TAXFAX- Updates to the PPP Loan Program and Cooperatives
Originally Published in The Cooperative Accountant, Spring 2021 Issue
Updates to the PPP Loan Program and Cooperatives
Under the Coronavirus Aid, Relief, and Economic Security Act (“CARES”) enacted in April of 2020, Congress announced the Paycheck Protection Program (“PPP”) to help small businesses weather the negative economic impact caused by the COVID pandemic. Loans under the PPP are 100% guaranteed by the Small Business Administration (“SBA”), and the full principal amount of the loans and any accrued interest may qualify for loan forgiveness.
The SBA, in consultation with the Department of Treasury, has intermittently published a list of “Paycheck Protection Program Loans Frequently Asked Questions” and in the April 24, 2020 version of that document, question #35 asked whether agricultural and other forms of cooperatives are eligible to receive PPP loans. The answer is yes – as long as other PPP eligibility requirements are met, small agricultural cooperatives and other cooperatives may receive PPP loans.
In response to questions from the electric cooperative community, the SBA issued an interim rule on May 19, 2020, stating that for purposes of the PPP, an electric cooperative that is exempt from Federal income taxation under section 501(c)(12) of the Code will be considered to be ‘‘a business entity organized for profit’’ under 13 CFR 121.105(a)(1). The result is that electric cooperatives are eligible PPP borrowers, as long as other eligibility requirements are met.
As cooperatives and other small businesses availed themselves to the PPP, questions arose as to the deductibility of expenses paid with loan proceeds in the event the loan was ultimately forgiven. In response, the IRS issued Notice 2020-32 on April 30, 2020 which squarely addressed the deductibility for Federal income tax purposes of certain otherwise deductible expenses incurred in a taxpayer’s trade or business when the taxpayer receives a PPP loan. The notice clarified that no deduction is allowed under the Code for an expense that is otherwise deductible if the payment of the expense results in forgiveness of a PPP loan pursuant to section 1106(b) of the CARES Act, and the income associated with the forgiveness is excluded from gross income for purposes of the Code pursuant to section 1106(i) of the CARES Act.
On November 18, 2020, the IRS issued further guidance to amplify Notice 2020-32, in the form of Rev. Rul. 2020-27 and Rev. Proc. 2020-51.
In Rev. Rul. 2020-27, the IRS addressed whether a taxpayer that received a PPP loan and paid or incurred certain otherwise deductible expenses allowed by the CARES Act can deduct those expenses in the taxable year in which the expenses were paid or incurred if, at the end of such taxable year, the taxpayer reasonably expects to receive forgiveness of the PPP loan based on the otherwise deductible expenses. The revenue ruling held that if a taxpayer received a PPP loan and paid or incurred certain otherwise deductible expenses allowed by the CARES Act, the taxpayer may not deduct those expenses in the taxable year in which the expenses were paid or incurred at the end of such taxable year, if the taxpayer reasonably expects to receive forgiveness of the PPP loan on the basis of the expenses it paid or accrued during the applicable period, even if the taxpayer has not submitted an application for forgiveness of the PPP loan by the end of such taxable year.
