The Balancing Act of GILTI and FDII

April 7, 2021

The tax treatment of intangible assets has come into the spotlight recently with the Biden administration proposing to undo a policy adopted in 2017 to encourage intellectual property (IP) to be located in the U.S. and Senate Democrats eyeing changes as well. The Tax Cuts and Jobs Act (TCJA) sought to create a balance between the tax treatment of the intellectual property of U.S. companies—whether that intellectual property is in the U.S. or abroad. Making changes to provisions adopted in the 2017 reform could upset that balance and lead companies to move their IP outside of the U.S.

Some types of business assets are easier to move than others. If a company has a manufacturing facility in the U.S., it is no small thing to leave that factory and set up shop in a different country. Additionally, relocating where a company does its research and development (R&D) can be a significant undertaking because R&D teams include highly specialized workers and use advanced facilities and laboratories.

But when it comes to intellectual property, the patents, software, and other assets that come from investing in R&D and lie behind manufactured goods, it is less challenging for a multinational business to change where that intellectual property is registered.

The taxable profits from intellectual property are often called mobile income. If a U.S. company decides it can get a better tax outcome having its intellectual property outside of the country than having those profits subject to U.S. tax, there are not too many barriers standing in the way of moving that IP abroad.

Prior to the recent tax reform, it was common for intellectual property that was developed in the U.S. to end up in an offshore jurisdiction for tax reasons. This was driven both by the high U.S. corporate tax rate and preferential tax regimes in other countries, like patent boxes. Instead of paying taxes at the 35 percent U.S. federal rate, a company might be able to pay the Irish corporate rate of 12.5 percent (or its patent box rate of 6.25 percent) or the UK patent box rate of 10 percent on returns accruing to intellectual property domiciled in those countries.

In recent years, countries have begun to require activities related to patents (such as R&D or some management functions) take place in the same jurisdiction where the intellectual property is located for a company to benefit from a lower patent box rate. Not all of these rules are immediately effective, but over time they will become more important. If a U.S. company were to benefit from offshore patent box incentives, it might have to relocate both its intellectual property and its R&D staff and facilities.

Two policies adopted in tax reform changed the incentives for companies deciding where to put their intellectual property. First, the U.S. adopted a global minimum tax in the form of Global Intangible Low Tax Income (GILTI). This tax means that earnings from intellectual property owned by U.S. companies would get taxed by the U.S. regardless of where it might be outside U.S. borders. GILTI was designed to have a tax rate between 10.5 and 13.125 percent, but interaction effects with other policies mean some companies pay much higher tax rates on GILTI.

GILTI tells U.S. companies that if they put their intellectual property in a foreign low-tax jurisdiction, they will still owe some tax to the IRS. This policy eats up some of the benefit of having intellectual property in a low-tax jurisdiction. GILTI is another layer of tax on foreign earnings, but if the offshore IP faces a high rate of tax, the tax burden of GILTI will be smaller.

A parallel policy was adopted for intellectual property that is held in the U.S. That policy is Foreign Derived Intangible Income (FDII). U.S. companies that keep their intellectual property in the U.S. or bring their intellectual property back to the U.S. can benefit from a lower tax rate on that income of 13.125 percent.

Whereas prior to tax reform companies had a clear incentive to offshore their intellectual property, GILTI and FDII are meant to change that incentive so there is a balance between keeping IP in the U.S. or placing it offshore. In fact, because of the layers of the tax burden on GILTI, FDII can make the U.S. a relatively more attractive place for owning intellectual property for some companies.

Analysis by economists Kartikeya Singh and Aparna Mathur has shown that the pairing of GILTI and FDII means that the U.S. is now a more attractive location for investment in intellectual property compared to offshore options. They compare the tax implications of investments earning various profit margins to show whether tax reform made holding IP in the U.S. or elsewhere more beneficial. Overall, their calculations show that the combination of GILTI and FDII makes the U.S. more attractive.

There is some evidence of this actually showing up in business decisions. At a recent Senate Finance Committee hearing, Sen. Rob Portman (R-OH) mentioned that some U.S. companies have brought their intellectual property back to the U.S. because of FDII.

Last week, the Biden administration announced that it would increase the tax rate on GILTI to 21 percent and eliminate FDII while increasing the U.S. corporate rate to 28 percent. If adopted, these changes would dramatically upset the balance set in 2017. Immediately, a U.S. company would recognize that paying taxes on intellectual property profits at a foreign 21 percent rate would be better than paying a 28 percent U.S. domestic rate.

If a company responded to the incentive by moving its intellectual property outside the U.S., it is possible that the associated R&D and manufacturing could follow.

This would be the exact opposite of the impact the Biden administration seems to be hoping for. The administration plan does suggest some benefits for companies that do R&D in the U.S., but it is unclear whether those additional benefits would be enough to offset the tax savings of offshoring intellectual property and related activities.

In addition to Biden’s proposal, this week, three Democratic members of the Senate Finance Committee released a plan that would also make some changes to GILTI and FDII. While the plan does not have many details on the exact changes the senators are considering, the balance between GILTI and FDII may be disrupted there as well.

Before making significant changes, however, lawmakers should consider how disrupting the balanced incentives for the location of intellectual property could impact where U.S. companies not only locate their intellectual property, but also the R&D and other related activities.

 

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Foreign Derived Intangible Income (FDII) is a special category of earnings that come from the sale of products related to intellectual property (IP). If a U.S. company holds IP in the U.S., such as patents or trademarks, and has sales to foreign customers based on that IP, the profits from those sales face a lower tax rate.

Global Intangible Low Tax Income (GILTI) is a special way to calculate a U.S. multinational company’s foreign earnings to ensure it pays a minimum level of tax. GILTI was adopted as part of the 2017 Tax Cuts and Jobs Act (TCJA) and can lead to high tax burdens on foreign profits, putting U.S. companies that operate abroad at a disadvantage.

A 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.

The Tax Cuts and Jobs Act in 2017 overhauled the federal tax code by reforming individual and business taxes. It was pro-growth reform, significantly lowering marginal tax rates and cost of capital. We estimated it reduced federal revenue by $1.47 trillion over 10 years before accounting for economic growth.