Does the Tax System Need FDII?

The Tax Cuts and Jobs Act’s deduction for foreign-derived intangible income is normally known by its acronym FDII, which tax practitioners tend to pronounce “Fiddy”--similar to how the rapper 50 Cent begins his stage name. Perhaps it’s appropriate, as the deduction is nearly 50 (per)Cent, reducing the tax rate by half for income that qualifies.

Well, not quite half–the deduction is actually 37.5 percent now, and will decrease to 21.875 percent in 2026. That equals a tax rate of 13.125 percent and 16.406 percent, respectively. (The tax rate on global intangible low-taxed income, or GILTI, is actually 50 percent of the 21 percent U.S. corporate tax rate, for a 10.5 percent rate.)

The point being, FDII is a very valuable deduction. Many companies are reporting large tax benefits due to FDII, and it seems to be a significant factor for the decision by many to repatriate valuable intellectual property. In that sense, it’s working as it was intended by the TCJA’s authors.

Its value has also put it on the chopping block. Democrats have long called for the provision to be repealed, whether or not the rest of the TCJA remains in place. President Biden’s latest budget request to Congress, released earlier this month, retains the proposal to repeal it altogether, which the U.S. Treasury Department said will raise $158 billion over 10 years.

That figure makes it a key bargaining chip in the upcoming showdown over extending the TCJA provisions which are set to expire next year. Both parties will be looking for sources of revenue to cover their preferred policies, and FDII could make for an enticing revenue source–especially for Democrats who claim it benefits tech companies that are already neglecting to pay their “fair share” of taxes.

FDII has flown under the radar, somewhat, in tax policy discussions. It doesn’t tend to get as much attention as its (nonidentical) twin GILTI. But policymakers and tax experts will soon need to grapple with the question–is FDII necessary?

In a sense, FDII is the American version of a patent box, a tax policy which has become ubiquitous across Europe and common around the globe. Patent, IP or “innovation” boxes offer favorable rates to income from valuable intellectual property held in the jurisdiction. In their purest form, patent boxes are used to entice companies to move IP from wherever it was generated to the country offering the benefit. That kind of policy is now effectively forbidden, as Organization for Economic Cooperation and Development rules require that patent boxes include requirements for real research and development spending in the jurisdiction with the benefit.

Ours works a bit differently. It’s aimed at IP used for sales abroad, and it uses a formulaic proxy to determine that income, rather than identifying the intangible assets themselves. The formula uses domestic income earned from sales to foreign parties, as well as domestic tangible assets, to define the intangible income applicable to FDII.

One of the challenges of implementing FDII has been the documentation rules that Treasury uses to verify that income is really from foreign sources–or when companies can make broad assumptions about the source, when verifying individual customers would be impossible.

According to the TCJA authors, FDII was a necessary pair for GILTI, which levies a 10.5 percent tax on intangible income held abroad by U.S. companies. The two policies, broadly speaking, define the income the same way, and while their rates don’t exactly match up–something the TCJA’s critics were quick to note–they’re close enough that there shouldn't be a distortion either way. One is a carrot, the other a stick, but they both achieve roughly the same result.

Because it doesn’t include a requirement for economic substance–in fact, FDII increases the less economic substance you have–it’s led to some OECD disputes. Although, given how much R&D spending happens in the U.S., it’s questionable whether this is ever a real-life concern.

In the Treasury explanations which accompany the budget request, the Biden Administration said that repealing FDII was justified as it does little to spur additional R&D spending, benefits multinational firms over domestic ones, and could encourage companies to locate tangible assets abroad.

“It provides large tax breaks to companies with excess profits–who are already reaping the rewards of prior innovation–rather than incentivizing new domestic investment,” the document states.

Indeed, numerous studies have shown that incentivizing tech development and the back end, when it has already become profitable, does little to spur economic activity that wouldn’t have happened anyways. Whereas incentivizing R&D spending–which the U.S. already does, through the R&D credit and deduction–can be a much more efficient way to juice a tech sector.

On the issue of IP location parity, one thing I wonder is whether the GILTI/FDII balance takes into account the structural costs of migrating IP. GILTI is designed to target jurisdictions where there are outsized profits compared to real assets, presumably held there due to a structure that shifted IP from where it was really developed. There are lots of risks involved in setting up an offshore cost-sharing arrangement or other system to locate IP in a low-tax jurisdiction–audit risk, compliance risk, reputational risk. But there are also costs that are certain, including whatever payment the U.S. company receives to compensate for its role in the IP creation.

