One of the most significant provisions of tax reform, commonly referred to as the Tax Cuts and Jobs Act of 2017, was the introduction of the concept of foreign-derived intangible income (FDII), intended as an incentive for US corporations to provide goods and services to foreign customers. Under the new Section 250(a)(1)(A), U.S. corporations are allowed a 37.5% deduction against qualifying income earned from the sale of property or services for foreign use. Although subject to limitations, the theoretical result of the provision is an effective federal tax rate of 13.125% for the qualifying income.
FDII can be created in two ways:
- a sale of tangible or intangible property to a foreign person for foreign use
- a provision of a service to a person, or with respect to property, located outside the United States
The requirements for documenting the qualifying sale of foreign use property or the provision of qualifying services is fact specific and may require a detailed assessment of the transactions in order to sustain the FDII tax deduction.
Determining Foreign Use
The Internal Revenue Code defines a foreign use as “any use, consumption, or disposition which is not within the United States.” However, the statute doesn’t provide significant guidance on determining whether property sold by the taxpayer is for a foreign use. Instead, the statute requires that the taxpayer establish the fact of foreign use “to the satisfaction of the Secretary [of the Treasury]”. This somewhat opaque requirement left some practitioners unsure how exactly to satisfy the foreign use requirement necessary to obtain FDII benefits.
On March 4, 2019, the Treasury Department issued proposed Section 250 regulations (REG-104464-18) which included rules for determining the various factors of the FDII calculation. The proposed regulations provide much-needed clarification on how foreign use is determined and documented for FDII purposes.
Tangible or General Property
The proposed regulations provide that a sale of tangible property is for a foreign use if the property meets at least one of these requirements:
- isn’t subsequently subject to a domestic use within three years of the date of delivery
- is subsequently subject to manufacture, assembly, or other processing outside the United States before the property is subject to a domestic use
Examples of sufficient documentation of foreign use include:
- A written statement from the recipient that the recipient’s use or intended use of the property is for a foreign use
- A binding contract between the seller and the recipient which provides that the recipient's use or intended use of the property is for a foreign use
- Documentation of shipment of the general property to a location outside the United States
These proposed regulations indicate that for the sale of tangible property, the shipment of the property to a destination outside of the United States should be sufficient prima facie evidence of foreign use. Accordingly, as a practical matter, substantiating foreign use should be relatively easy in the most typical tangible property sale situations.
The sale of intangible property is considered to be for a foreign use only to the extent that the intangible property generates revenue from exploitation outside the United States. Documenting foreign use of intangible property creates additional challenges compared with documenting the use of tangible property.
Examples of acceptable documentation of foreign use of intangible property include:
- A written statement from the recipient providing the amount of the annual revenue from sales or sublicenses of the intangible property or sales of products with respect to which the intangible property is used that’s generated as a result of exploitation of the intangible property outside the United States and the total amount of revenue from such sales or sublicenses worldwide
- A binding contract for the sale of the intangible property that provides that the intangible property can be exploited solely outside the United States
- Audited financial statements or annual reports of the recipient stating the amount of annual revenue earned within the United States and outside the United States from sales of products with respect to which the intangible property is used
- Any statements or documents used by the seller and the recipient to determine the amount of payment due for exploitation of the intangible property if those statements or documents provide reliable data on revenue earned within the United States and outside the United States.
The requirements for documenting the sale of foreign use intangible property and the foreign location of services are considerably more fact specific, and accordingly, will likely necessitate more detailed documentation to sustain the Section 250(a)(1)(A) deduction.
Special rules exist for small businesses with annual gross receipts of less than $10 million, as well as small transactions of less than $5,000 in receipts from a single recipient where a seller can rely on foreign billing addresses to establish foreign use.
Under the proposed regulations, whether a service is deemed to be provided to a person, or with respect to property, located outside the United States, depends on the type of service provided and, in the case of a “general” service, the type of recipient of the service.
There are four mutually exclusive categories of services:
- Proximate services
- Property services
- Transportation services
- General services
Each service uses a different method to determine whether this requirement has been satisfied. For example, for proximate services where substantially all of the service is performed in the physical presence of the recipient, the proposed regulations look to the location of the performance of the service.
FDII can’t be created when general services are provided to a related party located outside of the United States if the services are substantially similar to a service provided by the related party to persons located within the United States. This related party services rule prevents taxpayers from claiming FDII when the services primarily benefit persons within the United States by using a related party located outside the United States as a conduit.
Examples of sufficient documentation for general services include:
- A written statement indicating the consumer resides outside the United States when service is provided
- A written statement specifying location of business operations that benefit from service
- Binding contracts or other documentation obtained in ordinary course specifying location of business operations that benefit from service
- Publicly available information establishing the locations of business operations
- Exception for small businesses and small transactions
The proposed regulations also include a “reason to know” requirement, which is essentially an anti-abuse rule that disqualifies purported foreign sales from FDII treatment if the taxpayer “knows or has reason to know that the recipient isn’t a foreign person or that the property will not be for foreign use.”
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For more information about how the proposed regulations may affect you or your business, contact your Moss Adams professional or email email@example.com. You can also visit our dedicated tax reform page to learn more.