The IRS has released final regulations on Section 250 of the Internal Revenue Code (IRC), the deduction for foreign-derived intangible income (FDII). The new guidance modifies the proposed regulations released last year in several ways that may ease the administrative burden of claiming the deduction. Among other changes, the final regulations address widespread concerns that the documentation rules under the proposed regulations were burdensome and, in some cases, would preclude taxpayers from being able to claim the FDII deduction even if their facts otherwise aligned with the requirements.
A FDII recap
The Tax Cuts and Jobs Act (TCJA) created IRC Section 250 to incentivize corporations to base income-generating intangible property (IP) in the United States. The FDII deduction is 37.5% of a corporate taxpayer’s intangible income attributable to foreign sales through 2025 (after which, the deduction percentage decreases to 21.875%). Intangible income for FDII purposes is imputed as net income (after certain exclusions) less 10% of tax basis in production assets computed under the Alternate Depreciation System (ADS). Based on this calculation, the deduction will be available to all C corporations that have qualifying foreign sales of goods and services even if they don’t have significant IP.
What follows is a list of key changes in the final regulations, many of which are intended to ease the administrative burden and international tax consequences of claiming the deduction.
Key changes in final regulations
- Documentation: The proposed FDII regulations issued in March 2019 contained rigid documentation rules that would have required taxpayers, in many circumstances, to collect written certifications from their customers. The final regulations replaced the requirement for specified forms of documentation (such as signed statements) with a broad rule requiring taxpayers to maintain any “reasonable substantiation obtained in the course of business” to support their claim for a FDII deduction. The final regulations take a facts-and-circumstances-based approach on what is reasonable documentation for a specific taxpayer.
Additionally, the final regulations provide criteria that allow taxpayers to presume that transactions meet the “foreign person” or “foreign use” qualification in some circumstances. Taxpayers with retail sales to customers whose shipping addresses are outside of the United States, for example, may presume that the transaction meets the foreign person and foreign use tests unless the taxpayer knows or has reason to know otherwise.
- Sales of component property: The proposed regulations prohibited taxpayers from claiming the deduction for property ultimately used in the United States, but allowed an exemption for sales of components that were subject to further manufacture outside of the United States. To qualify for the exemption under the proposed rules, the taxpayer would have had to show that the component’s fair market value was less than 20% of the fair market value of the end product.
The final regulations acknowledge that this information may not be available to taxpayers and adopt a facts and circumstances rule that requires components to enter a manufacturing process that is “substantial in nature.” The final regulations do retain 20% as a safe harbor provision to meet the substantive rule, but it’s not the only way that taxpayers can demonstrate compliance.
- Coordination with other provisions: The computation of FDII affects the calculation of limitations under several other sections of the IRC. The proposed regulations provided an ordering rule that would have eliminated circular computations for FDII, certain interest limitations, and net operating loss (NOL) carryovers.
The final rules didn’t include any of the proposed ordering rules; the IRS noted that it will address the issue in future separate guidance. The final regulations did provide that taxpayers have the option of applying the originally proposed ordering rule, but that any reasonable method (including the use of simultaneous equations) could be used to determine these limitations until additional guidance is available.
- Modification of exclusion for foreign branch income: The proposed regulations would have excluded from deduction-eligible income (DEI) income from the sale of assets that produce foreign branch income. This would have created a conflict with U.S. foreign tax credit rules, which do not include sale of these assets in the calculation of foreign branch income. This modification to the definition of foreign branch income had the potential to be problematic for taxpayers intending to repatriate intangible property from foreign branches.
The final regulations eliminated the proposed modification and aligned the FDII rules with the foreign branch income definition under the foreign tax credit rules.
- Expense allocation: The proposed regulations were silent as to whether taxpayers were required to apportion pre-TCJA NOL carryforwards to the DEI and foreign-derived deduction-eligible income (FDDEI) groupings. The final regulations specifically eliminated any requirement to apportion NOL carryforwards in the FDII computation. (Note that FDII continues to be limited by taxable income, inclusive of NOL carryforwards). The Treasury noted that additional clarification on the apportionment of research and development costs in the FDII context may be provided as part of future foreign tax credit regulations.
Clarification on digital sales and services: The final regulations attempt to clarify how to determine “foreign use” for sales of digital content such as software, as well as for taxpayers providing digital services.
- Related party sales: The proposed regulations required that sales to related foreign resellers only qualified for FDII if a third-party resale had occurred prior to the filing date of the return claiming the deduction. The final regulations removed this tracing requirement and allow for those sales to qualify if the taxpayer can reasonably demonstrate that a subsequent third-party resale has occurred or will occur at some point with respect to the sale.
The final regulations on Section 250 are effective for tax years beginning on or after Jan. 1, 2021, but taxpayers may choose to apply them to prior tax years provided the final regulations are applied in their entirety.
This new guidance includes some helpful clarifications along with significant relief from documentation and other administrative burdens that would have been created under the proposed regulations. However, the FDII calculation still requires complex fact-specific analysis to determine what products and services will qualify.
If you have questions about whether you qualify for the FDII deduction or would like to discuss how the final regulations will impact your FDII calculation, documentation process, or international tax position, please contact Plante Moran.