In the same vein, Rev. Proc. 2020-51, issued along with Rev. Rul. 2020-27, provided a safe harbor allowing a taxpayer to claim a deduction in the taxpayer’s taxable year beginning or ending in 2020 for certain otherwise deductible eligible expenses, if: (1) the eligible expenses are paid or incurred during the taxpayer’s 2020 taxable year; (2) the taxpayer receives a PPP loan at the end of the taxpayer’s 2020 taxable year and the taxpayer expects it to be forgiven in a subsequent taxable year; and (3) in a subsequent taxable year, the taxpayer’s request for forgiveness of the PPP loan is denied, or the taxpayer decides never to request forgiveness of the PPP loan. Section 4.01 of the Rev. Proc. provided that a qualifying taxpayer may deduct non-deducted eligible expenses on the taxpayer’s original income tax or information return the 2020 taxable year, or on an amended return for the 2020 taxable year. Section 4.02 provided a qualifying taxpayer may deduct non-deducted eligible expenses in the year that the loan forgiveness is denied under general tax principles, assuming that the taxpayer does not elect to use the safe harbor in Section 4.01 of Rev. Proc. 2020-51. The deduction, of course, is limited to an amount no greater than the principal amount of the original PPP loan. In addition to the other qualification requirements in the Rev. Proc., the taxpayer must attach a statement to the return on which the taxpayer deducts non-deducted eligible expenses titled “Revenue Procedure 2020-51 Statement,” and must include: (1) the taxpayer’s name, address, and E.I.N.; (2) a statement affirming that the taxpayer is an eligible taxpayer under the Rev. Proc.; (3) a statement that the taxpayer is applying section 4.01 or section 4.02 of the Rev. Proc.; (4) the amount and date of disbursement of the taxpayer’s PPP loan; (5) the total amount of PPP loan forgiveness that the taxpayer was denied or decided to no longer seek; (6) the date the taxpayer was denied or decided not to seek PPP loan forgiveness; and (7) the total amount of eligible expenses and non-deducted eligible expenses that are reported on the return.
The rationale of the U.S. Treasury Department and the IRS for issuing this guidance was that since businesses are not taxed on the proceeds of a forgiven PPP loan, the expenses are not deductible. The result is neither a tax benefit nor tax burden since the taxpayer has not paid anything out of its own funds. In other words, if a business reasonably believes that a PPP loan will be forgiven in the future, expenses related to the loan are not deductible, whether the business has filed for forgiveness or not. However, in the case where a PPP loan was expected to be forgiven, and it is not, businesses will be able to deduct those expenses.
On December 27, 2020, the president signed the $900 billion, 5,600 page Consolidated Appropriations Act, 2021 (“CAA”), which extends authority to make PPP loans through March 31, 2021, and allows housing cooperatives to be eligible for PPP loans. Division N, Title III of the CAA, known as the “Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act” includes significant revisions to the eligibility and administration of PPP loans. Under the initial version of the CARES, there was no provision for housing cooperatives. Passive businesses owned by developers and landlords were deemed ineligible, and apartment complexes were also excluded.
The CAA also provides that deductible ordinary and necessary business expenditures that provide for the forgiveness of a PPP loan are deductible by the PPP loan borrower, reversing existing IRS guidance. On January 7, 2021, the IRS issued Rev. Rul. 2021-2, which obsoletes Notice 2020-32 and Rev. Rul. 2020-27, and provides that no amount shall be included in the gross income of an eligible recipient by reason of forgiveness of indebtedness of a PPP loan, and no deduction shall be denied, no tax attribute shall be reduced, and no basis increase shall be denied, by reason of an exclusion from gross income provided by the PPP.
Commentators advise that cooperative bylaws and other governing documents be reviewed to ensure that there are no restrictions on the cooperative’s authority to borrow money by applying for a PPP loan. And if a cooperative has an outstanding mortgage or other secured financing, the existing loan documentation should be checked to see if the consent of the current lender is be required.
The full scope of the CAA is well beyond the scope of this review, and cooperatives interesting in participating should consult with their primary lenders to determine their eligibility and the availability of a PPP loan. Interim final rules and additional guidance will be provided during the life of the PPP loan program, and practitioners accordingly should monitor guidance updates to ensure compliance.
Daniel S. Welytok
Treasury Department and IRS issue final regulations regarding like-kind exchanges of real property
In early December, the Treasury and Internal Revenue Service published final regulations providing guidance for like-kind exchanges under section 1031 of the Internal Revenue Code. T.D. 9935, 85 Fed. Reg. 77365 (December 2, 2020). These final regulations add a definition of real property, and provide a rule addressing receipt of personal property that is incidental to real property a taxpayer receives in an otherwise qualifying like-kind exchange. The final regulations affect taxpayers that exchange business or investment property for other business or investment property and apply to exchanges beginning after December 2, 2020.
