NCTI vs. FDDEI Who’s the Hero and Who’s the Villain?

The Foreign-Derived Deduction Eligible Income (“FDDEI”) and Net CFC Tested Income (“NCTI”) regimes are an attempt by Congress to use the Internal Revenue Code to encourage U.S. multinational corporations to increase investments in the United States. However FDDEI and NCTI are incredibly complicated tax regimes and it is not always clear which of these provisions is the hero or the villain in international tax planning. This article compares the FDDEI and NCTI tax rules.

What Exactly is the NCTI Tax Regime?

On July 4, 2025, the “One Big Beautiful Bill Act” (“OBBBA”) became law. The OBBBA made significant changes to domestic and international law provisions of the Internal Revenue Code. Before the OBBBA, the Congress enacted the 2017 Tax Cuts and Jobs Act. The Tax Cuts and Jobs Act altered the U.S. international tax system by enacting the GILTI rules. Under the GILTI rules, a domestic tax payer was required to include its GILTI for the taxable year similar to Subpart F income pro rata share rules. GILTI is the excess of a taxpayer’s pro rata share of the “tested income” of each Controlled Foreign Corporation (“CFC”) owned, directly or indirectly, by the taxpayer and with respect to which the taxpayer is a U.S. Shareholder, over the “tested loss” of each such CFC, less a deemed intangible income return. Tested income and tested loss generally are computed from each CFC’s gross income reduced by allocable deductions and excluding, among other items, Subpart F income and high-tax income. GILTI is not limited by the earnings and profits of the applicable CFC. Corporate taxpayers may claim a Section 250 deduction and a deemed-paid credit for GILTI foreign taxes with a 20 percent reduction, subject to limitations.

For taxable years beginning after 2025, the OBBBA alters the existing GILTI rules to increase the total CFC income subject to current taxation. Namely, U.S. shareholders of one or more CFCs will include their pro rata share of the CFC’s NCTI for the applicable taxable year, which is in excess of such CFCs’ tested income over their tested loss, unreduced by any deemed intangible income return. Corporate taxpayers that hold CFCs are eligible for a Section 250 deduction (now 40 percent) and a deemed-paid foreign tax credit (now with a 10 percent reduction).

Who is Subject to NCTI?

NCTI is assessed on a “United States shareholder” of any CFC for any taxable year of such United States shareholder. See IRC Section 951A(a). A CFC is defined as a foreign corporation in which 50 percent of: 1) the total combined voting power of all classes of stock of such corporation entitled to vote, or 2) the total value of the stock of such corporation is owned (within the meaning of Section 958(a), or is considered as owned by applying the rules of ownership of Section 958(b) during any day of the taxable year of such foreign corporation. See IRC Section 957(a).

A “United States shareholder” can be defined as a “U.S. person” (Section 7701(a)(1) of the Internal Revenue Code defines a “U.S. person” to include an individual, trust, estate, partnership, or corporation) who owns (within the meaning of Section 958(a)), or is considered as owning by applying the rules of ownership of Section 958(b), 10 percent or more of the total combined voting stock entitled to vote of such foreign corporation, or 10 percent or more of the total value of shares of all classes of stock of such foreign corporation. See IRC Section 951(b).

Calculating the NCTI Taxable Amount

For tax years 2026 and beyond, U.S. shareholders of domestic C corporations that hold CFCs are taxed at a 21 percent corporate rate. A domestic corporation can make a Section 250 deduction equal to 40 percent of the NCTI inclusion. This deduction effectively reduces the current 21 percent federal corporate rate to approximately 12.6 percent on a NCTI inclusion. Second, a domestic corporation may elect to use a foreign tax credit equal to 90 percent of the foreign taxes paid on the NCTI income.

Individual shareholders of CFC must include any NCTI as ordinary income. The current highest federal tax rate applicable to an individual is 37%. An additional 3.8% net investment income tax (the “NIIT”) is imposed upon the income of certain individuals. Individual CFC shareholders are not permitted to claim the Section 250 deduction or claim an indirect foreign tax credit for foreign taxes paid by the CFC.

In almost every case, an NCTI inclusion to a non-corporate CFC shareholder is taxed at a higher rate than to a corporate shareholder of a CFC. This is because non-corporate shareholders are not permitted to claim indirect foreign tax credits and the 250 deduction to reduce the NCTI income tax inclusion. There are three main options a CFC shareholder can do to mitigate its exposure to NCTI. First, the CFC shareholder can contribute his or her shares into a domestic C corporation. Second, the CFC shareholder can make a so-called Section 962 election. Third, in appropriate cases, a CFC shareholder can make a so-called 954 high tax election. This article will discuss all three of these options.

