Lower FDII Tax Rate Lures Foreign IP and Services Back to U.S.
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Fiddy. Foe-dee. Eff-Dee-Eye-Eye.
Whichever way you pronounce it, the new Foreign Derived Intangible Income (“FDII”) provision of President Donald Trump’s tax reform law means a significant reduction in taxes on exports by certain U.S.-based companies.
Lawmakers intended the new rule to incentivize companies that don’t have large amounts of fixed assets (e.g., technology or professional services firms) to develop or move more intellectual property to the U.S., according to the Tax Foundation, an independent tax policy nonprofit.
FDII rewards domestic companies taxed as C-corporations and U.S.-domiciled C-corporation subsidiaries of foreign multinational businesses with an effective tax rate of 13.125 percent on a certain portion of income derived from abroad on the sale of goods, services, property and royalties from licenses, patents and trademarks.
For example, a pharmaceutical company based in the U.S. that develops and patents a new drug could sell it abroad and pay a tax rate of 13.125 percent, which is much lower than the new headline corporate tax rate of 21 percent.
FDII was meant to help companies of all sizes, even if they only get a small percentage of income from exports. In the past, the export tax incentive, called Interest-Charge Domestic International Sales Corporation (IC-DISC), wasn’t very beneficial unless the company was large.
In May, a company that makes motors and pumps for water and fuel systems called Franklin Electric Co., estimated it would have a $3.1 million benefit from FDII, an amount that may be offset by larger tax obligations from other portions of the new tax laws. By comparison, the Fort Wayne, Indiana-based company’s total revenue last year was $1.1 billion.
“Companies are trying to figure out the net benefit of all these new parts of the tax code, and the calculations are incredibly complicated,” said Dr. Erin Towery, an assistant professor in the J.M. Tull School of Accounting at the Terry College of Business at the University of Georgia.
In addition to teaching, she does research on how the Internal Revenue Service handles changes such as the tax reform law, and how companies disclose tax issues in regulatory filings and public disclosures.
Carrot and Stick
Lawmakers wanted FDII to be the “carrot” that prompts greater investment in U.S. operations relative to foreign operations because it eliminates the incentive to locate intangible assets in their low-tax foreign subsidiaries when they sell to foreign markets.
There’s a companion “stick” provision called Global Intangible Low-Taxed Income (GILTI), which imposes a minimum effective rate of 10.5 percent on similar nonroutine portions of income and allowing a foreign tax credit for only 80 percent of the foreign taxes that were paid to the foreign jurisdiction.
GILTI was meant to essentially penalize U.S. corporations that earn income through offshore entities that had avoided U.S. taxes in the past. Funny aside: the GILTI tax has been misspelled as “guilty” in more than a dozen corporate conference calls transcribed for Standard & Poor’s since the end of 2017, Richard Rubin and Theo Francis wrote in The Wall Street Journal.
Together, FDII and GILTI are intended to keep more corporate profits and intellectual property anchored in the U.S. There is also a new Base Erosion & Anti-Abuse Tax (BEAT) that acts as a limited scope minimum alternative tax.
Domestic investment advisors may also qualify for the FDII deduction where they provide investment management services to foreign investment funds that are not considered related persons, according to the National Law Review.
Companies taxed as S-corporations, regulated investment companies, real estate investment trusts, partnerships, individuals and foreign companies aren’t eligible for the FDII benefit (although their U.S.-based subsidiaries are).
How It’s Calculated
The formula is simple, but calculating it is a multi-step process that should be led by a CPA who specializes in international tax accounting and is well-versed in the complexity and nuance of Trump’s Tax Cuts and Jobs Act.
First, one must calculate deduction eligible income by taking a domestic corporation’s gross income and then backing out certain items such as income earned in foreign offices or dividends from controlled foreign corporations.
Then the foreign portion of income must be calculated. That includes income from property sales to foreign entities or for foreign use such as leases, licenses or dispositions; and also services provided to any person outside of the U.S.
Gross foreign sales and services income gets reduced by expenses allocated to that income, which results in foreign-derived deduction eligible income.
