Tax Group Seeks Changes to Ease Burdens Under FDII, GILTI Regs

May 6, 2019

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 proposed § 250 FDII regulations in REG–104464–18

Dear Sirs or Madams,

The Silicon Valley Tax Directors Group (“SVTDG”) hereby submits these comments on the above-referenced proposed regulations issued under § 250 of the Internal Revenue Code of 1986, as amended, in REG–104464–18, 84 Fed. Reg. 8188 (March 6, 2019) (the “Proposed Regs”). SVTDG members are listed in the Appendix to this letter.

Sincerely,

Robert F. Johnson
Co-Chair, Silicon Valley Tax Directors Group
Capitola, CA

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I. INTRODUCTION AND SUMMARY

A. Background on the Silicon Valley Tax Directors Group

The SVTDG represents U.S. high technology companies with a significant presence in Silicon Valley, that are dependent on R&D and worldwide sales to remain competitive. The SVTDG promotes sound, long-term tax policies that allow the U.S. high tech technology industry to continue to be innovative and successful in the global marketplace.

B. Summary of recommendations — changes that should be made to the Proposed Regs

We recommend that Treasury and the IRS make certain specific changes to, and reconsider certain aspects, of the Proposed Regs. Here we summarize our main recommendations.

Two related themes run through several of our comments. The first is that the Proposed Regs make it unduly difficult, we think, for a domestic corporation to get § 250 benefits from its export of property and services. Foreign-derived deduction eligible income (“FDDEI”) is, under §250(b)(4), conditioned on selling property to a foreign person for foreign use (with parallel conditions for services). But the tenor of the Proposed Regs is that only certain foreign uses qualify, and that taxpayers should have to go to inordinate lengths to show that their exports won't somehow come back to the U.S. Our comments reflect the belief that “any use” in the statute means just that, and our belief that — unless facts are to the contrary — exports should be presumed to be for foreign use. The second theme is that the Proposed Regs impose documentation requirements divorced from the realities of normal commercial business practices. Foreign customers don't and won't provide U.S. businesses with certain information demanded in the Proposed Regs. Our recommendations below reflect a desire to make the § 250 deduction broadly available, consistent with the statute and its legislative history, with a burden of proof attainable using information readily generated in most commercial business transactions.

[A] The documentation rules are unduly burdensome and should be modified

We believe the documentation requirements in Prop. §§ 1.250(b)-4 through -6 would be unduly burdensome, and depend on taxpayers getting information customers in many instances wouldn't give, and/or making significant changes to their billing and IT systems. We recommend these documentation requirements be replaced with a permanent version of the “temporary” documentation rule in Prop. § 1.250-1(b). This temporary rule allows taxpayers, for taxable years beginning on or before March 4, 2019, to use “any reasonable documentation maintained in the ordinary course of the taxpayer's business” to satisfy the documentation requirements. If made permanent, this rule would allow taxpayers to use commonplace documents such as invoices, purchase orders, packing slips, bills of lading, and similar documents to show the requisite foreign use/person.

We recommend the removal of Prop. § 1.250(b)-3(d)(3), which states that documentation is reliable only if obtained no earlier than one year before the date of the sale or service to which it relates. This creates problems because contracts are often signed more than a year before delivery of the relevant product or service.

[B] The rule in Prop. § 1.250(b)-4(e)(2) for determining whether the sale of intangible property is for foreign use should be similar to the rule for foreign use of general property in Prop. § 1.250(b)-4(d)(2)(i)(B)

We recommend the rule in Prop. § 1.250(b)-4(e)(2) for determining whether the sale of intangible property is for foreign use be withdrawn and replaced with a rule similar to that in Prop. § 1.250(b)-4(d)(2)(i)(B) for determining whether a sale of general property is for foreign use. We recommend language for such a replacement rule, and give an example of its application.

The rule in Prop. § 1.250(b)-4(e)(2) is contrary to the § 250(b)(5)(A) plain meaning definition of “foreign use” of property, which is “any use, consumption, or disposition . . . not within the United States. This definition makes no distinction between tangible and intangible property, and should apply equally to both. The asserted justification for a rule for foreign use of intangible property different from such a rule for tangible (general) property is that language in the § 250 legislative history referring to “property [that] is subject to manufacture . . .” couldn't apply to intangible property. This is wrong. The legislative history of § 250 shows that Congress intended “property” to have its general meaning — both tangible and intangible property. Intangible property moreover can be subject to manufacture.

[C] The rules in Prop. § 1.250(b)-4(d)(2) (for determining whether the sale of general property is subject to foreign use) should be substantially changed

Prop. § 1.250(b)-4(d)(2)(i) provides in general that the sale of “general property” is for a foreign use if either of two alternative requirements are met. We make recommendations for each requirement.

The rule in Prop. § 1.250(b)-4(d)(2)(i)(A) — providing that a sale of general property is for foreign use if the property isn't subject to a domestic use within three years of the date of delivery — should be withdrawn because it relies on information most domestic corporations neither have nor can reasonably get. The inability of domestic corporations to make this determination, which is based on information not reasonably in their possession, would deprive them of a § 250 deductions in situations we believe Congress intended the deduction to apply. The proposed rule should be replaced by a rule deeming a sale of general property to a foreign person to be for foreign use if the property is shipped to a foreign location, unless the seller knows, or has reason to know, at the time of sale that the property will be subject to a domestic use within three years of the date of delivery.

The second foreign-use regulatory requirement — in Prop. § 1.250(b)-4(d)(2)(i)(B) — is met if general property is subject to manufacturing, etc. outside the U.S. This high-level requirement is reasonable, we believe, but the Proposed Regs recast this requirement into two alternative requirements that are problematic and restrictive: the general property must either be “physically or materially changed” or be “incorporated as a component into a second product.”

We recommend the two alternative requirements be supplemented with a third alternative test that can be met if the property is subject to manufacturing, 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 purchased.

Clause 1.250(b)-4(d)(2)(iii)(B) provides that the determination of whether general property is subject to a physical and material change is made based on all relevant facts and circumstances. We agree with a facts-and-circumstances determination, but we recommend that Treasury and the IRS provide some relevant examples — representative of U.S. industries featuring significant IP portfolios — to give guidance to taxpayers. We provide some examples for consideration.

Clause 1.250(b)-4(d)(2)(iii)(C) gives a “20-percent-FMV” rule pursuant to which, in essence, general property is treated as a component incorporated into a second product only if the FMV of such property is no more than 20 percent of the FMV of the second product. The Treasury and the IRS provide no justification for this rule, which is apparently based on a footnote in the legislative history, and the rule ignores the plain meaning of the word “component” and reads into the footnote a FMV qualifier not present: a relatively valuable component is a component nonetheless. The 20-percent-FMV rule is in any event not administrable. We recommend the clause be replaced with a default rule providing that general property is treated as a component incorporated into a second product based on all relevant facts and circumstances, with an alternative safe harbor that deems that situation if the FMV of the general property is no more than about 50 percent of the FMV of the second product.

[D] The definition and treatment of foreign branch income should be reconsidered

Prop. § 1.250(b)-1(c)(11) defines “foreign branch income” more expansively than does Prop. § 1.904-4(f)(2) — Prop. § 1.250(b)-1(c)(11) includes income that arises from direct or indirect sales of any asset (other than stock) that produces gross income attributable to a foreign branch. Because foreign branch income is excluded from deduction eligible income (“DEI”), this has the potential to whipsaw taxpayers: income that arises from sales of assets that produce gross income attributable to a foreign branch would — under the proposed § 250 regulation — be excluded from DEI (and thus not eligible for the § 250 deduction) but not allowed a foreign tax credit (“FTC”) (because such income wouldn't — under the proposed § 904 regulations — be foreign branch income). We recommend the definitions of “foreign branch income” be aligned.

In our comment letter on the proposed FTC regulations, we objected to the adjustments required by Prop. § 1.904-4(f)(2)(vi)(D). This proposed regulation requires adjustments with respect to certain disregarded transfers of intangible property between a foreign branch and its owner, regardless of whether a disregarded payment was made. We pointed out that this regulation can create, rather than prevent, distortions of income. We reiterate those concerns, and ask that Prop. § 1.904-4(f)(2)(vi) be modified to determine foreign branch income based on the branch's books and records. Regulations under § 250 should use the same definition of foreign branch income.

