Treasury and the IRS released final section 250 regulations on July 9, 2020, primarily focused on the deduction for foreign-derived intangible income (FDII). The final regulations make significant revisions to the proposed rules, addressing many of the concerns raised in comments. The burdensome documentation requirements have been removed and replaced in some cases with more flexible substantiation requirements.
The new rules generally take effect beginning in 2021, but they can be applied retroactively if applied in their entirety. It will be important for companies to analyze the different outcomes they might achieve in 2018, 2019 and 2020 by applying the final regulations, the proposed regulations or simply a well-reasoned interpretation of the statute.
The final section 250 regulations are generally prospective and apply to taxable years beginning on or after January 1, 2021. For taxable years beginning before 2021, taxpayers have three choices:
- Apply the final section 250 regulations in their entirety, with minor exceptions;
- Apply the proposed section 250 regulations in their entirety, using the reasonable documentation transition rule; or
- Apply the statutory provisions of section 250.
Taxpayers do not need to make the same choice each year. For example, a calendar year corporation might apply the statutory provisions in 2018, the proposed regulations in 2019, and the final regulations in 2020. Though nothing in the final regulations say so, Treasury and IRS officials have emphasized that once a taxpayer has chosen to use the final regulations, the taxpayer must continue to do so in subsequent years.
The final consolidated section 250 rules of section 1.1502-50 also generally apply to taxable years beginning on or after January 1, 2021. Taxpayers who choose to apply the final section 250 regulations to taxable years beginning before January 1, 2021, must also apply the provisions in section 1.1502-50 to those years. Similarly, taxpayers who rely on the proposed section 250 regulations for taxable years beginning before January 1, 2021, must also follow proposed section 1.1502-50. Taxpayers who simply follow the statutory provisions are not required to apply section 1.1502-50 and presumably can compute the group’s FDII deduction on a separate entity basis.
Section 250(a)(2) Limitation and Ordering Rule
Section 250(a)(2) limits the section 250 deduction when the sum of a corporation’s FDII and GILTI exceeds its taxable income. Other Code provisions also limit deductions based on taxable income: for example, section 172 limits the NOL deduction to 80% of taxable income before NOL (for post-2020 NOLs), and section 163(j) limits the deduction for business interest to 30% (or 50% for certain years) of adjusted taxable income.
Proposed section 1.250(a)-1 would have provided a five-step coordination rule to apply these limitations.
Treasury and the IRS determined that further study is needed before finalizing a coordination rule. Until further guidance is issued, taxpayers may use any reasonable method if they apply it consistently for all taxable years beginning on or after January 1, 2021. Reasonable methods could include the proposed regulations’ ordering rule or, interestingly, simultaneous equations. Any method chosen should consider the CARES Act amendments to section 172, which provide that the 80% taxable income limitation is determined without regard to the deductions under sections 172, 199A, and 250.
Computation of Foreign-Derived Intangible Income
The final regulations make several changes to the FDII computation. One helpful change is to conform the definition of foreign branch income with its definition in the section 904 regulations, consistent with section 250(b)(3). The proposed regulations would have created a category of income that was foreign branch income under section 250, but not under section 904, contrary to the statute.
With respect to cost of goods sold, the final rules confirm that COGS may generally be attributed to DEI or FDDEI gross receipts under any reasonable method, consistently applied. Deductions are allocated to gross DEI and gross FDDEI under the section 861 regulations. In the context of expense allocation, the final regulations define a new term “gross RDEI” to mean gross DEI that is not FDDEI. Expenses allocated to gross DEI are then further allocated between gross RDEI and gross FDDEI.
With respect to R&E expenses, the proposed regulations contained an explicit statement that exclusive apportionment (generally 50%) would not apply for FDII. The final regulations remove this statement. Treasury and IRS officials have emphasized, however, that the government has not decided whether to allow exclusive apportionment. That decision will be made as part of the process of finalizing the expense allocation regulations. Proposed section 1.861-17(c) would provide that exclusive apportionment only applies when section 904 is the operative section. On the other hand, many of the same policies that support exclusive apportionment in the section 904 context—encouraging research and development in the United States, for example—would seem to apply equally in the FDII context.
