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Practitioners Praise Proposed FDII Regs

Posted on Mar. 11, 2019

Practitioners are praising proposed regs on the foreign-derived intangible income provision for taking a comprehensive and reasonable approach, although some details may need to be further explained in final regs.

“Overall, taxpayers should be fairly happy with the result,” said Scott M. Levine of Jones Day. “They made a good attempt to be reasonable, especially on the documentation requirements.”

Michael DiFronzo of PwC described the proposed regs as “a valiant attempt” to cover the most significant issues. “There are still questions out there, and one of the things I always take comfort in when you see a proposed reg is that [it] is not usually as generous as the final reg,” DiFronzo said.

Designed as the Tax Cuts and Jobs Act’s carrot to attract intangible assets into the United States, the formula-based FDII rules allow a 37.5 percent deduction for a U.S. corporation’s deemed intangible income (DII) earned from the sale of property or services for foreign use. That results in an effective tax rate of 13.125 percent for qualifying income. FDII is defined as the DII multiplied by the foreign-derived deduction eligible income (FDDEI) divided by the deduction eligible income (DEI). DII is the excess of DEI over deemed tangible income return, the latter being 10 percent of a corporation’s qualified business asset investment.

Proposed regs (REG-104464-18) released March 5 provide rules for determining the various elements that make up the FDII calculation. A large portion of the proposed regs is dedicated to fleshing out how foreign use is determined, a challenge acknowledged by taxpayers and the IRS months ago as the guidance was being drafted, given how succinct the statute is in defining the term.

Under section 250, foreign use is defined as “use, consumption, or disposition which is not within the United States.” Special rules apply to related parties, such that sales are not foreign use unless the property is sold by the related party or used “in connection with property which is sold or the provision of services, to another person who is an unrelated party who is not a United States person.” A taxpayer must establish foreign use “to the satisfaction of the secretary.”

Sales and services are treated differently in determining whether a transaction is foreign, and how the transaction is classified depends on the “overall predominant character,” according to the preamble to the regs. Sales include the license and transfer of property under section 367, including intangible property transfers under section 367(d).

Levine said it wasn’t entirely clear under the regs whether section 367(d) sales made before the effective date of section 250 that would lead to royalty payments in the future would be eligible. While it appears they would, he said clarification is necessary.

Defense Industry Scores Direct Hit

For foreign military sales, the proposed regs state that the sale of property or the provision of services to the U.S. government for resale to a foreign government qualifies for the deduction, clearing up uncertainty about the statute.

DiFronzo noted that to control arms sales, under U.S. law, defense contractors must formally sell equipment to the U.S. government before it’s on-sold to foreign governments. “When you look at the regulations, they look through what’s really happening and find that the substance of that is really a sale to a foreign government,” DiFronzo said. “They’ve given us a very favorable but appropriate answer.”

Transportation property qualifies for foreign use only if it spends more than 50 percent of the time and 50 percent of the miles traveled outside the United States. Questions remained on how to substantiate the 50 percent thresholds, according to DiFronzo.

No Reason to Know

A sale of property qualifies as FDDEI only if the seller “does not know or have reason to know” that the recipient isn’t foreign or the property isn’t for foreign use under the regs, with knowledge not defined any further in the guidance. How taxpayers would know where a property is ultimately used had been a primary concern, given the lack of clarity in the statute. DiFronzo speculated that language regarding no “reason to know” of non-foreign use will start to make its way into sales contracts in the future, potentially represented by promises from the buyer about intended use.

Under the regs, for general property, a sale is for foreign use if the property isn’t used domestically within three years of delivery or it’s manufactured, assembled, or processed outside the United States. The latter condition is met if either there’s a physical and material change to the property, based on facts and circumstances, or it’s incorporated as a component into another product. For it to be incorporated as a component, the fair market value of the property must be at most 20 percent of the value of the second product once completed.

According to the regs, for the sale of intangible property, foreign use is established if revenue is earned from using the property outside the United States, documentation requirements are met, and the seller had no reason to know that a portion of the sale wasn’t for foreign use. Foreign use can be partial for intangible property. Where the revenue is earned is based on the location of end-user customers, as determined annually. For lump sales, the determination is based on the net present value the seller would have earned from exploiting the property.

Sound Policy on Foreign Branches

Under reg. section 1.250(b)-4(f), the sale of a security or a commodity isn’t an FDDEI sale.

Levine was unsurprised by that exclusion because the term “use” implies more than holding something as an asset. Under the statute, DEI excludes six categories of gross income, one of which is foreign branch income. In defining foreign branch income in the regs, Levine said it appears that Treasury was allowing domestic corporations to get the FDII benefit when selling to a foreign branch that then sells to a foreign unrelated party, clarifying the ambiguous statute. That determination represents sound policy, Levine argued.

“You shouldn’t get a different answer [when] a U.S. domestic corporation sells inventory to its foreign branch, [which] then on-sells it to an unrelated customer, [and] when a U.S. parent sells it to a [controlled foreign corporation], and it then on-sells,” Levine said. “This judgment call seems to have already been made in a prior regulatory package, and they just seem to be extending it to this rule.”

‘Spectrum of Trade-Offs’

Substantiating foreign use was a concern for taxpayers worried about administrability, and the regs make clear that documentation plays an important role in determining whether property is for foreign use. The necessary documentation is “readily accessible to most taxpayers,” according to the preamble.

