Deduction for Foreign-Derived Intangible Income and Global Intangible Low-Taxed Income

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9901]

RIN 1545-BO55

Deduction for Foreign-Derived Intangible Income and Global Intangible Low-Taxed Income

AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Final regulations.

SUMMARY:

This document contains final regulations that provide guidance regarding the deduction for foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI). This document also contains final regulations coordinating the deduction for FDII and GILTI with other provisions in the Internal Revenue Code. These regulations generally affect domestic corporations and individuals who elect to be subject to tax at corporate rates for purposes of inclusions under subpart F and GILTI.

DATES:

Effective Date:

These regulations are effective on September 14, 2020.

Applicability Dates:

For dates of applicability, see §§ 1.250-1(b), 1.962-1(d), 1.1502-50(g), 1.6038-2(m)(4), 1.6038-3(l), and 1.6038A-2(g).

FOR FURTHER INFORMATION CONTACT:

Concerning §§ 1.250-1 through 1.250(b)-6, 1.6038-2, 1.6038-3, and 1.6038A-2, Brad McCormack at (202) 317-6911 and Lorraine Rodriguez at (202) 317-6726; concerning § 1.962-1, Edward Tracy at (202) 317-6934; concerning §§ 1.1502-12, 1.1502-13 and 1.1502-50, Michelle A. Monroy at (202) 317-5363 (not toll free numbers).

SUPPLEMENTARY INFORMATION:

Background

Section 250 was added to the Internal Revenue Code (“Code”) by the Tax Cuts and Jobs Act, Public Law 115-97, 131 Stat. 2054, 2208 (2017) (the “Act”), which was enacted on December 22, 2017. On March 6, 2019, the Department of the Treasury (“Treasury Department”) and the IRS published proposed regulations (REG-104464-18) under sections 250, 962, 1502, 6038, and 6038A in the

Federal Register

(84 FR 8188) (the “proposed regulations”). Corrections to the proposed regulations were published on April 11, 2019, and April 12, 2019, in the

Federal Register

(84 FR 14634 and 84 FR 14901, respectively). A public hearing on the proposed regulations was held on July 10, 2019. The Treasury Department and the IRS also received written comments with respect to the proposed regulations.

All written comments received in response to the proposed regulations are available at

https://www.regulations.gov

or upon request. Terms used but not defined in this preamble have the meaning provided in these final regulations.

Summary of Comments and Explanation of Revisions

I. Overview

The final regulations retain the basic approach and structure of the proposed regulations, with certain revisions. This Summary of Comments and Explanation of Revisions section discusses those revisions as well as comments received in response to the solicitation of comments in the notice of proposed rulemaking. Comments outside the scope of this rulemaking are generally not addressed but may be considered in connection with future guidance projects.

II. Comments on and Revisions to Documentation Requirements and Applicability Dates

A. Documentation Requirements for Foreign Persons, Foreign Use, and Location Outside the United States

As described in parts VII.B, C.1, and D.1 and VIII.B.1 and B.2.c of this Summary of Comments and Explanation of Revisions section, the proposed regulations provided that to establish that a recipient is a foreign person, property is for a foreign use (within the meaning of proposed § 1.250(b)-4(d) and (e)), or a recipient of a general service is located outside the United States (within the meaning of proposed § 1.250(b)-5(d)(2)), the taxpayer must obtain specific types of documentation described in proposed §§ 1.250(b)-4(c)(2), (d)(3), and (e)(3) and 1.250(b)-5(d)(3) and (e)(3). The proposed regulations also provided a transition rule whereby for taxable years beginning on or before March 4, 2019, taxpayers could use any reasonable documentation maintained in the ordinary course of the taxpayer's business that establishes that a recipient is a foreign person, property is for a foreign use, or a recipient of a general service is located outside the United States, as applicable, in lieu of the specific documentation described in the regulations, provided that such documentation meets certain reliability requirements described in proposed § 1.250(b)-3(d). See proposed § 1.250-1(b). The preamble requested comments on this special transition rule.

Several comments recommended either making this transition rule permanent or extending it for a certain period after the regulations are finalized. The comments recommending that the transition rule be made permanent indicated that the documentation described in the proposed regulations may be difficult, if not impossible, to obtain in the ordinary course of business. The comments noted that customers are highly reluctant to provide some of the types of documents that the proposed regulations described. A comment noted that the documentation rules in the proposed regulations could require taxpayers to renegotiate contracts or make inquiries of their customers that could interfere with the customer relationship. Several comments were concerned with how the documentation rules and, in particular, the reliability requirements would apply to business models with longer-term contracts, especially those entered into during the 2019 tax year.

The comments that requested extending the transition rule suggested that this would allow adequate time for the IRS to gain experience with the types of documentation taxpayers collect in the ordinary course of business, and for taxpayers to gain experience complying with such rules by developing or improving internal compliance systems. Alternatively, some comments suggested that the next issuance of regulations should be in temporary form to allow additional time to consider the reasonableness of the documentation requirements before final regulations are issued and to allow taxpayers more time to identify distortive results.

Other comments recommended changes to the documentation rules if the final regulations do not make the transition rule permanent. Several comments suggested that any list of suitable documents (for either property sales or services) should be non-exclusive and include more documents obtained in the ordinary course of business. Some comments recommended allowing the use of documentation methods similar to those for sales of fungible mass property under proposed § 1.250(b)-4(d)(3)(iii) such as market research, statistical sampling, economic modeling or other similar methods to show foreign person status or foreign use.

The final regulations address these comments in several ways. First, the final regulations eliminate the requirement in the proposed regulations to obtain specific types of documents to

establish foreign person status, foreign use with respect to sales of certain general property that are made directly to end users, and the location of general services provided to consumers. The Treasury Department and the IRS have determined that requiring specific documentation with respect to these requirements is difficult given the variations in industry practices and is not necessary to achieve the purpose of the statute. Accordingly, the final regulations remove the specific documentation requirements to establish foreign person status and foreign use with respect to certain sales of general property and the location of a consumer of a general service. However, as explained in more detail in part II.D of this Summary of Comments and Explanation of Revisions section, as with any deduction, taxpayers claiming a deduction under section 250 bear the burden of demonstrating that they are entitled to the deduction. Therefore, the general requirement for taxpayers to substantiate their deductions will apply without any additional specific requirements as to the content of information or documents.

Second, the final regulations adopt a more flexible approach regarding the types of substantiation required for foreign use with respect to sales of general property to non-end users, foreign use with respect to sales of intangible property, and with respect to determining whether services are performed for business recipients located outside the United States. Although the substantiation requirements in the final regulations are more specific as to the nature of the information required, they are not limited to a narrow set of documents. The requirements also do not contain the specific reliability requirement set out in the proposed regulations because the reliability of documents or information can differ depending on the circumstances. For example, documents created in advance of a sales date (such as a long-term sales contract) may be as reliable as documents created at the time of the sale, depending on the facts and circumstances. Further, the final regulations continue to require that the substantiating documents be supported by credible evidence. See part II.C of this Summary of Comments and Explanation of Revisions section.

Finally, the applicability dates of the regulations have been revised, and taxpayers are permitted to rely on the proposed regulations for taxable years before the final regulations are applicable, including relying on the transition rules during the entirety of such period. See part II.F and XII of this Summary of Comments and Explanation of Revisions section.

B.

Specific Substantiation for Certain Transactions

In lieu of the documentation requirements in the proposed regulations, with respect to sales of general property to recipients other than end users, sales of intangible property, and general services provided to business recipients, the final regulations provide substantiation rules that are more flexible with respect to the types of corroborating evidence that may be used. See § 1.250(b)-3(f). For these transactions, specific substantiation requirements are needed to ensure that taxpayers make sufficient efforts to determine whether the regulatory requirement is met. Therefore, with respect to these transactions, the final regulations describe the type of information necessary to meet the substantiation requirements. The specific ways a taxpayer must substantiate these elements are described in parts VII.C.9, VII.D.2, and VIII.B.2.d of this Summary of Comments and Explanation of Revisions section. The substantiation requirements are modeled after substantiation rules under section 170 (requiring substantiation through receipts for certain charitable deductions) and section 274(d) (requiring substantiation by adequate records or a taxpayer statement with corroborating evidence). The Treasury Department and the IRS have determined that requiring a taxpayer to specifically substantiate certain transactions—in particular transactions where the relevant facts needed to satisfy the rules are generally in the hands of a third party with a business relationship with the taxpayer—is necessary and appropriate for establishing “to the satisfaction of the Secretary” that property is sold for a foreign use or that services are provided to persons located outside the United States. See section 250(b)(4) and (b)(5)(C).

C.

Timing To Obtain, Maintain, and Provide Specific Substantiation

In general, the substantiation rules require that the substantiating documents with respect to certain transactions that give rise to foreign-derived deduction eligible income (a “FDDEI transaction”) be in existence by the time the taxpayer files its return (including extensions) with respect to the FDDEI transaction (the “FDII filing date”). See § 1.250(b)-3(f)(1). The final regulations do not impose additional requirements relating to when substantiating documents must be in existence. However, the timing of when substantiating documents are created may affect the credibility of the substantiating documents. For example, substantiating documents created at or near the time of the transaction generally have a higher degree of credibility as compared to substantiating documents created later in time. With respect to long-term contracts, substantiating documents created when the transaction was entered into will be more credible in later years if the taxpayer periodically confirms that the terms of the long-term contract are being adhered to.

The final regulations provide that substantiating documents must be provided to the IRS upon request, generally within 30 days or some other period agreed upon by the IRS and the taxpayer. See § 1.250(b)-3(f)(1). This is necessary to allow the substantiation requirements to serve their purpose, including to allow the IRS to timely examine the taxpayer's qualification for the FDII deduction.

D.

Substantiation in All Other Cases

For the rules in the final regulations for which there are no specific substantiation requirements, taxpayers are already required under section 6001 to make returns, render statements, and keep the necessary records to show whether such person is liable for tax under the Code. Therefore, a taxpayer claiming a deduction under section 250 will still be required to substantiate that it is entitled to the deduction even if it is not subject to the specific substantiation requirements contained in the final regulations. See § 1.6001-1(a);

INDOPCO

v.

Commissioner,

503 U.S. 79, 84 (1992) (“an income tax deduction is a matter of legislative grace and . . . the burden of clearly showing the right to the claimed deduction is on the taxpayer” (internal citations omitted)).

The Treasury Department and the IRS expect that taxpayers may use a broader range of evidence to substantiate a section 250 deduction under the new substantiation requirements (and section 6001 where no specific substantiation requirements are provided) than they would have been able to use under the more specific documentation requirements detailed in the proposed regulations. Based on comments received, in many cases a taxpayer will be able to determine whether it meets the requirements in the final regulations using documents maintained in the ordinary course of its business, as provided in the transition rule. In some circumstances, however, it may be necessary for taxpayers to gather

additional information to establish that a requirement is met. The Treasury Department and the IRS are also considering issuing additional administrative guidance on acceptable documentation to substantiate the deduction.

E.

Small Business Exception

The final regulations include an exception for small businesses similar to the exceptions from the documentation requirements for small businesses that are in the proposed regulations. See proposed §§ 1.250(b)-4(c)(2)(ii)(A) and (d)(3)(ii)(A), and 1.250(b)-5(d)(3)(ii)(A) and (e)(3)(ii)(A). The exception provides that the substantiation requirements described generally in part II.B of this Summary of Comments and Explanation of Revisions section do not apply if the taxpayer and all related parties of the taxpayer, in the aggregate, receive less than $25,000,000 in gross receipts during the prior taxable year. See § 1.250(b)-3(f)(2). In response to comments that the final regulations should allow for broader application of the small business exception, the final regulations modify the threshold amount to qualify for that exception from $10,000,000 of gross receipts received by the seller of general property or renderer of services in the prior taxable year (the standard used in the proposed regulations) to $25,000,000 in gross receipts received by the taxpayer and all related parties. As a result of this exception, a small business will not need to satisfy the specific substantiation requirements in the regulations, although it must continue to comply with the general substantiation rules under section 6001. For example, small businesses may be able to substantiate that a sale of general property is for a foreign use by having evidence of a foreign shipping address and memorializing conversations with the recipients explaining where the property will be resold, if sufficiently reliable, or having a copy of an export bill of lading.

F.

Transition Rules

The final regulations modify the applicability dates of the regulations to give taxpayers additional time to develop systems for complying with the regulations. Generally, the final regulations are applicable for taxable years beginning on or after January 1, 2021. See § 1.250-1(b). This applicability date ensures that all taxpayers, regardless of whether they are fiscal- or calendar-year taxpayers, have at least three full taxable years after the Act was enacted before the final regulations become applicable. However, for taxable years beginning before January 1, 2021, taxpayers may apply the final regulations or rely on the proposed regulations, except that taxpayers that choose to rely on the proposed regulations may rely on the transition rule for documentation for all taxable years beginning before January 1, 2021 (rather than only for taxable years beginning on or before March 4, 2019, which was the limitation contained in the proposed regulations).

III. Comments on and Revisions to Proposed § 1.250(a)-1—Deduction for Foreign-Derived Intangible Income and Global Intangible Low-Taxed Income

Proposed § 1.250(a)-1 provided general rules to determine the amount of a taxpayer's section 250 deduction and associated definitions that apply for purposes of the proposed regulations.

A. Pre-Act NOLs

Several Code sections, including section 250, include limitations based on a taxpayer's taxable income or a percentage of taxable income. The proposed regulations provided an ordering rule for applying sections 163(j) and 172 in conjunction with section 250 that provided that a taxpayer's taxable income for purposes of applying the taxable income limitation of section 250(a)(2) is determined after all of the corporation's other deductions are taken into account, without distinguishing between pre-Act and post-Act net operating losses (“NOLs”). See proposed § 1.250(a)-1(c)(4).

Several comments noted that the proposed regulations did not explicitly address the impact of pre-Act NOLs on the deduction under section 250 and recommended that pre-Act NOLs not be taken into account for purposes of determining the deduction limit under section 250(a)(2). This would allow taxpayers to take a deduction under section 250 for FDII in lieu of utilizing available pre-Act NOLs.

Section 250(a)(2) limits the FDII deduction based on “taxable income,” which is defined in section 63 to include gross income minus deductions, including NOL deductions under section 172. Section 250(a)(2) contains no language that would support ignoring pre-Act NOLs for purposes of determining the amount of taxable income for purposes of section 250(a)(2). Cf. section 965(n) (providing an election to forgo usage of a portion of pre-Act NOLs against a taxpayer's inclusion under section 965). Therefore, the comment is not adopted.

B. Ordering Rule

As discussed in the previous section, the deduction under section 250 is subject to a taxable income limitation under section 250(a)(2). Proposed § 1.250(a)-1(c)(4) provided that the corporation's taxable income is determined with regard to all items of income, deduction, or loss, except for the deduction allowed under section 250.

