Energy Group Suggests Changes to FDII, GILTI Regs

May 6, 2019

CC:PA:LPD:PR (REG–104464–18)
Room 5203
Internal Revenue Service
Post Office Box 7604
Ben Franklin Station
Washington, DC 20044

To Whom It May Concern:

On behalf of the American Petroleum Institute (“API”) and its members I am submitting the attached comments pertaining to the Department of Treasury and Internal Revenue Service's (“Treasury and the IRS”) proposed regulations concerning the “Deduction for Foreign-Derived Intangible Income and Global Intangible Low-Taxed Income.” The Tax Cuts and Jobs Act (“TCJA”) made tremendous progress in modernizing the United States' international taxation rules. The proposed regulations put forth by Treasury and IRS helped to clarify many of the outstanding questions presented by the foreign-derived intangible income (“FDII”) deduction.

There are several issues contained in Treasury and the IRS' proposed regulations which API and its members would like to address. First, the exclusion of commodities based upon the type of contract used to conduct standard transactions conflicts with the inclusion of actively traded commodities and could be interpreted broadly to eliminate the benefit of the FDII for oil and gas companies. Furthermore, API and its members request further clarification on the treatment of financial derivatives used to hedge price risk on exported commodities. Second, the documentation requirements create an administratively burdensome process which can be simplified, but yet still provide the information desired by Treasury and the IRS. Third, the definition of the term “foreign person” should be expanded to include unrelated United States persons engaged in foreign market activity.

We welcome the opportunity to discuss these comments at your convenience. You can reach me at (202) 682-8455 or at comstocks@api.org.

Sincerely,

Stephen Comstock
Director — Tax & Accounting Policy
American Petroleum Institute
Washington D.C.

---

API Comments — Deduction for FDII and GILTI

Issue: API believes the definition of foreign-derived deduction eligible income (“FDDEI”) for sales of goods and services under Proposed Treasury Regulation section 1.250(b)-4(f), as written, is unclear in its treatment of export sales of commodities and related financial derivative contracts.

As the proposed regulations are currently drafted, certain types of commodity contracts are excluded from FDDEI through the exception for transactions described in sections 475(e)(2)(B) through (D). Any commodity which itself is actively traded is included in FDDEI because section 475(e)(2)(A) (the rule for physical commodities) is not an exception to FDDEI.

API member companies export commodities, which are actively traded. These sales are often effectuated pursuant to the physical settlement of a forward contract which is technically described in section 475(e)(2)(C). These forward contracts may range in term from short-term to relatively longer term, and are generally intended to support orderly settlement of sales transactions in the ordinary course of business. The broad exclusion of commodities based upon forward contracts used to effectuate the export sale conflicts with inclusion of any commodity that is actively traded and could distort the FDII deduction for API member companies.

Further, API members [often] hedge the price risk with respect to some portion of their export sales through the use of financially settled derivatives. The Treasury and IRS have recognized that commodity transactions that use forward and/or hedging contracts must be treated in a manner similar to the underlying hedged transaction. Examples include section 199, the section 965 guidance regarding “cash equivalents,” and similar rules. The approach has provided for clear reflection of income in other instances and we believe such principles ought to be applied to clearly reflect FDDEI.

Code Sections and Regulation Sections: Internal Revenue Code Sections 250(b)(4), 475(e)(2)(B), 1221(a); Proposed Treasury Regulation Section 1.250(b)-4(f)

Requested Action: In order to ensure the clear reflection of FDDEI income:

Discussion:

1. Background

Section 250 provides a deduction for foreign-derived intangible income, or FDII, and global intangible low-taxed income (“GILTI”). In order to determine the appropriate FDII deduction taxpayers are required to determine what amounts of income of a domestic corporation are attributable to income earned from sales of goods and services abroad.

Treasury and the IRS have determined that not all income earned by domestic corporations from the sales of goods and service to foreign persons will be eligible for the FDII calculation. In determining the FDDEI for sales of products numerous exceptions were created, including an exclusion of the sale of certain financial instruments. Proposed Treasury Regulation section 1.250(b)-4(f) provides that sales of “commodities”, as defined in section 475(e)(2)(B-D), will not qualify as FDDEI sales. Section 475(e)(2)(B-D) defines a “commodity” to include among other items, any notional principal contract with respect to any commodity, an interest in a forward contract, future contract or short, or any other similar instrument. The breadth of this definition of “commodity” creates ambiguity in respect of the majority of sales of oil and gas products undertaken by API member companies using forward contracts.

