Foreign-derived intangible income guidance addresses many open questions

By Jay Camillo; Jillian Chavis, CPA, J.D., LL.M.; Daniel Karnis, CPA; and Peter Marrs, J.D.

IMAGE BY METAMORWORKS/ISTOCK
IMAGE BY METAMORWORKS/ISTOCK
 

EXECUTIVE
SUMMARY

 
  • Proposed regulations (REG-104464-18) provide guidance on calculating the Sec. 250 deduction allowed to a domestic corporation for its foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI) but primarily focus on calculating a domestic corporation's FDII.
  • Sec. 250 generally provides a deduction for a domestic C corporation's FDII and its GILTI inclusion for tax years beginning after Dec. 31, 2017. For tax years beginning before Dec. 31, 2025, a domestic C corporation may claim a deduction equal to 37.5% of its FDII and 50% of its GILTI inclusion (including its GILTI dividend under Sec. 78). For tax years beginning after Dec. 31, 2025, the deduction rates decrease to 21.875% and 37.5%, respectively.
  • The proposed regulations clarify certain aspects of the FDII deduction computation, including consolidated group and partnership attribution rules, the definition and application of "foreign use" for qualifying sales of property, distinguishing between types of services, and providing ordering rules for the interaction of Sec. 250 with other tax provisions.
  • The proposed regulations also create some complexities in calculating the FDII deduction. In particular, domestic C corporations assessing whether they qualify for the FDII deduction should understand the effect their organizational structure may have on the FDII computation (i.e., consolidated group and partnership attribution rules), review revenue streams under the detailed rules for sales of property and services, and ensure they have procedures in place to gather and retain the detailed documentation needed to substantiate the deduction.
  • Due to the timing of these proposed regulations, the final Sec. 250 regulations are unlikely to be retroactive. Taxpayers should plan to put more effort into determining their qualification for the FDII deduction, including modeling the interaction of FDII in conjunction with other tax provisions (e.g., GILTI, foreign tax credits, etc.).

The law known as the Tax Cuts and Jobs Act of 2017 (TCJA)1 made many significant changes to the international tax regime. One important change is Sec. 250, which was enacted by Section 14202(a) of the TCJA, and generally provides a domestic C corporation (1) a deduction for its foreign-derived intangible income (FDII) for the tax year, and (2) a deduction for its Sec. 951A global intangible low-taxed income (GILTI) inclusion for the tax year.

For tax years beginning after Dec. 31, 2017, but before Jan. 1, 2026, a domestic C corporation may claim a deduction equal to 37.5% of its FDII and 50% of its GILTI (including any Sec. 78 gross-up for a deemed-paid foreign tax credit for GILTI). For tax years beginning after Dec. 31, 2025, these percentages decrease to 21.875% and 37.5%, respectively. However, the Sec. 250 deduction is limited to the domestic C corporation's taxable income for the tax year — if the sum of its FDII and GILTI (including the Sec. 78 gross-up) exceeds its taxable income (determined without regard to the Sec. 250 deduction), the amounts of FDII and GILTI taken into account to compute the Sec. 250 deduction decrease proportionally to eliminate the excess.

The FDII deduction has been described as being like the Holy Roman Empire — just as this European region was neither holy nor Roman nor an empire, the FDII deduction is not limited only to foreign-derived intangible income. Rather, FDII is a mechanical calculation that treats a portion of income as being attributable to a return on tangible asset investment (deemed tangible income return (DTIR)), with the remainder attributable to a return on intangible property (deemed intangible income (DII)). As such, the FDII deduction is not limited to income derived from dispositions or licenses of intangible property, and eligibility for the FDII deduction is not strictly dependent on the location of intangible property. The portion of this deemed intangible income derived from qualifying sales of property and services is a domestic C corporation's FDII.

FDII is computed in a three-step process, as shown in the chart, "FDII Computation" (below).

FDII computation


Step 1
:
Calculate deemed intangible income (DII) = Deduction-eligible income (DEI) - (10% × Qualified business asset investment (QBAI)).

DEI is the excess of a domestic C corporation's gross income, less the following six exclusions, less the deductions including taxes properly applicable to those gross DEI items: (1) Sec. 951(a)(1) (Subpart F income); (2) GILTI inclusion; (3) financial services income (defined in Sec. 904(d)(2)(D)); (4) dividends received from any 10%-owned controlled foreign corporation (CFC); (5) domestic oil and gas extraction income; and (6) foreign branch income (defined in Sec. 904(d)(2)(J)).2

QBAI is the average of the taxpayer's aggregate adjusted bases in specified tangible property, defined as tangible depreciable property used in the taxpayer's trade or business in the production of DEI.3

As discussed above, the FDII computation deems a portion of a domestic C corporation's income to be a return on its tangible asset investment (DTIR). The DTIR is 10% of a domestic C corporation's QBAI; the excess of a domestic C corporation's DEI over its DTIR is its deemed intangible income(DII).

