What You Must Know about the Final Regulations Under IRC Section 250, FDII and GILTI

On July 9, 2020, Treasury and the IRS released final regulations on the foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI) deduction under IRC Sec. 250.   For the most part, the final regulations adopt the proposed regulations issued by Treasury in March of 2019.  A significant development in the regulations is the elimination of certain documentation for determining the foreign destination requirements to substantiate income from sales and services as foreign derived.

Another notable development is that the regulations permit individuals making an IRC Sec. 962 election to take into account the deduction for GILTI under IRC Sec. 250. The preamble acknowledges the uncertainty regarding when an individual may make the IRC Sec. 962 election on an amended tax return. The regulations provide that until any final guidance, individuals may make an election on an amended return for 2018 and later.

Background:

IRC Sec. 250 generally allows a domestic corporation a deduction for its FDII and GILTI inclusions for a tax year. For tax years beginning after December 31, 2017, but on or before December 31, 2025, a domestic corporation may claim a deduction equal to 37.5% of its FDII (subject to limitations the theoretical result is an effective rate of 13.125%) and 50% of the sum of its GILTI and any IRC Sec. 78 dividend with respect to GILTI (IRC Sec. 78 GILTI dividend). For tax years beginning after December 31, 2025, these percentages decrease to 21.875% and 37.5%, respectively.

Specifically, U.S. corporations may be entitled to a deduction based on their “foreign-derived deduction eligible income” (FDDEI), which is income from certain sales or licenses of property to foreign persons for foreign use and services provided to persons, or with respect to property, located outside the United States. The benefit of the deduction is reduced by 10% of the amount of the corporation’s “qualified business asset investment” (QBAI), which generally is depreciable tangible property used in the production of “deduction eligible income” (DEI). DEI generally consists of all of a corporation’s gross income, other than a few exempt items, reduced by allocable deductions.

Similarly, a U.S. corporation may be entitled under IRC Sec. 250 to a deduction of up to 50% of its GILTI inclusion and related IRC Sec. 78 gross-up.

Proposed FDII Regulations

On March 4, 2019, the Treasury Department issued proposed regulations (REG-104464-18) which included rules for how foreign use is determined and documented for FDII purposes.

Tangible or General Property:

The Proposed and Final Regulations define “general property” as property other than intangible property, securities or commodities.

The proposed regulations provided that a sale of tangible property is for a foreign use if the property meets at least one of these requirements:

Is not 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.

Intangible Property:

Documentation of foreign use of intangible property included a written statement from the recipient providing the amount of the annual revenue from sales or sublicenses of the intangible property.

These documentation rules were considered difficult to apply and created a number of compliance issues. There was an exception 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 could rely on foreign billing addresses to establish foreign use.

Final FDII Regulations

The Final Regulations make significant changes to the Proposed Regulations’ documentation rules and provide a more workable approach.  This includes extending the documentation transition rule provided in the Proposed Regulations to permit any reasonable documentation maintained in the ordinary course of the taxpayer’s business, including that available for small transactions and small businesses, for FDDEI transactions effected in tax years that begin before January 1, 2021.

The Final Regulations eliminate the requirement to obtain specific types of documentation to substantiate certain elements (i.e., foreign person status, foreign use, or foreign location) in favor of the flexible

substantiation approach required to meet IRC Sec. 6001 standards, which apply more generally with respect to substantiation. The Final Regulations do retain specific substantiation requirements for certain types of transactions. The main categories for which specific substantiation is required are: (i) sales of intangible property, (ii) sales of general property to resellers and manufacturers, and (iii) the provision of general services to business recipients.

Rule for General Property:

For sales of general property, the final regulations generally provide that “foreign use” means the sale (or eventual sale) of property to end users outside the United States or the sale of general property to a person that subjects the property to manufacture, assembly, or other processing outside the United States. This is a major change from the proposed rules, which required the absence of domestic use within three years of delivery of the property unless the manufacturing exception applied.

Electronic Transfers of Digital Content Outside the United States:

The final regulations provide that whether a sale of general property that primarily contains digital content that is transferred electronically is for foreign use is determined based on the location where an end user downloads, installs, receives, or accesses the digital content. If such information is available, and the gross receipts from all sales with respect to the end user (which may be a business) are in the aggregate less than $50,000, a sale of such property is for a foreign use if it is to an end user that has a billing address located outside the United States. For these purposes, digital content is defined as a computer program or any other content in digital format (e.g., books, movies, and music in digital format). The final regulations do not provide guidance regarding the character of a transfer of copyrighted article, but defer to general U.S. tax principles, taking into account the regulations issued under IRC Sec. 861.