Example 2

in proposed § 1.250(a)-1(f)(2) applied the ordering rule with respect to sections 163(j), 172, and 250.

Some comments recommended that the regulations eliminate the ordering rule in favor of an approach that used simultaneous equations to compute taxable income for each Code provision that referred to taxable income, whereas other comments expressed concern with the complexity of performing simultaneous equations. One comment recommended that the regulations not consider section 163(j) and 172(b) carryforwards or carrybacks.

The Treasury Department and the IRS have determined that further study is required to determine the appropriate rule for coordinating section 250(a)(2), 163(j), 172, and other Code provisions (including, for example, sections 170(b)(2), 246(b), 613A(d), and 1503(d)) that limit the availability of deductions based, directly or indirectly, upon a taxpayer's taxable income. Therefore, the final regulations remove

Example 2

in proposed § 1.250(a)-1(f)(2) and reserve a paragraph in § 1.250(a)-1(c)(5)(ii) for coordinating section 250(a)(2) with other provisions calculated based on taxable income. The Treasury Department and the IRS are considering a separate guidance project to address the interaction of sections 163(j), 172, 250(a)(2), and other Code sections that refer to taxable income; this guidance may include an option to use simultaneous equations in lieu of an ordering rule.

1

Comments are requested in this regard.

1

Any separate guidance would take into account the recent addition of section 172(a)(2)(B)(ii)(I) by the Coronavirus Aid, Relief, and Economic Security Act, Public Law 116-136, 134 Stat. 281 (2020). That provision provides in relevant part that, for taxable years beginning after December 31, 2020, the taxable income limitation for purposes of deducting net operating loss carrybacks and carryovers is determined without regard to the deductions under sections 172, 199A, and 250.

Before further guidance is issued regarding how allowed deductions are taken into account in determining the taxable income limitation in section 250(a)(2), taxpayers may choose any reasonable method (which could include the ordering rule described in the proposed regulations or the use of simultaneous equations) if the method

is applied consistently for all taxable years beginning on or after January 1, 2021.

C. Carryovers of Excess FDII

Consistent with the statute, the proposed regulations did not contain any provision allowing the carryforward or carryback of a tax year's FDII deduction in excess of the taxpayer's taxable income limitation under section 250(b)(2) and proposed § 1.250(a)-1(b)(2). One comment argued that a provision allowing the carryforward or carryback should be added because the taxable income limitation frustrates the policy goal of the FDII regime of reducing the tax incentive to locate intellectual property outside the United States. A different comment recommended that where the taxable income limitation of the proposed regulations applies to a given tax year, the final regulations should allow for the creation of a FDII recapture account by which taxpayers can carry forward previously unused section 250 deductions to future tax years when they have enough taxable income to use these deductions. In contrast, another comment recommended that, consistent with the statute, the final regulations should not allow for carrybacks or carryforwards in order to limit the potential for abuse by taxpayers.

The section 250 deduction is an annual calculation, and nothing in the statute or legislative history contemplates the creation of carryforwards or carrybacks or a recapture account. Cf. section 163(j)(2) (providing for the carryforward of disallowed business interest). As a result, the final regulations do not adopt these recommendations.

D. Definition of GILTI

The final regulations under section 250 revise the definition of GILTI consistent with the final regulations under section 951A (“section 951A final regulations”). The term “GILTI” means, with respect to a domestic corporation for a taxable year, the corporation's GILTI inclusion amount under § 1.951A-1(c) for the taxable year. See § 1.250(a)-1(c)(3).

IV. Comments on and Revisions to Proposed § 1.250(b)-1—Computation of Foreign-Derived Intangible Income

The proposed regulations provided that a taxpayer's FDII is the taxpayer's deemed intangible income (“DII”) multiplied by the corporation's foreign-derived ratio. See proposed § 1.250(b)-1(b). A taxpayer's DII is the excess (if any) of the corporation's deduction eligible income (“DEI”) over its deemed tangible income return (“DTIR”). See proposed § 1.250(b)-1(c)(3). A taxpayer's DTIR is 10 percent of the taxpayer's qualified business asset investment (“QBAI”). See proposed § 1.250(b)-1(c)(4). The foreign-derived ratio is the taxpayer's ratio of foreign-derived deduction eligible income (“FDDEI”) to DEI. See proposed § 1.250(b)-1(c)(13).

A.

Financial Services Income

Section 250(b)(3)(A)(i)(III) excludes from DEI financial services income as defined in section 904(d)(2)(D). One comment requested a clarification that income that falls outside of the definition of section 904(d)(2)(D) should be eligible for inclusion in DEI, such as leasing or financing activities outside of the active conduct of a banking, financing, or similar business.

Section 250(b)(3)(A)(i)(III) excludes only financial services income as defined in section 904(d)(2)(D). Any leasing or financing activities that are not described in section 904(d)(2)(D) will not fall within this exclusion. Therefore, no changes are necessary.

Another comment suggested that the proposed regulations do not provide enough general guidance on non-active financial services income from financial instruments (such as derivatives and hedges), and, in particular, how to characterize such income (or losses) as a FDDEI transaction. Absent such guidance, the comment asserts that taxpayers could take inconsistent positions in characterizing a derivative or hedge and characterizing the underlying transaction as FDDEI transactions. This comment recommended adding a general rule that associates the income, loss, and expenses of a derivative or hedge with the underlying transaction. Alternatively, the comment suggested that the final regulations treat the derivative or hedge transaction as a separate transaction and test it for FDDEI under the rules regarding sales of intangible property.

Consistent with the proposed regulations, the final regulations provide that, in general, financial instruments are neither general property nor intangible property, and therefore their sales cannot give rise to FDDEI. See § 1.250(b)-3(b)(10) (excluding from the definition of general property a security defined under section 475(c)(2)) and § 1.250(b)-3(b)(11) (intangible property has the meaning set forth in section 367(d)(4)). However, the final regulations adopt the suggestion to provide a special rule for hedges to associate the income or loss from such hedges with the underlying transaction. See § 1.250(b)-4(f) and part VII.E of this Summary of Comments and Explanation of Revisions section.

B.

Definition of Foreign Branch Income

Section 250(b)(3) excludes from DEI foreign branch income as defined in section 904(d)(2)(J), which provides that foreign branch income is business profits attributable to one or more qualified business units. Proposed § 1.250(b)-1(c)(11) defined foreign branch income by cross-reference to § 1.904-4(f)(2), which provides that gross income is attributable to a foreign branch if the gross income is reflected on the separate set of books and records of the foreign branch. Proposed § 1.250(b)-1(c)(11), however, modified this definition to also include any income from the sale, directly or indirectly, 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.

Several comments requested that the final regulations remove the modification to the definition in proposed § 1.904-4(f)(2). Several comments noted that the definition, as proposed, would impermissibly create a class of income that is neither DEI nor foreign branch income for section 904 foreign tax credit purposes, and therefore, asserted that the definitions must be aligned consistently. Another comment argued that the proposed regulations under section 904 already contain rules that address the types of transactions that were described in proposed § 1.250(b)-1(c)(11). Multiple comments also noted that section 250(b)(3)(A)(i)(VI) cross references to section 904(d)(2)(J) without any modification to that latter provision and argued that modifying the definition in regulations exceeded the Treasury Department and IRS's regulatory authority. One comment argued that the expansion contravenes the Congressional purpose behind FDII of encouraging the repatriation of intangible property. Another comment noted that if the definition with the modification is applied retroactively, it could adversely affect taxpayers that undertook transactions to repatriate intellectual property before the proposed regulations were issued, a problem that the comment asserted is exacerbated by the differing effective dates of the proposed foreign tax credit regulations and the FDII proposed regulations.

If the final regulations were to retain the expanded definition, one comment requested that the definition also be

used for purposes of the foreign branch category definition in § 1.904-4(f). Another comment requested that the final regulations provide further clarification of the treatment of the disregarded transactions, particularly with respect to the disposition of a partnership interest, and provide relevant examples of other types of transactions that the expanded definition is intended to capture. Moreover, the comment requested that the definition of foreign branch income should be modified such that it would not include any adjustments that would increase the gross income attributable to the foreign branch as a result of the transfer of intangible property from the foreign branch to the foreign branch owner.

The Treasury Department and the IRS agree that there should be one consistent definition of foreign branch income in both §§ 1.250(b)-1(c)(11) and 1.904-4(f)(2) to avoid the various results suggested by comments. Accordingly, the final regulations define foreign branch income by cross reference to § 1.904-4(f)(2) and remove the modification to that definition in the proposed regulations that would have included as foreign branch income any income from the sale, directly or indirectly, 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. See § 1.250(b)-1(c)(11).

2

2

Under § 1.904-4(f)(2), a disposition of an interest in a disregarded entity could still result in foreign branch income. See § 1.904-4(f)(4)(ii)

Example 2.

C.

Cost of Goods Sold Allocation

The proposed regulations provided that for purposes of determining the gross income included in gross DEI and gross FDDEI, cost of goods sold is attributed to gross receipts with respect to gross DEI or gross FDDEI under any reasonable method. See proposed § 1.250(b)-1(d)(1). The final regulations clarify that the method chosen by the taxpayer must be consistently applied.

For purposes of this rule, any cost of goods sold associated with activities undertaken in an earlier taxable year cannot be segregated into component costs and attributed disproportionately to amounts excluded from gross FDDEI or to amounts excluded from gross DEI, similar to the rules in proposed § 1.199-4(b)(2)(iii)(A). The preamble to the proposed regulations requested comments on whether there are alternative approaches for dealing with timing issues, and whether additional rules should be provided for attributing cost of goods sold in determining gross DEI and gross FDDEI.

One comment recommended that the final regulations continue to allow cost of goods sold to be allocated under any reasonable method to provide flexibility to different taxpayers. Another comment agreed with the proposed regulations that cost of goods sold should be allocated between gross FDDEI and gross non-FDDEI

3

regardless of whether any component of the costs was associated with activities undertaken in a prior tax year. That comment, however, recommended that for future periods taxpayers that recognized revenue under section 451 for advance payments should be permitted an election to create an imputed cost of goods sold deduction based upon the taxpayer's gross profit percentage for that particular product or service. The comment argued this election is needed because recognition of an advance payment as income without associated cost of goods sold might be required under section 451 based upon certain facts and circumstances and the election would allow the taxpayer to avoid this distortive impact.

3

The final regulations rename “gross non-FDDEI” as “gross RDEI” to clarify that the term includes only the residual of gross DEI that is not gross FDDEI, rather than all gross income (including income that is not gross DEI) that is not gross FDDEI. See § 1.250(b)-1(c)(14).

Sections 451 and 461 provide the general rules on the timing of income recognition and taking a deduction into account, respectively. Nothing in section 250 suggests that Congress intended to change the scope of generally applicable income recognition rules. Therefore, the final regulations do not adopt the comment to permit an election to create an imputed cost of goods sold deduction in the context of advance payments with respect to section 250.

D.

Expense Allocation

1. In General

In calculating DEI under section 250(b)(3), a taxpayer must determine the deductions that are “properly allocable” to gross DEI. Proposed § 1.250(b)-1(d)(2)(i) further provided that, for purposes of calculating FDDEI, a taxpayer must determine the deductions that are “properly allocable” to gross FDDEI. Consistent with the rules for determining the foreign tax credit limitation under section 904 or qualified production activities income under former section 199, the proposed regulations provided that §§ 1.861-8 through 1.861-14T and 1.861-17 apply for purposes of allocating deductions to gross DEI and gross FDDEI. Id. Several comments supported using these general apportionment rules.

2. Research and Experimentation Expenditures

Under § 1.861-17(b), an exclusive apportionment of research and experimentation (“R&E”) expenditures is made if activities representing more than 50 percent of the R&E expenditures were performed in a particular geographic location, such as the United States. After this initial exclusive apportionment, the remainder of the taxpayer's R&E expenditures are apportioned under either the sales or gross income methods under § 1.861-17(c) and (d). Section 1.861-17(e) provides rules for making a binding election to use either the sales or gross income method.

a. Exclusive Apportionment and Direct Apportionment

The proposed regulations under section 250 specified that the exclusive apportionment rules in § 1.861-17(b) did not apply for purposes of apportioning R&E expenses to gross DEI and gross FDDEI. See proposed § 1.250(b)-1(d)(2)(i). Several comments requested that the final regulations allow taxpayers to use exclusive apportionment for purposes of determining FDII. One comment noted that the preamble to the proposed regulations does not justify the proposed regulations omitting the exclusive apportionment method in the FDII context. Another comment asserted that allowing exclusive apportionment would mitigate a significant disincentive for taxpayers to onshore intangible property into the United States. Other comments argued that allocating R&E expenses to FDDEI may discourage taxpayers from performing R&E activities in the United States.

Several comments recommended allocating R&E expenditures based on an optional books and records method that could be used when there is a clear factual relationship between the R&E expenditures and a particular amount of income. These comments noted that some taxpayers are subject to regulatory oversight with respect to their contract pricing and costs, and therefore such taxpayers' books and records could be an accurate way of showing the relationship between R&E expenses and gross income.

Several comments also requested that the final regulations adopt special rules for expenses that are market-restricted or market-required (for example, expenses required only by the U.S. Food

and Drug Administration concerning the U.S. market), including where the legally mandated rule in § 1.861-17(a)(4) would not apply. One comment noted that this rule could apply in situations where U.S. law limits the realization from certain research activities to the market in which the research is performed (such as export controls) and therefore the R&E expenditures would not be expected to generate gross income outside the United States.

Several comments requested that if none of these recommendations for allocating R&E expenses are adopted, the final regulations should reserve on this provision pending the broader ongoing review of § 1.861-17 by the Treasury Department.

In light of the issuance of proposed rules under § 1.861-17 on December 17, 2019 (84 FR 69124) (the “2019 FTC proposed regulations”), the final regulations remove the provision stating that the exclusive apportionment rules in § 1.861-17(b) do not apply for purposes of apportioning R&E expenses to gross DEI and gross FDDEI, and generally do not provide special rules for applying § 1.861-17 for purposes of section 250. Proposed § 1.861-17 in the 2019 FTC proposed regulations provides that the exclusive apportionment rule applies only to section 904 as the operative section, and also proposes eliminating the special rule for legally mandated R&E. As recommended by comments to the proposed regulations under section 250, the Treasury Department and the IRS will consider the issues raised regarding the application of exclusive apportionment for purposes of section 250 as part of finalizing the 2019 FTC proposed regulations.

b. Use of Sales or Gross Income Method

Several comments requested that the final regulations include an election to allocate R&E expenses under either the sales or gross income method. Comments also requested that taxpayers should be permitted to make this election annually to give taxpayers a longer period to assess the various new regimes that rely on § 1.861-17 such as section 250, and pending the finalization of the FDII regulations. Another comment suggested that the final regulations should provide that the provisions of § 1.861-17(c)(3) (requiring sales to third parties by controlled foreign affiliates to be included) should not apply as it might artificially apportion more R&E expense against FDDEI.

