The faction loyal to Sheikh Abdulqader Mumin was targeted by US drone strikes last week in the first US operation targeting IS in the Horn of Africa, US Africa Command said.
In the report, the UN monitoring group for Somalia said the IS faction, which was estimated in 2016 "to number not more than a few dozen, has grown significantly in strength" and may "consist of as many as 200 fighters."
Phone records from Mumin showed he was in contact with an IS operative in Yemen who acts as an intermediary with senior IS leaders in Iraq and Syria "though the exact nature of this contact is unclear," said the report.
Former members of the faction who defected in December said the Mumin group received orders as well as financing from Iraq and Syria, the report said.
The group captured the town of Qandala in Puntland's Bari region in October 2016, declaring it the seat of the Islamic Caliphate in Somalia before being pushed out two months later by Puntland forces backed by US military advisers.
In February, IS gunmen stormed a hotel in Bosaso, the economic capital of Puntland, and in May the faction carried out its first suicide attack at a police checkpoint near Bosaso, killing five people.
"The group showed signs of increasing tactical capabilities during its first attack target a hotel," said the UN monitors.
Haven for foreign fighters
The UN report raised concerns that the Bari region could become a potential haven for foreign IS fighters as the extremists are driven out of their strongholds in Syria and Iraq.
The IS group in Somalia "presents more natural appeal to foreign terrorist fighters than Al-Shabaab," whose aim is to establish a state government by Islamic law, it added.
Al-Shabaab, another Islamist militant group, is affiliated with IS's global rival Al-Qaeda.
The Bari region has attracted a limited number of foreign fighters including Sudanese national Abu Faris who is on the US terror list for recruiting foreign fighters for Al-Shabaab.
While the faction is expanding, its fighters appear to be poorly paid or not paid at all.
Unmarried fighters receive no salary, while married militants receive $50 per month plus $10-$20 per child, depending on the age.
The report estimated that the salary payments were between $3,000 and $9,000 per month, allowing IS leaders "to fund its insurgency on a limited budget".
UN monitors said the faction will likely face frequent defections from poorly paid fighters, a problem that also affects Al-Shabaab.
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