Tech Group Presses for Changes to Proposed FDII, GILTI Regs

May 5, 2019

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

Dear Sir or Madam:

The Information Technology Industry Council (ITI) appreciates the opportunity to comment on proposed regulations issued by the U.S. Department of the Treasury and the Internal Revenue Service providing guidance related to the determination of the deduction for Foreign-Derived Intangible Income (FDII) and Global Intangible Low-Taxed Income (GILTI), which were created by the Tax Cuts and Jobs Act (“TCJA”).

ITI represents the global voice of the high-tech community, advocating for policies that advance U.S. leadership in technology, promote innovation, open access to new and emerging markets, protect and enhance consumer choice, and foster increased global competition.¹ Our members are 67 high-tech and tech-enabled companies, including wireless and wireline network equipment providers, computer hardware and software companies, Internet and digital service providers, mobile computing and communications device manufacturers, consumer electronics companies, and network security providers. Many of our members are headquartered or significantly invested in the United States, and their investments have not only propelled economic growth and innovation across the country, but have also launched new global industries.

At ITI, we have long asserted the importance of modernizing and reforming the U.S. tax code to improve the competitiveness of the U.S. economy. We hope that the following issues can be addressed as the regulations are finalized.

I. Limitation on §250 Deduction

Under Prop. Reg. §1.250(a)-1(c)(4), for purposes of determining the taxable income limitation in calculating a U.S. corporate shareholder's §250 deduction, taxable income is determined by taking into account a current year operating loss or a §172(a) net operating loss (NOL) carryover deduction. Although a reduction or denial of the §250 deduction by reason of taking into account a current year operating loss or a §172(a) NOL carryover deduction in determining taxable income for the year should not result in additional U.S. tax on foreign-derived intangible income (FDII) or a Global Intangible Low-Taxed Income (GILTI) inclusion in the current year (because the current year loss, or NOL carryover deduction, similarly shelters FDII or the GILTI inclusion), the limitation on the allowable §250 deduction could result in additional U.S. tax being paid on income (GILTI and/or non-GILTI) earned by the U.S. shareholder in subsequent years.

Example: A U.S. corporation that generates a <$100x> NOL in Year 1, $100x operating profit in Year 2, and a $100x GILTI inclusion in Year 3, will incur cumulatively $10.50x of U.S. tax (21% of the net $50x GILTI inclusion in Year 3), while if the sequence of operating profit and GILTI were reversed in Years 2 and 3, the taxpayer would incur cumulatively $21x of U.S. tax (21% of the $100x operating profit earned in Year 3). Considering that a fundamental purpose for permitting NOL carryovers is to equalize the amount of U.S. tax for taxpayers having fluctuating income with the amount of U.S. tax for taxpayer's having stable income, this result is counter to the policy reason for allowing an NOL carryover deduction.

We recommend that the regulations allow a U.S. corporate shareholder to recover the §250 deduction that was disallowed against that year's FDII or GILTI by creating a cumulative “FDII recapture account” and “GILTI recapture account” to the extent of the §250 deduction that was disallowed against FDII or GILTI, respectively, as a result of the taxable income limitation for the year. In a subsequent year in which the U.S. shareholder has taxable income exceeding that year's GILTI and FDII amounts, the excess income would be treated as GILTI and FDII (on a proportionate basis based on the relative recapture account balances) solely for purposes of allowing an additional §250 deduction in that year.

For example, if in Year 1 the US corporate shareholder has taxable income of $50x (without regard to the §250 deduction), which includes $80x of FDII, $60x of GILTI and <$90x> of NOL absorption, the §250 taxable income limitation would reduce the $80x of FDII to $28.6x and $60x of GILTI to $21.4x (i.e., a total of $50x, reflecting the taxable income amount) for purposes of determining the §250 deduction allowed for that year. Under the recapture proposal, as of the end of Year 1, the U.S. shareholder would establish a FDII recapture account of $51.4x and a GILTI recapture account of $38.6x (i.e., a total of $90x, representing the amount of FDII and GILTI superseded by the NOL).

If in Year 2 the U.S. corporate shareholder has $200x of total taxable income (without regard to the §250 deduction), which includes $20x of FDII and $60x of GILTI, it would have $120x of excess taxable income that becomes subject to the GILTI and FDII recapture accounts created in Year 1. The excess taxable income treated as GILTI or FDII under the proposal would be limited to the lesser of (i) the relevant balance in the recapture account, or (ii) the excess taxable income allocated to that account for this purpose. In Year 2, the $120x of excess taxable income would be allocated between the two accounts based on the relative balances (i.e., $51.4/$90 to FDII and $38.6/$90 to GILTI), or $68.5x to the FDII recapture account, and $51.5 to the GILTI recapture account. The actual recapture in Year 2 would be limited to the recapture account balances created in Year 1 — $51.4x FDII and $38.6x GILTI.

