INSIGHT: Foreign-Derived Intangible Income and Lessons Learned

With a new reporting year underway, now is a good time to consider some of the valuable transfer pricing lessons learned regarding the Foreign-Derived Intangible Income (FDII) deduction under tax code Section 250 and the proposed regulations promulgated thereunder, as introduced through the U.S. Tax Cut and Jobs Act (TCJA) in 2017. Public Law 115-97.

The FDII provision allows companies to achieve an effective tax rate of 13.125% for income attributable to certain export transactions. The tax rate quoted is based on a 37.5% deduction applicable to the income attributable to such export transactions. The deduction decreases to 21.875% for tax years starting after Dec. 31, 2025. The tax rates given are based on applying the deduction to a 21% corporate tax rate. Interaction with other tax provisions (e.g., the GILTI) could cause the effective tax rate attributable to export transactions to vary.

“Exports” in a broad, non-technical sense of the term, means sales of goods, provision of services, or transfer of intangibles to foreign persons. The observations in this article focus on companies that were (or still may be) capable of claiming the deduction for calendar year 2018. Some taxpayers that have accumulated losses in the U.S. (and consequently do not have any taxable income) were not in a position to claim FDII (at least for the time being). Moreover, if a taxpayer’s return is filed incorrectly with respect to the FDII, the taxpayer may amend the return under Section 6511. Although many taxpayers have been focused on priorities other than FDII, it is likely that many of them will chose to file amended tax returns to claim an FDII deduction some time during the following calendar year. Furthermore, although the proposed regulations technically do not apply for calendar year 2018 filings (as they only apply to taxable years ending on or after March 4, 2019), taxpayers are still required to gather documentation available in the ordinary course of their business that satisfies the statutory reliability requirements of Section 250(b)(4) to establish the right to an FDII deduction in 2018.

Understanding some of the key takeaways and most commonly encountered FDII challenges and opportunities may help companies (1) optimize their FDII deduction now and in the future, and (2) prepare the required documentation in the most efficient manner and involve the right resources along the way.

Takeaway 1: Companies look to generate foreign-derived deduction eligible income (FDDEI)

Taxpayers’ efforts to generate an FDII deduction typically focus on three areas impacting the FDII calculation: (1) increasing the amount of the deductible eligible income (DEI), (2) decreasing the amount of the qualified business asset investment (QBAI), and (3) increasing the amount of foreign-derived deduction eligible income (FDDEI) resulting from either sales or services transactions. See Example 2 for a case in which Section 861 allocations interact with Section 245A deductions, resulting in some counter-intuitive results that ultimately optimize FDII.

Increasingly, companies are weighing strategic options that leverage existing transactions, create new transactions and/or changes in their supply chains to increase FDDEI. Transfer pricing is front and center in any of these FDDEI-focused exercises. Specifically, the supply chain, transactional, and volume-based data developed in any transfer pricing initiative provide the basis for securing an enhanced FDII deduction.

The table below depicts a spectrum of alternatives to provide enhanced FDII deductions. Most, if not all, of these strategic operating model options involve transfer pricing considerations that should be kept in mind when evaluating supply chain alternatives in respect of FDII. The horizontal axis in Figure 1 (below) represents the implementation effort in the value chain transformation, while the vertical axis shows the amount of DEI or FDDEI impacting the FDII deduction to be generated.

Figure 1: FDII deduction considerations

As a first option (reflected in the first oval starting from the origin of the axes), companies could consider computational changes affecting FDDEI through adjusting the transfer pricing between the U.S. and foreign related parties. This approach focuses on making an adjustment to an optimal point within the previously established interquartile range. The flows reviewed include royalties, rents, services and sales transactions across all supply chain segments. This option does not require taxpayers to change the substance of transactions to benefit from FDII.

The second oval represents changes in the facts and circumstances underlying a transaction. Those changes are typically accompanied by a review of the transfer pricing best-method selection and may justify a change in the transfer pricing methodology applied to the transaction. For example, U.S. entities that utilize a mark-up-on-operating-cost approach for a procurement function might have the correct facts and circumstances to move to a pricing system based on a commission as percentage of freight-on-board (FOB) purchases. Also, a U.S. entity that provides valuable supply chain management services benefiting foreign manufacturers might consider requiring payment of a new (or increased) inbound service fee.

