This notice provides the optional 2020 standard mileage rates for taxpayers to use in computing the deductible costs of operating an automobile for business, charitable, medical, or moving expense purposes. This notice also provides the amount taxpayers must use in calculating reductions to basis for depreciation taken under the business standard mileage rate, and the maximum standard automobile cost that may be used in computing the allowance under a fixed and variable rate (FAVR) plan. Additionally, this notice provides the maximum fair market value (FMV) of employer-provided automobiles first made available to employees for personal use in calendar year 2020 for which employers may use the fleet-average valuation rule in § 1.61-21(d)(5)(v) of the Income Tax Regulations or the vehicle cents-per-mile valuation rule in § 1.61-21(e).

Rev. Proc. 2019-46, 2019-49 I.R.B. 1301, provides rules for computing the deductible costs of operating an automobile for business, charitable, medical, or moving expense purposes, and for substantiating, under § 274(d) of the Internal Revenue Code and § 1.274-5, the amount of ordinary and necessary business expenses of local transportation or travel away from home. Taxpayers using the standard mileage rates must comply with Rev. Proc. 2019-46. However, a taxpayer is not required to use the substantiation methods described in Rev. Proc. 2019-46, but instead may substantiate using actual allowable expense amounts if the taxpayer maintains adequate records or other sufficient evidence.

An independent contractor conducts an annual study for the Internal Revenue Service of the fixed and variable costs of operating an automobile to determine the standard mileage rates for business, medical, and moving use reflected in this notice. The standard mileage rate for charitable use is set by § 170(i).

Longstanding regulations under § 61 provide special valuation rules for employer-provided automobiles. The amount that must be included in the employee’s income and wages for the personal use of an employer-provided automobile generally is determined by reference to the automobile’s FMV. If an employer chooses to use a special valuation rule, the special value is treated as the FMV of the benefit for income tax and employment tax purposes. Section 1.61-21(b)(4). Two such special valuation rules, the fleet-average valuation rule and the vehicle cents-per-mile valuation rule, are set forth in § 1.61-21(d)(5)(v) and § 1.61-21(e), respectively. These two special valuation rules are subject to limitations, including that they may be used only in connection with automobiles having values that do not exceed a maximum amount set forth in the regulations.

The standard mileage rate for transportation or travel expenses is 57.5 cents per mile for all miles of business use (business standard mileage rate). See section 4 of Rev. Proc. 2019-46. However, § 11045 of the Tax Cuts and Jobs Act, Public Law 115-97, 131. Stat. 2054 (December 22, 2017) (the “TCJA”) suspends all miscellaneous itemized deductions that are subject to the two-percent of adjusted gross income floor under § 67, including unreimbursed employee travel expenses, for taxable years beginning after December 31, 2017, and before January 1, 2026. Thus, the business standard mileage rate provided in this notice cannot be used to claim an itemized deduction for unreimbursed employee travel expenses during the suspension. Notwithstanding the foregoing suspension of miscellaneous itemized deductions, deductions for expenses that are deductible in determining adjusted gross income are not suspended. For example, members of a reserve component of the Armed Forces of the United States (Armed Forces), state or local government officials paid on a fee basis, and certain performing artists are entitled to deduct unreimbursed employee travel expenses as an adjustment to total income on line 11 of Schedule 1 of Form 1040 (2019), not as an itemized deduction on Schedule A of Form 1040 (2019), and therefore may continue to use the business standard mileage rate.

The standard mileage rate is 14 cents per mile for use of an automobile in rendering gratuitous services to a charitable organization under § 170. See section 5 of Rev. Proc. 2019-46.

The standard mileage rate is 17 cents per mile for use of an automobile: (1) for medical care described in § 213; or (2) as part of a move for which the expenses are deductible under § 217(g). See section 5 of Rev. Proc. 2019-46. Section 11049 of the TCJA suspends the deduction for moving expenses for taxable years beginning after December 31, 2017, and before January 1, 2026. However, the suspension does not apply to members of the Armed Forces on active duty who move pursuant to a military order and incident to a permanent change of station. Thus, except for taxpayers to whom § 217(g) applies, the standard mileage rate provided in this notice is not applicable for the use of an automobile as part of a move occurring during the suspension.

For automobiles a taxpayer uses for business purposes, the portion of the business standard mileage rate treated as depreciation is 24 cents per mile for 2016, 25 cents per mile for 2017, 25 cents per mile for 2018, 26 cents per mile for 2019, and 27 cents per mile for 2020. See section 4.04 of Rev. Proc. 2019-46.

For purposes of computing the allowance under a FAVR plan, the standard automobile cost may not exceed $50,400 for automobiles (including trucks and vans). See section 6.02(6) of Rev. Proc. 2019-46.

For purposes of the fleet-average valuation rule in § 1.61-21(d)(5)(v) and the vehicle cents-per-mile valuation rule in § 1.61-21(e), the maximum FMV of automobiles (including trucks and vans) first made available to employees in calendar year 2020 is $50,400.

This notice is effective for: (1) deductible transportation expenses paid or incurred on or after January 1, 2020; (2) mileage allowances or reimbursements paid to a charitable volunteer or a member of the Armed Forces to whom § 217(g) applies: (a) on or after January 1, 2020, and (b) for transportation expenses the charitable volunteer or such member of the Armed Forces pays or incurs on or after January 1, 2020; and (3) for purposes of the maximum FMV of employer-provided automobiles for which employers may use the fleet-average valuation rule in §1.61-21(d)(5)(v) or the vehicle cents-per-mile rule in §1.61-21(e), automobiles first made available to employees for personal use on or after January 1, 2020.

Notice 2019-02 is superseded.

DRAFTING INFORMATION

The principal author of this notice is Anna Gleysteen of the Office of Associate Chief Counsel (Income Tax and Accounting). For further information on this notice regarding the use of an employee-provided automobile, contact Ms. Gleysteen at (202) 317-7007 (not a toll-free number). For further information on this notice regarding the use of an employer-provided automobile, contact Stephanie Caden of the Office of Associate Chief Counsel (Employee Benefits, Exempt Organizations, and Employment Taxes), at (202) 317-4774 (not a toll-free number).

