As we have noted in past reports, tax reform is impacting the media industry in a number of important ways. In this installment of our focus on tax reform and the media, we will further explore the Foreign-Derived Intangible Income (FDII) Deduction and its role in international tax reform.
As discussed briefly in our prior installment, the Tax Cuts and Jobs Act (TCJA) contains a new provision which provides an incentive for US companies to provide goods and services to customers abroad. This new provision allows a deduction for the taxpayer’s so-called foreign-derived intangible income (FDII), which is only available to entities classified as corporations for U.S. federal tax purposes and reduces a corporation's effective rate to 13.125% with respect to such income (rather than the new 21% rate). As we have previously discussed, the largest actors in the media industry operate in corporate form, making the FDII deduction and its incentive for international commercial activity a particularly salient feature of reform for this sector.
The deduction is determined using a complex calculation. First, the domestic corporation must determine its “deduction eligible income” by determining its gross income and then reducing it by certain income items and deductions. Next, the taxpayer must determine the portion of this income which is from the sale of either property or services provided to a foreign person or for foreign use. Finally, the taxpayer must calculate its deemed intangible income, which is its deduction eligible income minus its deemed tangible income return, or 10% of its qualified business asset investment, which is, in turn, defined as the quarterly average of its adjusted bases in certain depreciable tangible property used in the corporation’s trade or business. Once these component parts are calculated, the FDII can be determined by multiplying the deemed intangible income by the percentage of the deduction eligible income that is foreign-derived. This FDII is then 37.5% deductible, which, when multiplied by the new 21% rate, yields a 13.125% effective tax rate. This may then be further reduced with foreign tax credits to the extent applicable. However, after December 31, 2025 the effective tax rate on FDII increases to 16.406% (again, based on the current 21 percent US corporate income tax rate).
The critical fact for the purpose of this provision is that the income in question is earned from foreign markets. In general, property must be sold or leased to a foreign person for use outside the United States, and services must be provided to persons, or performed with respect to property, located outside the United States. Consequently, the FDII deduction incentivizes domestic corporations to increase the percentage of their income they earn from foreign customers.
However, as the “simplified” description of the FDII above illustrates, the calculations are difficult, fact specific and pending further guidance, confusing. Time will tell how corporations are meant to, for example, allocate activity that takes place both within and outside the United States. Also, the FDII is a carrot in international tax reform, though it does not on its own encourage companies to bring production onshore, which seems inconsistent with the new international provisions otherwise. As we have discussed at length (here and here), the TCJA added a new tax (GILTI) on intangible assets held abroad. For some corporations, the FDII may serve only to mitigate the cost of that new tax. Further, media companies’ production often is inflexible as it is driven by the location of news reporting, from live coverage to in-depth documentaries. These companies may find themselves with little room to minimize GILTI and/or maximize the FDII. On the other hand, large movie studios and networks may have sufficient planning opportunities to leverage the new system – moving intangibles onshore to avoid or lower GILTI while otherwise revamping their international planning to take advantage of FDII. It remains to be seen whether Treasury will view this as a favored effect of the new laws or see creative tax planning around these new provisions as abusive. Even absent abuse, media and entertainment companies are dedicating vast resources simply to figure out their GILTI tax exposure and potential FDII – and to know whether planning will be effective, they need to know their starting point.
Even given the complexity of the FDII, and that it may be disingenuous to view it in isolation, it may be recognized as an attempt by Congress to allow truly international media and technology companies to compete on the global playing field, particularly where these companies have substantial non-tax reasons to hold intangibles and engage in production abroad. Of course, even in light of possible pre-TCJA tax abuse, the new taxes otherwise could have contained an exception for those companies with a non-tax business purpose for the location of these assets and activities.
Of course, the FDII is another way that Congress is favoring corporate form (in this case, given the assets at issue, in particular for media and tech). The FDII dovetails nicely with the new territorial corporate tax system with a lower tax rate. In an industry that already seems to favor corporate form, media stands to gain tremendously from tax reform – to the extent its actors have the flexibility for efficient tax planning. First, of course, they need to compute their new benefits.