Updated 5.11.2020 with information from the CARES Act
Enacted by the Tax Cuts and Jobs Act, the Foreign-Derived Intangible Income (FDII) deduction established preferential tax treatment for domestic C corporations serving foreign markets. The deduction is equal to 37.5% of the C corporation’s foreign-derived intangible income for years beginning in 2018. This means the FDII deduction could prove helpful today for companies that did not claim the FDII deduction in 2018 and that are now seeking additional cash. Claiming the deduction through a 2018 tax year amended filing with the IRS could mean a cash refund during these uncertain times.
Companies with eligible income can take advantage of this incentive by claiming a permanent deduction against taxable income; thus, lowering the cost to enter foreign markets. The deduction effectively reduces the tax rate on qualifying foreign-derived income from 21% to as low as 13.125% through 2025. Companies large and small, public and private may take advantage of the deduction. In many cases, the tax savings are substantial.
Your C corporation may qualify if you have income from any of the following:
- Sales of property to foreign persons that result in foreign use. Sales include any lease, license, exchange, or other disposition.
- Services provided to any person not located within the U.S. or any services provided with respect to property not located within the U.S.
The FDII deduction amount cannot exceed the company’s taxable income. Also, the FDII deduction is limited by the company’s Qualified Business Asset Investment (QBAI), which is defined as the net tax basis in the company’s fixed assets depreciated using the Alternative Depreciation System (ADS). The organization’s foreign net income, total taxable income, and amount of fixed assets can drive a significant FDII benefit.
As with many provisions under the Tax Cuts and Jobs Act, calculating the FDII deduction is complex and requires careful planning to obtain the full benefit. It also requires detailed documentation to substantiate any FDII deductions and ensure compliance with IRS regulations.
Update for the CARES Act
The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) was enacted on March 27, 2020 and includes a number of provisions that may impact FDII calculations past, present, and future.
The first such provision is the change to net operating loss (NOL) carryback rules, allowing a five-year carryback of losses for 2018 through 2020 tax years. While this provision appears favorable at first glance, it does carry the potential for a negative impact upon taxpayers’ FDII deduction calculations. For instance, the carryback of 2019 or 2020 NOLs to a 2018 amended return filing would reduce taxable income and, in turn, reduce the FDII deduction due to the taxable income limitation mentioned above. Relatedly, if NOLs carried back to 2018 reduce taxable income all the way to zero, then the FDII deduction is limited to zero. As a result, under certain facts, the carryback of NOLs allowed under the CARES Act may not serve the intended cash refund purpose a taxpayer may be seeking.
Another provision under the CARES Act that is meant to assist companies with their cash needs is the increase of the net business interest deduction limitation (“163(j) limitation”) to 50 percent of adjusted taxable income from 30 percent for tax years 2019 and 2020. The effects of this provision upon the FDII deduction could also prove negative. Just like NOLs, the FDII deduction statute requires a taxpayer to apply the 163(j) deduction before calculating its taxable income limitation, if any. Therefore an increase in the 163(j) limitation for 2019 and 2020 will translate to lower taxable income amounts and, in some cases, create an FDII deduction limitation for these tax years.
Finally, the CARES Act corrected a technical error in the Tax Cuts and Jobs Act for bonus depreciation of qualified improvement property (QIP). Such property, acquired and placed into service after September 27, 2017 and before January 1, 2023, is now eligible for 100 percent bonus depreciation. This correction in the CARES Act also allows certain taxpayers to amend returns and claim refunds or, where appropriate, file a Form 3115, Application for Change in Accounting Method, and claim the depreciation in the 2020 tax year. Therefore, the QIP change is a taxpayer-friendly benefit. However, in the FDII deduction context, additional depreciation could create a taxable income limitation for taxpayers seeking cash refunds by amending 2018 returns to benefit from unclaimed FDII deductions. Accordingly, the option to file an amended return versus a Form 3115 method change could have dramatic effects on the ability to claim the FDII deduction in prior, present, or future years.
The interplay between the FDII statutory provisions and the CARES Act provisions require a complex, detailed analysis to determine the best approach with the highest cash benefit under a company’s specific fact pattern.
Elliott Davis has prepared a downloadable PDF detailing information on the Foreign-Derived Intangible Income deduction and how we can assist with more information.