II. Computation of “Foreign-Derived Intangible Income”

A. Definition of “Foreign Branch Income”

The expansion of the definition of “foreign branch income” under Prop. Reg. §1.250(b)-1(c) to include income and gain from the sale of a foreign disregarded entity or partnership interest results in an inconsistency with the definition of “foreign branch income” under the proposed regulations in Prop. Reg. §1.904-4(f)(2)(iv). This essentially creates a class of income that is neither deduction-eligible income for purposes of §250 nor foreign branch income. This appears to contradict the binary test under §250(b)(3)(A)(i), which suggests that income either qualifies as foreign-derived deduction eligible income (FDDEI) or not.

We recommend eliminating this modified definition and instead using a definition of “foreign branch income” that is consistent with Prop. Reg. §1.904-4(f)(2)(iv), which we generally support.

B. Inclusion of Financial Services Income

Currently, FDDEI includes income generated from the sale or license of property or the provision of services to a foreign person. While §250(b)(3)(A)(i)(III) excludes financial services income (as defined in §904(d)(2)(D)) generated in the active conduct of a banking, financing, or similar business, financial services income other than that defined in §904(d)(2)(D) should be eligible for inclusion in FDDEI. Such activities would include (without limitation) leasing or financing activities with a foreign person that is not occurring in the active conduct of a banking, financing, or similar business as defined in §904(d)(2)(D). However, the proposed regulations do not contemplate these transactions.

We believe the proposed regulations should confirm that the definition of FDDEI includes income generated by a U.S. taxpayer from financial services through leasing or financing activity provided to foreign persons which is not conducted through an active trade or business as defined in §904(d)(2)(D) and as permitted under §250(b)(3)(A)(i)(III).

C. Allocation and Apportionment of Research and Experimentation (R&E) Expenses

As proposed, taxpayers must allocate research and experimentation (R&E) against DEI and FDDEI and correspondingly to GILTI (for §904 purposes) under the rules of Treas. Reg. §1.861-17 (without exclusive apportionment in the case of DEI and FDDEI). We understand that Treas. Reg. §1.861-17 is under more general review.

This mechanical allocation may discourage taxpayers from performing R&E and retaining IP in the U.S., or from transferring IP rights back to the U.S. By reducing the potential FDII deduction and also reducing any potential foreign tax credits (FTCs) associated with foreign/GILTI income, taxpayers that hold IP rights in the U.S. may be incentivized to increase R&E activities offshore, which runs counter to the policy intent of the provision. Additionally, because exclusive apportionment has been “turned off” for purposes of FDII, more U.S.-based R&E activities will be apportioned to FDDEI, reducing the §250 deduction available.

As the FDII and GILTI were designed to work in conjunction with one another, providing an elective option to utilize exclusive apportionment (yet requiring consistency between the two once a method is chosen) would further ensure that a consistent approach is applied between the two provisions. If Treasury deems it necessary to apply Treas. Reg. §1.861-17, we recommend giving taxpayers the right to elect to use exclusive apportionment for FDII purposes.

D. Election of Method for Allocating and Apportioning R&E Expenses

As outlined in the preamble, the proposed regulations do not address existing Treas. Reg. §1.861-17 and indicate that a more general review of Treas. Reg. §1.861-17 will occur at a later date. Under Treas. Reg. §1.861-17, taxpayers may use either the sales method or gross income method, but must use an elected method consistently for five years before changing to another method. For tax years beginning after December 31, 2017, Prop. Reg. §1.861-17(e)(3) provides taxpayers a one-time ability to change apportionment method without regard to the five-year restriction. However, this one-time change of method constitutes a binding election to use the chosen method for a five-year period. Given that the §250 and §904 regulations remain outstanding, it will be difficult for taxpayers to commit to a method for a five-year period without having had the opportunity to better understand the full impact of the new rules.

As taxpayers work to comply with the new system as well as existing and potential future changes to Treas. Reg. §1.861-17, we request that consideration be given to permitting the election to be made on an annual basis. We note that requiring taxpayers to stay with the same method for a five-year period was relevant under the pre-TCJA §902 regime to prevent taxpayers from gaming the system in the §902 world. But as the §902 foreign tax pooling has been repealed, we request that consideration be given to removing the five-year requirement and allowing an annual election. As an alternative, we request that consideration be given to allowing a one-time election under Prop. Reg. §1.861-17(e) to be non-binding for at least one additional year. This will enable taxpayers to better understand and comply with the new system, and better assess the impact of the election in light of the many changes to the foreign tax credit rules, the introduction of §250, and other relevant changes.

