By Howard Bakrins, Tax Director, Kutchins, Robbins & Diamond, Ltd. Previously published in the GGI International Tax Autumn 2019 Newsletter.
U.S. corporations that generate income from export activities should consider if the foreign-derived intangible income (FDII) deduction applies. The Tax Cuts and Jobs Act (TCJA) passed in 2017, made significant changes to the taxation of foreign income of U.S. businesses. One of these changes was the creation of the FDII deduction.
This deduction represents a valuable tax break for U.S. corporations with foreign sales. This article includes an overview of the deduction, its benefits, and describes some new terminology related to the deduction.
The FDII deduction creates a significant incentive to domestic C corporations by providing a tax deduction that effectively lowers the corporate tax rate on income derived from both tangible and intangible products and services in foreign markets. C corporations can claim a 37.5% tax deduction on FDII, which yields a 13.125% effective tax rate on FDII, as compared with a 21% rate on other income, for tax years beginning after Dec. 31, 2017. Beginning in 2026, the FDII deduction is reduced to 21.875%, which yielding an effective tax rate of 16.406%.
The FDII deduction is only available to domestic businesses that are taxed in the U.S. as C corporations.
Computing the FDII deduction is a complex process that starts with computing the qualified business asset investment (QBAI), the deduction-eligible income (DEI), and the foreign-derived deduction-eligible income (FDDEI). These items are required to then calculate the deemed intangible income (DII) and the foreign-derived intangible income (FDII).
The computation of deemed intangible income (DII) is made by taking the deduction-eligible income (DEI), minus 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 attributed to FDII and qualifies for the 37.5% deduction on the corporation’s U.S. income tax return. It is important to note that the property does not need to be manufactured or produced by the corporation for the income to be qualified.
The FDII computation is complicated, but it is designed to approximate income from the sale of goods and services abroad attributable to U.S.-based intangible assets such as patents, trademarks, and copyrights. It is computed by taking the income attributable to a U.S. business’ intangible assets that exceeds a 10 percent deemed return on its depreciable tangible property. The portion of this excess income allocated to the sale of goods and services outside of the U.S. is eligible for the deduction.
For example, assume a U.S. corporation earned $100 million, and has tangible assets of $200 million (QBAI). The corporation would allocate the deemed intangible income (DII), $80 million ($100 million of earnings less the $20 million deemed return on its tangible assets), between foreign sales and domestic sales of goods and services. The FDII deduction would apply to the portion of the $80 million allocated to foreign sales, effectively reducing the U.S. tax rate on this income from foreign sales to 13.125% percent, rather than the regular 21%.
In order to qualify for the deduction, the sales of products and services must be made to a person or business that is not a U.S. person and be for a foreign use. Included are sales, leases, licensing, exchanges, and other dispositions. Property includes both tangible and intangible property. The term “foreign use” means any use, consumption, or disposition that is not within the United States.
Some of the issues that require careful attention are selling to related parties, allocating expenses to various classes of income, the calculation of QBAI, and the corporation’s existing accounting methods.
If your business may be eligible for the FDII deduction or any other provisions of the TCJA, you should consult with your tax advisor in order to maximize the benefits and minimize the risks of these new provisions.