On March 4, 2019 in REG-104464-18, the government released proposed FDII regulations under section 250. The rules provide important computational and definitional provisions in applying section 250. The much-awaited proposed rule-making also contains rules coordinating the deduction for FDII with the  deduction also allowed under section 250 with respect to global intangible low-taxed income (GILTI). Under section 14202(a) of the Tax Cuts and Jobs Act, P.L. 115-97 (2017)(TCJA), section 250 allows for a deduction for a US domestic corporation’s FDII and its GILTI as well as the amount treated as a dividend under section 78 which is attributable to GILTI. Section 250 applies to taxable years commencing after December 31, 2017.

New section 951A, enacted into law by section 14201(a) of the TCJA, provides that a US shareholder of a controlled foreign corporation (CFC) for any taxable year include in gross income the shareholder’s amount of GILTI for the year.  Proposed regulations with respect to GILTI were issued last October. 83 FR 51072. [1] This provision profoundly changed the design of the international tax landscape previously drawn by Congress. Note that under sections 951 through 965, the subpart F provisions, anti-deferral rules have provided and continue to apply with respect to the current reporting of passive and transient forms of income by US shareholders, as defined in section 951(b), in the taxable year realized by controlled foreign corporations (CFCs). But subpart F income generally did not include “active” business income realized by a CFC as well as exceptions to subpart F income. This caused many US shareholders of CFCs to indefinitely postpone or defer US income taxation with respect to active foreign business income and further deflect such revenue streams to low tax jurisdictions such as Ireland for example or tax havens which impose no income tax. No taxation in the US occurred with respect to such earnings until repatriated to the US.

Congress decided to force the repatriation of foreign accumulated earnings and profits for post-1986 years even if there were not a corresponding distribution of funds or other property by dividend to the US shareholder of the CFC. The repatriation tax under section 965 allowed previously accumulated earnings and profits of a CFC to be repatriated at low tax rates payable in annual installments over an eight year period. Deferral was good despite involuntary repatriation for post-1986 accumulated foreign earnings and profits under section 965 which was not exactly the repatriation of (cash) dividends model that the Bush Administration convinced Congress to enact into law approximately 15 years ago.

Another key international tax provision enacted into law by the TCJA is the new participation exemption in section 245A. This permits US corporations to receive non-taxable dividends of certain earnings of a foreign corporation. [2] A central feature of the international tax law changes made by TCJA is the adoption of a participation exemption system, under which earnings of a foreign corporation can be repatriated to a qualifying corporate U.S. shareholder in the form of a dividend without U.S. tax under under section 245A. In other words, a 100% DRD is allowed to a “specified 10% owned foreign corporation” by a domestic corporation which is a U.S. shareholder with respect to the foreign corporation, but only to the extent of the “foreign-source portion” of the dividend. A “specified 10% owned foreign corporation” is any foreign corporation to which any domestic corporation is a U.S. shareholder as to that corporation. A passive foreign investment company (PFIC), as defined in section 1297 and which is not a CFC, is not a foreign corporation for this purpose.

In order to offset the large tax benefits derived from US shareholders under the TCJA as well as the new 21% flat rate tax on corporate income, Congress enacted section 951A, which requires a US shareholder’s share of GILTI derived from its ownership in a CFC to be currently included in US taxable income on a current basis in mimicking the taxation of subpart income of a CFC under section 951(a)(1)(A). [3] See August, “The Proposed GILTI Regulations Under Section 951A”, Corporate Taxation (WG&L), Mar/Apr 2019.

