In February 2018, the U.S. government was already preparing to defend before the OECD some of the international provisions of the Tax Cuts and Jobs Act, which was barely two months old. One year later, OECD officials are still questioning whether the TCJA deduction for foreign-derived intangible income is a harmful tax practice, and U.S. officials are still defending it as a necessary, albeit protectionist, measure.
This stalemate could soon change. The U.S. government is expected to release the much anticipated proposed FDII regulations, for which practitioners have long been waiting. But practitioners aren’t the only ones interested in getting their hands on the regulations. FDII review is in a holding pattern at the OECD’s Forum on Harmful Tax Practices (FHTP) pending the regs’ release, according to Gary Scanlon, attorney-adviser for the Office of the International Tax Counsel at the U.S. Treasury Department.
The FHTP analyzes whether tax regimes erode tax bases, particularly in the context of the OECD’s base erosion and profit-shifting action 5 on countering harmful tax practices. Action 5 requires that taxpayers enjoying preferential regimes engage in substantial activity. But U.S. officials strongly believe that FDII is out of the scope of the FHTP and argue that its effects must be viewed in tandem with the TCJA’s global intangible low-taxed income provision.
“We don’t see this regime as one that base erodes other regimes but as one that stops our country from being base eroded, particularly in the context of GILTI,” Scanlon said February 14 during a Tax Council Policy Institute (TCPI) conference in Washington. “When you look at GILTI and FDII together, it’s trying to neutralize the considerations tax plays in the location of intellectual property. We believe a lot of IP is being developed by folks in white lab coats here in the U.S., and we would like that IP to remain where it is being created and not be drawn out of the U.S. by these tax considerations,” he said.
But the international response to FDII and other TCJA international provisions, including GILTI and the base erosion and antiabuse tax, feeds into a larger discussion about whether one jurisdiction’s move toward protectionism can or should be viewed as a threat by others and how protectionist measures fit into the ongoing discussion of unilateral tax measures.
A group of panelists, including Robert Stack, managing director at Deloitte and former deputy assistant secretary for international tax affairs at the U.S. Treasury, and Manal Corwin, head of KPMG LLP’s Washington National Tax practice, discussed these issues in a panel separate from Scanlon at the TCPI Conference.
Germany’s Reaction
German officials have repeatedly voiced TCJA concerns, dating back to December 2017 (before the TCJA had even become law) when finance ministers from Germany, the United Kingdom, and several other European countries sent a letter to U.S. Treasury Secretary Steven Mnuchin. They were worried about potential treaty violations and argued that FDII and the resulting reduced corporate income tax rate would subsidize U.S. exports and could be subject to challenge before the WTO. In November 2018, German Finance Minister Olaf Scholz reportedly said that the TCJA’s tax reforms are unsustainable and will likely cause tax increases, according to Reuters. Those comments came amidst growing economic uncertainty for Germany, which is grappling with whether to cut taxes to avoid an economic slowdown.
Now that the TCJA has marked its first anniversary, have Germany’s feelings changed about the tax reform package? It appears that many of the same concerns remain.
Panelist Sandy Radmanesh, senior tax counsel for the German Embassy, said the reform package was a huge step for the United States in implementing anti-BEPS measures — including several rules put forth in the OECD BEPS recommendations. She also said that German officials were fine with the corporate rate drop from 35 percent to 21 percent, which they viewed as a U.S. effort to move closer to the OECD average of 24 percent and not as the beginning of a race to the bottom, as some speculated right after the TCJA was enacted. However, she told the panel:
There are things in the TCJA that got our attention, especially FDII and the BEAT. In terms of FDII, we analyzed it — it’s pretty obvious . . . it could [be] a patent box that does not align with the nexus approach. That has been discussed at the FHTP because it has no element of substantial activity; it doesn’t even have a proxy for substantial activity. We were concerned about the scope: It does not only include patents and copyright; it includes marketing intangibles or marketable IP. And the third point, with respect to the FDII: It could be seen as an export subsidy, which you probably don’t like that I say that. So we will have to wait to see what the FHTP will be doing and deciding on the facts.
Germany’s opinion on the rate reduction is in line with the OECD’s tax director, Pascal Saint-Amans, who made similar remarks in April 2018.
The FDII regime gives U.S. corporations a deduction on income derived from selling goods and services to foreign customers. Eligible taxpayers can receive a 37.5 percent corporate income tax deduction, which amounts to a 13.125 percent effective tax rate. The deduction will eventually decrease to 21.875 percent after 2025. As mentioned by Scanlon, it works in tandem with the GILTI tax, which imposes a minimum tax on GILTI earned by U.S. shareholders of controlled foreign corporations: 10.5 percent through 2025, increasing to 13.125 percent in 2026.
A Novel Way of Thinking
Traditional patent boxes require taxpayers to conduct a certain amount of research in the jurisdiction offering the benefit and are generally limited to legally protected intangibles. They generally apply the same rates whether the product is sold abroad or internally. That approach doesn’t quite mesh with how U.S. corporations conduct their research and development, Stack explained.