As described in the preamble to proposed § 1.861-17 in the 2019 FTC proposed regulations, the Treasury Department and the IRS are concerned that the gross income method could in some cases produce inappropriate results. See 84 FR 69124, 69129. As a result, the 2019 FTC proposed regulations proposed to eliminate the optional gross income method described in § 1.861-17(d) and require R&E expenditures in excess of the amount exclusively apportioned under § 1.861-17(b) to be apportioned based on gross receipts. See proposed § 1.861-17(d). Comments addressing the applicability of the gross income method will be addressed as part of finalizing the 2019 FTC proposed regulations.

Proposed § 1.861-17(e)(3), published December 7, 2018 (83 FR 63200), permitted taxpayers a one-time exception to what would otherwise be a five-year binding election period under § 1.861-17(e)(1) to use either the sales or the gross income method, in light of the many changes to the foreign tax credit rules made by the Act. Under proposed §  1.861-17(e)(3), even if a taxpayer is subject to the binding election period, for the taxpayer's first taxable year beginning after December 31, 2017, the taxpayer may change its apportionment method without obtaining the Commissioner's consent. Comments to the proposed regulations under section 250 requested that this one-time exception be extended to at least a second tax year beginning after December 31, 2017, potentially at the election of the taxpayer, pending the Treasury Department's ongoing review of § 1.861-17. The final regulations under § 1.861-17 issued on December 17, 2019, provide an additional year for taxpayers to change their election of the sales or gross income method. See § 1.861-17(e)(3).

3. Carryovers

Comments requested additional clarification regarding whether taxpayers are required to apportion expenses incurred before the effective date of the proposed regulations. Multiple comments specifically asked for a clarification that taxpayers are not required to apportion NOLs incurred before the effective date of the proposed regulations or, in some cases, before the effective date of the Act, recommending that a clarification could be along the lines of § 1.199-4(c)(2)(ii) (providing that a deduction under section 172 for a net operating loss is not allocated or apportioned to domestic production gross receipts or gross income attributable to domestic production gross receipts).

The final regulations address this comment by providing that the following provisions (which limit certain deductions and provide for the carryover of the amounts not currently allowed) do not apply when allocating and apportioning deductions to gross DEI or gross FDDEI of a taxpayer for a taxable year: Sections 163(j), 170(b)(2), 172, 246(b), and 250. See § 1.250(b)-1(d)(2)(ii). The Treasury Department and the IRS considered a rule that would require expenses incurred in prior years, including in years before the effective date of the proposed regulations, to be allocated to gross DEI and gross FDDEI, but determined that the benefit of the theoretical precision of this approach would be outweighed by the burden on taxpayers and the IRS that would be associated with making retroactive determinations. Further, the approach taken in the final regulations is consistent with the premise that the section 250 deduction is calculated based on annual income and expenses.

E. Foreign-Derived Ratio

The proposed regulations provided rules for determining a taxpayer's foreign-derived ratio, which is the ratio of FDDEI to DEI. See proposed § 1.250(b)-1(c)(13). The preamble to the proposed regulations observed that as a result of expense apportionment or attribution of cost of goods sold to gross receipts, a taxpayer's FDDEI could exceed its DEI, thereby resulting in a foreign-derived ratio greater than one. The preamble noted that this result would be inconsistent with section 250(b)(4), which defines FDDEI as a subset of DEI, as it would lead to having FDII in excess of DII. Therefore, the proposed regulations clarified that the foreign-derived ratio cannot exceed one.

Several comments requested that the final regulations allow the foreign-derived ratio to exceed one. The comments asserted that the foreign-derived ratio can in fact exceed one under the statute where the taxpayer has losses that cause its FDDEI to exceed its DEI, and that there is no evidence Congress intended to limit the foreign-derived ratio to no greater than one. One of the comments asserted that FDDEI and DEI are defined by the statute and that the Treasury Department and the IRS do not have the authority to define FDDEI more narrowly than the statute does. Another comment argued that section 250(a)(2) provides a separate taxable income limitation that limits the FDII deduction based on domestic losses. This comment further asserted that the foreign-derived ratio rule of the proposed regulations reduces a taxpayer's incentive for repatriating intangible property when the foreign income from these intangibles cannot be

used to offset domestic losses for purposes of applying section 250.

One comment further suggested that the final regulations allow a taxpayer to elect to determine its FDII deduction, including the various elements of the determination such as DII, QBAI, and DTIR, based on specific product lines or business lines, as determined by the taxpayer. The comment asserted that such an approach would be analogous to other provisions that calculate taxable income separately for different subsets of income such as former section 199, the foreign tax credit limitation under section 904(d), separate limitation loss recapture rules in sections 904(f) and (g), and §§ 1.994-1(c) and 1.994-2(b). The comment argued that such an approach to determining FDII is more consistent with the policy goal of reducing the tax incentive to locate intellectual property outside the United States, which the comment asserted would be frustrated if domestic losses reduce FDII-eligible income.

The Treasury Department and the IRS do not agree that limiting the foreign-derived ratio to no greater than one is inconsistent with the plain meaning of section 250. Specifically, the approach recommended by the comments would be inconsistent with the statutory language of section 250(b)(4), which defines FDDEI as a subset of DEI, that is, “any deduction eligible income of such taxpayer which is derived in connection with” certain transactions. Allowing the foreign-derived ratio to exceed one could also lead to anomalous results. For example, a cliff effect would arise whereby a taxpayer with significant FDDEI but only $1 of DEI would have a significant FDII deduction, whereas if it has $0 or less of DEI, then no FDII deduction would be allowed. This would also create further anomalous results and incentives with respect to section 163(j), which is determined taking into account the section 250 deduction.

In addition, nothing in section 250 provides for FDII to be calculated based on specific product lines or business lines, which would entail significant complexity for taxpayers and administrative burdens for the IRS. Instead, the statute is clear that the FDII deduction is calculated as an aggregate of all FDDEI transactions. Therefore, the final regulations do not adopt this comment.

F.

Partnership Reporting Requirements

The proposed regulations required partnership information reporting in order to administer section 250. See proposed §§ 1.250(b)-1(e)(2) and 1.6038-3(g)(4). One comment asserted that the partnership information reporting requirements of proposed § 1.250(b)-1(e)(2) impose unnecessary administrative burdens on a partnership that reasonably believes it has no (direct or indirect) domestic corporate partners, even after the partnership has performed reasonable due diligence as to the identity of its partners and reasonably relied on information provided by the partners. The comment requested that the Treasury Department and IRS consider some form of relief from this reporting; the comment expressed the view that this limited reporting requirement would not prejudice the government's interest because the use of partnership items can only reduce the partner's tax liability. The comment further requested the addition of a reasonable cause exception (consistent with the penalty defenses available for the Form 8865 penalties).

The final regulations do not include a more limited reporting requirement because the Treasury Department and IRS are concerned that this might undermine accurate reporting at the partner level. In addition, the Treasury Department and IRS disagree with the comment's observation that reporting by the partnership of items under section 250 could only reduce a partner's tax liability—for example, a domestic corporate partner might reduce its tax liability by failing to include partnership QBAI. As to the comment's request for a reasonable cause exception, generally applicable penalty exceptions already apply to the extent information relevant to FDII is not reported on the applicable form. See section 6698(a) for filing Form 1065, section 6038(c)(4)(B) for filing Form 8865, and section 6724(a) for filing Schedule K-1 (Form 1065). For example, under § 301.6724-1(a)(2)(ii) and (c)(6), a partnership may establish reasonable cause because a payee failed to provide information necessary for the partnership to comply (or because of incorrect information provided by the payee or any other person that the partnership relied on in good faith). However, the final regulations clarify the reporting rules for tiered-partnership situations as well as provide guidance on certain computational aspects. See § 1.250(b)-1(e)(2). Similar additions are made to the reporting rules with respect to controlled foreign partnerships. See § 1.6038-3(g)(3).

V. Comments on and Revisions to Proposed § 1.250(b)-2—Qualified Business Asset Investment

A.

In General

The proposed regulations provided general rules for determining the QBAI of a taxpayer for purposes of determining its DTIR, including defining QBAI, tangible property, and specified tangible property; rules regarding dual-use property; rules for determining adjusted basis; rules regarding short tax years; rules regarding property owned through a partnership; and an anti-avoidance rule. See proposed § 1.250(b)-2. Section 250(b)(2)(B) provides that QBAI, for purposes of section 250, is defined under section 951A(d), and is determined by substituting “deduction eligible income” for “tested income” and without regard to whether the corporation is a controlled foreign corporation (“CFC”). While the rules provided in § 1.951A-3 for determining QBAI of a CFC for purposes of section 951A do not apply in determining QBAI for purposes of computing the deduction of a taxpayer under section 250 for its FDII, the proposed regulations under section 250 provided a similar, but not identical, determination of QBAI for purposes of FDII.

The section 951A final regulations made certain revisions and clarifications to the proposed regulations under that section (“section 951A proposed regulations”). See § 1.951A-3. The preamble to the section 951A final regulations noted that, except as indicated with respect to the election to use a depreciation method other than the alternative depreciation system (“ADS”) for determining the adjusted basis in specified tangible property for assets placed in service before the enactment of section 951A (see part V.B of this Summary of Comments and Explanation of Revisions section), modifications similar to the revisions to proposed § 1.951A-3 will be made to proposed § 1.250(b)-2. These modifications generally clarify the QBAI computation with respect to dual-use property (§ 1.250(b)-2(d)) and partnerships (§ 1.250(b)-2(g)). Accordingly, the final regulations make conforming changes to QBAI for purposes of FDII similar to the changes made to proposed § 1.951A-3 in the section 951A final regulations. See § 1.250(b)-(2).

B.

Determination of Basis Under ADS

The proposed regulations provided that, for purposes of determining QBAI, the adjusted basis in specified tangible

property is determined by using ADS under section 168(g), and by allocating the depreciation deduction with respect to such property for the taxpayer's taxable year ratably to each day during the period in the taxable year to which such depreciation relates. See section 951A(d)(3)

4

and proposed § 1.250(b)-2(e)(1). ADS applies to determine the adjusted basis in property for purposes of determining QBAI regardless of whether the property was placed in service before the enactment of section 250 or section 951A, or whether the basis in the property is determined under another depreciation method for other purposes of the Code. See section 951A(d)(3) and proposed § 1.250(b)-2(e).

4

As enacted, section 951A(d) contains two paragraphs designated as paragraph (3). The section 951A(d)(3) discussed in this part V.B of the Summary of Comments and Explanation of Revisions section relates to the determination of the adjusted basis in property for purposes of calculating QBAI.

A comment recommended that the final regulations for FDII should permit taxpayers the opportunity to follow U.S. GAAP for purposes of determining QBAI where the difference between U.S. GAAP and ADS is immaterial. The final regulations do not adopt this recommendation. Section 951A(d)(3) (and, by reference, section 250(b)(2)(B)) is clear that the adjusted basis in specified tangible property is determined using ADS under section 168(g). In addition, permitting taxpayers to elect to follow U.S. GAAP in the context of FDII will impose significant administrative burdens on the IRS to determine what would be immaterial and account for different depreciation methods to compute QBAI.

C.

QBAI Anti-Avoidance Rule

In order to prevent artificial decreases to the DTIR amount, the proposed regulations disregarded certain transfers of specified tangible property by a domestic corporation to a related party where the corporation continues to use the property in production of gross DEI. In particular, proposed § 1.250(b)-2(h)(1) disregarded a transfer of specified tangible property by the taxpayer to a related party if, within a two-year period beginning one year before the transfer, the taxpayer leases the same or substantially similar property from a related party and such transfer and lease occur with a principal purpose of reducing the taxpayer's DTIR. In addition, a transfer or leaseback transaction was treated as per se undertaken for a principal purpose of reducing the transferor's DTIR if the transfer and leaseback each occur within a six-month span. See proposed § 1.250(b)-2(h)(3). Comments recommended that the final regulations contain a transition period for the QBAI anti-avoidance rule in proposed § 1.250(b)-2(h)(3) for transactions entered into before the date that the proposed regulations were issued. The final regulations adopt this comment. See § 1.250(b)-2(h)(5).

Another comment recommended that a taxpayer be able to rebut the presumption that a transfer or leaseback transaction was undertaken for a principal purpose of reducing the transferor's DTIR if the transfer and leaseback each occurred within a six-month span. The final regulations do not adopt this recommendation because a transfer and lease of the same or similar property that occurs between related parties within six months does not materially change the economic risk of the parties and is unlikely to be motivated by non-tax reasons. In addition, permitting taxpayers to rebut the presumption that such a transaction was undertaken for a principal purpose of reducing the transferor's DTIR creates significant administrative burdens.

VI. Comments on and Revisions to Proposed § 1.250(b)-3—FDDEI Transactions

The proposed regulations provided that FDDEI is the excess of gross FDDEI over deductions properly allocable to gross FDDEI. See proposed § 1.250(b)-1(c)(12). The proposed regulations defined gross FDDEI as the portion of a corporation's gross DEI that is derived from all of its “FDDEI sales” and “FDDEI services.” See proposed § 1.250(b)-1(c)(15). The proposed regulations defined “sale” to include a lease, license, exchange, or other disposition of property, including a transfer of property resulting in gain or an income inclusion under section 367. See proposed § 1.250(b)-3(b)(7).

A.

Definition of “General Property”

1. Treatment of Commodities

For purposes of determining what is a FDDEI sale (and relatedly, whether a sale is for a foreign use), the proposed regulations distinguished between “general property” and certain other types of property. The proposed regulations excluded any commodity (as defined in section 475(e)(2)(B) through (D)) from the definition of general property. See proposed § 1.250(b)-3(b)(3). The proposed regulations did not exclude from the definition of general property a commodity described in section 475(e)(2)(A), and therefore, the sale of such a commodity may qualify as a FDDEI sale. A comment raised a concern that the sale of a physical commodity effected through certain derivative contracts (described in section 475(e)(2)(B) through (D)) might not be treated as a sale of general property under the proposed regulations. The comment recommended clarifying that the sale of a physical commodity in satisfaction of a forward contract is not excluded from the definition of general property.

The Treasury Department and the IRS generally agree that a sale of a commodity such as an agricultural commodity or a natural resource should be a sale of general property whether it is sold pursuant to a spot contract or sold pursuant to a forward or option contract, other than a section 1256 contract or similar contract that is traded and cleared like a section 1256 contract. The sale of such a commodity through a futures or option contract that is a section 1256 contract or similar contract is not treated as a sale of general property because the interposition of a clearing organization as the counterparty to such contracts severs the connection between the original selling and buying parties to the contract such that no meaningful determination can be made whether the sale through such a contract is for a foreign use. The definition of “general property” in § 1.250(b)-3(b)(10) is modified accordingly. The final regulations also clarify that financial instruments or similar assets traded through futures or similar contracts do not qualify as general property.

