The new deduction for foreign-derived intangible income (FDII) enacted by the Tax Cuts and Jobs Act (TCJA) provides an important opportunity for global manufacturers and distributors selling products or providing services to foreign markets to claim tax savings, which in many cases are substantial.
Under the new rules, domestic entities taxed in the United States as C corporations may claim the FDII deduction for years beginning in 2018, creating a permanent increase in cash flow. The FDII deduction also lowers the effective tax rate for qualifying companies from the 21 percent corporate tax rate to as low as 13.125 percent on eligible income.
Manufacturers and distributors that export or provide services to foreign markets should consider whether their company could qualify. The deduction involves a multi-step process to identify the corporation’s foreign deduction eligible income (foreign gross income less foreign direct and indirect cost of goods sold and foreign SG&A expenses). Both sales to foreign persons for foreign use and services benefiting foreign markets can qualify.
For manufacturers and distributors, it’s particularly important to note that the product doesn’t have to be manufactured in the United States to qualify. Additionally, sales to foreign related parties can be eligible with some restrictions, and drop-shipment arrangements may also qualify.
Here are some examples of the types of companies that may benefit from the FDII deduction:
- a manufacturer of nonwoven materials that sells finished goods to unrelated foreign persons located in Europe;
- a distributor that purchases textiles from a related party in China and subsequently sells the goods to a related party in Canada via drop-shipments direct from China to Canada, then the related party sells the textiles to unrelated foreign persons in Canada;
- a software developer that licenses products to unrelated foreign persons internationally;
- an engineering firm that prepares designs for equipment installations for unrelated foreign persons in Mexico; and
- a chemical distributor that sells to unrelated foreign manufacturers in Canada which use the chemicals for further manufacturing of paper products that are subsequently sold globally, including some sales back to the United States.
Keep in mind that 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 TCJA, calculating the foreign-derived intangible income 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.
For additional information regarding the proposed FDII regulations, reference https://www.elliottdavis.com/an-overview-of-the-proposed-regs-on-the-fdii-and-gilti-deduction/.