Enacted by the Tax Cuts and Jobs Act of 2017, IRC Section 250 (Deduction for Foreign-Derived Intangible Income (FDII) and Global Intangible Low-Taxed Income (GILTI)) provides a favorable 50% U.S. tax deduction to shareholders of controlled foreign corporations (CFCs) on their GILTI deemed dividends.  In addition, Section 250 provides domestic C corporations a favorable 37.5% deduction on Foreign Derived Intangible Income that is derived from serving foreign markets via sales, services and licensing. This article primarily addresses issues related to the FDII deduction.

Treasury issued proposed regulations under IRC Section 250 in March 2019. The proposed regulations were viewed as complex and burdensome with respect to qualifying for the FDII deduction because they required, among other things, specific forms of documentation necessary to establish that (i) a recipient of property was a foreign person; (ii) the sale of property was for a foreign use, and (iii) general service was provided to a person located outside the US.

In July of 2020, the US Treasury and IRS issued final Section 250 regulations with modifications that took into account comments that the proposed rules involved unnecessary complexity, unwarranted restrictions and burdensome compliance requirements on US-based multinationals. The final Section 250 regulations apply to tax years beginning on or after January 1, 2021. For tax years before 2021, taxpayers have the option to apply the statute, the proposed rules, or the final rules. If proposed or final rules are chosen, they must be applied in their entirety. If the proposed rules are applied, transition documentation rules extend to any taxable year beginning before January 1, 2021. If the   final rules are chosen, the specific substantiation rules do not apply.

Documentation vs. Substantiation

As previously noted, the proposed regulations required specific forms of documentation to establish that a recipient of property was a foreign person, the sale of property was for a foreign use, and a general service was provided to a person located outside the US.

In place of the documentation requirements, the proposed regulations prescribe broader “substantiation requirements.” In other words, they focus on types of information rather than specific documents. 

General Substantiation

The final regulations rely in large part on the Section 6001 general substantiation rules that call for having books and records, as well as information and items gathered during the ordinary course of business, such as invoicing documents and receipts. These general substantiation rules apply to most relevant FDII determinations, including (1) foreign person status of the buyer or recipient;(2) foreign use with respect to sales of (i) general property directly to end users, (ii) digital content, or (ii) international transportation property; and (3) the location of general services to consumers or the location of services that are not general services.

Specific Substantiation

More onerous, specific substantiation is required for (1) sales of general property for resale; (2) the sales of general property for further manufacturing outside the US; (3) the sales of intangible property; and (4) general services provided to business recipients.

For example, with respect to sales to resellers, taxpayer must maintain evidence such as the following that the general property will ultimately be sold to end-users located outside the US.

• A binding contract that limits sales to outside of the US
• Proof that property is specifically designed, labeled, or adapted for a foreign market
• Proof that the shipping costs would be prohibitively expensive if sold back to the US
• Credible evidence obtained or created in the ordinary course of business from the recipient evidencing that property will be sold to an end-user outside the US
• A written statement prepared by the seller containing certain prescribed information, including how the seller determined that property will be sold to an end-user outside of the US

The final regulations require that relevant substantiating documents be in existence by the FDII filing date and provided to the IRS within 30 days of a request. There are no restrictions on how early the documents may be created or obtained. Businesses with less than $25 million in gross receipts are not subject to specific substantiation requirements and there is no small transaction exception.

The following is a short summary of key areas covered in the final Section 250 regulations.

General Property Sales

Under the final Section 250 regulations, foreign use of general property refers to the sale or eventual sale of property to end users outside the US. The final regulations define general property to mean any property other than intangible property, a security, an interest in a partnership, trust or estate or certain commodities.   The final regulations include digital content as general property.

For sales of general property, taxpayers must meet the “foreign person and “foreign use” requirements to claim an FDII benefit.  The final regulations permit a presumption of foreign person status for buyers based on the place of sale or a shipping or billing address. This presumption does not apply if the seller knows or has reason to know that the buyer is not a foreign person. The final regulations removed the small business exception general property substantiation that was available under the final regulations. 

