US Treasury Issues Proposed Regulations on the Beneficial IRC Section 250 Corporate Tax Deduction Related to Export Sales of Property and Services
US Treasury has now published detailed guidance on a significant US corporate tax rate benefit for any US company that conducts direct sales of property and/or services to foreign persons for foreign use. The tax rate benefit is achieved through a deduction of 37.5% from a direct foreign sales income base, before the 21%, corporate tax rate is imposed. The deduction results in a 13% effective tax rate on qualifying direct foreign sales income.
The regulatory guidance includes details for determining the foreign sales income base on which the deduction is made and what documentation is required in support of the income base determination (including a transitional rule for pre-guidance periods).
The regulations should now open the door for US companies large and small to explore planning opportunities to leverage the direct foreign sales corporate tax rate benefit. A US corporate group should include in its planning analysis a comparison of the tax cost of any existing or contemplated offshore production base. US companies are also encouraged to consider submitting comments to the guidance, which is published in proposed form, by or before May 6, 2019.
New IRC section 250 was one of several significant international provisions enacted under the 2017 Tax Cut and Jobs Act (“TCJA”). In general, the new international provisions were intended to encourage increased US investment through reduced US tax liability in order to drive US job creation. Section 250 allows US corporations a deduction with respect to a defined category of income referred to as ‘foreign derived intangible income” or “FDII”. Section 250 also allows the deduction for another favored category of income called “global intangible low taxed income” or “GILTI”. This note is limited to a discussion of the FDII rules.
On March 6, 2019, the US Treasury Department published proposed regulations on new section 250 of the Internal Revenue Code (the “regulations”). The regulations represent the last set of proposed regulations to be published on the international provisions of the 2017 US Tax Reform Act. To a large extent, taxpayers will consider the rules to have been worth the wait, especially for manufacturers, web-based global supply platforms, software developers, pharmaceutical companies and other US businesses that are doing business in the global marketplace. These regulations are in proposed form. Taxpayers have the opportunity to submit comments to the Internal Revenue Service (“IRS”) by or before May 6, 2019.
Comment: A significant volume of taxpayer comments can be anticipated. The preamble to the regulations is full of a number of specific requests for comments, although comments need not be limited to the issues in these requests. Thoughtful taxpayer comments could lead to amendments that would make the final version of the regulations even more taxpayer-friendly than the current version. It is therefore imperative that interested taxpayers take action to contribute to the improvement of the current version of the regulations through timely comments prepared in-house or with the help of their advisors.
The Section 250 Deduction for Foreign Derived Intangible Income
Section 250 allows a 37.5% deduction against a US corporation’s FDII base that results, in effect, in a 13.125% income tax rate on such income. Before the regulations were published, the US business community has seemed reticent about making changes to business models to leverage the new rules. Some foreign governments have criticized the FDII tax rate advantage as an illegal export subsidy that violates World Trade Organization principles.
Comment: Section 250 as currently written includes a reduction in the deduction percentage to 21.875% for taxable years beginning after December 31, 2025. This means that in 2026 the effective tax rate on FDII will be increased from the current 13.125% to 16.4%, assuming the 21% standard corporate tax rate remains unchanged. Given the global trend of statutory corporate tax rate reduction, this effective rate increase on FDII beginning in 2026 could mitigate if not eliminate the incentive for US businesses to make foreign sales from the US. Ideally, the 2026 change will be repealed and there will be no downward change in the future to the current deduction percentage.
Section 250 has already been in effect for taxable years beginning after December 31, 2017 and a large number of taxpayers will have already had significant FDII streams under existing direct foreign sales models. Now that the regulations have been published, taxpayers will have greater certainty how to maximize the FDII tax rate under existing US to foreign distribution chains and sales. At the same time, small and medium-sized enterprises (“SMEs”) might want to rethink any plans to set up offshore production bases in low tax jurisdictions. Existing offshore structures put into place under pre-TCJA tax law, i.e., under the assumption of a 35% US corporate tax rate, will also deserve a review as the effective US tax rate on FDII reduces if not eliminates the significant US to foreign tax rate gap that existed under prior law.
US Tax Policy
Many of the international provisions in TCJA were intended as to diminish the US tax planning value of using offshore structures to generate group income that could be indefinitely deferred from being subject to US corporate tax at the relatively high 35% tax rate.
FDII is only one of several measures that were enacted to make a US business base more attractive to US groups that sell goods and services into foreign markets. The FDII regime can also be attractive for planning for the US businesses of foreign groups that stretch into foreign markets from a US base, subject to a holistic review of the home country impact of such a structure, for example, the application of the foreign parent jurisdiction’s controlled foreign corporate rules and the limitation on benefits clauses under the relevant US income tax treaties for the US to foreign sales transactions from the foreign group’s US production base.
Calculating the FDII Base to which the Section 250 Deduction Applies
The effective 13.175% FDII tax rate is achieved by determining the FDII base and applying a 37.5% deduction to that base. The resulting net amount is then included in the general taxable income base of the US corporation and taxed at the standard 21% US corporate tax rate.
