Title 26—Internal Revenue--Volume 1
PART 1—INCOME TAXES
§ 1.249-1   Limitation on deduction of bond premium on repurchase.
(a) Limitation —(1) General rule. No deduction is allowed to the issuing corporation for any “repurchase premium” paid or incurred to repurchase a convertible obligation to the extent the repurchase premium exceeds a “normal call premium.”
(2) Exception. Under paragraph (e) of this section, the preceding sentence shall not apply to the extent the corporation demonstrates that such excess is attributable to the cost of borrowing and not to the conversion feature.
(b) Obligations —(1) Definition. For purposes of this section, the term obligation means any bond, debenture, note, or certificate or other evidence of indebtedness.
(2) Convertible obligation. Section 249 applies to an obligation which is convertible into the stock of the issuing corporation or a corporation which, at the time the obligation is issued or repurchased, is in control of or controlled by the issuing corporation. For purposes of this subparagraph, the term control has the meaning assigned to such term by section 368(c).
(3) Comparable nonconvertible obligation. A nonconvertible obligation is comparable to a convertible obligation if both obligations are of the same grade and classification, with the same issue and maturity dates, and bearing the same rate of interest. The term comparable nonconvertible obligation does not include any obligation which is convertible into property.
(c) Repurchase premium. For purposes of this section, the term repurchase premium means the excess of the repurchase price paid or incurred to repurchase the obligation over its adjusted issue price (within the meaning of § 1.1275-1(b)) as of the repurchase date. For the general rules applicable to the deductibility of repurchase premium, see § 1.163-7(c). This paragraph (c) applies to convertible obligations repurchased on or after March 2, 1998.
(d) Normal call premium —(1) In general. Except as provided in subparagraph (2) of this paragraph, for purposes of this section, a normal call premium on a convertible obligation is an amount equal to a normal call premium on a nonconvertible obligation which is comparable to the convertible obligation. A normal call premium on a comparable nonconvertible obligation is a call premium specified in dollars under the terms of such obligation. Thus, if such a specified call premium is constant over the entire term of the obligation, the normal call premium is the amount specified. If, however, the specified call premium varies during the period the comparable nonconvertible obligation is callable or if such obligation is not callable over its entire term, the normal call premium is the amount specified for the period during the term of such comparable nonconvertible obligation which corresponds to the period during which the convertible obligation was repurchased.
(2) One-year's interest rule. For a convertible obligation repurchased on or after March 2, 1998, a call premium specified in dollars under the terms of the obligation is considered to be a normal call premium on a nonconvertible obligation if the call premium applicable when the obligation is repurchased does not exceed an amount equal to the interest (including original issue discount) that otherwise would be deductible for the taxable year of repurchase (determined as if the obligation were not repurchased). The provisions of this subparagraph shall not apply if the amount of interest payable for the corporation's taxable year is subject under the terms of the obligation to any contingency other than repurchase prior to the close of such taxable year.
(e) Exception —(1) In general. If a repurchase premium exceeds a normal call premium, the general rule of paragraph (a) (1) of this section does not apply to the extent that the corporation demonstrates to the satisfaction of the Commissioner or his delegate that such repurchase premium is attributable to the cost of borrowing and is not attributable to the conversion feature. For purposes of this paragraph, if a normal call premium cannot be established under paragraph (d) of this section, the amount thereof shall be considered to be zero.
(2) Determination of the portion of a repurchase premium attributable to the cost of borrowing and not attributable to the conversion feature. (i) For purposes of subparagraph (1) of this paragraph, the portion of a repurchase premium which is attributable to the cost of borrowing and which is not attributable to the conversion feature is the amount by which the selling price of the convertible obligation increased between the dates it was issued and repurchased by reason of a decline in yields on comparable nonconvertible obligations traded on an established securities market or, if such comparable traded obligations do not exist, by reason of a decline in yields generally on nonconvertible obligations which are as nearly comparable as possible.
(ii) In determining the amount under paragraph (e)(2)(i) of this section, appropriate consideration shall be given to all factors affecting the selling price or yields of comparable nonconvertible obligations. Such factors include general changes in prevailing yields of comparable obligations between the dates the convertible obligation was issued and repurchased and the amount (if any) by which the selling price of the nonconvertible obligation was affected by reason of any change in the issuing corporation's credit quality or the credit quality of the obligation during such period (determined on the basis of widely published financial information or on the basis of other relevant facts and circumstances which reflect the relative credit quality of the corporation or the comparable obligation).
(iii) The relationship between selling price and yields in subdivision (i) of this subparagraph shall ordinarily be determined by means of standard bond tables.
(f) Effective/applicability dates —(1) In general. Under section 414(c) of the Tax Reform Act of 1969, the provisions of section 249 and this section shall apply to any repurchase of a convertible obligation occurring after April 22, 1969, other than a convertible obligation repurchased pursuant to a binding obligation incurred on or before April 22, 1969, to repurchase such convertible obligation at a specified call premium. A binding obligation on or before such date may arise if, for example, the issuer irrevocably obligates itself, on or before such date, to repurchase the convertible obligation at a specified price after such date, or if, for example, the issuer, without regard to the terms of the convertible obligation, negotiates a contract which, on or before such date, irrevocably obligates the issuer to repurchase the convertible obligation at a specified price after such date. A binding obligation on or before such date does not include a privilege in the convertible obligation permitting the issuer to call such convertible obligation after such date, which privilege was not exercised on or before such date.
(2) Effect on transactions not subject to this section. No inferences shall be drawn from the provisions of section 249 and this section as to the proper treatment of transactions not subject to such provisions because of the effective date limitations thereof. For provisions relating to repurchases of convertible bonds or other evidences of indebtedness to which section 249 and this section do not apply, see §§ 1.163-3(c) and 1.163-4(c).
(3) Portion of repurchase premium attributable to cost of borrowing. Paragraph (e)(2)(ii) of this section applies to any repurchase of a convertible obligation occurring on or after July 6, 2011.
(g) Example. The provisions of this section may be illustrated by the following example:
§ 1.250-0   Table of contents.
This section contains a listing of the headings for §§ 1.250-1, 1.250(a)-1, and 1.250(b)-1 through 1.250(b)-6.
(a) Overview.
(b) Applicability dates.
(a) Scope.
(b) Allowance of deduction.
(1) In general.
(2) Taxable income limitation.
(3) Reduction in deduction for taxable years after 2025.
(4) Treatment under section 4940.
(c) Definitions.
(1) Domestic corporation.
(2) Foreign-derived intangible income (FDII).
(3) Global intangible low-taxed income (GILTI).
(4) Section 250(a)(2) amount.
(5) Taxable income.
(i) In general.
(ii) [Reserved]
(d) Reporting requirement.
(e) Determination of deduction for consolidated groups.
(f) Example: Application of the taxable income limitation.
(a) Scope.
(b) Definition of FDII.
(c) Definitions.
(1) Controlled foreign corporation.
(2) Deduction eligible income.
(3) Deemed intangible income.
(4) Deemed tangible income return.
(5) Dividend.
(6) Domestic corporation.
(7) Domestic oil and gas extraction income.
(8) FDDEI sale.
(9) FDDEI service.
(10) FDDEI transaction.
(11) Foreign branch income.
(12) Foreign-derived deduction eligible income.
(13) Foreign-derived ratio.
(14) Gross RDEI.
(15) Gross DEI.
(16) Gross FDDEI.
(17) Modified affiliated group.
(i) In general.
(ii) Special rule for noncorporate entities.
(iii) Definition of control.
(18) Qualified business asset investment.
(19) Related party.
(20) United States shareholder.
(d) Treatment of cost of goods sold and allocation and apportionment of deductions.
(1) Cost of goods sold for determining gross DEI and gross FDDEI.
(2) Deductions properly allocable to gross DEI and gross FDDEI.
(i) In general.
(ii) Determination of deductions to allocate.
(3) Examples.
(e) Domestic corporate partners.
(1) In general.
(2) Reporting requirement for partnership with domestic corporate partners.
(3) Examples.
(f) Determination of FDII for consolidated groups.
(g) Determination of FDII for tax-exempt corporations.
(a) Scope.
(b) Definition of qualified business asset investment.
(c) Specified tangible property.
(1) In general.
(2) Tangible property.
(d) Dual use property.
(1) In general.
(2) Definition of dual use property.
(3) Dual use ratio.
(4) Example.
(e) Determination of adjusted basis of specified tangible property.
(1) In general.
(2) Effect of change in law.
(3) Specified tangible property placed in service before enactment of section 250.
(f) Special rules for short taxable years.
(1) In general.
(2) Determination of when the quarter closes.
(3) Reduction of qualified business asset investment.
(4) Example.
(g) Partnership property.
(1) In general.
(2) Determination of partnership QBAI.
(3) Determination of partner adjusted basis.
(i) In general.
(ii) Sole use partnership property.
(A) In general.
(B) Definition of sole use partnership property.
(iii) Dual use partnership property.
(A) In general.
(B) Definition of dual use partnership property.
(4) Determination of proportionate share of the partnership's adjusted basis in partnership specified tangible property.
(i) In general.
(ii) Proportionate share ratio.
(5) Definition of partnership specified tangible property.
(6) Determination of partnership adjusted basis.
(7) Determination of partner-specific QBAI basis.
(8) Examples.
(h) Anti-avoidance rule for certain transfers of property.
(1) In general.
(2) Rule for structured arrangements.
(3) Per se rules for certain transactions.
(4) Definitions related to anti-avoidance rule.
(i) Disqualified period.
(ii) FDII-eligible related party.
(iii) Specified related party.
(iv) Transfer.
(5) Transactions occurring before March 4, 2019.
(6) Examples.
(a) Scope.
(b) Definitions.
(1) Digital content.
(2) End user.
(3) FDII filing date.
(4) Finished goods.
(5) Foreign person.
(6) Foreign related party.
(7) Foreign retail sale.
(8) Foreign unrelated party.
(9) Fungible mass of general property.
(10) General property.
(11) Intangible property.
(12) International transportation property.
(13) IP address.
(14) Recipient.
(15) Renderer.
(16) Sale.
(17) Seller.
(18) United States.
(19) United States person.
(20) United States territory.
(c) Foreign military sales and services.
(d) Transactions with multiple elements.
(e) Treatment of partnerships.
(1) In general.
(2) Examples.
(f) Substantiation for certain FDDEI transactions.
(1) In general.
(2) Exception for small businesses.
(3) Treatment of certain loss transactions.
(i) In general.
(ii) Reason to know.
(A) Sales to a foreign person for a foreign use.
(B) General services provided to a business recipient located outside the United States.
(iii) Multiple transactions.
(iv) Example.
(a) Scope.
(b) Definition of FDDEI sale.
(c) Presumption of foreign person status.
(1) In general.
(2) Sales of property.
(d) Foreign use.
(1) Foreign use for general property.
(i) In general.
(ii) Rules for determining foreign use.
(A) Sales that are delivered to an end user by a carrier or freight forwarder.
(B) Sales to an end user without the use of a carrier or freight forwarder.
(C) Sales for resale.
(D) Sales of digital content.
(E) Sales of international transportation property used for compensation or hire.
(F) Sales of international transportation property not used for compensation or hire.
(iii) Sales for manufacturing, assembly, or other processing.
(A) In general.
(B) Property subject to a physical and material change.
(C) Property incorporated into a product as a component.
(iv) Sales of property subject to manufacturing, assembly, or other processing in the United States
(v) Examples.
(2) Foreign use for intangible property.
(i) In general.
(ii) Determination of end users and revenue earned from end users.
(A) Intangible property embedded in general property or used in connection with the sale of general property.
(B) Intangible property used in providing a service.
(C) Intangible property consisting of a manufacturing method or process.
( 1 ) In general.
( 2 ) Exception for certain manufacturing arrangements.
( 3 ) Manufacturing method or process.
(D) Intangible property used in research and development.
(iii) Determination of revenue for periodic payments versus lump sums.
(A) Sales in exchange for periodic payments.
(B) Sales in exchange for a lump sum.
(C) Sales to a foreign unrelated party of intangible property consisting of a manufacturing method or process.
(iv) Examples.
(3) Foreign use substantiation for certain sales of property.
(i) In general.
(ii) Substantiation of foreign use for resale.
(iii) Substantiation of foreign use for manufacturing, assembly, or other processing. outside the United States.
(iv) Substantiation of foreign use of intangible property.
(v) Examples.
(e) Sales of interests in a disregarded entity.
(f) FDDEI sales hedging transactions.
(1) In general.
(2) FDDEI sales hedging transaction.
(a) Scope.
(b) Definition of FDDEI service.
(c) Definitions.
(1) Advertising service.
(2) Benefit.
(3) Business recipient.
(4) Consumer.
(5) Electronically supplied service.
(6) General service.
(7) Property service.
(8) Proximate service.
(9) Transportation service.
(d) General services provided to consumers.
(1) In general.
(2) Electronically supplied services.
(3) Example.
(e) General services provided to business recipients.
(1) In general.
(2) Determination of business operations that benefit from the service.
(i) In general.
(ii) Advertising services.
(iii) Electronically supplied services.
(3) Identification of business recipient's operations.
(i) In general.
(ii) Advertising services and electronically supplied services.
(iii) No office or fixed place of business.
(4) Substantiation of the location of a business recipient's operations outside the United States.
(5) Examples.
(f) Proximate services.
(g) Property services.
(1) In general.
(2) Exception for service provided with respect to property temporarily in the United States.
(h) Transportation services.
(a) Scope.
(b) Definitions.
(1) Related party sale.
(2) Related party service.
(3) Unrelated party transaction.
(c) Related party sales.
(1) In general.
(i) Sale of property in an unrelated party transaction.
(ii) Use of property in an unrelated party transaction.
(2) Treatment of foreign related party as seller or renderer.
(3) Transactions between related parties.
(4) Example.
(d) Related party services.
(1) In general.
(2) Substantially similar services.
(3) Special rules.
(i) Rules for determining the location of and price paid by recipients of a service provided by a related party.
(ii) Rules for allocating the benefits provided by and price paid to the renderer of a related party service.
(4) Examples.
§ 1.250-1   Introduction.
(a) Overview. Sections 1.250(a)-1 and 1.250(b)-1 through 1.250(b)-6 provide rules to determine a domestic corporation's section 250 deduction. Section 1.250(a)-1 provides rules to determine the amount of a domestic corporation's deduction for foreign-derived intangible income and global intangible low-taxed income. Section 1.250(b)-1 provides general rules and definitions regarding the computation of foreign-derived intangible income. Section 1.250(b)-2 provides rules for determining a domestic corporation's qualified business asset investment. Section 1.250(b)-3 provides general rules and definitions regarding the determination of gross foreign-derived deduction eligible income. Section 1.250(b)-4 provides rules regarding the determination of gross foreign-derived deduction eligible income from the sale of property. Section 1.250(b)-5 provides rules regarding the determination of gross foreign-derived deduction eligible income from the provision of a service. Section 1.250(b)-6 provides rules regarding the sale of property or provision of a service to a related party.
(b) Applicability dates. Except as otherwise provided in this paragraph (b), §§ 1.250(a)-1 and 1.250(b)-1 through 1.250(b)-6 apply to taxable years beginning on or after January 1, 2021. Section 1.250(b)-2(h)

applies to taxable years ending on or after March 4, 2019. The last sentence in § 1.250(b)-2(e)(2) applies to taxable years beginning after December 31, 2017.
§ 1.250(a)-1   Deduction for foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI).
(a) Scope. This section provides rules for determining the amount of a domestic corporation's deduction for foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI). Paragraph (b) of this section provides general rules for determining the amount of the deduction. Paragraph (c) of this section provides definitions relevant for determining the amount of the deduction. Paragraph (d) of this section provides reporting requirements for a domestic corporation claiming the deduction. Paragraph (e) of this section provides a rule for determining the amount of the deduction of a member of a consolidated group. Paragraph (f) of this section provides examples illustrating the application of this section.
(b) Allowance of deduction —(1) In general. A domestic corporation is allowed a deduction for any taxable year equal to the sum of—
(i) 37.5 percent of its foreign-derived intangible income for the year; and
(ii) 50 percent of—
(A) Its global intangible low-taxed income for the year; and
(B) The amount treated as a dividend received by the corporation under section 78 which is attributable to its GILTI for the year.
(2) Taxable income limitation. In the case of a domestic corporation with a section 250(a)(2) amount for a taxable year, for purposes of applying paragraph (b)(1) of this section for the year—
(i) The corporation's FDII for the year (if any) is reduced (but not below zero) by an amount that bears the same ratio to the corporation's section 250(a)(2) amount that the corporation's FDII for the year bears to the sum of the corporation's FDII and GILTI for the year; and
(ii) The corporation's GILTI for the year (if any) is reduced (but not below zero) by the excess of the corporation's section 250(a)(2) amount over the amount of the reduction described in paragraph (b)(2)(i) of this section.
(3) Reduction in deduction for taxable years after 2025. For any taxable year of a domestic corporation beginning after December 31, 2025, paragraph (b)(1) of this section applies by substituting—
(i) 21.875 percent for 37.5 percent in paragraph (b)(1)(i) of this section; and
(ii) 37.5 percent for 50 percent in paragraph (b)(1)(ii) of this section.
(4) Treatment under section 4940. For purposes of section 4940(c)(3)(A), a deduction under section 250(a) is not treated as an ordinary and necessary expense paid or incurred for the production or collection of gross investment income.
(c) Definitions. The following definitions apply for purposes of this section.
(1) Domestic corporation. The term domestic corporation has the meaning set forth in section 7701(a), but does not include a regulated investment company (as defined in section 851), a real estate investment trust (as defined in section 856), or an S corporation (as defined in section 1361).
(2) Foreign-derived intangible income (FDII). The term foreign-derived intangible income or FDII has the meaning set forth in § 1.250(b)-1(b).
(3) Global intangible low-taxed income (GILTI). The term global intangible low-taxed income or 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.
(4) Section 250(a)(2) amount. The term section 250(a)(2) amount means, with respect to a domestic corporation for a taxable year, the excess (if any) of the sum of the corporation's FDII and GILTI (determined without regard to section 250(a)(2) and paragraph (b)(2) of this section), over the corporation's taxable income. For a corporation that is subject to the unrelated business income tax under section 511, taxable income is determined only by reference to that corporation's unrelated business taxable income defined under section 512.
(5) Taxable income —(i) In general. The term taxable income has the meaning set forth in section 63(a) determined without regard to the deduction allowed under section 250 and this section.
(ii) [Reserved]
(d) Reporting requirement. Each domestic corporation (or individual making an election under section 962) that claims a deduction under section 250 for a taxable year must make an annual return on Form 8993, “Section 250 Deduction for Foreign-Derived Intangible Income (FDII) and Global Intangible Low-Taxed Income (GILTI)” (or any successor form) for such year, setting forth the information, in such form and manner, as Form 8993 (or any successor form) or its instructions prescribe. Returns on Form 8993 (or any successor form) for a taxable year must be filed with the domestic corporation's (or in the case of a section 962 election, the individual's) income tax return on or before the due date (taking into account extensions) for filing the corporation's (or in the case of a section 962 election, the individual's) income tax return.
(e) Determination of deduction for consolidated groups. A member of a consolidated group (as defined in § 1.1502-1(h)) determines its deduction under section 250(a) and this section under the rules provided in § 1.1502-50(b).
(f) Example: Application of the taxable income limitation. The following example illustrates the application of this section. For purposes of the example, it is assumed that DC is a domestic corporation that is not a member of a consolidated group and the taxable year of DC begins after 2017 and before 2026.
(1) Facts. For the taxable year, without regard to section 250(a)(2) and paragraph (b)(2) of this section, DC has FDII of $100x and GILTI of $300x. DC's taxable income (without regard to section 250(a) and this section) is $300x.
