By Anthony Diosdi
Introduction
For those who are or will be involved in international business and investment transactions, it is important to have some basic understanding of the relevant tax laws. These series of articles are intended to warn individual shareholders of controlled foreign corporations (“CFCs”) (whether individual or corporate) of the mistakes that will likely catch the attention of the Internal Revenue Service (“IRS”) and trigger a potential costly audit. Over the several months we have noticed a number of IRS Form 8993 prepared incorrectly. In this article, we will discuss the Form 8993 and the mistakes on the form that will likely catch the attention of the IRS.
The Section 250 Deduction
Effective for taxable years of foreign corporations beginning after December 31, 2017 and to taxable years of U.S. shareholders in which or which such taxable years of foreign corporations end, Internal Revenue Code Section 250 allows a domestic C corporation and individual taxpayers that made a Section 962 election a deduction for a portion of the domestic corporation’s “foreign derived intangible income (“FDII”) and the taxpayer’s Global Low-Taxed Income (“GILTI”) income. Specifically, domestic corporations are allowed to deduct: 37.5 percent of the domestic corporation’s FDII, and 50 percent of the domestic corporation’s GILTI (as determined under Section 951A) plus GILTI Section 78 gross-up.
Computing the Section 250 Deduction
The Section 250 deduction is determined based on a multistep calculation discussed below.
1. First, a domestic corporation’s (or individual making a Section 962 election) gross income is determined and then reduced by certain items of income, including amounts included under subpart F, GILTI income, dividends received from CFCs, income earned in foreign branches, financial services, and domestic oil and gas production. This amount is reduced by deductions (including taxes) properly allocable to such income, yielding deduction eligible income (DEI).
2. Second, the deemed Intangible Income (DII) is determined. This is the excess (if any) of the domestic corporation’s deduction eligible income over 10 percent of its qualified business asset investment (“QBAI”). A domestic corporation’s QBAI is the average of its adjusted bases (using a quarterly measuring convention) in depreciable tangible property used in the corporation’s trade or business to generate the deduction eligible income. The adjusted bases are determined using straight line depreciation. A domestic corporation’s QBAI does not include land, intangible property or any assets that do not produce the deductible eligible income.
3. Third, the Section 250 calculation is made to determine the amount of deduction available from foreign source income characterized as FDII or GILTI. The Section 250 calculation is expressed by the following formula:
Deemed Intangible Income x Foreign-Derived Deduction Eligible Income
Deduction Eligible Income
The eligible deduction under Section 250 is determined by applying the above formula.
IRS Form 8993
IRS Form 8993 is utilized to determine the Section 250 deduction. All domestic corporations (and U.S. individual shareholders of CFCs making a Section 962 election) must utilize Form 8993 to determine the allowable Section 250 deduction. Completing the Form 8993 is no easy task. We have noticed that tax practitioners have had difficulties with the following questions on Form 8993:
Part I Line 1
The instructions to Form 8993 for Line 1 of Part I states that the domestic corporation (or individual shareholder making a Section 962 election) must list its total gross income. This includes both domestic and foreign source income. We have noticed some preparers erroneously list only foreign source income on Line 1 of Part 1. Only listing a domestic corporation’s foreign source income on line 1 of Part I will likely catch the attention of the IRS.
Part III Line 1a.
The instructions to Form 8993 for Line 1a of Part III states that the preparer should include DEI derived from the sales, lease, exchange, or other disposition (other than license) of property to foreign person for foreign use. This question asks the preparer to list a very specific category of foreign source income. That is, DEI income derived from the sales, lease, exchange, or disposition (other than a license) to a foreign person for foreign use. We have noticed a number of tax professionals entering all foreign source income of CFCs on line 1a. This is incorrect and will not only produce an incorrect amount for purposes of the Section 250 deduction, such a mistake will also likely catch the attention of the IRS. Another way to check the accuracy of Line 1a is check the entry on line 3 to Part III. The DEI income reported on line 1a for Part III should not exceed the amount stated on line 3 of Part III of Form 8993.
Part IV Line 5
The instructions to line 5 for Part IV of Form 8993 ask the preparer to enter the domestic taxable income (determined without regard to Section 250). The domestic taxable income of U.S. corporations can be found on line 30 of the Form 1120. We have noticed a number of tax preparers overthinking this question and entering some other number. This mistake has resulted in the flagging of a number of returns by the IRS and corresponding unfavorable adjustments.
Part IV Line 8 and Line 9
Line 8 of Part IV provides the Section 250 deduction amount for FDII. For domestic C corporations that sell goods and/or provide services to foreign customers, there is a deduction under Section 250 that reduces the effective tax rate on qualifying income to 13.125 percent. Line 9 of Part IV provides the Section 250 deduction for GILTI. Section 951A requires a U.S. shareholder of a CFC to include in the U.S. shareholder’s income an amount of its CFC’s income determined to be in excess of a specified return on the CFC’s investment in depreciable tangible personal property. Section 250 allows U.S. shareholders to deduct a portion of the GILTI which may achieve a rate lower than 13.124 percent (50% deduction multiplied by 21% U.S. tax equals 10.5 %, which equals 13.125% multiplied by the allowable 80% foreign tax credit).
Although the Section 250 reduction applies similarly when determining the Section 250 deduction to FDII and GILTI income. When the Section 250 formula is applied to these two items of income, the allocable deduction will also be different. Preparers must make sure not apply a FDII deduction to GILTI income or vica versa. Such a mistake would likely trigger IRS scrutiny.
Conclusion
If you are concerned that your Section 250 deduction was not computed properly, you should consult with a qualified international tax professional. A review of your individual and/or corporation tax return may provide you with peace of mind. If a mistake is found, it can be corrected before it is caught by the IRS. Sometimes a mistake may be in your favor. We provide international compliance assistance and international tax planning services to domestic corporations. We also assist other tax professionals who need guidance regarding international tax compliance matters.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.