Foreign Derived Intangible Income ( FDII ) Provision Mechanics, Issues, and Potential WTO or Other Challenges. November 2, 2018

Transcription

1 Foreign Derived Intangible Income ( FDII ) Provision Mechanics, Issues, and Potential WTO or Other Challenges November 2, 2018

2 Panelists Hal Hicks, Partner, Skadden, Arps, Slate, Meagher & Flom LLP, Washington, D.C. Reuven S. Avi Yonah, Irwin I. Cohn Professor of Law, Director, International Tax LLM Program, University of Michigan School of Law 2

3 Agenda Overview Mechanics of FDII Issues and Considerations Potential WTO or Other Challenges 3

4 Overview On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act ( TCJA ) TCJA often described as the most far reaching tax legislation since 1986 New provisions generally serve as an overlay on existing law, rather than a complete overhaul of the prior IRC No change to the top capital gains or qualified dividend income rate for individuals Substantial changes on both domestic tax issues and U.S. international tax issues (latter discussed below) 4

5 Overview (cont) Key International Provisions Dividend Exemption System The TCJA adopted a dividend exemption system, through which certain foreign source earnings of foreign subsidiaries of U.S. parented multinational companies generally are not subject to U.S. federal income tax on expatriation Meant to be cornerstone of a territorial tax system, but overall system is really now more like a full inclusion system with lower tax rates Transition Tax Transition tax (purportedly transitioning to a territorial system) on deferred foreign income at a rate of 15.5% for cash and cash equivalent profits, and 8% on other reinvested foreign earnings Preservation of subpart F and passive foreign investment company antideferral rules, with certain expansions and deletions 5

6 Overview (cont) Anti abuse erosion measures Limitations on interest deductions generally (new 163(j)) Hybrid dividends and transactions Tax on global intangible low tax income ( GILTI ) Base erosion and anti abuse tax ( BEAT ) New anti inversion provisions Deduction for a U.S. corporation's Foreign Derived Intangible Income ( FDII ) Effective tax rate on FDII = % (16.406% for years starting after 2025) 6

7 Background on FDII New section 250, a rare taxpayer favorable international provision in the TCJA Relates to in particular GILTI and BEAT Focus is on export sales (including licenses, leases, etc.) and exported services by U.S. corporations Apparently the provision is applied on a U.S. consolidated return basis (but one of many areas of needed guidance) General intention is to incentivize U.S. corporations to bring intangibles (and manufacturing) back to the United States by generating a significant deduction on certain inbound payments (sales proceeds, rents, royalties, etc.) 7

8 Background on FDII (cont) FDII does in some ways bring to mind patent box regimes adopted by certain foreign jurisdictions Regime where certain income associated with certain intangibles (patents, trademarks, etc.) may qualify for a reduced tax rate In general FDII is now eligible for a 37.5% deduction (3/8) On $100 of FDII, there is $62.50 of net income taxed at 21%, for tax of $ (a % effective tax rate) For years starting after 12/31/25, the deduction declines to %, for an effective tax rate of 16.41% ($16.41 tax assuming same 21% rate) As discussed below, basic approach to determine income that is eligible for the FDII deduction is (1) determine the excess of the non routine, deemed intangible income of a U.S. corporation (or group) over the deemed routine, tangible property income and (2) determine the portion of #1 that is treated as foreign for FDII purposes (and therefore eligible for the deduction) 8

9 Background on FDII (cont) Foreign portion above generally relates to income of a U.S. corporation (or group) in connection with 1. Property that the US Corp (or group) sells, leases, licenses, etc. a) To a non U.S. person and b) For use, consumption outside of the United States OR 2. Services provided by the US Corp (or group) a) To persons located outside the United States or b) With respect to property located outside the United States Significant issues relating to allocation of expenses to this foreign income, impact of NOLs and NOL carryforwards of U.S. taxpayer, etc. Also rules relating to intermediaries. Can apply to sales and services provided to related or unrelated foreign persons (if related foreign person must have ultimate unrelated party foreign use, etc.) 9

10 Background on FDII (cont) A Consideration for Both US Topco and Non-US Topco Structures US Parent Mexico/Canada Parent Purchase of property US Sub service fees royalties royalties service fees Purchase of property Mexico/Canada Sub Purchase of property US Sub service fees royalties royalties service fees Purchase of property Foreign Sub Foreign 3d Party Foreign 3d Party Generally foreign portion of payments from Related or Unrelated Party potentially eligible for 37.5% deduction Same analysis for 37.5% deduction 10

11 FDII and Hybrid Transactions US Parent Foreign Sub US Sub Royalty or Sales Proceeds Mexico/Canada Hybrid Entity Payments by e.g., a hybrid entity generally do not qualify for FDII deduction The statute does not require any causal connection between the hybrid status of an entity and the tax benefit, unlike generally what happens in the EU s ATAD (area of needed guidance) 11