(2) Analysis. DC has a section 250(a)(2) amount of $100x, which is equal to the excess of the sum of DC's FDII and GILTI of $400x ($100x + $300x) over its taxable income of $300x. As a result, DC's FDII and GILTI are reduced, in the aggregate, by $100x under section 250(a)(2) and paragraph (b)(2) of this section for purposes of calculating DC's deduction allowed under section 250(a)(1) and paragraph (b)(1) of this section. DC's FDII is reduced by $25x, the amount that bears the same ratio to the section 250(a)(2) amount ($100x) as DC's FDII ($100x) bears to the sum of DC's FDII and GILTI ($400x). DC's GILTI is reduced by $75x, which is the remainder of the section 250(a)(2) amount ($100x−$25x). Therefore, for purposes of calculating its deduction under section 250(a)(1) and paragraph (b)(1) of this section, DC's FDII is $75x ($100x−$25x) and its GILTI is $225x ($300x−$75x). Accordingly, DC is allowed a deduction for the taxable year under section 250(a)(1) and paragraph (b)(1) of this section of $140.63x ($75x × 0.375 + $225x × 0.50).
§ 1.250(b)-1   Computation of foreign-derived intangible income (FDII).
(a) Scope. This section provides rules for computing FDII. Paragraph (b) of this section defines FDII. Paragraph (c) of this section provides definitions that are relevant for computing FDII. Paragraph (d) of this section provides rules for computing gross income and allocating and apportioning deductions for purposes of computing deduction eligible income (DEI) and foreign-derived deduction eligible income (FDDEI). Paragraph (e) of this section provides rules for computing the DEI and FDDEI of a domestic corporate partner. Paragraph (f) of this section provides a rule for computing the FDII of a member of a consolidated group. Paragraph (g) of this section provides a rule for computing the FDII of a tax-exempt corporation.
(b) Definition of FDII. Subject to the provisions of this section, the term FDII means, with respect to a domestic corporation for a taxable year, the corporation's deemed intangible income for the year multiplied by the corporation's foreign-derived ratio for the year.
(c) Definitions. This paragraph (c) provides definitions that apply for purposes of this section and §§ 1.250(b)-2 through 1.250(b)-6.
(1) Controlled foreign corporation. The term controlled foreign corporation has the meaning set forth in section 957(a) and § 1.957-1(a).
(2) Deduction eligible income. The term deduction eligible income or DEI means, with respect to a domestic corporation for a taxable year, the excess (if any) of the corporation's gross DEI for the year over the deductions properly allocable to gross DEI for the year, as determined under paragraph (d)(2) of this section.
(3) Deemed intangible income. The term deemed intangible income means, with respect to a domestic corporation for a taxable year, the excess (if any) of the corporation's DEI for the year over the corporation's deemed tangible income return for the year.
(4) Deemed tangible income return. The term deemed tangible income return means, with respect to a domestic corporation and a taxable year, 10 percent of the corporation's qualified business asset investment for the year.
(5) Dividend. The term dividend has the meaning set forth in section 316, and includes any amount treated as a dividend under any other provision of subtitle A of the Internal Revenue Code or the regulations in this part (for example, under section 78, 356(a)(2), 367(b), or 1248).
(6) Domestic corporation. The term domestic corporation has the meaning set forth in § 1.250(a)-1(c)(1).
(7) Domestic oil and gas extraction income. The term domestic oil and gas extraction income means income described in section 907(c)(1), substituting “within the United States” for “without the United States.” A taxpayer must use a consistent method to determine the amount of its domestic oil and gas extraction income (“DOGEI”) and its foreign oil and gas extraction income (“FOGEI”) from the sale of oil or gas that has been transported or processed. For example, a taxpayer must use a consistent method to determine the amount of FOGEI from the sale of gasoline from foreign crude oil sources in computing the exclusion from gross tested income under § 1.951A-2(c)(1)(v) and the amount of DOGEI from the sale of gasoline from domestic crude oil sources in computing its section 250 deduction.
(8) FDDEI sale. The term FDDEI sale has the meaning set forth in § 1.250(b)-4(b).
(9) FDDEI service. The term FDDEI service has the meaning set forth in § 1.250(b)-5(b).
(10) FDDEI transaction. The term FDDEI transaction means a FDDEI sale or a FDDEI service.
(11) Foreign branch income. The term foreign branch income has the meaning set forth in section 904(d)(2)(J) and § 1.904-4(f)(2).
(12) Foreign-derived deduction eligible income. The term foreign-derived deduction eligible income or FDDEI means, with respect to a domestic corporation for a taxable year, the excess (if any) of the corporation's gross FDDEI for the year, over the deductions properly allocable to gross FDDEI for the year, as determined under paragraph (d)(2) of this section.
(13) Foreign-derived ratio. The term foreign-derived ratio means, with respect to a domestic corporation for a taxable year, the ratio (not to exceed one) of the corporation's FDDEI for the year to the corporation's DEI for the year. If a domestic corporation has no FDDEI for a taxable year, the corporation's foreign-derived ratio is zero for the taxable year.
(14) Gross RDEI. The term gross RDEI means, with respect to a domestic corporation or a partnership for a taxable year, the portion of the corporation or partnership's gross DEI for the year that is not included in gross FDDEI.
(15) Gross DEI. The term gross DEI means, with respect to a domestic corporation or a partnership for a taxable year, the gross income of the corporation or partnership for the year determined without regard to the following items of gross income—
(i) Amounts included in gross income under section 951(a)(1);
(ii) GILTI (as defined in § 1.250(a)-1(c)(3));
(iii) Financial services income (as defined in section 904(d)(2)(D) and § 1.904-4(e)(1)(ii));
(iv) Dividends received from a controlled foreign corporation with respect to which the corporation or partnership is a United States shareholder;
(v) Domestic oil and gas extraction income; and
(vi) Foreign branch income.
(16) Gross FDDEI. The term gross FDDEI means, with respect to a domestic corporation or a partnership for a taxable year, the portion of the gross DEI of the corporation or partnership for the year which is derived from all of its FDDEI transactions.
(17) Modified affiliated group —(i) In general. The term modified affiliated group means an affiliated group as defined in section 1504(a) determined by substituting “more than 50 percent” for “at least 80 percent” each place it appears, and without regard to section 1504(b)(2) and (3).
(ii) Special rule for noncorporate entities. Any person (other than a corporation) that is controlled by one or more members of a modified affiliated group (including one or more persons treated as a member or members of a modified affiliated group by reason of this paragraph (c)(17)(ii)) or that controls any such member is treated as a member of the modified affiliated group.
(iii) Definition of control. For purposes of paragraph (c)(17)(ii) of this section, the term control has the meaning set forth in section 954(d)(3).
(18) Qualified business asset investment. The term qualified business asset investment or QBAI has the meaning set forth in § 1.250(b)-2(b).
(19) Related party. The term related party means, with respect to any person, any member of a modified affiliated group that includes such person.
(20) United States shareholder. The term United States shareholder has the meaning set forth in section 951(b) and § 1.951-1(g).
(d) Treatment of cost of goods sold and allocation and apportionment of deductions —(1) Cost of goods sold for determining gross DEI and gross FDDEI. For purposes of determining the gross income included in gross DEI and gross FDDEI of a domestic corporation or a partnership, the cost of goods sold of the corporation or partnership is attributed to gross receipts with respect to gross DEI or gross FDDEI under any reasonable method that is applied consistently. Cost of goods sold must be attributed to gross receipts with respect to gross DEI or gross FDDEI regardless of whether certain costs included in cost of goods sold can be associated with activities undertaken in an earlier taxable year (including a year before the effective date of section 250). A domestic corporation or partnership may not segregate cost of goods sold with respect to a particular product into component costs and attribute those component costs disproportionately to gross receipts with respect to amounts excluded from gross DEI or gross FDDEI, as applicable.
(2) Deductions properly allocable to gross DEI and gross FDDEI —(i) In general. For purposes of determining a domestic corporation's deductions that are properly allocable to gross DEI and gross FDDEI, the corporation's deductions are allocated and apportioned to gross DEI and gross FDDEI under the rules of §§ 1.861-8 through 1.861-14T and 1.861-17 by treating section 250(b) as an operative section described in § 1.861-8(f). In allocating and apportioning deductions under §§ 1.861-8 through 1.861-14T and 1.861-17, gross FDDEI and gross RDEI are treated as separate statutory groupings. The deductions allocated and apportioned to gross DEI equal the sum of the deductions allocated and apportioned to gross FDDEI and gross RDEI. All items of gross income described in paragraphs (c)(15)(i) through (vi) of this section are in the residual grouping.
(ii) Determination of deductions to allocate. For purposes of determining the deductions of a domestic corporation for a taxable year properly allocable to gross DEI and gross FDDEI, the deductions of the corporation for the taxable year are determined without regard to sections 163(j), 170(b)(2), 172, 246(b), and 250.
(3) Examples. The following examples illustrate the application of this paragraph (d).
(i) Assumed facts. The following facts are assumed for purposes of the examples—
(A) DC is a domestic corporation that is not a member of a consolidated group.
(B) All sales and services are provided to persons that are not related parties.
(C) All sales and services to foreign persons qualify as FDDEI transactions.
(ii) Examples —
(A) Example 1: Allocation of deductions —( 1 ) Facts. For a taxable year, DC manufactures products A and B in the United States. DC sells products A and B and provides services associated with products A and B to United States and foreign persons. DC's QBAI for the taxable year is $1,000x. DC has $300x of deductible interest expense allowed under section 163. DC has assets with a tax book value of $2,500x. The tax book value of DC's assets used to produce products A and B and services is split evenly between assets that produce gross FDDEI and assets that produce gross RDEI. DC has $840x of supportive deductions, as defined in § 1.861-8(b)(3), attributable to general and administrative expenses incurred for the purpose of generating the class of gross income that consists of gross DEI. DC apportions the $840x of deductions on the basis of gross income in accordance with § 1.861-8T(c)(1). For purposes of determining gross FDDEI and gross DEI under paragraph (d)(1) of this section, DC attributes $200x of cost of goods sold to Product A and $400x of cost of goods sold to Product B, and then attributes the cost of goods sold for each product ratably between the gross receipts of such product sold to foreign persons and the gross receipts of such product sold to United States persons. The manner in which DC attributes the cost of goods sold is a reasonable method. DC has no other items of income, loss, or deduction. For the taxable year, DC has the following income tax items relevant to the determination of its FDII:
Table 1 to Paragraph ( d )(3)( ii )(A)( 1 )
( 2 ) Analysis —( i ) Determination of gross FDDEI and gross RDEI. Because DC does not have any income described in section 250(b)(3)(A)(i)(I) through (VI) and paragraphs (c)(15)(i) through (vi) of this section, none of its gross income is excluded from gross DEI. DC's gross DEI is $1,600x ($2,200x total gross receipts less $600x total cost of goods sold). DC's gross FDDEI is $800x ($1,100x of gross receipts from foreign persons minus attributable cost of goods sold of $300x).
( ii ) Determination of foreign-derived deduction eligible income. To calculate its FDDEI, DC must determine the amount of its deductions that are allocated and apportioned to gross FDDEI and then subtract those amounts from gross FDDEI. DC's interest deduction of $300x is allocated and apportioned to gross FDDEI on the basis of the average total value of DC's assets in each grouping. DC has assets with a tax book value of $2,500x split evenly between assets that produce gross FDDEI and assets that produce gross RDEI. Accordingly, an interest expense deduction of $150x is apportioned to DC's gross FDDEI. With respect to DC's supportive deductions of $840x that are related to DC's gross DEI, DC apportions such deductions between gross FDDEI and gross RDEI on the basis of gross income. Accordingly, supportive deductions of $420x are apportioned to DC's gross FDDEI. Thus, DC's FDDEI is $230x, which is equal to its gross FDDEI of $800x less $150x of interest expense deduction and $420x of supportive deductions.
( iii ) Determination of deemed intangible income. DC's deemed tangible income return is $100x, which is equal to 10 percent of its QBAI of $1,000x. DC's DEI is $460x, which is equal to its gross DEI of $1,600x less $300x of interest expense deductions and $840x of supportive deductions. Therefore, DC's deemed intangible income is $360x, which is equal to the excess of its DEI of $460x over its deemed tangible income return of $100x.
( iv ) Determination of foreign-derived intangible income. DC's foreign-derived ratio is 50 percent, which is the ratio of DC's FDDEI of $230x to DC's DEI of $460x. Therefore, DC's FDII is $180x, which is equal to DC's deemed intangible income of $360x multiplied by its foreign-derived ratio of 50 percent.
(B) Example 2: Allocation of deductions with respect to a partnership —( 1 ) Facts —( i ) DC's operations. DC is engaged in the production and sale of products consisting of two separate product groups in three-digit Standard Industrial Classification (SIC) Industry Groups, hereafter referred to as Group AAA and Group BBB. All of the gross income of DC is included in gross DEI. DC incurs $250x of research and experimental (R&E) expenditures in the United States that are deductible under section 174. None of the R&E is included in cost of goods sold. For purposes of determining gross FDDEI and gross DEI under paragraph (d)(1) of this section, DC attributes $210x of cost of goods sold to Group AAA products and $900x of cost of goods sold to Group BBB products, and then attributes the cost of goods sold with respect to each such product group ratably between the gross receipts with respect to such product group sold to foreign persons and the gross receipts with respect to such product group not sold to foreign persons. The manner in which DC attributes the cost of goods sold is a reasonable method. For the taxable year, DC has the following income tax items relevant to the determination of its FDII:
Table 2 to ( d )(3)( ii )(B)( 1 )( i )
( ii ) PRS's operations. In addition to its own operations, DC is a partner in PRS, a partnership that also produces products described in SIC Group AAA. DC is allocated 50 percent of all income, gain, loss, and deductions of PRS. During the taxable year, PRS sells Group AAA products solely to foreign persons, and all of its gross income is included in gross DEI. PRS has $400 of gross receipts from sales of Group AAA products for the taxable year and incurs $100x of research and experimental (R&E) expenditures in the United States that are deductible under section 174. None of the R&E is included in cost of goods sold. For purposes of determining gross FDDEI and gross DEI under paragraph (d)(1) of this section, PRS attributes $200x of cost of goods sold to Group AAA products, and then attributes the cost of goods sold with respect to such product group ratably between the gross receipts with respect to such product group sold to foreign persons and the gross receipts with respect to such product group not sold to foreign persons. The manner in which PRS attributes the cost of goods sold is a reasonable method. DC's distributive share of PRS taxable items is $100x of gross income and $50x of R&E deductions, and DC's share of PRS's gross receipts from sales of Group AAA products for the taxable year is $200x under § 1.861-17(f)(3).
( iii ) Application of the sales method to allocate and apportion R&E. DC applies the sales method to apportion its R&E deductions under § 1.861-17. Neither DC nor PRS licenses or sells its intangible property to controlled or uncontrolled corporations in a manner that necessitates including the sales by such corporations for purposes of apportioning DC's R&E deductions.
( 2 ) Analysis —( i ) Determination of gross DEI and gross FDDEI. Under paragraph (e)(1) of this section, DC's gross DEI, gross FDDEI, and deductions allocable to those amounts include its distributive share of gross DEI, gross FDDEI, and deductions of PRS. Thus, DC's gross DEI for the year is $490x ($390x attributable to DC and $100x attributable to DC's interest in PRS). DC's gross income from sales of Group AAA products to foreign persons is $30x ($100x of gross receipts minus attributable cost of goods sold of $70x). DC's gross income from sales of Group BBB products to foreign persons is $100x ($400x of gross receipts minus attributable cost of goods sold of $300x). DC's gross FDDEI for the year is $230x ($30x from DC's sale of Group AAA products plus $100x from DC's sale of Group BBB products plus DC's distributive share of PRS's gross FDDEI of $100x).
( ii ) Allocation and apportionment of R&E deductions. To determine FDDEI, DC must allocate and apportion its R&E expense of $300x ($250x incurred directly by DC and $50x incurred indirectly through DC's interest in PRS). In accordance with § 1.861-17, R&E expenses are first allocated to a class of gross income related to a three-digit SIC group code. DC's R&E expenses related to products in Group AAA are $90x ($40x incurred directly by DC and $50x incurred indirectly through DC's interest in PRS) and its expenses related to Group BBB are $210x. See paragraph (d)(2)(i) of this section. Accordingly, all R&E expense attributable to a particular SIC group code is apportioned on the basis of the amounts of sales within that SIC group code. Total sales within Group AAA were $500x ($300x directly by DC and $200x attributable to DC's interest in PRS), $300x of which were made to foreign persons ($100x directly by DC and $200x attributable to DC's interest in PRS). Therefore, the $90x of R&E expense related to Group AAA is apportioned $54x to gross FDDEI ($90x × $300x/$500x) and $36x to gross RDEI ($90x × $200x/$500x). Total sales within Group BBB were $1,200x, $400x of which were made to foreign persons. Therefore, the $210x of R&E expense related to products in Group BBB is apportioned $70x to gross FDDEI ($210x × $400x/$1,200x) and $140x to gross RDEI ($210x × $800x/$1,200x). Accordingly, DC's FDDEI for the tax year is $106x ($230x gross FDDEI minus $124x of R&E ($54x + $70x) allocated and apportioned to gross FDDEI).
(e) Domestic corporate partners —(1) In general. A domestic corporation's DEI and FDDEI for a taxable year are determined by taking into account the corporation's share of gross DEI, gross FDDEI, and deductions of any partnership (whether domestic or foreign) in which the corporation is a direct or indirect partner. For purposes of the preceding sentence, a domestic corporation's share of each such item of a partnership is determined in accordance with the corporation's distributive share of the underlying items of income, gain, deduction, and loss of the partnership that comprise such amounts. See § 1.250(b)-2(g) for rules on calculating the increase to a domestic corporation's QBAI by the corporation's share of partnership QBAI.
(2) Reporting requirement for partnership with domestic corporate partners. A partnership that has one or more direct partners that are domestic corporations and that is required to file a return under section 6031 must furnish to each such partner on or with such partner's Schedule K-1 (Form 1065 or any successor form) by the due date (including extensions) for furnishing Schedule K-1 the partner's share of the partnership's gross DEI, gross FDDEI, deductions that are properly allocable to the partnership's gross DEI and gross FDDEI, and partnership QBAI (as determined under § 1.250(b)-2(g)) for each taxable year in which the partnership has gross DEI, gross FDDEI, deductions that are properly allocable to the partnership's gross DEI or gross FDDEI, or partnership specified tangible property (as defined in § 1.250(b)-2(g)(5)). In the case of tiered partnerships where one or more partners of an upper-tier partnership are domestic corporations, a lower-tier partnership must report the amount specified in this paragraph (e)(2) to the upper-tier partnership to allow reporting of such information to any partner that is a domestic corporation. To the extent that a partnership cannot determine the information described in the first sentence of this paragraph (e)(2), the partnership must instead furnish to each partner its share of the partnership's attributes that a partner needs to determine the partner's gross DEI, gross FDDEI, deductions that are properly allocable to the partner's gross DEI and gross FDDEI, and the partner's adjusted bases in partnership specified tangible property.
(3) Examples. The following examples illustrate the application of this paragraph (e).
(i) Assumed facts. The following facts are assumed for purposes of the examples—
(A) DC, a domestic corporation, is a partner in PRS, a partnership.
(B) FP and FP2 are foreign persons.
(C) FC is a foreign corporation.
(D) The allocations under PRS's partnership agreement satisfy the requirements of section 704.
(E) No partner of PRS is a related party of DC.
(F) DC, PRS, and FC all use the calendar year as their taxable year.
(G) PRS has no items of income, loss, or deduction for its taxable year, except the items of income described.
(ii) Examples —
(A) Example 1: Sale by partnership to foreign person —( 1 ) Facts. Under the terms of the partnership agreement, DC is allocated 50 percent of all income, gain, loss, and deductions of PRS. For the taxable year, PRS recognizes $20x of gross income on the sale of general property (as defined in § 1.250(b)-3(b)(10)) to FP, a foreign person (as determined under § 1.250(b)-4(c)), for a foreign use (as determined under § 1.250(b)-4(d)). The gross income recognized on the sale of property is not described in section 250(b)(3)(A)(I) through (VI) or paragraphs (c)(15)(i) through (vi) of this section.