Small Business Relief from Documentation Requirements:

The proposed regs provided small businesses with further relief on documentation requirements, as the specific substantiation requirements for FDDEI transactions did not apply. That exception remains in the final regs, and the threshold to qualify for it has been relaxed going from $10 million of gross receipts to S25 million. The preamble states compliance with general substantiation rules is still needed, such as having evidence of a foreign shipping address, an export bill of lading, or "memorializing conversations with recipients" on where a property will be resold.

GILTI and the Ability of Individuals to Make IRC Sec. 962 Elections:

GILTI is the income earned by controlled foreign corporations (“CFCs”) from intangible assets. It requires a 10% U.S. shareholder of a CFC to include in its current income the shareholder’s prorated share of the GILTI income of the CFC. U.S. corporate shareholders and individual shareholders are taxed differently on GILTI. Subject to certain limitations, a U.S. corporate shareholder is allowed a 50% deduction against GILTI (the “IRC Sec. 250 deduction”), and is entitled to a credit for 80% of the CFC’s foreign tax allocable to GILTI. Individual shareholders are not allowed the deduction or the credit and are subject to a marginal tax rate of 37%. IRC Sec. 962 is an election that allows an individual to be taxed on subpart F income and GILTI at corporate tax rates. The final regulations permit individuals making an IRC Sec. 962 election to take into account the deduction for GILTI under IRC Sec. 250. The preamble to the regulations notes uncertainty regarding when an individual may make an IRC Sec. 962 election on an amended return. It states that, until any final guidance on this issue is published, individuals may make an otherwise valid election on an amended return for 2018 and later, provided the interests of the government are not prejudiced by the delay, as described in Treas. Reg. Sec. 301.9100-3(c).

Example:

During 2019, a U.S. individual wholly owns a foreign corporation that is a CFC. The CFC has $1 million of net active earnings before foreign income tax. The CFC does not have income characterized as subpart F income during the year. Further, the CFC does not have any qualified business asset investments. The CFC pays a foreign income tax of $180,000 on the earnings.

If the U.S. individual does not own any other CFCs, the total net tested income (the GILTI inclusion) is $820,000 [$1 million-$180,000]. The individual will owe a U.S. tax of $303,400 applying the maximum individual tax rate of 37% on the GILTI inclusion.  No deemed paid foreign tax credit pursuant to IRC Sec. 960 is allowed. This is the default outcome without the IRC Sec. 962 election.

If an IRC Sec. 962 election is made, the U.S. individual will recognized GILTI income of $820,000 plus the IRC Sec. 78 gross-up of $180,000. Therefore, the total deemed inclusion is $1 million.  An IRC Sec. 250 deduction will be allowed on 50% of the $1 million, or $500,000. Therefore, the U.S. taxable income on the inclusion is $500,000. The U.S. corporate tax rate of 21% will apply resulting in a tax liability before foreign tax credit of $105,000. The amount is further reduced by the deemed paid foreign tax credit. 80% of the deemed paid foreign tax credit attributable to tested income is allowed, or $144,000 [80% of $180,000]. The foreign tax credit is more than sufficient to offset the entire U.S. tax liability of $105,000, resulting in a zero tax.

When the CFC later distributes the $820,000 of earnings and profits of the CFC, the individual shareholder will be taxed on the dividend.  If the dividend is paid by a CFC organized in a country that has a comprehensive tax treaty with the U.S., it will be a qualified dividend and be eligible for the 20% preferential tax rates on qualified dividends (plus net investments tax and state and local taxes).  If it is from a CFC in a country that does not have a comprehensive income tax treaty with the U.S., it will be taxed at marginal rates of up to 37% (plus net investment income tax and state and local taxes).   

In the former case, there is a tax savings of 17%, and, in both cases, there is the deferral of U.S. tax on GILTI until the cash is distributed. 

Effective Date of Final Regulation:

The final regulations are generally applicable to tax years beginning on or after January 1, 2021, giving taxpayers additional time to develop systems and procedures for complying with the regulations. The proposed regulations were proposed to apply to taxable years ending on or after March 4, 2019.

Taxpayers may choose to apply the final regulations to tax years beginning before January 1, 2021, provided that they apply the final regulations in their entirety (with the exception of certain substantiation requirements). Alternatively, taxpayers may rely on the proposed regulations in their entirety for tax years beginning on or after January 1, 2018, except that taxpayers relying on the proposed regulations may rely on the transition rule for documentation for all taxable years beginning before January 1, 2021 (rather than only for taxable years beginning on or before March 4, 2019).