The US Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) have issued highly anticipated guidance (the Final Regulations) regarding the substantiation requirements necessary to claim a section 250 deduction with respect to foreign-derived intangible income. The Final Regulations significantly modified the proposed documentation requirements issued in March 2019 (the Proposed Regulations), generally allowing taxpayers more flexibility to substantiate their transactions as for foreign use. The Final Regulations also expanded the transition rule set forth under the Proposed Regulations, thereby allowing taxpayers to rely on the current taxpayer-friendly standard until the Final Regulations are effective.
On July 9, 2020, the Treasury and the IRS issued final section 250 regulations that address, among other items, the substantiation requirements that a taxpayer must satisfy to take a section 250 deduction on its foreign-derived intangible income (FDII).
Generally, taxpayers must meet „foreign use“ requirements to the satisfaction of the Secretary of the Treasury to claim a FDII benefit. A seller of property must establish that the property is sold to a foreign person for a foreign use; a renderer of services must establish that the services are provided to a person (or with respect to property) that is not located in the United States. The Final Regulations largely relaxed the rules that govern the documentation necessary to satisfy these requirements. Except for certain transactions, the Final Regulations generally do not require any specific documentation, instead allowing taxpayers to presume foreign person status and claim a FDII benefit so long as they can substantiate they are entitled to the section 250 deduction under section 6001 and its regulations. In the case of certain transactions, the Final Regulations still require specific substantiation, but are generally more flexible regarding the specificity and reliability of required documentation.
Specific Substantiation Requirements
The Final Regulations provide specific substantiation rules with respect to sales of general property to recipients other than end users (including property for resale and manufacturing), sales of intangible property and general services provided to business recipients. (See: Treas. Reg. § 1.250(b)–3(f).) The preamble to the Final Regulations (the Preamble) states that in these transactions, there is higher potential for mischaracterization regarding foreign use, because the facts needed to substantiate a deduction are typically held by a third party as opposed to the taxpayer. For example, the Preamble expresses concern that without specific substantiation requirements, taxpayers that sell finished goods to foreign resellers would not be able to confirm that the resellers did not immediately sell such property back into the United States, thereby frustrating the purpose of the statute. Similarly, the Preamble states that without specific substantiation requirements, taxpayers that provide services to multinational companies with operations inside and outside the United States would not be able to confirm that their services did not benefit the recipient’s US operations.
As a result, Treasury and IRS determined that for these transactions, specific substantiation requirements were necessary to establish foreign use. However, these specific substantiation requirements as revised are generally more flexible regarding what types of corroborating evidence may be used, and in all cases allow for taxpayers to satisfy the substantiation requirement through: (i) a specific document; (ii) credible evidence obtained from the recipient in the ordinary course of business; or (iii) a written statement prepared by the taxpayer, so long as the statement is corroborated by sufficient supporting evidence of the taxpayer’s choice. Taxpayers‘ ability to rely upon written statements based upon their own internal information, such as how much time they spend working with each of the recipient’s offices (in the case of general services to business recipients), will in some cases be a welcome relief.
Sale of General Property for Resale Under Treas. Reg. § 1.250(b)–4(d)(3)(ii), a seller of general property for resale must maintain one or more of the following types of information to substantiate foreign use: (i) a binding contract expressly limiting subsequent sales to outside the United States; (ii) proof that property is specifically designed, labeled or adapted for foreign use; (iii) proof that shipping costs back into the United States are impractical; (iv) credible evidence obtained or created in the ordinary course of business from the recipient establishing that the property will be sold to an end user outside the United States; or (v) a written statement describing, among other things, how the seller determined that the property will ultimately be sold to an end user outside the United States.
Sale of General Property for Further Manufacturing Sellers of general property for further manufacturing, assembly or processing outside the United States are limited to the following substantiating items: (i) credible evidence that the property has been sold to a foreign unrelated party that is a manufacturer, and that it cannot be sold to end users without undergoing physical and material change; (ii) credible evidence obtained or created in the ordinary course of business from the recipient that the property will be subject to manufacture, assembly or other processing outside the United States; or (iii) a written statement describing, among other things, how the seller determined that the general property was substantially transformed and, if applicable, that the general property does not exceed twenty percent of the fair market value of the finished goods. (See: Treas. Reg. § 1.250(b)–4(d)(3)(iii).)