The FDII base is determined by applying a multiplier to the “deemed intangible income” (also referred to as “gross FDII”) of the US corporation. The deemed intangible income (also referred to as the FDII base or “net FDII”) is the excess of the “deduction eligible income” over the “deemed tangible income return” of the corporation. The multiplier is the “foreign-derived deduction eligible income” over the “deduction eligible income” of the corporation.
The “deduction eligible income” is the adjusted gross income of the corporation less allocable deductions to such adjusted gross income. The “foreign-derived deduction eligible income” is any income derived in connection with (i) the sale of property, for foreign use, to a foreign person and (ii) services provided to any person, or with respect to any property, not located within the US.
The amount of the “deemed tangible income return” is equal to 10% of the corporation’s qualified business asset investment (“QBAI”). The QBAI is the adjusted basis of tangible property used in the production of “deduction eligible income”.
Comment. The deemed tangible income return is an important reduction in the FDII base as the amount corresponding to the 10% return reduces the FDII base dollar for dollar. It means that FDII included in the gross FDII base will be pulled out of that base to the extent of the amount corresponding to 10% of the QBAI when calculating net FDII. That carved out amount will be taxed at the 21% standard corporate tax rate. In calculating the FDII base, the section 250 rules make no distinction between capital intensive exporters such as manufacturers and those sectors that rely heavily on intangible property in their revenue models but this feature of the computation obviously encourages low capital, intellectual property based businesses to sell from the US. The more capital intensive the foreign sales business model is, the greater the QBAI return offset to the gross FDII base. When making a foreign production location decision analysis, the impact of the QBAI return on overall potential FDII-related tax savings needs to be factored in when comparing the tax cost of the US location to the foreign location. For such an analysis, other US tax attributes of the foreign production location must also be considered, not just the FDII comparison.
Qualifying Foreign Sales
The regulations provide definitions of key terms that were created under section 250. The term “sale” includes any lease, license, exchange, or other disposition. The two key conditions for qualifying for FDII on the sale of property is that the property is sold (i) to a foreign person (ii) for a foreign use.
A foreign person is defined as a person that is not a US person. Yet a buyer will be considered a foreign person only if the seller obtains documentation of the buyer’s foreign status and does not know or have reason to know that the recipient is not a foreign person. For small businesses, there are sales volume and transaction value exceptions to this documentation requirement. A seller that has less than $10,000,000 gross receipts in the prior taxable year, or less than $5,000 in gross receipts from a single recipient, can treat a buyer as a foreign person if the seller has a shipping address for the recipient that is outside the US.
Property for a Foreign Use
A sale of property will be treated as “for a foreign use” only if the seller obtains documentation that the property is for a foreign use and does not know or have reason to know, as of the FDII filing date, that the property is not for a foreign use. There are additional for a foreign use rules depending on whether the property sold is considered general property or intangible property.
The sale of a general property is for a foreign use if either the property is not subject to domestic use within three years of delivery of the property or the property is subject to manufacture, assembly, or other processing outside the US before any domestic use of the property. To be considered as property subject to manufacture, assembly or other processing outside the US, either one of two tests must be met. First, there must be a physical and material change to the property (a determination which itself is based on facts and circumstances). Alternatively, the property is incorporated as a component into a second product. The general property will meet this component threshold only if the fair market value of the property when it is delivered to the recipient constitutes no more than 20% of the fair market value of the second product, determined at the time the second product is completed.
A sale of intangible property includes a license and any transfer of property in which gain or income is recognized under section 367, including a transfer of intangible property subject to section 367(d). A sale of intangible property is for a foreign use to the extent revenue is earned from exploiting the intangible property outside the US, documentation requirements are satisfied and the seller does not know or have reason to know that that the sale is not for foreign use. The seller of intangible property can establish foreign use for a portion of the income from the intangible property.
The location where revenue is earned from intangible property is based on the location of end-user customers licensing the intangible property or purchasing products for which the intangible property was used in the development, manufacture, sale or distribution. There are special rules for determining a foreign use for so-called lump sum sales, where it is otherwise difficult to determine where the property will be used, and for the sale of rights in intangible property used both within and outside the US.
Services for a Foreign Use – 4 Exclusive Categories
The regulations include rules to determine whether a service is provided to a person located outside the US. The determination for a foreign use will depend on the type of service provided and is divided into specific categories defined in the regulations. Each category of service is mutually exclusive of each other category and every possible service is described in a single category.
The four categories of services for foreign use include: proximate services, property services, transportation services, and general services. The category for general services is the residual category of services for foreign use. If a foreign service is not specifically covered by one of the three other specific services categories, it falls within the general service category.
A general service will constitute a foreign service if the recipient of the service is located outside the US. There are separate rules for general services depending on whether the recipient is an individual consumer or a business. The consumer is located where the consumer resides when the service is provided. The domestic corporation must document the location of the consumer in order to treat revenue from the transaction as FDII, the regulations include a special rule for certain small businesses and small transactions that the domestic corporate can rely on the billing address of the recipient.
