IRS Clarifies “Foreign Derived” Service Income for FDII Regime

The IRS recently issued a ruling confirming that domestic corporations providing research and development services to a related foreign entity can classify the entire income as foreign-derived, provided the direct benefit is solely received by the foreign entity. The ruling reinforces the effective tax rate (“ETR”) benefits that US multinational groups receive under the foreign derived intangible income (“FDII”) regime from their global supply chain structures.

Overview of FDII and FDDEI

In 2017, Congress enacted into law the so-called FDII regime under I.R.C. §250 to encourage the onshore corporate ownership of intangible property (“IP”) used in offshore market activities. Toward this end, domestic corporations (other than Subchapter S corporations) are allowed a 37.5% deduction of their FDII, resulting in an ETR of 13.125%. It should be noted that the deduction is only available to domestic corporations with positive taxable income (See I.R.C. §250(a)(2)). Beginning in 2026, the deduction will be reduced to 21.875%, yielding an ETR of 16.406%, unless Congress passes tax legislation that maintains the current deduction percentage.

Very generally, FDII is the portion of a domestic corporation’s gross sales and/or service income derived from serving foreign markets less: (1) the deductions (including taxes) properly allocable to such gross income portion (known as foreign derived deduction eligible income (“FDDEI”); and (2) a 10% return on its tangible business assets attributable to FDDEI. A domestic corporation’s gross income out of which FDDEI is taken does not include:

• subpart F income (see I.R.C. §951(a)(1);
• global intangible low-taxed income (as defined in I.R.C. §951A);
• any financial services income (as defined in I.R.C. §904(d)(2)(D));
• any dividend received from a controlled foreign corporation (as defined in §957);
• any domestic oil and gas extraction income (as defined in I.R.C. §907(c)(1)); or
• any foreign branch income (as defined in I.R.C. §904(d)(2)(J)) (See I.R.C. §250(b)(3)).

Thus, the characterization of a domestic corporation’s income as derived from serving foreign markets (“foreign derived” in the statute parlance) is key in determining the FDII deductible amount under I.R.C. §250. In this respect, the statute provides different characterization rules for income from the sale of property and income from the provision of services. A domestic corporation’s income from the sale of property is “foreign derived” when such property is sold to a foreign person for a “foreign use” (See I.R.C. §250(b)(4)(A)), that is, for “use, consumption, or disposition” outside the US (See I.R.C. §250(b)(5)(A)). The taxpayer must retain proper documentation substantiating the foreign use of the property, to the satisfaction of the IRS.

Foreign Derived Services Income, Recipient Is Outside of the US

For services income, there is no foreign use requirement. There is also no requirement that a foreign person benefit from the services rendered. The domestic corporation need only establish that the services were rendered for any person or with respect to any property located outside the US (See I.R.C. §250(b)(4)(B)). Of course, this may occur when the services are rendered outside the US; however, the provision also permits the performance of services within the US, provided the recipient (or the property for which the services relate) is located outside the US. In fact, in keeping with the 2017 tax legislation’s goal of bolstering domestic employment, the provision was likely intended to promote the rendering of services from within the US (See Treas. Dept. Press Release, Unified Framework for Fixing Our Broken Tax Code (Sept. 27, 2017)).

Subsequent Use, Consumption, or Disposition by a Foreign Person. The statute also provides special rules for property or services provided to unrelated intermediaries as well as to related parties. Specifically, if a domestic corporation sells property to an unrelated person for further manufacture or other modification within the US, the property is not treated as sold for foreign use even if the unrelated party subsequently uses, consumes, or disposes of the property outside the US (See I.R.C. §250(b)(5)(B)(i)). While on its face the requirement is unforgiving, the interconnected nature of today’s global supply chains would make it administratively impracticable, if not impossible, to discern whether property sold to unrelated foreign persons will be, at some point, used or subject to further manufacturing or modification within the US.

In light of these practical difficulties, the regulations adopt a more expansive and nuanced view of a foreign use. Likewise, if a domestic corporation provides services to an unrelated person located within the US, those services do not constitute foreign derived services even if the unrelated person uses those services in providing services to a foreign person, or with respect to property located outside the US (See I.R.C. §250(b)(5)(B)(ii)). In such circumstances, a work-around solution may entail reversing the subcontracting relationship, so that the domestic corporation performs services directly for the benefit of persons located outside the US and compensates the intermediary for the services rendered within the US. Of course, this work-around may run counter to the intermediary’s self-interest, and may thus require additional compensation, if the intermediary could have claimed the FDII deduction with respect to its services but for the rewiring of the subcontracting arrangement.