On the other hand, in order to reduce the incentive for US corporations to continue to engage in efforts to defer the US taxation of offshore active business income for GILTI and FDII species of income. Accordingly, section 250 provides a lower effective U.S. tax rate with respect to FDII through a 37.5% deduction for taxable years beginning after December 31, 2017, and before January 1, 2026 and a 50% deduction with respect to GILTI. When foreign tax credits are factored into the mix the effective rates of tax are lower. With respect to FDII, which is, in general, income derived by a domestic corporation from foreign property sales and provision of services to foreign persons results in an effective tax rate of 13.125% through 2025 and 16.4% thereafter. The purpose of the FDII rule is to encourage US corporations to remain “on-shore” by being subject to reduced rates of US tax on foreign sales and services income directly or through a foreign subsidiary. [4] 

Meet FDII: Computationally That Is, But Only Briefly

FDII is a US corporation’s deemed intangible income (“DII”) multiplied by the corporation’s foreign-derived ratio. See Prop. Reg. §1.250(b)-1(b). A domestic corporation’s DII is the excess (if any) of the corporation’s deduction eligible income (“DEI”) over its deemed tangible income return (“DTIR”). Prop. Reg. §1.250(b)-1(c)(3). A domestic corporation’s DTIR is 10% of the corporation’s QBAI (qualified business asset investment). Prop. Reg. §1.250(b)-1 (c)(4). The foreign-derived ratio is the domestic corporation’s ratio of foreign-derived deduction eligible income (“FDDEI”) to DEI. Prop. Reg. § 1.250(b)-1(c)(13). This sounds quite complex doesn’t it? It is. And the proposed regulations provide a labyrinthian set of operative rules and calculations which are also part of the GILTI proposed regulations. Yes, computer software that can make these calculations accurately are worthy of purchase.

Let’s avoid going into depth of the complex rules and computations for this post and focus on some of the other main features of the proposed rule-making on FDII.

Treatment of Partnerships

As mentioned in the Preamble to the rule-making, section 250(a)(1) allows a deduction for FDII with respect to a domestic corporation but did not set forth rules for domestic corporations that are partners in a partnership. The Conference Report to the TCJA suggested that Congress intended that a domestic corporate partner of a partnership receive the benefit of a section 250 deduction for its FDII and GILTI. See H. Rept. 115-466, at 623, fn. 1517 (2017) (Conf. Rep.). The proposed regulations confirm this was the intent of Congress and provides that a domestic corporate partner of a partnership is allocated its distributive share of a partnership’s gross DEI, gross FDDEI, and deductions in determining the partner’s FDII. Prop. Reg. § 1.250(b)-1(e)(1). As to a domestic corporate partner’s DTIR, a domestic corporation’s QBAI is increased by its share of the partnership’s adjusted basis in partnership specified tangible property. Prop. Reg. §1.250(b)-2(g).

Tax Exempts Entitled to FDII Deduction on Unrelated Business Taxable Income (UBIT)

A tax-exempt US domestic corporation subject to UBIT may claim a section 250 deduction. The proposed regulations clarify that FDII for this purpose is determined only with respect to the corporation’s items of income, gain, deduction, or loss, and adjusted bases in property, that are taken into account in computing UBIT. See Prop. Reg. §1.250(b)-1(g).

Proving Foreign Use of Property

The FDII deduction requires the realization of foreign-derived deduction eligible income (FDDEI) which is income realized with respect to property sold to foreign persons for foreign use or services provided to a person or for property not in the United States. Prop. Regs. §§1.250(b)-4(d) and -4(e) state that whether a sale of property is for foreign use is dependent on whether the property sold is intangible or “general”. General property is property other than intangible property. Intangible property includes goodwill and going concern value. See §367(d)(4). The sale of general property to foreign persons is for foreign use if either: (i) it is not put to domestic use within three years of its delivery; or (ii) the property is subject to manufacture, assembly, or other processing outside the United States before its ultimate sale. Manufacture, assembly, or other processing occurs in instances where the property is physically and materially changed or is incorporated as a component into a second product and is no more than 20% of the fair market value of that product. Special rules apply for motor vehicles and aircraft. Foreign use is established if during the three years beginning on delivery the property is located out of the US more than 50% of the time and more than 50% of its miles are incurred while outside of the US mass). Other applicable rules are provided. There are no shortcuts, the actual language and rules in the regulations must be carefully analyzed and applied.