The final regulations provide helpful clarification for NOLs and other deductions carried from other years. Several commentators (including the authors) had requested clarification that certain NOLs carried forward from earlier years are not allocated to reduce FDII. Under final section 1.250(b)-1(d)(2)(ii), a domestic corporation’s deductions allocated to its gross DEI and gross FDDEI are determined without regard to sections 163(j), 170(b)(2), 172, 246(b)(2) and 250. Thus, neither DEI nor FDDEI will be reduced on account of deductions for NOL carryovers and carrybacks, excess interest expense carryovers under section 163(j), or charitable contribution carryovers. This is a favorable rule for taxpayers and will ease administrative burdens for both taxpayers and the IRS.
Foreign Military Sales
The final regulations significantly relax the requirements to obtain a FDII benefit for foreign military sales and services. If a taxpayer sells property or provides a service to the U.S. government pursuant to the Arms Export Control Act, the sale or service is automatically treated as a FDDEI sale or a FDDEI service. The general requirements for FDDEI sales and FDDEI services do not apply. The proposed requirement that the sale or service be made “on commercial terms” is also eliminated.
Transactions with Multiple Elements
The final regulations retain and expand the proposed predominant character rule. Under section 1.250-3(d), a transaction is treated as either a sale or a service based on its predominant character. Disaggregation into sale and service components is not permitted. The final regulations also apply the rule to treat a transaction that includes both a sale of general property and a sale of intangible property as either one or the other, based on its overall predominant character.
The proposed section 250 regulations contained strict documentation requirements to establish that a person is a foreign person, property is for a foreign use, or services are provided to a person located outside the United States. In response to comments, the final regulations relax these rules in two ways.
First, under the final regulations, no specific types of documents are required to establish (i) foreign person status, (ii) foreign use for certain general property sold directly to end users, or (iii) the foreign location of general services provided to consumers. However, in all cases, taxpayers are required to substantiate their entitlement to the section 250 deduction under the general recordkeeping rules of section 6001. Treasury and the IRS expect that taxpayers will be able to use a broader range of evidence to substantiate a section 250 deduction than they would have been able to use under the proposed regulations. Treasury and the IRS are considering issuing additional administrative guidance on acceptable forms of substantiation.
Second, under section 1.250(b)-3(f), specific types of information are still required to substantiate foreign use for intangible property sales and general property sales to non‑end users, and the foreign location of services provided to business recipients. However, the final rules adopt a more flexible approach regarding the types of documents that will be accepted. Details of the various substantiation requirements are provided in Appendix A. The specific substantiation rules do not apply to small businesses with less than $25 million in gross receipts.
Where specific substantiation is required, the substantiating documents must be in existence as of the FDII filing date—the due date of the tax return, including extensions—and must be provided to the IRS upon request, generally within 30 days or some other agreed period.
The proposed regulations provided a special rule that a seller cannot avoid treating a transaction as a FDDEI transaction by failing to provide the required documentation if the seller knows or has reason to know that the applicable requirements are met. The final regulations retain this rule, but only for transactions to which the specific substantiation rules apply. The narrowing of the rule is not meant to imply that FDII can be determined on a transaction-by-transaction basis.
The final rules provide a non-exhaustive list of information that indicates prima facie that a recipient is a foreign person, a sale is for a foreign use, a service is provided to a business recipient, or a business recipient is located outside the United States. When these indicators (e.g., a foreign phone number or billing address) point to a FDDEI transaction, the loss transaction will be treated as such unless the taxpayer can prove otherwise.
Reason to Know
For loss transactions, as well as certain other substantiation requirements, the final regulations helpfully clarify that the proposed “reason to know” standard looks only to the information the taxpayer receives as part of the sales process.
FDDEI Sales – Definitions
Consistent with the proposed regulations, a FDDEI sale is defined as a sale of general property or intangible property to a foreign person for a foreign use.
General property under the final rules includes physical commodities and certain related forward or option contracts but does not include financial instruments or similar assets traded through futures or similar contracts. The final rules also exclude partnership interests and interests in a trust or estate from general property. Thus, the sale of these types of property can never qualify as FDDEI under the final rules.
