What Is Foreign-Derived Intangible Income?
Foreign-derived intangible income is likely a term few have heard before, but with the United States’ enactment of the Tax Cuts and Jobs Act (TCJA) on December 22, 2017, the largest overhaul of the US Internal Revenue Code (IRC) since 1986, it has become a topic of serious debate amongst international trade law and tax law experts. A US corporation’s foreign-derived intangible income is essentially income related to the sale and provision of goods and services to foreign entities or for a foreign use. More specifically, it is calculated using complex formulas that measure the extent to which a US corporation’s income in excess of a specified return on its US depreciable assets is attributable to: (1) the sale of goods or property to foreign persons for use outside the US; or (2) the provision of services to foreign entities or for property located outside the US, as succinctly summarized by Baker Botts. For a more technical breakdown of the process used to determine deduction eligible foreign-derived intangible income, see Deloitte’s explanation.
Why Is Foreign-Derived Intangible Income Suddenly in the Spotlight?
The TCJA inserted a new section into the IRC, § 250. Foreign-Derived Intangible Income and Global Intangible Low-Taxed Income, which allows for a deduction of 37.5% on all foreign-derived intangible income received by a US corporation in a taxable year. A major aspect of the TCJA was the lowering of the statutory corporate income tax rate from 35% to 21%, which means that a 37.5% deduction through 2025 on any foreign-derived intangible income grants an effective tax rate of 13.125% for US corporations’ foreign-derived intangible income. Cleary Gottlieb speculates that this rule is designed to provide a rate low enough to encourage US corporations conducting business offshore to move their business activities that have a nexus with foreign-derived intangible income to the US, now that the US has a special income tax deduction specifically for income earned abroad. The idea behind it is to make the US more attractive than other countries by providing a deduction for foreign-derived intangible income.
That, however, is the root of the dispute. For some background on WTO-inconsistent tax incentives, the World Trade Organization’s (WTO) Appellate Body (AB), which is the appellate organ of the WTO that settles trade disputes between member countries, issued on February 24, 2000, a report (WT/DS108/AB/R) ruling against the US, and in favor of the European Communities, concerning preferential tax treatment that the US had granted to Foreign Sales Corporations (the FSC measures). The European Communities filed a complaint with the WTO claiming that the FSC measures were prohibited export subsidies, violating Article 3.1 of the WTO’s Agreement on Subsidies and Countervailing Measures (SCM Agreement). First, the WTO determined that the tax exemptions granted via the FSC measures on foreign income satisfied the definition of a subsidy under Article 1.1, which states that there must be a financial contribution by a government, and in the case of the FSC measures, it was satisfied by foregone government revenue, due to the tax exemption. Second, the WTO determined that the subsidy qualified as a prohibited export subsidy under Article 3.1 because it was contingent upon export performance, or the actual exporting of the goods. The FSC measures were only available to corporations receiving income for goods sold to foreign entities, and because of the tax exemptions, the FSC measures allowed for goods to be exported more cheaply, meaning US corporations were encouraged to export and could undercut competing foreign corporations. The WTO deemed the FSC measures an illegal prohibited subsidy and required they be repealed.
Prof. Rebecca Kysar of Brooklyn Law School, who coauthored The Games They Will Play: An Update on the Conference Committee Tax Bill, suggests that the foreign-derived intangible income deduction in the TCJA is very similar to the old FSC measures to the extent that it likely is inconsistent with the United States’ WTO obligations. She argues that, because of the tax incentive granting an effective corporate tax rate of only 13.125% on foreign-derived intangible income, as opposed to the statutory 21% corporate tax rate for domestic-derived income, US corporations will focus on the more profitable market, which is the market returning income that will only be taxed at 13.125%. This is essentially an implicit government promotion of export-oriented goods and services via tax incentives that make the export market more lucrative, which also would allow US corporations to undercut foreign corporations, disrupting international trade. However, academics are not the only ones concerned with the likely WTO-inconsistent export subsidy disguised as an innocent tax incentive.
State Sovereignty, International Trade Norms, and WTO Compliance
Early in December, before the TCJA was finalized and signed into law by President Trump, the finance ministers of Europe’s five largest economies, the UK’s Philip Hammond, Germany’s Peter Altmaier, France’s Bruno Le Maire, Italy’s Pier Carlo Padoan, and Spain’s Cristóbal Montoro, sent a letter to the White House and the US Department of the Treasury, specifically to US Treasury Secretary Steven Mnuchin, and Gary Cohn, the top White House economic adviser, addressing the several issues that European countries saw as potential violations of both international trade norms and WTO obligations. The finance ministers listed some issues that were not included in the final legislation, however, the foreign-derived intangible income deduction survived. The letter was an obvious warning of European retaliation if these likely WTO-inconsistent measures were not removed from the legislation.
However, the letter from the European finance ministers also referenced the fact that domestic tax policy is one of the main pillars of state sovereignty, and was insistent that Europe’s goal was not to intervene in a debate concerning domestic tax policy. The question is, when is a tax incentive simply a domestic tax policy issue, and not the concern of other countries, and when is an incentive widespread enough or drastic enough that international organizations have the right to undermine a nation’s sovereignty and rule a specific tax incentive a violation? With the FSC measures that provided for complete exemptions, the international trade playing field became too uneven, understandably so, and I also expect that US corporations will embrace the enacted 37.5% deduction for eligible foreign-derived intangible income to the extent that it could reasonably be seen as a prohibited export subsidy and WTO-inconsistent. But where is the line in the sand? Perhaps the WTO would overlook a smaller deduction, such as 5%, as opposed to 37.5%, because of its limited impact? Although, would a provision allowing for such a small deduction be unreasonable because of the de minimis impact? The only way to know is for the WTO to rule on a trade dispute centered on the TCJA’s foreign-derived intangible income provision.
Alexander E. Lloyd graduated with a BA from Sarah Lawrence College in 2012. Alexander will be working for the IRS this summer and is currently researching tax incentives that are WTO-inconsistent.