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Final IRS FDII regulations ease administrative concerns

July 23, 2020 / 5 min read

New guidance reduces administrative burdens and clarifies rules for expense apportionment and limitations when computing the FDII deduction.

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

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.

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.

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.

The final regulations eliminated the proposed modification and aligned the FDII rules with the foreign branch income definition under the foreign tax credit rules.

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.

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.

Closing thoughts

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.

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