For this week’s in review, we are providing a practitioner’s insight on the newly released final Foreign Derived Intangible Income deduction regulations, updates from the IRS on their plan to audit those subject to the one-time transition tax back in 2017, an overview on Senator Bernie Sander’s recent tax proposal, and a look at how professional athletes will be taxed since they’ve resumed play in the face of COVID-19.
Specifically, we will be covering the following this week—
- Practitioner Insight: Foreign Derived Intangible Income Final Regulation Overview
- IRS to Begin Hundreds of Audits on the One-Time Repatriation Tax This Upcoming October
- Bernie Sanders Tax Proposal Seeks to Raise Taxes on Billionaires with Large Gains; and
- How Pro-Athletes Will Be Taxed When They Resume Play
Practitioner Insight: Foreign Derived Intangible Income Final Regulation Overview
On July 9, 2020, Treasury and the IRS released final regulations under tax code Section 250, providing guidance on the deduction for foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI).
The final regulations generally reduce certain documentation burdens. The regulations also provide greater flexibility in other areas, such as with respect to the taxable income limitation, and certain helpful clarifications.
This review contains an overview of some of the most significant changes made by the final regulations and certain practical implications for taxpayers.
OVERVIEW OF SECTION 250 AND THE PROPOSED REGULATIONS
Section 250 was enacted in 2017 as part of the Tax Cuts and Jobs Act (TCJA). Subject to a taxable income limitation, Section 250 allows a domestic C corporation to deduct an amount equal to the sum of 37.5% of its FDII, plus 50% of its GILTI inclusion (as computed under tax code Section 951A). For taxable years beginning after Dec. 31, 2025, the deduction for FDII is reduced to 21.875% and the deduction for GILTI is reduced to 37.5%.
The general formula for the FDII deduction can be summarized as follows:
FDII = Deemed Intangible Income x Foreign Derived Deduction Eligible Income / Deduction Eligible Income
In general terms, “deemed intangible income” is equal to the excess of deduction eligible income (DEI) over deemed tangible income return (DTIR), which is a fixed return of 10% on “qualified business asset investment” (QBAI).
DEI is gross income without regard to excluded income, minus properly allocable deductions.
QBAI is determined as the average of the adjusted U.S. tax basis (determined at the end of each quarter of a tax year) in specified tangible property that is used in a trade or business and is subject to U.S. tax depreciation.
“Foreign-derived deduction eligible income” (FDDEI) is equal to gross FDDEI over properly allocable deductions, with gross FDDEI being the portion of gross DEI derived from foreign-derived sales and services.
IMPACT OF THE FINAL REGULATIONS
- Applicability Dates – Tax Years beginning on or after January 1, 2021
The final regulations are generally applicable to tax years beginning on or after Jan. 1, 2021, giving taxpayers additional time to develop systems and procedures for complying with the regulations.
Taxpayers may choose to apply the final regulations to tax years beginning before Jan. 1, 2021, provided that taxpayers apply the final regulations in their entirety.
The preamble also states that taxpayers are permitted to rely on the proposed regulations in their entirety for tax years beginning before Jan. 1, 2021, except that taxpayers relying on the proposed regulations may rely on the transition rule for documentation for all taxable years beginning before Jan. 1, 2021 (rather than only for taxable years beginning on or before March 4, 2019).
- Taxable Income Limitation
Like several other tax code provisions, the Section 250 deduction is subject to a taxable income limitation. The proposed regulations provided an ordering rule stating that a taxpayer’s taxable income for purposes of applying the Section 250(a)(2) limitation is determined after all other deductions are taken into account.
- Cost of Goods Sold Allocation
Under the proposed regulations, 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. The final regulations retain this approach and clarify that the method chosen by the taxpayer must be consistently applied.