( 2 ) Analysis. PRS's sale of property to FP is a FDDEI sale as described in § 1.250(b)-4(b). Therefore, the gross income derived from the sale ($20x) is included in PRS's gross DEI and gross FDDEI, and DC's share of PRS's gross DEI and gross FDDEI ($10x) is included in DC's gross DEI and gross FDDEI for the taxable year.
(B) Example 2: Sale by partnership to foreign person attributable to foreign branch —( 1 ) Facts. The facts are the same as in paragraph (e)(3)(ii)(A)( 1 ) of this section (the facts in Example 1 ), except the income from the sale of property to FP is attributable to a foreign branch of PRS.
( 2 ) Analysis. PRS's sale of property to FP is excluded from PRS's gross DEI under section 250(b)(3)(A)(VI) and paragraph (c)(15)(vi) of this section. Accordingly, DC's share of PRS's gross income of $10x from the sale is not included in DC's gross DEI or gross FDDEI for the taxable year.
(C) Example 3: Partnership with a loss in gross FDDEI —( 1 ) Facts. The facts are the same as in paragraph (e)(3)(ii)(A)( 1 ) of this section (the facts in Example 1 ), except that in the same taxable year, PRS also sells property to FP2, a foreign person (as determined under § 1.250(b)-4(c)), for a foreign use (as determined under § 1.250(b)-4(d)). After taking into account both sales, PRS has a gross loss of $30x.
( 2 ) Analysis. Both the sale of property to FP and the sale of property to FP2 are FDDEI sales because each sale is described in § 1.250(b)-4(b). DC's share of PRS's gross loss ($15x) from the sales is included in DC's gross DEI and gross FDDEI.
(D) Example 4: Sale by partnership to foreign related party of the partnership —( 1 ) Facts. Under the terms of the partnership agreement, DC has 25 percent of the capital and profits interest in the partnership and is allocated 25 percent of all income, gain, loss, and deductions of PRS. PRS owns 100 percent of the single class of stock of FC. In the taxable year, PRS has $20x of gain on the sale of general property (as defined in § 1.250(b)-3(b)(10)) to FC, and FC makes a physical and material change to the property within the meaning of § 1.250(b)-4(d)(1)(iii)(B) outside the United States before selling the property to customers in the United States.
( 2 ) Analysis. The sale of property by PRS to FC is described in § 1.250(b)-4(b) without regard to the application of § 1.250(b)-6, since the sale is to a foreign person (as determined under § 1.250(b)-4(c)) for a foreign use (as determined under § 1.250(b)-4(d)). However, FC is a foreign related party of PRS within the meaning of section 250(b)(5)(D) and § 1.250(b)-3(b)(6), because FC and PRS are members of a modified affiliated group within the meaning of paragraph (c)(17) of this section. Therefore, the sale by PRS to FC is a related party sale within the meaning of § 1.250(b)-6(b)(1). Under section 250(b)(5)(C)(i) and § 1.250(b)-6(c), because FC did not sell the property, or use the property in connection with other property sold or the provision of a service, to a foreign unrelated party before the property was subject to a domestic use, the sale by PRS to FC is not a FDDEI sale. See § 1.250(b)-6(c)(1). Accordingly, the gain from the sale ($20x) is included in PRS's gross DEI but not its gross FDDEI, and DC's share of PRS's gain ($5x) is included in DC's gross DEI but not gross FDDEI. This is the result notwithstanding that FC is not a related party of DC because FC and DC are not members of a modified affiliated group within the meaning of paragraph (c)(17) of this section.
(f) Determination of FDII for consolidated groups. A member of a consolidated group (as defined in § 1.1502-1(h)) determines its FDII under the rules provided in § 1.1502-50.
(g) Determination of FDII for tax-exempt corporations. The FDII of a corporation that is subject to the unrelated business income tax under section 511 is determined only by reference to that corporation's items of income, gain, deduction, or loss, and adjusted bases in property, that are taken into account in computing the corporation's unrelated business taxable income (as defined in section 512). For example, if a corporation that is subject to the unrelated business income tax under section 511 has tangible property used in the production of both unrelated business income and gross income that is not unrelated business income, only the portion of the basis of such property taken into account in computing the corporation's unrelated business taxable income is taken into account in determining the corporation's QBAI. Similarly, if a corporation that is subject to the unrelated business income tax under section 511 has tangible property that is used in both the production of gross DEI and the production of gross income that is not gross DEI, only the corporation's unrelated business income is taken into account in determining the corporation's dual use ratio with respect to such property under § 1.250(b)-2(d)(3).
§ 1.250(b)-2   Qualified business asset investment (QBAI).
(a) Scope. This section provides general rules for determining the qualified business asset investment of a domestic corporation for purposes of determining its deemed tangible income return under § 1.250(b)-1(c)(4). Paragraph (b) of this section defines qualified business asset investment (QBAI). Paragraph (c) of this section defines tangible property and specified tangible property. Paragraph (d) of this section provides rules for determining the portion of property that is specified tangible property when the property is used in the production of both gross DEI and gross income that is not gross DEI. Paragraph (e) of this section provides rules for determining the adjusted basis of specified tangible property. Paragraph (f) of this section provides rules for determining QBAI of a domestic corporation with a short taxable year. Paragraph (g) of this section provides rules for increasing the QBAI of a domestic corporation by reason of property owned through a partnership. Paragraph (h) of this section provides an anti-avoidance rule that disregards certain transfers when determining the QBAI of a domestic corporation.
(b) Definition of qualified business asset investment. The term qualified business asset investment (QBAI) means the average of a domestic corporation's aggregate adjusted bases as of the close of each quarter of the domestic corporation's taxable year in specified tangible property that is used in a trade or business of the domestic corporation and is of a type with respect to which a deduction is allowable under section 167. In the case of partially depreciable property, only the depreciable portion of the property is of a type with respect to which a deduction is allowable under section 167.
(c) Specified tangible property —(1) In general. The term specified tangible property means, with respect to a domestic corporation for a taxable year, tangible property of the domestic corporation used in the production of gross DEI for the taxable year. For purposes of the preceding sentence, tangible property of a domestic corporation is used in the production of gross DEI for a taxable year if some or all of the depreciation or cost recovery allowance with respect to the tangible property is either allocated and apportioned to the gross DEI of the domestic corporation for the taxable year under § 1.250(b)-1(d)(2) or capitalized to inventory or other property held for sale, some or all of the gross income or loss from the sale of which is taken into account in determining DEI of the domestic corporation for the taxable year.
(2) Tangible property. The term tangible property means property for which the depreciation deduction provided by section 167(a) is eligible to be determined under section 168 without regard to section 168(f)(1), (2), or (5), section 168(k)(2)(A)(i)(II), (IV), or (V), and the date placed in service.
(d) Dual use property —(1) In general. The amount of the adjusted basis in dual use property of a domestic corporation for a taxable year that is treated as adjusted basis in specified tangible property for the taxable year is the average of the domestic corporation's adjusted basis in the property multiplied by the dual use ratio with respect to the property for the taxable year.
(2) Definition of dual use property. The term dual use property means, with respect to a domestic corporation and a taxable year, specified tangible property of the domestic corporation that is used in both the production of gross DEI and the production of gross income that is not gross DEI for the taxable year. For purposes of the preceding sentence, specified tangible property of a domestic corporation is used in the production of gross DEI and the production of gross income that is not gross DEI for a taxable year if less than all of the depreciation or cost recovery allowance with respect to the property is either allocated and apportioned to the gross DEI of the domestic corporation for the taxable year under § 1.250(b)-1(d)(2) or capitalized to inventory or other property held for sale, the gross income or loss from the sale of which is taken into account in determining the DEI of the domestic corporation for the taxable year.
(3) Dual use ratio. The term dual use ratio means, with respect to dual use property, a domestic corporation, and a taxable year, a ratio (expressed as a percentage) calculated as—
(i) The sum of—
(A) The depreciation deduction or cost recovery allowance with respect to the property that is allocated and apportioned to the gross DEI of the domestic corporation for the taxable year under § 1.250(b)-1(d)(2); and
(B) The depreciation or cost recovery allowance with respect to the property that is capitalized to inventory or other property held for sale, the gross income or loss from the sale of which is taken into account in determining the DEI of the domestic corporation for the taxable year; divided by
(ii) The sum of—
(A) The total amount of the domestic corporation's depreciation deduction or cost recovery allowance with respect to the property for the taxable year; and
(B) The total amount of the domestic corporation's depreciation or cost recovery allowance with respect to the property capitalized to inventory or other property held for sale, the gross income or loss from the sale of which is taken into account in determining the income or loss of the domestic corporation for the taxable year.
(4) Example. The following example illustrates the application of this paragraph (d).
(i) Facts. DC, a domestic corporation, owns a machine that produces both gross DEI and income that is not gross DEI. The average adjusted basis of the machine for the taxable year in the hands of DC is $4,000x. The depreciation with respect to the machine for the taxable year is $400x, $320x of which is capitalized to inventory of Product A, gross income or loss from the sale of which is taken into account in determining DC's gross DEI for the taxable year, and $80x of which is capitalized to inventory of Product B, gross income or loss from the sale of which is not taken into account in determining DC's gross DEI for the taxable year. DC also owns an office building for its administrative functions with an average adjusted basis for the taxable year of $10,000x. DC does not capitalize depreciation with respect to the office building to inventory or other property held for sale. DC's depreciation deduction with respect to the office building is $1,000x for the taxable year, $750x of which is allocated and apportioned to gross DEI under § 1.250(b)-1(d)(2), and $250x of which is allocated and apportioned to income other than gross DEI under § 1.250(b)-1(d)(2).
(ii) Analysis —(A) Dual use property. The machine and office building are property for which the depreciation deduction provided by section 167(a) is eligible to be determined under section 168 (without regard to section 168(f)(1), (2), or (5), section 168(k)(2)(A)(i)(II), (IV), or (V), and the date placed in service). Therefore, under paragraph (c)(2) of this section, the machine and office building are tangible property. Furthermore, because the machine and office building are used in the production of gross DEI for the taxable year within the meaning of paragraph (c)(1) of this section, the machine and office building are specified tangible property. Finally, because the machine and office building are used in both the production of gross DEI and the production of gross income that is not gross DEI for the taxable year within the meaning of paragraph (d)(2) of this section, the machine and office building are dual use property. Therefore, under paragraph (d)(1) of this section, the amount of DC's adjusted basis in the machine and office building that is treated as adjusted basis in specified tangible property for the taxable year is determined by multiplying DC's adjusted basis in the machine and office building by DC's dual use ratio with respect to the machine and office building determined under paragraph (d)(3) of this section.
(B) Depreciation not capitalized to inventory. Because none of the depreciation with respect to the office building is capitalized to inventory or other property held for sale, DC's dual use ratio with respect to the office building is determined entirely by reference to the depreciation deduction with respect to the office building. Therefore, under paragraph (d)(3) of this section, DC's dual use ratio with respect to the office building for Year 1 is 75 percent, which is DC's depreciation deduction with respect to the office building that is allocated and apportioned to gross DEI under § 1.250(b)-1(d)(2) for Year 1 ($750x), divided by the total amount of DC's depreciation deduction with respect to the office building for Year 1 ($1000x). Accordingly, under paragraph (d)(1) of this section, $7,500x ($10,000x × 0.75) of DC's average adjusted bases in the office building is taken into account under paragraph (b) of this section in determining DC's QBAI for the taxable year.
(C) Depreciation capitalized to inventory. Because all of the depreciation with respect to the machine is capitalized to inventory, DC's dual use ratio with respect to the machine is determined entirely by reference to the depreciation with respect to the machine that is capitalized to inventory and included in cost of goods sold. Therefore, under paragraph (d)(3) of this section, DC's dual use ratio with respect to the machine for the taxable year is 80 percent, which is DC's depreciation with respect to the machine that is capitalized to inventory of Product A, the gross income or loss from the sale of which is taken into account in determining DC's DEI for the taxable year ($320x), divided by DC's depreciation with respect to the machine that is capitalized to inventory, the gross income or loss from the sale of which is taken into account in determining DC's income for Year 1 ($400x). 



Accordingly, under paragraph (d)(1) of this section, $3,200x ($4,000x × 0.8) of DC's average adjusted basis in the machine is taken into account under paragraph (b) of this section in determining DC's QBAI for the taxable year.
(e) Determination of adjusted basis of specified tangible property —(1) In general. The adjusted basis in specified tangible property for purposes of this section is determined by using the cost capitalization methods of accounting used by the domestic corporation for purposes of determining the gross income and deductions of the domestic corporation and the alternative depreciation system under section 168(g), and by allocating the depreciation deduction with respect to such property for the domestic corporation's taxable year ratably to each day during the period in the taxable year to which such depreciation relates. For purposes of the preceding sentence, the period in the taxable year to which such depreciation relates is determined without regard to the applicable convention under section 168(d).
(2) Effect of change in law. The adjusted basis in specified tangible property is determined without regard to any provision of law enacted after December 22, 2017, unless such later enacted law specifically and directly amends the definition of QBAI under section 250 or section 951A. For purposes of applying section 250(b)(2)(B) and this paragraph (e), the technical amendment to section 168(g) (to provide a recovery period of 20 years for qualified improvement property for purposes of the alternative depreciation system) enacted in section 2307(a) of the Coronavirus Aid, Relief, and Economic Security Act, Public Law 116-136 (2020) is treated as enacted on December 22, 2017.
(3) Specified tangible property placed in service before enactment of section 250. The adjusted basis in specified tangible property placed in service before December 22, 2017, is determined using the alternative depreciation system under section 168(g), as if this system had applied from the date that the property was placed in service.
(f) Special rules for short taxable years —(1) In general. In the case of a domestic corporation that has a taxable year that is less than twelve months (a short taxable year ), the rules for determining the QBAI of the domestic corporation under this section are modified as provided in paragraphs (f)(2) and (3) of this section with respect to the taxable year.
(2) Determination of when the quarter closes. For purposes of determining when the quarter closes, in determining the QBAI of a domestic corporation for a short taxable year, the quarters of the domestic corporation for purposes of this section are the full quarters beginning and ending within the short taxable year (if any), determining quarter length as if the domestic corporation did not have a short taxable year, plus one or more short quarters (if any).
(3) Reduction of qualified business asset investment. The QBAI of a domestic corporation for a short taxable year is the sum of—
(i) The sum of the domestic corporation's aggregate adjusted bases in specified tangible property as of the close of each full quarter (if any) in the domestic corporation's taxable year divided by four; plus
(ii) The domestic corporation's aggregate adjusted bases in specified tangible property as of the close of each short quarter (if any) in the domestic corporation's taxable year multiplied by the sum of the number of days in each short quarter divided by 365.
(4) Example. The following example illustrates the application of this paragraph (f).
(i) Facts. A, an individual, owns all of the stock of DC, a domestic corporation. A owns DC from the beginning of the taxable year. On July 15 of the taxable year, A sells DC to USP, a domestic corporation that is unrelated to A. DC becomes a member of the consolidated group of which USP is the common parent and as a result, under § 1.1502-76(b)(2)(ii), DC's taxable year is treated as ending on July 15. USP and DC both use the calendar year as their taxable year. DC's aggregate adjusted bases in specified tangible property for the taxable year are $250x as of March 31, $300x as of June 30, $275x as of July 15, $500x as of September 30, and $450x as of December 31.
(ii) Analysis —(A) Determination of short taxable years and quarters. DC has two short taxable years during the year. The first short taxable year is from January 1 to July 15, with two full quarters (January 1 through March 31 and April 1 through June 30) and one short quarter (July 1 through July 15). The second taxable year is from July 16 to December 31, with one short quarter (July 16 through September 30) and one full quarter (October 1 through December 31).
(B) Calculation of qualified business asset investment for the first short taxable year. Under paragraph (f)(2) of this section, for the first short taxable year, DC has three quarter closes (March 31, June 30, and July 15). Under paragraph (f)(3) of this section, the QBAI of DC for the first short taxable year is $148.80x, the sum of $137.50x (($250x + $300x)/4) attributable to the two full quarters and $11.30x ($275x × 15/365) attributable to the short quarter.
(C) Calculation of qualified business asset investment for the second short taxable year. Under paragraph (f)(2) of this section, for the second short taxable year, DC has two quarter closes (September 30 and December 31). Under paragraph (f)(3) of this section, the QBAI of DC for the second short taxable year is $217.98x, the sum of $112.50x ($450x/4) attributable to the one full quarter and $105.48x ($500x × 77/365) attributable to the short quarter.
(g) Partnership property —(1) In general. If a domestic corporation holds an interest in one or more partnerships during a taxable year (including indirectly through one or more partnerships that are partners in a lower-tier partnership), the QBAI of the domestic corporation for the taxable year (determined without regard to this paragraph (g)(1)) is increased by the sum of the domestic corporation's partnership QBAI with respect to each partnership for the taxable year.
(2) Determination of partnership QBAI. For purposes of paragraph (g)(1) of this section, the term partnership QBAI means, with respect to a partnership, a domestic corporation, and a taxable year, the sum of the domestic corporation's partner adjusted basis in each partnership specified tangible property of the partnership for each partnership taxable year that ends with or within the taxable year. If a partnership taxable year is less than twelve months, the principles of paragraph (f) of this section apply in determining a domestic corporation's partnership QBAI with respect to the partnership.
(3) Determination of partner adjusted basis —(i) In general. For purposes of paragraph (g)(2) of this section, the term partner adjusted basis means the amount described in paragraph (g)(3)(ii) of this section with respect to sole use partnership property or paragraph (g)(3)(iii) of this section with respect to dual use partnership property. The principles of section 706(d) apply to this determination.
(ii) Sole use partnership property —(A) In general. The amount described in this paragraph (g)(3)(ii), with respect to sole use partnership property, a partnership taxable year, and a domestic corporation, is the sum of the domestic corporation's proportionate share of the partnership adjusted basis in the sole use partnership property for the partnership taxable year and the domestic corporation's partner-specific QBAI basis in the sole use partnership property for the partnership taxable year.
(B) Definition of sole use partnership property. The term sole use partnership property means, with respect to a partnership, a partnership taxable year, and a domestic corporation, partnership specified tangible property of the partnership that is used in the production of only gross DEI of the domestic corporation for the taxable year in which or with which the partnership taxable year ends. For purposes of the preceding sentence, partnership specified tangible property of a partnership is used in the production of only gross DEI for a taxable year if all the domestic corporation's distributive share of the partnership's depreciation deduction or cost recovery allowance with respect to the property (if any) for the partnership taxable year that ends with or within the taxable year is allocated and apportioned to the domestic corporation's gross DEI for the taxable year under § 1.250(b)-1(d)(2) and, if any of the partnership's depreciation or cost recovery allowance with respect to the property is capitalized to inventory or other property held for sale, all the domestic corporation's distributive share of the partnership's gross income or loss from the sale of such inventory or other property for the partnership taxable year that ends with or within the taxable year is taken into account in determining the DEI of the domestic corporation for the taxable year.
(iii) Dual use partnership property —(A) In general. The amount described in this paragraph (g)(3)(iii), with respect to dual use partnership property, a partnership taxable year, and a domestic corporation, is the sum of the domestic corporation's proportionate share of the partnership adjusted basis in the property for the partnership taxable year and the domestic corporation's partner-specific QBAI basis in the property for the partnership taxable year, multiplied by the domestic corporation's dual use ratio with respect to the property for the partnership taxable year determined under the principles of paragraph (d)(3) of this section, except that the ratio described in paragraph (d)(3) of this section is determined by reference to the domestic corporation's distributive share of the amounts described in paragraph (d)(3) of this section.