These regulations (the “proposed regulations”) contain proposed amendments to 26 CFR part 1 revising the rules under section 863 of the Internal Revenue Code (the “Code”) for determining the source of gross income from sales of certain property, and under section 864 for treating foreign source income as effectively connected with the conduct of a trade or business within the United States. Conforming revisions are made to current regulations that reference section 863. The proposed regulations also provide guidance under section 865(e)(2) and (3) regarding the source of income from the sale of personal property, including inventory property, within the meaning of section 865(i)(1) (“inventory”), by nonresidents.

The Tax Cuts and Jobs Act, Pub. L. 115-97 (2017) (the “Act”), enacted on December 22, 2017, amended section 863 of the Code, which provides special rules for determining the source of income, including income partly from within and partly from without the United States. Specifically, section 14303 of the Act amended section 863(b) to allocate or apportion income from the sale or exchange of inventory property produced (in whole or in part) by a taxpayer within and sold or exchanged without the United States or produced (in whole or in part) by the taxpayer without and sold or exchanged within the United States (collectively, “Section 863(b)(2) Sales”) solely on the basis of production activities with respect to that inventory. Before the Act, section 863(b) provided that income from Section 863(b)(2) Sales would be treated as derived partly from sources within and partly from sources without the United States without providing the basis for such allocation or apportionment.

Current §1.863-3 provides rules for allocating or apportioning gross income from Section 863(b)(2) Sales. Those rules provide 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, with different rules then applying to source the portion of the income derived from production activity versus sales activity. See current §1.863-3(b). Current §1.863-3(f) provides rules for gains, profits, and income that are treated as derived partly from sources within the United States and partly from sources within a possession of the United States (generally referred to herein as a “U.S. territory”).

With respect to production activity, current §1.863-3(c)(1)(ii) provides a formula for allocating or apportioning gross income where there is production activity both within and without the United States. Current §1.863-3(c)(1)(ii)(A) determines the amount of income from sources without the United States by multiplying all the income attributable to taxpayer’s production activities by a fraction, the numerator of which is the average adjusted basis of production assets that are located outside the United States and the denominator of which is the average adjusted basis of all the production assets located within and without the United States. For purposes of applying this formula, the adjusted basis of production assets is determined under section 1011, which is adjusted under section 1016 for depreciation deductions allowed. Section 13201 of the Act amended section 168(k) to allow an additional first-year depreciation deduction of 100 percent of the basis of certain property placed in service after September 27, 2017, and before January 1, 2023. Therefore, certain new and used production assets placed in service and used predominantly within the United States during this period may have an adjusted basis of zero. After December 31, 2022, qualifying property placed in service before January 1, 2027 (or, in the case of certain property, January 1, 2028), is still subject to accelerated depreciation for an amount equal to the applicable percentage of the basis of the property. Section 168(k)(1) and (6). However, production assets placed in service or used predominantly without the United States, or both, do not qualify for this accelerated depreciation and must be depreciated using the straight line method under the alternative depreciation system (“ADS”) of section 168(g)(2). See section 168(g)(1)(A).

Section 865, added to the Code as part of the Tax Reform Act of 1986, Pub. L. 99-514 (1986) (the “TRA”), provides rules for sourcing sales of personal property. The general rule of section 865(a)(1) is that income from a sale of personal property is sourced based on the residence of the seller. Section 865(b) excepts inventory from this rule and sources income from the sale of inventory generally based on either the place of sale (for purchased inventory under section 861(a)(6) or 862(a)(6)) or based on the allocation and apportionment rules of section 863 (for inventory produced by the taxpayer). The place of sale rules typically depend upon the location where title to the inventory passes from the seller to the buyer. See §1.861-7(c).

Section 865(c) provides special rules for sourcing gain from the sale of depreciable personal property. Under section 865(c)(1), gain from the sale of depreciable personal property that is not in excess of depreciation adjustments is allocated between sources within and without the United States by treating the same proportion of such gain as sourced within the United States as the United States depreciation adjustments (as defined in section 865(c)(3)) with respect to such property bear to the total depreciation adjustments, and by treating the remaining portion of such gain as sourced without the United States. Under section 865(c)(2), gain in excess of the depreciation adjustments is sourced as if such property were inventory.

Section 865(e)(2) provides a further overlay to these rules with respect to all sales of personal property (including inventory) by nonresidents, as that term is defined in section 865(g)(1)(B), attributable to an office or other fixed place of business in the United States. Section 865(e)(2)(A) generally provides that income from any sale of personal property attributable to such an office or other fixed place of business is sourced in the United States. An exception is provided in section 865(e)(2)(B) for a sale of inventory for use, disposition, or consumption outside the United States if a foreign office of the nonresident “materially participated” in the sale. Section 865(e)(3) provides that the “principles of section 864(c)(5) shall apply” to determine whether a nonresident has an office or other fixed place of business and whether a sale is attributable to such office or other fixed place of business. Where applicable, section 865(e)(2) applies “[n]otwithstanding any other provisions” of subchapter N, part I, including sections 863(b), 861(a)(6), and 862(a)(6).

Section 864(c) provides the general rules for determining whether income is treated as effectively connected with the conduct of a trade or business within the United States. Nonresident alien individuals, foreign corporations, and bona fide residents of a U.S. territory (“non-U.S. persons”) engaged in a trade or business within the United States are generally subject to U.S. net basis taxation on income that is effectively connected with that trade or business. Section 864(c)(2) provides that income described in section 871(a)(1) or (h) or section 881(a) or (c), as well as U.S. source capital gains or losses, are determined to be effectively connected or not based on two tests—whether the income is “derived from assets” used in the non-U.S. person’s trade or business or whether the activities of the trade or business were a “material factor” in the realization of the income. Section 864(c)(3) generally treats U.S. source income not described in section 864(c)(2) as effectively connected with a non-U.S. person’s trade or business within the United States. Section 864(c)(4)(B) sets forth additional rules that treat certain foreign source income as effectively connected with the conduct of a U.S. trade or business if a non-U.S. person has an office or other fixed place of business within the United States to which the income is attributable, including income from certain sales of inventory as described in section 864(c)(4)(B)(iii).