The Treasury Department and the IRS are concerned, however, that a taxpayer could manipulate its FDDEI by selectively physically settling only its commodities forward or option contracts in which it has a gain. To prevent this manipulation, the final regulations provide that the sale of a commodity pursuant to a forward or option contract is treated as a sale of general property only to the extent that a taxpayer physically settled the contract pursuant to a consistent practice adopted for business purposes of determining whether to cash or physically settle such contracts under similar circumstances. See § 1.250(b)-3(b)(10).

The proposed regulations further provided that a sale of a security (as defined in section 475(c)(2)) or a commodity (as defined in section 475(e)(2)(B) through (D)) is not a FDDEI sale. See proposed § 1.250(b)-4(f). This rule is no longer necessary because the final regulations exclude such property from the definition of general property.

2. Treatment of Interests in Partnerships

The proposed regulations did not address the conditions under which the sale of a partnership interest that is not described in section 475(c)(2) will satisfy the foreign use requirement. One comment suggested that when a taxpayer sells a partnership interest, a look-through approach should apply such that the sale of a partnership interest would be considered a sale of the partner's proportionate share in the partnership's assets. As such, the sale of the partnership interest could be considered a sale of general property and would qualify as a FDDEI sale so long as the other relevant requirements of the regulations were met. The same comment noted an alternative approach that would preclude looking through to the underlying assets and instead would require the foreign purchaser to determine if the acquisition of the partnership interest is for a foreign use.

The Treasury Department and the IRS have determined that, like an interest in a corporation (which is a security under section 475(c)(2)(A) and therefore not general property under § 1.250(b)-3(b)(10)), interests in a partnership are not the type of property that can be subject to “any use, consumption, or disposition” outside the United States. Furthermore, a look-through approach would be inconsistent with the fact that title to the partnership's property does not change upon the sale of an interest in a partnership and also would be difficult to administer given that the underlying property that would be tested for foreign use is not actually being transferred. Accordingly, the final regulations provide that an interest in a partnership, as well as an interest in a trust or estate, is not general property. See § 1.250(b)-3(b)(10).

3. Exclusion of Intangible Property

Under the proposed regulations, the rules applicable to the determination of whether a sale of property is for a foreign use depends on whether the property sold is “general property” or “intangible property.” See proposed § 1.250(b)-4(d) and (e). The proposed regulations defined general property as property other than intangible property, a security (as defined in section 475(c)(2)), or a commodity (as defined in section 475(e)(2)(B) through (D)). See proposed § 1.250(b)-3(b)(3). The proposed regulations defined intangible property by cross-reference to section 367(d)(4). See proposed § 1.250(b)-3(b)(4).

Two examples in the proposed regulations suggested that a limited use license of a copyrighted article is analyzed under the rules for sales of intangible property. See proposed § 1.250(b)-4(e)(4)(ii)(D) and (E) (

Example 4

and

5

). One comment recommended that if the distinction between sales of tangible and intangible property is maintained, then the final regulations should provide that software transactions involving the sale or lease of copyrighted articles are governed by the general property rules and not the intangible property rules.

The final regulations make several changes in response to this comment. Consistent with the request in the comment, the definition of “intangible property” for purposes of section 250 is clarified to not include a copyrighted article as defined in § 1.861-18(c)(3). See § 1.250(b)-3(b)(11). However, the rules for determining foreign use that apply to general property are not suitable for sales of digital content, including copyrighted articles, that are transferred electronically, because those rules focus on the physical transfer of property to end users. Therefore, the final regulations provide an additional rule for sales of general property that primarily contain digital content. See § 1.250(b)-4(d)(1)(ii)(D). Under the final regulations, “digital content” is defined as a computer program or any other content in digital format. See § 1.250(b)-3(b)(1). The determination of how a transfer of a copyrighted article is characterized (for example, as a sale or a service) for purposes of applying the final regulations is based on general U.S. tax principles, taking into account the regulations issued under section 861.

5

5

See proposed § 1.861-18(a) (84 FR 40317) (adding section 250 to the list of provisions to which § 1.861-18 applies).

Notwithstanding the final regulations' treatment of sales of copyrighted articles for purposes of determining foreign use, no inference is intended with respect to the treatment of sales of copyrighted articles under other sections of the Code. For example, the fact that a sale of a copyrighted article (or other property) is treated as a FDDEI sale does not necessarily mean that the income from the sale is foreign source under section 861.

B.

Foreign Military Sales and Services

The proposed regulations provided that for purposes of section 250 a sale of property or a provision of service to the U.S. government that is governed by the Arms Export Control Act of 1976, as amended (22 U.S.C. 2751

et. seq.

), is treated as a sale of property or provision of a service to a foreign government, and therefore may qualify as a FDDEI transaction if the other requirements under proposed §§ 1.250(b)-3 through 1.250(b)-6 are satisfied. See proposed § 1.250(b)-3(c). The proposed regulations requested comments on identifying readily available documentation sufficient to demonstrate that a particular sale or service was made pursuant to the Arms Export Control Act.

Several comments requested removal of the requirement in proposed § 1.250(b)-3(c) that the resale or on-service to a foreign government or agency or instrumentality thereof must be “on commercial terms.” The comments asserted that this requirement was ambiguous and observed that the taxpayer would not necessarily have access to the contract between the U.S. government and the foreign counterparty and therefore could not necessarily evaluate the commerciality of such contract. The comments also objected to the requirement that the contract between the taxpayer and the U.S. government specifically refer to the resale or on-service to the foreign government, stating that the contract may not always specify this information but that the resale or on-service could be evidenced by the taxpayer's generally available records.

In response to the preamble's request for comments on suitable documentation to demonstrate that a foreign military sale qualifies under this special rule, several comments noted that no one particular document will suffice to demonstrate that a given sale or service qualifies. Nevertheless, comments stated that ordinary course documentation should suffice to show that the sale or service qualifies. If the final regulations were to retain a list of particular documents required to demonstrate that a particular sale or service was made pursuant to the Arms Export Control Act, the comments suggested various types of documents that might be available but also stated that any list of these documents should be non-exclusive since any one document may not exist for a particular sale or service, and, in any event, the Department of Defense and the State Department modify their forms frequently. One comment asked for transitional relief for any pre-existing contracts, if the final regulations were to provide an exclusive list of required documentation. Another comment requested a presumption of foreign use in the context of foreign military sales based on the high likelihood that defense articles would satisfy foreign use—sales made pursuant to the Arms Export Control Act are limited to foreign strategic partners who intend to use

articles in a certain manner, such as, self-defense and internal security—and the low likelihood that a foreign person could use a defense article within the United States.

In general, the final regulations adopt the comments. Section 1.250(b)-3(c) does not include a requirement that the foreign military sale or service be “on commercial terms” or that the contract specifically refer to the resale or on-service to the foreign government. Instead, if a sale of property or a provision of a service is made pursuant to the Arms Export Control Act, then the sale of property or provision of a service is treated as a FDDEI sale or FDDEI service without needing to apply the general rules in § 1.250(b)-4 or § 1.250(b)-5. See § 1.250(b)-3(c). The final regulations also do not require any particular documentation to substantiate that a transaction qualifies under the rule in § 1.250(b)-3(c). Taxpayers will continue to be required to substantiate under section 6001 that any foreign military sale or service qualifies for a section 250 deduction.

C.

Reliability of Documentation and Reason To Know Standard

The proposed regulations provided that to establish that a recipient is a foreign person, property is for a foreign use, or a recipient of a general service is located outside the United States, the taxpayer must obtain specific types of documentation described in proposed §§ 1.250(b)-4(c)(2), (d)(3), and (e)(3) and 1.250(b)-5(d)(3) and (e)(3). The proposed regulations also provided that the seller or renderer must not know or have reason to know that the documentation is incorrect or unreliable. Proposed § 1.250(b)-3(d)(1). One comment requested that the final regulations provide more guidance and relevant examples regarding the scope of this rule, in particular what knowledge should be imputed across a large organization and how the standard should apply when relevant information is legally protected by data privacy laws.

As described in part II of this Summary of Comments and Explanation of Revisions section, the final regulations replace the documentation requirements with substantiation rules that are more flexible with respect to the types of corroborating evidence that may be used. The knowledge or reason to know standard is retained in §§ 1.250(b)-3(f)(3) (treatment of certain loss transactions), 1.250(b)-4(c)(1) (foreign person requirement), (d)(1)(iii)(C) (general property incorporated into a product as a component) and (d)(2)(ii)(C)(

2

) (sale of intangible property consisting of a manufacturing method or process to a foreign unrelated party), and 1.250(b)-5(d)(1) (general services provided to consumers). In response to comments, the final regulations provide additional detail regarding the application of the reason to know standard in these sections. The final regulations generally provide that a taxpayer has reason to know that a transaction fails to satisfy a substantive requirement if the information that the taxpayer receives as part of the sales process contains information that indicates that the substantive requirement is not met and, after making reasonable efforts, the taxpayer cannot establish that the substantive requirement is met. See §§ 1.250(b)-3(f)(3), 1.250(b)-4(c)(1), (d)(1)(iii)(C) and (d)(2)(ii)(C)(

2

), and § 1.250(b)-5(d)(1).

D.

Sales or Services to a Partnership

For purposes of determining a taxpayer's FDII attributable to sales of property or services to a partnership, the proposed regulations adopted an entity approach to partnerships. See proposed § 1.250(b)-3(g)(1). One comment suggested that if a seller of a good has a greater than 10 percent ownership interest in the recipient domestic partnership, the final regulations should also permit aggregate treatment of the partnership for this limited purpose. The comment observed that the proposed regulations do not permit sales to a domestic partnership to qualify as a FDDEI sale because a domestic partnership is not a foreign person under proposed § 1.250(b)-3(b)(2). According to the comment, in certain industries, customers request “teaming arrangements” that require bidders to form a single domestic bidding entity that will govern the relationship between the members of the team, but most of the work is performed by the partners, under subcontract from the partnership. The comment recommended that the practice of joint bidding should not disqualify the activity for FDII purposes.

With respect to a taxpayer's sales of property to a partnership, one comment suggested that the final regulations consider alternatives to a pure entity approach. The comment outlined two other approaches to determine if a sale to a partnership qualifies as a FDDEI sale based on whether the partnership is predominantly engaged in foreign business or a pure aggregate approach to treat the partnership as a foreign person to the extent of its ownership by direct or indirect foreign partners. With respect to a partnership engaged in multiple lines of business, each business could be viewed as a separate person for FDII purposes. While the comment did not support an aggregate approach or advocate a specific approach, the comment noted that the Treasury Department and the IRS should balance legislative intent, administrative burden, and precision.

The final regulations do not adopt these comments. The statute is clear that in the case of sales of property, the sale must be to a person that is not a United States person, and a domestic partnership is a United States person. See part VII.B of this Summary of Comments and Explanation of Revisions section. In addition, requiring taxpayers to trace the ownership, potentially through multiple tiers, of third-party partnership recipients presents significant administrative hurdles. If, alternatively, this regime were elective, it would create the potential for abuse or uneven results for similarly situated taxpayers.

E.

Treatment of Certain Loss Transactions

The proposed regulations provided that if a seller or renderer knows or has reason to know that property is sold to a foreign person for a foreign use or a general service is provided to a person located outside the United States, but the seller or renderer does not satisfy the documentation requirements applicable to such sale or service, the sale of property or provision of a service is nonetheless deemed a FDDEI transaction if treating the sale or service as a FDDEI transaction would reduce a taxpayer's FDDEI. See proposed § 1.250(b)-3(f). One comment requested a clarification that taking the FDII deduction should be considered an elective action and that this rule does not impact such an election.

As described in part II of this Summary of Comments and Explanation of Revisions section, in response to comments, the final regulations adopt a more flexible approach to the FDII-specific documentation rules and instead provide specific substantiation requirements for certain elements of the regulations. Accordingly, the rule with respect to loss transactions is revised so that it only applies to transactions for which there is a specific substantiation requirement. See § 1.250(b)-3(f)(3)(i). However, the fact that § 1.250(b)-3(f)(3) has been narrowed in the final regulations does not mean that the allowed FDII deduction can be determined on a transaction-by-transaction basis. As provided in the final regulations, FDII is determined on a single aggregate basis, not on a

transaction-by-transaction basis. See § 1.250(b)-1.

The final regulations also clarify that for purposes of the loss transaction rule, whether a taxpayer has reason to know that a sale of property is to a foreign person for a foreign use, or that a general service is provided to a business recipient located outside the United States, depends on the information received as part of the sales process. If the information received as part of the sales process contains information that indicates that a sale is to a foreign person for a foreign use or that a general service is to a business recipient located outside the United States, the requisite reason to know is present unless the taxpayer can prove otherwise. See § 1.250(b)-3(f)(3)(ii). With respect to sales, the final regulations provide a non-exhaustive list of information that indicates that a recipient is a foreign person or that the sale is for a foreign use, such as a foreign address or phone number. While not all sales to a foreign person are for a foreign use (nor are all sales for a foreign use made to foreign persons), the final regulations use the same indicia for both requirements because a foreign person is more likely to make a purchase for a foreign use compared to a U.S. person. With respect to general services, information that indicates that a recipient is a business recipient include indicia of a business status, such as “LLC” or “Company,” or similar indicia under applicable law, in its name. Information that indicates that a business recipient is located outside the United States includes, but is not limited to, a foreign phone number, billing address, and evidence that the business was formed or is managed outside the United States. These rules can also apply in the case of sales made by related parties where the foreign related party is treated as the seller and the unrelated party transaction is being analyzed. See § 1.250(b)-6(c)(2).

The final regulations do not include a rule specifying that a taxpayer may choose not to claim a FDII deduction. Whether an allowable deduction must be claimed is governed by general tax principles and rules on whether such deduction can be elective is beyond the scope of these regulations.

F.

Predominant Character Rule

The proposed regulations provided that if a transaction includes both a sale component and a service component, the transaction is classified according to the overall predominant character of the transaction for purposes of determining whether the transaction is subject to the FDDEI sales rules of proposed § 1.250(b)-4 or the FDDEI services rules of proposed § 1.250(b)-5. See proposed § 1.250(b)-3(e). A comment expressed support for the predominant character rule for transactions that contain both sale and service components in general but also suggested that the final regulations allow taxpayers to elect to follow U.S. GAAP accounting, which may in certain circumstances require the disaggregation of the sale and service components of a single transaction.

For purposes of simplicity and to avoid the need for complex apportionment rules, § 1.250(b)-3(d) provides a rule to determine the predominant character of the transaction when a transaction has multiple elements, such as a sale of general property and a service or sale of general property and sale of intangible property. The Treasury Department and the IRS have determined that an elective rule that allows for disaggregation would create significant complexity for taxpayers and be difficult for the IRS to administer, and could lead to whipsaw for the IRS as taxpayers elect to disaggregate when it increases the FDII deduction but not otherwise. Accordingly, the final regulations do not adopt the comment to include an election to follow U.S. GAAP to disaggregate a single transaction.

