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FDII and Export Subsidies: Trade Politics

Posted on June 10, 2019

On May 6 the European Commission submitted comments on proposed regulations interpreting section 250, saying the deduction for foreign-derived intangible income (REG-104464-18) probably breaches WTO and other international obligations. In support of its argument, the commission quoted a 2018 Congressional Research Service report (R45186) that claimed the FDII “would probably violate the WTO rules against export subsidies.”

But in relying on one select CRS report, the commission ignored others that consider the nuanced history of EU-U.S. disputes on export subsidies and analyze the benefits of various regimes as part of the overall U.S. tax system. As those reports suggest, whether a tax measure can be considered harmful or a violation of a trade agreement because of its economic consequences is better analyzed within the context of the overall U.S. system, including changes introduced by the Tax Cuts and Jobs Act.

The FDII Deduction

Section 250, enacted as part of the TCJA, allows U.S. corporations to claim a deduction equal to a percentage of their FDII, defined as deemed intangible income times the percentage of deduction-eligible income derived from serving foreign markets. Deemed intangible income is the excess of a corporation’s deduction-eligible income over a 10 percent return on its qualified business asset income. In establishing the FDII rate and the method for calculating intangible income (or a proxy thereof), the FDII regime mirrors the global intangible low-taxed income regime.

In the preamble to the proposed regulations issued in March, the IRS said the FDII regime was enacted as part of the TCJA’s move to a territorial system, which the United States undertook to facilitate the efficient redeployment of foreign earnings. But that also meant that earnings from intangibles allocated to low- or no-tax jurisdictions could be repatriated tax free. GILTI and FDII were Congress’s response to the need for corresponding base protection measures to prevent shifting more income overseas, with GILTI subjecting much of the earnings of U.S.-owned controlled foreign corporations to immediate U.S. tax (albeit at a reduced rate because of the section 250 deduction).

The IRS noted that while some countries have CFC inclusion regimes similar to subpart F that subject narrow classes of CFC income to current taxation in the residence country, most don’t apply those rules to CFCs’ active foreign business income. It said that absent a deduction for intangible income attributable to foreign market activity and earned directly by domestic corporations — that is, the FDII deduction — the lower effective rate for GILTI would perpetuate the pre-TCJA “incentive for domestic corporations to allocate intangible income to CFCs formed in low- or zero-tax jurisdictions.” To neutralize the effect of the lower U.S. effective tax rate on CFCs’ active earnings resulting from the GILTI deduction, section 250 attempts to achieve parity in the U.S. tax rate for FDII, regardless of the corporate form in which the earnings are generated or the location of the income-generating intangibles.

The Commission’s Gripe

In its comment letter, the commission said it supports the TCJA’s goal of reducing tax avoidance and aggressive tax planning in accordance with international best practices. But it found fault with section 250 and the proposed regulations, saying they are unfit to achieve that goal and most likely breach U.S. trade obligations.

The commission highlighted U.S. inconsistencies in its positions on restrictions on export subsidies in trade agreements, saying the country pressed for measures to be included in trade agreements that it then proceeded to violate. It said the fact that the FDII deduction applies irrespective of whether the taxpayer owns any intangibles indicates its failure to achieve its stated purpose. As a result, according to the commission, the FDII deduction “cannot be an expedient solution to reduce the shift of intangibles to lower-taxing economies.” It added that because FDII effectively provides U.S. corporations with a deduction directly linked to exports, it also provides companies with a financial incentive to export. The commission concluded that given its design and effect, the regime is most likely a prohibited export subsidy under the WTO Agreement on Subsidies and Countervailing Measures (ASCM).

According to the commission, the deduction distorts the playing field by providing a financial subsidy to exports in an attempt to increase the competitiveness of U.S. corporations in foreign markets, which encourages tax avoidance and aggressive tax planning by offering a way to undercut local tax rates in foreign economies. It’s “an incentive for foreign economies to lower corporate tax rates in a ‘race to the bottom,’” the commission concluded.

The concern over maintaining high corporate tax rates — rather than over any specific subsidy provided by the FDII deduction — may be at the heart of the commission’s grievance. Countries with high rates might have a reason to complain that the blended GILTI rate combined with the FDII deduction discourages countries from increasing their rates above 13 percent. But that hardly means U.S. tax rules are responsible for a race to the bottom — especially given the downward trajectory of corporate tax rates led by European countries over the past 30 years.

