The tax treatment of intangible assets has recently come under the spotlight when the Biden administration proposed reversing a policy passed in 2017 designed to encourage the relocation of intellectual property (IP) to the US and Senate Democrats have also changes in mind. The Tax Cuts and Jobs Act (TCJA) attempted to strike a balance between the tax treatment of US corporations’ intellectual property, whether that intellectual property is located in the United States or abroad. Changes to the provisions enacted in the 2017 reform could upset this balance and prompt companies to relocate their intellectual property outside of the United States
Some types of business assets are easier to move than others. When a company has a manufacturing facility in the US, it is no small feat to leave that factory and settle in another country. In addition, relocating the location where a company conducts its research and development (R&D) can be a significant endeavor as the R&D teams comprise highly specialized staff and utilize advanced facilities and laboratories.
But when it comes to intellectual property, patents, software and other assets that stem from R&D investments and lie behind manufactured goods, it is less difficult for a multinational to change where that intellectual property is registered.
The taxable gains from intellectual property are often referred to as mobile income. If a US company decides that it can achieve a better tax outcome by having its IP outside the country than by subjecting those profits to US tax, there aren’t too many barriers to moving that IP overseas stand in the way.
Prior to the recent tax reform, it was common for US-developed intellectual property to end up in an offshore jurisdiction for tax purposes. This was due to both the high US corporate tax rate and tax breaks in other countries such as patent boxes. Instead of paying the US federal tax rate of 35 per cent, a company could potentially pay Ireland’s corporate tax rate of 12.5 per cent (or its patent box rate of 6.25 per cent) or the UK patent box rate of 10 per cent on income that Intellectuals accrue real estate based in these countries.
In recent years, countries have started to require patent-related activities (such as R&D or some managerial functions) to take place in the same jurisdiction where the intellectual property resides in order for a company to benefit from a lower patent box rate. Not all of these rules are effective immediately, but they become more important over time. If a US company were to benefit from offshore patent box incentives, it might need to relocate both its intellectual property and its R&D personnel and facilities.
Two directives passed as part of the tax reform changed the incentives for companies to choose where to place their intellectual property. First, the US introduced a global minimum tax in the form of Global Intangible Low Tax Income (GILTI). This tax means that intellectual property income of US companies is taxed by the US regardless of where it is located outside US borders. GILTI was designed for a tax rate of between 10.5 and 13.125 percent, but interaction effects with other policies mean some companies pay much higher tax rates on GILTI.
GILTI tells US companies they still owe taxes to the IRS if they place their intellectual property in a foreign low-tax jurisdiction. This policy eats away at some of the benefit of having intellectual property in a low-tax jurisdiction. GILTI is another tax tier for foreign income, but if the offshore IP is subject to a high tax rate, the tax burden of GILTI will be lower.
A parallel policy has been introduced for intellectual property held in the United States. This policy is Foreign Derived Intangible Income (FDII). US companies that retain their intellectual property in the US or bring their intellectual property back to the US can benefit from a lower tax rate on that income of 13.125 percent.
While prior to the tax reform, companies had a clear incentive to move their IP overseas, the GILTI and FDII aim to change that incentive so that there is a balance between keeping the IP in the US or moving it overseas. In fact, due to GILTI’s tax burden, FDII may make the US a relatively more attractive place to own intellectual property for some companies.
Analysis by economists Kartikeya Singh and Aparna Mathur has shown that the pairing of GILTI and FDII means the US is now a more attractive location for intellectual property investment than offshore options. They compare the tax effects of investments that earn different profit margins to show whether tax reform has made holding intellectual property more beneficial in the US or elsewhere. Overall, their calculations show that the combination of GILTI and FDII makes the US more attractive.
There is some evidence that this actually shows up in business decisions. At a recent Senate Finance Committee hearing, Senator Rob Portman (R-OH) mentioned that some US companies have brought their intellectual property back to the US for FDII.
Last week, the Biden administration announced it would increase the GILTI tax rate to 21 percent and scrap FDII, while raising the tax rate for US corporations to 28 percent. If adopted, these changes would dramatically upset the 2017 balance. A US company would immediately recognize that paying taxes on intellectual property profits at a foreign rate of 21 percent would be better than a US domestic rate of 28 percent.
If a company responds to the stimulus by moving its intellectual property out of the US, it’s possible that associated R&D and manufacturing could follow.
This would be exactly the opposite of what the Biden administration seems to be hoping. The management plan proposes some benefits for companies conducting R&D in the US, but it is unclear whether these additional benefits would be enough to offset the tax savings from outsourcing intellectual property and related activities.
In addition to Biden’s proposal, this week three Democratic members of the Senate Finance Committee released a plan that would also include some changes to GILTI and FDII. While the plan doesn’t provide many details on the exact changes senators are considering, the balance between GILTI and FDII could be upset there as well.
Before making any significant changes, however, lawmakers should consider how disrupting balanced incentives for where intellectual property is located might affect where US companies locate not only their intellectual property but also their R&D and other related activities.