What Is the FDII Deduction and How Does It Work?

The Foreign-Derived Intangible Income (FDII) deduction is a tax incentive for U.S. companies that generate income from foreign sales or services. It was introduced as part of the Tax Cuts and Jobs Act (TCJA) of 2017 to encourage domestic corporations to retain and expand their intellectual property and related operations within the United States. The deduction aims to lower the effective tax rate on certain income derived from exporting goods and services from the U.S. to foreign markets. This tax provision seeks to make the U.S. a more attractive location for companies to hold their intangible assets and conduct their business activities.

Eligibility for the FDII Deduction

The FDII deduction is available to domestic C corporations. Partnerships, S corporations, or sole proprietorships are not eligible. This incentivizes U.S.-based corporate operations engaged in foreign commerce.

To qualify, income must be “foreign-derived,” encompassing property sold or services provided to foreign persons for foreign use. For example, selling U.S.-manufactured goods for consumption abroad or providing architectural design services for an overseas project can qualify.

The “foreign use” requirement means property or services must be consumed or disposed of outside the United States. Sales to foreign persons for further manufacturing or modification within the U.S. generally do not qualify, even if the final product is subsequently exported. Special rules also apply to transactions with related foreign parties, requiring that the property be resold or used in connection with property sold to an unrelated foreign person, or that similar services are not provided by the related party within the U.S. Income from sales of property includes leases, licenses, exchanges, or other dispositions. Income from services covers a broad range, provided they are rendered to a person or with respect to property located outside the U.S.

Excluded income types include financial services, dividends from controlled foreign corporations, domestic oil and gas extraction income, and amounts related to Subpart F income or Global Intangible Low-Taxed Income (GILTI). These exclusions ensure the deduction targets specific export-oriented income.

Components and Calculation of the FDII Deduction

The FDII deduction calculation involves several distinct components, each requiring precise determination. It identifies the portion of a U.S. corporation’s income that is considered to be derived from intangible assets used in foreign markets, beyond a routine return on tangible property. The deduction effectively reduces the corporate tax rate on this qualifying income.

The first step is to determine Deduction Eligible Income (DEI). DEI represents a domestic corporation’s gross income, with specific exclusions, reduced by deductions properly allocable to that income. Exclusions from gross income for DEI purposes include Subpart F income, GILTI inclusions, financial services income, dividends received from controlled foreign corporations (CFCs), domestic oil and gas extraction income, and foreign branch income. The deductions allocable to DEI are determined without regard to certain limitations.

Next, the corporation calculates its Deemed Intangible Income (DII). DII captures income presumed to be generated from its intangible assets, as opposed to its tangible assets. It is computed as the excess of the corporation’s DEI over its Deemed Tangible Income Return (DTIR). The DTIR is a fixed 10% return on the corporation’s Qualified Business Asset Investment (QBAI).

QBAI represents the average of the adjusted bases of a domestic corporation’s tangible property used in its trade or business to produce DEI, including machinery, buildings, and equipment. The average is typically calculated quarterly. Land and intangible property are not included in QBAI.

Following the determination of DII, the corporation computes its Foreign-Derived Deduction Eligible Income (FDDEI). FDDEI is the portion of a corporation’s DEI that is derived from qualifying foreign sales and services. This includes income from property sold to a foreign person for foreign use, or services provided to any person or with respect to property located outside the United States. Similar to DEI, FDDEI is a net amount, meaning gross foreign-derived income is reduced by allocable deductions.

The FDII is then calculated by multiplying the DII by the foreign-derived ratio (FDDEI / DEI). The formula can be expressed as: FDII = DII × (FDDEI / DEI). This effectively allocates a portion of the DII to the foreign-derived activities.

Once the FDII amount is determined, the deduction is applied. For tax years beginning after December 31, 2017, and before January 1, 2026, the deduction rate is 37.5% of the calculated FDII. This rate is scheduled to decrease to 21.875% for taxable years beginning after December 31, 2025. This deduction results in a preferential effective tax rate on the qualifying foreign-derived income, currently around 13.125% compared to the standard corporate tax rate of 21%.

A limitation on the FDII deduction is that it cannot exceed the corporation’s taxable income, determined without regard to the FDII deduction itself. If the sum of a domestic corporation’s FDII and GILTI (if applicable) exceeds its taxable income, a pro-rata reduction is applied to both amounts to ensure the deduction does not create or increase a net operating loss. This limitation ensures the deduction only reduces tax liability on positive taxable income.

Reporting the FDII Deduction

Corporations claiming the FDII deduction report it on their annual corporate income tax return, Form 1120. The specific calculation of the FDII deduction is detailed on Form 8993, Section 250 Deduction for Foreign-Derived Intangible Income (FDII) and Global Intangible Low-Taxed Income (GILTI). This form is attached to the Form 1120.

Form 8993 requires corporations to itemize the various components used in the FDII calculation, including Deduction Eligible Income (DEI), Qualified Business Asset Investment (QBAI), and Foreign-Derived Deduction Eligible Income (FDDEI). Each section of the form guides the taxpayer through the steps of determining these amounts and ultimately arriving at the FDII deduction. This detailed reporting ensures transparency and allows the Internal Revenue Service (IRS) to verify the accuracy of the claimed deduction.

Maintaining comprehensive and accurate records is important for substantiating the FDII calculation. This includes documentation to support the foreign person and foreign use requirements for sales and services, as well as records for the adjusted basis of tangible property included in QBAI. The IRS instructions for Form 8993 emphasize the need for such documentation to establish eligibility and the correctness of the figures reported. The due date for filing Form 8993 is the same as that for the corporation’s income tax return, including any extensions.