As background, the 2017 Tax Cuts and Jobs Act (TCJA) amended section 1031 to limit its application to exchanges of real property. Specifically, section 1031 after amendment provides that no gain or loss is recognized on the exchange of real property held for productive use in a trade or business or for investment if the real property is exchanged solely for real property of a like kind that is to be held either for productive use in a trade or business or for investment. As of January 1, 2018, exchanges of personal or intangible property such as vehicles, artwork, collectibles, patents, and other intellectual property generally do not qualify for nonrecognition of gain as like-kind exchanges. To implement these statutory changes, the final regulations limit the application of the like-kind exchange rules to exchanges of real property, add a definition of real property, and adapt an existing incidental property exception to apply to a taxpayer’s receipt of personal property that is incidental to real property the taxpayer receives in the exchange.
Real property includes land and generally anything permanently built on or attached to the land, such as a building, fence, parking lot, and other inherently permanent structure that is a distinct asset. In addition, the final regulations provide that property is real property for purposes of section 1031 if, on the date it is transferred in an exchange, that property is classified as real property under the law of the State or local jurisdiction in which that property is located.
Items treated as real property specifically mentioned in the final regulations include:
- Grain storage bins and silos.
- Unsevered natural products of land (such as growing crops, plants and timber) – however, once harvested, they become personal property.
- Stock of mutual ditch (irrigation) companies exempt under section 501(c)(12) “if, at the time of the exchange, the shares have been recognized by the highest court of the State in which the company was organized, or by a State statute, as constituting or representing real property or an interest in real property.” (This follows prior law.)
- Stock held by a tenant-stockholder of a cooperative housing corporation.
The final regulations also revise the proposed definition of real property to eliminate any consideration of whether the particular property contributes to the production of income unrelated to the use or occupancy of space (referred to as the ‘‘purpose or use test’’). With regard to tangible property, if such property is permanently affixed to real property and will ordinarily remain affixed for an indefinite period of time, the property generally is an inherently permanent structure and thus real property for section 1031 purposes, irrespective of the purpose or use of the property or whether it contributes to the production of income.
Regarding personal property, the final regulations retain the rule relating to personal property in an exchange that is incidental to the real property exchange. Under this rule personal property is incidental to real property acquired in an exchange if, in standard commercial transactions, the personal property typically is transferred together with the real property, and the aggregate fair market value of the incidental personal property transferred with the real property does not exceed 15 percent of the aggregate fair market value of the replacement real property. This incidental property rule in the proposed regulations is based on an existing rule in the regulations under section 1031, which provides that certain incidental property is ignored in determining whether a taxpayer has properly identified replacement property. Note, however, while the presence of incidental person property will not spoil an exchange of real property, the personal property will be treated as boot.
In summary, real property eligible for like-kind exchange treatment under the law in effect prior to enactment of the TCJA will continue to be eligible for like-kind exchange treatment after enactment of the TCJA and the final regulations, and property ineligible for like-kind exchange treatment prior to enactment of the TCJA remains ineligible, including real property that was excluded from the application of section 1031.
Sandra E. Hofmann, CPA
Iowa Court Concludes Feed Mill Ingredient Bins Are Exempt “Machinery” for Property Tax Purposes
The Court of Appeals of Iowa recently decided a dispute between a cooperative and local taxing authorities over the extent to which a feed manufacturing facility was subject to property tax. See, StateLine Cooperative v. Iowa Property Assessment Appeal Board, Case No. 190674 (November 4, 2020).
A portion of the decision deals with procedural and run-of-the-mill valuation issues, and that part will not be discussed here. More interesting is the Court’s analysis of whether several ingredient receiving and storage bins and a finished product storage bin qualified as “manufacturing machinery.”
The analysis in the opinion begins with the language of the Iowa Code, which exempts “machinery used in manufacturing establishments” from property taxation. The Court noted that a prior Iowa Supreme Court decision had concluded that the term “machinery” should be broadly construed, and that it included “all machinery, attached or unattached, fixtures or movable items.” The Court also observed that what qualifies as machinery is inherently factual and “must logically be made based on the circumstances on a case-by-case basis.”
The Court noted that the parties agreed that the cooperative was engaged in “manufacturing” at its feed mill. The dispute was over whether exempt ingredient and load-out bins qualified for the “machinery” exemption.