Section 962 Election

The Internal Revenue Code permits certain non-corporate shareholders of a CFC to elect to be treated as a domestic corporation for purposes of GILTI and Subpart F inclusions. When a CFC has NCTI, the non-corporate U.S. shareholders will be taxed on that income at the corporate rate of 21% and will be eligible for foreign tax credits on foreign taxes associated with that income, A 40% deduction also applies to non-corporate U.S. shareholders making a Section 962 election.

If such an election is made, the amounts of NCTI income included in the individual’s gross income are also treated as if the amounts were received by a domestic corporation for purposes of applying Section 960. A Section 962 election applies only with respect to the E&P of the CFC that is considered NCTI. As a result of making a Section 962 election, a second layer of tax results when the CFC actually distributes the foreign earnings that have already been included in gross income under Section 951(a) (and are this PTEP under Section 959).

When an individual U.S. shareholder of a CFC has an income inclusion under either NCTI and makes an election pursuant to Section 962 to be taxed at corporate rates, the amount of income itself is not reported on Form 1040. Instead, taxpayers must track that information separately, attach a statement to the tax return, and report any tax directly on Form 1040, line 12a.

All taxpayers must include Form 8992, U.S. Shareholder Calculation of Global Intangible Low-Taxed Income with a U.S. tax return to calculate NCTI. Corporations are required to file Form 8993, Section 250 Deduction to Foreign-Derived Intangible Income and Global Intangible Low-Taxed Income, and Form 1118, Foreign Tax Credit.

The treasury regulations under Section 962 provide a unique set of ordering rules with respect to distributions of PTEP and current year earnings, which modify the traditional Section 959 rules. When a CFC makes an actual distribution of E&P, the regulations distinguish between E&P earned during a tax year in which the individual U.S. shareholder has made an election under Section 962 (962 E&P) and other, non-section 962 E&P (Non-962 E&P). Section 962 E&P is further classified between (i) “Excludable 962 E&P,” which represents an amount of 962 E&P equal to the amount of U.S. federal corporate tax paid on 962 E&P, and ii) “Taxable 962 E&P,” which is the excess of 962 E&P over Excludable 962 E&P.

Generally, a distribution of E&P that the U.S. shareholder has already included in his or her income is tax-free to the U.S. shareholder. However, when a CFC distributes 962 E&P, the portion of the earnings that comprise Taxable 962 E&P is subject to a second layer shareholder level tax. If no Section 962 election had been made, then the distribution of all of the PTEP would have been tax-free to the recipient shareholder. Thus, the Section 962 election results in the imposition of an additional layer of tax on the 962 E&P that is considered Taxable 962 E&P. This second layer of tax is consistent with treating the U.S. individual shareholder in the same manner as if his or she invested in the CFC through a domestic corporation.

Examples of 962 Computations

When a CFC shareholder does not make a Section 962 election, he or she is taxed at ordinary individual income tax rates and the CFC shareholder cannot claim a foreign tax credit for foreign taxes paid by the CFC.

Below please see Illustration 1 which demonstrates the typical federal tax consequence to a CFC shareholder who did not make a Section 962 election.

Illustration 1.

Tom is a U.S. person taxed at the highest marginal tax rates for federal income tax purposes. Tom wholly owns 100 percent of FC 1 and FC 2. FC 1 and FC 2 are South Korean corporations in the business of providing personal services throughout Asia. FC 1 and FC 2 are CFCs. FC 1 and FC 2 do not own any assets. Tom received pre-tax income of $100,000 FC 1 and $100,000 of pre-tax income from FC 2. Tom paid 19 percent corporate taxes to the South Korea government. For purposes of this example, Tom did not receive any distributions from either FC 1 or FC 2 during the tax year.

Since Tom did not make a Section 962 election, for U.S. federal income tax purposes, he cannot receive a deduction for the foreign income taxes paid by his CFC.

Illustration 2.

Assume the same facts in Illustration 1. However, in this case, Tom made a 962 election for income he received prior to the enactment of OBBBA.

(Under Section 78, taxes “deemed paid” by U.S. corporations under Sections 902 and 960(a). Consequently, the dividend income is “grossed-up” by the amount of taxes deemed paid on the income from which the dividend was paid).

