INCOME FROM MIXED SOURCES
Some income may have multiple sources. The rule varies according to the type of income-producing asset.
INVENTORY SALES: GENERAL RULES
There are two basic rules for determining the source of income from gains on the sale of inventory property. Which of these applies turns on whether the inventory was (a) bought by the seller to resell it, or (b) it was manufactured by the seller. A good basic definition of inventory for this purpose is personal property held for sale to customers in the ordinary course of the seller’s business.
SALE OF PROPERTY MANUFACTURED BY SELLER (INVENTORY)
Under IRC § 863(b), the income from gain on the sale of inventory property that was produced or manufactured by the seller in one jurisdiction and later sold in another is mixed source income (i.e. manufactured in U.S. and sold in Non U.S. locals or manufactured in Non U.S. locals and sold in U.S.). Mixed sourced income is both U.S. and foreign sourced income. The allocation of the gain, between the country of sale and country of production, depends upon whether an independent factory price (IFP) can be established. If not, the regulations under IRC § 863 indicate it should be split evenly (50/50). However, if the taxpayer is capable of determining the IFP, (the amount a third party buyer would have paid for the property immediately after it was made), the taxpayer may use this to calculate the inventory gain (i.e. for the allocation for the country of production – U.S. source income); the remaining part is allocated to the country of sale – Foreign source income. This process will also be reversed where the property is manufactured overseas by a foreign entity or corporation and subsequently sold in the U.S.
GAINS FROM THE SALE OF PURCHASED (NOT MANUFACTURED) INVENTORY
Section 861(a)(6) classifies as U.S. source the income derived from the purchase of inventory offshore and its sale or exchange within the United States (onshore). Inventory is broadly defined to include property held for sale to customers in the ordinary course of business. This classification covers a very economically significant set of transactions in the U.S Economy.
Generally, when the seller purchases inventory rather than manufacturing it, the location where the title to the goods passes from buyer to seller is where the sale is sourced. Often, this location will be identified by the commercial shipping terms; however, that identified location may change if the risk of loss of the goods that passes from seller to buyer lies elsewhere which is a factual determination.
DETERMINING THE LOCATION THAT SALE TO PLACE
International sales of inventory ordinarily entail a myriad of physical and legal components, involving a sales contract and a physical transfer of merchandise. When these physical and legal components all arise in the same location, that location, unequivocally, is the sale location. However, when the components of an international sale are geographically dispersed, as commonly occurs in international trade, there may be arguably several logical interpretations for the location of sale. Sale negotiations may occur in one location, the contract may be executed in a second locale, the goods may be delivered for shipment at a third local, and title to the goods sold may ultimately pass to the buyer at a forth. Any one of these locals could be argued as the location of sale, or a weighing of all the locals and significance of what occurred at that local might be attempted to determine the local and legal event that caries the most significance.
PASSAGE OF TITLE
In the late 1940s the location of the passage of legal title, with some exceptions, is the legal event that controls the place of a sale for U.S. tax purposes.
Consider the following treasury regulation:
[A] sale of personal property is consummated at the time when, and the place where, the rights, title, and interest of the seller in the property are transferred to the buyer. Where bare legal title is retained by the seller, the sale shall be deemed to have occurred at the time and place of passage to the buyer of beneficial ownership and the risk of loss. However, in any case in which the sales transaction is arranged in a particular manner for the primary purpose of tax avoidance, the foregoing rules will not be applied. In such cases, all factors of the transaction, such as negotiations, the execution of the agreement, the location of the property, and the place of payment, will be considered, and the sale will be treated as having been consummated where the substance of the sale occurred.
Where the sellers retains legal title solely as a security measure in the ordinary course of commerce this action will not alter the location of sale.
LOCATION WHERE TITLE PASSES
Generally, title to merchandise sold passes from the seller to the buyer at the location of delivery of the goods by the seller for shipment via a common carrier. Delivery to a common carrier for U.S. tax purposes is legally effective to pass title, bus must be accompanies by the seller forwarding the necessary shipping and title documents to the purchaser. Where these steps all transpire in the same location, the location of the passage of title is unequivocal. Where they do not, ordinarily the controlling step of the international sales transaction is delivery of the merchandise to a common carrier.
TAX PLANNING ADVANTAGE
The flexibility under U.S. tax law that facilitates the seller to control the location of the passage of title provides powerful tax planning advantages. As long as the sales contract and shipping arrangements are standard international commercial practice, the seller has control over the source of the associated gains from the international sale of inventory. For foreign taxpayers, foreign-source income generally escapes U.S. taxation altogether. It is possible to structure international sales under standard commercial practice to have title pass either onshore or offshore. For inbound planning purposes, foreign manufacturers selling onshore into the U.S. (inbound tax planning) may benefit for tax purposes by planning for title to pass offshore rather than onshore.
From the perspective of U.S. taxpayers, (outbound tax planning) this provides the ability to increase or decrease foreign-source income, if the foreign sales are taxed at less than U.S. tax rates offshore, passing title offshore can increase the amount of allowable foreign tax credits. U.S. manufacturing companies can either sell to offshore distributors into to derive substantial foreign-source income under the mixed sourcing rules, even though the bulk of economic activity (manufacturing) is carried out in the U.S.
TRANSFER PRICING AND INTERNATIONAL TAXATION
All international tax systems regulate transfer pricing. Transfer pricing is the term coined to describe the prices at which goods and services are transferred between related parties that are not dealing at arm’s-length. Where unrelated buyers and sellers deal at arm’s-length, neither party controls the prices at which commerce is transacted as market conditions effect the bargaining between the parties. In stark contrast, where buyer and seller are under common control / ownership, a parent and sub, brother sister and a controlled group of corporations, for example, unfettered transfer pricing between the related parties often reflects an attempt to adjust the profit and loss allocation for tax planning purposes within the group.
The U.S. Treasury’s main attempt to regulate artificial and unfettered transfer pricing is found under section 482.
Consider the following except from section 482:
In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or to clearly reflect the income of any of such organizations, trades, or businesses. In the case of any transfer (or license) of intangible property . . . the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.
Usually, the source for income derived from the transmission of communication (or data) between the U.S. and a foreign country (or U.S. possession) is mixed and sourced on a 50/50 basis. The sourcing allocation turns upon whether the income is derived by a U.S. person or entity or foreign person or entity. If generated by a U.S. person or entity, the income is allocated evenly between the U.S. and the foreign country. If generated by a foreign person or entity, the income is entirely foreign source, unless and to the extent that the communications income is traceable to an office (or fixed place of business) within the U.S. that is maintained by the foreign person or entity.
Generally, income from international transportation is sourced in three different manners. First, the source for income that is derived from the use (or hire) of a vessel or aircraft is wholly a U.S. source, if the transportation (i) is what generates the income, and (ii) the transportation begins and ends within the U.S. Second, transportation income has a wholly foreign source if the transportation ends outside the U.S.. Third, all other transportation income is sourced 50/50 U.S. and Foreign.
PERSONAL SERVICE INCOME
Typically, the source of income from personal services that are rendered both inside and outside the U.S. turns on whether the service provider is an employee. If so, employee’s compensation is sourced according to a time basis (hours provided in U.S. versus hours provided outside the U.S.). If services are provided by a non-employee, the income is sourced under a facts and circumstances test.