[E] The rules relating to FDDEI services should be modified

The definition of “property service” should be modified to remove the requirement that only tangible property can be the subject of the service. Services can be provided with respect to intangible property located outside the U.S., and the statute doesn't distinguish between services provided with respect to tangible or intangible property.

Paragraph 250(b)(4) provides that FDDEI includes income derived in connection with “services . . . provided to any person, or with respect to property, not located within the United States.” (Emphasis added.) By contrast, Prop. § 1.250(b)-5(g) only treats a property service as a FDDEI service if it's provided with respect to property outside the U.S. We recommend the Proposed Regs be modified to provide the same two-part test as the statute — in particular, a FDDEI service should include a service provided to a foreign person with respect to property in the U.S. This could be accomplished by redefining “general service” or “property service,” such that a service can qualify as a FDDEI service even if provided with respect to property located in the U.S., as long as the service is provided to a foreign person.

We recommend that, consistent with the request for comment, an exception be made for property temporarily in the U.S. for certain services, such as maintenance or repair.

Under Prop. § 1.250(b)-5(e)(2)(i)(A), in determining the location of general services provided to businesses, a service provider must determine which locations of the recipient benefit from the services. While “any reasonable method” can be used, getting the necessary information about recipients may be difficult, if not impossible, in many cases. We therefore suggest — if our comment regarding making the transition documentation rule permanent isn't adopted — the documentation for all transactions be the same as the rule in Prop. § 1.250(b)-5(e)(3)(ii)(B) for small transactions: documentation showing the billing address of the recipient is sufficient, with some exceptions.

The definition of proximate services should be clarified so that they include a service performed in the physical presence of persons working for a business recipient (not just employees of the business recipient).

By definition, property, proximate, and transportation services must be provided outside the U.S., and general services must be provided to persons located outside the U.S. The final regulations should clarify that providing such services doesn't create foreign branch income, as defined in Prop. § 1.250(b)-1(c)(11).

[F] The related party sales and services rules should be modified

If a domestic corporation sells general property to a related party for resale (either directly or as a component in other property), income from the related party sale is included in DEI but is only included in FDDEI if the related party resells such property to an unrelated foreign person before the FDII filing date. If the resale occurs after the FDII filing date, taxpayers must file amended returns to include income from the related party sale in FDDEI. Because sales to unrelated parties can easily occur after the FDDEI filing date, this rule could lead to a large number of amended returns for each taxpayer. We recommend the rule be modified to be less burdensome on taxpayers (and the IRS), such as by incorporating a “reasonable expectation” standard, similar to that in Prop. § 1.250(b)-6(c)(1)(ii). Under this standard, sales to related parties could be treated as giving rise to FDDEI, even if the ultimate sale to a foreign unrelated party is after the FDII filing date, if the taxpayer reasonably expects — based on contractual provisions or past practice — that the related party will in fact sell such property to a foreign unrelated person.

A service provided to a related party is a FDDEI service only if the service isn't substantially similar to a service provided by the related party to a person in the U.S.¹ Prop. §1.250(b)-6(d)(2) provides that a service provided by a related party is substantially similar to a service provided to a related party only if either (a) 60 percent or more of the benefits of the related party service are conferred to persons located in the U.S., or (b) 60 percent or more of the price of the service provided by the related party is attributable to the related party service. We generally endorse a bright-line test as a workable rule that should help avoid disputes over the meaning of “substantially similar,” but we recommend it be changed to require both (a) and (b) be met for substantial similarity to arise.

[G] Miscellaneous comments

A taxpayer's deemed tangible income return (“DTIR”) reduces foreign derived intangible income (“FDII”), and DTIR depends on the amount of qualified business asset investment (“QBAI”). QBAI in turn depends on the taxpayer's aggregate bases in depreciable tangible property held at the end of each quarter.² Prop. § 1.250(b)-2(h) treats a domestic corporation as owning certain tangible property that's transferred and leased back, if a principal purpose of the transaction is decreasing DTIR. A per se rule deems the “principal purpose” standard met if the transfer and leaseback occur within six months of each other.³ We recommend Treasury and the IRS adopt a transition rule, as this anti-abuse rule, including the per se provision, would retroactively catch taxpayers who had no notice of such a rule.

The ordering rule of Prop. § 1.250(a)-1(c)(4) provides that the taxable income limitation of § 250(a)(2) is determined after all the corporation's other deductions — which includes § 172 net operating loss (“NOL”) carryovers — are taken into account. This can have the effect of limiting the § 250 deduction. We recommend that Treasury and the IRS provide by regulation that losses generated in tax years beginning before December 31, 2017 don't, in any later taxable year, reduce the amount of deduction available under § 250. We also recommend that in calculating the amount of any pre-TCJA NOL carryover to a post-TCJA taxable year under § 172(b)(2), the modification under § 172(d)(9) would not be taken into account.

Taxpayers ability to comment on the proposed § 250 regulations is somewhat limited at this time because they don't yet have experience complying with the numerous tracking and information gathering requirements. This may be in an instance in which temporary regulations are warranted, as they would give taxpayers and Treasury and the IRS a chance to revisit these requirements after gaining some experience trying to comply.

[H] The rules in Prop. § 1.250(b)-4(e)(3) governing documentation of foreign use of intangible property should be expanded to contemplate use of intangible property to provide services

The types of documentation required, under Prop. § 1.250(b)-4(e)(3)(i), for determining when intangible property is sold for a foreign use contemplate that intangible property is used in products but make no mention of the use of intangible property to provide services. If Treasury and the IRS adopt our recommendation in [A] to replace the many complicated foreign use documentation requirements with a single, simple requirement, we ask that they acknowledge that foreign use of intangibles can include use providing services. If instead Treasury and the IRS reject our recommendation in [A], we recommend Treasury and the IRS amend whatever documentation rules are kept to contemplate use of intangible property in providing services.

[I] Treasury and the IRS should allow global sales contracts to be eligible, at least in part, for FDDEI treatment by modifying the definition of foreign person

Global contracts for the sale of property — pursuant to which a domestic corporation contracts with a U.S. affiliate of a multinational group of companies, which buys from the domestic corporation and resells to its foreign affiliates — are routinely executed by U.S. corporations for sound business reasons. Such global contracts are akin to foreign military sales — pursuant to which property is first sold to the U.S. or an instrumentality thereof for subsequent resale to a foreign government — and Treasury and the IRS carved out an exception in Prop. § 1.250(b)-3(c) for foreign military sales so they could qualify as FDDEI sales. We believe Treasury and the IRS have no rational basis for treating foreign military sales under §250 differently from sales under global contracts in which property is ultimately sold to a foreign person.

We believe income from such global sales contracts should be eligible for § 250 benefits to the extent property sold initially to the domestic contracting affiliate is resold by it to its foreign affiliates for foreign use. We accordingly recommend that Treasury and the IRS augment the definition in Prop. § 1.250(b)-4(c) (of when a recipient of a sale of property is a foreign person) to allow global sales contracts, in part, to qualify for § 250 benefits. We suggest language that could be used.

II. SVTDG CONCERNS WITH, AND RECOMMENDATIONS FOR CHANGES TO, THE PROPOSED REGS

A. The documentation rules are unduly burdensome and should be modified

1. The documentation rules in Prop. § 1.250-1(b) should be made permanent

Prop. §§ 1.250(b)-4 through -6 have detailed documentation requirements for FDDEI sales and services. Prop. § 1.250-1(b) allows taxpayers — for taxable years beginning on or before March 4, 2019 — to use “any reasonable documentation maintained in the ordinary course of the taxpayer's business” to establish that the recipient is a foreign person, property is for a foreign use (within the meaning of Prop. §§ 1.250(b)-4(d) and -4(e)), or a recipient of a general service is located outside the U.S. (within the meaning of Prop. §§ 1.250(b)-5(d)(2) and -5(e)(2)), provided such reasonable documentation meets the reliability requirements in Prop. § 1.250(b)-3(d).

We recommend this temporary rule be made permanent and replace the documentation rules in Prop. §§ 1.250(b)-4 through -6. The documentation requirements in Prop. §§ 1.250(b)-4 through -6 will be unduly burdensome. We think it unlikely that third party customers would provide documentation meeting many of the requirements imposed in Prop. §§ 1.250(b)-4 through -6 — for example, where purchased products are used or resold, or where services will benefit the customer. Many SVTDG member companies, for example, typically wouldn't provide information regarding where they plan to use a product they purchase. We therefore anticipate significant difficulties in meeting the documentation required by Prop. §§ 1.250(b)-4 through -6.

