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Today in Tax: Eligibility of Electronic Services Income for FDII Deduction

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Brief commentary on recent cases, rulings, notices, and related federal tax guidance.

Regulations open door for cloud computing, streaming, and related electronic services to be included in deduction computation.

In late 2017 the Tax Cuts and Jobs Act created a deduction that would create a lower tax rate for certain income earned by U.S. taxpayers from selling goods and services to non-U.S. customers. Recent regulations expand (ever so slightly) the scope of electronic services that may generate income eligible for the deduction. U.S.-based companies providing web-based services should review these regulations with their tax advisors and update their tax models to take advantage of applicable deductions.

On December 28, 2021, the Department of Treasury and Internal Revenue Service released final regulations in Treasury Decision 9959 (T.D. 9959) covering a variety of issues relevant to taxpayers with multinational operations. Of particular interest to technology-driven companies are the final regulations governing the deduction relating to foreign derived intangible income (or “FDII”). These regulations become effective on March 7, 2022. Under the regulations, content streaming and cloud computing services, particularly software as a service (“SaaS”) and platform as a service (“PaaS”), may generate income that is subject to less US federal income tax. However, technology companies providing those services abroad may be subject to taxation in foreign countries, as well.

For more information about non-US taxation of digital services access: Foreign Tax Credits Against Digital Service Taxes and When Worlds Collide: How Tangible Tax Burdens Attach to Digital Commerce across the Globe.

The FDII deduction is computed in part by reference to income that is derived from foreign, rather than U.S., sources, essentially meaning that some amount of certain foreign-sourced income will be subject to a preferred tax rate after applying the deduction.

One of the primary questions resolved by the final regulations relates to how a taxpayer determines what income is eligible for the FDII deduction. The final regulations provide that deduction-eligible income includes electronic services that are rendered to consumers or businesses that use the service (or receive the benefit of the service) outside the U.S. And, unlike the proposed regulations, the final regulations do not require these electronic services to be delivered contemporaneously (for example, a training webcast in real time). Instead, electronic services income may be eligible for inclusion in the FDII deduction computation if those services are rendered to a consumer with an IP address or billing address outside the U.S., regardless of whether the service is provided simultaneously with the recipient’s access of the service.

Electronic services rendered to business consumers are eligible for inclusion in the FDII deduction computation on a slightly different basis. Those services are eligible only if the benefit of the services is received outside the U.S., for example, by reason of the service recipient having a non-US IP address. If the service provider can’t determine whether the business consumer received the services outside the U.S., then the sourcing determination will depend on the recipient’s billing address, but only if the total revenue from the recipient is less than $50,000 in the year. Otherwise, the regulations presume that the services are rendered in the U.S. and therefore, not eligible for inclusion in the FDII deduction computation.

Access last week’s installment here.