E. Allocation and Apportionment of Expenses Incurred Pre-Implementation

The proposed regulations contained in Prop. Reg. §1.250(b)-1(d) are not sufficiently clear as to whether taxpayers are required to apportion expenses incurred prior to the effective date of the FDII regulations to their FDII income. For example, it is not clear how NOL carryforwards from acquisitions would be treated.

The final regulations should clarify how pre-implementation expenses should be allocated to FDII income. We suggest that one option would be looking to the allocation method for prior-period expenses for purposes of §199, which indicated that cost of goods sold must be allocated between DPGR and non-DPGR, regardless of whether any component of the costs included were associated with activities undertaken in an earlier taxable year.

III. Documentation Requirements

A. Extension of Transition Period

The proposed regulations currently provide a transition period that allows taxpayers to demonstrate that property or services have been provided to a foreign person for foreign use using “any reasonable documentation maintained in the ordinary course of business.” This type of approach allows a taxpayer to use existing business documents (e.g., commercial invoices, purchase orders, packing slips, bills of lading, etc.) without the creation of unnecessary recordkeeping. The transition period only covers tax years beginning before March 6, 2019. Following this period, taxpayers are required to create and maintain additional documentation that may not be necessary or accessible in the ordinary course of business. Unfortunately, several of the items listed in Prop. Regs. §1.250(b)-4 and 1.250(b)-5 would not be created or available to a taxpayer in the ordinary course of business, and may not be readily provided by the foreign counterparty. Additionally, for taxpayers with longer contract cycles, certain documentation (such as a binding contract) will not be able to be obtained by the taxpayer “no earlier than one year before the date of the sale or service.”

For administrative ease, consideration should be given to extending the transition period for the documentation requirements to take effect and determining the extent to which, if at all, such rules prove deficient or problematic in practice once taxpayers and the IRS have some experience complying with or administering the rules. Identifying and potentially implementing new documentation requirements will take time, particularly for business models with longer-term contracts. Lengthening the transition period to at least five years would provide greater certainty in the near term, accommodate different business models, and ease the ability to get new compliance systems or contract provisions in place if necessary. Providing a longer transition period would allow taxpayers a sufficient amount of time to develop and improve internal administrative systems as well as enhance the stability of the new system.

B. Acceptable Documentation

Following the transition period, companies are required to provide additional documentation. Unfortunately, several of the items listed in Prop. Reg. §1.250(b)-4 and Prop. Reg. §1.250(b)-5 would not realistically be able to be obtained by a taxpayer in the ordinary course of business (nor would they be offered or possibly even provided at all by the counterparty).

Indeed, in almost all instances, the types of information the proposed regulations contemplate is not information that customers can reasonably be expected to provide, including potentially confidential business information such as where their businesses are located and their U.S./foreign revenue splits. In some cases, the customer themselves may not even be able to reasonably provide the information — such as what their three-year intended use is for the product or what specific location benefits from services. This is especially true in cases of sales of consumer products, in which case consumers could not possibly be expected to have this level of foresight or provide such information, or sales of services to small businesses, where the same is likely to be true.

Additionally, in sales of products or services to a multinational enterprise where a single entity could be purchasing for multiple offices and affiliates around the world, it is impractical to obtain information on the use of that product or service by such offices and affiliates. The impracticality of this requirement increases exponentially as the number of transactions and number of customers increases (which could be in the millions).

We note that modern accounting /ERP systems track extensive data for each item or service exported, such as the name and address of the vendor, where property is shipped, and other similar data points. Although information is collected by the modern ERP systems, the type of documentation set forth in the proposed regulation is not collected.

We respectfully request taxpayers be permitted to rely upon existing documentation created in the normal course of business to meet the documentation requirements, rather than attempting to obtain additional information from third parties that may be extremely difficult to obtain. We further request that reliance upon this documentation be available for all periods, including after finalization of the §250 regulations.

As proposed, absent a taxpayer's ability to obtain the types of documents listed, a taxpayer will default to “other forms of documentation as prescribed by the Secretary.” In lieu of providing a restricted list, which may not be flexible enough to address many different business models, we recommend that the qualifying documents for both property sales and services that must be obtained be expanded to include additional documents or other information that can more readily be obtained from a customer or other unrelated parties and are utilized in the ordinary course of business, such as commercial invoices, packaging slips, purchase orders, bills of lading, or usage data. Additionally, to account for variablility in the types of documentation that taxpayers maintain in the ordinary course of business, we recommend that the final regulations permit taxpayers to rely on alternative documention not specifically enumerated in the final regulations, provided that taxpayers provide an explanation of why it would be impractical to obtain any of the enumerated documentation and how the alternative documentation serves as a reasonable alternative to the enumerated documentation.

Any challenges that may exist with obtaining the requisite documentation will be compounded for taxpayers with 10,000 or more customers or transactions (i.e., a large numbers of customers). Accordingly, we recommend that these taxpayers be permitted to establish that a recipient is a foreign person, property is for foreign use (including for sales of intangible property), or a recipient is located outside the United States, as applicable, using market research, statistical sampling, economic modeling, or other similar methods in lieu of the general documentation requirements. Additionally, if otherwise not permitted under the documentation requirements, we recommend that taxpayers with 10,000 or more customers be permitted to rely on shipping address or billing address, as applicable, to establish that a recipient is a foreign person, property is for foreign use (including for sales of intangible property), or a recipient is located outside the United States. We recommend a similar approach for companies with large numbers of transactions, which we suggest be allowed to rely on shipping or billing address data, further supported by additional analysis of whether the U.S. or foreign operations of the service recipient benefit from the service by sampling a number of transactions chosen based on established statistical sampling methodologies.

C. Annual Updates to Documentation

The proposed regulations contained in Prop. Reg. §1.250(b)-3(d) require documentation to be obtained by the seller or renderer by the FDII filing date, which is an annual occurrence, and prohibit documentation from being obtained more than one year prior to the date of the sale or service. This suggests that documentation or certification must be obtained annually, which presents a difficulty for long-term or multi-year contracts. For example, in the case of a five year supply contract, there would be no commercial expectation of obtaining new certifications each year. Indeed, as may be the case with other documentation required under the new regulations as noted above, it is likely that foreign counterparties would be hesitant to provide annual certifications, and accordingly, it may be difficult for taxpayers to obtain this information from their customers.

Additionally, as facts under a long-term contract are generally consistent each year of the contract, obtaining annual certifications or updates to the initially required documentation is likely to be of limited usefulness in ensuring that the facts of a given sale continue to allow the resulting income to qualify as FDDEI. Accordingly, we recommend that the documentation obtained for the first year of a multi-year contract be permitted to be used for each year of the contract without requiring updates or validation of the documentation unless (1) the taxpayer knows or should have reason to know the information has materially changed, or (2) there is a change in the foreign parties to the contract (for instance, through assignment, successor-in-interest, etc.).

Notably, small amendments are often made to contracts to expand the scope of covered products, geography of sales force participation, and other aspects that generally would not be relevant to analysis of whether the resulting income qualifies as FDDEI, so we emphasize that only material changes to a multi-year contract should trigger the need to secure another certification that the foreign counterparty is a foreign party and that the products are to be used or consumed in a non-U.S. jurisdiction.

IV. Determination of Foreign Use of Property or Foreign Location of Service Recipient

A. Scope of the “Know or Have Reason to Know” Test

A sale of property or provision of a service qualifies as FDDEI only if the seller “does not know or have reason to know” that the recipient is not foreign, the property is not for foreign use, or the recipient is located within the United States under the regulations, as applicable, with the requirement to establish knowledge or a reason to know not elaborated on further in the guidance. This raises a number of questions, including how far imputation of knowledge might extend across a global organization and how a taxpayer should apply the “reason to know” standard when some employees in the organization may have reason to know that a sale is not for foreign use or a service recipient is located within the United States, but do not have a reason to know that they need to communicate that information. Additionally, some information may be protected by data privacy regulations, but it is not clear whether there are any carve-outs for protected information.

Additionally, for companies that make consumer products, in many cases, it will not be possible for the seller to reasonably know or ascertain whether a good is going to be subject to foreign or domestic use.

The final regulations should clarify the scope of the “know or have reason to know” standard, including how it should be applied across large organizations and how protected information should be taken into account. Specifically, we recommend incorporating examples into the final regulations that illustrate instances where a company would or would not be expected to know or have reason to know standard under this standard — for instance, an example that clearly shows that a company is not responsible for knowing the contents of conversations with account managers, or an example showing that if a company agreed to a discount with the seller in exchange for procuring through its non-U.S. entity (knowing that they would on-sell to related entities), that would be an example of knowing or having reason to know.

