Enacted by the Tax Cuts and Jobs Act, the Foreign-Derived Intangible Income (FDII) deduction under Internal Revenue Code Section 250 allows for a deduction against taxable income for domestic C corporations serving foreign markets.
The deduction is generally equal to 37.5% of foreign-derived intangible income for years beginning in 2018, effectively reducing the tax rate on qualifying foreign derived income from 21% to as low as 13.125% through 2025.
Your company may qualify if it’s a C corporation, has taxable income, and income is derived from any of the following:
- Sales of property or inventory to foreign persons and for foreign use, including 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 does contain certain limitations. Calculating and substantiating the FDII deduction is complex and requires careful planning to maximize the full benefit.
Beneficial Modifications under Final Regulations
The recently released final regulations make certain important modifications to crucial components of the law, particularly qualification for the deduction and documentation requirements. The final regulations are applicable for tax years beginning on or after January 1, 2021, but taxpayers may choose to adopt them for tax years beginning on or after January 1, 2018. For companies that may previously have not satisfied the specific documentation requirements of the proposed regulations under Section 250, the increased flexibility of final regulations creates an opportunity for such companies to file an amended return to early adopt the final regulations and apply for a refund of taxes paid from the 2018 tax year.
The primary requirements for FDII qualification—that a qualifying sale must be for foreign use and to a foreign person—remain, but the final regulations provide a broader application of the types of documentation required to substantiate the deduction.
Moreover, for sales of general property or inventory, a general presumption of foreign person status now exists under the final regulations that can be relied upon when the taxpayer maintains certain shipping documentation. Previously, companies may have encountered road blocks in obtaining written statements from customers to prove foreign person status, an administratively burdensome requirement of the proposed regulations.
An added benefit is the removal of the specific documentation requirements for foreign use of sales of general property under the final regulations, further removing barriers to taking the FDII deduction. The foreign use documentation rules for the following sales or services have been updated in an attempt to better align with documentation already maintained in the course of ordinary business:
- Sales of general property subject to manufacture, assembly, or other processing outside of the United States;
- Sales of general property for resale;
- Sales of intangibles; or
- Services performed for businesses outside of the United States.
“Reason to Know” Requirement
Under the proposed regulations, businesses are required to exclude from qualifying sales any products sold to foreign customers for which the taxpayer has reason to know that the product would ultimately return to the United States for domestic use. Under the final regulations, the reason to know presumption has been removed. Qualifying exported property sales are those that either:
- End with users outside the United States, or
- Are sold to a person that subjects the property to manufacture, assembly, or other processing outside the United States.
This is a significant change to the regulations that could re-qualify many businesses, such as those in the automotive industry. There are many other favorable changes to the final regulations for taxpayers, a few of which are highlighted below.
The proposed regulations provide for specific ordering rules for taxpayers applying the interest limitation under Section 163(j). The final regulations alternatively provide that any reasonable method may be used to order allowed deductions until further guidance is issued.
This seemingly minor distinction provides the opportunity for companies to prioritize their FDII deduction, which disallows a carryforward of benefit to a subsequent taxable year, over their interest deduction, which can be carried forward indefinitely. This is a significant planning opportunity for businesses with interest limitations and qualifying FDII activities.
Practical Examples of Favorable Taxpayer Application of the Final Regulations
Example 1 – Component test and the 20-percent rule
In cases where general property is sold and subsequently incorporated into another finished good, the final regulations convert what was a 20-percent component test under the proposed regulations into a safe harbor (the “20-percent rule”). The updated component test is based on facts and circumstances to show that the sold general property has been incorporated into another product through substantial activities rising to the nature of manufacturing, assembly, or processing.
The newly established safe harbor will serve to substantiate the sale where the fair market value of the general property sold does not exceed 20-percent of the fair market value of the finished good into which the property has been incorporated (or 20- percent of the average fair market value of the finished goods in the case where the component is incorporated into several products). In the context of component part manufacturing, like in the automotive part industry, for example, the 20-percent rule provides an easier path to qualifying FDII-eligible sales and perhaps also the benefit of an increased FDII deduction.
Example 2 – Unrelated party transaction timing in a related party sale
Another important change rendered by the final regulations touches foreign related party sales and the question of timing of a required subsequent unrelated foreign party transaction. Under both the proposed and final regulations, 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.
However, the proposed and final regulations diverge on the question of timing of the unrelated party transaction. The proposed regulations require that the unrelated party transaction occur on or before the taxpayer’s FDII filing date in order to qualify, but such a brief period proves challenging for taxpayers or even entire industries, like agriculture, where the sale life cycle could extend years into the future. Fortunately, the final regulations have eliminated the filing date rule in favor of a highly 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.
You may want to revisit the final regulations if circumstances or factors, such as the following, have previously precluded your business from receiving the FDII deduction.
- A business model with a long production cycle;
- Layered related party transactions within the sales cycle;
- Foreign customers that previously would not provide documentation as evidence of their foreign person status;
- Airline or transportation business previously unable to prove foreign use of transportation services or equipment;
- Automotive industry business whose product would be manufactured into a vehicle and ultimately returned to the United States;
- Providing digital services to foreign persons or for use in foreign locations;
- Providing advertising services to an audience in a foreign location;
- Large interest deductions that limited an FDII benefit.
We Can Help
Despite many taxpayer-friendly changes enacted by the final regulations, FDII remains a complex subject requiring in-depth, expert analysis. If you would like to discuss anything contained in this alert, or generally whether your business could qualify for the FDII deduction, please reach out to our FDII Practice Specialist: Lauren Smith at firstname.lastname@example.org.
The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information is subject to change as a result of evolving legislative developments and government guidance.