Frank J. Vari, JD, MTax, CPA, Boston, Massachusetts
Last week, US Treasury and the IRS issued long-awaited proposed tax regulations under IRC §250, providing the very first time administrative guidance on the foreign-derived intangible income (FDII) regime, added in the US tax reform.
The proposed FDII regulations (REG-104464-18) eliminate much of the ambiguity around the granular calculation of the FDII benefit but, at the same time, illuminate the complexity of the calculation itself. The new regulations also introduce new documentation and qualification rules.
This article is intended to provide a general overview of the proposed FDII regulations and introduce practitioners to specifics around benefit qualification.
The FDII regime
The FDII regime provides important benefits to corporate taxpayers that have foreign income. Under these rules, qualifying corporate taxpayers receive a significantly reduced 13.125% US tax rate on qualifying FDII income as opposed to a regular 21% corporate tax rate.
Even though IRC §250 also contains the global low taxed intangible income (GILTI) rules, IRC §250 does not require a taxpayer to have foreign operations, a foreign subsidiary, or a GILTI inclusion to take a FDII deduction which makes FDII a significant new benefit to US corporations with foreign-derived income but no foreign operations.
The basic FDII benefit calculation is outlined in IRC §250(b) as a series of steps. First, the taxpayer calculates its deduction eligible income (DEI), which is its gross income determined without regard to certain items of income, including any foreign branch income, less deductions allocable to the gross income.
Second, the corporation determines foreign-derived deduction eligible income (FDDEI), which is the foreign portion of the DEI. FDDEI includes the DEI produced by a sale of property to a foreign person for foreign use or services provided to a person or with respect to property located outside the US.
A “sale” is defined very broadly and includes any lease, license, exchange, or other disposition. Foreign use is any use, consumption, or disposition that is not within the United States.
Third, the corporation calculates its deemed intangible income (DII). This is the excess of DEI over 10% of its qualified business asset investment (QBAI). QBAI is the corporation’s adjusted basis in its DEI producing depreciable tangible property used in the corporation’s trade or business.
Fourth, the corporation calculates its IRC §250 and FDII deduction. The corporation calculates its FDII by multiplying its DII by the ratio of its FDDEI to its DEI by this fraction:
DII × (FDDEI / DEI)
The resulting FDII deduction reduces the corporate taxpayer’s US taxable income and delivers the aforementioned tax benefits. However, both the statute and proposed regulations provide that the IRC §250 FDII deduction may not reduce the taxpayer’s income below zero.
The proposed FDII regulations
The proposed FDII regulations tell us that FDII eligibility is limited to US corporations as defined by IRC §7701(a), which excludes S Corporations, partnerships, individuals, and others.
The proposed regulations did confirm practitioner’s belief that US individual controlled foreign corporation (CFC) shareholders who make an IRC §962 election may qualify both for FDII and the IRC §250 deduction for GILTI purposes.
The proposed FDII regulations do allow partnerships with qualifying activities to claim benefits at the corporate partner level, which is further discussed below.
Qualifying sales of property
A qualifying FDDEI sale is a sale of property to a foreign person for foreign use.
There are two types of property that qualify: general property and intellectual property.
General property is defined as any property except intellectual property, securities, and certain commodity contracts. Intellectual property is that defined by IRC §367(d)(4), which includes patents, trademarks, and franchises if the revenue is earned from the intellectual property’s foreign use.
General property is considered for foreign use if the property is either (i) not subject to domestic use within three years of delivery or (ii) the property is subject to further manufacturing or assembly outside of the US prior to any domestic use. Further manufacturing or assembly only occurs if (i) there is a physical and material change to the property beyond minor assembly or labeling or (ii) the property is incorporated as a component into another finished product.
The proposed regulations contain an interesting rule for intellectual property used in the development, manufacturing, sale, or distribution of a product which treats this type of IP as exploited at the location of the end user to which the product is sold.
That is an interesting rule that could permit derivative benefits to US software developers who sell research, manufacturing, or sales support software to US-based multinationals.
Qualifying services
The proposed FDII regulations create four categories of FDDEI qualifying services. They are (i) proximate services, (ii) property services, (iii) transportation services, and (iv) general services. Each category contains a different foreign use test.
Proximate services are those performed in the physical presence of the recipient. The service is an FDDEI service if it takes place outside the US but it may qualify in part if it takes place partly within the US. This generally includes consulting like services.
Property services are provided with respect to tangible property if “substantially all” of the service is performed to tangible property located outside the US. This includes repair and warranty services where more than 80%, i.e., substantially all, of the time is spent at or near the foreign location of the property.
Transportation services, e.g., airline, shipping, or trucking services, qualify based on a destination test. If both the origin and destination are outside the US, the service qualifies as FDDEI. If either the origin or destination is within the US then only 50% of the services qualify.
