United States: FDII Deduction For Foreign-Owned US Companies- An Overlooked Opportunity?

Last Updated: November 14 2019
Article by Bryan Kelly

This article was originally published in Bloomberg Tax and discusses the current status of the Foreign-Derived Intangible Income (FDII) rules and the availability of the FDII deduction with respect to income realized by foreign-owned U.S. companies from sale of goods or rendering of services to foreign affiliates.

For foreign multinationals doing business in the U.S. through a U.S. branch or subsidiary, some portion of their U.S. profits will likely be subject to U.S. income tax. The Tax Cuts and Jobs Act of 2017, P.L. 115-97, introduced many changes relevant to such companies, including a reduction of the top federal corporate income tax rate from 35% to a flat 21%.

Also introduced was a deduction for FDII reported by domestic C corporations. Subject to the limitation described below, the deduction is equal to 37.5% of a qualifying domestic corporation's FDII for tax years beginning in 2018 and before 2026, resulting in an effective U.S. federal income tax rate of 13.125% on such income. (For taxable years beginning after 2025, the amount of the deduction is reduced to 21.875%, resulting in an effective federal rate of approximately 16.4% on FDII).

The FDII deduction is available to foreign multinationals with U.S. subsidiaries. It is not unusual for such subsidiaries to sell goods or provide services to foreign affiliates. For example, a U.S. subsidiary might provide marketing or R&D services to a foreign affiliate. Depending on their specific facts, income derived from provision of the services may qualify for the FDII deduction.

The FDII deduction has received a cool reception from taxpayers and their advisers, mainly due to uncertainty over its sustainability (i.e. risk of a successful WTO challenge) and the practicality of the documentation requirements. Subject to one exception discussed below, neither of those concerns should be a practical obstacle for inter-company transactions of foreign multinationals.

Typically, a foreign-parented multinational enterprise would not need to make changes to its company structure or operations to avail itself of the deduction; if the FDII regime is modified or repealed in the future, it has lost nothing by availing itself of the deduction. Additionally, where transactions occur between commonly controlled parties, satisfying the documentation requirements will often be manageable.

Substantive Requirements

FDII of a domestic C corporation is determined under a formula. Essentially, FDII is the income of a domestic C corporation (subject to certain exclusions and net of attributable deductions) derived from:

  • sales of property to foreign persons for foreign use; and
  • provision of services to a recipient or with respect to property located outside the U.S.

In either case, such income is reduced by a notional 10% return on the corporation's depreciable tangible property. The amount of FDII and global intangible low-taxed income may not exceed the total taxable income of the domestic corporation. The FDII deduction is 37.5% of FDII, as limited (21.875% for taxable years beginning after 2025).

For sales of property (including leases and licenses), the corporation must establish that the customer is a foreign person and that the property has been sold for foreign use. Proposed regulations issued under section 250 on March 4, 2019 (the "proposed regulations") described these requirements.

Under the proposed regulations, a customer will be considered a foreign person as long as the customer is neither an individual citizen or resident of the U.S., nor a legal entity organized under domestic laws. What constitutes "foreign use" depends on the type of property. A sale or license of intangible property (IP), such as copyrights, trademarks, patents, inventions, and formulae satisfies foreign use requirements only to the extent that the revenue it generates is deemed to arise from exploitation of the IP outside the U.S.

Planning Point: Due to the complexity of making these determinations, if feasible, it may make sense for IP transactions to be split up and governed by two separate contracts—one governing U.S. rights and one governing the rest of the world.

All other property (excluding certain property used in international transportation) satisfies the foreign use requirement if it is not used domestically within three years following its date of delivery, or it is subject to manufacture, assembly or other processing outside the U.S. before being used within the U.S.

The proposed regulations categorize services into five categories. In the context of foreign-owned U.S. companies providing services to affiliates, the category likely to be most relevant is general services provided to business recipients. The other categories are general services provided to consumers, property services (certain services provided with respect to tangible property performed substantially outside the U.S.), transportation services, and proximate services (services other than property services or transportation services if substantially all of the services are performed outside the U.S. in the presence of the recipient or its employees).

Under the proposed regulations, general services satisfy the foreign use requirement to the extent that the benefit of the services is considered to run to the recipient's business locations outside the U.S. In cases where a service benefits a recipient's business at large, or reliable information on the location of benefits is unavailable, the service provider's gross income is allocated ratably to all of the recipient's operations using a reasonable method (e.g. by reference to the recipient's revenues, or the service provider's time spent or costs incurred).

Documentation Requirements

Sales and services otherwise eligible for the FDII deduction will not qualify unless specific documentation requirements are satisfied.

Under the proposed regulations, documentation may be relied upon only if:

  • it has been obtained by the seller or service provider no later than the date by which the seller/service provider is required to file a federal income tax return reporting the income from the services;
  • it was obtained no earlier than one year before the date of the relevant sale or provision of services; and
  • as of the tax return filing date, the seller/service provider does not know or have reason to know that the documentation obtained is unreliable or incorrect.

The specific documentation requirements vary, depending on the type of property sold or service provided. For property sales, the status of the recipient as a foreign person can be established by a valid government-issued ID, documentation establishing that a legal entity is organized or created under the laws of a foreign jurisdiction (e.g. articles of organization or other constitutional documents), documents filed with a government agency (e.g. a securities regulatory agency), or a written statement that the recipient is a foreign person.