When the $162,000 E&P is distributed in a future year to Tom, the distribution will be subject to federal income tax. In this case, the distribution will be taxed at a favorable rate. This is because South Korea is a country that has entered into a bilateral tax treaty with the United States. Under the tax treaty, the $162,000 distribution will be eligible for a preferential 20 percent qualified dividend rate. Thus, in this case, Tom’s federal tax liability associated with FC 1 and FC 2 (excluding Medicare tax) is only $32,400. ($162,000 x 20% = $32,400). By making a 962 election, Tom saved $27,594 ($59,994 – $32,400 = $27,594) in federal income taxes.

However, making a Section 962 election does not always result in tax savings. Depending on the facts and circumstances of the case, sometimes making a 962 election can result in a CFC shareholder paying more federal income taxes in the long term.

For Illustration 3, let’s assume that Tom is the sole shareholder of FC 1 and FC 2.
Only this time, FC 1 and FC 2 are incorporated in the British Virgin Islands. FC 1 and FC 2 are both CFCs. Assume that the foreign earnings of FC 1 and FC 2 are the same as in Illustration 1. Let’s also assume that FC 1 and FC 2 did not pay any foreign taxes.

At the time of the 962 election, Tom will pay $17,010 in taxes (excluding Medicare tax).

However, in the future, Tom must pay a second tax once the E&P from FC 1 and FC 2 associated with the 962 PTEP  is distributed to him. In this case, Tom will owe an additional $59,994 (assuming federal tax from the first layer of 962 tax cannot be used to offset the second layer of 962 tax) in federal income tax (excluding Medicare tax). Tom’s total federal tax liability associated with the 962 election will be $77,004. In this example, by making the 962 election, Tom increased his tax liability by $17,010 ($77,004 – $59,994 = $17,010). But, Tom has had the benefit of deferring his tax liability.

Translation of Foreign Currency Issues

Anyone considering making a 962 election must understand there will likely be foreign conversion issues. A CFC will probably use a foreign currency as its functional currency. Anytime a 962 election is made for a CFC which has a functional currency that is not the dollar, the rules stated in Section 986 of the Internal Revenue Code must be used to translate the foreign taxes and E&P of the CFC. Section 986 uses the average exchange rate of the year when translating foreign taxes. The average exchange rate of the year is also used for purposes of 951 inclusions on subpart F income and GILTI. In the case of distributions of the CFC, the amount of deemed distributions and the earnings and profits out of which the deemed distribution is made are translated at the average exchange rate for the tax year. See IRC Section 986(b); 989(b)(3).

Pros to Making a Section 962 Election

The benefits of making a 962 election is that it provides the CFC shareholder with an opportunity to be taxed for federal income tax purposes at 12.6 percent on NCTI inclusions. It also allows the CFC shareholder the opportunity to claim 80 percent of foreign tax credits. When a 962 election is made, NCTI income of the CFC is treated as PTEP which is classified as with “Excludable Section 962 E&P” to the extent of the income paid by the U.S. shareholder, or “Taxable Section 962 E&P” to the extent of the excess of Section 962 E&P over Excludable Section 962 E&P.

Generally, a distribution of E&P that the U.S. shareholder has already included in his or her income is tax-free to the U.S. shareholder. However, when a CFC distributes 962 E&P, the portion of the earnings that compromises Taxable 962 E&P is subject to a second layer shareholder level tax.

A 962 election provides simplicity in that a CFC shareholder can potentially obtain more favorable rates without the cost of restructuring a CFC. In addition, a 962 election provides flexibility. It can be made annually.

Cons to Making a Section 962 Election

Although a 962 election is less complicated than restructuring a CFC to obtain beneficial tax rates and allows a deferral of some foreign source income from taxation, its calculations can be tedious and thus there typically is an added compliance cost. A 962 election also subjects the CFC shareholder to a second layer of tax. This may result in the CFC paying more federal tax than doing nothing in the long run. Furthermore, this second layer of tax may or may not qualify for reduced corporate dividend rates under a tax treaty.

For example, the Section 962 regulations adopt the general Section 962 ordering rules with respect to a CFC’s distribution of E&P, but modify them by providing a priority between 962 E&P and non-962 E&P. First, distributions of E&P that are PTEP under 959(c)(1) (i.e., 956 inclusions) are distributed first, E&P that is PTEP under Section 959(c)(2) (e.g. GILTI and Subpart F inclusions) is distributed second, and all other E&P under Section 959(c)(3) (i.e. E&P related to the net deemed tangible return amount, high-taxed exception) is distributed last. This is the case irrespective of the year in which the E&P is earned. Second, when distributions of E&P that is PTEP under Section 959(c)(1) (e.g. Section 956 inclusions) are made, distributions of E&P come from Non-962 E&P. The distributions of E&P that is PTEP under Section 959(c)(1) then comprise Excludable 962 E&P, and finally Taxable 962 E&P. The same ordering rule applies to distributions of E&P that is PTEP under Section 959(c)(2) (e.g. GILTI and Subpart F inclusions). That is, distributions that are PTEP under Section 959(c)(2) come first from Non-962 E&P, then Excludable 962 E&P, and finally 962 E&P. Finally, within each subset of PTEP (e,g., Sections 959(c)(1) and 959(c)(2))), the ordering rule is LIFO, meaning that E&P from the current year is distributed first, then the E&P from the prior year, and then E&P from all other prior years in descending order.

