This article has been previously published in the Tax Adviser magazine published by the American Society of Certified Public Accountants (AICPA) in the August, 2018 edition.
The newly enacted U.S. tax act has ushered in a number of new rules and, to strategic tax planners, new opportunities. This new opportunity is a preferential tax rate for U.S. C corporations that sell goods and/or provide services to foreign customers. Qualifying income is subject to a rate of approximately 13% which is even lower than the new 21% corporate rate. This new opportunity is IRC §250(a) containing the Foreign Derived Intangible Income (FDII) deduction.
FDII is intended to operate in tandem with newly enacted IRC §951A describing Global Intangible Low-Tax Income (GILTI). GILTI is a new category of income for U.S. taxpayers owning a Controlled Foreign Corporations (CFC). GILTI, similar to the existing Subpart F provisions, is a deemed income inclusion. The interaction of these rules, a benefit for the use of intangible property in the U.S. via FDII and a deemed income inclusion for using intellectual property outside the U.S. via GILTI, has been referred to as a “carrot and a stick” approach to taxing intellectual property on a global basis. However, if the taxpayer does not own a CFC, meaning it has no GILTI exposure, it secures all the carrots without worrying about any stick.
The bottom line is a new benefit to U.S. C corporations for using U.S. based intangible property that they’ve owned all along. Even better, they don’t have to patent, copyright, or even identify the intangible property as the benefit is derived from a deemed return on assets calculation. Because FDII is intertwined with GILTI, many believe it is simply an international tax provision and fail to see the benefits to U.S. exporters with no foreign operations.
The FDII benefit itself is not difficult to understand. FDII produces an effective tax rate, based on the newly enacted 21% corporate tax rate, as follows:
13.125% for tax years beginning after December 31, 2017 and before January 1, 2026
16.406% for tax years beginning after December 31, 2025
Even with reduced corporate tax rates, it is still a benefit well worth pursuing.
The FDII calculation is rather complex but it can be summarized in steps. First, the U.S. corporation’s gross income is determined and then reduced by certain items of income including any foreign branch income. This amount is further reduced by deductions allocable to such income bringing about deduction eligible income.
Second, any foreign portion of such income is established. This includes any income derived from a sale of property or certain services to a foreign person for foreign use. Please note that here a “sale” is defined very broadly and includes any lease, license (including royalties), exchange, or other disposition. Foreign use is any use, consumption, or disposition which is not within the United States.
Third, the foreign sales and services income from step two above is reduced by expenses properly allocated to such income. The result is foreign derived income.
Fourth, the corporation’s deemed intangible income is determined. This is the excess of the corporation’s foreign derived income less 10% of its qualified business asset investment (QBAI). QBAI is the average of the corporation’s adjusted basis in its tangible property used to produce the deduction eligible income. For this purpose, adjusted basis is determined using straight line depreciation and an annual average using quarterly measures.
For example, assume a domestic C corporation produces widgets for a foreign customer that are used outside of the U.S. The corporation earned $100,000 in deduction eligible income and $20,000 of foreign derived income. QBAI is $120,000 (calculated separately) which results in deemed intangible income of $88,000 ($100,000 foreign derived income less 10% of QBAI, i.e., $12,000). FDII is $17,600 or the deemed intangible income of $88,000 multiplied by the ratio of foreign derived income to deduction eligible income (20% or $20,000/$100,000). The FDII deduction is $6,600 (FDII of $17,600 at a corporate tax rate of 37.5%).
The Corporation is then allowed to deduct 37.5% of FDII against its taxable income. The upshot is taxable FDII of $1,000 and a tax liability of $210 which is an effective tax rate of 13.125% on the FDII of $1,600 and a $126 tax savings.
|Deduction Eligible Income||$100,000|
|Foreign Derived Income||$20,000|
|Foreign Derived Income||$20,000|
|Less: QBAI Exemption (10% of $120,000)||$12,000|
|Deemed Intangible Income||$88,000|
|FDII ($88,000 x ($20,000/$100,000))||$17,600|
|Taxable FDII (FDII less 37.5%)||$11,000|
|Corporate Tax (21% Rate)||$2,310|
|FDII Effective Tax Rate ($210/$1,600)||13.125%|
Please do note that the benefit is subject to a taxable income limitation which means the FDII deduction cannot reduce taxable income below zero. Likewise, there is no benefit if deemed intangible income is zero or less.
