JCT Releases Overview of Drug Manufacturers, International Tax

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CONTENTS

INTRODUCTION AND SUMMARY

APPENDIX A: SELECTION OF DIGITAL SERVICE TAXES

APPENDIX B: SELECTION OF COUNTRIES ADOPTING PILLAR TWO

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INTRODUCTION AND SUMMARY

The Senate Committee on Finance has scheduled a public hearing on May 11, 2023, titled “Cross-border Rx: Pharmaceutical Manufacturers and U.S. International Tax Policy.” This document,¹ prepared by the staff of the Joint Committee on Taxation, describes legal and economic background on U.S. taxation of U.S. multinational corporations and their cross-border activities.

Part I includes a general overview of present law relating to U.S. corporate income taxation, with a focus on selected provisions relevant to U.S.-based pharmaceutical companies.

Part II provides a summary of select issues of U.S. taxation of cross-border activity. Subpart A describes select U.S. tax rules common to multinational corporations, subpart B is a general overview of select U.S. tax rules applicable to foreign activities of U.S. taxpayers, and subpart C provides a high-level overview of the latest status of the Organisation for Economic Cooperation and Development's two-pillar solution.

Part III provides an analysis of recent economic literature that addresses cross-border taxation.

Part IV analyzes data based on U.S. corporate tax filings from 2014 through 2020 to provide insight on trends in U.S. pharmaceutical foreign- and U.S.-source income and activities.

I. GENERAL OVERVIEW OF U.S. CORPORATE INCOME TAX

Corporations organized under the laws of any of the 50 States or the District of Columbia generally are subject to the U.S. corporate income tax on their U.S.-source and certain foreign-source income.² Foreign corporations generally are subject to the U.S. corporate income tax only on income that is effectively connected with a U.S. trade or business.

A. Taxable Income

1. In general

The taxable income of a corporation generally is its gross income less allowable deductions, computed based on the corporation's methods of accounting. Large C corporations (i.e., those with average annual gross receipts for the three-taxable-year period ending with the prior taxable year that exceed $29 million (for 2023³)) are generally required to use an accrual method of accounting.⁴ Under the accrual method of accounting, items of income generally accrue when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy, but no later than the taxable year in which such income is included as revenue for financial reporting purposes.⁵ Items of expense generally may not be deducted prior to when all the events have occurred that fix the obligation to pay the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred.⁶

For businesses involving the sale of property to others (e.g., drug manufacturers), gross income is total sales less the cost of goods sold, plus any income from investment and from incidental or outside sources. ⁷ Gross income is determined on an annual or taxable year basis with the amount of each item of gross income (e.g., total sales) for the taxable year determined under the taxpayer's method of accounting for each item.⁸ In determining gross income, the amount of total sales included as an item of gross income is determined in accordance with the taxpayer's method of accounting under the income recognition rules.⁹

2. Income recognition

An accrual method taxpayer generally includes sales, gross receipts, and other items of gross income that have been realized in income no later than the taxable year in which such income is included as revenue for book purposes. Advance payments received for the sale of goods, services, or certain other items of income may generally only be deferred using a one-year deferral method.¹⁰ An advance payment generally occurs when a taxpayer receives payment before the taxpayer provides goods, services, or other items to its customer.

Reduction for cost of goods sold

As previously noted, for businesses involving the sale of property, in determining gross income for the taxable year, sales are reduced by cost of goods sold. The amount of cost of goods sold included as a subtraction from total sales is determined in accordance with the taxpayer's methods of accounting for items included in cost of goods sold.¹¹ An amount may not be taken into account in the computation of cost of goods sold, and thus reduce total sales, any earlier than the taxable year in which economic performance occurs with respect to such amount.¹² Once economic performance occurs, amounts may only be taken into account in the computation of cost of goods sold if they are not required to be capitalized and are not subject to any other provision of the Code that requires the deduction to be taken in a taxable year later than the year when economic performance occurs.

Accounting for inventories

In general, for Federal income tax purposes, taxpayers must account for inventories if the production, purchase, or sale of merchandise is a material income-producing factor to the taxpayer.¹³ In those circumstances in which a taxpayer is required to account for inventory, the taxpayer must maintain inventory records to determine the cost of goods sold during the taxable period.¹⁴ Cost of goods sold generally is determined by adding the taxpayer's inventory at the beginning of the period to the purchases made during the period and subtracting from that sum the taxpayer's inventory at the end of the period.¹⁵ Because of the difficulty of accounting for inventory on an item-by-item basis, taxpayers often use conventions that assume certain item or cost flows. Among these conventions are the first-in, first-out (“FIFO”) method, which assumes that the items in ending inventory are those most recently acquired by the taxpayer,¹⁶ and the last-in, first-out (“LIFO”) method, which assumes that the items in ending inventory are those earliest acquired by the taxpayer.¹⁷

FIFO valuation methods

Treasury regulations provide that taxpayers that maintain inventories under section 471 may determine the value of ending inventory under the cost method or the lower-of-cost-or-market (“LCM”) method.¹⁸ Under the LCM method, the value of each article in ending inventory is written down if its market value is less than its cost.¹⁹ Additionally, subnormal goods, defined as goods that are unsalable at normal prices or in the normal way because of damage, imperfections, shop wear, changes of style, odd or broken lots, or similar causes, may be written down to bona fide net selling price, under either the cost or LCM method.²⁰

LIFO

Under the LIFO method, it is assumed that the last items entered into inventory are the first items sold.²¹ Because the most recently acquired or produced units are deemed to be sold first, cost of goods sold is valued at the most recent costs; the effect of cost fluctuations is reflected in the ending inventory, which is valued at the historical costs rather than the most recent costs.²² Compared to FIFO, LIFO produces net income that more closely reflects the difference between sale proceeds and current market cost of inventory. When costs are rising, the LIFO method results in a higher measure of cost of goods sold and, consequently, a lower measure of income when compared to the FIFO method. The inflationary gain experienced by the business in its inventory generally is not reflected in income, but rather, remains in ending inventory as a deferred gain until a future period in which the quantity of items sold exceeds purchases.²³

Section 263A

Section 263A and the regulations thereunder require that direct costs and certain indirect costs incurred by the taxpayer (i.e., costs for which economic performance has occurred) must be capitalized and included in the basis of property produced or acquired for resale by the taxpayer with the capitalized costs recovered by including such amounts in cost of goods sold when the underlying inventory or property is sold.²⁴ Capitalizable indirect costs include royalty payments incurred by reason of production or resale activities (commonly referred to as “sales-based royalties”).²⁵ Sales-based royalties, which are common in the pharmaceutical industry, may either be (i) entirely allocated to property produced or acquired for resale by the taxpayer that has been sold (i.e., deducted as cost of goods sold in the taxable year of sale), or (ii) allocated between cost of goods sold and ending inventory.²⁶

3. Expense recognition

As noted above, items of expense generally may not be deducted by an accrual method taxpayer prior to when all the events have occurred that fix the obligation to pay the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred.²⁷ Allowable deductions include ordinary and necessary business expenditures,²⁸ such as salaries, wages, contributions to qualified retirement plans and certain other employee benefit programs, repairs, bad debts, taxes (other than Federal income taxes), contributions to charitable organizations (subject to an income limitation), advertising, interest expense (subject to limitation), certain losses, selling expenses, and other expenses. In the event these deductions exceed gross income, a net operating loss (“NOL”) deduction may be allowed in other years, as described below. Deductions are also allowed for certain amounts despite the lack of a direct expenditure by the taxpayer. For example, a deduction is allowed for all or a portion of the amount of dividends received by a corporation from another corporation (provided certain ownership requirements are satisfied).²⁹

Expenditures that produce benefits in future taxable years for a taxpayer's business or income-producing activities (such as the purchase of plant and equipment) generally are capitalized³⁰ and recovered over time through depreciation, amortization, or depletion allowances.³¹ In some instances, taxpayers can recover their costs more quickly than under the general rules. An additional first-year depreciation deduction is allowed equal to up to 100 percent of the adjusted basis of qualified property.³²

Certain expenditures may not be deducted, such as dividends paid to shareholders, expenses associated with earning tax-exempt income,³³ certain meal and entertainment expenses,³⁴ certain qualified transportation fringe and commuter benefits, ³⁵ certain highly compensated employee remuneration in excess of $1 million per year,³⁶ a portion of the interest on certain high-yield debt obligations that resemble equity,³⁷ as well as fines,³⁸ penalties,³⁹ bribes,⁴⁰ kickbacks,⁴¹ illegal payments,⁴² and settlements subject to nondisclosure agreements paid in connection with sexual harassment or abuse.⁴³

Certain allowable deductions commonly incurred in the pharmaceutical industry

Rebates and chargebacks

In the United States, sales discounts for pharmaceuticals are generally issued to customers at the point-of-sale, through an intermediary wholesaler/distributor in the form of a chargeback, or in the form of rebates through contractual or legal agreements with the private and public sector ( e.g., Medicaid and Medicare Part D).⁴⁴ The liability to pay a chargeback or rebate is generally deductible when paid by the taxpayer to the wholesaler/distributor.⁴⁵ However, an accrual method taxpayer who has adopted the recurring item exception method of accounting for its chargeback or rebate liabilities may generally deduct such liabilities for which it has a fixed and determinable liability by the end of its taxable year (i.e., the taxable year of the sale to the end customer) if it pays the wholesaler/distributor by the earlier of the date the it files a timely income tax return (including extensions) for such taxable year or the 15^th day of the ninth calendar month following the close of such taxable year (e.g., by September 15, 2023, for the 2022 calendar taxable year).⁴⁶