Step 2: Calculate FDII= DII (computed in Step 1) × [Foreign-derived deduction-eligible income (FDDEI) ÷ DEI].

FDDEI is the portion of DEI gross income derived from qualifying sales of property and services and is generally any DEI derived in connection with (1) property sold to any non-U.S. person for foreign use, or (2) services provided to a person, or with respect to property, not located within the United States.4

A domestic C corporation's FDII is the portion of its DII that bears the same ratio as its FDDEI bears to its DEI.

Step 3: Determine FDII deduction= FDII × Applicable deduction percentage.

As discussed previously, a domestic C corporation's FDII deduction is its FDII multiplied by the applicable percentage, which is 37.5% for tax years beginning after Dec. 31, 2017, but before Jan. 1, 2026.

The proposed regulations

While Sec. 250 includes deductions related to both FDII and GILTI, the Sec. 250 proposed regulations5 primarily focus on the deduction for FDII, as proposed regulations for calculating GILTI were released Sept. 13, 2018. The FDII proposed regulations provide specific guidance for computing the variables of the FDII deduction — DEI, FDDEI, and QBAI. Of key importance, the FDII proposed regulations provide detailed rules regarding the requirements for qualifying FDDEI transactions of tangible and intangible property and different types of services. The FDII proposed regulations also provide strict documentation requirements to substantiate FDDEI transactions for purposes of the FDII deduction.

In addition, the FDII proposed regulations clarify that the FDII deduction is not computed on a single-entity basis, as was implied by the statutory language, and provide rules for consolidated groups as well as partnership attribution. Finally, the FDII proposed regulations provide ordering rules to coordinate the interaction of the Sec. 250 deduction with the application of other limitations in the Code (i.e., the Sec. 163(j) interest deduction limitation and the Sec. 172(a) net operating loss (NOL) limitation).

Computing FDII

Consistent with the statute, the calculation of FDII under the FDII proposed regulations is a multistep process that begins with the concepts of "gross DEI" and "gross FDDEI." All gross FDDEI is included in gross DEI, but not all gross DEI is included in gross FDDEI. After calculating the gross amounts, deductions of the domestic corporation are allocated against the gross items to arrive at DEI and FDDEI.

Depending on the attribution of cost of goods sold (COGS) (discussed later) and allocation/apportionment of deductions (also discussed later), FDDEI may be greater than DEI, or vice versa. When both amounts are positive, and DEI is greater than DTIR, subject to the taxable income limitation of Sec. 250(a)(2), the domestic corporation will be allowed a Sec. 250 deduction; if DEI is zero or negative, the domestic corporation will not be allowed a deduction. If a domestic corporation's FDDEI exceeds its DEI and would otherwise result in a foreign-derived ratio exceeding 1 (e.g., due to losses attributable to domestic market sales), the proposed regulations provide that the ratio of FDDEI to DEI cannot exceed 1. As a result, careful application of the computational rules and consideration of the various decisions to be made in that application (e.g., attribution of COGS, allocation of deductions, etc.) is important.

Excluded gross income: Consistent with the Code, the proposed regulations exclude the following items from gross DEI: (1) inclusions under Sec. 951(a)(1) (including any associated Sec. 78 dividend); (2) GILTI inclusions (including any associated Sec. 78 dividend); (3) financial services income (as defined in Sec. 904(d)(2)(D)); (4) dividends received from certain CFCs; (5) domestic oil and gas income; and (6) foreign branch income. Diverging from the statute, the proposed regulations would provide a broader definition of foreign branch income, including any income or gain that arises from a direct or indirect sale of any asset (other than stock) that produces gross income attributable to a foreign branch, including by reason of the sale of a disregarded entity or partnership interest. Domestic C corporations incorporating foreign branches that currently hold intangible property should consider the impacts of this broader definition — any income inclusions under Sec. 367(d) appear to be included as foreign branch income for this purpose and are therefore not eligible for gross DEI and gross FDDEI treatment.

Attribution of COGS: For purposes of determining the amount of gross income attributable to separate income items that compose gross DEI and gross FDDEI, the proposed regulations require an attribution of COGS to gross receipts under any reasonable method, including for COGS associated with activities undertaken in prior tax years. However, COGS must be attributed to gross receipts with respect to gross DEI or gross FDDEI regardless of whether certain costs included in COGS can be associated with activities undertaken in an earlier tax year (including a year before the effective date of Sec. 250).

