In short
The foreign derived intangible income (FDII) deduction, now called foreign derived deduction eligible income (FDDEI) after the One Big Beautiful Bill Act (OBBBA), allows a domestic C corporation to pay an effective tax rate as low as 13.125% on income from selling goods and services to foreign customers. Income from AI software, software as a service subscriptions, and AI research and development can all qualify. For tax years beginning after December 31, 2025, the OBBBA permanently set the deduction rate at 33.34%, which yields an effective rate of about 14%. The new law also simplified the calculation by removing the old tangible asset offset that penalized capital intensive businesses. Large technology companies like Google, Microsoft, and Nvidia have saved billions of dollars through this deduction, and US corporations with foreign-derived intangible income can plan to use it. Law firm analysis, Tax policy research
What is the FDII deduction and how does it lower tax on AI exports?
Congress created the FDII deduction in the Tax Cuts and Jobs Act of 2017. Only a domestic C corporation may claim the deduction. A partnership or S corporation cannot claim it directly, but a corporate partner can use its distributive share of partnership items to compute its own deduction. 26 U.S.C. §250, 26 CFR §1.250(a)-1(c)(1), Treas. Reg. §1.250(b)-1(e)
The deduction works by letting the corporation subtract a portion of its foreign derived income from its taxable income. The math changes for tax years before and after 2026.
For tax years through December 31, 2025, the deduction is 37.5% of FDII. Because the federal corporate tax rate is 21%, the effective tax rate on that income works out to 13.125% (21% times 62.5%). 26 U.S.C. § 250(a)(1)(A), IRS LB&I Practice Unit INT-C-238
The old formula was multi step. First the corporation figured its deduction eligible income (DEI). That is gross income minus certain excluded categories of income and minus deductions (other than interest expense and research or experimental expenditures) properly allocable to that income. 26 U.S.C. §250(b)(3) Next it identified the portion of DEI that came from foreign sales and services, called foreign-derived deduction eligible income (FDDEI). 26 U.S.C. §250(b)(1) The deduction did not simply multiply a rate by FDDEI. Instead, the law first subtracted a deemed return on tangible assets. The corporation took 10% of its qualified business asset investment (QBAI), which is roughly the average adjusted basis of its tangible property like servers and buildings. That 10% amount was called deemed tangible income return (DTIR). Subtracting DTIR from DEI gave deemed intangible income (DII). Finally, the deduction was 37.5% of DII times the ratio of FDDEI to DEI. 26 U.S.C. §250(a)(1)(A), (b)(1), pre-2026 In plain terms, the more tangible assets a company had, the smaller its deduction, because DTIR grew and shrank DII.
The OBBBA eliminated this complexity. After 2025 the deduction is simply 33.34% of FDDEI. There is no more QBAI subtraction, no DII, and no ratio. The formula is a straightforward multiplication. Law firm analysis, Pub. L. 119-21, §§ 70321, 70323
How does an AI company’s income qualify as foreign derived?
Income from AI exports can fall into two main buckets under the FDII rules. The law then subdivides services further, but the starting point is straightforward.
Sale of property. The statute says sold includes any lease, license, exchange, or other disposition. 26 U.S.C. §250(b)(2)(E) So when a US AI company licenses its large language model to a foreign customer through an API subscription, the law treats that license the same as a sale of property for FDII purposes. The licensed software must be used outside the United States (a foreign use). 26 U.S.C. §250(b)(1)(A), 26 U.S.C. §250(b)(2)(A), 26 U.S.C. §250(b)(2)(E)
Providing services. The regulations split services into four types. General services include any service that is not a property, proximate, or transportation service. Within general services, the regulations specifically name electronically supplied services. Treas. Reg. §1.250(b)-5(c)(6) A cloud based AI service or a software as a service platform is an electronically supplied service, which is a general service.
For a general service sold to a business recipient located outside the United States, the income is FDDEI to the extent the service benefits the recipient’s operations outside the United States. The benefit is measured under the same principles used for transfer pricing under §482. Treas. Reg. §1.250(b)-5(e)(1), (e)(2)
Real example. A US AI company provides a multilingual chatbot API to a German company. The German company integrates it into its customer service platform and uses it only in Europe. The US company obtains a statement from the German company confirming its foreign status and foreign use. The subscription revenue is FDDEI.
