Public Law 115-97 (the Tax Cuts and Jobs Act) added a new foreign income inclusion rule for global intangible low-taxed income (GILTI) under section 951A. The Tax Cuts and Jobs Act also added section 250, which permits domestic corporations a deduction in respect of their GILTI and foreign-derived intangible income (FDII). On March 4, 2019, the Department of the Treasury and the Internal Revenue Service (IRS) issued proposed regulations (REG-104464-18) under section 250 (the Proposed Regulations).

• The Proposed Regulations clarify the determination of FDII and the calculation of the deduction under section 250 in respect of GILTI and FDII.
• The Proposed Regulations set out detailed documentation rules for establishing that sales of property and the provision of services qualify as FDII.
• The Proposed Regulations clarify that individual United States shareholders that make an election under section 962 may claim the deduction under section 250.

The Proposed Regulations are long (177 pages), detailed and comprehensive. The Proposed Regulations generally apply to taxable years ending on or after March 4, 2019. Noting that some taxpayers may have entered into transactions prior to this date and may not have obtained the required documentation described below, the Proposed Regulations provide that for taxable years beginning on or before March 4, 2019, taxpayers may use any reasonable documentation maintained in the ordinary course of a taxpayer’s business to establish that a recipient is a foreign person, property is for a foreign use, or a recipient of a general service is located outside the US (provided such documentation meets certain reliability requirements). Comments on the Proposed Regulations are due by May 6, 2019.

The Section 250 Deduction

For tax years beginning after December 31, 2017, section 250 permits a domestic corporation a deduction in an amount equal to the sum of (i) 37.5% of the FDII of such domestic corporation for the tax year, plus (ii) 50% of the GILTI included by such corporation under section 951A for the year and the associated section 78 gross-up. For tax years beginning after December 31, 2025, the amount of the deduction is calculated by substituting 21.875% for 37.5% and 37.5% for 50%, respectively.

The effect of the section 250 deduction is to reduce the effective rate of US tax on FDII and GILTI. As a result of the section 250 deduction, the effective rate of US tax on FDII is 13.125% (16.40625% for taxable years beginning after 2025). As discussed below, before taking into account the potential limitation resulting from expense allocation to the GILTI foreign tax credit basket, a taxpayer’s GILTI inclusion will not be subject to US residual income tax if the income has been subject to an average foreign effective rate of tax of at least 13.125% (16.40625% for taxable years beginning after 2025). As noted in the preamble to the Proposed Regulations, the legislative history reflects that Congress intended that effective rates of tax “neutralize the role that tax considerations play” when a domestic corporation is considering whether to sell property or provide services that would qualify as FDII either directly or through a foreign subsidiary.

The section 250 deduction is subject to a taxable income limitation. If the sum of a domestic corporation’s FDII and GILTI exceeds its taxable income for a given year, the excess is allocated pro rata to reduce the corporation’s FDII and GILTI solely for purposes of computing the amount of the section 250 deduction.

The Proposed Regulations provide a complicated, 5-step ordering rule (and helpfully, an illustrative example) for applying sections 163(j) (limitation on business interest expense) and 172 (net operating losses) in conjunction with section 250. Specifically, the Proposed Regulations provide that a domestic corporation’s taxable income for purposes of the taxable income limitation described above is determined after all of the corporation’s other (i.e., non-section 250) deductions are taken into account.

GILTI Recap

Under section 951A, a US shareholder must include in gross income its GILTI with respect to controlled foreign corporations (CFCs) whose taxable years begin after December 31, 2017. A US shareholder does not compute a separate GILTI inclusion with respect to each CFC, but rather, it computes a single GILTI inclusion amount by reference to all of its CFCs. GILTI is the US shareholder’s “net CFC tested income” less its “net deemed tangible income return.” Net CFC tested income is the excess, if any, of the US shareholder’s aggregate pro rata share of its CFC tested income over its aggregate pro rata share of CFC tested loss. Net deemed tangible income return is 10% of a US shareholder’s aggregate pro rata share of a qualified business asset investment (i.e., depreciable tangible property used in a business that produces CFC tested income) of each CFC, reduced for its “specified interest expense.” See our prior alert on the proposed regulations under section 951A.