Allocation of deductions: After determining gross DEI and gross FDDEI, the domestic C corporation allocates applicable deductions against those items to arrive at DEI and FDDEI, respectively. While the statute provides simply that FDDEI is DEI derived from specified transactions, the proposed regulations clarify that deductions are allocated and apportioned to gross FDDEI and gross non-FDDEI, and that the sum of the two equals the deductions allocated to gross DEI. As was widely expected, the FDII proposed regulations direct taxpayers to the rules of Regs. Secs. 1.861-8 through Temp. Regs. Sec. 1.861-14T and Regs. Sec. 1.861-17, providing that these rules apply to allocate and apportion deductions against gross DEI and gross FDDEI to arrive at DEI and FDDEI. However, research and development expenditures are allocated without regard to the exclusive geographic apportionment rule of Regs. Sec. 1.861-17(b) (the preamble to the proposed regulations did not provide an explanation for this treatment).

Unlike the prohibition of attributing COGS to periods prior to the enactment of Sec. 250, there is no such prohibition for expenses allocated under Sec. 861. Accordingly, similar to the application of the Sec. 861 rules in allocating expenses under former Sec. 199, reasonable methods for allocating and apportioning expenses may include apportioning deductions to periods prior to the effective date of Sec. 250.

FDDEI calculation

The FDII proposed regulations provide detailed rules expanding on the statutory concept that gross FDDEI equals the portion of the domestic corporation's gross DEI that is derived from the domestic corporation's "FDDEI transactions." The proposed regulations define FDDEI transactions as an FDDEI sale or an FDDEI service.

FDDEI sales: The proposed regulations provide distinct qualification and documentation rules for general property (general property sales) and intangible property as defined in Sec. 367(d)(4) (intangible property sales).6 Special rules are further provided for general property sales that involve international transportation property (e.g., planes, trains, or automobiles). Regardless of the property type, however, the seller would have to obtain specified documentation to establish the recipient of the property is a foreign person and to prove foreign use. The proposed regulations also provide special rules for sales to foreign related parties.

General property: The sale of general property, other than international transportation property, is considered for a foreign use if the property is either (1) not subject to a domestic use within three years of the date of delivery, or (2) subject to manufacture, assembly, or other processing outside the United States before the property is subject to a domestic use. Domestic use for this purpose consists of any use, consumption, disposition, manufacturing, assembly, or other processing in the United States. Further manufacturing, assembly, or other processing for this purpose means the property is physically or materially changed (as determined under the facts and circumstances) or incorporated as a component into a second product (as determined by a value-based, ­mathematical test).7

International transportation property is treated as a subset of general property and consists of "aircraft, railroad rolling stock, vessel, motor vehicle, or similar property that provides a mode of transportation and is capable of traveling internationally." Sales of international transportation property are for foreign use only if, during the three years from the date of delivery, (1) the property is located outside the United States more than 50% of the time, and (2) more than 50% of the miles traversed in the use of the property are outside the United States.

The FDII proposed regulations specify the documentation a seller must obtain to substantiate foreign use (see "FDDEI Transactions: Documentation and Reliability Requirements" section of this article below).

Intangible propertyA sale of intangible property is considered to be for foreign use to the extent that the intangible property generates revenue from exploitation outside the United States. If intangible property is used to develop, manufacture, sell, or distribute products, it is treated as exploited based on the location of the end user. For intangible property exploited both inside and outside the United States, special rules determine the portion of the intangible property transferred for foreign use.

Military sales: For purposes of Sec. 250(b), sales by a domestic corporation to the U.S. government for resale to a foreign government under the Arms Export Control Act (AECA) are treated as sales by a domestic corporation to a foreign government. The sales must satisfy the requirements of foreign use provided in the FDII proposed regulations, including documentation requirements. The FDII proposed regulations do not include guidance on how taxpayers can demonstrate that sales were made under the AECA. Treasury and the IRS requested comments on whether the final regulations should include that guidance. This guidance applies for military services as well.

Related-party sales: Sec. 250 provides rules for the qualification of sales of property to related parties — a sale to a foreign related party is only treated as for a foreign use when the property is either (1) resold by the foreign related party to an unrelated foreign party for foreign use, or (2) used by the foreign related party in connection with the sale of property or the provision of services to an unrelated foreign party for foreign use. Under the FDII proposed regulations, a related-party sale of general property qualifies as FDDEI only if either (1) the foreign related party resells the property to an unrelated foreign person (either on its own or as a component part of other property), or (2) the seller reasonably expects the property to be used in connection with a sale of other property, or the provision of services, to an unrelated foreign party8 ("unrelated-party transactions"). The FDII proposed regulations treat all foreign related parties as if they were a single foreign related party.

