The tax implications of foreign-derived intangible income
INSIGHT ARTICLE |
As part of H.R. 1, commonly known as the Tax Cuts and Jobs Act, Congress added a section that effectively establishes a new preferential tax rate by which automakers and suppliers, organized as domestic C corporations, can generate income derived from qualifying foreign sales, licensing, leasing and service activities.
Accordingly, foreign-derived intangible income (FDII) is considered in the broad application of these rules to a variety of transactions. This is generally because these rules were designed to entice U.S. multinationals to relocate foreign operations back to the United States and/or to increase new investment dollars in U.S. operations. This is good news for corporations with sizable export activities, as such businesses can pay an effective tax rate of 13.125 percent (rather than 21 percent) on income generated from foreign markets above a certain threshold.
Qualifying for a reduced tax rate
Depending on the circumstances, the underlying foreign transactions that can qualify for the reduced tax rate can be with unrelated and related parties. Thus, it is important that multinational corporations perform a detailed transaction analysis to identify areas of opportunities and quantify the related tax benefits.
The FDII tax benefit is computed using a complex, multistep process. In general, a corporation will need to determine the foreign portion of its deduction-eligible income. This portion will include any income generated from the sale of property to any foreign person for foreign use, consumption or other disposition which is not within the United States; a sale can also include leasing and licensing activities. For FDII purposes, foreign income can also include income generated from qualifying services provided to persons outside of the United States or with respect to property located outside of the country. These services can be performed within or outside of the United States.
A corporation will then need to determine its deemed intangible income. This is the excess of a corporation’s deduction eligible income over 10 percent of its qualified business asset investment (QBAI). Using a quarterly measuring convention, QBAI is the average of a corporation’s adjusted tax basis of its depreciable tangible assets used in its business. Straight-line depreciation will need to be used to compute QBAI.
Based on the foreign portion of a corporation’s deduction eligible income, a ratio will be computed and applied to the deemed intangible income to derive FDII. A corporation’s FDII is 37.5 percent deductible in determining its taxable income.
A corporation’s ability to capitalize on its foreign-derived income is a key factor in reaping the tax benefits of FDII. Accordingly, performing a detailed value-chain analysis will be an important element in identifying transactions that meet the foreign-use requirement or could meet this requirement with some viable modifications to the integrated transaction flows. While qualifying foreign transactions can be with related or unrelated parties, special rules will need to be considered.
Following are a few examples of transaction flows that will need to be considered as part of a domestic exporter’s transaction analysis:
- Property that is sold to a related party will meet the foreign use requirement as long as it can be established that the foreign-related party ultimately sells the property to an unrelated party who uses the property outside of the United States. In addition, a U.S. taxpayer could license its intellectual property (IP) to a related foreign manufacturer who uses the IP in manufacturing goods which it sells to distributors in foreign countries for ultimate use by foreign customers.
- There are also special provisions that apply to property and services sold to unrelated parties. For example, property sold to an unrelated person will not be considered to meet the foreign use requirement if such goods are subject to additional manufacturing in the United States, even if the finished products are subsequently exported for final use outside the United States.
- Although the U.S. Treasury will likely need to provide additional guidance for component part sales, it appears there may be an expanded scope of what constitutes foreign use. If a domestic corporation sells component parts to a foreign entity for further manufacturing (or processing) and the final product is ultimately sold to U.S. customers, it appears that sale to the foreign manufacturer may qualify as foreign use.
- With respect to services, a domestic corporation must provide qualifying services to persons located outside the United States, or with respect to property located outside the United States. Although additional guidance is necessary in this area, it appears clear that the services do not have to be performed outside of the United States to qualify as foreign use. For example, management fees and other fees related to operational support charged by a U.S. parent corporation to its foreign subsidiaries would appear to be qualifying transactions.
Understand the transaction flows
In general, FDII is a welcome tax preference for domestic automakers and suppliers that engage in the exporting of products and services outside of the United States. There is still much guidance that the U.S. Treasury needs to provide taxpayers in order to properly apply these rules to modern day business models.
Based on current guidance, however, it is imperative that multinational automakers and suppliers analyze their transaction flows in order to begin to formulate the best possible tax positions and to quantitatively model the potential FDII tax benefit.