Finding no Iowa authority on point, the Court reviewed decisions of courts in other states considering such things as silos at a concrete-manufacturing facility, oil storage tanks, blast furnace stock bins, railroad track used to transfer work-in-process from one processing facility to another, ammonia tanks used principally to store ammonia, and machinery used by distilleries in bottling whisky. In particular, the Court focused on a series of Pennsylvania decisions. The Court observed that other courts have focused on how storage facilities are used and how they relate to the manufacturing process. Facilities that predominately serve a storage function do not qualify. Those that hold products temporarily and which feed into a manufacturing function can qualify.
The Court concluded that the ingredient bins qualified, but the load-out bins did not.
“Corn and other ingredients are conveyed to the ingredient bins in building one and buildings five and six, each of which are essentially temporary storage facilities. The ingredients are then fed into machinery to produce a finished product. The product then makes its way to the load-out bins, where it is held until loaded into trucks for delivery. The structures essentially amount to nonautomated equipment. … With the exception of the load-out bins, the structures are ‘used directly in manufacturing the products that the establishment is intended to produce and are necessary and integral parts of the manufacturing process.’ … The load-out bins, however, are not used directly in the manufacturing process, and they only contain finished product ‘ready to be put on the market so as to be sold to the consuming public for the purpose for which it was intended.’ … We conclude the ingredient bins and exterior grain bins, but not the load-out bins, amount to machinery used in a manufacturing facility and are exempt from taxation.”
Property tax rules are peculiar to each state and, as illustrated by this case, frequently involve distinctions that are fact intensive. However, many states do have a “machinery used in manufacturing” exemption, and this decision illustrates the potential scope of that exemption.
George W. Benson, Counsel
Patronage dividends properly continue to avoid classification as “tax expenditures”
Each year, the Staff of the Joint Committee on Taxation and the Office of Tax Policy of the Treasury Department prepare reports estimating “federal tax expenditures.” See, “Estimates of Federal Tax Expenditures for Fiscal Years 2020-2024” prepared by the Staff of the Joint Committee, JCX-23-20 (November 5, 2020) (the “JCT report”) and “Tax Expenditures” prepared by the U.S. Department of the Treasury, Office of Tax Analysis (February 26, 2020) (the “Treasury report”).1
The JCT report states its purposes are to “help both policymakers and the public to understand the actual size of government, the uses to which government resources are put, and the tax and economic policy consequences that follow from the implicit or explicit choices made in fashioning legislation.” The Treasury report observes that special provisions involving tax expenditures “may be viewed as alternatives to other policy instruments, such as spending or regulatory programs.”
The starting point of both reports is the definition of “tax expenditures” contained in the Congressional Budget Act of 1974. Tax expenditures are “revenue losses attributable to provisions of the Federal tax laws which allow special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability.”
The JCT report identifies both positive and negative tax expenditures. Positive expenditures are items that reduce tax revenue and, as a result, “may be analogous to direct outlay programs and may be considered alternative means of accomplishing similar budget objectives.” Negative expenditures are “[t]ax provisions that provide treatment less favorable than normal income tax law and are not related directly to progressivity.”
The Treasury report identifies only positive tax expenditures.
The starting place in each report is a determination of what is regarded as “normal” or as the “baseline.” The JCT report acknowledges that the “Joint Committee staff uses its judgment in distinguishing between those income tax provisions (and regulations) that can be viewed as part of normal income tax law and those special provisions that result in tax expenditures.” The Treasury report contains a similar statement: “Identification and measurement of tax expenditures depends crucially on the baseline tax system against which the actual tax system is compared.”
Items treated as tax expenditures are similar, but not identical, in the two reports. The JCT report estimates tax expenditures five years in the future. The Treasury report uses a ten-year time horizon.
From the perspective of Subchapter T cooperatives, what is most important is that neither treats Subchapter T (and its exemption/deduction for patronage dividends and per-unit retain allocations) as giving rise to a “tax expenditure.”
This is not new. However, it is significant because it reflects acceptance by Treasury and the Joint Committee Staff of Subchapter T as part of the “baseline tax system” or as part of the “normal income tax law.”
