royalty income Archives - TAX CONTROVERSY 360

Tax Reform Insight: Eligibility Requirements for Reduced Tax Rate on FDII for Royalties

A domestic corporation’s royalty income derived in connection with business conducted outside the United States generally is eligible for the reduced 13.125 percent effective tax rate on foreign derived intangible income (FDII). To qualify, the licensee must be a foreign person, and the intangible property must be used outside the US for the ultimate benefit of an unrelated foreign person.

For example, the lower rate generally should be available for royalties from licensing intangible property to an unrelated foreign person for use: (1) in the production and sale of products to foreign customers; (2) to provide services to foreign customers; or (3) to sublicense the intangible property to foreign persons.

Royalties from licensing intangible property to an unrelated US corporation that is for use outside the US may not qualify for FDII benefits. Such royalties should qualify, however, if instead the license is with a foreign subsidiary of the US corporation, or if a foreign subsidiary otherwise economically is considered the licensee.

The 13.125 percent tax rate is also available for certain royalties derived from licensing intangible property to related foreign persons. For example, royalties generally should qualify if the related foreign person uses the intangibles outside the United States to (1) produce and sell products to unrelated foreign customers; (2) provide services to unrelated foreign customers, or (3) sublicense the intangibles to unrelated foreign persons. (more…)

IRS and Taxpayers Continue Fight over Regulations Intended to Overrule Judicial Precedent

In March 2013, 3M filed a petition with the US Tax Court challenging the Internal Revenue Service’s (IRS) determination that additional royalty income should be allocated to 3M’s US headquarters from its Brazilian subsidiary. See 3M Co. v. Commissioner, T.C. Dkt. No. 5186-13. Specifically, the IRS determined that Brazilian legal restrictions on the payment of royalties to the US parent should not be taken into account in determining the arm’s-length price between 3M and the subsidiary under Treas. Reg. § 1.482-1(h)(2). 3M’s position will require the Tax Court to revisit its earlier, pre-regulations holdings on the subject and to decide whether the Supreme Court of the United States has already resolved the issue.

The parties recently submitted the case fully stipulated under Tax Court Rule 122, with simultaneous opening briefs due on March 21, 2016. The parties will then have the opportunity to submit reply briefs responding to each other’s arguments.

More than 40 years ago, the Supreme Court in Commissioner v. First Sec. Bank of Utah, 405 U.S. 394 (1972), rejected the IRS’s attempt to apply section 482 where federal law prohibited the taxpayer from receiving the income the IRS was seeking to allocate to it. Subsequent Tax Court and appellate court decisions applied the Supreme Court’s holding to restrictions under foreign and state law. In 1994, the IRS promulgated current Treas. Reg. § 1.482-1(h)(2), which provides, in part, that “a foreign legal restriction will be taken into account only to the extent that it is shown that the restriction affected an uncontrolled taxpayer under comparable circumstances for a comparable period of time.” Although the regulation also contains a deferred income election that permits the deferred recognition of restricted income, subject to a matching deferral of deductions, it may be difficult in most situations to meet these requirements.

Whether 3M succeeds may depend on how the Tax Court applies the recent Supreme Court decision in U.S. v. Home Concrete & Supply LLC, 132 S.Ct. 1836 (2012). There, the Supreme Court held that its prior interpretation of a statute meant that “there is no longer any different construction that is consistent with [the prior opinion] and available for adoption by the agency.” This is an important case for all taxpayers, not just those dealing with the blocked income issue, and the Tax Court’s determination may have a broad impact on future challenges to tax regulations.