FDII Sense

There’s a contradiction–critics might say hypocrisy–in how the United States approaches unilateral actions on the tax front. On the one hand, it has adamantly opposed digital services taxes and other measures which it claims flout international norms and harm its taxpayers. The U.S. is very invested in maintaining the status quo and global tax consensus.

And yet, Congress and successive presidential administrations have also never hesitated to go out on their own, the rest of the world be damned, in pursuit of various tax policy goals.

When crafting the 2017 Tax Cuts and Jobs Act, for instance, there was very little–if any–public debate about whether the international tax measures in the bill conformed with Organization for Economic Cooperation and Development guidelines, or other global rules. It just wasn’t much of a concern, either way. Only afterwards did policymakers start to grapple with the implications of disconnects, and even then legislative reversals weren’t seen as an option.

One of the biggest potential sticking points in the TCJA is the deduction for foreign-derived intangible income, a tax benefit that’s meant to mirror patent boxes and provide an incentive for U.S. companies to keep valuable intellectual property in the U.S. It achieves roughly the same rate as the tax on global intangible low-taxed income, which is measured the same way but imposed on income held abroad.

It only applies to income from foreign sales, making it an export subsidy and, possibly, a violation of World Trade Organization rules. While European countries made noise about challenging it in that forum, that case has languished as the WTO work ground to a halt under the Trump Administration.

It also could potentially violate OECD standards, by granting a tax benefit to IP income without any nexus requirement for substantial activities in the jurisdiction. That’s been part of the OECD “minimum standards” since the 2015 Base Erosion and Profit Shifting project. It’s no longer considered kosher for jurisdictions to try to lure on-paper profits through single-digit or zero tax rates–a benefit to intangibles needs to be matched with economic evidence that the intangibles were created or maintained there as well.

FDII doesn’t have such a requirement. In fact, the benefit of the deduction increases the less economic substance is held in the U.S., because it measures intangible income as a return over the value of depreciable tangible property.

The minimum standards aren’t self-executing–it’s up to countries themselves to decide what to do when trading partners don’t follow the rules. Some raised the possibility of retaliatory measures, should FDII be found in violation.

Some apparently have already acted.

According to Peter Blessing, associate chief counsel for international at the Internal Revenue Service, a European country has denied royalty deductions by, supposedly, ruling FDII to be a harmful tax practice.

“We're well aware of that, and that is not something that we are happy about,” Blessing said, speaking at the American Bar Association Tax Section’s annual May conference in Washington, D.C.

Blessing didn’t say which European country he was talking about. I’ll just mention that Germany has a regime which denies or limits royalty deductions based on the OECD guidelines, and has previously indicated that FDII may be subject to it.

The OECD’s Forum on Harmful Tax Practices has put the FDII review on pause, designating the regime as “in the process of being eliminated” since the Biden Administration’s budget request issued in 2022 called for FDII to be replaced with other, unspecified R&D incentives.

That’s…a bit of a stretch in 2024. In countries with parliamentary systems, the government’s proposed budget is the start of the legislative process, but in the U.S. system it’s more of a messaging document. It’s not clear that Democrats would have repealed FDII even if they got the chance, and that chance is now gone until at least 2025.

If countries could protect their tax benefits from being designated as harmful by simply putting out a press release stating that they plan to repeal them, there’s obviously a big problem with OECD Harmful Tax Practice standards.

Another complicating factor is that FDII doesn’t, technically, give a tax benefit to IP income. Just like GILTI (or the OECD’s global minimum tax, for that matter), it uses a formulaic proxy to estimate profits from intangibles. This is probably why the OECD peer review reports list FDII under both IP regimes and “Miscellaneous.” The OECD’s modified nexus standards define IP income broadly, though, including assets that are “functionally equivalent” to IP. It also includes rules for non-IP benefits, mandating that those also be paired with substantial activity relevant for whatever the purpose of the special incentive is.

So there are some issues to be worked out before the OECD issues a final decree on FDII. But Germany apparently is done waiting, and has decided to levy its anti-abuse rules now. From my perspective, it seems a little nitpicky to make a big deal about FDII’s noncompliance. While rules are rules, no one thinks that companies are taking advantage of the benefit the same way that they used Ireland’s old patent box. Some U.S. companies re-shored their IP following the TCJA, but it’s virtually unheard of for companies without a significant presence in the U.S. to shift IP there.

But, just as with the DSTs, there’s not much the U.S. can do to stop it, other than to firmly push back on the foreign tax authorities. This is a reminder that however strictly or loosely the OECD draws up its standards, it’s ultimately up to countries to carry these rules out. And they’ll decide for themselves how much aggressiveness is needed.

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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LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

• Manal Corwin, the OECD’s director of tax policy and administration, finally addressed the apparent delay in finalizing text for the Pillar One agreement during a D.C. tax conference Friday. The organization had set a deadline of March 31 for all participating countries to agree on text of the multilateral convention to implement Pillar One--which has come and gone without an announcement. Corwin said the March 31 timeline was a “pragmatic matter,” and that the OECD was still committed to presenting a document for countries to sign by the end of June. Corwin also said that one of the issues that needs to be worked out is an Amount B framework that is strong enough to provide certainty while also workable. Her statement gives those hoping for Pillar One to work out some hope, while also emphasizing how significant some of the challenges are.
• U.S. Treasury Secretary Janet Yellen has thrown a bucket of ice-cold water on the United Nations proposal for a global wealth tax, telling the Wall Street Journal that it’s not “something we could sign onto.” This initiative is just at the conception stage, as it’s pushed by some jurisdictions such as France. Given the constitutional questions about a wealth tax in the U.S., Yellen’s position isn’t surprising, despite the Biden Administration’s focus on taxing billionaires and its own proposal for a “Billionaire Minimum Tax.” But I wonder how important it is to have the U.S., or an overwhelming majority of nations generally, agree to be part of the plan. That was necessary for the OECD’s global minimum tax, because of how transfer pricing and international corporate taxation work. Near-unanimous buy-in of a wealth tax may help with the politics. But administratively, there’s no reason why a group of countries couldn’t do this own their own, with exit taxes charged to departing wealthy individuals and robust reporting requirements to ensure they can’t hide their wealth in havens. European countries are still scarred by their experiences with this in the 90s, but it’s a vastly different world now.
• Senate Finance Committee Chairman Ron Wyden, D-Ore., isn’t letting up on his committee’s investigation into the tax practices of “Big Pharma.” On Tuesday the committee released a letter it wrote to Pfizer’s CEO, asking the company to explain single-digit effective tax rates in recent years, including a negative rate in 2023, based on its Securities and Exchange Commission reports. Wyden claims these reports would seem to indicate that the company is still shifting what should be U.S. profits offshore. One thing I’ll note is that even if a company is reporting income offshore, that doesn’t mean that profits from those transactions aren’t represented in the U.S.--they could be generating GILTI tax payments, as well as payments that are part of a cost-sharing arrangement. But a research-heavy firm like a pharmaceutical company would also have significant domestic credits and expenses that could offset those. It’s complicated. (Last week, I discussed using SEC reports to estimate tax rates with Matthew Gardner of the Institute on Taxation and Economic Policy. For Emperor Subscribers only.)

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