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GILTI as Charged: FDII Regulations Prove Harmful Tax Export Subsidy

Posted on Mar. 25, 2019
Benjamin M. Willis
Benjamin M. Willis

Benjamin M. Willis (@willisweighsin on Twitter; ben.willis@taxanalysts.org) is a contributing editor for Tax Notes. He formerly worked in the mergers and acquisitions and international tax groups at PwC, and the Treasury Office of Tax Policy, the IRS, and the Senate Finance Committee. Before joining Tax Analysts, he was the corporate tax leader in the national office of BDO USA LLP.

In this article, Willis points out that section 250 could be seen as creating an illegal export subsidy, and he explains how the deductions for foreign-derived intangible income and global intangible low-taxed income under that section are two distinct regimes.

When Is It Time to Declare a National Emergency?

A global trade war has been brewing for decades and may now be culminating under the administration of President Trump, who said in his nomination acceptance speech, “Americanism, not globalism, will be our credo.” As he promised, the United States has acted to beat its trading partners so America can begin winning again. But for America to win a global trade war there must be losers, and based on Trump’s incredibly broad tax export subsidy, that could result in a lot of economically disadvantaged and angry trading partners.

Attempts were made before the Tax Cuts and Jobs Act was enacted to stop what will likely be viewed as the most underhanded attack ever on the tax revenues of foreign nations. In December 2017 various countries from the OECD wrote Treasury Secretary Steven Mnuchin to explain that the export trade subsidy in proposed section 250 violated international trade principles. The TCJA was signed into law just 11 days after those complaints, ensuring that Congress and the public had little time to consider the monumental trade ramifications the export subsidy could have.

In a joint letter sent December 11, 2017, finance ministers of France, Germany, Italy, Spain, and the United Kingdom told Mnuchin that under new section 250, “income from the sales or licensing of goods and the provision on services for use outside the US that is deemed to be in excess of the return from tangible assets will benefit from a reduced corporate tax” and “could therefore face challenges as an illegal export subsidy under WTO Subsidies and Countervailing Measures Agreement rules.” If the administration fails in its efforts to deny that an export subsidy was created, the impending trade war likely to ensue could be catastrophic to the U.S. economy.

Why Would This Hurt America?

Similar retaliatory provisions could create additional trade distortions on the consumption of goods resulting from the flagrant disregard of trade neutrality by the export subsidy. By providing aid in the form of a tax deduction to U.S. companies selling goods overseas, the export subsidy undercuts the competition by pulling revenue from U.S. trading partners and lowering tax revenue they would otherwise collect on unsubsidized goods — an effective cash subsidy indeed. This broadens the U.S. tax base by allowing U.S. corporations to sell goods cheaper and to more foreign buyers. It also violates the cornerstone of international tax law: neutrality.

International neutrality is designed to ensure that investment and consumption decisions are not based on tax. Sadly, we know all too well that countries often drop tax rates incredibly and then layer on additional tax incentives (for example, export subsidies) to become what are known as tax havens. The goal of neutrality is to ensure the tax laws of global trading partners don’t put others at an economic disadvantage. A deduction on the income from foreign exports subsidizes those exports, thereby making them cheaper, which is what Trump has claimed other countries like China have been doing illegally.

The United States tried to use subsidies and incentives in the 1970s and 1980s, but those were ultimately found to be illegal. Domestic international sales corporations were created in 1971, eliminated in 1984, and replaced with foreign sales corporations that were eliminated in 2000 after it was determined they violated international law. Other countries have used similar tactics to enhance their trade postures. After seeing the United States violate international trade principles, other countries quickly joined in the race to the bottom to increase investments and exports. But more has been done than risk trade relations, that could lower the price of U.S. produce, steel, and energy, for the sake of Americanism.

Is This Worse Than Other Harmful Tax Tactics?

First, the U.S. economy now depends more on its foreign trading partners than at any time in history, and we have more to lose by destroying trade relations. Second, the risks to the United States of such deception have never been so great: The world’s largest trading partners are joining forces to prevent deceptive trade and harmful tax practices. Third, and most important, the difference between the development and implementation of the recent globally harmful trade provisions of the TCJA shows the depths the government has gone to deceive its own citizens, Congress, and the world.