Section 864(c)(5)(A) provides rules for determining whether a non-U.S. person has an office or other fixed place of business to which section 864(c)(4)(B) may apply as the result of the presence of an agent in the United States, and section 864(c)(5)(B) provides a threshold requirement for determining whether any income is attributable to such an office or other fixed place of business. Once it is determined that an office or other fixed place of business in the United States exists and income is attributable thereto, section 864(c)(5)(C) provides that the amount of income so attributable is generally the amount that is properly allocable to the office or other fixed place of business. Section 864(c)(5)(C) further provides that, with respect to certain sales of inventory described in section 864(c)(4)(B)(iii), the amount attributable to the office or fixed place of business cannot exceed the income that would otherwise have been U.S. source had the sale been made in the United States. As noted, the principles of section 864(c)(5) apply in the context of section 865(e)(2) pursuant to section 865(e)(3).

Consistent with the Act’s changes to section 863(b)(2), these proposed regulations amend §1.863-3 in order to properly allocate or apportion gross income from Section 863(b)(2) Sales based solely on production activity, and remove the methods for allocating or apportioning gross income between production and sales activity. In addition, because of the Act’s change to section 168(k) to allow accelerated depreciation in some circumstances, these proposed regulations provide a new rule for computing the adjusted basis of production assets for purposes of applying the formula for allocating or apportioning gross income where there is production activity both within and without the United States. These proposed regulations also contain conforming amendments to other regulations that allocate or apportion income between production and sales activity. In addition, these proposed regulations make minor changes to §§1.937-2, 1.937-3, and 1.1502-13 to update relevant cross references and examples.

These regulations also add proposed §1.865-3 to clarify the proper scope and application of section 865(e)(2), as well as the interaction between section 865(e)(2) and section 865(c) regarding the sourcing of income from the sale of certain depreciable personal property. The proposed regulations also clarify the interaction between the section 865(e)(2) rules and the rules governing effectively connected income under section 864(c)(4)(B)(iii) and (c)(5). The proposed regulations amend §1.864-6(c), the current rules for determining the amount of foreign source effectively connected income attributable to an office or other fixed place of business within the United States, to be consistent with the proposed sourcing rules applicable to produced inventory sales under section 865(e)(2).

The regulations are proposed to apply to taxable years ending on or after December 23, 2019. As proposed, the regulations will permit taxpayers to apply the rules therein in their entirety for taxable years beginning after December 31, 2017, and before these regulations apply.

In addition, taxpayers may rely on the rules in the proposed regulations for taxable years beginning after December 31, 2017, and before the final regulations are applicable, provided that the taxpayer and persons that are related (within the meaning of section 267 or 707) to the taxpayer apply the proposed regulations in their entirety. For taxable years before these regulations apply, the IRS may, where appropriate, challenge certain positions described in this preamble, including that following the amendment to section 863(b)(2) income earned by nonresidents from sales of personal property produced outside the United States and sold through an office or other fixed place of business in the United States is 100 percent foreign source.

The Administrator of the Office of Information and Regulatory Affairs (OIRA), Office of Management and Budget, has determined that this proposed rule is not a significant regulatory action, as that term is defined in section 3(f) of Executive Order 12866. Therefore, OIRA has not reviewed this proposed rule pursuant to section 6(a)(3)(A) of Executive Order 12866 and the April 11, 2018, Memorandum of Agreement between the Treasury Department and the Office of Management and Budget (“OMB”).

Before the proposed regulations are adopted as final regulations, consideration will be given to any comments that are submitted timely to the IRS as prescribed in this preamble under “Addresses.” The Treasury Department and the IRS request comments on all aspects of the proposed rules. See also sections I.C, II.A.4, and II.B of the Explanation of Provisions (requesting specific comments related to the suitability of using ADS, other potential approaches to determine the location or existence of production activity, or other modifications to §1.863-3 that may be appropriate; related to whether there are other suitable methods for allocating or apportioning income attributable to Section 865(e)(2) Sales between U.S. and foreign sources; and related to the impact of these proposed regulations on the determination of qualified business income for purposes of section 199A, respectively). All comments will be available at www.regulations.gov or upon request. A public hearing will be scheduled if requested in writing by any person that timely submits comments. If a public hearing is scheduled, notice of the date, time, and place for the public hearing will be published in the Federal Register.

The principal authors of the proposed regulations are Brad McCormack and Anisa Afshar of the Office of Associate Chief Counsel (International). However, other personnel from the Treasury Department and the IRS participated in their development.

Income taxes, Reporting and recordkeeping requirements.

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by:

The revisions and addition read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.863-1 also issued under 26 U.S.C. 863(a).

Section 1.863-2 also issued under 26 U.S.C. 863(a).

Section 1.863-3 also issued under 26 U.S.C. 863(a).

* * * * *

Section 1.863-8 also issued under 26 U.S.C. 863(a).

* * * * *

Section 1.865-3 also issued under 26 U.S.C. 865(j).

* * * * *

Section 1.937-2 also issued under 26 U.S.C. 937(b).

Section 1.937-3 also issued under 26 U.S.C. 937(b).

* * * * *

Section 1.1502-13 also issued under 26 U.S.C. 1502.

* * * * *

Par. 2. Section 1.863-1 is amended as follows:

The revisions read as follows:

§1.863-1 Allocation of gross income under section 863(a).

(a) * * * See also section 865(b) for rules for sourcing income from the sale of inventory property, within the meaning of section 865(i)(1) (inventory), generally, and section 865(e)(2) and §1.865-3 for sourcing income from the sale of personal property (including inventory) by a nonresident that is attributable to the nonresident’s office or other fixed place of business in the United States. * * *

(b) * * *

(1) * * * Notwithstanding any other provision of this part, except to the extent provided in paragraph (b)(2) of this section or §1.865-3, gross receipts from the sale within the United States of products derived from the ownership or operation of any farm, mine, oil or gas well, other natural deposit, or timber outside the United States shall be treated as attributable to production activities without the United States and therefore treated as income from sources without the United States.