Alternatively, Medicaid rebates paid to State agencies by pharmaceutical manufacturers under the Medicaid Rebate Program are generally treated as purchase price adjustments that are subtracted from gross receipts.⁴⁷ Medicaid rebates are made with the purpose of reaching an agreed-upon selling price for drugs that are negotiated before the sale takes place and is treated as an adjustment to the manufacturer's gross receipts. However, the Internal Revenue Service (“IRS”) generally limits this treatment to Medicaid rebates that a pharmaceutical manufacturer pays pursuant to the Medicaid Rebate Program.⁴⁸

Income tax treatment of employer stock transferred to an employee

Specific rules apply to property, including employer stock, transferred to an employee in connection with the performance of services.⁴⁹ These rules govern the amount and timing of income inclusion by the employee and the amount and timing of the employer's compensation deduction. In the case of stock transferred to an employee, the employer is generally allowed a deduction (to the extent a deduction for a business expense is otherwise allowable) equal to the amount included in the employee's income as a result of transfer of the stock.⁵⁰ An employee generally must recognize income for the taxable year in which the employee's right to the stock is first substantially vested (i.e., the earlier of when the stock is transferable or not subject to a substantial risk of forfeiture).⁵¹ Thus, if the employee's right to the stock is substantially vested when the employee receives the stock (e.g., a bonus stock award), income is recognized (and a corresponding employer deduction is generally allowed) for the taxable year in which received. If the employee's right to the stock is not substantially vested at the time of receipt (e.g., a restricted stock award or restricted stock unit), income is generally recognized (and a corresponding employer deduction is generally allowed) for the taxable year in which the employee's right becomes substantially vested.⁵² The amount includible in the employee's income is the excess of the fair market value of the stock over the amount, if any, paid for the stock.⁵³

Limitation on deduction for interest

The amount allowed as a deduction for business interest for a taxable year is generally limited to the sum of: (1) the business interest income of the taxpayer for the taxable year, (2) 30 percent of adjusted taxable income of the taxpayer for the taxable year (not less than zero), and (3) the floor plan financing interest of the taxpayer for the taxable year.⁵⁴ Thus, other than floor plan financing interest, business interest expense in excess of business interest income is generally deductible only to the extent of 30 percent of adjusted taxable income.⁵⁵ The amount of any business interest expense not allowed as a deduction for any taxable year may be carried forward indefinitely. The limitation generally applies at the taxpayer level (although special carryforward rules apply in the case of partnerships). In the case of a group of affiliated corporations that file a consolidated return, the limitation applies at the consolidated tax return filing level.⁵⁶

Adjusted taxable income for purposes of section 163(j) generally means the taxable income of the taxpayer (A) computed without regard to (i) any item of income, gain, deduction, or loss that is not properly allocable to a trade or business; (ii) any business interest or business interest income; (iii) the amount of any net operating loss deduction; (iv) the amount of any deduction allowed under section 199A; and (v) in the case of taxable years beginning before January 1, 2022, any deduction allowable for depreciation, amortization, or depletion; and (B) computed with such other adjustments as provided by the Secretary.⁵⁷ For taxable years beginning after December 31, 2021, adjusted taxable income for purposes of the section 163(j) limitation on business interest is computed with regard to any deduction for depreciation, amortization, or depletion.⁵⁸

Charitable contributions of inventory

In general, an income tax deduction is permitted for charitable contributions, subject to certain limitations that depend on the type of taxpayer, the property contributed, and the donee organization.⁵⁹ Charitable contributions of cash are deductible in the amount contributed. Subject to several exceptions, contributions of property are deductible at the fair market value of the property. One exception provides that the amount of the charitable contribution is reduced by the amount of any gain which would not have been long-term capital gain if the property contributed had been sold by the taxpayer at its fair market value at the time of the contribution. ⁶⁰ As a result of this exception, a taxpayer's deduction for charitable contributions of inventory generally is limited to the lesser of the taxpayer's basis in the inventory or the fair market value of the inventory. However, for certain contributions of inventory, a C corporation may claim an enhanced deduction equal to the lesser of (1) basis plus one-half of the item's appreciation (i.e., basis plus one-half of the fair market value in excess of basis), or (2) two times basis.⁶¹ To be eligible for the enhanced deduction, the contributed property generally must be inventory of the taxpayer, contributed to a charitable organization described in section 501(c)(3) (except for private nonoperating foundations), and the donee must (1) use the property consistent with the donee's exempt purpose solely for the care of the ill, the needy, or infants; (2) not transfer the property in exchange for money, other property, or services; and (3) provide the taxpayer a written statement that the donee's use of the property will be consistent with such requirements.⁶² In the case of contributed property subject to the Federal Food, Drug, and Cosmetic Act, as amended (e.g., drugs, medical devices, etc.), the property must satisfy the applicable requirements of such Act on the date of transfer and for 180 days prior to the transfer.⁶³ In addition, if a taxpayer contributes inventory at a time when it could not reasonably expect to realize its usual selling price (e.g., a donation of drugs close to their expiration date), the value of the item is not its usual selling price, but rather the amount for which the item would have been sold at the time of the contribution.⁶⁴

Charitable contributions by a C corporation generally may not exceed 10 percent of the corporation's taxable income for the taxable year.⁶⁵ Excess contributions may be carried forward for up to five taxable years. ⁶⁶ Thus, the enhanced deduction may be limited, depending on the corporation's taxable income for the taxable year of the contribution.

NOL deduction

For NOLs arising in taxable years beginning after 2020, the NOL deduction is generally limited to 80 percent of taxable income (computed without regard to the NOL deduction and deductions under sections 199A and 250), and excess losses generally may be carried forward indefinitely, but not back (with certain exceptions).⁶⁷

4. Recovery of capital expenditures

A taxpayer generally must capitalize the cost of property used in a trade or business or held for the production of income and recover such cost over time through annual deductions for depreciation or amortization.⁶⁸ The period for depreciation or amortization generally begins when the asset is placed in service by the taxpayer.⁶⁹

Additional first-year depreciation deduction

An additional first-year depreciation deduction is allowed equal to 100 percent of the adjusted basis of qualified property acquired after September 27, 2017, and placed in service before January 1, 2023 (January 1, 2024, for certain property with a recovery period of at least 10 years or certain transportation property,⁷⁰ and certain aircraft⁷¹).⁷² The 100-percent allowance is phased down by 20 percent per calendar year for property acquired after September 27, 2017, and placed in service after December 31, 2022 (after December 31, 2023, for longer production period property and certain aircraft).⁷³ This additional first-year depreciation is commonly referred to as “bonus depreciation.”⁷⁴

Amortization of certain intangible assets

A taxpayer generally must capitalize certain amounts paid to acquire or create an intangible asset.⁷⁵ This includes amounts paid or incurred to acquire a patent, to obtain certain rights from a government agency, and any transaction costs incurred to facilitate such amounts (e.g., legal fees).⁷⁶ Certain intangible assets are subject to 15-year straight-line amortization under section 197 (“section 197 intangibles”).⁷⁷ Section 197 intangibles include, for example, any patent, copyright, formula, process, design, pattern, knowhow, format, or similar item; any license, permit, or other right granted by a governmental unit; and any franchise, trademark, or trade name.⁷⁸ However, certain rights acquired separately from the acquisition of assets constituting a trade or business (or substantial portion thereof) are not subject to 15-year amortization under section 197 and are instead subject to amortization under section 167, depending on the type of interest or right separately acquired. ⁷⁹ For example, an interest in a patent that is not acquired as part of the acquisition of a trade or business is not a section 197 intangible, but instead is generally amortized either over the patent's remaining useful life or under the income forecast method of section 167(g).⁸⁰

In the pharmaceutical industry, capitalizable amounts paid to obtain or facilitate a governmental right include those amounts attributable to new drug applications (“NDA”)⁸¹ and abbreviated new drug applications (“ANDA”)⁸² filed with the U.S. Food and Drug Administration (“FDA”) (e.g., legal fees incurred in connection with preparing the applications and obtaining FDA approval). ⁸³ Once approved by the FDA, an NDA or ANDA is generally amortizable under section 197 (i.e., generally recovered ratably over a 15-year period, beginning on the first day of the month the FDA approval is obtained).⁸⁴ Similarly, the cost of acquiring a priority review voucher (“PRV”) from a third-party pharmaceutical company in order to expedite the processing of an NDA filed with the FDA is generally required to be capitalized, and then may subsequently be amortized under section 197 beginning in the month that the FDA approves the NDA.⁸⁵ Alternatively, if a taxpayer does not use a PRV to expedite the processing of an NDA filed with the FDA and instead intends to resell it or hold it for investment, the cost of the PRV is not amortizable, but rather will generally be recovered through the recognition of gain or loss when the taxpayer sells, transfers, or exchanges the PRV.⁸⁶