The temporary rule avoids these issues by allowing taxpayers to use readily available documents — e.g., invoices, purchase orders, packing slips, bills of lading, etc. The standard “any reasonable documentation maintained in the ordinary course of the taxpayer's business” would ease the burden on taxpayers and the IRS by allowing documentation that's readily generated and that doesn't require significant changes to taxpayers' or customers' processes and systems. The backstop rules denying benefits if, as of the FDII filing date, the taxpayer knows or has reason to know that certain conditions haven't been met,⁴ should be sufficient to prevent abuse.

If the Treasury and the IRS don't adopt this recommendation, we recommend as an alternative that the temporary rule be extended for five years to allow the IRS time to assess which, if any, ways the transition rule is insufficient or problematic. At the same time, an extended transition period would give taxpayers a more reasonable period to implement IT systems and transition customer contract documentation to more closely track the documentation requirements in Prop. §§ 1.250(b)-4 through -6.

2. Qualifying documents should be expanded

Our concerns with the documentation requirements in Prop. §§ 1.250(b)-4 through -6 could also be addressed in part by expanding the types of documents that qualify. As noted above, taxpayers typically get invoices, purchase orders, packing slips, and similar documents in the ordinary course of their businesses. These documents help demonstrate that the recipient of the property or service is a foreign person.

3. The timeline should be extended for getting documentation to show its reliability

Prop. § 1.250(b)-3(d) provides that for purposes of the documentation requirements in Prop. §§ 1.250(b)-4 through -6, documentation is considered reliable only if each of listed requirements (1)–(3) is met. Prop. § 1.250(b)-3(d)(3) states that documentation is reliable only if obtained no earlier than one year before the date of the sale or service to which it relates. The “date of the sale or service” appears to be the date general property title transfers (if actually sold) or intangible property is licensed, or the date services are rendered.

This rule could be problematic because there are situations in which there could be a large time gap between contract signature and delivery of goods or services. For example, contracts for the manufacture of large or complex property or contracts with multiple sales or services provided over a long period of time wouldn't qualify as reliable documentation under Prop. § 1.250(b)-3(d)(3). In some situations, such as advance payments or § 460 contracts, income could be received more than one year before the date of sale or service. Moreover, in many ordinary commercial transactions property is transferred or services are performed pursuant to terms of a “master” agreement executed several years before transference or performance. Such master agreements remain vital, and are no less reliable for being executed more than a year in the past.

We therefore recommend Prop. § 1.250(b)-3(d)(3) be eliminated.

B. The rule in Prop. § 1.250(b)-4(e)(2) for determining whether the sale of intangible property is for foreign use should be similar to the rule for foreign use of general property in Prop. § 1.250(b)-4(d)(2)(i)(B)

1. Background on Prop. §§ 1.250-4(d) & -4(e)

Although § 250 doesn't distinguish between tangible and intangible property, Prop. §1.250(b)-4 (FDDEI sales) does. Under the Proposed Regs, the term “FDDEI sale” means — except in the case of a related party transaction — a “sale” of “general property” or “intangible property” to a “foreign person” for a “foreign use.”⁵ Consistent with the inclusive definition of “sale” under § 250(b)(5)(E), the Proposed Regs define “sale” to mean a sale, lease, license, exchange, or disposition of property.⁶ “General property” includes tangible property but excludes “intangible property,” and “intangible property” has the meaning in § 367(d)(4).

The rule in the Proposed Regs for when a sale of general property is for foreign use differs from the rule for when a sale of intangible property is for foreign use.

With one exception not relevant, the sale of general property is for a foreign use if (A) the property isn't subject to a domestic use within three years of the date of delivery; or (B) the property is subject to manufacture, assembly, or other processing outside the U.S. before the property is subject to a domestic use.⁷

Under the Proposed Regs, the sale of intangible property is for a foreign use — 

[Statement 1] only to the extent that the intangible property generates revenue from exploitation outside the United States. [Statement 2] A sale of intangible property rights providing for exploitation both within the United States and outside the United States is for a foreign use in proportion to the revenue generated from exploitation of the intangible property outside the United States over the total revenue generated from the exploitation of the intangible property. [Statement 3] 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.⁸ [Statement numbers added]

The preamble to the Proposed Regs tries to justify a distinction between the rule for foreign use of intangible property sold and the rule for foreign use of general property sold. But the preamble also asks for comments on whether a rule for intangible property similar to Prop. §1.250(b)-4(d)(2)(i)(B) (for general property) is appropriate.⁹ As explained below, we believe it is appropriate, and we recommend Treasury and the IRS adopt such a rule.

2. Section 250 and its legislative history support similar rules for foreign use of intangible and tangible property sold

(a) Subsection 250(b) makes no distinction between tangible and intangible property, and neither requires foreign use to be revenue generating, nor focuses on end-customer sales of products

Treasury and the IRS cannot change the § 250(b)(5)(A) definition of “foreign use” of property, which is “any use, consumption, or disposition which is not within the United States.” Because §§ 250(b)(4) and (b)(5) make no distinction between tangible and intangible property, the rule for foreign use of property should apply equally to both.

The rule for foreign use of intangible property in Prop. § 1.250(b)-4(e)(1)(i) (quoted above) has three untenable Statements. Statement 1 is contrary to §§ 250(b)(4) & (b)(5). Subparagraph 250(b)(5)(A) defines “foreign use” to include “any use . . . not within the United States,” and this definition applies to tangible and intangible property alike. So Statement 1 contradicts the statute by conditioning “foreign use” for intangible property only on revenue generation from intangible exploitation. Foreign manufacture (for example) is a foreign use of intangible property, and § 250(b)(4)(A) tells us there is FDDEI derived in connection with the intangible property for such use. Statement 1 in effect impermissibly rewrites § 250(b)(4)(A) as —

(A) FOREIGN USE. — The term “foreign use” means any revenue-generating use, consumption, or disposition which is not within the United States.

Treasury and the IRS cannot impose restrictions not found in the statute,¹⁰ which says nothing about revenue generation in the definition of FDDEI and “foreign use.”¹¹ Treasury and the IRS can't pluck from the range of “any use” in the definition of “foreign use” simply revenue generating use. Aside from the general prohibition on agencies adding restrictions to statutory definitions, the focus on revenue generation use ignores the fact that “any use” by the purchaser of an intangible property could include uses that reduce COGS (increasing gross income but leaving revenue unchanged), reduce deductions (increasing taxable income but leaving revenue and gross income unchanged), or lead to the development of new intangible property. Such common uses of intangible property are covered by “any use” in the statute, and it's entirely reasonable to think Congress contemplated such uses when enacting § 250. We recommend Treasury and the IRS reject the focus on revenue generation use and abide by “any use” in the statutory definition of “foreign use.”

Statement 2 is also contrary to §§ 250(b)(4) & (b)(5)(A), for the same reason Statement 1 is: Treasury and the IRS can't limit “use” in the statutory definition to “revenue generation use.” Statement 3 is also contrary to §§ 250(b)(4) & (b)(5)(A), but for a slightly different reason. Statement 3 in effect ignores the foreign use that is manufacture, and conflates it with the foreign use that is sale. This again is impermissible.

(b) The legislative history supports a rule for intangible property similar to that in Prop. § 1.250(b)-4(d)(2)(i)(B)

The House Bill had no provision corresponding to § 250, and the conference agreement followed the Senate amendment, with a few changes not relevant here.¹² The Senate amendment was explicit that one of its goals in tax reform was to remove the tax incentive to locate intangible income abroad and encourage U.S. taxpayers to locate intangible income, and potentially valuable economic activity, in the U.S.¹³

The Senate amendment introduced the definition of FDDEI found in § 250(b)(4). In stating the definition of FDDEI, the Senate amendment explained in a footnote (the “Footnote”) 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.¹⁴

The Conference Report, in describing the Senate amendment, included the Footnote verbatim.¹⁵

Because for § 250 the conference agreement followed the Senate amendment, adopting without change the Senate's definition of FDDEI used in § 250(b)(4), the Senate Explanation is relevant in understanding Congressional intent behind the rule providing a FDII benefit for intangible property transfers.¹⁶

The Senate Explanation provides not only the mechanical description of how § 250 works (cribbed almost verbatim in the Conference Report), but also the policy reasons — the Congressional intent behind the provision. In the seven sentences describing “reasons for change” the phrase “intangible income” is used seven times, and “intellectual property” is used three times.¹⁷ “Tangible property” or “general property” isn't mentioned. So, interpreting the Footnote in light of Congressional intent underlying § 250, there's every indication that at a minimum “property” as used in the Footnote refers to intangible property as well as tangible property.¹⁸

The Footnote hypothesizes that “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.” In the same main text passage, the Senate Explanation tells us that “sold” or “sale” “includes any lease, license, exchange, or other disposition.”¹⁹ So the phrase “property is sold” must include situations in which intangible property is licensed.

