By Sylvia Chan, CPA, Tax Manager
The Tax Cut and Jobs Act (TCJA), P.L. 115-97 enacted in December 2017 has brought about exciting changes to the tax world. I would like to draw your attention to a provision that was written specifically to encourage U.S. companies to expand their operations globally without leaving the United States. Some technology companies have moved their intangible assets offshore to low-income tax jurisdictions and shifted the related income outside the United States. While tax-avoidance may not always be the primary motive, it was an inevitable truth that the U.S. Treasury was losing a portion of its revenue due to this income shifting tactic.
Two provisions within TCJA address this problem. One is referred to as the global intangible low-taxed income (GILTI) and the other is the foreign-derived intangible income (FDII). GILTI is referred to as the stick as it has a punitive effect on companies who have moved their intangibles and some of their operations offshore. On the other hand, FDII is the carrot, as it “rewards” U.S. companies for keeping their intangibles and operations in the United States.
Code Section 250 governs the calculation of FDII. For taxable years beginning after December 31, 2017, a domestic corporation is allowed to take a deduction that equals 37.5% of the corporation’s FDII. The end result is that profits on export sales are only subject to an effective rate of 13.125%. This rate is applicable for taxable years beginning after December 31, 2017 and before January 1, 2026. The effective tax rate then becomes 16.406% for taxable years beginning after December 31, 2025. This provision applies to C-corporations only, excluding regulated investment companies and real estate investment trusts (REITs).
The calculation of FDII involves several steps. Let’s go over the steps at a high-level. First, a corporation has to determine its Deduction Eligible Income (DEI), which can generally be referred to as its gross income less allocable deductions. DEI excludes certain income such as Subpart F income, GILTI inclusion, etc. Next, the corporation will have to determine its Foreign-Derived Deduction Eligible Income (FD DEI), also net of allocable deductions. FD DEI is the income from selling goods or services to a foreign person for use outside the United States. It includes income from any lease, license, exchange or other disposition outside the United States.
The next step is to compute Deemed Intangible Income (DII). DII is the excess of the DEI over the deemed tangible income return of the corporation. The deemed tangible income return is an amount equal to 10 percent of the corporation’s Qualified Business Asset Investment (QBAI). QBAI is the average of a corporation’s adjusted basis in its depreciable tangible assets as of the close of each quarter of a taxable year.
FDII is derived by multiplying DII by the ratio of FD DEI over DEI. The deduction is 37.5% of the FDII. The result of this calculation is the equivalent of applying an effective tax rate of 13.125% on foreign sales.
A picture is worth a thousand words, let’s take a look at an example below:
| Deduction eligible income | DEI | $200,000 | A |
| Foreign derived deduction eligible income | FDDEI | $50,000 | B |
| Average QBAI | QBAI | $100,000 | |
| 10% of average QBAI | $10,000 | C | |
| Deemed intangible income | DII | $190,000 | A-C |
| Foreign derived intangible income | FDII | $47,500 | (A-C)*B/A |
| Foreign derived intangible income deduction | ($17,813) | [(A-C)*B/A]*37.5% | |
| $29,688 | |||
| Tax rate | 21% | ||
| Corporate tax | $6,234 | ||
| Effective tax rate | 13.125% | Corporate tax/FDII |
Note, the FDII deduction cannot reduce taxable income to an extent that it creates a net operating loss. This benefit also does not apply to companies with no deemed intangible income.
Anti-abuse rules are also mentioned in this provision. A few include:
- In a situation where a corporation sells or provides services to a foreign related party, FDII is acceptable as long as the related foreign party resells the goods or provides the services to an unrelated foreign party. A foreign related party cannot provide similar services back to a customer in the United States after receiving the service from its affiliate in the United States.
- When a corporation sells or provides services to an unrelated foreign party, if the product sold or services provided are later manufactured or tailored in the United States even if the property is later re-sold to a foreign country, the transaction does not qualify for FDII.
- If a corporation provides services to an unrelated party in the United States and that unrelated party later uses the services received to provide services to a foreign party, the use is not qualified as “foreign” to the first corporation providing the services.
FDII is definitely considered “low-hanging fruit” to corporations with no foreign subsidiaries who sell to foreign countries directly from the United States. It is an incentive to encourage hi-tech companies to keep their valuable intangibles in the United States while using the intangibles to generate foreign income.
If you have foreign operations or merely just sell to foreign customers, there are tax implications to your business as a result of the TCJA changes. If you have any questions or need assistance in determining the implications to your business, please contact one of our experienced professionals.