Last week the Organization for Economic Co-operation and Development (OECD) published an updated list of “harmful tax practices” identified through a peer review process. A notable item on the recent list states that the United States has committed to abolishing the Foreign Intangible Income Deduction (FDII). While the Biden administration has certainly proposed the removal of FDII, it is not clear whether Congress agrees with this approach.
Whether FDII should remain part of the tax system, be changed or eliminated requires policymakers to weigh the costs and benefits of these options.
FDII effectively provides a lower tax rate (13.125 percent) on profits made from highly mobile intangibles designed to aid export. In the Tax Cuts and Jobs Act, it was paired with the Global Intangible Low-Tax Income (GILTI), which was supposed to set a similar rate of 13.125 percent for foreign income. The tax rate was chosen so that it is competitive with the foreign tax rates on intangible income and especially the patent boxes that exist in many countries with tax rates of typically 10 percent or less.
Like a patent box, FDII should encourage companies to keep their intellectual property (IP) in the US or bring it back to the US from offshore locations. It actually happened.
However, Biden’s government has argued that FDII and GILTI lead to offshoring. This argument is based on a partial analysis of how these regulations work, however the administration has proposed repealing FDII and adding a new tax benefit to research and development (R&D) instead of intellectual property.
There’s a slightly different story about the development of FDII in Congress. Earlier this year, Senate Finance Committee Chairman Ron Wyden (D-OR) and Sens. Mark Warner (D-VA) and Sherrod Brown (D-OH) published a framework for international tax reform that included some changes to FDII . Rather than suggesting repealing the directive, the three senators recommended changing the way the FDII is calculated and reforming it to benefit companies investing in innovative activities in the US
Republican members of the House Ways and Means Committee recently sent a letter to Treasury Secretary Janet Yellen explaining their support for the FDII in its current form.
While the ultimate fate of FDII is unclear, it is worth exploring the political rationale behind FDII and how changes to it could affect business decisions regarding R&D and the location of its intellectual property.
If policy makers are simply looking to incentivize R&D activities in the US, a tax subsidy targeting those activities may make the most economic sense. However, the location of IP is still important for two reasons.
First, companies that develop intellectual property and own that property in the United States pay taxes to the US government on their intellectual property profits. Under FDII, the tax rate on intellectual property gains may be lower than the total corporate tax rate, but the proceeds go to the US Treasury Department. If a company develops intellectual property in the US and later moves it overseas, the US Treasury Department is likely to receive a smaller, if any, portion of the tax revenue from that intellectual property.
A second consideration is the location of the R&D activities. In recent years, countries have changed the tax rules on their patent boxes to require that intellectual property-related business activities that benefit from a patent box be in the same jurisdiction. These rules follow the modified nexus approach defined by the OECD in Action 5 of the Base Erosion and Profit Shifting (BEPS) action plan.
If the US were to remove the tax breaks from FDII and companies then chose to move their intellectual property overseas to benefit from a foreign patent box, the US could also gain investment and jobs related to some tax revenue from the IP gains in addition to Lose R&D.
Even without considering the potential of R&D jobs to leave the US coast, repealing the FDII would increase the incentives for US companies to move intellectual property overseas or to participate in profit shifting in general. The Tax Foundation’s model has shown that this effect reduces the potential revenue from President Biden’s tax increases for US multinational corporations.
The framework of the three senators would potentially create a stronger link between FDII and the location of the R&D activity. Instead of a tax benefit on IP revenues, the benefit would be given to companies based on their share of “innovation-enhancing” activities such as R&D and employee training. The framework also recognizes the role that equal rates on GILTI and FDII play in balancing investment decisions between the US and overseas, potentially mitigating profit shifting effects. However, the framework does not mention whether the tax break for innovations would be tied to the location of IP assets.
The letter from the Republican members of the Ways and Means Committee focuses on the pooling of R&D and IP assets, arguing that FDII benefits the US, lawmakers argue for both a research and development tax break (which the US has) also for a tax benefit related to the location of the intellectual property.
While the Biden administration welcomes repeal of the FDII and is telling other OECD governments that it will be repealed, it is clear that other policy makers in Washington, DC have a different view.
Preferential guidelines such as patent boxes and FDII are by definition not neutral and therefore not ideal. However, turning away from the reforms adopted in 2017 would have economic consequences. The question that politicians must ask is how to ensure that tax law does not unnecessarily encourage US companies to relocate R&D and IP assets abroad. The Biden approach would likely do just that, and it is encouraging that some members of Congress are looking for other options.
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