Related Party Transactions. With regard to related party transactions, the statute provides that if a domestic corporation sells property to a foreign related party, the sale is not treated as for a foreign use unless the property is ultimately sold by the foreign related party or used by that foreign related party in connection with property that is sold, or the provision of services, to another person who is a foreign unrelated party. Proof of foreign use of the property must be established by the taxpayer to the IRS’s satisfaction (See I.R.C. §250(b)(5)(C)(i)). If a service is provided to a foreign related party, that service will not qualify for the FDII deduction unless the domestic corporation establishes to the IRS’s satisfaction that the service is not substantially similar to services provided by the foreign related party to persons located within the US (See I.R.C. §250(b)(5)(C)(ii)).

Characterization of Sales and Service Income as FDII. Regulations finalized in 2020 provide extensive guidance on the characterization of sale and service income as foreign derived income. Such guidance includes a myriad of technical rules for a host of subcategories of foreign derived sales and service incomes that are beyond the scope of this article (See Treas. Reg. §1.250(b)-3, -4, -5 and -6). It is, however, worth noting that services are broken into four categories with specified characterization rules for:

1. general services,
2. property services,
3. proximate services, and
4. transportation services (See Treas. Reg. §1.250(b)-5(b) for a definition of each of these services).

General Services. A general service is any service, including an advertising service or an electronically supplied service, other than a property service, proximate service, or transportation service (See Treas. Reg. §1.250(b)-5(c) for a definition of an advertising service and an electronically supplied service). A general service provided by a domestic corporation to a business recipient (i.e., a recipient other than a consumer) (See Treas. Reg. §1.250(b)-5(c)(3)) constitutes a foreign derived service to the extent that the business recipient is located outside the US when the service is provided, and the service confers a benefit, in accordance with the principles of I.R.C. §482 (transfer pricing) regulations, on the business recipient’s operations outside the US (See Treas. Reg. §1.250(b)-5(e)(1)). Those operations are generally deemed to exist where the business recipient maintains an office or other fixed place of business outside the US (See Treas. Reg. §1.250(b)-5(e)(3)(i)).

Transfer Pricing. The reference to the transfer pricing concept of “benefit” to determine a foreign derived general service creates uncertainties regarding the scope of the benefit conferred to a foreign business recipient. Uncertainties exist, in particular, with respect to services provided by a domestic corporation to a foreign corporation in the context of a global supply chain involving sales and services amongst multiple foreign and US parties. For example, it is unclear whether a domestic corporation’s sourcing and procurement services provided to a foreign global procurement company benefit each entity or person in the supply chain, including a US distributor that purchases products from the procurement company for resale in the US market, or benefit solely the foreign procurement company that concludes contracts with and purchases products from suppliers for resale to its distributors around the world. At stake is the amount of income from the provision of services that a taxpayer can deduct under the FDII regime in view of the rule in the FDII regulations stating that if only a portion of a service is treated as provided to a foreign person, or with respect to property outside the US, the provision of the service is a foreign derived service only to the extent of the gross income derived with respect to such portion (See Treas. Reg. §1.250(b)-5(b)).

The I.R.C. §482 regulations distinguish between direct and indirect or remote benefits. To be considered as providing a benefit to a recipient, an activity must directly result in a “reasonably identifiable increment of economic or commercial value that enhances the recipient’s commercial position, or that may reasonably be anticipated to do so.” (See Treas. Reg. §1.482-9(l)(3)(i)). For example, services that are reasonably anticipated to result in an increase in the value of an IP provide a direct benefit to its owner (See id.). Conversely, an activity is not considered to provide a benefit to the recipient if, at the time the activity is performed and taking into consideration all facts and circumstances, the present or reasonably anticipated benefit from that activity is so indirect or remote that the recipient would be willing to neither pay an uncontrolled party to perform a similar activity nor perform the activity for itself (See Treas. Reg. §1.482-9(l)(3)(ii)). For example, in the context of a multinational group, certain changes in the management structure and compensation of executives of the US business units based on recommendations contained in a study performed by its internal staff may only provide an indirect or remote benefit to the group’s foreign subsidiaries since the internal study and the resultant changes are reasonably anticipated to increase the competitiveness and overall efficiency of the affected US business units only. Thus, the foreign subsidiaries are not considered to obtain a benefit from the study (See Treas. Reg. §1.482-9(l)(5), Ex. 2).

