What is FDII?
The FDII deduction was introduced by the 2017 Tax Cuts and Jobs Act (TCJA). For taxable years beginning after December 31, 2017, a U.S. corporation may claim an FDII deduction that generally is determined by its net foreign-derived income relative to its total net income and its deemed intangible income, which generally is the excess of its total net income over a routine 10% rate of return on the adjusted tax basis of its total fixed assets.
Under this broad definition of FDII, a corporation’s foreign-derived income may include sales of intangible or tangible products (whether manufactured or purchased for resale by the corporation) to a foreign person for use outside the U.S., as well as income derived from a broad range of services.
Certain income, however, is categorically excluded from qualifying as FDII:
– Amounts included in gross income under §951(a)(1) (subpart F and investments in U.S. property)
– Global intangible low-taxed income included in gross income
– Financial services income
– Any dividend received from a controlled foreign corporation with respect to which the corporation is a U.S. shareholder
– Any domestic oil and gas extraction income
– Any foreign branch income
Subscriber-Only Resource: Export Tax Incentives Portfolio
Read Section III of Portfolio 6360-1st: Export Tax Incentives to learn more about the deduction for domestic corporations that earn foreign-derived intangible income (FDII).
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 to increase their investments in the U.S.
The intent appears to have been to favor structures where a USMNC prioritizes its high-return, foreign income-producing assets and operations in the U.S. over placing those assets and operations in overseas subsidiaries.
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 include in their income (in a manner similar to the inclusion of subpart F income) the excess of the CFCs’ “tested income” over the shareholder’s share of the deemed tangible income return of its CFCs
- On the other hand, FDII allows domestic corporations a deduction of 37.5% of the excess of each 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” 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.
Download our complimentary roadmap for an overview of the 2019 and 2020 final regulations relating to foreign tax credit.
What tax considerations surround the FDII and IC-DISC regimes?
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 actually 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 deferred from tax 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.
Many qualifying FDII transactions are the same as qualifying IC-DISC transactions. Neither regime requires that the same transaction not be used for one or the other. Therefore, 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 be increased.
Because mutual deduction requirements reduce the benefit of each deduction, a formula must be employed to compute the allowable deduction after the FDII or IC-DISC deduction is taken into account.
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.
Subscriber-Only Resource: Section 250 Deduction for FDII and GILTI Regulations
This OnPoint presentation highlights key takeaways from regulations finalized in July 2020. The final regulations generally apply to tax years beginning on or after January 1, 2021.
What are the 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. Thus, 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. The foreign tax credit limitation is computed as a taxpayer’s pre-credit U.S. tax liability multiplied by a ratio (not to exceed one), the numerator of which is the taxpayer’s foreign source taxable income and the denominator of which is the taxpayer’s worldwide taxable income for the year.
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.
Download: Section 250 Final Regulations Roadmap
This comprehensive report will guide your organization and clients in 250 deductions and related definitions for taxable years beginning January 1, 2021.
What are the tax implications for a 10% owner of a controlled foreign corporation?
A CFC’s “subpart F income” is the major component of a CFC’s income that is taxed currently to any U.S. shareholder who owns directly, or indirectly, at least 10% of the CFC. 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 services, take(s) place outside the country of incorporation, subject to exceptions in each case
- Insurance income from policies outside a CFC’s country of incorporation
- Items imposed as a penalty, including the amount of bribes, kickbacks, and so forth; a portion of income not otherwise treated as subpart F income if a CFC has business considered to be affected by an international boycott; and income from unrecognized countries, countries with which diplomatic relations are severed, and countries that support terrorism
In addition, a CFC’s 10% U.S. shareholders are taxed on amounts considered to be “invested in United States property,” such as property owned in the U.S., stock or securities of U.S. persons (with some exceptions), and U.S. rights to certain intangible properties such as patents, copyrights, and business intangibles, 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.
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.
Download: 2021 Federal Tax Guide
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