Then deemed intangible income must be calculated. That is an excess (if applicable) of the corporation’s deduction eligible income beyond 10 percent of its qualified business asset investment (QBAI), which takes into account depreciable tangible property and excludes land, intangible property and assets that don’t create deductible eligible income. If deemed intangible income is zero or less, there isn’t a benefit.
For example, if a company had total U.S. income of $10,000 and its export share of income was $1,000, its QBAI would be the remaining $9,000 and 10 percent of QBAI would be $900.
To calculate FDII, take the $1,000 in foreign derived income, minus $900 (which was 10% of QBAI) to get $100 in FDII.
Subtract a 37.5 percent deduction, which results in taxable FDII of $62.50. When the new corporate tax rate of 21 percent is applied to that amount, the FDII tax liability is $13.125. That shows the effective 13.125 percent beneficial rate on FDII under the new law.
Here’s an illustration by the Tax Foundation.
After 2025, the FDII deduction drops to 21.875 percent (from 37.5 percent currently), which will raise the effective FDII tax rate to 16.4 percent (from 13.125 percent currently).
Some observers have been concerned that FDII, GILTI and other provisions of Trump’s tax reform could be viewed as backdoor export subsidies that are barred by the World Trade Organization (WTO), according to the Tax Policy Center.
In March, the European Union asked the Organisation for Economic Co-operation and Development (OECD) to conduct a “fast track” review of the tax changes in the U.S. Some European leaders were debating whether to take retaliatory measures through the WTO, Bloomberg BNA reported.
Others have speculated that individual countries may take retaliatory actions to compete for investments by U.S.-based companies by passing their own individual tax laws that might have lower corporate tax rates or other incentives, according to a March presentation at the Georgetown Tax Law and Public Finance Workshop by Eric Solomon, a former Assistant Secretary focusing on Tax Policy at the Treasury Department from 2006 to 2009.
That could strip low taxers such as Luxembourg and Ireland of their historical attractiveness, The Wall Street Journal’s editorial board wrote in February. Or it could incentivize certain countries to set limits on low national rates.
“A lot is going to depend on how these other countries react to these U.S. changes,” said Towery, the professor at the University of Georgia. “And on top of this the U.S. is talking about tariffs, and China wants to do its own tariffs on U.S. goods. It’s difficult to tell which provisions do what because there is so much happening at the same time.”
France is still lobbying for a “digital tax” on revenue earned in the EU that would hit internet giants like Google, Apple, Facebook and Amazon, even after other members of the EU criticized such plans as potentially harmful to the economy, The Financial Times has reported.
So What Happens Now?
Government officials acknowledge that questions abound on the details and nuance of the new FDII provisions of the Tax Cuts and Jobs Act.
Doug Poms, international tax counsel with the U.S. Treasury Department, noted at an April tax conference that “there are a number of issues here” that are unclear and that “we intend to address them,” according to a report in The Wall Street Journal.
In the meantime, C-corporations with exports should talk with an accountant or tax advisor and do some work in advance to determine whether they can take advantage of FDII.
Companies must be able to isolate sales for exports and expenses for exports that qualify for FDII, GILTI and other provisions. They may need to change financial reporting systems or financial statement line items to capture and break out the necessary information.
There are also wild cards such as the outcome of the midterm U.S. elections this fall, and whether Democrats gain control of the Senate or the House of Representatives, which could theoretically lead to revisions or new legislation.
“If these provisions stick, companies might need to think about restructuring parts of their business, their intellectual property, their supply chains, whether to ask other countries for incentives to keep their IP there,” Towery said. “They’re asking themselves ‘What should our global footprint look like?’”
The new FDII provision of Trump’s tax reform law is intended to keep more intellectual property based in the U.S.
The FDII benefit results in an effective tax rate of 13.125 percent on qualifying exports such as royalties from patents or licenses for U.S. companies taxed as C-corporations, compared with a 21 percent headline corporate tax rate.
Financial reporting systems may need to be adjusted to capture the necessary data to take advantage of FDII, and companies are awaiting guidelines from the Treasury Department on how to interpret some parts of the new tax reform law.