VII. Comments on and Revisions to Proposed § 1.250(b)-4—FDDEI Sales

Section 250(b)(4)(A) provides that FDDEI includes income from property the taxpayer sells to any person who is not a U.S. person and that the taxpayer establishes to the satisfaction of the Secretary is for a foreign use. Accordingly, the proposed regulations defined a FDDEI sale as a sale of property to a foreign person for a foreign use. See proposed § 1.250(b)-4(b).

A.

End User Requirement

The proposed regulations provided that a sale of intangible property is for a foreign use to the extent the intangible property generates revenue from exploitation outside the United States, which is generally determined based on the location of end users purchasing products for which the intangible property was used in development, manufacture, sale, or distribution. See proposed § 1.250(b)-4(e)(2)(i).

Several comments requested that the final regulations clarify the definition of an “end user.” One comment recommended that an “end user” be defined as any consumer or business recipient that purchases a finished good for its own use or consumption (not for resale or further manufacture, assembly, or other processing). Another recommended that the finished good manufacturer or original equipment manufacturer, rather than the ultimate customer of the manufacturer, be treated as the end user.

The final regulations generally adopt the comment that the end user should be the consumer that purchases the property for its own consumption. See § 1.250(b)-3(b)(2). Further, as discussed in part VII.C.1 of this Summary of Comments and Explanation of Revisions section, the concept of an end user is also incorporated into the rules for determining whether a sale of general property, in addition to intangible property, is for a foreign use. See § 1.250-4(d). In this way, to the extent possible, the final regulations harmonize the rules for sales of general property and intangible property.

Section 1.250(b)-3(b)(2) defines the “end user” as the person that ultimately uses the property, and that a person who acquires property for resale or otherwise as an intermediary is not an end user. The definition of end user is modified for intangible property used in connection with the sale of general property, provision of services, sale of a manufacturing method or process intangible property, and for research and development as provided in § 1.250(b)-4(d)(2)(ii).

The final regulations do not adopt the comments that in all cases a finished goods manufacturer may be an end user. However, as described in part VII.C.7 of this Summary of Comments and Explanation of Revisions section, the final regulations continue to provide that sales of general property for manufacturing, assembly, or other processing outside the United States are sales for a foreign use. See § 1.250(b)-4(d)(1)(iii). In addition, as described in part VII.D.4 of this Summary of Comments and Explanation of Revisions section, an unrelated manufacturer (such as an original equipment manufacturer) that uses intangible property that consists of a manufacturing method or process, as provided in § 1.250(b)-4(d)(2)(ii)(C), is treated as the end user if it has purchased (or licensed) the manufacturing method or process intangible property from an unrelated party.

B.

Foreign Person

The proposed regulations provided that a recipient is treated as a foreign person only if the seller obtains documentation of the recipient's foreign status and does not know or have reason to know that the recipient is not a foreign person. See proposed § 1.250(b)-4(c)(1). The proposed regulations

provided several types of permissible documentation for this purpose, such as a written statement by the recipient indicating that the recipient is a foreign person. See proposed § 1.250(b)-4(c)(2)(i).

As explained in part II of this Summary of Comments and Explanation of Revisions section, in response to comments, the final regulations remove the specific documentation requirements with respect to certain requirements, including the foreign person requirement, and further identify the substantive standards by which taxpayers must meet the requirements of the FDII regime. To address situations in which taxpayers may not be able to determine whether the recipient is a foreign person within the meaning of section 7701(a)(1), the final regulations provide that the sale of property is presumed made to a recipient that is a foreign person if the sale is as described in one of four categories: (1) Foreign retail sales; (2) sales of general property that are delivered to an address outside the United States; (3) in the case of general property that is not sold in a foreign retail sale or delivered overseas, the billing address of the recipient is outside the United States; or (4) in the case of sales of intangible property, the billing address of the recipient is outside the United States. See § 1.250(b)-4(c)(2)(i) through (iv). The presumption does not apply if the seller knows or has reason to know that the sale is to a recipient other than a foreign person. See § 1.250(b)-4(c)(1). The final regulations also specify that a seller has reason to know that a sale is to a recipient other than a foreign person if the information received as part of the sales process contains information that indicates that the recipient is not a foreign person and the seller fails to obtain evidence establishing that the recipient is in fact a foreign person. See § 1.250(b)-4(c)(1). Information that indicates that a recipient is not a foreign person includes, but is not limited to, a United States phone number, billing address, shipping address, or place of residence; and, with respect to an entity, evidence that the entity is incorporated, formed, or managed in the United States. Id.

One comment requested that the final regulations include exceptions similar to the foreign military sales rule in the proposed regulations for other sales or licenses of property through an intermediate domestic person. The comment asserted that, for various business reasons including historic relationships with unrelated parties and efficiencies from entering into global deals to sell property to unrelated parties, certain U.S. manufacturers sell products to another U.S. entity, even though that intermediary never actually takes possession, and the product is immediately resold to a foreign person and used outside the United States. In the licensing context, a U.S. taxpayer may enter a global licensing deal with another U.S. entity whereby this intermediary is granted the authority to sub-license the intangible property to its foreign affiliates. While in both cases the transactions could potentially be restructured so that the taxpayer enters into the transactions with a foreign person that is related to the U.S. intermediary, the comment suggested that unrelated counterparties could demand compensation for any restructuring. The comment also noted that the title to section 250(b)(5)(B) references rules for “[p]roperty or services provided to domestic intermediaries,” suggesting that Congress contemplated situations where sales to a U.S. intermediary could be treated as a sale to a non-U.S. person, although the rule itself does not reference domestic intermediaries.

As explained in the preamble to the proposed regulations, section 250(b)(4)(A)(i) requires that a sale of property (which includes licenses of intangible property) be made to a person who is not a United States person. This requirement ensures that only the domestic corporation that makes the final sale to a foreign person can claim a section 250 deduction for a FDDEI sale (rather than allowing the benefit to multiple unrelated domestic corporations that all participate in a sale). Furthermore, the Treasury Department and the IRS do not agree that the heading to section 250(b)(5)(B) implies an exception to the requirement in section 250(b)(4)(A)(i) that the sale be to a foreign person. The rule in section 250(b)(5)(B)(i) refers only to other “persons” and is not limited to domestic persons. In contrast, the Treasury Department and the IRS have determined that it is necessary and appropriate to provide a special rule for military sales in recognition that sales pursuant to the Arms Export Control Act are required to be made to the U.S. government, but are in effect sales to a foreign government. Therefore, the comment is not adopted.

C.

Foreign Use of General Property

1. Determination of Foreign Use in General

The proposed regulations provided that the sale of general property is for a foreign use if either the property is not subject to domestic use within three years of delivery of the property or the property is subject to manufacture, assembly, or other processing outside the United States before any domestic use of the property. See proposed § 1.250(b)-4(d)(2)(i). Domestic use was defined in the proposed regulations as the use, consumption, or disposition of property within the United States, including manufacture, assembly, or other processing within the United States. See proposed § 1.250(b)-4(d)(2)(ii). In order to establish that general property is for a foreign use, the seller must generally obtain certain documentation with respect to the sale, such as proof of shipment of the property to a foreign address, and the seller cannot know or have reason to know that the property is not for a foreign use. See proposed § 1.250(b)-4(d)(1) and (3).

Several comments noted that the definition of foreign use combined with the narrow documentation requirements make it difficult for taxpayers to satisfy the foreign use requirement. Several comments interpreted the proposed regulations as requiring taxpayers to determine whether general property that was sold would actually be subject to a domestic use within three years of the date of delivery. Other comments similarly expressed confusion regarding the obligation imposed on taxpayers to determine whether there was a reason to know that property would be subject to a domestic use. One comment requested that the Treasury Department and the IRS treat certain types of sales, such as foreign retail sales at a physical store even where the consumer might ultimately use the property within the United States, as sales for foreign use.

As explained in part II of this Summary of Comments and Explanation of Revisions section, in response to comments on documentation, the final regulations take a more flexible approach to documentation and provide specific substantiation requirements for certain transactions (described in part VII.C.9 of this Summary of Comments and Explanation of Revisions section).

In addition, with respect to the requirement of “foreign use” for sales of general property, the final regulations clarify the meaning of that term to provide that it generally means the sale (or eventual sale) of the property to end users outside the United States or the sale of the property to a person that subjects the property to manufacture, assembly, or other processing outside the United States. See § 1.250(b)-4(d)(1)(ii) and (iii). Consistent with the recommendations from comments, the Treasury Department and the IRS have determined that a more flexible

definition of foreign use of general property that accounts for the possibility of some limited domestic use is more reasonable for taxpayers to apply and for the IRS to administer. Accordingly, the final regulations eliminate the requirement that the taxpayer have no “reason to know” of some domestic use for sales of general property. As described in part VII.C.2 through 8 of this Summary of Comments and Explanation of Revisions section, the final regulations generally provide that the sale of general property is for a foreign use if the seller determines that such sale is to an end user described in one of five categories. See § 1.250(b)-4(d)(1)(ii)(A)-(F).

2. Delivery of Property Outside the United States

The first category of sales that are for a foreign use is sales to a recipient that are delivered by a freight forwarder or carrier to an end user if the end user receives delivery of the general property outside the United States. See § 1.250(b)-4(d)(1)(ii)(A). The Treasury Department and the IRS have determined that, in general, if an end user receives delivery of general property outside the United States, the general property will be “for a foreign use” as contemplated by section 250(b)(4)(A)(ii) and additional detail regarding the actual use of the property is unnecessary. However, it would be inappropriate to treat these sales as FDDEI sales if the seller and buyer arrange for general property to be delivered to a location outside the United States only to be redelivered for use or consumption into the United States with a principal purpose of causing what would otherwise not be a FDDEI sale to be treated as a FDDEI sale. Therefore, § 1.250-4(b)(1)(ii)(A) provides an anti-abuse rule to address these concerns.

3. Location of Property Outside the United States

The second category of sales that are for a foreign use is sales of general property to an end user where the property is already located outside the United States, and includes foreign retail sales. See § 1.250(b)-4(d)(1)(ii)(B). In general, sales of general property from a foreign retail sale will be used outside the United States. While it may be possible that some end users will purchase property in a foreign retail store and use it solely within the United States, the Treasury Department and the IRS have determined that requiring a determination of the actual use of these sales would be unnecessarily burdensome.

4. Resale of Property Outside the United States

The third category of sales for a foreign use is sales to a recipient such as a distributor or retailer that will resell the general property, if the seller determines that the general property will ultimately be sold to end users outside the United States. See § 1.250(b)-4(d)(1)(ii)(C). This category is intended to apply to sales to distributors and retailers, but may also apply to other sales to foreign persons for resale. In addition, the final regulations provide that for purposes of this rule, the seller must substantiate the portion of sales to end users outside the United States under the rules described in parts II and VII.C.9 of this Summary of Comments and Explanation of Revisions section.

The proposed regulations contained alternative documentation requirements for a sale of multiple items of general property that because of their fungible nature are difficult to specifically trace to a location of use (fungible mass). See proposed § 1.250(b)-4(d)(3)(iii). Under the proposed regulations, a seller establishes foreign use of a fungible mass through market research, including statistical sampling, economic modeling and other similar methods. Id. The proposed regulations also provided that if a seller establishes that 90 percent or more of a fungible mass is for a foreign use, the entire fungible mass is treated as for a foreign use and if the seller cannot establish that 10 percent or more of the sale of a fungible mass is for a foreign use, then no part of the fungible mass is treated as for a foreign use. Id.

One comment stated that the fungible mass rules created overly stringent documentation requirements that were unnecessary, impractical, and unreliable because a U.S. seller would need to perform market research in order to meet the 90 percent threshold to qualify for foreign use. Conversely, the comment noted that a U.S. seller that could not meet the 10 percent threshold through market research could see their deduction eliminated in its entirety. The comment suggested instead a rebuttable presumption that fungible mass property sold outside the United States is for a foreign use unless a taxpayer knows or has reason to know that a material amount will be used within the United States.

In response to the comment, the final regulations eliminate the 10 percent and 90 percent thresholds and apply a proportionate rule. See § 1.250(b)-4(d)(1)(ii)(C). Under this rule, in the case of a sale of a fungible mass of general property, if a portion of the property sold is not for a foreign use, the seller may rely on the proportion of the recipient's resales of fungible mass to end users outside the United States to determine its proportion of ultimate sales to end users outside the United States. Id. In addition, the Treasury Department and the IRS have determined that prescribing specific methods such as market research, statistical sampling, economic modeling, and other similar methods to determine foreign use from the sale of a fungible mass of general property (or a sale of any general property) is unnecessary given the more flexible approach to documentation. It should be noted that market research or information from public data, such as general internet searches of secondary sources, is generally not a source of reliable information. In contrast, statistical sampling, economic modeling, or market research based on the taxpayer's own data will be more reliable.

5. Electronic Transfer of Digital Content Outside the United States

The fourth category of sales for a foreign use is for sales of digital content that are transferred electronically. Sales of digital content transferred in a physical medium are for a foreign use if described in one of the first three categories. The final regulations provide that digital content that is transferred electronically is for a foreign use if it is sold to a recipient that is an end user that downloads, installs, receives, or accesses the digital content on the end user's device outside the United States. See § 1.250(b)-4(d)(1)(ii)(D). However, if this information is unavailable, such as where the device's internet Protocol address (“IP address”) is not available or does not serve as a reliable proxy for the end user's location (for example, using a business headquarters' IP address when it has employees located both within and outside the United States who use the digital content), then the sale is for a foreign use if made to an end user with a foreign billing address, but only if the gross receipts from all sales with respect to the end user (which may be a business) are in the aggregate less than $50,000.

6. International Transportation Property

The fifth category of sales for a foreign use is sales of international transportation property. The proposed regulations provided a special rule for determining whether transportation property like aircraft, railroad rolling stock, vessels, motor vehicles or similar property that travels internationally is

sold for foreign use and therefore constitutes a FDDEI sale. See proposed § 1.250(b)-4(d)(2)(iv). Under this rule, such transportation property is sold for foreign use only if during the three-year period from the date of delivery of the property the property is located outside the United States more than 50 percent of the time and more than 50 percent of the miles traversed in the use of such property will be traversed outside the United States. The seller can establish that these criteria are satisfied by obtaining a written statement from the recipient that the property is anticipated to satisfy these tests over the requisite three-year period. See proposed § 1.250(b)-4(d)(3)(i)(A). With respect to air transportation, the proposed regulations provided that, for purposes of the above tests, international transportation property is deemed to be within the United States at all times during which it is engaged in transport between any two points within the United States, except where the transport constitutes uninterrupted international air transportation within the meaning of section 4262(c)(3) and the regulations under that section. See proposed § 1.250(b)-4(d)(2)(iv).

