One of the stranger features of President
corporate-tax plan is the war he’s waging on incentives for research and development in the U.S. Behold a case study in what happens when an Administration’s desire to punish taxpayers outpaces its understanding of the tax code.
This misstep concerns the tax treatment of foreign-derived intangible income, or FDII. This is global income arising from intellectual property such as copyrights or patents held in America. The 2017 Tax Cuts and Jobs Act created a new deduction for this income that brought the effective tax rate down to about 13%. The Biden plan would eliminate that deduction, raising the tax on this income to the proposed new top statutory rate of 28%.
The Administration says the FDII exemption “gave corporations a tax break for shifting assets abroad and is ineffective at encouraging corporations to invest in R&D.” They must be reading some other tax code, because the FDII as written does exactly the opposite.
FDII was intended to be the domestic twin for the new global minimum tax the 2017 reform imposed on profits related to intellectual property held overseas. We’ve described that tax on global intangible low-tax income, or Gilti, in some detail.
In the years before 2017, countries such as Ireland, the Netherlands and the United Kingdom enticed companies to deposit intellectual property in subsidiaries in those jurisdictions where profits would be taxed at lower rates. Gilti and FDII combined make the U.S. a more competitive home for intellectual property by lowering the domestic tax rate on those profits relative to the headline corporate rate (FDII) while imposing an equal effective tax rate on profits earned in foreign subsidiaries (Gilti).
The point was that a special tax regime for this type of profit is necessary because intellectual property is so mobile. Before 2017 the U.S. struggled to tax any of this income because companies could park their patents and copyrights offshore, book profits there, and spare themselves U.S. taxation by never repatriating the returns.
The 2017 approach is flawed, but the Biden plan to make Gilti more onerous while scrapping FDII entirely is the wrong solution. To start, this Biden one-two punch risks reviving incentives for corporate inversions while making it harder for American companies to expand overseas.
Inversions—when an American company acquires an overseas firm and relocates its head office to the target’s country—stopped after the 2017 tax reform reduced the tax punishment for U.S.-headquartered firms. The White House threatens to impose new curbs on the practice, because it knows its tax plan otherwise would encourage more inversions.
Perhaps the blocks will work and inversions per se won’t make a comeback. But meantime, American companies will struggle to outbid foreign rivals for foreign takeover targets once investors take into account the U.S. tax code. American companies also will face new investor pressure to sell off foreign units to avoid the Biden plan’s punitive taxation on earnings from intellectual property.
The Biden plan risks pushing more R&D overseas. Other countries reformed their tax codes in recent years, too. Following negotiations at the Organization for Economic Cooperation and Development in 2015, governments now require companies to conduct more R&D and other activity within those countries to benefit from tax breaks related to intellectual property.
The OECD overhaul was billed as a way to cut down on corporate tax evasion, but it’s sparking a new and healthy form of tax competition as countries vie to entice more high-powered R&D. The Biden plan’s combination of much higher taxes on profits from onshore intellectual property and more onerous taxation of American companies’ foreign profits will make Ireland or the U.K. look like better R&D destinations by comparison.
Precisely because intellectual property must follow other tangible economic activity such as manufacturing or research, the damage from the Biden plan will be hard to reverse. Companies will have workers and buildings abroad they won’t relocate at the drop of a hat even if a future President or Congress changes course.
The Administration bills this as the “Made in America” tax plan. Congress should make sure it doesn’t become a “Research in Europe” tax plan instead.
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Appeared in the May 1, 2021, print edition.