“When I was at Treasury, [I was told] that U.S. multinationals do 85 percent of their R&D here anyway. Unlike the patent box, where the absence of that rule invited moving paper IP around, for the U.S. that’s almost a superfluous requirement,” Stack said.
All in all, classical patent box rules were written for a “very mechanical” kind of approach, one championed by the United Kingdom but counter to the U.S. approach, which invites a different kind of discussion, according to Stack.
“The U.S. [came] up with a completely different way of thinking about the taxation of excess returns; we treat it the same way whether it is foreign or domestic, therefore we sit totally outside the debate about the patent box. I think that’s an argument that’s worth people hearing,” Stack said. As for whether the international community will be willing to listen, that remains to be seen, he added.
Not Your Typical Preferential Regime
Corwin agreed that FDII does not fit within the parameters of a typical patent box regime. It is much broader and includes items like sales, royalties, and services, and it is not tied by its terms to intangibles, despite the fact that it deceptively has the word “intangible” in its name, she said.
“It does carve out [qualified business asset investment] as a return on tangible assets that’s carved out of the beneficial regime, but nobody would suggest that economically that’s the equivalent of determining the return on intangible profit,” Corwin said.
“Frankly it hasn’t really been tested as to whether under the standards within [BEPS] Action 5 . . . it would fail substantial activity,” Corwin added. “I’m not sure it would fail. Often the FDII activity has significant substantial activity.”
Treasury has been clear that FDII was designed to eliminate distortions when taxpayers shift business activity overseas and into a CFC to obtain the GILTI rate rather than carrying out those functions in the United States and paying the full 21 percent corporate rate. Corwin said that although FDII is not a typical preferential regime, she can see how other countries might misinterpret it as such.
“That distortion was created to make a level playing field about business decisions. [But] I can see how other jurisdictions could say ‘well, that makes a difference for us because when it’s from a CFC we get to tax it,’” Corwin said.
GILTI Inspirations
GILTI, on the other hand, is receiving a better reception. Some international stakeholders are eyeing it as a model for the OECD’s project on the digital economy and BEPS. In November 2018, France and Germany presented their own version of a minimum tax to the OECD that would tax base-eroding outbound payments. It also contains an income inclusion rule for situations involving CFCs. The income inclusion rule is reportedly being described as similar to GILTI, according to stakeholders who were present for the proposal’s unveiling at a November 6, 2018, conference cosponsored by the OECD.
The OECD relied on the French-German proposal in the latter half of its recently released discussion draft on the digital economy. The relevant section lays out a global anti-base-erosion proposal that would deny deductions or treaty relief for certain payments unless they are taxed above a minimum rate or are subject to an effective tax rate. The income inclusion rule would tax income from foreign branches or CFCs that is subject to a low effective tax rate.
“The genius, if there is one of GILTI, is that it says, ‘let’s stop trying to chase the intangibles around the world from one jurisdiction to another, and let’s just use a proxy, that every X dollar in advance of a return on your QBAI must be what the economists call rent or excess return, and just tax it,” Stack explained. “Now the German-French proposal is sort of following along with the same concept. So it’s kind of a revolutionary approach on CFC rules, specifically because of the mobility of capital and intangibles.”
Certainty vs. Politics
As countries devise ways to protect their tax bases, there is a danger of believing that a unilateral action in one jurisdiction could be construed as a “dagger” toward others, according to Grant Aldonas, the managing director of Split Rock International and panel moderator. But panelist Tom Roesser, senior director of tax affairs at Microsoft, said he expects that there will always be unilateral actions, and he outlined some of the proposals Microsoft has been tracking over the years:
Just over the past couple of years, we’ve seen 34 indirect tax proposals being enacted, with VATs or [goods and service taxes]. We’ve seen various turnover tax proposals and digital services tax proposals; at least 17 have been introduced or proposed. We’ve seen lots of permanent establishment-type of proposals — 12 plus of those. And then you also have antiavoidance-type notions that have been proposed; we’ve seen four of those. . . . Then, in a grab-all basket, there’s been over 15 proposals in other directions, just trying to get more income attributable to the local jurisdiction. There’s been a lot of uncertainty over the years, and from a company perspective certainty is important, and clarity of the rules and administration of the rules is important.
Despite the current climate of uncertainty, Corwin said she anticipates that the pendulum will swing in the other direction, considering that governments are “self-interested” and need certainty as well.
“Economic prosperity of jurisdictions depends on certain business activity and the way businesses are behaving. We will get to a point . . . where there is a realization that we need to get back to where we were with more certainty about economic activity and growth,” Corwin said. “How long that will take, and what it will take to overcome what is now a lot of individual politically driven incentives to take immediate action in the tax space, I don’t know,” she said.
Stack agreed, also emphasizing that it will be difficult to tamp down the political pressures that governments are currently facing.
“The real question that we’ll look back on in four to five years is: If we all agree to some sort of consensus, will countries pull back from unilateral actions, or will the political pressures . . . continue to push them in this direction?” Stack asked. “We’ll all be watching that.”