The IRS has shown a favorable reading of the benefit test in an important ruling. In PLR 202502002, two US entities performed research and development services for a foreign parent company. The foreign parent owned the resulting intellectual property and manufactured products entirely outside the United States. A separate US affiliate then sold the finished products in the US market. The IRS held that 100% of the R&D service income was FDDEI. The benefit test focused on the direct recipient (the foreign parent) rather than on the related US distributor. PLR 202502002 A private letter ruling is not binding on other taxpayers, but it can provide penalty protection for someone who relies on it under the substantial authority standards. IRC §6110(k)(3), Treas. Reg. §1.6662-4(d)(3)(iii)
Documentation. Under the FDII regulations, a sale is presumed to be to a foreign person if it is a foreign retail sale or the property is shipped to a foreign address, unless the seller knows or has reason to know otherwise. For sales of general property delivered to an end user outside the United States, foreign use is determined by the delivery location without specific substantiation. For sales for resale, substantiation methods include a binding contract limiting subsequent sales to foreign markets, credible evidence from the recipient, or a written statement prepared by the seller, among other options. For sales for manufacturing or processing outside the United States, substantiation is satisfied by credible evidence from the recipient or a written statement prepared by the seller. For sales of intangible property, substantiation methods include a binding contract limiting exploitation to foreign markets, credible evidence from the recipient, or a written statement prepared by the seller. Treas. Reg. §1.250(b)-4(d)(3)(ii), Treas. Reg. §1.250(b)-4(d)(3)(iii), Treas. Reg. §1.250(b)-4(d)(3)(iv), Treas. Reg. §1.250(b)-3(f)
What changed under the One Big Beautiful Bill Act?
The OBBBA, signed on July 4, 2025, made several permanent changes to the FDII deduction. The table below shows the high level comparison.
| Feature | Before OBBBA (tax years through 2025) | After OBBBA (tax years beginning after 12/31/2025) |
|---|---|---|
| Deduction rate | 37.5% | 33.34% |
| Effective tax rate on qualified income | 13.125% | about 14% |
| Formula | 37.5% × (DEI − 10% × QBAI) × (FDDEI ÷ DEI) | 33.34% × FDDEI |
| Tangible asset offset | 10% × QBAI reduced DII | Eliminated. Deduction depends only on FDDEI |
| Interest and R&D allocation | Required to be allocated against DEI | No longer allocated to DEI |
| New excluded income categories | Not excluded | Gains from sale of intangible property (as defined in §367(d)(4)) and depreciable or amortizable property are excluded, but leases and licenses remain eligible |
The new rule means a capital intensive AI company that owns its own servers and other hardware will often see a larger deduction than under the old law, because the tangible asset penalty is gone. Pub. L. 119-21, § 70323, BDO analysis
The change that removes the requirement to allocate interest expense and research or experimental expenditures against DEI also tends to increase the deduction base. The OBBBA changed the statutory language to say that those amounts are not properly allocable deductions or expenses to gross DEI. Pub. L. 119-21 No IRS guidance has yet explained whether the addition of the word expenses changes the practical computation.
The law also renamed the deduction from FDII to FDDEI, and the companion deduction for GILTI became NCTI. The effective dates are important. The new 33.34% rate and the simpler formula apply to tax years beginning after December 31, 2025. However, the two new income exclusions apply to dispositions occurring after June 16, 2025, which is in the middle of many taxpayers’ 2025 calendar year. Form 8993 Instructions at 2
How the taxable income limit interacts with new depreciation and R&D expensing
The total §250 deduction cannot be larger than the corporation’s taxable income, figured without the §250 deduction itself. If FDDEI plus NCTI (the renamed GILTI) is more than taxable income, the deduction is reduced proportionally. 26 U.S.C. §250(a)(2), Form 8993 Instructions, lines 25-27
The OBBBA also restored 100% bonus depreciation for qualified property acquired and placed in service after January 19, 2025, and enacted new §174A to allow immediate expensing of domestic research and experimental costs. Pub. L. 119-21 For an AI company that is buying a lot of servers or building an AI data center, bonus depreciation alone can create a large current year deduction. The new R&D expensing can do the same. If those deductions push taxable income down to zero or near zero, the FDDEI deduction may be curtailed or eliminated for that year. The deduction is not a credit and cannot be carried forward. Companies will need to model the tradeoff. They may choose to elect out of full bonus depreciation on some assets or to capitalize some R&D costs to preserve taxable income and use the FDDEI benefit. There is no IRS guidance yet on this specific interaction.
What are the open questions and risks?
OECD harmful tax practices review. The OECD Forum on Harmful Tax Practices placed the FDII regime under peer review as a potentially harmful preferential tax regime. The United States previously committed to abolish it. The OBBBA reformed and made the regime permanent instead. The February 2026 OECD peer review update omitted the FDII regime, which the August 2021 update had listed as in the process of elimination, with the United States committed to abolishing it. OECD consolidated peer review results, Feb 2026, Tax alert, Aug 2021
WTO challenge risk. Earlier US export incentives, including the Domestic International Sales Corporation (DISC) and the Foreign Sales Corporation (FSC), were ruled illegal export subsidies under World Trade Organization rules. The FDII deduction could face a similar challenge, though no formal dispute has been filed as of May 2026.
Drafting ambiguity on expenses versus deductions. The OBBBA amended the DEI allocation rule to say that interest expense and research or experimental expenditures are not properly allocable deductions or expenses to gross DEI. Pub. L. 119-21, § 70322(b)(1) (codified at 26 U.S.C. § 250(b)(3)(A)(ii)) The addition of expenses raises a drafting question because the statute previously referred only to deductions. No IRS guidance has yet clarified whether the term expenses has a different effect. Practitioners will need to follow developments.
