The 2017 Tax Cuts & Jobs Act made many fundamental changes in the area of International Taxation. One of the international provisions, Sec. 250, provides for a reduced rate of tax on sales of products and services to foreign customers of U.S. domestic corporations. Known as the Foreign Derived Intangible Income deduction, or FDII deduction, this provision allows a domestic corporation a deduction on a portion of its deemed intangible income resulting in an effective tax rate as low as 13.125% on FDII instead of the US corporate tax rate of 21%. The FDII deduction is intended to work in tandem with the new Global Intangible Low-Tax Income tax (GILTI) to incentivize domestic corporations to keep their operations in the U.S. rather than sourcing them to countries with lower tax rates.
The FDII deduction is determined via a complex formula. In very basic terms, corporate eligible income is reduced by 10% of the tangible property in use. This net amount is then apportioned between foreign and domestic sales of products and services based on foreign gross sales to total sales. The resulting foreign income portion (i.e. Foreign Derived Deduction Income) is then multiplied by 37.5% to determine the deduction from taxable income.
Although the name of the deduction hints that only intangible income is included, the FDII calculation considers all income. The resulting FDII deduction will be larger for items of income with high margins and low capital investment. For example, a company with intellectual property and trademarks may not have as many capital assets and therefore will have a larger FDII deduction and a lower overall tax rather than a company with a significant investment in buildings and equipment.
For purposes of the FDII calculation, foreign use is any use, consumption or disposition which is not within the United States.1 Sales to a related party in a foreign country are not included in FDII until the property is ultimately sold by the related party or used by the related party in connection with property sold to an unrelated party in a foreign country. Services have to be provided for foreign use. Services performed in the U.S. are not treated as foreign services, even if they are ultimately used to provide services which are outside of the U.S.
The FDII deduction is for "C" corporations only. If the company is taxed as an "S" corporation or a partnership, the FDII deduction is not an option. However, the S corporation or partnership may use a tax-saving vehicle known as an IC-DISC (Interest Charge Domestic International Sales Corporation) to transform the character of foreign income so that it qualifies for a more favorable qualified dividend rate. The IC-DISC is an entity often used by U.S. manufacturers and exporters and their shareholders to defer taxation on offshore profits and should not be overlooked in determining an entire tax reduction strategy.
The new FDII deduction encourages domestic corporations with foreign sales to keep their operations based in the U.S. The FDII calculation is complex but can help minimize the overall tax burden for the corporation. While the FDII deduction is not available for S corporations and partnerships, other tax-saving vehicles, such as IC-DISCs, may help reduce the tax burden for these entities, as well. We strongly encourage those who have interests in domestic entities with foreign sales to contact our International Tax advisors for further consultation on these tax provisions and planning strategies.