The guidance clarifies that documentation requirements differ depending on whether the sale is to a foreign person, is of general or intangible property for foreign use, is to an individual consumer, or is for a business recipient of a general service. In balancing the “spectrum of trade-offs” between rigorous proof and taxpayer burden, the regs decline to hold that written statements of foreign use under penalties of perjury and evidence of use are necessary as documentation.

“Overly burdensome documentation requirements might shift transactions to sellers that do not need or cannot use the FDII deduction, or may discourage foreign persons from transacting with a U.S. seller or renderer. The Treasury Department and the IRS aimed to propose rules that would not alter economic decisions because of these concerns,” the preamble states, also citing concerns over abuse.

Small businesses — defined as having annual gross receipts of less than $10 million and small transactions, defined as less than $5,000 in receipts from a single recipient — often catch a break on documentation requirements because throughout the regs, they can rely on foreign billing addresses to establish foreign use.

Pointing to the $10 million threshold, Levine said there appears to be no aggregation rule. “If you had a private equity fund that owned multiple portfolio investments . . . it doesn’t look like you would aggregate the two for purposes of their gross receipts,” Levine said. “In most cases . . . [they] are going to be big enough companies that they are going to blow right through $10 million in revenue.”

Chris Hanfling of Jones Day was surprised by the regs’ lack of explicit attention to the digital economy. But Levine wondered whether the $5,000 threshold might capture some of those transactions.

By Service Type

For FDDEI services, whether the service is provided outside the United States depends on the type of service provided, with the regs establishing mutually exclusive categories of proximate services, property services for tangible property, transport services, and the catchall general services. “A lot of digital services will be harder to fit these facts, and whether you are in the residual [category] or not could have a material difference,” Hanfling said.

General services are provided outside the United States if the provider has no reason to know the consumer or business recipient is in the United States, according to the regs. A business recipient’s location is based on the operation’s location and the location of any related party that is receiving a benefit. Documentation for a business recipient’s operations includes a statement specifying the location of the operation or a statement in a binding contract. “Information provided in the ordinary course of the provision of a service or publicly available information” will also suffice, according to the regs.

Proximate services — such as training, consulting, and auditing — are defined as services during which the provider spends more than 80 percent of its time in the physical presence of the recipient, according to the regs. Property and transportation services are FDDEI based on the location of the property rather than the recipient, the guidance says.

Section 250(b)(5)(B)(ii) could be read literally to provide that an FDDEI service includes only services provided to a person not located within the United States, in which case a service provided ‘with respect to property located outside the United States’ would not qualify as an FDDEI service if the recipient of such service was located within the United States,” the preamble states. “The Treasury Department and the IRS have determined that an interpretation of section 250(b)(5)(B)(ii) that effectively eliminates the disjunctive test of section 250(b)(4)(B) would not be reasonable.”

Substantially all property services — defined as services (other than transportation services) provided on tangible property that involve physical manipulation — are performed at the location of the property if more than 80 percent of the time is spent near that location.

Transportation services are determined based on the origin and destination of the service, and if only one is outside the United States, then 50 percent of the service is FDDEI, according to the regs. “Basing the location of a transportation service on the residence of the recipient of the transportation service could provide inconsistent results with respect to similar services. Similarly, providing different rules for the transportation of a person or property could provide inconsistent results with respect to similar services,” the preamble explains.

“It’s administrable and it’s pretty easy, but you can also make the argument that if you have international transportation services, that those services really wouldn’t exist but for the foreign market,” DiFronzo said.

DiFronzo said the guidance on transportation services is one of the more disappointing parts of the regs. He noted that the 50-50 split appears to be rooted in other parts of the code, such as section 863.

“It’s administrable and it’s pretty easy, but you can also make the argument that if you have international transportation services, that those services really wouldn’t exist but for the foreign market,” DiFronzo said. “A 50-50 rule may be a little harsh, especially looking at what they were able to do with the sale rule of transportation property . . . but it’s not completely out of bounds.”

Related-Party Tests

The regs state that additional requirements must be met for a sale or service to a related party to qualify as FDDEI. For related-party reselling, the sale qualifies as FDDEI only if an unrelated-party transaction takes place that is an FDDEI sale. For sales resulting in related-party use, the sale isn’t FDDEI unless the seller reasonably expects more than 80 percent of the revenue earned by the related party from the use to be earned in unrelated-party transactions that are FDDEI.

Under section 250(b)(5)(C)(ii), related-party services aren’t FDDEI unless they aren’t “substantially similar to services provided by such related party” to U.S. persons. The regs establish two tests — the benefit test and the price test — to determine whether services are substantially similar.

The benefit test is met if at least 60 percent of the benefits from a service — defined as “a reasonably identifiable increment of economic or commercial value” — are from a person in the United States. Alternatively, the price test is met if at least 60 percent of the price of the service is attributable to the provider’s service. “Consequently, a related-party service that is not treated as substantially similar to a service provided by the related party to persons located in the United States under the benefit test, because more than 40 percent of the benefits from the service are conferred to persons located outside the United States, is nonetheless treated as ‘substantially similar’ under the price test if the related-party service accounts for 60 percent or more of the total price that is charged to customers located within the United States,” the preamble explains.

If only the price test disqualifies a service as FDDEI, a portion of income from the service is still treated as FDDEI based on the ratio of benefits conferred by the service to persons not in the United States to the sum of all benefits from the service.

DiFronzo said he was pleased that the regs don’t take a broader view of substantially similar services because he views the provision as designed to target round-tripping.

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