United Airlines Seeks Revisions to FDII Rules

May 2, 2019

CC:PA:LPD:PR (REG-104464-18)
Room 5203
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, DC 20444

Re: Guidance Regarding Foreign-Derived Intangible Income Deduction

Dear Sirs and Madams:

On September 4, 2018, United Airlines, Inc. ("United") submitted a letter requesting guidance to determine the amount of the deduction provided by section 250 for a portion of a domestic corporation's foreign-derived intangible income ("FDII").¹ That letter identified certain ambiguities in the statute and requested guidance with respect to some of section 250's core concepts.

The proposed regulations published in the Federal Register on March 6, 2019 (the "Proposed Regulations") provided helpful clarity on many of these statutory ambiguities, including the question of how to determine the extent of foreign-derived deduction eligible income ("FDDEI") earned from the provision of "transportation services" that have an origin or destination (but not both) outside the United States ("cross-border transportation services"). United Airlines, Inc. ("United") appreciates that the Treasury Department ("Treasury") and the Internal Revenue Service ("IRS") recognized that the transportation industry often requires rules specific to its mobile nature. However, United is concerned that the transportation services rules set forth in the Proposed Regulations would not be appropriate and would provide renderers of cross-border transportation services with disparate treatment compared to taxpayers in other industries.

United respectfully requests that Treasury and the IRS consider the recommendations summarized immediately below, and discussed in more detail throughout the remainder of this letter, when drafting and issuing final regulations under section 250 (the "Final Regulations"):

• Confirm that intermediate domestic stops (i.e., domestic layovers) are disregarded for purposes of determining the origin and destination of a transportation service.

• Replace the rule in the Proposed Regulations treating 50 percent of the income from cross-border transportation services as gross FDDEI with one of the following methods:

  (1) Policy-based method: All income from providing a transportation service with an origin or destination outside the United States is treated as FDDEI, under a policy-based reading of section 250(b)(4)(B) and the legislative history.

  (2) Annual elective method: Domestic corporations make an annual election to apply any one of the following methods:

  (i) a comparative mileage method, pursuant to which income from providing a cross-border transportation service is treated as FDDEI in the same proportion as mileage without the United States bears to total trip mileage;²

  (ii) a predominant location cliff method, pursuant to which (A) all income from providing a cross-border transportation service is treated as FDDEI if a taxpayer can demonstrate that more than 50 percent of such services are provided to a person, or with respect to property, located without the United States on a comparative mileage basis, and (B) none of the income from providing such services is treated as FDDEI in instances where the more-than-50-percent predominant location threshold cannot be demonstrated; or

  (iii) a 50:50 split method based on origin and destination, as currently provided in the Proposed Regulations.

  Under this elective method, a domestic corporation could change its election from year to year, but must apply the elected method consistently to all applicable transactions within a given taxable year.³

I. Executive Summary

A domestic corporation calculating the amount of its FDII (against which to apply a 37.5-percent deduction) must first determine, inter alia, the amount of FDDEI that it derives from providing services to persons, or with respect to property, not located within the United States. The statute does not provide a method for determining the location of persons to whom, and/or property with respect to which, a domestic corporation provides a cross-border transportation service. The recently issued Proposed Regulations have clarified certain statutory ambiguities, including rules specific to transportation services (i.e., domestic-to-domestic, foreign-to-foreign, and cross-border transportation services).

The Proposed Regulations state that income from providing a transportation service is (i) 100 percent FDDEI if both the origin and destination are outside the United States, and (ii) 50 percent FDDEI if either the origin or destination (but not both) is outside the United States. United commends Treasury and the IRS for acknowledging the unique nature of transportation services, but nevertheless believes that these rules (i) are not mandated by the statute, (ii) are inconsistent with the policy underlying the FDII deduction, and (iii) would produce unfair treatment for members of the transportation services industries. United therefore suggests alternative methodologies — each consistent with Treasury's rationale for proposing a 50:50 rule — for determining the extent to which income from providing a transportation service is treated as FDDEI.

