The foreign-derived intangible income (FDII) deduction provides a planning tool for U.S. C corporations that export goods to, or perform services for, foreign persons. In a 2018 Tax Insider, I wrote about FDII providing tax rates as low as 13.125% to qualifying taxpayers and how the benefit itself is calculated. Since that time, various issues and strategies have evolved around FDII where, despite proposed and final regulations, there has been very little primary or interpretive guidance. The purpose of this article is to outline some of those issues and some practical strategies to better take advantage of the FDII regime.
Services for related or unrelated parties
Many taxpayers performing services for unrelated or related parties have not taken advantage of benefits available to them under FDII, which was enacted as part of the law known as the Tax Cuts and Jobs Act, P.L. 115-97. This occurs primarily at small to medium-size U.S. C corporations that have not traditionally been exporters or have customers/clients, related or unrelated, outside the United States. The basic rule is that services performed in the United States qualify for FDII benefits if the U.S.-provided service benefits the recipient’s non-U.S. operations.
Some businesses that may be missing FDII benefits include advertising agencies working on foreign advertising programs, freight forwarders shipping U.S. goods or importing on behalf of a foreign person, or software customization performed in the United States for a foreign end user. These rules can be complex, especially when related parties are involved, but they also greatly widen the scope of FDII benefits available to U.S. service providers, which many of them are missing.
C corporation limitation planning
The Sec. 250 FDII deduction was legislatively enacted as a counter to the global low-taxed intangible income (GILTI) regime of Sec. 951A. The problem is that this legislative offset works as far as C corporations go, but FDII remains unavailable to any other U.S. taxpayers, including individuals, partnerships, and S corporations, which remain very much subject to GILTI. There was certainly hope in many quarters that FDII would be expanded to match the GILTI application to non–C corporations, but this has not occurred, and even a Sec. 962 election to be taxed as a domestic corporation does not help because a shareholder making the election is not treated as a domestic corporation for purposes of Sec. 250.
However, C corporation partners can take advantage of special FDII rules. A partnership, domestic or foreign, determines whether it entered into FDII transactions during the tax year at the entity level, while domestic C corporation partners may claim FDII benefits based on their distributable share of the partnership’s FDII items. While limited in scope, it does permit U.S. partnerships with C corporation partners to provide FDII benefits.
Offshore intellectual property planning
FDII was intended, along with GILTI, to provide an incentive for U.S.-based multinational taxpayers to relocate intellectual property (IP) ownership to the United States. Likewise, in connection with U.S. research-and-development tax incentives, taxpayers would capture tax benefits by developing and owning IP in the United States. It does not appear that many U.S. companies have abandoned their foreign IP tax and ownership structures in favor of FDII. However, it is important to point out that much of this may have to do with the long-term uncertainty over FDII’s remaining viable law, as discussed below, rather than with FDII’s not working as designed.
Clearly, FDII does provide benefits for U.S.-based multinational C corporations that own and manage their IP in the United States and have not taken actions to move this IP offshore. In that case, FDII is a bit of a windfall that significantly reduces their U.S. tax rate on the income from foreign sources generated by this IP, plus research-and-development benefits continue to accrue. Thus, at the same time that companies with offshore IP structures have held off moving this IP back to the United States, companies with U.S.-based IP structures have little incentive to move their IP offshore as long as FDII benefits continue to accrue.
Foreign branch planning
Under the FDII rules, income from foreign branches does not qualify for benefits, but transactions performed by a foreign branch’s U.S. owner in the United States that relate to foreign branches do qualify. The FDII rules define “foreign branch” by cross-reference to the foreign tax credit definition in Regs. Sec. 1.904-4(f)(2). However, Regs. Sec. 1.904-4(f)(2)(ii) tells us that foreign branch income, so defined, does not include activities that take place in the United States that can create FDII. For example, a U.S. person owning/operating a foreign branch and selling goods or performing services for the foreign branch can claim FDII benefits for the U.S.-based activities even though the activities performed by the foreign branch do not qualify for FDII benefits. Proactive taxpayers are closely scrutinizing exactly what income from a related-party sale or service is attributable to the foreign branch (not FDII qualifying) as opposed to its U.S. owner (FDII qualifying).