Additional alternatives (in the top right corner, ovals 5 through 8) involve different degrees of changes to transfer pricing through (1) the substance of the transactions, (2) the supply chain, or (3) the operating model. The strategic changes that companies make to their operating models range from implementing or converting to a U.S.-sourcing company, U.S. (non-transactional) supply chain management company, or a U.S. transactional principal company with or without bringing intellectual property (IP) back to the U.S.. Aligning IP ownership could reduce risks associated with a bifurcation of development, enhancement, maintenance, protection, and exploitation functions and IP returns.

Example 1:

To further illustrate how transfer pricing could impact FDDEI, consider a potentially novel application of Section 482 principles, consistent with the new guidance on risk in the 2017 OECD Guidelines:

Similar to an often and typical fact pattern, let us consider a U.S.-parented group with significant substance (people functions) in the U.S., and significant profits in one or more Controlled Foreign Corporations (CFCs) in high-tax countries. All high-tax countries in our example have concluded treaties for the avoidance of double taxation with the U.S.. The U.S. parent provides each CFC with:

1. Management and control of one or more economically significant specific risks by U.S. employees of the parent, and

2. Contingent reimbursement of CFC for losses incurred because of those risks.

In turn, each CFC pays to the U.S. parent a risk-based fee (RBF) for the combination of active risk management activities and bearing the risk. Finally, if the risk results in a loss to a CFC, the U.S. parent reimburses that CFC.

Analysis: the RBF could be considered a General Service and therefore constitute FDII taxable at 13.125%. For completeness sake, note that if the U.S. parent needs to reimburse the CFC, that payment is theoretically subject to BEAT, which adds an additional level of complexity to the analysis (beyond the scope of this example).

Takeaway 2: Taxpayer must consider expense allocations to ensure FDDEI translates into FDII benefit

The new international tax provisions overlap with existing provisions and introduce interdependent relationships, new data points, and complexity. The interdependencies create the potential for permanent-income items, loss-of-deduction items, and/or loss of credits or the capacity for tax credits. These relationships create a paradigm shift and the need for modeling to understand the complexities. Modeling can help companies assess their current operating models and consider potential alternative flows and structures, particularly with respect to FDII.

As part of this approach, the taxpayer will need to consider the direct and indirect expense allocations in the proposed Section 861 regulations, published under 84 FR 69124-01 (Dec. 17, 2019). The proposed expense allocation regulations generally prescribe rules for allocating and apportioning expenses, deductions, and losses (collectively, “deductions”) for the purposes of computing the taxpayer’s net U.S.- and foreign-source income. Certain expenses (e.g., research and development expenses) have specific operative regulations that apply.

As expected, the expense allocation rules under the proposed regulations are applied to allocate and apportion deductions against gross DEI and gross FDDEI to arrive at DEI and FDDEI. As noted, allocating expenses under the proposed regulations is essential to provide the taxpayer with all the data points. Only afterwards, will the taxpayer have the ability to strategize and perhaps shift allocations to generate a larger FDII benefit. To illustrate this point, consider the following example related to the allocation of stewardship expenses below.

Takeaway 3: Transfer-pricing documentation or a similar document is generally a fundamental part of taxpayer’s FDII documentation

Surprisingly, the FDII documentation requirements are not so different from the annual transfer pricing requirements for filing the tax return. In fact, as discussed below, taxpayer’s transfer pricing documentation (or documentation akin to transfer pricing documentation) is generally a fundamental part of taxpayer’s FDII documentation. The table below summarizes the FDII documentation requirements while the following subsections explain why transfer pricing and FDII documentation are interrelated.

FDDEI Sales of General Property

At a high level, Proposed Treasury Regulation 1.250(b)-4(c)(2) and (d)(3) provide documentation requirements for sales transactions that can be divided into two sections: (1) demonstrating that the recipient is a foreign person; and (2) demonstrating that the property is for foreign use.

