Welcome
Daily Tax Report ®

INSIGHT: Fundamentals of Tax Reform: FDII

Aug. 13, 2018, 1:15 PM

Introduction

FDII, or the foreign-derived intangible income deduction, is among the constellation of new acronyms created by the recent tax reform act of 2017. Unlike counterparts such as BEAT and GILTI, FDII is a “carrot” rather than a “stick,” in that it is aimed at promoting U.S. export activity, rather than discouraging specific activities and structures deemed to be contrary to U.S. fiscal interests. Like tax code Section 199 before it (which likewise had been intended as a carrot for domestic growth), new Section 250 does not fit neatly into either the international or the domestic tax spheres. As a result, FDII interacts—and not often simply—with old as well as new features of the U.S. tax system, and can give rise to counterintuitive results, particularly in light of its overall objective.

This article does not intend to delve comprehensively into the multiple complex (and in many cases as yet unanswered) aspects of FDII. Instead, our goal is to provide practitioners who do not regularly work in the international tax area with a general understanding of the purpose and basic operation of the new FDII rules in Section 250, and a sense of sticking points that may merit more careful consideration. To that end, we have included in every section a basic discussion of the key operating rules, plus a few “Practical Notes.”

Big Picture

At a high level, FDII is an effort to incentivize U.S. corporations to use the United States as an export hub. With its historically high corporate tax rates, many U.S. and foreign-based multinationals used the United States to access the U.S. economy but structured many of their cross-border activities offshore, where foreign profits could be taxed at a relatively low rate. The FDII rules begin with the corporate rate drop (from 35 percent to 21 percent), which very generally incentivizes increased U.S. profit-making activities, and add momentum by offering additional tax rate reductions for specified export activities. Curiously, the FDII rules do not contain U.S. “content” rules, so the benefits are solely triggered by the act of exporting. “Sourcing” or other U.S. tax rules that attempt to identify an origin or locus of economic activity are irrelevant for FDII purposes. Technically, a taxpayer could import and re-export goods, so long as it can demonstrate that property or services have a foreign destination.

At its most simplistic, FDII begins with the general, 21 percent corporate rate for U.S. corporate earnings attributable to non-export activities. (Note, corporations can potentially claim FDII benefits on their distributive share of partnership income, when the income otherwise qualifies.) Income from export activities is divided between income deemed earned with respect to the taxpayer’s tangible assets (the “QBAI return” described below)—which remains subject to the 21 percent rate—and tax-benefited income deemed attributable to remaining, “intangible” assets. (This conceptual division is what gives rise to the regime’s otherwise confusing name.) By application of a significant deduction per Section 250, and subject to a taxable income limitation, the FDII rules effectively tax qualifying income at a rate of 13.125 percent (until 2025, and 16.046 percent thereafter).

Understanding FDII’s acronym-rich vocabulary is central to fully understanding the operation of the FDII rules. Let’s walk through the relevant terms and the steps for calculating FDII benefits.

Deduction Eligible Income (DEI)

The first step toward calculating FDII is determining the taxpayer’s net income from certain (in fact, most) sources. The taxpayer begins with its gross income and subtracts six specific categories of income that are already subject to special regimes: (i) subpart F and Section 956 income; (ii) GILTI income; (iii) financial services income; (iv) domestic oil and gas extraction income; (v) dividends from CFCs; and (vi) foreign branch income.

After removing these categories of what some informally refer to as “deduction ineligible” income, the taxpayer next subtracts expenses—including taxes—allocable to the remaining “deduction eligible” income, moving the calculation from gross to net income. Section 250 provides no guidance regarding the methodology for doing so but presumably (and subject to further guidance) taxpayers may use the allocation methodology of Treasury Regulations Section 1.861-8 or another “reasonable method.”

Having removed from its gross income all of its deduction ineligible income as well as the expenses properly allocable to the remaining pool of eligible income, the taxpayer is left with its net income potentially eligible for FDII benefits, referred to as its “deduction eligible income” or “DEI.”