(B) Definition of dual use partnership property. The term dual use partnership property means partnership specified tangible property other than sole use partnership property.
(4) Determination of proportionate share of the partnership's adjusted basis in partnership specified tangible property —(i) In general. For purposes of paragraph (g)(3) of this section, the domestic corporation's proportionate share of the partnership adjusted basis in partnership specified tangible property for a partnership taxable year is the partnership adjusted basis in the property multiplied by the domestic corporation's proportionate share ratio with respect to the property for the partnership taxable year. Solely for purposes of determining the proportionate share ratio under paragraph (g)(4)(ii) of this section, the partnership's calculation of, and a partner's distributive share of, any income, loss, depreciation, or cost recovery allowance is determined under section 704(b).
(ii) Proportionate share ratio. The term proportionate share ratio means, with respect to a partnership, a partnership taxable year, and a domestic corporation, the ratio (expressed as a percentage) calculated as—
(A) The sum of—
( 1 ) The domestic corporation's distributive share of the partnership's depreciation deduction or cost recovery allowance with respect to the property for the partnership taxable year; and
( 2 ) The amount of the partnership's depreciation or cost recovery allowance with respect to the property that is capitalized to inventory or other property held for sale, the gross income or loss from the sale of which is taken into account in determining the domestic corporation's distributive share of the partnership's income or loss for the partnership taxable year; divided by
(B) The sum of—
( 1 ) The total amount of the partnership's depreciation deduction or cost recovery allowance with respect to the property for the partnership taxable year; and
( 2 ) The total amount of the partnership's depreciation or cost recovery allowance with respect to the property capitalized to inventory or other property held for sale, the gross income or loss from the sale of which is taken into account in determining the partnership's income or loss for the partnership taxable year.
(5) Definition of partnership specified tangible property. The term partnership specified tangible property means, with respect to a domestic corporation, tangible property (as defined in paragraph (c)(2) of this section) of a partnership that is—
(i) Used in the trade or business of the partnership;
(ii) Of a type with respect to which a deduction is allowable under section 167; and
(iii) Used in the production of gross income included in the domestic corporation's gross DEI.
(6) Determination of partnership adjusted basis. For purposes of this paragraph (g), the term partnership adjusted basis means, with respect to a partnership, partnership specified tangible property, and a partnership taxable year, the amount equal to the average of the partnership's adjusted basis in the partnership specified tangible property as of the close of each quarter in the partnership taxable year determined without regard to any adjustments under section 734(b) except for adjustments under section 734(b)(1)(B) or section 734(b)(2)(B) that are attributable to distributions of tangible property (as defined in paragraph (c)(2) of this section) and for adjustments under section 734(b)(1)(A) or 734(b)(2)(A). The principles of paragraphs (e) and (h) of this section apply for purposes of determining a partnership's adjusted basis in partnership specified tangible property and the proportionate share of the partnership's adjusted basis in partnership specified tangible property.
(7) Determination of partner-specific QBAI basis. For purposes of this paragraph (g), the term partner-specific QBAI basis means, with respect to a domestic corporation, a partnership, and partnership specified tangible property, the amount that is equal to the average of the basis adjustment under section 743(b) that is allocated to the partnership specified tangible property of the partnership with respect to the domestic corporation as of the close of each quarter in the partnership taxable year. For this purpose, a negative basis adjustment under section 743(b) is expressed as a negative number. The principles of paragraphs (e) and (h) of this section apply for purposes of determining the partner-specific QBAI basis with respect to partnership specified tangible property.
(8) Examples. The following examples illustrate the rules of this paragraph (g).
(i) Assumed facts. Except as otherwise stated, the following facts are assumed for purposes of the examples:
(A) DC, DC1, DC2, and DC3 are domestic corporations.
(B) PRS is a partnership and its allocations satisfy the requirements of section 704.
(C) All properties are partnership specified tangible property.
(D) All persons use the calendar year as their taxable year.
(E) There is no partner-specific QBAI basis with respect to any property.
(ii) Example 1: Sole use partnership property —(A) Facts. DC is a partner in PRS. PRS owns two properties, Asset A and Asset B. The average of PRS's adjusted basis as of the close of each quarter of PRS's taxable year in Asset A is $100x and in Asset B is $500x. In Year 1, PRS's section 704(b) depreciation deduction is $10x with respect to Asset A and $5x with respect to Asset B, and DC's section 704(b) distributive share of the depreciation deduction is $8x with respect to Asset A and $1x with respect to Asset B. None of the depreciation with respect to Asset A or Asset B is capitalized to inventory or other property held for sale. DC's entire distributive share of the depreciation deduction with respect to Asset A and Asset B is allocated and apportioned to DC's gross DEI for Year 1 under § 1.250(b)-1(d)(2).
(B) Analysis —( 1 ) Sole use partnership property. Because all of DC's distributive share of the depreciation deduction with respect to Asset A and B is allocated and apportioned to gross DEI for Year 1, Asset A and Asset B are sole use partnership property within the meaning of paragraph (g)(3)(ii)(B) of this section. Therefore, under paragraph (g)(3)(ii)(A) of this section, DC's partner adjusted basis in Asset A and Asset B is equal to the sum of DC's proportionate share of PRS's partnership adjusted basis in Asset A and Asset B for Year 1 and DC's partner-specific QBAI basis in Asset A and Asset B for Year 1, respectively.
( 2 ) Proportionate share. Under paragraph (g)(4)(i) of this section, DC's proportionate share of PRS's partnership adjusted basis in Asset A and Asset B is PRS's partnership adjusted basis in Asset A and Asset B for Year 1, multiplied by DC's proportionate share ratio with respect to Asset A and Asset B for Year 1, respectively. Because none of the depreciation with respect to Asset A or Asset B is capitalized to inventory or other property held for sale, DC's proportionate share ratio with respect to Asset A and Asset B is determined entirely by reference to the depreciation deduction with respect to Asset A and Asset B. Therefore, DC's proportionate share ratio with respect to Asset A for Year 1 is 80 percent, which is the ratio of DC's section 704(b) distributive share of PRS's section 704(b) depreciation deduction with respect to Asset A for Year 1 ($8x), divided by the total amount of PRS's section 704(b) depreciation deduction with respect to Asset A for Year 1 ($10x). DC's proportionate share ratio with respect to Asset B for Year 1 is 20 percent, which is the ratio of DC's section 704(b) distributive share of PRS's section 704(b) depreciation deduction with respect to Asset B for Year 1 ($1x), divided by the total amount of PRS's section 704(b) depreciation deduction with respect to Asset B for Year 1 ($5x). Accordingly, under paragraph (g)(4)(i) of this section, DC's proportionate share of PRS's partnership adjusted basis in Asset A is $80x ($100x × 0.8), and DC's proportionate share of PRS's partnership adjusted basis in Asset B is $100x ($500x × 0.2).
( 3 ) Partner adjusted basis. Because DC has no partner-specific QBAI basis with respect to Asset A and Asset B, DC's partner adjusted basis in Asset A and Asset B is determined entirely by reference to its proportionate share of PRS's partnership adjusted basis in Asset A and Asset B. Therefore, under paragraph (g)(3)(ii)(A) of this section, DC's partner adjusted basis in Asset A is $80x, DC's proportionate share of PRS's partnership adjusted basis in Asset A, and DC's partner adjusted basis in Asset B is $100x, DC's proportionate share of PRS's partnership adjusted basis in Asset B.
( 4 ) Partnership QBAI. Under paragraph (g)(2) of this section, DC's partnership QBAI with respect to PRS is $180x, the sum of DC's partner adjusted basis in Asset A ($80x) and DC's partner adjusted basis in Asset B ($100x). Accordingly, under paragraph (g)(1) of this section, DC increases its QBAI for Year 1 by $180x.
(iii) Example 2: Dual use partnership property —(A) Facts. DC owns a 50 percent interest in PRS. All section 704(b) and tax items are identical and are allocated equally between DC and its other partner. PRS owns three properties, Asset C, Asset D, and Asset E. PRS sells two products, Product A and Product B. All of DC's distributive share of the gross income or loss from the sale of Product A is taken into account in determining DC's DEI, and none of DC's distributive share of the gross income or loss from the sale of Product B is taken into account in determining DC's DEI.
( 1 ) Asset C. The average of PRS's adjusted basis as of the close of each quarter of PRS's taxable year in Asset C is $100x. In Year 1, PRS's depreciation is $10x with respect to Asset C, none of which is capitalized to inventory or other property held for sale. DC's distributive share of the depreciation deduction with respect to Asset C is $5x ($10x × 0.5), $3x of which is allocated and apportioned to DC's gross DEI under § 1.250(b)-1(d)(2).
( 2 ) Asset D. The average of PRS's adjusted basis as of the close of each quarter of PRS's taxable year in Asset D is $500x. In Year 1, PRS's depreciation is $50x with respect to Asset D, $10x of which is capitalized to inventory of Product A and $40x is capitalized to inventory of Product B. None of the $10x depreciation with respect to Asset D capitalized to inventory of Product A is capitalized to ending inventory. However, of the $40x capitalized to inventory of Product B, $10x is capitalized to ending inventory. Therefore, the amount of depreciation with respect to Asset D capitalized to inventory of Product A that is taken into account in determining DC's distributive share of the income or loss of PRS for Year 1 is $5x ($10x × 0.5), and the amount of depreciation with respect to Asset D capitalized to inventory of Product B that is taken into account in determining DC's distributive share of the income or loss of PRS for Year 1 is $15x ($30x × 0.5).
( 3 ) Asset E. The average of PRS's adjusted basis as of the close of each quarter of PRS's taxable year in Asset E is $600x. In Year 1, PRS's depreciation is $60x with respect to Asset E. Of the $60x depreciation with respect to Asset E, $20x is allowed as a deduction, $24x is capitalized to inventory of Product A, and $16x is capitalized to inventory of Product B. DC's distributive share of the depreciation deduction with respect to Asset E is $10x ($20x × 0.5), $8x of which is allocated and apportioned to DC's gross DEI under § 1.250(b)-1(d)(2). None of the $24x depreciation with respect to Asset E capitalized to inventory of Product A is capitalized to ending inventory. However, of the $16x depreciation with respect to Asset E capitalized to inventory of Product B, $10x is capitalized to ending inventory. Therefore, the amount of depreciation with respect to Asset E capitalized to inventory of Product A that is taken into account in determining DC's distributive share of the income or loss of PRS for Year 1 is $12x ($24x × 0.5), and the amount of depreciation with respect to Asset E capitalized to inventory of Product B that is taken into account in determining DC's distributive share of the income or loss of PRS for Year 1 is $3x ($6x × 0.5).
(B) Analysis. Because Asset C, Asset D, and Asset E are not used in the production of only gross DEI in Year 1 within the meaning of paragraph (g)(3)(ii)(B) of this section, Asset C, Asset D, and Asset E are dual use partnership property within the meaning of paragraph (g)(3)(iii)(B) of this section. Therefore, under paragraph (g)(3)(iii)(A) of this section, DC's partner adjusted basis in Asset C, Asset D, and Asset E is the sum of DC's proportionate share of PRS's partnership adjusted basis in Asset C, Asset D, and Asset E, respectively, for Year 1, and DC's partner-specific QBAI basis in Asset C, Asset D, and Asset E, respectively, for Year 1, multiplied by DC's dual use ratio with respect to Asset C, Asset D, and Asset E, respectively, for Year 1, determined under the principles of paragraph (d)(3) of this section, except that the ratio described in paragraph (d)(3) of this section is determined by reference to DC's distributive share of the amounts described in paragraph (d)(3) of this section.
( 1 ) Asset C —( i ) Proportionate share. Under paragraph (g)(4)(i) of this section, DC's proportionate share of PRS's partnership adjusted basis in Asset C is PRS's partnership adjusted basis in Asset C for Year 1, multiplied by DC's proportionate share ratio with respect to Asset C for Year 1. Because none of the depreciation with respect to Asset C is capitalized to inventory or other property held for sale, DC's proportionate share ratio with respect to Asset C is determined entirely by reference to the depreciation deduction with respect to Asset C. Therefore, DC's proportionate share ratio with respect to Asset C is 50 percent, which is the ratio calculated as the amount of DC's section 704(b) distributive share of PRS's section 704(b) depreciation deduction with respect to Asset C for Year 1 ($5x), divided by the total amount of PRS's section 704(b) depreciation deduction with respect to Asset C for Year 1 ($10x). Accordingly, under paragraph (g)(4)(i) of this section, DC's proportionate share of PRS's partnership adjusted basis in Asset C is $50x ($100x × 0.5).
( ii ) Dual use ratio. Because none of the depreciation with respect to Asset C is capitalized to inventory or other property held for sale, DC's dual use ratio with respect to Asset C is determined entirely by reference to the depreciation deduction with respect to Asset C. Therefore, DC's dual use ratio with respect to Asset C is 60 percent, which is the ratio calculated as the amount of DC's distributive share of PRS's depreciation deduction with respect to Asset C that is allocated and apportioned to DC's gross DEI under § 1.250(b)-1(d)(2) for Year 1 ($3x), divided by the total amount of DC's distributive share of PRS's depreciation deduction with respect to Asset C for Year 1 ($5x).
( iii ) Partner adjusted basis. Because DC has no partner-specific QBAI basis with respect to Asset C, DC's partner adjusted basis in Asset C is determined entirely by reference to DC's proportionate share of PRS's partnership adjusted basis in Asset C, multiplied by DC's dual use ratio with respect to Asset C. Under paragraph (g)(3)(iii)(A) of this section, DC's partner adjusted basis in Asset C is $30x, DC's proportionate share of PRS's partnership adjusted basis in Asset C for Year 1 ($50x), multiplied by DC's dual use ratio with respect to Asset C for Year 1 (60 percent).
( 2 ) Asset D —( i ) Proportionate share. Under paragraph (g)(4)(i) of this section, DC's proportionate share of PRS's partnership adjusted basis in Asset D is PRS's partnership adjusted basis in Asset D for Year 1, multiplied by DC's proportionate share ratio with respect to Asset D for Year 1. Because all of the depreciation with respect to Asset D is capitalized to inventory, DC's proportionate share ratio with respect to Asset D is determined entirely by reference to the depreciation with respect to Asset D that is capitalized to inventory and included in cost of goods sold. Therefore, DC's proportionate share ratio with respect to Asset D is 50 percent, which is the ratio calculated as the amount of PRS's section 704(b) depreciation with respect to Asset D capitalized to Product A and Product B that is taken into account in determining DC's section 704(b) distributive share of PRS's income or loss for Year 1 ($20x), divided by the total amount of PRS's section 704(b) depreciation with respect to Asset D capitalized to Product A and Product B that is taken into account in determining PRS's section 704(b) income or loss for Year 1 ($40x). Accordingly, under paragraph (g)(4)(i) of this section, DC's proportionate share of PRS's partnership adjusted basis in Asset D is $250x ($500x × 0.5).
( ii ) Dual use ratio. Because all of the depreciation with respect to Asset D is capitalized to inventory, DC's dual use ratio with respect to Asset D is determined entirely by reference to the depreciation with respect to Asset D that is capitalized to inventory and included in cost of goods sold. Therefore, DC's dual use ratio with respect to Asset D is 25 percent, which is the ratio calculated as the amount of depreciation with respect to Asset D capitalized to inventory of Product A and Product B that is taken into account in determining DC's DEI for Year 1 ($5x), divided by the total amount of depreciation with respect to Asset D capitalized to inventory of Product A and Product B that is taken into account in determining DC's income or loss for Year 1 ($20x).
( iii ) Partner adjusted basis. Because DC has no partner-specific QBAI basis with respect to Asset D, DC's partner adjusted basis in Asset D is determined entirely by reference to DC's proportionate share of PRS's partnership adjusted basis in Asset D, multiplied by DC's dual use ratio with respect to Asset D. Under paragraph (g)(3)(iii)(A) of this section, DC's partner adjusted basis in Asset D is $62.50x, DC's proportionate share of PRS's partnership adjusted basis in Asset D for Year 1 ($250x), multiplied by DC's dual use ratio with respect to Asset D for Year 1 (25 percent).
( 3 ) Asset E —( i ) Proportionate share. Under paragraph (g)(4)(i) of this section, DC's proportionate share of PRS's partnership adjusted basis in Asset E is PRS's partnership adjusted basis in Asset E for Year 1, multiplied by DC's proportionate share ratio with respect to Asset E for Year 1. Because the depreciation with respect to Asset E is partly deducted and partly capitalized to inventory, DC's proportionate share ratio with respect to Asset E is determined by reference to both the depreciation that is deducted and the depreciation that is capitalized to inventory and included in cost of goods sold. Therefore, DC's proportionate share ratio with respect to Asset E is 50 percent, which is the ratio calculated as the sum ($25x) of the amount of DC's section 704(b) distributive share of PRS's section 704(b) depreciation deduction with respect to Asset E for Year 1 ($10x) and the amount of PRS's section 704(b) depreciation with respect to Asset E capitalized to inventory of Product A and Product B that is taken into account in determining DC's section 704(b) distributive share of PRS's income or loss for Year 1 ($15x), divided by the sum ($50x) of the total amount of PRS's section 704(b) depreciation deduction with respect to Asset E for Year 1 ($20x) and the total amount of PRS's section 704(b) depreciation with respect to Asset E capitalized to inventory of Product A and Product B that is taken into account in determining PRS's section 704(b) income or loss for Year 1 ($30x). Accordingly, under paragraph (g)(4)(i) of this section, DC's proportionate share of PRS's partnership adjusted basis in Asset E is $300x ($600x × 0.5).
( ii ) Dual use ratio. Because the depreciation with respect to Asset E is partly deducted and partly capitalized to inventory, DC's dual use ratio with respect to Asset E is determined by reference to the depreciation that is deducted and the depreciation that is capitalized to inventory and included in cost of goods sold. Therefore, DC's dual use ratio with respect to Asset E is 80 percent, which is the ratio calculated as the sum ($20x) of the amount of DC's distributive share of PRS's depreciation deduction with respect to Asset E that is allocated and apportioned to DC's gross DEI under § 1.250(b)-1(d)(2) for Year 1 ($8x) and the amount of depreciation with respect to Asset E capitalized to inventory of Product A and Product B that is taken into account in determining DC's DEI for Year 1 ($12x), divided by the sum ($25x) of the total amount of DC's distributive share of PRS's depreciation deduction with respect to Asset E for Year 1 ($10x) and the total amount of depreciation with respect to Asset E capitalized to inventory of Product A and Product B that is taken into account in determining DC's income or loss for Year 1 ($15x).
( iii ) Partner adjusted basis. Because DC has no partner-specific QBAI basis with respect to Asset E, DC's partner adjusted basis in Asset E is determined entirely by reference to DC's proportionate share of PRS's partnership adjusted basis in Asset E, multiplied by DC's dual use ratio with respect to Asset E. Under paragraph (g)(3)(iii)(A) of this section, DC's partner adjusted basis in Asset E is $240x, DC's proportionate share of PRS's partnership adjusted basis in Asset E for Year 1 ($300x), multiplied by DC's dual use ratio with respect to Asset E for Year 1 (80 percent).
( 4 ) Partnership QBAI. Under paragraph (g)(2) of this section, DC's partnership QBAI with respect to PRS is $332.50x, the sum of DC's partner adjusted basis in Asset C ($30x), DC's partner adjusted basis in Asset D ($62.50x), and DC's partner adjusted basis in Asset E ($240x). Accordingly, under paragraph (g)(1) of this section, DC increases its QBAI for Year 1 by $332.50x.
(iv) Example 3: Sole use partnership specified tangible property; section 743(b) adjustments —(A) Facts. The facts are the same as in paragraph (g)(8)(ii)(A) of this section (the facts in Example 1 ), except that there is an average of $40x positive adjustment to the adjusted basis in Asset A as of the close of each quarter of PRS's taxable year with respect to DC under section 743(b) and an average of $20x negative adjustment to the adjusted basis in Asset B as of the close of each quarter of PRS's taxable year with respect to DC under section 743(b).