One comment suggested supplementing these tests with a rebuttable presumption that any foreign-registered aircraft sold to a foreign person is for foreign use. The comment observes that “cabotage rules” significantly restrict the use of foreign registered aircraft within the United States such that a foreign registered aircraft cannot travel between two points in the United States unless the route is part of a through trip on the way to, or coming from, a foreign destination. The comment further noted that the ability of foreign persons to register aircraft in the United States is restricted. Therefore, the comment proposed that a document evidencing foreign registration of an aircraft to a foreign person should suffice to establish foreign use.

Other comments suggested changes to the thresholds in the foreign use tests in the proposed regulations. Several comments suggested reducing the thresholds from 50 percent to 20 percent and making these tests disjunctive. Another comment would retain the 50 percent threshold but eliminate the three-year period so that the foreign use test would only have to be satisfied as of the filing date of the FDII return, and that the taxpayer be permitted to elect annually to bifurcate income from foreign and domestic use based on the percentage of actual time spent or miles traversed outside and inside the United States. A different comment suggested reducing the three-year period to one year after the date of delivery.

The Treasury Department and the IRS generally agree with the comment that place of registration is appropriate as evidence of “use.” Therefore, the final regulations provide that international transportation property used for compensation or hire is considered for a foreign use if it is sold to an end user that registers the property with a foreign jurisdiction. See § 1.250(b)-4(d)(1)(ii)(E). The final regulations provide that other international transportation property is considered for a foreign use if sold to an end user that registers the property with a foreign jurisdiction

and

the property is hangared or primarily stored outside the United States. See § 1.250(b)-4(d)(1)(ii)(F). This rule reflects the fact that many recipients of international transportation property will not be further using the property for the provision of international transportation services. As a result, the property will be primarily used in the place it is registered or otherwise hangared or stored. Even if such property enters the United States, because it originated in a different country, the use should not be considered domestic use because the international transportation property will generally be located outside the United States. As a result, the Treasury Department and the IRS have determined that there is no need to determine the amount of time or miles that such property is inside or outside the United States.

Finally, one comment suggested expanding the definition of transportation property to include parts of transportation property like engines, tires, electronic equipment and spare parts, even if such parts would not otherwise satisfy the foreign use tests for general property. The comment expressed concern that the sale of parts that were included within international transportation property could fail the foreign use test for general property because the parts may enter the United States as part of the transportation property. At the same time, such parts would be ineligible for the special rules for international transportation property. The comment suggested expanding the definition of transportation property to include additional parts, even if such parts would not otherwise satisfy the foreign use tests for general property.

This comment is not adopted. Such a rule would be administratively burdensome and could lead to inconsistency through the application of two sets of rules to the same transaction and property. Furthermore, the Treasury Department and the IRS have determined that the concerns that were the basis for the comment are generally addressed through the adoption of the new general rules with respect to general property and international transportation property. In particular, parts that are used outside the United States by an end user, including when incorporated into transportation property through manufacturing, assembly or other processing, would generally be considered for a foreign use under the general test for general property. As described in part VII.C.1 of this Summary of Comments and Explanation of Revisions section, this is the case even if there is the possibility of some domestic use of the property.

7. Manufacturing, Assembly, or Other Processing Outside the United States

As described in part VII.C.1 of this Summary of Comments and Explanation of Revisions section, the proposed regulations provided that the sale of general property is for a foreign use if either the property is not subject to domestic use within three years of delivery of the property or the property is subject to manufacture, assembly, or other processing outside the United States before any domestic use of the property. See proposed § 1.250(b)-4(d)(2)(i). Under the proposed regulations, general property is subject to manufacturing, assembly, or other processing only if it meets either of the following two tests: (1) There is a physical and material change to the property, or (2) the property is incorporated as a component into a second product. See proposed § 1.250(b)-4(d)(2)(iii)(A).

The proposed regulations clarified that a physical and material change does not include “minor assembly, packaging, or labeling.” See proposed § 1.250(b)-4(d)(2)(iii)(B). Whether property has undergone a physical and material change (as opposed to minor assembly, packaging, or labeling) is determined based on all the relevant facts and circumstances. The proposed regulations provided that general property is incorporated as a component into a second product only if the fair market value of the property when it is delivered to the recipient constitutes no more than 20 percent of the fair market value of the second product, determined when the second product is completed. See proposed § 1.250(b)-4(d)(2)(iii)(C). For purposes of this rule, the proposed regulations included an aggregation rule providing that if the seller sells multiple items of property that are incorporated into the second product, all of the property sold by the seller that is

incorporated into the second product is treated as a single item of property.

Several comments recommended that the final regulations provide more flexibility in satisfying the manufacturing, assembly, or other processing rule, especially in the context of sales to foreign unrelated parties where information to establish the two distinct tests may not be readily available. Several comments suggested that the “physical and material change” test should be satisfied where general property is subject to processing or manufacturing activities that are substantial in nature and that are generally considered to constitute manufacturing or production of a substantially different product. Other comments suggested that the final regulations could provide for such a “substantial in nature” rule as a third test in addition to the “physical and material change” and component tests. Comments also recommended a rebuttable presumption where a taxpayer could show that the physical and material change test had been met through reasonable documentation created in the ordinary course of its business. In addition, these comments suggested that general property sold to an unrelated party can be presumed to be sold for use, consumption, or disposition in the country of destination of the property sold, unless the taxpayer knows, or has reason to know otherwise.

With respect to the component test, comments suggested the 20 percent threshold should function as a safe harbor similar to the safe harbor under the subpart F components manufacturing rule in § 1.954-3(a)(4)(iii). Another comment suggested the addition of a facts and circumstances test. Citing concerns with lack of readily available information, comments further suggested allowing taxpayers to satisfy the 20 percent threshold through market research or other methods similar to the fungible mass rule. Another comment suggested the 20 percent threshold was too low and should be increased to 50 percent. In the case of sales of multiple components by the same seller, comments suggested that the sales should not be integrated unless actual knowledge exists as to where the products will be incorporated (such as knowledge that the product will be included in the same second product or the nature of the component compels inclusion into the second product).

Comments also noted similarities and differences with the manufacturing, assembly, or other processing requirement under FDII and the manufacturing rules under subpart F. In particular, comments pointed out that in the subpart F context, the rules address parties under common control where information is more readily available, while in the FDII context, information may not be available. A CFC's foreign base company sales income does not include income of a CFC derived in connection with the sale of personal property manufactured, produced, or constructed by such corporation. Notably, Treasury regulations provide two special manufacturing rules, often referred to as, the “substantial transformation” test and the “component parts” test. See § 1.954-3(a)(4)(ii) and (iii). Under the first test, if property is “substantially transformed” by the CFC before sale, the property sold is considered manufactured, produced, or constructed by the selling corporation. Under the second test, a sale of property is treated as the sale of a manufactured product, rather than the sale of component parts, if the assembly or conversion of the component parts into the final product by the selling corporation involves activities that are substantial in nature and generally considered to constitute the manufacture, production, or construction of property. A CFC is deemed to have manufactured the product if its conversion costs represent 20 percent or more of the total cost of goods sold.

In response to comments, the final regulations make several changes to the rule for manufacturing, assembly, and other processing. The final regulations clarify that general property is subject to a physical and material change if it is substantially transformed and is distinguishable from and cannot be readily returned to its original state. See § 1.250(b)-4(d)(1)(iii)(B). The final regulations also provide a separate substantive rule for the component test and retain the 20 percent threshold as a safe harbor. See § 1.250(b)-4(d)(1)(iii)(C). Under this substantive rule, general property is a component incorporated into another product if the incorporation of the general property into another product involves activities that are substantial in nature and generally considered to constitute the manufacture, assembly, or other processing of property based on all the relevant facts and circumstances. Id. The final regulations also clarify that general property is not considered a component incorporated into another product if it is subject only to packaging, repackaging, labeling, or minor assembly operations. See id. While the structure and some of the mechanics of the rule share similarities with the subpart F manufacturing component parts test, the rule is different in terms of purpose and substance.

Finally, in response to comments, the final regulations revise the safe harbor in the component test by specifying that the comparison should be between the fair market value of the property sold by the taxpayer and the fair market value of the final finished goods sold to consumers. See § 1.250(b)-4(d)(1)(iii)(C). Because some general property could be incorporated into several different finished goods, the final regulations provide that a reliable estimate of the fair market value of the finished good could include the average fair market value of a representative range of the finished goods that could incorporate the component. An example of this is provided in § 1.250(b)-4(d)(1)(v)(B)(

1

) (

Example 1

). The final regulations also modify the aggregation rule so that it applies only if the seller sells the property to the buyer and knows or has reason to know that the components will be incorporated into a single item of property (for example, where multiple components are sold as a kit). The final regulations specify that a seller has reason to know that the components will be incorporated into a single item of property if the information received as part of the sales process contains information that indicates that the components will be included in the same second product or the nature of the components compels inclusion into the second product. See § 1.250(b)-4(d)(1)(iii)(C).

8. Manufacturing, Assembly, or Other Processing in the United States

Section 250(b)(5)(B)(i) provides that if a seller sells property to another person (other than a related party) for further manufacture or other modification within the United States, the property is not treated as sold for a foreign use even if such other person subsequently uses such property for a foreign use. Section 250(b)(5)(B)(i) could apply in the case of a sale directly to a person that is a foreign person if the property is subject to further manufacture or other modification in the United States after the sale but before the property is delivered to the end user.

As described in the preamble to the proposed regulations, the proposed regulations did not contain specific rules corresponding to section 250(b)(5)(B)(i) because that rule is encompassed within the general rules relating to FDDEI sales in the proposed regulations. The proposed regulations generally provided that general property is not for a foreign use if the property

is subject to a domestic use, which includes manufacture, assembly, or other processing within the United States. See proposed § 1.250(b)-4(d)(2)(i) and (ii)(B).

Because the final regulations no longer define “foreign use” by reference to whether the property is subject to a domestic use, the rule in section 250(b)(5)(B)(i) is no longer encompassed within the general rules in the regulations relating to FDDEI sales. Accordingly, the final regulations include a rule that provides that if the seller sells general property to a recipient (other than a related party, for which separate rules apply) for manufacturing, assembly, or other processing within the United States, such property is not sold for a foreign use even if the requirements for foreign use are subsequently satisfied. See § 1.250(b)-4(d)(1)(iv). For consistency, the final regulations cross reference the rules described in part VII.C.7 of this Summary of Comments and Explanation of Revisions section for the meaning of “manufacturing, assembly, or other processing.”

9. Specific Substantiation for Foreign Use of General Property

The final regulations specifically require a taxpayer to substantiate foreign use for general property for sales of general property to resellers and manufacturers. See § 1.250(b)-4(d)(3)(ii) and (iii). In the case of sales to resellers, a taxpayer must maintain and provide credible evidence upon request that the general property will ultimately be sold to end users located outside the United States. See part VII.C.4 of this Summary of Comments and Explanation of Revisions section. This requirement is satisfied if the taxpayer maintains evidence of foreign use such as the following: a binding contract that limits sales to outside of the United States, proof that the general property is suited only for a foreign market, or proof that the shipping costs would be prohibitively expensive if sold back to the United States. See § 1.250(b)-4(d)(3)(ii)(A)-(C). Certain information from the recipient or a taxpayer with corroborating evidence that credibly supports the information will also suffice. See § 1.250(b)-4(d)(3)(ii)(D)-(E). With respect to manufacturing outside the United States, the substantiation requirements are met if a taxpayer maintains proof that the property is typically not sold to end users without being subject to manufacture, assembly or other processing, obtains credible information from a recipient, or, provides a statement containing certain information with corroborating evidence. See § 1.250(b)-4(d)(3)(iii).

D.

Foreign Use of Intangible Property

1. In General

The proposed regulations provided that a sale of intangible property (which includes a license or any transfer of such property in which gain or income is recognized under section 367) is for a foreign use to the extent revenue is earned from exploiting the intangible property outside the United States. See proposed § 1.250(b)-4(e)(1). Where the revenue is considered earned is generally determined based on the location of the end user. See proposed § 1.250(b)-4(e)(2). The seller of the intangible property must satisfy certain documentation requirements showing foreign use and have no knowledge, or reason to know, that the portion of the sale of the intangible property for which the seller establishes foreign use is not for foreign use. The proposed regulations also provided rules to determine foreign use for the sale of intangible property to a foreign person in exchange for periodic payments or a lump sum payment. See proposed § 1.250(b)-4(e)(2).

2. Substantiating Foreign Use of Intangible Property

Several comments recommended changes to the documentation rules. In response to those comments, and as explained in part II of this Summary of Comments and Explanation of Revisions section, the final regulations adopt a more flexible approach to documentation, but require a taxpayer to specifically substantiate foreign use for sales of intangible property. See § 1.250(b)-4(d)(3)(iv). A taxpayer must maintain and provide credible evidence upon request that a sale of intangible property will be used to earn revenue from end users located outside the United States. A taxpayer may satisfy the substantiation requirement by maintaining certain items as specified in the final regulations. See § 1.250(b)-4(d)(3)(iv). For example, a binding contract providing that the intangible property can be exploited solely outside the United States would generally satisfy the substantiation requirements demonstrating foreign use of the intangible property. See § 1.250(b)-4(d)(3)(iv)(A). Certain information from the recipient obtained or created in the ordinary course of business or corroborating evidence maintained by the taxpayer that credibly supports the information may also suffice. See § 1.250(b)-4(d)(3)(iv)(B)-(C).

3. Determining Foreign Use of Intangible Property

Comments suggested that sales with respect to intangible property be divided into several subcategories. One comment suggested dividing intangibles into production and marketing categories, with income from sales of production intangibles used in the development or manufacture of products outside the United States being FDDEI sales regardless of the location of the end user, and income from sales of marketing intangibles analyzed based on the location of the end user. Another comment suggested three subcategories of intangible sales: (i) Sales of manufacturing intangibles to foreign unrelated parties, which would be considered for a foreign use if manufacturing occurs outside the United States; (ii) sales of manufacturing intangibles to related parties, which would be considered for a foreign use if the end product is sold to a foreign person for foreign use; and (iii) sales of marketing intangibles, which would be considered for a foreign use if the end user purchases the resulting product outside the United States.

Consistent with the proposed regulations, the final regulations provide that foreign use of intangible property is determined based on revenue earned from end users located within versus outside the United States. See § 1.250(b)-4(d)(2)(i). The focus on the location of end users is derived from the requirement in section 250(b)(5)(A) that sales for a foreign use require “use” or “consumption” outside the United States and the end user is the person that ultimately consumes or uses the intangible property. In the case of legally protected intangible property (such as patents or trademarks), the location in which legal rights to the intangible property are granted and exploited generally determines the location of the end users. Therefore, for example, in the case of intangible property such as patents that provide rights only for markets outside the United States, the end users will generally be located solely outside the United States. In the case of intangible property that allows for worldwide exploitation (or intangible property that is not legally protected), a more specific determination of end users will generally be necessary to determine the portion of intangible property income that is for a foreign use versus not for a foreign use.