Practical Notes: As a subcategory of (net) taxable income, U.S. corporate taxpayers should be considering the most favorable methods of allocating deductions (i.e., away from DEI) and potentially accelerating income / deferring deductions into the earlier years of FDII, before the higher FDII rate kicks in. In addition, keep an eye on the evolving definition of “branch” for these purposes. Ideally, it will clarify whether, and the extent to which, income flowing to a corporate taxpayer’s U.S. tax return is not caught within the prohibition of branch income, as it would be disqualified from FDII benefits. In that case, the objective would be to allocate income away from the branch but allocate deductions to the branch, in a manner that is otherwise consistent with allocation methodology adopted for FDII purposes more broadly.

Deemed Intangible Income (DII)

The second step in calculating a taxpayer’s FDII benefit is a nod to its name. The preferential tax rates are available for income over and above amounts deemed to be earned by virtue of the taxpayer’s tangible capital assets (i.e., the residual is tagged as the taxpayer’s “intangible” income, although in reality the income may not necessarily arise from proprietary IP, goodwill, etc.). For this purpose, Section 250 creates a fiction that the taxpayer will earn a 10 percent return on depreciable tangible property used in producing DEI (otherwise known as its “qualified business asset investment,” or “QBAI”). QBAI is the average of the taxpayer’s aggregate basis in “specified property,” notably not including land, computed quarterly using the alternative depreciation system (“ADS”) of Section 168. The resulting amount is the taxpayer’s “deemed tangible income return” or “DTIR.”

Consider what this means as a practical matter: The deduction of the DTIR is not a deduction from taxable income as a whole. Instead, it is a deduction from the taxpayer’s rate-preferenced amount. The effect of the deduction is to shift the DTIR back to the normal corporate tax rules, at the 21 percent corporate tax rate. This means that, at a high level (and unexpectedly), a build-up of tangible capital assets hurts a taxpayer from a FDII perspective. This may not be fatal to a taxpayer that believes its increased production or distribution capacity, bonus depreciation, etc., will result in enough overall benefit to make additional domestic investment worthwhile. But it’s something taxpayers should understand when assessing the potential all-in value of such an investment.

Practical Notes: ADS is most typically employed for property used outside the United States (as well as in some other circumstances), so many multinational taxpayers will have a working familiarity with it, but likely do not currently apply it to their domestic fixed assets. They will now need to do so (and do so quarterly), and track FDII depreciation separately from their “normal” depreciation schedules. This could include resurrecting assets that were fully depreciated pre-Tax Reform but that are still within the ADS recovery period. Taxpayers will also need to track depreciation for state FDII purposes, in the states that allow for FDII benefits and under the depreciation methods they adopt.

Foreign-Derived DEI (FDDEI)

So far in computing FDII we have reduced the company’s gross income to its total net income potentially eligible for the deduction (DEI). We then removed from DEI the portion derived from tangible property (DTIR), leaving us with the company’s net income derived from “intangibles” (DII). The final step requires removing from DII the portion derived from domestic and ineligible non-domestic activities. Put differently, we need to identify the taxpayer’s FDDEI, or the portion of the taxpayer’s DEI derived from qualifying export activities.

FDII is available for two big buckets of corporate activities, each having different factual requirements. As noted above, these activities do not correspond to any of the U.S. “sourcing” rules, which at a very high level provide conditions under which specified types of income (including income from property and services transactions) are treated as economically arising from inside—or, conversely, from outside—the United States. The FDII rules disregard those rules entirely, and create different factual paradigms for the benefitted activities.

a. Export Property Rules

The first set of paradigms applies to a U.S. corporation’s export sales (which also include leases and licenses, together referred to as “sales” for purposes of this article) of property. There are two separate factors that must be present in order for property transactions to qualify for FDII treatment:

  • The sales are to an unrelated foreign person; and

  • The sales must be for the customer’s foreign use (i.e., use, consumption, or disposition not in the United States) of the transferred property.

Of course, not all sales are entered into with, and shipped directly to, an unrelated foreign buyer. The statute provides special rules addressing these situations. The first involves sales by the U.S. corporation to a related non-U.S. person. Under Section 250, sales to a related foreign person will be for “foreign use” only if the property is ultimately sold to an unrelated foreign person, or if the property is used in connection with other property that is sold, or in connection with the provision of services, to an unrelated foreign person (also for foreign use). This enables multinational groups to use the United States as an export hub to regional distribution centers or even to regional services centers that use and re-convey exported goods to unrelated customers in the course of their service activities.