Form 8993 instructions not yet fully updated. The December 2025 revision of the Form 8993 instructions states the new 33.34% and 40% rates in its Important Reminders section, but the line by line instructions for lines 28 and 29 still show the old 37.5% and 50% rates. Form 8993 Instructions Tax preparers should watch for a corrected version.
AI classification gap. The proper classification of cross border AI items such as training data, model weights, and inference services has not been addressed in any IRS guidance. Whether such items are sales of property or services could affect documentation rules and eligibility.
Key takeaways
- The FDII deduction (now FDDEI) gives US C corporations a permanent lower tax rate of about 14% on export income from AI software, services, and licensing.
- Only domestic C corporations can claim the deduction. Pass through entities and individuals do not qualify directly, but a corporate partner in a partnership can use its share of partnership items.
- The OBBBA eliminated the old tangible asset penalty. An AI company that owns its own servers and facilities no longer loses part of the deduction because of them.
- Documentation is essential. Keep contracts, customer statements, and other records that prove the foreign status of the buyer and the foreign use of the product or service.
- The new deduction rate and simple formula start for tax years after December 31, 2025. The new exclusions for certain property sales already apply to dispositions after June 16, 2025. Watch your transaction dates.
- Large bonus depreciation and immediate R&D expensing can shrink taxable income and limit the FDDEI deduction. Model the numbers before you decide how to handle capital spending.
- The deduction faces ongoing international scrutiny. The OECD review and possible WTO challenges create some risk for the regime’s long term stability. Stay informed.
Frequently asked questions
Q:What is the FDII deduction and who can claim it?
A:It is a deduction under Internal Revenue Code Section 250 that lowers the effective federal tax rate on income that a US corporation earns from selling goods and services to foreign customers. Only a domestic C corporation may claim it directly. 26 U.S.C. §250
Q:How much is the deduction under the new law?
A:For tax years beginning after December 31, 2025, the deduction is 33.34% of foreign-derived deduction eligible income (FDDEI). At the 21% corporate rate, that works out to an effective rate of about 14% on that income. Form 8993 Instructions at 1
Q:What AI income can qualify for the deduction?
A:Income from licensing AI models, providing AI software as a service, selling cloud based AI APIs, and performing AI research and development services for a foreign business customer can all qualify. For a general service provided to a consumer to qualify as FDDEI, the consumer must reside outside the United States when the service is provided, and for a business recipient, the service must benefit the recipient’s operations outside the United States. Treas. Reg. §1.250(b)-5
Q:What records must a company keep?
A:A sale of general property delivered through a carrier to an end user outside the United States is for a foreign use, and a sale at a physical retail location outside the United States is also for a foreign use. Treas. Reg. §1.250(b)-4(d)(1)(ii)
Q:When do the OBBBA changes take effect?
A:The new 33.34% rate and simplified formula apply to tax years beginning after December 31, 2025 (generally 2026 and later years). The two new exclusions for gains from selling intangible property or depreciable property apply to dispositions that occur after June 16, 2025. Pub. L. 119-21
Q:How does the taxable income limit work?
A:The total Section 250 deduction cannot be larger than the corporation’s taxable income, figured without the deduction itself. If FDDEI plus NCTI (the renamed GILTI) is more than taxable income, the deduction is reduced proportionally. 26 U.S.C. §250(a)(2), Form 8993 Instructions, lines 25-27
Q:Can an S corporation or individual claim the deduction?
A:No. The deduction is only for domestic C corporations. An individual or a passthrough entity cannot claim it directly. A domestic corporate partner in a partnership determines its DEI and FDDEI by taking into account its share of the partnership’s gross DEI, gross FDDEI, and deductions. Treas. Reg. §1.250(a)-1(c)(1), Treas. Reg. §1.250(b)-1(e)
Q:How much have large tech companies saved from the FDII break?
A:From 2018 through 2023, Alphabet (Google) reported nearly $12 billion in FDII tax benefits. Microsoft reported over $5 billion, and Nvidia reported over $1.4 billion in 2023 alone. Ten of the largest technology companies together received about $44 billion in FDII benefit over those years. Tax policy research
Q:Is the OECD still reviewing the FDDEI deduction?
A:Yes. The OECD has flagged the FDII regime as a potentially harmful preferential tax practice. The United States had previously committed to abolish it. The OBBBA reformed rather than abolished the regime, but the OECD classified the FDII regime as in the process of being eliminated in 2021. The FDII regime does not appear in the OECD’s February 2026 consolidated peer review results. Tax alert, OECD peer review, Feb 2026
Q:What should an AI company do right now to capture the benefit?
A:Review your customer contracts and identify revenue from foreign customers. Build a system to collect and store the required foreign status and foreign use documentation. Model the effect of large deductions from bonus depreciation and R&D expensing on your taxable income so you do not accidentally lose the deduction. Watch for IRS guidance on the new terminology and on the classification of AI data and model weights.
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Junde Liu, JD, LL.M. (Taxation) candidate at UF Law. Originally published on Compute Law Blog. This article is general information and does not constitute legal advice. Reading it does not create an attorney client relationship. The reader should not act on the basis of any content here without first consulting a licensed attorney in the relevant state. Last reviewed for accuracy May 23, 2026.