Companies are waiting for IRS guidance to see whether and how they can benefit from a new tax deduction designed to encourage exports.
The foreign-derived intangible income provision, introduced in the 2017 U.S. tax overhaul, aims to encourage manufacturing in the U.S. and on-shoring of intellectual property. Congress intended it to work in concert with the law’s global intangible low-taxed income provision to neutralize a company’s decision about locating in the U.S. or abroad.
The FDII provision, under tax code Section 250, offers a sizable benefit: U.S. companies can pay just over 13 percent tax on income that qualifies for the deduction, a good deal less than the new 21 percent corporate income tax rate.
The deduction applies to income U.S. corporations earn from the sale of goods to non-U.S. persons for foreign use, or provision of services to any person with respect to any property not in the U.S.
Because the FDII rate is so attractive, the companies’ main questions center on whether they will qualify for it.
“The questions are really dealing with the fact that a lot of the language is—I’ll call it conceptual. It’s hard to see how it would apply in practice,” said John Harrington, a partner at Dentons.
The proposed rules on FDII will be among the last pieces of guidance released on the international aspects of the 2017 tax overhaul. The rules have been at the White House’s regulatory review body since Dec. 14, and could be released soon.
Here are four questions companies hope to see answered when the rules come out.
How do you prove that an item is sold for foreign use?
FDII is an export incentive, only applicable to income from sale of goods or services outside the U.S. or to a non-U.S. person. Companies hoping to qualify for the benefit aren’t sure how to show they’ve met the requirements.
“What is going to be required to demonstrate that it’s a foreign sale versus a domestic sale? Those are questions that could be addressed by Treasury” in the forthcoming guidance, said Josh Odintz, a partner at Baker McKenzie.
To answer the question, Treasury may include “documentation and substantiation guidelines,” said Adnan Islam, an international tax partner and co-practice leader at Friedman LLP.
Substantiation could include shipping receipts, verified invoices, or the physical addresses of customers if the good is a tangible, he said. For online services, companies could be required to track customers’ IP addresses to prove they are foreign.
Different types of businesses will likely have different requirements, Islam said. “They’re hoping for as little cost of record-keeping as possible.”
How will FDII treat ‘bundled’ transactions?
In a bundled transaction, a company sells separate goods or services together—like a product that comes with a warranty or installation services. Companies aren’t sure how FDII’s different standards for goods and services will treat such transactions.
“If I’m selling property, the rules say I have to sell the property to a foreign person and for foreign use and consumption,” said Derek Schraw, partner and national FDII leader at Deloitte Tax LLP. “If it’s a service, I can provide that service to any person or with regards to property not located in the U.S.”
The guidance could allow companies to count some of the income in a bundled transaction as FDII-eligible, some not.
“I expect we’ll be in a situation where some companies have to split their contracts,” Schraw said. “It’s not going to be an all-or-nothing.”
What is a ‘substantially similar’ service?
FDII benefits are denied when a service is provided to a related party outside the U.S. who also provides “substantially similar” services to a person in the U.S. The provision is meant to prevent “round-tripping,” when a company sells a good or service out of the U.S., and then right back in, to take advantage of the export benefits.
“The question here is, how do you demonstrate to the satisfaction of the Secretary that the service is not substantially similar to services provided by related parties to persons located within the U.S.?” Odintz said. “What proof is required? How can a taxpayer demonstrate it?”
A clarification on “substantially similar” is “one thing a lot of people are waiting for in the regs,” Schraw said.
“I think there’s room for interpretation,” he added. “I see it could mean, all services deemed to be the same. Or a distinction between R&D and management services.”
How is foreign branch income calculated?
The statute says that “foreign branch income” isn’t eligible for the FDII deduction—but ultimately leaves the calculation of that income to be “determined under rules established by the Secretary,” under Section 904.
“The confusing part, what multiple companies are dealing with, is from the standpoint of ‘what is a foreign branch,’” Schraw said.
In part, that’s because foreign branch income is defined as income from a “qualified business unit,” which is then defined as a unit of trade or business of a taxpayer that maintains separate books and records.
“But the concept of ‘books and records’, with modern technology—some things we think about now as books or records may not have been what was intended when the law was put together,” Schraw said.
—With assistance from Siri Bulusu.