Understanding the FDII deduction
C corporations with foreign-derived intangible income can benefit from a 37.5% deduction.
By Daniel Karnis, CPA
Every C corporation that derives gross income from export activities should consider the foreign-derived intangible income (FDII) deduction. While the FDII deduction comes with a complex set of rules, it nonetheless represents a valuable tax break for U.S. corporations. This article provides guidance and dispels general misconceptions or mistaken impressions regarding this new deduction. Further, the article provides an overview of the FDII concepts and pertinent definitions and terminology, as well as practice tips and implications for claiming the FDII deduction, for which many companies are not certain whether they qualify.
The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, has had a significant impact on decisions such as whether taxpayers should operate their business in the United States or in foreign jurisdictions, the choice of legal entity, and myriad other business decisions that can have profound short-term and long-term implications. One of the centerpieces of the tax reform was to create a more tax-efficient environment in the United States for companies to operate in and to make the U.S. tax system competitive with the other tax regimes around the world. The various components of the tax reform were designed to address the flight of capital to lower-tax-rate jurisdictions and "penalize" companies by levying new taxes, while at the same time providing incentives for retaining presence and contributing to job creation in the UnitedStates.
In the spirit of increasing the U.S. tax system's competitiveness, Congress added Sec. 250 to the Internal Revenue Code and with it the FDII deduction, which provides an incentive to domestic corporations in the form of a lower tax rate on income derived from tangible and intangible products and services in foreign markets. As a result, a corporation can claim a 37.5% deduction, which results in a permanent tax benefit and 13.125% effective tax rate, as compared with a 21% corporate rate, for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026, after which the deduction is reduced to 21.875%, resulting in an effective tax rate of 16.406%.
The FDII deduction is available to domestic entities across a broad range of industries that are taxed as C corporations. This includes U.S.-based companies and non-U.S. companies doing business in the United States.
In general, the income of a U.S. corporation can be divided into regular income and FDII, which is the excess income over a fixed return on the depreciable tangible property used in a trade or business of the corporation; FDII is taxed at a lower rate. The determination of the FDII deduction, both from the qualitative and quantitative standpoint, can involve a rather complex analysis. The computation itself is a multistep process that requires determining qualified business asset investment (QBAI), deduction-eligible income (DEI), and foreign-derived deduction-eligible income (FDDEI) as a prelude to calculating deemed intangible income (DII) and FDII, which is then multiplied by 37.5% to arrive at the deductibleamount.
COMPUTATION OF DII
The first step in the overall FDII analysis is the computation of DII, defined as DEI less 10% of the value of the depreciable tangible assets used in production of DEI of the U.S. corporation. The foreign portion of this excess return is then attributed to FDII and taxed at a lower rate than the headline corporate rate of 21%.
The key analysis in determining DII is the computation of DEI, defined as the corporation's gross income (determined without regard to Subpart F income, the global intangible low-taxed income (GILTI) inclusion, financial services income, dividends received from 10%-owned controlled foreign corporations, domestic oil and gas extraction income, and foreign branch income), less any deductions (including taxes) properly allocable to such gross income.
The foreign sales income in the context of FDDEI (and, in turn, FII) means foreign-derived versus foreign-sourcedincome. Income can be derived both from the sale of qualifying property and provision of services, so the pool of potentially qualifying revenue can be quite large. An important point is that the property does not need to be manufactured or produced by the corporation (a key requirement of the former Sec. 199 domestic production activities deduction, which the TCJA repealed) for the gross income to be qualified.
The rule for property sales requires the property to be sold by the taxpayer to any person that is not a U.S. person for a foreign use. The term "sold" is defined as a sale, lease, license, exchange, or other disposition. Property includes both tangible and intangible property. The term "foreign use" means any use, consumption, or disposition that is not within the United States.
The FDII deduction provision also contemplates and provides guidance for related-party considerations. The rule is that property sold to a related party that is not a U.S. person will not qualify unless the property is for foreign use and is ultimately sold to an unrelated party that is not a U.S. person, or the property is used by a related party in connection with property that is sold to or in connection with the provision of services to an unrelated party that is also a non-U.S. person.
For example, if a domestic corporation licenses intangible property to a foreign subsidiary, and then the foreign subsidiary uses the intangible property in selling its products to unrelated foreign customers, the royalty income earned by the domestic corporation should qualify as FDDEI. This also should be the result even if the related foreign person licensing the intangible property from the domestic corporation further licenses it to another related foreign person, which then uses the intangible property to market and sell products to unrelated foreign customers for use outside the United States.
The FDII deduction is also available to taxpayers that derive gross income from providing services to their customers. For gross income derived from services to qualify, the services must be provided by the taxpayer to any person not located within the United States, or with respect to property not located within the United States. Different interpretations are possible, and the Treasury Department and the IRS will need to provide further guidance and clarification on how to interpret "with respect to property" not located within the United States.