A key issue in the ultimate qualification of related-party sales of property as FDDEI is the timing of the ultimate unrelated-party transaction. To qualify as FDDEI for a given tax year, the unrelated-party transaction must occur before the "FDII filing date" (i.e., the date the taxpayer's tax return is due, including extensions). If the unrelated-party transaction does not occur on or before the FDII filing date, the taxpayer would need to amend its return for the year in which the related-party sale occurred to claim the benefit once the unrelated-party transaction occurs (see "FDDEI Transactions: Documentation and Reliability Requirements," on p. 578, for further discussion)

The FDII proposed regulations explicitly state that the related-party sales rules do not apply to dispositions of intangible property — as noted previously and as provided in the preamble to the proposed regulations, no additional rules are necessary for dispositions of intangible property because those dispositions qualify only to the extent the intangible property is exploited outside the United States.

FDDEI services: The FDII proposed regulations divide services into four mutually exclusive categories, each with its own rule to determine qualification as an FDDEI transaction: (1) transportation services, (2) property services, (3) proximate services, and (4) (residual) general services. General services are further divided between services provided to individuals for personal consumption (consumers) and other recipients (business recipients). Because general services is a residual category, the proposed regulations cover all services. In contrast to property sales, documentation to substantiate foreign use is required only for general services.

Transportation servicesA transportation service is a service to transport a person or property using aircraft, railroad rolling stock, a vessel, a motor vehicle, or any similar mode of transportation.

NoteThe origin and destination determine whether the transaction qualifies as FDDEI. If both the origin and destination of the transportation service are outside the United States, the entire transaction is located outside the United States and qualifies as FDDEI. However, if either the origin or the destination (but not both) of the transportation service are within the United States, 50% of the transaction qualifies as FDDEI.

Property services: A property service is a service, other than a transportation service, provided with respect to tangible property. To be considered "with respect to tangible property," (1) substantially all the service must be provided at the location of the property, and (2) the service must result in the physical manipulation of the property, such as through assembly, maintenance, or repair. The FDII proposed regulations provide that substantially all the service is provided at the location of the tangible property only if the service provider spends at least 80% of the time providing the service at or near the location of the property. This 80% threshold appears to be a bright-line test, so it is unclear whether a lesser percentage of time spent at or near the location of the property can satisfy the substantially all standard.

Note: The location of the property (which indicates the location where the services are performed) determines whether the transaction qualifies as FDDEI — if the services are performed with respect to property located outside the United States, even if the recipient is located inside the United States, the transaction will likely qualify as FDDEI.

Proximate services: A proximate service is a service, other than a property or transportation service, provided to a recipient but only if substantially all of the service is performed in the physical presence of the recipient, or in the case of a business recipient, its employees. Like a property service, for this purpose, substantially all the service is performed in the physical presence of the recipient or its employees if the service provider spends at least 80% of the time providing the service in the physical presence of the recipient or its employees.

Note: The location of the recipient (which indicates the location where the services are performed) determines whether the transaction qualifies as FDDEI.

General services: A general service is any service other than a transportation service, a property service, or a proximate service. Whether a general service is for foreign use depends on whether the recipient is a consumer (an individual) or a business recipient.

A general service provided to a consumer is provided in the location where the consumer resides when the service is provided. The FDII proposed regulations specify the documentation that must be obtained by the renderer of the service to document the location of the consumer. It is important to note that the reference to a consumer's residence for qualification of general services is a stricter rule and higher threshold for qualification than is provided in the statute. Sec. 250(b)(4)(B) defines qualifying FDDEI in connection with the provision of services as "services provided by the taxpayer which the taxpayer establishes to the satisfaction of the Secretary are provided to any person, or with respect to property, not located within the United States" (emphasis added).

Taking together both the regulatory language and the documentation requirements (discussed further below), the FDII proposed regulations imply that the consumer's mere location outside the United States when the general service is performed will not satisfy the requirements for FDDEI; rather, the FDII proposed regulations indicate that the consumer must be a non-U.S. resident in order for the general services transaction to qualify as FDDEI. This rule seems to blur the distinction between the statutory requirements for sales of property ((1) sale to non-U.S. person, and (2) for foreign use)) and for sales of services (provided to any person, or with respect to property, not located within the United States), requiring sales of services to satisfy the higher sales-of-property threshold of being provided to a non-U.S. person.