In contrast, the JCT report provides that the “tax exemption for noncharitable organizations that have a direct business analogue or compete with for-profit organizations organized for similar purposes is a tax expenditure.” Included in this category are mutual or cooperative electric companies. The Treasury report similarly classifies the exemption for “mutual and cooperative telephone and electric companies” as a tax expenditure. The Treasury report puts a ten-year cost on this exemption at $1.05 billion.
Both reports identify Section 199A as giving rise to a tax expenditure. The JCT report estimates the cost at approximately $50 billion per year. The Treasury report puts the cost slightly higher, and ranks the impact as the 16th highest tax expenditure item (out of 165 items). Neither report contains a separate estimate of the cost of Section 199A(g).
The Treasury report identifies Section 1042(g) as giving rise to a tax expenditure. This provision allows for a taxpayer to sell stock in a farm refiner to a farmer’s cooperative and to defer recognition of the gain if the proceeds are re-invested in qualified replacement property. It is very narrowly drafted and not much used (if it is used at all). The Treasury report places a ten-year cost of this provision at $185 million.2 (Section 1042(g) does not appear on the list in the JCT report.)
Each of the reports identifies numerous “special” provisions. The Treasury report lists 165. The JCT report identifies more, though many on the JCT’s list that are not on the Treasury’s list are described as giving rise to “quantitatively de minimis tax expenditures.”
Not surprisingly, the two reports also reveal that, at this point, there are not a lot of easy ways to raise significant revenue short of raising tax rates. The large tax expenditures largely involve provisions that are sacred cows and/or have many politically-connected defenders.
George W. Benson, Counsel
FDII: Opportunities and Challenges for Cooperatives Report on Issuance of Final Regulations
This is part of a series of articles that The Cooperative Accountant TAXFAX column has been publishing periodically regarding various tax reform rules enacted on December 22, 2017 (“2017 Act”).3 On July 15, 2020, the IRS issued final regulations4 that apply to determine the amount of deduction a taxpayer may take under the foreign-derived intangible income (“FDII”) rules of section 250.5 Such rules were enacted as part of the 2017 Act. The final regulations generally apply to tax years beginning on or after January 1, 2021. For tax years beginning before January 1, 2021, taxpayers can apply either the proposed regulations or the final regulations provided the rules are applied in their entirety. The following article highlights material updates included in the final regulations and discusses their application to cooperatives.
II. What are FDII Benefits, and Who Can Claim Them?
The FDII provisions grant export incentives for certain types of activities conducted by U.S. corporations. As with other similar incentives enacted by Congress in the past,6 the basic policy behind the FDII rules is to encourage U.S. corporations to export goods and services and thereby “serve foreign markets”7 from within the United States, instead of using a foreign corporation to serve those foreign markets. Essentially the rules are intended to eliminate or neutralize the role that tax considerations have historically played in a taxpayer’s decision to locate assets and business activities in the United States versus a foreign location.
FDII benefits come in the form of a permanent deduction that can be claimed only by domestic corporations (including corporations that own a share in a pass-through entity). Unfortunately, REITs, RICs, “S” corporations, and individuals are not eligible for FDII benefits. Because a cooperative is a type of C corporation (albeit subject to special tax rules in subchapter T of the Code), cooperatives can claim FDII benefits.
For taxable years beginning after December 31, 2017 and ending before January 1, 2026, a cooperative can claim a deduction equal to 37.5% of its FDII, subject to a taxable income limitation (discussed in more detail below). Assuming a full 37.5% deduction, the effective tax rate on FDII is approximately 13.125%. For taxable years beginning on or after January 1, 2026 the deduction is reduced to 21.875%, resulting in an effective tax rate of approximately 16.406%, based on a corporate tax rate of 21%.
