Firm Seeks Clarity on ‘Foreign Use’ in Proposed FDII, GILTI Regs

May 1, 2019

Hon. Charles P. Rettig
Commissioner
Internal Revenue Service
CC:PA:LPD:PR (REG-104259-18)
Room 5203, Internal Revenue Service
P.O. Box 7604, Ben Franklin Station
Washington, DC 20044

Re: Comments on Proposed Regulations Regarding Foreign-Derived Intangible Income (RIN 1545-BO55), Section 1.250(b)-4(d)(2)(i)(B)

Dear Commissioner Rettig:

This letter is submitted in response to the request for comments on proposed regulations relating to the determination of foreign-derived intangible income (“FDII”) under section 250(b), which were published in the Federal Register on March 6, 2019 (the “Proposed Regulations”).¹ This letter responds specifically to the request for comments regarding whether a rule similar to Proposed Regulations section 1.250(b)-4(d)(2)(i)(B) is appropriate for intangible property.² The Proposed Regulations, in that section, provide that “a sale of general property is treated as for a foreign use if the property is subject to manufacturing, assembly, or other processing outside the United States.” No such rule is provided for the license of intangible property, including the license of “make, use, and sell” rights under a patent to an unrelated foreign manufacturer for use in products manufactured outside the United States.

For the reasons discussed below, we believe that a rule similar to Proposed Regulations section 1.250(b)-4(d)(2)(i)(B) should be provided for such intangible property. We request that in computing foreign derived deduction eligible income (“FDDEI”), the final regulations treat a license of intangible property to an unrelated foreign person as for a foreign use if the intangible property is a patent used in products manufactured outside the United States. Such a rule would account appropriately for the equivalent treatment of income from tangible and intangible property provided by section 250(b), find support in at least one analogous definition of the word “use,” and create a more administrable standard for defining FDDEI for intangible property than the Proposed Regulations as drafted.

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Section 250(b) allows taxpayers to generate deduction eligible income from licensing intangible property to a foreign person who makes “any use” of that property outside the United States. Specifically, taking into account relevant definitions from section 250(b)(5), section 250(b)(4) defines FDDEI as “any deduction eligible income of such taxpayer which is derived in connection with . . . property . . . which is [licensed] by the taxpayer to any person who is not a United States person, and . . . which the taxpayer establishes to the satisfaction of the Secretary is for [any use . . . which is not within the United States].” We request that the Proposed Regulations, when finalized, clarify that “any use” for this purpose includes the use of a patent in a product manufactured by an unrelated foreign person outside the United States, in circumstances analogous to those described for tangible property in Proposed Regulations section 1.250(b)-4(d)(2). When an unrelated foreign manufacturer uses a patent to manufacture a product outside the United States, a foreign use of the patent has occurred, and the licensor's income should be potentially eligible for FDDEI treatment by virtue of that use.³

The Proposed Regulations, as drafted, appear to disregard categorically this type of use. According to the Proposed Regulations, “[f]or intangible property used in the . . . manufacture . . . of a product, the intangible property is treated as exploited at the location of the end user when the product is sold to the end user.”⁴ The Proposed Regulations thus appear to treat the ultimate consumer of a product manufactured using a patent as the sole user of the patent, even though the consumer did not license the patent from the taxpayer, exploit the patent through “make, use, or sell” rights, or pay royalties to the taxpayer. In this respect, the Proposed Regulations cannot be reconciled with section 250(b)(5)(A), which treats any use of the patent by a foreign person outside the United States as a foreign use.⁵

The Proposed Regulations, as drafted, also appear to conflict with the applicable statutory language by limiting FDDEI arising from the license of a patent, relative to FDDEI arising from the sale of goods produced using the patent. The statutory language admits no such distinction. All licenses are treated as sales: “For purposes of this subsection, the terms 'sold', 'sells', and 'sale' shall include any lease, license, exchange, or other disposition.”⁶ Nevertheless, the Proposed Regulations, in section 1.250(b)-4(d)(2)(i)(B), provide a type of presumption for the sale of goods to a foreign manufacturer, without applying a similar presumption to the license of a patent to the foreign manufacturer.