As indicated above, the tax accounting associated with a 962 election can be extremely complicated and costly.

The Section 954 High-Tax Election

A CFC shareholder may make a high-tax election to NCTI inclusions. This exception applies to NCTI inclusions. The NCTI high-tax exception generally excludes a “tentative gross tested income item” of a CFC to the extent the “tentative net tested income item” was subject to the foreign effective rate of tax that is greater than 90% of the maximum rate under Section 11. In general, the regulations enable CFC shareholders to exclude amounts that would otherwise be tested income from its NCTI computation if the foreign effective tax rate on such amounts exceeds 90 percent of the top U.S. corporate tax rate (currently 18.9 percent based on the current 21 percent corporate tax rate).

In order to make a GILTI high-tax foreign election, the  shareholder must be subject to an effective foreign tax rate of 18.9 percent. This is calculated by dividing the U.S. dollar amount of foreign income taxes paid or accrued by the U.S. dollar amount of the tentative tested income item increased by the U.S. dollar amount of the relevant foreign income tax. This requires determining the tentative gross tested income and the tentative tested income.

Pros to Making a Section 954 Election

The high-tax exception applies to the extent the foreign income from the CFC exceeds 90 percent of the U.S. federal corporate tax rate. Consequently, if the effective foreign tax rate exceeds 18.9 percent, the CFC shareholder can elect to utilize the high-tax election. This option is far more simple than the 962 election. Thus, the compliance cost should be less than a 962 election. When a high tax exception is used, the CFC retains undistributed profits as E&P. If the CFC is incorporated in a country that has entered into a double tax treaty with the United States, it is possible that the dividend may result in a reduced qualified dividend rate. Making a Section 954 election also eliminates the second layer of tax associated with making a 962 election.

Cons to Making a Section 954 Election

The high tax exception results in the CFC retaining undistributed profits as E&P.
This classification difference makes a big difference for cross-border tax planning. In addition, foreign tax credits may be lost through the use of a 954 election. Finally, a 954 election must be made with respect to all CFCs controlled by the CFC. The election cannot be made on a CFC basis. This may result in the loss of cross-crediting of high-taxed CFC’s foreign taxes.

Contributing CFC Shares to a Domestic C Corporation

In order to reduce the sting of a NCTI inclusion, an individual CFC shareholder may contribute his or her shares to C corporation. This would result in the C corporation becoming a U.S. shareholder of the CFC. The short-term benefits of this strategy are clear. The contribution, when structured properly, should qualify as a tax-free Section 351 contribution. (Shareholders in an incorporation transaction will not recognize any gain or loss on the exchange if they satisfy three requirements of Internal Revenue Code Section 351(a)). First, there must be a contribution of property. Second, the contribution must be solely in exchange for stock and, third, the contributors must control the corporation immediately after the exchange).

NCTI earned by a domestic C corporation should receive the benefits of the Section 250 deduction and flow-through of foreign tax credits. In addition, a distribution of the CFC’s PTEP should not be subject to further U.S. federal tax. Moreover, if the CFC has any E&P (that is not otherwise PTEP) a distribution of such an amount from the CFC to a domestic corporation may qualify for the Section 245A participation exemption. Internal Revenue Code Section 245A allows an exemption for certain foreign income of a domestic C corporation that is a U.S. shareholder by means of a 100 percent dividends received deduction for the foreign-source portion of the dividends. Proper planning may also result in dividend distributions from the C corporate holding company qualifying for reduced qualified dividend rate of 20 percent (plus medicare, state, and local taxes).

However, anyone considering transferring CFC shares into a domestic C corporate holding company must understand there are significant long term costs. First, typically, if an individual were to sell CFC shares, the gain on such sale would likely be classified as long-term capital gain for federal tax purposes. Long-term capital gains are subject to federal income tax at a preferential 20 percent rate. To the extent that the CFC has E&P, then some or all of this gain may be recharacterized as a dividend under Section 1248. Under Section 1248(a) of the Internal Revenue Code, gain recognized on a U.S. shareholder’s disposition of stock in a CFC is treated as dividends to the extent of relevant E&P accumulated while the person held the stock. With respect to individual U.S. shareholders who sell shares of a C corporation holding CFC shares, recharacterization is significant due to the rate differential between long-term capital gains, (maximum 20 percent) and ordinary income (maximum 37 percent).