Another related issue affecting FDII and foreign branch income is that income from disregarded transactions is taken into account when determining a foreign branch’s income. This means that if a foreign branch makes a disregarded payment to its foreign branch owner, income will be reattributed from the foreign branch’s separate limitation category to the foreign branch owner’s separate general limitation category. This happens to the extent that the payment would have been allocable under the applicable Sec. 861 rules, possibly qualifying it for FDII treatment. Of course, the opposite is true as well, meaning that accurate recordkeeping of foreign branch transactions, regarded or not, could be the key to expanding FDII benefits or reducing risk both to FDII and foreign tax credit treatment.
Destination testing and further manufacturing/components parts testing
FDII-qualifying export property sales include sales to a foreign person where that foreign person subjects the property to further manufacture, assembly, or other processing outside the United States. This rule qualifies sales of component parts to foreign persons who, after further manufacturing or processing, will ultimately import the property to the United States for use within the United States. This rule has particular application in the automotive industry where U.S.-based parts suppliers routinely export products that are incorporated into completed vehicles that are, in turn, imported into the United States for sale in the U.S. market.
Taxpayers who take advantage of this must be aware that although the regulations apply a test similar to the Subpart F substantial-transformation test, the regulation’s preamble states that FDII’s component parts test is different. With the exception of the 20% safe harbor in Regs. Sec. 1.250(b)-4(d)(1)(iii), it is very difficult to see any material difference with the Subpart F test. As a result, taxpayers claiming benefits should keep in mind the Subpart F authority in this area despite the regulations’ preamble language.
In the final regulations, the IRS determined that additional study is needed to determine the appropriate methodology for coordinating Secs. 250(a)(2), 163(j), 172, and others. By reserving final rules coordinating Sec. 250(a)(2) with other provisions with limitations calculated based on taxable income, the IRS allows taxpayers to select any reasonable method if the method is consistently applied for all tax years beginning on or after Jan. 1, 2021, until further guidance is issued.
This seemingly minor distinction provides the opportunity for companies to prioritize their FDII deduction, which disallows a carryforward of FDII benefits to a subsequent tax year, over, for example, their interest deduction, which can be carried forward indefinitely. This is a significant planning opportunity for businesses with interest limitations and qualifying FDII activities. It also allows a hedge if FDII is eliminated, as discussed below, by claiming immediate FDII benefits and extending non-FDII deductions with carryforward options.
Timing of a related-party sale
Property transferred in a foreign related-party sale must be sold or used in a subsequent unrelated-party transaction in order to meet the FDII requirements and qualify as an FDII deduction–eligible sale. Fortunately, the final regulations adopt a taxpayer-friendly approach where the unrelated-foreign-party transaction may occur at any time after the related-party sale so long as the related party makes the unrelated-party sale in the ordinary course of its business. This is a big deal for sellers of inventory that will ultimately be sold to foreign persons. This acceleration of benefits may also be quite helpful if FDII benefits are eliminated as discussed below.
The future risks of FDII
The primary risk to many FDII transactions is a contemporaneous documentation deficiency. Many taxpayers will properly claim FDII benefits but fail to adequately document either the qualification or the foreign use/destination requirements at the time of the transaction. Although these documentation exercises can add cost or administrative burden to claiming the benefits, they are essential when one takes into consideration that an IRS audit will likely take place years in the future when memories fade or proper documentation is simply unavailable. Thus, the failure to properly answer a future IRS documentation inquiry with proper documentation is both fatal and avoidable.
Another very significant risk is that, traditionally, U.S. export-related tax benefits like FDII have suffered due to foreign claims that they represent illegal trade subsidies. This opposition led to the demise of both the foreign sales corporation (FSC) and extraterritorial income exclusion (ETI) regimes. Like FSC and ETI, the FDII regime provides U.S. domestic corporations a tax incentive in the form of a lower tax rate on income derived from tangible and intangible goods and services provided to markets outside of the United States.
In the case of FDII, there is some foreign opposition (e.g., Germany is analyzing whether FDII is a preferential tax regime under its rules) but nothing similar to the aggressive opposition against FSC and ETI by world trade authorities. However, the Biden administration may in fact pose the biggest danger to FDII by seeking to eliminate it as part of a general corporate tax increase (see “President’s Budget Contains Many Tax Proposals”). Whether FDII benefits survive or not, it is important to act quickly to capture these benefits currently or via properly amended returns.
— Frank J. Vari, CPA, J.D., M.Tax., is the practice leader of FJV Tax Consulting, a CPA firm specializing in complex international and U.S. tax planning. FJV Tax Consulting has offices in Wellesley, Mass., and Boston. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld, a senior editor with the Association’s Magazines & Newsletters team, at David.Strausfeld@aicpa-cima.com.