Firm Raises Transportation Property Concerns Under FDII, GILTI Regs

May 3, 2019

Office of Associate Chief Counsel (International)
Attention: Kenneth Jeruchim
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC, 20224

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 Section 250 Proposed Regulations

Dear Mr. Jeruchim:

McDermott Will & Emery LLP appreciates the opportunity to comment on the proposed section 250 regulations published in the Federal Register on March 6, 2019, 84 Fed. Reg. 8188 (the "Proposed Regulations") providing guidance with respect to the application of the deduction for foreign-derived intangible income ("FDIr) under section 250. We respectfully submit this letter requesting the Department of Treasury and the Internal Revenue Service to revise the Proposed Regulations to address several concerns that arise in the context of international transportation property, including international transportation property sold for private use.

I. Executive Summary

Based on the discussion below, we respectfully request that the final regulations:

II. Background

This Part I provides general background information with respect to the FDII deduction provided under section 250 and the Proposed Regulations.

A. Section 250 Deduction for HMI

Section 250 was enacted to provide reduced rates of tax with respect to certain types of income including FDII. As described in more detail below, FDII generally results from sales of property or services by domestic corporations to foreign persons.

FDII is determined with a four-step calculation. The first step in the overall calculation is to determine deduction eligible income ("DEr).¹ A domestic corporation's gross income is determined and then reduced by certain income items.² These amounts include amounts included in income under Subpart F, dividends received from controlled foreign corporations, and income earned in foreign branches.³ The domestic corporation's reduced gross income is further reduced by deductions (including taxes) properly allocable to such income.⁴

The second step is to determine the foreign-derived deduction eligible income ("FDDEV) amount.⁵ This amount includes any income derived from the sale of property to any person who is not a United States person for a foreign use.⁶ The term "sale is defined for this purpose to include any lease, license, exchange or other disposition.⁷ The term "foreign use" is defined to mean "any use, consumption, or disposition which is not within the United States."⁸ The FDDEI amount also includes income derived in connection with services provided to any person not located within the United States, or with respect to property not located in the United States.⁹ Lastly, the FDDEI amount is calculated by reducing gross foreign sales and services income by expenses properly allocated to such income. FDDEI does not include income derived from the sale of property to a domestic intermediary for further manufacture or other modification within the United States even if such other person subsequently uses such property for a foreign use.¹⁰

The third step is to determine the deemed intangible income ("DII") amount. DII is the excess (if any) of the corporation's DEI over 10% of its qualified business asset investment ("QBAI").¹¹ A domestic corporation's QBAI is the average of its adjusted bases (using a quarterly measuring convention) in depreciable tangible property used in the corporation's trade or business to generate the DEL¹² The adjusted bases are determined using straight line depreciation. A domestic corporation's QBAI does not include land, intangible property or any assets that do not produce DEL

The fourth and final step is to determine the proportion of DII that is foreign derived by multiplying DII by the quotient of FDDEI and DEL

Overall, the FDII calculation is expressed by the following formula:

FDII = Deemed Intangible Income x	Foreign-Derived Deduction Eligible Income
	Deduction Eligible Income

B. The Proposed Regulations

The Proposed Regulations provide guidance with respect to the application of section 250. Summarized below are aspects of the Proposed Regulations that are relevant to these comments. In particular, the Proposed Regulations provide (1) documentation rules for establishing a "foreign use," (2) service rules for determining whether a service is rendered for a "foreign use," and (3) related party rules for determining whether a property sold to a foreign related party is treated as sold for a "foreign use."

1. Documentation Rules

As discussed above, FDDEI includes any income derived from the sale of property to any person who is not a United States person for a foreign use (a "FDDEI sale"). Prop. Reg. § 1.250(b)-4 provides rules for determining whether a sale of property qualifies as a FDDEI sale. In addition, it requires that a taxpayer claiming a FDII deduction provide documentation establishing that (i) the property is sold to a foreign person and (ii) the property is sold for a foreign use (the "Documentation Rules").¹³

The term "foreign persoe generally means a person that is not a United States person.¹⁴ In general, a taxpayer may establish the recipient's foreign status by obtaining one of the listed documents from the recipient, including a written statement that the recipient is a foreign person, documentation that the recipient is an entity organized under the laws of a foreign jurisdiction, valid identification issued by a foreign government or agency, or other documents filed with a government or agency indicating the foreign jurisdiction of the entity or residence.¹⁵