The sale, including a license or any transfer of property in which gain or income is recognized under section 367, of intangible property to foreign persons is for a foreign use where the revenue generated from the economic exploitation of the intangible occurs outside of the US, e.g., where the ultimate product is sold. Unlike a sale of general property, a seller can establish foreign use for a portion of the income from the sale of intangible property. Whether a sale is foreign use also depends on the type of payment made for the intangible property, i.e., periodic payments, percentage of gross revenues or receipts, lump sum payment, etc.

FDDEI Service Income

Section 250(b)(4)(B) states that FDDEI includes income from services provided by a domestic corporation to any person, or with respect to property, not located in the US. Section 250 does not contain language on when a person or property is “not located within the United States.”

Prop. Reg. §1.250(b)-5 provides rules for determining whether a service is provided to a person, or with respect to property, located outside the United States. The proposed regulations answer to that question with respect to services depends on the type of service provided. As to a “general service” it is important to consider the type of recipient of the service. The proposed regulations distinguish between services where the service provider (the “renderer”) and the recipient are in physical proximity when the service is performed (“proximate services”), services with respect to tangible property (“property services”), services to transport people or property (“transportation services”), and all other services (“general services”). Prop. Regs. §§1.250(b)-5(b) and (c)(4) through (7). For purposes of determining whether a service constitutes a FDDEI service, the proposed regulations look to the location of the performance of the service for proximate services, the location of the property for property services, the origin and destination of transportation services, and the location of the recipient for general services. See proposed §1.250(b)-5(d) through (h). Each category of service listed in Prop. Reg. §1.250(b)-5 is mutually exclusive of each other category, and every possible service is described in a single category. A FDDEI service is determined under the rules relevant to one, and only one, category of service in Treas. Reg. §1.250(b)-5. For example, a general service that is provided to a recipient located within the United States is not a FDDEI service, even if the service is performed outside the United States, whereas a property service that is performed outside the United States is a FDDEI service, even if the recipient of the service is located within the United States.

Again, the proposed regulations focus on the recipient of the services as well and distinguish between general services provided to consumers, or individuals purchasing general services for personal use, and to business recipients. A consumer or business recipient’s location outside the US is established if the renderer obtains appropriate documentation under the reliability requirement and does not know or have reason to know otherwise as of the FDII filing date. A consumer’s location is where it resides when the service is performed. A business recipient’s location is the location of an office or fixed place of business where the renderer’s earned gross income is allocated, with allocation occurring based on where the business recipient’s, including its related parties’, operations benefit from the service.

Related Party Transactions

A sale of property or rendition of service may qualify as a FDDEI transaction, regardless of whether the recipient of such service is a related party of the seller or renderer. However, as to a sale of general property or the rendering of a general service to a related party, section 250(b)(5)(C) and Prop. Reg. §1.250 (b)-6 provide additional requirements that must be satisfied for the transaction to qualify as a FDDEI sale or FDDEI service. The detailed rules must again be carefully reviewed and applied.

 

Application of Section 250 Deduction for Individuals Making a Section 962 Election

As explained above, the section 250 deduction for FDII and GILTI is available only to domestic corporations. However, section 962(a)(1) provides that an individual who is a U.S. shareholder may generally elect to be taxed on amounts included in the individual’s gross income under section 951(a) in “an amount equal to the tax that would be imposed under section 11 if such amounts were received by a domestic corporation.” Fortunately, the government has conceded that GILTI is treated as an amount included under section 951(a) for purposes of section 962. See section 951A(f)(1)(A) and Prop. Reg. § 1.951A-6(b)(1). A section 962 election can be made by an individual U.S. shareholder who is considered, by reason of section 958 (b), to own stock of a foreign corporation owned (within the meaning of section 958(a)) by a domestic pass-through entity, including a partnership or an S corporation. See Treas. Reg. §1.962-2(a).

