Aerospace Industry Powers Up for FDII, GILTI Regs

May 3, 2019

CC:PA:LPD:PR (REG-104464-18)
Room 5203
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

Re: Comments on Proposed Regulations (REG-104464-18) Relating to the Deduction for Foreign-Derived Intangible Income and Global Intangible Low-Taxed Income

Dear Sir or Madam:

The Aerospace Industries Association ("AlA") is our nation's leading trade association for the aerospace and defense industry, representing nearly 340 member companies. AIA respectfully submits this letter in response to the Notice of Proposed Rulemaking (REG-104464-18) providing guidance related to the Deduction for Foreign-Derived Intangible Income and Global Intangible Low-Taxed Income, published in the Federal Register on March 6, 2019 (the "Proposed Regulations"). AIA commends the Treasury Department ("Treasury") and the Internal Revenue Service ("IRS") for their efforts to craft comprehensive regulations for this critical provision. This letter responds to several issues for which Treasury and the IRS requested specific comments. The letter further recommends changes that AIA believes will reduce administrative burden to taxpayers and the IRS, while facilitating accurate determination of the deduction.

I. Documentation of Foreign Use Generally

The general documentation requirements outlined under the Proposed Regulations prescribe a specific set of documents to substantiate foreign use, many of which are not available or created in the ordinary course of business.¹ As a result, these requirements may require taxpayers to change their contracting and/or recordkeeping processes to demonstrate FDII eligibility. AIA does not believe that Treasury has appropriately balanced the burden that the documentation requirements will impose on taxpayers with the benefit that this documentation will provide to the government, in part because the government's needs may be satisfied by documents that are already created in the ordinary course of a taxpayer's business.

Prop. Treas. Reg. § 1.250(b)-4(d)(3)(i)(A) provides that a written statement provided by the recipient of property would establish that such property is for a foreign use if the statement provides that the use or intended use of the property is for a foreign use (within the meaning of Prop. Treas. Reg. § 1.250(b)-4(d)(2)). Other acceptable forms of documentation include a binding contract between the seller and the recipient providing that the recipient's use or intended use of the property is for a foreign use and, except in the case of international transportation property, documentation of shipment of the property to a location outside of the United States.²

The list of acceptable documentation in Prop. Treas. Reg. § 1.250(b)-4(d)(3) is further limited by the general rules addressing reliability of documentation, particularly the requirement that the documentation be provided no earlier than one year before the date of the sale (see discussion in Section IV, below), which for certain manufacturers that execute contracts years in advance of the date of sale effectively negates the reliability of a binding contract. Particularly for manufacturers of international transportation property, the confluence of these rules requires taxpayers to collect statements from their customers solely for the purposes of documenting a U.S. tax position of the manufacturer. Expanding the list of acceptable forms of documentation would prevent sellers of property from having to create documentation that is prepared specifically for tax purposes. Further, under Prop. Treas. Reg. § 1.250(b)-3(d)(1), documentation is considered reliable only if the seller of property does not know or have reason to know that the documentation is unreliable or incorrect, based on all relevant facts and circumstances. This requirement necessitates a careful analysis by a seller of property of any documentation obtained under Prop. Treas. Reg. § 1.250(b)-4(d)(3), so a broader list of documentation used or created in the ordinary course of a seller's business is appropriate for establishing foreign use.

AIA recommends that Treasury expand the scope of Prop. Treas. Reg. § 1.250(b)-4(d)(3)(i) to provide that a seller, including a seller of international transportation property, establishes foreign use by obtaining documentation that is used or created in the seller's ordinary course of business, including, for example, a binding contract, a written statement by the recipient indicating intended foreign use, commercial invoices, bills of lading, customs documentation, tax exemption documentation completed by the recipient, import licenses obtained by the recipient from a foreign jurisdiction, insurance documentation for property delivered outside of the United States, documentation certifying that property is registered with a foreign government or agency or instrumentality thereof, or other documentation prepared in the ordinary course of business that establishes to the satisfaction of the Secretary that the property is for any foreign use. Many of the items of documentation identified above — such as customs documentation, import licenses, insurance documentation, and documents demonstrating foreign registration — effectively serve the purpose of substantiating a good's foreign use for purposes other than tax. A broader list of acceptable documentation reasonably balances the burden imposed on taxpayers to substantiate foreign use with the government's need for a consistent standard for documentation that it can apply to all taxpayers.