Figure 2: Documentation requirements for FDDEI Sales for general property and for intangible property (IP)

The binary nature of the documentation requirements is demonstrated by the following hypothetical. The taxpayer in this example is a medical device manufacturer that exports products to related party distributors all over the world. The affiliated distributors, in turn, sell the devices to local hospitals outside the U.S.. Per the proposed regulations, the taxpayer should document that its “general property sales” (i.e., the sale of these devices) are to foreign persons (requirement 1) and for foreign use (requirement 2). The taxpayer should easily be able to prove that its affiliated distributors constitute foreign persons in order meet the first requirement. Furthermore, it should be substantiated that the hospitals purchasing the devices from the affiliated distributors are foreign persons as well. This may prove more difficult, but public records attesting that the hospitals are organized under the laws of a foreign jurisdiction should allow the taxpayer to meet this requirement.

To satisfy the second requirement, the taxpayer needs to reasonably demonstrate that the products do not come back to the U.S. within three years, i.e., that there is no “round-tripping.” One possible answer (there are others) would be to prepare a pseudo transfer pricing report that includes all the items listed above plus a company, industry and functional analysis.

The company and functional analyses should focus on the business structure by describing the functions performed by the U.S. taxpayer and the local distributors. The industry analysis can explain how the medical device industry operates and that products need to satisfy local regulatory requirements. Generally, a product that is sold in Brazil is not allowed to be sold in the U.S. or France, as each country typically has its own regulatory requirements and approval processes. Furthermore, the industry analysis should explain that the hospitals are the ultimate consumers of the goods. It is obvious that hospitals are not in the business of reselling, let alone exporting medical devices but rather use these devices to care for their patients.

In summary, a “pseudo” transfer pricing report (that leverages much of the information taxpayers need to satisfy transfer pricing documentation requirements anyway) will often constitute good FDII documentation. It provides the required documents and tells a story, adding context to the documents required to be prepared and maintained under the proposed regulations.

FDDEI Sales of IP

In the context of a lump-sum sale of an intangible, the proposed documentation requirements require the taxpayer to compare the (projected) annual sales revenue from exploitation of the IP in the U.S. with the (projected) annual sales revenue from the foreign exploitation of the IP to substantiate foreign use.

In most cases, a transfer pricing valuation report dealing with the transfer of IP to a related party is prepared using the “income method” as the best method or as a corroborative method. From there, little additional work is required to develop the taxpayer’s FDII documentation. The transfer pricing valuation report already includes sales projections and explains the specific facts and circumstances affecting the parties involved as well as the industry in which they operate (to support the projections used in the valuation).

FDDEI and provision of general services

With respect to the provision of general services (a residual category but also the most common category of services), the proposed regulations state that taxpayers must establish that the location of the business operation (or consumer) receiving the benefit of the service is located outside the U.S.. Once more, pre-existing transfer pricing documentation can easily be modified to meet these FDII documentation requirements.

For example, a U.S. taxpayer would like to allocate a portion of the costs of headquarter services to its subsidiaries world-wide, plus a mark-up. Most likely, the taxpayer must prepare a transfer pricing report documenting the services allocation methodology to its subsidiaries. The heart of such transfer pricing report usually explains why these services result in a benefit for the various services recipients. With very little modification this report can double as FDII documentation to demonstrate that such benefit is received by foreign entities.

Takeaway 4: The proposed regulations are very transfer-pricingoriented

The fourth takeaway, and probably a surprise for most tax professionals, is that FDII as well as the proposed regulations are very transfer-pricing oriented.

A few examples from transfer pricing references in the proposed regulations are highlighted below:

1. Prop. Treas. Reg. 1.250(b)-5contains a paragraph devoted to services transactions and specifically cross-references (i) the definition of a “benefit” under Treas. Reg. 1.482-9(l) and Prop. Treas. Reg. 1.250(b)-5(c)(1) and (ii) the methods used to determine the beneficiary of services under Treas. Reg. 1.482-9(l) and Prop. Treas. Reg. 1.250(b)-5(e)(2)(b).

2. The discussion in Prop. Treas. Reg. 1.250(b)-3(e) on determining the predominant character of a transaction (as a sale or service) should be very familiar to transfer pricing professionals. Transfer pricing specialists deals with questions such as whether transactions should be aggregated for purposes of determining an arm’s-length price daily.