Congress enacted section 962 to ensure that individuals’ tax burdens with respect to undistributed foreign earnings of their CFCs “will be no heavier than they would have been had they invested in an American corporation doing business abroad.” S. Rept. 1881, 1962-3 C.B. 784, at 798. Treas. Reg. §1.962-1(b)(1)(i) provides that a deduction of a U.S. shareholder does not reduce the amount included in gross income under section 951(a) for purposes of computing the amount of tax that would be imposed under section 11. However, allowing a section 250 deduction with respect to GILTI of an individual (including an individual that is a shareholder of an S corporation or a partner in a partnership) that makes an election under section 962 is consistent with the purpose of that provision of ensuring that such individual’s tax burden with respect to its CFC’s undistributed foreign earnings is no greater than if the individual owned such CFC through a domestic corporation. Accordingly, the proposed regulations provide that, for purposes of section 962, “taxable income” as used in section 11 of an electing individual is reduced by the portion of the section 250 deduction that would be allowed to a domestic corporation with respect to the individual’s GILTI and the section 78 gross-up attributable to the shareholder’s GILTI. See proposed §1.962-1(b)(1)(i) (B)(3). What great news this is!!

This is just a summary of some of the important parts of the proposed regulations to FDII. There is bound to be much commentary on the subject as well as the submissions of comments by bar associations, the AICPA, industry representatives and the academic community.

This post is intended solely for informational purposes and the reader may not rely upon the information provided herein for any purpose. It is not legal advice. Any reader or person who is potentially subject to the FDII and GILTI provisions, as well as the section 962 election, must consult with its tax counsel or tax advisor. You may call upon your lawyer at Fox Rothschild LLP or the undersigned if you have any questions on this Current Development.

[1] Under TCJA §14302(a), a new foreign tax credit category was added with respect foreign branch income (per §904(d) (2)(J)), which new FTC category is referenced in § 250(b)(3)(A)(i)(VI). Proposed rule-making on determining a corporation’s foreign branch income was issued in December, 2018. 83 FR 63200.

[2] The US participation exemption for US domestic corporations that are US shareholders of a CFC was designed to level the international tax playing field which had long-favored multinational business corporations resident in foreign industrial countries. How? Because most member countries of the Organisation for Economic Co-operation and Development (OECD) provide for a full or partial (e.g., 95%) participation exemption with respect to income of foreign subsidiaries distributed to domestic shareholders. See OECD (2018), Tax Policy Reforms 2018: OECD and Selected Partner Economies, at 73, OECD Publishing, Paris (Sept. 2018).

[3] Because Congress recognized that taxing active business income of a CFC would have an adverse impact on U.S. corporations relative to their foreign competitors, it determined that GILTI earned by such corporations should be subject to a reduced effective U.S. tax rate. Accordingly, §250, provides corporate U.S. shareholders a deduction of 50% for taxable years beginning after December 31, 2017, and before January 1, 2026, with respect to their GILTI, and the amount treated as a dividend under section 78 which is attributable to their GILTI (“section 78 gross-up”). In contrast, a domestic corporation’s inclusion of its CFCs’ subpart F income is not eligible for the §250 deduction and is subject to the full corporate tax rate now set at 21%, which is obviously better than the former 35% maximum corporate income tax rate.

[4] The overall §250 deduction is subject to a taxable income limitation. If, for any taxable year, the sum of a domestic corporation’s FDII and GILTI exceeds its taxable income. No deduction is allowed for the excess amount in the current year. In such event, the excess is allocated pro rata to reduce the corporation’s FDII and GILTI solely for purposes of computing the amount of the §250 deduction. The proposed regulations provide that a domestic corporation’s taxable income for the §250(a)(2) is determined after all of the corporation’s other deductions are taken into account. Prop. Treas. Reg. §1.250 (a)-1(c)(4). Therefore, a US corporation’s taxable income in applying §250(a)(2) is its taxable income determined without regard to the FDII and GILTI deductions but after taking into account §§163(j) and 172(a), including amounts permitted to be carried forward to such taxable year per §§163(j)(2) and 172(b).