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GLTI

Foreign Derived Intangible Income Deduction – Tax Reform’s Overlooked New Benefit for U.S. Corporate Exporters

by

Frank J. Vari, JD, MTax, CPA

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 Benefit

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.

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The Calculation

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
QBAI $120,000
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%
FDII Savings $1,386

 

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.

Beneficiaries

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.

Conclusion

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 frank.vari@fjvtax.com or telephone at 617-770-7286/800-685-2324.  You can learn more about FJV Tax at fjvtax.com.

 

New U.S. Global Intangible Income Rules – New Opportunities and New Risks

by

Frank J. Vari, JD, MTax, CPA

There is certainly a great deal of buzz around the new Global Low Tax Intangible Income (GLTI) and Foreign Derived Intangible income (FDII) rules enacted as part of the Tax Cuts and Jobs Act (TCJA) in late 2017.  At this same time, there is a lack of understanding amongst many practitioners and taxpayers as to what this means for them.  What follows here is a general explanation of how these new rules work.

GLTI

The TCJA has introduced newly enacted IRC Code §951A as well as the catchy new acronym pronounced as “guilty” by those who want to be hip and cool in tax circles.  GLTI requires U.S. CFC shareholders to include in income its GLTI income in a very similar manner to our old friend Subpart F.  The entire GILTI amount is included in a U.S. shareholder’s income in a manner similar to Subpart F.  Corporate shareholders are allowed a deduction equal to 50% of GILTI for 2018 through 2025, which is reduced to 37.5% in 2026.  As a result of the 50% deduction, the effective tax rate will be 10.5% until 2026 and increasing to 13.125% when the deduction is reduced in 2026.

The GLTI deduction is limited when the GILTI inclusion and FDII (described below) exceed the corporation’s taxable income determined without regard to the GILTI and FDII deductions.  Because the GILTI deduction is limited by taxable income, net operating losses are used first against the gross GILTI amount before any GILTI deduction is allowed.  Further, there is no carryforward for the lost portion of the GILTI deduction due to the taxable income limitation.

It is very important to understand who GLTI applies to.  In general, when a U.S. person is (i) a 10% U.S. shareholder of a CFC, under the Subpart F constructive ownership rules, on any day during the CFC’s tax year during which the foreign corporation is a CFC; and (ii) the U.S. person owns a direct or indirect interest in the CFC on the last day of the foreign corporation’s tax year on which it is a CFC without regard to whether the U.S. person is a 10% shareholder on that date, then the U.S. person will be required to include in its own income its pro-rata share of the GILTI amount allocated to the CFC for the CFC’s tax year that ends with or within its own tax year.  The U.S. shareholder will increase their basis in the CFC stock for the GILTI inclusion, which generally would be treated as “previously taxed income” for Subpart F purposes.  This may be a little hard to follow but it is absolutely critical to understand who GLTI applies to.

Individual and noncorporate shareholders are generally subject to full U.S. tax on GILTI inclusions.  However, qualifying U.S. shareholders may make an IRC Code §962 election with respect to GILTI inclusions where the electing shareholder is subject to tax on the GILTI inclusion based on corporate rates and may claim foreign tax credits on the GLTI inclusion as if the noncorporate shareholder were a corporation.  This is intended, in theory, to place corporate and noncorporate shareholders with a similar tax burden.

GILTI is calculated at the U.S. shareholder level as the excess of the CFCs’ net income over a deemed return on tangible assets.  The GILTI inclusion is calculated as the excess of a U.S. shareholder’s “net CFC tested income” over its “net deemed tangible income return,” which is 10% of the CFC’s “qualified business asset investment” (QBAI) reduced by certain interest expense.

“Net CFC tested income” is the excess of the U.S. shareholder’s aggregate pro rata share of the tested income of each CFC for which the shareholder is a U.S. shareholder for such taxable year over the aggregate pro rata share of the tested loss of each such CFC.  For this purpose, “tested income” of a CFC generally is described as the CFC’s gross income other than (i) effectively connected income; (ii) Subpart F income; (iii) amounts excluded from subpart F income under the IRC §954(b)(4) high-tax exception; (iv) dividends received from a related person (as defined in Code section 954(d)); and (v) foreign oil and gas extraction income, over deductions allocable to such gross income under rules similar to IRC Code §954(b)(5) or to which such deductions would be allocable if there were such gross income.  “Tested loss” is defined to mean the excess of deductions allocable to such gross income over the gross income itself.