Documentation required to establish foreign use depends on the type of property sold. For example, in the case of general services provided to a business recipient, the business recipient's location may be established by a binding contract, other ordinary course of business documentation, or a written statement from the business recipient specifying the locations of the recipient's operations that benefit from the services, or from publicly available information that establishes the locations of operations of the recipient.

The proposed regulations also include substantially reduced documentation requirements for small businesses (i.e., service providers whose gross receipts for the prior taxable year are under $10 million) and for small transactions (i.e. those for which gross receipts from a particular recipient are under $5,000 for the year). Due to the low thresholds, those exceptions may not be helpful in the context of type of inter-company transactions contemplated by this article.

Related Party Rules

Sales and services to related parties may qualify for the FDII deduction if they satisfy certain additional requirements.

For purposes of these rules, parties are generally considered to be related if they are members of an affiliated group of companies connected by more than 50% ownership. These additional requirements do not apply to certain related party transactions, notably IP transfers. Where a sale of property is made to a foreign related party, the outcome depends on whether:

  • the property is resold to an unrelated party or parties (either as originally purchased or as a component of other property sold); or
  • the property is used in the process of providing property or services to unrelated parties.

Planning Point: Where property is sold to a foreign related party for resale, and the unrelated party transaction has not occurred before the relevant tax return filing date, the FDII deduction cannot be claimed on the seller's original tax return, but may be claimed subsequently on an amended return when an unrelated party transaction meeting those requirements occurs, provided that the statute of limitations remains open.

In the second case, the FDII benefit may be claimed if the seller in the related party sale reasonably expects that more than 80% of the revenue earned from the use of the property received in the related party transaction will be derived from unrelated party sales or services transactions that meet the substantive FDII requirements (but not necessarily the documentation requirements). For example, assume a U.S. subsidiary sells manufacturing equipment to a foreign affiliate and the equipment is used to produce inventory sold worldwide. The requirement is met if the foreign affiliate has a reasonable expectation that more than 80% of the revenue from that inventory will be from sales to foreign unrelated persons for foreign use.

Note that, in the case of a provision of property to a foreign affiliate that is resold (rather than used to produce other property or provide services) to foreign unrelated parties, the documentation requirements become a practical issue for foreign-parented multinational companies.

A related party services transaction may qualify for the FDII deduction if the services rendered are not considered to be "substantially similar" to services provided by the related party service recipient to a person or persons located in the U.S. Under the proposed regulations, the services provided by the related party service recipient are considered to be substantially similar services if:

(i) 60% or more of the benefits conferred by the related party service ultimately accrue to persons located in the U.S.; or

(ii) 60% or more of the price paid by the persons located in the U.S. is attributable to the related party service.

For purposes of these tests, a service is generally considered to provide a benefit if it directly results in a reasonably identifiable increment of economic or commercial value that enhances the service recipient's commercial position, or may be reasonably anticipated to do so. Under a proportional savings rule, if a related party service is deemed to be substantially similar to an unrelated party service rendered to persons located in the U.S. only under the test in (ii) above, the portion of the related party service not attributable to the services provided by the related party service recipient may still qualify as for the FDII deduction.

The proposed regulations provide examples illustrating the application of these tests. The examples posit a foreign corporation that has entered into a contract to provide design consulting services to a restaurant company, and has subcontracted a portion of that work to its U.S affiliate. The examples indicate repeatedly that the services rendered by the U.S. subsidiary will serve no purpose other than to enable the foreign parent to provide its services under the contract.

One inference reasonably drawn from the examples is that related party services generally will not be considered substantially similar to unrelated party services unless there is some direct connection between them. Without such a direct connection, it would be difficult to apply either of the 60% attribution tests in any meaningful way. In some cases, there will not be a direct connection between services provided by a U.S. subsidiary to a foreign affiliate and other unrelated party services provided by the foreign affiliate (e.g. R&D services).

Opportunity for Foreign Multinationals

Transactions undertaken between U.S. subsidiaries of foreign multinationals and their foreign affiliates may generate U.S. taxable income that satisfies the requirements for the FDII deduction.

The documentation requirements set out in the proposed regulations are a significant hurdle to claiming the deduction. These requirements could be prohibitive in the context of an unrelated party transaction. The requirements put U.S. companies in a position of having to request information and certifications not previously required from foreign customers, and which customers may not always be willing or able to provide. Moreover, in some cases, the use of property sold will need to be tracked over a period of years—e.g., to make a determination as to whether it has become subject to domestic use within three years of its initial sale. Some customers may not currently track this information.

The concerns described above are not completely eliminated in the case of transactions between commonly controlled parties, but are often greatly diminished. In particular, the documentation requirements may be manageable in the context of related party transactions if the relevant personnel are properly trained and the required documentation is built into protocols (subject to the caveat that, for sales of property to a foreign affiliate that are resold to unrelated buyers, the proposed regulations require the foreign affiliate to comply with the documentation rules in connection with those resales). It is also possible that the documentation requirements laid out in the proposed regulations will be liberalized in the final regulations.

Withers partner Bryan Kelly co-authored the piece with William Norman of Ord & Norman Attorneys at Law.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions