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IRS Finalizes Guidance on Deduction for Foreign-Derived Intangible Income (FDII) & Global Intangible Low-Taxed Income (GILTI)

By: John V. Aksak Jason Carter Alexis Bergman |

On July 9, 2020, Treasury and the IRS issued final regulations (“Final Regulations”) that provide guidance on deductions for Foreign-Derived Intangible Income (FDII) and Global Intangible Low-Taxed Income (GILTI) allowed to domestic corporations under §250 of the Internal Revenue Code (the Code).  These Final Regulations provide guidance on the computation of both deductions, substantiation and documentation requirements, and whether income is foreign-derived for the purpose of FDII.  The guidance also finalizes the reporting rules requiring the filing of Form 8993, Section 250 Deduction for Foreign-Derived Intangible Income and Global Intangible Low-Taxed Income.

Proposed regulations (“Proposed Regulations”) were issued in March of 2019, providing computational and definitional guidance for determining FDII and coordinating the deduction with other provisions of the Code.  In the Final Regulations, the IRS states that the finalized rules “retain the basic approach and structure of the proposed regulations,” but key revisions are included in the new guidance that reduce certain documentation burdens and provide greater flexibility to taxpayers in substantiating their FDII deduction. Additionally, the Final Regulations contain a transition rule allowing taxpayers to rely on the current relaxed documentation standard until the Final Regulations are applicable.

This True Alert will explain those revisions and highlight the key issues addressed in the Final Regulations.

Summary

  • The Final Regulations provide important guidance to taxpayers regarding the calculation of FDII, substantiation and documentation requirements, and qualification of sales and services income as foreign-derived.
  • The Final Regulations are generally applicable to tax years beginning on or after January 1, 2021, which should allow taxpayers time to establish procedures for complying with the regulations. However, taxpayers are permitted to rely on the proposed regulations (including the transition rules) for tax years before the final regulations apply.
  • The Final Regulations relax the documentation requirements for taxpayers to show that they are entitled to the FDII deduction and adopt a more flexible approach. Taxpayers claiming a 250 deduction must, however, still substantiate that they are entitled to the deduction.
  • The Final Regulations drop a requirement to obtain specific types of documents to establish foreign person status, foreign use with respect to sales of certain general property that are made directly to end users, and the location of general services provided to consumers.
  • The Final Regulations adopt specific substantiation requirements with respect to these transactions: (1) sales of general property to resellers and manufacturers; (2) sales of intangible property; and (3) the provision of general services to business recipients.
  • The Final Regulations include revisions applicable to the related party rules, digital content, and general property sold for foreign use.
  • The Final Regulations align the definition of “foreign branch income” to the definition used in the context of the foreign tax credit.
  • The Final Regulations provide rules for the sale of a partnership interest.
  • The Final Regulations follow the general approach of the Proposed Regulations that the expense allocation and apportionment regulations under 861 apply. The Final Regulations make one key change, however, related to the rule for apportioning research and experimentation (R&E) expenditures and the applicability of the “exclusive apportionment” rule for purposes of FDII. 
  • The Final Regulations withdraw the ordering rule of the Proposed Regulations that coordinated the taxable income limitations of §163(j), 172 and 250 and reserve on this issue pending further study. The Preamble states that Treasury and the IRS are considering a separate guidance project to address the interaction of these and other tax code sections containing deductions limited by taxable income.

Background

The Tax Cuts and Job Act (TCJA) provides a domestic corporation with a deduction for: (i) 37.5% of its FDII, plus (ii) 50% of the amount of its GILTI and any deemed dividend under Section 78 attributable to GILTI (“GILTI inclusion”).  §250 limits the amount against which the deduction may be claimed to the domestic corporation’s “taxable income” as determined before the §250 deduction.

The two components of the §250 deduction each have their own purpose.  FDII is an export incentive intended to encourage US companies to increase investments in their US operations, while the deduction for 50% of the GILTI inclusion intends to lessen the tax burden of this new category of foreign income that was established by TCJA. Many commentators have used the analogy characterizing the §250 deduction as the “carrot” and GILTI as the “stick.”

The Proposed Regulations included documentation requirements designed to help the IRS substantiate a company’s eligibility for the FDII deduction, including detailed rules for establishing the foreign status or location of a recipient of good or services as well as the foreign use of property.

Generally, a taxpayer’s FDII is calculated by multiplying (1) the ratio of foreign-derived deduction eligible income (FDDEI) to total deduction eligible income (DEI), by (2) the corporation’s deemed intangible income.  FDDEI is equal to gross FDDEI over properly allocable deductions, with gross FDDEI being the portion of gross DEI derived from FDDEI transactions, i.e. FDDEI sales and services.

