Foreign-derived intangible income guidance addresses many open questions.

• Author: Camillo, Jay

The law known as the Tax Cuts and Jobs Act of 2017 (TCJA) (1) made many significant changes to the international tax regime. One important change is Sec. 250, which was enacted by Section 14202(a) of the TCJA, and generally provides a domestic C corporation (1) a deduction for its foreign-derived intangible income (FDII) for the tax year, and (2) a deduction for its Sec. 951A global intangible low-taxed income (GILTI) inclusion for the tax year.

For tax years beginning after Dec. 31, 2017, but before Jan. 1, 2026, a domestic C corporation may claim a deduction equal to 37.5% of its FDII and 50% of its GILTI (including any Sec. 78 gross-up for a deemed-paid foreign tax credit for GILTI). For tax years beginning after Dec. 31, 2025, these percentages decrease to 21.875% and 37.5%, respectively. However, the Sec. 250 deduction is limited to the domestic C corporation's taxable income for the tax year--if the sum of its FDII and GILTI (including the Sec. 78 gross-up) exceeds its taxable income (determined without regard to the Sec. 250 deduction), the amounts of FDII and GILTI taken into account to compute the Sec. 250 deduction decrease proportionally to eliminate the excess.

The FDII deduction has been described as being like the Holy Roman Empire--just as this European region was neither holy nor Roman nor an empire, the FDII deduction is not limited only to foreign-derived intangible income. Rather, FDII is a mechanical calculation that treats a portion of income as being attributable to a return on tangible asset investment (deemed tangible income return (DTIR)),with the remainder attributable to a return on intangible property (deemed intangible income (DII)). As such, the FDII deduction is not limited to income derived from dispositions or licenses of intangible property, and eligibility for the FDII deduction is not strictly dependent on the location of intangible property. The portion of this deemed intangible income derived from qualifying sales of property and services is a domestic C corporation's FDII.

FDII is computed in a three-step process, as shown in the chart, "FDII Computation."

Step 1: Calculate deemed intangible income (DII) = Deduction-eligible income (DEI) - (10% x Qualified business asset investment (QBAI)).

DEI is the excess of a domestic C corporation's gross income, less the following six exclusions, less the deductions including taxes properly applicable to those gross DEI items: (1) Sec. 951(a)(1) (Subpart F income); (2) GILTI inclusion; (3) financial services income (defined in Sec. 904(d)(2) (D)); (4) dividends received from any 10%-owned controlled foreign corporation (CFC); (5) domestic oil and gas extraction income; and (6) foreign branch income (defined in Sec. 904(d)(2)(J)). (2)

QBAI is the average of the taxpayer's aggregate adjusted bases in specified tangible property, defined as tangible depreciable property used in the taxpayer's trade or business in the production of DEI. (3)

As discussed above, the FDII computation deems a portion of a domestic C corporation's income to be a return on its tangible asset investment (DTIR). The DTIR is 10% of a domestic C corporation's QBAI; the excess of a domestic C corporation's DEI over its DTIR is its deemed intangible income (DII).

Step 2: Calculate FDII = DII (computed in Step 1) x [Foreign-derived deduction-eligible income (FDDEI) /DEI].

FDDEI is the portion of DEI gross income derived from qualifying sales of property and services and is generally any DEI derived in connection with (1) property sold to any non-U. S. person for foreign use, or (2) services provided to a person, or with respect to property, not located within the United States. (4)

A domestic C corporation's FDII is the portion of its DII that bears the same ratio as its FDDEI bears to its DEI.

Step 3: Determine FDII deduction = FDII x Applicable deduction percentage.

As discussed previously, a domestic C corporation's FDII deduction is its FDII multiplied by the applicable percentage, which is 37.5% for tax years beginning after Dec. 31, 2017, but before Jan. 1,2026.

The proposed regulations

While Sec. 250 includes deductions related to both FDII and GILTI, the Sec. 250 proposed regulations (5) primarily focus on the deduction for FDII, as proposed regulations for calculating GILTI were released Sept. 13,2018. The FDII proposed regulations provide specific guidance for computing the variables of the FDII deduction--DEI, FDDEI, and QBAI. Of key importance, the FDII proposed regulations provide detailed rules regarding the requirements for qualifying FDDEI transactions of tangible and intangible property and different types of services. The FDII proposed regulations also provide strict documentation requirements to substantiate FDDEI transactions for purposes of the FDII deduction.