B. Sales of Property: General Property

As a general rule, for general property sold to an unrelated party, the regulations should incorporate a rebuttable presumption test where general property sold to an unrelated person is presumed to have been sold for use, consumption, or disposition in the country of destination of the property sold unless the taxpayer knows, or has reason to know, that the general property will be used in the United States.

U.S.-Originated Global Contracts

Under §250, the sale of property is generally eligible for the FDII deduction only if such property is sold to a non-U.S. person. However, §250(b)(5)(B) provides that property can qualify for the FDII benefits if sold to a U.S. domestic intermediary for on-sale to a foreign related party as long as the U.S. domestic intermediary does not perform further manufacturing or other modification before on-selling to a foreign party. Such U.S. commercial arrangements are common.

U.S. taxpayers routinely enter into global long-term supply contracts to sell or license property to a foreign third-party where the form of the contract is a sale or license by the U.S. Taxpayer (Party A) to a third-party U.S. person (Party B), followed by a Party B on-sale or sub-license to a foreign person (Party C) who is unrelated to Party A. In many circumstances, Party B (the U.S. domestic intermediary) and Party C (the foreign party) may also be unrelated to each other.

Under this arrangement, Party A ships the product either (i) directly to the foreign third-party Party C or (ii) to a foreign warehouse leased from a third party and stored by Party A until Party C picks up the product from the foreign warehouse. In either event, Party B never obtains physical custody of the product, and therefore does not further manufacture or modify the product in any capacity whatsoever within the United States, but simply on-sales title or sub-licenses the product to Party C.

This type of arrangement is directly addressed in §250(b)(5)(B), which provides that if product is sold to an unrelated domestic intermediary for further manufacture or other modification before on-selling to a foreign party, such further manufacturing or other modification would cause the transaction as not treated as sold for foreign use. In the case illustrated above, however, the domestic intermediary does not further manufacture or perform any other modification to the product (as it never physically obtains the product), and so the prohibition under §250(b)(5)(B) to treat the product as a foreign sale does not apply.

The final regulations therefore should clarify that in the context of such transactions, foreign revenues from the contract should be eligible foreign derived intangible income where: (a) the contract reflects that unrelated foreign parties are the recipients of the goods or licensed property; and (b) the taxpayer can identify the compensation for unrelated foreign party purchase (from a sale) or use (in the case of a license) in the contract or its books and records. Under this approach, U.S. taxpayers would not be forced to alter their contractual arrangements solely to ensure §250 eligibility. Without this change, it is possible that purchasers or licensees would otherwise extract an economic concession from the seller or licensor to change the commercial arrangement and enable a U.S. taxpayer to qualify its foreign sales or licensing revenues, creating a situation where a U.S. taxpayer is discouraged from acting as a global principal for a global contract. Such discouragement would go against the policy objective of §250.

Suggested language is as follows:

“For purposes of section 250(b)(4), property shall be treated as sold (as defined in section 250(b)(5)(E)) to a person that is not a United States person if the taxpayer (“seller”): (i) sells property to a United States person (“purchaser”); (ii) the purchaser does not engage in further manufacture or other modification of the property within the United States within the meaning of section 250(b)(5)(B); (iii) the property is sold or sublicensed by the purchaser to a foreign person; and (iv) the property is shipped by the seller either directly to such foreign person or the foreign person picks up the property from the seller (whether from the seller's premises or from a warehouse or other location owned or leased by the seller).”

Further, to avoid Party A and Party B both claiming full §250 benefit for the same export sale, the final regulations could provide that, as Party A is recognizing the FDII benefit from transaction and as Party B's income relates to the facilitation of a transaction by a U.S. taxpayer (Party A), Party B's revenue would not qualify for the benefits of §250.

C. Sales of Property: General Property — Property for Manufacturing, Assembly, or Other Processing Outside the U.S.

To qualify as manufactured, assembled or processed, general property must meet one of two tests: (1) it is “subject to a physical and material change,” or (2) it is incorporated into another product as a component.

We note that this standard appears to incorporate elements from the standards in the regulations under former §199 and the regulations under §954. In each of those contexts, the taxpayer is testing whether activities it conducts itself constitute manufacturing, assembly, or other processing. Accordingly, the taxpayer will have direct information regarding the extent of physical and material change to property.

In the case of §250, a taxpayer may not know for certain, or be able to demonstrate, the extent of physical or material change to the property being sold to an unrelated party, or the extent to which its product is incorporated into a different product or contributes to the value of the finished product.