One potential method (the "policy-based method") would be to treat 100 percent of the income from the provision of a cross-border transportation service as FDDEI. Such an approach would reduce the disparity in the tax treatment of cross-border transportation services provided by domestic versus foreign corporations and, consequently, would correspond with legislative intent to reduce the incentive for domestic corporations to serve foreign markets through foreign subsidiaries.⁴ Such treatment (i.e., as fully FDDEI) also would be: (i) consistent with Treasury's rationale for providing rules specific to transportation services; (ii) easily administrable for taxpayers and the IRS; (iii) equitable among domestic corporations providing cross-border transportation services both within and among industries; and (iv) consistent with analogous provisions that apply when specific income-producing activities involve one or more locations outside the United States (as generally defined).

An alternative and more flexible approach (the "annual election method") would be to permit domestic corporations to make an annual election to apply any one of the following methods:

Under this method, a domestic corporation may change its election from year to year, but must apply the election consistently to all applicable transactions within a given taxable year.

This elective method is administrable and remains mindful to (i) the policies underlying the FDII rules, (ii) the highly mobile nature of the transportation industry, and (iii) Treasury's rationale for providing rules specific to transportation services. In addition, the elective method allows for greater flexibility and promotes consistent treatment among differently situated taxpayers in the transportation services industry.

One statutory ambiguity not explicitly addressed by the Proposed Regulations is whether to disregard intermediate domestic stops for purposes of determining the origin and destination of a transportation service. Such treatment is implied by the reference in the transportation services rules to the origin and destination, but not to one or more intermediate stops, of an instance of transportation services. Moreover, it seems inappropriate (and contrary to Treasury's rationale for providing rules specific to transportation services) for a domestic layover to decrease the amount of FDDEI generated by transporting persons or property from a U.S. origin to a foreign destination (or vice versa).

II. Description of the Relevant Rules

A. Section 250 and the Proposed Regulations

Section 250 permits a domestic corporation to claim an annual deduction equal to the sum of 37.5 percent of its FDII plus 50 percent of its GILTI inclusion,⁵ but limited to the amount of the domestic corporation's taxable income (determined without regard to section 250).⁶ These percentages are calibrated in a manner that reduces the incentive for domestic corporations to consider tax rate differentials when deciding whether to service non-U.S. markets locally or from within the United States.⁷

Under the statute, a domestic corporation's FDII bears the same proportion to its deemed intangible income ("DII") as its FDDEI bears to its deduction eligible income ("DEI").⁸ Thus, FDII/DII = FDDEI/DEI, or, FDII = (FDDEI/DEI) x DII. A domestic corporation calculating its FDII must first calculate each of these other items. DII is DEI less the corporation's deemed tangible income return ("DTIR"), which, in turn, is equal to 10 percent of its qualified business asset investment ("QBAI"), a term defined by cross reference to section 951A(d).⁹ A domestic corporation's DEI is its gross income (determined without regard to certain enumerated excluded items) less the deductions allocable to such income.¹⁰ Lastly, a domestic corporation's FDDEI is the DEI that it derives from either (i) a FDDEI sale or (ii) a FDDEI service.¹¹

Section 250(b)(4)(A) provides that income from the sale of property is treated as FDDEI if such property is sold to a non-U.S. person for a foreign use. Section 250(b)(4)(B) provides that income from the provision of services is treated as FDDEI if provided to any person, or with respect to property, not located within the United States.

The preamble to the Proposed Regulations (the "Preamble") acknowledges that "[s]ection 250 does not prescribe rules for determining whether a person or property is 'not located within the United States.'"¹² The Proposed Regulations provide such rules, which differ based on the type of service provided and, for "general services," on the type of recipient. For these purposes, the Proposed Regulations provide the following definitions and rules:

General service. The term general service means any service other than a property service, proximate service, or transportation service.¹³ A general service provided to a consumer is located according to the consumer's residence when the services are provided.¹⁴ A general service provided to a business recipient is located in the country (or countries) in which the business recipient (or a related person) has an office or fixed place of business that directly benefits from the provision of services.¹⁵