The exclusion of partnership interests is an unfortunate change, adopted without notice or an opportunity for affected parties to comment. It runs counter to decades of IRS policy treating partnerships as an aggregate and applying look-through principles to determine the consequences of a partnership interest sale. There is no good reason for refusing to apply a look-through approach to determine whether a sale of a partnership interest is a FDDEI sale.
In response to a comment, the final regulations modify the definition of intangible property to exclude copyrighted articles as defined in section 1.861-18 (i.e., computer programs transferred with no copyright rights). Thus, downloaded software will be treated as general property. This is an appropriate rule, conforming the treatment of copyrighted articles under FDII with its treatment under other international provisions.
FDDEI Sales – Foreign Person Presumption
The final regulations add a helpful presumption of foreign person status. A sale of property is presumed to be made to a foreign person if (i) it is a foreign retail sale, (ii) it is a sale of general property delivered to an end user at a foreign address, or (iii) in the case of intangible property sales and other general property sales, the recipient has a foreign billing address. The presumption does not apply if the seller knows or has reason to know that the sale is to a recipient other than a foreign person.
FDDEI Sales – Foreign Use of General Property
Under the proposed regulations, the foreign use of general property required no U.S. use of the property within three years unless the property was subject to further manufacture, assembly, or other processing outside the United States. The final regulations eliminate the three-year rule. This is a very important and welcome change. The final regulations also eliminate the proposed requirement that the taxpayer have no reason to know of some domestic use for the property. This, too, is a welcome change.
The final regulations adopt an end user concept for determining whether a sale of general property is for a foreign use. An “end user” is defined as the person who ultimately uses or consumes property, or who acquires property in a foreign retail sale. There are five categories of sales of general property to end users that qualify as foreign use sales:
- Sales of general property delivered by a freight forwarder or carrier, if the end user receives the delivery outside the United States, subject to an anti-avoidance rule to address round-tripping concerns.
- Sales of general property already located outside the United States, including foreign retail sales.
- Sales of general property for resale, if the property will ultimately be sold to end users outside the United States and those ultimate sales are substantiated. See Appendix A for substantiation requirement details.
- Sales of general property containing primarily digital content, if the property is transferred electronically and the end user downloads, installs, receives, or accesses the purchased digital content on a device outside the United States. If this information is unavailable, the end user’s billing address may be used provided the gross receipts from all sales to the end user are less than $50,000 in the aggregate. “Digital content” means a computer program or other content in digital format, including, for example, books, movies, or music.
- Sales of international transportation property, if the end user registers the property in a foreign jurisdiction. If the property is not used for compensation or hire, the end user must also hangar or store the property primarily outside the United States.
The final regulations also retain, with modifications, the proposed rule that a sale of general property is for a foreign use if the sale is to a foreign unrelated party that subjects the property to manufacture, assembly, or other processing outside the United States and the manufacture, etc. is substantiated. See Appendix A for substantiation requirement details.
The final regulations significantly modify (and generally improve upon) the proposed rules for determining whether property is subject to manufacture. The final rules are more closely aligned with the Subpart F physical manufacturing tests, but government officials have emphasized they are not the same. For example, the final rules clarify that a physical and material change to property occurs if the property is substantially transformed and is distinguishable from and cannot be readily returned to its original state. It’s not easy to see a difference between this test and Subpart F “substantial transformation.”
The component part test in the final regulations bears a close resemblance to the Subpart F “substantial in nature” test: General property is treated as a component incorporated into another product if the incorporation involves activities that are substantial in nature and generally considered to constitute the manufacture, assembly, or other processing of property. The proposed regulations’ test was more rigid, requiring that the general property when delivered constituted no more than 20% of the fair market value of the second product. Under the final regulations, the 20% test is retained as a safe harbor. Despite these similarities with Subpart F, the preamble insists that the FDII component part test is different in terms of purpose and substance. And Treasury officials have stated informally that decisions in Subpart F manufacturing cases are not necessarily controlling under FDII, citing the sunglasses assembly in Bausch & Lomb.