Pharmaceutical companies also generally incur significant legal expenses to defend patent infringement litigation. While expenses to defend or perfect title to intangible property are generally capitalizable,⁸⁷ patent infringement expenses are generally deductible as ordinary and necessary trade or business expenses to defend against gains or profits lost by the patent owner.⁸⁸ For example, the Tax Court recently held in Mylan that legal expenses incurred by a pharmaceutical manufacturer to defend against patent infringement lawsuits, including those related to ANDAs filed by the taxpayer, are deductible ordinary and necessary business expenses.⁸⁹ However, the IRS generally views NDA and ANDA litigation expenses as capitalizable amounts paid to acquire, create, or facilitate an intangible asset (i.e., as costs incurred in pursuing FDA approval of the NDA or ANDA), and has appealed the Tax Court's ruling in Mylan with respect to the treatment of such costs to the Third Circuit Court of Appeals.⁹⁰

Capitalization and recovery of research and experimentation expenditures

For taxable years beginning after December 31, 2021, amounts defined as specified research or experimental expenditures are required to be capitalized and amortized ratably over a five-year period (15-year period for expenditures that are attributable to research that is conducted outside of the United States⁹¹), beginning with the midpoint of the taxable year in which the specified research or experimental expenditures were paid or incurred.⁹² Specified research or experimental expenditures subject to capitalization include expenditures for software development.⁹³ Specified research or experimental expenditures exclude expenditures for the acquisition or improvement of land or for depreciable or depletable property used in connection with the research or experimentation, but do include the depreciation and depletion allowances of such property.⁹⁴ Research or experimental expenditures also exclude the costs of acquiring another person's patent, model, production, or process (commonly referred to as “in-process R&D”).⁹⁵

In the case of retired, abandoned, or disposed property with respect to which specified research or experimental expenditures are paid or incurred, any remaining basis may not be recovered in the year of retirement, abandonment, or disposal, but instead must continue to be amortized over the remaining amortization period.⁹⁶

5. U.S. tax rules applicable to foreign activities of U.S. taxpayers

In general, income earned directly by a U.S. person from the conduct of a foreign trade or business is taxed currently,⁹⁷ while income earned indirectly through certain related foreign entities (i.e., controlled foreign corporations (“CFCs”))⁹⁸ is taxed in the year earned or not at all. Indirect earnings of CFCs are generally taxable in one of two ways. First, the earnings may constitute income to U.S. shareholders under the traditional anti-deferral regime of subpart F, which applies to certain passive income and certain other related-party income that is readily movable from one jurisdiction to another.⁹⁹ Second, the earnings may be subject to section 951A, which applies to some foreign-source income of a CFC that is not subpart F income (referred to as global intangible low-taxed income (“GILTI”)). Subpart F income is taxed at full rates, while GILTI is taxed at preferential rates, both without regard to whether the income is distributed to shareholders. The preferential rate on GILTI is achieved by means of allowing corporations a 50-percent deduction (a “section 250 deduction”) on their GILTI (and the corresponding section 78 gross up amount).¹⁰⁰ A foreign tax credit generally is available to offset, in whole or in part, the U.S. tax owed on foreign-source income.¹⁰¹

Foreign earnings not subject to tax as subpart F income or GILTI generally are exempt from U.S. tax. To exempt those earnings, dividends received by corporate U.S. shareholders from specified 10-percent owned foreign corporations (including CFCs) generally are eligible for a 100-percent dividends-received deduction (“DRD”).¹⁰²

For a deeper discussion of select issues, see Part II.B. below.

B. Corporate Tax Liability

1. In general

A domestic corporation generally is subject to Federal income tax at a rate of 21 percent rate.¹⁰³ Domestic corporations that are affiliated through 80-percent or more corporate ownership may elect to file a consolidated return in lieu of filing separate returns.¹⁰⁴ Corporations filing a consolidated return generally are treated as a single corporation; thus, the losses of one corporation can offset the income (and thus reduce the otherwise applicable tax) of other affiliated corporations.

Certain corporations whose annual gross receipts meet or exceed certain thresholds are subject to an additional tax under section 59A (the base erosion and anti-abuse tax, discussed below).

In contrast to the treatment of capital gains in the individual income tax, no separate rate structure exists for corporate capital gains. A corporation may not deduct the amount of capital losses in excess of capital gains for any taxable year. Disallowed capital losses may be carried back three years or carried forward five years.

Corporations generally are taxed at lower rates on their foreign-derived intangible income (“FDII”).¹⁰⁵ The preferential rate is accomplished by the allowance of a 37.5-percent deduction under section 250, resulting in an effective tax rate of 13.125 percent on FDII (discussed below).

2. Corporate alternative minimum tax

For taxable years beginning after December 31, 2022, large C corporations meeting certain requirements (“applicable corporations”) are subject to a new corporate alternative minimum tax that is based on adjusted financial statement income. ¹⁰⁶ The tax equals the excess (if any) of (1) the tentative minimum tax for the taxable year, over (2) the regular tax (as defined in section 55(c)) plus the tax imposed by section 59A for the taxable year.¹⁰⁷ The tentative minimum tax for an applicable corporation for a taxable year is the excess of (i) 15 percent of the adjusted financial statement income (“AFSI,” as reduced by certain financial statement NOLs¹⁰⁸) for the taxable year, over (ii) the book minimum tax foreign tax credit for such taxable year.¹⁰⁹ In the case of any corporation that is not an applicable corporation, the tentative minimum tax for the taxable year is zero.¹¹⁰ In general, an applicable corporation is entitled for any taxable year to a credit against its Federal income tax in an amount equal to the minimum tax credit for such taxable year.¹¹¹

Section 56A sets forth the general definition of AFSI, which is used for purposes of determining the corporate alternative minimum tax liability and, with certain modifications provided in section 59(k), for purposes of determining whether a corporation is an applicable corporation subject to the corporate alternative minimum tax. AFSI is the net income or loss of the taxpayer set forth on the taxpayer's applicable financial statement for such taxable year, adjusted as set forth in section 56A. Adjustments to net financial statement income include adjustments for: (1) statements covering different taxable years, (2) consolidated tax returns, (3) dividends and other amounts, (4) earnings of certain partnerships, (5) certain foreign income, (6) certain Federal and foreign taxes, (7) income of disregarded entities, (8) patronage dividends and per-unit retain allocations of cooperatives, (9) certain items of Alaska Native Corporations, (10) amounts attributable to elections for direct payment of certain credits, (11) reasonable mortgage servicing income, (12) defined benefit pensions, (13) tax-exempt entities, (14) depreciation, and (15) qualified wireless spectrum. The Secretary is directed to issue regulations to prevent the omission or duplication of any item, to address corporate organizations and reorganizations, and to address the effect of these provisions on partnerships with an applicable corporation as a partner.

In general, a corporation is an applicable corporation subject to the corporate alternative minimum tax if it meets the average annual AFSI test for one or more taxable years which are prior to such taxable year, and end after December 31, 2021.¹¹² A corporation meets such test for a taxable year if its average annual AFSI for the three-taxable-year period ending with such taxable year exceeds $1 billion. In the case of a foreign-parented corporation, there is an additional test requiring that the average annual AFSI of the corporation (not including income of the group not subject to U.S. tax) for the three-taxable-year period ending with such taxable be $100 million or more. Aggregation rules and certain adjustments apply in determining AFSI for purposes of determining whether a corporation is an applicable corporation.¹¹³

3. Tax credits

General business credits, including the research credit and orphan drug credit (discussed below), generally may offset up to approximately 75 percent of the sum of a corporation's normal income tax and alternative minimum tax.¹¹⁴ Any general business credit in excess of this limitation generally may be carried back one year and forward up to 20 years.¹¹⁵

Corporations may reduce their tax liability by any applicable general business credits.¹¹⁶ The three largest dollar amount credits are the research credit (discussed below), the low-income housing credit, and the energy credit, which provide incentives for intangible investment, affordable housing investment, and energy production, respectively.¹¹⁷ Other credits applicable to businesses include the orphan drug credit (discussed below), investment tax credits (including an investment credit for qualified investments in an advanced manufacturing facility (i.e., a semiconductor manufacturing facility)), the work opportunity credit (applicable to a portion of first-year wages paid to individuals from certain targeted groups), the employer-provided child care credit (applicable to certain expenditures to provide child care for employees), and the employer credit for paid family and medical leave (applicable to wages paid to employees on family and medical leave).¹¹⁸

Research credit

A taxpayer may generally claim a research credit equal to 20 percent of the amount by which the taxpayer's qualified research expenses for a taxable year exceed its base amount for that year.¹¹⁹ Thus, the research credit is generally available with respect to incremental increases in qualified research. An alternative simplified credit (with a 14-percent rate and a different base amount) may be claimed in lieu of this credit.¹²⁰

A 20-percent research credit also is available with respect to the excess of (1) 100 percent of corporate cash expenses (including grants or contributions) paid for basic research conducted by universities (and certain nonprofit scientific research organizations) over (2) the sum of (a) the greater of two minimum basic research floors plus (b) an amount reflecting any decrease in nonresearch giving to universities by the corporation as compared to such giving during a fixed-base period, as adjusted for inflation.¹²¹ This separate credit computation commonly is referred to as the “basic research credit.”

Finally, a 20-percent research credit is available for a taxpayer's expenditures on research undertaken by an energy research consortium for energy research.¹²² This separate credit computation commonly is referred to as the “energy research credit.” Unlike the other research credits, the energy research credit applies to all qualified expenditures, not just those in excess of a base amount.

