On July 9, 2020, the U.S. Treasury Department (Treasury) and the Internal Revenue Service (IRS) issued final regulations (the Final Regulations) on the section 250 deduction for foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI), two important international provisions added to the Internal Revenue Code (IRC) by the 2017 Tax Cuts and Jobs Act (TCJA).
The FDII provisions are intended to encourage exports of certain goods and services by allowing domestic corporations to take a 37.5% deduction on their FDII—bringing the effective tax rate on that income down to 13.125%—through the end of 2025. Beginning in 2026, the FDII deduction shrinks to 21.875% and the effective tax rate rises to 16.406%.
The GILTI provisions, on the other hand, are intended to discourage U.S. persons from shifting intangible property to low-tax jurisdictions. This is achieved by subjecting U.S. shareholders of a controlled foreign corporation (CFC) to current U.S. taxation on certain CFC earnings that exceed a 10% return on foreign tangible assets. Domestic corporations, and certain noncorporate shareholders that make a section 962 election, however, are allowed a deduction equal to 50% of their GILTI inclusion and any related section 78 gross-up until 2025. After 2025, the GILTI deduction is reduced to 37.5%.
Proposed regulations issued on March 4, 2019 (the Proposed Regulations), offered guidance on both the computation of the deductions available and the determination of FDII. The Final Regulations retain the basic approach and structure of the Proposed Regulations but contain several significant changes. This alert provides an overview of some of the key changes made (and not made) by the Final Regulations. We expect to publish an in-depth white paper in the coming weeks.
FDII of a domestic corporation is determined through a series of complex calculations meant to approximate income from the sale of goods and services abroad attributable to U.S.-based intangible assets. Broadly, FDII is the income of a domestic corporation (subject to certain exclusions and net of attributable deductions) derived from (i) sales of property to foreign persons for foreign use; and (ii) services provided to any person located outside the United States or with respect to property located outside of the United States. In both cases, such income is reduced by a ‘routine’ 10% return on the domestic corporation’s tangible assets.
Documentation rules relaxed
The Proposed Regulations provided that sales and services otherwise eligible for the FDII deduction would not qualify unless the taxpayer obtained specific types of documentation. However, under a transition rule for taxable 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.
In response to comments pointing out the difficulties of requiring specific documentation given the variations in industry practices, the Final Regulations relax the documentation requirements by removing the specific documentation requirements to establish foreign person status and foreign use with respect to certain sales of general property (i.e., property other than intangible property, securities or commodities) sold to an end user, and the location of a consumer of a general service. Instead, the general requirement for taxpayers to substantiate their deductions will apply without any additional specific requirements as to the content of information or documents.
The Final Regulations also relax the substantiation requirements for foreign use with respect to sales of general property to non-end users (i.e., retailers and distributors), for foreign use with respect to intangible property, and for determining whether services are performed for business recipients outside the United States.
To give taxpayers additional time to develop systems for complying with the Final Regulations, the transition rule noted above has been extended to taxable years beginning before Jan. 1, 2021.
Determining foreign person
The Final Regulations add that a sale of property is presumed made to a foreign person if the sale is described in one of four categories:
- Foreign retail sales;
- Sales of general property that are delivered to an address outside the United States;
- Other sales of general property (i.e., sales not described in categories 1 or 2) with a billing address outside the United States; or
- Sales of intangible property with a billing address outside the United States.
The presumption does not apply, however, if the seller knows or has reason to know that the sale is to a recipient other than a foreign person.
Determining foreign use
Under the Final Regulations, a sale of general property will be deemed to be for a foreign use if:
- The property is subject to manufacturing, assembly or other processing outside the United States; or
- The property is, in specified cases, delivered to an end user (e.g., a foreign retail sale, property delivered to a location outside the United States, or an electronic transfer of digital content outside the United States)
Further, a sale of intangible property will be deemed to be for a foreign use if the end user of the intangible is located outside the United States, including when the intangible is used to provide a service outside the United States.
