FDII deduction: Options for determining taxable income

Editor: Christine M. Turgeon, CPA

This discussion highlights some of the uncertainties that may arise in determining a corporation’s taxable income for purposes of calculating its foreign-derived intangible income (FDII) deduction under Sec. 250. Because the FDII deduction is limited based on taxable income, corporations must calculate certain other deductions to compute it. Because some other Code provisions also limit the availability of a deduction based on taxable income — e.g., Secs. 163(j) and 172 — an ordering issue can arise. Without guidance, it was unclear how taxpayers could navigate a potentially circular result when determining these deductions.

As discussed below, Treasury and the IRS proposed an ordering rule in 2019 but chose not to adopt it when the regulations were finalized in 2020, stating that the issue would require further study. Until Treasury and the IRS provide additional guidance, taxpayers have several options for determining taxable income for purposes of the FDII deduction, but with some apparent contradictions.

The FDII deduction

As background, Sec. 250(a)(1) currently allows domestic C corporations to claim a deduction equal to, in part, 37.5% of their FDII (the deduction is reduced to 21.875% for tax years beginning Jan. 1, 2026, or later) and 50% of the taxpayer’s global intangible low-taxed income (GILTI) inclusion. The FDII-related Sec. 250 deduction is limited based on the corporation’s taxable income, which is determined without regard to Sec. 250 (see Sec. 250(a)(2) and Regs. Sec. 1.250(a)-1(b)(2)).

Proposed ordering rule

In 2019, Treasury issued proposed regulations (REG-104464-18; 84 Fed. Reg. 8188) under Sec. 250 that set forth the following five-step ordering rule to eliminate the circularity in the application of the above-mentioned Code sections:

1. Calculate a “tentative Sec. 250 deduction” without regard to the Sec. 163(j) interest deduction limitation, Sec. 172 net operating losses (NOLs), or the Sec. 250(a)(2) taxable income limitation;
2. Calculate the interest deduction disallowance under Sec. 163(j), taking into account the tentative Sec. 250 deduction (determined in step 1), but without regard to Sec. 172(a);
3. Calculate the NOL deduction under Sec. 172(a), taking into account Sec. 163(j), but without regard to Sec. 250(a);
4. Calculate FDII (and thus foreignderived deduction eligible income (FDDEI) and deduction eligible income (DEI)) by allocating all deductions allowed after application of Secs. 163(j) and 172(a); and
5. Determine the Sec. 250 deduction after applying Sec. 250(a)(2), which uses a taxable income amount that accounts for the business interest deduction allowed under Sec. 163(j) and the NOL deduction under Sec. 172(a).

Final regulations

Forthcoming guidance project: The Sec. 250 regulations were finalized in 2020. While the final Sec. 250 regulations retained the basic approach and the structure of the 2019 proposed regulations in many respects, they did not include the ordering rule described above. Instead, Treasury noted that further study would be required to determine the appropriate coordination rules and interaction of Sec. 250(a)(2) with Sec. 163(j), Sec. 172, and other Code provisions keyed off taxable income. The preamble indicated that Treasury and the IRS “are considering a separate guidance project to address the interaction of sections 163(j), 172, 250(a)(2), and other Code sections that refer to taxable income; this guidance may include an option to use simultaneous equations in lieu of an ordering rule” (T.D. 9901; 85 Fed. Reg. 43,042, 43,044 (July 15, 2020)).

Further, Treasury and the IRS noted, “Any separate guidance would take into account the recent addition of section 172(a)(2)(B)(ii)(I) by the Coronavirus Aid, Relief, and Economic Security Act [P.L. 116-136]” (T.D. 9901; 85 Fed. Reg. 43,044, n. 1). That provision provides, in relevant part, that for tax years beginning after Dec. 31, 2020, the taxable income limitation for purposes of deducting NOL carrybacks and carryovers is determined without regard to the deductions under Secs. 172, 199A, and 250. Therefore, under this Code section, the NOL limitation applies before the Sec. 250 taxable income limitation in 2021 and later.

Meanwhile, the preamble to the final Sec. 250 regulations provided that before further guidance is issued, “taxpayers may choose any reasonable method (which could include the ordering rule described in the proposed regulations or the use of simultaneous equations) if the method is applied consistently for all taxable years beginning on or after January 1, 2021” (T.D. 9901; 85 Fed. Reg. 43,044–45). This change from the guidance in the proposed regulations regarding the order for determining taxable income may cause taxpayers some concern, as the ordering rule remains unclear, and additional guidance has yet to be issued. However, more uncertainty arises when the language in the preamble is read in conjunction with the new rule provided in the final Sec. 250 regulations.

Limitation on carryover of deductions under other Code sections: In addition to the abovementioned removal of the proposed regulations’ ordering rule, the final Sec. 250 regulations also modified the language in Regs. Sec. 1.250(b)-1(d)(2) (ii). The newly added language states that “[f]or purposes of determining the deductions of a domestic corporation for a taxable year properly allocable to gross DEI and gross FDDEI, the deductions of the corporation for the taxable year are determined without regard to sections 163(j), 170(b)(2), 172, 246(b), and 250.” The preamble to the final Sec. 250 regulations states that this approach “is consistent with the premise that the section 250 deduction is calculated based on annual income and expenses.” Therefore, under this rule set forth in the regulations, neither DEI nor FDDEI is reduced by NOL carryovers and carrybacks, excess interest expense carryovers under Sec. 163(j), or charitable contribution carryovers. Similarly, caps on such expenses for a current year are not taken into account.

This approach appears inconsistent with step 4 of the ordering rule in the proposed Sec. 250 regulations, which provided that the corporation compute the amount of its FDII (and thus its FDDEI and DEI) by taking into account the amount of its business interest allowed after application of Sec. 163(j) and the amount of its NOL deduction under Sec. 172(a) (determined in steps 2 and 3, respectively). The preamble to the final Sec. 250 regulations addresses both the ordering rule and the use of carryforwards (and limitations) separately; thus, uncertainty remains as to how these two rules could both apply for purposes of calculating FDDEI and DEI (and thus FDII).

Potential approaches: One potential approach to address this inconsistent treatment would be to follow the rule provided in the final Sec. 250 regulations and complete step 4 of the ordering rule by not taking into account the limitation under Sec. 163(j), thus allocating and apportioning all interest expense for the current year. On the other hand, because the ordering rule described in the proposed Sec. 250 regulations was specifically enumerated in the preamble to the final regulations as one of the reasonable methods — provided it is applied consistently — it is unclear whether taxpayers instead may choose to follow the ordering rule and thus not take into account the modified language in Regs. Sec. 1.250(b)-1(d)(2)(ii).

As taxpayers await further clarification from Treasury and the IRS, uncertainty remains on the application and interaction of these provisions.

Editor Notes

Christine M. Turgeon, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in New York City. For additional information about these items, contact Turgeon at christine.turgeon@pwc.com. Contributors are members of or associated with PricewaterhouseCoopers LLP.