(B) Analysis. Under paragraph (g)(3)(ii)(A) of this section, DC's partner adjusted basis in Asset A is $120x, which is the sum of $80x (DC's proportionate share of PRS's partnership adjusted basis in Asset A as illustrated in paragraph (g)(8)(ii)(B)( 2 ) of this section (the analysis in Example 1 )) and $40x (DC's partner-specific QBAI basis in Asset A). Under paragraph (g)(3)(ii)(A) of this section, DC's partner adjusted basis in Asset B is $80x, the sum of $100x (DC's proportionate share of the partnership adjusted basis in the property as illustrated in paragraph (g)(8)(ii)(B)( 2 ) of this section (the analysis in Example 1 )) and (−$20x) (DC's partner-specific QBAI basis in Asset B). Therefore, under paragraph (g)(2) of this section, DC's partnership QBAI with respect to PRS is $200x ($120x + $80x). Accordingly, under paragraph (g)(1) of this section, DC increases its QBAI for Year 1 by $200x.
(v) Example 4: Sale of partnership interest before close of taxable year —(A) Facts. DC1 owns a 50 percent interest in PRS on January 1 of Year 1. PRS does not have an election under section 754 in effect. On July 1 of Year 1, DC1 sells its entire interest in PRS to DC2. PRS owns Asset G. The average of PRS's adjusted basis as of the close of each quarter of PRS's taxable year in Asset G is $100x. DC1's section 704(b) distributive share of the depreciation deduction with respect to Asset G is 25 percent with respect to PRS's entire year. DC2's section 704(b) distributive share of the depreciation deduction with respect to Asset G is also 25 percent with respect to PRS's entire year. Both DC1's and DC2's entire distributive shares of the depreciation deduction with respect to Asset G are allocated and apportioned under § 1.250(b)-1(d)(2) to DC1's and DC2's gross DEI, respectively, for Year 1. PRS's allocations satisfy section 706(d).
(B) Analysis —( 1 ) DC1. Because DC1 owns an interest in PRS during DC1's taxable year and receives a distributive share of partnership items of the partnership under section 706(d), DC1 has partnership QBAI with respect to PRS in the amount determined under paragraph (g)(2) of this section. Under paragraph (g)(3)(i) of this section, DC1's partner adjusted basis in Asset G is $25x, the product of $100x (the partnership's adjusted basis in the property) and 25 percent (DC1's section 704(b) distributive share of depreciation deduction with respect to Asset G). Therefore, DC1's partnership QBAI with respect to PRS is $25x. Accordingly, under paragraph (g)(1) of this section, DC1 increases its QBAI by $25x for Year 1.
( 2 ) DC2. DC2's partner adjusted basis in Asset G is also $25x, the product of $100x (the partnership's adjusted basis in the property) and 25 percent (DC2's section 704(b) distributive share of depreciation deduction with respect to Asset G). Therefore, DC2's partnership QBAI with respect to PRS is $25x. Accordingly, under paragraph (g)(1) of this section, DC2 increases its QBAI by $25x for Year 1.
(vi) Example 5: Partnership adjusted basis; distribution of property in liquidation of partnership interest —(A) Facts. DC1, DC2, and DC3 are equal partners in PRS, a partnership. DC1 and DC2 each has an adjusted basis of $100x in its partnership interest. DC3 has an adjusted basis of $50x in its partnership interest. PRS has a section 754 election in effect. PRS owns Asset H with a fair market value of $50x and an adjusted basis of $0, Asset I with a fair market value of $100x and an adjusted basis of $100x, and Asset J with a fair market value of $150x and an adjusted basis of $150x. Asset H and Asset J are tangible property, but Asset I is not tangible property. PRS distributes Asset I to DC3 in liquidation of DC3's interest in PRS. None of DC1, DC2, DC3, or PRS recognizes gain on the distribution. Under section 732(b), DC3's adjusted basis in Asset I is $50x. PRS's adjusted basis in Asset H is increased by $50x to $50x under section 734(b)(1)(B), which is the amount by which PRS's adjusted basis in Asset I immediately before the distribution exceeds DC3's adjusted basis in Asset I.
(B) Analysis. Under paragraph (g)(6) of this section, PRS's adjusted basis in Asset H is determined without regard to any adjustments under section 734(b) except for adjustments under section 734(b)(1)(B) or section 734(b)(2)(B) that are attributable to distributions of tangible property and for adjustments under section 734(b)(1)(A) or 734(b)(2)(A). The adjustment to the adjusted basis in Asset H is under section 734(b)(1)(B) and is attributable to the distribution of Asset I, which is not tangible property. Accordingly, for purposes of applying paragraph (g)(1) of this section, PRS's adjusted basis in Asset H is $0.
(h) Anti-avoidance rule for certain transfers of property —(1) In general. If, with a principal purpose of decreasing the amount of its deemed tangible income return, a domestic corporation transfers specified tangible property ( transferred property ) to a specified related party of the domestic corporation and, within the disqualified period, the domestic corporation or an FDII-eligible related party of the domestic corporation leases the same or substantially similar property from any specified related party, then, solely for purposes of determining the QBAI of the domestic corporation under paragraph (b) of this section, the domestic corporation is treated as owning the transferred property from the later of the beginning of the term of the lease or date of the transfer of the property until the earlier of the end of the term of the lease or the end of the recovery period of the property.
(2) Rule for structured arrangements. For purposes of paragraph (h)(1) of this section, a transfer of specified tangible property to a person that is not a related party or lease of property from a person that is not a related party is treated as a transfer to or lease from a specified related party if the transfer or lease is pursuant to a structured arrangement. A structured arrangement exists only if either paragraph (h)(2)(i) or (ii) of this section is satisfied.
(i) The reduction in the domestic corporation's deemed tangible income return is priced into the terms of the arrangement with the transferee.
(ii) Based on all the facts and circumstances, the reduction in the domestic corporation's deemed tangible income return is a principal purpose of the arrangement. Facts and circumstances that indicate the reduction in the domestic corporation's deemed tangible income return is a principal purpose of the arrangement include—
(A) Marketing the arrangement as tax-advantaged where some or all of the tax advantage derives from the reduction in the domestic corporation's deemed tangible income return;
(B) Primarily marketing the arrangement to domestic corporations which earn FDDEI;
(C) Features that alter the terms of the arrangement, including the return, in the event the reduction in the domestic corporation's deemed tangible income return is no longer relevant; or
(D) A below-market return absent the tax effects or benefits resulting from the reduction in the domestic corporation's deemed tangible income return.
(3) Per se rules for certain transactions. For purposes of paragraph (h)(1) of this section, a transfer of property by a domestic corporation to a specified related party (including a party deemed to be a specified related party under paragraph (h)(2) of this section) followed by a lease of the same or substantially similar property by the domestic corporation or an FDII-eligible related party from a specified related party (including a party deemed to be a specified related party under paragraph (h)(2) of this section) is treated per se as occurring pursuant to a principal purpose of decreasing the amount of the domestic corporation's deemed tangible income return if both the transfer and the lease occur within a six-month period.
(4) Definitions related to anti-avoidance rule. The following definitions apply for purpose of this paragraph (h).
(i) Disqualified period. The term disqualified period means, with respect to a transfer, the period beginning one year before the date of the transfer and ending the earlier of the end of the remaining recovery period (under the system described in section 951A(d)(3)(A)) of the property or one year after the date of the transfer.
(ii) FDII-eligible related party. The term FDII-eligible related party means, with respect to a domestic corporation, a member of the same consolidated group as the domestic corporation or a partnership with respect to which at least 80 percent of the interests in partnership capital and profits are owned, directly or indirectly, by the domestic corporation or one or more members of the consolidated group that includes the domestic corporation.
(iii) Specified related party. The term specified related party means, with respect to a domestic corporation, a related party other than an FDII-eligible related party.
(iv) Transfer. The term transfer means any disposition, exchange, contribution, or distribution of property, and includes an indirect transfer. For example, a transfer of an interest in a partnership is treated as a transfer of the assets of the partnership. In addition, if paragraph (h)(1) of this section applies to treat a domestic corporation as owning specified tangible property by reason of a lease of property, the termination or lapse of the lease of the property is treated as a transfer of the specified tangible property by the domestic corporation to the lessor.
(5) Transactions occurring before March 4, 2019. Paragraph (h)(1) of this section does not apply to a transfer of property that occurs before March 4, 2019.
(6) Examples. The following examples illustrate the application of this paragraph (h).
(i) Example 1: Sale-leaseback with a related party —(A) Facts. DC, a domestic corporation, owns Asset A, which is specified tangible property. DC also owns all the single class of stock of DS, a domestic corporation, and FS1 and FS2, each a controlled foreign corporation. DC and DS are members of the same consolidated group. On January 1, Year 1, DC sells Asset A to FS1. At the time of the sale, Asset A had a remaining recovery period of 10 years under the alternative depreciation system. On February 1, Year 1, FS2 leases Asset B, which is substantially similar to Asset A, to DS for a five-year term ending on January 31, Year 6.
(B) Analysis. Because DC transfers specified tangible property (Asset A), to a specified related party of DC (FS1), and, within a six month period (January 1, Year 1 to February 1, Year 1), an FDII-eligible related party of DC (DS) leases a substantially similar property (Asset B) from a specified related party (FS2), DC's transfer of Asset A and lease of Asset B are treated as per se occurring pursuant to a principal purpose of decreasing the amount of its deemed tangible income return. Accordingly, for purposes of determining DC's QBAI, DC is treated as owning Asset A from February 1, Year 1, the later of the date of the transfer of Asset A (January 1, Year 1) and the beginning of the term of the lease of Asset B (February 1, Year 1), until January 31, Year 6, the earlier of the end of the term of the lease of Asset B (January 31, Year 6) or the remaining recovery period of Asset A (December 31, Year 10).
(ii) Example 2: Sale-leaseback with a related party; lapse of initial lease —(A) Facts. The facts are the same as in paragraph (h)(6)(i)(A) of this section (the facts in Example 1 ). In addition, DS allows the lease of Asset B to expire on February 1, Year 6. On June 1, Year 6, DS and FS2 renew the lease for a five-year term ending on May 31, Year 11.
(B) Analysis. Because DC is treated as owning Asset A under paragraph (h)(1) of this section, the lapse of the lease of Asset B is treated as a transfer of Asset A to FS2 on February 1, Year 6, under paragraph (h)(4)(iv) of this section. Further, because DC is deemed to transfer specified tangible property (Asset A) to a specified related party (FS2) upon the lapse of the lease, and within a six month period (February 1, Year 6 to June 1, Year 6), an FDII-eligible related party of DC (DS) leases a substantially similar property (Asset B), DC's deemed transfer of Asset A under paragraph (h)(4)(iv) of this section and lease of Asset B are treated as per se occurring pursuant to a principal purpose of decreasing the amount of its deemed tangible income return. Accordingly, for purposes of determining DC's QBAI, DC is treated as owning Asset A from June 1, Year 6, the later of the date of the deemed transfer of Asset A (February 1, Year 6) and the beginning of the term of the lease of Asset B (June 1, Year 6), until December 31, Year 10, the earlier of the end of the term of the lease of Asset B (May 31, Year 11) or the remaining recovery period of Asset A (December 31, Year 10).
§ 1.250(b)-3   Foreign-derived deduction eligible income (FDDEI) transactions.
(a) Scope. This section provides rules related to the determination of whether a sale of property or provision of a service is a FDDEI transaction. Paragraph (b) of this section provides definitions related to the determination of whether a sale of property or provision of a service is a FDDEI transaction. Paragraph (c) of this section provides rules regarding a sale of property or provision of a service to a foreign government or an agency or instrumentality thereof. Paragraph (d) of this section provides a rule for characterizing a transaction with both sales and services elements. Paragraph (e) of this section provides a rule for determining whether a sale of property or provision of a service to a partnership is a FDDEI transaction. Paragraph (f) of this section provides rules for substantiating certain FDDEI transactions.
(b) Definitions. This paragraph (b) provides definitions that apply for purposes of this section and §§ 1.250(b)-4 through 1.250(b)-6.
(1) Digital content. The term digital content means a computer program or any other content in digital format. For example, digital content includes books in digital format, movies in digital format, and music in digital format. For purposes of this section, a computer program is a set of statements or instructions to be used directly or indirectly in a computer or other electronic device in order to bring about a certain result, and includes any media, user manuals, documentation, data base, or similar item if the media, user manuals, documentation, data base, or other similar item is incidental to the operation of the computer program.
(2) End user. Except as modified by § 1.250(b)-4(d)(2)(ii), the term end user means the person that ultimately uses or consumes property or a person that acquires property in a foreign retail sale. A person that acquires property for resale or otherwise as an intermediary is not an end user.
(3) FDII filing date. The term FDII filing date means, with respect to a sale of property by a seller or provision of a service by a renderer, the date, including extensions, by which the seller or renderer is required to file an income tax return (or in the case of a seller or renderer that is a partnership, a return of partnership income) for the taxable year in which the gross income from the sale of property or provision of a service is included in the gross income of the seller or renderer.
(4) Finished goods. The term finished goods means general property that is acquired by an end user.
(5) Foreign person. The term foreign person means a person (as defined in section 7701(a)(1)) that is not a United States person and includes a foreign government or an international organization.
(6) Foreign related party. The term foreign related party means, with respect to a seller or renderer, any foreign person that is a related party of the seller or renderer.
(7) Foreign retail sale. The term foreign retail sale means a sale of general property to a recipient that acquires the general property at a physical retail location (such as a store or warehouse) outside the United States.
(8) Foreign unrelated party. The term foreign unrelated party means, with respect to a seller, a foreign person that is not a related party of the seller.
(9) Fungible mass of general property. The term fungible mass of general property means multiple units of property for sale with similar or identical characteristics for which the seller does not know the specific identity of the recipient or the end user for a particular unit.
(10) General property. The term general property means any property other than: Intangible property (as defined in paragraph (b)(11) of this section); a security (as defined in section 475(c)(2)); an interest in a partnership, trust, or estate; a commodity described in section 475(e)(2)(A) that is not a physical commodity; or a commodity described in section 475(e)(2)(B) through (D). A physical commodity described in section 475(e)(2)(A) is treated as general property, including if it is sold pursuant to a forward or option contract (including a contract described in section 475(e)(2)(C), but not a section 1256 contract as defined in section 1256(b) or other similar contract that is traded on a U.S. or non-U.S. regulated exchange and cleared by a central clearing organization in a manner similar to a section 1256 contract) that is physically settled by delivery of the commodity (provided that the 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).
(11) Intangible property. The term intangible property has the meaning set forth in section 367(d)(4). For purposes of section 250, intangible property does not include a copyrighted article as defined in § 1.861-18(c)(3).
(12) International transportation property. The term international transportation property means aircraft, railroad rolling stock, vessel, motor vehicle, or similar property that provides a mode of transportation and is capable of traveling internationally.
(13) IP address. The term IP address means a device's internet Protocol address.
(14) Recipient. The term recipient means a person that purchases property or services from a seller or renderer.
(15) Renderer. The term renderer means a person that provides a service to a recipient.
(16) Sale. The term sale means any sale, lease, license, sublicense, exchange, or other disposition of property, and includes any transfer of property in which gain or income is recognized under section 367. In addition, the term sell (and any form of the word sell) means any transfer by sale.
(17) Seller. The term seller means a person that sells property to a recipient.
(18) United States. The term United States has the meaning set forth in section 7701(a)(9), as expanded by section 638(1) with respect to mines, oil and gas wells, and other natural deposits.
(19) United States person. The term United States person has the meaning set forth in section 7701(a)(30), except that the term does not include an individual that is a bona fide resident of a United States territory within the meaning of section 937(a).
(20) United States territory. The term United States territory means American Samoa, Guam, the Northern Mariana Islands, Puerto Rico, or the U.S. Virgin Islands.
(c) Foreign military sales and services. If a sale of property or a provision of a service is made to the United States or an instrumentality thereof pursuant to 22 U.S.C. 2751 et seq. under which the United States or an instrumentality thereof purchases the property or service for resale or on-service to a foreign government or agency or instrumentality thereof, then the sale of property or provision of a service is treated as a FDDEI sale or FDDEI service without regard to § 1.250(b)-4 or § 1.250(b)-5.
(d) Transactions with multiple elements. A transaction is classified according to its overall predominant character for purposes of determining whether the transaction is a FDDEI sale under § 1.250(b)-4 or a FDDEI service under § 1.250(b)-5. For example, whether a transaction that includes both a sales component and a service component is subject to § 1.250(b)-4 or § 1.250(b)-5 is determined based on whether the overall predominant character, taking into account all relevant facts and circumstances, is a sale or service. In addition, whether a transaction that includes both a sale of general property and a sale of intangible property is subject to § 1.250(b)-4(d)(1) or § 1.250(b)-4(d)(2) is determined based on whether the overall predominant character, taking into account all relevant facts and circumstances, is a sale of general property or a sale of intangible property.
(e) Treatment of partnerships —(1) In general. For purposes of determining whether a sale of property to or by a partnership or a provision of a service to or by a partnership is a FDDEI transaction, a partnership is treated as a person. Accordingly, for example, a partnership may be a seller, renderer, recipient, or related party, including a foreign related party (as defined in paragraph (b)(6) of this section).
(2) Examples. The following examples illustrate the application of this paragraph (e).
(i) Example 1: Domestic partner sale to foreign partnership with a foreign branch —(A) Facts. DC, a domestic corporation, is a partner in PRS, a foreign partnership. DC and PRS are not related parties. PRS has a foreign branch within the meaning of § 1.904-4(f)(3)(iii). DC and PRS both use the calendar year as their taxable year. For the taxable year, DC recognizes $20x of gain on the sale of general property to PRS for a foreign use (as determined under § 1.250(b)-4(d)). During the same taxable year, PRS recognizes $20x of gain on the sale of other general property to a foreign person for a foreign use (as determined under § 1.250(b)-4(d)). PRS's income on the sale of the property is attributable to its foreign branch.
(B) Analysis. DC's sale of property to PRS, a foreign partnership, is a FDDEI sale because it is a sale to a foreign person for a foreign use. Therefore, DC's gain of $20x on the sale to PRS is included in DC's gross DEI and gross FDDEI. However, PRS's gain of $20x is not included in the gross DEI or gross FDDEI of PRS because the gain is foreign branch income within the meaning of § 1.250(b)-1(c)(11). Accordingly, none of PRS's gain on the sale of property is included in DC's gross DEI or gross FDDEI under § 1.250(b)-1(e)(1).
(ii) Example 2: Domestic partner sale to domestic partnership without a foreign branch —(A) Facts. The facts are the same as in paragraph (e)(2)(i)(A) of this section (the facts in Example 1 ), except PRS is a domestic partnership that does not have a foreign branch within the meaning of § 1.904-4(f)(3)(iii).
(B) Analysis. DC's sale of property to PRS, a domestic partnership, is not a FDDEI sale because the sale is to a United States person. Therefore, the gross income from DC's sale to PRS is included in DC's gross DEI but is not included in its gross FDDEI. However, PRS's sale of other general property is a FDDEI sale, and therefore the gain of $20x is included in the gross DEI and gross FDDEI of PRS. Accordingly, DC includes its distributive share of PRS's gain from the sale in determining DC's gross DEI and gross FDDEI for the taxable year under § 1.250(b)-1(e)(1).