In addition, on the sale of the CFC stock by a domestic C corporation, the shareholder of the domestic C corporation is subject to two layers of tax. First, the sale of CFC stock by the domestic C corporation would be subject to 21 percent federal corporate tax rate. A second layer of tax is assessed when the C corporation makes a distribution of the CFC gains to its shareholders. Planning opportunities may be used to reduce or even eliminate the 21 percent corporate rate on the sale of CFC shares. This could be done by making an election under Section 338(g) of the Internal Revenue Code. When a Section 338(g) election is made, the target CFC is deemed to sell its assets and must recognize any gain resulting from the deemed asset sale. If the seller is a domestic C corporation, the CFC target’s gain on non-trade or business assets typically is classified as Subpart F income, and the remaining gain (with respect to trade or business assets) instead is classified as tested income for NCTI purposes. The CFC’s tax year closes, and its Subpart F income and GILTI through the date of sale are included in the gross income of the domestic C corporate seller.

With a Section 338(g) election, the domestic seller also will be taxed on the gain from the sale of the CFC stock, with the basis of such stock being increased to account for any inclusions under Subpart F or NCTI for the year (including the Subpart F and GILTI income generated by the deemed asset sale). Subject to holding period requirements, the stock gain will be recharacterized as a dividend under Section 1248 and generally will be deductible under Section 245A to the extent of the CFC’s prior year untaxed earnings and profits and current year earnings that are not Subpart F income or tested income, as well as earnings arising from gain on deemed sale of assets that are not subject to Subpart F or NCTI. Because of the dividends received under Section 245A, there may be a preference for C corporate sellers toward dividend characterization under Section 1248 (i.e., a stock sale), which may be exempt from U.S. tax under Section 245A, as compared to gain that may be classified as NCTI income (i.e., an asset sale), which would trigger a 12.6 percent corporate tax. However, if sufficient E&P exists, corporate sellers will likely prefer stock sales over asset sales. In this case, utilizing a Section 338(g) election will convert gains to NCTI tax which will be taxed 12.6 percent.

The liquidation or distribution of the sale proceeds of CFC would be subject to an additional tax at the shareholder level. As discussed above, this may be reduced to 20 percent for federal income tax purposes. A word of caution when using C corporate structure to hold CFC shares. Some holding corporations are developed to avoid shareholder level tax by simply failing to make corporate distributions. In these cases, the IRS may assess penalty taxes under the provisions of the accumulated earnings tax and the personal holdings company tax.

The accumulated earnings penalty tax is imposed upon corporations “availed of for the purpose of avoiding the income tax with respect to its shareholders…by permitting earnings and profits to accumulate instead of being divided or distributed.” See IRC Section 532(a). Once the IRS determines that a corporation is subject to the accumulated earnings penalty tax, a tax imposed upon “accumulated taxable income” at the 37 percent top marginal tax rate imposed on individuals. See IRC Sections 532, 535. Under the personal holding company tax provisions of the Internal Revenue Code, a penalty tax is imposed upon undistributed personal holding company at the top individual marginal tax rate of 37 percent. See IRC Section 541.

Contributing CFC Shares to a Partnership or S Corporation

CFC shareholders may also contribute CFC shares to flow-through structures such as partnerships or S corporations through tax-free transactions. Compared to utilizing a C corporate corporation, placing  CFC shares through flow-through structure does not result in a second layer of tax. Individuals that place CFC shares into flow-through structures may also be able to foreign tax credits without a 90 percent limitation. However, flow-through structures are not likely eligible to utilize the Section 250 deduction. Thus, a flow-through structure may not be an optimal structure if the CFC is operating in a zero or low tax country. There still remains some uncertainty regarding S corporations holding CFC shares with accumulated E&P and PTEPs. The IRS may issue regulations addressing these issues in the future.

What Exactly is the FDDEI Tax Regime?

The FDII deduction was enacted as part of the 2017 Tax Cuts and Jobs Act. Similar to the changes from GILTI to NCTI, the OBBBA renamed what used to be “foreign derived intangible income” to “foreign derived deduction eligible income” (“FDDEI”). FDDEI permits a 33.34% deduction. This results in a 14% effective tax rate on FDDEI.

