Sourcing Inventory Income: Understanding Section 70313 and Its Impact on U.S. Manufacturers

ChatGPT Image Sep 18, 2025 at 11_49_36 AM

Sourcing Inventory Income: Understanding Section 70313 and Its Impact on U.S. Manufacturers

Section 70313 of the recent tax legislation introduces new rules for sourcing income from the sale of inventory produced in the United States but sold abroad through foreign branches. While this may sound technical, it carries significant consequences for how U.S. manufacturers are taxed on their international operations, particularly in relation to the foreign tax credit (FTC).

This article provides background on sourcing rules, walks through the mechanics of the new provision, illustrates with examples, and evaluates whether this change is a positive development or an undue limitation for U.S. exporters.

Background: Why Sourcing Rules Matter

The U.S. tax system distinguishes between U.S.-source and foreign-source income. This distinction is critical because:

  • Foreign Tax Credit (FTC): U.S. taxpayers can claim credits for taxes paid to foreign governments, but only against U.S. tax on foreign-source income.
  • Double Taxation Concerns: If too much income is classified as U.S.-source, U.S. companies selling abroad may face double taxation—paying tax to both the foreign government and the IRS without sufficient FTC relief.
  • Revenue Protection: If too much income is classified as foreign-source, the U.S. Treasury risks losing revenue as foreign taxes crowd out U.S. taxes on what is essentially domestically generated profit.

Historically, this tension has been most pronounced in cases where goods are made in the U.S. but sold to foreign customers through overseas branches.

The Preexisting Framework

1. Section 863(b): Mixed-Source Rule for Production vs. Sale

If goods are produced in one country and sold in another, income is allocated between the two.Example: A machine produced in Ohio but sold in Brazil might be considered 60% U.S.-source (production) and 40% foreign-source (sales).

2. Section 865(i)(1): Definition of Inventory Property

Ensures the rules only apply to goods held for sale (not investments or capital assets).

3. Section 864(c)(5): Fixed Place of Business Test

Determines whether income is “attributable” to a real foreign branch or office.Prevents abuse by requiring that the branch be substantively involved in the sale, not just a mailbox.

What Section 70313 Adds

The amendment states that when a U.S. person has a foreign office and sells inventory:

  • Up to 50% of the profit may be treated as foreign-source income.

The goods must be:

  • – Produced in the U.S.,
  • – Sold outside the U.S.
  • – For use outside the U.S.

Importantly, even if Section 863(b) might suggest a greater foreign allocation, the new rule imposes a hard ceiling at 50%.

Illustrative Examples

Example 1: Without the 50% Cap

  • Profit from a foreign sale = $100,000.
  • Section 863(b) allocates: $60,000 U.S.-source, $40,000 foreign-source.
  • The taxpayer treats $40,000 as foreign-source, claiming FTCs for foreign taxes on that portion.

Example 2: With the 50% Cap (70313)

  • If the branch’s role in sales were large enough that 863(b) would allocate $70,000 foreign-source, Section 70313 would limit it to $50,000 foreign-source.
  • Result: the taxpayer cannot treat more than half of the profit as foreign-source, even if the foreign branch’s sales function was dominant.
Policy Rationale

Congress imposed the 50% limitation to:

  • Preserve U.S. taxing rights: Recognize that production in the U.S. is a substantial source of value.
  • Prevent base erosion: Stop companies from routing all sales through foreign branches and claiming 100% foreign-source treatment.
  • Balance competitiveness: Allow some relief so exporters can use FTCs, but not full relief that would wipe out U.S. tax on domestically produced goods.
Is This Fair?

Critics argue that if goods are sold abroad to foreign customers and the foreign branch plays a real role, it is logical to treat all of that income as foreign-source, since the sale would not occur without foreign market access. They see the 50% ceiling as an artificial limit that continues to expose U.S. exporters to double taxation.

Supporters counter that allowing 100% foreign sourcing would let foreign tax authorities collect tax on value that was fundamentally created in the U.S. economy. The cap ensures the U.S. keeps its fair share.

Opinion: Positive Development or Undue Limitation?

Positive Aspects for U.S. Manufacturers

  • – This provision is an improvement compared to prior law, where inventory profits from U.S. production often defaulted heavily toward U.S.-source treatment.
  • – By guaranteeing that at least some portion (up to 50%) can be foreign-source, it expands FTC utilization and reduces double taxation.
  • – It may help U.S. companies compete more effectively when foreign governments impose high corporate tax rates.

Limitations

  • – The 50% ceiling is arbitrary and may not reflect economic reality. For some industries—especially those where sales, distribution, and marketing in foreign markets generate more than half the value—it seems unfair to cap foreign sourcing below their actual foreign economic contribution.
  • – Companies in high-tax foreign jurisdictions may still face residual double taxation, even after applying the FTC.
Conclusion

Section 70313 represents a compromise: it gives U.S. manufacturers partial relief by treating up to half of certain profits as foreign-source, while ensuring the U.S. does not lose its taxing rights over income tied to domestic production.

In my view, this is a net positive step compared to the old regime, but the 50% ceiling remains too restrictive for globally competitive manufacturers. A more flexible rule—one tied more closely to actual economic activity rather than a flat cap—would strike a better balance between protecting the U.S. tax base and avoiding double taxation for exporters.

Additional Context: Other U.S. Export and Manufacturing Incentives

Section 70313 does not exist in isolation. It fits into a broader ecosystem of tax incentives and structures designed to support U.S. exporters and manufacturers:

  • IC-DISC (Interest-Charge Domestic International Sales Corporation): A mechanism allowing exporters, especially smaller and mid-sized firms, to route export profits through a DISC. The DISC’s profits are taxed as qualified dividends to shareholders, creating a permanent rate reduction on export income.
  • FDII (Foreign-Derived Intangible Income): Provides a reduced effective tax rate (13.125% through 2025, rising to 16.406%) on certain export income tied to U.S.-based intangibles. Aimed at keeping intellectual property in the U.S. while encouraging exports.
  • R&E Tax Credit: Supports domestic innovation, indirectly boosting export competitiveness by incentivizing research and production in the U.S.
  • Historical Regimes (DISC, FSC, ETI): Earlier export subsidies and exclusions, many of which were challenged under trade law and struck down as inconsistent with international obligations.

FTC and GILTI: The foreign tax credit remains the backbone relief for double taxation, while Global Intangible Low-Taxed Income (GILTI) rules impose a floor on how lightly foreign income can be taxed. Together, these shape how exporters manage cross-border profits.

Final Takeaway

The new sourcing rule under Section 70313 is best understood as one more piece in the patchwork of U.S. international tax incentives. Unlike FDII or IC-DISC, it does not directly lower tax rates. Instead, it adjusts sourcing rules to ensure that exporters can partially benefit from foreign tax credits without fully shifting income offshore.

In that sense, Section 70313 strikes a middle ground: an improvement for manufacturers facing double taxation, but still a rigid limitation that falls short of fully supporting U.S. exporters in the global marketplace.

We welcome your feedback, questions and ideas — comment below or email us at info@ifindtaxpro.com.

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