The Footnote then refers to the property sold — which can mean intangible property licensed — being “subject to manufacture . . . or other processing.” Can intangible property be subject to manufacture or other processing? Taking the example of a patent covering a semiconductor chip, the patent owner can allow or prevent the manufacture of a chip. Because a patent license is needed to manufacture, if the manufacture is allowed, the patent is used in the manufacture. In the sense that the patent is used in the manufacture, it's exposed to the manufacturing, or experiencing the manufacturing — both are acceptable meanings of “subject to.”²⁰ Both meanings also allow “property sold” to take on its natural meaning in this context — i.e., including intangible property licensed. Taking another example of software, the owner may license the software and grant a licensee the right to make derivative works or make copies for distribution. If either copyright right is given, the software is used in the manufacture (making) — either of derivative works or of copies for distribution — and is thus subject to the manufacture.

In contrasting the rule for intangible property sales with that for tangible property (general property), the preamble to the Proposed Regs quotes the Footnote and then asserts that “[i]ntangible 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.”²¹ This interpretation of the Footnote is wrong. Above we explained how the Footnote is most naturally read to signal Congressional intention that a license of intangible property for manufacture outside the U.S. is a “foreign use” of the intangible.

The Footnote simply confirms what's evident from the plain meaning of § 250(b)(5)(a) — a license or sale of intangible property for manufacture or other processing outside the U.S. is a use of the intangible property not within the U.S., thus a “foreign use.” Treasury and the IRS cannot restrict the statutory definition of foreign use by allowing only revenue-generating uses, or by focusing on end-customers from sales of products.

Recognition of foreign manufacturing as included in “any use” under § 250(b)(5)(A) is also consistent with the § 263A requirement that taxpayers subject to § 263A must capitalize (as part of COGS) all indirect costs properly allocable to property produced.²² Indirect costs that must be capitalized to the extent they're properly allocable to property produced include royalties paid in securing intangible property rights associated with property produced, even if such royalties are incurred only upon sale of the property produced.²³ It would be irrational to disregard manufacturing use of intangible property when royalties for such use must be included in COGS.

3. Recommended language for intangible property similar to Prop. § 1.250(b)-4(d)(2)(i)(B)

For the reasons outlined above, we believe § 250 and its legislative history support the promulgation of similar rules for determination of foreign use of sold tangible property and sold intangible property. We accordingly recommend Treasury and the IRS adopt a rule for determination of foreign use of sold intangible property as follows —

Prop. § 1.250(b)-4(e)(1) In general. A sale of intangible property is for a foreign use if the intangible property is used outside the United States, including situations in which such intangible property is used in, or subject to, manufacture, assembly, or other processing outside the United States.

As outlined above, we believe intangible property can be subject to manufacture, assembly, or other processing, but the addition of “used in” clarifies that concept.²⁴ This rule could be augmented with an example:

Example. DC licenses patents to FP for FP to make products in factories outside the United States, and to sell those products worldwide. Because the intangible property DC licenses to FP is used in, or subject to, manufacture outside the United States, this license constitutes a FDDEI sale.

The suggested definition, above, of foreign use of intangible property sold supports the same results in Prop. §§ 1.250(b)-4(e)(4)(ii)(D) & (E) (Examples 4 & 5, involving software licenses), but for a different reason, depending on use of the software: in Example 4 the software licensed to FP is for a foreign use because FP's foreign employees use the software; in Example 5, only a portion of DC's license to FP is for a foreign use because only a portion of the software is used by FP's foreign employees. A recommended further example would show application of the suggested definition of foreign use of intangible property sold and the simplified documentation rules recommended in A:

Example. DC sells Composition A, a copyrighted article, to customers (for their personal use and consumption) through digital downloads from servers. DC collects customer addresses as part of the online sale process. In the taxable year, DC earns $100 in revenue from selling copies of Composition A to customers, $60 of which is from customers with U.S. addresses and $40 of which is from customers with foreign addresses.

Analysis. DC has established — for all its sales of Composition A to customers with foreign addresses — that it sold $40 of intangible property to foreign persons for a foreign use, with such transactions accordingly constituting FDDEI sales. DC's revenue of $100 can be used to determine its gross DEI, and then its gross FDDEI, FDDEI, and FDII for the taxable year.

C. Recommendations relating to the rules in Prop. § 1.250(b)-4(d)(2) for determining whether the sale of general property is subject to foreign use

Prop. § 1.250(b)-4(d)(2)(i) provides in general that the sale of “general property” is for a foreign use if either of two alternative requirements is met. The two requirements apply in different situations. We give recommendations for each requirement.

1. The three-year rule in Prop. § 1.250(b)-4(d)(2)(i)(A) for determination of foreign use of general property should be replaced with a rule deeming foreign use unless the seller knows, or has reason to know, of a domestic use within three years

The first foreign-use regulatory requirement is met if “[t]he [general] property is not subject to a domestic use within three years of the date of delivery.”²⁵ This requirement is obviously intended to prevent FDDEI from arising from short-term movement of general property outside the U.S., then back in. This reads into the § 250(b)(5)(A) definition of “foreign use” a timing condition not present. We believe very few domestic corporations selling general property outside the U.S. will have — nor can they get — information categorically confirming that general property they sell won't be subject to a domestic use within three years of the delivery date. Many such domestic corporations will thus be deprived of a § 250 deduction in situations in which we think Congress intended the deduction to apply. The problem is that this requirement relies on information domestic corporations in many situations cannot know or get. We believe the first requirement should be replaced with a presumption that a sale of general property to a non-related foreign person is for a foreign use if the property is shipped to a foreign location, unless the domestic corporation knows, or has reason to know, at the time of sale that the general property will be subject to a domestic use within three years of the date of delivery.

We accordingly recommend the requirement in Prop. § 1.250(b)-4(d)(2)(i)(A) be replaced with the following requirement —

(2) Determination of foreign use — (i) In general. Except as provided in [Prop. § 1.250(b)-4(d)(2)(iv)], the sale of general property is for a foreign use if —

(A) the general property is sold to a foreign person and shipped to a foreign location and the seller neither knows, nor has reason to know, at the time of sale that the property will be subject to a domestic use within three years of the date of delivery; or

* * *

Prop. § 1.250(b)-4(d)(1) provides that a taxpayer establishes that a sale of general property is for a foreign use by obtaining documentation described in Prop. § 1.250(b)-4(d)(3). We accordingly ask — consistent with our documentation recommendation in § II.A.1, above — that the documentation description in Prop. § 1.250(b)-4(d)(3) be changed to provide a description mirroring the rebuttable presumption above. That is, a taxpayer should be allowed to use documentation created in the ordinary course of commercial business dealings to demonstrate the presumption that a sale of general property is to non-related foreign persons. Prop. § 1.250(b)-4(d)(1) conditions foreign use on the seller — as of the FDII filing date — neither knowing, nor having reason to know that the property isn't for a foreign use within the meaning of Prop. § 1.250(b)-4(d)(2). This imposes additional significant burdens on taxpayer to gather information on each transaction many months after it's completed. This is unduly burdensome and accordingly we recommend it be removed.

2. The recasting of the rule in Prop. § 1.250(b)-4(d)(2)(i)(B) for determining whether general property is subject to manufacture, assembly, or other processing outside the U.S. should be expanded, augmented with examples in part, and rewritten in part

The second foreign-use regulatory requirement is met if general property is subject to manufacturing, etc. outside the U.S.²⁶ We believe this high-level requirement is reasonable, but the Proposed Regs recast this requirement into two alternative requirements that are problematic and too restrictive. Clause 1.250(b)-4(d)(2)(iii)(A) provides that general property is subject to manufacture, assembly, or other processing only if the property is “physically and materially changed” or “is incorporated as a component into a second product.” We take our recommendations in turn.