Property service. The term property service means a service, other than a transportation service, provided with respect to tangible property, but only if substantially all of the service is performed at the location of the property and results in physical manipulation of the property such as through assembly, maintenance, or repair. Substantially all of a service is performed at the location of property if the renderer spends more than 80 percent of the time providing the service at or near the location of the property.¹⁶ A property service is located outside the United States if the property is located outside the United States "for the duration of the period the service is performed."¹⁷

Proximate service. The term proximate service means a service, other than a property service or a 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. Substantially all of a service is performed in the physical presence of the recipient or its employees if the renderer spends more than 80 percent of the time providing the service in the physical presence of the recipient or its employees.¹⁸ A proximate service is located outside the United States to the extent the service or a proportionate amount thereof is provided outside the United States.¹⁹

Transportation service. The term transportation service means a service to transport a person or property using aircraft, railroad rolling stock, vessel, motor vehicle, or any similar mode of transportation.²⁰ The location of a transportation service is based on the origin and destination of such service, as follows: income derived from providing a transportation service is (i) 100 percent FDDEI if both the origin and destination are outside the United States, and (ii) 50 percent FDDEI if either the origin or destination (but not both) is outside the United States.²¹

The Preamble provides the following rationale for the Treasury and IRS's decision to provide a set of rules specific to transportation services:

"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. Therefore, the proposed regulations provide that whether a 'transportation service' is provided to a recipient, or with respect to property, located outside the United States is determined based on the origin and destination of the service."²²

Treasury and the IRS recognized that separate rules are necessary to account for the special nature of transportation property,²³ and therefore included in the Proposed Regulations rules specific to sales of transportation property and rules specific to the provision of transportation services.²⁴ For sales of transportation property, the Proposed Regulations provide a predominant location cliff methodology for determining whether sales of transportation property are sales for a foreign use (and thus, potentially qualify as FDDEI if also sold to a foreign person). Specifically, "such property is sold for a foreign use only if, during the three year period from the date of delivery, the property is located outside the United States more than 50 percent of the time and more than 50 percent of the miles traversed in the use of the property are traversed outside the United States."²⁵

B. Issues with Treatment of Cross-Border Transportation Services

The rationale noted immediately above supports Treasury's and the IRS's decision to provide rules specific to transportation services. The 50:50 method set forth in the Proposed Regulations, however, is not the only method consistent with such stated rationale, and the Preamble does not explain why the proposed regulations did not adopt any other method consistent with such rationale. United recognizes that treating all instances of cross-border transportation services as 50% FDDEI, similar to the 50:50 transportation income sourcing rules under section 863(c), is an administrable methodology,²⁶ but it is not the only administrable method, and mandating such method can produce unfair results.

As described above, the Proposed Regulations divide services into five categories. If Treasury did not provide a rule specific to transportation services, such services (at least with respect to transportation of persons) likely would meet the definition of a proximate service.²⁷ The Proposed Regulations provide that proximate services are provided to recipients located outside the United States, and income from such services is thus eligible for FDDEI treatment, "if the proximate service is performed outside the United States."²⁸

Importantly, the proximate service rule provides for proportionate FDDEI treatment in the event a proximate service is performed partly within the United States and partly outside the United States. The proportionate amount of income treated as FDDEI is based on the portion of time the renderer spends providing the service outside the United States.²⁹ Thus, for example, if the transportation service rules mirrored the proximate service rules, a cross-border transportation service that occurs 99 percent outside the United States would result in 99 percent FDDEI. The transportation services rule applied to the same service, however, would result in only 50 percent FDDEI.³⁰ On the other hand, such a transaction (assuming the 99 percent of time and mileage was over a three-year period) would result in 100-percent FDDEI treatment under the rules for sales of transportation property.