(f) Substantiation for certain FDDEI transactions —(1) In general. Except as provided in paragraph (f)(2) of this section, for purposes of § 1.250(b)-4(d)(1)(ii)(C) (foreign use for sale of general property for resale), § 1.250(b)-4(d)(1)(iii) (foreign use for sale of general property subject to manufacturing, assembly, or processing outside the United States), § 1.250(b)-4(d)(2) (foreign use for sale of intangible property), and § 1.250(b)-5(e) (general services provided to business recipients located outside the United States), a transaction is a FDDEI transaction only if the taxpayer substantiates its determination of foreign use (in the case of sales of property) or location outside the United States (in the case of general services provided to a business recipient) as described in the applicable paragraph of § 1.250(b)-4(d)(3) or § 1.250(b)-5(e)(4). The substantiating documents must be in existence as of the FDII filing date with respect to the FDDEI transaction, and a taxpayer must provide the required substantiating documents within 30 days of a request by the Commissioner or another period as agreed between the Commissioner and the taxpayer.
(2) Exception for small businesses. Paragraph (f)(1) of this section, and the specific substantiation requirements described in the applicable paragraph of § 1.250(b)-4(d)(3) or § 1.250(b)-5(e)(4), do not apply to a taxpayer if the taxpayer and all related parties of the taxpayer, in the aggregate, receive less than $25,000,000 in gross receipts during the taxable year prior to the FDDEI transaction. If the taxpayer's prior taxable year was less than 12 months (a short period), gross receipts are annualized by multiplying the gross receipts for the short period by 365 and dividing the result by the number of days in the short period.
(3) Treatment of certain loss transactions —(i) In general. If a domestic corporation fails to satisfy the substantiation requirements described in the applicable paragraph of § 1.250(b)-4(d)(3) or § 1.250(b)-5(e)(4) with respect to a transaction (including in connection with a related party transaction described in § 1.250(b)-6), the gross income from the transaction will be treated as gross FDDEI if—
(A) In the case of a sale of property, the seller knows or has reason to know that property is sold to a foreign person for a foreign use (within the meaning of § 1.250(b)-4(d)(1) or (2));
(B) In the case of the provision of a general service to a business recipient, the renderer knows or has reason to know that a service is provided to a business recipient located outside the United States; and
(C) Not treating the transaction as a FDDEI transaction would increase the amount of the corporation's FDDEI for the taxable year relative to its FDDEI that would be determined if the transaction were treated as a FDDEI transaction.
(ii) Reason to know —(A) Sales to a foreign person for a foreign use. For purposes of paragraph (f)(3)(i)(A) of this section, a seller has reason to know that a sale is to a foreign person for a foreign use if the information received as part of the sales process contains information that indicates that the recipient is a foreign person or that the sale is for a foreign use, and the seller fails to obtain evidence establishing that the recipient is not in fact a foreign person or that the sale is not in fact for a foreign use. Information that indicates that a recipient is a foreign person or that the sale is for a foreign use includes, but is not limited to, a foreign 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 outside the United States.
(B) General services provided to a business recipient located outside the United States. For purposes of paragraph (f)(3)(i)(B) of this section, a renderer has reason to know that the provision of a general service is to a business recipient located outside the United States if the information received as part of the sales process contains information that indicates that the recipient is a business recipient located outside the United States and the seller fails to obtain evidence establishing that the recipient is not in fact a business recipient located outside the United States. Information that indicates that a recipient is a business recipient includes, but is not limited to, indicia of a business status (such as “LLC” or “Company,” or similar indicia under applicable domestic or foreign law, in the name) or statements by the recipient indicating that it is a business. 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 entity or business is incorporated, formed, or managed outside the United States.
(iii) Multiple transactions. If a seller or renderer engages in more than one transaction described in paragraph (f)(3)(i) of this section in a taxable year, paragraph (f)(3)(i) of this section applies by comparing the corporation's FDDEI if each such transaction were not treated as a FDDEI transaction to its FDDEI if each such transaction were treated as a FDDEI transaction.
(iv) Example. The following example illustrates the application of this paragraph (f)(3).
(A) Facts. During a taxable year, DC, a domestic corporation, manufactures products A and B in the United States. DC sells product A and product B to Y, a foreign person that is a distributor, for $200x and $800x, respectively. DC knows or has reason to know that all of its sales of product A and product B will ultimately be sold to end users located outside the United States. Y provides DC with a statement that satisfies the substantiation requirement of paragraph (f)(1) of this section and § 1.250(b)-4(d)(3)(ii) that establishes that its sales of product B are for a foreign use but does not obtain substantiation establishing that any sales of product A are for a foreign use. DC's cost of goods sold is $450x. For purposes of determining gross FDDEI, under § 1.250(b)-1(d)(1) DC attributes $250x of cost of goods sold to product A and $200x of cost of goods sold to product B, and then attributes the cost of goods sold for each product ratably between the gross receipts of such product sold to foreign persons and the gross receipts of such product not sold to foreign persons. The manner in which DC attributes the cost of goods sold is a reasonable method. DC has no other items of income, loss, or deduction.
Table 1 to Paragraph (f)(3)(iv)(A)
(B) Analysis. By not treating the sales of product A as FDDEI sales, the amount of DC's FDDEI would increase by $50x relative to its FDDEI if the sales of product A were treated as FDDEI sales. Accordingly, because DC knows or has reason to know that its sales of product A are to foreign persons for a foreign use, the sales of product A constitute FDDEI sales under paragraph (f)(3) of this section, and thus the $50x loss from the sale of product A is included in DC's gross FDDEI.
§ 1.250(b)-4   Foreign-derived deduction eligible income (FDDEI) sales.
(a) Scope. This section provides rules for determining whether a sale of property is a FDDEI sale. Paragraph (b) of this section defines a FDDEI sale. Paragraph (c) of this section provides rules for determining whether a recipient is a foreign person. Paragraph (d) of this section provides rules for determining whether property is sold for a foreign use. Paragraph (e) of this section provides a special rule for the sale of interests in a disregarded entity. Paragraph (f) of this section provides a rule regarding certain hedging transactions with respect to FDDEI sales.
(b) Definition of FDDEI sale. Except as provided in § 1.250(b)-6(c), the term FDDEI sale means a sale of general property or intangible property to a recipient that is a foreign person (see paragraph (c) of this section for presumption rules relating to determining foreign person status) and that is for a foreign use (as determined under paragraph (d) of this section). A sale of any property other than general property or intangible property is not a FDDEI sale.
(c) Presumption of foreign person status —(1) In general. The sale of property is presumed to be to a recipient that is a foreign person for purposes of paragraph (b) of this section if the sale is described in paragraph (c)(2) of this section. However, this presumption does not apply if the seller knows or has reason to know that the sale is not to a foreign person. A seller has reason to know that a sale is not to 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. Information that indicates that a recipient is not a foreign person include, but are 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.
(2) Sales of property. A sale of a property is described in this paragraph (c)(2) if:
(i) The sale is a foreign retail sale;
(ii) In the case of a sale of general property that is not a foreign retail sale and the general property is delivered (such as through a commercial carrier) to the recipient or an end user, the shipping address of the recipient or end user is outside the United States;
(iii) In the case of a sale of general property that is not described in either paragraph (c)(2)(i) or (ii) of this section, the billing address of the recipient is outside the United States; or
(iv) In the case of a sale of intangible property, the billing address of the recipient is outside the United States.
(d) Foreign use —(1) Foreign use for general property —(i) In general. The sale of general property is for a foreign use for purposes of paragraph (b) of this section if the seller determines that the sale is for a foreign use under the rules of paragraph (d)(1)(ii) or (iii) of this section and the exception in paragraph (d)(1)(iv) of this section does not apply.
(ii) Rules for determining foreign use —(A) Sales that are delivered to an end user by a carrier or freight forwarder. Except as otherwise provided in this paragraph (d)(1)(ii)(A), a sale of general property (other than a sale of general property described in paragraphs (d)(1)(ii)(D) through (F) of this section) that is delivered through a carrier or freight forwarder to a recipient that is an end user is for a foreign use if the end user receives delivery of the general property outside the United States. However, a sale described in the preceding sentence is not treated as a sale to an end user for a foreign use if the sale is made with a principal purpose of having the property transported from its location outside the United States to a location within the United States for ultimate use or consumption.
(B) Sales to an end user without the use of a carrier or freight forwarder. With respect to sales that are not delivered through the use of a carrier or freight forwarder, a sale of general property (other than a sale of general property described in paragraphs (d)(1)(ii)(D) through (F) of this section) to a recipient that is an end user is for a foreign use if the property is located outside the United States at the time of the sale (including as part of foreign retail sales).
(C) Sales for resale. A sale of general property (other than a sale of general property described in paragraphs (d)(1)(ii)(D) through (F) of this section) to a recipient (such as a distributor or retailer) that will resell the general property is for a foreign use if the general property will ultimately be sold to end users outside the United States (including in foreign retail sales) and such sales to end users outside the United States are substantiated under paragraph (d)(3)(ii) of this section. In the case of sales of a fungible mass of general property, the taxpayer may presume that the proportion of its sales that are ultimately sold to end users outside the United States is the same as the proportion of the recipient's resales of that fungible mass to end users outside the United States.
(D) Sales of digital content. A sale of general property that primarily contains digital content that is transferred electronically rather than in a physical medium is for a foreign use if the end user downloads, installs, receives, or accesses the purchased digital content on the end user's device outside the United States (see § 1.250(b)-5(d)(2) and (e)(2)(iii) for rules that apply in the case of digital content that is not purchased in a sale but is electronically supplied as a service). If information about where the digital content is downloaded, installed, received, or accessed (such as the device's IP address) is unavailable, and 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 for the seller's taxable year, a sale of general property described in the preceding sentence is for a foreign use if it is to an end user that has a billing address located outside the United States.
(E) Sales of international transportation property used for compensation or hire. A sale of international transportation property used for compensation or hire is for a foreign use if the end user registers the property with a foreign jurisdiction.
(F) Sales of international transportation property not used for compensation or hire. A sale of international transportation property not used for compensation or hire is for a foreign use if the end user registers the property in a foreign jurisdiction and hangars or stores the property primarily outside the United States.
(iii) Sales for manufacturing, assembly, or other processing —(A) In general. A sale of general property is for a foreign use if the sale is to a foreign unrelated party that subjects the property to manufacture, assembly, or other processing outside the United States and such manufacturing, assembly, or other processing outside the United States is substantiated under paragraph (d)(3)(iii) of this section. Property is subject to manufacture, assembly, or other processing only if the property is physically and materially changed (as described in paragraph (d)(1)(iii)(B) of this section) or the property is incorporated as a component into another product (as described in paragraph (d)(1)(iii)(C) of this section).
(B) Property subject to a physical and material change. The determination of whether general property is subject to a physical and material change is made based on all the relevant facts and circumstances. 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.
(C) Property incorporated into a product as a component. 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 processing of property based on all the relevant facts and circumstances. However, general property is not considered a component incorporated into another product if it is subject only to packaging, repackaging, labeling, or minor assembly operations. In addition, general property is treated as a component if the seller expects, using reliable estimates, that the fair market value of the property when it is delivered to the recipient will constitute no more than 20 percent of the fair market value of the finished good into which the general property is directly or indirectly incorporated when the finished good is sold to end users (the “20-percent rule”). If the property could be incorporated into a number of different finished goods, a reliable estimate of the fair market value of the finished good may include the average fair market value of a representative range of such goods. For purposes of the 20-percent rule, all general property that is sold by the seller and incorporated into the finished good is treated as a single item of property if the seller sells the property to the recipient and the seller 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). A seller knows or 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 indicates that the components will be included in the same second product or the nature of the components compels inclusion into the second product and the seller fails to obtain evidence to the contrary.
(iv) Sales of property subject to manufacturing, assembly, or other processing in the United States. If the seller sells general property to a recipient (other than a related party) for manufacturing, assembly, or other processing within the United States, such property is not sold for a foreign use even if the requirements of paragraph (d)(1)(ii) or (iii) of this section are subsequently satisfied. See § 1.250(b)-6(c) for rules governing sales of general property to a foreign person that is a related party. Property is subject to manufacture, assembly, or other processing only if the property is physically and materially changed (as described in paragraph (d)(1)(iii)(B) of this section) or the property is incorporated as a component into another product (as described in paragraph (d)(1)(iii)(C) of this section).
(v) Examples. The following examples illustrate the application of this paragraph (d)(1).
(A) Assumed facts. The following facts are assumed for purposes of the examples—
( 1 ) DC is a domestic corporation.
( 2 ) FP is a foreign person that is a foreign unrelated party with respect to DC.
( 3 ) To the extent a sale is for a foreign use, any applicable substantiation requirements described in paragraph (d)(3)(ii) or (iii) of this section are satisfied.
(B) Examples —
( 1 ) Example 1: Manufacturing outside the United States —( i ) Facts. DC sells batteries for $18x to FP. DC expects that FP will insert the batteries into tablets as part of the process of assembling tablets outside the United States. While the tablets are manufactured in a way that end users would not easily be able to remove the batteries, the batteries could be removed from the tablets and would resemble their original state following the removal. The finished tablets will be sold to end users within and outside the United States. DC's batteries are used in two types of tablets, Tablet A and Tablet B. Based on an economic analysis, DC determines that the fair market value of Tablet A is $90x and the fair market value of Tablet B is $110x. FP informs DC that the number of sales of Tablet A is approximately equal to the number of sales of Tablet B.
( ii ) Analysis. Because the batteries could be removed from the tablets and be returned to their original state, the insertion of the batteries into the tablets does not constitute a physical and material change described in paragraph (d)(1)(iii)(B) of this section. However, the average fair market value of a representative range of tablets that incorporate the batteries is $100x (the average of $90x for Tablet A and $110x for Tablet B because their sales are approximately equal), and $18x is less than 20 percent of $100x. Therefore, the batteries are considered components of the tablets and treated as subject to manufacture, assembly, or other processing outside the United States. See paragraphs (d)(1)(iii)(A) and (C) of this section. As a result, notwithstanding that some tablets incorporating the batteries may be sold to an end user in the United States, DC's sale of batteries is considered for a foreign use. Accordingly, DC's sale of batteries to FP is for a foreign use under paragraph (d)(1)(iii)(A) and (C) of this section, and the sale is a FDDEI sale.
( 2 ) Example 2: Manufacturing outside the United States —( i ) Facts. The facts are the same as in paragraph (d)(1)(v)(B)( 1 ) of this section (the facts in Example 1 ), except FP purchases the batteries from DC for $25x. In addition, FP purchased other components of tablets from other parties. FP has a substantial investment in machinery and tools that are used to assemble tablets.
( ii ) Analysis. Even though the fair market value of the batteries that FP purchases from DC and incorporates into the tablets exceeds 20 percent of the fair market value of the tablets, because the batteries are used by FP in activities that are substantial in nature and generally considered to constitute the manufacture, assembly or other processing of property, the batteries are components of the tablets. As a result, DC's sale of property to FP is still for a foreign use under paragraph (d)(1)(iii)(A) and (C) of this section, and the sale is a FDDEI sale.
( 3 ) Example 3: Sale of products to distributor outside the United States —( i ) Facts. DC sells smartphones to FP, a distributor of electronics located within Country A. The sales contract between DC and FP provides that FP may sell the smartphones it purchases from DC only to specified retailers located within Country A. The specified retailers only sell electronics, including smartphones, in foreign retail sales.
( ii ) Analysis. Although FP does not sell the smartphones it purchases from DC to end users, FP sells to retailers that sell the smartphones in foreign retail sales. All of the sales of smartphones from DC to FP are sales of general property for a foreign use under paragraph (d)(1)(ii)(C) of this section because FP is only allowed to sell the smartphones to retailers who sell such property in foreign retail sales. As a result, DC's sales of smartphones to FP are FDDEI sales.
( 4 ) Example 4: Sale of a fungible mass of products —( i ) Facts. DC and persons other than DC sell multiple units of printer paper that is considered fungible general property to FP during the taxable year. FP is a distributor that sells paper to retail stores within and outside the United States. FP informs DC that approximately 25 percent of FP's sales of the paper are to retail stores located outside of the United States for foreign retail sales.
( ii ) Analysis. The sale of paper to FP is for a foreign use to the extent that the paper will be sold to end users located outside the United States under paragraph (d)(1)(ii)(C) of this section. Because a portion of DC's sales to FP are not for a foreign use, DC must determine the amount of paper that is sold for a foreign use. Based on the information provided by FP about its own sales, DC determines under paragraph (d)(1)(ii)(C) of this section that 25 percent of the total units of paper that is fungible general property that FP purchased from all persons in the taxable year will ultimately be sold to end users located outside the United States. Accordingly, DC satisfies the test for a foreign use under paragraph (d)(1)(ii)(C) of this section with respect to 25 percent of its sales of the paper to FP.
( 5 ) Example 5: Limited use license of copyrighted computer software —( i ) Facts. DC provides FP with a limited use license to copyrighted computer software in exchange for an annual fee of $100x. The limited use license restricts FP's use of the computer software to 100 of FP's employees, who download the software onto their computers. The limited use license prohibits FP from using the computer software in any way other than as an end user, which includes prohibiting sublicensing, selling, reverse engineering, or modifying the computer software. All of FP's employees download the software onto computers that are physically located outside the United States.
( ii ) Analysis. The software licensed to FP is digital content as defined in § 1.250(b)-3(b)(1), and is downloaded by an end user as defined in § 1.250(b)-3(b)(2). Accordingly, because the software is downloaded solely onto computers outside the United States, DC's license to FP is for a foreign use and therefore a FDDEI sale under paragraph (d)(1)(ii)(D) of this section. The entire $100x of the license fee is included in DC's gross FDDEI for the taxable year.
( 6 ) Example 6: Limited use license of copyrighted computer software used within and outside the United States —( i ) Facts. The facts are the same as in paragraph (d)(1)(v)(B)( 5 ) of this section (the facts in Example 5 ), except that FP has offices both within and outside the United States, and DC's internal records indicates that 50 percent of the downloads of the software are onto computers located outside the United States.
( ii ) Analysis. Because 50 percent of the downloads of the software are onto computers located outside the United States, a portion of DC's license to FP is for a foreign use and therefore such portion is a FDDEI sale. The $50x of license fee derived with respect to such portion is included in DC's gross FDDEI for the taxable year.
( 7 ) Example 7: Sale of a copyrighted article —( i ) Facts. DC sells copyrighted music available for download on its website. Once downloaded, the recipient listens to the music on electronic devices that do not need to be connected to the internet. DC has data that an individual accesses the website to purchase a song for download on a device located outside the United States. The terms of the sale permit the recipient to use the song for personal use, but convey no other rights to the copyrighted music to the recipient.
( ii ) Analysis. The music acquired through download is digital content as defined in § 1.250(b)-3(b)(1). Because the recipient acquires no ownership in copyright rights to the music, the sale is considered a sale of a copyrighted article, and thus is a sale of general property. See § 1.250(b)-3(b)(10) and (11). As a result, the sale is considered for a foreign use under paragraph (d)(1)(ii)(D) of this section because the digital content was installed, received, or accessed on the end user's device outside the United States. The income derived with respect to the sale of the music is included in DC's gross FDDEI for the taxable year. See § 1.250(b)-5(d)(3) for an example of digital content provided to consumers as a service rather than as a sale.
(2) Foreign use for intangible property —(i) In general. A sale of rights to exploit intangible property solely outside the United States is for a foreign use. A sale of rights to exploit intangible property solely within the United States is not for a foreign use. A sale of rights to exploit intangible property worldwide is partially for a foreign use and partially not for a foreign use. Whether intangible property is exploited within versus outside the United States is determined based on revenue earned from end users located within versus outside the United States. Therefore, a sale of rights to exploit intangible property both within and outside the United States is for a foreign use in proportion to the revenue earned from end users located outside the United States over the total revenue earned from the exploitation of the intangible property. A sale of intangible property will be treated as a FDDEI sale only if the substantiation requirements of paragraph (d)(3)(iv) of this section are satisfied. For rules specific to determining end users and revenue earned from end users for intangible property used in sales of general property, provision of services, research and development, or consisting of a manufacturing method or process, see paragraph (d)(2)(ii) of this section.
