IRS ruling clarifies treatment of R&D when computing the FDII deduction

Editor: Rochelle Hodes, J.D., LL.M.

As globalization continues to shape business strategies, many U.S.-based multinational corporations have established their global supply chains with a principal company situated outside the United States. In these arrangements, there has been uncertainty regarding whether service income earned by U.S. affiliates from a non–U.S. principal company is treated as foreign–derived and therefore a favorable factor when computing the foreign–derived intangible income (FDII) deduction under Sec. 250(b). This question arises when a non–U.S. principal company sells products into the U.S. market through its related U.S. distributor.

In January 2025, the IRS released Letter Ruling 202502002, which concluded that income from research–and–development (R&D) services provided by U.S. entities to their foreign parent principal company may be characterized entirely as foreign–derived deduction–eligible income (FDDEI) for FDII purposes. Technically, the letter ruling does not serve as a binding precedent and cannot be relied upon by taxpayers other than the taxpayer to whom it was issued. However, it provides valuable insight into the IRS’s current interpretation of cross–border R&D services and intellectual property (IP) management under the FDII regime and is authority for purposes of the accuracy–related penalty under Sec. 6662 (Regs. Sec. 1.6662–4(d)(3)(iii)).

FDII rules relevant for R&D services

The FDII regime, enacted in 2017 as part of the Tax Cuts and Jobs Act, P.L. 115–97, allows a domestic corporation to claim a 37.5% deduction on qualifying FDII income (Sec. 250(a)(1)(A)). FDII is calculated as the product of a corporation’s deemed intangible income (DII) multiplied by a fraction (known as the foreign–derived ratio), which is the ratio of FDDEI to deduction–eligible income (DEI) (Sec. 250(b)(1)).

DII equals the corporation’s DEI minus its deemed tangible income return (DTIR). DTIR is 10% of the corporation’s qualified business asset investment (QBAI), representing the domestic corporation’s average value of certain tangible assets (Sec. 250(b)(2) and Regs. Secs. 1.250(b)-1(c)(3) and (c)(4)).

H.R. 1, P.L. 119–21, commonly known as the One Big Beautiful Bill Act, enacted on July 4, 2025, rebrands the FDII regime as the FDDEI regime (foreign–derived deduction–eligible income). Under this new framework, a deduction rate of 33.34% directly applies to qualifying FDDEI from tax years beginning after Dec. 31, 2025. As a result, the concepts of DII and DTIR will no longer be relevant under the FDDEI regime. Despite the transition, the principles outlined in the letter ruling, which primarily address FDDEI, should remain applicable and unaffected.

DEI is defined as the excess of a corporation’s gross income (with specific exclusions) over deductions properly allocable to such income (Sec. 250(b)(3) and Regs. Sec. 1.250(b)-1(c)(2)). The excluded items include income under Subpart F, global intangible low–taxed income (GILTI), financial services income, dividends from controlled foreign corporations, domestic oil and gas extraction income, and foreign branch income (Regs. Sec. 1.250(b)-1(c)(15)). H.R. 1 further excludes from DEI any gains from the sale or disposition of intangible property and any other property subject to depreciation, amortization, or depletion.

FDDEI means DEI derived from either (1) property sold to non–U.S. persons for foreign use or (2) services provided to persons or property not located in the United States (Sec. 250(b)(4)). The regulations categorize FDDEI services into five types, which include general services to business recipients located outside the United States (Regs. Sec. 1.250(b)-5(b)).

General services provided to a business recipient located outside the United States generate FDDEI to the extent that they benefit the recipient’s operations outside the United States (Regs. Sec. 1.250(b)-5(e)(1)). A business recipient is defined as any recipient other than an individual consumer and includes all related parties of the recipient (excluding the service renderer) (Regs. Sec. 1.250(b)-5(c)(3)). The location of the benefit depends on where the business operations benefiting from the service are located, that is, where the business recipient maintains an office or fixed place of business rather than the place of residence or incorporation (Regs. Secs. 1.250(b)-5(e)(1) and (3)).

In order to determine which operations of the related–party business recipient benefit from a service, Regs. Sec. 1.250(b)-5(e)(2) applies principles from Regs. Sec. 1.482–9. That section treats the service provider as one controlled taxpayer and the business recipient’s U.S. and non–U.S. operations as separate controlled taxpayers (Regs. Sec. 1.250(b)-5(e)(2)). An activity provides a benefit if it directly creates a reasonably identifiable increment of economic or commercial value that enhances the recipient’s commercial position or that may reasonably be anticipated to do so (Regs. Sec. 1.482–9(l)(3)(i)). An activity generally confers a benefit if an uncontrolled taxpayer in comparable circumstances would pay for it or perform it themselves (id.). Conversely, an activity does not confer a benefit to an uncontrolled recipient if the recipient would not conduct the activity itself and would not be willing to pay an uncontrolled party to perform a similar activity (Regs. Sec. 1.482–9(l)(3)(ii)).