(a) We recommend Treasury and the IRS allow a third way of meeting the second foreign-use requirement

We recommend Treasury and the IRS augment the “physically and materially changed” and “component” tests in Prop. § 1.250(b)-4(d)(2)(iii) (for determining if general property is subject to manufacture, assembly, or other processing) — modified as recommended below — with a test that can be met if the property is subject to manufacturing, 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 purchased. This test could be illustrated with an example included in Prop. § 1.250(b)-4(d)(4)(ii):

(D) Example 4: Property physically and materially changed. DC makes and sells to FP integrated circuit chips that FP will, via a surface mount process at a foreign contract manufacturing site, have fastened to a printed circuit board used in a finished product that FP sells. The contract manufacturing process is substantial in nature and generally considered to constitute the manufacture of a finished product different than a chip. The chips DC sells FP qualify as manufactured, assembled, or processed outside the United States.

(b) We recommend Treasury and the IRS give more guidance on when general property is “physically and materially changed”

Clause 1.250(b)-4(d)(2)(iii)(B) provides that the determination of whether general property is subject to a physical and material change is made based on all relevant facts and circumstances. We agree a facts-and-circumstances determination can be reasonable, and sensible, but we recommend that Treasury and the IRS provide some examples to give guidance to taxpayers. We respectfully ask that such examples be representative of (and so helpful for taxpayers in) U.S. industries featuring significant IP portfolios.²⁷

(c) We recommend Treasury and the IRS make the bright-line rule (for determining whether general property is treated as a component incorporated into a second product) into a safe harbor under a general rule

Clause 1.250(b)-4(d)(2)(iii)(C) says —

general property is treated as a component incorporated into a second product only if the fair market value of such property when it is delivered to the recipient constitutes no more than 20 percent of the fair market value of the second product, determined when the second product is completed [the “20-percent-FMV rule”]. For purposes of the preceding sentence, all general property that is sold by the seller and incorporated into the second product is treated as a single item of property.

The 20-percent-FMV rule is seemingly based on the parenthetical in the Footnote, which cites as an example of property sold being for a foreign use “the inclusion of such property, as a component, into a second product by means of production, manufacture, or assembly.”²⁸ The clause asserts that for property sold to constitute a component of a second (presumably different) product, the fair market value (“FMV”) of such property can't be any more than 20 percent of the FMV of the second product. This clause is troublesome for four reasons.

First, the preamble to the Proposed Regs gives no explanation why Treasury and the IRS chose the 20-percent-FMV rule. This can hardly be reasoned decisionmaking. Speculating, perhaps Treasury and the IRS believed semantically that whether a constituent piece of property constitutes a “component” of a second product turns on relative values, or perhaps they simply wanted a bright-line rule they believed could be administered. If these are reasons for choosing the 20-percent-FMV rule, they're flawed.

Second, presumably when Congress in the Footnote used “component” it did so with ordinary meanings in mind. “Component” ordinarily means simply “a constituent part; an ingredient”²⁹ or “a constituent element or part,”³⁰ with no suggestion that a property's FMV has any bearing on whether that property can be a component of a second product. Congress didn't write the Footnote parenthetical as “the inclusion of such property, as a non-valuable component, into a second product. . ., ” yet that's how the proposed clause appears to interpret it.

Third, again speculating, if Treasury and the IRS wanted to prevent, as FDII-qualifying situations, the export of all or most components of a finished product that might be imported back to the U.S., then (a) it's unclear that § 250 benefits should be denied for this transaction, because using the components to manufacture a finished product outside the U.S. is clearly a “foreign use” within the meaning of § 250(b)(5)(A) (it's a “use” of the components); and (b) even if Congress did intend to discourage FDII benefits in such a situation, the approach taken in Prop. § 1.250(b)-4(d)(2)(iii)(C) to accomplish this is clearly overkill, and would deny FDII benefits in many situations we believe Congress intended to qualify.

Fourth, the 20-percent-FMV isn't generally administrable. Domestic corporations exporting components for foreign manufacture of a finished good in many cases don't know — and can't find out — the FMV of the finished good when manufacture is completed,³¹ nor can they be certain whether or not the finished good will be sold back into the U.S. Aside from basing the test on information not readily available, the bright-line rule in the clause can have the effect of export sales of the same property fluctuating in and out of “foreign use,” depending on fluctuations in the relative FMVs. This is impracticable.

Because of these concerns, we recommend Prop. § 1.250(b)-4(d)(2)(iii)(C) be entirely rewritten. Whether general property is a component of a second product should be determined based on all facts and circumstances. This is a determination reasonable minds can make — we think a facts-and-circumstances test can eliminate abusive situations involving export of all, or almost all, components used to make a finished product that's imported into the U.S. We don't believe the determination of whether certain property is a “component” of a finished product should generally turn on relative FMVs, but having a semi-bright-line rule may allow some taxpayers to readily qualify, avoiding potential disputes arising under a facts-and-circumstances determination. A 20-percent threshold is, however, far too low — it defies common sense notions that relatively valuable components are nonetheless components of a finished product. We accordingly recommend Prop. § 1.250(b)-4(d)(2)(iii)(C) be rewritten as follows:

(C) Property incorporated into second product as a component. For purposes of clause (d)(2)(iii)(A) of this section, general property is treated as a component incorporated into a second product based on all the relevant facts and circumstances. Without limiting this substantive test, general property will be considered to be a component incorporated into a second product if the fair market value of such property when it is delivered to the recipient constitutes no more than approximately 50 percent of the fair market value of the second product, determined when the second product is completed. For purposes of the preceding sentence, all general property that is sold by the seller and incorporated into the second product is treated as a single item of property.

Shunting a FMV test to a safe harbor doesn't, of course, remedy the impracticability of the test, signaled above. To address this, we recommend Treasury and IRS adapt the “fungible mass” foreign-use documentation requirements in Prop. § 1.250(b)-4(d)(3)(iii). That is, taxpayers should be permitted to estimate FMVs of finished goods using market research, including statistical sampling, economic modeling, and other similar methods.

D. The definition and treatment of foreign branch income should be reconsidered

1. Background and concerns

(a) Prop. § 1.250(b)-1(c)(11) expands the definition of foreign branch income from Prop. § 1.904-4(f)(2)

Under § 250(b)(3)(A)(i)(VI), foreign branch income is excluded from DEI and thus can't constitute FDDEI or FDII. The definition of foreign branch income is therefore crucial. Subclause 250(b)(3)(A)(i)(VI) says foreign branch income is defined in § 904(d)(2)(J). Subparagraph 904(d)(2)(J) defines foreign branch income — which was added by the TCJA as a new § 904 FTC limitation category (basket)³² — as “the business profits of such United States person [that] are attributable to 1 or more qualified business units (as defined in [§ 989(a)]) in 1 or more foreign countries,” excluding passive category income. Prop. § 1.250(b)-1(c)(11), however, defines foreign branch income as “gross income attributable to a foreign branch of a domestic corporation or a partnership under § 1.904-4(f)(2)” — roughly consistent so far with § 904(d)(2)(J) — but continues:

also includes any income or gain that would not be treated as gross income attributable to a foreign branch under § 1.904-4(f) but that arises from the direct or indirect sales . . . of any asset (other than stock) that produces gross income attributable to a foreign branch, including by reason of the sale of a disregarded entity or interest in a partnership. [Emphasis added]

Thus, Prop. § 1.250(b)-1(c)(11) expands the § 904 definition of foreign branch income to include income from sales of assets that produce income attributable to a foreign branch.

This expanded definition of foreign branch income can whipsaw taxpayers because income arising from sales of assets that produce gross income attributable to foreign branches would be excluded from DEI but also not added to the taxpayer's FTC limitation in the foreign branch basket. For example, if a taxpayer disposes of an interest in a disregarded entity treated as a branch, gain on that disposition is treated as foreign branch income for § 250 purposes (and thus excluded from DEI) but generally not treated as foreign branch income for § 904 purposes (and therefore not added to limitation in the foreign branch basket).

