Substantiating an FDII Deduction: Certain Deal-Related Considerations Raised by New Regulations
One of the cornerstones of the current U.S. international tax system, as revised under the 2017 tax law commonly known as the Tax Cuts and Jobs Act, is the deduction provided to U.S. corporate taxpayers under section 250(b) of the Internal Revenue Code (the Code), which results in a reduced, effective tax rate of 13.125% on “foreign-derived intangible income” (FDII) for tax years beginning after December 31, 2017 and before January 1, 2026.
The U.S. Department of the Treasury and the Internal Revenue Service (IRS) recently issued highly anticipated regulations (the Regulations) regarding FDII that, among other things, establish the records that must be maintained to substantiate any FDII deduction claimed (the Substantiation Requirements). Although the Substantiation Requirements are generally more flexible than those included in previously issued proposed regulations on the subject, their application is complex and detailed information and documentation may still need to be obtained.
This Tax Alert generally summarizes the Substantiation Requirements and provides suggestions regarding contractual provisions (including example language) for taxpayers to consider in light of them (see sections labeled Deal Tip).
General FDII Requirements
The FDII calculation is based on a series of complex definitions. However, only income derived in connection with (1) the sale, license, lease, exchange or other disposition (FDII Sale) of certain intellectual property (IP) or tangible property to a “foreign person” (Foreign Person) for a “foreign use” (Foreign Use), or (2) a service (FDII Service) provided to a person, or with respect to property, outside the United States, will potentially qualify. A taxpayer will also need to establish “to the satisfaction of the Secretary” that an FDII Sale or FDII Service exists by complying with the Substantiation Requirements.
Substantiation of an FDII Sale Under the Regulations
The Regulations presume that a transferee is a Foreign Person in many cases such that no tax records beyond what a taxpayer generally maintains may be required. Where, however, a transferor receives information indicating that a transferee may not be a Foreign Person, further evidence may be needed to establish the transferee’s non-U.S. status.
Deal Tip: To avoid issues caused by a taxpayer having received such information (even unknowingly), applicable IRS Form(s) W-8 (e.g., Form W-8BEN or Form W-8BEN-E) may be sought. A representation and covenant consistent with the following may also suffice:
“[Transferee/Lessee/Licensee] (a) represents and warrants that it is a “foreign person” as defined in U.S. Treasury Regulations § 1.250(b)-3(b)(5), and (b) agrees to promptly notify [Transferor/Lessor/Licensor] upon becoming aware of a change in facts, circumstances or law that may reasonably be expected to cause the statement made in (a) to be untrue.”
The Substantiation Requirements related to Foreign Use may often be met based solely on a user’s (Internet Protocol or physical) address or the property’s location at the time of delivery, sale, use, license or lease. However, additional documentation or information is required in certain circumstances, including the following four:
Transportation Property: Where a sale, lease or other applicable disposition involves a plane, boat or other similar transportation property (Transportation Property), such property will generally be treated as subject to Foreign Use if it is registered in a foreign jurisdiction. Unless the Transportation Property will be used for compensation or hire, the taxpayer will also need to establish that it will be primarily stored outside of the U.S. following the sale, lease or other applicable disposition.
Deal Tip: An example covenant addressing these requirements is as follows:
“(a) [Transferee/Lessee] (or its affiliates) shall take all actions necessary to register the [Transportation Property] [acquired/leased] by the [Transferee/Lessee] pursuant to this [Agreement] under the laws of a jurisdiction outside the United States, and none of the [Transferee/Lessee] (or any of its affiliates) shall take any action to register such [Transportation Property] under the laws of the United States or any state thereof (including the District of Columbia).
(b) [Transferee/Lessee] and its affiliates agree to store the [Transportation Property] primarily in a hangar or other appropriate location outside the United States.
(c) [Transferee/Lessee] agrees to (i) promptly (and in any event within 10 business days) provide the [Transferor/Lessor] with a copy of any confirmation or other similar documentation received from the appropriate governmental authority with respect to its registration of the [Transportation Property] in a jurisdiction outside the United States, and (ii) promptly (and in any event within 10 business days) notify the [Transferor/Lessor] upon becoming aware of a change in facts, circumstances, law or other event that may reasonably be expected to cause any of the statements made in subclauses (a) or (b) to be untrue.”
Unfinished Property: Property that will be subject to further significant manufacturing, processing or assembly by the purchaser (Unfinished Property) will be for Foreign Use only if the taxpayer maintains (and timely provides) one or more of (1) credible evidence that the property was sold to a foreign unrelated manufacturer and cannot be sold to end users absent a physical and material change (as defined under the Regulations), (2) credible evidence from the purchaser that the property will be subject to sufficient modification outside the United States, or (3) a written, corroborated statement that includes specified information.
Deal Tip: Given the detailed information that may be required from the transferee, a general cooperation covenant may be advisable. An example of such a provision is below, though further specificity may be preferable. Applicable representations and covenants may also be appropriate.
