Effects of the New Sourcing Rule: ECI and Profit Shifting

Abstract

For the first time in decades, Congress, as part of the recently enacted TCJA, changed a sourcing rule for determining gross income from the sale of manufactured inventory property that will affect both domestic and foreign taxpayers. This new rule, introduced with the addition of only one sentence, states that for tax years beginning after December 31, 2017, gross income from the sale or exchange of property produced by the taxpayer will be sourced at the place of manufacture, which is a departure from the old rule that assigned gross income partially to the place of sale (the old title passage rule) and partially to the place of manufacture.

This change is significant and has important implications in at least three situations.

First, it closes a longstanding loophole by reducing the amount of foreign source income used by U.S. taxpayers in their foreign tax credit limitation computations.

Second, multinationals using profit shifting structures may also be affected, including those that are U.S.-based and others that are foreign-based such as U.S.-based multinationals that have inverted. A number of multinationals have fact patterns that may cause an unacknowledged partnership for U.S. tax purposes with both U.S. and foreign group members as partners. Where this is the case, some portion of the profits shifted into zero-or low-taxed foreign group member partners may be subject to U.S. taxation under the effectively connected income (ECI) rules. In such cases, the new sourcing rule should cause the amount of ECI to be increased since all gross income will be attributed to the place of manufacture. Further, some portion of the profits in these foreign group members not caught by ECI taxation may be taxable under the subpart F manufacturing branch rule.

Third, this new sourcing rule provides foreign based entities selling manufactured products into the U.S. with a clear roadmap as to how they may avoid U.S. tax on those sales. Presently, many, if not most, foreign based manufacturers selling products in the U.S. establish U.S. subsidiaries to conduct their U.S. sales/distribution operations. This is in contrast to the use of a sales branch. With the new sourcing rule, the use of a sales branch may carry substantial tax benefits since no part of the gross income from inbound sales will be subject to ECI taxation. This in turn may encourage foreign manufacturers to adopt profit shifting structures using hybrid entities that could avoid tax in both the country of manufacture and the country of sale (i.e., the U.S.). If this occurs, the Treasury and the IRS may need to promulgate new rules and regulatory approaches to prevent such double non-taxation.

With the change of this sourcing rule, it is possible that Treasury and the IRS will take the opportunity to modernize Reg §1.863-3 and other related rules to reflect not only this TCJA change but also modern business models using contract manufacturers and other mechanisms rarely used or unknown decades ago when the existing regulations were issued. This article makes a number of suggestions, and emphasizes that any new rules should be consistent with Reg §1.954-3(a)(4)(iv), which was amended effective from 2009 to focus on contract manufacturing business models for purposes of Subpart F.

Keywords: Section 863(b), Sourcing, Sourcing of Income, International Taxation, Profit Shifting, Effectively Connected Income, ECI, U.S. Trade or Business

JEL Classification: H21, H25, K34, E62