Specifically, Proposed Regulations section 1.250(b)-4(d)(2)(i)(B) treats tangible property as subject to 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.” Even if such tangible property is then imported into the United States for further manufacture or for sale to a U.S. consumer, it does not cease to be “foreign use” property.⁷ By contrast, a patent licensed to a foreign manufacturer is not treated as foreign use property to the extent of any ultimate sales of the product to a U.S. consumer.

The Preamble to the Proposed Regulations offers the following rationale for excluding intangible property from the presumption of foreign use:

[A] sale of general property is treated as for a foreign use if the property is subject to manufacturing, assembly, or other processing outside the United States. See proposed § 1.250(b)-4(d)(2)(i)(B). This rule is based on footnote 1522 of the Conference Report, 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 foreign use.' 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.⁸

To the contrary, the language of the statute itself expresses Congressional intent to provide equivalent treatment of tangible and intangible property. A duplicative example for intangible property should not be required for the regulations to account for this intent. Simply substituting a license for a sale, as section 250(b)(5)(E) does, indicates that the use of a patent in a product manufactured abroad by a foreign person is as much a “foreign use” as incorporation of a component part, embodying the patented technology, into a product manufactured abroad by a foreign person. If Congress had intended to require taxpayers owning patents to take the extra steps of manufacturing components incorporating their patented technology and selling those components to a foreign manufacturer, rather than simply licensing the patent to the foreign manufacturer, Congress would not have provided simply that a sale “shall include” a license.

The language of the statute would govern in the event of a conflict with a footnote in the legislative history, but such a conflict is not inevitable here. The Preamble's interpretation of the footnote is not the only interpretation, nor is it the most compelling. The intellectual property embodied in a patent is effectively incorporated into a product as a component when the patent is used in finished products manufactured outside the United States.⁹ Nothing in the footnote says otherwise. At most, the footnote merely provides a non-exclusive illustration of one type of foreign use. It does not purport to prevent foreign use from occurring when patented technology is incorporated in a product manufactured abroad.

The Preamble requests comments on whether a rule similar to Proposed Regulations section 1.250(b)-4(d)(2)(i)(B) is appropriate for intangible property.¹⁰ For the foregoing reasons, we believe that a similar rule is appropriate and necessary to realize fully the intent of Congress. Incorporation of such a rule could be accomplished in several ways. One narrow way would be to specify that an unrelated foreign person who uses a patent in property manufactured outside the United States is the “end user” of the patent for purposes of Treasury Regulations section 1.250(b)-4(e)(2)(i), as follows:

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For intangible property used in the development, manufacture, sale, or distribution of a product, the intangible property is treated as exploited at the location of the end user when the product is sold to the end user, except that a patent licensed to an unrelated person with respect to property produced by such person at a location outside the United States is treated as exploited at that location by the unrelated person, who is treated as the end user of the patent.

A broader alternative might simply create rules for the foreign use of intangible property that parallel the rules for general property. The following version would merge Proposed Regulations section 1.250(b)-1(d)(2) and (e)(2) to cover the license of intangible property to an unrelated foreign manufacturer for use outside the United States, and it would include for this purpose the 20-percent limitation found in Proposed Regulations section 1.250(b)-4(d)(2)(iii)(C). If necessary, a narrower version of this same alternative could be written to apply to patents only.

(e)(2) Determination of foreign use — (i) In general. The sale of intangible property is for a foreign use if —

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(B) The property is subject to manufacture, assembly, or other processing outside the United States before the property is subject to a domestic use.

(ii) Determination of domestic use. Intangible property is subject to domestic use to the extent that the intangible property generates revenue from exploitation within the United States. A sale of intangible property rights providing for exploitation both within the United States and outside the United States is for a domestic use in proportion to the revenue generated from exploitation of the intangible property within the United States over the total revenue generated from the exploitation of the intangible property. For intangible property used in the development, manufacture, sale, or distribution of a product, the intangible property is treated as exploited at the location of the end user when the product is sold to the end user.