* * * * *

(7) * * *

(i) Example 1. No additional production. U.S. Mines, a domestic corporation, operates a copper mine and mill in Country X. U.S. Mines extracts copper-bearing rocks from the ground and transports the rocks to the mill where the rocks are ground and processed to produce copper-bearing concentrate. The concentrate is transported to a port where it is dried in preparation for export, stored, and then shipped to purchasers in the United States. Because there is no additional production, paragraph (b)(3)(ii) of this section does not apply, and under paragraph (b)(1) of this section, gross receipts from the sale of the concentrate will be from sources without the United States.

(ii) Example 2. No additional production. U.S. Gas, a domestic corporation, extracts natural gas within the United States, and transports the natural gas to a Country X port where it is liquefied in preparation for shipment. The liquefied natural gas is then transported via freighter and sold without additional production activities in a foreign country. Liquefaction of natural gas is not an additional production activity because liquefaction prepares the natural gas for transportation. Therefore, under paragraph (b)(1) of this section, gross receipts from the sale of the liquefied natural gas will be from sources within the United States.

(iii) Example 3. Production in United States. U.S. Gold, a domestic corporation, mines gold in Country X, produces gold jewelry using production assets located in the United States, and sells the jewelry in Country Y. Assume that the fair market value of the gold before the additional production activities in the United States is $40x and that U.S. Gold ultimately sells the gold jewelry in Country Y for $100x. Under paragraph (b)(2) of this section, $40x of U.S. Gold’s gross receipts will be allocated to sources without the United States, and the remaining $60x of gross receipts will be U.S. source under §1.863-3.

(iv) Example 4. Production in United States. U.S. Oil, a domestic corporation, extracts oil in Country X, transports the oil via a pipeline to the United States, refines the oil using production assets located in the United States, and sells the refined product in the United States to unrelated persons. Assume that the fair market value of the oil before refinement in the United States is $80x and U.S. Oil ultimately sells the refined product for $100x. Under paragraph (b)(2) of this section, $80 of gross receipts will be allocated to sources without the United States, and the remaining $20 of gross receipts will be allocated to sources within the United States.

* * * * *

Par. 3. Section 1.863-2 is amended as follows:

The revision reads as follows:

§1.863-2 Allocation and apportionment of taxable income.

* * * * *

(b) Determination of source of taxable income. Income treated as derived from sources partly within and partly without the United States under paragraph (a) of this section may be allocated or apportioned to sources within and without the United States pursuant to §§1.863-1, 1.863-3, 1.863-4, 1.863-8, and 1.863-9. To determine the source of certain types of income described in paragraph (a)(1) of this section, see §1.863-4. To determine the source of gross income described in paragraph (a)(2) of this section, see §1.863-1 for natural resources and §1.863-3 for all other sales of inventory property. Section 1.865-3 may apply instead of the provisions in this part to source gross income from sales of personal property (including inventory property) by nonresidents attributable to an office or other fixed place of business in the United States. To determine the source of income partly from sources within a possession of the United States, including income described in paragraph (a)(3) of this section, see §1.863-3(e).

* * * * *

Par. 4. Section 1.863-3 is amended as follows:

 

10. Revising newly redesignated paragraph (c)(2)(ii).

11. In newly redesignated paragraph (c)(4):

i. In the introductory text, removing “(c)(1)” and adding in its place “(c)”; and

ii. Designating Examples 1, 2, and 3 as paragraphs (c)(4)(i) through (iii).

12. In newly designated paragraph (c)(4)(i):

i. Removing “production” from the heading and adding in its place “gross”; and

ii. Redesignating paragraphs (c)(1)(i)(i) and (ii) as paragraphs (c)(4)(i)(A) and (B).

13. In newly redesignated paragraph (c)(4)(i)(A), removing the ninth sentence.

14. In newly redesignated paragraph (c)(4)(i)(B):

i. Removing “production”, “one half of”, and “or $6,” from the first sentence;

ii. Removing “production” from the second sentence; and

iii. In the last sentence, removing “$2” and “$6” and adding in their places “$4” and “$12”, respectively.

15. In newly designated paragraph (c)(4)(ii):

i. Removing “Example 1” from the first sentence and adding in its place “in paragraph (c)(4)(i)(A) of this section (Example 1)”; and

ii. Removing “from production activity” from the second sentence.

16. In newly designated paragraph (c)(4)(iii), redesignating paragraphs (c)(4)(iii)(i) and (ii) as paragraphs (c)(4)(iii)(A) and (B).

17. In newly redesignated paragraph (c)(4)(iii)(A):

i. Removing “Example 1” from the first sentence and adding in its place “in paragraph (c)(4)(i)(A) of this section (Example 1)”; and

ii. Removing “(c)(1)(ii)” and “production income” from the fourth sentence and adding in their places “(c)(2)” and “gross income”, respectively.

18. In newly redesignated paragraph (c)(4)(iii)(B):

i. Removing “(c)(1)(ii)(A)” from the first sentence and adding in its place “(c)(2)(i)”; and

ii. Removing “production income” from the second sentence and adding in its place “gross income”.

19. Revising paragraph (d).

20. Removing paragraph (e).

21. Redesignating paragraph (f) as paragraph (e).

22. Revising newly redesignated paragraphs (e)(1) and (2) and (e)(3)(i).

23. Removing “(f)(3)(ii)” from newly redesignated paragraph (e)(3)(ii)(B) introductory text and adding in its place “(e)(3)(ii)”.

24. Revising newly redesignated paragraph (e)(3)(ii)(C)(1).

25. Removing newly redesignated paragraph (e)(4).

26. Further redesignating paragraph (e)(3)(iii) as paragraph (e)(4).

27. In newly redesignated paragraph (e)(4):

i. Removing “(f)(3)(ii)” from the introductory text and adding in its place “(e)(3)(ii)”; and

ii. Designating Examples 1 and 2 as paragraphs (e)(4)(i) and (ii).

28. In newly designated paragraph (e)(4)(i), redesignating paragraphs (e)(4)(i)(i) and (ii) as paragraphs (e)(4)(i)(A) and (B).

29. In newly designated paragraph (e)(4)(ii), redesignating paragraphs (e)(4)(ii)(i) and (ii) as paragraphs (e)(4)(ii)(A) and (B).

30. In newly redesignated paragraph (e)(4)(ii)(A), removing “Example 1” and adding “paragraph (e)(4)(i)(A) of this section (Example 1)”.