II. Military Sales

A. Presumption of Foreign Use for Sales of Defense Articles (Property and Services) to Foreign Persons

With respect to the Foreign Use Requirement, the Proposed Regulations do not provide any specific rules in the context of defense articles — i.e., items of property and services that are used for defense-related purposes, as such term is used in the International Traffic in Arms Regulations ("ITAR").³ The U.S. government's (USG") policy rationale for selling defense articles, the applicable statutory and regulatory regimes, and the practical realities associated with sales of defense articles to foreign persons, all support modifying the final regulations to explicitly provide that if a defense article is sold to a foreign person, it is presumed that such defense article has a foreign use for purposes of FDII.

The Arms Export Control Act of 1976 (AECA") was enacted, in part, to further the United States national security interests around the world and clearly provides that defense articles may only be sold to strategic partners of the United States who intend to use such articles for internal security, self-defense, and similarly permitted purposes.⁴ End-use monitoring for defense articles that are sold pursuant to the AECA, as well as complementary regulatory regimes, such as the ITAR and Treasury's Office of Foreign Assets Control (OFAC"), proscribe the sale to or use of defense articles by hostile state and non-state actors.⁵ Finally, as a practical matter, there are only a limited number of ways for a foreign person to "use" a defense article for its intended purpose within the United States, none of which can be expected to arise in the reasonably foreseeable future (e.g., a hostile military action by a U.S. ally directly against, and within, the United States). In light of the above, Treasury should revise the final regulations to explicitly provide that if a defense article is sold to a foreign person, whether under the AECA or otherwise, its use in the hands of such person is presumed to be a foreign use.

B. Documentation for Military Sales

In response to the Preamble's request for comments on "how taxpayers can demonstrate that a sale or service has been made pursuant to the Arms Export Control Act,"⁶ we recommend that Treasury modify the final regulations to permit taxpayers to use the documentation described below to establish that sales of defense articles and services are made pursuant to the AECA and thus, under the rule proposed above, for a foreign use.

U.S. defense contractors primarily sell defense articles and services to foreign persons through two channels: (i) direct commercial sales ("DCS"), which involve transactions negotiated directly between a U.S. defense contractor and a foreign purchaser; and (ii) foreign military sales ("FMS"), which involve a sale of property or the provision of services to the USG for resale or on-service to a foreign government.⁷ The FMS and DCS processes, including the types of documentation used for purposes of such sales, are described below.

1. Foreign Military Sales

The FMS program is a form of security assistance authorized by the AECA. The FMS process begins with the foreign government customer's submission of a Letter of Request (LOW') to an implementing agency, which serves as a written request for information or a formal purchase offer from the USG. Once the USG, after consultations with the foreign government and potential defense contractors, has determined that the request can be fulfilled, it enters into a Letter of Offer and Acceptance ("LOA") with the foreign government customer, which serves as an official offer on the part of the USG to the foreign purchaser to enter into a binding contract. As described below, Congressional approval may be required. The LOA becomes effective if the foreign government customer signs it and makes the required initial deposit within the specified timeframe. The signed LOA is referred to as an "FMS case and in most cases is assigned a unique case identifier number. The USG and the defense contractor then enter into a contract calling for the defense contractor to provide the goods and services that are the subject of the LOA. In most instances, the U.S. defense contractor does not receive a copy of the LOA, but its contract with the USG references the unique case identifier number.

An FMS case is closed when all of the defense articles and services listed in the LOA have been delivered and/or performance of the contract is complete. The USG documents contract performance through various forms, including Form DD 250 (Material Inspection and Receiving Report). A case is officially closed once Defense Finance and Accounting Services issues a final statement of account to the customer, the Form DD 645 (Foreign Military Sale Billing Statement). Both Form DD 250 and Form DD 645 provide evidence of delivery and/or completion of a U.S. defense contractor's performance obligations under an FMS contract. In addition, defense contractors must submit documentation satisfactory to the Department of State, identifying transactions for which an export license exemption has been claimed as a foreign military sale under the AECA.⁸

In summary, many types of documents may evidence that the USG has purchased property (or a service) for resale (or on-service) to a foreign government under the AECA. However, a single type of document is not available to the taxpayer in all cases and at all relevant points in time. The particular government forms prescribed by the Departments of Defense and of State may also be modified over time. AIA therefore recommends that the final regulations allow taxpayers and the IRS to rely on a non-exclusive list of document types to demonstrate that a transaction constitutes a foreign military sale transaction described in Prop. Treas. Reg. § 1.250(b)-3(c). The list would include, but not be limited to:

The proposed non-exclusive list should resolve the documentation for the substantial majority of foreign military sale transactions, while retaining flexibility to provide appropriate documentation for all qualifying transactions.

