The Tax Cuts and Jobs Act of 2017 (TCJA) provided a new deduction for C corporations, incentivizing them to generate revenue from foreign markets. The deduction is 37.5% of FDII, which generally is computed as the excess income over a fixed rate of return on a corporation’s tangible assets multiplied by the ratio based on the relationship of foreign qualifying income to total qualifying income. The deduction, while simple in concept, can be complex to calculate. Additionally, the regulations require taxpayers to adhere to a strict set of documentation rules to comply with the FDII regime, adding another layer of complexity. Following are five things to keep in mind to comply with the FDII requirements.
The final FDII regulations apply to taxable years beginning on or after Jan. 1, 2021. In general, the final rules stipulate that the documentation substantiating qualification for the deduction must exist prior to the filing of the tax return, including extensions. As such, calendar year taxpayers have until Oct. 15, 2022, to have documentation in place for the 2021 tax year. While this date might seem like a long time off, the nature of the transactions and a taxpayer’s supply chain might necessitate a significant amount of lead time to establish processes to ensure that proper documentation procedures are in place. Additionally, the IRS has indicated that the timing of when substantiation documents are created might affect the credibility of the documents.
Under the final FDII regulations, taxpayers are expected to know who their customers are and, more specifically, whether their customers are foreign persons. To substantiate that a transaction is eligible for the FDII deduction, a taxpayer first must establish that the sale or service was to a foreign person, which often is easier said than done. U.S.-based customers, for example in the manufacturing and distribution space, commonly provide a foreign shipping address on a purchase order. When taxpayers then identify their export sales, they often do so based on the shipping address. As a result, a foreign shipping address can make a purchase from a U.S. company appear to be from a foreign customer even though it is not. It is incredibly important for a taxpayer to scrutinize all information available to make sure a customer is undoubtedly foreign.
The substantiation required by the final regulations requires taxpayers to know very specific details regarding what occurs with their product, whether it is tangible or intangible, on its journey to final use or consumption by an end consumer. This is a relatively simple exercise when a taxpayer sells a finished product directly to an end consumer outside of the U.S. However, the task quickly can become onerous if the product is sold to a foreign retailer or distributor and the taxpayer must affirmatively prove that the product is not coming back into the U.S. Additionally, if the product is subject to further manufacturing or processing by the customer, the taxpayer will be responsible for documenting the process by which that product will undergo a physical and material change from its current state as a result of the customer’s actions. For intangible sales, such as sales of digital content, the substantiation rules present a very different set of unique challenges. As such, a taxpayer might find it needs to obtain information or representations from its customers, which could require significant lead time.
Many U.S. corporations accustomed to doing business internationally understand the inherent risk and additional IRS scrutiny anytime they transact across borders with related parties. The FDII deduction is no different. While the final regulations relax some of the related-party documentation from the proposed version, taxpayers still are required to maintain more substantiation for related-party transactions than what is required for transactions with unrelated parties. Additionally, in the case of foreign subsidiaries of a U.S. corporation, the U.S. entity classification of the foreign entity likely will have a dramatic impact on how the transaction qualifies for the FDII deduction and therefore requires a detailed analysis.
The IRS has stated that review of TCJA-related provisions is high on its list of audit issues, announcing a Large Business and International Division campaign focused on the TCJA. Given this and the fact that the FDII deduction is 37.5% of FDII until 2026 – its peak rate benefit – FDII is likely to be a focus of any IRS audit. While a taxpayer has the burden of supporting any deduction claimed, the addition of specific substantiation required by the regulations means that IRS agents will be looking for particular documents. Therefore, taxpayers would be well served to have these required documents ready in anticipation of what is likely to be included in standard information document requests on any future audits.
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