The U.S. Treasury Department and IRS on March 4, 2019, released proposed regulations (REG-104464-18) relating to the deduction for “foreign-derived intangible income” (FDII) and “global intangible low-taxed income” (GILTI) under section 250.
The proposed regulations [PDF 446 KB] (47 pages) were published in the Federal Register on March 6, 2019.
This report provides initial impressions and observations about these proposed rules. Read a printable version of this report: KPMG report: Initial impressions, observations on proposed FDII, GILTI regulations under section 250 [PDF 409 KB]
The applicability dates for the proposed rules generally fall into three categories:
Nevertheless, taxpayers would not be required to follow the documentation requirements in the proposed regulations (discussed below) for tax years beginning on or before March 4, 2019. Instead, the proposed regulations allow a taxpayer to use any reasonable documentation maintained in the ordinary course of the taxpayer’s business that establishes, with respect to property transactions, that a recipient is a foreign person and that the property is for a foreign use, or with respect to services, that a recipient of a general service is located outside of the United States. This documentation must still satisfy the reliability requirements set forth in the proposed rules.
Significantly, taxpayers are permitted to rely on the proposed regulations for tax years ending before March 4, 2019, without any explicit requirement to consistently apply all of the proposed rules.
The preamble to the proposed regulations includes over 20 requests for comments. Any comments or requests for a public hearing must be submitted by May 6, 2019.
The new U.S. tax law (Pub. L. No. 115-97, enacted December 22, 2017) made a number of significant changes to the U.S. international tax system, including the enactment of the FDII and GILTI regimes. The FDII regime provides a preferential U.S. effective tax rate to U.S. corporations on certain income, by means of a deduction under section 250. Specifically, U.S. corporations may be entitled to a deduction based on their “foreign-derived deduction eligible income” (FDDEI), which is income from certain sales or licenses of property to foreign persons for foreign use and services provided to persons, or with respect to property, located outside the United States. The benefit of the deduction is reduced by 10% of the amount of the corporation’s “qualified business asset investment” (QBAI), which generally is depreciable tangible property used in the production of “deduction eligible income” (DEI). DEI generally consists of all of a corporation’s gross income, other than a few exempt items, reduced by allocable deductions.
Similarly, a U.S. corporation may be entitled under section 250 to a deduction of up to 50% of its GILTI inclusion and related section 78 gross-up. Proposed regulations issued last year addressed a number of questions relating to the calculation of a U.S. shareholder’s GILTI inclusion. [Read TaxNewsFlash for KPMG’s report that examines the GILTI proposed regulations.] The GILTI proposed regulations did not, however, address the U.S. shareholder’s deduction under section 250.
The FDII deduction is subject to a taxable income limitation, which generally reduces the section 250 deduction when the taxpayer’s FDII and GILTI inclusions exceed its taxable income.
To the extent a taxpayer’s section 250 deduction is limited under the taxable income limitation, accounting methods planning may be used to increase taxable income, provided the collateral impacts on all other tax attributes are considered. Accounting methods planning can also be used to reduce a taxpayer’s QBAI, resulting in an increased FDII deduction. Any accounting methods planning should be done while maintaining a holistic perspective of the taxpayer’s tax profile, as this type of planning has the potential to be either beneficial or detrimental in the context of other tax provisions.
The initial statutory building block in the FDII regime is the definition of DEI. The statute defines DEI as the excess (if any) of gross income determined without regard to certain specified classes of gross income, reduced by properly allocable deductions—with the result that DEI represents a net income concept. FDDEI is then defined as “any” DEI that is foreign-derived.
The policy basis for reducing the FDII benefit through a DEI limitation when a taxpayer has domestic losses (that is, negative non-FDDEI) and positive FDDEI is not clear. The statute seems aimed at providing a benefit based on positive FDDEI, and includes a separate taxable income limitation that could limit the FDII deduction based on domestic losses. Further, the requirement to separately allocate expenses to gross FDDEI seems inconsistent with the view that FDDEI is limited to DEI.
The use of the section 861 rules was foreshadowed in Prop. Reg. section 1.861-8(d)(2)(ii)(C)(4), included in the proposed foreign tax credit regulations. That proposed rule would provide that “for purposes of determining deduction eligible income under the operative section of section 250(b)(3),” the proposed exempt income and exempt asset rules under section 864(e)(3) would not apply. The reference to section 250(b)(3) as an operative section under section 861 in the proposed foreign tax credit regulations—which are proposed to have an applicability date that is earlier than the applicability date of the section 250 proposed regulations—raises the question of whether the effect of this reference is to require the application of section 861 to any tax years to which the foreign tax regulations apply but the section 250 regulations do not apply.