Prop. Treas. Reg. § 1.250(b)-3(c) states that "the contracr specifies that the seller/renderer is providing the property or service to the USG for re-sale or on-service to the foreign government end user. For the avoidance of doubt, we request that Prop. Treas. Reg. § 1.250(b)-3(c) be modified to refer to "the contract and/or associated documentation. . . ." As explained above, it is possible that the base contact document itself may not contain the full detail described in Prop. Treas. Reg. § 1.250(b)-3(c), but the taxpayer would nevertheless be able to substantiate that the affected transaction constituted an applicable sale or service. We note that U.S. defense contractors are subject to stringent, non-tax regulatory requirements for all FMS transactions and maintain detailed books and records properly identifying and tracking all such transactions.

2. Direct Commercial Sales

Generally, in a DCS transaction, a foreign buyer contracts directly with a U.S. defense contractor to purchase defense articles or services and neither the USG nor the U.S. military is directly involved with the sale.⁹ Under the ITAR, when a U.S. defense contactor makes a foreign sale of a defense article or service, it must generally apply for and receive an export license (unless an exemption applies). The form used to apply for the export license must identify certain information to the Department of State's satisfaction, including the country of ultimate destination and the end-user for the defense article.¹⁰ Certain "materiar sales of defense articles and services are subject to an additional requirement under the AECA, under which the President submits a certification to Congress and an export license is not issued until Congress completes its review (provided Congress does not object to the proposed sale). Certain sales qualify for an exemption from the export license but, in any event, the U.S. defense contractor must still receive written approval for the sale and, at the time of export, must make an Electronic Export Information filing. Should a taxpayer receive payments under a DCS contract prior to the issuance of an export license or receipt of a written statement, a copy of an application for permanent export (e.g., a Form DSP-5 or Form DSP-85) or a certificate of "non-transfer and use (e.g., Form DSP-83) evidence that the defense articles sold under the relevant contract will be sold for ultimate end-use to a foreign person.

3. Documentation Establishing that a Defense Article Sold Under the AECA Has a Foreign Use

As highlighted above, many types of documents may evidence that a transaction is either a Foreign Military Sale or Direct Commercial Sale pursuant to the AECA. However, there is not a single type of document available to the taxpayer in all cases that would indicate that a transaction occurs pursuant to the AECA. Accordingly, we recommend that Treasury revise the final regulations to provide that a taxpayer may establish that a defense article is sold under the AECA and is for a foreign use by providing a non-exclusive list of documents on which the taxpayer may rely. Such list should include the documentation listed in Prop. Treas. Reg. § 1.250(b)-4(d)(3)(i) (including documentation of shipment under Prop. Treas. Reg. § 1.250(b)-4(d)(3)(i), even if the relevant defense article would otherwise constitute international transportation property) as well as the following types of documentation that are currently and typically prepared in the DCS or FMS process:

C. On Commercial Terms

Proposed Treasury Regulations section 1.250(b)-3(c) provides, in part, that with respect to an FMS transaction, in order for such sale to qualify as being made to a foreign person, it must be made "on commercial terms." The proposed regulations do not explain what it means for an FMS transaction to be "on commercial terms." We recommend that Treasury remove the phrase "on commercial terms" from Prop. Treas. Reg. § 1.250(b)-3(c) when it finalizes the regulations.

