On March 4, 2019, the IRS released highly anticipated proposed regulations regarding the foreign-derived intangible income (FDII) deduction that was introduced as part of the 2017 Tax Cuts and Jobs Act. The FDII rules are intended to incentivize U.S. businesses to operate domestically by allowing for a reduced effective tax rate of 13.125% on certain foreign-derived income (increased to 16.41% after 2026). As explored in more detail below, the newly issued Treasury guidance provides clarity regarding how taxpayers can best position themselves to benefit from the FDII deduction.
Eligible Taxpayers and Transactions
To qualify for the FDII deduction, the taxpayer must be either (a) a U.S. C-corporation or (b) a U.S. individual who elects to be taxed as a C-corporation under Section 962. Qualifying entities and individuals are also eligible for the deduction with respect to their allocable shares of qualifying foreign-derived revenue that flows up via interests in partnerships. Related party sales and services provided to foreign affiliates may also qualify for the deduction in certain scenarios; however, income earned by foreign branches is will not.
Qualifying Foreign-Derived Income
Services income is generally eligible for the FDII deduction if a qualifying taxpayer establishes that the service is provided to persons who are located outside of the United States or with regard to property that is not located within the United States.
Sales income must be generated from sales made to foreign persons for a foreign use in order to be eligible for the FDII deduction. Sales are defined broadly to include leases, licenses, exchanges, or other dispositions. In general, income derived from the foreign exploitation of intangible property, as broken out by the location of the ultimate end users, should qualify for the FDII deduction.
FDII Deduction Mechanics
The FDII deduction involves a multistep calculation that excludes foreign revenue attributable to financial services income, subpart F inclusions, foreign branch income, global intangible low taxed income (GILTI), dividends from foreign subsidiaries, and domestic oil and gas extraction income. The income eligible for the deduction is reduced by the U.S. taxpayer's net-deemed tangible income return (which is assumed to be 10% of the adjusted tax basis of the taxpayer's tangible business assets).
The proposed regulations provide specific documentation requirements for establishing whether foreign sales and services income qualifies for the FDII deduction, including certain mandatory information collection and timing provisions.
How Venable Can Help
For U.S.-based businesses with current or anticipated foreign-source income, Venable's international tax team can help explore structuring alternatives that take advantage of the highly nuanced FDII regime.