How Companies Can Benefit From Foreign Tax Incentives

Businesses often pursue attractive opportunities to increase their customer base and revenue by expanding overseas. This can be done in several ways, including through direct exports, or by forming or purchasing a foreign subsidiary to conduct sales on your behalf.

Beyond the direct business benefits of generating international revenue, overseas operations can provide a variety of tax benefits that can further increase a company’s profitability.

If sales are performed as direct exports, for instance, it is important to track these sales as there are multiple ways to gain income tax benefits from the foreign sales if you are organized as a C-Corp.

The first way C-corps can benefit is from the Foreign-Derived Intangible Income (FDII) deduction allowed under section 250 of the Internal Revenue Code. This deduction, intended to incentivize U.S. companies to keep intellectual property and related profits in the United States, was introduced as part of the 2017 Tax Cuts and Jobs Act.

The corporation would be allowed a 37.5% (reduced to 21.875% in 2026) deduction of their foreign derived income after taking into account the ratio of the foreign sales to domestic sales and expense allocation/apportionment. FDII provides a reduced effective tax rate of 13.125% on qualifying foreign-derived income, compared to the standard 21% corporate tax rate.

Qualifying income includes revenue from:

To claim the deduction, corporations need to carefully track and calculate their foreign-derived income and related expenses. The complex calculations and data requirements make it important for companies to analyze their eligibility and potential benefits thoroughly from the FDII deduction.

The deduction rate is scheduled to decrease to 21.875% in 2026, resulting in an effective tax rate of 16.406% on FDII.

The second way to benefit from non-U.S. sales is from the foreign tax credit (FTC), which is a benefit that allows U.S. taxpayers to offset income taxes paid to foreign countries against their U.S. tax liability. The primary purpose of this credit is to prevent double taxation on income earned abroad.

The FTC allows taxpayers to reduce their U.S. tax liability dollar-for-dollar based on the amount of foreign income tax they pay. Taxpayers can choose to claim foreign taxes as either a credit or an itemized deduction. The credit is usually more beneficial as it reduces the U.S. tax liability directly.

Most foreign sales would be considered general limitation income for purposes of the foreign tax credit, as long as:

Any income or withholding foreign taxes paid (not including VAT and similar taxes) can be used to offset the income due in the U.S., subject to the foreign tax credit limitation calculation. The most important point to remember as you prepare for year-end would be to document the amount of foreign sales, and the methodology used to conclude the sales as foreign source.

U.S. corporations must complete Form 1118 to compute and claim their FTC. The form requires extensive documentation about the corporation, its foreign income, and applicable deductions or credits.

Form 1118 requires separate calculations for different categories of foreign income, such as:

When completing Form 1118, corporations must maintain detailed records of foreign taxes paid, including tax receipts, returns, and other relevant documentation. Foreign income, expenses, and reported taxes must be converted to U.S. dollars using IRS-approved exchange rates.

Excess foreign tax credits can be carried back one year or forward up to 10 years.

It is similarly important to track your basis in the foreign entities you own, both in the cases of selling your shares in the foreign entity or receiving a distribution from the entity.

Basis is calculated based on the initial contribution or purchase price. Basis is increased by any future contribution or additional purchase of shares as well as the accumulation of earnings of profits, and, similarly, is decreased by any distributions received.

This is important no matter how the entity is treated in the U.S., whether as a controlled foreign corporation (CFC), a passive foreign investment company (PFIC), controlled foreign partnership (CFP), or simply an entity held for investment.

It takes much more effort and expense to gather the required data together while a transaction is taking place. Instead, it is much more efficient to begin tracking the necessary information ahead of any potential transaction.

This can also be important as companies are often required to book a deferred tax liability for any potential withholding taxes that would be due upon the distribution of all earnings and profits of the foreign entity and document under APB 23 as a temporary difference unless there exists in the tax law a means by which the investment can be recovered tax-free.

The presumption that all undistributed earnings will be transferred to the parent company may be overcome, and no income taxes should be accrued by the parent company, if sufficient evidence shows that the subsidiary has invested or will invest the undistributed earnings indefinitely or that the earnings will be remitted in a tax-free liquidation.

In this case, a memo should be prepared documenting the position and relative evidence including specific plans for the reinvestment of the undistributed earnings showing that the remittance of the earnings will be postponed indefinitely.

To learn more about how international tax incentives can benefit your business, contact us.