The shortcomings of the Proposed Regulations methodology for transportation services are particularly impactful when applied to a taxpayer in a capital-intensive business (e.g., cross-border transportation services), whose relatively higher amounts of QBAI produce relatively lower (deemed) amounts of intangible income that qualify for the preferential rate of tax. Such taxpayers would, inversely, have relatively higher (deemed) amounts of tangible income with respect to which there remains a tax disparity depending on whether that income is earned domestically or abroad (i.e., 21% if earned in the United States as opposed to potentially no U.S. tax when earned by a foreign subsidiary). Therefore, particularly in capital-intensive cases, failure to provide tax parity vs GILTI on the intangible income preserves to a greater extent the disparity that exists with respect to the taxation of the tangible income return (and provides less incentive to service foreign markets directly rather than through a foreign subsidiary).

III. Determining FDDEI for Cross-Border Transportation Services

A. Potential Methodologies for Determining the FDDEI Portion of Income Received for Cross-Border Transportation Services

As described above, the Proposed Regulations adopt a methodology that determines FDDEI for transportation services by looking solely to the service's origin and destination. This method could provide unfair results when compared to the rule for proximate services, which receive proportionate FDDEI treatment based on the amount of the service occurring outside the United States, and sales of transportation property, which receive full FDDEI treatment if the 50-percent threshold is met. Further, due to the capital-intensive nature of businesses that provide transportation services, automatically losing FDDEI treatment for 50 percent of the income (from the provision of a cross-border transportation service) materially reduces any potential FDII benefit.

United therefore proposes that the Final Regulations adopt either of the following two methods — each administrable, equitable, consistent with the statute and underlying policy, and consistent with Treasury and the IRS's rationale for providing rules specific to transportation services — for determining the extent to which income derived from the provision of cross-border transportation services is treated as FDDEI: (1) a policy-based method that applies full FDDEI treatment to income derived from transportation services that have a foreign origin or destination; or (2) a method that allows domestic corporations to make an annual election to apply a comparative mileage method, a predominant location cliff method, or a 50:50 split method.

i. Policy-Based Method

(a) Description of Policy-Based Method

As enacted, section 250 provides that FDDEI includes all deduction eligible income (DEI) derived from, in part, "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). This language does not expressly require the person or property to be located without the United States at all times while the service is being provided, nor does it make any reference to the U.S.-to-foreign ratio of any cross-border services. Instead, it could be read to require only that such person or property be located without the United States at some point (rather than for both the origin and destination) during which such services are provided (e.g., during a foreign departure or arrival) and that the services be performed as a result of servicing a foreign market. Under this policy-based method of testing cross-border transportation services income, all of the income received for a trip that originates or concludes outside the United States would qualify as FDDEI.

Such policy-based method would be (i) consistent with legislative intent; (ii) consistent with Treasury's rationale for providing rules specific to transportation services; (iii) easily administrable for taxpayers and the IRS; (iv) equitable among domestic corporations providing cross-border transportation services to and from different domestic and foreign locations; and (v) consistent with analogous provisions that apply when specific income-producing activities involve one or more locations outside the United States.

(b) Support for Policy-Based Method

Consistent with legislative intent: As noted above, Congress intended to create better tax parity for domestic corporations choosing whether to service foreign markets directly or through a foreign subsidiary.³¹ The policy-based reading set forth immediately above advances this legislative goal by allowing domestic corporations to deduct a portion of their income received for providing cross-border transportation services that serve foreign markets.³² As stated by the Senate, "[t]he Committee believes that offering similar [to GILTI], preferential rates for intangible income derived from serving foreign markets . . . reduces or eliminates the tax incentive to locate or move intangible income abroad."³³ This deduction, in effect, lowers the domestic corporation's tax rate on its FDII (13.125 percent) to the same rate as the break-even GILTI rate for foreign taxes (i.e., the rate at which GILTI can be taxed in a foreign jurisdiction that would result in sufficient FTCs to eliminate any residual U.S. tax on GILTI).³⁴