Example: U.S. corporation (U.S. parent) sells automobile components to an indirectly wholly owned controlled foreign corporation (CFC). The CFC sells the components to Buyer, an unrelated foreign car manufacturer in Country X, for the final assembly of Buyer-brand automobiles, to be sold outside the United States. U.S. parent’s sale to the CFC (but not CFC’s sale to Buyer, as the CFC is not a domestic corporation) produces FDDEI used in computing the U.S. parent’s FDII.

It is important to remember that the main operating rule requires a property transfer to a foreign person. There is an open question here as to whether a sale from one domestic corporation to another member of a U.S. consolidated group could qualify, e.g., under the Section 1502 redetermination rules, where the second member subsequently transfers the property to a foreign buyer that satisfies the foreign use requirements.

Section 250 includes a warning that is to be read in light of the general rule: Property cannot qualify as sold for “foreign use” if transferred to an unrelated intermediary that further manufactures or otherwise modifies the goods inside the United States, even if the foreign purchaser subsequently uses the property in activities that would otherwise qualify as “foreign use.” Query what level of activity would count as disqualifying manufacturing or modification. In addition, the scope of this provision is a little confusing, as the relevant statutory subheading refers to “domestic” intermediaries. However, the general rule is that a qualifying sale must be made to a non-U.S. person, regardless of relationship (unlike the services rules, which do not contain similar limiting language). Subject to further guidance, we read this warning as a clarification: The foreign use requirement will not be met if an unrelated foreign purchaser engages in U.S. modification activities. It may be helpful to remember that, in the case of a back-to-back sale—U.S. corporation to an unrelated intermediary, then unrelated intermediary to foreign purchaser—even if the first sale does not qualify for FDII benefits, the second one retains eligibility.

Finally, the taxpayer must be able to demonstrate “foreign use” of the export property (i.e., use, consumption, or disposition not within the United States) to qualify for FDII benefits. The practical definition of that term, as well as the timing and manner for establishing compliance with its requirements, must await further guidance. In any case, but definitely pending guidance, companies should document their methodology for determining whether particular sales are for a “foreign use.” At a minimum, taxpayers should be able to piggyback off their export compliance processes to show the movement of goods offshore. Among the open issue are:

  • The standard of care a U.S. seller is required to exercise—actual knowledge? reason to know?—regarding a buyer’s intended use of the exported property;
  • Specific factors, e.g., contractual representations and warranties, that could presumptively establish the buyer’s foreign use; and
  • The consequences of a post-sale change in circumstances that result in a buyer reselling the property to U.S. buyers or for use in the United States.

For example, is the seller’s entitlement to a FDII deduction affected if the foreign purchaser places the acquired property in a distribution center located outside the United States, with the goods held for sale to any interested customer—including those in the United States? Under a strict reading of the FDII rules, the answer would have to be “yes.” At the same time, there are longstanding, pre-Tax Reform provisions, e.g., the foreign base company sales rules of Section 954(d)(1)(B), that also test whether property is sold for use, consumption, or disposition outside the country where a controlled foreign corporation is created or organized. Those rules include some helpful presumptions. For example, for unrelated property sales, place of use is the country of the sales destination, unless the seller knew or should have known otherwise. (See Treas. Reg. Section 1.954-3(a)(3)(ii).) It will be interesting to see whether future FDII guidance adopts the same regulatory mechanisms as subpart F or whether the government will draw clearer, potentially harder, lines in the FDII context.

Practical Notes: At a minimum, taxpayers will need to show that products were transferred outside the United States.Absent guidance, export compliance records should be used to demonstrate this. Taxpayers should be aware of information tracking and reporting, as well as technical arguments being advanced, e.g., for IC-DISC purposes, to ensure that enterprise-wide positions are internally consistent and demonstrable.

b. Export Services Rules

FDII also is available for services provided by a domestic corporation to any person, or with respect to any property, not located in the United States. As noted above, in contrast to the export property rules (particularly with respect to sales to domestic persons), the FDII benefit may be available for services provided to U.S. persons. In addition, proceeds from export services transactions can be FDDEI even if the services are provided to a related foreign person, so long as the related person does not provide substantially similar services to persons located in the United States. To be clear, the general rule and substantially similar provision both focus on the location of the service recipient, and not the place where services are performed / the source of the services income.