III. Relaxation of Documentation Requirements
The final regulations generally adopt the proposed regulations in their original form. However, the final regulations include rules that relax the strict documentation requirements included in the proposed regulations. As a general observation, such rules replace the form-based documentation requirements included in the proposed regulations with more flexible “substantiation requirements,” which are less prescriptive and focus more on the information needed to be substantiated rather than the form of such substantiation. The documentation rules outlined in the proposed regulations included stringent requirements that limited the specific form of documentation that would be accepted to specific formal types of documents, for example, a written statement from the recipient representing that they are a foreign person or a bill of lading evidencing foreign status. New rules provide specific substantiation requirements for only a subset of transactions (e.g., a sale or license of IP or sales of general property for resale), but then provide wide latitude in the form of such substantiation, including a “catch-all” for any “credible evidence obtained or created in the ordinary course of business” or a statement describing how the taxpayer determined that the relevant substantive requirement was satisfied.8 For transactions not subject to the specific substantiation requirements, the preamble to the final regulations clarifies the government’s view that a taxpayer is required under section 6001 and Treas. Reg. § 1.6001-1(a) to substantiate that it is entitled to the section 250 deduction. Though the rules, in general, are more flexible, there are certain specific circumstances where the final regulations remove rules of convenience that applied to certain particular fact patterns that are laid out in the proposed regulations. Such circumstances are described in greater detail later in this article.
For transactions subject to the specific substantiation requirements, the final regulations require that substantiation be “in existence” as of the FDII filing date (including extensions) of the taxpayer’s return that includes the FDII benefit.9 This is a material change from the proposed regulations which required that the seller or renderer, in the case of services, obtain the documentation by 1) the FDII filing date with respect to the FDDEI transactions (described below) and 2) no earlier than one year before the date of the sale or service. The final regulations’ elimination of the prohibition against “stale” substantiation should provide substantial relief to certain taxpayers, as they significantly relax the burden in place for many cooperatives to gather very specific evidence within a strict time frame. However, the requirement that the substantiation must be in existence as of the FDII filing date may be troublesome for taxpayers that procrastinate or otherwise struggle to compile the requisite substantiation. Note further that the preamble to the final regulations implies that Treasury generally views substantiating documents created contemporaneously with a transaction as more credible that documents created or gathered at a later time.
The final regulations provide certain anti-abuse measures designed to curb abusive transactions and require taxpayers to obtain and retain specific evidentiary support in order to claim a deduction. This might include a transaction where a taxpayer intentionally fails documentation rules for a loss transaction in order to increase FDDEI.10 The final regulations, consistent with the proposed regulations, treat a sale of property or the rendering of a service to a foreign person as FDDEI if the treatment of such income as FDDEI would reduce FDDEI, though they narrow the scope of application to transactions that are subject to specific substantiation requirements.
Note that cooperatives’ foreign sales often involve the sale of products to foreign resellers. The final regulations include specific substantiation requirements that apply to such situations. Specifically, the cooperative must maintain credible evidence that the property will ultimately be sold to an end user located outside the United States. This can include:
- A binding contract specifically limiting subsequent sales to outside the United States;
- Proof that the property is specifically designed, labeled, or adapted for a foreign market;
- Proof that the cost of shipping the property back to the United States relative to the value of the property makes it impractical to resell the property in the United States;
- Credible evidence obtained or created in the ordinary course of business from the recipient that the property (or, in the case of fungible mass property, a specified portion of the property) will be sold to an end user outside the United States; or
- A written statement prepared by the seller, corroborated by credible evidence, that contains specifically enumerated information.
IV. Clarification of Foreign Use Requirements
Under both the proposed and final regulations, there are two general types of income that can qualify as FDDEI eligible for FDII benefits under section 250(b): (i) income derived in connection with certain sales (including leases, licenses, exchanges, and other dispositions of property12); and (ii) income from the performance of certain services. FDDEI sales are sales of tangible or intangible property to a recipient that is a foreign person and for a foreign use. The final regulations provide detailed rules that govern the foreign person and foreign use requirements. A recipient is presumed to be to a foreign person if:
- The sale is a foreign retail sale;
- In the case of a sale of tangible property that is not a foreign retail sale, the property is delivered to the recipient or an end user with a foreign shipping address; or
- In the case of a sale of intangible property or tangible property that is not described in the two bullets above, the billing address of the recipient is outside the United States.13
The final regulations provide guidance for determining whether a sale is for a foreign use, including:
- A sale of tangible property delivered by carrier or freight forwarder to an end user is for a foreign use if the end user takes delivery outside of the United States;
- A sale of tangible property delivered to an end user without a carrier or freight forwarder is for a foreign use if the property is located outside the United States at the time of the sale;
- A sale of digital content is for a foreign use if the end user downloads, installs, receives or accesses the digital content on the end user’s device outside the United States;
- A sale of international transportation property is for a foreign use if the end user registers the property with a foreign jurisdiction;
- A sale of tangible property to an intermediary that is subject to manufacturing, assembly, or other processing is for a foreign use only if such manufacturing, assembly, or other processing occurs outside the United States;14
- A sale of intangible property is for a foreign use to the extent the intangible property is exploited outside of the U.S.
