GILTI and FDII: Proposed Regulations Give Clarity to International Companies
The IRS has issued proposed regulations related to the deduction for global intangible low-taxed income (GILTI) and foreign-derived intangible income (FDII). The GILTI and FDII regimes were introduced in the tax reform legislation in conjunction with a new participation exemption regime, which enables tax-free repatriation of certain foreign subsidiary income to C corporations.
Before we cover the proposed regulations, it’s important to remember that GILTI is a “stick” intended to backstop this new participation exemption regime by preventing the permanent deferral of profits earned in controlled foreign corporations (CFCs) owned by U.S. taxpayers. The new GILTI regime subjects a CFC’s profits that are in excess of a 10 percent return (reduced by some interest expense incurred by CFCs) on its depreciable tangible property to current year U.S. taxation. The new rules, however, allow both a 50 percent (37.5 percent starting in 2026) deduction against the GILTI amount and the use of foreign tax credits to offset any resulting U.S. tax liability.
In contrast, FDII is a “carrot” that enables a 37.5 percent deduction (reduced to 21.875 percent starting in 2026) for a portion of a C corporation’s income earned from certain export or foreign source income. The approaches under both GILTI and FDII are complementary insofar as both target a 13.125 percent effective rate.
Here’s how the IRS’s proposed regulations may apply to you and your business.
GILTI deduction extended to individual taxpayers
Generally, the deductions allowed under GILTI and FDII only apply to C corporations. The proposed regulations extend the GILTI deduction to electing individual taxpayers as well. Under the new rule, you may utilize the 50 percent GILTI deduction to reduce your income attributable to GILTI income and related deemed dividend gross-up that your CFC generates. (Form 8993, Section 250 Deduction for Foreign-Derived Intangible Income (FDII) and Global Intangible Low-Taxed Income (GILTI), must be included in the electing taxpayer’s annual return to reflect any GILTI or FDII deduction claimed in connection with this election.)
This had been a major unanswered question subject to considerable debate prior to the issuance of these proposed regulations. This clarification puts U.S. individuals, S corporations, and partnerships on more equal footing with C corporations when it comes to ownership of CFCs.
FDII deduction extended to U.S. corporate partners
Though partnerships generally cannot claim this deduction, U.S. corporate partners in a U.S. partnership can receive the allocable benefit of the FDII deduction. Such a deduction will not, however, reduce the corporation’s basis in the partnership. Allocable deduction-eligible income and foreign-derived deduction-eligible income (FDDEI) should be reported on Schedules K-1 of the U.S. partnership’s return.
Consolidated groups for GILTI and FDII
The proposed regulations adopt an aggregation approach for the GILTI and FDII deduction in a consolidated group context. Rather than providing for separate determinations of the deduction for each consolidated group member, the proposed regulations provide for an allocation methodology whereby each member’s deduction is based on its ratable share of consolidated GILTI and FDDEI income.
Interplay with interest limitation and net operating loss calculations
Multiple code provisions can simultaneously limit the availability of the FDII deduction based, directly or indirectly, upon taxable income, including the Section 163(j) limitation on the deduction for business interest and the net operating loss (NOL) deduction (Section 172(a)). This means the proposed regulations provide an ordering rule for applying Section 163(j) and the NOL deduction in conjunction with FDII income limitations used to compute the FDII deduction. Specifically, the proposed regulations provide that a domestic corporation’s taxable income (for purposes of applying the FDII taxable income limitation) is determined after all of the corporation’s other deductions. So, a domestic corporation’s taxable income (for purposes of computing its FDII deduction) is its taxable income, determined after application of Sections 163(j) and 172(a), including the deduction for amounts carried forward to such taxable year.
Clarification on qualification as FDDEI
In order to qualify as FDDEI, your company’s sales or service income must meet certain requirements based on the nature of the products sold or the services provided. You must document the foreign residence of the customer, and in certain cases, that the products or services sold have a foreign use. For this purpose, income derived from products or services used in Puerto Rico or other U.S. possessions is considered to be foreign income and, thus, may qualify for FDII.
The proposed regulations list the acceptable forms of documentation, but generally a residency certification and a shipping document showing a foreign point of sale are required for sales of general property (defined below). Documentation must be current and dated no earlier than one year before the sale date, although this requirement is eased for tax years before 2019. For pre-2019 tax years, documentation that ordinary course of your business operations can be used to support FDDEI characterization.