Domestic corporations in cross-border transportation service industries, including the airline industry, service foreign markets by providing transportation (e.g., by operating flights) that have either an origin or destination in a foreign country. Congress did not include any language in either section 250 or the legislative history thereto that indicates an intent to limit the FDII deduction when applied with respect to foreign market services when provided from the United States. Given this focus on providing services to foreign markets, it would be consistent with underlying policy to include in FDDEI the full amount received for providing such services, even if — as is generally required for flights or other cross-border transportation services that interface with a foreign market — a portion of the services is provided while the person is within the United States (e.g., a domestic arrival bringing passengers traveling from a foreign market).³⁵

Consistent with Treasury and IRS rationale: In contrast to a residence-based method, this policy-based method provides consistent results with respect to similar services — i.e., the same treatment applies with respect to the provision of such service to all passengers, regardless of their respective countries of residence. In addition, this policy based method results in consistent treatment of similar services provided to persons or with respect to property.

Easily administrable: A domestic corporation (and the IRS) would need to look only to whether there is a non-U.S. origin or destination to determine the extent to which income derived from providing that instance of cross-border transportation services qualifies as FDDEI. Eliminating the need for computations (and, e.g., mileage tracking) would result in a test that would be easy to apply, presumably resulting in both high levels of compliance and minimization of the number of disputes between taxpayers and the IRS.

Equitable among domestic corporations providing cross-border transportation services to and from different domestic and foreign locations: Applying this policy-based method would provide equal treatment for companies providing cross-border transportation services, and would avoid favoring certain U.S. and foreign locations, by treating all cross-border transportation services with a foreign origin or destination uniformly, regardless of the locations distance from the U.S. border.³⁶ For example, transportation providers on the East Coast would not receive favorable treatment as compared to transportation providers on the West Coast when serving European markets, and a Southwest provider would not be favored over a Northeast provider when servicing Central and South American markets.

Consistent with analogous provisions: There is precedent for a policy-based rule to designate as foreign 100 percent of the income derived from an activity that involves a non-U.S. location (e.g., air transportation services on a flight that departs from or arrives at a non-U.S. location). This precedent typically assigns a foreign or international designation to income derived from an activity that involves a non-U.S. location, without regard to, e.g., the amount of time, mileage, or costs spent inside the United States.

For example, for purposes of identifying activities that generate income excluded under the section 883 reciprocal exemption, "the term international operation of ships or aircraft means the operation of ships or aircraft . . . with respect to the carriage of passengers or cargo on voyages or flights that begin or end in the United States. . . ."³⁷ Similarly, for purposes of identifying the activities to which the tonnage tax rules apply (including activities generating income excluded under section 1357(a)), section 1355(a)(7) defines "United States foreign trade as "the transportation of goods or passengers between a place in the United States and a foreign place or between foreign places."³⁸

Treaty provisions currently in effect similarly support this interpretation. For example, Article 3(i)(f) of the U.S.-U.K. income tax treaty defines the term "international traffic to mean "any transport by a ship or aircraft, except when the ship or aircraft is operated solely between places in the other Contracting State."³⁹ The U.S.-U.K. Treaty then provides, in Article 8(1), that "[p]rofits of an enterprise of a Contracting State from the operation of ships or aircraft in international traffic shall be taxable only in that State."⁴⁰

ii. Annual Election Method

Alternatively, if Treasury and the IRS determine that 100-percent designation as FDDEI is not appropriate for every cross-border transportation service that serves a non-U.S. location, a method that allows domestic corporations to make an annual election between a comparative mileage method, a predominant location cliff method, and a 50:50 method would be (i) consistent with legislative intent; (ii) consistent with Treasury's rationale for providing rules specific to transportation services; (iii) easily administrable for taxpayers and the IRS; and (iv) equitable among domestic corporations providing cross-border transportation services to and from different domestic and foreign locations.

(a) Description of each separate elective method

Comparative Mileage Method: Under this method, the amount of income treated as FDDEI would be proportionate to the percentage of miles traveled outside the United States as compared to the trip's total miles.⁴¹

Predominant Location Cliff Method: Under this methodology, (1) all income from providing a cross-border transportation service is treated as FDDEI if 50 percent or more of such service is provided to a person, or with respect to property, located without the United States on a comparative mileage basis; and (2) none of the income from providing such services is treated as FDDEI if less than 50 percent of such services are provided to a person, or with respect to property, located without the United States on a comparative mileage basis.⁴²

50:50 Method: Under this method, income derived from providing a transportation service is (1) 100-percent FDDEI if both the origin and destination are outside the United States, and (2) 50-percent FDDEI if either the origin or destination (but not both) is outside the United States.