PLR on Service Income Being Characterized as FDDEI

This brings us to PLR 202502002 (released on January 10, 2025), in which the IRS sheds light on the extent to which services provided by a domestic corporation to a foreign business recipient benefit its foreign operations such that the service income may be characterized in full, or in part, as being foreign derived for purposes of the FDII regime.

In the PLR, two domestic corporations provide research and development (“R&D”) services to a foreign related party for developing IP under a master services agreement in exchange for an arm’s length consideration. Such services are general services under the FDII regulations. The foreign related party develops, manufactures, and distributes pharmaceutical products, medical devices, and other biotechnology products worldwide. It owns all the IP developed under the master services agreement and pays the US service providers an arm’s length service fee calculated under the cost-plus method. Once the IP is developed, the foreign IP owner itself, or through third parties, manufactures products using the developed IP. It sells such products at arm’s length to a US related party (the “US Distributor”) under a distribution agreement for resale in the US market. Per the distribution agreement, the US Distributor has no ownership interests in the IP and does not bear any risk of loss if the R&D services do not result in marketable products in the US. The US Distributor earns an arm’s length return for its distribution activities in the US, determined under the comparable profits method. The distribution agreement may be terminated at will by either party.

The foreign IP owner and manufacturer as well as the US service companies and the US Distributor involved in the supply chain are commonly and wholly owned by a foreign public company.

The issue raised by the taxpayer was whether the R&D services provided by the US service companies benefitted not only the foreign IP owner and manufacturer but also the US Distributor, in which case only a portion of the service income was foreign derived and, thus, eligible for the FDII deduction.

The IRS relied on the concept of benefit as set forth in the controlled services regulations under I.R.C. §482 to determine the extent to which the R&D services performed by the US service companies were foreign derived services. The IRS reasoned that any benefit the US Distributor may receive from buying at-arm’s-length products incorporating the IP developed or enhanced by the R&D services and reselling them to US customers is only indirect. This is because the US Distributor does not own the resulting IP. Therefore, the R&D services do not confer any reasonably identifiable increment of economic or commercial value that enhances the US Distributor’s commercial position. In the IRS’s view, the US Distributor is in the same commercial position as a third-party distributor purchasing the same products from the foreign IP owner and manufacturer for an arm’s-length price with no ownership rights in the IP incorporated in such products for resale in the US market. Neither the third-party distributor nor the US Distributor can be considered to receive any direct benefit from the R&D services, regardless of the IP having been incorporated into the purchased products.

As noted, the foreign IP owner and manufacturer is the sole owner of the IP developed or enhanced by the R&D services. It is the sole entity in the supply chain that has the obligation to pay an arm’s-length fee to the US service companies for the R&D services and uses the IP in its manufacturing operations. The commercial position of the foreign IP owner and manufacturer is undisputably enhanced by the economic or commercial value created by the R&D services. Accordingly, the US service companies can treat the full amount of the income from providing R&D services to the foreign IP owner and manufacturer as FDDEI under I.R.C. §250.

The IRS ruling provides helpful comfort for the ETR benefits that US multinational groups derive under the FDII regime from global procurement structures in which sourcing and procurement services are provided by US service companies to a foreign global procurement company that contracts with identified suppliers and is the true owner, in the US sense, of the products purchased. All substantial rights related to the products are vested with the foreign global procurement company, which has all the benefits and burdens of ownership. A US distributor that purchases products from the foreign global procurement company at an arm’s-length price for resale in the US market only receives an indirect benefit from the sourcing and procurement services. It neither transacts with suppliers nor owns the products purchased by the foreign global procurement company. Therefore, the full amount of the income earned by the US service companies solely from the provision of the sourcing and procurement services to the foreign global procurement company is foreign derived income eligible for the benefit of the reduced corporate tax rate under the FDII regime.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Marcellin N. Mbwa-Mboma and Mitchell B. Weiss are partners at K&L Gates LLP in Houston and Chicago, respectively.

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