Establishing “A Physical or Material Change”

As discussed above, to the extent that sales that result in FDDEI are sales to an unrelated party, a taxpayer is unlikely to have complete information about the extent of a physical or material change made to property, which is required to qualify under the first prong of the test. We recommend addressing this concern through one of two options. First, for general property sold to an unrelated party, the regulations could incorporate a rebuttable presumption test. Under such a rebuttable presumption test, a taxpayer would need to be able to show reasonable documentation created in the ordinary course of business regarding the sale to persons outside the U.S. The regulations may build off of place-of-use rules that appear elsewhere in existing regulations so that general property which is sold to an unrelated person shall be presumed to have been sold for use, consumption, or disposition in the country of destination of the property sold unless the taxpayer knows, or has reason to know, that the general property will be used in the United States [Treas. Reg. § 1.864-6(b)(3)(ii)(a); Treas. Reg. § 1.971-1(b)(1)(i); Treas. Reg. § 1.956-2(b)(1)(iv)].

As a second option to address this concern, the regulations could add language to further define a “physical and material change.” In particular, we recommend adding language that would consider the first prong of “subject to a physical and material change” satisfied where the general property is subject to processing or assembly activities that are substantial in nature and generally considered to constitute the manufacture or production of property that is different than the property which was purchased. This language is similar to the language in the regulations under §954.

Example: U.S. Corporation, Corporation A, manufactures computer chips. The chips are sold to an unrelated foreign party, Corporation B, incorporated under the laws of foreign country X. Corporation B manufactures computers, tablets and other computer accessories. Corporation B will incorporate the chips purchased from Corporation A in its manufacturing process. Company B's manufacturing process is substantial in nature and is generally considered to constitute the manufacture or production of computers, tablets and other computer accessories. The chips are not the same product as the computers, tablets and other computer accessories. Thus, they qualify as manufactured, assembled or processed outside the United States.

Fair Market Valuation (FMV) Test for Components

Similarly, to the extent that a sale of a component is to an unrelated party, it will be difficult for taxpayers to meaningfully establish the second prong of the test based on the property qualifying as a component. Under the proposed regulations, to be considered a component, the fair market value (FMV) of the general property sold must be no more than 20 percent of the FMV of the second product upon completion. For purposes of this rule, the proposed regulations provide that if the taxpayer sells multiple items of property that are incorporated into the second product, then all of the property sold by the seller is treated as a single item of property.

We note that this standard appears to incorporate elements from the standards in the regulations under former §199 and the regulations under §954. In each of those contexts, the taxpayer is testing whether activities it conducts itself constitute manufacturing, assembly, or other processing. Accordingly, the taxpayer will have direct information regarding the extent of physical and material change to property. In the case of §250, a taxpayer may not know for certain, or be able to demonstrate, that this test is met.

We recommend providing a safe harbor or methodology for the determination of the FMV of the completed product. In many cases, a seller of components would have no access to or actual knowledge of which finished product(s) incorporate such components — much less the FMV of such product(s). We recommend that the regulations provide, for example, that a taxpayer who is not able to determine the final product(s) in which the component is used be able to establish that it qualifies as a component (valued at no more than 20 percent of the ultimate selling price of the finished product) through publicly available data, market research or other similar methods. This language is consistent with the methods to establish foreign use for “fungible mass” in Prop. Reg. §1.250(b)-4(d)(3)(iii). As it is not feasible that a buyer will share (or even possibly know) this type of information at the time of purchase for certain types of products, a simplified method should be provided in the final regulations.

In addition, in the case of a taxpayer that sells multiple items of property that may be incorporated into products, we recommend providing that the components be treated as separate component items if the seller can establish that a determination of the destination of the component is not feasible based on facts and circumstances. As discussed above, if the seller has no knowledge of which component(s) may be incorporated into the second product(s), it would not be possible to aggregate the components for testing purposes. Moreover, the policy underlying the aggregation rule – to ensure that taxpayers cannot avoid the component rule by disaggregating sales of otherwise integrated components – is not implicated to the extent that the taxpayer has no knowledge of which components may be incorporated into which second products.

Example: Corporation A, incorporated under the laws of the United States, manufactures and sells computer chips. The chips are shipped to and billed to Corporation B, incorporated under the laws of foreign country X. Corporation B manufactures various types and models of computers that use the chips purchased from Corporation A. Upon the sale of chips to Corporation B, Corporation A has no knowledge of which types or models of computers that Corporation B will manufacture using the chips. The fair market value of the computers could vary greatly by model. However, based on market research or other publicly available data (such as Corporation B's revenue), Corporation A estimates that the chips sold to Corporation B constitute less than 20% percent of the fair market value of the computers into which they are incorporated. Thus, the chips are deemed to be components and qualify as manufactured, assembled, or processed outside the United States.