Orphan drug credit

Section 45C provides a 25-percent tax credit for qualified clinical testing expenses incurred in the testing of certain drugs for rare diseases or conditions, generally referred to as “orphan drugs.” Qualified clinical testing expenses are costs incurred to test an orphan drug after the drug has been approved for human testing by the FDA but before the drug has been approved for sale by the FDA.¹²³ A rare disease or condition is defined as one that (1) affects fewer than 200,000 persons in the United States, or (2) affects more than 200,000 persons, but for which there is no reasonable expectation that a business could recoup the costs of developing a drug for such disease or condition from sales in the United States of the drug.¹²⁴

Amounts included in computing the credit under this section are excluded from the computation of the research credit under section 41.¹²⁵ If a taxpayer claims the orphan drug credit, it either (i) reduces its otherwise allowable deduction for qualified clinical testing expenses by the amount of the credit allowed, or (ii) elects a reduced credit by an amount equal to the credit multiplied by the highest corporate tax rate.¹²⁶

4. Excise taxes

Excise tax on certain stock repurchases

In the case of repurchases of stock after December 31, 2022, section 4501 imposes a nondeductible¹²⁷ one percent excise tax on the aggregate fair market value of stock that a covered corporation repurchases during the taxable year, subject to certain adjustments and exceptions. A covered corporation is any domestic corporation the stock of which is traded on an established securities market (within the meaning of section 7704(b)(1)).¹²⁸

Annual fee on branded prescription pharmaceutical manufacturers and importers

An annual fee is imposed on covered entities engaged in the business of manufacturing or importing branded prescription drugs for sale to any specified government program or pursuant to coverage under any such program.¹²⁹ The aggregate annual fee imposed on all covered entities is $2.8 billion for calendar year 2023.¹³⁰ The aggregate fee is apportioned among the covered entities each year based on their relative market share of branded prescription drug sales taken into account during the previous calendar year. A covered entity is any manufacturer or importer with gross receipts from branded prescription drug sales. The fee is considered to be a nondeductible tax for purposes of section 275 and therefore is not deductible against income taxes.¹³¹

Excise tax on taxable vaccines

An excise tax is imposed on any taxable vaccine sold by the manufacturer, producer, or importer of such vaccine.¹³² Manufacturers, producers, and importers are responsible for paying 75 cents per dose of a taxable vaccine upon the sale of the vaccine, but the tax does not apply if it has already been imposed on a prior sale of such vaccine.¹³³ Vaccines which include multiple taxable vaccines are taxed cumulatively as if each taxable vaccine were a separate dose — that is, if two taxable vaccines are combined, then the tax imposed is $1.50 per dose.¹³⁴ Similarly, fractional doses are taxed at the same fraction of the amount of such tax imposed on a whole dose.¹³⁵ Doses which are used by a manufacturer, producer, or importer before being sold are taxed as if the vaccine were sold by such manufacturer, producer, or importer.¹³⁶

Excise tax for noncompliance with the Drug Price Negotiation Program

Applicable pharmaceutical manufacturers, producers, and importers who do not comply with certain requirements of the Drug Price Negotiation Program administered by the Secretary of Health and Human Services (“HHS”)¹³⁷ are subject to a nondeductible excise tax ranging from 65 to 95 percent on designated drug sales during periods of noncompliance.¹³⁸

5. The base erosion and anti-abuse tax

The base erosion and anti-abuse tax (the “BEAT”) is an additional tax imposed on certain multinational corporations with respect to payments to foreign affiliates.¹³⁹

The BEAT applies only to corporate taxpayers with average gross receipts in excess of $500 million and is determined, in part, by the extent to which a taxpayer has made payments to foreign related parties.¹⁴⁰ The BEAT generally does not apply to taxpayers for which reductions to taxable income (“base erosion tax benefits”) arising from payments to foreign related parties (“base erosion payments”) are less than three percent of total deductions (i.e., a “base erosion percentage” of less than three percent).¹⁴¹

A base erosion tax benefit generally reflects the reduction in taxable income arising from the associated base erosion payment. A base erosion payment generally is any amount paid or accrued by a taxpayer to a foreign person that is a related party of the taxpayer and with respect to which a deduction is allowable.¹⁴² A base erosion payment includes any amount paid or accrued by the taxpayer to a foreign related party in connection with the acquisition by the taxpayer from the related party of property of a character subject to the allowance for depreciation (or amortization in lieu of depreciation).¹⁴³ Base erosion payments generally do not include any amount that constitutes a reduction in gross receipts, including payments for cost of goods sold. Certain other payments are excluded from the definition of base erosion payment, including certain payments for services¹⁴⁴ and any qualified derivative payments.¹⁴⁵

For a taxpayer subject to the BEAT (an “applicable taxpayer”), the additional tax (the “base erosion minimum tax amount” or “BEAT liability”) for the year generally equals the excess, if any, of 10 percent of its modified taxable income over an amount equal to its regular tax liability¹⁴⁶ reduced (but not below zero) by the sum of a certain tax credits under chapter 1 of the Code.¹⁴⁷ Modified taxable income is the taxpayer's regular taxable income determined without regard to a certain portion of any NOL deduction allowed for the taxable year and without regard to any base erosion tax benefit with respect to certain items (i.e., base erosion payments), including (1) certain deductible payments made to foreign related parties, (2) deductions allowed for depreciation (or amortization in lieu of deprecation) with respect to property acquired from foreign related parties, and (3) reinsurance premiums paid to foreign related parties.¹⁴⁸

Special rules apply to banks and securities dealers.¹⁴⁹ For taxable years beginning after December 31, 2025, the 10-percent rate on modified taxable income is increased to 12.5 percent, and regular tax liability is reduced (and the base erosion minimum tax amount is therefore increased) by the sum of all the taxpayer's income tax credits for the taxable year.¹⁵⁰

6. Transition tax on U.S. shareholders of certain controlled foreign corporations

In 2017, many changes were made to the taxation of the foreign activities of U.S. persons, which had the effect of moving the United States from a worldwide system with limited deferral toward a participation exemption system with current inclusion of certain additional income. As part of the transition to this new participation exemption system, Congress enacted a one-time tax (the “transition tax”) on undistributed foreign earnings that accrued before the effective date of the new system. The transition tax allowed for the uniform applicability of the participation exemption with respect to post-enactment foreign earnings of foreign subsidiaries.

The transition tax requires certain foreign corporations to include as subpart F income the untaxed and undistributed foreign earnings that were accumulated by those corporations in taxable years since 1986. The U.S. shareholders of those corporations are subject to the transition tax with respect to the shareholders' pro rata shares of such subpart F income.

The transition tax generally applies for the last taxable year beginning before January 1, 2018, requiring that any U.S. shareholder of a specified foreign corporation must include in income its pro rata share of the accumulated post-1986 deferred foreign income of the corporation. However, a portion of that pro rata share of foreign earnings is deductible, depending on the proportion of the deferred earnings that are held in cash or other assets. The structure of the allowable deduction results in a bifurcated rate of tax on amounts required to be included in income: the rate is 15.5 percent for cash assets and eight percent for noncash assets. A corresponding portion of the credit for foreign taxes paid with respect to such income is disallowed, thus limiting the credit to the taxable portion of the included income. ¹⁵¹ A U.S. shareholder may elect to forgo the use of an NOL deduction to offset the amount included under the transition tax, and if the U.S. shareholder so elects, neither the section 951 inclusion nor any related deemed paid foreign tax credits may be taken into account in computing the NOL deduction for that year.¹⁵²

A taxpayer may elect to pay the transition tax over an eight-year period without accruing underpayment interest. Special rules are provided for S corporations and REITs.

II. OVERVIEW OF SELECT ISSUES OF U.S. TAXATION OF CROSS-BORDER ACTIVITY

The following discussion provides an overview of select principles, issues, and rules relating to the U.S. taxation of income from cross-border business activity of large U.S. multinational corporations, including those in the pharmaceutical industry, as well as a general description of the current status of the Organisation for Economic Cooperation and Development's proposed two-pillar solution to addressing certain base-erosion and profit shifting concerns.

A. Select U.S. Tax Rules Common to Inbound and Outbound Taxation

The United States imposes source-based taxation on U.S.-source income of nonresident alien individuals and other foreign persons. Under this system, the application of the Code differs depending on whether income arises from outbound investment (i.e., foreign investments by U.S. persons) or inbound investment (i.e., U.S. investment by foreign persons). While the United States taxes inbound and outbound investment differently, certain rules are common to the taxation of both, including rules relating to residency, entity classification, source determination, and transfer pricing.

1. Residence

The Code defines U.S. person to include all U.S. citizens and residents as well as domestic entities such as partnerships, corporations, trusts and estates.¹⁵³ Partnerships and corporations are domestic if organized or created under the laws of the United States, any State, or the District of Columbia, unless, in the case of a partnership, the Secretary prescribes otherwise by regulation.¹⁵⁴ All other partnerships and corporations (i.e., those organized under the laws of foreign countries) are foreign.¹⁵⁵ Other jurisdictions may use factors such as situs or management and control to determine residence. As a result, legal entities may have more than one tax residence, or, in some cases, no residence. In such cases, bilateral treaties may resolve conflicting claims of residence.