Prop. Reg. § 1.250(b)-4(d) provides guidance on the documentation for purposes of establishing a "foreign use" of general property sold to a foreign person. The term "general property is generally defined as any property other than intangible property, a security, or a commodity.¹⁶ A sale of general property is for foreign use if (i) the property is not subject to a domestic use within three years of the date of delivery or (ii) the property is subject to manufacture, assembly, or other processing outside the United States before the property is subject to a domestic use.¹⁷ An item of general property is subject to domestic use if it is subject to any use, consumption, manufacture, assembly, or other disposition or processing within the United States.¹⁸ Prop. Reg. § 1.250(b)-4(d) further provides a special rule for transportation property (the "Transportation Property Rule). Under the special rule, if a property "provides a mode of transportation and is capable of traveling internationally (international transportation property), such property is 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."¹⁹

Under Prop. Reg. § 1.250(b)-4(d), a taxpayer may establish a foreign use by one of the following types of documentation:

Exceptions may apply to exempt certain small business or small transactions from the documentation requirements.²¹

Accordingly, if a taxpayer sells international transportation property such as an aircraft to a foreign person for a foreign use, to claim a FDII deduction with respect to the sale, the taxpayer must establish the foreign use by either obtaining a written statement from the recipient or entering into a binding contract with the recipient that within three years from the date of delivery, the property will be located outside the United States for more than 50 percent of the time and will traverse more than 50 percent of its miles outside the United States.

The Documentation Rules are generally applicable to taxable years ending on or after March 4, 2019. However, because taxpayers may not be able to obtain documentation for transactions completed before the issuance of the Proposed Regulations, for taxable years beginning on or before March 4, 2019, taxpayers may use any reasonable documentation maintained in the ordinary course of the taxpayer's business to establish that the property is sold to a foreign person for a foreign use (the "Grandfathering RuIC).²² Reasonable documentation includes, but is not limited to, documents described in or similar to those required under the Documentation Rules.²³

2. Service Rules

The FDDEI amount includes income derived in connection with services provided to any person not located within the United States, or with respect to property not located in the United States ("FDDEI services").²⁴ Prop. Reg. § 1.250(b)-5 provides rules for determining whether a service constitutes a FDDEI service for purposes of section 250.

Under Prop. Reg. § 1.250(b)-5, FDDEI services include:

The term "general service" means any service other than a property service, proximate service, or transportation service.²⁶ The term "property service" generally means a service, other than a transportation service, provided with respect to tangible property but only if certain conditions are satisfied.²⁷ 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 its employees.²⁸ Finally, the term "transportation service" means a service to transport a person or property using aircraft, railroad, vessel, motor vehicle, or any similarly mode of transportation.²⁹

In addition, as relevant here, a property service is provided with respect to tangible property located outside the United States only if the property is located outside the United States for the duration of the period the service is performed.³⁰ In the preamble to the Proposed Regulations the Service indicated that the Treasury and the Service are considering "an exception for property that is located in the United States temporarily solely for purposes of the performance of certain services, such as maintenance or repairs."³¹

3. Related Party Rules

The Proposed Regulations provide special rules for determining whether a sale of property to a person related to the seller constitutes a FDDEI sale (the "Related Party Rules"). The term "related party sale is defined as a FDDEI sale of general property to a foreign related party.³² The term "foreign related party" means any foreign person that is a member of an affiliated group that includes the seller within the meaning of section 1504(a) with certain modifications.³³ The term "foreign unrelated party" means any foreign person that is not a foreign related party.³⁴

Under Prop. Reg. § 1.250(b)-6(c), a sale of property to a foreign related party is a FDDEI sale only if one of four unrelated party transactions occurs following the related party sale:

With respect to unrelated party transactions described in (i) and (ii) above, the original related party sale is a FDDEI sale only if the unrelated transaction occurs on or before the FDII filing date.³⁶ The term "FDII filing date means the date by which the seller is required to file an income tax return for the taxable year in which the gross income from the sale is included in the seller's gross income.³⁷ For purposes of this rule, the documentation requirements under Prop. Reg. § 1.250(b)-4 described above must be satisfied.³⁸ In the event the subsequent unrelated party sale occurs after the FDII filing date, the taxpayer may file an amended return for the taxable year in which the related party sale occurred, within the period of limitations provided by section 6511 to claim a FDII deduction.³⁹

A related party sale of property may also qualify as a FDDEI sale if, as of the FDII filing date, the seller in the related party sale reasonably expects that an unrelated party transaction described in (iii) and (iv) above will occur, and more than 80 percent of the revenue earned by the foreign related party with respect to the property will be earned from the FDDEI sale or the FDDEI service (the "80 Percent Rule).⁴⁰ In addition, the Documentation Rules are disregarded for purposes of determining whether the unrelated party sale qualifies as a FDDEI sale or whether the service provided to the foreign unrelated party qualifies as a FDDEI service under the 80 Percent Rule.