31. Removing “(f)” from newly redesignated paragraph (e)(5) and adding in its place “(e)” and removing “(g)” and adding in its place “(f)”.

32. Removing newly redesignated paragraph (e)(6).

33. Redesignating paragraph (g) as paragraph (f).

34. In newly redesignated paragraph (f)(1), removing “(g)(2)” and adding in its place “(f)(2)”.

35. In newly redesignated paragraph (f)(2)(ii), removing “(g)(2)(i)” and adding in its place “(f)(2)(i)” and removing “(c)(1)(ii)(B)” and adding in its place “(c)(2)(ii)”.

36. Removing newly redesignated paragraph (f)(2)(iv).

37. In newly redesignated paragraph (f)(3):

i. Removing “(g)” from the introductory text and adding in its place “(f)”; and

ii. Designating Examples 1 and 2 as paragraphs (f)(3)(i) and (ii).

38. In newly designated paragraph (f)(3)(ii):

i. Removing “Example 1” from the first sentence and adding in its place “paragraph (f)(3)(i) of this section (Example 1)”;

ii. Removing “these regulations” in the fourth sentence and adding in its place “this section”;

iii. Removing the fifth sentence; and

iii. Removing “(1)” from the last sentence.

39. Redesignating paragraph (h) as (g) and revising newly redesignated paragraph (g).

The revisions and additions read as follows:

§1.863-3 Allocation and apportionment of income from certain sales of inventory.

(a) In general—(1) Scope. Subject to the rules of §1.865-3, paragraphs (a) through (d) of this section apply to determine the source of income derived from the sale of inventory property (inventory) that a taxpayer produces (in whole or in part) within the United States and sells without the United States, or that a taxpayer produces (in whole or in part) without the United States and sells within the United States (Section 863(b)(2) Sales). See section 865(i)(1) for the definition of inventory. Paragraph (b) of this section provides that the source of gross income from the sale or exchange of inventory in Section 863(b)(2) Sales is based solely on the production activities with respect to the inventory. Paragraph (c) of this section describes how to determine source based on production activity, including where inventory is produced partly within the United States and partly without the United States. Paragraph (d) of this section determines taxable income from Section 863(b)(2) Sales. Paragraph (e) of this section applies to determine the source of certain income derived from a possession of the United States. Paragraph (f) of this section provides special rules for partnerships for all sales subject to §§1.863-1 through 1.863-3. Paragraph (g) of this section provides applicability dates for the rules in this section.

(2) Cross references. To determine the source of income derived from the sale of personal property (including inventory) by a nonresident that is attributable to the nonresident’s office or other fixed place of business in the United States under section 865(e)(2), the rules of §1.865-3 apply, and the rules of this section do not apply. To determine the source of income from sales of property produced by the taxpayer, when the property is either produced in whole or in part in space or on or under water not within the jurisdiction (as recognized by the United States) of a foreign country, possession of the United States, or the United States (in international water), or is sold in space or international water, the rules of §1.863-8 apply, and the rules of this section do not apply except to the extent provided in §1.863-8.

(b) Sourcing based solely on production activities. Subject to the rules of §1.865-3, all gain, profit, and income derived from Section 863(b)(2) Sales is allocated and apportioned solely on the basis of the production activities with respect to the inventory.

(c) * * *

(2) * * *

(ii) Adjusted basis of production assets—(A) In general. For purposes of paragraph (c)(2)(i) of this section, the adjusted basis of an asset is determined by using the alternative depreciation system under section 168(g)(2). The adjusted basis of all production assets for purposes of paragraph (c)(2)(i) of this section is determined as though such production assets were subject to the alternative depreciation system set forth in section 168(g)(2) for the entire period that such property has been in service. The adjusted basis of the production assets is determined without regard to the election to expense certain depreciable assets under section 179 and without regard to any additional first-year depreciation provision (for example, sections 168(k), 168(l), and 168(m), and former sections 1400L(b) and 1400N(d)). The average adjusted basis is computed by averaging the adjusted basis of the asset at the beginning and end of the taxable year, unless by reason of material changes during the taxable year such average does not fairly represent the average for such year. In this event, the average adjusted basis is determined upon a more appropriate basis.

(B) Production assets used to produce other property. If a production asset is used to produce inventory sold in Section 863(b)(2) Sales and also used to produce other property during the taxable year, the portion of its adjusted basis that is included in the fraction described in paragraph (c)(2)(i) of this section will be determined under any method that reasonably reflects the portion of the asset that produces inventory sold in Section 863(b)(2) Sales. For example, the portion of such an asset that is included in the formula may be determined by multiplying the asset’s average adjusted basis by a fraction, the numerator of which is the gross receipts from sales of inventory from Section 863(b)(2) Sales produced by the asset, and the denominator of which is the gross receipts from all property produced by that asset.

* * * * *

(d) Determination of source of taxable income. Once the source of gross income has been determined under paragraph (c) of this section, the taxpayer must properly allocate and apportion under §§1.861-8 through 1.861-14T and 1.861-17 its expenses, losses and other deductions to its respective amounts of gross income from sources within and without the United States from its Section 863(b)(2) Sales.

(e) Income partly from sources within a possession of the United States—(1) In general. This paragraph (e) relates to certain sales that give rise to gains, profits, and income that are treated as derived partly from sources within the United States and partly from sources within a possession of the United States (Section 863 Possession Sales). This paragraph (e) applies to determine the source of income derived from the sale of inventory produced (in whole or in part) by the taxpayer within the United States and sold within a possession, or produced (in whole or in part) by a taxpayer in a possession and sold within the United States (Possession Production Sales). It also applies to determine the source of income derived from the purchase of personal property within a possession of the United States and its sale within the United States (Possession Purchase Sales). A taxpayer subject to this paragraph (e) must apportion gross income from Section 863 Possession Sales under paragraph (e)(2) of this section (in the case of Possession Production Sales) or using the business activity method described in paragraph (e)(3)(i) of this section (in the case of Possession Purchase Sales). The source of gross income from each type of activity from Possession Purchase Sales must then be determined under paragraph (e)(3)(ii) of this section. The source of taxable income from Possession Production Sales is determined under paragraph (c) of this section. The source of taxable income from Section 863 Possession Sales is determined under paragraph (d) of this section.