Exception for corporate inversions

In certain cases, a foreign corporation that acquires a domestic corporation or partnership may be treated as a domestic corporation for Federal tax purposes.¹⁵⁶ That result generally applies following a transaction in which, pursuant to a plan or a series of related transactions: (1) a domestic corporation becomes a subsidiary of a foreign-incorporated entity or otherwise transfers substantially all of its properties to such an entity; (2) the former shareholders of the domestic corporation hold (by reason of the stock they had held in the domestic corporation) at least 80 percent (by vote or value) of the stock of the foreign-incorporated entity after the transaction (often referred to as “stock held by reason of”); and (3) the foreign-incorporated entity, considered together with all companies connected to it by a chain of greater than 50-percent ownership (the “expanded affiliated group”), does not have substantial business activities in the entity's country of organization, compared to the total worldwide business activities of the expanded affiliated group. If the above requirements are satisfied except that the “stock held by reason of” the acquisition is less than 80 percent, but at least 60 percent of the stock of the foreign corporation, the foreign corporation is not treated as a domestic corporation and is instead considered a surrogate foreign corporation for the acquired domestic company which is an expatriated entity that must recognize certain “inversion gain” post-acquisition restructuring¹⁵⁷ and may be subject to other consequences under the provisions enacted in 2017.¹⁵⁸

Pharmaceutical companies have inverted in several mergers with foreign companies that have attracted attention.¹⁵⁹ Of the 60 inversions documented from 1983 through 2015, pharmaceutical companies experienced the most inversion activity.¹⁶⁰

2. Entity classification

The Code defines various entity classifications, including partnership and corporation;¹⁶¹ such classification matters for many Federal income tax purposes. In addition, certain entities other than “per se” corporations (e.g., incorporated domestic business entities, banks, insurance companies, and any entity included in a list of foreign business entities)¹⁶² are eligible to elect their classification. Under the so-called “check-the-box” regulations, these eligible entities may elect their classification as a corporation, a partnership, or an entity disregarded as separate from its owner (“DRE”).¹⁶³ A DRE is treated in the same manner as a sole proprietorship, in the case of an entity owned by an individual, and in the same manner as a branch or division, in the case of an entity owned by a corporation or partnership. Both foreign and domestic entities may make the election.¹⁶⁴

As a result of the check-the-box regulations, an entity formed in the United States and operating in at least one other jurisdiction may be treated as a hybrid entity (i.e., treated as a partnership or disregarded entity for U.S. tax purposes but as a corporation for foreign tax purposes) or a reverse hybrid entity (i.e., treated as a corporation for U.S. tax purposes but as a partnership or disregarded entity for foreign tax purposes).

Congress has recognized that such hybrid entities or reverse hybrid entities may improperly reduce subpart F income, allow for payments that generate deductions without offsetting inclusions, and use tax treaties to reduce withholding tax on payments that are not subject to tax under the laws of any jurisdiction, and have accordingly attempted to limit their use as a tax planning tool.¹⁶⁵

3. Source of income rules

Various factors determine the source of income for U.S. tax purposes, including the status or nationality of the payor or recipient and the location of the activities or assets that generate the income. The Code includes extensive rules on determining whether income is considered to be from U.S. sources or from foreign sources.¹⁶⁶ Special rules are provided for certain industries, (e.g., transportation, shipping, and certain space and ocean activities) as well as for income partly from within and partly from without the United States.¹⁶⁷

While many rules for determining source have been unchanged over the years, changes made in 2017 addressed the sale of inventory by eliminating the title passage rule. Gains, profits, and income from the sale or exchange of inventory property that is either (1) produced (in whole or in part) inside the United States and then sold or exchanged outside the United States, or (2) produced (in whole or part) outside the United States and then sold or exchanged inside the United States is allocated and apportioned solely on the basis of the location of production activity.¹⁶⁸ For example, income derived from the sale of inventory produced entirely in the United States is wholly from U.S. sources, even if title passage occurs elsewhere. Likewise, income derived from the sale of inventory produced entirely in another country is wholly from foreign sources, even if title passage occurs in the United States. If inventory is produced only partly in the United States, the income derived from its sale is sourced partly in the United States regardless of where title to the property passes.

4. Transfer pricing

General rule — arm's length standard

Section 482 authorizes the Secretary to allocate income, deductions, credits, or allowances among related business entities when necessary to clearly reflect income or otherwise prevent tax avoidance. Comprehensive Treasury regulations under that section generally adopt the arm's-length standard as the method for determining whether a particular allocation is appropriate.¹⁶⁹ Under that standard, the amount of profit allocated to each related taxpayer must be measured by reference to the amount of profit that a similarly situated taxpayer would realize in a similar transaction with unrelated parties bargaining at arm's length. The arm's length standard is broadly accepted internationally, including all members of the OECD as well as many nonmembers.¹⁷⁰

Special rules for intangible property transfers

Section 482 requires that the income with respect to a transfer of intangible property be commensurate with the income attributable to the intangible. By requiring inclusion of amounts commensurate with the income attributable to the intangible, Congress was responding to concerns regarding the effectiveness of the arm's-length standard with respect to intangible property — including, in particular, high-profit-potential intangibles.¹⁷¹

A U.S. person may transfer intangible property to a related person (typically, a foreign affiliate) in one of four ways: Outright transfer of the intangible property; a license of the intangible property, in which the U.S. person transfers less than all substantial rights in the intangible property to the foreign affiliate; the provision of a service by the U.S. person to the foreign affiliate using the intangible property, rather than a direct transfer of the property; and finally, a transfer by the U.S. person of intangible property through a qualified cost-sharing arrangement with one or more foreign affiliates, under which the participants make resources available and contribute funds (through a combination of cash and existing intangible property rights) toward the joint development of a new marketable product or service. A qualified cost-sharing arrangement is an agreement between taxpayers under common control that satisfies the requirements prescribed under regulations.¹⁷² The method of transfer may determine whether the applicable section is section 482 or section 367(d).¹⁷³

Despite consensus around the use of arm's length standard and extensive guidance, questions surrounding the difficulties posed by intercompany pricing requirements were raised, including recurring definitional and methodological issues and concerns about the use of aggressive transfer pricing.¹⁷⁴ In 2013, the OECD began a study of the existing international standards for transfer pricing and challenges presented by those standards in relation to intangible assets, risk and capital allocation, and other transactions which would not, or would only very rarely, occur between third parties.¹⁷⁵ Similar definitional and methodological issues raised in litigation¹⁷⁶ led to clarification of the definition of intangible property and valuation methods in 2017, as described below.

Definition of intangible property

For purposes of section 482, intangible property is defined by reference to the provision governing gain recognition from outbound transfers of intangible property.¹⁷⁷ That provision includes a list of enumerated items that specifically include goodwill, going-concern value, and workforce-in-place. It clarifies the definition by replacing the residual category of “any similar item” with “any item the value of which is not attributable to tangible property or the services of any individual” and removing certain language to make clear that neither source nor amount of value is relevant in determining whether property in one of the other enumerated categories is within the scope of the definition.¹⁷⁸

Valuation of intangibles

Section 482 provides that “[f]or purposes of this section, the Secretary shall require the valuation of transfers of intangible property (including intangible property transferred with other property or services) on an aggregate basis or the valuation of such a transfer on the basis of the realistic alternatives to such a transfer, if the Secretary determines that such basis is the most reliable means of valuation of such transfers.” ¹⁷⁹ The mandated use of the aggregate basis valuation method in these cases under section 482 is consistent with regulations promulgated prior to the 2017 revision of the statute, which required that synergies created by the interrelated nature of intangible assets that are transferred in one or more contemporaneous transactions be properly taken into account in order to reach an arm's length result.¹⁸⁰ The approach is also consistent with Tax Court decisions in cases outside of the section 482 context, in which collections of multiple, related intangible assets were viewed by the Tax Court in the aggregate,¹⁸¹ as well as existing cost-sharing regulations.¹⁸²

Similarly, the realistic alternative principle was explicit in regulations as an underpinning of all transfer pricing methodologies for a transfer of intangibles. “Realistic alternative” was first adopted as an expressly articulated principle in 1994, following IRS defeats in Bausch & Lomb v. Commissioner,¹⁸³ Eli Lilly v. Commissioner,¹⁸⁴ and G.D. Searle & Co. v. Commissioner.¹⁸⁵ In determining the income attributable to a taxpayer that participated in a specific transfer of intangibles, the method of valuation chosen must yield results consistent with the economic results from alternative arrangements that were realistically available to that taxpayer. The degree of consistency between anticipated benefits from the transactions under the chosen pricing method and the anticipated benefits of a realistic alternative to the transaction indicates the reliability and appropriateness of the valuation.¹⁸⁶ This principle is predicated on the notion that a taxpayer enters into a particular transaction only if none of its realistic alternatives is economically preferable to the transaction under consideration.