We now see the real reason for the government’s stance. Treasury and the IRS want to have their cake and eat it too. They want to incorporate the established Subpart F manufacturing tests—just without the established taxpayer-favorable court decisions! But how can the two be separated? If the FDII regulation language is identical to, and was borrowed from Subpart F, how could the FDII case be decided differently?
The final regulations include a specific rule that if the seller sells general property to an unrelated buyer for manufacturing, assembly, or other processing within the United States, the property is not sold for a foreign use even if the requirements for foreign use are later satisfied.
FDDEI Sales – Foreign Use of Intangible Property
The final regulations, like the proposed regulations, provide that foreign use of intangible property is determined based on revenue earned from end users located within versus outside the United States. Several commentators questioned the proposed rule. The final regulation preamble offers support for the rule by reference to section 250(b)(4)’s requirement of “use” or “consumption” outside the United States. In this regard, the preamble states that the end user is the person who ultimately consumes or uses the intangible property.
The final regulations provide more detailed guidance on determining where revenue is earned from “end users” of intangible property. In the case of intangible property embedded in general property or used in connection with the sale of general property, the end user is the person who ultimately uses the general property and the revenue is treated as earned outside the United States to the extent the sale of the general property is for a foreign use. Similarly, in the case of intangible property used to provide services, the end user is the service recipient and is treated as located outside the United States to the extent the service qualifies as a FDDEI service.
If intangible property is used to provide a service, the end user of the intangible is the appropriate recipient or consumer under the FDII service rules.
If the intangible consists of a manufacturing method or process, the foreign unrelated party (including in a sale by a foreign related party) is treated as the end user, unless the seller has reason to know otherwise. This rule does not apply to any manufacturing method or process used in manufacturing products for the seller.
If an intangible is used in R&D, the end user of the intangible is the end user of the new or modified intangible. This rule will create significant issues in practice, as illustrated by section 1.250(b)-4(d)(2)(iv), Example 13. In the example, DC licenses worldwide rights to Patent A to FP for an annual royalty of 100. FP uses Patent A in R&D. It earns no revenue from sales under the patent in Years 1 through 4. Ultimately, in Year 5, FP’s R&D is successful, and it earns 1,000 of revenue from sales under the patent. The example concludes that none of DC’s 100 royalty in Years 1 through 4 is FDDEI, because “end users” have not yet used or consumed the product produced by FP. This conclusion is highly questionable, and is likely to be challenged by taxpayers, particularly in the pharmaceutical industry where the life cycle between R&D and eventual sales to customers is often quite long.
Taxpayers must provide specific types of substantiation of the foreign use of intangible property. See Appendix A for details.
FDDEI Services – Categories
The final regulations retain the five mutually exclusive categories of services that can qualify as FDDEI services: general services provided to consumers, general services provided to business recipients, proximate services, property services and transportation services. The final regulations also create two new subcategories of general services—electronically supplied services and advertising services—and provide additional guidance on each.
FDDEI Services – General Services Provided to Consumers
Under the final regulations, a general service is provided to a consumer located outside the United States if the consumer resides outside the United States when the service is provided. In the case of an electronically supplied service, the consumer is deemed to reside at the location of the device used to receive the service. The device’s IP address can be used for this purpose. If the taxpayer does not have or cannot after reasonable efforts obtain the consumer’s residence (or the device’s location) when the service is provided, the consumer’s billing address can be used unless the taxpayer knows or has reason to know that the consumer does not reside outside the United States.
FDDEI Services – General Services Provided to Business Recipients
Like the proposed regulations, the final regulations provide that a general service is provided to a business recipient located outside the United States to the extent it benefits the business recipient’s operations outside the United States. A business recipient includes related parties.
The final regulations clarify that the relevant business operations are those conducted through an office or other fixed place of business, that is, a fixed facility through which the business recipient engages in a trade or business. The definition is intentionally somewhat different from section 864(c)’s “office or fixed place of business,” which is determined on a separate entity basis. In addition, the final regulations allow the location of the business recipient to be determined based on reasonable assumptions from the information available. A business with no operations is deemed to be located at its primary billing address.
