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Maximizing Tax Benefits: Navigating Section 174 Rules and Leveraging the FDII Deduction for R&E Costs

The latest regulations, known as Section 174 rules, now require taxpayers to capitalize and gradually deduct research and experimental (R&E) costs incurred in taxable years starting on or after January 1, 2022. The deduction is calculated based on a straight-line recovery period of either five years for costs incurred within the U.S. or 15 years for costs incurred outside the U.S. As taxpayers adjust to these new rules and strive for compliance, they may encounter several challenges, including a significant increase in taxable income, a faster utilization of net operating losses (NOLs), which may require a valuation allowance analysis for ASC 740 purposes, and a strain on cash flow due to higher current tax liabilities.

Effective tax planning will depend on each taxpayer’s specific circumstances and will be influenced by future guidance from the IRS. However, under the current rules, the foreign-derived intangible income (FDII) deduction could serve as an important tax planning strategy to help mitigate the adverse effects of the new rules.

How Does the FDII Deduction Benefit U.S. Companies Serving Foreign Markets?”

The Section 174 rules introduced under the Tax Cuts and Jobs Act of 2017 (TCJA) brought about various tax changes, including the creation of the FDII deduction under Section 250. This deduction grants a preferential tax rate for income derived by U.S. C corporations or partnerships with C corporation partners that serve foreign markets. FDII encompasses a broad range of income sources, not limited to intangible assets direct exploitation. It includes revenues from selling, leasing, licensing, exchanging, or disposing of general and intangible property to foreign individuals or entities, as well as revenues from providing services to foreign individuals or entities.

If applicable, the FDII deduction provides a permanent tax benefit equal to 37.5% times the net income from qualifying revenue streams, resulting in an effective tax rate of 13.125% on qualified income, compared to the federal statutory corporate rate of 21%. Calculating the FDII deduction is complex and requires identifying and analyzing potentially qualifying revenue streams, understanding the taxpayer’s organizational structure and intercompany transactions, and allocating expenses and making other necessary tax adjustments.

What are the Limitations on FDII and GILTI Deduction?

There is a limitation on taxable income when computing the FDII deduction. If a taxpayer’s combined FDII and GILTI (global intangible low-taxed income) amount exceeds taxable income after applying any NOL deductions, the FDII and GILTI deduction needs to be proportionally reduced by the excess amount. Additionally, taxpayers who were previously in an NOL position or could fully offset taxable income with pre-TCJA NOL carryforwards were ineligible for the FDII deduction.

In the 2022 tax year, some taxpayers with historical losses are now becoming taxable due to the new Section 174 rules and are seeking ways to offset the increased taxable income. If these taxpayers engage in foreign transactions, they should carefully evaluate their activities to determine if they qualify for the FDII deduction in all taxable years. Even taxpayers who have previously claimed the FDII deduction should review their approach in light of Section 174 and the historical allocation and apportionment of expenses, as well as other tax provisions.

Ultimately, taxpayers may not only see a reduction in their current federal income taxes but also a substantial decrease in their effective tax rate due to the increased FDII benefit resulting from the change in Section 174 tax treatment. It is crucial to carefully consider and take a multidisciplinary approach when assessing the benefits. Several key considerations include evaluating and classifying expenses as U.S. or foreign Section 174 expenses, reviewing transfer pricing studies related to R&D arrangements, and properly allocating and apportioning Section 174 expenses based on specific rules to determine the impact on FDII, and other provisions related to expense allocation.

Article by Muhammad Junaid, Senior Tax Manager

Matthew John McNally
Matthew is an enrolled agent with two decades of tax planning, compliance, and advisory experience, much of it at Big Four accounting firms, where he guided clients with wide-reaching financial concerns.