Trump’s infamous trade speech in Monessen, Pennsylvania, on June 28, 2016, was prophetic in terms of the TCJA. Trump explained at length the result of foreign export subsidies: “Trillions of our dollars and millions of our jobs flowed overseas.” In arguing against the U.S. participation in the Trans-Pacific Partnership, he explained: “They are not playing by the rules. They are cheating. It would make it easier for our trading competitors to ship cheap subsidized goods into United States markets.” But perhaps cheating by shipping cheaper subsidized goods to trading competitors applies only when it violates the trade principles of Trump’s Americanism.

Regarding enforcing international trade laws, Trump declared: “I’m going to instruct the U.S. trade representative to bring trade cases against China, both in this country and at the WTO. China’s unfair subsidy behavior is prohibited by the terms of its entrance to the WTO and I intend to enforce those rules and regulations.” But Trump’s U.S. representative acted to the contrary regarding unfair subsidy behavior.

To justify that the foreign-derived intangible income deduction is not a harmful tax practice, the U.S. delegate to the OECD’s Forum on Harmful Tax Practices (FHTP), Gary Scanlon, stated that: “We think that you have to look at FDII in the context of GILTI as a single system.” That is false. FDII and global intangible low-taxed income are separate and distinct. They can and will apply to different taxpayers.

A taxpayer can take full advantage of the FDII deduction — an export subsidy — with no controlled foreign corporations, GILTI income, GILTI deduction, or ability to partake in the participation exemption system of section 245A. These provisions comprise much of the explanation in the preamble to the recent FDII regulations, and could be irrelevant to most U.S. corporations claiming the FDII deduction.

What Did You Say?

The first structural key to understanding the separation between the FDII and GILTI deductions is the title of section 250: “Foreign-derived intangible income and global intangible low-taxed income” (emphasis added). Section 250 allows for two separate deductions, which are: (1) a 37.5 percent deduction for FDII under section 250(a)(1)(A), and (2) a 50 percent deduction for the GILTI amount (if any) that is included in the gross income of a domestic corporation under section 951A and any corresponding section 78 gross-up amount as provided for in section 250(a)(1)(B).

Justifications for why the 37.5 percent FDII deduction isn’t a blatant export subsidy are often based on the 50 percent GILTI deduction’s reduction of the section 951A GILTI inclusion, which could have been lowered in that subpart F provision easily. However, the FDII deduction can give corporations with no ownership in CFCs — and no possible GILTI income or GILTI deduction — a 37.5 percent deduction on income derived from selling goods and services to foreign customers. So contrary to Scanlon’s statement, you do not “have to look at FDII in the context of GILTI as a single system.”

GILTI is unnecessary to the analysis of the FDII deduction under fair trade principles. The executive branch’s official explanation as provided to the OECD is false. The FDII deduction should not be looked at in the context of GILTI, and they are not part of a single system. In short, the separate and distinct FDII deduction subsidizes foreign purchases from U.S. corporations while the GILTI deduction merely reduces this includable type of subpart F income. But at the core, any U.S. company can take advantage of the FDII export subsidy regardless of whether it has CFCs or GILTI income.

Despite the complexity of the formulas for determining the deduction, the following language of section 250 makes clear the goal of exporting foreign goods: “The term ‘foreign use’ means any use, consumption, or disposition which is not within the United States.” Foreign use is of course required for the FDII deduction, because the policy goal set forth by the administration through Americanism is clear: America must win against its foreign competition. Of course, foreign use is irrelevant to the GILTI deduction.

Placing these two separate deductions within the same code section, each with complex formulas, may on the surface appear to connect FDII and GILTI. But now with the release of the FDII regulations and a thorough parsing of the statute, the rules fail to justify how the 37.5 percent subsidy for foreign exports that give rise to FDII are tied to GILTI in any way. The deductions are based on separate systems found within a single code section. Their location in the code is irrelevant to their underlying policies and economic impacts.

On March 4 the FDII regulations (REG-104464-18) were released and stated that “the purpose of the section 250 deduction is to minimize the role that U.S. tax considerations play in a domestic corporation’s decision whether to service foreign markets directly or through a” CFC. I’m not sure how this statement is helping the cause — it does not negate U.S. efforts to make American exports cheaper relative to foreign goods. This language also refers to a single deduction under section 250, when there are two with completely different rates and policies. While they both can reduce taxes for corporations, only one subsidizes exports to foreign countries. It also confirms that U.S. corporations don’t need CFCs to take advantage of the foreign export subsidy and can simply sell their goods to customers in foreign countries, leaving those countries disadvantaged compared with products purchased in the United States that do not receive this 37.5 percent subsidy. This preamble statement effectively provides: We needed an export subsidy because we set the GILTI inclusion amount too high.