Interplay of sections 163(j) and 172 with section 250
Section 250 provides that the FDII, GILTI, and related section 78 gross-up deductions cannot exceed the taxpayer’s taxable income (meaning taxpayers cannot create a loss under these rules). Several other provisions, such as section 163(j) (interest deduction) and 172 (net operating loss deduction), also contain a limitation based, in one shape or another, on taxable income. The Proposed Regulations provided an ordering rule in their preamble and in an example for applying sections 163(j) and 172 in conjunction with section 250.
The Final Regulations do not include this ordering rule. The preamble to the Final Regulations states that Treasury and the IRS are considering a separate guidance project to address the interplay of sections 164(j), 172, 250(a)(2), and other 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 apply the Proposed Regulations or any other reasonable method.
Other noteworthy provisions
Net operating losses generated pre-TCJA. The Final Regulations reject comments asking that pre-TCJA NOL carryforwards not be factored into the calculation of taxable income for purposes of the section 250 deduction.
Carryovers. The Final Regulations also reject comments asking that taxpayers be allowed to carryforward or carryback of any excess FDII that is limited due to the taxable income limitation. In addition, the Final Regulations clarify that deductions carried over under sections 163(j), 170(b)(2), 172, 246(b) and 250 do not apply when allocating and apportioning deductions to gross deduction eligible income (DEI) or gross foreign-derived deduction eligible income (FDDEI) of a taxpayer for a taxable year.
Definition of general property. The Final Regulations clarify that that an interest in a partnership, trust or estate is not general property.
New categories of services. The Final Regulations create a new category of general services defined as “electronically supplied services,” which includes general services (other than advertising services) that are delivered over the internet or an electronic network. The Final Regulations also create a new subcategory of general services for advertising services, including advertising services to display content on the internet, and provide additional guidance with respect to these services.
Branch income. Foreign branch income is not taken into account as eligible for the FDII deduction. The Proposed Regulations had defined foreign branch income by cross-reference to the foreign tax credit regulations but also added that for purposes of FDII, income from the sale of a branch asset, including the sale of an interest in a disregarded entity or partnership (but not a corporation) would be considered foreign branch income. The Final Regulations have removed that modification to the definition of foreign branch income.
Hedging transactions. The Final Regulations provide that a corporation’s or partnership’s gross income resulting from FDDEI sales of general property is adjusted by reference to certain hedging transactions. The hedging transaction must meet the requirements of regulation section 1.1221-2, including the identification requirement under regulation section 1.1221-2(f), the transaction must hedge price risk or currency fluctuation with respect to ordinary property, and the property being hedged must be general property that is sold in a FDDEI sale.
Sale leaseback transactions. The Final Regulations adopt the rule that says that, for purposes of calculating a domestic corporation's qualified business asset investment (QBAI), a transfer of specified tangible property by a domestic corporation to a related party is disregarded if, within a two-year period beginning one year before the transfer, the domestic corporation leases the same or substantially similar property from a related party and such transfer and lease occur pursuant to a principal purpose of reducing the domestic corporation’s deemed tangible income return (DTIR). The Final Regulations, however, say that this anti-avoidance rule does not apply to a transfer of property that occurs before March 4, 2019.
Application of GILTI deduction to taxpayers making a section 962 election. The Final Regulations adopt the rule permitting individuals making a section 962 election to take into account the deduction for GILTI under section 250. The preamble to the Final 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.
The Final Regulations are generally applicable to tax years beginning on or after Jan. 1, 2021. For tax years beginning before Jan. 1, 2021, taxpayers may apply the Final Regulations or rely on the Proposed Regulations (including, as previously noted, the documentation transition rule whereby a transaction may be substantiated by any reasonable documentation maintained in the ordinary course).
Taxpayers should carefully review the Final Regulations to determine the implications, if any, on their prior FDII and GILTI calculations for both tax return and financial statement purposes.