- Deductions Properly Allocable to Gross DEI and Gross FDDEI
Like the proposed regulations, the final regulations treat Section 250(b) as an operative section under the allocation and apportionment rules in the tax code. Gross FDDEI and gross residual deduction eligible income (“RDEI,” renamed from the term “gross non-FDDEI” used in the proposed regulations) are treated as separate statutory groupings. However, the final regulations remove the provision in the proposed regulations stating that the exclusive apportionment rules in Treas. Reg. Section 1.861-17(b) do not apply for purposes of apportioning research and experimentation (R&E) expenses to gross DEI and gross FDDEI.
- Foreign Derived Deduction Eligible Income Transactions
As stated above, a taxpayer’s FDDEI is equal to gross FDDEI over properly allocable deductions, with gross FDDEI being the portion of gross DEI derived from FDDEI transactions, i.e., FDDEI sales and FDDEI services. The regulations make several important changes with respect to the scope of FDDEI sales and FDDEI services, as well as with respect to the substantiation or documentation required to establish qualification as a FDDEI sale or service.
- Foreign Derived Deduction Eligible Income Sales
Under the final regulations, a FDDEI sale is generally defined as a sale of general property or intangible property to a recipient that is a foreign person and that is for a foreign use. While the proposed regulations generally required certain documentation to establish that the foreign person and foreign use requirements are satisfied, the final regulations take a more flexible approach, including providing certain presumptions and providing specific substantiation requirements only in certain cases.
The proposed regulations generally required a seller to establish that the recipient is a foreign person by obtaining certain documentation. Under the final regulations, a sale of property is presumed made to a foreign person if:
1. It is a foreign retail sale (i.e., a sale of general property to a recipient that acquires general property at a physical retail location outside the U.S.);
2. In the case of general property that is not sold in a foreign retail sale and is delivered to the recipient or end user, the shipping address of the recipient or end user is outside the U.S.;
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 U.S.; or
4. In the case of sales of intangible property, the billing address of the recipient is outside the U.S.
However, the presumption as to foreign person status does not apply if the seller knows or has reason to know that the sale is to a recipient other than a foreign person. A seller knows or 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 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.
- The Definition of Foreign Use of General Property
The proposed regulations provided that a sale of general property is for foreign use if the property is not subject to domestic use within three years of delivery or the property is subject to manufacture, assembly, or other processing outside the U.S. before being subject to a domestic use. Certain documentation was generally required to establish foreign use.
The final regulations provide that sale of general property is for a foreign use if the seller determines that the sale is to an end user in one of the following categories:
1. A sale (including a sale of digital content transferred in a physical medium) to a recipient that is delivered by a freight forwarder or carrier to an end user if the end user receives delivery of the general property outside the U.S. (subject to an anti-abuse rule);
2. Where a sale is not delivered through a carrier or freight forwarder, a sale (including a sale of digital content transferred in a physical medium) to an end user where the property is located outside the U.S. at the time of the sale (including a foreign retail sale);
3. A sale (including a sale of digital content transferred in a physical medium) 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 U.S. (and such sales to end users outside the U.S. are substantiated);
4. A sale of digital content that is transferred electronically if sold to an end user that downloads, installs, receives, or accesses the digital content on the end user’s device outside of the U.S.; and
5. A sale of international transportation property if, in the case of property used for compensation or hire, the end user registers the property in a foreign jurisdiction, or, in the case of property not used for compensation or hire, if the end user registers the property in a foreign jurisdiction and hangars or stores the property primarily outside the U.S.
In addition, a sale of general property is for foreign use if the sale is to a foreign unrelated party that subjects the property to manufacture, assembly, or other processing outside the U.S. and certain substantiation requirements are satisfied. Property is subject to manufacture, assembly, or other processing only if the property is physically and materially changed or the property is incorporated as a component into another product.