The commission said it supports tax measures that encourage research and development spending — which it says are crucial for economic growth — as long as they’re both well designed and in line with international commitments. But the FDII benefit is broader than targeted R&D tax credits and expensing provisions, it said. It faulted the deduction for applying to exports and rewarding outputs regardless of innovation, rather than subsidizing R&D input, an argument that’s hard to square with the EU’s patent box history.

EU members have enacted ever more generous patent boxes, and economic arguments against those regimes have generally shown that they have no concrete benefits, but instead simply increase tax planning opportunities (Annette Alstadsæter et al., “Patent Boxes Design, Patents Location and Local R&D” (Mar. 28, 2017)). Research generally shows that direct R&D subsidies — even those with substantial nexus requirements —would be more beneficial than many EU patent boxes (Peter Merrill, “Innovation Boxes: BEPS and Beyond,” 69 Nat’l Tax J. (2016)).

A Broader Perspective

In a series of reports written about the regimes for domestic international sales corporations, foreign sales corporations, and extraterritorial income, the CRS explained that while those regimes provided export-related benefits to U.S. multinationals, they needed to be considered along with other such benefits provided by the U.S. international system, as well as relative to the U.S. tax system as a whole (see, for example, RS20746 and RS20571).

According to the CRS, the FSC and ETI regimes provided one of only two tax benefits for exporting in the U.S. tax code (generally an exemption of between 15 and 30 percent of export income). The other was the section 863(b) sourcing rule, which made it possible for companies generating revenue from overseas sales to exempt up to 50 percent of export income from U.S. tax (depending on foreign tax imposed and the company’s foreign tax credit position). Perhaps because that section’s link to exports was more tenuous, the EU never brought a claim against it as violating U.S. trade agreements. The TCJA made it less likely that companies can source export income as foreign (because of amendments to section 863(b)) or claim FTC on foreign-source income (because of the repeal of section 902 and changes to the section 904 FTC baskets).

Earlier CRS reports also analyze FSC and ETI benefits from a macroeconomic perspective, stating that because they increased the after-tax return on investing in the export sector, they likely attracted investment in that sector. As a result, U.S. exports were probably higher than they would have been. But the CRS also questioned how much higher exports really were, because the tax benefit’s impact depends on how much of it is passed on to foreign consumers as lower prices and how responsive those consumers are to reduced prices. The CRS pointed out that traditional economic theory indicates that because exchange rate adjustments should result in a decrease in FSC- or ETI-induced exports and an increase in U.S. imports, the export benefits produced effects that might seem counterintuitive. And while the provisions might increase the overall level of U.S. trade, they wouldn’t change the trade balance. (Economists made similar arguments in connection with the 2016 destination-based cash flow tax proposal.)

The CRS also questioned who benefited from those export regimes, suggesting that they reduced overall U.S. economic welfare because at least part of the tax benefit flowed to foreign consumers in the form of lower prices; export subsidies thus result in a transfer of economic welfare from U.S. taxpayers to foreign consumers. At the same time, the CRS said those effects were probably not large, with data indicating that FSC increased the quantity of U.S. exports by less than half of 1 percent. It concluded that the effect on the trade balance was probably negligible.

Export Subsidies and Trade Disputes

To understand the history of European opposition to the FDII — and its quasi-predecessor, export subsidies — one must go back to the 1970s and the dispute over whether the U.S. DISC regime violated the General Agreement on Tariffs and Trade. Some have characterized the DISC’s enactment as a U.S. response to perceived disparities between U.S. and European exporters that resulted from tax system differences as European nations adopted territoriality (Jeffrey F. Ryan, “An Analysis of the GATT-Compatibility of the New Foreign Sales Corporation,” 26 Santa Clara L. Rev. 693 (1986)).

The late trade lawyer and University of Michigan law professor John Jackson argued then that the GATT process — which ultimately resulted in a finding that DISC violated the trade agreement as an export subsidy — was fatally flawed (“The Jurisprudence of International Trade: The Disc Case in GATT,” 72 Amer. J. Int’l L. 747 (1978)). He said that finding suffered from “opaque, questionable and incomplete” reasoning and a lack of “legal craftsmanship.” He suggested that the poor decision-making may have been the result of behind-the-scenes political compromises, as well as party advocacy and argumentation “that was inadequate to give the Panels the assistance they needed.” Jackson also asked whether the DISC benefit should be considered a subsidy under GATT, calling that question “particularly murky” for tax practices because almost any tax advantage — even a low rate — is arguably a subsidy.