(ii) Determination of end users and revenue earned from end users —(A) Intangible property embedded in general property or used in connection with the sale of general property. If intangible property is embedded in general property that is sold, or used in connection with a sale of general property, then the end user of the intangible property is the end user of the general property. Revenue is earned from the end user of the general property outside the United States to the extent the sale of the general property is for a foreign use under paragraph (d)(1)(ii) or (iii) of this section.
(B) Intangible property used in providing a service. If intangible property is used to provide a service, then the end user of that intangible property is the recipient, consumer, or business recipient of the service or, in the case of a property service or a transportation service that involves the transportation of property, the end user is the owner of the property on which such service is being performed. Such end users are treated as located outside the United States only to the extent the service qualifies as a FDDEI service under § 1.250(b)-5. Therefore, in the case of a recipient of a sale of intangible property that uses such intangible property to provide a property service that qualifies as a FDDEI service to another person, that person is the end user and is treated as located outside the United States.
(C) Intangible property consisting of a manufacturing method or process —( 1 ) In general. Except as provided in paragraph (d)(2)(ii)(C)( 2 ) of this section, if intangible property consists of a manufacturing method or process (as defined in paragraph (d)(2)(ii)(C)( 3 ) of this section) and is sold to a foreign unrelated party (including in a sale by a foreign related party), 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. A seller has reason to know that the manufacturing method or process will be used in the United States if the information received from the recipient as part of the sales process contains information that indicates that the recipient intends to use the manufacturing method or process in the United States and the seller fails to obtain evidence establishing that the recipient does not intend to use the manufacturing method or process in the United States.
( 2 ) Exception for certain manufacturing arrangements. A sale of intangible property consisting of a manufacturing method or process (including a sale by a foreign related party) to a foreign unrelated party for use in manufacturing products for or on behalf of the seller or any person related to the seller does not qualify as a sale to a foreign unrelated party for purposes of determining the end user under paragraph (d)(2)(ii)(C)( 1 ) of this section.
( 3 ) Manufacturing method or process. For purposes of this section, a manufacturing method or process consists of a sequence of actions or steps that comprise an overall method or process that is used to manufacture a product or produce a particular manufacturing result, which may be in the form of a patent or know-how. Intangible property consisting of the right to make and sell an item of property is not a manufacturing method or process, whereas intangible property consisting of the right to apply a series of actions or steps to be performed to achieve a particular manufacturing result is a manufacturing method or process. For example, a utility or design patent on an article of manufacture, machine, composition of matter, design, or providing the right to sell equipment to perform a process is not a manufacturing method or process, whereas a utility patent covering a method or process of manufacturing is a manufacturing method or process for purposes of this section.
(D) Intangible property used in research and development. If intangible property (primary IP) is used to develop new or modify other intangible property (secondary IP), then the end user of the primary IP is the end user (applying paragraph (d)(2)(ii)(A), (B), or (C) of this section) of the secondary IP.
(iii) Determination of revenue for periodic payments versus lump sums —(A) Sales in exchange for periodic payments. In the case of a sale of intangible property, other than intangible property consisting of a manufacturing method or process that is sold to a foreign unrelated party, to a recipient in exchange for periodic payments, the extent to which the sale is for a foreign use is determined annually based on the actual revenue earned by the recipient from any use of the intangible property for the taxable year in which a periodic payment is received. If actual revenue earned by the recipient cannot be obtained after reasonable efforts, then estimated revenue earned by a recipient that is not a related party of the seller from the use of the intangible property may be used based on the principles of paragraph (d)(2)(iii)(B) of this section.
(B) Sales in exchange for a lump sum. In the case of a sale of intangible property, other than intangible property consisting of a manufacturing method or process that is sold to a foreign unrelated party, for a lump sum, the extent to which the sale is for a foreign use is determined based on the ratio of the total net present value of revenue the seller would have expected to earn from the exploitation of the intangible property outside the United States to the total net present value of revenue the seller would have expected to earn from the exploitation of the intangible property. In the case of a recipient that is a foreign unrelated party, net present values of revenue that the recipient expected to earn from the exploitation of the intangible property within and outside the United States may also be used 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. Net present values must be determined using reliable inputs including, but not limited to, reliable revenue, expenses, and discount rates. 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 in determining whether such inputs are reliable. If the intangible property is sold to a foreign related party, the reliability of the inputs used to determine net present values and the net present values are determined under section 482.
(C) Sales to a foreign unrelated party of intangible property consisting of a manufacturing method or process. In the case of a sale to an unrelated foreign party of intangible property consisting of a manufacturing method or process, the revenue earned from the end user is equal to the amount received from the recipient in exchange for the manufacturing method or process. In the case of a bundled sale of intangible property consisting of a manufacturing method or process and intangible property not consisting of a manufacturing method or process, the revenue earned from the intangible property consisting of the manufacturing method or process equals the total amount paid for the bundled sale multiplied by the proportion that the value of the manufacturing method or process bears to the total value of the intangible property. The value of the manufacturing method or process to the total value of the intangible property must be determined using the principles of section 482.
(iv) Examples. The following examples illustrate the application of this paragraph (d)(2).
(A) Assumed facts. The following facts are assumed for purposes of the examples—
( 1 ) DC is a domestic corporation.
( 2 ) Except as otherwise provided, FP and FP2 are foreign persons that are foreign unrelated parties with respect to DC.
( 3 ) All of DC's income is DEI.
( 4 ) Except as otherwise provided, the substantiation requirements described in paragraph (d)(3)(iv) of this section are satisfied.
( 5 ) Except as otherwise provided, inputs used to determine the net present values of the revenue are reliable.
(B) Examples —
( 1 ) Example 1: License of worldwide rights with actual revenue data from recipient —( i ) Facts. DC licenses to FP worldwide rights to the copyright to composition A in exchange for annual royalties of 60 percent of revenue from FP's sales of composition A. FP sells composition A to customers through digital downloads from servers. In the taxable year, FP earns $100x in revenue from sales of copies of composition A to customers, of which $60x is from customers located in the United States and the remaining $40x is from customers located outside the United States. FP provides DC with reliable records showing the amount of revenue earned in the taxable year from sales of composition A to establish the royalties owed to DC. These records also provide DC with the amount of revenue earned from sales of composition A to customers located within the United States.
( ii ) Analysis. FP is not the end user of the copyright to composition A under paragraph (d)(2)(ii)(A) of this section because the copyright is used in the sale of general property (the sale of copyrighted articles to customers). The customers that purchase a copy of composition A from FP are the end users (as defined in § 1.250(b)-3(b)(2) and paragraph (d)(2)(ii)(A) of this section) because those customers are the recipients of composition A when sold as general property. Based on the actual revenue earned by FP from sales of composition A, 40 percent ($40x/$100x) of the revenue generated by the copyright during the taxable year is earned outside the United States. Accordingly, a portion of DC's license to FP is for a foreign use under paragraph (d)(2) of this section and therefore such portion is a FDDEI sale. The $24x of royalty (0.40 x $60x of total royalties owed to DC during the taxable year) derived with respect to such portion is included in DC's gross FDDEI for the taxable year.
( 2 ) Example 2: Fixed annual payments for worldwide rights without actual revenue data from recipient —( i ) Facts. The facts are the same as in paragraph (d)(2)(iv)(B)( 1 )( i ) of this section (the facts in Example 1 ), except FP pays DC a fixed annual payment of $60x each year for the worldwide rights to the copyright to composition A and does not provide DC with data showing how much revenue FP earned from sales of composition A, even after DC requests that FP provide it with such information. DC also is unable to determine how much revenue FP earned from sales of composition A to customers within the United States from the data it has with respect to FP and publicly available data with respect to FP. However, DC's economic analysis of the revenue DC expected it could earn annually from use of composition A as part of determining the annual payments DC would receive from FP from the license of composition A supports a determination that 40 percent of sales of composition A during the tax year would be to customers located outside the United States. During an examination of DC's return for the taxable year, DC provides the IRS with data explaining the economic analysis, inputs, and results from its valuation of composition A used in determining the amount of annual payments agreed to by DC and FP.
( ii ) Analysis. For the same reasons provided in paragraph (d)(2)(iv)(B)( 1 )( ii ) of this section (the analysis in Example 1 ), the customers that purchase copies of composition A from FP are the end users. DC is allowed to use reliable economic analysis to estimate revenue earned by FP from the use of the copyright to composition A under paragraph (d)(2)(iii)(A) of this section because DC was unable to obtain actual revenue earned by FP from use of the copyright to composition A during the taxable year after reasonable efforts to obtain the actual revenue data. Based on DC's economic analysis, a portion of DC's license to FP is for a foreign use under paragraph (d)(2) of this section and therefore such portion is a FDDEI sale. $24x of the $60x fixed payment to DC (0.40 x $60x) is included in DC's gross FDDEI for the taxable year.
( 3 ) Example 3: Sale of patent rights protected in the United States and other countries; use of financial projections in sale to foreign unrelated party —( i ) Facts. DC owns a patent for an active pharmaceutical ingredient (“API”) approved for treatment of disease A (“indication A”) in the United States and in Countries A, B, and C. The patent is registered in the United States and in Countries A, B, and C. DC sells to FP all of its patent rights to the API for indication A for a lump sum payment of $1,000x. DC has no basis in the patent rights. To determine the sales price for the patent rights, DC projected that the net present value of the revenue it would earn from selling a pharmaceutical product incorporating the API for indication A was $5,000x, with 15 percent of the net present value of revenue earned from sales within the United States and 85 percent of the net present value of revenue earned from sales outside the United States. DC did not obtain revenue projections from the recipient.
( ii ) Analysis. FP is not the end user of the patent under paragraph (d)(2)(ii)(A) of this section because the patent is used in the sale of general property (the sale of pharmaceutical products to customers) and FP is not the recipient of that general property. The unrelated party customers that purchase the finished pharmaceutical product from FP are the end users (as defined in § 1.250(b)-3(b)(2) and paragraph (d)(2)(ii)(A) of this section) because those customers are the unrelated party recipients of the pharmaceutical product when sold as general property. Based on the financial projections DC used to determine the sales price of the patent that FP purchased, a portion of DC's sale to FP is for a foreign use under paragraph (d)(2) of this section and such portion is a FDDEI sale. The $850x (85 percent × $1,000x) of gain derived with respect to such portion is included in DC's gross FDDEI for the taxable year.
( 4 ) Example 4: Sale of patent rights protected in the United States and other countries; use of financial projections in sale to foreign related party —( i ) Facts. The facts are the same as in paragraph (d)(2)(iv)(B)( 3 )( i ) of this section (the facts in Example 3 ), except that FP is a foreign related party with respect to DC, and DC projected that the net present value of the revenue it would earn from selling a pharmaceutical product incorporating the API for indication A would result in 1 percent of the revenue earned from sales within the United States and 99 percent of the revenue earned from sales outside the United States. During the examination of DC's return for the taxable year, the IRS determines that DC's substantiation allocating the projected revenue from sales within the United States and outside the United States does not reflect reliable inputs to determine the net present values of revenues under section 482, but determines that the total lump sum price FP paid for DC's patent rights is an arm's length price. The IRS determines that the most reliable net present values of revenue DC would have earned from sales within the United States and outside the United States is $750x and $4250x, respectively.
( ii ) Analysis. For the same reasons provided in paragraph (d)(2)(iv)(B)( 3 )( ii ) of this section (the analysis in Example 3 ), the customers that purchase the finished pharmaceutical product from FP are the end users. Under paragraph (d)(2)(iii)(B) of this section, the reliability of the inputs DC used to determine the net present values and the net present values are determined under section 482. Based on the sales price of the patent that FP purchased and the IRS-determined net present values of revenue DC would have earned from sales within the United States and outside the United States, a portion of DC's sale to FP is for a foreign use under paragraph (d)(2) of this section and such portion is a FDDEI sale. DC is allowed to include $850x (($4250x divided by $5000x) × $1,000x) of gain in DC's gross FDDEI for the taxable year.
( 5 ) Example 5: Sale of patent of manufacturing method or process protected in the United States and other countries; foreign unrelated party —( i ) Facts. DC owns the worldwide rights to a patent covering a process for refining crude oil. DC sells to FP the right to DC's patented process for refining crude oil for a lump sum payment of $100x. DC has no basis in the patent rights. DC does not know or have reason to know that FP will use the patented process to refine crude oil within the United States or will sell or license the rights to the patent to a person to refine crude oil within the United States.
( ii ) Analysis. DC's patent covering a process for refining crude oil is a manufacturing method or process as defined in paragraph (d)(2)(ii)(C)( 3 ) of this section. Under paragraph (d)(2)(ii)(C)( 1 ) of this section, FP is treated as the end user of the patent, and is treated as located outside the United States because FP is a foreign unrelated party and DC does not know or have reason to know that the patented process will be used in the United States. As a result, all of the sale to FP is for a foreign use under paragraph (d)(2) of this section and therefore is a FDDEI sale. The entire $100x lump sum payment is included in DC's gross FDDEI for the taxable year.
( 6 ) Example 6: License of intangible property that includes a patented manufacturing method or process protected in the United States and other countries; foreign unrelated party —( i ) Facts. DC owns worldwide rights to patents, know-how, and a trademark and tradename for product Z. The patents consist of: a patent covering the right to make, use, and sell product Z (article of manufacture), a patent covering the rights to make, use, and sell a composition of substances used in certain components of product Z (composition of matter), and a patent covering the right to use a manufacturing process consisting of a series of manufacturing steps to manufacture product Z (manufacturing method or process as defined in paragraph (d)(2)(ii)(C)( 3 ) of this section) and to sell the product Z that FP manufactures using the manufacturing method or process. The know-how consists entirely of manufacturing know-how used to implement the manufacturing steps that comprise the manufacturing method or process. DC licenses the worldwide rights to the patents, know-how, and the trademark and tradename for product Z to FP in exchange for annual royalties of 60 percent of revenue from sales of product Z. FP manufactures product Z in country X and sells product Z to DC2, a domestic corporation and unrelated party to DC and FP, for resale to customers located within the United States. FP also sells product Z to FP2, a foreign unrelated party with respect to DC and FP, for resale to customers located outside the United States. During the taxable year, FP sells to DC2 $140x of product Z. Also, during the taxable year, FP sells to FP2 $60x of product Z. DC determines under the principles of section 482 that the licensed know-how and the patented manufacturing method or process comprise 10 percent of the arm's length price of the intangible property DC licenses to FP.
( ii ) Analysis —(A) End users. Under paragraph (d)(2)(ii)(C)( 1 ) of this section, FP is treated as the end user of the patent covering the right to use the manufacturing process and the manufacturing know-how used to implement the manufacturing method or process, and is treated as located outside the United States because FP is a foreign unrelated party and DC does not know or have reason to know that the patented process and know-how will be used in the United States. DC2, FP, and FP2 are not the end users of the remaining intangible property under paragraph (d)(2)(ii)(A) of this section because that intangible property is used in the sale of general property (the sale of product Z) and DC2, FP, and FP2 are not the end users of that general property. The unrelated party customers that purchase product Z from DC2 and FP2 are the end users (as defined in § 1.250(b)-3(b)(2) and paragraph (d)(2)(ii)(A) of this section) because those customers are the unrelated party recipients of product Z.
(B) Foreign use. Under paragraph (d)(2)(ii)(A) of this section, revenue from royalties paid for the intangible property other than the manufacturing method or process is earned from end users outside the United States to the extent the sale of the general property is for a foreign use under paragraph (d)(1) of this section. FP2 is a reseller of product Z to end users outside the United States, so all sales of product Z to FP2 are for a foreign use under paragraph (d)(1)(ii)(C) of this section. Because DC has determined that 10 percent of the value of the intangible property consists of a manufacturing method or process (as defined in paragraph (d)(2)(ii)(C)( 3 ) of this section) used to manufacture product Z, $12x of the $120x royalty FP pays to DC during the taxable year is for foreign use ($120x total royalty × 0.10) based on the location of FP's manufacturing utilizing the know-how or all of the sequence of actions that comprise the manufacturing method or process under paragraph (d)(2)(ii)(C)( 3 ) of this section. Based on the sales of product Z within and outside the United States, $32.4x of the royalties FP pays DC for rights to the licensed intangible property during the taxable year (($60x of revenue from sales to FP2 for resale to customers located outside the United States divided by $200x total worldwide sales revenue FP receives from DC2 and FP2) × ($120x total royalties less $12 of those royalties attributable to the manufacturing method or process)) qualifies as income earned from the sale of intangible property for a foreign use under paragraph (d)(2) of this section and therefore such portion is a FDDEI sale. As a result, $44.40x of royalties ($12x + $32.40x) is included in DC's gross FDDEI for the taxable year.
( 7 ) Example 7: License of intangible property that includes a patented manufacturing method or process protected in the United States and other countries; foreign related party with third-party manufacturer —( i ) Facts. The facts are the same as in paragraph (d)(2)(iv)(B)( 6 )( i ) of this section (the facts in Example 6 ), except that FP is a foreign related party with respect to DC and FP engages FP2, a foreign unrelated party, to manufacture product Z. FP sublicenses to FP2 the rights to the intangible property FP licenses from DC solely to manufacture product Z and sell product Z to FP. FP2 manufactures product Z in country Y and sells all of product Z it manufactures to FP. During the taxable year, FP sold $80x of product Z to DC2, which DC2 resold to customers located within the United States. Also, during the taxable year, FP sold $120x of product Z to customers located outside the United States.
( ii ) Analysis —(A) End users. Under paragraph (d)(2)(ii)(C)( 1 ) of this section, FP is not treated as the end user of the patent covering the right to use the manufacturing process and the manufacturing know-how used to implement the manufacturing method or process because FP is a foreign related party with respect to DC. Under paragraph (d)(2)(ii)(C)( 2 ) of this section, FP2 is also not treated as the end user of the patent covering the right to use the manufacturing process and the manufacturing know-how used to implement the manufacturing method or process because FP2 is using that intangible property to manufacture product Z for FP. DC2 is also not treated as the end user of the patent covering the right to use the manufacturing process and the manufacturing know-how used to implement the manufacturing method or process because DC2 does not use the patent or know-how in manufacturing. DC2, FP, and FP2 are not the end users of the remaining intangible property under paragraph (d)(2)(ii)(A) of this section because that intangible property is used in the sale of general property (the sale of product Z) and DC2, FP, and FP2 are not the end users of that general property. The unrelated party customers that purchase the Product Z from DC2 and FP are the end users (as defined in § 1.250(b)-3(b)(2) and paragraph (d)(2)(ii)(A) of this section) of the intangible property because those customers are the persons that ultimately use or consume product Z.
(B) Foreign use. Based on the sales of product Z to customers located within and outside the United States, $72x of the royalties FP pays DC for rights to the licensed intangible property during the taxable year (($120x of revenue from sales to customers located outside the United States divided by $200x total worldwide sales revenue) × $120x total royalties) qualifies as income earned from the sale of intangible property for a foreign use under paragraph (d)(2) of this section and therefore such portion is a FDDEI sale. As a result, $72x of royalties is included in DC's gross FDDEI for the taxable year.
( 8 ) Example 8: Deemed sale in exchange for contingent payments under section 367(d) —( i ) Facts. DC owns 100 percent of the stock of FP, a foreign related party with respect to DC. FP manufactures and sells product A. For the taxable year, DC contributes to FP exclusive worldwide rights to patents, trademarks, know-how, customer lists, and goodwill and going concern value (collectively, intangible property) related to product A in an exchange described in section 351. DC is required to report an annual income inclusion on its Federal income tax return based on the productivity, use, or disposition of the contributed intangible property under section 367(d). DC includes a percentage of FP's revenue in its gross income under section 367(d) each year. In the current taxable year, FP earns $1,000x of revenue from sales of product A. Based on reliable sales records kept by FP for the taxable year, $300x of FP's revenue is earned from sales of product A to customers within the United States, and $700x of its revenue is earned from sales of product A to customers outside the United States.