- Foreign Use of Intangible Property
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 U.S., 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. The final regulations clarify that the end user is the person that ultimately uses or consumes the property, or the person that acquires the property in a foreign retail sale. A person who acquires the property for resale or otherwise as an intermediary is not an end user. The final regulations also incorporate the concept of an end user into the rules for determining whether a sale of general property, in addition to intangible property, is for a foreign use.
- Related party Transactions
The statute provides that the sale of property to a foreign related person is treated as for a foreign use when the foreign related party resells the property to an unrelated foreign party for foreign use or uses the property in connection with the sale of other property or provision of services to an unrelated foreign party for a foreign use.
Under the final regulations, a sale to a foreign related party for resale is treated as a FDDEI sale in the year it occurs if a sale to an unrelated party occurs in such year or will occur in the future in the ordinary course of business. The seller in the related party sale may establish that an unrelated party transaction will occur based on contractual terms, past practices of the foreign related party, a showing that the product sold is designed specifically for a foreign market, or books and records otherwise evidencing that sales will be made to foreign unrelated parties. Unlike the proposed regulations, the final regulations do not require the taxpayer to file an amended return to claim an FDII benefit for an unrelated party sale occurring after the FDII filing date (i.e., the date, including extensions, by which the taxpayer is required to file an income tax return for the taxable year in which gross income from the transaction is included in the taxpayer’s income).
A related party service is a FDDEI service only if the service is not substantially similar to a service that is or will be provided by the related person to a person located in the U.S. The regulations retain two bright-line tests aimed at “round tripping” arrangements where the provision of services primarily benefits persons within the U.S. but a related party located outside the U.S. is interposed. Under these tests, a service is considered substantially similar to a service provided by the related party if either 60% or more of the benefits conferred by the related party service are to persons located within the U.S. (the “benefit test”) or if the renderer’s service is used by the related party to provide a service to a person located within the U.S. and 60% or more of the price that persons located within the U.S. pay for the service provided by the related party is attributable to the renderer’s service (the “price test”). If the benefit test is failed, the transaction does not qualify as a FDDEI transaction. If only the price test is failed, qualifying revenue is reduced based on the benefits provided to persons located in the U.S. The final regulations also clarify that services provided to a related party that only indirectly benefit the related party’s service recipients are not “substantially similar” to the services provided by the related party.
CONCLUSION
This article only covers some of the major changes brought about by the final regulations for the FDII provision. For a full overview of the regulations, you can read them on the US Department of Treasury website here.
IRS to Begin Hundreds of Audits on the One-Time Repatriation Tax This Upcoming October
The IRS in October plans to carry out hundreds of audits against shareholders suspected of not paying the tax they owe on offshore earnings brought back to the U.S. under the 2017 tax law.
One of the major provisions passed under the Tax Cuts and Jobs Act of 2017 is the one-time repatriation tax that was aimed at taxing the previously untaxed accumulated earnings and profits that US companies held in foreign subsidiaries.
The IRS’s Large Business and International Division earlier this month announced a new compliance effort focused on U.S. shareholders with interests in certain types of foreign corporations who were supposed to pay tax on profits repatriated under tax code Section 965 of the 2017 law.
“We believe that there’s a high likelihood of noncompliance in this space,” Douglas O’Donnell, the division’s commissioner, said during an American Bar Association webcast.
The new code section is complex, and the taxpayers may have difficulty obtaining the information they need to compute shareholder liability, which may lead to errors, he said.
In addition to audits, the division expects to send thousands of taxpayers letters this fall suggesting that they take a second look at what they’ve reported to the IRS and consider filing an amended return, O’Donnell said.
Bernie Sanders Tax Proposal Seeks to Raise Taxes on Billionaires with Large Gains
U.S. Senator Bernie Sanders introduced legislation to tax what he called “obscene wealth gains” during the coronavirus crisis.
