US Exporters: The FDII Deduction Is Tax Reform’s Gift to You
If your U.S. company has income from the sale of goods or services abroad, you should take notice of the new foreign-derived intangible income (FDII) deduction in the Tax Cuts and Jobs Act, which is designed to be an export incentive.
The deduction is only available to domestic C corporations, but because it is quite generous, you should study up on the provision (and its impending legal challenge) regardless of your entity type and consider a tax-advantaged restructure if it makes sense for your company.
Definition of intangible income
A corporation’s intangible income is not based on its intangible assets or its income derived from those assets. A corporation is deemed to have intangible income to the extent that its income exceeds a presumed rate of return on its tangible assets. For the purposes of that FDII deduction, that intangible income must be derived from the sale of property or services to non-U.S. persons.
The FDII deduction considerably reduces effective tax rates
A domestic C corporation may deduct 37.5 percent of its FDII during the taxable year through 2025, resulting in an effective tax rate of 13.125 percent on such income. Beginning in tax years after 2025, the deduction is reduced to 21.875 percent of FDII, resulting in an effective tax rate of 16.406 percent.
This example helps to illustrate how the FDII deduction is figured:
A domestic C corporation has deduction-eligible income (DEI) of $100,000, all of which is derived from the sale of property to non-U.S. persons for foreign use. The adjusted basis of its tangible assets used in a trade or business (qualified business asset investment, or QBAI) is zero.
|Example: calculating the FDII deduction|
|Deduction-eligible income (DEI)||$100,000|
|Less: deemed tangible income return (QBAI x 10%)||($0)|
|Deemed intangible income (DII)||$100,000|
|Foreign-derived deduction-eligible income (FDDEI)||$100,000|
|Percentage of FDDEI to DEI||
(100% x 100,000)
|Less: 37.5% deduction for FDII||($37,500)|
|U.S. tax at 21%||$13,125|
|Effective tax rate||13.125%|
Some caveats and complications to consider
In arriving at a corporation’s deduction eligible income, the statute only provides that deductions “properly allocable to such gross income” will reduce the corporation’s gross income. Unfortunately, at this time there is no further guidance as to the methodology to be used in these allocations.
The statute is clear that only domestic corporations are eligible for the FDII deduction. However, a footnote to the Conference Report to the Tax Cuts and Jobs Act outlines the expectation that guidance will be issued with respect to basis adjustments under IRC Sec. 705(a)(1) “due to the reduction in the effective US tax rate resulting from the deduction for FDII.” This suggests that a domestic corporate partner of a domestic partnership may be able to include in foreign-derived deduction-eligible income (FDDEI) its pro rata share of the partnership’s income from the sale of property for foreign use or provision of services to a foreign person.
Complications in determining whether property is sold “for foreign use” arise in the use of intermediary manufacturers. If a domestic C corporation sells property to a U.S. person, regardless of the ultimate purchaser of that property, the property is not considered to be “for foreign use” for purposes of the FDII deduction. However, if the property is sold to a non-U.S. person, subsequent to which the non-U.S. person subjects the property to further manufacture or assembly outside the United States, the property is considered to be “for foreign use,” seemingly regardless of whether a U.S. person ultimately purchases the property. Further guidance will be necessary to define manufacturing and processing activities in this context, and whether the characterization of the use of such property as “foreign” would require a substantial contribution analysis similar to that used in determining foreign-based company sales income.
The fate of the FDII deduction is uncertain
Finance ministers of the European Union are poised to challenge the FDII provision as an illegal export subsidy under World Trade Organization (WTO) rules, which do not allow what the rules call “prohibitive subsidies contingent on export.” The tax benefit allowed to exporting U.S. corporations could be viewed as such a subsidy.
If a challenge progresses, it could take the WTO 12 to 18 months to reach a final determination of whether the FDII is an illegal subsidy. The EU has in the meantime asked the Organization for Economic Cooperation and Development to review the FDII provision and determine whether it could qualify as a “harmful tax practice.”
How we can help
If your company exports goods or services, CLA’s international tax professionals can help you take advantage of the generous new FDII deduction by increasing your DEI and FDDEI, while decreasing your QBAI. We can also help you weigh your entity type options and restructure your company to be eligible for the FDII deduction, if you so choose.