Under the Proposed Regulations, the 80 Percent Rule does not apply to related party sales in which the foreign related party resells the purchased property to unrelated foreign parties, or incorporates the purchased property as a component in other property sold to unrelated foreign parties. In these fact patterns, a taxpayer must establish that such unrelated party transactions have occurred by the FDII filing date in order qualify the sale as a FDDEI sale or, if the unrelated party transactions occur after the FDII filing date, file an amended return to claim a FDII deduction.

III. International Transportation Property in General

Documentation for sales of certain international transportation property could be entered into prior to the effective date of final regulations. Within the U.S. aerospace industry, several corporate taxpayers manufacture aircraft in the United States and sell the aircraft to foreign customers, and these aircraft generally will be treated as international transportation property under the Proposed Regulations. Aircraft are long-lead time products with a high amount of customization (aircraft interior, paint, etc.), and it is not uncommon for customers to enter into purchase agreements even before an aircraft model has received type certification from the U.S. Federal Aviation Administration (FAA) or other applicable non-U.S. regulatory authority. Therefore, a customer often executes aircraft purchase agreement documentation months or even years prior to the time that the aircraft is delivered. In general, the manufacturer only includes the sales proceeds in gross income (and FDDEI) for U.S. federal income tax purposes at the time it delivers the aircraft.

The Documentation Rules would be burdensome for sellers of international transportation property sold for non-commercial uses. While some types of aircraft manufactured by U.S. corporate taxpayers are purchased by airlines for use in providing the commercial travel services to passengers, other aircraft are sold to individuals and corporations for private business or personal use. These types of aircraft are typically operated under a U.S. or non-U.S. certification that specifies a non-commercial use. For example, FAA "Part 91" (14 C.F.R. part 91) provides general operating and flight rules for civil aircraft, which generally contemplate that no compensation will be paid for carriage of passengers or cargo. On the other hand, FAA "Part 135" (14 C.F.R. part 135) applies to commuter and on-demand operations (i.e., charter operators), and FAA "Part 121" applies to scheduled air carriers (i.e., airlines). Non-U.S. aviation regulatory authorities typically have similar delineations for registration of aircraft between commercial and non-commercial uses. For example, the European Union Aviation Safety Agency (EASA), which covers aircraft operations in 32 countries, provides separate rules for non-commercial aircraft ("Part-NCO" and "Part-NCC') and commercial air transport operations ("Part-CAT"). Because commercial airlines may purchase an aircraft solely for certain routes, they might be able to provide documentation establishing that within the next three years, the aircraft purchased will be located outside the United States more than 50 percent of the time, and more than 50 percent of the miles the aircraft travel will be outside the United States. In contrast, foreign individual buyers and corporations purchasing aircraft exclusively for private business or personal use may have difficulty in providing such documentation because aircraft used in private transportation is generally not limited to certain routes, even if the buyers expect to use the aircraft predominantly outside the United States.

Certain international transportation property will be temporarily located in the United States for maintenance and repair services. When aircraft purchased for private use require maintenance, repair and overhaul services to be performed on an aircraft purchased for private use, many foreign purchasers of aircraft manufactured in United States will take their aircraft to service centers operated by the U.S. manufacturer and located in the United States. This is especially true in the case of complex services for which the customer prefers the expertise of the original U.S. manufacturer. In these situations, the aircraft will be located in the United States temporarily while the maintenance, repair or overhaul services are performed. Under the Proposed Regulations, these maintenance and repair services would not qualify as FDDEI services because, during the performance of the services, the aircraft is physically located within the United States, even if the aircraft is predominantly used outside the United States by foreign persons.