Under the final regulations, foreign use of general property refers to the sale or eventual sale of property to end users outside the US.   The “end user” concept serves as method of confirming that the sale of general property is for foreign use.  In this regard, a buyer who acquires property as an intermediary or reseller would not generally be considered an end user and the specific substantiation requirements are needed in such cases to confirm that the item is not sold to an end user in the U.S.

The following categories of sales of general property to end users 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 US.  However, if delivery is arranged with a principal purpose of having the property transported from its location outside the US to a location within the US for ultimate use or consumption, this does not qualify as foreign use.
• Sales to an end user outside the US without the use of a carrier or freight forwarder if the property is located outside the US at the time of sale. This includes sales made in a foreign retail store.
• Sales of general property for resale, if the property will ultimately be sold to end users outside the US and those ultimate sales are substantiated. 
• Sales of general property containing primarily digital content.  Digital content includes a computer program or other content in digital.  Sales of such content is considered for foreign use if the property is transferred electronically and the end user downloads, installs, receives, or accesses the purchased digital content on a device outside the U.S. In some cases, the end user’s billing address may be used if the gross receipts from all sales to the end user are less than $50,000. A billing address may be used to establish the location of the recipient’s access if actual information about the location, such as an IP address, is unavailable and gross receipts from all sales to the end user are less than $50,000.

In the case of sales of international transportation property used for compensation or hire, foreign use is determined based on the location where the end user registers the property. In the case of sales of international transportation property not used for compensation or hire, foreign use is determined based on where the end user registers the property and the location where the property is hangered or stored.

General Property Subject to Manufacture

The final regulations generally follow the proposed regulations regarding the sale general property that is subject to manufacturing. Specifically, the final rules provide 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 U.S. and such foreign transformation is substantiated.

The final rules clarify that general property is subject to manufacturing, assembly or other processing if (i) the property is physically and materially changed, or (ii) the property is incorporated as a component into a second product and the fair market value of the property sold by the taxpayer is 20% or less of the fair market value of the second product (the “component test”).  The final regulations elaborate by indicating that property is subject to material change if it is substantially transformed and distinguishable from, and cannot be readily returned, to its original state.  Meanwhile, the component test is satisfied if a component is incorporated into another product if such incorporation involves activities that are substantial in nature and generally considered to constitute manufacture, assembly, or other processing of property based on facts and circumstances. 

The substantiation requirements for manufactured property are as follows:

• Credible evidence of sale to manufacturer that is a foreign unrelated party and cannot be sold to end users without physical and material change.
• Credible evidence obtained or created in ordinary course of business from recipient that the product will be subject to manufacture.
• Written statement by seller containing certain information corroborated by evidence that is credible and sufficient to support the information provided.

Related Party Sales

Section 250 provides that the sale of property to a foreign related party is treated as for a foreign use when the foreign related party (i) resells the property to an unrelated foreign party for foreign use, or (ii) uses the property in connection with the sale of other property or provision of services to an unrelated foreign party for a foreign use.

Under the final regulations the outbound sale to a related party (“the related-party sale”) qualifies for the FDII deduction if the unrelated party sale occurs in such year or will occur in the future in the ordinary course of business. The final regulations strike the ruled in the proposed regulations requiring the US seller to file an amended return to claim an FDII benefit for an unrelated party sale occurring after the FDII filing date.

The final regulations do not apply the related-party sales rules to sales of intangible property, because a sale of intangible property qualifies for the FDII deduction only to the extent the intangible property is used outside the US.

Intangible Property

The final regulations determine foreign use of intangible property by whether revenue from the intangible is earned from end-users located outside the US.  Where intangible property is used to provide a service, foreign use is generally determined based on the location of the recipient. When intangible property is embedded in general property, foreign use is determined by where the end user of the property is located.  In scenarios involving intangible property that is used in research and development, foreign use is determined by the location of the end-user of the secondary IP.  Finally, a sale of intangible property to an unrelated party is treated as foreign use if the intangible consists of a manufacturing method or process used outside the U.S.  