(b) Support for the elective method

While not as straightforward as the policy-based method, the annual elective method would afford domestic corporations the option annually to elect among a method that requires detailed tracking and two alternative methods that are more administrable, particularly for domestic corporations that lack access to mileage tracking information.

Consistent with legislative intent: Similar to the policy-based method described above, the elective method provides taxpayers with an opportunity to pay the same effective tax rate on income for services provided from the United States (and treated as FDII) or through foreign corporations (and treated as GILTI). If taxpayers do not elect to use the predominant location cliff method, they still could treat a portion of the income received from providing cross-border services as FDDEI by electing either the comparative mileage or 50:50 method. If taxpayers do not elect the comparative mileage method, potentially because they lack the ability to track their individual services with such specificity, they still could treat 50 percent of the income from the provision of a cross-border service as FDDEI.

As described above, the intent behind the section 250 deduction is, in part, to remove tax considerations from the decision-making process of whether to serve foreign markets from the United States or through foreign corporations. Allowing taxpayers the potential to create parity is essential to achieving this goal, and the elective method provides taxpayers with such opportunity (i.e, if they have the ability to establish that the predominant location cliff method test is met).

Consistent with Treasury and IRS rationale: The elective method is consistent with the Treasury and IRS rationale for providing rules specific to transportation services. United recognizes that use of a predominant location cliff method may treat two providers of transportation services differently, depending on which foreign markets they serve and from where in the United States they operate. For this reason, in part, United does not recommend that either a predominant location cliff method or a comparative mileage method be used as a stand-alone method; rather, either should be used as part of the elective method.⁴³ Importantly, this method provides these taxpayers with the option to elect 50:50 treatment, which puts them in the same position as the current rule provided in the Proposed Regulations.

Easily administrable: The predominant location cliff method would allow taxpayers effectively to apply the regime even in cases where they do not have sufficiently specific tracking information to use a mileage approach but nevertheless are able to identify cases in which the predominant location is outside the United States. In the event a taxpayer does not have the ability to meaningfully identify such cases, such taxpayer could elect to apply the easily administrable 50:50 split method, which only requires knowledge of the origin and destination of each trip.

Equitable among domestic corporations providing cross-border transportation services to and from different domestic and foreign locations: This approach recognizes that not all domestic corporations may be similarly situated and that many do not have the ability to perform the detailed calculations required by a comparative mileage method. This option provides some benefit to taxpayers that may not have access to the detailed mileage tracking data necessary to demonstrate that the more-than-50-percent threshold is met. In this regard, it seems inappropriately harsh to fully deny FDII benefits for a domestic corporation that provides cross-border transportation services but does not have access to mileage tracking information, particularly in light of the statutory language and underlying policy (both of which support the provision of an FDDEI benefit for services provided to persons located outside the United States).

Consistent with analogous provisions: A comparative mileage method would be consistent with both the proximate services rules described above and other analogous authorities that provide for pro rata treatment based on the proportion in which the rule is satisfied.⁴⁴

Precedent exists for adopting a predominant location cliff method, including its use in the Proposed Regulations with respect to the determination of foreign use of international transportation property.⁴⁵ A predominant location method also is included in the provisions of the subpart F regulations that provide for active rent exceptions to foreign personal holding company income,⁴⁶ one of which is certain rental income related to "aircraft or vessels leased in foreign commerce."⁴⁷ The subpart F regulations explain that "an aircraft or vessel is considered to be leased in foreign commerce if the aircraft or vessel is used in foreign commerce and is used predominantly outside the United States."⁴⁸

The predominant location cliff method has existing analogs in current law, including provisions that adopt a cliff approach for purposes of determining whether property is predominantly located without the United States. For example, regulations promulgated under former section 927 used a 50-percent threshold for determining whether an aircraft or other property used for transportation services should be deemed to be used predominantly outside the United States.⁴⁹

The 50:50 split method incorporates the sole methodology currently provided for in the Proposed Regulations and is analogous to section 863(c), which treats income from cross-border transportation services as being 50 percent from U.S. sources and 50 percent from foreign sources.