Letter Ruling 202502002

The letter ruling’s facts generally are as follows: Two U.S. entities render R&D services to a foreign affiliate on certain IP and receive a cost–plus markup fee under a master services agreement. The foreign affiliate develops, manufactures, and distributes pharmaceutical products, medical devices, and other biotechnology products. None of the foreign affiliate’s other U.S. or foreign affiliates are directly involved in the supply chain relating to the IP or pay any of the costs of developing the IP. The foreign affiliate does not have any significant operations outside its home country.

The foreign affiliate has a distribution agreement to sell the manufactured products incorporating the IP to a related U.S. distributor for the U.S. market. The U.S. distributor does not hold any ownership rights, nor does it bear any risk of loss related to the IP. The U.S. distributor generally earns a cost–plus markup for its distribution under the distribution agreement, and the agreement is terminable at will by either party. The foreign affiliate indirectly owns all the stock of the two U.S. R&D service providers and the stock of the U.S. distributor through its wholly owned U.S. holding company.

The letter ruling also includes a number of representations from the taxpayer including that the fee received by the U.S. R&D service providers and the purchase price paid by the U.S. distributor for products were determined under Sec. 482; the R&D services are general services under the FDII regulations; and the foreign affiliate owns and retains full ownership rights to any IP developed through the U.S. R&D services and operates only outside the United States without providing services to businesses or customers located in the United States.

The key issue in the letter ruling is whether the distribution of IP–embedded products by the U.S. distributor in the U.S. market renders income earned from the R&D services ineligible to be included in FDDEI. Based on the facts and representations submitted, the IRS ruled that 100% of the R&D service income is gross FDDEI, clarifying that the services do not provide any benefit to the U.S. distributor. The ruling is supported by the fact that the R&D services rendered by the two U.S. entities are general services and the foreign affiliate is a business recipient based on its fixed business in the home country outside the United States. Also, under the principles of Regs. Sec. 1.482–9, the U.S. distributor is treated as a separate controlled taxpayer from the foreign affiliate when analyzing which operations benefit from the R&D services.

The analysis provides that the R&D services directly result in a reasonably identifiable increment of economic or commercial value that enhances the foreign affiliate’s commercial position and confers a benefit on its operations as the IP owner and manufacturer. Further, the U.S. distributor’s operations are limited because it was an uncontrolled taxpayer that purchased finished goods at an arm’s–length price without any IP ownership rights or exposure to the risks of loss for unsuccessful R&D services. As such, under Regs. Sec. 1.482–9, the R&D services do not confer a reasonably identifiable increment of economic value on the U.S. distributor’s commercial position. As a result, no cost allocation of the R&D services is required between the foreign affiliate and the U.S. distributor.

The letter ruling concludes that the foreign affiliate is the sole business recipient of the R&D services, and, therefore, all of the income earned by the U.S. R&D service providers from their services provided to the foreign affiliate is treated as FDDEI.

Considerations for FDDEI eligibility in cross-border R&D services

In the ruling, the IRS primarily focused on IP ownership and value capture when evaluating FDDEI eligibility. When a U.S.-based entity provides R&D services to a foreign affiliate, the allocation of economic benefits and risks associated with the underlying IP should align with the requirements for FDDEI services. To that end, documentation should clearly demonstrate that foreign recipients retain exclusive ownership of the IP developed through R&D services and that they bear the associated economic risks. Correspondingly, U.S. distributors should possess no ownership or licensing rights to the IP, beyond nonexclusive, royalty–free use for localized sales.

For example, R&D service agreements should define the scope of IP ownership and identify the appropriate recipient entities, clearly vesting the benefits and risks of the R&D services in those designated entities. To further support this position, other U.S. affiliates, including limited risk distributors in the U.S. market, should be expressly excluded not only from service recipients but also from any decision–making authority over the direction of R&D.

Clarity for US multinationals engaged in outbound R&D services

Letter Ruling 202502002 offers clarity for U.S. multinationals engaged in outbound R&D services for related parties. Under the new FDDEI deduction framework, taxpayers should assess FDDEI–based planning as an alternative to IP ownership restructuring. Additionally, U.S. multinationals should evaluate intercompany R&D services and distribution arrangements in light of the favorable treatment outlined in the letter ruling.

Editor

Rochelle Hodes, J.D., LL.M., is principal with Washington National Tax, Crowe LLP, in Washington, D.C.

For additional information about these items, contact Hodes at Rochelle.Hodes@crowe.com.

Contributors are members of or associated with Crowe LLP.