As part of reforming the US international tax regime, Congress also enacted the foreign-derived intangible income (FDII) regime. Under the FDII regime, a US multinational’s income from accessing or serving foreign markets, either through goods or services, is subject to a preferential tax rate achieved through a 37.5% deduction.
The intent behind the enactment of the FDII regime was to complement the GILTI regime. Specifically, income earned by a US multinational from directly accessing foreign markets would be taxed under the preferential FDII regime and income (indirectly) earned by the US multinational through its controlled foreign corporation would be taxed under the preferential GILTI regime. In both cases, the foreign income earned by the US multinational would be taxed (effectively) at a preferential tax rate with the two regimes working in concert.
Former Vice President Joe Biden, the presumptive Democratic nominee for president in the 2020 election, has put forward a variety of tax proposals. In a report dated 5 March 2020, the Tax Policy Center (TPC) analyzed the details of the tax proposals. A number of think tanks have also analyzed Biden’s tax proposals, primarily focusing on the macroeconomic effects of the proposals. According to the TPC, Biden’s tax proposals would increase federal revenues relative to current law by approximately USD 4 trillion over the traditional 10-year budget window (2021-2030). Approximately half of this revenue would come from businesses, primarily corporations.
Specifically, on the corporate side, the former vice president has proposed increasing the corporate tax rate from the current 21% to 28%. According to the TPC, this change would raise approximately USD 1.3 trillion over 10 years. Biden has also proposed doubling the effective tax rate on GILTI from the current 10.5% to 21%, which the TPC estimates would raise approximately USD 300 billion over 10 years. The assumption is that this would be accomplished by allowing only a 25% deduction for GILTI.
In his tax proposals, Biden does not reference FDII and we are not aware of the rationale for making changes to the GILTI regime while leaving FDII unaltered. More details of Biden’s tax proposals may emerge later this month or in the fall. Leaving FDII intact is interesting, as decreasing (or repealing) the deduction for FDII could raise a significant amount of revenue from corporations. If the FDII regime is left in place with the 37.5% deduction, and the corporate tax rate is increased to 28% and the GILTI deduction is only 25%, the result would be a de-linkage of the FDII and GILTI regimes. In other words, the symmetry between the two regimes would no longer exist.
In enacting the GILTI regime, Congress considered the foreign income taxes that could be imposed on GILTI. To encourage US corporations to minimize the foreign income taxes imposed on GILTI, a decision was made to decrease (or “haircut”) the foreign tax credits on GILTI by 20% so that only 80% of the foreign income taxes on GILTI could be credited against the US multinational’s US income tax liability. The result was that a break-even point was created for GILTI at 13.125%. Specifically, if GILTI is subject to foreign income tax at a rate of 13.125% (or higher), no residual US tax is owed (21% US corporate tax rate, 50% GILTI deduction, 80% of the foreign income taxes creditable against the US tax liability and setting aside the allocation of expenses).
With a GILTI break-even point of 13.125%, Congress set the FDII deduction at 37.5%, which results in an effective tax rate on FDII of 13.125%, thereby creating symmetry between FDII and GILTI. Even in 2026 and subsequent years, when the GILTI deduction is scheduled to be reduced from 50% to 37.5%, Congress maintained the symmetry between FDII and GILTI by also scheduling the FDII deduction to be reduced from 37.5% to 21.875%. The result is that, in 2026, the GILTI break-even point is 16.406% (21% US corporate tax rate, 37.5% GILTI deduction and 80% of the foreign income taxes creditable against US tax liability) and the FDII effective tax rate is also 16.406% (21% US corporate tax rate coupled with 21.875% FDII deduction).
If the US corporate tax rate is increased to 28% and the GILTI deduction is reduced to 25% as proposed by the former vice president, the GILTI break-even rate becomes 26.25% (assuming that only 80% of foreign income taxes imposed on GILTI continues to be permitted as a foreign tax credit). If the symmetry between FDII and GILTI is to be maintained, the FDII deduction needs to be reduced from 37.5% to only 6.25%, resulting in an effective tax rate on FDII of 26.25% (28% corporate tax rate coupled with 6.25% FDII deduction). The FDII benefit is significantly reduced.
If the FDII deduction remains at 37.5% (or 21.875% for 2026 and subsequent years), the symmetry between FDII and GILTI no longer exists. While this could be beneficial for companies in the short term, this could make it harder to defend the FDII regime, which is under review by the OECD’s Forum on Harmful Tax Practices (FHTP) to determine if it is a harmful tax regime. Treasury officials have publicly stated that FDII and GILTI are intended to operate together as a single system to prevent the US from being base eroded. The Treasury contrasted this to the work of the FHTP and Base Erosion and Profit Shifting (BEPS) Action 5, which is to address regimes that base erode other countries. In addition, defending the FDII, if it is challenged at the World Trade Organization as a prohibited export subsidy, could become more difficult if the symmetry between FDII and GILTI is not maintained.