(2) Allocation or apportionment for Possession Production Sales. The source of gross income from Possession Production Sales is determined under the rules of paragraph (c) of this section, except that the term possession of the United States is substituted for foreign country wherever it appears.

(3) Allocation or apportionment for Possession Purchase Sales—(i) Determination of source of gross income for Possession Purchase Sales. Gross income from Possession Purchase Sales is allocated in its entirety to the taxpayer’s business activity, and is then apportioned between sources within the United States and sources within a possession of the United States under paragraph (e)(3)(ii) of this section.

(ii) * * *

(C) * * *

(1) Sales activity. The source of the taxpayer’s income that is attributable to sales activity will be determined under the provisions of §1.861-7(c). Notwithstanding any other provision of this part, for rules regarding the source of income when a sale takes place in space or international water, the rules of §1.863-8 apply, and the rules of this section do not apply except to the extent provided in §1.863-8.

* * * * *

(g) Applicability dates. This section applies to taxable years ending on or after December 23, 2019. However, taxpayers may apply this section in its entirety for taxable years beginning after December 31, 2017, and ending before December 23, 2019, provided that the taxpayer and persons that are related (within the meaning of section 267 or 707) to the taxpayer apply this section in its entirety.

Par. 5. Section 1.863-8 is amended as follows:

The revisions read as follows:

§1.863-8 Source of income derived from space and ocean activity under section 863(d).

* * * * *

(b) * * *

(3) * * *

(ii) Sales of property produced by the taxpayer—(A) General. If the taxpayer both produces property and sells such property, the taxpayer must allocate and apportion all gain, profit, and income derived from sales of such property solely on the basis of the production activities with respect to such property, and the source of that income will be determined under paragraph (b)(3)(ii)(B) or (C) of this section. To determine the source of income derived from the sale of personal property (including inventory) by a nonresident that is attributable to the nonresident’s office or other fixed place of business in the United States under section 865(e)(2), the rules of §1.865-3 apply, and the rules of this section do not apply.

* * * * *

(f) * * *

(6) * * *

(ii) Analysis. The collection of data and creation of images in space is characterized as the creation of property in space. Because S both produces and sells the data, the source of the gross income from the sale of the data is determined under paragraph (b)(3)(ii) of this section (by reference to §1.863-3(c)) solely on the basis of the production activities. The source of S’s gross income is determined under §1.863-3(c)(2) because production activities occur both in space and on land. * * *

(11) * * *

(ii) Analysis. Because S’s rights, title, and interest in the satellite pass to the customer in space, the sale takes place in space under § 1.861-7(c), and the sale transaction is space activity under paragraph (d)(1)(i) of this section. The source of income derived from the sale of the satellite in space is determined under paragraph (b)(3)(ii) of this section (by reference to §1.863-3(c)) solely on the basis of the production activities with respect to the satellite.

* * * * *

Par. 6. Section 1.864-6 is amended by revising paragraphs (c)(2) and (3) and adding paragraph (c)(4) to read as follows:

§1.864-6 Income, gain, or loss attributable to an office or other fixed place of business in the United States.

* * * * *

(c) * * *

(2) Special limitation in case of sales of goods or merchandise through U.S. office. Notwithstanding paragraph (c)(1) of this section, the special rules described in this paragraph (c)(2) apply with respect to a sale of goods or merchandise specified in §1.864-5(b)(3), to which paragraph (b)(3)(i) of this section does not apply. In the case of a nonresident alien with a tax home within the United States, as defined in section 911(d)(3), the amount of income from the sale of goods or merchandise that is properly allocable to the individual’s U.S. office is determined under §1.865-3(d)

(3) Examples. The application of this paragraph (c) may be illustrated by the following examples—

(i) Example 1. Nonresident alien individual A, who has a tax home in the United States, manufactures machinery in a foreign country and sells the machinery outside the United States through A’s sales office in the United States for use in foreign countries. Title to the property sold is transferred to the foreign purchaser outside the United States, but no office or other fixed place of business of A in a foreign country participates materially in the sale made through its U.S. office. By reason of its sales activities in the United States, A is engaged in business in the United States during the taxable year. During the taxable year, A derives a total income of $250,000x from these sales. Under section 865(b)(2), all of A’s income from these sales is foreign source as production occurs outside the United States. Under paragraph (c)(2) of this section, the amount of income that is allocable to A’s U.S. office is determined under §1.865-3(d)(2). The taxpayer does not allocate income from the sale under the books and records method described in §1.865-3(d)(2)(ii). Thus, 50 percent of A’s foreign source income, plus any additional income allocable based on the location of production activities under §§1.863-3(b) and 1.865-3(d)(2)(i) (in this case, $0x), is effectively connected for the taxable year with the conduct of A’s U.S. trade or business, or $125,000x.

(ii) Example 2. Nonresident alien individual B, who has a tax home in the United States, has an office in a foreign country that purchases merchandise and sells it through B’s sales office in the United States for use in various foreign countries, with title to the property passing outside the United States. No other office of B participates materially in these sales made through its U.S. office. By reason of its sales activities in the United States, B is engaged in business in the United States during the taxable year. During the taxable year, B derives income of $300,000x from these sales made through its U.S. sales office. Under section 865(b), all of B’s income from these sales is foreign source as title to the merchandise passes outside the United States. The amount of income properly allocable to B’s US office determined under §1.865-3(d)(3) is $300,000x.

(iii) Example 3. The facts are the same as in paragraph (c)(3)(ii) of this section (Example 2), except that B has an office in a foreign country which participates materially in the sales which are made through its U.S. office. The income which is allocable to B’s U.S. sales office is not effectively connected for the taxable year with the conduct of a trade or business in the United States by that corporation.

(4) Applicability date. Paragraphs (c)(2) and (3) of this section, to the extent they apply to sales of inventory described in section 864(c)(4)(B)(iii), apply to sales occurring in taxable years ending on or after December 23, 2019. However, taxpayers may apply this section in its entirety for taxable years beginning after December 31, 2017, and ending before December 23, 2019, provided that the taxpayer and persons that are related (within the meaning of section 267 or 707) to the taxpayer apply this section in its entirety.