Additional rules apply with respect to sales of tangible property to related parties. A sale to a foreign related party generally qualifies as a FDDEI sale if the related purchaser sells the property to an unrelated foreign person. A sale to a foreign related party also qualifies as a FDII sale if the related purchaser uses the property to produce products that it sells to unrelated persons or if the related party uses the property to render services to unrelated persons to the extent that such unrelated purchasers are foreign.15
The final regulations also provide guidance on whether a service qualifies as a FDDEI service, for this purpose distinguishing between seven types of services and providing different rules for determining the portion of the revenue from each service that is FDII eligible. A high-level summary of the services and associated requirements are as follows:
- Transportation services are services to transport people or property. 50% of transportation services qualify as FDDEI services if the origin or destination of the transportation is outside the United States. 100% of the services qualify as FDDEI services if both the origin and destination are outside of the United States;
- Property services are services other than transportation services performed with respect to tangible property. The services generally qualify as FDDEI services if the property is located outside of the United States for the duration of the service;16
- Proximate services are services other than transportation services or property services that are performed in physical proximity to the recipient. These services qualify as FDDEI services if the services are performed outside of the United States;
- Advertising services are services that consist of transmitting or displaying advertising content. Advertising services qualify as FDDEI services to the extent the related advertisement is viewed or accessed outside of the United States;
- Electronically supplied services are services other than advertising services that are delivered primarily over the Internet or an electronic network. These services qualify as FDDEI services if the services are accessed outside of the United States;
- General consumer services are all other services provided to non-business recipients. These services are FDDEI services if the consumer of the service resides outside of the United States while the service is provided. Final regulations are helpful in that provide that renderers who do not have, or cannot reasonably obtain, a consumer’s place of residence (which was required in proposed regulations) can presume that the consumer is outside the United States if the consumer has a foreign billing address;
- General business services are all other services provided to business recipients. These services are FDDEI services to the extent that the business operations of the recipients that benefit from the services are located outside of the United States.
Both proposed and final regulations include relaxed documentation rules, with a minor modification, for small businesses. Under the final regulations, such rules apply to businesses where the business itself, and their related parties, have less than $25 million in gross receipts in the previous tax year.
There are also additional requirements that apply in the case of transactions involving related persons. Final regulations generally retain restrictions included in the proposed regulations with certain modifications. First, the final regulations clarify that a related-party service is a FDDEI service only if the related-party service is not substantially similar to a second service that “has been or will be” provided by the related party to a person located in the United States.17 Second, the final regulations retain certain restriction rules intended to eliminate benefits where a related party uses services to perform substantially similar services to a person located in the U.S. The final regulations modify the benefit test (which is intended to identify these situations) to be met only if 60 percent or more of the benefits conferred by the related party service are directly used by the related party to confer benefits on consumers or business recipients in the United States.18 Essentially, these modifications limit FDII benefits from a related-party service only in cases where the related party “directly uses” the service to confer benefits on persons in the United States.
V. QBAI/Taxable Income Limitation
A FDII deduction is reduced by 10% of the aggregate adjusted basis (determined quarterly and using section 168(g) “ADS” depreciation) of a U.S. corporation’s depreciable tangible property that is used to produce qualifying income (qualified business asset investment or “QBAI”). As a result of the QBAI limitation, a cooperative is subject to the standard 21% U.S. corporate tax rate to the extent its taxable income (after its section 1382 patronage deduction) is equal to or less than a fixed 10% return on its QBAI, and a 13.25% rate (increased to 16.406% in 2026) on its excess return that is attributable to qualifying exports (i.e., its qualifying FDII). In addition, a taxpayer’s section 250 deduction, which applies both for its FDII and GILTI, is subject to a “taxable income limitation” which applies if the sum of a taxpayer’s GILTI inclusion and FDII amount exceed its taxable income. Where the taxpayer’s GILTI and FDII exceed its taxable income, the taxpayer’s GILTI and FDII are reduced proportionately solely for purposes of calculating the section 250 deduction.