In order to determine FDDEI and DEI, a taxpayer must determine its gross income from eligible sources. This raises the question of how cost of goods sold (COGS) are allocated. For this purpose, the proposed regulations generally allow a taxpayer to attribute COGS between gross DEI and gross FDDEI using any reasonable method. The proposed regulations explicitly provide, however, that COGS must be attributed to gross receipts with respect to gross DEI and gross FDDEI regardless of whether certain costs included in COGS can be associated with activities undertaken in an earlier tax year (including a year before the effective date of section 250). For example, if a taxpayer has environmental remediation expenses associated with a 2015 event, any associated expenses will be capitalized to inventory and recognized as COGS as a result of section 263A. Even though the event generating the environmental remediation liability occurred prior to the effective date of section 250, the expenses will be attributed to gross DEI and gross FDDEI.
In contrast to the COGS attribution, the proposed rules do not prevent a facts-and-circumstances-based allocation of below-the-line expenses away from DEI and FDDEI under the principles of section 861. Therefore, taxpayers can evaluate below-the-line deductions to determine whether any of those are attributable to revenue that accrued prior to the effective date of section 250. Pension expense is a common example of an expense that can be partially attributed to activities that occurred in the years before the expense is incurred.
One of the items excluded from DEI is foreign branch income, defined in the statute by cross-reference to section 904(d)(2)(J), which defines “foreign branch income” for purposes of the new foreign tax credit basket for such income. Proposed regulations under section 904(d)(2)(J) provide additional guidance on determining foreign branch income for “foreign tax credit” (FTC) purposes.
It seems likely this difference was driven by the different policy considerations underlying the FDII rules and FTC branch rules. The FDII rules have their genesis in moderating the tax incentives that otherwise exist to shift certain domestic income offshore, while the FTC branch rules are more focused on when a foreign country is likely to impose net basis tax on the operations of a U.S. company. Nonetheless, commentators are sure to question the ability of the regulations to provide a different meaning of foreign branch income for purposes of section 250 when the statute defines it by cross reference to the foreign tax credit rules.
The statute defines QBAI by cross-reference to the definition of the term in section 951A (the GILTI provisions).
The proposed regulations include guidance for determining the amount of the section 250 deduction for taxpayers that file consolidated returns.
A critical element of the FDII deduction is the computation of FDDEI—a subset of DEI that relates to income from certain sales of property to foreign persons for foreign use and from the provision of services to persons, or with respect to property, located outside the United States. The proposed rules refer to these transactions individually as “FDDEI sales” and “FDDEI services” and collectively as “FDDEI transactions.”
The proposed rules provide guidance to assist taxpayers in determining and documenting whether a sale or service transaction is a FDDEI transaction, including a number of general operating rules related to all FDDEI transactions as well as specific rules for FDDEI sales and FDDEI services.
The proposed regulations include operating rules to assist taxpayers in determining whether a sale or service transaction is a FDDEI transaction, as well as extensive rules on documentation to substantiate a FDDEI transaction.
The statute requires that a taxpayer establish the “foreign use” of property in order for a sale to qualify as a FDDEI sale, as well as to establish that a service is provided to a person, or with respect to property, located outside the United States in order for a service to qualify as a FDDEI service, but does not provide any guidance on documentation standards. The proposed rules include a number of specific documentation requirements to satisfy specific elements (foreign use, foreign person, and foreign location). The proposed rules also include a “reason to know” standard (as of the date of filing the relevant tax return) for determining the reliability of the documentation.
This prohibition could imply that the FDII deduction is not elective and may need to be claimed even if the deduction results in negative tax consequences, for example, as a result of the treatment of the related deduction under a foreign tax law that denies deductions for amounts that benefit from certain preferential regimes.
The statute provides that income from the sale or license of property to a foreign person for foreign use is FDDEI, and includes special rules for related-party transactions. Although the taxpayer has the burden of proving foreign use in order to claim a FDII deduction, the statute does not contain any guidance on documentation that would establish foreign use. The proposed rules provide new provisions for determining FDDEI sales, as well as separate rules on documentation that establishes the elements of a FDDEI sale.
The view expressed in the preamble that the financial instruments cannot satisfy the “foreign use” requirement could create an inference that all financial instruments and similar items are excluded from FDDEI. Alternatively, the arguably exclusive definition of stocks and commodities in the proposed regulations could be interpreted as permission to treat a financial instrument or similar item that is not described in the proposed regulations as satisfying “foreign use” if appropriate documentation establishing foreign use under the proposed regulations was obtained.