D. Sales of Property: Intangible Property

Manufacture, Assembly, or Other Processing Outside the United States

The preamble asks for comments on whether a rule similar to Prop. Reg. §1.250(b)-4(d)(2)(i)(B) — the rule that determines foreign use for tangible property — is appropriate for intangible property. As discussed below, we believe that it would be.

§250(b)(4)(A) provides that FDDEI is DEI derived in connection with property (i) sold by the taxpayer to any person who is not a U.S. person, and (ii) that the taxpayer establishes to the satisfaction of the Secretary is for a foreign use. As discussed more fully above, §250(b)(5)(A) defines “foreign use” as any use, consumption, or disposition that is not within the United States. In §250(b)(5)(E), the statute specifies that the terms “sold,” “sells” and “sale” shall include any lease, license, exchange, or other disposition of the property.

Although the relevant code sections make no distinction between the sale of tangible property and the license of intangible property, the proposed regulations adopt significantly different rules.

The rule for tangible property (referred to as general property) in Prop. Reg. §1.250(b)-4(d)(2)(i)(B) indicates that property is for foreign use if it is subject to “manufacture, assembly, or other processing” outside the United States before the property is subject to a domestic use. Conversely, Prop. Reg. §1.250(b)-4(e)(2) provides that for purposes of determining whether a sale of intangible property is for a foreign use, use is foreign use to the extent that revenue is earned from exploiting the intangible property outside of the United States. For purposes of applying this rule, the location where revenue is earned is determined based on the location of end-user customers licensing the intangible property or purchasing products for which the intangible property was used in development, manufacture, sale, or distribution.

The preamble to the proposed regulations explains the distinction between determining the location of use of intangible property versus general property based on Footnote 1522 of the Conference Report of the Tax Cuts and Jobs Act, which provides that “[i]f property is sold by a taxpayer to a person who is not a U.S. person, and after such sale the property is subject to manufacture, assembly, or other processing (including the incorporation of such property, as a component, into a second product by means of production, manufacture, or assembly) outside the United States by such person, then the property is for a foreign use.” The preamble goes on to state “Intangible property is not 'subject to' manufacture, assembly, or processing, and there is no other discussion in the Conference Report that indicates an intent to provide an analogous rule for intangible property otherwise used in the manufacturing process.”

We believe that the proposed regulations for the license of intangible property should recognize that there is a foreign use of the intangible property when rights to manufacture are granted to the licensee and the manufacturing takes place outside the U.S. Therefore, a rule similar to Prop. Reg. §1.250(b)-4(d)(2)(i)(B) — the rule for tangible property — should be adopted for intangible property.

We are concerned that the reliance on the phrasing “subject to” in Footnote 1522 of the Conference Report is misplaced and the conclusion that intangible property is not “subject to” manufacture, assembly, or processing is not correct. Accordingly, we believe that a rule more akin to the rule for general (tangible) property is more appropriate. §250 does not make any distinction between tangible and intangible property and §250(b)(5) makes it clear that a sale includes a license of intangible property. If the Conference Committee had wanted to make a distinction between tangible and intangible property, it could have easily done so by specifying in Footnote 1522 that the intent was only to address tangible property, rather than hoping that a distinction would be drawn based on the phrase “subject to.”

We believe that patents which grant rights to “make, use and sell” products using patented technologies are used by foreign licensees outside the U.S. if the product is manufactured outside the U.S. This rule should be adopted in the final regulations.

Documentation for Sales in Exchange for a Lump Sum

Additionally, there is an inherent conflict between the requirement as proposed that foreign use be determined by the location where the product is sold to the end user and Prop. Reg. §1.250(b)-4(e)(3)(iii), which relates to documentation necessary for these transactions and provides that, in the case of a lump sum payment, a seller can document foreign use through documentation containing reasonable projections, which “to be considered reasonable, [. . .] must be consistent with the financial data and projections used by the seller to determine the price it sold the intangible property to the foreign person.”

Accordingly, the proposed regulations would presumably require that reasonable projections be based on projections of sales to the end user (since that is the basis for determining foreign use), while also being based on projections used by the seller at the time that the seller negotiated the license, which may not have been based on sales to the end user. Absent clarification in the regulations, this would appear to automatically disqualify the seller's efforts to prepare reasonable documentation on usage. We believe this inconsistency could be resolved by eliminating the last sentence in Prop. Reg. §1.250(b)-4(e)(3)(iii).