Crude oil and finished products are typically sold either at a spot price or by using privately negotiated forward contract for the purchase and sale of these commodities. In either case, these sales are settled by the delivery of physical product to the customer. Because of this physical delivery, the foreign use of physical commodities delivered can be established regardless of whether the delivery is pursuant to a spot or forward sale. The Internal Revenue Service directly addresses this issue in its guidance covering the energy sector, “[t]he forward market is where oil is bought and sold between two parties with the delivery of the commodity to be consummated at a future date.”¹

2. Physically Settled Commodity Contracts

As described above, it is common in the energy industry to execute forward agreements to sell energy commodities (specifying price, place of delivery, date of delivery and certain other specifics in the contracts). API member companies do not believe that physically settled commodity contracts were the intended target of the limitation contained in Prop. Reg. §1.250(b)-4(f). In fact, we believe the preamble to the Proposed Regulations supports this conclusion. Specifically, the concern memorialized in the preamble in the proposed regulations as to why they created the §475(e)(2)(B-D) “foreign-derived deduction eligible income” exception is that such financial instruments are not subject to foreign use for purposes of section 250(b)(5)(A).² Foreign use can be readily established when physical commodities are sold under a forward or other commodity derivative instrument given that the actual place of delivery for the physical commodity delivered is readily ascertainable. Furthermore, the income or loss attributable to physically settled commodity forward contracts is not viewed as attributable to the sale of the forward contract itself, but rather to the underlying physical product being exchange. Therefore, sales of physical commodities pursuant to contracts described in §475(e)(2)(B-D) do not appear to be within the scope of what Treasury and the IRS were primarily concerned.

The section 199 regulations have addressed a similar issue with respect to characterization, timing and matching of expenses in instances where gross receipts and corresponding expenses are recognized in different taxable years. Reg. §1.199-1(e), provides guidance for multi-year contracts that involve advance payments or other similar payments. The Treasury and IRS clearly recognized that the advance payments could be qualifying if the underlying property that was subject to the contract was qualifying production property.

3. Hedging Positions

To minimize price risk on their exports, API member companies will frequently execute one or more financial derivative transactions to hedge against price movements with respect to the delivery of underlying physical commodities. For example, when product is sold to a foreign person, there can be a multi-week transport period before the foreign person will actually take physical delivery of the commodity. A financially settled derivative hedge often is used to guard against price fluctuations during this time period. These hedge contracts may be transacted on a domestic contracts market (for example, NYMEX) or a foreign contracts market (for example, ICE Europe). The combined value of the settled physical and financial derivative hedge transaction constitutes the true cost of the good sold. Therefore, API and its members believe that the combined value of both the settled physical and financial derivative hedge contract should both qualify as FDDEI as the combined value reflects the true cost of the good sold to the foreign person.

The section 199 regulations again provide an example of how the Treasury and IRS have appropriately addressed this area in the past. Reg. §1.199-3(i)(3) provides that to the extent the risk that is being hedged relates to qualifying production property, the transaction meets the definition of a hedging transaction and is properly identified as such under the section 1221 rules, the hedge gains or losses are allocable to the proceeds from the sale of the underlying qualifying property and thus they impact the domestic production gross receipts and cost of sales accordingly.

4. Requested Action

Treasury and the IRS should further narrow the exclusion of certain financial instruments ineligible to be characterized as FDDEI. For contracts described in section 475(e)(2)(B-D), the Treasury and IRS should further clarify that if a sale or taxable transfer of a physical commodity occurs pursuant to that contract then the sale of that underlying physical commodity qualifies as FDDEI.

Likewise, to the extent a taxpayer enters one or more financial derivative transactions to hedge price risk on an exported commodity, and timely identifies the hedge(s) per the requirements of section 1221(a)(7), such commodities hedge transactions should be considered integrated with the value of the exported commodity with the taxpayer's net gain or loss on the combined physical and financial positions included in the taxpayer's FDDEI.

Issue: The documentation requirements proposed by Treasury and the IRS create an administratively burdensome process which can be simplified, but yet still provide the information necessary to determine whether sales of goods and services qualify for the FDII deduction.

Code Sections and Regulation Sections: Proposed Treasury Regulation Sections 1.250(b)-4(c)(2)(ii), 1.250(b)-4(d)(3)(ii), 1.250(b)-5(d)(3)(ii) and 1.250(b)-5(e)(3)(ii)

Requested Action: Provide for the universal application of the “Small Business Exception,” relaxation of the reliability requirements for long-term contacts and provide for a rebuttable presumption of foreign use for the sale of fungible goods.

Discussion:

The proposed regulations set forth documentation deemed sufficient to substantiate that sales and services qualify as "foreign-derived" for purposes of FDII and the section 250 deduction. API and its members appreciate the Treasury and the IRS' need to balance the practicality of administering these rules with Congress' overall intention of only allowing the FDII deduction for foreign-derived income. To further this goal, API and its members propose the clarifications and modifications outlined below to simplify the FDII reporting requirements and alleviate the onerous documentation burden on taxpayers seeking to benefit from the FDII deduction.

1. Universal Application of Small Business Exception

The proposed regulations expressly state Treasury and the IRS' desire to minimize the administrative burden and costs to taxpayers for complying with the rigorous documentation requirements set forth.³ In order to alleviate the burden on small business taxpayers that may have limited resources, the Treasury and the IRS have created small business exceptions for the FDII documentation requirements throughout the proposed regulations.⁴

While API and its members agree that small businesses may be unduly burdened with the documentation compliance aspects of FDII, large multi-national corporations are also unduly burdened by the stringent FDII documentation requirements. Large multi-national corporations consummate significant volumes of transactions with large quantities of customers every day, thereby making the FDII documentation requirements set forth in the proposed regulations equally, if not more, burdensome on large business taxpayers. Therefore, we urge Treasury and the IRS to apply the documentation rules carved out for small businesses to all taxpayers, regardless of size.