Jackson suggested that under GATT, determining whether a deduction for a portion of a company’s income that has nexus to export-related income is a trade violation requires more than simply examining domestic statutory language tying the tax benefit to exports. Instead, any income tax benefit — even one that on its face is linked to export income — should be analyzed in the context of a country’s overall tax system, taking into account larger economic forces (such as impact on trade balance, economic welfare, and exchange rates) and actual effects (such as how large an effect on exports the alleged subsidy really has).

Jackson wrote his article before the Uruguay round of trade negotiations resulted in the ASCM, which completely banned export subsidies for goods. Under that ban, countries don’t have to show injury for an export subsidy to be considered a violation. But as noted by Robert Lawrence and Nathaniel Stankard in a 2005 paper, there’s no good explanation for the ban if markets aren’t necessarily competitive and countries aren’t necessarily always seeking to maximize national welfare (“Should Export Subsidies Be Treated Differently?” (2005)). In those cases, it’s unclear why governments subsidize exports in the first place, and why they need an agreement to do something that’s in their own interest. Instead, Lawrence and Stankard argue, it’s more likely that while some governments believed those kinds of practices benefited them, they agreed to a ban to constrain others. They suggest that WTO members care more about protecting their producers from adverse competitive effects of others’ export subsidies than about enhancing the welfare of their consumers. While that theory helps explain when countervailing duties against foreign subsidies apply (in cases of injury to material producers rather than reduction of national welfare), Lawrence and Stankard don’t believe it justifies an outright ban on export subsidies.

Further, Lawrence and Stankard suggest that the ban might be counterproductive for the WTO because it increases costs relative to benefits, gives credence to those who claim that the WTO poses a threat to national sovereignty, highlights inequities among members, and risks escalating retaliation. They conclude that the “theory does not readily justify the distinctive treatment of export subsidies.” All of their arguments — made over a decade ago — ring even truer now, given the tension over trade agreements.

Some observers have asserted that the WTO’s decisions on FSC and ETI conflict with the U.S. understanding of the agreements reached during the Uruguay round. A former Treasury trade official has argued that during those negotiations, the United States believed that European countries weren’t opposed to the FSC, which it saw as an acceptable response to challenges to the DISC (Gary Clyde Hufbauer, “The Foreign Sales Corporation: Reaching the Last Act?” (2002)). Because of European silence on the FSC — which can arguably be construed as acquiescence — he claims that U.S. negotiators were lulled into “innocently believing that the 1970s disputes had been resolved.” He argues that the EU’s subsequent challenge to the FSC was simply a politically motivated negotiating tactic in response to other trade disputes.

Footnote 59 to the ASCM states that an exemption from direct tax “specifically related to exports” is a prohibited export subsidy. It also says that deferral need not amount to an export subsidy when, for example, appropriate interest charges are collected. The question regarding the TCJA changes is whether a nominally territorial system that effectively eliminates deferral and is primarily intended to prevent a shift too far in favor of encouraging its headquartered companies to organize their business and assets overseas should be considered a subsidy, especially when its effects are likely nominal.

A separate question is whether FDII disputes are worthwhile. Complaints against the FDII deduction may provide the EU with a bargaining chip in some negotiations, including those over state aid and taxation of the digital economy, but they could backfire in today’s tension-filled cross-border trade environment.

Looking a Gift Horse in the Mouth

Speaking at the National Tax Association’s spring symposium last month, David Noren of McDermott Will & Emery pointed out that despite many of the TCJA’s flaws and resulting uncertainties, the lower corporate tax rate and other relatively favorable design features mean that current international tax rules are “as good as it’s going to get” for many U.S. companies. That’s a good way for other countries to think about post-TCJA U.S. tax law: It might be as good as it’s going to get.

As indicated by economic research performed by the Joint Committee on Taxation on the now-repealed section 199 and recent studies of the financial statements of U.S. corporate taxpayers, the companies that have traditionally benefited from U.S. export regimes are likely to continue to receive some type of tax benefit, regardless of whether its technical terms conflict with WTO agreements. (Prior analysis: Tax Notes Int’l, May 27, 2019, p. 795.) Given that likelihood (and that the TCJA somewhat subsidizes other countries’ corporate tax systems through GILTI and other provisions, such as the anti-hybrid rules), and considering congressional and administration views about other countries taking advantage of U.S. trade commitments, the commission’s complaints about FDII might result in negative unexpected consequences.

Mindy Herzfeld is professor of tax practice at University of Florida Levin College of Law, of counsel at Ivins, Phillips & Barker Chtd., and a contributor to Tax Notes International.

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