(iii) Determination of manufacture, assembly, or other processing — (A) In general. Intangible property is subject to manufacture, assembly, or other processing only if the intangible property itself is materially modified (as described in paragraph (e)(2)(iii)(B) of this section) or the intangible property is incorporated as a component into a product (as described in paragraph (e)(2)(iii)(C) of this section).

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(C) Intangible property incorporated into a product as a component. For purposes of paragraph (e)(2)(iii)(A) of this section, intangible property sold to an unrelated person with respect to a product manufactured by the unrelated person is incorporated as a component into the product, provided that the royalty and any other consideration received by the seller for exploitation of the intangible property constitute no more than 20 percent of the price of the product, determined when the product is sold by the unrelated person. For purposes of the preceding sentence, all intangible property that is sold by the seller and incorporated into the product is treated as a single item of property.

Either of these alternatives would achieve the parallel treatment of tangible and intangible property intended by Congress.

Treating royalties from the use of a patent in a product manufactured overseas as income from a foreign use of the patent for purposes of computing FDDEI would not be a novel concept. For example, section 862(a)(4) treats royalties for the use of patents and like property outside the United States as foreign source income, and courts and the IRS have treated the place of manufacture as the place of use based on the facts.

In Sanchez v. Commissioner,¹¹ for instance, the court rejected the taxpayer's claim that royalties from the use of a U.S. patent to produce a chemical re-agent in the United States should be partly foreign source income based on foreign sales of the re-agent. Instead, the court treated the patent as used solely within the United States, where production occurred. It concluded that “[a]ll of the amount in controversy was received by him as of right by virtue of his contract entitling him to it as part of the selling price of the re-agent sold to foreign purchasers and delivered by [the manufacturer] to a common carrier in the United States.”¹² Similarly, in Revenue Ruling 55-17,¹³ the IRS treated payments made by a domestic corporation to a foreign corporation for the use of technical “know-how” in connection with the production of certain chemicals as U.S. source income. According to the ruling, “[t]he essence of the contract is the making available to the domestic corporation the technical knowledge, methods, experience, that is, the 'know-how' of the foreign corporation.” The place of ultimate consumption of the chemicals was not considered relevant.¹⁴

Authorities regarding the source of income are not uniform, and they apply in a context somewhat different from the context of FDDEI. Nevertheless, they represent part of the legal background for the enactment of section 250(b), and they offer support for creating a rule for patents and like property, used in a foreign manufacturing process, analogous to the rule for tangible property in Proposed Regulations section 1.250(b)-4(d)(2)(i)(B).

As noted above, the rule we propose would treat patents as used outside the United States by an unrelated foreign manufacturer even though products containing the patented technology are subsequently sold into the United States, provided that the consideration for the patent comprises no more than 20 percent of the price of the product. This rule simply matches the analogous 20-percent limitation for tangible property, and in both cases a numerical threshold would promote certainty and ease the potential documentation burden of the Proposed Regulations. In the case of a royalty based on net sales of a product, it usually would be a relatively simple matter for the licensor to compute the cost of the royalty to the unrelated licensee as a percentage of each unit sold because that is likely how they are already computing the royalty. No further rule requiring an allocation of use should be necessary for either tangible property or intangible property in this context. A limit on the cost of the patent to 20 percent of the price of the product sold would represent a more administrable rule than one requiring an allocation between multiple forms of use, based on data that the taxpayer must assemble from unrelated licensees (who may have no reason to collect such data themselves).

For the foregoing reasons, we request that the Proposed Regulations, when finalized, clarify that foreign use includes the use of a patent in a product manufactured by an unrelated foreign person outside the United States, in circumstances analogous to those described for tangible property in Proposed Regulations section 1.250(b)-4(d)(2)(i)(B).

We appreciate the opportunity to comment on this aspect of the Proposed Regulations and look forward to working with you on this matter.

Respectfully submitted,

Dirk Suringa
Covington & Burling LLP
Washington, DC

cc:
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

Jason Yen, Attorney-Advisor, Office of International Tax Counsel, 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, Senior Counsel, Branch 6, Office of Associate Chief Counsel (International), Internal Revenue Service