“Net deemed tangible income return” is the excess of 10% of the aggregate of each CFC’s QBAI over the interest expense taken into account in determining the shareholder’s net CFC tested income to the extent the interest income attributable to the expense is not taken into account in determining the shareholder’s net CFC tested income. QBAI is determined as the average of the adjusted bases, determined at the end of each quarter of a tax year, in “specified tangible property” that is used in the production of tested income and that is subject to IRC §167 depreciation.  The conference explanation states that specified tangible property would not include property used in the production of a tested loss, so a CFC that has a tested loss in a taxable year would not have any QBAI for that year.

If GILTI is includible in a U.S. corporate shareholder’s income, the new law provides for a limited deemed paid credit of 80% of the foreign taxes attributable to the CFC’s tested income as defined above.  The foreign taxes attributable to the tested income are determined using a U.S. shareholder level calculation as the product of (i) the domestic corporation’s “inclusion percentage,” multiplied by (ii) the aggregate foreign income taxes paid or accrued by each of the shareholder’s CFCs that are properly attributable to tested income of the CFC that is taken into account by the U.S. shareholder under IRC §951A.

The inclusion percentage is the ratio of the U.S. shareholder’s aggregate GILTI amount divided by the aggregate U.S. shareholder’s share of the tested income of each CFC.  This ratio seeks to compare the amount included in the U.S. shareholder’s income to the amount upon which the foreign taxes are imposed, i.e., the tested income, to determine the percentage of foreign taxes that should be viewed as deemed paid for purposes of the U.S. foreign tax credit.

The IRC Code §78 gross-up is calculated traditionally by including 100% of the related taxes rather than the 80% that are allowable as a credit.  Although the gross-up amount is included in income as a dividend, it is not eligible for the IRC Code §245A 100% dividend received deduction but is eligible for the GILTI deduction.

There is also now a new separate basket for the GLTI deemed paid taxes to prevent them from being credited against U.S. tax imposed on other foreign-source income.  Additionally, any GLTI deemed-paid taxes cannot be carried back or forward to other tax years.

These rules are effective for tax years of foreign corporations beginning after December 31, 2017 and for tax years of U.S. shareholders in which or with which such foreign corporation’s tax years end.

FDII

In connection with the new GLTI tax regime on excess returns earned by a CFC, the TCJA provides a 13.125% effective tax rate on excess returns earned by a U.S. corporation from foreign sales, including licenses, leases, and services, which increases to 16.406% starting in 2026.  For tax years 2018-2025, a U.S. corporation may deduct 37.5% of its “foreign-derived intangible income” (FDII).  Starting in 2026, the deduction percentage is reduced to 21.875%.  The FDII deduction is limited when the GILTI inclusion and FDII exceed the corporation’s taxable income determined without regard to the GILTI and FDII deductions.  The deduction is not available for S corporations or domestic corporations that are RICs or REITs.

Generally, a U.S. corporation’s FDII is the amount of its “deemed intangible income” attributable to sales, or leases or licenses, of property to foreign persons for use outside the United States or the performance of services to persons, or with respect to property, located outside the United States.  A U.S. corporation’s deemed intangible income generally is its gross income that is not attributable to a CFC or foreign branch reduced by (i) related deductions including taxes and (ii) an amount equal to 10% of the aggregate adjusted basis of its tangible depreciable assets other than assets that produce excluded categories of gross income, such as branch assets.

Thus, a domestic corporation is subject to the now standard 21% corporate tax rate to the extent of a fixed 10% return on depreciable assets and a 13.125%, increased to 16.406% as of 2026, tax rate on any excess return that is attributable to exports of goods or services.

There are special rules for foreign related-party transactions.  A sale of property to a foreign related person does not qualify for FDII benefits unless the property is ultimately sold to an unrelated foreign person, or is used by a related person in connection with sales of property or the provision of services to an unrelated foreign person for use outside the United States.  A sale of property is treated as a sale of each of the components thereof.

The provision of services to a foreign related person does not qualify for FDII benefits if the services are substantially similar to services provided by the foreign related person to persons located in the United States.

The FDII provisions are effective for tax years beginning after December 31, 2017.

Summary

The GLTI and FDII rules in connection with the new territorial income rules are a seismic shift in the international tax landscape for those who have learned and practiced international tax under the post-1986 international tax regime.  This article is really only a primer of these evolving rules.  Once official guidance is produced, we will be able to deliver clearer client guidance on these important new rules.

 

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 frank.vari@fjvtax.com or telephone at 617-770-7286/800-685-2324.  You can learn more about FJV Tax at fjvtax.com.