As noted above, under section 250, a domestic corporation is permitted a deduction in an amount equal to 50% (37.5% for taxable years beginning after 2025) of the amount of the GILTI inclusion (and associated section 78 gross-up) in calculating the US shareholder’s taxable income, resulting in an effective rate of US tax of 10.5% (13.125% for taxable years beginning after 2025). In addition, 80% of the foreign income taxes attributable to the GILTI inclusion can be claimed as a foreign tax credit, subject to applicable foreign tax credit limitations. See our prior alert on the proposed foreign tax credit regulations. Before taking into account the potential limitation resulting from expense allocation to the GILTI basket, a taxpayer’s GILTI inclusion will not be subject to US residual income tax if the income has been subject to an average foreign effective rate of tax of at least 13.125% (16.40625% for taxable years beginning after 2025), which, as noted above, is equal to the effective rate of US tax on FDII.

Under section 962, an individual that is a US shareholder of a CFC may elect to be taxed on amounts included in the individual’s gross income under section 951(a) in “an amount equal to the tax that would be imposed under section 11 if such amounts were received by a domestic corporation.” GILTI is treated as an amount included under section 951(a) for purposes of section 962. Prior to the Proposed Regulations, it was not clear whether an individual US shareholder making an election under section 962 would be able to claim a deduction under section 250, resulting in US tax on such individual’s GILTI inclusion (and associated section 78 gross-up) at rates up to 37%. The Proposed Regulations provide that an individual US shareholder electing under section 78 is permitted to claim the section 250 deduction.

FDII

FDII is certain income of a domestic corporation in excess of a permitted return on tangible assets that is attributable to certain sales, and the provision of certain services, to foreign persons. As reflected below, calculating FDII involves working through numerous defined terms.

• FDII is equal to a domestic corporation’s deemed intangible income (DII) for the year multiplied by the corporation’s foreign-derived ratio for the year.
• DII is equal to a domestic corporation’s deduction eligible income (DEI) for the year over the corporation’s deemed tangible income return (DTIR) for the year.
  • DEI is equal to the gross income of the corporation (or partnership) for the year (i) determined without regard to certain items, including: subpart F income and amounts included under section 956; GILTI; dividends from CFCs; and foreign branch income, and (ii) reduced by deductions properly allocated to such income.

Eversheds Sutherland Observation: There is a tension between DEI and foreign branch income because the two are mutually exclusive. The proposed foreign tax credit regulations provide a general anti-abuse provision that would prevent a taxpayer from artificially increasing either foreign branch income or DEI and decreasing the other. Although the proposed foreign tax credit regulations provide no indicators or examples of when the anti-abuse rule would apply, Treasury Regulation section 1.987-2(b)(3) provides factors that indicate tax avoidance and factors that do not indicate tax avoidance. Presumably, the principles of those rules may be applied to determine when the anti-abuse rule would apply.

• DTIR is equal to 10% of the corporation’s qualified business asset investment (QBAI) for the year. QBAI is described in greater detail below.

• A corporation’s foreign-derived ratio is the ratio (not to exceed one) of (i) the corporation’s foreign-derived deduction eligible income (FDDEI) for the year to (ii) the corporation’s DEI.
  • FDDEI is equal to the gross income of the corporation (or partnership) from FDDEI transactions reduced by deductions properly allocable to such income.
  • FDDEI transactions include FDDEI sales and FDDEI services, which are described in greater detail below.

The Proposed Regulations provide that for purposes of determining the gross income included in DEI or FDDEI of a corporation (or a partnership) the cost of goods sold may be attributed to gross receipts with respect to DEI or FDDEI under any reasonable method. A domestic corporation’s deductions that are properly allocable to DEI and FDDEI are allocated and apportioned to DEI and FDDEI under the rules of Treasury Regulation sections 1.861-8 through 1.861-14T and 1.861-17.

