Final regulations provide additional guidance on FDII calculation

| 8/6/2020
Final regulations provide additional guidance on FDII calculation

On July 15, the U.S. Department of the Treasury and the IRS published final regulations addressing the computation of the deduction for foreign-derived intangible income (FDII) under IRC Section 250. Enacted as part of the Tax Cuts and Jobs Act of 2017 (TCJA) and effective for taxable years beginning on or after Jan. 1, 2018, Section 250 allows corporate taxpayers a deduction equal to 37.5% of their FDII and 50% of their global intangible low-taxed income inclusion under Section 951A. Although the final regulations largely adopted the calculus guidance in the proposed regulations issued in March 2019, they provide additional guidance and clarification. Following are highlights of the calculation mechanics of the deduction under the final regulations. A previous article focused on the documentation requirements under the final regulations.

Net operating losses (NOLs)

Section 250(a)(2) limits the benefit of the FDII deduction based on a taxpayer’s taxable income. The proposed regulations did not explicitly address whether pre-TCJA NOLs must be considered for this limitation. The final regulations expressly provide that all NOLs, including those arising in pre-TCJA years, are taken into account when determining a taxpayer’s taxable income.

Ordering rules

IRC Sections 163(j), 172, and 250 all are used in determining taxable income and are based, in part, on taxable income, resulting in a circular calculation. The proposed regulations contained a five-step ordering rule that directed taxpayers on how to resolve the circularity. Taxpayers submitted numerous comments noting problems and weaknesses with the ordering rule application. In response to these comments, the preamble to the final regulations explains that the final regulations do not include an ordering rule so Treasury and the IRS can study the issue. In the interim, taxpayers are permitted to use any reasonable method to address the circular calculation as long as the method is applied consistently for all tax years beginning on or after Jan. 1, 2021. Both the ordering rule contained in the proposed regulations and a simultaneous computation method are considered reasonable methods.

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Loss transactions

The final regulations adopt without change the prohibition in the proposed rules that prevented taxpayers from using a transaction-by-transaction methodology and excluding loss transactions in the computation of FDII. The final regulations also adopt the provision in the proposed regulations that prevents taxpayers from intentionally failing the documentation requirements with respect to a loss transaction as a way to exclude the transaction from the FDII computation.

Expense apportionment

The proposed regulations required taxpayers to allocate and apportion expenses to gross deduction eligible income (DEI) and gross foreign-derived DEI (FDDEI) under Sections 1.861-8 through 1.861-14T and 1.861-17, but they required an adjustment to reverse the exclusive geographic apportionment for research and development (R&D) expenses contained in Section 1.861-17(b). The final regulations adopt the general rules for allocating and apportioning expenses to gross DEI and gross FDDEI but do not adopt the adjustment for R&D expenses, leaving the issue for future guidance.

The final regulations also modify Section 1.250(b)-1(d)(ii) of the proposed regulations to clarify that IRC Sections 163(j), 170(b)(2),172, 246(b), and 250 do not apply when allocating and apportioning deductions to gross DEI or gross FDDEI.

Foreign branch income

Foreign branch income is excluded from gross DEI and is defined by reference to Section 1.904-4(f) of the proposed regulations with modification. Under the modification, the definition is expanded to include the sale, directly or indirectly, of any asset (other than stock) that produces gross income attributable to the foreign branch, including the sale of a disregarded entity or partnership interest. The final regulations do not adopt the expanded definition of branch income, making the definition for purposes of DEI consistent with the definition under Section 904.

Qualified business asset investment (QBAI)

Generally, Section 250 defines intangible income as any income other than deemed tangible income return (DTIR) net of certain interest. DTIR is defined as 10% of a taxpayer’s qualified business asset investment (QBAI), and QBAI, in turn, comprises the tax basis of specified tangible property, which is tangible depreciable property under domestic cost recovery rules. Consequently, the FDII benefit increases as QBAI decreases.

To prevent abuse, the proposed regulations disregarded certain transfers of specified tangible property to a related party when the transferor continues to use the property transferred in the production of gross DEI, thereby reducing a taxpayer’s DTIR. Specifically, Section 1.250(b)-2(h) of the proposed regulations disregarded transfers of specified tangible property if the transferor leases the same or similar property back within a two-year period beginning one year before the transfer and if a principal purpose of the transaction is to reduce the taxpayer’s DTIR. Under the proposed regulations, a sale and leaseback consummated within a six-month period was considered a per se abusive transaction. The final regulations retain the anti-abuse rule but exclude transfers occurring before March 4, 2019, the date the proposed regulations were published.

Effective date

Although the final regulations are effective for years beginning on or after Jan. 1, 2021, taxpayers may elect to apply the final regulations to tax years beginning on or after Jan. 1, 2018, provided they apply them in their entirety excluding relief for documentation. For tax years before Jan. 1, 2021, taxpayers will need to consider, likely with extensive modeling, whether it is more advantageous to calculate the Section 250 deduction under the proposed or final regulations, taking into account the current-year impact as well as the effect of attributes that may be carried forward.

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Brent Felten
John Kelleher - Large
John Kelleher