When the goal was a single-digit effective tax rate, it could still be worth all of that. But GILTI takes that off the table. Maybe that’s incentive enough to prevent this kind of profit-shifting?

All I can say is that the authors of the TCJA felt pretty strongly it wasn’t.

On the flip side, Democrats want to repeal FDII–but they wouldn’t stop there. They would also increase the GILTI rate, apply it on a country-by-country basis, and put into effect other provisions to clamp down on alleged corporate tax avoidance. (While also raising the overall corporate rate.) Maybe repealing FDII needs to be balanced out with these other measures, or it will lead to yet another outflow of revenue.

These are questions that tax wonks will need to start asking, because no matter what happens in the upcoming election, the 2025 tax situation will almost certainly require a compromise that will include parts of both the Democratic and the Republican visions of the tax system.

Policies won’t need to be judged in the abstract, but as part of a comprehensive scheme.

DISCLAIMER: These views are the author's own, and do not reflect those of his current employer or any of its clients. Alex Parker is not an attorney or accountant, and none of this should be construed as tax advice.

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Emperor Subscribers can also access my interview with Pascal Saint-Amans, former director of the OECD’s Centre for Tax Policy and Administration, posted last week.

LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

• U.S. Treasury Secretary Janet Yellen testified before the Senate Finance Committee on March 21, as part of the budgetary process. She spent maybe a quarter of the time parrying barbed questions from Republicans on the committee about the OECD Two-Pillar agreement, which they still see as a travesty and capitulation of American tax sovereignty. There wasn’t much new for those who have been following the debates, but some lines to parse for anyone eager for hints about how the Paris negotiations are going. Yellen expressed optimism that the U.S. would reach an agreement on Pillar One that “will bring significant benefits to American businesses,” even as we await final text any day now. On the issue of how Pillar Two will treat the U.S. R&D credit, Yellen said that Treasury believed it “had an opening” to resolve it “in a way that will be favorable” to the U.S. What, if anything, does that mean? Beats me–but corporate America is eagerly awaiting to find out.
• One of the initiatives of the other OECD tax project–the 2015 Action Plan on Base Erosion and Profit Shifting–was to stop “treaty-shopping,” or when companies route transactions through a country solely to take advantage of the treaty benefits. Countries agreed to adopt, as a minimum standard, the “principal purpose test,” which denies treaty benefits if the principal purpose behind a transaction is to obtain better treatment through the treaty. Unlike some of the other BEPS minimum standards, this can only be implemented through amending or enacting treaties, which requires a gradual process. The OECD’s latest peer review report, released March 20, shows steady progress, with 1,360 agreements compliant with the standard as of May 2023.
• Senate Finance Committee Chairman Ron Wyden, D-Ore., released on March 21 a letter to Pictet, requesting information for the committee’s investigation into whether the Swiss bank may have aided evasion of the U.S. Foreign Account Tax Compliance Act, as well as other tax obligations. The letter follows a December announcement from the Department of Justice that it had entered into a deferred prosecution agreement with Pictet, in which the bank agreed to pay $122.9 million and admitted to helping U.S. clients conceal assets and income abroad, according to Justice. Wyden claimed that amount seems too low, considering the $5.6 billion in income that Pictet allegedly helped hide. He also said that the committee has uncovered documents showing that the bank helped an unnamed U.S. billionaire–reported elsewhere as Living Essentials CEO Manoj Bhargava–conceal $255 million in assets. The inquiry is part of the committee’s focus on individual offshore evasion, which is parallel to new Internal Revenue Service’s efforts in the same area. It will be interesting to see if this results in further disclosures.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Every week, a new character from the Golden Age of Superheroes who's fallen out of use.

Rocket Man, first appearing in Scoop Comics #1 in 1941. Carl Martin invented a "three-cartridge rocket pack," and decided to fight crime and Nazis together with his fiancée, who became Rocketgirl. Eventually reprinted with the name "Zip-Jet." Unrelated, of course, to the Elton John protagonist.

Contact the author at amparkerdc@gmail.com.