In response to the comments received, the final regulations provide more detailed guidance on determining where

revenue is earned from end users of the intangible property, including rules for intangible property embedded in general property or used in connection with the sale of general property, intangible property used to provide services, and intangible property used in research and development. See § 1.250(b)-4(d)(2)(ii). The final regulations also include rules for determining revenue earned from sales of a manufacturing method or process, which is similar to the separate rule for “production intangibles” or “manufacturing intangibles” that was suggested by comments.

Revenue is generally earned from intangible property used to manufacture products or provide services through sales of such products or services, or from limited use licenses of the intangible property, whether those sales, services, or limited use licenses are executed by an owner, licensee, or sub-licensee of the intangible property. Until revenue is earned from sales, services, or limited-use licenses to the end user that ultimately consumes the property or receives the service, the intangible property is generally not “exploited.” Consistent with this view, the final regulations generally place the location of use of the intangible property with the location of the end user, which is generally the person who ultimately uses the general property in which the intangible property is embedded or associated with, or, if the intangible property is used to provide a service, the service recipient. See § 1.250(b)-4(d)(2)(ii)(A) and (B). These rules provide the same determination of location of end user for sales or licenses of intangible property used in research and development. See § 1.250(b)-4(d)(2)(ii)(D).

4. Intangible Property Used in Manufacturing

The preamble to the proposed regulations requested comments regarding whether to adopt a rule for intangible property similar to proposed § 1.250(b)-4(d)(2)(i)(B) (treating a sale of general property as for a foreign use if the property is subject to manufacturing, assembly, or other processing outside the United States). Several comments supported a rule that treats the sale of intangible property as for a foreign use where intangibles are used in manufacturing that takes place outside the United States. Some of the comments also suggested that footnote 1522 of the Conference Report to the Act supported this position because that footnote did not specify that its application is limited to only tangible property that is subject to manufacturing, assembling, or other processing outside the United States.

6

6

See H. Rept. 115-466, at 625, fn. 1522 (2017) (Conf. Rept.) (“If property is sold by a taxpayer to a person who is not a U.S. person, and after such sale the property is subject to manufacture, assembly, or other processing (including the incorporation of such property, as a component, into a second product by means of production, manufacture, or assembly) outside the United States by such person, then the property is for a foreign use.”).

Based on comments received, the final regulations provide a special rule for sales to a foreign unrelated party of a manufacturing method or process or for know-how used to put the manufacturing method or process to use in manufacturing (the “manufacturing method or process rule”). See § 1.250(b)-4(d)(2)(ii)(C). The final regulations provide that when this rule applies, then the foreign unrelated party is treated as an end user located outside the United States, unless the seller knows or has reason to know that the manufacturing method or process will be used in the United States, in which case the foreign unrelated party is treated as an end user located within the United States. For purposes of this rule, reason to know is determined based on the information received from the recipient during the sales process. See § 1.250(b)-4(d)(2)(ii)(C)(

1

).

The manufacturing method or process rule does not apply to sales or licenses of a manufacturing method or process to an unrelated foreign party for purposes of manufacturing products for or on behalf of the seller of the manufacturing method or process or any of the seller's affiliates. See § 1.250(b)-4(d)(2)(ii)(C)(

2

). Applying the manufacturing method or process rule to determine the end user with respect to such an arrangement, such as a contract or toll manufacturing arrangement, is not appropriate because the seller or related party to the seller is using the manufacturing method or process in manufacturing for itself. Such use by the seller is effectively a circular transfer of the intangible property back to the seller. However, the sale of the manufactured products by the seller of the manufacturing method or process or the seller's affiliates can still qualify as a FDDEI sale under other provisions such as § 1.250(b)-4(d)(1)(ii).

The manufacturing method or process rule applies only to certain types of intangibles that are used in the manufacturing process. The distinction between the types of intangibles that qualify for this rule and other types of intangibles that may be used by manufacturers is based on a distinction between use of a patented method or process and use of other types of patented items. In all other cases, the foreign use of intangible property is determined based on revenue earned from end users located within versus outside the United States.

The manufacturing method or process rule applies only to sales to unrelated parties (including sales made through related parties that ultimately result in a sale of the manufacturing method or process to an unrelated party). Section 250(b)(5)(C) provides that sales to related parties are treated as for a foreign use only if the property is ultimately sold or used in connection with property that is sold to an unrelated party who is not a United States person. While § 1.250(b)-6(c) gives effect to this rule by providing special rules for sales of general property to related parties (which apply in the case of sales of property to related parties for further manufacturing), those rules do not apply to sales of intangible property. Under the proposed regulations, a related party rule was not needed for sales of intangible property, including property consisting of a manufacturing method or process, because the proposed regulations generally provided that intangible property used in the manufacture of a product is treated as exploited at the location of the end user when the product is sold to the end user. Proposed § 1.250(b)-4(e)(2)(i). Under the final regulations, limiting the manufacturing method or process rule to unrelated party sales serves the purpose of ensuring that such sales are FDDEI sales only to the extent contemplated by section 250(b)(5)(C). For example, if the taxpayer sells to a foreign related party a manufacturing method used to produce general property, then the sale of the manufacturing method is for a foreign use to the extent that the foreign related party's sales of the general property are for a foreign use under the rules applicable to sales of general property. See § 1.250(b)-4(d)(2)(ii)(A). This result is generally consistent with the result if the related party sale had instead been of general property that was used in manufacturing.

5. Bundled Intangible Property

One comment requested that where a taxpayer licenses a bundle of intangibles, it should be allowed to elect the application of the potentially applicable rules based either on the predominant feature of the bundle or using any reasonable method. The Treasury Department and the IRS recognize that intangible property is sometimes sold or licensed as a bundle, such as the license of patents, copyrights, trademarks, tradenames, and

know-how in a single transaction, without specifying the amount of payment required for each item of intangible property. The final regulations provide for a predominant character determination when a transaction has multiple elements, such as a service and sale or a sale of general property and intangible property, to determine whether to apply the provisions for sales of general property, sales of intangible property, or the provision of services. See § 1.250(b)-3(d).

In the case of a sale or license of bundled intangible property, the final regulations will generally base the location of exploitation on the location of the end user who ultimately uses the general property in which the intangible property is embedded or associated with, or, if the intangible property is used to provide a service, the location of the service recipient. See § 1.250(b)-4(d)(2)(ii)(A)-(B), (D). Only in an unrelated party transaction involving the manufacturing method or process rule will the end user location be determined differently than a transaction involving intangible property used with general property, services, or research and development. However, the manufacturing method or process rule does not determine the location of the end user of other intangible property bundled with the manufacturing method or process. As a result, the final regulations do not provide for an election to treat or characterize the sale or license of bundled intangible property that includes manufacturing method or process intangibles as well as other intangible property as falling entirely within one of the categories of intangible property specified in § 1.250(b)-4(d)(2).

6. Treatment of Product Intangibles as Components

One comment suggested that the final regulations include a rule that would treat certain “product intangibles” as a component of the finished product and provide a rule that is analogous to the rule for sales of general property that is incorporated as a component of another product outside the United States. See § 1.250(b)-4(d)(1)(iii)(A) and (C). The final regulations do not adopt this comment. Intangible property has no physical properties, and therefore cannot be incorporated into a finished good or otherwise be a “component” of the finished good in the same way as items of general property that are considered to be components. See section 367(d)(4) (defining intangible property). For example, a patent on an article of manufacture is not a component of the finished product protected by the patent. Similarly, while a trademark design may be placed on a component of a finished product, the trademark itself is not a component of the finished product. Therefore, the final regulations do not provide a component rule for the sale or license of intangible property. Instead, the general rule that use is determined based on where the intangible property is exploited applies to these types of sales.

7. Intangible Property Used To Enhance Other Intangible Property

One comment discussed intangibles that are sold to an unrelated foreign person who enhances the intangible (for example, by adapting it to local markets) or uses the intangible property to develop other intangible property and subsequently sells such enhanced or newly created intangible property outside the United States. In these situations, the comment recommended that the sale of the original intangible property should be presumed to be for foreign use if the location of the research and development is outside the United States and the recipient is unrelated to the original seller, and suggested that footnote 1522 of the Conference Report supports such a rule.

The final regulations do not adopt the comment. As discussed in part VII.D.3 of this Summary of Comments and Explanation of Revisions section, revenue is generally earned from intangible property used to manufacture products or provide services through sales of such products or services, or from limited use licenses of the intangible property, whether those sales, services, or limited use licenses are executed by an owner, licensee, or sub-licensee of the intangible property. Until revenue is earned from sales, services, or limited-use licenses to the end user that ultimately consumes the property or receives the service, the intangible property is generally not “exploited.” Although the final regulations provide a limited exception from this end user requirement for intangible property that consists of a manufacturing method or process (see part VII.D.4 of this Summary of Comments and Explanation of Revisions section), no exception is included for intangible property used to enhance or create other intangible property. The Treasury Department and the IRS have determined that the activities described in the comment do not constitute “use” by end users but rather are intermediate steps in the development of the intangible property before being exploited and used. In addition, nothing in the text of section 250 or footnote 1522 of the Conference Report suggests that a different definition of foreign use should apply in the case of research and development.

However, in response to comments, the final regulations clarify the rule for sales of intangible property used to develop other intangible property or to modify existing intangible property. See § 1.250(b)-4(d)(2)(ii)(D). In such a case, the end user of the intangible property (primary IP) used to develop other intangible property or to modify existing intangible property (secondary IP) is the end user of the property in which the secondary IP is embedded. If the secondary IP is used to provide a service, the end user is the unrelated party recipient. If the secondary IP qualifies as a manufacturing method or process (as described in part VII.D.4 of this Summary of Comments and Explanation of Revisions section), then the rules applicable to sales of a manufacturing method or process apply to determine if the sale of the secondary IP is for a foreign use. See § 1.250(b)-4(d)(2)(ii)(C).

8. Intangible Property Used To Provide Services

One comment noted that intangible property may be sold to recipients that provide services, rather than solely to recipients that manufacture and sell goods, and that the proposed regulations did not specifically address the sale of intangible property used to provide services. For such sales, the comment recommended that the intangible property be treated as exploited in the locations in which the recipient receives legal rights to the intangible property under the terms of the contract or other applicable law. Another comment recommended that for sales of intangible property to unrelated persons for use in the provision of services, the sales should be presumed to be for foreign use if the services will be performed outside the United States without regard to the location of the person or persons receiving such services.

Revenue may be earned from intangible property through the provision of services, but until that revenue is earned, the intangible property is generally not used or “exploited.” Consistent with this view, the final regulations generally place the location of use of the intangible property with the location of the end user, which in the case of intangible property used to provide a service, is the service recipient. See § 1.250(b)-4(d)(2). These rules are generally consistent with the location in which legal rights to the intangible property

are granted and exploited, with exploitation generally being located where the end user ultimately consumes the property or the services the intangible property is used to provide. See § 1.250(b)-4(d)(2)(i). The rules in § 1.250(b)-5 for FDDEI services generally apply for purposes of determining the location of the end user. Therefore, for example, the location of the end user of intangible property that is used to provide advertising services is determined based on the location of the individuals viewing the advertisements. See § 1.250(b)-5(e)(2)(ii).

However, the regulations do not provide a presumption that a sale to a foreign unrelated party that uses that intangible property to provide services outside the United States is presumed to be for foreign use. Such a presumption could produce results that would be inconsistent with the general approach for determining the location of use of intangible property by reference to the location of exploitation (which, in the case of intangible property used to provide services, is generally the location of the person or persons receiving such services), and the Treasury Department and the IRS have determined that a departure is not warranted in this case.

9. Determination of Revenue

The proposed regulations provided that when intangible property is sold in exchange for periodic payments, the extent to which the sale qualifies for a foreign use is made annually based on actual revenue earned by the recipient. Proposed § 1.250(b)-4(e)(2)(ii). In the case of a sale of intangible property in exchange for a lump sum payment, the extent to which the sale qualifies for foreign use is determined based on the ratio of total net present value the seller would have reasonably expected to earn from exploiting the intangible property outside the United States to total net present value the seller reasonably expected to earn from exploiting the intangible property worldwide. Proposed § 1.250(b)-4(e)(2)(iii). However, for purposes of satisfying the documentation requirements, the proposed regulations provided that in the case of sales in exchange for periodic payments that are not contingent on the revenue or profit of a foreign unrelated party, a taxpayer may establish the extent to which a sale of intangible property is for a foreign use using the principles applicable to sales in exchange for a lump sum payment, except that the taxpayer must make projections on an annual basis. See proposed § 1.250(b)-4(d)(3)(ii). This rule recognized that if the recipient of the intangible property makes periodic payments that are not contingent on the recipient's sales or revenue, the recipient may not be willing to provide information about the end users of the intangible property.

a. Periodic Payments

Like the proposed regulations, the final regulations provide that for periodic payments (such as annual royalty payments or fixed installment payments) in exchange for rights to intangible property, other than intangible property consisting of a manufacturing method or process that is sold to a foreign unrelated party, taxpayers may estimate revenue earned by unrelated party recipients from any use of the intangible property based on the principles for determining revenue from lump sum sales, if actual revenue earned by the foreign party cannot be obtained after reasonable efforts. See § 1.250(b)-4(d)(2)(iii)(A). While the proposed regulations required estimated revenue to be determined on an annual basis when a taxpayer relies on this rule, the final regulations eliminate this requirement. The Treasury Department and the IRS have determined that when estimated revenue earned by unrelated party recipients must be used, information available at the time of the sale will be more reliable than information available subsequently. In addition, eliminating the requirement to determine estimated revenue annually reduces the administrative burden on the taxpayer. See § 1.250(b)-4(d)(2)(iii)(A).

b. Lump Sum Payments

One comment recommended that the seller be allowed to use revenue the recipient (rather than the seller) earns or expects to earn from use of the intangible property to determine the extent to which a sale of intangible property in exchange for a lump sum payment qualifies for foreign use because using the recipient's expected or actual revenue is more accurate for determining foreign use. The comment acknowledges the administrative difficulty inherent in determining foreign use in the case of sales of intangible property for a lump sum payment and in obtaining actual or expected revenue data from the recipient.

