Rulings clarify income sourcing regulations.
Both Intel Corp. v. Commissioner, 100 TC no. 39 (1993), and Phillips Petroleum Co. v. Commissioner, 101 TC no. 6 (1993), concerned how to apportion income between domestic and foreign sources for goods produced in the United States but sold abroad.
Determining the income source is crucial for foreign tax credit purposes because such credits generally are limited to the pre-credit U.S. tax that would be imposed on foreign source income. Therefore, the greater the amount of income allocated to foreign sources is, the greater the limitation or the amount of foreign taxes that may be credited against U.S. tax.
IRC section 863(b)(2) and regulations section 1.863-3(b)2) provide rules, in the form of examples, for apportioning income. Example 1 provides that when (1) the manufacturer regularly sells part of its output to independent distributors in a way that establishes an independent factory price (IFP) for the products sold and (2) the selling or distributing branch of the manufacturer is not located in the same country as the manufacturer's factory, income from sales to customers is allocated between U.S. and foreign source income based on a deemed sale of products by the production department to the sales branch at the IFP. This method generally results in allocating all or most of the income from the sale to U.S.sources.
Example 2 treats one-half the income as manufacturing income and apportions it according to the location of the taxpayer's property. The remaining half of the income is deemed selling or distributing income and apportioned according to the sales location. This generally results in an allocation of one-half the income to U.S. sources and one-half to foreign sources (known as the "50/50 split method").
The IRS and the Tax Court agreed example 2 applies only when an IFP cannot be established under example 1.
In both Tax Court cases the IRS attempted to apply example 1, arguing the sales to customers by the corporate taxpayers in these cases established an IFP. Using example 1 in this case resulted in little or no net foreign source income from the sales.
In Intel, the court held the existence of a selling or distributing branch outside the United States was a prerequisite for applying example 1. Since Intel did not have such a branch, example 1 was found inapplicable.
In Phillips, the court found the IRS had taken too broad a view of what constitutes an independent distributor, holding the term did not include a purchaser that transformed or integrated the taxpayer's product into another product. The court found the Japanese power companies that purchased liquified gas from Phillips to convert it to nonliquified gas or to generate electricity were not distributors. Accordingly, an IFP could not be established and example 2 was held to apply.
Observation: These cases are good news for corporate taxpayers wishing to use the 50/50 split method under example 2 of the income sourcing regulations.
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|Publication:||Journal of Accountancy|
|Date:||Oct 1, 1993|
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