By Anthony Diosdi
A U.S. corporation’s lease or licensing of property and license of intellectual property to non-U.S. customers may be subject to U.S. federal tax at a rate of only 13.125 percent. This reduced tax rate can apply to cross-border licenses of software, apps, streaming of audio or video, and proprietary knowhow that is essentially secret or confidential information not known to the public.
This article explains the general framework for the Foreign Derived Intangible Income (“FDII”) deductions available to U.S. corporations that license intellectual property to non-U.S. entities or persons and foreign tax considerations associated with cross-border licensing agreements.
Tax Incentives to Cross-Border Licensing
Tax considerations often create major incentives for licensing of intangible rights to unaffiliated and foreign affiliates controlled by the licensor as a result of the FDII deduction. FDII is a type of income that when earned by a U.S. domestic C corporation is entitled to a deduction equal to 37.5 percent of the FDII. Since the current U.S. federal corporate income tax rate is 21 percent FDII income is taxed at an effective rate of 13.125 percent (21% – 37.5% = 13.125%).
There are three steps to calculating FDII. First, a C corporation’s gross income is determined and then reduced by certain items of income, including income under subpart F, dividends received from controlled foreign corporations and income earned in foreign branches. This amount is reduced by deductions properly allocable to such income. This amount yields deduction eligible income or “DEI.”
Second, the foreign portion of such income is determined. This amount includes any income derived from the sale of property to any foreign person for foreign use. The term “sale” is specifically defined for this purpose to include licenses. “Foreign use” is defined as “any use, consumption, or disposition which is not within the United States.” Qualifying foreign income 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. However, (subject to exceptions discussed below) services may not be performed in a foreign branch of a U.S. corporation.
In the context of intangible property licensed to a foreign entity or foreign person, foreign use is determined by where the end user will generate revenue from the exploitation of the intangible property. Thus, a license agreement of intangible property for exploitation abroad will be considered to be for foreign use. On the other hand, a license of intangible property that is intended to be exploited in the U.S. will not be considered to be for foreign use for purposes of FDII. As indicated above, the general rule is that a U.S. corporation’s services provided to foreign related parties are not for foreign use and as such is not treated as FDDEI for purposes of the FDII deduction. The Internal Revenue Code classifies a foreign related party as any foreign entity or person related to the seller or render of services. There are a number of exceptions which make the FDII deduction available to U.S. corporations that transfer licenses to a related foreign party or foreign branch. For example, with regards to FDDEI general property, a sale to a foreign related party will be treated as a sale for foreign use if either (1) the foreign related party subsequently sells the property to an unrelated foreign party for foreign use or 2) the foreign related party uses the property in connection with the provision of services or sale of property to a foreign unrelated party. See FDII Planning, Steven Hadjilogiou, McDermott Will & Emery, LLP Miami. Once the deemed intangible income is determined, the gross foreign sales and services income is reduced by expenses properly allocated to such income.
Finally, a C corporation’s deemed intangible income must be determined. This is the excess (if any) of the domestic corporation’s deduction eligible income over 10 percent of its qualified business asset investment or “QBAI.” A C corporation’s QBAI is the average of its adjusted bases (using a quarterly measuring convention) in depreciable tangible property used in the corporation’s trade or business to generate the deduction eligible income. The adjusted bases is determined using straight line depreciation. This does not include land or intangible property.
Once all three parts of the FDII formular have been determined, it is time to calculate the FDII deduction. FDII can be expressed as follows:
FDII=Deemed Intangible Income x Foreign-Derived Deduction Eligible Income
Deduction Eligible Income
The FDII computation is a single calculation done on a consolidated group basis which nets a 37.5 percent deduction. The U.S. income tax on FDII may be further reduced by foreign tax credits. However, only 62.5 percent of the FDII should be taken into account for purposes of calculating the foreign tax credit. FDII deduction should be calculated and reported to the Internal Revenue Service (“IRS”) on Form 8993.
Foreign Tax Considerations
A transfer of intellectual property will typically result in the foreign licensee paying royalties. When intangible property is licensed to a related foreign branch or related foreign entity, the foreign tax consequences of royalty payment should be considered.
Under the tax laws of many foreign countries, royalty payments under an exclusive or nonexclusive license are deductible by the licensee as business expenses. If the licensor and licensee are related entities, however, the amount of the royalties may be scrutinized by a foreign tax authority. In some cases, the deduction may be denied to the extent that the royalties are excessive when judged against the standard of a royalty rate that might reasonably have been adopted by independent parties dealing at arm’s length.
The bilateral income tax treaties between the U.S. and foreigtn countries provide that royalties under exclusive or nonexclusive licenses are exempt from income tax or are subject to reduced tax in the source country so long as the licensor does not have a permanent establishment in that country to which the royalties are attributable. If such treaty exemption does not apply, royalties are subject to the normally applicable (or reduced treaty) rate of tax that must be withheld by the licensee in the source country on royalties paid to foreign licensors. Occasionally, such royalties are exempt from withholding tax under the law of the source country.
Despite its complicated framework, a U.S. corporation may license its intellectual property to a foreign entity to be subject to U.S. federal tax rates of only 13.125 percent. However, because FDII is limited to cross-border transactions, a U.S. licensee must take into consideration foreign income tax consequences. If foreign tax tax is not taken into consideration with planning the licensing of intellectual property, the low FDII domestic rate may be irrelevant.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or firstname.lastname@example.org.
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.