Income is eligible for the FDII deduction only if derived from:

  • Services rendered to any person, or with respect to property, not located in the US, or
  • Property sold, leased, licensed, exchanged or otherwise disposed of to a recipient who is not a US person, and is for a foreign use.

The rules for determining and documenting the existence of these facts depend on the type of services or property.  For purposes of applying the regulations, each service is placed in one of five mutually exclusive categories:

  • Property services
  • Proximate services
  • Transportation services
  • General services (any services not otherwise categorized, including advertising services and electronically supplied services) to consumers, and
  • General services to business recipients

Property sold is categorized as either intangible property or general property (any property other than intangible property, securities, interests in a partnership, trust, or estate, and certain commodities).

FINAL REGULATIONS

Documentation Rules

The Final Regulations make significant revisions to the documentation requirements under §250 that were included in the Proposed Regulations.  The Proposed Regulations provided that taxpayers had to obtain specific types of documentation in order to establish that transactions qualify as FDDEI sales or services, including documentation to establish that:

  • A recipient of property is a foreign person;
  • A sale of property is for foreign use; or
  • A recipient of general services is located outside the United States.

Also, under the Proposed Regulations, the documentation obtained by the taxpayer had to comply with additional requirements intended to corroborate the reliability of the documentation, including that the taxpayer obtained the documentation no later than the “FDII filing date” and no earlier than one year before the date of the relevant sale or service.

Generally, taxpayer comments that were filed noted that the documentation requirements were onerous and created practical implementation issues for many otherwise qualifying taxpayers, with many of the required documents difficult to obtain in the ordinary course of business.  Also, there were comments that some types of required documentation with respect to establishing a recipient’s foreign person status raised privacy concerns, especially in business-to-consumer transactions.

Elimination of Specific Documentation Requirements in Certain Instances

The Final Regulations eliminate the requirement to obtain specific types of documents to establish foreign person status, foreign use with respect to sales of certain general property that are made directly to end users, and the location of general services provided to consumers.

Where the Final Regulations do not adopt specific substantiation requirements, the general requirements of § 6001 still apply, which means that taxpayers must keep permanent records that are sufficient to establish the amount of any deduction claimed on a return.  The Final Regulations also provide presumptions of facts in specific circumstances, such as presumption of foreign person status, but these presumptions will not apply if the seller knows or has reason to know that the sale is not to a foreign person based on information received as part of the sales process.

Transactions Subject to Specific Documentation Requirements

The Final Regulations adopt specific substantiation requirements with respect to these transactions:

  • Sales of general property to resellers and manufacturers;
  • Sales of intangible property; and
  • The provision of general services to business recipients

Taxpayers must maintain at least one of the documents listed in the Final Regulations, in the following categories:

  • Credible evidence from the recipient obtained or created in the ordinary course of business establishing the requisite factors.
  • A written statement prepared by the taxpayer containing the information described in the Final Regulations, which statement is corroborated by credible and sufficient evidence.
  • For sales of general property to resellers and manufacturers and sales of intangible property, other specific documents are set forth in the Final Regulations.

The documents must be in existence as of the FDII filing date and must be provided to the IRS within 30 days of a request.

Small Business Exception

The Final Regulations expand the availability of the small business exception from the specific documentation requirements.  They do not apply if the taxpayer and all related parties of the taxpayer, in the aggregate, receive less than $25 million (instead of $10 million) in gross receipts during the prior taxable year.

Related Party Rules

Under the Proposed Regulations, a taxpayer that sold property to a related party for resale to an unrelated party could treat the related-party sale as a FDDEI sale only if the unrelated-party transaction took place by the filing date of the tax return that includes the related-party sale, i.e. by the FDII filing date.  If the unrelated-party transaction did not take place by the FDII filing date, the taxpayer would have had to file an amended return in the year the unrelated-party transaction occurred for the prior tax year to report the related-party sale as a FDDEI sale.  Taxpayer comments stated that this rule created administrative burdens, so the Final Regulations rule states that taxpayers are allowed to treat a related-party sale as a FDDEI sale in the year the related-party sale occurs, so long as an unrelated-party transaction already occurred or will occur in the ordinary course of business with respect to the property at issue.

FDDEI Sales & FDDEI Services

Digital Content & Electronically Supplied Services:  The Final Regulations include new guidance for taxpayers in the software industry with respect to sales or leases of copyrighted articles, stating that the rules for sales of general property, not the rules for sales of intangible property, apply.  They also provide new guidance for those involved in the provision of digital services, creating two new subcategories of general services: “electronically supplied services” and “advertising services.”

General Property Sold for Foreign Use:  The Final Regulations relax the rules for establishing that general property was sold for a foreign use by (1) clarifying the meaning of “foreign use” for sales of general property, (2) eliminating the requirement that the taxpayer have no “reason to know” of some domestic use of the property, and (3) loosening the rules for meeting the foreign use requirement when property is exported for manufacture, assembly, or other processing.