(b) Problem of disregarded transactions imported from Prop. § 1.904-4(f)(2)

In our comment letter³³ on the proposed FTC regulations,³⁴ we expressed concern with Prop. § 1.904-4(f)(2)(vi), which allocates income to or from a foreign branch with respect to certain disregarded payments between foreign branches and their owners. With respect to disregarded transfers of intangible property to or from a foreign branch (for example, a distribution of intangible property from a foreign branch to its owner), Prop. § 1.904-4(f)(2)(vi)(D) mandates adjustments to gross income be made regardless of whether a disregarded payment was in fact made. Comment letters noted a number of problems with this rule: the rule is contrary to legislative intent, distorts the foreign branch owner's gross income, causes — rather than prevents — non-economic reallocation of income, ignores the reality of the foreign branch's activities, and penalizes taxpayers who brought intangible property to the U.S. consistent with the purpose of § 250. Because Prop. § 1.250(b)-1(c)(11) imports the definition of foreign branch income from § 1.904-4(f)(2), Prop. § 1.250(b)-1(c)(11) imports the problem discussed in the comment letters.

2. Recommendations

The definition of foreign branch income in Prop. § 1.250(b)-1(c)(11) and Prop. § 1.904-4(f)(2) should be consistent to avoid the potential to whipsaw taxpayers.

In our comment letter on the proposed FTC regulations, we recommended that foreign branch income be determined simply using the foreign branch books and records. This would prevent non-economic reallocations by using foreign country determinations of income and property ownership. We again urge Treasury and the IRS to adopt this suggestion. Regulations under § 250 should use the same definition of foreign branch income

E. The rules relating to FDDEI services should be modified

1. The rules for property services are problematic

(a) Property services shouldn't be limited to services provided with respect to tangible property

Prop. § 1.250(b)-5(c)(5) defines a “property service” as “a service, other than a transportation service, provided with respect to tangible property. . . .” (Emphasis added.) Prop. §1.250(b)-5(b)(4) provides a property service gives rise to FDDEI only if provided “with respect to tangible property located outside the [U.S.].” The statute contains no such limitation: §250(b)(4) provides that FDDEI includes income derived in connection with “services . . . provided . . . with respect to property, not located in the [U.S.].” “Property” includes tangible property and intangible property. Intangible property can be “located” in a particular jurisdiction: for example, § 862(a)(4) treats as foreign source income rents and royalties from property — including intangible property — located outside the U.S.³⁵ We therefore recommend “tangible” be deleted from Prop. §§ 1.250(b)-5(b)(4) and -5(c)(5).

(b) The mutually exclusive service categories in the Proposed Regs are inconsistent with the statute

The rule in the Proposed Regs for property services is arguably inconsistent with the statute. Paragraph 250(b)(4) provides that FDDEI includes income derived in connection with “services . . . provided to any person, or with respect to property, not located within the [U.S.]” (Emphasis added.) Thus, under the statute, a service can be a FDDEI service if it's either provided to a person outside the U.S. or provided with respect to property located outside the U.S.³⁶ The Proposed Regs give four non-overlapping types of services — general services, property services, proximate services, and transportation services — but these mutually exclusive categories conflict with the statute.

Prop. § 1.250(b)-5(c)(5) provides that a “property service” is a service, other than a transportation service, provided with respect to tangible property, but only if substantially all the service is performed at the location of the property and results in physical manipulation of the property. Under Prop. § 1.250(b)-5(b)(4), a property service gives rise to FDDEI only if provided “with respect to tangible property located outside the [U.S.].” Thus, if, under the Proposed Regs, a property service isn't provided with respect to property located outside the U.S., that service can't constitute a FDDEI service, even if provided to a person located outside the U.S. This is inconsistent with § 250(b)(4)(B).³⁷

To resolve this tension between the statute and the Proposed Regs, the definition of “general service” in the Proposed Regs should be modified. A “general service” could be defined as “any service other than a property service provided with respect to property located outside the United States, or a proximate service, or transportation service.” Consistent with the statute, services provided with respect to property located in the U.S. would therefore be general services and could be FDDEI services if provided to a foreign person.

(c) Recommendation for temporary visit safe harbor

The preamble requests comments on whether an exception should be made for property that is temporarily in the U.S. solely for the performance of certain services, such as maintenance or repair.³⁸ We believe that such an exception or de minimis rule would be appropriate. Because Prop. § 1.250(b)-5(g) requires property be located outside the U.S. for the duration of the period the service is performed, temporary visits of property to the U.S. could, absent such an exception, disqualify the entire service from being an FDDEI service. A temporary visit to the U.S. for maintenance, repair, or similar activities doesn't change the overall character of the service as being provided with respect to property located outside the U.S., and therefore shouldn't prevent such service from being a FDDEI service. If this exception isn't included, taxpayers might be more likely to create foreign subsidiaries to provide maintenance and repair services. Thus, we recommend Prop. § 1.250(b)-5(g) be amended to include the following sentence: “This paragraph shall not apply where property is temporarily located in the United States for purposes of performing maintenance, repair, or similar activities.”

2. The information required to determine the location of general services provided to businesses is likely to be difficult to get

Services that aren't property services, proximate services, or transportation services are general services.³⁹ There are separate rules in the Proposed Regs for determining whether general services are provided to a person outside the U.S. depending on whether the recipient is a consumer or business. For business recipients, if the service provides a benefit to the operations of the recipient in specific locations, gross income of the renderer is allocated to the recipient's operations outside the U.S. to the extent the benefit of the service is conferred on operations of the recipient outside the U.S.⁴⁰ Any reasonable method ⁴¹ can be used to determine the amount of benefit conferred on a recipient's operations outside the U.S. The renderer must get specific forms of documentation that specify the locations of the operations of the recipient that benefit from the service.⁴² This documentation includes documentation (written statements, binding contracts, or information obtained in the ordinary course of business) that specifies all locations of the recipient that benefit from the service.⁴³ If the renderer can't get reliable information as to which of the recipient's locations get a benefit, or if the service provides a benefit to all locations of the recipient's operations, the renderer's gross income is allocated ratably to all the recipient's operations at the time the service is provided.⁴⁴

This information is likely to be very difficult, if not impossible, to get. We don't believe service recipients are likely to provide detailed information on which locations benefit from a service. Many SVTDG member companies typically don't provide this information. Renderers often won't be able to get this information. Getting this information can be particularly troublesome in the software-as-a-service context. Such software may be provided only to a recipient's corporate intranet, and the service provider may have no visibility as to which locations use such software. Moreover, such detailed information isn't necessary. The only relevant question is whether general services are provided to persons inside or outside the U.S. — a complete listing of all the foreign locations that benefit from a service is unnecessary and unduly burdensome.

The overall documentation rule we recommend above in § II.A would alleviate these concerns. If that recommendation isn't adopted, we recommend that the rule for determining the recipient's location for general services be the same as the proposed rule for determining the recipient's location for small transactions — the service is provided to a business recipient located outside the U.S. if the billing address for the recipient is outside the U.S.⁴⁵ This should be the default rule — i.e., a billing address outside the U.S. would create a rebuttable presumption the service is provided to the recipient's locations outside the U.S. There could be exceptions to the extent the contract specifies the services would benefit other offices, to the extent services are specifically provided to a business recipient's other offices or fixed places of business, or if the renderer knows or has reason to know the service benefits an office or fixed place of business of the recipient in the U.S. If any of these exceptions arise the taxpayer would have to demonstrate, using any reasonable means, the extent to which the services are provided to the recipient's operations outside the U.S. Similarly, if the renderer's billing address for the recipient is in the U.S., that would create a rebuttable presumption the service is provided to the recipient's locations in the U.S. A taxpayer should be able to rebut this presumption by demonstrating, using any reasonable means, the extent to which the service is provided to the recipient's locations outside the U.S.

Prop. §§ 1.250(b)-5(d)(1) and -5(e)(1) condition provision of a general service to a consumer (respectively, business recipient) on the renderer — as of the FDII filing date — neither knowing, nor having reason to know that the consumer (respectively, the business recipient) isn't located within the U.S. when the service is provided. This imposes additional significant burdens on taxpayer to gather information on each transaction many months after it's completed. This is unduly burdensome and accordingly we recommend it be removed.

3. The definition of proximate services should be clarified

Prop. § 1.250(b)-5(c)(6) provides that a proximate service is a service, other than a property service or a transportation service, provided to a recipient, but only if substantially all (defined as more than 80 percent of the renderer's time) of the service is performed in the physical presence of the recipient or, in the case of a business recipient, its employees.