(c) The elective methods should not be utilized as stand-alone methods

Although United recommends consideration of a comparative mileage method, a predominant location cliff method, and a 50:50 split method as potential elective options, United does not believe it is appropriate to adopt any of these alternative methods as a stand-alone method. The primary advantage of the comparative mileage method is accuracy, although this method would not be administrable for taxpayers that do not have access to detailed mileage tracking information. The primary advantage of each of the predominant location cliff method and the 50:50 split method is administrability; it seems unnecessarily arbitrary to require a taxpayer to adopt these methods if it has access to detailed mileage tracking information (making such method administrable for that taxpayer) and would prefer using the more precise comparative mileage method. Eliminating comparative mileage as an elective alternative in favor of a stand-alone predominant location cliff method would seem particularly inappropriate in that it would deny any FDDEI benefit to cross-border transportation service providers that cannot establish a predominant location outside of the United States, due to either lack of empirical information or due to the percentage of mileage traversed outside the United States (e.g., transportation to or from Canada or Mexico could be completely ineligible for FDII under this method in many cases).

B. What Income Should be Tested as Potential FDDEI

DEI is defined in section 250(b)(3) as a corporation's gross income (excluding any subpart F, GILTL foreign branch, financial services, or domestic oil and gas extraction income and any dividends received from CFCs) less deductions allocable to such gross income. For service companies, FDDEI is the portion of such DEI derived in connection with "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."⁵⁰

The Proposed Regulations use an origin and destination test to determine FDDEI for transportation services, but do not define these terms. Because transportation services, such as flights or trips by train, often have intermediate stops, clarification in the Final Regulations is needed to address what income may qualify as FDDEI in such situations.

Considering that DEI includes all income (less certain exclusions unrelated to location), it follows that all income from transportation services with either an origin or final destination outside the United States, including those with a domestic stop or layover, should be tested as potential FDDEI. As discussed below, existing Code sections and related commentary generally view transportation services as being provided to passengers.

In order to accurately determine FDDEI, income from providing cross-border transportation services should be tested on a passenger-by-passenger or cargo-by-cargo basis (since, for example, different passengers or shipments may have different origins or destinations due to layovers) and should include the income relating to a passenger's or shipments entire travel itinerary rather than solely the portion of the income relating to the international portion of such travel. For example, an airline passenger whose trip originates in El Paso, TX, has a six-hour layover in Chicago, IL, and ends in Quebec City, should be tested separately from a passenger whose trip only includes the Chicago to Quebec City flight. Both passengers have an origin in the United States and a destination outside the United States; however, it would be inappropriate to treat them as having taken the same trip.

This approach finds support in the Code and regulations. For purposes of the section 883 reciprocal exemption, the regulations clarify that (i) "whether income is derived from international operation of ships or aircraft is determined on a passenger by passenger basis,"⁵¹ and "income derived from the carriage of a passenger will be income from international operation of ships or aircraft if the passenger is carried between a beginning point in the United States and an ending point outside the United States, or vice versa."⁵² The section 883 regulations then clarify that, "[c]arriage of a passenger will be treated as ending at the passenger's final destination even if en route to the passenger's final destination, a stop is made at an intermediate point . . .".⁵³ Similarly, the 1984 Blue Book, in describing the section 904 income sourcing rules, makes clear that "transportation of persons will not be considered to begin and end in the United States when it involves transportation from one U.S. point to an intermediate U.S. point . . . en route to the persons destination in a foreign country provided . . . the persons do not change aircraft or vessels at the U.S. intermediate point."⁵⁴

