Last week the Organisation for Economic Co-operation and Development (OECD) released an updated list of “Harmful TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. Practices” that have been identified as part of a country peer review process. One notable element of the recent list states that the United States has committed to abolish the deduction for Foreign Derived Intangible Income (FDII). However, while the Biden administration has certainly proposed to remove FDII, it is not clear that Congress is on board with that approach.
Whether FDII should remain part of the tax system, be changed, or removed requires policymakers to weigh the costs and benefits of those options.
FDII effectively provides a lower tax rate (13.125 percent) on profits that are earned from highly mobile intangible assets that are to support exports. In the Tax Cuts and Jobs Act, it was paired with Global Intangible Low-Tax Income (GILTI), which was meant to set a similar 13.125 percent rate on foreign earnings. The tax rate was selected to be competitive with foreign tax rates on intangible income, and particularly the patent boxes that exist in many countries with tax rates typically around 10 percent or less.
Like a patent boxA patent box—also referred to as intellectual property (IP) regime—taxes business income earned from IP at a rate below the statutory corporate income tax rate, aiming to encourage local research and development. Many patent boxes around the world have undergone substantial reforms due to profit shifting concerns. , FDII was meant to encourage companies to keep their intellectual property (IP) in the U.S. or bring it back to the U.S. from offshore locations. This did in fact happen.
However, the Biden administration has made a case that FDII and GILTI lead to offshoring. This argument is based on a partial analysis of how those rules work, but nonetheless, the administration has proposed repealing FDII and providing a new tax benefit for Research & Development (R&D) rather than IP.
There’s a slightly different story on FDII developing in Congress. Earlier this year, Senate Finance Committee Chairman Ron Wyden (D-OR) and Sens. Mark Warner (D-VA) and Sherrod Brown (D-OH) released a framework for international tax reform that included some changes to FDII. Rather than proposing to repeal the policy, the three senators recommended changing how FDII is calculated and reforming it to benefit companies that invest in innovative activities in the U.S.
Republican members of the House Ways and Means CommitteeThe Committee on Ways and Means, more commonly referred to as the House Ways and Means Committee, is one of 29 U.S. House of Representative committees and is the chief tax-writing committee in the U.S. The House Ways and Means Committee has jurisdiction over all bills relating to taxes and other revenue generation, as well as spending programs like Social Security, Medicare, and unemployment insurance, among others. recently sent a letter to Treasury Secretary Janet Yellen outlining their support for FDII as it stands.
While FDII’s ultimate fate is unclear, it is worth exploring the policy rationale behind FDII and how changes to it might impact business decisions on R&D and the location of their IP.
If policymakers want simply to incentivize R&D activities that occur in the U.S., a tax subsidy directed at those activities may make the most economic sense. However, the location of IP is still important for two reasons.
First, businesses that develop IP and hold that property in the U.S. pay taxes on IP profits to the U.S. government. Under FDII, the tax rate on profits from IP can be lower than the overall corporate tax rate, but the revenue goes to the U.S. Treasury. If a company develops IP in the U.S. and later moves it offshore, it is likely that the U.S. Treasury will get a smaller slice of the tax revenue from that IP, if any.
A second consideration is the location of R&D activities. In recent years countries have been changing the tax rules of their patent boxes to require business activities related to IP benefiting from a patent box to be in the same jurisdiction. These rules follow the Modified Nexus Approach set out by the OECD in Action 5 of the Base Erosion and Profit Shifting (BEPS) Action Plan.
If the U.S. were to remove the tax benefit from FDII and companies then chose to move their IP offshore to benefit from a foreign patent box, the U.S. could lose out on investment and jobs related to R&D in addition to some tax revenue from the IP profits.
Even without considering the potential for R&D jobs to leave U.S. shores, the repeal of FDII would increase incentives for U.S. companies to move IP assets overseas or engage in profit shiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens. more generally. Tax Foundation modeling has shown that this effect reduces the potential revenue from President Biden’s tax increases on U.S. multinational companies.
The framework from the three senators would potentially create a stronger link between FDII and the location of R&D activities. Instead of having a tax benefit in relation to IP earnings, the benefit would accrue to companies based on the share of their “innovation-spurring” activities like R&D and worker training. The framework also recognizes the role that equal rates on GILTI and FDII play in balancing investment decisions between the U.S. and abroad, potentially mitigating profit shifting effects. The framework does not mention whether the tax break for innovation would be linked to the location of IP assets, though.
The letter from the Republican members of the Ways and Means Committee does focus on the colocation of R&D and IP assets, and argues that FDII benefits the U.S. Although current law does not require R&D to be done in the U.S. for a company to benefit from FDII, the lawmakers make the case for both a tax benefit to R&D (which the U.S. has) and a tax benefit connected to the location of IP.
While the Biden administration would like to see FDII repealed and is communicating to other governments at the OECD that it will be repealed, it is clear that other policymakers in Washington, D.C., have a different view.
Preferential policies like patent boxes and FDII are by definition non-neutral and thus less than ideal. However, there would be economic consequences for moving away from the reforms adopted in 2017. The question policymakers need to be asking is how to ensure that the tax code does not unnecessarily encourage U.S. companies to offshore R&D and IP assets. The Biden approach would likely do just that, and it is encouraging that some members of Congress are looking at other options.
Stay informed on the tax policies impacting you.
Subscribe to get insights from our trusted experts delivered straight to your inbox.Subscribe