The final regulations should clarify that, for business recipients, the service may be performed in the physical presence of either the business recipient's employees or other persons working for the business recipient. For example, if the business recipient pays the renderer to provide services (such as training) to the recipient's contract workers, those services should qualify as proximate services, and therefore FDDEI services to the extent provided outside the U.S. We therefore recommend the first sentence of Prop. § 1.250(b)-5(c)(6) be modified to read: “The term proximate service means a service, other than a property service or a transportation service, provided to a recipient, but only if substantially all of the service is performed in the physical presence of the recipient or, in the case of a business recipient, persons working for the recipient.”⁴⁶

4. Final regulations should clarify that services income isn't foreign branch income

To be FDDEI services, property, proximate, and transportation services must be performed outside the U.S., and general services may be performed outside the U.S. There's the potential for the provision of such services to create a foreign branch. It would be inappropriate to characterize income from FDDEI services as foreign branch income. The final regulations therefore should clarify that income from the provision of FDDEI services isn't foreign branch income within the meaning of Prop. § 1.250(b)-1(c)(11).

F. The related party sales and services rules should be modified

1. The related party sales rule is overly burdensome to taxpayers

(a) The related party sales rule requires taxpayers to file amended returns if the sale to an unrelated party doesn't occur by the FDII filing date

Prop. § 1.250(b)-6(c) provides rules for determining if a sale of general property to a foreign related party (the “related party sale”) is a FDDEI sale. A related party sale is a FDDEI sale only if Prop. §§ 1.250(b)-6(c)(1)(i) or (ii) are met, and satisfying either (i) or (ii) depends on how the related party uses the property purchased from the taxpayer. Prop. § 1.250(b)-6(c)(1)(i) refers to transactions in which the related party resells the purchased property to unrelated foreign parties, either directly or by selling property in which the purchased property is a component (such property, “resale property”).⁴⁷ Prop. § 1.250(b)-6(c)(1)(ii) refers to transactions in which the related party uses the purchased property, either in connection with property sold to unrelated foreign parties (e.g., the related party purchases from the taxpayer a machine the related party uses to make property it sells to unrelated parties) or in connection with providing services to an unrelated foreign party (such property, “use property”).⁴⁸

For resale property to qualify as a FDDEI sale, Prop. § 1.250(b)-6(c)(1)(i) requires the unrelated party transaction occur on or before the FDII filing date.⁴⁹ If the unrelated party sale occurs after the FDII filing date, the gross income from the related party sale is included in the taxpayer's gross DEI for the taxable year of the related party sale, but is not included in its gross FDDEI.⁵⁰ To ensure this timing requirement is satisfied, taxpayers will have to closely track and match related party sales to unrelated party transactions, which can be difficult for many taxpayers given the potentially high volume of sales and number of unrelated foreign buyers.

While taxpayers could get FDII treatment for unrelated foreign party sales after the FDII filing date, doing so requires filing an amended return. Unrelated party sales may frequently occur after the FDII filing date. Suppose, for example, pursuant to a distribution agreement, a U.S. corporation sells products to its foreign subsidiary for exclusive distribution to unrelated foreign customers. The subsidiary is therefore contractually bound to sell the products to unrelated foreign parties, but will do so in several transactions with different unrelated foreign customers, e.g., consumers, retailers, and enterprise customers. This distribution process can easily result in unrelated party transactions occurring after the FDII filing date, and such timing can frequently change due to customer needs. The timing requirement in Prop. § 1.250(b)-6(c)(1)(i) could therefore result in repeated amended returns, despite the fact that the subsidiary is obligated to sell the products to foreign parties. A requirement that could result in large numbers of amended returns is burdensome for taxpayers (who incur knock-on effects, for example with State tax return filings) and difficult for the IRS to administer.

In contrast, a related party sale of use property is a FDDEI sale under Prop. § 1.250(b)-6(c)(1)(ii) if, as of the FDII filing date, the taxpayer reasonably expects an unrelated party transaction described in Prop. §§ 1.250(b)-6(b)(5)(iii) or (iv) will occur, and more than 80 percent of the revenue earned by the foreign related party in the unrelated party transaction is from the related party sale property. Thus, the Proposed Regulations provide a more practical rule for use property.

(b) Recommendations

We recommend Prop. § 1.250(b)-6(c)(1)(i) include a reasonable expectation standard — similar to that in Prop. § 1.250(b)-6(c)(1)(ii) — which would alleviate the burdens on taxpayers trying to satisfy the FDDEI requirements for resale property. This could be achieved by amending Prop. § 1.250(b)-6(c)(1)(i) so a related party sale can qualify as a FDDEI sale if the taxpayer reasonably expects, as of the FDII filing date, the resale property will be part of an unrelated party transaction to a foreign person for foreign use. This “reasonable expectation” could be based on contractual provisions (e.g., the related party is contractually bound to sell the resale property to an unrelated foreign party), or reasonable assumptions based on past practice (e.g., the foreign related party only sells products to unrelated foreign customers), or on market research (including statistical sampling, economic modeling, and other similar methods). An amended return would only be necessary in the unlikely event the contractual provision or past practice isn't followed, in which case the benefit of the relevant § 250 deduction would be recaptured. This reasonable expectation standard would provide taxpayers a practicable option in satisfying the FDDEI requirements for resale property, and aligns with the greater flexibility offered in Prop. § 1.250(b)-6(c)(1)(ii).

Alternatively, we recommend giving taxpayers the option to delay recognition of the related party sale in its gross DEI until the corresponding unrelated party transaction has occurred, should this second sale occur after the FDII filing date. This would allow the taxpayer to file with certainty with respect to qualifying FDDEI sales, and avoid the administrative burden of needing to file amended returns.

2. The related party services rule of Prop. § 1.250(b)-6(d)(2) is sensible but should be modified

Clause 250(b)(5)(C)(ii) states that a service provided to a related party (a “related party service”) is a FDDEI service only if the service isn't substantially similar to a service provided by the related party to a person located within the U.S. Under the Proposed Regs, a related party service is substantially similar to a service provided by the related party to a person in the U.S. if either (a) 60 percent or more of the benefits of the related party service are conferred to persons in the U.S. (the “benefit test”), or (b) 60 percent or more of the price of the service provided by the related party is attributable to the related party service (the “price test”).⁵¹ If the benefit test is met, the entire related party service is prevented from being a FDDEI service. If the price test is met, the proportion of gross income from the related party service that's attributable to a FDDEI service is equal to the proportion of total benefits conferred by the related party service that are conferred to persons located outside the U.S.

We believe a bright-line test is practicable and should help avoid disputes about whether the service provided by the related party is substantially similar to the service provided to the related party. We believe, however, it would in many cases be burdensome for taxpayers to apply both the benefit test and the price test. We recommend that either only the price test be retained, or that the tests be applied conjunctively — that is, only if both tests are met is a service provided to the related party substantially similar to a service provided by the related party to a person in the U.S.

G. Miscellaneous comments

1. There should be a transition provision for the QBAI anti-abuse rule

To determine FDII, DTIR is subtracted from deduction eligible income determining FDII.⁵² DTIR is 10 percent of the QBAI of a domestic corporation.⁵³ QBAI is a corporation's aggregate adjusted bases at the close of each quarter of a domestic corporation's taxable year in specified tangible property used in trade or business of the domestic corporation and of a type with respect to which a § 167 depreciation deduction is allowed.⁵⁴ Prop. § 1.250(b)-2(h) has an anti-avoidance rule that treats a domestic corporation as owning specified tangible property it has transferred to a related party and leased back during a certain disqualified period, if a principal purpose of the transaction is decreasing DTIR. There's a per se rule that deems the “principal purpose” requirement met if the transfer and leaseback occur within six months of each other.⁵⁵

We encourage Treasury and the IRS to adopt a transition provision for applying this QBAI anti-avoidance rule. Such an anti-avoidance rule isn't in the statute, and taxpayers weren't on notice that such a rule would be included in the Proposed Regs. Taxpayers may have entered into sale-leaseback transactions without a principal purpose of reducing DTIR, and such transactions are now caught by the per se rule. We believe it appropriate for the anti-abuse rule to not apply to transactions entered into prior to March 6, 2019, the date the Proposed Regs were published in the Federal Register.

2. Ordering of §§ 250 and 172

The Proposed Regs limit the § 250 deduction by applying NOL carryovers from other years before computing the § 250 deduction. Prop. § 1.250(a)-1(c)(4)) provides that the taxable income limitation of § 250(a)(2) is determined after all the corporation's other deductions are taken into account. This has the effect of limiting the § 250 deduction — a § 172 carryover from a previous year will reduce current year taxable income and § 250 deduction.