Par. 7. Section 1.865-3 is added to read as follows:

§1.865-3 Source of income from sales of personal property (including inventory property) by a nonresident attributable to an office or other fixed place of business in the United States.

(a) In general. Notwithstanding any other provisions of sections 861 through 865 or the regulations in this part except paragraph (b) of this section, if a nonresident, as defined in section 865(g)(1)(B), maintains an office or other fixed place of business in the United States, income from any sale of personal property (including inventory property) attributable to such office or other fixed place of business (as determined under paragraph (c) of this section) is sourced in the United States in an amount described in paragraph (d) of this section. See section 865(i)(1) for the definition of inventory property.

(b) Exceptions for inventory property. Paragraph (a) of this section does not apply with respect to the income derived by a nonresident from any sale of inventory property that is sold for use, disposition, or consumption outside the United States if an office or other fixed place of business of the nonresident in a foreign country materially participated in the sale. See §1.864-6(b)(3) to determine whether a foreign office materially participated in the sale and whether the property was destined for foreign use.

(c) Attribution of a sale to a United States office. In determining whether a sale of personal property by a nonresident is attributable to an office or other fixed place of business in the United States, the principles of section 864(c)(5)(B) as prescribed in §1.864-6(b) and (c) apply. The rule in this paragraph (c) applies without regard to whether the property is described in §1.864-5(b)(3)(iii). In determining whether a nonresident maintains an office or other fixed place of business in the United States, the principles of section 864(c)(5)(A) as prescribed in §1.864-7 apply, including the rules of paragraph (d) of that section regarding the office or fixed place of business of a dependent agent of the nonresident.

(d) Amount of income or loss on sale of personal property attributable to a U.S. office—(1) In general. Subject to the special rules described in paragraphs (d)(2), (3), and (4) of this section, the amount of income, gain, or loss from the sale of personal property attributable to an office or other fixed place of business in the United States is determined under §1.864-6(c)(1).

(2) Produced inventory property—(i) In general. With respect to income from the sale of inventory property subject to paragraph (a) of this section that is produced by a nonresident, 50 percent of the gross income from such sale is properly allocable to the office or fixed place of business in the United States. The remaining 50 percent of the gross income is allocable to production activities and is sourced in accordance with §1.863-3 (the “50/50 method”). However, in lieu of the 50/50 method, a taxpayer may elect to allocate income from the sale of inventory property that is produced by a nonresident under the books and records method described in paragraph (d)(2)(ii) of this section, provided it satisfies all of the requirements described in that paragraph to the satisfaction of the Commissioner. For purposes of this paragraph (d)(2)(i), the term “produced” includes created, fabricated, manufactured, extracted, processed, cured, and aged. See section 864(a) and §1.864-1.

(ii) Books and records method—(A) Method. A taxpayer may elect to determine the amount of its gross income from the sale of inventory property subject to paragraph (a) of this section and produced by a nonresident that is allocable to production and sales activities for the taxable year based upon its books of account. The taxpayer must establish that the taxpayer, in good faith and unaffected by considerations of tax liability, regularly employs in its books of account a detailed allocation of receipts and expenditures that clearly reflects the amount of the taxpayer’s gross income from its inventory sales that is attributable to its sales activities, and gross income from sales that is attributable to its production activities under the principles of section 482. For purposes of this paragraph (d)(2)(ii)(A), section 482 principles will apply as if the office or fixed place of business in the United States were a separate taxpayer from the nonresident (whether or not payments are made between the United States office or other fixed place of business and the nonresident taxpayer’s other offices). The gross income allocable to sales activity under this method is treated as properly allocable to the office or other fixed place of business in the United States. The gross income allocable to production activities is sourced in accordance with §1.863-3.

(B) Election and reporting rules—(1) In general. A taxpayer making an allocation of gross income under the books and records method in paragraph (d)(2)(ii)(A) of this section must satisfy the requirements of paragraphs (d)(2)(ii)(B)(2) and (3) of this section. Failure to satisfy the requirements in paragraphs (d)(2)(ii)(B)(2) and (3) in full and to the satisfaction of the Commissioner will result in application of the 50/50 method specified in paragraph (d)(2)(i) of this section.

(2) Required records. A taxpayer electing the books and records method under paragraph (d)(2)(ii)(A) of this section must prepare and maintain records that are in existence when its return is filed regarding the allocation of gross income between sales and production activities in its books of account. The taxpayer must also prepare an explanation of how such allocation clearly reflects the taxpayer’s income from production and sales activities under the principles of section 482. The taxpayer must make available such explanation and records for both the U.S. sales office and the entity or entities that perform the production activities upon request of the Commissioner, generally within 30 days or some other time period as agreed between the Commissioner and the taxpayer.

(3) Disclosure on a tax return. A taxpayer who chooses to apply the books and records method under paragraph (d)(2)(ii)(A) of this section must indicate in a statement attached to a timely filed return (including extensions) that it elects to apply such method and has prepared the records described in paragraph (d)(2)(ii)(B)(2) of this section.

(3) Purchased inventory property. With respect to income from the sale of inventory property subject to paragraph (a) of this section that is purchased by the nonresident, the entire income from such sale is properly allocable to the office or other fixed place of business in the United States.

(4) Depreciable personal property. With respect to income from the sale of depreciable personal property subject to paragraph (a) of this section—

(i) The gain not in excess of the depreciation adjustments is allocable to an office or other fixed place of business in the United States to the same extent that the gain would be allocated to sources within the United States under the rules of section 865(c)(1). The remaining gain not in excess of the depreciation adjustments is allocated to sources without the United States in accordance with section 865(c)(1). However, notwithstanding the preceding sentences, if the property was predominantly used in the United States, within the meaning of section 865(c)(3)(B)(i), for a specific year, all of the gain not in excess of depreciation for that year is allocated to sources within the United States.

(ii) The gain in excess of the depreciation adjustments is treated as if such property were inventory and is sourced under paragraph (d)(2) or (3) of this section as applicable.

(e) Determination of source of taxable income. For rules allocating and apportioning expenses to income effectively connected with the conduct of a trade or business in the United States, see §§1.882-4 and 1.882-5.