General, or residual, services are those outside of the categories described above. These services are categorized into either consumer or business services. Consumer services qualify if the recipient resides outside the US. Business services qualify based on the location of the recipient’s business operations and the operations of any related party that benefits from the services. Thus, business services do not depend on the residence or incorporation of the recipient.
Partnership rules
As noted above, the proposed regulations do allow partnerships with qualifying activities to claim benefits at the corporate partner level.
Thus, even though partnerships themselves may not claim benefits at the partnership level, they will need to ensure benefit qualification, and maintain proper and timely documentation, on behalf of their direct or indirect corporate partners as they must properly report this information on the corporate shareholder’s Schedule K-1.
Despite the aforementioned partnership benefit rule, IRC §250 does consider a partnership a person. As such, a sale from a US corporation to a foreign partnership qualifies as a FDDEI sale. However, a sale from a US corporation to a US partnership does not qualify as a US partnership is not a foreign person.
Related party rules for general property
The proposed FDII regulations introduce an interesting related party rule for general property.
The sale of general property to a foreign related party qualifies if the property is resold to an unrelated foreign person for foreign use on or before the US seller’s tax return due date including extensions for the year of the related party sale.
Further, if the unrelated party sale happens after the US seller files its tax return for the year of the related party sale, the US seller must file an amended return to claim FDII benefits.
When coupled with the documentation requirements (discussed below), this is a potentially cumbersome requirement particularly for larger US multinationals and, as such, this could be a prime area for comment by impacted parties before these rules are finalized.
Related party business services produce FDDEI if the services are not “substantially similar” to services performed by the related party to US persons in a rule intended to prevent “round-tripping” of services.
What is substantially similar is defined by new “benefit” and “price” tests. Related party services fail the benefit test if 60% or more of the benefits arising from the related party service are to US persons.
Under the price test, the related party services do not qualify if 60% or more of the price paid by domestic recipients is attributable to the domestic corporation’s efforts.
This section of the proposed regulations allows a wide range of services to qualify as FDDEI that would have otherwise failed had a cliff type approach been adopted, i.e., one where a small amount of domestic benefits services would have disqualified the entire service transaction.
Documentation rules
The proposed FDII regulations introduce a number of new documentation rules that, if they survive into the final rules, will require taxpayers to obtain and maintain written documentation related to FDDEI transactions.
The proposed regulations introduce a number of new documentation rules that, if they survive into the final rules, will require taxpayers to obtain and maintain written documentation related to FDDEI transactions.
The specific documentation rules differ by type of property or service. The taxpayer must also generally obtain this information by the FDII filing date, i.e., the time of the US taxpayer’s income tax return due date including extensions. This specifically precludes taxpayers from waiting until the IRS requests this information to obtain it.
These rules contain exceptions for “small business” or “small transactions”. Small business is generally defined as taxpayers with less than $10 million in gross receipts in the prior tax year. Small transactions are those less than $5,000 from a specific recipient in a tax year.
In these cases, the taxpayer may establish foreign person status or foreign use by using the foreign recipient’s shipping address.
In addition to written documentation, there is a new reliability standard where the seller or renderer, as a “reasonably prudent person”, must not have any reason to know that the required documentation is inaccurate or unreliable as of the FDII filing date.
Thus, in addition to existing Circular 230 rules, this requires that written documentation be tested at a specific time for reliability. This makes documentation and the reliability thereof a critically important element of the FDII regime.
Proposed FDII regulations – computational rules
As expected, the proposed FDII regulations outline a number of rules related to the statutory FDII benefit calculation. The discussion below will highlight some of the more interesting sections of the proposed regulations rather than an exhaustive analysis of these new rules.
Allocation of cost of goods sold (COGS)
COGS must be allocated to gross income under any reasonable method for purposes of calculating gross DEI and gross FDEII.
However, the proposed regulations state that permissible COGS allocation methodologies do not include any method that, intended or not, allocates or apportions COGS attributable to items included in gross DEI or FDEII to other categories of income past or present (a “throwback” element to the FDII COGS apportionment analysis?).
Thus, a taxpayer or practitioner must fully understand existing US corporate tax COGS rules to ensure compliance here.
Application of IRC §861 rules for allocating deductions
IRC §250 requires that gross DEI is reduced by deductions, including taxes, properly allocated to such DEI but does not specify any allocation methodology.
As noted above, the proposed regulations require that COGS may be apportioned under any reasonable basis. However, deductions must be allocated and apportioned to qualifying income under IRC Treas. Reg. §§1.861-8 through 1.861-14T and 1.861-17.