3. To establish foreign use in relation to general (tangible) property that is subject to manufacture, assembly or other processing outside the U.S. before any domestic use, Prop. Treas. Reg. 1.250(b)-4(d)(2)(iii)(C) requires that the property be proved to have been incorporated as a component into a second product. That test is met if the fair market value of the property when it is delivered to the recipient constitutes no more than 20 % of the fair market value of the completed second product. If the seller sells multiple items that are incorporated into the second product, an aggregation rule treats all items that are incorporated into the second product as a single item of property. Determining the relative value of items is a common exercise in transfer pricing.

4. Finally, Prop. Treas. Reg. 1.250(b)-4(d)(3)(iii) contains specific rules for multiple items that a domestic corporation sells in large numbers to a foreign corporation and, due to their nature cannot reasonably be specifically traced (“fungible mass” property). They state that one may use empirical evidence, including statistical sampling, economic modeling, and other similar methods to determine what portion of the fungible mass qualifies as FDDEI. This empirical evidence is similar to the empirical evidence often used to determine an arm’s length price in a transfer pricing study.

To summarize, the concepts found in Section 250, the proposed regulations promulgated thereunder, and Section 482 are closely aligned. Therefore, transfer pricing professionals can not only assist with considering a company’s strategic options in view of FDII, but can also assist with calculations required to establish that certain income is FDII, the allocation of benefits among parties, or an analysis of the predominant character of a transaction (based on transfer pricing principles) as a service or a sale.

Example 2:

To further illustrate certain points indicated above, the proposed regulations state that the amount of benefit (as defined in Treas. Reg. 1.482-9(l)(3)) conferred on a business recipient outside the U.S. may be determined under any method that is reasonable under Treas. Reg. 1.482-9(k)(2).

For example, a domestic corporation enters into an agreement with an unrelated foreign corporation to provide computer software and five years of information technology support. The overall predominant nature of the transaction is determined to be a service, due to the specialized nature of the training that the employees receive to offer information technology support and the value added. The unrelated foreign corporation will utilize the software and information technology services in its offices around the world. The unrelated foreign corporation’s business operations (as measured by third-party revenues reported by the foreign corporation’s annual report) are 70 % outside the U.S. and 30 % within the U.S.. Note that the domestic corporation does not have access to other possible allocation keys for benefits such as profits or number of employees by jurisdiction. In addition, revenues are considered a reasonable (though indirect) measure of benefits, listed under Treas. Reg. 1.482-9(k)(2)(i).

The following conclusions can be reached: The overall predominant character of the transaction is a service. Because the service is not a military service, property service, or proximate service under the specific FDII rules characterizing the transaction, it is a general service. This general service is not provided to a foreign related party. Since the service is provided to a business but not a specific business location, gross income is allocated ratably to all the unrelated foreign corporation’s business operations at the time the service is provided. As a result, the domestic corporation takes the position that 70% of gross income qualifies as FDDEII.

Conclusion

Companies should understand the transfer pricing considerations that may impact their FDII deduction and consider their strategic options within the overall context of their global transfer pricing model, supply chain, and operating model. Additionally, for many taxpayers, documentation to support their FDII deduction is most easily created by leveraging information readily available in preexisting or to-be-developed transfer pricing documentation. If not already doing so, companies should involve transfer pricing professionals to determine the transfer pricing overlay in their FDII deduction calculation, to analyze any strategic changes to transactions and/or changes in their U.S. supply chains to earn FDDEI and to assist in meeting the FDII documentation requirements.

Additionally, it is not too late for companies to amend their 2018 returns and claim their FDII deduction. For taxpayers that have claimed a “de minimis” deduction, there could be the opportunity to recalculate and properly substantiate the FDII deduction.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Jay Camillo is a partner with Ernst & Young LLP and Americas Operating Model Effectiveness Leader for EY Transfer Pricing. Melody H. Leung is a partner, Kenneth Christman and Carlos Mallo are managing directors, and Kelly Stals and Heather Gorman are senior managers.

The views expressed are those of the authors and do not necessarily reflect the views of Ernst & Young LLP or other members of the global EY organization.