A FDDEI deduction can be extremely beneficial to U.S. exporters of goods, services, and intellectual property such as the sale of software or apps, and the streaming of audio or video. A FDDEI deduction is not available for income received from financial services, any domestic oil and gas extraction, activities performed through a branch, and certain passive income. The FDDEI 14% federal tax rate is not only available to domestic exporters of goods and services, with proper planning, even U.S.-exporters of goods and services can take advantage of FDDEI favorable rates.

For example, let’s assume a Japanese multinational corporation manufactures automobile parts. Let’s also assume that the Japanese multinational establishes a U.S. corporate subsidiary in Las Vegas, Nevada as the exclusive distributor of the automotive parts throughout Europe.The U.S. corporation negotiates sales of its goods to unrelated retailers in Europe. These sales would be subject to a federal tax rate of up to 14 percent. Any dividends paid from the U.S. corporate subsidiary out of its E&P will not be subject to additional U.S. tax as a result of the United States-Japan tax treaty.

Overview of U.S. Taxation of Exported Goods, Services, and Outbound Licenses of IP

For U.S. C corporations that sell goods and/or provide services to foreign countries, there is a deduction pursuant to Internal Revenue Code Section 250 that reduces the effective tax rate on qualifying income to 14 percent. This includes U.S. corporate subsidiaries of foreign-based multinationals.

The FDDEI deduction is determined based on the following multi-step calculation.

DEI

The FDDEI calculation starts with the computing of a U.S. corporation’s deduction eligible income (“DEI”). DEI is a corporation’s gross income which is adjusted to take into consideration certain items and is reduced by certain deductions allocable to gross income. DEI adjusts gross income to exclude certain types of income such as Subpart F income, dividends received from foreign controlled corporations, income from foreign branches, and the NCTI.

FDDEI

The next step in calculating FDDEI is to determine a U.S. corporation’s FDDEI. FDDEI is DEI that is 1) derived in connection with property sold (including property leased, licensed, or exchanged) by a U.S. corporation to a foreign person for foreign use or 2) services provided to any foreign person. FDDEI can be broken down into the following categories: sales of general property, intangibles, and services.

FDDEI Sales- General Property

This includes any income derived from the sale of property to any foreign person for a foreign use. The term “sale” is specifically defined for this purpose to include any lease, license, exchange, or disposition which is not within the United States.” The sale of the property must only be for foreign use. The question is what is foreign use? Under the proposed regulations for the FDDEI tax regime, sales of property were considered to be foreign use if either the property was not subject to domestic use within three years, or the property was subject to manufacturer, assembly, or other processing outside the United States before any domestic use of the property. These rules also provided that general property was subject to manufacturing, assembly or other processing only if it meets one of two tests. The final regulations did away with the two part test and adopted a more flexible approach. The final regulations provide that the sale of property is for foreign use if the property is subject to manufacturing, assembly or other processing outside the United States, or if delivered to an end-user outside the United States.

The final regulations to former FDII also provide an additional rule for the sale of general property that includes digital content. The term digital contest is defined in the final regulations as a computer program or any other content in digital form. The final regulations go on to provide that a sale of general property that primarily contains digital content that is transferred electronically rather than in a physical medium is for a foreign use if the end-user downloads, installs, receives, or accesses the purchased digital content on the end-user’s device is downloaded, installed, received, or accessed (such as the device’s IP address) is unavailable, and the aggregate gross receipts from all sales with respect to the end user are far less than $50,000, the final regulations provide that a sale of general property is for foreign use if the end-user that has a billing address located outside the United States.

FDDEI Sales- Services

Qualifying foreign income also includes income derived in connection with services provided to any person not located within the United States, or with respect to property that is not located in the United States. The services may be performed within or outside the United States (but not in a foreign branch of the domestic corporation), which limits the extent of permissible qualifying activity outside the United States. The gross foreign sales and services income is reduced by expenses properly allocated to such income. The sum of these two amounts yields foreign-derived deductible eligible income.

FDDEI Related Party Rules

The general rule is that a U.S. corporation’s sales or services provided to foreign related parties are not for foreign use and, therefore, are not treated as FDDEI for purposes of the FDDEI deduction. Under the FDDEI rules, parties are generally considered to be related if they are members of an affiliated group of companies connected by more than 50 percent ownership. In certain cases, sales and services to related parties may qualify for the FDDEI deduction if the transaction satisfies certain additional requirements. Where a sale of property is made to a foreign related party, the outcome depends on whether: 1) the property is resold to an unrelated party or parties; or 2) the property is used in the process of providing property or services to unrelated parties.