The taxpayer may take a foreign tax credit against any taxes levied upon the foreign derived income if it otherwise qualifies. The credit will only apply to the taxable FDII within the general limitation basket matching the FDII but all of the associated foreign tax credits should remain available for credit.
Taxpayers wishing to utilize FDII benefits should be aware of rules regarding the involvement of related parties. FDII applies to sales or services rendered to related foreign persons provided that the property is either resold or used in the sale of other property to an unrelated foreign person. Thus, the sale of goods, the provision of services, and the license of intangible property to related foreign persons may yield FDII-eligible income. In the case of services, the related party may not provide substantially similar services to persons in the U.S. or FDII benefits can be limited or eliminated entirely. Service industry corporations should explore these rules in more detail.
The benefits only apply to property sold or services rendered for foreign use. On its face, this appears quite simple. However, the taxpayer must be very careful to support this as special rules apply here. For example, property sold to an unrelated foreign person is not treated as sold for foreign use if it is further manufactured or modified within the United States even if the property is only used outside the U.S. Likewise, services provided to an unrelated person located within the United States are not treated as “foreign use” even if the other person uses such services in providing services outside the United States. Both of these results can be favorably changed with planning but one must make sure their entire supply chain qualifies.
The clear beneficiary of these new provisions are U.S. based corporate exporters of goods and services with no CFC ownership. These corporations have long suffered higher tax rates than their multinational competitors who have had the ability to move intellectual property outside of the U.S. to lower tax jurisdictions. FDII is a big step toward eliminating their competitor’s tax advantage. Furthermore, because FDII does not involve intangible asset identification, it avoids cumbersome and expensive valuation and segregation studies as well as complex legal and tax intellectual property undertakings.
The bigger winners will certainly include technology corporations including software developers, pharmaceutical manufacturers, and similar industries. These corporations generate foreign sales including FDII eligible licensing and royalty income with minimal tangible assets. These types of industries generally also produce higher margins which will further increase the FDII benefits.
Issues to Consider
FDII only pertains to C corporations for now. This includes U.S. subsidiaries of foreign-based multinationals that are taxed as C corporations. However, FDII excludes S corporations, REITs, partnerships, LLCs, and individuals.
As of the date of this article, FDII lacks any technical guidance via regulations or otherwise. The IRS has not issued a Notice or other guidance on FDII as they have on other parts of tax reform. A technical corrections bill affecting FDII will be issued but it’s difficult to speculate on when, what it will contain, and in what form it will become law. However, one may reasonably speculate that FDII could be expanded to include pass-throughs and individuals to alleviate some of the corporate centric aspects of the entire act that have drawn scrutiny.
It is possible that FDII will be contested by our foreign trade partners as an impermissible tax benefit. Practitioners who recall the journey of DISC to FSC to ETI will be able to see the clear parallels here. The good news is that if this does occur, it will likely take years to resolve any international tribunal litigation and, in the event FDII is deemed to be illegal, the IRS is unlikely to claw back benefits that have already been claimed by U.S. taxpayers.
FDII is certainly a gift to U.S. C corporations that export goods and services but do not own a CFC. This is particularly true for technology companies with higher margins and limited tangible assets. As with any new comprehensive tax law, uncertainties abound and guidance is limited but there is no doubt that FDII is a benefit worth pursuing.
Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning. FJV Tax has offices in Wellesley and Boston. The author can be reached via email at firstname.lastname@example.org or telephone at 617-770-7286/800-685-2324. You can learn more about FJV Tax at fjvtax.com.