On-Shoring U.S. Supply Chains: The Foreign-Derived Intangible Income

Leading up to the COVID-19 pandemic, many businesses were grappling with concerns about the reliability of their international supply chains. Among other things, changes in consumer behaviors, growth of the digital economy, increased desire for transparency about consumer products, the impacts of globalization on society, and geopolitical uncertainty were raising questions in the minds of many. Concerns about actual or potential supply chain disruptions, as well as rapidly changing regulatory environments, suddenly became a reality due to the effects of the COVID-19 pandemic and the responses of different nations.

In the United States, in response to the COVID-19 crisis, numerous proposals are being crafted or have been introduced within each of the Chambers of Congress in recent months with the stated objective of encouraging and supporting the return of offshore manufacturing to the United States and the diversification of supply chains. Proposals have been introduced by members of both parties, as well as on a bi-partisan basis, and Executive Orders have been issued, such as Executive Order 13922 signed on May 14, 2020, with a policy objective “…to create, maintain, protect, expand, and restore the domestic industrial base capabilities, including supply chains within the United States and its territories (“domestic supply chains”), needed to respond to the COVID-19 outbreak.”

Meanwhile, a provision included in the Tax Cuts and Jobs Act of 2017 (“TCJA”) that was intended to support and incentivize the on-shoring of offshore activities has seemingly been underutilized – the Foreign-Derived Intangible Income (“FDII”) deduction. To the extent that certain requirements are met, qualifying taxable income of a domestic corporation may be subject to a reduced effective tax rate of 13.125 percent, which would be a very attractive effective U.S. tax rate for many corporations. Guidance with respect to the benefit was slow in coming, and the proposed regulations that were issued were quite complex while leaving open many questions.

Fortunately, final regulations were released with respect to FDII on July 9, 2020. Although still quite complex, the final regulations provide considerable clarification with respect to important questions, as well as a number of taxpayer-friendly changes from the proposed regulations, including:

• An expanded timeframe during which taxpayers may rely on the transition rule that was provided in the proposed regulations;
• The replacement of the specific documentation requirements for establishing that a recipient is a foreign person and that a sale of property or provision of a service is for foreign use with more flexible substantiation requirements that may be more practical to implement;
• A presumption that certain sales are made to a foreign person if they are foreign retail sales or, alternatively, sales of general property that is delivered to recipients with foreign addresses;
• A presumption that sales of tangible and intangible property are for a foreign use where certain requirements are met; and
• The elimination, in recognition of its impracticality, of the requirement that the taxpayer have no “reason to know” of a subsequent domestic use of general property previously sold to a foreign person.

Meanwhile, the final regulations have also left open or created new questions by reserving on certain matters that will be the subject of future guidance by the U.S. Treasury.

As businesses adapt to changes in their operations and supply chains, and as many consider bringing functions and activities into the United States as a result of such changes, FDII represents one incentive that may affect decisions to be made by key stakeholders. Whereas the initial guidance in the proposed regulations had requirements that may have been cost prohibitive or simply impractical to administer in order to claim the deduction, it seems that Treasury has moved significantly in favor of the taxpayer so that businesses can have more confidence when taking account for the tax benefit.