Our recommendation should be adopted, in part, because assuming that "on commercial terms" refers to a standard set of terms used in business transactions generally, case law and IRS guidance identify several non-exhaustive standards that may be applied and it is unclear which of these standards, if any, Treasury intended to apply here.¹¹

Finally, it is our understanding that Treasury's use of the phrase "on commercial terms" may have been intended to distinguish FMS sales from cases in which U.S. defense contractors sell defense articles to the USG, the USG takes beneficial ownership to the property, and then, at a later date, the USG provides such defense articles to a foreign government, perhaps through a foreign assistance initiative. This hypothetical should not arise in a sale that is subject to the FMS rules because the initial sale in the hypothetical — a sale between the U.S. defense contractor and the USG — is not an FMS transaction pursuant to section 1.250(b)-3(c) where the USG "purchases the property or service for resale or on-service . . . to a foreign government" but is instead a sale between two U.S. persons for use by the USG.

For the foregoing reasons, we recommend that Treasury remove the phrase "on commercial terms" from Prop. Treas. Reg. § 1.250(b)-3(c) from the final regulations.

III. International Transportation Property

The Proposed Regulations provide that international transportation property is only for a foreign use if, during the three-year period from the date of its delivery, such property is located outside the United States more than 50 percent of the time and more than 50 percent of the miles traversed by such property are traversed outside the United States (the "50% Time/Miles Test"). For the reasons described below, we respectfully request that Treasury and the IRS, in final regulations, (i) lower the percentage thresholds used for purposes of the 50% Time/Miles Test to 20%; (ii) make the 50% Time/Miles Test disjunctive; and (iii) provide a rebuttable presumption that any foreign-registered aircraft sold to a foreign person is for a foreign use.

Section 250(b)(5)(A) defines "foreign use for such purposes as "any use, consumption, or disposition which is not within the United States."¹² The word "any" indicates that the modified term should be construed as broadly as possible.¹³ Current precedent illustrates that Congress, on other occasions, has used the unmodified term "use" and a modified form of the term "use" (e.g., "primarily use) in the same statute, signaling it appreciates and intends the distinction between the different forms.¹⁴

Furthermore, the 50% Time/Miles Test clearly leverages language used in other regulations; however, such other regulations were promulgated under a "primary use or "predominant use" standard and therefore the 50% thresholds used therein, although appropriate under a more stringent standard such as "predominant use," are inapplicable in the context of a statutory scheme which provides that "any use" suffices.¹⁵ Thus, we suggest that a 20% threshold would be more appropriate because such a threshold more closely aligns with an "any use test and a 20% threshold is already used in the Proposed Regulations with respect to the "component rule,"¹⁶ suggesting it is appropriate in the FDII context.

In addition, Treasury has historically used a disjunctive test in other regulations, which allowed taxpayers to satisfy the relevant test by establishing that the tested property satisfied either the 50% time requirement or the 50% miles requirement.¹⁷ Thus, the conjunctive test used in the 50% Time/Miles Test is inappropriate because (i) it conflicts with Treasury and the IRS's historical practice of using a disjunctive test for purposes of a transportation-property-specific physical presence test and (ii) a conjunctive test represents a higher threshold to establish foreign use — the threshold for foreign use should be lower when Treasury is interpreting the statutory phrase "any use than when Treasury is interpreting the statutory phrase "predominant use," not higher.

Lastly, at least with respect to commercial aircraft, "cabotage rules" impose such significant limitations on the use of foreign-registered aircraft in the United States that we recommend that the final regulations provide that any aircraft subject to the cabotage rules benefits from a rebuttable presumption that the aircraft is for a foreign use. Foreign persons (e.g., foreign citizens who are not permanent residents of the United States, foreign-registered corporations, or foreign-registered governmental units) are not eligible to register aircraft with the United States,¹⁸ and foreign-registered aircraft are subject to the "cabotage rules," which proscribe such aircraft from traveling between two points within the United States unless the route is part of a through trip on the way to, or coming fi-om, a foreign destination.¹⁹ Thus, as a practical reality, foreign-registered aircraft cannot conduct any significant travel within the United States and a document evidencing foreign-registration of an aircraft sold to a foreign person — e.g., a foreign registration certificate or number — should be sufficient to establish foreign use.²⁰

For the foregoing reasons, we recommend that Treasury revise the final regulations to (i) replace the 50% thresholds in the 50% Times/Miles Test with 20% thresholds; (ii) provide for a disjunctive, not conjunctive, test; and (iii) provide a rebuttable presumption that foreign-registered aircraft that are sold to foreign persons are for a foreign use.

