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Tax Reform’s Great Overlooked Opportunity—Is Your Company Missing Out?

POSTED 11/20/2018

For certain multinationals, a 13.125% tax rate on some export income is a hidden gem called FDII

The Tax Cuts and Jobs Act of 2017 (TCJA) has left companies, advisors and commentators wrestling with the implications of a completely new tax environment. Complicating matters is a host of new international provisions with ominous terms such as BEAT and GILTI. Meanwhile, specific guidance and regulations trickle out as the IRS interprets countless provisions in the new tax law.

While the calculation of taxes due after year-end may take some time, a closer look at the Foreign Derived Intangible Income (FDII) provision may lead to both tax and cash savings opportunities—applicable now.

Wait and See—Or Is Opportunity Knocking?
The new 21 percent federal corporate tax rate is considered the most noteworthy benefit for C-Corporations. The old 35 percent rate was regularly cited as uncompetitive by comparison to most countries. However, a lower overall tax rate is not the end of the story.

Many C-Corporations Selling to Foreign Markets Already Qualify
In essence, certain companies serving foreign markets may be taxed at a beneficial 13.125 percent rate on some of their foreign-derived “intangible” income. Companies may not have fully explored this opportunity due to some misleading terminology. Practically speaking, this foreign “intangible” income can be generated from such transactions as:

  • Inventory sold to non-US companies for use outside of the US; and
  • Services provided by the taxpayer to non-US companies for use outside of the United States and not provided to US customers; and
  • Royalty income from licensing intangibles to non-US companies serving foreign markets

The guiding factor is that the transactions must involve selling to a foreign customer—including foreign related companies—rather than US markets. The 13.125 percent rate is an additional incentive to encourage research and development along with other investments for companies serving foreign markets; in effect, an export subsidy.

Like many tax rules, FDII is a mechanical calculation process. However, the thought process behind FDII is relatively clear. After exceeding a certain profit threshold on foreign sales, companies pay tax at a beneficial 13.125 percent rate, rather than the standard 21 percent rate. The threshold is based upon the assets utilized in producing this foreign income.

They May Be Able to Do Even Better—Transfer Pricing
For multinationals, one critical driver of profitability in the US versus other countries is transfer pricing. Where warranted, transfer pricing increases could result in additional profits in the US while reducing overseas tax liabilities. Of course, such price adjustments must comply with the arm’s-length standard.

Where Might This Work Best?
Companies revisiting their investment strategy and global supply chain footprint may be best placed to benefit from the FDII rate. For example:

  • Increases in US research and development may warrant higher royalties charged to affiliates
  • New product improvements may justify increases in outbound transfer prices
  • Additional value-added services provided to affiliates could lead to higher service charges

In practice, companies that have minimized their tax footprint over the years may find the incentives for making investments in the US have changed, resulting in higher transfer prices.

How it Works
A numerical example may help illustrate how FDII planning could work in practice: a US company sells products to a related party operating in a 30 percent tax jurisdiction. From a high-level, the FDII calculation is as follows:

  1. Calculate “Deduction Eligible Income,” a domestic corporation’s gross income reduced by deductions properly allocable to such income
  2. Determine the foreign derived portion of the Deduction Eligible Income
  3. Subtract a 10 percent return on qualified business assets to calculate “Deemed Intangible Income”
  4. The residual, foreign, income is taxed at 13.125 percent as Foreign Derived Intangible Income

While the calculation is a multi-step process, increases to the foreign-derived intangible taxable income would be taxed at 13.125 percent, all other things being equal.

Assuming that a company is in a tax-paying position in the US and also pays tax overseas at a 30 percent rate:

  • A $1000 increase in foreign-derived intangible income would lead to additional tax of $131.25 in the US, but also a reduction of foreign taxes payable of $300.00
  • From a global perspective, this change leads to a worldwide tax savings of $168.75 per $1000 increase annually

Nine Important Considerations

  1. The FDII benefit is available to both US and foreign-owned domestic C-Corporations
  2. The standard 21 percent rate applies to a 10 percent return on Qualified Business Asset Investment (QBAI). The FDII rate only applies to income over-and-above this return on assets threshold.
  3. FDII provides a deduction rate of 37.5 percent to reach the 13.125 percent tax rate, reduced to 21.87 percent after 2025 resulting in a 16.406 percent tax rate
  4. Companies in asset intensive industries (high QBAI) will have a higher taxable income threshold before the FDII rate applies
  5. Regulations applicable for FDII are still a work-in-progress, for example, the IRS will need to clarify how foreign derived profits should be calculated
  6. The World Trade Organization could challenge FDII as an unfair trade subsidy
  7. State taxes, withholding tax, customs duties, Subpart F, BEAT, and GILTI, among other issues, are all important issues for consideration and do affect the global effective tax rate and should be considered as part of an overall analysis
  8. Increasing transfer prices may increase foreign audit exposure as less taxable income is earned in the foreign jurisdiction
  9. Foreign tax authorities are likely to be taking a closer look at transfer pricing, however comprehensive global transfer pricing documentation can mitigate those risks

Caveats aside, the FDII provision under TCJA may provide an overlooked bonus for those companies generating substantial taxable income when serving foreign markets, including sales to foreign related companies. It is important to consult with an experienced tax advisor to determine the best approach for your company. With the right fact-pattern and thorough transfer pricing documentation, there may be a hidden gem under tax reform.

For more information, contact Clayton & McKervey.