In the second case, the FDDEI benefit may be claimed if the seller in the related party sale reasonably expects that more than 80 percent of the revenue earned from the use of the property received in the related party transaction will be derived from unrelated party sales or services transactions that meet the substantive FDDEI requirements. For example, assume from the example above, the Japanese subsidiary sells manufactured automotive equipment to its Japanese parent and the parts are used to produce other inventory sold worldwide. The requirement is met if the foreign affiliate has a reasonable expectation that more than 80 percent of the revenue from that inventory will be from sales to foreign unrelated persons for foreign use.

A related party services transaction may qualify for the FDDEI deduction if the services rendered are not considered to be “substantially similar” to the services provided by the related party services recipient to the person or persons located in the U.S. Under the FDII rules, the services provided by the related party service recipient are considered to be substantially similar services if: 1) 60 percent or more of the benefits conferred by the related party service ultimately accrue to persons located in the U.S.; or 2) 60 percent or more of the price paid by the persons located in the U.S. is attributable to the related party services.

A related party service provided to a foreign related party is considered to be substantially similar to the services that the foreign related party provides to U.S. persons if 1) the related party services are used by the foreign related party to serve a U.S. person and 2) the services fall within the Benefit Test or Price Test. If the related service does fall within the Benefit Test or the Price Test then the U.S. corporation has established that the service is not substantially similar to the services that the foreign related party providers to U.S. persons.

The Benefit Test deems a related party service to be substantially similar to services that the foreign related party provides to U.S. persons if at least 60 percent of the benefits conferred to the related party are used to confer benefits to a U.S. person. As a simplified example of the Benefit Test, assume that a domestic corporation (DC) is hired by a foreign related party (FC) to create architectural plans for FC’s U.S. customer R who only operates in the U.S. Since all of the benefits that DC confers to FC are directly used in the provision of FC’s services to R, a U.S. person, the Benefit Test would deem the service provided by DC to FC substantially similar to the service that FC provides to R. Therefore, DC’s creation of the architectural plans would not be treated as FDDEI services income.

The Price Test deems a related service to be substantially similar to the services that a foreign related party provides to U.S. persons if at least 60% of the price paid by the U.S. person for the foreign related party service is attributable to the related party service. As a simplified example, the Price Test, assumes that a domestic corporation (DC) is hired by a foreign related party corporation (FC) to create architectural plans for FC’s customer R. In this example, R is a multinational corporation whose operations are 90% foreign and 10% U.S. FC pays DC $75 for the architectural service which DC includes in its gross income and FC charges R $100 for the total services.

Applying the Price Test, the first step is to determine the price paid by persons located in the U.S. As applied to the facts, the price paid by R to FC ($100) is allocated proportionally based on the locations in which R benefits from the service. Accordingly, $10 of R’s benefit is allocated to the U.S. ($100  10% of R’s operations). The next step is to determine the amount attributable to the related party services. FC paid DC $75 of which $7.5 ($75  10% of R’s U.S. operations) is treated as attributable to related party services provided in the U.S. Applying the Price Test, more than 60% of the price paid to FC is attributable to DC’s related party service 75% (7.5 / 10), and thus the services provided by DC to FC is substantially similar to the service that FC provided to R. There, only $67.5 ($75 – $7.5) of DC’s gross income can be treated as FDDEI services.

Deemed Tangible Income No Longer Considered Under the OBBBA

Similar to NCTI, the OBBBA eliminated the qualified business activity investment (“QBAI”) calculation for FDDEI.

Cross-Border Tax Considerations

Because FDDEI involves cross-border transactions which are subject foreign taxes such as value added tax (“VAT”), income tax, and customs tax, foreign taxes must be considered. If the foreign tax component is significant on the cross-border transaction, any FDDEI planning may quickly become irrelevant. Consequently, foreign taxes should be considered before any FDDEI planning begins.

Repatriating Income from a US Subsidiary

Multinationals operating a U.S. subsidiary may be subject to a 30-percent withholdings on any dividend distributions. However, tax treaties generally provide for a reduction or elimination of this withholding tax. However, if the parent corporation is a member of a country that has entered into a tax treaty with the U.S. such withholding may be reduced or eliminated. Because each treaty results from separate bilateral negotiations, the extent to which the withholding on dividends varies substantially among the treaties currently in force between the U.S. and other countries. The withholding tax on dividends is reduced generally to 15 percent. If the foreign shareholder is a corporation that owns at least ten percent of the U.S. corporation, however, the withholding could be as low as five percent. See U.S. Model Treaty, Art. 10. In some treaties, certain dividend payments have been exempted from the withholding tax. See e.g., United States-Japan Treaty, Art. 10(3); Protocol to United States-Netherlands Treaty, which amends Art. 10 of the treaty.