VI. Consolidated Calculations
A cooperative that is part of a consolidated tax return filing determines its section 250 deduction by aggregating the DEI, FDDEI, QBAI, and GILTI of all members to determine an overall dedication, applying the taxable income limitation discussed above on a consolidated basis, and allocating the remaining deduction among the members of the group based on their respective contributions to the aggregate FDDEI and GILTI amounts.19
VII. FDII Opportunities for Cooperatives
The FDII rules generally apply to cooperatives in the same manner as they apply to other C corporations. Given the special rules that apply to cooperatives, however, the availability of benefits may depend on whether a cooperative has positive retained taxable income after its section 1382 patronage deduction. Such taxable income earned by a cooperative may be derived from any retained patronage income or nonpatronage income.
As we describe above, sales of product by a cooperative to a related or unrelated foreign person can qualify for FDII benefits if the cooperative can determine that the sales are to a foreign person for a foreign use and that certain substantiation requirements are satisfied. Likewise services appropriately categorized among the seven categories of services income and meeting the requirements set forth with respect to the particularly category can qualify.
VIII. FDII Challenges for Cooperatives
The final regulations provided no specific rules related to the treatment of patronage dividends, and their impact on cooperatives. Because section 250 and the regulations thereunder do not contain any rule that takes into account the special nature of patronage dividends, cooperatives may find that the benefit of the FDII deduction is diminished for two reasons. A U.S. corporation’s FDII benefit is calculated by reference to its gross FDDEI from sales and services, reduced by deductions properly allocable to such income.20 A cooperative’s section 1382 deduction therefore must be allocated between gross FDDEI and other gross income, and any portion of the 1382 deduction allocated against gross FDDEI reduces the cooperative’s FDII benefit. Second, the section 1382 deduction reduces the corporation’s taxable income and therefore makes the section 250 taxable income limitation described above more likely to haircut or eliminate the corporation’s FDII deduction.
Also, as we discuss above, sales to U.S. persons and the provision of services to persons located in the United States generally do not qualify for FDII benefits. As a result, in general, income from the sale by members of product to a cooperative would not qualify for FDII benefits even if the sale or service relates to what ultimately is an export transaction. However, if the member and the cooperative file a consolidated tax return, sales from the member to the cooperative could qualify for FDII benefits if the subsequent sale by the cooperative is to a foreign person and for a foreign use.
Under the former ETI rules, a corporation generally determined its qualifying export income at the cooperative level. Nevertheless, the ETI rules contained a specific rule that allowed a cooperative to pass-through benefits to its members.21 Similarly, section 199A(g) allows a specified agricultural or horticultural cooperative 22 to choose between claiming section 199A(g) benefits itself or passing all or a portion of them through to members.23 However, the final FDII regulations contain no comparable measure that enables the cooperative to pass a portion of the FDII benefit to its members.
Another consideration for some cooperatives involves the interaction of the FDII rules with contract manufacturing agreements. Some cooperatives structure certain contract manufacturing agreements as a sale and a repurchase of the refined product (for ultimate sale to a foreign person), instead of engaging the contract manufacturer to perform services. The FDII rules would deny FDII benefits with respect to the income attributable to the cooperative’s “sale” to a U.S. manufacturer, 24 although profits from the sale of the refined product could qualify for
FDII benefits. A cooperative could therefore evaluate whether it obtains a larger FDII deduction, and whether its overall tax liability decreases, if it engages the refiner to provide refining services without taking title to the product.
The information contained herein is of a general nature and based on authorities
that are subject to change. Applicability of the information specific situations should be
determined through consultation with your tax adviser.
This article represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP.