Foreign-Derived Intangible Income (FDII)
Last Updated October 4, 2022
Foreign-derived intangible income (FDII) is the portion of a domestic corporation’s intangible income that is derived from serving foreign markets, determined on a formulaic basis. Section 250 allows domestic corporations that have FDII to deduct a specified percentage of the excess of the corporation’s income from export sales over a fixed return on its tangible depreciable assets for the year. The FDII tax deduction rules operate in tandem with the global intangible low-taxed income (GILTI) rules under §951A.
How do FDII and GILTI interact?
The FDII and global intangible low-taxed income (GILTI) regimes are an attempt by Congress to use tax reform to encourage U.S. multinational corporations (USMNC) to increase their investments in the U.S. The intent appears to have been to favor structures where a USMNC holds its high-return, foreign-income-producing assets and operations in the U.S. over placing those assets and operations in overseas subsidiaries.
How are FDII and GILTI each applied to foreign income?
Despite their common policy objective, the two regimes use very different statutory schemes:
- In the case of GILTI, U.S. shareholders of controlled foreign corporations (CFCs) include in income (in a manner similar to the inclusion of subpart F income) the excess of the CFC’s “tested income” over the shareholder’s share of the deemed tangible income return of its CFC.
- On the other hand, FDII allows a domestic corporation a deduction of 37.5% of the excess of the corporation’s income from export sales over a fixed return on its tangible depreciable assets for the year.
Both regimes use the term “qualified business asset investment” (QBAI) to refer to this tangible depreciable asset base.
FDII thus permits deduction of a specified percentage of the excess income derived from export sales, above a fixed return on QBAI, while GILTI requires inclusion of the U.S. shareholders’ share of the excess of CFC income over the fixed return on QBAI.
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How do the IC-DISC and FDII tax incentives compare?
Many qualifying FDII transactions are the same as qualifying IC-DISC transactions. Neither regime requires that the same transaction not be used for the other.
Because mutual deduction requirements reduce the benefit of each deduction, computing the allowable deduction after the FDII or IC-DISC deduction is taken must be done formulaically.
What is IC-DISC?
The interest charge domestic international sales corporation (IC-DISC) is a separate corporate entity set up to earn a deemed commission from the U.S. operating company that receives income from export transactions. While the commission is fully deductible by the U.S. operating company, the IC-DISC pays no income tax on its commission income. These export profits may be tax-deferred until the IC-DISC income is actually distributed or deemed distributed to the IC-DISC shareholders.
If deferred, the shareholders pay interest on the amount deferred, but at the base period T-bill rate for the one-year period ending September 30. Upon distribution of export profits, IC-DISC dividends are taxable at capital gains rates for individual shareholders.
What are the important considerations to make when deciding how to apply FDII and IC-DISC deductions to maximize tax benefits?
There is no impediment to paying the maximum IC-DISC commission on a transaction and taking the maximum FDII deduction on the same transaction. However, in so doing, the IC-DISC commission would reduce the foreign-derived deduction eligible income pursuant to §250(b)(3)(A)(ii). Similarly, the IC-DISC net profits would be reduced by the FDII deduction. Consequently, the maximum deduction for each regime would be reduced, but the total deduction would increase.
Despite the increase in the total deduction, concurrently using both regimes may not have the greatest tax benefit. If the IC-DISC is owned by a corporation, the benefit only defers tax on export-related income, while the FDII benefit is a permanent reduction. Similarly, where the IC-DISC is owned by an individual, it eliminates corporate tax on the amount of the commission, while the FDII deduction still results in the corporation paying more corporate tax. In addition, the use of transaction-by-transaction computation for the IC-DISC may make it harder to readily compute FDII because FDDEI transactions are aggregated to computed FDII.
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Are there limitations on foreign tax credits for U.S. corporations?
Foreign tax credits are limited annually to the amount of U.S. tax on foreign source taxable income as computed under U.S. tax principles.
Therefore, if the U.S. person pays more tax to the source country on the foreign source income than is due to the U.S. on the same foreign source income, the U.S. will limit the amount of taxes paid to the source country that can be used as credits against U.S. tax liability.
How is the foreign tax credit limit calculated?
The foreign tax credit limitation is computed as a taxpayer’s pre-credit U.S. tax liability multiplied by a ratio (not to exceed 1), of which:
- The numerator is the taxpayer’s foreign source taxable income, and
- The denominator is the taxpayer’s worldwide taxable income for the year.
Can foreign income taxes that exceed the foreign tax credit limit be carried over to other taxable years?
Yes, foreign income taxes not credited because of the limitation can generally be carried back or forward to other taxable years, subject to the limitations for those years. However, foreign income taxes paid or accrued with respect to amounts includible in gross income under the GILTI regime may not be carried back or carried forward.
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What are the income tax implications for a 10% owner of a controlled foreign corporation?
Any U.S. shareholder who directly or indirectly owns as least 10% of a CFC is taxed on the portion of the CFC’s income that qualifies as subpart F income. Subpart F is the major component of taxable income for these shareholders, but they may also be taxed separately on CFC earnings and profits that don’t qualify as subpart F income.
What qualifies as subpart F income?
Subpart F income consists of the following:
- Foreign personal holding company income, including income generally considered to be passive – such as interest, dividends, rent, royalties, capital gains, exchange gains, and so on – with some exceptions when these items are earned in active businesses.
- Sales and services income from transactions with or on behalf of related persons when either the purchase or sale, or the service, takes place outside the country of incorporation, subject to exceptions in each case.
- Insurance incomefrom policies outside a CFC’s country of incorporation.
- Items imposed as a penalty, including:
- the amount of bribes, kickbacks, etc.
- a portion of income not otherwise treated as subpart F income if a CFC has business considered to be affected by an international boycott
- income from unrecognized countries, countries with which diplomatic relations are severed, and countries that support terrorism
Are 10% shareholders taxed on CFC earnings and profits that aren’t considered subpart F income
In addition to subpart F income, a CFC’s 10% U.S. shareholders are taxed on amounts considered to be “invested in United States property” up to the amount of the CFC’s earnings and profits that have not been taxed by subpart F, even though they are not actually subpart F income. These include:
- Property owned in the U.S.
- Stock or securities of U.S. persons (with some exceptions)
- U.S. rights to certain intangible properties such as patents, copyrights, and business intangibles
Finally, 10% U.S. shareholders must pay tax on the aggregate of the CFC’s global intangible low-taxed income, or GILTI – this also is not subpart F income.
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