Final regulations provide additional guidance on FDII calculation

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.