Please also note that research and development expenses are allocated for DEI and FDDEI purposes without regard to the exclusive geographic apportionment rule of IRC Treas. Reg. §1.861-17(b) that would otherwise apply.
There is no safe harbor for small taxpayers. Thus, to properly comply with these rules a taxpayer or practitioner must understand these very complex rules in detail or risk the FDII benefit.
When one considers the impact that expense allocation and apportionment have on the FDII benefit itself, it is hard to understate how important understanding and complying with the aforementioned IRC §861 rules is to the FDII benefit.
When one considers the impact that expense allocation and apportionment has on the FDII benefit itself, it is hard to understate how important understanding and complying with the aforementioned IRC §861 rules is to the FDII benefit
Consolidated return rules
The proposed FDII regulations set forth new rules that impact the benefit calculation for consolidated return taxpayers. Primarily, the proposed regulations detail how to calculate FDII benefits on a consolidated basis with specific guidance on how to allocate the FDII benefits amongst group members.
QBAI rules
QBAI is calculated as the average of the corporation’s aggregate adjusted basis in specified depreciable tangible property in the production of DEI. Property may also be considered “dual-use property” if it produces both DEI and non-DEI.
Perhaps most significantly, the adjusted basis in any QBAI property must be determined using the IRC §168(g) alternative depreciation system (ADS). All IRC §250 property must use ADS, meaning that even if the property was placed into service prior to the 2017 enactment of IRC §250 the taxpayer must apply ADS from the date the property was acquired however far back.
Though not exactly hidden, this is an important new rule that must not be overlooked when calculating QBAI.
Also included in the proposed regulations are limitations on any strategies or transactions intended to reduce QBAI via intergroup or related party transactions. It is a very good bet that any transfer or lease of QBAI property amongst related parties will be scrutinized under these new anti-abuse rules.
Loss transactions
The IRS has never been a fan of excluding loss transactions intended to artificially inflate benefits from regimes such as this dating back to the former foreign sales corporation rules.
Based on statutory guidance alone, it appeared that failing, intentionally or not; the documentation requirements would exclude what would otherwise be an FDEII loss transaction from the FDEII calculation, thus, inflating the FDEII amount.
The proposed FDII regulations specifically state that a loss transaction is not excluded solely on the basis that it does not meet the documentation requirement. This requires that taxpayers and practitioners identify and include transactions that would have been excluded from FDEII due to failure to meet documentation requirements. This is certainly something that can be easily overlooked.
Reporting rules
Any taxpayer claiming an IRC §250 deduction must file the new Form 8993 Section 250 Deduction for Foreign Derived Intangible Income (FDII) and Global Low Taxed Intangible Income (GILTI).
This must be timely filed as part of the taxpayer’s annual income tax filings. The proposed regulations also require that taxpayers timely file Forms 5471, 5472, and 8865 if they take an IRC §250 deduction and information required to be reported on the applicable form affects the taxpayer’s IRC §250 deduction.
This is another reminder of the heightened importance of information reporting and disclosure that is part of IRC §250 and beyond as each of these forms carries significant penalties for failure to file and, perhaps most importantly, failure to completely and accurately file.
Assessment
The proposed regulations provide the very first administrative guidance on IRC §250 and the complex FDII benefit calculation.
They provide what is certainly a mixed bag of taxpayer-friendly provisions, e.g., allowing benefits for services with a domestic element, and those that are not so taxpayer-friendly, e.g., documentation and specific reasonable knowledge rules.
The proposed regulations apply to any domestic corporation’s tax year that ends after March 4, 2019. They may be relied upon for any tax year ending before May 4, 2019, which includes 2018 for calendar year taxpayers.
Perhaps most importantly, taxpayers and practitioners have until May 6, 2019, to submit comments or request a public hearing. Considering the wide-ranging implications of these proposed regulations, it is not unreasonable to expect numerous suggested changes or modifications before these new rules become final.
Frank J. Vari, B.Sci.Acc., JD, MTax, CPA, is a tax, finance, and legal professional with over 25 years of experience advising global businesses ranging from technology start-ups, large private equity investors, to Fortune 100 corporations. He provides unique and innovative solutions to complex international tax and business issues.
Frank has designed and implemented complex tax planning strategies for both U.S. based and international clients. Frank coordinated the worldwide tax, accounting, finance, and cash flow aspects of these transactions as well as the coordination of client finance, legal, and audit teams.
Frank has also been a Professor of Taxation to collegiate law and business students on international tax and corporate mergers and acquisitions. He is a frequent speaker and author on complex international tax topics and issues.
Frank is the Practice Leader at FJV Tax Consulting in Boston and Wellesley, Massachusetts. You can learn more about FJV Tax Consulting at fjvtax.com or contact Frank via email at [email protected] or telephone at 617-770-7266 / 800-685-2324.
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