Is FDDEI Truly the Carrot?

NCTI was designed to be a “stick” to FDDEI “carrot” for outbound international tax purposes. For the unprepared and ill-informed CFC shareholder, NCTI can be definitely punitive and can be characterized as a stick. At the same time, FDDEI is supposed to be beneficial or a “carrot.” Let’s take a closer look at FDDEI to see if this is true. Like NCTI, the benefits of FDDEI are designed for C corporations. Therefore, CFCs that are held directly by individuals or through entities other than C corporations are not eligible to claim the benefits of FDDEI.

For C corporate shareholders of CFCs that sell and/or provide services to customers located in foreign countries, a deduction is available. This provision of the Code reduces the overall effective tax rate on qualifying income to 14 percent. The FDII benefit is determined by performing a calculation. Like NCTI, FDDEI involves a multi-step calculation. FDDEI begins with taking into consideration the CFC’s corporate holder’s gross income. The gross income is calculated and then reduced by certain items of income. The items that reduce the income include Subpart F income, dividends received from CFCs and income earned in foreign branches. This amount is further reduced by deductions which include taxes. At the conclusion of these reductions an amount is determined. This amount is known as the “yielding deduction eligible income.”

The second step of the FDDEI formula is to determine the foreign amounts of the domestic corporation which holds the CFCs. This amount includes any income that is derived from the “sale” of property to any foreign person for a “foreign use.” The terms “sale” and “foreign use” are defined by FDDEI. For purposes of FDDEI, the term “sale” includes any lease, license, exchange or other disposition. The term “Foreign use” is defined by the Code to mean “any use, consumption, or disposition which is not within the United States.” FDDEI has also defined the term “qualifying foreign.” Qualifying foreign includes income derived in connection with services provided to any person not located within the United States, or with respect to property that is not located in the United States. Qualifying foreign does not just apply to goods. It also applies to services. For FDDEI purposes, services may be performed within or outside the United States. However, services may not be performed in a foreign branch of a domestic corporation. The gross foreign sales and services income is reduced by expenses properly allocated to such income. The sum amounts of the first and second part of the formula yields FDDEI eligible income.

The FDDEI computation is a single calculation performed on a consolidated group of CFCs.  A domestic corporation’s FDDEI is 33.34 percent deductible in determining its taxable income (subject to a taxable income limitation), which yields a 14 percent effective tax rate. U.S. tax on FDDEI may be reduced with foreign tax credits to the extent the FDDEI is foreign source income. Foreign source FDDEI generally should fall within the general foreign tax credit limitation category, and therefore foreign taxes paid on other active foreign source income earned directly by the U.S. corporation should be available as a credit.

Unfortunately, FDDEI only provides favorable treatment to property sold or services designed on foreign land for foreign use. Any CFC shareholder seeking to take advantage of FDDEI must understand the limitations of this rule. For example, property sold to a foreign person or foreign corporation is not treated as FDDEI income if it is manufactured or modified within the United States. This is the case even if the property is subsequently used outside the United States. Likewise with services, if services are provided to a foreign person or business located within the United States, the services are not treated as “foreign use” for FDDEI purposes. This is even the case if the foreign person or business uses those services outside the United States.

Who’s the Hero and Who’s the Villain?

Both NCTI and FDDEI are taxed at preferential rates (with proper planning). However, NCTI was intended to be punitive and FDDEI was supposed to be beneficial. However, with NCTI apparently being taxed at approximately 14 percent and FDDEI also being taxed at approximately 14 percent. With proper planning, neither NCTI or FDDEI should be punitive. However, FDDEI may only be utilized in very limited circumstances. Thus, FDDEI may not live up to its promised benefits. On the other hand, NCTI or the former GILTI never pretended to be beneficial. Although NCTI was never supposed to be beneficial, with proper planning, NCTI tax consequences can be mitigated in almost all circumstances.

And The Winner is…………

The winner is….tax and entity planning! With proper planning the devastating impact of the NCTI tax regime can potentially be managed. On the other hand, U.S. outbound investors operating through a C corporation may utilize FDDEI deduction to significantly reduce the U.S. tax on foreign source income and certain FDDEI may be foreign-source income that can be further reduced with foreign tax credits.

Obviously, this is a very complex area of tax law. No CFC shareholder or outbound investor should face the battle with the new NCTI or FDDEI provisions without the benefit of a skilled international tax attorney on their side.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony has advised various Fortune 500 companies and large privately held businesses in their cross-border tax planning. Anthony is a frequent author and speaker on international tax topics.

Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.