QBAI

QBAI is the average of a domestic corporation’s aggregate adjusted basis as of the close of each quarter of the year in specified tangible property - generally, depreciable tangible property used in the production of DEI. In the case of tangible property that is used in both the production of DEI and the production of income that is not DEI (dual use property), the Proposed Regulations provide rules that allocate and treat a portion of the adjusted basis in such property as adjusted basis in specified tangible property.

The Proposed Regulations include anti-avoidance rules applicable where a domestic corporation transfers specified tangible property to a related, or in some cases unrelated, party and leases back the same or substantially similar property to decrease the domestic corporation’s DTIR. Where applicable, the anti-avoidance rules treat the domestic corporation, solely for purposes of determining its QBAI, as continuing to own the transferred property.

Eversheds Sutherland Observation: While some early commentators had suggested sale-leaseback transactions as a planning technique, the Proposed Regulations make clear that if such a transaction occurs within a 6-month period, the transaction will be disregarded for purposes of determining QBAI.

FDDEI Transactions

One of the central issues addressed by the Proposed Regulations is whether a transaction qualifies as an FDDEI sale or an FDDEI service. If a transaction includes both a sale component and a service component, it is classified according to its overall predominant character for purposes of determining whether it is subject to the FDDEI sales or FDDEI services rules. The FDDEI transaction rules incorporate some familiar rules from the “manufacturing” rules under foreign base sales company income regulations and the defunct foreign sales company regulations.

FDDEI Sales

An FDDEI sale is a sale of general property or intangible property to a foreign person for foreign use. For these purposes, a “sale” includes any lease, license, exchange or other disposition of property, including a transfer of property resulting in gain or an income inclusion under section 367. A recipient is a foreign person for these purposes only if the seller obtains prescribed documentation establishing the recipient’s status as a foreign person. A sale of general property is for foreign use for these purposes only if the seller obtains prescribed documentation that the property is for a foreign use.

A sale of general property is for a foreign use if the property (i) is not subject to domestic use within 3 years of delivery or (ii) is subject to manufacture, assembly or other processing outside the US before the property is subject to a domestic use. General property is subject to manufacturing, assembly or other processing only if (i) there is a physical or material change to the property (a facts and circumstances standard) or (ii) the property is incorporated as a component into a second product (and the fair market value of the component does not exceed 20% of the fair market value of the second component).

A sale of intangible property is for a foreign use only to the extent that the intangible property generates revenue from exploitation outside the US. In the case of intangible property rights providing for exploitation within and outside of the US, the seller will need to be able document an allocation of the recipient’s revenues from exploiting the intangible property within and outside of the US.

Sales of securities (as defined in section 475(c)(2)) and commodities (as defined in section 475(e)(2)(B)) are not FDDEI sales. As a result, sales of stock and partnership interests do not qualify as FDII.

FDDEI Services

FDDEI services include the provision of a general service to a consumer or a business recipient located outside the US.

A general service is provided to a consumer outside of the US only if the provider obtains prescribed documentation that the consumer is located outside the US. A consumer is located where the consumer resides when the service is provided.

A general service is provided to a business recipient outside the US only if the provider obtains prescribed documentation that the service is provided to a business recipient outside the US. A service is provided to a business recipient outside the US to the extent the gross income of the service provider is allocated to the recipient’s business operations outside the US – generally based on the location of the operations of the recipient benefitting from the service.

FDDEI services also include the provision of certain proximate services (generally where substantially all of the service is performed in the physical presence of the recipient or its employees) to recipients located outside the US, the provision of certain property services (generally where substantially all of the service is performed at the location of the tangible property and results in physical manipulation of the property) with respect to tangible property located outside the US and the provision of certain transportation service to recipients, or with respect to property, located outside the US.