Once a taxpayer has determined its gross income for purposes of calculating the DEI, the next step involves allocating deductions to various classes of gross income. While no current guidance specifically addresses the allocation of expenses against gross DEI, taxpayers may be able to look to the Senate version of Sec. 250(b)(3)(A)(ii), which provided for the allocation of expenses "under rules similar to the rules of Section 954(b)(5)," though this reference was removed in the final version. Sec. 250 may also be an "operative section" for purposes of Sec. 861 expense allocation, given that Sec. 199 ultimately relied on Sec. 861 principles for purposes of allocating expenses including interest expense; research and development expenses; selling, general, and administrative expense; and stewardship expense between qualified and nonqualified gross receipts. This area also would benefit from further guidance and rules specific to allocating expenses to classes of gross income.
COMPUTATION OF QBAI
Following the determination of DEI, which is a key component of the DII calculation, the next step involves the computation of QBAI. The QBAI amount is multiplied by 10%, and the resulting amount is subtracted from DEI to arrive at DII. QBAI is a pool of all tangible assets, which is used to compute a tangible asset return, which is then used to compute the excess that is the deemed return on intangible assets. A good way to think about QBAI is as the pool of tangible assets used to generate DEI. The QBAI amount is the average adjusted bases (using a quarterly measuring convention) in tangible property depreciable under Sec. 167 that is used in the corporation's trade or business to generate DEI. The adjusted bases are determined using straight-line depreciation, and QBAI does not include land, intangible property, or any assets that do not produce DEI. So the QBAI computation is critical, as any reduction in the QBAI amount increases the FDII by 10% and, as such, can have a material impact on FDII.
The final step involves the determination of FDII, which is calculated by multiplying DII by the ratio of FDDEI and DEI.
The complex nature of the FDII deduction presents numerous pitfalls. The following are just a few examples of potential missteps that could prevent companies from maximizing the FDII deduction:
Improperly characterizing classes of gross income and improperly allocated expenses to DEI
The FDII is a multistep process. Considering that most companies derive income from multiple sources, it will be imperative to subdivide the various income streams into categories that may be subject to different tax rates. To maximize the available benefit, it is important that taxpayers consider various aspects and components of the FDII computation to determine which areas may have the most impact. For example, it is generally beneficial to increase the DEI, which is used as a basis for determining the FDDEI. The higher the DEI, the higher the FDII and hence the deduction. In this area, taxpayers should pay special attention to various exclusions from gross income and consider, for example, various cost allocation methodologies to allocate the costs to these exclusions to increase the DEI.
Failing to consider cost structures
In regard to expenses allocable to DEI, it is important that taxpayers contemplate various cost structures in place, their impact on the company's profitability or gross income, and whether they can identify the costs that would not be attributable to the FDDEI. This would also include a review of the Sec. 861 allocation methodologies and understanding the factual relationship between various classes of gross income and incurred expenses.
Not planning for accounting methods
Various accounting methods planning may be applicable, and taxpayers may also need to keep in mind the opportunities that may arise from any business restructuring, transfer-pricing planning, and potential changes to their supply chains.
Improperly computing the QBAI amount
Taxpayers will want to decrease QBAI because it is used to compute DII by subtracting the 10% of QBAI from DEI, to increase the DII. Some areas for consideration include the determination of asset ownership, location, and asset classification. For example, the decision as to whether to purchase or lease property should be considered, as leased property would not be included in QBAI.
Improperly reviewing various classes of gross income, causing a reduction in FDDEI
Taxpayers will want to increase the FDDEI, which is used in the FDDEI-to-DEI ratio computation to determine the FDII. FDDEI is in the numerator of the ratio, so the higher the FDDEI, the higher the overall ratio becomes, which has a positive impact on FDII. Taxpayers should identify all sources of qualifying gross receipts, including related-party transactions that meet the requirements under Sec. 250. It is also important to understand the transactional flow and how the various classes of gross income were derived from the sale of property and services.
A lack of modeling of, and failing to consider the interplay between, FDII and other provisions
It is equally important to understand the interplay between FDII and other provisions, such as GILTI and the base-erosionand anti-abuse tax. For example, a taxable income limitation is determined without regard to Sec. 250 (i.e., GILTI and FDII) as the aggregate of GILTI and the FDII inclusion, which may not exceed taxable income. Any excess of GILTI and FDII over taxable income is reduced proportionally. Considering that GILTI is reduced by a 50% deduction, versus FDII, which is reduced by a 37.5% deduction, taxpayers should model the broader implications and impact of the FDII on their tax posture.
WHAT'S NEXT FOR THE FDII DEDUCTION
As mentioned earlier, Treasury and the IRS will need to provide further guidance so that taxpayers can properly determine and compute the FDII deduction.
While the FDII deduction is potentially available to every U.S. corporation that exports property or provides services to a person located outside the United States, including sales and services provided to related parties, it has been identified by the European Union (EU) as an export incentive that potentially violates the Organisation for Economic Co-operation and Development's Base Erosion and Profit-Shifting (BEPS) Action 5 recommendations on substantial activity requirements for intellectual property incentive regimes. By contrast, Treasury believes that the FDII rules comply with the BEPS Action 5 recommendations, so it remains to be seen whether the EU will challenge FDII as an illegal export subsidy.
Nevertheless, considering the value of the FDII deduction and its broad applicability to U.S. corporations (U.S.-basedcompanies and non-U.S. companies doing business in the United States), taxpayers should spend time understanding the rules to determine how to apply them to their specific facts. Taxpayers who consider the above steps and ensure that a proper methodology is in place will be on their way to maximizing this deduction for years to come.