“[Transferee] and [Transferor] shall cooperate fully, and shall cause their respective affiliates to cooperate fully, as and to the extent reasonably requested by the other party in connection with the filing of any tax returns regarding the [Transportation Property] and the transactions taken pursuant to this [Agreement], including by providing such information as may be reasonably requested by [Transferor] to comply with the requirements imposed under Section 250(b) of the Internal Revenue Code and the Treasury Regulations promulgated thereunder. The party requesting such cooperation will pay the reasonable out-of-pocket third-party expenses incurred by the other party (or its affiliates) in complying with such request.”
Resale Property: Property sold to a person for resale to another party will only be for a Foreign Use if the taxpayer maintains (and timely provides) one or more of (1) a contract explicitly limiting property resales to non-U.S. ones, (2) proof that the property is specifically suited for a foreign market or that shipping it back to the United States is impractical, (3) credible evidence from the purchaser that the property will be sold outside the United States, or (4) a written, corroborated statement that includes specified detailed information.
Deal Tip: An example of a covenant that may be sought where property will only be resold outside the United States is below. A cooperation covenant consistent with that discussed above under “Unfinished Property” and/or other supporting language may also be appropriate.
“[Transferee] shall not (and shall not cause any of its affiliates to) sell, exchange or otherwise dispose of the [Products] except to a party that is located outside the United States at the time of such sale, exchange or other disposition.”
IP: Establishing Foreign Use in the context of an IP-related transaction can be especially burdensome, particularly where worldwide rights are transferred. In that respect, IP that is sold, leased or licensed will only be treated as subject to Foreign Use if the taxpayer maintains (and timely provides) one or more of (1) a binding contract explicitly providing for non-U.S. exploitation only, (2) credible evidence from the recipient establishing the portion of revenue derived from non-U.S. exploitation of the IP, or (3) a written, corroborated statement that includes specified detailed information regarding the IP and its exploitation. If the IP consists of a manufacturing method or process, the rules applicable to Unfinished Property may also be relevant.
Deal Tip: An example of a covenant that may be sought where IP will only be exploited outside the United States is below. Where, however, worldwide exploitation rights are being transferred, a detailed cooperation covenant consistent with that discussed above under “Unfinished Property” may be particularly important.
“Notwithstanding anything to the contrary in this [Agreement], [Transferee/Licensee/Lessee] agrees and acknowledges that [Transferee/Licensee/Lessee] is not being granted, and is not otherwise acquiring, any rights or authorities to exploit, develop, transfer or use the [IP] in or under the laws of the United States or any state thereof (including the District of Columbia).”
Substantiation of an FDII Service under the Regulations
Where a service is performed in the physical presence of the recipient (or its agent) outside the United States, involves the transportation of people or property outside the United States, or results in the physical manipulation (e.g., through manufacture, assembly, maintenance or repair) of tangible property outside the United States, the Substantiation Requirements for a FDII Service may generally be met based on standard U.S. federal income tax records. Where, however, a service is not described in the preceding sentence (a General Service), additional information may be required.
In particular, although the Substantiation Requirements may generally be met for a General Service provided to a consumer in the consumer’s personal (rather than business) capacity based on the consumer’s non-U.S. address, the consumer’s non-U.S. status will need to be established where the taxpayer has knowledge (or reason to know) of information suggesting otherwise.
Deal Tip: Consider obtaining IRS Form(s) W-8, or a representation and covenant, from the recipient consistent with discussion above under “Foreign Person – Deal Tip.”
In addition, a General Service provided to a recipient in a business capacity will only be treated as a FDII Service if the taxpayer maintains (and timely provides) one or more of (1) credible evidence from the recipient establishing the extent to which the service supports non-U.S. operations, or (2) a written, corroborated statement that includes specified detailed information, including how the benefits to the recipient’s U.S. and non-U.S. operations were apportioned. Because determining which operations benefit from a service may depend on a complex transfer pricing analysis, substantial information from the recipient may be required.
Deal Tip: An example of a general representation and covenant regarding a recipient with only non-U.S. offices is below. If the recipient instead has U.S. and non-U.S. operations, a cooperation covenant similar to that discussed above under “Unfinished Property – Deal Tip” may be particularly beneficial.
“[Recipient] (a) represents and warrants that it does not maintain an office or other fixed place of business (including, a fixed place, site, structure, or other similar facility) in the United States, and (b) agrees to promptly notify [Provider] upon becoming aware of a change in facts, circumstances, law or other event that may reasonably be expected to cause the statement made in (a) to be untrue.”
Although the Regulations are applicable for all taxable years beginning on or after January 1, 2021, they can generally be applied now. Whether the Regulations will apply to the current taxable year or only to future ones, taxpayers should consider now what undertakings to include in applicable agreements to ensure the relevant Substantiation Requirements can be met going forward.