Manufacturers of certain international transportation property also sell fungible replacement parts to foreign affiliates. In addition to the sale of whole aircraft, U.S. aircraft manufacturers typically sell aircraft replacement parts and components to their foreign customers, often through related-party service centers or related-party parts distributors. The quality of aftermarket customer service is a differentiator in the aerospace industry, and a hallmark of good customer service is the manufacturer's ability to deliver certified replacement parts quickly anywhere in the world where a customer's aircraft is located. To this end, U.S. aircraft manufacturers often maintain a supply of replacement parts with non-U.S. affiliates; these affiliates could be selling the replacement parts directly to unrelated foreign customers, and/or could be using the replacement parts in providing aircraft repair, maintenance and overhaul services to unrelated foreign customers. The types of replacement parts stocked at foreign affiliates tend to be high-volume parts such as bearings, cables, wing and rudder tips, tires, etc., which because of their fungible nature may not be able to be specifically traced to when a particular part was purchased by the non-U.S. affiliate or when the non-U.S. affiliate sold a particular part to an unrelated foreign customer or used the part in services provided to an unrelated foreign customer. As a result, while a large portion of the replacement parts produced in the United States and sold to a foreign related party is consistently resold to foreign unrelated parties, the domestic corporate taxpayer may not be eligible for a FDII deduction with respect to the sale of the parts under the Proposed Regulations. In addition, filing an amended return years after the close of the taxable year on a regular basis would result in considerable administrative burden for corporate taxpayers that have return filing obligations in multiple states in addition to their federal return filing obligations. Moreover, in some circumstances, the statute of limitations could close before the date on which the taxpayer could file an amended return claiming the FDII deduction. Claiming a FDII deduction with respect to the replacement parts sold to foreign related parties thus may be impracticable to these corporate taxpayers due to the excessive administrative difficulty.

IV. Recommendations

A. Expansion of the Grandfathering Rule

We respectfully request that the Grandfathering Rule be extended to sales of international transportation property undertaken pursuant to contracts entered into during taxable years beginning on or prior to March 4, 2019.

As discussed above, due to the nature of aviation industry, corporate taxpayers often do not deliver aircraft and related products until a few years after signing the contracts with the buyers. In such case, similar to transactions completed prior to the issuance of the Proposed Regulations, corporate taxpayers may not be able to obtain the documentation required under the Documentation Rules with respect to the property the taxpayer contracted to sell during the taxable year beginning on or before March 4, 2019. In addition, the Transportation Property Rule, coupled with the Documentation Rules, imposes a substantial burden on corporate taxpayers selling international transportation property that may render obtaining the required documentation impracticable.

The requested change will reasonably accommodate sellers of international transportation property by allowing such taxpayers to establish a foreign use for sales agreed to prior to March 4, 2019, by providing documentation obtained in the ordinary course or business.

B. Documentation Rules for International Transportation Property Sold for Private Use

We respectfully request that the final regulations allow taxpayers to establish a foreign use of international transportation property sold for private transportation by obtaining the following documentation:

We believe the requested changes would alleviate the excessive administrative burden imposed on taxpayers selling international transportation property to unrelated foreign parties for private use. In addition, international transportation property sold for private use does not implicate the same policy concern regarding international transportation property sold for commercial use. For example, while a commercial airline generally operates numerous international and domestic routes and may be able to use the same international transportation property for multiple international and domestic routes, a foreign person purchasing an international transportation property for private use is less likely to have the needs or capacity to do so.

We also note the competitive nature of the aerospace industry, especially with respect to non-commercial aircraft manufacturers, which include several non-U.S. manufacturers of both fixed-wing aircraft and helicopters. In the preamble to the Proposed Regulations the Service indicated that:

Overly burdensome documentation requirements might shift transactions to sellers that do not need or cannot use the FDII deduction, or it 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.⁴¹

The requested changes to the Documentation Rules would further this goal, by not imposing customer documentation requirements on U.S. sellers of international transportation property that are more stringent and burdensome than those required of their non-U.S. competitors.

C. Service Rules for International Transportation Property Sold for Private Use

We respectfully request to modify Prop. Reg. § 1.250-6(g) to better address international transportation property as follows:

We believe the requested changes are consistent with other parts of the Proposed Regulations that recognize the unique nature of international transportation property and thus provide special treatment accordingly. Compared to other general property, international transportation property purchased for a foreign use is more likely to be transported to the United States temporarily solely for purposes of maintenance and repairs due to its size and mobility as well as the technical expertise required. Further, as discussed above, a foreign person purchasing international transportation property for private use is unlikely to have the needs or capacity to use the property for multiple international and domestic routes.