Treasury and the IRS have authority to provide transition relief. We recommend that Treasury and the IRS provide by regulation that losses generated in tax years beginning before January 1, 2018 don't, in any later taxable year, reduce the amount of deduction available under §250. We also recommend that in calculating the amount of any pre-TCJA NOL carryover to a post-TCJA taxable year under § 172(b)(2), the modification under § 172(d)(9) would not be taken into account.

3. Treasury and the IRS should consider issuing temporary regulations

While we generally appreciate Treasury's and the IRS's decreased reliance on temporary regulations, § 250 may be an instance in which temporary regulations are warranted. Taxpayers don't yet have experience complying with the tracking and information gathering requirements in the Proposed Regs. These rules may trigger a number of changes to taxpayers' business systems, and the reasonableness and practicality of these rules likely won't be clear until taxpayers have had experience modifying their business systems and collecting documentation. We believe it appropriate to allow taxpayers an opportunity to comment after gaining experience complying with the Proposed Regs. Issuing final regulations too hastily might entrench any problems before they're fully understood.

H. Rules governing documentation of foreign use of intangible property should be expanded to contemplate use of intangible property to provide services

Prop. § 1.250(b)-4(e)(1) provides that a sale of intangible property is for a foreign use only to the extent the seller establishes that the sale is for a foreign use (within the meaning of Prop. § 1.250(b)-4(e)(2)) by obtaining reliable documentation described in Prop. § 1.250(b)-4(e)(3). Prop. § 1.250(b)-4(e)(3)(i) provides generally that a seller establishes the extent to which a sale of intangible property is for foreign use by obtaining one or more of five specified types of documentation. Although two types of documentation contemplate use of intangible property in products,⁵⁶ the use of intangible property to provide services isn't contemplated.

In § II.A above we recommended that the myriad complex documentation requirements in the Proposed Regs be replaced with the simple rule in Prop. § 1.250-1(b) allowing any reasonable documentation maintained in the ordinary course of the taxpayer's business to establish — among other things — that property is for a foreign use (within the meaning of Prop. 1.250(b)-4(e)), provided such reasonable documentation meets the reliability requirements in Prop. § 1.250(b)-3(d). If Treasury and the IRS adopt this recommendation, we ask that they acknowledge that foreign use of intangibles can include use providing services. If Treasury and the IRS reject the recommendation and keep the documentation rules in the Proposed Regs, we recommend Prop. § 1.250(b)-4(e)(3)(i) be amended to contemplate use of intangible property to provide services.

I. Global sales contracts should be eligible, at least in part, for FDDEI treatment by modifying the definition of foreign person

A domestic corporation's FDII is its “deemed intangible income” multiplied by its “foreign derived ratio,”⁵⁷ and the “foreign derived ratio” depends directly on the domestic corporation's “gross FDDEI.”⁵⁸ “Gross FDDEI” of a domestic corporation means the portion of the “gross DEI” (as defined) of the corporation that's derived from all the corporation's “FDDEI transactions.”⁵⁹ A “FDDEI transaction” means either a “FDDEI sale” or a “FDDEI service,”⁶⁰ and a “FDDEI sale” has the meaning in Prop. § 1.250(b)-4(b).⁶¹ Prop. § 1.250(b)-4(b) provides that a “FDDEI sale” generally means a sale of “general property” or “intangible property” to a foreign person for a foreign use.⁶²

The requirement in Prop. § 1.250(b)-4(b) that a FDDEI sale can only arise if property is sold to a foreign person seemingly ignores the reality of “global contracts” entered into by many U.S. corporations. Global contracts often involve a domestic corporation contracting with a U.S. affiliate of a multinational group of companies. The U.S. contracting affiliate “resells” to its multinational affiliates — many of whom are foreign companies — general property or intangible property “bought” from the domestic corporation. Global contracts are executed for sound business reasons, independent of tax considerations. A domestic corporation may not be allowed to bypass a U.S. contracting affiliate, or may be forced to pay a concession to do so. Even though a domestic corporation in a global contract would indirectly be selling property to foreign persons — foreign affiliates of the U.S. contracting affiliate — the rule in Prop. § 1.250(b)-4(b) would deny FDDEI sale treatment to sales under the global contract because the domestic corporation isn't directly selling to a foreign person, even though the some of the property under the global contract is for foreign use.

Global sales contracts involving U.S. contracting affiliates are akin to foreign military sales of property to the United States or an instrumentality thereof under the Export Control Act of 1976, as amended (26 U.S.C. 2751), in that in both cases the first sale of property isn't to “a person who is not a United States person” (a requirement under § 250(b)(4)(A)(i)) although the property may ultimately be resold to a foreign person. Treasury and the IRS carved out an exception in Prop. § 1.250(b)-3(c) for foreign military sales. The proposed rule provides that a sale of property to the U.S. or an instrumentality thereof is treated as a sale of property to a foreign government if the governing contract provides that the relevant property is purchased for resale to such foreign government. We believe Treasury and the IRS have no rational basis for treating foreign military sales under § 250 differently from sales under global contracts in which the property is ultimately sold to a foreign person. Both should be excepted from the strict requirements of § 250(b)(4)(A)(i). We accordingly recommend that Treasury and the IRS revise Prop. § 1.250(b)-4 to provide that global sales contracts can, in part, constitute FDDEI sales to the extent (a) the agreement documenting the contract reflects the intention that foreign persons unrelated to the domestic corporation are intended recipients of the property sold by such corporation under the global contract; and (b) the domestic corporation can — either through the agreement documenting the contract or through its books and records — identify what part of the overall global contract consideration is from foreign use of property by a foreign person.

The change could be made by augmenting the definition in Prop. § 1.250(b)-4(c) — of when a recipient of a sale of property is a foreign person — with the following:

A recipient is also a foreign person for purposes of § 1.250(b)-4(b) to the extent that —

(i) the seller sells property to an unrelated United States person;

(ii) the purchaser does not engage in further manufacture or modification of the property within the United States within the meaning of § 250(b)(5)(B);

(iii) the written agreement governing the legal terms of the sale explicitly provides that some or all of the property is intended to be sold (resold) by the purchaser to one or more foreign persons unrelated to the seller; and

(iv) a portion of the seller's compensation under the sale reflects the sale (resale) by the purchaser to one or more foreign persons unrelated to the seller, either

(A) under the written agreement governing the legal terms of the sale; or

(B) under the seller's books and records.

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 Appendix — SVTDG Membership

10x Genomics

Accenture

Activision Blizzard

Acxiom

Adobe

Agilent

Airbnb

Amazon

AMD

Analog Devices

Ancestry.com

Apple

Applied Materials

Aptiv

Arista

Atlassian

Autodesk

Bio-Rad Laboratories

BMC Software

Broadcom Limited

CA Technologies

Cadence

CDK Global

Chegg, Inc.

Cisco Systems, Inc.

Coinbase

Dell Inc.

DocuSign

Dolby Laboratories, Inc.

Dropbox Inc.

eBay

Electronic Arts

Expedia, Inc.

Facebook

FireEye

Fitbit, Inc.

Flex

Fortinet

Genentech

Genesys

Genomic Health

Gigamon, Inc.

Gilead Sciences, Inc.

GitHub

GLOBALFOUNDRIES

GlobalLogic

Google Inc.

GoPro

Grail, Inc.

Guidewire

Hewlett-Packard Enterprise

HP Inc.

Indeed.com

Informatica

Ingram Micro, Inc.

Integrated Device Technology

Intel

Intuit Inc.

Intuitive Surgical

Keysight Technologies

KLA-Tencor Corporation

Lam Research

Lime

LiveRamp

Marvell

Maxim Integrated

MaxLinear

Mentor Graphics

Microsoft

Netflix

NVIDIA

Oracle Corporation

Palo Alto Networks

PayPal

Pivotal Software, Inc.

Pure Storage

Qualcomm

Red Hat Inc.

Ripple Labs, Inc.

salesforce.com

Sanmina-SCI Corporation

Seagate Technology

ServiceNow

Snap, Inc.

SurveyMonkey

Symantec Corporation

Synopsys, Inc.

The Cooper Companies

The Walt Disney Company

TiVo Corporation

Trimble, Inc.

Uber Technologies

Velodyne LiDAR

Veritas

Verizon Media

Visa

VMware

Western Digital

Workday, Inc.

Xilinx, Inc.

Yelp