In response to the comment, the final regulations allow taxpayers to use net present values using reliable inputs, which may include net present values of revenue that the recipient expected to earn from the exploitation of the intangible property within and outside the United States if the seller obtained such revenue data from the recipient near the time of the sale and such revenue data was used to negotiate the lump sum price paid for the intangible property. See § 1.250(b)-4(d)(2)(iii)(B). In determining whether such inputs are reliable, the extent to which the inputs are used by the parties to determine the sales price agreed to between the seller and a foreign unrelated party purchasing the intangible property will be a factor. The final regulations do not allow for use of actual revenue earned by the recipient from the use of the intangible property in a lump sum sale because actual revenue earned by the recipient for all the years the recipient uses the intangible property will not be known when the seller files its tax return for the tax year in which the sale of the intangible property occurred.

c. Payments for Manufacturing Method or Process

With respect to sales to a foreign unrelated party of intangible property consisting of a manufacturing method or process, the final regulations provide that the revenue earned from the end user is equal to the amount received from the recipient in exchange for the manufacturing method or process. See § 1.250(b)-4(d)(2)(iii)(C). In the case of a bundled sale of intangible property consisting of a manufacturing method or process and other intangible property, the value of the manufacturing method or process relative to the total value of the intangible property must be determined using the principles of section 482.

E. Treatment of Certain Hedging Transactions

Several comments recommended that gain or loss from certain hedging transactions with respect to commodities be considered gain or loss from sales of general property. In support, the comments noted that the Federal income tax treatment of certain hedging transactions (for example, character and timing) corresponds to the treatment of the underlying physical transaction. Comments noted that these rules exist, in part, because the combined value of the hedging transaction and the underlying physical transaction generally reflects a taxpayer's true economic exposure to the underlying physical commodity. Consistent with that approach and rationale, these comments recommended a similar approach for purposes of determining FDDEI sales income.

The Treasury Department and the IRS agree that certain hedging transactions

should be treated in a manner that is similar to the treatment of the commodities hedged by those transactions. Furthermore, the Treasury Department and the IRS have determined that the adjustment for qualified hedging transactions should apply to all general property, rather than only commodities. Hedges of property other than commodities have the same economic effect as hedges of commodities, such that the rationale for determining FDDEI sales income from hedges by reference to hedges of commodities applies equally to other types of property. Accordingly, the final regulations generally provide that a corporation's or partnership's gross income resulting from FDDEI sales of general property is adjusted by reference to certain hedging transactions. See § 1.250(b)-4(f). The hedging transaction must meet the requirements of § 1.1221-2, including the identification requirement under § 1.1221-2(f), the transaction must hedge price risk or currency fluctuation with respect to ordinary property, and the property being hedged must be general property that is sold in a FDDEI sale. The Treasury Department and the IRS are considering issuing more detailed guidance on hedging transactions in the form of future proposed regulations. Comments are requested on this topic.

VIII. Comments on and Revisions to Proposed § 1.250(b)-5—FDDEI Services

Section 250(b)(4)(B) provides that FDDEI includes income from services provided by a domestic corporation to any person, or with respect to property, not located within the United States. Section 250 does not prescribe rules for determining whether a person or property is “not located within the United States.” Accordingly, proposed § 1.250(b)-5 provided rules for determining whether a service is provided to a person, or with respect to property, located outside the United States.

A.

Categories of Services

The proposed regulations separated all services into five mutually exclusive and comprehensive categories: general services provided to consumers, general services provided to business recipients, proximate services, property services, and transportation services. See proposed § 1.250(b)-5(b). Whether a service is a FDDEI service is determined under the rules relevant to the applicable category.

One comment requested that the final regulations address how “digital services” are treated and classified under the FDDEI services regulations, although no recommendation was provided. Another comment requested more guidance on the application of the rules for general services to business recipients in the software-as-a-service context.

In response to these comments, the final regulations provide additional guidance, as described in parts VIII.B.1 and VIII.B.2.c of this Summary of Comments and Explanation of Revisions section, with respect to services that are “electronically supplied.” Services that are provided electronically typically will be categorized as general services because they will not meet the definitions of proximate services, property services, or transportation services. To provide additional guidance for determining the location of the recipients of services that are electronically supplied, the final regulations create a new category of general services defined as “electronically supplied services,” which includes general services (other than advertising services, described in the following sentence) that are delivered over the internet or an electronic network. See § 1.250(b)-5(c)(5). In addition, the final regulations create a new subcategory of general services for advertising services, including advertising services to display content via the internet, and provide additional guidance with respect to these services as described in part VIII.B.2.c of this Summary of Comments and Explanation of Revisions section. See § 1.250(b)-5(c)(1).

B.

General Services

1. General Services Provided to Consumers

The proposed regulations provided that a consumer is located where the consumer resides when the service is provided and required documentation to establish the place of residence. See proposed § 1.250(b)-5(d)(2) and (3). Special rules for small transactions or small taxpayers allowed the taxpayer to establish the consumer's location using the taxpayer's billing address for the consumer. See proposed § 1.250(b)-5(d)(3)(ii).

Comments suggested that rather than limiting taxpayers to a finite list of documentation, the rules should allow taxpayers to support the status of the consumer as a person located outside the United States using documentation that is collected in the ordinary course of the taxpayer's trade or business.

As discussed in part II of this Summary of Comments and Explanation of Revisions section, the final regulations adopt a more flexible approach to documentation requirements compared to the proposed regulations. While the final regulations include specific substantiation requirements for certain elements of the regulations, no such rules are provided for general services to consumers. Furthermore, to minimize the burden associated with determining the residence of consumers, the final regulations provide that if the renderer does not have (or cannot after reasonable efforts obtain) the consumer's location of residence when the service is provided, the consumer of a general service is treated as residing outside the United States if the consumer's billing address is outside of the United States. See § 1.250(b)-5(d)(1). However, this rule does not apply if the renderer knows or has reason to know that the consumer does not reside outside the United States. The final regulations clarify that “reason to know” is determined based only on whether the information received as part of the provision of the service contains information that indicates that the consumer resides in the United States. Because this rule applies to all services provided to consumers (with the modification for electronically supplied services described in the next paragraph), the final regulations do not provide a special rule for small transactions or small taxpayers.

With respect to electronically supplied services that are provided to consumers, the final regulations provide that the consumer is deemed to reside at the location of the device used to receive the service, which may be an IP address, if available. However, if the renderer cannot determine the location of that device after reasonable efforts, the general rule based on billing address applies, subject to the renderer not knowing or having reason to know that the consumer does not reside outside the United States.

2. General Services Provided to Business Recipients

The proposed regulations determined the location of a business recipient based on the location of its operations, and the operations of any related party of the recipient, that receive a benefit (as defined in § 1.482-9(l)(3)) from such service. See proposed § 1.250(b)-5(e)(2) and (4). The proposed regulations provided that a service is generally provided to a business recipient located outside the United States to the extent that the renderer's gross income from providing the service is allocated to the business recipient's operations outside the United States. See proposed § 1.250(b)-5(e)(2)(i). Where the service

confers a benefit on the operations of the business recipient in specific locations, the proposed regulations provided that gross income of the renderer is allocated based on the location of the operations in specific locations that receive the benefit. See proposed § 1.250(b)-5(e)(2)(i)(A). Where a service confers a benefit on the recipient's business as a whole, or where reliable information about the particular portion of the operations that specifically receive a benefit from the service is unavailable, the proposed regulations provided that the service is deemed to confer a benefit on all of the business recipient's operations. See proposed § 1.250(b)-5(e)(2)(i)(A). For purposes of this rule, a business recipient is treated as having operations in any location where it maintains an office or other fixed place of business. See proposed § 1.250(b)-5(e)(2)(ii). The proposed regulations also required a taxpayer to obtain documentation sufficient to establish the location of a business recipient's operations that benefit from the service. See proposed § 1.250(b)-5(e)(1) and (3). Under the proposed regulations, special rules for small transactions or small taxpayers allowed the taxpayer to establish the consumer's location using the taxpayer's billing address for the consumer. See proposed § 1.250(b)-5(e)(3)(ii).

a. Operations of a Business Recipient of General Services

Several comments requested clarification regarding the definition of a business recipient's operations. Some comments requested that the rule be expanded to include operations performed outside of the locations where the business recipient maintains an office or other fixed place of business. For example, where business recipients operate satellites or vessels, the comment suggested that business recipients should be treated as having operations at the location of the satellite or vessel.

The location of a business recipient's operations that benefit from a general service is based on the geographical location where the business recipient's activities are regular and continuous and is not based on the current location of mobile property such as satellites or vessels. Moreover, as noted in the next paragraph, the final regulations clarify that an office or other fixed place of business is a fixed facility through which the business recipient engages in a trade or business. See § 1.250(b)-5(e)(3)(i). In the case of services performed with respect to a satellite, the location of the business recipient that receives services with respect to the satellite is based on where the business recipient remotely performs activities with respect to the satellite (which could be within the United States or in a foreign country), rather than in space. In addition, services performed with respect to a vessel owned by a business recipient may qualify as proximate services or property services, depending on the nature of the services. Therefore, no further changes to the regulations are necessary to respond to the comment.

One comment requested further clarification of the term “fixed place of business,” such as whether it has the same meaning as it does for section 864(c) purposes. The comment did not specify whether using the meaning that the term has for section 864(c) purposes would be appropriate. However, the Treasury Department and the IRS have determined that it would not be appropriate to adopt the definition that applies for purposes of section 864(c). Because the final regulations define a business recipient as including all related parties of the recipient, whereas section 864(c) applies on a taxpayer-by-taxpayer basis, adopting the definition of an office or other fixed place of business that is in § 1.864-7 would cause confusion. However, the final regulations clarify that an office or other fixed place of business is a fixed facility, that is, a place, site, structure, or other similar facility, through which the business recipient engages in a trade or business. See § 1.250(b)-5(e)(3)(i). In addition, the final regulations provide that for purposes of determining the location of the business recipient, the renderer may make reasonable assumptions based on the information available to it. The Treasury Department and the IRS recognize that taxpayers may not be able to obtain precise information about unrelated business recipients; therefore, the final regulations allow taxpayers to make reliable assumptions based on the information available to them. See id.

One comment requested guidance on how to determine the location of operations of a business recipient that does not have an office or fixed place of business. As an example, this could occur when the business recipient is a partnership that does not itself have any offices or employees but is managed by one or more of its partners. The comment suggested that in these circumstances, the final regulations presume that the business recipient has operations where it is formed or incorporated.

To address this comment, the final regulations provide that if the business recipient does not have an identifiable office or fixed place of business (including the office of a principal manager or managing owner), the business recipient is deemed to be located at its primary billing address. See § 1.250(b)-5(e)(3)(iii). The Treasury Department and the IRS considered using place of formation or place of incorporation, but determined that a business recipient's billing address is generally available to the renderer and often bears a closer connection to the business recipient's location of actual operations.

Finally, for the sake of concision, the final regulations expand the definition of a “business recipient” to include all related parties (as defined in § 1.250(b)-1(c)(19)) of the recipient. Compare § 1.250(b)-5(c)(3) with proposed § 1.250(b)-5(e)(4) (the latter providing, in a separate paragraph, that a reference to a business recipient includes a reference to any related party of the business recipient). However, to avoid circularity in circumstances where the business recipient is a related party of the taxpayer, in these circumstances, the term “business recipient” does not include the taxpayer. See § 1.250(b)-5(c)(3).

b. The Meaning of “Benefit”

One comment expressed concern that the proposed regulations' reliance on the principles of § 1.482-9(l)(3), which explains when an activity is considered to provide a “benefit” to a recipient, would be difficult to apply outside the related party context because the renderer may not have the information necessary to perform a detailed analysis of the recipient's operations. The comment suggests that transfer pricing standards should not be applied to evaluate transactions for purposes of section 250. The comment suggested that the term “benefit” should retain the reference to § 1.482-9(l)(3), but that the regulations should include a presumption that a general service provided to a foreign person benefits operations located outside the United States.

The Treasury Department and the IRS do not intend that the reference to § 1.482-9(l)(3) in the definition of “benefit” be interpreted as suggesting that taxpayers are required to perform a transfer pricing-like analysis of the recipient's operations. Rather, the reference is intended to clarify, using a concept that is based on existing tax principles, that a service confers a benefit on operations of a recipient only if an uncontrolled party with similar operations would pay for the service under comparable circumstances. For example, if a service benefits particular operations of a business recipient so

indirectly or remotely that an unrelated party with similar operations would not pay for the service, the service does not confer a benefit on those operations. See § 1.482-9(l)(3)(ii). Accordingly, the final regulations retain the reference to § 1.482-9(l)(3) in defining “benefit.”

One comment also requested clarification regarding the types of benefits that must be considered in determining the location of the business recipient of a general service. The comment gives the example of a U.S. financial advisor providing advice to a foreign parent that is expected to increase the value of the foreign parent's publicly traded stock, which would also benefit any U.S. subsidiaries by making their equity-based compensation more valuable. The implication of the comment is that it is unclear whether the U.S. subsidiaries receive a compensable benefit from the service provided because their employees are also shareholders of the foreign parent.

As noted, the reference to § 1.482-9(l)(3) in the definition of “benefit” is intended to provide clarity on the meaning of “benefit” using a concept that is based on existing tax principles. As described in the previous paragraph, under § 1.482-9(l)(3)(ii), an activity is not considered to provide a “benefit” within the meaning of § 1.482-9(l)(3) if the benefit to the recipient is “so indirect or remote” that the recipient would not be willing to pay an uncontrolled party to perform a similar activity. Accordingly, in fact patterns such as the one described in the comment (where the service potentially confers a benefit on a related party of the recipient if the employees of the related party are also shareholders of the recipient), taxpayers must determine whether a related party with employees that are shareholders of a company would generally pay a financial advisor to provide advice to the company or whether the benefit to the related party is too indirect or remote. Section 1.482-9(l) provides comprehensive guidance, including twenty-one examples, to assist taxpayers in understanding when an activity is considered to confer a benefit on a party other than the direct recipient. Accordingly, the comment is not adopted.

c. Determining the Locations of the Business Recipient's Operations That Benefit From General Services

Several comments addressed the proposed regulations' rule for determining the location of the recipient of general services that benefits from the service. See proposed § 1.250(b)-5(e)(2). One comment suggested that the final regulations include language included in the preamble to the proposed regulations stating that for purposes of this rule, “the location of residence, incorporation, or formation of a business recipient is not relevant.” The final regulations adopt this comment. See § 1.250(b)-5(e)(1).

Several comments indicated that it would be difficult, if not impossible, for taxpayers to obtain information regarding which of a business recipient's locations benefits from a service. While the proposed regulations allowed taxpayers in these circumstances to assume that the services will benefit all of the business recipient's operations ratably, several comments suggested that this simplification was not sufficient. Several comments stated that these difficulties could be alleviated by making the transition rule in proposed § 1.250-1(b) permanent or by making the rules applicable to small businesses and small transactions available to all taxpayers. Several comments requested that the final regulations incorporate certain presumptions to simplify the rule, such as a presumption that any operations of the service recipient that are not known to be (or ident

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