Example: U.S. corporation is an IT support services provider. U.S. corporation may qualify for FDII benefits with respect to income arising from IT support services to foreign unrelated customers, as well as U.S. unrelated customers with respect to their foreign IT systems (e.g., systems physically located in foreign branch offices). For these purposes, it is irrelevant whether U.S. corporation’s employees are on-site, in or outside of the United States, or performing these services remotely.

In addition, U.S. corporation may act as an intercompany IT services provider, provided that its related “customers” are not providing substantially similar services to any related or unrelated person located in the United States.

The statute does not define “substantially similar” for this purpose. This lack of clarity is unfortunate in light of the “cliff effect” of even a minor foot fault. None of the revenue arising from the services provided to the related foreign person qualifies as FDII-benefitted if that entity provides any substantially similar services to a person located in the United States. Pending guidance defining “substantially similar” for this purpose and hopefully providing a more graduated disallowance, U.S. companies need to be particularly cautious of service agreements with related foreign entities that themselves provide services on a global basis.

Query exactly how “location” is determined. What happens, for example, if a U.S. corporation provides services to a U.S. branch of a foreign entity? How do the rules apply to mobile property or jointly (U.S. and foreign) owned property? Absent guidance that clearly declares that scenario eligible for FDII benefits, we would recommend proceeding with caution.

Practical Notes: While the property and services rules differ significantly in terms of factual requirements, there may be real questions as to which rules could apply in a given case. Take, for example, U.S. taxpayers with stripped risk operations in the U.S.Whether structured as buy-sell or distribution arrangements, the limited nature of these activities generally results in relatively low U.S. profit margins. From an economic standpoint, the two different arrangements are very similar—having the U.S. distributor take temporary title to goods before resale generally does not have a significant effect on profit margins—but in structuring their supply chains to gain FDII benefits, taxpayers should consider which FDII requirements they could most easily satisfy. Would it be easier to track facts relevant to foreign use of transferred goods, or facts regarding services performed? And does that answer change depending on whether there are related intermediaries involved? The two arrangements may not differ significant in terms of taxable income, but a little planning can increase the sustainability of FDII benefits for the arrangement chosen.

Foreign-Derived Intangible Income (FDII)

Now that we have winnowed down gross income to identify DEI, subtracted the portion attributable to tangible property (DTIR) to derive DII, and identified the portion of our DEI that is sufficiently export related, we are ready for the final step in computing FDII. Section 250 defines FDII as the amount that bears the same ratio to the taxpayer’s DII as its foreign-derived DEI bears to its total DEI. This can be determined in either of the two ways shown above.

First, the taxpayer could multiply its DII by the ratio of its foreign-derived DEI to all of its DEI (FDDEI / DEI) in order to divide DII into the foreign-derived intangible income (which becomes FDII) and the domestic-derived intangible income (which is discarded with the earlier jetsam produced by this winnowing process).

Alternatively, the taxpayer could multiply its foreign-derived DEI (FDDEI) by the ratio of its deemed intangible income to all of its deemed eligible income (DII / DEI) to produce the percentage of its foreign-derived income resulting from transactions involving intangibles.

Mathematically, each produces the same result in computing FDII. The only difference lies in which approach is easier for a particular individual to conceptualize. The first takes intangibles income and bifurcates it into a domestic piece and a foreign piece. The second takes foreign income and bifurcates it into tangible and intangible. Because the ultimate goal is reducing DEI to just the amounts that are both “foreign” and “intangible,” the order in which the unwanted pieces are removed is irrelevant.