12 Interaction Between GILTI and FDII GILTI, BEAT, and the Transition Tax have gotten considerably more attention than FDII GILTI and FDII in particular are distinct but related in many ways GILTI is covered by new section 951A generally applicable to tax years beginning after 12/31/17 Focus primarily on certain income of controlled foreign corporations (CFCs) In general, non Subpart F income of a CFC in excess of deemed routine tangible property income is subject to U.S. tax for certain U.S. shareholders at an effective tax rate of 10.5% (21% base rate less 50% GILTI deduction) Enormously complex provision with significant complications for expense allocations, impacts of NOLs, availability of foreign tax credits, etc. Computational Treasury Regulations issued on September 13, 2018 (more coming) 12

13 Interaction Between GILTI and FDII (cont) GILTI and FDII each seek to carve out from gross income deemed routine tangible returns from deemed non routine intangible returns Rules for neither are truly tied or traced to actual tangible or intangible income (just loose reference to the mechanical allocation process) Both regimes work off same deemed tangible base qualified business asset investments or QBAI looking generally to tax basis of QBAI (tangible depreciable property); 10% of QBAI is income base Recent proposed GILTI regulations (Sept. 13, 2018) address, among other things, some basic provisions regarding QBAI that also apply to FDII (including certain anti abuse rules) However, impact of QBAI is completely different under each regime (really mirror images of each other) GILTI effectively subjects the excess over 10% of QBAI each year to current U.S. taxation (subject to U.S. 50% deduction and haircut of foreign tax credits) punishes for IP being offshore! FDII does the opposite the excess over 10% of QBAI each year is potentially eligible for the FDII 37.5% deduction, provided that and to the extent that such excess is allocable to foreign use, consumption, etc. benefit for IP being onshore! Odd dichotomy of incentives (1) GILTI incentivizes CFCs and their U.S. shareholders to invest in tangible assets and income offshore in order to reduce GILTI, while (2) FDII incentivizes for US corp to divest domestic tangible assets and income to increase FDII 13

14 Interaction Between GILTI and FDII (cont) US Parent Mexico/Canada or Other Foreign Sub US Sub Mexico/Canada or Other Foreign Sub US Sub Foreign Sub Foreign Sub is a CFC for U.S. tax purposes Have to consider both impact of GILTI and availability of FDII deduction If, e.g., Cost Sharing Arrangement between US and Foreign Sub 1) Could have GILTI impact on cost shared IP to Foreign Sub 2) But could have FDII deduction for cost shared buy in payments by Foreign Sub Foreign Sub is not a CFC for income inclusion purposes NB expanded definition of CFC because of repeal of section 958(b)(4) As a result, GILTI is not an issue here (only an issue for foreign subs of US Sub) FDII still a consideration as Mexico/Canada parent wants to reduce its US Sub s U.S. tax base For example, same cost sharing buy in payment consideration 14

15 FDII Mechanics FDII mechanics involve a series of complex computations and determinations FDII = Foreign Derived Intangible Income FDII = Deemed Intangible Income (DII)* (Foreign Derived Deduction Eligible Income (FDDEI)/Deduction Eligible Income (DEI)) This ratio encapsulates the foreign portion allocation discussed above DII = DEI minus Deemed Tangible Income (DTI) DTI = 10% of Qualified Business Asset Investment (QBAI) discussed above FDDEI (amount potentially eligible for 37.5% deduction) = DEI derived from foreign sales and services DEI = Total Net Income of US corporation (or group) excluding specific categories (Subpart F, GILTI, Foreign Branch Income, Financial Services Income, CFC dividends) 15

16 FDII Basic Example Example 1 USCo has $1000 of net income, $1000 of Qualified Business Asset Investment, 10% of QBAI is $100, and $500 of net income from foreign sales FDII = ($1000 $100) * ($500/$1000) = $450 (37.5% of which is deductible) Example 2 USCo has $1100 of net income, $1000 of Qualified Business Asset Investment, 10% of QBAII is $100, and $600 of net income from foreign sales FDII = ($1100 $100) * ($600/$1100) = $ The additional $100 of net income from foreign sales only generated ~$95 of additional FDII. Key Observation: An additional dollar of FDDEI does not generate an additional dollar of FDII 16

17 FDII Considerations What Counts as Foreign? Direct Third Party Sales Goods must be sold to non United States person for use, consumption, disposition outside of the United States Direct Third Party Services Services must be provided to any person located outside of the United States Related Party Sales or License with Third Party Sales Goods or IP must be used in connection with sale of goods to an unrelated non United States person for use, consumption, disposition outside of the United States 17

18 FDII Considerations (cont) What Counts as Foreign? (cont.) Related Party Sales or Licenses with Third Party Services Goods or IP must be used in connection with provision of services to a non United States person Related Party Services with Third Party Sales No special related party rule; service must be provided to any person located outside of the United States Related Party Services with Third Party Services Not FDII eligible if related foreign person provides any substantially similar service to persons located in the United States (conduit round tripping concept) Note that there is a potential cliff effect disallowance is not limited to the extent of similar services Round tripping safeguards for sales/services going outbound but returned to the United States can lose deduction. 18