As under the proposed regulations, “benefit” is defined by reference to Treasury Regulation section 1.482-9. The preamble states that the reference is not meant to suggest that a transfer pricing analysis is required; it is only meant to clarify that a service confers a benefit on particular business operations only if an unrelated party with similar operations would pay for the service. On the other hand, the final regulations require that in applying section 1.482-9, (i) the taxpayer, (ii) the recipient’s U.S. operations, and (iii) the recipient’s foreign operations, each be treated as a separate controlled taxpayer. The amount of benefit conferred on separate business operations is determined under a reasonable method consistent with the cost allocation principles of section 1.482-9(k), treating the taxpayer’s gross income from the service as if it were a “cost.”
For electronically supplied services, the location of the benefit is deemed to be the location where the business recipient accesses the service. The billing address can be used if this information is unavailable and the gross receipts from all services to the business recipient during the taxable year are less than $50,000. This rule also applies where services are partially electronically supplied and partially other general services, if the primary purpose of the service is to provide electronically supplied services.
For advertising services, the location of the benefit is deemed to be the location where the advertisements are viewed by individuals. For advertisements displayed via the internet, the advertising services are treated as viewed at the location of the device on which the individual views the advertisements. This location may be established by the IP address.
Specific substantiation is required for general services provided to business recipients. See Appendix A for details.
FDDEI Services – Other Services
In response to comments, the final regulations clarify that proximate services include services substantially all of which are performed in the physical presence of not only the recipient’s employees, but also its contractors and agents.
The final regulations retain the proposed rule that property services are FDDEI services if they are performed on tangible property located outside the United States. In response to comments, the final regulations clarify that manufacturing services are property services and provide a helpful exception for property that is temporarily in the United States during the performance of the service. As a result, manufacturing services performed in the United States can qualify as FDDEI services if certain conditions are met.
The final regulations retain without change the proposed rules on transportation services. A transportation service is a FDDEI service if both the origin and the destination are outside the United States. If either the origin or destination (but not both) are outside the United States, 50% of the service is considered a FDDEI service.
Related Party Transactions – Resales
Section 250(b)(5)(C) provides special rules for related party transactions. For sales of property to a foreign related party, the sale is not treated as for a foreign use unless the foreign-related party resells the property in a FDDEI sale or uses the property in connection with a FDDEI sale of other property or in connection with FDDEI services.
The proposed regulations would not have allowed a taxpayer to treat a related party sale as a FDDEI sale unless the unrelated party sale had occurred by the FDII filing date. The taxpayer could then file an amended return once the unrelated party sale had occurred. The final regulations remove this requirement. Under the final rules, a taxpayer can treat a related party sale as a FDDEI sale if the unrelated party transaction has occurred or will occur in the ordinary course of business. The unrelated party sale can occur at any time in the future so that taxpayers with long production cycles are not unduly prevented from claiming FDII benefits.
To demonstrate that an unrelated party sale will occur, the regulations provide that contractual agreements or historical practices indicating that the related party only sells products to unrelated foreign customers will suffice. Moreover, if the product design indicates that it is destined only for foreign customers, taxpayers can establish that an unrelated party sale will occur.
The proposed regulations provided that for purposes of determining whether a related party sale is for a foreign use, all foreign related parties of the seller are treated as if they were a single foreign related party. One comment requested clarification for semi-finished products.
The final regulations clarify that a U.S. person (either the seller itself or another U.S. person that is a related party of the seller) is treated as part of the single foreign related party—but only for purposes of determining whether the initial related party sale is for a foreign use. The rule does not modify or eliminate the requirement that a seller must sell property to a foreign person for the sale to be a FDDEI sale. Also, to prevent manipulation, the rule only treats a U.S. person as related to the seller if the U.S. person is related under the 80 percent vote or value test in section 1504(a).
Related Party Transactions – Use of Property in an Unrelated Party Transaction
For transactions other than the resale of purchased property, such as where the foreign related party uses the purchased property to produce other property, or to provide a service, the proposed regulations required the seller to reasonably expect that more than 80 percent of the revenue earned would be from unrelated party FDDEI transactions.
The final regulations remove the 80% cutoff rule and instead provide a helpful proration rule that allocates the revenues ratably between related and unrelated party transactions based on revenues reasonably expected to be earned as of the FDII filing date. Revenue is based on the price of all transactions with unrelated parties.
