Overview
On Thursday, July 9, Treasury and the IRS released final regulations under section 250, providing guidance on the deduction for foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI). With respect to FDII, the regulations provide important guidance to taxpayers regarding the calculation of FDII, substantiation and documentation, and qualification of sales and services income as foreign-derived. The final regulations retain the basic approach and structure of the proposed regulations with certain revisions that reduce certain documentation burdens and provide greater flexibility to taxpayers to substantiate their FDII deduction, though the relief does not go as far as some taxpayers had hoped.
This alert provides an overview of several highlights of the final regulations and initial practical considerations for taxpayers. In sum:
- The final regulations are generally applicable to tax years beginning on or after January 1, 2021, giving taxpayers additional time to develop systems and procedures for complying with the regulations.
- The final regulations loosen the documentation requirements in several respects, providing greater flexibility to taxpayers to substantiate income from sales and services as foreign-derived.
- The final regulations treat section 250(b) (the FDII rules) as an operative section under the section 861 regulations, thus adopting those expense allocation rules into the FDII regime. However, the final regulations remove the provision in the proposed regulations stating that the exclusive apportionment rules in current Treas. Reg. 1.861-17(b) do not apply for purposes of apportioning R&E expenses to gross deduction eligible income (DEI) and gross foreign-derived deduction eligible income (FDDEI). The application of exclusive apportionment in the FDII context is being considered in connection with the finalization of proposed regulations under Treas. Reg. § 1.861-17.
- The final regulations do not contain an ordering rule for the taxable income limitation, allowing taxpayers to choose any reasonable method as long as it is applied consistently for all taxable years beginning on or after January 1, 2021.
- The regulations make various changes to the rules for determining whether a transaction generates income from a FDDEI sale or service, including, but not limited to, providing an additional rule for sales of general property that primarily contain digital content, streamlining the rule for foreign military sales, expanding certain presumptions about when a sale can be considered to be made to a foreign person or for foreign use, providing a rule for a sale or license of bundled IP, clarifying the term "benefit" used in determining whether income from a service is foreign-derived, and allowing certain property services to be treated as FDDEI services where the service is provided in the United States.
In addition, although not the main topic of this alert, the final regulations permit individuals making a section 962 election to take into account the deduction for GILTI under section 250. The preamble to the regulations notes uncertainty regarding when an individual may make a section 962 election on an amended return and states that, until any final guidance on this issue is published, individuals may make an otherwise valid election on an amended return for 2018 and later, provided the interests of the government are not prejudiced by the delay, as described in Treas.Reg. § 301.9100-3(c).
Refresher on Section 250
Subject to a taxable income limitation, section 250 allows a domestic corporation to deduct an amount equal to the sum of 37.5% of its FDII, plus 50% of its GILTI inclusion. Generally, a taxpayer's FDII is calculated by multiplying (i) the ratio of FDDEI to total DEI, by (ii) the corporation’s deemed intangible income. FDDEI is equal to gross FDDEI over properly allocable deductions, with gross FDDEI being the portion of gross DEI derived from FDDEI transactions (i.e., FDDEI sales and FDDEI services).
Transition Rules
The final regulations are generally applicable to tax years beginning on or after January 1, 2021, giving taxpayers additional time to develop systems and procedures for complying with the regulations. The proposed regulations were proposed to apply to taxable years ending on or after March 4, 2019.
Taxpayers may choose to apply the final regulations to tax years beginning before January 1, 2021, provided that they apply the final regulations in their entirety (with the exception of certain substantiation requirements). The preamble to the regulations also states that taxpayers are permitted to rely on the proposed regulations in their entirety for tax years beginning before January 1, 2021, except that taxpayers relying on the proposed regulations may rely on the transition rule for documentation for all taxable years beginning before January 1, 2021 (rather than only for taxable years beginning on or before March 4, 2019).
Documentation Relief
The proposed regulations provided that taxpayers must obtain specific types of documentation in order to establish that transactions qualify as FDDEI sales or services, including documentation to establish that a recipient is a foreign person and, in the case of certain sales, the property is for a foreign use. However, under a transition rule for tax years beginning on or before March 4, 2019, taxpayers could satisfy the documentation requirements with any reasonable documentation maintained in the ordinary course of the taxpayer’s business, provided that such documentation met certain reliability requirements.
In response to comments noting the difficulties of requiring specific documentation given variations in industry practices, the final regulations loosen the documentation requirements by eliminating the specific documentation requirements to establish foreign person status and foreign use with respect to certain sales of general property and the location of a consumer of a general service. The final regulations also do not require any particular documentation to substantiate that a transaction qualifies as foreign military sale or service. Substantiation is required for foreign use with respect to sales of general property to non-end users, foreign use with respect to sales of intangible property, and with respect to determining whether services are performed for business recipients located outside the United States, but the taxpayer is not limited to only certain documents. The rules for determining whether a sale or service is made to a foreign person have also been loosened, including allowing the taxpayer to presume that the recipient is a foreign person in certain cases. The documentation changes are welcome although do not go as far as some taxpayers had requested.
Expense Allocation
Like the proposed regulations, the final regulations treat section 250(b) as an operative section under the section 861 allocation and apportionment rules. However, the final regulations remove the provision in the proposed regulations stating that the exclusive apportionment rules in Treas. Reg. § 1.861-17(b) do not apply for purposes of apportioning R&E expenses to gross DEI and gross FDDEI. The preamble notes that Treasury and the IRS will consider the issues raised regarding the application of exclusive apportionment for purposes of section 250, as well as comments regarding the applicability of the gross income method of allocating R&E expenses, as part of finalizing the proposed regulations under Treas. Reg. § 1.861-17, issued on December 17, 2019. Those regulations may be finalized this year, and were proposed to apply to taxable years beginning after December 31, 2019.
Taxable Income Limitation
Like several other Code provisions, the section 250 deduction is subject to a taxable income limitation. The proposed regulations provided an ordering rule stating that a taxpayer’s taxable income for purposes of applying the section 250(a)(2) limitation is determined after all other deductions are taken into account (with no distinction between pre-TCJA and post-TCJA net operating losses). The final regulations continue to not distinguish between pre- and post-TCJA losses. With respect to ordering, Treasury and the IRS determined that further study was required. The preamble states that they are considering a separate guidance project to address the interaction of sections 163(j), 172, 250(a)(2), and other Code sections that refer to taxable income and that such guidance may include the use of simultaneous equations rather than an ordering rule. Until guidance is issued, taxpayers may choose any reasonable method as long as it is applied consistently for all taxable years beginning on or after January 1, 2021.
FDDEI Sales and Services
The regulations make various changes to the rules for determining whether a transaction generates income from a FDDEI sale or service, including, but not limited to, providing an additional rule for sales of general property that primarily contain digital content, streamlining the rule for foreign military sales, expanding certain presumptions about when a sale can be considered to be made to a foreign person or for foreign use, providing a rule for a sale or license of bundled IP, clarifying the term "benefit" used in determining whether income from a service is foreign-derived, and allowing certain property services to be treated as FDDEI services where the service is provided in the United States.