50-50 EXPORT SOURCE RULE CANNOT BE USED IF THERE IS AN INDEPENDENT FACTORY PRICE, IRS REVENUE RULING HOLDS.

Rev. Rul. 88-73

ISSUE

If a taxpayer that produces and sells inventory within the United States and also sells the inventory outside the United States makes certain sales which establish an independent factory or production price for such inventory, must such price be used for purposes of determining the division between domestic and foreign sources of income from sales of the inventory outside the United States, including sales to foreign subsidiaries of the taxpayer?

FACTS

Corporation X, a domestic corporation, is engaged in the production and sale of product A in the United States and the sale of such product outside the United States, including sales to its foreign subsidiaries. Product A is inventory, within the meaning of section 865(h)(1) of the Internal Revenue Code of 1986, in X's hands. Certain sales by X to unrelated distributors establish an independent factory or production price, as described in section 1.863-3(b) of the income tax regulations, for sales of product A outside the United States.

LAW AND ANALYSIS

Under section 863(b) of the Code, income from the sale of inventory (within the meaning of section 865(h)(1)) which is produced (in whole or in part) in the United States and sold in a different country is treated as derived from sources partly within and partly without the United States. That section gives the Secretary of the Treasury the authority to prescribe processes or formulas of general apportionment to determine the division of income between domestic and foreign sources in such cases.

The processes or formulas of general apportionment to be used under section 863(b) of the Code are prescribed through three examples contained in section 1.863-3(b) of the regulations. Example (1) of these regulations provides as follows:

Where the manufacturer or producer regularly sells part of his output to wholly independent distributors or other selling concerns in such a way as to establish fairly an independent factory or production price -- or shows to the satisfaction of the district director (or, if applicable, the Director of International Operations) that such an independent factory or production price has been otherwise established -- unaffected by considerations of tax liability and the selling or distributing branch or department of the business is located in a different country from that in which the factory is located or the production carried on, the taxable income attributable to sources within the United States SHALL be computed by an accounting which treats the products as sold by the factory or productive department of the business to the distributing or selling department at the independent factory price so established. In all such cases the basis of the accounting shall be fully explained in a statement attached to the return for the taxable year. (Emphasis added.)

Example (1) requires a taxpayer to use an independent factory or production price, if such a price exists, to determine the division between domestic and foreign sources of income from sales outside the United States of inventory produced (in whole or in part) within the United States. The priority of Example (1) over the other methods of apportionment described in section 1.863-3(b) of the regulations is confirmed by language contained in the legislative history of the Tax Reform Act of 1986. In the House Ways and Means Committee, Senate Finance Committee, and Conference Committee Reports, the description of current law provides that the division of income must be made on the basis of an independent factory or production price if such a price exists. H.R. Rep. No. 841 (Conf. Rep.), 99th Cong., 2d Sess. II-595 (1986), 1986-3 (Vol. 4) C.B. 1, 595; S. Rep. No. 313, 99th Cong., 2d Sess. 329 (1986), 1986-3 (Vol. 3) C.B. 1, 329; H.R. Rep. No. 426, 99th Cong., 1st Sess. 359 (1985), 1986-3 (Vol. 2) C.B. 1, 359.

HOLDING

Corporation X must use the independent factory or production price for purposes of determining the division between domestic and foreign sources of income from sales of product A outside the United States, including sales to its foreign subsidiaries.