Documentation Rules

The Proposed Regulations require documentation to establish the qualification of transactions as FDDEI sales and FDDEI services. These documentation requirements present a menu of items in order to be flexible but which may, in the end, be more difficult and burdensome to apply than if a withholding certification similar to the IRS Form W-8BEN-E were required that only required a recipient of the services or goods to check a box on the form.

Documentation may only be relied upon if it satisfies the following requirements:

• As of the date the seller/service provider is required to file (including extensions) an income tax return for the year the income from the sale/provision of service is included in income (the FDII filing date), the seller/service provided does not know or have reason to know that the documentation is unreliable or incorrect;
• The documentation is obtained by the seller/service provider by the FDII filing date with respect to the sale/service; and
• The documentation is obtained no earlier than one year before the date or the sale or service.

A seller with less than $10 million in gross receipts during a prior tax year may rely on the recipient’s address to (i) in the case of sales of general property, establish the recipient’s status as a foreign person and that the sale is for foreign use, and (ii) in the case of provision of general services to consumers and business recipients, establish that the recipient is located outside the US.

A seller that receives less than $5,000 in gross receipts during a tax year from a recipient may rely on the recipient’s address to (i) in the case of sales of general property, establish the recipient’s status as a foreign person and that the sale is for foreign use, and (ii) in the case of provision of general services to consumers and business recipients, establish that the recipient is located outside the US.

The Proposed Regulations include a special rule for certain loss transactions. If a seller/service provider knows or has reason to know that property is sold to a foreign person for foreign use or a general service is provided to a person outside the US, but does not satisfy the documentation rules, the sale/provision of service is nonetheless treated as an FDDEI transaction if doing so would reduce a domestic corporation’s FDDEI (and correspondingly, its FDII).

Related Party Transactions

A sale of property or a provision of a service to a related foreign party (generally, a member of a modified affiliated group) may qualify as an FDDEI transaction if certain additional requirements are satisfied.

A sale of general property to a foreign related party qualifies as an FDDEI sale only if an unrelated party transaction with respect to such sale occurs and the unrelated party transaction qualifies as an FDDEI sale. The Proposed Regulations include special rules for determining whether certain other related party transactions qualify as FDDEI sales, including where the related foreign party uses the purchase property to produce another product that is then sold in an unrelated party transaction, or where the foreign related party uses the property in the provision of a service to an unrelated party.

The provision of a general service to a related business recipient qualifies as an FDDEI service only if the service is not substantially similar to a service provided by the related person to persons located in the US.

Partnerships

A domestic corporation’s DEI and FDDEI for a taxable year are determined taking into account the corporation’s share of DEI, FDDEI and related deductions of any partnership in which the corporation is a direct or indirect partner. The Proposed Regulations provide rules for determining a domestic corporation’s partnership QBAI.

While the Proposed Regulations adopt an aggregate approach for the purposes noted above, for purposes of determining whether a sale of property to or by a partnership qualifies as an FDDEI sale, or the provision of services to or by a partnership qualifies as an FDDEI service, the Proposed Regulations treat a partnership as an entity.

A partnership that has one or more direct or indirect partners that are domestic corporations and that is required under section 6031 to file returns must furnish each such partner, on the partner’s Schedule K-1, the partner’s share of the partnership’s DEI, FDDEI, related deductions and partnership QBAI for each year the partnership has such items.

Consolidated Groups

For consolidated groups, the section 250 deduction is determined at the group level. The Proposed Regulations include rules for allocating the consolidated section 250 deduction among members of the group on the basis of their respective contributions to the group’s aggregate amount of FDDEI and GILTI.

Reporting Requirements

A domestic corporation (or an individual making an election under section 962) that claims a deduction under section 250 for a taxable year, must file new IRS Form 8993, Section 250 Deduction for Foreign-Derived Intangible Income (FDII) and Global Intangible Low-Taxed Income (GILTI), for such year.

[View source.]