Practical Notes: After determining which revenue streams satisfy the FDDEI sales or services requirements, taxpayers must calculate the amount of FDDEI. Unhelpfully, the FDII rules do not provide any particular methodology for quantifying FDDEI. In the absence of any guidance, it could be reasonable to determine FDDEI based on a couple of methodologies. Under a “tracing” approach, FDDEI could be determined by identifying the gross income items in DEI that are qualifying income, and then allocating expenses to those items. Under a “proration” approach, FDDEI could be determined by prorating the amount of net DEI between FDDEI and non-FDDEI, based on a reasonable proration methodology. Either approach should be consistently applied. A tracing approach could result in FDDEI exceeding DEI in certain situations, which raises an additional issue of whether FDDEI is capped at DEI for purposes of the FDII calculation. The statute does not address this circumstance, so taxpayers will need to live with some uncertainty around FDII computations until future guidance is issued, and may want to model various FDII estimates accordingly.

Let’s take a quick example that walks through the entire calculation at a high level:

Example

A German automotive group has a U.S. corporate subsidiary (US Sub) that produces one of the group’s car series. The cars are sold by US sub to U.S. and foreign unrelated customers, and to a related foreign distributor (For Sub).

US Sub earns $1,000 of gross income from global sales. Eighty percent of its sales are to foreign unrelated customers—40 percent via direct sales by the US Sub, and 40 percent through sales to For Sub—for foreign use. US Sub has $700 of expenses attributable to car production. (Assume no non-deductible expenses.)

US Sub owns production equipment and other depreciable tangible assets that are used in the production and sale of cars (regardless of export vs. non-export breakdown). For FY18, the average quarter-end aggregate adjusted basis of this property is $400.

Let’s go over US Sub’s determination of FDII benefits.

* Alternatively, taxpayers could determine FDDEI using a direct tracing methodology.

Taxable Income Limitation

The FDII deduction is subject to a taxable-income based limitation that works in conjunction with the GILTI rules. That is, if the taxpayer’s FDII plus GILTI income exceeds the taxpayer’s taxable income for the taxable year (i.e., FDII plus GILTI plus other income) determined without regard to Section 250, the excess is allocated pro rata to reduce the taxpayer’s FDII and GILTI income for purposes of Section 250. The respective deductions for FDII and for GILTI are computed based on these reduced amounts.

Just as with Section 199 before it, taxpayers with little or no taxable income for a given year will be unable to claim the full (or any) benefits under Section 250.

Big Picture Planning Considerations

FDII planning cannot be conducted in a vacuum. FDII offers an opportunity to substantially reduce the effective tax rate on at least a portion of the taxpayer’s taxable income for the year, producing a permanent tax benefit. However, FDII is interdependent with other international tax provisions, and an interactive analysis of all of the interwoven provisions is essential to understanding whether, how, and to what extent a taxpayer will benefit from FDII. Could a taxpayer source or produce goods offshore, sell to a U.S. entity, then re-export those products for an overall tax benefit? Possibly yes, so long as that taxpayer keeps a close eye on subpart F, GILTI, foreign tax credit, BEAT, permanent establishment, and FDII considerations, and is not running overall losses, and understands and can quantify potential state tax (e.g., whether the Section 250 deduction will be allowed from the relevant state tax bases) and trade (e.g., customs and export) implications.

Still, on a stand-alone basis, there are several potential issues that taxpayers should explore for maximizing potential FDII benefits:

  • What existing activities and revenue streams—or even projected ones—might contribute to FDDEI?

  • How could the allocation of expenditures to the eligible categories of gross income be fine-tuned in order to maximize the net income eligible for the FDII benefit?

  • Are there supply chain, commercial, or contract modifications that would be worthwhile for maximizing FDII?

  • What systems and processes already in place could be used or supplemented to demonstrate the identity of customers and their satisfaction of the “foreign use” requirements?

The first two bullets in particular harken back to planning techniques designed to maximize the domestic production activities deduction of former Section 199, and similar tools and techniques can be employed for purposes of FDII.

Given early reactions by some European trading partners and the potential for review by the World Trade Organization, there is no certainty as to the window of opportunity for reducing the taxpayer’s effective tax rate using the FDII deduction. Those reactions, including unilateral retaliatory measures that could be taken by individual jurisdictions, must be taken into account for assessing and measuring overall FDII benefits for U.S. taxpayers. For now, however, FDII offers a carrot that should be included in any comprehensive cross-border tax planning discussions.

The information in this article is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230 because the content is issued for general informational purposes only. The information contained in this article is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG LLP.