years beginning prior to 2020 but, as already provided in the proposed rule-making, also be allowed to rely on the revisions under the proposed regulations in filing returns for tax years beginning after 2017.

Respectfully Submitted,

Jerald David August
Fox Rothschild LLP
Phildelphia, PA