Wednesday, January 24, 2018

Summary

The 2017 tax reform legislation added section 250 to the Internal Revenue Code, effectively creating a new preferential tax rate for income derived by domestic corporations from serving foreign markets. The new deduction is described as a deduction for foreign-derived intangible income, or FDII. This lower tax rate provides a new benefit for owning intangible property and conducting business operations in the United States.

In Depth

Overview of the FDII Benefit

As part of the 2017 tax reform legislation (the Tax Act), Congress added section 250 to the Internal Revenue Code, which effectively creates a new preferential tax rate for income derived by domestic corporations from serving foreign markets. A corporation pays an effective rate of 13.125 percent (rather than 21 percent) on its above-routine income arising from foreign markets. This new deduction is described as a deduction for foreign-derived intangible income, or FDII.

The FDII deduction is available to domestic corporations that are taxed as C corporations. This includes US corporate subsidiaries of foreign-based multinationals. On the other hand, foreign corporations with income effectively connected with a US trade or business, S corporations, regulated investment companies, real estate investment trusts, partnerships and individuals are not eligible to claim a FDII deduction.

The FDII benefit is determined based on a multi-step calculation. First, a domestic corporation’s gross income is determined and then reduced by certain items of income, including amounts included in income under Subpart F, dividends received from controlled foreign corporations and income earned in foreign branches. This amount is reduced by deductions (including taxes) properly allocable to such income, yielding deduction eligible income.

Second, the foreign portion of such income is determined. This amount includes any income derived from the sale of property to any foreign person for a foreign use. The term “sale” is specially defined for this purpose to include any lease, license, exchange or other disposition. “Foreign use” is defined to mean “any use, consumption, or disposition which is not within the United States.”

Qualifying foreign income also includes income derived in connection with services provided to any person not located within the United States, or with respect to property that is not located in the United States. The services may be performed within or outside the United States (but not in a foreign branch of the domestic corporation, which limits the extent of permissible qualifying activity outside the United States).

The gross foreign sales and services income is reduced by expenses properly allocated to such income. The sum of these two amounts yields foreign-derived deductible eligible income.

Third, a domestic corporation’s deemed intangible income is determined. This is the excess (if any) of the corporation’s deduction eligible income over 10 percent of its qualified business asset investment (QBAI). A domestic corporation’s QBAI is the average of its adjusted bases (using a quarterly measuring convention) in depreciable tangible property used in the corporation’s trade or business to generate the deduction eligible income. The adjusted bases are determined using straight line depreciation. A domestic corporation’s QBAI does not include land, intangible property or any assets that do not produce the deductible eligible income.

The FDII calculation is expressed by the following formula:

FDII = Deemed Intangible Income x Foreign-Derived Deduction Eligible Income Deduction Eligible Income

The FDII computation is apparently a single calculation performed on a consolidated group basis.

A domestic corporation’s FDII is 37.5 percent deductible in determining its taxable income (subject to a taxable income limitation), which yields a 13.125 percent effective tax rate. If deemed intangible income is zero or less, there is no benefit.

US tax on FDII may be reduced with foreign tax credits to the extent the FDII is foreign source income. Foreign source FDII generally should fall within the general foreign tax credit limitation category, and therefore foreign taxes paid on other active foreign source income earned directly by the US corporation should be available as a credit (except for foreign income taxes paid by a foreign branch which are in a separate limitation category). For purposes of calculating the foreign tax credit limitation, only 62.5 percent of the FDII should be taken into account (but all foreign taxes imposed on FDII should be available for credit).

Rules for Determining Foreign Use

An important determination in calculating FDII is identifying the income that is considered “foreign-derived” income. The key concept is that the income is considered as earned for providing goods or services to persons outside the United States. As previously described, property must be sold, licensed or leased to a foreign person (related or unrelated) for use outside the United States, and services must be provided to persons located outside the United States, or with respect to property located outside the United States.

Two special rules apply to property and services provided to unrelated persons. Property sold to an unrelated person is not treated as sold for foreign use if it is further manufactured or modified within the United States, even if the unrelated person subsequently uses such property for a foreign use. A taxpayer may instead consider hiring the domestic manufacturer to finish the goods on a consignment manufacturing basis, and then the taxpayer can sell the finished goods for foreign use.

Similarly, services provided to an unrelated person located within the United States are not treated as foreign-derived even if the other person uses such services in providing services outside the United States. In such cases, the taxpayer may consider contracting directly with the foreign persons benefiting from such services and pay the intermediary a smaller service fee.

Special rules also are provided for situations in which property is sold to a related foreign person. In such a case, it must be established that the related foreign person sells the property to an unrelated foreign person for foreign use. Alternatively, foreign use can be established if the related foreign person uses the property outside the United States in connection with property which is sold to an unrelated foreign person, or uses the property outside the United States in providing services to an unrelated foreign person. As previously noted, for these purposes a sale of property includes a lease, license, exchange or other disposition of the property.

For example, a domestic corporation may sell components to a related foreign person for further manufacture and sale to foreign unrelated persons for use outside the United States. The income from the sale of the components should qualify as foreign-derived. The foreign related person that purchased the property from the domestic corporation may also sell the property to another related foreign person that subsequently sells the property to an unrelated foreign person without altering this conclusion.

In another common example, a domestic corporation may license intangible property to a foreign subsidiary. The foreign subsidiary uses the intangible property in marketing and selling its products to unrelated foreign customers. The royalty income earned by the domestic corporation should be considered as foreign-derived income. 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.

A special rule is also provided for determining foreign-derived income when a domestic corporation provides services to a related person who is not located in the United States. Such services will qualify only if it is established that the service is not substantially similar to services provided by such related person to persons located within the United States. Thus, it will be important to show that the relevant services are being used outside the United States.

In summary, domestic corporations now enjoy a tax preference in deriving income from selling, licensing or leasing property for use outside the United States, and providing services for use outside the United States. This lower tax rate of 13.125 percent reduces the relative tax advantage of owning property and conducting operations in a foreign subsidiary. It should be noted, however, that for tax years beginning after December 31, 2025, the deduction percentage decreases, thereby increasing the effective tax rate on FDII to 16.406 percent (based on the current 21 percent US corporate income tax rate).

Several European Union finance ministers have indicated that they may challenge the FDII deduction under World Trade Organization rules, claiming that the deduction provides an impermissible export subsidy. While that possibility should be borne in mind, the outcome of any such case is unpredictable, and ultimate resolution likely would take several years.