Service Transactions

The final regulations divide services into the following five categories:  

1. Transportation services, which are services to transport a person or property using aircraft, railroad rolling stock, vessel, motor vehicle or any similar mode of transportation
2. Property services, which are services (other than a proximate or transportation service) provided with respect to tangible property, if substantially all the service is provided at the location of the property and the service results in the physical manipulation of the property
3. Proximate services, which are services (other than a property or transportation service) provided to a recipient, if substantially all of the service is performed in the physical presence of the recipient
4. General services provided to consumers that does not fall into one of the other categories
5. General services provided to business recipients: a service that is provided to a business recipient and does not fall into one of the other categories. General services are further divided into:
   
   

• services provided to consumers, and
• services provided to businesses

General substantiation applies to every category of services above, except for general services to business recipients.  

The final regulations provide that the location of a business recipient of a general service is the location of the business recipients office or other fixed place of business.  However, the location where advertising services are provided is the location where the advertisements are viewed by individuals, not necessarily where the recipient is located.  Finally, the location where electronically supplied services are provided is the location where the recipients employees and agents access the service, not necessarily where the location of the purchaser of the services. 

The substantiation requirements for services are generally as follows:

• Credible evidence obtained or created in the ordinary course of business from the business recipient establishing extent to which operations outside the US benefit from services.
• A written statement containing certain corroborated information.
• Under the final regulations’ small business exception, the specific substantiation requirements described above do not apply if the taxpayer and all related parties of the taxpayer, in the aggregate, (as opposed to an individual seller/renderer) receive less than $25 million in gross receipts during the prior tax year.

Related Party Services

A related-party service qualifies for the FDII deduction only if the service is not substantially similar to a service that is or will be provided by the related person to a person located in the US. The final regulations clarify that services provided to a related party that only indirectly benefit the related party's service recipients are not "substantially similar" to the services provided by the related party.

The final Section 250 regulations treat the business recipient as including all related parties. However, a related party service does not qualify at all if it is used by the related party to provide a service to a person located in the US, and either the benefit test or price test is failed.

The Path Forward

This article highlighted several key areas of the final Section 250 regulations, but there are many additional details for domestic corporate taxpayers to consider and evaluate in order to ensure they can benefit from the FDDII deduction.  While the final regulations provide welcome flexibility that should reduce impact on business processes, the specific substantiation requirements may, in certain circumstances, require corporate taxpayers to update contracts or to request additional information from customers.

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Fernando R. Lopez, JD, MBA, is a principal at Prager Metis, a member of Prager Metis International Group. He has been a practicing accountant since 1998. Fernando advises his clients on a full range of cross-border tax planning and compliance matters aimed at efficient cross-border structures and operations. He counsels businesses in various industries regarding US and foreign tax considerations related to overseas activities and expansion. This includes foreign clients regarding inbound considerations, US permanent establishment considerations, entity selection and considerations related to investments in real property. Fernando is also knowledgeable on tax-efficient restructuring; M&A, dispositions; joint ventures; global trading structures; tax deferral; foreign currency transactions; repatriation; foreign tax credits, IP migration; transfer pricing; tax accounting, FIN 48 reporting; and international compliance. Fernando always makes it his initial objective to establish a personal relationship with all his clients that promotes a healthy and strong understanding of their businesses and operations. Prior to joining Prager Metis, he worked with Big 4 firms in the Silicon Valley, Stamford, Atlanta, South Florida and Paris. Fernando supports the Chamber of Commerce and the World Trade Center in locations where he practices. He also has participated in the American bar Association and International Fiscal Association. He has written numerous articles and alerts related to inbound and outbound international tax issues. He is a frequent speaker on international tax topics. Most recently, he presented on the US tax reform at GGI’s North American Regional Conference. Fernando is a supporter of international adoption and has three adopted children of his own. He can be reached at flopez@pragermetis.com.