Transfer pricing and challenges to blocked income regulations

Under limited exceptions, the IRS will respect a foreign law proscription that limits cross-border payments when determining whether an arm's length price was paid for cross-border goods or services (the “blocked income regulation”).¹⁸⁷ The validity of the blocked income regulation has been challenged in two recent cases involving aspects of Brazil's domestic law: 3M Company and Subsidiaries,¹⁸⁸ and The Coca Cola Company and Subsidiaries.¹⁸⁹ In both cases, the taxpayers presented alternative theories based on the Administrative Procedure Act, as well as standards of judicial deference and prior case law on blocked income.¹⁹⁰

In 3M Company and Subsidiaries,¹⁹¹ the Tax Court recently upheld the validity of the regulation in a fully reviewed opinion with nine judges in the majority and eight dissenting. In doing so, the Court analyzed the conditions in the regulation for recognizing a foreign law prohibition. The blocked income regulation recognizes a foreign legal prohibition only if four requirements are met: (1) the foreign law or regulation was publicly promulgated, (2) it applies to both controlled and uncontrolled parties, (3) it prevents the payment in any form, and (4) the taxpayer has exhausted efforts to seek remedy under local law. The Court found that the foreign law prohibition in question failed both the first and second of those four requirements.

In the second case, The Coca Cola Company and Subsidiaries, presenting a similar challenge to the blocked income regulation, the Court reserved on the issue ¹⁹² after resolving the issues regarding transfer pricing methodology, and subsequently requested further briefing in light of the holding in 3M Company and Subsidiaries.¹⁹³

B. Select U.S. Tax Rules Applicable to Foreign Activities of U.S. Taxpayers

1. Subpart F income

Under subpart F, U.S. shareholders of a CFC must include in income their pro rata shares of subpart F income, without regard to whether the income is distributed to the shareholders.¹⁹⁴ In effect, U.S. shareholders of a CFC are treated as having received a current distribution of the CFC's subpart F income. With exceptions described below, subpart F income generally includes passive income and other income that is readily movable from one jurisdiction to another. Subpart F income consists of foreign base company income,¹⁹⁵ insurance income,¹⁹⁶ and certain income relating to international boycotts and other violations of public policy.¹⁹⁷

Foreign base company income

Foreign base company income consists of foreign personal holding company income, which includes passive income such as dividends, interest, rents, and royalties, and a number of categories of income from business operations, including foreign base company sales income and foreign base company services income.¹⁹⁸

Foreign personal holding company income

Foreign personal holding company income (“FPHCI”) generally includes income from dividends, interest, royalties, rents, annuities; net gains on certain property transactions; net gains from commodities transactions; net gains from foreign currency transactions; income equivalent to interest; income from notional principal contracts; payments in lieu of dividends; and amounts received under certain personal service contracts.¹⁹⁹

Several exceptions apply to exclude certain income from FPHCI. For example, FPHCI does not include certain dividends, interest, rents, and royalties received by a CFC from a related corporation organized and operating in the same foreign country in which the CFC is organized.²⁰⁰ The same-country exception is not available to the extent that the payments reduce the subpart F income of the payor. Another exception excludes from FPHCI dividends, interest, rents, and royalties received or accrued by one CFC from a related CFC to the extent attributable or properly allocable to income of the payor that is not subpart F income.²⁰¹

In addition, there is an “active business” exception for rents and royalties that are derived from an active trade or business conducted by the CFC and not received from a related party.²⁰² In general, payments by a branch to its owner are disregarded. Thus, in this context, royalty payments by a branch to its CFC owner are disregarded. A branch may include a foreign entity that has elected for U.S. Federal tax purposes to be disregarded as an entity separate from its CFC owner (a “disregarded entity” or “DRE”).

Foreign base company sales income

Foreign base company sales income (“FBC sales income”) is income derived by a CFC in connection with (1) the purchase of personal property from a related person and its sale to any person; (2) the sale of personal property to any person on behalf of a related person; (3) the purchase of personal property from any person and its sale to a related person; or (4) the purchase of personal property from any person on behalf of a related person. In each of the situations described in items (1) through (4), the property must be both manufactured and sold for use outside the country in which the CFC is organized for the income from its sale to be considered FBC sales income.²⁰³

There are several exceptions to FBC sales income, including the same country manufacturing exception, same country sales or use exception, and the CFC manufacturing exception. The same country manufacturing exception excludes from FBC sales income any income from the sale of goods manufactured in the country in which the CFC is organized.²⁰⁴ The same country sales or use exception excludes from FBC sales income any income from the sale of goods for the use, consumption, or disposition in the country in which the CFC is organized.²⁰⁵

A second manufacturing exception (i.e., the CFC manufacturing exception), which is set forth in regulations, provides that FBC sales income does not include income from the sale of property that the CFC manufactures, purchases, or sells outside the country in which the CFC is organized if the CFC does not violate the branch rule (discussed below).²⁰⁶ Manufacturing is defined by physical manufacturing tests such as the substantial transformation test and the substantial activity test, as well as nonphysical activities such as the substantial contribution test.²⁰⁷

Manufacturing, purchasing, and selling through branches

To qualify for the CFC manufacturing exception, a CFC that manufactures, purchases, or sells outside its country of organization through a branch must satisfy the “branch rule.” Under the branch rule, a CFC must show (in effect) that the use of the branch is not to move income from a high-tax jurisdiction to a low-tax jurisdiction. The branch rule provides that, if a CFC manufactures, purchases, or sells through a branch outside its country of organization and the use of the branch has “substantially the same effect” as would the use of a wholly owned subsidiary corporation of the CFC, then the branch and the CFC are treated as separate corporations for purposes of determining FBC sales income of the CFC.

The use of the branch has “substantially the same effect” if a tax rate disparity test is met. The test looks to whether the tax rate of the branch is too low in comparison to that of the CFC. Under the sales branch rule, the test looks to whether the tax rate of the sales branch is too low in comparison to the CFC (where the manufacturing is).²⁰⁸ Under the manufacturing branch rule, the test looks to whether the tax rate of the CFC (where the sales are) is too low in comparison to the manufacturing branch.²⁰⁹ If the relevant tax rate (under either test) is too low, then the related income is FBC sales income.

Foreign base company services income

Foreign base company services income (“FBC services income”) is income (whether in the form of compensation, commissions, fees, or otherwise) derived in connection with the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial, or like services which (1) are performed for or on behalf of any related person, and (2) are performed outside the country in which the CFC is organized.²¹⁰

FBC services income does not include income derived in connection with the performance of services which are directly related to (1) the sale or exchange by the CFC of property manufactured, produced, grown, or extracted by the CFC and which are performed before the time of the sale or exchange, or (2) an offer or effort to sell or exchange such property.²¹¹

Insurance income

Insurance income subject to current inclusion under subpart F includes any income of a CFC attributable to the issuing or reinsuring of any insurance or annuity contract in connection with risks located in a country other than the CFC's country of organization.²¹²

Investments in U.S. property

U.S. shareholders also must include their pro rata shares of a CFC's untaxed earnings invested in certain items of U.S. property.²¹³ For this purpose, U.S. property generally includes tangible property located in the United States, stock of a U.S. corporation, an obligation of a U.S. person, and certain intangible assets (such as patents and copyrights) acquired or developed by the CFC for use in the United States.²¹⁴ There are specific exceptions to the general definition of U.S. property, including for bank deposits, certain export property, and certain trade or business obligations.²¹⁵

Other exceptions

An exception to foreign base company income and insurance income (the “high-tax exception”) is available for any item of income received by a CFC if the taxpayer establishes that the income was subject to an effective foreign income tax rate greater than 90 percent of the maximum U.S. corporate income tax rate in effect at the time the income was earned ( e.g., for income earned by a CFC in tax year 2020, more than 90 percent of 21 percent, or 18.9 percent).²¹⁶

There is also an exclusion from subpart F income for certain income of a CFC that is derived in the active conduct of a banking or financing business (“active financing income”).²¹⁷ With respect to income derived in the active conduct of a banking, financing, or similar business, a CFC is required to be predominantly engaged in such business and to conduct substantial activity with respect to such business, and other requirements must be met.

For a securities dealer, foreign personal holding company income excludes any interest or dividend (or certain equivalent amounts) from any transaction entered into in the ordinary course of the dealer's trade or business as a dealer in securities within the meaning of section 475.²¹⁸

Exclusion of previously taxed earnings and profits

A U.S. shareholder may exclude from its income actual distributions of earnings and profits from a CFC that were previously included in income by the U.S. shareholder under subpart F.²¹⁹ Any income inclusion resulting from an investment in U.S. property also may be excluded when such earnings and profits are ultimately distributed.²²⁰

Basis adjustments

A U.S. shareholder of a CFC generally increases the basis in its CFC stock by the amount of subpart F income inclusions and generally reduces the basis in its CFC stock by the amount of any distributions that are excluded from its income as previously taxed earnings and profits.²²¹

2. GILTI

A U.S. shareholder of a CFC also must include in gross income its GILTI. GILTI is the excess of the shareholder's net CFC tested income over the shareholder's net deemed tangible income return. The shareholder's net deemed tangible income return equals the excess of 10 percent of the aggregate of its pro rata share of the qualified business asset investment (“QBAI”) of each CFC over certain interest expense.²²²

Although a GILTI inclusion is generally treated in the same manner as a subpart F inclusion, GILTI is not subpart F income. GILTI is computed at the U.S.-shareholder level rather than the CFC level, with a U.S. shareholder allowed to offset tested income of its CFCs with tested loss of other CFCs in computing net CFC tested income. When computing tax liability associated with GILTI, U.S. shareholders may not take into account certain tax attributes of CFCs with tested loss, such as foreign tax credits and QBAI. In addition, the foreign tax credit limitation is applied separately with respect to GILTI, and no carryovers and carrybacks of excess foreign tax credits are allowed in the GILTI foreign tax credit limitation category.