Sales and Licenses of Intangible Property To substantiate that intangible property is sold or licensed for foreign use, taxpayers must maintain one or more of the following substantiating items: (i) a binding contract expressly providing that the intangible property can be exploited solely outside the United States; (ii) credible evidence obtained or created in the ordinary course of business from the recipient establishing what portion of its revenue for the taxable year was derived from exploiting the intangible property outside the United States; or (iii) a written statement describing, among other things, how the seller determined (a) the non-US portion of the sale; (b) for periodic payments, the extent of foreign use based on actual revenue earned by the recipient or, if unavailable, an explanation of why such information was unavailable and how the seller determined the extent of foreign use based on estimated revenue; and (c) for lump sum payments, how the seller determined the net present value of expected revenue both inside and outside the United States. (See: Treas. Reg. § 1.250(b)–4(d)(3)(iv).)
Rendering General Services to Business Recipients Finally, a renderer of general services to business recipients must maintain either: (i) credible evidence obtained or created in the ordinary course of business from the recipient establishing the extent to which the non-US operations of the business recipient benefit from the service; or (ii) a written statement explaining, among other things, how the renderer determined what portion of the service will benefit the recipient’s non-US operations, including by potentially relying upon information such as the amount of time that the taxpayer works with each of the recipient’s offices. (See: Treas. Reg. § 1.250(b)–5(e)(4).) Notably, the Preamble confirms that taxpayers that rely upon credible information provided by the recipient will not need the recipient to specify which of its locations benefit from the service—for example, whether the services benefit the recipient’s European operations or its Asian operations—so long as they specify the portion that benefits non-US operations more generally.
Other Changes to the Substantiation Requirements
The Final Regulations removed certain documentation requirements that practitioners found to be particularly onerous or otherwise unnecessary to furthering the purpose of the statute. Now, taxpayers no longer need specific documentation to establish foreign person status and can instead often rely on the Final Regulations‘ new presumption of foreign person status, which applies where certain facts are met. For example, the Final Regulations provide that certain sales of property are assumed to have been made to a foreign person where the recipient’s billing address is outside the United States. In addition, taxpayers no longer need specific documentation to establish: (i) foreign use with respect to sales of general property directly to end users; and (ii) the location of a consumer of a general service. Instead, the Final Regulations simply set forth which facts must be established for the income to qualify for the deduction.
As with any deduction, taxpayers that claim a deduction under section 250 bear the burden of demonstrating that they are entitled to their deduction. The Preamble makes clear that even in the absence of specific substantiation requirements, taxpayers must make returns, render statements and keep necessary records to comply with section 6001 and the regulations thereunder. Thus, unlike the Proposed Regulations, the Final Regulations will not impose additional requirements for specific documents or information for transactions that do not have specific substantiation requirements.
The Final Regulations also provided much-needed clarity and relief regarding certain reliability requirements. For example, the Proposed Regulations contained a constructive knowledge standard under which a seller must not know or have reason to know that documentation was incorrect or unreliable, based on a reasonably prudent person standard. Understandably, practitioners requested further guidance regarding when the constructive knowledge standard applies. In response, under Treas. Reg. § 1.250(b)–4(c)(1), the Final Regulations clarify that a seller would have such constructive knowledge if it receives information—including an individual’s phone number or billing and shipping address or a business’s place of incorporation or management—indicating that the recipient is not a foreign person and if it fails to obtain evidence establishing otherwise. The Final Regulations apply this constructive knowledge standard to: (i) the treatment of certain loss transactions; (ii) the foreign person status presumption; (iii) sales of general property incorporated into a product as a component; (iv) sales of intangible property consisting of a manufacturing method or process to a foreign unrelated party; and (v) general services provided to consumers.
