US companies are struggling to claim FDII since the Trump administration introduced the provision into the Tax Code. The FDII offers US businesses a 37.5% tax deduction until 2025 on foreign revenue streams. However, the calculation involves a greater level of information than past deductions.
“The burden of calculating the FDII is huge, especially for multinationals with hundreds, if not thousands, of entities,” said one tax director at a medical device company.
The FDII is an aggregate calculation and foreign-derived income is defined as revenue from sales of goods and services to a foreign company for foreign use that will not be used within the US within three years.
“You need to provide a lot of information,” the director explained. “You have to go to the local level to figure out everything because the burden of proof is much higher.”
“People want the deduction, but it means you have to go to extreme lengths to get it,” they stressed.
Tax departments can’t afford to work in silos from business centres to secure this advantage. The FDII requires taxpayers to look at third-party sales and work out the gross margins to calculate the profits and take into consideration expense allocations. This means following the business and product lines.
Not only does the FDII require a more granular analysis, it demands that businesses trace their goods and services after the sale. Global supply chains can be highly complex, so the US authorities want to be sure they are providing incentives for exports and not goods that end up on the US market.
The burden of proof is much higher precisely because the deduction is so worthwhile. Some industries find it easier to meet this burden of proof than others and, for them, the regulatory framework is more a help than a hindrance.
“The regulations are much stricter about tracing medical devices compared to other products. The car manufacturing industry will find it especially difficult when it comes to parts sold in Europe and used in different vehicles before being sold back to the US,” said the tax director.
“You have to be able to prove where these parts end up, but it doesn’t stop there,” the director explained. “You have to prove that the value of the widgets that went into the car is no more than 20% of the value of the car that came back into the US.”
“The same goes for computer software businesses whose programmes end up in someone else’s product,” they added. “The factual basis is hard to prove.”
Two sticks, one carrot
The Tax Cuts and Jobs Act (TCJA) was pitched as a way to level the playing field for American multinationals with foreign competition and bring back US business operations and assets to the domestic market. Yet this meant greater complexity, not less.
“The tax compliance burden has tripled as a result of the TCJA. The complexity arises from changes requiring much more complicated calculations,” said the tax director.
“Not only are companies having to come up with regular tax calculations, they have to consider new principles because of these provisions,” the director told ITR.
The base erosion and anti-abuse tax (BEAT) and the global intangible low-taxed income (GILTI) rules were designed to increase the costs of offshoring assets. The FDII was different insofar as it was designed to give US exporters a new competitive advantage.
“Everybody is paranoid about making sure they’re compliant. Some companies are so risk averse they want to know they’re 100% compliant with no exposure whatsoever,” said the tax director.
“US tax reform has created more risks,” the director added. “The BEAT and the GILTI rules are one form of exposure, while FDII is another possible exposure if you apply for the wrong deduction.”
The BEAT and the GILTI rules are like two sticks for the US to wield, but the FDII is more like a carrot. Nevertheless, all three have created new challenges.
Import/export challenges
One problem is that many US companies manufacture, assemble and process goods in foreign jurisdictions, particularly Canada and Mexico, then sell these to the US domestic market. The components can’t exceed more than 20% of the value of the product, but it also can’t be minor changes to be eligible for certain incentives.
“If you’re in an inbound situation, your company buys everything as finished goods for the US market,” said the tax director. “Most in-bound companies don’t have to record the sales unless they have manufacturing in the country.”
“The FDII doesn’t apply because you’re not selling abroad, the goods are coming into the country. So most of these inbound entities won’t be able to claim this deduction,” the director continued.
Although there is a rationale to these rules, there will always be unintended consequences. US manufacturers often run supply chains through foreign jurisdictions as part of exporting those goods because they are not only sold to American consumers.
“Even if you have manufacturing plants in the US and you export to Mexico, you won’t be able to claim the deduction,” said the tax director. “The Mexican factory finished the product and shipped it to the US, where it was sold.”
“It’s the same with Canada. Car companies might buy certain parts from US factories or they will ship in goods into Canada via Japan,” they explained. “The design of the car and the manufacturing may happen in Canada, but you can’t claim the deduction.”
The North American Free Trade Agreement (NAFTA) helped such supply chains develop across the region and increase growth in the US car industry. This came at the cost of jobs in the US. The Trump administration is set to ‘disrupt’ and redraw American trade policy since coming into power in 2016. The FDII is just one fiscal tool being used for this.
“Multinationals who rely on buying finished goods for the US use will probably never be able to claim FDII,” the director told ITR. “So the only way to claim the FDII is to bring manufacturing operations back to the US.”
However, the US economy still has comparatively high labour costs for investment, making Trump’s vision to bring manufacturing back to the US challenging. This means long-term investments into the US will need more automation than in the past and companies are waiting for technology to catch up with their needs.
In addition, the presidential election in November 2020 means many businesses fear that the reformed Tax Code is not here to stay and will either be watered-down or repealed. This means Trump’s re-election is also the key to making tax reform permanent.
“Companies are not going to pull the trigger,” said the tax director. “US tax reform is temporary until we have assurances it is permanent.”