( ii ) Analysis. DC's deemed sale of the intangible property to FP in exchange for payments contingent upon the productivity, use, or disposition of the intangible property related to product A under section 367(d) is a sale for purposes of section 250 and this section. See § 1.250(b)-3(b)(16). Based on FP's sales records for the taxable year, 70 percent of DC's deemed sale to FP is for a foreign use, and 70 percent of DC's income inclusion under section 367(d) derived with respect to such portion is included in DC's gross FDDEI for the taxable year.
( 9 ) Example 9: License of intangible property followed by a sale of general property in which the intangible property is embedded; unrelated parties —( i ) Facts. DC owns the worldwide rights to a patent on a silicon chip used in computers, tablets, and smartphones. The patent does not qualify as a manufacturing method or process (as defined in paragraph (d)(2)(ii)(C)( 3 ) of this section). DC licenses the worldwide rights to the patent to FP in exchange for annual royalties of 30 percent of revenue from sales of the silicon chips. During the taxable year, FP manufactures silicon chips protected by the patent and sells all of those chips to FP2 for $1,000x. FP2 also purchases similar silicon chips from other suppliers. FP2 uses the silicon chips in computers, tablets, smartphones, and motherboards that FP2 manufactures in country X and sells to its customers located within the United States and foreign countries. For purposes of this example, FP2's manufacturing qualifies as subjecting the silicon chips to manufacture, assembly, or other processing outside the United States as provided in paragraph (d)(1)(iii) of this section.
( ii ) Analysis. FP is not the end user or treated as an end user (as defined in § 1.250(b)-3(b)(2) and paragraph (d)(2)(ii)(A) of this section) because FP is not the unrelated party recipient of the general property in which the patent is embedded, and the patent does not qualify as a manufacturing method or process. Under paragraph (d)(2)(ii)(A) of this section, revenue from royalties paid for the patent is earned from end users outside the United States to the extent the sale of the general property is for a foreign use under paragraph (d)(1) of this section. Because FP2 is subjecting the silicon chips to manufacture, assembly, or other processing outside the United States, the revenue from royalties FP pays to DC qualifies for foreign use based on the location of FP2's manufacturing and qualifies as a FDDEI sale. As a result, the entire $300x of annual royalties paid by FP to DC during the taxable year is included in DC's gross FDDEI for the taxable year.
( 10 ) Example 10: License of intangible property followed by a sale of general property in which the intangible property is embedded; related parties —( i ) Facts. The facts are the same as in paragraph (d)(2)(iv)(B)( 9 )( i ) of this section (the facts in Example 9 ), except that FP and FP2 are foreign related parties with respect to DC. FP2 sells and ships computers, tablets, and smartphones it manufactures with the silicon chips it purchases from FP to unrelated party wholesalers located within and outside the United States. The wholesalers within the United States only sell to retailers located within the United States and the wholesalers outside the United States only sell to retailers located outside the United States. The retailers within the United States only sell to customers located within the United States and the retailers located outside the United States only sell to customers located outside the United States. FP2 earns $15,000x of revenue from sales to unrelated party wholesalers located outside the United States and $10,000x of revenue from sales to unrelated party wholesalers located within the United States. FP2 also sells and ships motherboards with the silicon chips it purchases from FP to unrelated party manufacturers located outside the United States. FP2 does not sell motherboards with the silicon chips it purchases from FP to unrelated party manufacturers located within the United States. FP2 earns $5,000x of revenue from the sales of these motherboards to manufacturers located outside the United States. For purposes of this example, these manufacturers subject the motherboards to manufacture, assembly, or other processing outside the United States as provided in paragraph (d)(1)(iii) of this section.
( ii ) Analysis. FP is not the end user or treated as an end user (as defined in § 1.250(b)-3(b)(2) and paragraph (d)(2)(ii)(A) of this section) of the intangible property because FP is not the end user of the general property in which the patent is embedded (the silicon chips). FP2 is also not the end user (as defined in § 1.250(b)-3(b)(2) and paragraph (d)(2)(ii)(A) of this section) of the intangible property because FP2 is not the end user of the silicon chips. Under paragraph (d)(2)(ii)(A) of this section, the customers of the retailers that purchase from the unrelated party wholesalers are the end users. Because the wholesalers located outside the United States only sell to retailers located outside the United States that sell to end users located outside the United States, the location of the wholesalers is a reliable basis for determining the location of the end users. Revenue from royalties paid for the patent is earned from end users outside the United States to the extent the sale of the general property is for a foreign use under paragraph (d)(1) of this section. A portion of the sales to the unrelated party wholesalers qualify as foreign use under paragraph (d)(1) of this section and the sales to the unrelated party manufacturers qualify as foreign use under paragraph (d)(1)(iii) of this section. Accordingly, revenue from royalties FP pays to DC is from a FDDEI sale to the extent of such sales to the unrelated party manufacturers and such portion of sales to unrelated party wholesalers that qualify for foreign use. As a result, $200x of annual royalties paid by FP to DC during the taxable year ((($15,000x of sales to wholesalers located outside the United States plus $5,000x of sales to manufacturers located outside the United States) divided by $30,000x total sales) × $300x) is included in DC's gross FDDEI for the taxable year.
( 11 ) Example 11: License of intangible property followed by a sale of general property that incorporates the intangible property; unrelated parties with manufacturing within the United States —( i ) Facts. The facts are the same as in paragraph (d)(2)(iv)(B)( 9 )( i ) of this section (the facts in Example 9 ), except that FP2 manufactures its computers, tablets, smartphones, and motherboards in the United States.
( ii ) Analysis. FP is not the end user or treated as an end user (as defined in § 1.250(b)-3(b)(2) and paragraph (d)(2)(ii)(A) of this section) because FP is not the unrelated party recipient of the general property in which the patent is embedded (the silicon chips) and the patent does not qualify as a manufacturing method or process. Under paragraph (d)(2)(ii)(A) of this section, revenue from royalties paid for the patent is earned from end users outside the United States to the extent the sale of the general property is for a foreign use under paragraph (d)(1) of this section. Because FP2 is subjecting the silicon chips to manufacture, assembly, or other processing within the United States, the revenue from royalties FP pays to DC does not qualify as foreign use based on the location of FP2's manufacturing and therefore does not qualify as a FDDEI sale. As a result, none of the $300x of annual royalties paid by FP to DC during the taxable year is included in DC's gross FDDEI for the taxable year.
( 12 ) Example 12: License of intangible property used to provide a service —( i ) Facts. DC licenses to FP worldwide rights to the copyrights on movies in exchange for an annual royalty of $100x. FP also licenses copyrights on movies from persons other than DC. FP provides a streaming service that meets the definition of an electronically supplied service in § 1.250(b)-5(c)(5) to its customers within the United States and foreign countries. FP's streaming service provides its customers a catalog of movies to choose to stream. These movies include the copyrighted movies FP licenses from DC. FP does not provide DC with data showing how much revenue FP earned from streaming services during the taxable year, even after DC requests that FP provide it with such information. DC also is unable to determine how much revenue FP earned from streaming services to customers within the United States from the data it has with respect to FP and publicly available data with respect to FP. However, DC's economic analysis of the revenue DC expected it could earn annually from use of the copyrights as part of determining the annual payments DC would receive from FP from the license of the copyrights supports a determination that $10,000x of revenue would be earned during the taxable year from customers worldwide, and that 40 percent of that revenue would be earned from customers located outside the United States. During an examination of DC's return for the taxable year, DC provides the IRS with data explaining the economic analysis, inputs, and results from its valuation of the copyrights used in determining the amount of annual payments agreed to by DC and FP.
( ii ) Analysis. Under paragraph (d)(2)(ii)(B) of this section, FP's customers are the end users of the copyrights FP licenses from DC because FP uses those copyrights to provide the general service to FP's customers. Under paragraph (d)(2)(ii)(B) of this section, revenue from royalties paid for the copyrights is earned from end users outside the United States to the extent the service qualifies as a FDDEI service under § 1.250(b)-5. DC is allowed to use reliable economic analysis to estimate revenue earned by FP from streaming the licensed movies under paragraph (d)(2)(iii)(A) of this section because DC was unable to obtain actual revenue earned by FP from use of the copyrights during the taxable year after reasonable efforts to obtain the actual revenue data. Based on DC's reliable economic analysis, $40x of the annual royalty payment to DC (0.40 × $100x total annual royalty payment) is included in DC's gross FDDEI for the taxable year.
( 13 ) Example 13: License of intangible property used in research and development of other intangible property — ( i ) Facts. DC owns a patent (“patent A”) for an active pharmaceutical ingredient (“API”) approved for treatment of disease A in the United States and in foreign countries. DC licenses to FP worldwide rights to patent A for an annual royalty of $100x. FP uses patent A in research and development of a new API for treatment of disease B. Patent A does not consist of a manufacturing method or process (as defined in paragraph (d)(2)(ii)(C)( 3 ) of this section). FP's research and development is successful, resulting in FP obtaining both a patent for the new API for treatment of disease B and approval for use in the United States and foreign countries. FP does not earn any revenue from sales of finished pharmaceutical products containing the API during years 1 through 4 of the license of patent A. In year 5 of the license of patent A, FP earns $800x of revenue from sales of finished pharmaceutical products containing the API to customers located within the United States and $200x of revenue from sales to customers located in foreign countries.
( ii ) Analysis. FP is not the end user (as defined in § 1.250(b)-3(b)(2) and paragraph (d)(2)(ii)(D) of this section) of patent A because FP is not the end user described in paragraph (d)(2)(ii)(A) of this section of the product in which the API that was developed from patent A is embedded. The unrelated party customers that purchase the finished pharmaceutical product from FP are the end users (as defined in § 1.250(b)-3(b)(2) and paragraph (d)(2)(ii)(D) of this section) because those customers are the end users described in paragraph (d)(2)(ii)(A) of this section of the pharmaceutical product in which the newly developed patent is embedded. During the taxable years that include years 1 through 4 of the license of patent A, FP earns no revenue from sales of the API to a foreign person for a foreign use. Under paragraph (d)(2)(ii)(D) of this section, none of the $100x annual royalty payments to DC for each of the tax years that include years 1 through 4 of the license of patent A is included in DC's gross FDDEI. Based on FP's sales of the API during the tax year that includes year 5 of the license of patent A, $20x of the annual royalty payment to DC ($200x of revenue from sales of API to customers located outside the United States divided by $1,000x total worldwide revenue earned from sales of the API) × $100x annual royalty) is included in DC's gross FDDEI for the taxable year.
(3) Foreign use substantiation for certain sales of property —(i) In general. Except as provided in § 1.250(b)-3(f)(3) (relating to certain loss transactions), a sale of property described in paragraphs (d)(1)(ii)(C) of this section (foreign use for sale of general property for resale), (d)(1)(iii) of this section (foreign use for sale of general property subject to manufacturing, assembly, or processing outside the United States), or (d)(2) of this section (foreign use for sale of intangible property) is a FDDEI transaction only if the taxpayer satisfies the substantiation requirements described in paragraphs (d)(3)(ii), (iii), or (iv) of this section, as applicable.
(ii) Substantiation of foreign use for resale. A seller satisfies the substantiation requirements with respect to a sale of property described in paragraph (d)(1)(ii)(C) of this section (sales of general property for resale) only if the seller maintains one or more of the following items—
(A) A binding contract that specifically limits subsequent sales to sales outside the United States;
(B) Proof that property is specifically designed, labeled, or adapted for a foreign market;
(C) Proof that the cost of shipping the property back to the United States relative to the value of the property makes it impractical that the property will be resold in the United States;
(D) Credible evidence obtained or created in the ordinary course of business from the recipient evidencing that property will be sold to an end user outside the United States (or, in the case of sales of fungible mass property, stating what portion of the property will be sold to end users outside the United States); or
(E) A written statement prepared by the seller containing the information described in paragraphs (d)(3)(ii)(E)( 1 ) through ( 7 ) of this section corroborated by evidence that is credible and sufficient to support the information provided.
( 1 ) The name and address of the recipient;
( 2 ) The date or dates the property was shipped or delivered to the recipient;
( 3 ) The amount of gross income from the sale;
( 4 ) A full description of the property subject to resale;
( 5 ) A description of the method of sales to the end users, such as direct sales by the recipient or sales by the recipient to retail stores;
( 6 ) If known, a description of the end users; and
( 7 ) A description of how the seller determined that property will be ultimately sold to an end user outside the United States (or, in the case of sales of fungible mass property, of how the taxpayer determined what portion of the property that will ultimately be sold to end users outside the United States).
(iii) Substantiation of foreign use for manufacturing, assembly, or other processing outside the United States. A seller satisfies the substantiation requirements with respect to a sale of property described in paragraph (d)(1)(iii) of this section (sales of general property subject to manufacturing, assembly, or other processing outside the United States) if the seller maintains one or more of the following items—
(A) Credible evidence that the property has been sold to a foreign unrelated party that is a manufacturer and such property generally cannot be sold to end users without being subject to a physical and material change (for example, the sale of raw materials that cannot be used except in a manufacturing process);
(B) Credible evidence obtained or created in the ordinary course of business from the recipient to support that the product purchased will be subject to manufacture, assembly, or other processing outside the United States within the meaning of paragraph (d)(1)(iii) of this section; or
(C) A written statement prepared by the seller containing the information described in paragraphs (d)(3)(iii)(C)( 1 ) through ( 7 ) of this section corroborated by evidence that is credible and sufficient to support the information provided.
( 1 ) The name and address of the manufacturer of the property;
( 2 ) The date or dates the property was shipped or delivered to the recipient;
( 3 ) The amount of gross income from the sale;
( 4 ) A full description of the general property sold and the type or types of finished goods that will incorporate the general property the taxpayer sold;
( 5 ) A description of the manufacturing, assembly, or other processing operations, including the location or locations of manufacture, assembly, or other processing; how the general property will be used in the finished good; and the nature of the finished good's manufacturing, assembly, or other processing operations as compared to the process used to make the general property used to make the finished good;
( 6 ) A description of how the seller determined the general property was substantially transformed or the activities were substantial in nature within the meaning of paragraph (d)(1)(iii)(B) or (C) of this section, whichever the case may be; and,
( 7 ) If the seller is relying on the rule described in paragraph (d)(1)(iii)(C) of this section (that the fair market value of the general property be no more than twenty percent of the fair market value when incorporated into the finished goods sold to end users), an explanation of how the seller satisfies the requirements in that paragraph.
(iv) Substantiation of foreign use of intangible property. A taxpayer satisfies the substantiation requirements with respect to a sale of property described in paragraph (d)(2) of this section (foreign use for intangible property) if the seller maintains one or more of the following items—
(A) A binding contract that specifically provides that the intangible property can be exploited solely outside the United States;
(B) Credible evidence obtained or created in the ordinary course of business from the recipient establishing the portion of its revenue for a taxable year that was derived from exploiting the intangible property outside the United States; or
(C) A written statement prepared by the seller containing the information described in paragraphs (d)(3)(iv)(C)( 1 ) through ( 9 ) of this section corroborated by evidence that is credible and sufficient to support the information provided.
( 1 ) The name and address of the recipient;
( 2 ) The date of the sale;
( 3 ) The amount of gross income from the sale;
( 4 ) A description of the intangible property;
( 5 ) An explanation of how the intangible property will be used by the recipient (embedded in general property, used to provide a service, used as a manufacturing method or process, or used in research and development);
( 6 ) An explanation of how the seller determined what portion of the sale is a FDDEI sale;
( 7 ) If the intangible property consists of a manufacturing method or process, an explanation of how the elements of paragraph (d)(2)(ii)(C) of this section are satisfied;
( 8 ) If the sale is for periodic payments, an explanation of how the seller determined the extent of foreign use based on the actual revenue earned by the recipient from the use of the intangible property for the taxable year in which a periodic payment is received as required by paragraph (d)(2)(iii)(A) of this section, or, if actual revenue cannot be obtained after reasonable efforts, an explanation of why actual revenue is unavailable and how the seller determined the extent of foreign use based on estimated revenue; and
( 9 ) If the sale is for a lump sum, an explanation of how the seller determined the total net present value of revenue it expected to earn from the exploitation of the intangible property outside the United States and the total net present value of revenue it expected to earn from the exploitation of the intangible property as required by paragraph (d)(2)(iii)(B) of this section.
(v) Examples. The following examples illustrate the application of this paragraph (d)(3).
(A) Assumed facts. The following facts are assumed for purposes of the examples—
( 1 ) DC is a domestic corporation.
( 2 ) FP is a foreign person located within Country A that is a foreign unrelated party with respect to DC.
( 3 ) All of DC's income is DEI.
( 4 ) Except as otherwise provided, the substantive rule for foreign use as described in paragraphs (d)(1) and (2) of this section are satisfied.
(B) Examples —
( 1 ) Example 1: Substantiation by seller of sale of products to distributor outside the United States with taxpayer statement and corroborating evidence —( i ) Facts. DC sells smartphones to FP, a distributor of electronics that sells property to end users. As part of their regular business process and pursuant to DC's terms and conditions of sales, DC issues commercial invoices to FP that contain a condition that any subsequent sales must be to end users outside the United States. At or near the time of the FDII filing date, DC prepares a statement containing the information required in paragraph (d)(3)(ii)(E) of this section. During an examination of DC's return for the taxable year, the IRS requests substantiation information of foreign use. DC submits the commercial invoices issued to FP as supporting information that FP's customers are end users outside the United States and all other corroborating evidence to the IRS.
( ii ) Analysis. DC's sale to FP is a sale of general property for resale subject to the substantiation requirements of paragraph (d)(3)(ii) of this section. DC satisfies the substantiation requirement by providing the statement that satisfies the requirements of paragraph (d)(3)(ii)(E) of this section. The commercial invoices issued pursuant to the terms and conditions of sales sufficiently corroborate DC's statement that the smartphones will ultimately be sold to end users outside of the United States.
( 2 ) Example 2: Substantiation of sale of products to distributor outside the United States with recipient provided information —( i ) Facts. DC sells cameras to FP, a distributor of electronics that sells property to end users outside the United States. FP issues sales invoices to its end users. The invoices contain detailed information about the nature of the subsequent sales of the cameras and the location of the end users for value added tax (VAT) purposes. DC is able to obtain copies of FP's VAT invoices with respect to the camera sales that were maintained and submitted pursuant to Country A law. Rather than prepare a statement described in paragraph (d)(3)(ii)(E) of this section, DC submits FP's invoices to the IRS as substantiation of foreign use.
( ii ) Analysis. DC's sale to FP is a sale of general property for resale subject to the substantiation requirements of paragraph (d)(3)(ii) of this section. DC satisfies the substantiation requirements by providing the invoices that satisfy the requirements of paragraph (d)(3)(ii)(D) of this section. The VAT invoices issued by FP pursuant to Country A law constitute credible evidence from FP that ultimate sales are to end users located outside the United States.
(e) Sales of interests in a disregarded entity. Under Federal income tax principles, the sale of any interest in an entity that is disregarded for Federal income tax purposes is considered the sale of the assets of that entity, and this section applies to the sale of each such asset that is general property or intangible property for purposes of determining whether such sale qualifies as a FDDEI sale.
(f) FDDEI sales hedging transactions —(1) In general. The amount of a corporation's or partnership's gross FDDEI from FDDEI sales of general property in a taxable year is increased by any gain, or decreased by any loss, taken into account in that taxable year with respect to any FDDEI sales hedging transactions (determined by taking into account the applicable Federal income tax accounting rules, including § 1.446-4).
(2) FDDEI sales hedging transaction —The term FDDEI sales hedging transaction means a transaction that meets the requirements of § 1.1221-2(a) through (e) and that is identified in accordance with the requirements of § 1.1221-2(f), except that the transaction must manage risk of price changes or currency fluctuations with respect to ordinary property, as provided in § 1.1221-2(b)(1), and the ordinary property whose price risk is being hedged must be general property that is sold in a FDDEI sale.