Net CFC tested income

Net CFC tested income means the excess of the aggregate of the shareholder's pro rata share of the tested income of each CFC over the aggregate of its pro rata share of the tested loss of each CFC.²²³

The tested income of a CFC is the excess of the gross income of the CFC determined without regard to certain amounts that are exceptions to tested income (referred to in this document as “gross tested income”) over deductions (including taxes) properly allocable to such gross tested income. The exceptions to tested income are: (1) any effectively connected income described in section 952(b); (2) any gross income taken into account in determining the CFC's subpart F income; (3) any gross income excluded from foreign base company income or insurance income by reason of the high-tax exception under section 954(b)(4);²²⁴ (4) any dividend received from a related person (as defined in section 954(d)(3)); and (5) any foreign oil and gas extraction income (as defined in section 907(c)(1)).

The tested loss of a CFC means the excess of deductions (including taxes) properly allocable to the CFC's gross tested income over the amount of such gross tested income.

Qualified business asset investment

QBAI means, with respect to any CFC for a taxable year, the average of the aggregate of the CFC's adjusted bases in specified tangible property that is both used in its trade or business and of a type with respect to which a deduction is generally allowable under section 167.²²⁵ The adjusted basis in any property generally must be determined using the alternative depreciation system under section 168(g) as in effect on December 22, 2017.

Specified tangible property means any property used in the production of tested income.²²⁶

Treatment as subpart F income

GILTI inclusions generally are treated in the same manner as amounts included as subpart F income.²²⁷

Preferential rate on GILTI

The preferential rate on GILTI is achieved by allowing corporations a deduction equal to 50 percent²²⁸ of their GILTI (including the corresponding section 78 gross-up amount).²²⁹

3. Foreign tax credit

Subject to certain limitations, U.S. citizens, resident individuals, and domestic corporations are allowed a credit for foreign income taxes they pay. In addition, a domestic corporation is allowed a credit for foreign income taxes paid by a CFC with respect to income included by the corporation as subpart F income and GILTI; such taxes are deemed to have been paid by the domestic corporation for purposes of calculating the foreign tax credit.²³⁰

The foreign tax credit generally is limited to a taxpayer's U.S. tax liability on its foreign-source taxable income. The limit is intended to ensure that the credit mitigates double taxation of foreign-source income without offsetting U.S. tax on U.S.-source income.²³¹ The limit is computed by multiplying a taxpayer's total pre-credit U.S. tax liability for the year by the ratio of the taxpayer's foreign-source taxable income for the year to the taxpayer's total taxable income for the year. If the total amount of foreign income taxes paid and deemed paid for the year exceeds the taxpayer's foreign tax credit limitation for the year, the taxpayer may (in certain cases) carry back the excess foreign taxes to the previous year or carry forward to one of the succeeding 10 years.²³² No carryback or carryover of excess foreign tax credits are allowed in the GILTI foreign tax credit limitation category.

Deemed-paid taxes

For any subpart F income included in the gross income of a domestic corporation, the corporation is deemed to have paid foreign taxes equal to the aggregate foreign income taxes paid or accrued with respect to such income by the CFC.

For any GILTI included in the gross income of a domestic corporation, the corporation is deemed to have paid foreign taxes equal to 80 percent of the corporation's inclusion percentage multiplied by the aggregate foreign income taxes paid or accrued with respect to tested income (but not tested loss) by each CFC with respect to which the domestic corporation is a U.S. shareholder.²³³

Allocation and apportionment of expenses

To determine its foreign tax credit limitation, a taxpayer must first determine its taxable income from foreign sources by allocating and apportioning deductions between U.S.-source gross income and foreign-source gross income in each limitation category. In general, deductions are allocated and apportioned to the gross income to which the deductions factually relate.²³⁴ However, subject to certain exceptions, deductions for interest expense, stewardship expenses, and research and experimental expenses are apportioned based on certain ratios.²³⁵ For example, interest expense is apportioned based on the ratio of the corporation's foreign or domestic (as applicable) assets to its worldwide assets.²³⁶

Limitation categories (“baskets”)

The foreign tax credit limitation is applied separately to GILTI, foreign branch income,²³⁷ passive category income, and general category income.²³⁸ For this purpose, GILTI and foreign branch income include only income that is not passive category income. Passive category income includes passive income, such as portfolio interest and dividend income, and certain specified types of income.²³⁹ All other income is in the general category. Passive income is treated as general category income if earned by a qualifying financial services entity or if highly taxed (i.e., if the foreign tax rate is determined to exceed the highest tax rate specified in section 1 or 11, as applicable).²⁴⁰ Dividends (and subpart F inclusions), interest, rents, and royalties received by a U.S. shareholder from a CFC are assigned to the passive category to the extent the payments or inclusions are allocable to passive category income of the CFC. ²⁴¹ Dividends received by a 10-percent corporate shareholder of a foreign corporation that is not a CFC are also categorized on a look-through basis.²⁴²

Special rules apply to the allocation of income and losses from foreign and U.S. sources within each category of income.²⁴³ Foreign losses from one category first offset foreign-source income from other categories. Any remaining overall foreign loss offsets U.S.-source income. The same principle applies to losses from U.S. sources. In subsequent years, any losses deducted against another category or source of income are recaptured. That is, an equal amount of income from the same category or source that generated a loss in a prior year is recharacterized as income from the other category or source against which the loss was deducted. Foreign-source income in a particular category may be fully recharacterized as income in another category, whereas only up to 50 percent of income from one source in any subsequent year may be recharacterized as income from the other source.

A taxpayer's ability to claim a foreign tax credit may be further limited by a matching rule that prevents the separation of creditable foreign taxes from the associated foreign income. Under this rule, a foreign tax generally is not taken into account for U.S. tax purposes, and thus no foreign tax credit is available with respect to that foreign tax, until the taxable year in which the related income is taken into account for U.S. tax purposes.²⁴⁴

4. Dividends-received deduction

As discussed above, income earned indirectly through CFCs is taxed either in the year earned (as subpart F income or GILTI) or not at all. Distributions of previously taxed earnings and profits do not constitute dividends.²⁴⁵

A domestic U.S. shareholder generally is allowed a 100-percent DRD for the foreign-source portion of dividends received from a specified 10-percent owned foreign corporation,²⁴⁶ provided that certain holding period requirements are satisfied.²⁴⁷ A specified 10-percent owned foreign corporation is any foreign corporation (other than a PFIC that is not also a CFC) with respect to which any domestic corporation is a U.S. shareholder.²⁴⁸

The term “dividend received” is intended to be interpreted broadly, consistent with the meaning of the phrases “amount received as dividends” and “dividends received” under sections 243 and 245, respectively. The DRD is not available for any hybrid dividend.²⁴⁹

No foreign tax credit or deduction is allowed for any taxes paid or accrued with respect to any dividend that qualifies for the DRD.²⁵⁰ Further, no foreign tax credit or deduction is allowed for any taxes paid or accrued with respect to the U.S.-source portion of any dividend received by a domestic corporation from a qualified 10-percent owned foreign corporation.²⁵¹

5. FDII

Domestic corporations generally are taxed at preferential rates on their FDII.²⁵² The preferential rate is achieved by allowing corporations a deduction equal to 37.5 percent of their FDII.²⁵³ FDII is calculated by multiplying a corporation's “deemed intangible income” by the percentage of its “deduction eligible income” that is derived from serving foreign markets (i.e., “foreign-derived deduction eligible income”).²⁵⁴ A corporation's deemed intangible income equals the excess, if any, of its deduction eligible income over a 10-percent return on its qualified business asset investment (“QBAI”).²⁵⁵ The formula for FDII can be expressed as the following:

For purposes of computing FDII, a domestic corporation's QBAI is the average of the aggregate of its adjusted bases, determined as of the close of each quarter of the taxable year, in specified tangible property²⁵⁶ used in its trade or business and of a type with respect to which a deduction is allowable under section 167.²⁵⁷ The adjusted basis in any property generally must be determined using the alternative depreciation system under section 168(g) as in effect on December 22, 2017.

Deduction eligible income and foreign-derived deduction eligible income

Deduction eligible income means, with respect to any domestic corporation, the excess (if any) of the gross income of the corporation determined without regard to certain amounts that are excluded from deduction eligible income (referred to in this document as “gross deduction eligible income”) over deductions (including taxes) properly allocable to such gross income.²⁵⁸

Foreign-derived deduction eligible income means, with respect to a taxpayer for its taxable year, any deduction eligible income of the taxpayer that is derived in connection with (1) property that is sold²⁵⁹ by the taxpayer to any person who is not a U.S. person and that the taxpayer establishes to the satisfaction of the Secretary is for a foreign use²⁶⁰ or (2) services provided by the taxpayer that the taxpayer establishes to the satisfaction of the Secretary are provided to any person, or with respect to property, not located within the United States.²⁶¹

Foreign use means any use, consumption, or disposition that is not within the United States.²⁶² Special rules for determining foreign use apply to transactions that involve property or services provided to domestic intermediaries or to certain related parties.²⁶³

Special rules apply with respect to property or services provided to domestic intermediaries²⁶⁴ and with respect to certain related party transactions.²⁶⁵

Taxable income limitation

If the sum of a domestic corporation's FDII and GILTI (including GILTI-attributable section 78 gross-up amounts) exceeds its taxable income determined without regard to this provision, then the amount of FDII and GILTI (including GILTI-attributable section 78 gross-up) for which a deduction is allowed is reduced (but not below zero) by an amount determined by such excess.

