The Senate Tax Plan Has a WTO Problem (Guest Post by Rebecca Kysar)
Buried in one of the pillars of the Senate’s new international tax plan is an export subsidy, perhaps violating WTO rules and our obligations under various trade treaties. This has the danger of reviving a three-decades long controversy between the United States and the European Union that was thought to have been put to rest in 2004.
The Senate proposal’s reduction of the corporate rate to 20%, as well as a new 12.5% minimum tax on foreign intangible income has been reported. Flying under the radar, however, is that the proposal also essentially imposes a favored rate as low as 12.5% on a U.S. company’s intangible profits from exports of property and services. This special rate for domestic intellectual property was put in to induce companies to keep their intellectual property in the U.S., but it also represents yet another chapter in the U.S.’s longstanding attempts to subsidize exports in violation of WTO rules.
The statutory path to this conclusion seems to be purposefully convoluted, so bear with me. First, the proposal creates a new category of intangible income referred to as global intangible low-taxed income, or “GILTI” (which is as about as good as tax humor gets). A U.S. shareholder must include in gross income its GILTI as a deemed dividend. GILTI is calculated as the excess of the shareholder’s pro rata share in a related foreign corporation’s “tested income” (which is essentially its gross income without regard to subpart F income or effectively connected income) over the “deemed tangible income return.” The deemed tangible income return is, in turn, defined as 10% of the U.S. shareholder’s pro rata share of the related foreign corporation’s average adjusted bases in business tangible property (“qualified business asset investment” or QBAI).
This latter part of the equation is an attempt at approximating the “normal” return on the investment, so that only “excess” returns generated from intangibles are taxed. Notice also that the formula rewards corporations that transfer assets to the related foreign corporation because doing so increases the “deemed tangible income return,” thereby minimizing the income inclusion.
So far, it would seem that the new system creates current taxation of a related foreign corporation’s earnings at the 20% corporate rate, but the proposal goes on to further provide a U.S. corporation a deduction equal to 37.5% of the lesser of (1) its “foreign-derived intangible income” plus the included GILTI or (2) its taxable income without giving effect to the new proposal. GILTI, after the 37.5% deduction, is thus actually taxed at a 12.5% minimum rate ((100–37.5) x 20%).
The other category getting the 37.5% deduction and consequently 12.5% tax rate is “foreign derived intangible income,” which is defined as the amount which bears the same ratio to the corporation’s “deemed intangible income” as its “foreign-derived deduction eligible income” bears to its “deduction eligible income.”
“Deemed intangible income” is the excess of a domestic corporation’s “deduction eligible income” (essentially modified gross income, determined without regard to subpart F income, GILTI, and a few other enumerated categories) over its deemed tangible income return (10% of its QBAI, as above).
Here is where things get interesting. The “foreign-derived deduction eligible income” is defined as income derived in connection with (1) property that is sold by the taxpayer to any foreign person for a foreign use or (2) services to any foreign person or with respect to foreign property. In other words, this category comprises exports for property and services.
So a U.S. company’s foreign derived intangible income, which gets the same 12.5% rate as GILTI, is the amount that bears the same ratio to the deemed intangible income as the U.S. company’s exports bear to its modified gross income. Another way of looking at this is that a percentage of income from exports is taxed at the 12.5% rate, the percentage being the ratio of the deemed intangible income of the U.S. company to the modified gross income of the U.S. company. The greater the income from exports, the greater the amount of income that gets the 12.5% rate, which is a subsidy in comparison with the baseline 20% rate that would apply to imports.
To summarize, the Senate has proposed a tax subsidy that is directly linked to the income from exports and, as such, likely violates our international trade obligations, specificially the WTO Subsidies and Countervailing Measures Agreement. This scheme is broadly comparable to the now extinct Foreign Sales Corporation (FSC) and later extraterritorial income system (ETI), which provided tax benefits to American companies with a foreign presence that exported goods and services. The WTO struck down these schemes as illegal export subsidies since the Federal government did not collect tax related to exports that was “otherwise due.”
Similarly, the WTO could rule here that the 12.5% rate was below the 20% rate otherwise due on other U.S. source income. The U.S. might counter that the reduced rate also potentially applies to non-export foreign earnings (GILTI). In the context of ETI, the WTO has previously rejected such an argument, however, reasoning that the tax subsidy was contingent on export performance (as would be the case here).
It is important to note that the history of this controversy is long and tortured, beginning in 1971 with tax provisions that were enacted by the Nixon Administration and designed to help exports (the Domestic International Sales Corporation or “DISC” provisions). Almost immediately, the European Community contested the DISC provisions under GATT, the WTO’s predecessor. In 1976, a GATT panel ruled against DISC, and the United States eventually replaced the system with the FSC provisions in 1984.
As mentioned above, the WTO would later rule against the FSC system, issuing its decision in 1999. In 2000, Congress enacted the ETI system to replace the illegal Foreign Sales Corporation system, but, in 2002, the WTO also decided that the tax benefits provided under ETI were illegal export subsidies. Congress eventually gave up the fight. The repeal of ETI was the impetus for the American Job Creation Act of 2004 (and the now scheduled to be repealed Section 199 deduction for domestic manufacturing).
If the Senate plan goes forward, we can expect this protracted battle to be reignited. The obvious remedy is to remove the 12.5% rate as it applies to income from exports by U.S. companies. This, however, would lead to multinationals shifting their profits abroad in order to obtain the 12.5% rate on GILTI as opposed to the otherwise applicable 20% corporate rate.
*Thanks to Vic Fleischer, Mike Schler, Steve Shay, and Reuven Avi-Yonah for helpful comments. All errors are my own.