In light of the similarity between the statutory rules for determining FDII and sourcing royalties, the FDII proposed rules raise the question whether Treasury and the IRS will interpret the sourcing rules in the future in a manner similar to the FDII proposed regulations (for example, sourcing royalties from manufacturing IP based on the location of the end user of the manufactured product). On the other hand, the lack of a similar end-user rule in the proposed rules for IP used to provide a service to a recipient could indicate that the special end-user standard applies solely for FDII purposes, and only to determine the foreign use of IP that is used to develop, manufacture, sell, or distribute a product to an end user.
The interaction of the three-year rule with the documentation requirements is unclear, and raises issues as to whether the documentation rule subsumes the three-year period rule. Is the foreign use standard always satisfied when the documentation rule is satisfied and there was no reason to know of any expected domestic use as of the filing date, even if domestic use actually occurs within the three-year period?
Although the proposed rules do not cross reference or otherwise refer to the manufacturing rules in the subpart F foreign base company sales income regulations, there are similarities between the proposed rules and the “substantial transformation” and “component part” rules in Reg. section1.954-3(a)(4). In contrast, the proposed rules do not contain rules similar to the “substantial contribution” rules that are part of the same foreign base company sales income regulation, perhaps because only the location of manufacture—and not the identity of the manufacturer—is relevant to the foreign use determination.
The analysis is also reminiscent of the section 199 analysis to determine whether a product was domestically manufactured or produced in whole or significant part in the United States. There is beneficial case law under section 199 that establishes a fairly low bar for these activities. See Dean Foods v. United States, Precision Dose v. United States.
The statute provides that services provided to a person, or with respect to property, located outside the United States are FDDEI, and includes special rules for related-party transactions.
In contrast to the other types of services, for general services, the proposed regulations require documentation in order to establish the location of the recipient. The proposed regulations provide that documentation establishing the location of a business recipient includes publicly available information about the recipient.
One favorable difference between section 250 and section 199 relates to the treatment of online software, which follows from the fact that, in contrast to section 199, services are generally eligible for benefits under section 250. Under section 199, the regulations permitted a taxpayer to treat the sale of online software as eligible for section 199 only if certain stringent requirements were satisfied, and these criteria have been the source of ongoing controversy between taxpayers and the IRS. Because section 250 generally applies to income from the delivery of services, this controversy is eliminated under section 250, with a new focus on the location of the consumer or business recipient of the service.
Section 250 treats sales and services made to related foreign parties as not for a “foreign use” unless additional requirements are satisfied. In general, in the case of related-party sale transactions, property is not treated as sold for a foreign use unless it is subsequently sold to an unrelated party for a foreign use or used by a related party in connection with property that is sold, or the provision of services to, an unrelated foreign person for foreign use. In the case of related-party service transactions, the service is not considered a FDDEI service if the foreign related person performs substantially similar services for persons located within the United States. The proposed regulations provide guidance on the application of the related-party rules, including helpful guidance that narrows the application of those rules.
Because the related-party service rule is based on the relative benefit provided by the related party to persons located in the United States, a taxpayer cannot improve its position under the benefit test by having the related party bundle high value services with the related-party service, even though the bundling would improve its position under the price test.
The statute could have been interpreted as having a cliff effect, such that related-party services would be disqualified if a related recipient of services provided a de minimis amount of substantially similar services to a person located in the United States. This result would not occur under the proposed regulations. For example, assume that USS provides $75 of services to FP (a foreign related party). FP uses the related-party service to provide $90 of services to X, a customer located outside the United States, and $10 of services to Y, a customer located in the United States. Although USS would pass the benefit test because 90% (90/(90 + 10)) of the benefits are provided by FP to persons located outside the United States, USS would fail the price test because 75% (75/100) of the price paid by FP’s customers for FP’s service is attributable to the services provided by USS to FP. As a result, the $75 of services income treated as FDDEI services is reduced to $67.50 based on the portion of the total benefit provided by FP to persons located outside the United States ($75 x 90/100 = $67.50), rather than being fully disallowed as would occur under a “cliff effect” rule.
Although the section 250 deduction generally is available only to corporations, the proposed rules allow U.S. individuals, trusts, and estates that make a section 962 election with respect to a controlled foreign corporation to take into account the section 250 deduction applicable to GILTI inclusions and the related section 78 gross-up in determining the amount of tax imposed on their GILTI inclusions under the section 962 rules. This favorable rule would make the section 962 election beneficial to a broader range of individuals, trusts, and estates. Although the rule is proposed to apply to tax years that end on or after March 4, 2019, taxpayers can rely on the proposed regulations for tax years that end before March 4, 2019.
The proposed rules contain a number of information reporting requirements, which are largely consistent with relevant forms previously released by the IRS.
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