Foreign Derived Intangible Income

By Baker Newman Noyes March 4, 2020

I. Background

The Tax Cuts and Jobs Act of 2017 introduced the concept of foreign-derived intangible income (“FDII”), which is intended as an incentive for U.S. corporations¹ to provide goods and services to foreign customers.

Under the new Internal Revenue Code 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 sale² 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

Foreign person

The proposed Section 250 regulations (REG-104464-18) define a foreign person as a person that is not a U.S. person, which includes a foreign government or international organization for purposes of the proposed regulations. A recipient is treated as a foreign person only if the seller obtains documentation of the recipient’s foreign status and does not know or have reason to know that the recipient is not a foreign person.³

Several types of documentation are permissible for this purpose, including the following:

• A written statement by recipients attesting to their foreign status
• Documentation of organization under laws of the foreign jurisdiction
• Valid identification used by a foreign government for individuals
• Documentation filed with a foreign government evidencing the organization or residency of the entity in a foreign country
• Other documentation as prescribed

Foreign use

The Internal Revenue Code defines a foreign use as “any use, consumption, or disposition which is not within the United States.” The statute requires that the taxpayer establish the fact of foreign use “to the satisfaction of the Secretary” of the Treasury.

II. Documentation rules

The proposed Section 250 regulations include rules for determining the various factors of the FDII calculation. As discussed below, the proposed regulations also provide clarification on how foreign use is determined and documented for FDII purposes. Due to the distinction between types of qualifying transactions (property, services) the documentation requirements vary depending on the nature of such transactions.

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.

A. Applicability

Documentation requirements (as discussed in detail below) apply to tax years ending on or after March 4, 2019.

NOTE: Taxpayers are not required to follow the documentation requirements outlined below for tax years beginning on or before March 4, 2019. Instead, the proposed regulations allow taxpayers to use any reasonable documentation maintained in the ordinary course of the business that establishes the recipient as a foreign person, the property is for a foreign use, or that a recipient of a general service is located outside the United States.

Examples may include the following:

• • • • Invoice with shipping address
      • Tracking information
      • Billing address for service recipients

B. Documentation reliability requirement⁴

In general, any documentation supporting any type of FDII transaction must meet certain reliability requirements. For documentation to be relied upon,

• The seller or renderer must obtain the documentation by the FDII filing date⁵,
• 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

Purported foreign sales are disqualified 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.”

III. Foreign use determination and documentation requirements – property and services

As discussed below, the foreign use determination and related documentation requirements are dependent on the type of property or services.

A. Property

The rules applicable to the determination of whether a sale of property is for a foreign use depends on whether the property sold is tangible (or general) or intangible.

1. Tangible or general property

a) Determination of foreign use

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

b) Documentation of foreign use

Examples of acceptable documentation of foreign use of general property 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
• Exception for small businesses and small transactions (as discussed below)

NOTE: 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. Thus, substantiating foreign use should be not be difficult in most typical tangible property sale situations.

2. Intangible property

a) Determination of foreign use

The sale of intangible property is considered to be for foreign use only to the extent that the intangible property generates revenue from exploitation outside the United States. As a result, documentation is more challenging for intangible property than it is for tangible property.

b) Documentation of foreign use

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 is 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 using the intangible property.
• 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.
• Exception for small businesses and small transactions (as discussed below)

NOTE: 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.

c) Small business exception: property⁶

Special rules exist for small businesses with annual gross receipts of less than $10 million in the prior taxable year and small transactions of less than $5,000 in receipts from a single recipient during the current taxable year.

Foreign person and foreign use requirements are met if the seller has a shipping address for the recipient that is outside the United States.

B. Services

a) Determination of location – outside the United States

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 (i.e. consumer or business) of the service.

As detailed below, the proposed regulations introduce four mutually exclusive categories of qualifying services; each service uses a different method to determine whether this requirement has been satisfied:

1. Proximate services: a service, other than property or transportation, substantially all⁷ of which is performed in the physical presence of the recipient or if a business, its employees.
2. Property services: a service, other than proximate or transportation, provided with respect to tangible property, but only if substantially all⁸ of the service is performed at the foreign location of the property and results in physical manipulation of the property. Physical manipulation includes assembly, maintenance or repair.
3. Transportation services: a service to transport a person or property using any mode of transportation. The proposed regulations provide that the origin and destination of the service will determine whether the service was provided outside the United States.
   • If both the origin and destination of the service are outside the US then 100% of the gross income qualifies as foreign.
   • If either the origin or destination of the service is outside the US then only 50% of the gross income qualifies as foreign.
4. General services: a service other than proximate, property or transportation service.⁹

b) Documentation of location – outside the United States

The proposed regulations do not require specific documentation with respect to proximate, property or transportation services.¹⁰

Examples of sufficient documentation for general services to a consumer or business recipient 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 (as discussed below)

c) Small business exception: services¹¹

Special rules exist for small businesses with annual gross receipts of less than $10 million in the prior taxable year and small transactions of less than $5,000 in receipts from a single recipient during the current taxable year.

A seller can rely on foreign billing addresses of the consumer to establish foreign use.

C. Related party transactions¹² – foreign use and documentation requirements

A sale of property or rendering of services to a related foreign party may qualify as a FDDEI transaction if certain additional requirements are satisfied.

1. Property

A sale of property to a foreign related party qualifies if the following conditions are met:

1. The sale of property otherwise qualifies (e.g. sale of general property to foreign person for a foreign use)
2. The related party sells the property to a foreign unrelated party or uses the property to provide a service to a foreign unrelated party
3. The unrelated party transaction occurs on or before the due date of the return (including extensions)

There are no specific rules related to the sale of intangible property to a foreign related party. Whether to related or unrelated party, sale is for foreign use only to the extent the intangible generated revenue from exploitation outside the United States.

If the unrelated party transaction occurs after the due date of the return (including extensions), a taxpayer may file an amended return for the tax year in which the related-party sale occurs.

2. Services

Related-party services are only considered FDDEI services if the related-party service is not substantially similar to a service provided by the related party to a person located within the United States.

Substantially similar

Services will be deemed to be substantially similar services if:

• 60% or more of the related party’s services are rendered (benefit conferred) to persons located in the United States, OR
• 60% or more of the price paid by persons within the United States to the related party are attributable to the related party service.

If the 60% benefit test is failed, the entire transaction is disqualified from FDDEI treatment.

However, if the 60% price test is failed, there is partial disallowance whereby only a portion of the income is disqualified in proportion to the amount that benefitted persons located in the United States.

Conclusion

Foreign-derived intangible income is an entirely new category of income created by IRC 250(a)(1)(A). It provides a meaningful deduction for corporations that qualify, but comes with a number of restrictions and numerous documentation guidelines that taxpayers must navigate.

For more information, please contact Stuart Lyons, lead of BNN’s international tax practice, or Andrea Reilly at 1.800.244.7444.