Included in the many provisions of 2017’s Tax Cuts and Jobs Act (“TCJA”) was the creation of the Foreign Derived Intangible Income (“FDII”) Deduction for tax years beginning after December 31, 2017. While the naming of the deduction may lead taxpayers to question their eligibility, many U.S. companies with foreign sales may find that they do in fact qualify for the deduction and could stand to save significant tax dollars as a result. This deduction results in an effective tax rate of 13.125% on FDII.
Created under Section 250 of the Internal Revenue Code, the FDII deduction is available to certain U.S. based C corporations who sell tangible and/or intangible property, or provide services, to foreign persons for use outside of the U.S. While the terminology used may seem to indicate that income must be derived from an intangible asset to qualify, the IRS actually defines intangible income as any income that exceeds 10% of the taxpayer’s net book value of tangible assets. Therefore, taxpayers with little to no intangible assets on their books may still qualify for the deduction.
To calculate the deduction, taxpayers will determine their worldwide net income, net of certain exclusion items (i.e. Subpart F income, GILTI income)1, to arrive at their “Deduction Eligible Income”. This amount will be further reduced by 10% of the taxpayer’s tangible assets (at net book value)2 to arrive at the “Deemed Intangible Income”. Deemed intangible income will be allocated between foreign and domestic (i.e. based on the percentage of foreign sales)3 , and a 37.5% federal tax deduction will be allowed on the foreign portion. As a result, any C corporation with income in excess of 10% of their tangible assets and any foreign sales could receive a benefit from this deduction.
While this provides a brief overview of credit eligibility and calculations, there are a number of nuances that should be considered when calculating this deduction. If a taxpayer believes they may qualify for the FDII in any tax year after December 31, 2017, we recommend a consultation with a tax advisor to discuss the specifics in more detail.
1 Additional exclusion items include financial services income, dividends received from CFCs, domestic oil and gas extraction income, and foreign branch income.
2 The net book value of the assets is calculated as the quarterly average net book value based on ADS depreciation. Land, intangible assets, and any assets not used to produce deduction eligible income should not be included.
3 When allocating worldwide income and deductions, items should be allocated to foreign and domestic as appropriate based on the category of income or expense. Items that can be traced directly to foreign or domestic activity can be allocated directly. For example, U.S. taxes, interest paid to a U.S. bank, and depreciation on assets used only to produce U.S. income would likely be sourced directly to domestic. Items that cannot be directly allocated can be apportioned using a reasonable allocation method (i.e. percentage of foreign vs domestic sales).