Tax incentives for selling to foreign customers: Foreign-Derived Intangible Income Deduction

The 2017 Tax Cuts and Jobs Act (TCJA) brought significant changes to the U.S. tax code, including the introduction of a new deduction called the Foreign-Derived Intangible Income (FDII) deduction. The aim of this deduction is to incentivize U.S. C corporations to promote exports and service foreign markets. In this article, we will discuss what FDII is, who benefits from it, and provide examples to help you better understand the concept.

What is FDII?

FDII stands for Foreign-Derived Intangible Income. It is a new deduction introduced by the TCJA that allows domestic C corporations to lower the effective tax rate on income generated from international sales from 21% to 13.125%. In layman’s terms, the FDII deduction attempts to provide a deduction equal to 37.5% of qualifying income, less 10% of net fixed assets.

This deduction applies to C corporations that generate income from export sales or services. It is meant to promote exports and service foreign markets by providing a deduction on profits generated from international sales.

Who Benefits from FDII?

The FDII deduction generally applies to C corporations that generate income from export sales or services. The corporation's foreign-derived income can include income from sales of tangible or intangible products (whether produced or bought for resale by the corporation) to a foreign person for use outside the U.S. Sales include any lease, license, exchange, or other disposition. Furthermore, any services provided to individuals or entities outside of the U.S. or any services related to property located outside of the U.S. can qualify.  Additionally, sales and services to foreign related parties can qualify for the deduction.

Examples of FDII Eligible Income

Sale of tangible goods: A U.S.-based automobile manufacturer (Corp A) produces cars and sells them both domestically and internationally. Corp A exports a portion of its cars to countries outside the United States, including Canada and Mexico. The cars sold to these foreign countries are considered foreign-derived sales and are eligible for the FDII deduction.

Licensing intangible products: A U.S.-based software company (Corp A) develops and licenses software products to customers both domestically and internationally. Corp A licenses its software to a customer located outside the United States (Customer B), who uses the software to provide financial services to clients in multiple countries.

Engineering services: A U.S.-based engineering firm (Corp A) provides engineering consulting services to a client located outside the United States (Client B). Corp A's engineers are based in the United States, but they provide their services remotely to Client B, who is located outside the United States. The consulting services are related to the design and construction of a new manufacturing facility outside of the U.S. for Client B.

FDII Deduction Calculation

 FDII = FDDEI / DEI * (DEI - 10% of QBAI)

DEI: Deduction Eligible Income

QBAI: Qualified Business Asset Investment

FDDEI: Foreign-Derived Deduction Eligible Income

The deemed intangible income (DEI) is calculated as the excess of a corporation's gross income over the sum of its deductions properly allocable to such income. The qualified business asset investment (QBAI) is the average of a corporation's quarterly adjusted basis of its qualified property, which generally includes depreciable tangible property used in its trade or business. The foreign-derived deduction eligible income (FDDEI) is the portion of a corporation's income that is derived from sales to foreign customers or from services provided to foreign customers.

Here are some simplified examples to help illustrate how the FDII deduction is calculated:

Example #1: A U.S.-based manufacturer of TVs and remotes reported the following numbers for its most recent tax year. The DEI (Deduction Eligible Income) is $10,000,000. The FDDEI (Foreign Derived Deduction Eligible Income) is $4,500,000. The QBAI (Qualified Business Asset Investment) is $20,000,000.

Calculation:

FDII = $4,500,000 / $10,000,000 * ($10,000,000 - (10% * $20,000,000))

FDII = 0.45 * $8,000,000

FDII = $3,600,000

FDII Deduction = $3,600,000 * 37.5% = $1,350,000

Permanent cash tax savings = $1,350,000 * 21% = $283,500

Example #2: A U.S. based software company sells Software and Cloud-Services worldwide. Their total deduction eligible income is $15,000,000. $6,000,000 of its income is coming from sales to foreign countries. The qualified Business Asset Investment is $10,000,000.

Calculation:

FDII = $6,000,000 / $15,000,000 * ($15,000,000 - (10% * $10,000,000)

FDII = 0.4 * $14,000,000

FDII= $5,600,000

FDII Deduction= $5,600,000 * 37.5%= $1,800,000

Permanent cash tax savings = $1,800,000 * 21% = $378,000

Example #3: Here's an example of how FDII might work for related parties:

Let's say that Company A is a U.S.-based company that manufactures phones. Company A has a subsidiary, Company B, which is located in a foreign country. Company A sells phones to Company B, which then sells those phones to customers in the foreign country. The profits from those sales are taxed in the foreign country.

Under FDII, Company A can claim a tax deduction for the income it earns from selling phones to Company B, as long as the income is derived from the sale of goods or services to foreign customers. However, the deduction is reduced by the portion of the income that is allocable to Company B.

In other words, if Company A earns $1,000,000 from selling phones to Company B, and $800,000 of that income is derived from sales to foreign customers, then Company A can claim a tax deduction for $800,000. The remaining $200,000, which is allocable to Company B, is not eligible for the FDII deduction.

Let our team of experienced professionals help you analyze the potential tax benefits.  Call us to schedule a consultation and determine whether your company may be eligible for substantial tax savings.

For additional information concerning this alert, please contact:

Melody C. Horton or Maurice Niklos at (864) 502-8311.

The information contained herein is of a general nature and should not be construed as professional advice. The reader should also be cautioned that the alert may not be specific to the reader’s exact circumstances and needs and may require additional information.  You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.