2. Reliability Requirements Should be Relaxed to Allow for Long-Term Contracts

Pursuant to Prop. Treas. Reg. § 1.250(b)-4(d)(3)(B), a binding contract between a U.S. seller and a foreign buyer that identifies the buyer's use or intended use of the property as foreign use is sufficient to document foreign use for FDDEI sales and services. However, the requirement in Prop. Treas. Reg. § 1.250(b)-3(d) further provides that, with respect to FDDEI sales and services, in order for documentation to be reliable, it must be obtained no earlier than one year before the date of the sale or service in order to be considered reliable. Therefore, binding contracts that have been in place for longer than one year will not be considered reliable if the existing regulations remain in effect. As such, in order to remain compliant for FDII purposes, U.S. taxpayers would need to obtain a written statement or other satisfactory documentation from foreign customers each and every year. This will likely prove to be burdensome and unsuccessful due to the fact that foreign customers are disinterested parties for the FDII regime with no incentive to comply.

Due to the prevalence of long-term supply contracts, many of which pre-date the TCJA, API and its members recommend Treasury and the IRS strike the one-year requirement in Prop. Treas. Reg. § 1.250(b)-3(d). Instead, we propose that the one-year requirement be replaced with a more reasonable requirement that if a taxpayer has reason to question whether the FDII representation in a contract may no longer be accurate, then the U.S. taxpayer must seek confirmation from the foreign buyer or through other reasonably reliable means (due to the difficulty in obtaining such information from disinterested foreign third parties) before including the associated sale or service as FDDEI in the FDII calculation. We believe this is a strong alternative, particularly given the fact that a customer's status as a foreign person using goods or services for foreign use, consumption, or disposition is unlikely to change during subsequent years without creating a need to draft a new or amended contract.

In the event that Treasury and the IRS retains the one-year rule promulgated in Prop. Treas. Reg. § 1.250(b)-3(d), we request clarification that annual, automatic contract renewals satisfy the FDII documentation and reliability requirements.

3. Sales of Fungible Goods Should be Excepted

The application of the FDII documentation requirements to fungible goods (goods that cannot be traced through a supply chain because each unit is identical and interchangeable) is of particular interest to API and its members due to the fungible nature of commodities.

The existing regulations unfairly provide for even more stringent documentation requirements for fungible goods in § 1.250(b)–4(d)(3)(iii) by requiring a U.S. seller of fungible goods to perform market research, including statistical sampling, economic modeling, and other similar methods to establish that 90% of the fungible goods sold are for foreign use. This additional burden being placed on commodity businesses is unnecessary, impractical, and unreliable. Moreover, entirely eliminating a U.S. seller's FDII benefit when a seller cannot substantiate that at least 10% of fungible goods sold are for foreign use disincentivizes the sale of commodities to foreign markets, which are a cornerstone of the U.S. market.

Because there does not appear to be any practical way for a U.S. seller or a foreign purchaser to know whether fungible goods that have been commingled with other fungible goods are subsequently sold in the U.S after export, we suggest that the documentation rules be further modified to account for the lack of traceability of such goods by instituting a rebuttable presumption that exported fungible goods are sold for foreign use, consumption, or disposition unless the U.S. seller knows or has reason to know that a material amount of the goods will boomerang back into the U.S. for resale or further manufacturing. This presumption should apply to both unrelated and related party sales, as the issue of fungibility arises in both scenarios, and section 250(b)(5)(C)(i) requires a U.S. taxpayer that sold goods to a foreign related party to determine where the goods were resold to establish whether they were sold for a foreign use.

Issue: The definition of the term “foreign person” should be expanded to include sales of goods or services to an unrelated U.S. company, provided it is substantiated the domestic company taking the FDII deduction has exported the goods or performed the services outside the United States.

Proposed Code Section and Regulation Sections: Proposed Treasury Regulation Section 1.250(b)-4(c)

Requested Action: Expand the definition of “foreign person” to include U.S. persons engaged in foreign market activity.

Discussion:

The underlying purpose for instituting the FDII incentive is to minimize the role that U.S. tax considerations play in a domestic corporation's decision of whether to service foreign markets directly or through a controlled foreign corporation.⁵ We believe that it is not necessary to limit the sale of goods and services to foreign persons to accomplish that purpose. As such, it is our position that if the foreign use documentation requirements are satisfied, then the fact that the export sale or service is to a U.S. company with global operations should not be to our detriment.

Based on the foregoing, we propose that the definition of “foreign persons” in Prop. Treas. Reg. § 1.250(b)-4(c) be expanded to include unrelated U.S. persons engaged in foreign market activity if it is substantiated that the U.S. seller or service provider taking the FDII deduction has exported the goods or performed the services outside of the U.S. In addition, the foreign use documentation requirements must be satisfied to confirm that the U.S. buyer intends to sell the goods or use the services for foreign use, consumption, or disposition.