A general service provided to a business recipient is provided outside of the United States to the extent the business recipient's operations outside of the United States benefit from the service. A business recipient is treated as having operations where it maintains an office or other fixed place of business. If the business recipient's business presence is entirely outside the United States, determining how the general services benefit the business recipient will generally be relatively straightforward. In more complicated fact patterns (which may be the norm), however, identifying the extent to which general services benefit a business recipient's U.S. and non-U.S. operations will likely be an involved, complicated analysis that may require alternative methods, for example, application of transfer-pricing principles in a manner not generally needed for other purposes of the Code.

Generally, the amount of the benefit provided to the business recipient's operations outside (or inside) the United States is "determined under any method that is reasonable under the circumstances."9 This standard differs from the "any reasonable method standard" and is to be generally determined by applying the principles of Regs. Sec. 1.482-9(k). The use of this transfer-pricing provision, which generally applies for purposes of allocating costs between members of a controlled group when a controlled transaction benefits more than one member of the controlled group, is an interesting option outside the context of controlled transactions. The FDII proposed regulations provide, however, that reasonable methods may include allocations based on time spent or costs incurred by the service provider, or gross receipts, revenue, profits, or assets of the business recipient.

Related-party servicesIt is important to note that the FDII proposed regulations only provide rules for related-party transactions for general services because there is a risk of "round-tripping" (i.e., a domestic C corporation provides services to a related party, and the related party provides similar services to customers located within the United States, in an attempt to qualify otherwise nonqualifying services as FDDEI). Due to the requirements for transportation, property, and proximate services, there is minimal risk of round-tripping related to these services.

Sec. 250(b)(5)(C)(ii) provides that a service provided to a related party not located in the United States (a related-party service) will not be an FDDEI service unless the related-party service is "not substantially similar" to services the related person provides to persons located in the United States. The FDII proposed regulations clarify the meaning of "not substantially similar," establishing two tests by which to assess related-party transactions with respect to services. First, the benefits test is satisfied if 60% or more of the benefits of the related-party service were to persons located in the United States.

Second, the price test is satisfied if 60% or more of the price paid by persons located in the United States for the service provided by the related party was attributable to the related-party services. If a service is considered substantially similar solely because of satisfying the price test, a portion of the gross income from the related-party service, corresponding to the ratio of benefits conferred by the related-party service to persons not located within the United States to the sum of all benefits conferred by the related-party service, will qualify as an FDDEI service. The FDII proposed regulations apply the related-party services rules only to a general service provided to a business recipient and not to any other type of service.

FDDEI transactions: Documentation and reliability requirements

To treat sales or services as FDDEI, the FDII proposed regulations require the domestic C corporation to collect certain documentation to establish the facts necessary for the gross income from the transaction to be treated as FDDEI. The seller or renderer would generally have to obtain the documentation no later than the "FDII filing date" and no earlier than one year before the date of the sale or service. The FDII filing date is the due date, including extensions, for the income tax return for the tax year in which the gross income from the sale or service is included in the gross income of the seller or renderer.

The FDII proposed regulations specify the types of documents that satisfy the documentation requirements for each type of transaction, generally consisting of: statements by the recipient as to foreign status, intended use, or intended location of use; valid identification provided by a foreign government (in the case of individuals); contractual documents between the parties; publicly available information (such as annual reports or audited financial statements); or other documents prescribed by the IRS in forms or subsequent guidance.

For lump-sum intangible property sales or noncontingent sales of intangible property to third parties, a seller could establish foreign use through documentation containing financial projections of the amount and location of revenue the seller would have reasonably expected to earn from exploiting the property. Such documentation would have to be consistent with the financial projections used to determine the sales price.10

The FDII proposed regulations provide exceptions for "fungible mass" sales of general property, transactions undertaken by small businesses, or small transactions, when documentation requirements would otherwise apply. For fungible mass sales that cannot reasonably be specifically traced, the FDII proposed regulations allow a seller to establish foreign use through statistical sampling, economic modeling, or other similar methods. When a seller or renderer is a small business (less than $10 million in gross receipts in the prior tax year, annualized in the case of short years) or for small transactions (less than $5,000 in gross receipts from a single recipient in a tax year), the seller or renderer may establish foreign-person status, foreign use, or location outside the United States (as relevant for each transaction) by using the recipient's shipping address.