The “Make Billionaires Pay Act” would tax 60% of the increase in the ultra-wealthy’s net worth from March 18 through the end of the year and use the revenue to cover out-of-pocket health-care expenses of all Americans, according to a statement from Sanders’s office. The bill, which would apply to individuals with assets exceeding $1 billion as of Dec. 31, 2020, is co-sponsored by Democratic senators Ed Markey and Kirsten Gillibrand.
Sanders’s tax proposal would require approval of both houses of Congress, which is highly unlikely given Republican control of the Senate.
With his latest proposal, Sanders is focused on the increase in asset values of the super-rich since the Covid-19 crisis started. The 60% wealth tax on the “windfall gains” of billionaires from March until August alone would raise $421.7 billion, according to his office, which cited data from Americans for Tax Fairness, a progressive advocacy group. That would be enough to allow Medicare to pay all out-of-pocket expenses for everyone in the U.S., his office said.
How Will Pro-Athletes Be Taxed When They Resume Play?
The income professional athletes earn in any opposing team’s state they play in over the course of a season is typically subject to those states’ income taxes, what is known as the jock tax. For states with income taxes such as California, it means hundreds of thousands in additional tax revenue for every game California professional sports team’s host. With Covid-19 forcing the NBA and NHL to play out the rest of their season in select cities, some players will avoid state income taxes altogether while others will be on the hook for much more. This all depending on which state they call home.
The out-of-state taxes professional athletes typically pay get applied to the total number of days they perform “income-related work” like play in games, team meetings, or practices in a given state. Even if a player lives in a state like Florida that doesn’t have an income tax, they still pay state income taxes for games played outside their home state.
This is better known as the “jock tax”. Like many things in sports, jock taxes can be traced to Michael Jordan and came about after the Chicago Bulls beat the Lakers in the 1991 NBA finals. California sought to capture some of the pay Jordan earned while playing in Los Angeles.
THE NBA IN FLORIDA
With the NBA finishing out its season in Florida’s Disney World, players who are residents of the Sunshine State will avoid income taxes altogether as they’re no longer earning pay in other states that impose income taxes. For everyone else, it’s a different ballgame.
Typically, if a player is already paying jock taxes to the state they’re playing an away game in, their resident state lets them use a tax credit to avoid any double taxation and offset the difference in rates.
For an all-time great like LeBron James, who plays for the Lakers, will still owe California’s 13% tax on the income he makes in Florida, while someone like the Heat’s Jimmy Butler won’t owe any state income taxes, as his home state doesn’t impose one.
THE NHL IS A BIT DIFFERENT
American NHL players playing out their seasons in the league’s two hub-designated cities in Canada of Toronto and Edmonton, Alberta province, could be on the hook for double the taxes.
International tax treaties will acknowledge taxes paid in Canada as a tax credit for US federal income taxes, but states vary in respect to provincial taxes.
That means hockey players who don’t hold Canadian residency could end up paying Edmonton and Toronto’s provincial rates for their pay on top of their home-state’s rates. Also, the time players who are American residents spend in Canada will rise higher than what it would be compared to a normal season—putting them on the hook for higher than usual rates.
Anyone staying over 183 days in Canada is typically liable for income taxes. Although the Canada Revenue Agency is allowing exceptions for those who can’t leave because of Covid-19, playing hockey probably doesn’t qualify.
THE MLB IS GENERALLY MORE OF THE SAME
Major League Baseball’s decision to forgo fixed game locations and play the rest of its season in a condensed 60-game format won’t change most players’ taxes as they’re still traveling from city to city.
But for the Toronto Blue Jays, who are playing out home games in Buffalo, New York, instead of Toronto—after Canada denied the league’s request for an exemption to cross the closed border because of high U.S. Covid-19 rates—taxes will look different.
Those Blue Jays players who are American residents should save money as New York imposes less income taxes than Canada, but Canadian players could be on the hook for twice the tax
Canada’s tax-residency rules are tied to how many days you spend in the country and claiming U.S. Therefore, claiming residency for temporary work travel could be difficult, and any legal challenge would be tricky.