Related Party Services
Like section 250(b)(5)(C) and the proposed regulations, the final regulations provide that a related party service is a FDDEI service only if it is not substantially similar to a service that has been or will be provided by the related party to a person located within the United States. The final regulations clarify that this restriction applies even if the related party’s substantially similar service will only occur in a future year.
The final regulations maintain the proposed rule that a related party service is substantially similar only if the related party service is used by the related party to provide a service to a person located within the United States, and either the “benefit” test or the “price” test is met. The final regulations make certain minor clarifications with respect to these two tests.
Consolidated Section 250
The final regulations largely retain the rules of the proposed regulations pertaining to consolidated groups. Under section 1.1502-50, there is no consolidated section 250 deduction as such. A consolidated group determines a “consolidated FDII deduction amount” and a “consolidated GILTI deduction amount,” but these amounts are then allocated to the individual group members. The members’ respective section 250 deductions enter into consolidated taxable income through the general mechanism of sections 1.1502-11 and -12.
The proposed regulations provided that intercompany transactions do not affect a member’s QBAI. The final regulations clarify that this rule only applies for so long as the gain or loss from the transaction continues to be deferred under section 1.1502-13.
FDDEI Sales – Foreign Use of General Property
Substantiation for sales of general property for foreign end user resale, requires the seller to have one or more of the following items of credible evidence:
- A binding contract that limits sales to areas outside the United States,
- Proof that property is designed, labeled or adapted for a foreign market,
- Proof that cost of shipping the property back to the United States makes it impractical,
- Ordinary course information from the recipient evidencing resale to a foreign end user, or
- A written statement, corroborated by credible evidence, that provides:
- Name and address of the recipient and description of the end user (if known)
- Shipment/delivery dates
- Gross income from the sale
- Description of the property
- Description of the method of sales to end users (i.e. direct, retail)
- Description of how the seller determined the property will be ultimately sold to an end user outside the United States
To substantiate foreign manufacture assembly or other processing, the seller must maintain one or more of the following items:
- Credible evidence that the property has been sold to a foreign unrelated manufacturer and it cannot be sold to end users without being physically and materially changed,
- Credible evidence obtained in the ordinary course from the recipient supporting that the product purchased will be subject to manufacture, assembly, or other processing outside the U.S., or
- A written statement prepared by the seller, that provides:
- The manufacturer’s name and address
- Shipment/delivery dates
- Gross income from the sale
- Description of the property and manufacturing, assembly or other processing
- Description of how the seller determined the property was substantially transformed or the activities were substantial in nature
- If using 20 percent component part safe harbor, an explanation of how the requirements are satisfied
FDDEI Sales – Foreign Use of Intangible Property
Foreign use for the sale of IP must be substantiated with one or more of the following:
- A binding contract that the intangible can be exploited solely outside the United States,
- Credible evidence establishing the portion of the recipient’srevenue derived from exploiting intangible outside the United States, or
- A written statement, corroborated by credible evidence, that provides:
- The name and address of the recipient and description of the IP
- Date of sale
- Gross income from the sale
- Description of the IP and how it is used by the recipient (embedded in general property, used to provide a service, used as a manufacturing method or process, or used in R&D)
- Description of how the seller determined the FDDEI portion of the sale
- For periodic payments, an explanation of how the seller determined (i) the extent of foreign use based on actual revenue or (ii) why actual revenue cannot be obtained after reasonable efforts and how foreign use is determined based on estimated revenue.
- For lump sum payments, an explanation of how the seller determined the total net present value of revenue it expected to earn from the exploitation of the intangible property outside of the United States and the total net present value of revenue expected to be earned.
FDDEI Services – General Services Provided to Business Recipients
One of the following types of specific substantiation is required to establish the business operations that benefit from general services provided to business recipients:
- Credible evidence obtained or created in the ordinary course of business from the business recipient establishing the extent to which business operations outside the United States benefit from the service, or
- A written statement, corroborated by evidence, that credible:
- The name and address of the business recipient and a full description of the service
- Date of the service
- Gross income from the service
- Description of how the service will benefit the business
- An explanation how the renderer determined what portion of the service will benefit the business recipient’s operations located outside the United States.