The location of the business recipient of general services is based on the location of the business recipient’s operations, and the operations of any related party of the recipient that receives a benefit. In order to determine the amount of FDII, the service renderer’s gross income from providing the service must be allocated to the business recipient’s operations outside the US either directly or indirectly, in the event operations benefit from the service both within and outside the US. The regulations contain examples of the allocation rules for unrelated and related party transactions.
The regulations provide for five types of evidence that the US service renderer can rely on to establish that the business recipient is located outside the US: a written statement from the recipient, a binding contract specifying the beneficiaries and locations outside the US, documentation in the ordinary course of business, publicly available information and any other documentation prescribed by the US Treasury Secretary. As in the case of consumers of services for a foreign use, for business recipients there are simplified documentation rules for small businesses and small transactions.
Special Rule for Foreign Government Military Sales
The US defense industry transacts a significant amount of its equipment sales and services with foreign governments. In order to carry out certain transactions with foreign governments, the Arms Export Control Act of 1976 requires that such transactions first be made to the US government for resale to the ultimate foreign government recipient. The regulations clarify that resales of equipment and services to a foreign government under the Arms Export Control Act of 1976 is considered a foreign sale by US defense industry seller for FDII purposes.
Rules for Related Party Sales and Services
The regulations provide detailed rules for determining FDII-qualified related party sales and services. Section 250 provides that for a sale of property to a related party that is not a US person, the sale will not be treated as for a foreign use unless (1) the property is ultimately sold by a related party, or used by a related party in connection with property which is sold or the provision of services, to another person who is an unrelated party who is not a US person and (2) the taxpayer establishes to the satisfaction of the US Treasury Secretary that the property is for a foreign use.
The sale of intangibles, whether to a related or an unrelated party, is for a foreign use only to the extent that the intangible property generated revenue from exploitation outside of the US.
For related party services, the regulations provide that a provision of general services to a related party business recipient qualifies as FDII only if the service is notsubstantially similar to a service provided by the related party to persons located within the US. Whether a general service is “substantially similar” in this sense (and therefore does not generate FDII) is to be determined under either a benefits test or a price test.
The benefits test is satisfied, and thus FDII status will not be allowed if 60 percent or more of the benefits conferred by the related party service are to persons located within the US. “Benefit” is a defined term cross-reference to the section 482 (transfer pricing) regulations.
The price test compares (i) the value of the service that is provided by the renderer to the related party to (ii) the value of the service that is provided by the related party to its customers. A service provided by a renderer to a related party is “substantially similar” to a service provided by the related party to a person located within the US if the renderer’s service is used by the related party to provide a service to a person located within the US and 60 percent or more of the price that persons located within the US pay for the service provided by the related party is attributable to the renderer’s service. Examples of the operation of these rules are included in the regulations.
US Corporate Partner in a Partnership Earning FDII
As emphasized at the outset of this note, section 250 provides that the FDII deduction is only available to US corporations. The regulations expand the FDII deduction to the US corporate partners of a partnership that earns FDII. The US corporate partner will be entitled to the benefit of the FDII deduction with respect to its distributive share of the income and expense elements that go into the calculation of the FDII.
Section 962 Election to be Treated as a Corporation
Section 962 allows an individual to elect to be treated as a corporation with respect to certain amounts that would be included under section 951 (Subpart F inclusion) had the amounts been received by a US corporation. The preamble to the proposed regulations mentions the section 962 election only in the context of the deduction under section 250 for “global intangible low taxed income” or GILTI.
FDII Reporting Requirements
The reporting requirementst for the section 250 deduction will be fulfilled on new and existing IRS forms. Taxpayers can claim the annual section 250 deduction on new Form 8993. The preamtble to the regulations provides further guidance on how the section 250 deduction relates to existing reporting obligations for taxpayers that concern: related party transactions, interests in foreign corporations, domestic partnerships and certain foreign partnerships with US owners.
Documentation Requirements before and after the Effective Date of the Regulations
The regulations are heavy on documentation requirements to establish that income of the US corporate can be treated as FDII for purposes of the section 250 deduction. The documentation requirements in the regulations apply to taxable years ending on or after March 4, 2019. For taxable years beginning on or before March 4, 2019, the regulations provide generally that taxpayers may use any reasonable documentation maintained in the ordinary course of business that establishes 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.
The regulations provide guidance on organizing the documentation, namely, (1) that the seller of property or renderer of services must obtain documentation when required for the foreign sales transaction by the FDII filing date, (2) the documentation must be obtained no earlier than one year before the sale or service, and the seller or renderer must not know or have reason to know that the documentation is incorrect or unreliable.
Comment: Having proper documentation in place and organized as part of the taxpayer audit file could be a significant project for the taxpayer. Given the time gap between the 2018 effective date for section 250 and the issuance of these regulations, getting an FDII documentation system in place should be treated as a priority.