The excise tax regime also provides support for disregarding an intermediate domestic stop (i.e., a domestic layover). Generally, an excise tax is imposed on the amount paid by a passenger for aircraft transportation.⁵⁵ An additional excise tax is imposed for each "domestic segment" of taxable air transportation (i.e., segments wholly within the United States).⁵⁶ However, these domestic air passenger excise taxes do not apply to domestic segments that are part of uninterrupted international air transportation."⁵⁷ Uninterrupted international air transportation includes air transportation that does not have both an origin and final destination in the United States and during which there is no more than a 12-hour scheduled period between arrival at and departure from an intermediate point in the United States.⁵⁸ Therefore, any layover at an intermediate U.S. point is disregarded for purposes of the domestic air passenger excise tax as long as the layover is no more than 12 hours.

For the above reasons, it would seem appropriate that the Final Regulations clarify that all income from transportation services with either an origin or destination outside the United States, including those with a domestic stop or layover, be tested as potential FDDEI.

V. Conclusion

Ambiguity in the statutory rules for FDII calls for guidance regarding the application of the FDII deduction. The Proposed Regulations provided significant guidance and much-needed clarification with respect to many issues and statutory ambiguities relating to the determination of the amount of the section 250 deduction, including FDDEI determinations. At the same time, certain questions remain.

United requests that the Final Regulations confirm that, for purposes of determining the destination of a transportation service, intermediate stops are disregarded. Further, while United commends Treasury and the IRS's recognition that the transportation industry is unique and often requires special rules specific to its mobile nature, United believes the Proposed Regulations treatment of transportation services would be inequitable to businesses that operate in this industry and respectfully requests the transportation services rules set forth in the Proposed Regulations be revised in accordance with the recommendations in this letter.

Potential methods (for determining the FDDEI treatment of cross-border transportation services) that we have identified as equitable, administrable, and consistent with the statute, legislative intent, and Treasury's and the IRS's rationale regarding transportation services are: (1) a policy-based method that supports full inclusion of all income related to cross-border services provided to passengers as long as such services have a foreign origin or destination; and (2) an elective method, under which taxpayers must make an annual election to determine the amount of FDDEI received from a service using either (a) a comparative mileage method, (b) a predominant location cliff method, or (c) a 50:50 split.

* * * * *

We appreciate your consideration of our recommendations detailed above and welcome the opportunity to discuss any questions you may have. We believe that the Final Regulations' treatment of cross-border transportation services in one of the manners discussed above would be very helpful to taxpayers and the IRS in applying section 250 in an administrable, efficient, and manageable way while remaining equitable across industries.

Respectfully submitted,

Tim Tamer,
United Airlines, Inc.
Chicago, IL

CC:
Mr. Lafyette "Chip" G. Harter III, Deputy Assistant Secretary (International Tax Affairs), U.S. Department of the Treasury

Mr. Douglas L. Poms, International Tax Counsel, U.S. Department of the Treasury

Mr. Peter Blessing, Associate Chief Counsel (International), Internal Revenue Service

Ms. Margaret "Peg" O'Connor, [Acting/Deputy] Associate Chief Counsel (International), Internal Revenue Service

Mr. Brian Jenn, Deputy International Tax Counsel, U.S. Department of the Treasury

Mr. Daniel McCall, Deputy Associate Chief Counsel (International-Technical), Internal Revenue Service

Mr. John Merrick, Senior Special Counsel to the Associate Chief Counsel (International), Internal Revenue Service

Gary Scanlon, Attorney-Advisor, U.S. Department of the Treasury

Mr. Jeffery G. Mitchell, Branch 2 Chief (International), Internal Revenue Service

Mr. Christopher Bello, Branch 6 Chief (International), Internal Revenue Service

Mr. Joseph Dewald, Senior Technical Reviewer, Branch 6, Internal Revenue Service

Mr. Jason Yen, Attorney Advisor, Office of International Tax Counsel, U.S. Department of the Treasury

Ms. Carol Tan, Special Counsel to the Associate Chief Counsel (International), Internal Revenue Service

Mr. Kenneth Jeruchim, Attorney Advisor, Branch 6, Internal Revenue Service