IV. Documentation Reliability Rules

In order for a docurnent to be "reliable within the meaning of Prop. Treas. Reg. § 1.250(b)-3(d), it must, in part, be obtained no earlier than one year before the "date of the sale (the "DOTS Condition). For certain manufactures that execute contracts years in advance of the "date of the sale," this rule eliminates the ability to utilize a binding contract that remains in effect to substantiate foreign person and foreign use. As a binding contract is a reliable source, and in combination with the other documentation reliability rules, it is recommended that Treasury remove this rule in the final regulations. In the alternative, if Treasury chooses to retain the DOTS Condition in the final regulations we recommend that Treasury amend "the date of the sale to be "the date of contract execution."

V. Allocation of Research & Experimental ("R&E") Expenditures

The proposed section 250 regulations address the allocation and apportionment of deductions for purposes of calculating FDII.²¹ In general, AIA supports the application of the rules in Treas. Reg. §§ 1.861-8 through 1.861-14T to the allocation and apportionment of deductions in the context of section 250. In calculating the FDII deduction, the proposed section 250 regulations provide that the rules in Treas. Reg. § 1.861-17 shall apply without the exclusive apportionment rule under Treas. Reg. § 1.861-17(b) to allocated research and experimental ("R&E") expenditures. AIA believes the approach to allocating R&E expenditures in the proposed regulations would not properly measure the intangible income derived from serving foreign markets, particularly for the aerospace and defense industry.

In the aerospace and defense industry, the USG may delay or otherwise regulate the use of certain advanced technologies in foreign markets. The general premise underlying Treas. Reg. § 1.861-17 — that the connection between R&E and any particular revenue steam is speculative and that the gross income derived from successful R&E must bear the cost of unsuccessful R&E — does not consistently extend to foreign market activity of the aerospace and defense industry. Applying Treas. Reg. § 1.861-17s sales or gross income method to allocate R&E expenditures pro rata based on sales or gross income may systematically and inappropriately over-allocate R&E expenditures to gross FDDEI. Therefore, we request that the final regulations prevent this over-allocation by using one of the following approaches: (1) a modified exclusive apportionment approach where, for purposes of Treas. Reg. § 1.861-17(b)(1), R&E is first apportioned exclusively to gross non-FDDEI if more than fifty percent of the R&E is performed in the United States, (2) a rule for certain market-restricted R&E expenditures where the legally-mandated rule in Treas. Reg. § 1.861-17(a)(4) would not apply to appropriately match that expense and income, or (3) an optional books and records method.

Applying a modified exclusive apportionment rule by reference to the geographical location of R&E activities as a proxy for the market in which a product or service is sold for use would address the issue. When issuing Treas. Reg. § 1.861-17, Treasury and the IRS determined that domestic R&E expenses are not proportionally allocable to income derived from foreign markets. To that end, Treasury and IRS expanded the exclusive apportionment rule, with the explanation that research and experimentation performed in the United States is generally most valuable in the U.S. market, and the exploitation of advanced technologies in foreign markets is more likely to be delayed.²² These conclusions were validated by an economic study performed by Treasury.²³ The preamble to the proposed section 250 regulations does not articulate any reason for departing from these principles.²⁴

A rule for certain market-restricted research could apply to situations where the laws of the United States, such as export controls, limit the realization of income from certain research activities to the market in which the research is performed but where the legally-mandated rule would not otherwise apply. The R&E expenditures are not reasonably anticipated to generate amounts of gross income outside of the jurisdiction imposing the legal or contractual restrictions. Under these circumstances, the policy justifications for allocating certain research expenditures to the relevant market are the same as those underlying the existing legally-mandated rule.

A books and records approach could also be used to allocate R&E expenditures by taxpayers who are subject to extensive regulation and oversight by other government agencies with respect to contract pricing and costs under the Federal Acquisition Regulations and Cost Accounting Standards. Adopting this method would provide taxpayers and the IRS with a precise means of ensuring that there is a clear, direct, and factual relationship between the expenditures and the gross income.

We understand that Treasury and the IRS are undertaking a broader review of Treas. Reg. § 1.861-17 in light of tax reform and other developments in the tax law since those rules were originally promulgated. If Treasury and the IRS do not incorporate any of the above suggestions to the final section 250 regulations, we request that Treasury and the IRS reserve on the allocation of R&E expenditures and consider our recommendations in connection with potential modifications of Treas. Reg. § 1.861-17.