6. Gain recognition on outbound transfers of intangible property

If a transfer of intangible property to a foreign affiliate occurs in connection with certain corporate transactions (e.g., section 351 or 361), nonrecognition rules that may otherwise apply are suspended. The transferor of intangible property must recognize gain from the transfer as though the transferor had sold the intangible (regardless of the stage of development of the intangible property) in exchange for payments contingent on the use, productivity, or disposition of the transferred property in amounts that would have been received either annually over the useful life of the property or upon disposition of the property after the transfer.²⁶⁶ The appropriate amounts of those imputed payments are determined using transfer-pricing principles.

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APPENDIX A: SELECTION OF DIGITAL SERVICE TAXES

Digital services taxes (“DSTs”) refer to unilateral attempts by countries to impose taxes on the revenue generated by the digital activity of (largely) foreign multinational companies operating within their jurisdiction. Often, companies who generate digital revenue across many jurisdictions do not maintain a physical presence in the countries in which they operate. DSTs are a mechanism for taxing the activity of companies who might otherwise fall out of the country's income tax base. DSTs can target a range of digital activities, including advertising, streaming, the operation of intermediary services (such as online marketplaces), and the collection and sale of user data. For example, the United Kingdom's DST imposes a two percent tax on the revenue from online marketplaces, search engines, and social media platforms which derive value from United Kingdom users. Austria's DST imposes a five percent tax on revenues from digital advertisement services. Certain countries, like Colombia and Belgium, have proposed or enacted laws that deem a foreign company to have a significant economic presence (“SEP”) if they provide digital services to domestic users. Companies with SEP status are subject either to the country's income tax or to a tax on their revenues. The table below gives an overview of some the various DSTs proposed or enacted by countries.

Country	Status	Effective Date	Type	Rate
Argentina	Enacted	December 15, 2020	WHT	8 percent
Austria*	Enacted	January 1, 2020	DST	5 percent
Belgium	Waiting for Global Solution	Expected 2023 if global consensus is not reached	DST/Digital PE	3 percent
Brazil	Proposed	TBD	DST	1 percent – 5 percent (depending on revenue)
Canada	Proposed	January 1, 2024 (on revenues earned as of January 1, 2022)	DST	3 percent
Colombia	Enacted	January 1, 2024	SEP or alternatively WHT	10 percent WHT or 3 percent income tax
Republic of Congo	Enacted	January 1, 2021	WHT	10 percent
Costa Rica	Enacted	November 19, 2019	General income tax on digital tourist rental services income	NA
Czech Republic	Proposed (rejected)	TBD	DST	7 percent but may be reduced to 5 percent
Denmark	Proposed	TBD	DST	6 Percent
France*	Enacted	1/1/2019	DST	3 percent
Hungary	Enacted	July 1, 2017 (Implementation delayed until December 31, 2023)	DAT	7.5 percent
India*	Enacted	April 1, 2022	SEP	N/A
	Enacted	April 1, 2020	DST	2 percent
	Enacted	June 1, 2016	DAT	6 percent
Indonesia	Waiting for Global Solution	March 31, 2020	Digital PE	NA
	Waiting for Global Solution	March 31, 2020	DST	N/A
Israel	Enacted	April 11, 2016	Digital PE	NA
Italy*	Enacted	January 1, 2020	DST	3 percent
Kenya	Enacted	January 1, 2021	DST	1.5 Percent
Malaysia	Enacted	May 13, 2019	WHT	Variable
Mexico	Enacted	June 1, 2020	WHT	Variable
Nepal	Proposed	July 17, 2022	DST	2 percent
Nigeria	Enacted	February 3, 2020	SEP	6 percent
Pakistan	Enacted	July 1, 2018	WHT	10 percent
Paraguay	Enacted	January 1, 2021	WHT	4.5 percent
Peru	Enacted	January 1, 2007	WHT	30 percent
Poland	Enacted	July 1, 2020	DST	1.5 percent
	Proposed	TBD	DAT	5 Percent
	Proposed	TBD	DST	7 Percent
Portugal	Enacted	February 17, 2021	Exhibition levy	4 percent
	Enacted	February 17, 2021	Annual levy	1 percent
Sierra Leone	Enacted	January 1, 2021	DST	1.5 percent
Slovakia	Enacted	January 1, 2018	Digital PE	N/A
Spain*	Enacted	January 16, 2021	DST	3 percent
Taiwan	Enacted	January 1, 2017	WHT	To be agreed with the tax authority
Tanzania	Enacted	July 1, 2022	DST	2 percent
Tunisia	Enacted	January 1, 2020	DST	3 percent
Turkey*	Enacted	January 1, 2019	WHT	15 percent
	Enacted	March 1, 2020	DST	7.5 percent but the President can reduce to 1 percent or increase to 15 percent
United Kingdom*	Enacted	April 1, 2020	DST	2 percent
Uruguay	Enacted	January 1, 2018	Non-resident income tax	12 percent
Vietnam	Enacted	January 1, 2021	WHT	Variable
Zimbabwe	Enacted	January 1, 2019	General income tax on certain digital services income	5 percent
* Entered into agreement with the United States whereby the United States terminates tariffs imposed under Section 301 of the Trade Act of 1974 in exchange for country making any DST liabilities collected before the implementation of Pillar One creditable against future Pillar One taxes. DAT: Digital Advertising Tax DST: Digital Service Tax PE: Permanent Establishment SEP: Significant Economic Presence WHT: Withholding Tax Source: Joint Committee compilation from text of local country statutes.

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APPENDIX B: SELECTION OF COUNTRIES ADOPTING PILLAR TWO

Country	Legislation	Status	IIR	UTPR	QDMTT
Canada	2023 Budget stated government's plan to introduce draft legislation implementing IIR and QDMTT, with UTPR to follow at later time, March 28, 2023.	Plan to Introduce legislation	Yes (From December 31, 2023)	Yes (From December 31, 2024)	Yes (From December 31, 2023)
Japan	Japanese Parliament passed legislation which included the implementation of certain Pillar Two global minimum tax rules, March 28, 2023.	Enacted Law	Yes (From April 1, 2024)	No	No
Liechtenstein	Government published draft legislation and open consultation on measures to implement a global minimum tax, March 29, 2023.	Draft Legislation Published	Yes (From January 1, 2024)	Yes (From January 1, 2025)	Yes (From January 1, 2024)
South Korea	Korea enacted new global minimum tax rules to align with the OECD's Pillar Two Model Rules, December 31, 2022.	Enacted Law	Yes (From January 1, 2024)	Yes (From January 1, 2024)	No
Switzerland	The Swiss Federal Council opened consultation on a temporary ordinary entitled for the implementation of Pillar Two, August 17, 2022.	Draft Legislation Published	Yes (From January 1, 2024)	Yes (From January 1, 2024)	Yes (From January 1, 2024)
United Kingdom	Building on draft legislation published in July 2022, Finance (No. 2) Bill was introduced in the House of Commons and included measures to implement a 'Multinational Top-Up Tax', March 23, 2023.	Legislation Introduced to Parliament	Yes (From December 31, 2023)	No (Intention to implement at later time)	Yes (From December 31, 2023)
EU	Unanimous agreement on EU Global Minimum Tax Directive for the implementation of Pillar Two global minimum tax rules among member states, December 14, 2022.	EU Directive	Yes (From December 31, 2023)	Yes (From December 31, 2024)	Optional for Member States
EU Member Countries
Germany	The German Federal Ministry of Finance published a consultation including a draft law to implement the EU Global Minimum Tax Directive, March 20, 2023.	Draft Legislation Published	Yes (From December 31, 2023)	Yes (From December 31, 2024)	Yes (From December 31, 2023)
Ireland	Ireland's Department of Finance published a Feedback Statement including possible draft legislation to implement the EU Global Minimum Tax Directive, March 31, 2023.	Feedback Statement	Yes (From December 31, 2023)	Yes (From December 31, 2024)	No (Intention to implement at later time)
The Netherlands	Open consultation on draft legislation entitled “Minimum Tax Rate Act 2024”, to implement Pillar Two, October 24, 2022.	Draft Legislation Published	Yes (From December 31, 2023)	Yes (From December 31, 2024)	Yes (From December 31, 2023)
Sweden	Swedish Special Investigator submitted an interim report which included draft legislation for the implementation of the EU Global Minimum Tax Directive, February 7, 2023.	Draft Legislation Published	Yes (After December 31, 2023)	Yes (After December 31, 2024)	Yes (After December 31, 2023)
Note: Other countries that have introduced or plan to introduce legislation adopting Pillar Two: Australia, Azerbaijan, Bulgaria, EU member countries (Austria, Belgium, Croatia, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Greece, Hungary, Italy, Latvia, Lithuania, Luxembourg, Malta, Poland, Portugal, Romania, Slovakia, and Slovenia), Guernsey, Indonesia, Jersey, Malaysia, Mauritius, New Zealand, Norway, Qatar, Singapore, South Africa, Thailand, United Arab Emirates, and Vietnam. Source: Joint Committee compilation from text of local country statutes and Council Directive (EU) 2022/2523 of 14 December 2022.