THE TAX CUTS AND JOBS ACT PROVIDES A NEW APPROACH FOR THE TAXATION OF FOREIGN-RELATED INTANGIBLE INCOME OF US MULTINATIONALS, WHETHER EARNED BY U.S. OR NON-U.S. MEMBERS OF THE MULTINATIONAL GROUP.
The Act also defines intangible income to be that income exceeding a deemed tangible income return equal to 10 percent of qualified business asset investment (“QBAI”). (In the case of intangible income earned offshore, the tangible return is reduced by allocable interest expense, resulting in a net deemed intangible income return.) Foreign-related intangible income that is earned in the United States is known as foreign-derived intangible income (“FDII”); that which is earned outside the United States is known as global intangible low-taxed income (“GILTI”). In prior Transfer Pricing Updates, I explain how, through deductions and haircuts to foreign tax credits, the effective rate on both FDII and GILTI is intended to be 13.125 percent through 2025 and roughly 16.4 percent thereafter.
Many U.S. multinationals will likely choose to continue with their current international operating structures and intangible property (“IP”) ownership approaches under the Act. But all should at least consider the potential benefits of moving IP, capital, functions, risks, and anything else that may result in intangible income, as defined in the Act, to the United States (“onshoring”). Here are some reasons:
- Onshoring can help U.S. multinationals that do not have adequate functions located outside of the United States for the development, enhancement, maintenance, protection, and exploitation (“DEMPE”) of intangibles;
- The benefits for deemed tangible income returns earned offshore may be low;
- Onshoring may help avoid the base erosion and anti-abuse tax;
- The effective rate on GILTI may be higher than that for FDII, at least for a period; and
- The U.S. corporate tax rate will be lasting.
The initiative by the Organisation for Economic Co-operation and Development (“OECD”) to combat base erosion and profit shifting (“BEPS”) has placed an important emphasis on aligning transfer pricing results with value creation. Part of this emphasis is the expectation that any entity owning intangibles should have the appropriate DEMPE functions for those intangibles. Many U.S. multinationals have already established robust structures offshore for the DEMPE of intangibles. But those with less robust structures may likely benefit from moving intangibles to the United States, thereby helping to avoid transfer pricing disputes in jurisdictions with subsidiaries that transact with a limited-substance principal company in a low-tax jurisdiction (not to mention having the U.S. competent authority on their side in tax disputes with other taxing authorities).
Another benefit for perhaps all U.S. multinationals is the effect on country-by-country (“CbC”) reporting. DEMPE functions notwithstanding, the “optics” of a CbC report may improve by having intangible income in the United States where there is likely to be considerable amount of the reported variables (e.g., stated capital, headcount, and tangible assets). This is not a trivial matter when there is concern that such reports may become public.
DEEMED TANGIBLE INCOME RETURN
The net deemed tangible income return earned offshore will not be included in GILTI, meaning it can enjoy whatever rate it is taxed at locally. But how likely is it that considerable tangible income will be earned in low-tax jurisdictions? QBAI is the aggregate adjusted bases of specified tangible property, meaning any tangible property used in the production of tested income. Many of these fixed assets tend to be in high-tax jurisdictions. U.S. multinationals that manufacture in low-tax jurisdictions will get some benefit. Still, a 10-percent return on depreciating assets, less interest, would hardly seem the cornerstone of any tax-planning strategy.
BASE EROSION AND ANTI-ABUSE TAX
The Act also provides for a base erosion and anti-abuse tax (“BEAT”), effectively an alternative minimum tax on U.S. companies that transact with foreign related parties. The BEAT is based on modified taxable income, which adds base erosion payments back to taxable income. Base erosion payments are payments to related parties that are taken as deductions (such as royalty payments). Ownership of IP in the United States could potentially reduce the amount of base erosion payments and application of the BEAT.
HIGHER EFFECTIVE RATE ON GILTI
Taxpayers are quickly realizing that, due to certain cost allocations limiting the use of foreign tax credits, the effective rate on GILTI may be higher, and perhaps substantially higher, than that on FDII. The Treasury Department is aware of this issue and will likely address it so that GILTI is not penalized vis-a-vis FDII. The intent is to have rate parity between FDII and GILTI; not to favor one over the other. But until this anomaly is adequately address, it could result in a “hurt” from intangible income earned outside of the United States instead of within the United States.
U.S. CORPORATE TAX RATE
I may be stark raving mad, but I do not expect the U.S. corporate tax rate to increase whether Republicans or Democrats control Congress and the White House. I believe there is enough bipartisan consensus that the U.S. corporate tax must not put U.S. companies at a disadvantage to their international competitors. As House Ways and Means Chairman Kevin Brady said at a recent conference, the U.S. system of taxation “will never again fall so far behind.” The United States will certainly need to address its fiscal imbalances but I think it is more likely that increased revenues will come from a consumption-based tax. Of the three principal bases on which to tax: income, consumption, and wealth; much of the world increasingly moves to taxing consumption. The United States might no longer be an outlier. Further, even if the deduction for FDII is successfully challenged as an illegal export subsidy at the World Trade Organization (“WTO”), how likely is it that the deduction on GILTI will not change in step? The intent of the government has been to provide rate parity for FDII and GILTI. If the rate on FDII increases, I would not necessarily expect the rate on GILTI to remain unchanged. Now that we are effectively in a worldwide, full-inclusion (territorial in name only) system of taxation for U.S. multinationals that provides deductions for foreign related intangible income, an unfavorable ruling at the WTO on FDII could also potentially increase the rate on GILTI.
Finally, the increase in the rate for FDII and GILTI to 16.4 percent in 2026 was established solely to have the increase in the deficit resulting from the Act not to exceed USD 1.5 trillion over a ten-year period. Perhaps I am being too optimistic but the intent of lawmakers is to extend the 13.125 rate before it increases in 2026.