Foreign Branch Income

The Final Regulations align the definition of “foreign branch income,” which is excluded from DEI and FDDEI, to the definition of that term in the context of the foreign tax credit.  As a result, the Final Regulations permit gain from the sale of a disregarded entity that is not reflected on the books and records of a branch to be included in DEI and FDDEI, if the other requirements for FDDEI treatment are met.

Partnership Interests

The Final Regulations provide that a sale of a partnership interest cannot be a FDDEI sale because a partnership interest is not general property.  This issue was not addressed by the Proposed Regulations.  The Preamble states that Treasury and the IRS considered providing for a “look-through” rule for partnership interests, but rejected that approach.

R&E Expense Apportionment

DEI and FDDEI are determined by taking into account properly allocable deductions.  The Final Regulations follow the general approach of the Proposed Regulations that the expense allocation and apportionment regulations under §861 apply for this purpose.

The Final Regulations make one key change, however, related to the rule for apportioning research and experimentation (R&E) expenditures and the applicability of the “exclusive apportionment” rule for purposes of FDII.  The exclusive apportionment rule provides that 50 percent of R&E expenditures are apportioned exclusively to the geographic location where R&E activity predominantly occurs.  The Proposed Regulations said that this exclusive apportionment rule did not apply for purposes of FDII, but the Final Regulations remove this provision.

The Preamble states that Treasury and the IRS continue to study the exclusive apportionment and other issues raised in taxpayer comments in connection with the application of these R&E expense allocation and apportionment rules to FDII.  It states that this issue and the taxpayer comments will be considered as part of finalizing the proposed regulations under Treas. Reg. §1.861-17, which were issued on December 17, 2019, and could be completed in 2020.

Effective Date

The applicability dates of the final rules have been modified.  The Final Regulations are generally applicable for tax years beginning on or after January 1, 2021.  For tax years beginning before January 1, 2021, taxpayers may apply the Final Regulations or rely on the Proposed Regulations, including the transitional rule included in the Proposed Regulations, which permits taxpayers to use any reasonable documentation maintained in the ordinary course of the taxpayer’s business to establish foreign person status, foreign use, or location of service recipient.   Taxpayers may rely on the transition rules for documentation for all tax years before January 21, 2021, regardless of whether they otherwise are generally relying on the Proposed Regulations or the Final Regulations.

FUTURE GUIDANCE REQUIRED

Coordination of §250, §163(j) and §172 related to Taxable Income Limitation Rules

The taxable income limitation for purposes of §250 must be considered in connection with taxable income limitations on other deductions that are taken into account under that section including §163(j) and §172.

As enacted in the TCJA with amendments in the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), the rules are:

  • 163(j) generally limits the deduction for net business interest expense to 30% of the taxpayer’s adjusted taxable income, net of the §250 deduction but prior to the §172 deduction. For 2019 and 2020, taxpayers are permitted to elect to deduct up to 50% of their adjusted taxable income.
  • 172 limits the deduction of NOL carryforwards arising from post-TCJA tax years to 80% of the taxpayer’s taxable income, net of the §163(j) deduction but prior to the §250 deduction, effective beginning in 2021. Pre-TCJA year NOLs will not be restricted in this manner.

In addition, the §250 deduction depends on its FDII, which must take into account the allocation and apportionment of the §163 and 172 deductions against eligible income.

The TCJA did not provide an ordering rule for these limitations.  An additional complication is that unused §250 deductions do not carry over, but unused §163(j) limitations and 172 deductions are suspended or carried forward and are potentially usable in future tax years.

The Proposed Regulations included a proposed method of calculation – an ordering rule — that was intended to address this issue. The Final Regulations withdraw the ordering rule of the Proposed Regulations and reserve on this issue pending further study.

The Preamble states that Treasury and the IRS are considering a separate guidance project to address the interaction of §§163(j), 172, 250 and other tax code sections that refer to taxable income.  Until guidance is issued, taxpayers may choose any reasonable method as long as it is applied consistently for all taxable years beginning on or after January 1, 2021.  The Preamble states that a reasonable method includes either simultaneous equations or the Proposed Regulations’ ordering rule.  The consistency requirement applies only with respect to taxable years beginning on or after January 1, 2021, when the CARES Act modifications generally will have expired, and §163(j) and §172 will apply as enacted in the TCJA.

Other issues

Treasury and the IRS are considering issuing additional administrative guidance on acceptable documentation to substantiate the §250 deduction.

The FDII rules are under review by the OECD as a potential harmful preferential regime, and the European Union has stated that the FDII rules may violate international trade law.