Considerations for comments on proposed FDDEI regulations

One area that deserves attention is loss symmetry. New section 250(b)(3)(A)(i)(VII) excludes “income and gain” from dispositions of specified intangible and depreciable property, but it does not expressly address related losses. Existing regulations under section 861 treat losses as deductions, and Reg. section 1.250(b)-1(d)(2) allocates deductions to gross deduction-eligible income (DEI) and gross FDDEI. Under the proposed rules, this could produce an uneven result: Gain from selling a depreciated asset to a foreign customer may be excluded from DEI, while a loss on an economically similar asset could still reduce DEI or FDDEI under the general deduction-allocation rules, thereby decreasing the FDDEI benefit.

Asset-heavy exporters often sell groups of used assets, some at gains and others at losses. If gain from excluded-property dispositions is removed from the FDDEI base, the Treasury Department and the IRS should clarify whether related losses follow the same treatment; otherwise, those losses could still reduce DEI or FDDEI through allocation and materially reduce the taxpayer’s FDDEI benefit. Comments should ask for a symmetrical rule or examples addressing losses from excluded-property dispositions.

Comments may also want to focus on what is regarded as the same property. Under the proposed regulations, property is “other excluded property” only if, in the seller’s hands, it is or has been property of a character subject to depreciation, amortization or depletion.

The Treasury Department and the IRS have already declined to adopt a general remanufacturing exception and rejected limiting the exclusion to depreciation recapture, so comments may be more useful if they address the narrower boundary between previously depreciated property and newly manufactured property that includes used components. 

For example, if a taxpayer starts with a depreciated engine, machine or aircraft component; replaces 80% of its parts; installs new technology and materially changes its capacity or function, when would the sale be treated as a sale of the previously depreciated property, rather than a sale of newly manufactured property containing used components?

It would be especially helpful if taxpayers could provide real production data and suggest objective markers, such as changes in function, physical identity, relative value or basis, or the percentage of original components that remain. The Treasury Department and the IRS need an administrable line, instead of simply a rejection of the remanufacturing exception. A percentage-of-parts or value-added metric may help draw that line.

Another issue is incidental depreciable use. Businesses often use products as demonstrators, loaners, testing units or short-term rental equipment before selling them. The proposed “is or has been” standard appears broad enough to permanently taint an asset after even limited depreciable use.

That result could create arbitrary distinctions. Two identical machines could be sold to identical foreign customers, but only one sale may produce FDDEI because the other machine spent two months as a demonstration unit.

Comments should give the Treasury Department and the IRS real business-cycle examples and ask whether a de minimis rule based on time, depreciation claimed or extent of business use would better distinguish ordinary inventory practices from dispositions of operating assets the proposed regulations are intended to exclude.

A similar administrability issue arises when a single software or cloud contract combines standard platform access with customization or other activities that may implicate research and experimental expenditure rules. Many companies’ R&D tracking systems were built for section 41 or section 174A/174 studies and generally classify engineering time as qualified or nonqualified research, not as a section-250-eligible digital service or article or an excluded IP asset or amortizable tool. As a result, records that support section 41 or section 174A/174 positions may not provide the data needed to defend the FDDEI treatment of a mixed software or cloud transaction.

The proposed regulations do not provide a bright-line rule, safe-harbor percentage or statistical threshold for allocating the purchase price between the eligible component and the excluded component. Instead, the analysis may turn on a subjective assessment of the transaction’s predominant character. That approach could create a significant audit issue, particularly where internal time-tracking and project-management systems do not map engineering work to the legal categories used for FDDEI purposes.

Comments may want to provide the Treasury Department and the IRS with practical examples for mixed software transactions, including cases involving standard SaaS access, customized functionality and separately priced development or analytics work. Without clearer boundaries, taxpayers and exam teams may reach very different conclusions about whether the eligible product or the excluded development component drives the value of the contract.

The Treasury Department and the IRS appear to have provided solutions on many of the major concerns in the proposal. Comments are most likely to be useful if they show how those concerns apply to real transactions. Practitioners can help bring clarity to the comment process by focusing on specific fact patterns, explaining where the proposed rules are unclear or difficult to administer and suggesting practical lines the Treasury Department and the IRS could draw in final regulations.