Under the first example in REG-104464-18, one corporation can qualify for the GILTI deduction, thereby reducing its GILTI income described in subpart F of $225x by 50 percent. Under the second example a corporation can benefit solely from the 37.5 percent FDII export subsidy on its $200x of foreign-derived deduction-eligible income with no GILTI income. This confirms that FDII must not be looked at in the context of GILTI as a single system.

Who Created This Innovation?

The most recent legislative proposal incorporating a new section 250 with policies and terms most like the TCJA’s FDII deduction comes from the Innovation Promotion Act of 2015 draft, released by House Ways and Means Committee Chair Richard E. Neal, D-Mass., and then-member Charles Boustany Jr., R-La., on July 28, 2015. This section 250 deduction proposal was released after the Camp proposals. Unlike the code’s current version of section 250’s FDII deduction, this earlier version of section 250, titled “innovation box profits,” was proudly designed to join other countries in the patent box party. The section 250 deduction was for innovation box profits (for example, from patents) as defined therein.

The Innovation Promotion Act of 2015, like the Senate version of the TCJA, contained a new section 966. Both provisions had the same effect — to allow taxpayers to domesticate appreciated intangible property into the United States without giving rise to taxable income. However, the new section 966 was pulled from the final TCJA bill with no explanation.

The TCJA’s Senate amendment proposal of section 966 is the clearest link to the innovation box proposal in the Innovation Promotion Act of 2015. The Camp proposal did not contain a similar section 966 provision. The Camp proposal had a provision similar to GILTI’s expansion of subpart F income and provides a better cover story for why section 250 should be viewed as linked to GILTI under a new participation exemption regime as opposed to the FDII deduction being a separate export subsidy.

Where Do We Go From Here?

As one of more than 125 member countries of the inclusive framework on the OECD’s base erosion and profit-shifting project, the United States has agreed to be bound by the action 5 minimum standards relating to preferential tax regimes. Scanlon, as the U.S. delegate, will now have to defend his written response to the OECD’s FHTP inquiry. Unfortunately, the examples in the regulations themselves are difficult to ignore, and nothing in the regulation package bolsters his statement about looking at FDII “in the context of GILTI as a single system.” Further, the statute alone shows a clear export subsidy as pointed out by five OECD finance ministers just before Trump signed the concerning bill into law.

The FDII deduction regime gives U.S. corporations a deduction on income derived from selling goods and services to foreign customers. Taxpayers eligible for FDII can receive a 37.5 percent corporate income tax deduction, which amounts to a 13.125 percent effective tax rate based on the current 21 percent corporate tax rate.

Many countries will continue to argue that this provides an unfair advantage to U.S. exports and that the FDII deduction should be removed from section 250 to avoid foreign base erosion that shifts profits to the United States, to avoid retaliatory consequences that would hurt anyone that engages in global trade from the United States, such as our farmers and manufacturers of machinery and fuels. If the GILTI income tax rate is too high, it can be reduced in section 951A as part of a single system. There is no clear reason or justification for an export subsidy that has results and policies completely different from GILTI, aside from that found in the stand-alone 2015 innovation box proposal designed to compete with patent box regimes in other countries.

Alternatively, the FDII deduction could be modified to comport with international standards of neutrality that do not encourage the purchase of goods from one country over another based on tax considerations. In other words, U.S. companies would not only get the deduction by infringing on foreign country revenues with cheaper, subsidized goods but also receive the deduction for selling such products in the United States (that is, removal of the foreign use requirement). This could prevent a global trade war and a WTO ruling that the FDII deduction is an illegal export subsidy.

As a former attorney-adviser in the Treasury Office of Tax Policy, I took an oath to defend the Constitution of the United States. One cannot deny that the FDII deduction can be a stand-alone deduction, with no correlation or adjustment for GILTI. To say otherwise is to ignore the laws created by Congress as authorized by Article I of the Constitution.

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