What Is Foreign-Derived Intangible Income (FDII)?

Understanding Foreign-Derived Intangible Income

Foreign-Derived Intangible Income (FDII) is a specific category of earnings for U.S. companies, established under the Tax Cuts and Jobs Act (TCJA) of 2017. This provision aims to provide a tax incentive for businesses that generate income from intellectual property (IP) and other U.S.-based assets through sales or services to foreign markets. By reducing the effective tax rate on such income, the law seeks to encourage domestic companies to maintain and expand their intellectual property within the United States and promote the export of U.S. goods and services globally.

The concept of “foreign-derived” means income earned from customers or markets outside the United States, contrasting with purely domestic sales. “Intangible income” refers to the portion of a company’s profit attributed to its intellectual property, such as patents, copyrights, trademarks, or other valuable non-physical assets. This is typically defined as income exceeding a routine return on a company’s tangible assets.

The legislative intent behind the FDII deduction was to make the U.S. tax system more competitive internationally. It works in conjunction with other TCJA provisions, like Global Intangible Low-Taxed Income (GILTI), which addresses foreign earnings. While GILTI aims to ensure a minimum tax on foreign earnings from intangible assets held abroad, FDII provides a benefit for similar income generated from IP located within the U.S. This dual approach was designed to reduce incentives for companies to shift their intangible assets or related profits to low-tax jurisdictions outside the United States, thereby encouraging domestic investment and export activities.

Eligibility for the FDII Deduction

The Foreign-Derived Intangible Income deduction is available only to domestic C corporations. This means that other business structures, such as S corporations, partnerships, limited liability companies (LLCs) taxed as partnerships, real estate investment trusts (REITs), or individuals, are not eligible to claim this tax benefit.

This narrow eligibility reflects the broader corporate tax reforms introduced by the TCJA. The law primarily focused on restructuring the taxation of corporate income, particularly for large multinational corporations. By limiting the FDII deduction to C corporations, Congress aimed to provide a direct incentive to these entities to keep their intellectual property and related profit-generating activities within the United States. The provision aligns with the goal of encouraging U.S.-based operations and exports from these specific corporate taxpayers.

Calculating Foreign-Derived Intangible Income

The calculation of Foreign-Derived Intangible Income involves a multi-step process, designed to identify the portion of a domestic C corporation’s income that is considered to be derived from intangible assets and generated from foreign markets.

This calculation begins by determining the company’s Deduction Eligible Income (DEI). DEI generally represents the gross income of the corporation, reduced by certain excluded categories of income and properly allocable deductions. Exclusions from DEI include amounts like Subpart F income, Global Intangible Low-Taxed Income (GILTI) inclusions, financial services income, dividends received from controlled foreign corporations (CFCs), domestic oil and gas extraction income, and foreign branch income.

Once DEI is established, the next step involves calculating Deemed Intangible Income (DII). DII is determined by subtracting a deemed routine return on the corporation’s tangible assets from its DEI. This routine return is set at 10% of the company’s Qualified Business Asset Investment (QBAI). QBAI represents the average adjusted basis of the depreciable tangible property used by the corporation in its trade or business to produce DEI. It typically includes assets like factories, machinery, and equipment. The premise is that income exceeding this 10% return on tangible assets is attributable to the company’s intangible assets.

After determining DII, the actual FDII amount is calculated. This is done by multiplying the DII by a ratio that reflects the proportion of the company’s foreign-derived income relative to its total deduction-eligible income. This ratio, known as the Foreign-Derived Ratio (FDR), is computed by dividing Foreign-Derived Deduction Eligible Income (FDDEI) by DEI. FDDEI is the subset of DEI that comes from qualifying foreign sales and services. The resulting FDII amount is then eligible for a deduction.

For tax years beginning before January 1, 2026, eligible domestic C corporations can claim a deduction equal to 37.5% of their calculated FDII, which effectively lowers the corporate tax rate on this income from 21% to 13.125%. For taxable years beginning after December 31, 2025, the deduction is scheduled to decrease to 21.875%, raising the effective tax rate on FDII to 16.406%. The FDII deduction cannot reduce a corporation’s taxable income below zero.

Types of Qualifying Foreign-Derived Income

To qualify for the Foreign-Derived Intangible Income (FDII) deduction, the income must fall into specific categories of “foreign-derived deduction eligible income” (FDDEI). This generally includes gross income derived from the sale or license of property to foreign persons for foreign use. The term “sale” is broadly defined to encompass any lease, license, exchange, or other disposition of property, which can include both tangible and intangible assets. The critical aspect here is the “foreign use” requirement, meaning the property must be consumed, used, or disposed of outside the United States.

Income from services provided to foreign persons or with respect to property located outside the U.S. also qualifies as FDDEI. This covers a wide range of services, provided the recipient is not located in the U.S. or the service relates to property situated abroad. For instance, engineering services performed in the U.S. for a foreign client building a facility overseas, or software development services for a foreign company’s international operations, could potentially qualify.

Special rules apply to transactions involving related parties. Sales to related foreign parties can qualify as FDDEI if the property is subsequently resold to an unrelated foreign person, or if it is used by the related party in connection with providing services or selling property to an unrelated foreign person. Similarly, services provided to a related foreign party may qualify if those services are not substantially similar to services the related party provides to persons located within the U.S.

Certain types of income are specifically excluded from qualifying as FDDEI. These exclusions include amounts already covered by other international tax provisions, such as Subpart F income and Global Intangible Low-Taxed Income (GILTI) inclusions. Income from financial services, dividends received from a controlled foreign corporation (CFC), domestic oil and gas extraction income, and foreign branch income are also explicitly excluded from FDDEI. To substantiate claims for the FDII deduction, taxpayers must maintain credible evidence, typically obtained in the ordinary course of business, demonstrating that sales or services meet the foreign person and foreign use requirements.