In addition, the FDII proposed regulations clarify that the FDII deduction is not computed on a single-entity basis, as was implied by the statutory language, and provide rules for consolidated groups as well as partnership attribution. Finally, the FDII proposed regulations provide ordering rules to coordinate the interaction of the Sec. 250 deduction with the application of other limitations in the Code (i.e., the Sec. 163(j) interest deduction limitation and the Sec. 172(a) net operating loss (NOL) limitation).

Computing FDII

Consistent with the statute, the calculation of FDII under the FDII proposed regulations is a multistep process that begins with the concepts of "gross DEI" and "gross FDDEI." All gross FDDEI is included in gross DEI, but not all gross DEI is included in gross FDDEI. After calculating the gross amounts, deductions of the domestic corporation are allocated against the gross items to arrive at DEI and FDDEI.

Depending on the attribution of cost of goods sold (COGS) (discussed later) and allocation/apportionment of deductions (also discussed later), FDDEI may be greater than DEI, or vice versa. When both amounts are positive, and DEI is greater than DTIR, subject to the taxable income limitation of Sec. 250(a)(2), the domestic corporation will be allowed a Sec. 250 deduction; if DEI is zero or negative, the domestic corporation will not be allowed a deduction. If a domestic corporation's FDDEI exceeds its DEI and would otherwise result in a foreign-derived ratio exceeding 1 (e.g., due to losses attributable to domestic market sales), the proposed regulations provide that the ratio of FDDEI to DEI cannot exceed 1. As a result, careful application of the computational rules and consideration of the various decisions to be made in that application (e.g., attribution of COGS, allocation of deductions, etc.) is important.

Excluded gross income: Consistent with the Code, the proposed regulations exclude the following items from gross DEI: (1) inclusions under Sec. 951(a)(1) (including any associated Sec. 78 dividend); (2) GILTI inclusions (including any associated Sec. 78 dividend); (3) financial services income (as defined in Sec. 904(d)(2)(D)); (4) dividends received from certain CFCs; (5) domestic oil and gas income; and (6) foreign branch income. Diverging from the statute, the proposed regulations would provide a broader definition of foreign branch income, including any income or gain that arises from a direct or indirect sale of any asset (other than stock) that produces gross income attributable to a foreign branch, including by reason of the sale of a disregarded entity or partnership interest. Domestic C corporations incorporating foreign branches that currently hold intangible property should consider the impacts of this broader definition--any income inclusions under Sec. 367(d) appear to be included as foreign branch income for this purpose and are therefore not eligible for gross DEI and gross FDDEI treatment.

Attribution of COGS: For purposes of determining the amount of gross income attributable to separate income items that compose gross DEI and gross FDDEI, the proposed regulations require an attribution of COGS to gross receipts under any reasonable method, including for COGS associated with activities undertaken in prior tax years. However, COGS must be attributed to gross receipts with respect to gross DEI or gross FDDEI regardless of whether certain costs included in COGS can be associated with activities undertaken in an earlier tax year (including a year before the effective date of Sec. 250).

Allocation of deductions: After determining gross DEI and gross FDDEI, the domestic C corporation allocates applicable deductions against those items to arrive at DEI and FDDEI, respectively. While the statute provides simply that FDDEI is DEI derived from specified transactions, the proposed regulations clarify that deductions are allocated and apportioned to gross FDDEI and gross non-FDDEI, and that the sum of the two equals the deductions allocated to gross DEI. As was widely expected, the FDII proposed regulations direct taxpayers to the rules of Regs. Secs. 1.861-8 through Temp. Regs. Sec. 1.861-14T and Regs. Sec. 1.861-17, providing that these rules apply to allocate and apportion deductions against gross DEI and gross FDDEI to arrive at DEI and FDDEI. However, research and development expenditures are allocated without regard to the exclusive geographic apportionment rule of Regs. Sec. 1.861-17(b) (the preamble to the proposed regulations did not provide an explanation for this treatment).

Unlike the prohibition of attributing COGS to periods prior to the enactment of Sec. 250, there is no such prohibition for expenses allocated under Sec. 861. Accordingly, similar to the application of the Sec. 861 rules in allocating expenses under former Sec. 199, reasonable methods for allocating and apportioning expenses...