The Tax Cuts and Jobs Act (TCJA) of 2017 provided for a 37.5 percent tax deduction under IRC §250 on Foreign-Derived Intangible Income (FDII). The introduction of tax on Global Intangible Low-Taxed Income (GILTI), FDII and GILTI deductions are attempts by the U.S. Congress to encourage U.S. multinational corporations to increase their investments in the U.S. and can be characterized as an export incentive.
However, export incentives are not new. Since the early 1960s, the U.S. has provided a series of export-related tax benefits. A 1971 U.S. tax law introduced a concept of a Domestic International Sales Tax Corporation (DISC) to subsidize exports of U.S.-made goods. It was successfully challenged by the European countries in 1984 for violating the General Agreement on Tariffs and Trade. It was then replaced by the U.S. Congress with the Foreign Sales Corporation (FSC) concept. It allowed companies to receive a reduction in U.S. federal income tax for profits derived from exports. However, the European Union (EU) challenged the legality of the FSC regime before the World Trade Organization (WTO) in 1997, and the WTO panel agreed with the EU. In 2000, the U.S. Congress replaced FSC with the Extraterritorial Income Exclusion Act (ETI). Once again, the EU challenged the ETI regime; and the WTO Appellate Body ruled in 2002 that the ETI constituted a prohibited export subsidy. Later that year, the WTO ruled that if the U.S. did not come into compliance with the decision, the EU could impose more than $4 billion in sanctions against U.S. products1. We are hopeful that FDII will not be challenged by the EU.
So, what is an FDII deduction? The FDII comes from the use of intellectual property in the U.S. in creating an export. Note, it applies for domestic C corporations, and not Controlled Foreign Corporations (CFCs).. IRC §250 allows the domestic corporation a deduction of 37.5 percent of the FDII (foreign-derived intangible income) plus 50 percent of the GILTI included in gross income of the corporation and the §78 gross-up attributable to the GILTI inclusion2.
FDII and the FDII deduction are determined by means of a series of mechanical computations. For the most part, the inputs into the computations are figures pulled from the tax return and the tax balance sheet.
Income can only be FDII if it is derived in connection with:
- A sale of general or intangible property to a foreign person for a foreign use; and
- Services provided to a person, or with respect to property not located in the United States.3
Let’s break down this definition in order to get a better understanding.
First, who is a foreign person? According to the regulations, a foreign person is a person who is not a U.S. person, a foreign government, or an international organization. The Internal Revenue Code defines a U.S. person as someone who is:
- A citizen or resident of the United States
- A domestic partnership
- A domestic corporation
- Any estate (other than a foreign estate)
- Any trust, if a court within the U.S. is able to exercise primary supervision over the administration of the Trust, and one or more U.S.
persons have the authority to control all substantial decisions of the trust. 4
Hence, anyone who is not included above as a U.S. person would be presumed a foreign person. In addition, a person that is a bona fide resident of a U.S. territory such as American Samoa, Guam, the Northern Mariana Islands, Puerto Rico, and the U.S. Virgin Islands is treated as a foreign person for FDII purposes.
Next, what type of transactions qualify as FDII? There are four categories of sale of property that can qualify for FDII deduction:
- A foreign retail sale
- Sale of general property that is delivered (for example through a common carrier) to the recipient or an end user, and their shipping address is outside the U.S.
- Sales of general property not described in 1 or 2 above, where the recipient’s billing address is outside the U.S.
- Sale of intangible property, where the recipient’s billing address is outside the United States.
If the seller knows or has reason to know that the sale is not to a foreign person, the sale would not be included in FDII. Generally, a seller has reason to know that a sale is not to a foreign person if the information received as part of the sales process contains information that indicates that the recipient is not a foreign person; and the seller fails to obtain evidence establishing that the recipient is in fact a foreign person. Evidence may include a U.S. phone number, billing address, shipping address, place or residence, or proof the entity is incorporated, formed, or managed in the U.S.5
As well, the sale of general or intangible property must be for “foreign use,” meaning the property must be used, consumed, or disposed of outside the U.S. 6 For example, foreign use of intangible property is determined based on the revenue earned from end users located within or outside the U.S. A sale of rights to exploit intangible property solely outside the U.S. is for a foreign use. While a sale of rights to exploit intangible property solely within the U.S. is not for a foreign use.7 Intangible property includes such items as patents; inventions; formulas; processes; designs; patterns or know-how; copyrights; literary, musical and artistic compositions; trademarks; trade or brand names; franchises; licenses; and contracts.8 The list is not all-inclusive.
In addition to sales of general or intangible property, certain services U.S. corporations provide to foreign persons may qualify for the FDII deduction. These include services provided to any person or with respect to property not located within the U.S. For example:
- A general service to a consumer located outside the U.S.
- A general service to a business recipient located outside the U.S.
- A proximate service to a recipient located outside the U.S.
- A property service with respect to tangible property located outside the U.S.; or
- A transportation service to a recipient, or with respect to property, located outside the U.S.9
A general service typically qualifies if it is provided to a consumer located outside the U.S. or the consumer resides outside the U.S. when the service is provided. The provider of services must establish the location of the consumer of general services by obtaining reliable documentation establishing that the consumer is located outside the U.S., and as of the FDII filing date, the provider is not aware or has no reason to know that the consumer is located within the U.S. when the service is provided. Note that the billing address rule does not apply if the provider of the services knows or has reason to believe that the consumer does not reside outside the U.S.10
Even though we have referenced only a fraction of the rules and in a very generalized way, it is evident that the rules for determining an FDII deduction are quite complex. If you think you have these types of transactions and could benefit from the FDII deduction, call us to discuss how you can capitalize on this benefit provided by U.S. Congress.
1.Overview of the Foreign Sales Corporation/Extraterritorial Income (FSC/ETI) Exclusion, 1/2/2002, taxfoundation.org
2. §§250, 951A
3. §250(b)(4)(A) & (B)
4. §7701(a)(30), Reg. §1.250(b)-3(5)
5. Reg. §1.250(b)-4(c)(1)
9. Reg. §1.250(b)-5(b)10.
10. Reg. §1.250(b)-5(d)(1)