Sale of Non-U.S. Intangible Property Rights

We recommend that the final regulations include a rule permitting taxpayers to treat the sale or license of only non-U.S. intangible property rights to a third party or related party as a sale of intangible property for only foreign use.

To guard against possible roundtripping concerns, the final regulations could provide that taxpayers can treat a sale of intangible property as only for foreign use under this rule to the extent that taxpayers establish that less than 10 percent (the lower threshold in the fungible mass exception) of the licensee's revenues derived from the non-U.S. intangible property rights is attributable to selling products or providing services within the United States using market research, statistical sampling, economic modeling, or other similar methods. Above this 10 percent threshold, the final regulations could provide that taxpayers can only treat the portion of the sale or license of non-U.S. intangible property rights as for foreign use that taxpayers can establish through market research, statistical sampling, economic modeling, or other similar methods.

E. Sales of Services: General Services — Sales to Business

In the case of general services, establishing that a service recipient's location is outside the United States requires a complex analysis of the location of business operations receiving benefits, which contemplates both the ability to obtain information from third-party customers that they may not agree to provide (including confidential business information), and information that the customer may not necessarily know themselves. This creates the potential to make it not just difficult — but actually impossible — for companies to establish foreign location with respect to services.

In general, business customers will not share detailed information with vendors about where services are beneficially used — that would typically be considered confidential, business critical information. Additionally, publicly available information will not be particularly helpful in establishing foreign use because most business customers potentially generating FDII benefits will be privately held (severely limiting any public information available), and foreign (so that even if they are a public company, their 10-K equivalent would not show U.S. results).

These concerns would apply in the case of, for example, cloud services, which may be sold to a particular customer that the seller directly contracts with, but the seller has no way to validate that no U.S. office or related U.S. affiliate receives a benefit from the services. Indeed, in the case of cloud services, at best, a provider would typically see only the business customer's IP gateway location — not where services are used inside the customer's intranet. In other cases, the customer's IP location could be so frequently changing as to be unreliable for purposes of determining where services are being beneficially used.

As a general rule, for general services provided to an unrelated business recipient, the regulations should provide that if such services are contracted with and provided to a location of the recipient outside the United States, the services will be considered to be provided to a recipient outside the United States even if the recipient has multiple offices or affiliates, unless the taxpayer knows, or has reason to know, that the services will be used by the recipient's office or affiliates in the United States. Indeed, other tax systems have faced similar concerns in terms of determining the beneficial recipient of services, and have largely decided to rely on purchasing location information such as VAT numbers, billing addresses, bank account jurisdiction, and the like, unless the taxpayer knows or has a reason to know otherwise.

The government may be concerned about instances where customers may provide the foreign documentation recommended above but then internally transfer services to U.S. affiliates. However, we note that the inverse is also true: that is, in certain cases a U.S. service recipient may internally transfer a service benefit to foreign affiliates. While the internal transfer in the former case would disqualify part of the services income, the same internal transfer in the latter would qualify otherwise non-quaified services income. However, given the difficulities related to getting any reliable information about such end-users from business recipients as described above, we believe the issue of internal transfers by service recipients can be best resolved by Treasury requiring taxpayers to apply a consistent methodology to determine the location of general business services, disallowing a “cherry-picking” of looking through customers only when such look-though is beneficial to the government.

Accordingly, services should be considered provided at the location of the recipient purchasing the service, including in cases where IP is being sold for purposes of the provision of services.

V. Related Party Transactions

A sale of general property to a foreign related party is only eligible to include in FDDEI once an unrelated party sale occurs. If that sale occurs after the FDII filing date, a taxpayer must amend its tax return to claim the FDII benefit. This approach puts significant administrative burdens on taxpayers selling through affiliated non-U.S. distribution entities. It will be difficult for large global organizations to accurately track the affiliates' inventory turnover at each level as of the FDII filing date. This is especially problematic from a compliance perspective, because returns customarily cannot be amended repeatedly.

We recommend that the final regulations apply a more administrable approach for large organizations to determine the amount of gross DEI income treated as gross FDDEI by the FDII filing date that does not require amending returns for regular inventory cycles.

We appreciate the opportunity to provide feedback on these proposed regulations, and look forward to answering any additional questions to the extent helpful.

Sincerely,

Sarah Shive
Senior Director, Government Affairs
Information Technology Industry Council (ITI)
1101 K Street NW, Suite 610
Washington, DC 20005
202-626-5745
www.itic.org