Documentation requirements differ depending on the type of products or services being sold. In cases where a sale of product and services are bundled, the regulations provide for a “facts and circumstances” classification based on the “overall predominant character” of the transaction as either a sale of product or a service.
A de minimis exception to these documentation requirements also applies for taxpayers with less than $10 million in total sales or less than $5,000 in sales to a single customer. This exception relies on a reasonable knowledge standard and simply allows for a non-U.S. billing address for the recipient of the goods or services.
Sales income qualifies as FDDEI only if the sale is made to a foreign person for a foreign use. For purposes of determining foreign use, the regulations define four types of sale property: general, intangible, sales, and commodities.
- General property — Unlike other export incentives (e.g., IC-DISC, FSC, ETI), there is no requirement that the property sold to the foreign person be manufactured in the United States. And if manufactured in the United States, there is no requirement that the property have a certain level of U.S. content (e.g., component or labor).
If the property is not of a type defined in the other sections below, it is treated as general property. The sale of general property can be foreign source only if the property is not used domestically within three years of delivery, or where the property is subject to manufacturing, assembly, or processing outside the United States before being used domestically. The product must be subject to physical, material change or incorporated as a component of a second product, but only if the fair market value of the property constitutes no more than 20 percent of the fair market value of the second product.
- Intangible property — Sales of intangible property (e.g., patent, design, copyright, trademark, goodwill, etc.), including income from licensing (i.e., royalties) or gains from the sale or transfer of intangible property, are considered foreign use to the extent they are earned from use of intangible property outside the United States. Determining the extent to which income is attributable to non-U.S. exploitation is not “all or none” — income can be allocated as foreign source based on use of a reasonable method for attributing use between U.S. and non-U.S. sources. Where intangible property is sold as a lump-sum, this allocation can be based on the net present value of expected exploitation, based on reasonable projections.
- Securities and commodities — Sales of securities and commodities do not qualify as FDDEI since their place of use is ambiguous.
Similar to product sales, the regulations define four types of services for determining whether service income is derived from foreign use: proximate, property, transportation, and general.
- Proximate services — Proximate services are services provided to a recipient during which the provider spends more than 80 percent of its time in the physical presence of the recipient. Proximate services are sourced based on the location of the performance of the services.
- Property services —Property services are services (other than transportation services) provided on tangible property that involve physical manipulation, where performed at the location of the property, and if more than 80 percent of the time is spent near the location of the property. Property services are sourced based on the location of the property.
- Transportation services — Transportation services are sourced based on the origin and destination of the service; if only one is outside the United States, then 50 percent of the service is FDDEI.
- General services — The general services category is a residual, catch-all category. General services are provided outside the United States if the provider has no reason to know the consumer or business recipient is in the United States. A business recipient’s location is based on the operations’ location and the location of any related party that is receiving a benefit. Documentation for a business recipient's operations includes a statement specifying the location of the operation or a statement in a binding contract. “Information provided in the ordinary course of the provision of a service or publicly available information” will also suffice.
Related party transactions
The sourcing rules apply only in the context of third-party sales or services. Where sales are made to a foreign related party (i.e., a member of the “modified affiliated group” sharing greater-than-50 percent ownership), additional sourcing requirements apply. The foreign related party must on-sell to an unrelated foreign person by the taxpayer’s return filing date or the related party sale is deemed non-FDDEI. However, if the related party sale occurs within three years of the return filing date, an amended return can be filed to re-characterize the income as FDDEI.
Similarly, general services performed for a related party are foreign source only if they are not substantially similar to services performed by the related party to U.S. persons. One of two tests (the “benefits” test and the “price” test) must be met in order for the services not to be considered substantially similar. These tests require that either 60 percent or more of the benefits conferred by the related party service are to persons located within the United States, or 60 percent or more of the price paid by persons located within the United States for the service provided by the related party is attributable to the related party service. Proximate, property and transportation services provided to related parties are not subject to this limitation since by nature these services present little risk of “round tripping.”
How we can help
CLA’s global tax professionals can help you consider the options and complexities involved in calculating FDII within the specific context of your business. We can help you navigate these new proposed regulations to ensure your sales or service income qualifies and the appropriate documentation is gathered for FDII eligibility.