D. Related Party Transactions Involving Fungible Property.

Similar to the special rule for "fungible mass" property in the Documentation Rules in Prop. Reg. § 1.250-4(d)(3)(iii), we respectfully request a special rule for fungible property be added to the Related Party Rules in Prop. Reg. § 1.250-6(c)(1) as follows:

(iii) Related party sales of fungible general property. In the case of related party sales of multiple items of general property, which because of their fungible nature cannot reasonably be specifically traced by the foreign related party to an unrelated party transaction, the seller in the related party sale may establish that an unrelated party transaction has occurred on or before the FDII filing date through market research, including inventory turnover, statistical sampling, economic modeling and other similar methods indicating that an unrelated party transaction has occurred on or before the FDII filing date. If, under the preceding sentence, the seller establishes that an unrelated party transaction occurred with respect to 90 percent or more of related party sales of fungible property to a foreign related party in a taxable year, then all of the related party sales of fungible property to such foreign related party for such year may qualify as FDDEI sales. If, under the first sentence of this paragraph (c)(1)(iii), the seller does not establish that an unrelated party transaction occurred with respect to 10 percent or more of related party sales of fungible property to a foreign related party in a taxable year, then no portion of the related party sales of fungible property to such foreign related party for such year may qualify as FDDEI sales.

We believe the requested change is consistent with the Documentation Rules in Prop. Reg. § 1.250-4(d)(3)(iii) that recognize the impracticability of specifically tracking sales of fungible property. This impracticability is present not just in documenting the foreign use of fungible property, but also in a foreign related party's ability to establish the timing of a subsequent sale of fungible property to an unrelated foreign party. Consistent with the Service's statement in the preamble to the Proposed Regulations explaining the more flexible approach for documenting the foreign use of sales of fungible general property,⁴² we believe specific tracking of unrelated party transactions involving fungible general property would be burdensome and unnecessary as long as the taxpayer can establish by other means that an unrelated party transaction occurred by the FDII filing date.

E. Deferral of Deductions for FDDEI Sales of International Transportation Property for Private Use

We respectfully request that the Related Party Rules under Prop. Reg. § 1.250(b)-6 be revised to allow taxpayers to elect to defer an FDII deduction rather than file an amended return to claim it.

Section 267(f) provides a similar deferral regime with respect to losses incurred in an intercompany transaction between related parties. Under section 267 (0, losses from property sales between members of a controlled group of corporations are generally deferred.⁴³ Treasury Regulation § 1.267(f)-1(a)(2) provides that the "matching" and "acceleration" rules of Treas. Reg. § 1.1502-13(c) and (d) generally govern the timing of when the losses are taken into account with certain modifications. Under the matching and acceleration rules, members of a controlled group are generally treated as divisions of a single corporation for purposes of taking into account losses incurred by a member in an intercompany transaction.⁴⁴ Thus, under the matching rule, a member is generally required to defer a loss incurred in an intercompany sale of property to another member of the controlled group until such other member disposes of the property with a nonmember in a taxable transaction.⁴⁵ The acceleration rule, on the other hand, provides that a taxpayer takes into account a loss incurred in an intercompany sale of property when the loss can no longer be reflected in an item of the controlled group.⁴⁶ For example, if a member incurs a loss on a sale of property to another member of the same controlled group, and such other member subsequently ceases to be a member of the controlled group, the selling member generally takes into account the loss at the time such other member leaves the group.⁴⁷

Consistent with the Proposed Regulations, we believe the Related Party Rules should permit taxpayers to claim the FDII deduction in the year of a FDDEI sale to a foreign related party, provided that the corresponding sale to a foreign unrelated party occurs on or before the FDII filing date. With respect to FDDEI sales for which the corresponding unrelated party sale occurs after the FDII filing date, we respectfully propose that taxpayers be permitted to elect to either file an amended tax return to take the FDII deduction into account in the tax year of the original FDDEI sale or in a subsequent taxable year under principles of section 267(f).

We believe the requested revision to the Related Party Rules is consistent with the current deferral regime under section 267(f) and will alleviate the administrative burden of having to file amended returns that could cause claiming a FDII deduction to be impractical for many taxpayers.

Sincerely,

Jay Singer
McDermott Will & Emery LLP
Washington, DC

Cc:
David J. Kautter
Assistant Secretary of the Treasury (Tax Policy)
Department of the Treasury

Charles P. Rettig
Commissioner
Internal Revenue Service

Michael J. Desmond
Chief Counsel
Internal Revenue Service

Lafayette "Chip" G. Harter III
Deputy Assistant Secretary (International Tax Affairs)
Department of the Treasury

Douglas L. Poms
International Tax Counsel
Department of the Treasury

Gary Scanlon
Attorney-Advisor
Department of the Treasury

Jason Yen
Attorney-Advisor
Department of the Treasury

Peter Blessing
Associate Chief Counsel (International)
Internal Revenue Service

Daniel M. McCall
Deputy Associate Chief Counsel (International—Technical)
Internal Revenue Service

Marissa Rensen
Office of the Associate Chief Counsel (International)
Internal Revenue Service