(f) Export trade corporations. This section is not applicable for purposes of defining an export trade corporation under section 971.

(g) Applicability date. This section applies to sales occurring in taxable years ending on or after December 23, 2019. However, taxpayers may apply this section in its entirety for taxable years beginning after December 31, 2017, and ending before December 23, 2019, provided that the taxpayer and persons that are related (within the meaning of section 267 or 707) to the taxpayer apply this section in its entirety.

§1.937-2 [Amended]

Par. 8. Section 1.937-2 is amended by removing “§1.863-3(f)” from paragraph (d) and adding in its place “§1.863-3(e)”.

§1.937-3 [Amended]

Par. 9. Section 1.937-3 is amended by removing “§1.863-3(f)” from paragraph (d) and adding in its place “§1.863-3(e)”.

Par. 10. Section 1.1502-13, as proposed to be amended at 83 FR 67490 (December 28, 2018), is further amended by revising paragraph (c)(7)(ii)(N) is to read as follows:

§1.1502-13 Intercompany transactions.

* * * * *

(c) * * *

(7) * * *

(ii) * * *

(N) Example (14): Source of income under section 863—(1) Intercompany sale—(i) Facts. S manufactures inventory property solely in the United States, and recognizes $75x of income on sales to B in Year 1. B conducts further production activity on the inventory property solely in Country Y and then sells the inventory property to X in Country Y and recognizes $25x of income on the sale to X, also in Year 1. Title passes from S to B, and from B to X, in Country Y. Assume that applying §1.863-3 on a single entity basis, including the formula for apportionment of multi-country production activities by reference to the basis of production assets, $10x is treated as foreign source income and $90x is treated as U.S. source income (that is, 10 percent of the production occurred outside the United States and 90 percent occurred within the United States, as measured by the basis of assets used in production activities with respect to the property). Assume further that, on a separate entity basis, S would have $0 of foreign source income and $75x of U.S. source income and all of B’s $25x of income would be foreign source income.

(ii) Analysis. Under the matching rule , both S’s $75x intercompany income and B’s $25x corresponding income are taken into account in Year 1. In determining the source of S and B’s income from the inventory property sales, the attributes of S’s intercompany item and B’s corresponding item are redetermined to the extent necessary to produce the same effect on consolidated taxable income (and consolidated tax liability) as if S and B were divisions of a single corporation. See paragraph (c)(1)(i) of this section. On a separate entity basis, S would have $75x of U.S. source income because the product would be treated as produced wholly in the United States and sold outside the United States, and B would have $25x of foreign source income because the product would be treated as produced wholly outside the United States and sold outside the United States. On a single entity basis, S and B are treated as divisions of a single corporation, and section 863 applies as if $100x of income were recognized from producing partly in the United States and partly in Country Y and selling in Country Y. This results in $10x of foreign source income and $90x of U.S. source income. Accordingly, under single entity treatment, $15x of B’s sales income that would be treated as foreign source income on a separate entity basis is redetermined to be U.S. source income. Under paragraph (c)(1)(i) of this section, attributes are redetermined only to the extent of the $15x necessary to achieve the same effect as if S and B were divisions of a single corporation. Under paragraph (c)(4)(ii) of this section, the redetermined attribute must be allocated between S and B using a reasonable method. In this case, only B would have foreign source income on a separate entity basis, and thus $15x of B’s foreign source income must be recharacterized as U.S. source income.

(2) Sale of property reflecting intercompany services or intangibles—(i) Facts. S earns $10x of income performing services in the United States for B. B capitalizes S’s fees into the basis of inventory property that it manufactures in the United States and sells to an unrelated person in Year 1 at a $90x profit, with title passing in Country Y. Assume that on a single entity basis, $100x is treated as U.S. source income and $0 is treated as foreign source income. Further assume that on a separate entity basis, S would have $10x of U.S. source income, and B would have $90x of U.S. source income, with neither having any foreign source income.

(ii) Analysis. Under the matching rule, S’s $10x income and B’s $90x income are taken into account in Year 1. In determining the source of S and B’s income, the attributes of S’s intercompany item and B’s corresponding item are redetermined to the extent necessary to produce the same effect on consolidated taxable income (and consolidated tax liability) as if S and B were divisions of a single corporation, such that section 863 applies as if $100x were earned from manufacturing in the United States and selling in Country Y. Because the results are the same on a single entity basis and a separate entity basis ($100x of U.S. source income and $0x of foreign source income), the attributes are not redetermined under paragraph (c)(1)(i) of this section.

* * * * *

Sunita Lough

Deputy Commissioner for Services and Enforcement

(Filed by the Office of the Federal Register on December 23, 2019, 4:15 p.m., and published in the issue of the Federal Register for December 30, 2019, 84 F.R. 71836)

Treasury Decision 8687, 1996-2 C.B. 47, added the export terminal rule in current §1.863-1(b) partly in response to the decision in Phillips Petroleum Co. v. Commissioner, 97 T.C. 30 (1991), aff’d without published opinion, 70 F.3d 1282 (10th Cir. 1995). These proposed regulations follow Phillips Petroleum in treating natural resources, once extracted, in the same way as other types of inventory and therefore subject to section 863(b)(2), as amended.

² As defined in section 865(i)(2).

³ Inventory property, as defined in section 865(i)(1).

⁴ Section 864(c)(5)(C) actually states “the income, gain or loss property [sic] allocable thereto.” Based on the legislative history behind The Foreign Investors Tax Act, Pub. L. 89-809 (1966), which added section 864(c) to the Code, the use of “property” in the final bill appears to be a typographical error. The Senate Report that added this provision used the word “properly” not “property.” See S. Rep. No. 1707 at 1275 (1966).

⁵ In the case of inventory property purchased outside the United States (other than in a U.S. territory of the United States) and sold through an office or other fixed place of business in the United States, section 863(b) has no application and hence, regardless of where title passage occurs, all of the income is considered attributable to such office or other fixed place of business and sourced in the United States.

⁶ This statement appears to conflict with another statement in the 2018 Blue Book with respect to prior law to the effect that the application of section 865(e)(2) to a sale of personal property made by a nonresident attributable to its office or fixed place of business in the United States results in all income from the sale being sourced in the United States. Id. at 396-97.