Lockheed Martin Corp. and fellow defense industry giants want to know if foreign military sales are eligible for a tax deduction aimed at increasing U.S. exports.
Billions of dollars in foreign sales could qualify for the tax break, which would further spur an industry that has already seen a boost from the U.S.’s slashed corporate tax rate. The federal government facilitated the sale of $32 billion in weapons and equipment from U.S. defense companies to foreign militaries in fiscal year 2017. Lockheed alone made about $9.5 billion—63 percent of the company’s total $15 billion in net sales to international customers—in 2017 through foreign military sales, according to its 2017 annual report.
The 2017 tax overhaul includes a tax break to encourage companies to export U.S.-made goods, known as the foreign-derived intangible income (FDII) deduction.
The law was written in a way that doesn’t make it clear whether income from foreign military sales qualifies for the deduction, given that the U.S. government acts as an intermediary in the sales, said Dan Stohr, director of communications at the Aerospace Industries Association (AIA). The group, whose members include Lockheed, Boeing Co., General Dynamics Co., and Raytheon Co, has asked Congress to clarify that it does. But it may be up to the Treasury Department and the Internal Revenue Service to make the final decision in FDII guidance later this year.
The rules around the provision are complex, but they essentially allow U.S. multinational companies to take a 37.5 percent deduction on FDII—bringing the effective tax rate on that income down to about 13.1 percent—through the end of 2025. After 2025 the write-off shrinks to about 22 percent and the effective tax rate rises to about 16.4 percent.
Lockheed mentioned the issue in a lobbying disclosure for the third quarter of 2018 that ended Sept. 30, in which the company said it lobbied on several tax-related issues including a clarification on FDII and “congressional intent related to Foreign Military Sales.” Lockheed said in an email AIA’s position reflects its views.
Boeing also mentioned the provision in its third-quarter filing, although it didn’t explicitly cite the foreign military sale issue. The company declined to comment.
FDII is income earned from foreign sales or services above a deemed 10 percent rate of return on tangible assets.
Companies that want a deduction on such income have to meet two general requirements: the property or services they sell must be for “foreign use,” meaning “any use, consumption, or disposition which is not within the United States,” and the sale must be made to a non-U.S. person, according to tax code Section 250.
This complicates things for companies that use intermediaries to sell their products abroad, said Derek Schraw, a partner and national FDII leader at Deloitte Tax LLP in Nashville, Tenn. And the issue expands beyond just defense companies. For example, it affects businesses that manufacture a product and then sell it to a large U.S. retailer—like Walmart Inc.—for distribution overseas, he said.
The ambiguity didn’t exist in a precursor to the FDII deduction. The previous version was included in the tax reform proposal introduced in 2014 by former House Ways and Means Committee Chairman Dave Camp (R-Mich.), said Craig Hillier, Americas International Tax Services director at Ernst & Young LLP in Boston.
That proposal provided that companies could get a tax break as long as the property they sold was “ultimately” for use, consumption, or disposition outside the U.S. “The jurisdiction in which the buyer was resident was not relevant,” Hillier said in an email.
In the case of foreign military sales, Stohr said AIA has asked the Joint Committee on Taxation, a nonpartisan congressional panel, to confirm that income from such sales will be treated as foreign-derived income and eligible for the tax break. The JCT is set to release its “blue book"—a document that explains provisions in enacted tax legislation—on tax reform by the end of the year. Practitioners and businesses look to the blue book for an idea of how they should interpret legislative changes.
Until then, AIA “will continue to engage with decision-makers on this issue,” Stohr said. He said the group hasn’t done an analysis on the amount defense companies would lose in tax breaks if they aren’t able to apply the FDII deduction to income from foreign military sales.
Further Manufacture or Modify?
Schraw, referencing specific language in the 2017 tax law (Pub. L. No. 115-97), said companies should be able to use U.S. intermediaries for sales overseas, while also getting the FDII tax break, as long as the intermediary doesn’t “further manufacture” or modify the product.
In that case, it would seem that both the original manufacturer and the distributor could get a benefit, he said.
“People want a little clarification just because this is a large potential tax benefit for some companies,” Schraw said.
Treasury and the IRS will likely address these issues in regulations on the FDII deduction, Schraw said. Treasury officials have said they plan to release proposed regulations later this year.