In general, the documentation requirements are onerous and present practical implementation issues for many otherwise qualifying taxpayers. Many taxpayers do not have the systems and processes in place to collect the required information and documentation. Further, certain examples of required documentation in the FDII proposed regulations present burdensome administration requirements and create privacy concerns, particularly in business-to-consumer transactions, as customers may be required to establish their foreign status.

Qualified business asset investment

QBAI is the average of the taxpayer's aggregate adjusted bases in specified tangible property, defined as tangible depreciable property used in the taxpayer's trade or business in the production of DEI.11 Specified tangible property of a domestic corporation includes the adjusted basis of "dual-use property"12 based on the same proportion that the DEI bears to the total gross income produced (the dual-use ratio).

QBAI adjusted basis is determined using the alternative depreciation system (ADS) under Sec. 168(g). The FDII proposed regulations clarify that ADS applies to all property for purposes of Sec. 250(b), even if the property was placed into service before Dec. 22, 2017, and that basis is determined as if the ADS had been used from the date the property was placed in service.

The FDII proposed regulations provide special rules for short tax years. When a domestic corporation has a tax year that is less than 12 months, the domestic corporation's QBAI is the aggregate adjusted bases in its specified tangible property at the close of each full quarter divided by four (quarters in a year), plus the aggregate adjusted bases in the specified tangible property at the close of each short quarter, multiplied by the number of days in the short quarter over 365 (days in a year).

Anti-abuse rules: The FDII proposed regulations include anti-abuse rules for transfers of specified tangible property to related parties and certain unrelated parties. A domestic corporation is treated as owning specified tangible property that it transfers to a "specified related party" if (1) the corporation transfers the property with a principal purpose of decreasing its DTIR, and (2) the domestic corporation or an FDII-eligible related party (i.e., a member of the same domestic consolidated group or a partnership at least 80% of which is owned by members of the consolidated group) leases the same or substantially similar property back during the "disqualified period." The disqualified period is the period beginning one year before the transfer and ending the earlier of (1) the end of the remaining recovery period of the property or (2) one year after the date of the transfer.

A transfer or lease to an unrelated party would be treated as made to a specified related party if done under a "structured arrangement." A structured arrangement will exist if (1) the reduction to the domestic corporation's DTIR is a material factor in pricing the transfer or lease, or (2) a principal purpose of the arrangement (applying a facts-and-circumstances test) is the reduction in the domestic corporation's DTIR.

A transfer of property to a specified related party (or a party deemed to be a specified related party), followed by a leaseback of the same or substantially similar property within six months of the transfer, would be treated as per se having a principal purpose of decreasing the domestic corporation's DTIR.

Application to consolidated groups

While the statutory language implied the FDII deduction may be a single-entity computation,13 the FDII proposed regulations provide aggregation and intercompany elimination rules for determining the Sec. 250 deduction for members of a consolidated group. The proposed regulations (1) determine the Sec. 250 deduction by reference to the relevant items and attributes of all members of the group; (2) apply attribute redetermination under Regs. Sec. 1.1502-13(c) to determine each member's FDDEI; (3) prevent intercompany transactions from affecting QBAI; and (4) treat income offset by the Sec. 250 deduction as tax-exempt income for purposes of basis adjustments in member stock.

The FDII proposed regulations would determine the consolidated group's Sec. 250 deduction by referencing the relevant items of all members of a consolidated group, aggregating each member's DEI, FDDEI, and DTIR, and also aggregating each member's GILTI inclusions (and associated Sec. 78 dividends). A consolidated group calculates its aggregate FDII by using the members' aggregate DEI, FDDEI, and DTIR (the location of QBAI ownership as between members of a consolidated group (or their tested income CFCs) is not relevant), and then reduces the aggregate FDII, if necessary, under the consolidated taxable income limitation. This limitation (similar to the taxable income limitation in the separate-entity context) would reduce a group's FDII and GILTI (and associated Sec. 78 dividends) proportionally to the extent that, in aggregate, they exceed consolidated taxable income (CTI) (with CTI taking into account all items (including business interest expense allowed under Sec. 163(j) and the NOL deduction under Sec. 172) other than the Sec. 250 deduction).

The group then would allocate the consolidated FDII deduction amount (for years beginning before Jan. 1, 2026, the group's aggregate FDII multiplied by 37.5%) to each member in proportion to relative positive FDDEI. Similarly, a group would aggregate the GILTI inclusions (and associated Sec. 78 dividends) of each member, reduce these aggregate amounts, if necessary, by reason of the CTI limitation, and then allocate the resulting deduction (for years beginning before Jan. 1, 2026, the aggregate GILTI and Sec. 78 dividends multiplied by 50%) to each member in proportion to relative GILTI (and associated Sec. 78 dividends).