19 Interaction of GILTI and FDII GILTI and FDII deductions are reduced where FDII and GILTI exceed taxable income Example FDII = $75; GILTI = $100; Total Taxable Income = $100 FDII + GILTI Taxable Income = $75 FDII Reduction = $75 * ($75 / $175 ) = $32.14 GILTI Reduction = $75 $32.14 = $42.86 FDII = $75 $32.14 = $42.86; FDII Deduction = $42.86 * 37.5% = $16.1 GILTI = $100 $42.86 = $57.14; GILTI Deduction = $57.14 * 50% = $28.57 Taxable Income = $100 $16.1 $28.57 = $55.3 Tax = $55.2 * 21% = $11.6 Absent haircut FDII + GILTI Deduction = $75 * 37.5% + $100 * 50% = $ Taxable Income = $ Tax = $4.6 19

20 Overview of Areas of Uncertainty/Need for Guidance Like many TCJA provisions there is a real need for guidance to fill in holes of what were in many case provisions that were rushed through the legislative process FDII is no exception Been overshadowed by other provisions and so extent of benefit from FDII is unclear; but pursuit of FDII benefit can require operational, accounting, and other business changes that are tougher to undertake given uncertainty and lack of guidance Selected areas of uncertainty/need for guidance 1) Whether FDII applies to U.S. corporations on a consolidated group basis 2) Interaction of FDII with U.S. transfer pricing principles and BEPS principles (routine versus nonroutine returns, etc.) 3) Coordination with GILTI (note some addressed on QBAI in recent proposed GILTI regulations) 4) Treatment of allocable expenses to reduce FDII 5) Impact of NOLs and NOL carryforwards 20

21 Overview of Areas of Uncertainty/Need for Guidance (cont) 6) Foreign use or consumption generally 7) Treatment of bundled transactions involving both sales (and licenses) and services (different rules) 8) Treatment of related and unrelated intermediaries 9) Scope and mechanics of the QBAI base (issue for GILTI as well) Addressed to some extent in recent proposed GILTI regulations 10) For services, the location point location of person outside the U.S. (as opposed to non U.S. person) and location of property outside the U.S. 11) Guidance on hybrid rules and FDII 12) Impact of potential WTO or other challenges Turn this important topic over to Reuven!! 21

22 FDII and the WTO

23 The WTO s SCM Agreement The non collection or forgiveness of taxes otherwise due is considered a subsidy for the purposes of the SCM agreement (Art. 1) The SCM distinguishes 2 types of subsidies: Prohibited subsidies Actionable subsidies The SCM agreement does not apply to services 23

24 Prohibited & Actionable Subsidies PROHIBITTED SUBSIDIES Requirements: Subsidies contingent, in law or in fact, upon export performance, or; Subsidies contingent upon the use of domestic over imported goods. ACTIONABLE SUBSIDIES Requirements: Specificity Prejudice Effects: Disallowed Outright Effects Disallowed only if is considered specific and produces a serious prejudice to the interests of another member, an injury to its domestic industry, or a nullification or impairment of benefits. 24

25 Summary Is the subsidy contingent upon exportation or use of local products? No Is the subsidy directed at an industry enterprise or geographical region? No Yes Yes Permitted Subsidy Is the subsidy intended to relieve double taxation? Does the subsidy result in an adverse effect upon member states? No No Yes Yes Prohibited Subsidy Permitted Subsidy Actionable Subsidy 25

26 FDII and SCM While services are excluded from the SCM, the FDII provision clearly applies a lower rate (13.125% instead of 21%) to a domestic US corporation s sales of goods to any foreign person for a foreign use. FDII clearly involves the non collection or forgiveness of taxes otherwise due, i.e., a subsidy under the SCM, and the subsidy is likewise clearly contingent in law and in fact upon export performance. Thus, there is little doubt that the FDII provision is prohibited subsidy in violation of the SCM that entitles trading partners to impose sanctions (unilaterally or after receiving approval from the WTO s Dispute Resolution Body). 26

27 What if the US Loses a WTO Challenge to FDII? A WTO challenge to the FDII could result in a major clash between the US and the WTO, with potentially disastrous consequences. The willingness of the GOP Congressional majorities to defy the WTO in enacting FDII stands in stark opposition to the way the GOP behaved in 2004 (when the GOP controlled Congress repealed ETI in response to a WTO loss). Will the US respond to a loss over FDII by repealing it, or by leaving the WTO? 27

28 Summary: Three problems with FDII 1. FDII discourages domestic manufacturing because it taxes tangible investments at 21% up to a 10% return, while a domestic corporation that has no US activities and just imports goods and re exports them benefits from the lower % rate. 2. Unlike former section 199, section 250 is a blatant violation of the SCM, and will certainly be struck down if challenged, because it is de jure as well as de facto contingent on export performance. 28

29 Does FDII Achieve Its Purpose? 3. Section 250 has not so far encouraged inbound FDI. See: Foreign Direct Investment in the United States, Preliminary 1st Quarter 2018 (2018), direct investment in the united statespreliminary 1st quarter The reason may be that it is too risky to move intangibles into the US, because it may be a Hotel California situation ( you can check in, but you cannot check out ) if the law is changed, and then the intangibles are trapped in the US because of the enhanced IRC 367 and 482. Ironically, this may also be why FDII has not been challenged in WTO. 29