Practitioners also objected to a particularly harsh bright-line rule in the Proposed Regulations that stated that taxpayers could not rely upon documents created more than a year prior to the applicable sale or service. These practitioners argued that as proposed, the regulations arguably required domestic businesses to renegotiate long-term contracts annually, thereby opening themselves up to potential economic changes in long-term relationships and putting them at a competitive disadvantage in the international arena. The Final Regulations no longer provide that taxpayers cannot rely upon long-term contracts created more than a year in advance of a sale. In all cases, though, substantiating documentation must be credible, and the age of substantiating documentation may affect its credibility. For example, the Preamble notes that use of long-term contracts will depend upon all facts and circumstances, and that long-term contracts will be more credible in later years than otherwise if taxpayers periodically confirm that both parties are adhering to the terms of the contract.
The Final Regulations removed two additional bright-line rules that taxpayers had been able to rely upon under the Proposed Regulations, taking the view in each case that the Final Regulations‘ more flexible documentation requirements rendered these inflexible rules inappropriate. Under the Proposed Regulations, certain methods used to determine foreign use from the sale of a fungible mass of general property—including market research, statistical sampling, economic modeling and other similar methods—were sufficient to substantiate foreign use. In addition, the Proposed Regulations explicitly allowed taxpayers that provided services to businesses to use publicly available information, including financial statements, to determine and substantiate the foreign use portion of such services. The Preamble states that given the Final Regulations‘ approach, it is no longer necessary to prescribe that specific substantiation methods—including market research and publicly available information—are reliable sources of information for these purposes. To the contrary, the Preamble notes that these specific methods are now presumed to be unreliable sources of information for these purposes, based on a view that substantiation that relies upon statistical sampling, economic modeling or market data research based upon taxpayers‘ own data will generally be more reliable. Especially given that the Final Regulations retained the rule that a business recipient includes all related parties (as defined in Treas. Reg. § 1.250(b)–(1)(c)(19)), taxpayers that had relied upon publicly available information to substantiate general services provided to business recipients may find themselves worse off than they had been under the Proposed Regulations.
The Proposed Regulations included an exception that exempted small businesses—defined as taxpayers with less than $10 million USD of gross receipts per taxable year—from certain documentation requirements. Taxpayers requested that Treasury expand this exception to apply to larger companies. In response, the Final Regulations increased the threshold to $25 million USD of gross receipts. (See: Treas. Reg. § 1.250(b)–3(f)(2).) However, this change is not as far-reaching as taxpayers had hoped. This is especially true in light of the fact that the threshold calculation now includes not only gross receipts received by the taxpayer, but also gross receipts received by related parties (defined as any members of an affiliated group under section 1504(a), when modified to include a 50%, as opposed to 80%, threshold). (See: Treas. Reg. §§ 1.250(b)–1(c)(17) and –(1)(c)(19).) As a result, businesses that previously qualified for this benefit will need to confirm that the exception still applies. Small businesses that qualify will not need to satisfy any specific substantiation requirement, though they are still subject to the general substantiation rules under section 6001.
As before, the Final Regulations maintain the rule that substantiating documentation must be in existence at the time the taxpayer files its tax return (including extensions). (See: Treas. Reg. § 1.250(b)–3(f)(1).) The Final Regulations further provide that taxpayers must submit substantiating documentation to the IRS within 30 days of its request, unless otherwise agreed. (See: Treas. Reg. § 1.250(b)–3(f)(1).)
Effective Date and Transition Rule
Taxpayers are provided some flexibility in determining which set of regulations to apply for taxable years beginning before January 1, 2021, when the entirety of the Final Regulations become mandatory. Until then, taxpayers may choose to apply either the Proposed Regulations or the Final Regulations in their entirety. However, acknowledging that taxpayers may not be able to substantiate their deductions with information already available to them, the Final Regulations provide that taxpayers that choose to rely on the Final Regulations in pre-2021 tax years do not need to comply with the specific substantiation rules described in the first part of this article during this interim period. (See: Treas. Reg. § 1.250-1(b).)
Taxpayers that choose to rely on the Proposed Regulations are entitled to rely upon the favorable „documentation transition rule“ as previously set forth, under which a taxpayer may substantiate its FDII deduction by using any reasonable documentation maintained in its ordinary course of business. Though the Proposed Regulations limited this transition rule to taxable years beginning on or before March 4, 2019, the Preamble makes clear that taxpayers may rely on the transition rule for documentation for all taxable years beginning before January 1, 2021. When deciding which regulations to apply, taxpayers should thus carefully analyze both the substantive provisions and the documentation requirements set forth under each regime.