The FDII proposed regulations would apply attribute redetermination under Regs. Sec. 1.1502-13(c) to determine each member's FDDEI. This would not be a change in rules but rather would be an extension of existing single-entity attribute-redetermination principles through the addition of an example. As illustrated by the example, in determining whether gain of a selling member (S) is DEI and/or FDDEI (attributes of S's gain), S and the buying member (B) are treated as divisions of a single corporation. If B subsequently sells the property to a foreign person for a foreign use, then S's item (in addition to B's item) could qualify as FDDEI, notwithstanding that S sold the property to B, a U.S. person. Similarly, if S sells property at a loss to B, S's loss is allocated solely to B's gross income from the property for purposes of determining B's DEI and FDDEI.

The FDII proposed regulations would prevent an intercompany transaction from affecting QBAI. Generally, an intercompany transaction can affect a member's basis in assets because basis is determined under relevant Code rules. For example, if B buys property from S for cash in a Sec. 1001 transaction, B takes a Sec. 1012 cost basis in the property. If an intercompany transaction changed the basis in tangible depreciable property for purposes of determining QBAI, however, then this would allow an intercompany transaction to affect CTI, which would be inconsistent with single-entity principles. Thus, a special rule would cause a member's basis in property to exclude amounts realized by another member in an intercompany transaction, regardless of whether the amount realized was taken into account. This is similar to the rule in the proposed Sec. 163(j) regulations that would disregard basis from intercompany transactions for purposes of adding back depreciation to calculate adjusted taxable income.14 An intercompany transaction would not affect QBAI even if gain or loss from the transaction were accelerated (for example, if S ceased to be a member of the group).

Finally, the FDII proposed regulations would treat the amount of a member's income offset by the Sec. 250 deduction as tax-exempt income and thus would increase basis in the member's stock by that amount (other than stock of the common parent). Generally, this would have the effect of increasing basis in subsidiary stock by the amount of FDII and GILTI without regard to the Sec. 250 deduction.

Partnership attribution rules

The FDII proposed regulations treat a partnership as a person for purposes of determining whether a sale or service rendered to or by a partnership is an FDDEI transaction. While a partnership is not eligible to claim an FDII deduction because it is not a domestic C corporation, the FDII proposed regulations provide that a domestic C corporate partner in a partnership would take into account its distributive share of partnership gross DEI, gross FDDEI, and deductions in order to calculate the partner's FDII. A partner's distributive share would be determined in accordance with the partner's distributive share of the underlying items of income, gain, deduction, and loss of the partnership. Further, a domestic C corporation that holds a partnership interest at the end of its tax year increases its QBAI by its share of the partnership's adjusted basis in the partnership specified tangible property (partnership QBAI).15

Coordination rule: Secs. 163(j), 172, and 250

The FDII proposed regulations provide a five-step ordering rule to coordinate the application of Secs. 163(j) (limitation on business interest), 172 (NOL deductions), and 250. This multistep process eliminates the circularity inherent in the Code and is in lieu of requiring "simultaneous equations" to be applied for this purpose. However, the proposed ordering rule requires taxpayers to essentially compute the FDII deduction twice — the first computation to determine a "tentative Sec. 250 deduction" to be used as an input in the Sec. 163(j) interest limitation computation, and the second to determine the final Sec. 250 deduction, taking both the Sec. 163(j) and Sec. 172 limitations into account.

Additionally, the proposed ordering rule does not include the charitable contributions deduction under Sec. 170, which also refers to an adjusted taxable income concept. Without further guidance relating to the order of application of these provisions, taxpayers will face uncertainty in computing respective limitations.

Reporting requirements

The FDII proposed regulations would require any taxpayer claiming a deduction under Sec. 250 to file new Form 8993, Section 250 Deduction for Foreign-Derived Intangible Income (FDII) and Global Intangible Low-Taxed Income (GILTI), with the taxpayer's annual income tax return. In addition, the proposed regulations would also require taxpayers that must file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations; Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business (Under Sections 6038A and 6038C of the Internal Revenue Code); and Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, to include certain information related to the Sec. 250 deduction when information otherwise required to be reported on the form affects the filer's Sec. 250 deduction.

Prop. Regs. Sec. 1.6038-3(g)(4) also requires domestic partnerships to provide information to domestic corporate partners regarding a partner's share of the partnership's gross DEI, gross FDDEI, deductions that are definitely related to the partnership's gross DEI and gross FDDEI, and partnership QBAI on the Form 1065 Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., for each tax year in which the partnership has gross DEI, gross FDDEI, or partnership specified tangible property. Certain foreign partnerships controlled by U.S. persons must include the same information on the Form 8865 Schedule K-1.