VI. Property Services and Temporarily Imported Property

Treasury and the IRS requested comments on whether to apply the FDII deduction to services with respect to property temporarily located in the United States for maintenance, repair, or similar services.²⁵ We request that the final regulations provide that FDDEI services include maintenance, repair, or similar services performed with respect to property that is temporarily located in the United States if, after the completion of such services, the property is used outside of the United States, defined by reference to Prop. Treas. Reg. § 1.250(b)-4(d)(2).

FDDEI includes DEI derived in connection with "services provided . . . to any person, or with respect to property, not located within the United States."²⁶ Section 250(b)(4)(B) does not define the point in time at which property must be located outside the United States.²⁷ The provision should be interpreted in light of Congressional intent that the FDII deduction apply to intangible income derived "from serving foreign markets."²⁸ Services performed with respect to temporarily imported property benefit the continued foreign use of the property, thereby serving a foreign market. Further, where tangible property, located outside the US, is capable of shipment to international service locations, the market for maintenance, repair, and overhaul services is global.

The requested rule would avoid an unintended mismatch between the taxation of property services when rendered by a domestic corporation compared to a controlled foreign corporation ("CFC") where both result in income derived from serving foreign markets. If property (located and used outside the United States) were shipped to a non-U.S. location of a CFC for service, the U.S. shareholder of that CFC would be entitled to the GILTI deduction for the associated intangible income. Under the proposed regulations, if the property were instead shipped to a U.S. location of a domestic corporation, the intangible income derived would not qualify for the FDII deduction. If the property were shipped to a foreign location of a domestic corporation, in many cases the resulting income would be excluded from FDII as foreign branch income.²⁹ Without adjustment, the proposed regulations would therefore incentivize taxpayers to serve this type of foreign market through CFCs.

VII. Location of Business Recipient of General Services

Under the proposed regulations, the provision of a general service to a business recipient located outside the United States is a FDDEI service.³⁰ General services are provided to a business recipient located outside the United States to the extent that gross income derived by the renderer is allocated to the business recipient's operations outside the United States.³¹ The location of the business recipient's operations is not determined based on its "location of residence, incorporation, or formation[.]"³² Instead, for this purpose, "a business recipient is treated as having operations in any location where it maintains an office or other fixed place of business."³³ We request that Treasury and the IRS clarify the proposed rule to confirm that business operations that occur outside the United States, but which are mobile in nature, constitute "operations of the business recipient that are located outside the United States."

For example, business recipients may operate commercial satellites in specific orbital slots. Domestic corporations may remotely perform general services, such as tracking, telemetry, and control that are allocable to such spacecraft. Similarly, business recipients may operate vessels in locations outside U.S. territorial waters. Domestic corporations may remotely perform general services, including engineering and technical support, that are allocable to such vessels. In each case, the general services confer a benefit on the activity of a business recipient that is conducted exclusively outside the United States, and the services are appropriately treated as "services provided by the taxpayer . . . to any person . . . not located within the United States."³⁴

This treatment furthers the legislative purpose of the section 250 deduction "to help neutralize the role that tax considerations play when a domestic corporation chooses the location of intangible income attributable to foreign-market activity[.]"³⁵ If the remote services described above were conducted from a non-U.S. location by a CFC, the U.S. shareholder would be entitled to the GILTI deduction under section 250(a)(1)(B).³⁶

We request that the final regulations specify that a service is provided to a business recipient located outside the United States to the extent that the service is not provided to a business recipient located within the United States.³⁷ Adopting this residual approach would properly characterize non-U.S. business activity of a mobile nature. Alternatively, Prop. Treas. Reg. § 1.250(b)-5(e)(2)(ii) could be supplemented to specify that regular and continuous operations in outer space, the ocean, and international airspace are treated as operations outside the United States.

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Thank you for your consideration of these comments. If you need further information on these issues, please contact Ms. Kathryn Verona, AIA Legislative Affairs, at (703) 358-1000 or Kathryn.verona@aia-aero space. org.

Respectfully submitted,

Remy Nathan
Vice President, International Affairs
Aerospace Industries Association
Arlington, VA