Effective date

The FDII proposed regulations under Sec. 250 would apply to tax years ending on or after March 4, 2019. The IRS acknowledged, though, in the preamble to the proposed regulations that they may apply to transactions that have occurred before the filing of the proposed regulations and that taxpayers may not be able to obtain the documentation required for transactions that have already been completed. Thus, for tax years prior to that date, the proposed regulations provide that taxpayers may use any reasonable documentation maintained in the ordinary course of business that establishes that a recipient is a foreign person, property is for a foreign use, or a recipient of a general service is located outside the United States in lieu of the documentation required in the proposed regulations. The documentation provided must, however, meet the reliability requirements.

Due to the timing of these proposed regulations, the final Sec. 250 regulations are unlikely to be retroactive. Taxpayers should therefore plan to put more effort into determining their qualification for the FDII deduction, including modeling the interaction of FDII in conjunction with other tax provisions (e.g., GILTI, foreign tax credits, etc.).  

Footnotes

1P.L. 115-97.

2Sec. 250(b)(3).

3Secs. 250(b)(2)(B) and 951A(d). Note that QBAI basis is determined using the alternative depreciation system under Sec. 168(g) rather than the general depreciation system (Sec. 951A(d)(3)(A)).

4Sec. 250(b)(4). Special rules apply to sales of property or services provided to related persons or domestic intermediaries (Secs. 250(b)(5)(B) and 250(b)(5)(C)).

5REG-104464-18.

6The proposed regulations specifically state that sales of securities or certain commodities do not qualify as FDDEI sales because, as noted in the preamble, those sales cannot be for a foreign use.

7Specifically, general property would be treated as a component of a second product only if the fair market value (FMV) of all general property sold by the seller and incorporated into the second product constitutes no more than 20% of the FMV of the second product. To illustrate this concept, assume a domestic corporation sells wood pulp to an unrelated foreign person that uses the wood pulp to manufacture paper in a foreign jurisdiction. The paper is then sold to consumers in the United States. The sale of the wood pulp to the foreign person is considered for foreign use because it would be subject to manufacture and processing outside the United States before it was subject to domestic use.

8When the foreign related party uses the purchased property to produce other property or to provide a service, the FDII proposed regulations require the seller to reasonably expect that the unrelated-party transaction would qualify as an FDDEI sale or an FDDEI service (without regard to the documentation rules). Additionally, the seller would have to reasonably expect that more than 80% of the revenue earned by the foreign related party would be earned from unrelated FDDEI transactions.

9Prop. Regs. Sec. 1.250(b)-5(e)(2)(i)(B).

10To rely on the documentation, the seller or renderer must not know or have reason to know that the documentation is unreliable or incorrect as of the FDII filing date. The FDII proposed regulations would treat the seller or renderer as knowing or having reason to know that the documentation is unreliable or incorrect if the seller or renderer's knowledge of the relevant facts and/or statements is such that a "reasonably prudent person" would question the accuracy or reliability of the documentation. The proposed regulations include a special rule for loss transactions. When the seller or renderer knows or has reason to know that a sale or general service would otherwise meet the requirements for an FDDEI sale or service, but the seller or renderer fails to meet the documentation requirements, the transaction would be deemed to be an FDDEI transaction if not treating it as an FDDEI transaction would increase the corporation's FDII deduction for the year.

11Secs. 250(b)(2)(B) and 951A(d).

12"Dual-use property" is property that produces DEI and gross income that is not DEI.

13Sec. 250(a)(1) provides, "In the case of a domestic corporation for any taxable year . . ." (emphasis added).

14Prop. Regs. Sec. 1.163(j)-4(d)(2).

15The domestic C corporation's share is calculated using the partnership QBAI ratio. The partnership's adjusted basis in specified tangible property and the portion taken into account in determining a domestic corporation's partnership QBAI would be determined by applying the principles applicable to domestic corporations described previously.

 

Contributors

Jay Camillo, MBA, is a principal in international tax in Atlanta and is EY's Americas Operating Model Effectiveness leader. Jillian Chavis, CPA, J.D., LL.M., is a manager in EY National Tax in Washington, D.C. Daniel Karnis, CPA, is a partner in EY National Tax—Business Tax Services in Atlanta. Peter Marrs, J.D., is a managing director, EY National Tax—International Tax Services in New York City. For more information on this article, contact thetaxadviser@aicpa.org.

 

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